SOLUTIONS MANUAL FOR Foundations of MacroEconomics 9th Edition. Robin Bade, Michael Parkin by StudyGuide

Foundations of MacroEconomics 9e Robin Bade, Michael Parkin (Solutions Manual All Chapters, 100% Original Verified, A+ Grade) Chapter 18 Is Missing

Chapter

Getting Started ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications 1.

Provide three examples of scarcity that illustrate why even the 1,826 billionaires in the formworld face scarcity. The 1,826 billionaires might want to be able to eat unlimited meals without gaining weight; live to be at least 140 years old and enjoy perfect health everyday; be able to wake up in San Francisco and go to sleep in Paris after spending no more than 3 hours on a plane. None of these wants can be fulfilled given the present state of technology and resources available.

Label each entry in the list as dealing with a microeconomic topic or a macroeconomic topic. Explain your answer. • Motor vehicles production in China is growing by 10 percent a year. This entry is a microeconomic topic because individuals and businesses make decisions whether to buy or sell cars. •

Coffee prices rocket. This entry is a microeconomic topic because individuals and businesses make decisions whether to buy or sell coffee.

•

Globalization has reduced African poverty. This entry is a macroeconomic topic because globalization is the result of choices made by billions of people rather than an individual or business.

•

The government must cut its budget deficit. This entry is a macroeconomic topic because neither an individual nor a business makes decision to cut expenditures.

•

Apple sells 20 million iPhone 6 smartphones a month. This entry is a microeconomic topic because individuals and Apple make decision whether to buy or sell iPhones.

Part 1 . INTRODUCTION

Use the following information to work Problems 3 to 6. Jurassic World had world-wide box office receipts of $1.66 billion. The movie’s production budget was $150 million with additional marketing costs. A successful movie brings pleasure to millions, creates work for thousands, and makes a few people rich. 3. What contribution does a movie like Jurassic World make to coping with scarcity? When you buy a movie ticket, are you buying a good or a service? Scarcity still exists but the amount of entertainment available in the economy increases. Buying a ticket to watch a movie is buying a service. 4.

Who decides whether a movie is going to be a blockbuster? How do you think the creation of a blockbuster movie influences what, how, and for whom goods and services are produced? The audience decides whether a movie will be a blockbuster because the audience decides whether to attend the movie. The “what” question is affected in three ways: First, one good or service that is produced is the blockbuster movie. Second, the people whose incomes are higher as a result of the blockbuster then buy an assortment of goods and services and so this assortment of goods and services is produced. Finally, the “what” question is influenced if the movie leads to spinoff goods (such as toys) or creates a series of sequels or similar films. The “how” question is affected to the extent that movies use different production methods. Some movies, for instance, have a lot of special effects while other movies have few or none. The “for whom” question is influenced because those people who receive the profits of a blockbuster movie have higher incomes and so more goods and services are produced for them.

What are some of the components of marginal cost and marginal benefit that the producer of a movie faces? Some of the marginal costs the producer faces are the cost of an actor or actress, the costs of the crew for a day, the costs of a location, and the costs of advertising in a newspaper. The marginal benefits the producer enjoys are his or her salary and/or profit participation from the movie, royalties from the movie, the prestige resulting from a successful movie, and any awards given to the producer of the movie.

Suppose that Chris Pratt had been offered a part in another movie and that to hire him for Jurassic World, the producer had to double Chris Pratt’s pay. What incentives would have changed? How might the changed incentives have changed the choices that people made? The higher pay would have increased Mr. Pratt’s incentive to make Jurassic World rather than the other movie and perhaps affected his choice to

Chapter 1 . Getting Started

make Jurassic World rather than the other movie. The higher pay would have increased the incentive of the producer to decrease the expense of other aspects of the movie so the producer might have chosen to reduce the pay of the other stars in the movie. 7.

What is the social interest? Distinguish it from self-interest. In your answer give an example of self-interest and an example of social interest. The social interest looks at what is best for society as a whole; choices that are best for society as a whole are said to be in the social interest. The selfinterest looks at what is best for the individual; choices that are best for the individual making the choice are said to be in the self-interest. An example of a choice made in the self-interest is a student’s decision to take an economics class. An example of a choice made in the social interest is a firm’s decision to reduce its air pollution.

Pam, Pru, and Pat are deciding how they will celebrate the New Year. Pam prefers to take a cruise, is happy to go to Hawaii, but does not want to go skiing. Pru prefers to go skiing, is happy to go to Hawaii, but does not want to take a cruise. Pat prefers to go to Hawaii or to take a cruise but does not want to go skiing. Their decision is to go to Hawaii. Is this decision rational? What is the opportunity cost of the trip to Hawaii for each of them? What is the benefit that each gets? Pam, Pru and Pat’s decision to go to Hawaii is rational. All three of them considered the cost and benefit of various New Year’s plans. All three were at least willing to go to Hawaii while Pam and Pat were unwilling to go skiing and Pru was unwilling to go on a cruise. The opportunity cost of the trip for Pam is a cruise; for Pru, it is skiing; and for Pat, it is a cruise. The benefit each receives is the pleasure, the relaxation, excitement, and/or knowledge gained from the trip.

Label each of the entries in the list as a positive or a normative statement. • Low-income people pay too much for housing. The entry that low-income people pay too much for housing is a normative statement. •

The number of U.S. farms has decreased over the past 50 years. The entry about the number of farms is a positive statement.

•

Toyota expands parts production in the United States. The entry about Toyota expanding parts production is a positive statement.

•

Imports from China are swamping U.S. department stores. The entry about imports is a normative statement.

•

The rural population in the United States is declining. The entry about the population in rural areas is a positive statement.

