NAME___KEY_____________________
ECON 2630: Assignment 2 This assignment is worth 26 points and is due at the start of class on Friday,
7/27. Late assignments will NOT be accepted. Please staple your assignment prior to turning it in.
1.) (2) The price of a stamp in 1933 was $0.03 when the CPI was 0.13. The price of a stamp today is $0.45
(the CPI today is 2.29). What was the real price of a stamp in 1933? Is the real price higher or lower today?
The real price is given by (CPI today / CPI then) * price then = 2.29/.13 * $0.03 = $0.53.
The real price is lower today.
2a.) (2) Suppose Aggregate Expenditures (AE) in an economy are given by: 400 + 0.6Y. Calculate the
short run equilibrium output for this economy.
AE = Y
400 + 0.6Y = Y
400 = 0.4Y
Y*=1,000
b.) (2) If AE are reduced to 300 + 0.6Y, what is the new short run equilibrium? If your answer for a.) is
the potential output, what is the output gap in this economy?
300 + 0.6Y = Y
300 = 0.4Y
Y* = 750
The recessionary gap = potential output – actual output = 1,000 – 750 = 250
c.) (2) According to Okun’s Law, what is the change to cyclical unemployment as a result of this change
in output?
Output decreased by 25% (-250/1000)*100, so according to Okun’s Law, cyclical unemployment would
increase by 12.5% (one half whatever the percentage change in output is).
d.) (2) What could the government do to government expenditures and/or taxes to address this output
gap? By how much should they try to change AE to address this output gap?
The government could increase government expenditures and/or decrease taxes.
They should base the change in AE on the change in initial spending, which in this case is 100
(they should increase G or decrease taxes enough to increase spending by 100)
e.) (3) Depict this situation on the following set of axes. Graph both AE lines and show the equilibrium
output levels associated with each AE.
AE
Y=AE
AE=400+0.6Y
AE=300+0.6Y
400
300
750
1000
Y (output)
3. (4) Suppose an economy’s aggregate demand function is given by: Y=13,000 – 20,000π
Where Y is output and π is inflation. Initially the inflation rate is 0.04 (4%). Potential output is 12,000.
a.) What is the output level in the short – run? What does the output gap equal? Is it expansionary or
recessionary?
In the short run, the equilibrium inflation rate and output level are given by the intersection of the
AD and AS curves. Algebraically, the short run equilibrium level of output is found by
substituting the current inflation rate into the AD equation. Doing this, we have:
Y  13,000  20,000
Y  13,000  20,000(0.04)
Y  12,200
The economy has an expansionary gap of 200 since potential output is 12,000 and actual output
is 12,200.
b.) What is the inflation rate in the long run equilibrium (when output is at its potential level)?
In the long run, the equilibrium inflation rate and output level are given by the intersection of the
LRAS and AD curves. Algebraically, the long-run equilibrium inflation rate is found by
substituting the level of potential output (in this case, 12,000) into the AD equation. Doing this,
we have:
12,000  13,000  20,000
 1,000  20,000
 1,000
   0.05  5%
 20,000
4. (5) Suppose that a permanent increase in oil prices creates both an inflationary shock and reduces
potential output (LRAS). Use an AD-AS diagram to show the effects of the oil price increase on output and
inflation in the short run and the long run. Label everything.
5. (4) Go to the following site: http://www.theatlantic.com/business/archive/2011/04/where-do-your-taxdollars-go-a-long-story-in-5-quick-graphs/237128/
a. According to Chart 2, The Policy Breakdown, what are the top three programs in terms of
expenditures and what percent of total expenditures do these three programs represent?
The top 3 programs are Defense (20%), Social Security (20%), and Medicare/Medicaid (21%). Together
these programs represent 61% of total expenditures.
b. Discretionary spending is given by spending outside of Defense, Medicare /Medicaid, Social Security,
and interest payments. Using this definition, what share of spending is currently discretionary?
Defense represents 20%, Medicare/Medicaid represents 21%, Social Security represents 20%, and Interest
represents 6%. Therefore, discretionary spending is 100%-67%=33% of total expenditures.
c. What share of spending is foreign aid (international non-security spending)?
Foreign aid (international non-security spending) represents 1% of the budget. I asked this because many
people believe that it is much higher than this.
d. According to Chart 5, Future Projections, what share of total spending is predicted to be discretionary
in 2020?
Defense represents 15% Medicare/Medicaid represents 25%, Social Security represents 22%, and Interest
represents 14%. Therefore, discretionary spending is only 100%-76%=24% of total expenditures. The
chart shows “other spending” equal to 23% due to rounding. Either answer is acceptable.