Part 1 . INTRODUCTION

Use the following information to work Problems 10 to 12. REI is paying its employees to take Black Friday, Thanksgiving off REI, the outdoor gear and apparel retailer, is paying employees to celebrate Thanksgiving 2015 by spending Black Friday outdoors with their families. Source: Sustainable Brands, October 28, 2015 10. With Black Friday off with full pay, explain what is free and what is scarce. The workers’ time remains scarce because Black Friday remains only one day. REI’s gear and apparel remain scarce because there is a still a limited amount of these products. The publicity that REI received is not free because the company paid for it with less production and, accordingly, less revenue and profit. 11. What is REI’s incentive to give its workers Black Friday off? Was REI’s decision made in self-interest or in the social interest? Explain your answer. REI’s managers have the incentive to give their employees the day off if they believe that the positive publicity that resulted could lead to increased future sales. The managers might also believe that the employees would feel grateful and would worker harder in the future. Of course, the managers also had the incentive to give their workers the day off because many other employers do so. REI’s decision to give its workers a paid day off had elements of both selfinterest and social interest. To the extent that his decision was motivated by the free publicity and a resulting rise in sales, or the expectation that its employees would work more diligently in the future, the decision was motivated by self-interest. However to the extent that a desire to allow the workers a chance to spend time with their families, the decision also had elements of social interest. 12. Do you think that REI workers will shop or spend the day with family? Explain your answer. REI workers will make a rational choice. People make a rational choice when they undertake an activity in which the marginal benefit of the activity exceeds the marginal cost of the activity. Some REI workers will shop and others will spend the day with their family, depending on which alternative’s marginal benefit exceeds its marginal cost. 13. Read Eye on the Benefit and Cost of School on p. 12 and explain why both you and Clayton Kershaw made the right decision. Clayton Kershaw made the right decision to skip college because his opportunity cost of attending college (which includes his forgone salary playing baseball) exceeded his benefits from attending college. For most students, the opportunity cost of attending college is not so large, so for most students the benefits from attending college exceed the opportunity cost of attendance. For these students, attending college is the right decision.

Chapter 1 . Getting Started

 Additional Problems and Applications 1.

Read Eye on the Benefit and Cost of School on p. 12 and explain which of the following items are components of the opportunity cost of being a full-time college student who lives at home. The things that the student would have bought with • A higher income The items the student would have purchased with the higher income he or she would have earned if he or she was not a full-time student are an opportunity cost of being a full-time student. •

Expenditure on tuition The cost of tuition is part of the opportunity cost of being a full-time student because this expense is paid only because the person is a student.

•

A subscription to the Rolling Stone magazine If the subscription was required by a class and the individual subscribed only because of the class requirement, then the cost of the subscription is an opportunity cost of being a student. However if the person would have subscribed to Rolling Stone even if he or she was not a student, then the cost of the subscription is not an opportunity cost of being a student.

•

The income a student will earn after graduating The income earned after graduation is not an opportunity cost of being a student.

Think about the following news items and label each as involving a what, how, or for whom question: • Today, most stores use computers to keep their inventory records, whereas 20 years ago most stores used paper records. Stores using computers for inventory records today versus paper 20 years ago answers the how question. •

Healthcare professionals and drug companies recommend that Medicaid drug rebates be made available to everyone in need. Deciding whether to offer lower Medicaid drug rebates, which would lower the prices for drugs, is a for whom question.

•

An increase in the gas tax pays for low-cost public transit. Building a low-cost public transit system answers a what question. Because not everyone will use the public transportation equally nor will everyone pay the same amount of taxes, there also is a for whom aspect of the headline.

The headlines in the list appeared in The Wall Street Journal. Classify each

Part 1 . INTRODUCTION

headline as a signal that the news article is about a microeconomic topic or a macroeconomic topic. Explain your answers. • U.S. hiring bounces back This entry is a macroeconomic topic because the hiring bounce concerns the hiring in the overall economy and neither an individual nor a business makes the decision to increase aggregate hiring. •

Sears to open three small-format stores This entry is a microeconomic topic because it concerns the decision made by one business, Sears.

•

Samsung expects 60% profit drop This entry is a microeconomic topic. It describes the change in profit of one business.

•

U.S. sees trade deal with China This entry is a macroeconomic topic because the trade deal affects a large number of imported and exported goods and services and thereby affects the national and global economies.

Your school decides to increase the intake of new students next year. To make its decision, what economic concepts would it have considered? Would the school have used the “economic way of thinking” in reaching its decision? Would the school have made its decision on the margin? The school would consider the extra revenue that each additional student would bring and compare that to the extra cost of providing each student with instruction and service. By comparing the extra revenue and the extra cost, the school is making its decision on the margin and is using the economic way of thinking. If the school compares the additional revenue to the additional cost, it makes its decision on the margin.

Provide examples of (a) a monetary incentive and (b) a non-monetary incentive, a carrot and a stick of each, that government policies use to influence behavior. (a) A monetary carrot that the students might answer because it is close to their lives is student aid, such as Pell grants. A monetary stick might be taxes on liquor. (b)

A non-monetary carrot is government support for youth sports, such as allowing little league teams to use a county park, and a nonmonetary stick is jail terms for illegal drug or alcohol use.

Think about each of the items in the list and explain how they affect incentives and might change the choices that people make: • A hurricane hits Central Florida. The hurricane affects the people in Central Florida and the consumers who purchase the products produced in Central Florida, such as orang-

Chapter 1 . Getting Started

es or vacation services. Residents’ incentives change if they suffered damage from the hurricane because they have the incentive to repair the damage. If the price of home repair rises, residents who specialize in home repair have an incentive to work longer hours to earn the higher price. If the hurricane raises the price of the goods and services produced in Central Florida, consumers have the incentive to buy less of these particular goods and services because they are more expensive. •

The World Series begins tonight but a storm warning is in effect for the area around the stadium. The report of the possible storm decreases fans’ incentive to attend the game. Some fans decide to stay at home and watch the game on television.

•

The price of gasoline falls as the supply of oil increases. The fall in the price of gasoline affects drivers’ incentives to buy gasoline and large gas-guzzling cars. Drivers decide to buy more gasoline and more large gas-guzzling cars. They also might decide to ride public transportation less often.

•

Economists expect hiring to increase. The report that economists expect that hiring will increase raises unemployed people’s incentives to look for a job. It also might lead some employed workers to look for a new, better job.

Does the decision to make a blockbuster movie mean that some other more desirable activities get fewer resources than they deserve? Is your answer positive or normative? Explain your answer. Making a blockbuster movie means that some other activities get fewer resources. But whether “more desirable” activities get fewer resources than they “deserve” is a normative answer for two reasons. First the question of whether an activity is more desirable or less desirable depends on the person’s judgment and values. Second the determination of whether an activity gets fewer resources than it deserves also involves the normative decision about the quantity of resources an activity deserves. So the answer to the question of whether making a blockbuster movie means that other more desirable activities get fewer resources than they deserve is a normative answer that depends on the student’s values.

Provide two examples of economics being used as a tool by (a) a student, (b) a business, and (c) a government. Classify your examples as dealing with microeconomic topics and macroeconomic topics. (a) Students might answer that they use economics as a tool when they budget their student aid and when they decided which college to attend based on the costs of their options. Both instances deal with microeconomics. (b)

A business uses economics as a tool when it decides the price it

Part 1 . INTRODUCTION

(c)

charges for its product and the salaries it pays its managers. Both instances are microeconomic examples. The government use economics as a tool when it decides whether to increase taxes on cigarettes or lower the interest rate. The first example is microeconomic in nature and the second involves macroeconomics.

Use the following news clip to work Problems 9 to 11. Are carbon prices working? Economists say that raising the cost of burning coal, oil, and gas is a costeffective way to lower carbon emissions, but most countries that have tried this solution have not set prices high enough to bring large enough cuts. Source: New York Times, April 2, 2019 9. What are the benefits of burning less coal, oil, and gas to produce electricity? Who receives these benefits: the users of electricity or the owners of power plants, or both the users and the owners? Benefits include: (1) a reduction in carbon emissions, which brings a decrease in the contribution of human activity to global warming and climate change, and (2) cleaner air, which contributes to improved health. Both the users of electricity and the owners of power plants receive the benefits. 10. What are the costs of using less coal, oil, and gas to produce electricity? Who bears these costs: the users of electricity or the owners of power plants, or both the users and the owners? The cost of higher prices for using less coal, oil, and gas will be the directly higher price for these resources as well as the costs of any equipment that enables the power plant to use less coal, oil, or gas. Another cost could be the lost jobs in the coal, oil, and gas sectors. Users of electricity, who pay higher prices for electricity, will pay some of these costs and owners of power plants, who receive lower profits from producing electricity, also will pay some of the costs. 11. Explain whether lowering carbon emissions has an opportunity cost. Lowering carbon emissions has an opportunity cost because the resources devoted to this reduction could be used instead to producing other goods and services.

Chapter 1 . Getting Started

 Multiple Choice Quiz 1.

Which of the following describes the reason why scarcity exists? A. Governments make bad economic decisions. B. The gap between the rich and the poor is too wide. C. Wants exceed the resources available to satisfy them. D. There is too much unemployment. Answer: C Answer C uses the definition of scarcity on page 2. 2.

Which of the following defines economics? Economics is the social science that studies ___________. A. the best way of eliminating scarcity B. the choices made to cope with scarcity, how incentives influence those choices, and how the choices are coordinated C. how money is created and used D. the inevitable conflict between self-interest and the social interest Answer: B Answer B uses the definition of economics on page 2. 3.

Of the three big questions, what, how, and for whom, which of the following is an example of a how question? A. Why do doctors and lawyers earn high incomes? B. Why don’t we produce more small cars and fewer gas guzzlers? C. Why do we use machines rather than migrant workers to pick grapes? D. Why do college football coaches earn more than professors? Answer: C Answer C describes how grapes are picked. 4

Which of the following is not a key idea in the economic way of thinking? A. People make rational choices by comparing costs and benefits. B. Poor people are discriminated against and should be treated more fairly. C. A rational choice is made at the margin. D. Choices respond to incentives. Answer: B Answer B is not part of description of the economic way of thinking on page 8.

Part 1 . INTRODUCTION

A rational choice is ___________. A. the best thing you must forgo to get something B. what you are willing to forgo to get something C. made by comparing marginal benefit and marginal cost D. the best for society Answer: C Answer C is part of description of a rational choice on pages 8 and 9. 6.

Which of the following best illustrates your marginal benefit of studying? A. The knowledge you gain from studying 2 hours a night for a month B. The best things forgone by studying 2 hours a night for a month C. What you are willing to give up to study for one additional hour D. What you must give up to be able to study for one additional hour Answer: C Page 10 shows that answer C is the marginal benefit of studying. 7.

The scientific method uses models to ___________. A. clarify normative disagreements B. avoid the need to study real questions C. replicate all the features of the real world D. focus on those features of reality assumed relevant for understanding a cause and effect relationship Answer: D Answer D uses the definition of an economic model from Checkpoint 1.3.

Which of the following is a positive statement? A. We should stop using corn to make ethanol because it is raising the cost of food. B. You will get the most out of college life if you play a sport once a week. C. Competition among wireless service providers across the borders of Canada, Mexico, and the United States has driven roaming rates down. D. Bill Gates ought to spend more helping to eradicate malaria in Africa. Answer: C Answer C is a positive statement because it can, in theory, be tested.

Chapter

Appendix: Making and Using Graphs ANSWERS TO APPENDIX CHECKPOINT

 Problems and Applications The spreadsheet in the table provides data on the U.S. economy: Column A is the year; the other columns are quantities sold in millions per year of compact discs (column B), music videos (column C), and video streaming (column D). Use this spreadsheet to work Problems 1 and 2. 1.

2007

500

2009

297

2011

241

2013

174

5 Draw a scatter diagram to show the relationship between the quantities sold of compact discs 6 and music videos. Describe the relationship. Figure A1.1 illustrates the relationship of the data from the spreadsheet between the quantities sold of compact discs and the quantities sold of music videos. Over all the period, there appears to be a positive or direct relationship; that is, when more compact discs are sold, more music videos are sold.

2015

117

2017

125

Part 1 . INTRODUCTION

Draw a time-series graph of quantity of compact discs sold. Say in which year or years the quantity sold (a) was highest, (b) was lowest, (c) increased the most, and (d) decreased the most. If the data show a trend, describe it. Figure A1.2 illustrates the time series of the quantity of compact discs sold using the data from the spreadsheet. a. b. c. d.

The quantity sold was the highest in 2007. The quantity sold was the lowest in 2017. The quantity sold never increased. The quantity sold decreased the most between 2007 and 2009 when it decreased by 203 million. Over the entire time period covered in the figure, there is a downward trend in the quantity of compact discs sold.

The following data shows the relationship between two variables x and y. x

Is the relationship between x and y positive or negative? Calculate the slope of the relationship when x equals 2 and when x equals 4. How does the slope change as the value of x increases? The relationship is negative: When x increases, y decreases. The slope of the relationship equals the change in y divided by the change in x along the tangent line; that is, the slope of the relationship at a point equals the slope of the tangent line at that point. When x equals 2, the slope of the tangent line equals –4, so the slope of the relationship equals –4. When x equals 4, the slope of the tangent line equals –8, so the slope of the relationship equals –8. The slope of the relationship increases in magnitude (the line becomes steeper) as x increases.

Appendix 1 . Making and Using Graphs

The table provides data on the Price price of a balloon ride, the tem(dollars perature, and the number of per ride) rides a day. Draw graphs to 5 show the relationship between 10 • The price and the number of 15 rides, when the temperature 20 is 70°F. Figure A1.3 illustrates the relationship between the price and the number of rides when the temperature is 70°F.

Balloon rides (number per day) 50°F

70°F

90°F

32 27 18 10

50 40 32 27

40 32 27 18

• The number of rides and the temperature, when the price is $15 a ride. Figure A1.4 illustrates the relationship between the number of rides and the temperature, when the price is $15 a ride.

Part 1 . INTRODUCTION

 Additional Problems and Applications Use the information in the table to work Problems 1 and 2. Column A is the year; the other columns are quantities sold in millions per year of compact discs (column B), music videos (column C), and video streaming (column D). 1.

2007

500

2009

297

2011

241

4 Draw a scatter diagram to show the relationship between quantities sold of music 5 videos and video streaming. Describe the 6 relationship. Figure A1.5 illustrates the relationship of the data from the spreadsheet between the quantities sold of music videos and singles downloads. Over all the period, is negative or indirect relationship; that is, when fewer music videos are sold, more video is streamed.

2013

174

2015

117

2017

125

Appendix 1 . Making and Using Graphs

Draw a time-series graph of the quantity of music videos sold. Say in which year or years the quantity sold (a) was highest, (b) was lowest, (c) decreased the most, and (d) decreased the least. If the data show a trend, describe it. Figure A1.6 illustrates the time series of music videos sold using the data from the spreadsheet. a. The quantity sold was the highest in 2007. b. The quantity sold was the lowest in 2017. c. The quantity sold decreased the most between 2007 and 2009, when it decreased by 16 million. d. The quantity sold decreased the least between 2013 and 2015, when it decreased by 1 million. There is a downward trend in the quantity of music videos sold.

Use the following data on the relationship between two variables x and y to work Problems 3 and 4. x

Is the relationship between x and y positive or negative? Explain. The relationship is positive: When x increases, y also increases.

Calculate the slope of the relationship when x equals 2 and x equals 4. How does the slope change as the value of x increases? The slope of the relationship equals the change in y divided by the change in x along the tangent line; that is, the slope of the relationship at a point equals the slope of the tangent line at that point. When x equals 2, the slope of the tangent line equals 4, so the slope of the relationship equals 4. When x equals 4, the slope of the tangent line equals 8, so the slope of the relationship equals 8. The slope of the relationship increases as x increases.

Part 1 . INTRODUCTION

The table provides data on Price the price of hot chocolate, the (dollars temperature, and the cups of per cup) hot chocolate bought. Draw graphs to show the 2.00 relationship between 2.50 3.00 • The price and cups of hot 3.50 chocolate bought, when the temperature is constant. Figure A1.7 illustrates the relationship between the price and the number of cups bought holding constant the temperature. Note that there are three relationships, one for each temperature.

Hot chocolate (cups per week) 50°F

70°F

90°F

40 30 20 10

30 20 10 0

20 10 0 0

• The temperature and cups of hot chocolate bought, when the price is constant. Figure A1.8 illustrates the relationship between the number of cups bought and the temperature, holding constant the price. Note that there are four relationships, one for each price.

The U.S. and Global Economies ANSWERS TO CHAPTER CHECKPOINT

 Problems and Applications 1.

Which of the following items are not consumption goods and services? Explain why not. • A chocolate bar A chocolate bar is a consumption good. • A ski lift A ski lift is not a consumption good. It is capital that produces a service for skiers. • A golf ball A golf ball is a consumption good. 2. Which of the following items are not capital goods? Explain why not. • An auto assembly line An auto assembly line is a capital good. • A shopping mall A shopping mall is a capital good. • A golf ball A golf ball is not a capital good. It is a consumption good. 3. Which of the following items are not factors of production? Explain why not. • Vans used by a baker to deliver bread Vans used to deliver bread are capital, so they are factors of production. • 1,000 shares of Amazon.com stock 1,000 shares of Amazon.com stock are not a factor of production. The shares represent partial ownership of Amazon.com and therefore are financial capital. • Undiscovered oil in the Arctic Ocean Undiscovered oil is not a factor of production because it is not used to produce goods or services. Once it is discovered, it will become a factor of production.

Chapter

Part 1 . INTRODUCTION

Which factor of production earns the highest percentage of total U.S. income? Define that factor of production. What is the income earned by this factor of production called? Labor earns by far the largest percentage of total U.S. income, 68 percent of total income in 2017. Labor consists of the work time and the work effort that people devote to producing goods and services. The income earned by labor is a wage.

With more job training and more scholarships to poor American students, which special factor of production is likely to grow faster than in the past? As more people go to school and/or receive job training, the nation’s human capital will grow more rapidly. Human capital is the knowledge and skills people obtain from education, on-the-job training, and work experience. With more job training and more scholarships, human capital will grow more rapidly.

Define the factor of production called capital. Give three examples of capital, different from those in the chapter. Distinguish between the factor of production capital and financial capital. Capital is the tools, instruments, machines, buildings, and other items that have been produced in the past and that businesses now use to produce goods and services. Capital includes railroad engines and cars, servers, and ATMs. The factor of production “capital” is the actual good itself; “financial capital,” such as stocks and bonds, are the funds that provide businesses with their financial resources which can be used to acquire capital goods.

California added construction and manufacturing jobs. California added 25,000 jobs in March, particularly in construction and manufacturing. Construction jobs showed the most growth. Source: Los Angeles Times, April 19, 2019 Explain how you would expect these facts to influence what, how, and for whom goods and services are produced in the United States. Because more workers are hired in the construction and manufacturing sectors, what goods and services are produced as the new construction and manufacturing goods and. With the increase in employment, how the goods and services are produced is by using more labor. For whom goods and services depends on people’s incomes. Consequently, for whom goods and services are produced is determined by the income of the people employed in the 25,000 jobs.

Chapter 2 . The U.S. and Global Economies

In the circular flow model, explain the real flow and/or the money flow in which each item below belongs. Illustrate your answers on a circular flow diagram. • You buy a coffee at Starbucks. In Figure 2.1 the dark arrows represent money flows and the grey arrows represent flows of goods and services and factors of production. If you buy a coffee at Starbucks, your expenditure is a money flow from households to the goods market, labeled a in the figure. • The government buys some Dell computers. The purchase of computers by the government represents a flow of computers from the goods market to the government, labeled b in the figure. • A student works at a FedEx office. The student working at FedEx is a factor of production, so the flow is a flow of the services of factor of production from households to the factor markets, labeled c in the figure. • Donald Trump rents a Manhattan building to a hotel. Donald Trump’s building in Manhattan is a factor of production, so the flow is the services from this factor of production from households to the factor markets, labeled d in the figure. • You pay your income tax. Your income tax payment is a money flow from households to the government and is labeled e in the figure. Why you can get a free college education in Germany but not in California Even American students can get a free college degree in Germany, where

Part 1 . INTRODUCTION

high taxes pay for colleges. Despite college being free, fewer students in Germany earn college degrees than in the United States and more enter vocational apprenticeships. Source: Los Angeles Times, October 29, 2015 If California adopted the German model of higher education, how would that change for whom goods and services are produced? The students in California who otherwise would not have gone to college but who take advantage of the “free” college education will have higher incomes than otherwise. Consequently, more goods and services will be produced for them. The taxpayers who must pay the taxes necessary to fund these college educations will have less income to spend on goods and services, so fewer goods and services will be produced for them. 10. Read Eye on the Dreamliner on p. 43 and then answer the following questions: • How many firms are involved in the production of the Dreamliner and how many are identified in the figure on p. 43? Over 400 firms are involved in the production of the Dreamliner. Only 15 of them are identified in the figure. • Is the Dreamliner a capital good or a consumption good? Explain why? The Dreamliner is a capital good because it will be used to produce services (airline travel) throughout many future years. • State the factors of production that make the Dreamliner and provide an example of each. All the factors of production—land, labor, capital, and entrepreneurship—are used to make the Dreamliner. The copper used for wiring is an example of the land used; the engineer who helped design the landing gear is an example of labor; the huge cranes that lift the various pieces of the Dreamliner to assemble them is an example of capital; and the creative and imaginative input of Boeing’s top managers who organize the resources used to produce the Dreamliner exemplify entrepreneurship. • Explain how the production of the Dreamliner influences what, how, and for whom, goods and services are produced. Dreamliner influences “what” goods and services are produced by creating a demand for components manufactured around the world. It influences “how: goods are produced because Boeing and the other 400 firms all determine the best way to produce each particular part of the Dreamliner. It influences “for whom” because factors of production employed to make the Dreamliner receive income from this

Chapter 2 . The U.S. and Global Economies

•

production, thereby increasing the quantity of goods and services they can purchase. Use a graph to show where in the circular flow model of the global economy the flows of the components listed on p. 43 appear and where the sales of Dreamliners appear. Except for the components built in the United States, spending on the other components appear in the flow of expenditure on U.S. imports. Sales of Dreamliners appear in the flow of expenditure on U.S. exports.

Part 1 . INTRODUCTION

 Additional Problems and Applications 1.

Read Eye on the Dreamliner on p. 43 and then answer the following questions: • Why doesn’t Boeing manufacture all the components of the Dreamliner at its own factory in the United States? Boeing wants to manufacture the Dreamliner at the lowest possible cost. It would be more expensive for Boeing to manufacture Dreamliners at its own factory in the United States because Boeing does not have the expertise possessed by its subcontractors and because the wages Boeing pays U.S. workers exceed the wages its subcontractors pays their workers. • Describe some of the changes in what, how, and for whom, that would occur if Boeing manufactured all the components of the Dreamliner at its own factories in the United States. If Boeing manufactured all the components of the Dreamliner at its own factories in the United States, more components would be produced in the United States and more capital would have been used in their production. U.S. workers and investors would have received higher incomes but the Dreamliner would cost more to produce so Boeing would have earned a lower profit. • State some of the tradeoffs that Boeing faces in making the Dreamliner. Boeing faced a huge number of tradeoffs. For example, when designing the plane, Boeing’s engineers had to make decisions about fuel economy and passenger load. Increasing the passenger load decreased fuel economy, so the engineers traded passenger load for fuel economy. Another example revolves around the construction of the Dreamliner. Boeing could have constructed the plane using just a few companies but instead it used over 400. Boeing was trading off the simplicity of dealing with just a handful of companies for the increased specialization by dealing with many specialized companies. • Why might Boeing’s decisions in making the Dreamliner be in the social interest? Building the Dreamliner itself advances the social interest because it increases the quantity of comfortable, rapid transportation. The amount of high-quality transportation available in the economy increases, which benefits society. The decisions in making the Dreamliner advance the social interest because they were designed to make the Dreamliner at low cost and thereby avoid wasting resources.

Chapter 2 . The U.S. and Global Economies

The global economy has seen a fall in the number of landlines and rapid growth in the number of smartphones. In the United States, 51 percent of households have no landline and 95 percent have a smartphone. In Africa, 70 percent have a smartphone. Describe the changes in what, how, and for whom telecommunication services are produced in the global economy. What: As the number of cell phone users increases, the global economy has been producing more cell phone telecommunication services. More cell phones are produced, fewer land phones are produced, and presumably more cell phone frequencies are used. How: More telecommunication services are being produced using cell phones rather than fixed-line phones. For whom: While the amount of telecommunication services has been rising throughout the world, it has been increasing most rapidly in Africa. So more telecommunication services are being produced for residents of Africa as well as for residents in the rest of the world.

Which of the entries in the list are conList sumption goods and services? Explain your • An interstate highway choice. • An airplane A pack of bubble gum and a movie are • A school teacher consumption goods. They are purchased • A stealth bomber by consumers. • A garbage truck Which of the entries in the list are capital • A pack of bubble gum goods? Explain your choice. • President of the United States An airplane, a garbage truck, and an ATM • A strawberry field are capital goods. All provide services to • A movie produce other goods and services. The in• An ATM terstate highway and the stealth bomber also are capital goods. They also provide services (transportation and defense) that help produce other goods and services. Which of the entries in the list are factors of production? Explain your choice. An interstate highway, an airplane, a school teacher, a stealth bomber, a garbage truck, the President of the United States, a strawberry field, and an ATM are factors of production. A school teacher and the President are labor; an interstate highway, an airplane, a stealth bomber, a garbage truck, and an ATM are capital; and, a strawberry field is land.

Part 1 . INTRODUCTION

In the African nation of Senegal, to enroll in school a child needs a Birth Certificate that costs $25. This price is several weeks’ income for many families. Explain how this requirement is likely to affect the growth of human capital in Senegal. Human capital growth depends, in part, on the extent of schooling: More schooling means more human capital. Because of Senegal’s hefty fee for a required Birth Certificate, fewer children will enroll in school, thereby decreasing Senegal’s human capital growth.

China’s race to the top in income inequality China has lifted millions out of poverty, but inequality has also increased. In 2017, 8 million students graduated from Chinese universities, 10 times more than two decades ago and double the number at U.S. universities. But the gap in graduation rates between rural to urban areas and richer and poorer people widened. Source: Bloomberg, September 23, 2018 Explain how the distribution of personal income in China can be getting more unequal even though the poorest are getting richer. The distribution of income in China can be getting more unequal even when the poorest are getting richer if the richest are getting richer even faster. If the rich are getting richer faster, the fraction of the nation’s total income received by the poorest 20 percent falls, which makes the personal distribution of income more unequal.

Compare the scale of agricultural production in the advanced and developing economies. In which is the percentage higher? In which is the total amount produced greater? Agricultural is a small part of total production in advanced economies. It is a much larger part in developing economies. Even though advanced economies devote only a small part of their total production to agriculture, they still produce about one third of the world’s total production of food. The remaining two thirds is produced in the developing nations.

Chapter 2 . The U.S. and Global Economies

On a diagram of the circular flow model, indicate in which real or money flow each entry in the list belongs. • General Motors’ pays its workers wages. General Motors wage payment is a money flow that is a payment for use of the services of a factor of production and so flows out of the factor market to households (it flowed into the factor market from General Motors, a firm). In Figure 2.3 the dark arrows represent money flows and the grey arrows represent flows of goods and services and factors. The flow of wage payments to households is labeled a in the figure in Figure 2.3. • IBM pays a dividend to its stockholders. IBM’s dividend payment is a money flow that is a payment for use of the services of a factor of production and so flows out of the factor market to households (it flowed into the factor market from IBM, a firm). The flow to households is labeled b in the figure. • You buy your groceries. Your purchase of groceries represents a money flow from households to the goods market, labeled c in the figure. • Southwest rents some aircraft. The aircraft are factors of production, so the flow is the services from these factors of production from the factor markets to firms, labeled d in the figure. • Nike pays Serena Williams for promoting its sports shoes. Serena Williams is a factor of production, so the flow is a money flow

Part 1 . INTRODUCTION

from the factor markets to households in exchange for Ms. Williams’ services of promoting the sports shoes. The flow is labeled e in the figure. 10. Led by China, a new billionaire is created in Asia every other day Billionaire wealth in Asia increased 17 percent to $6 trillion in 2016. Led by China, the number of the region’s billionaires surpassed the United States for the first time. Source: The Straits Times, October 26, 2017 How is the personal distribution of income in Asia changing? If the number of billionaires is growing more rapidly than the number of other income groups, it will be the case that the personal distribution of income in Asia is becoming less equally distributed.

Chapter 2 . The U.S. and Global Economies

 Multiple Choice Quiz 1.

Which of the following classifications is correct? A. City streets are consumption goods because they wear out with use. B. Stocks are capital goods because when people buy and sell them they make a profit. C. The coffee maker in the coffee shop at an airport is a consumption good because people buy the coffee it produces. D. White House security is a government service because it is paid for by the government. Answer: D Answer D is correct. 2.

Which of the following statements about U.S. production is correct? A. Construction accounts for a larger percentage of total production than does manufacturing. B. Real estate services account for 14.5 percent of the value of total production, larger than any other item of services or goods. C. Consumption goods and services represent 78.5 percent of U.S. production by value and that percentage doesn’t fluctuate much. D. The manufacture of goods represents more than 50 percent of total production. Answer: C Answer C is correct as the data on page 34 show. 3.

Which of the following items is not a factor of production? A. An oil rig in the Gulf of Mexico B. A ski jump in Utah C. A bank loan to a farmer D. An orange grove in Florida Answer: C Answer C is not a factor of production because it is financial capital; see page 37. 4.

What is human capital? A. A fruit picker B. Unskilled labor C. Your professor’s knowledge of the economy D. An auto assembly line robot Answer: C Answer C uses the definition of human capital on page 37.

Part 1 . INTRODUCTION

Which of the following statements is correct? A. Labor earns wages and entrepreneurship earns bonuses. B. Land earns interest and capital earns rent. C. Entrepreneurship earns interest and capital earns profit. D. Capital earns interest and labor earns wages. Answer: D Page 39 shows that answer D is correct. 6.

How are goods and services produced in the global economy? A. Developing countries use less human capital but just as much physical capital as advanced economies. B. Emerging economies use more capital-intensive technology than do developing economies. C. Human capital in all economies is similar. D. Advanced economies use less capital than developing economies. Answer: B Developing countries have less capital than emerging economies. 7.

In the circular flow model, which of the following items is a real flow? A. The flow of government expenditures to firms for the goods bought B. The flow of income from firms to households for the services of the factors of production hired C. The flow of U.S. borrowing from the rest of the world D. The flow of labor services from households to firms Answer: D Answer D is a real flow because it is a labor service.

The Economic Problem

Chapter

ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications 1.

The table shows the quantities of corn and beef that a farm Corn can produce in a year. Draw a graph of the farm’s PPF. Mark (bushels) on the graph: 250 200 • An inefficient combination of corn and beef—label this 100 point A. 0 • An unattainable combination of corn and beef—label this point B. • An efficient combination of corn and beef—label this point C. The production possibilities frontier is illustrated in Figure 3.1. Any production point inside the PPF, such as the point marked A, is an inefficient combination of corn and beef. Any production point beyond the PPF, such as the point marked B, is an unattainable combination of corn and beef. Any production point on the PPF, such as the point marked C is a production efficient combination of corn and beef.

Use the following information to work Problems 2 and 3. The people of Leisure Island have 50 hours of labor a day that can be used to

Beef (pounds) and and and and

0 300 500 600

Part 1 . INTRODUCTION

produce entertainment and good food. The Entertainment table shows the maximum quantity of either Labor (units) entertainment or good food that Leisure Is0 0 or 10 20 or land can produce with different quantities of 20 40 or labor. 30 60 or 2. Is an output of 50 units of entertainment 40 80 or 50 100 or and 50 units of good food attainable and efficient? With a production of 50 units of entertainment and 50 units of good food, do the people of Leisure Island face a tradeoff? Producing 50 units of good food and 50 units of entertainment is attainable. However, at this production point, Leisure Island’s resources are not fully employed or are misallocated. They are producing inside their PPF. As a result, the people of Leisure Island do not face a tradeoff—they can produce more entertainment without giving up any good food, or they can produce more good food without giving up any entertainment. 3.

What is the opportunity cost of producing an additional unit of entertainment? Explain how the opportunity cost of producing a unit of entertainment changes as more entertainment is produced. If production is initially inside the PPF, the opportunity cost of producing an additional unit of entertainment is zero. If production is on the PPF there is an opportunity cost of producing a unit of entertainment because good food must be forgone. The opportunity cost of producing a unit of entertainment while moving along the PPF equals the loss in good food produced divided by the gain in entertainment produced. For example, increasing production of entertainment by changing from the production of 20 units of entertainment and 65 units of good food (10 units of labor devoted to entertainment and 40 to good food) to 40 units of entertainment and 60 units of good food has an opportunity cost of 5 units of good food ÷ 10 units of entertainment = 1/2 of a unit of good food per unit of entertainment. On the PPF, as more entertainment is produced, the opportunity cost of producing an additional unit of entertainment increases. Use the following information to work Problems 4 to 6. Is a cure for Aids within reach? More than 50 years after one of the most devastating viruses to affect mankind, HIV remains a stubborn adversary. Treatment has improved dramatically over the past 20 years and now, a cure could be in sight. Source: The Guardian, November 30, 2018 4. Make a graph of the production possibilities frontier with HIV/AIDS cases treated on the x-axis and other goods and services on the y-axis before and after the advance in technology. Figure 3.2 (on the next page) shows the PPF. When the technology used to treat HIV/AIDS advances, the production possibilities increase so, as

Good food (units) 0 30 50 60 65 67

Chapter 3 . The Economic Problem

shown in Figure 3.2, the PPF shifts outward. 5.

How does the opportunity cost of treating HIV/AIDS changes as the number of cases treated increases with no change in technology? With no change in technology, moving along a PPF as the number of cases treated rises the opportunity cost of treating a case increases.

How has the opportunity cost of treating HIV/AIDS changed as the technology for treating it has advanced? With advances in technology in HIV/AIDS treatments, along the New PPF resources are more productive and fewer other goods and services must be given up to increase production of HIV/AIDS treatments. So the opportunity cost of producing HIV/AIDS treatments decreases.

Explain how the following events influence U.S. production possibilities: • Some retail workers are re-employed building dams and wind farms. When these former retail workers are re-employed at their new occupations, more dams and wind farms are produced and fewer retail services are produced. The opportunity cost of the increased numbers of dams and wind farms is the forgone production of retail services. There is a movement along the PPF. • More people take early retirement. As more people retire, the quantity of labor available in the economy shrinks. As a result, the nation’s PPF shifts inward. • Drought devastates California’s economy. The nation’s PPF shifts inward as a result of the drought. The drought decreases the amount of productive land, thereby decreasing production of agricultural products and shifting the PPF inward. Use the following information to work Problems 8 and 9. Figure 3.3 (on the next page) shows Tom’s production possibilities and Figure 3.4 (on the next page) shows Abby’s production possibilities. Tom uses all his resources and produces 2 rackets and 20 balls an hour. Abby uses all her resources and produces 2 rackets and 40 balls an hour. 8. What is Tom’s opportunity cost of producing a racket? What is Abby’s opportunity cost of a racket? Who has a comparative advantage in producing rackets? Who has a comparative advantage in producing balls? If Tom increases his production by 1 racket, he forgoes 10 balls. So his opportunity cost of 1 racket is 10 balls ÷ 1 racket, or 10 balls per racket.

Part 1 . INTRODUCTION

If Abby increases her production by 1 racket, she forgoes 20 balls. So her opportunity cost of 1 racket is 20 balls ÷ 1 racket, or 20 balls per racket. Tom has the comparative advantage in producing rackets. Tom’s opportunity cost of a racket is 10 balls per racket and Abby’s opportunity cost of a racket is 20 balls per racket. Abby has the comparative advantage in producing balls. Tom’s opportunity cost of a ball is 0.10 rackets per ball and Abby’s opportunity cost of a ball is 0.05 rackets per ball. 9.

If Tom and Abby specialize and trade 15 balls for 1 racket, what are the gains from trade? Both Tom and Abby gain from their specialization and trade. Tom could produce 4 rackets and then trade 2 of the rackets for 30 balls. Tom would wind up with 2 rackets and 30 balls, 10 more balls than he had without the specialization and trade. Abby could produce 80 balls and then trade 30 of them for 2 rackets. Abby would wind up with 2 rackets and 50 balls, also 10 more balls than she had without the specialization and trade.

10. Read Eye on the Environment on p. 68 and describe a tradeoff faced when deciding how to generate electricity and whether to use wind power. Using wind power to generate electricity requires that the wind turbines be located in areas with wind which often are not near population centers. Long transmission lines are required which means transmissions losses are large. Long transmission lines are not necessary if other sources are used to generate power, so smaller generating facilities are required because transmissions losses are less. If wind power is used to generate power, more resources are used and fewer other goods can be produced.

Chapter 3 . The Economic Problem

 Additional Problems and Applications Use the following information to work Problems 1 to 4. Representatives Waxman of California and Markey of Massachusetts proposed a law to limit greenhouse gas emissions from electricity generation and require electricity producers to generate a minimum percentage of power using renewable fuels, with some emission rights to be auctioned. The Congressional Budget Office estimated that the government would receive $846 billion from auctions and would spend $821 billion on incentive programs and compensation for higher energy prices. Electricity producers would spend $208 million a year to comply with the new rules. (Think of these dollar amounts as dollars’ worth of other goods and services.) 1. Would the Waxman-Markey law achieve production efficiency? Production efficiency requires producing on the PPF. Use a PPF showing the tradeoff between electricity and clean air. Production efficiency requires producing on the PPF so that gaining more clean air means giving up some electricity. Before the new law, production might have been on the PPF if the producers had used the most efficient technologies and taken account of the pollution they created. After the law is in place, production might be inside the PPF if the law requires more production of energy from renewable sources than is production efficient. 2.

Is the $846 billion that electricity producers would pay for the right to emit greenhouse gasses part of the opportunity cost of producing electricity? To the extent that the $846 billion pays for the cost that greenhouse gasses impose on society (by way of forgone production of other goods and services), the $846 billion is part of the opportunity cost of generating electricity.

Is the $821 billion that the government would spend on incentive programs and compensation for higher energy prices part of the opportunity cost of producing electricity? The incentive programs change what electricity providers buy in order to produce electricity with lower emissions. The goods and services forgone are the opportunity cost of these programs. Compensation for higher energy prices is a transfer payment from taxpayers to consumers. Nothing is forgone and so it is not an opportunity cost.

Is the $208 million that electricity producers will spend to comply with the new rules part of the opportunity cost of producing electricity? The electricity producers will spend $208 million on other goods and services to comply with the law. These goods and services had other alternative uses that are now foregone, so this expenditure is part of the opportunity cost of producing electricity.

Part 1 . INTRODUCTION

The people of Foodland have 40 hours of Bread labor a day to bake pizza and bread. The Labor Pizzas (loaves) 0 0 or 0 table shows the maximum quantity of 10 30 or 10 either pizza or bread that Foodland can 20 50 or 20 bake with different quantities of labor. 30 30 60 or Can Foodland produce 30 pizzas and 30 40 65 or 40 loaves of bread a day? If it can, is this output efficient, do the people of Foodland face a tradeoff, and what is the opportunity cost of producing an additional pizza? Producing 30 pizzas and 30 loaves of bread is attainable and efficient. There is a tradeoff because the nation is operating on its production possibilities frontier. As a result, if the production of pizza increases, less bread can be produced and if the production of bread increases, less pizza can be produced. For the nation to produce 20 more pizzas requires 10 more hours of labor devoted to making pizza, which means 10 fewer hours devoted to making bread. Foodland gives up 10 loaves of bread. The opportunity cost of another pizza equals the loaves of bread forgone, 10 loaves, divided by the pizzas obtained, 20 pizzas, or 10 loaves of bread ÷ 20 pizzas, or 1/2 of a loaf of bread per pizza. Use the table, which shows a farm’s production Soybean Chicken (bushels (pounds possibilities, to work Problems 6 and 7. per year) per year) 6. If the farm uses its resources efficiently, what is the 500

and

opportunity cost of an increase in chicken production 400 and from 300 pounds to 500 pounds a year? Explain your 200 and 0 and answer. If the farm expands chicken production from 300 pounds to 500 pounds, soybean production decreases from 400 to 200 bushels. The opportunity cost of the additional 200 pounds of chicken is 200 bushels of soybean, or 1 bushel of soybeans per pound of chicken. 7.

If the farm adopted a new technology, which allows it to use fewer resources to fatten chickens, explain how the farm’s production possibilities will change. Explain how the opportunity cost of producing a bushel of soybean will be affected. The farm’s PPF rotates outward; the maximum quantity of soybeans (500 bushels) does not change but the maximum quantity of chicken increases. The opportunity cost of a bushel of soybeans increases because more chicken must be given up to produce additional soybeans.

In an hour, Sue can produce 40 caps or 4 jackets and Tessa can produce 80 caps or 4 jackets. Who has a comparative advantage in producing caps? If Sue and Tessa specialize and trade, who will gain? Sue forgoes 4 jackets to produce 40 caps, so Sue’s opportunity cost of pro-

0 300 500 550

Chapter 3 . The Economic Problem

ducing one cap is (4 jackets) ÷ (40 caps) or 0.1 jackets per cap. Tessa forgoes 4 jackets to produce 80 caps, so Tessa’s opportunity cost of producing one cap is (4 jackets) ÷ (80 caps) or 0.05 jackets per cap. Tessa’s opportunity cost of a cap is lower than Sue’s opportunity cost, so Tessa has a comparative advantage in producing caps. If Tessa specializes in caps and Sue specializes in jackets, both Sue and Tessa gain from trade. For instance, suppose they settle upon a price of 1 jacket for 15 caps. Sue gains because she can obtain caps from Tessa at a cost of (1 jacket) ÷ (15 caps), which is 0.067 jacket per cap, a cost that is lower than what it would cost her to produce caps herself. Tessa also gains from trade because she trades caps for jackets for 0.067 jacket per cap, which is higher than her cost of producing a cap. Use the following opinion to work Problems 9 to 11. Free Internet? Everyone should have free Internet access to education, news, jobs, and more. 9. Explain how Internet access has changed the production possibilities and the opportunity cost of producing education and news. Internet access is a technological advance that has increased the production possibilities of all goods and services. The opportunity cost of producing more education and news is the quantity of other goods and services that must be given up to get an additional unit of education and news. If Internet access expands the production possibilities of education and news by more than it expands the production possibilities of goods and services, fewer other goods and services must be given up to produce an additional unit of education and news. The opportunity cost of producing more education and news decreases. 10. Sketch a PPF with education and news on the x-axis and other goods and services on the y-axis before and after the Internet. The PPFs in Figure 3.5 have the conventional outward bowed shape. The figure shows that the introduction of the Internet shifted the production possibilities frontier outward from the PPF labeled “Initial PPF,” to the PPF labelled “New PPF.” The illustrated PPF assumes that effect on education and news is larger than the effect on other goods and services.

Part 1 . INTRODUCTION

11. Explain why it is not possible for everyone to have free Internet access to education, news, jobs, and more. Providing Internet access is not free because it takes resources. But the opportunity cost of Internet service increases as more people gain access , so the opportunity cost of giving everyone “free” access to the Internet would be extremely high, probably much higher than society is willing to pay.

Chapter 3 . The Economic Problem

 Multiple Choice Quiz 1.

The table shows the production possibilFish Berries ities of an island community. Choose the Possibility (pounds) (pounds) best statement. A 0 and 40 B 1 and 36 A. This community has enough reC 2 and 30 sources to produce 2 pounds of fish D 3 and 22 and 36 pounds of berries. E 4 and 12 B. This community cannot produce 2 F 5 and 0 pounds of fish and 36 pounds of berries because this combination is inefficient. C. This community will waste resources if it produces 2 pounds of fish and 22 pounds of berries. D. This community can produce 2 pounds of fish and 30 pounds of berries but this combination is inefficient. Answer: C The economy is wasting resources because if it produces 2 pounds of fish, it can also produce 30 pounds of berries (which is more than the 22 pounds it is producing), and if it produces 22 pounds of berries, it can also produce 3 pounds of fish (which is more than the 2 pounds it is producing). 2.

The table above shows the production possibilities of an island community. Choose the best statement. A. Suppose that this community produces 3 pounds of fish and 20 pounds of berries. If it decides to gather more berries, it faces a tradeoff. B. When this community produces 4 pounds of fish and 12 pounds of berries it faces a tradeoff, but it is inefficient. C. Suppose that this community produces 5 pounds of fish and 0 pounds of berries. If it decides to gather some berries, it will get a free lunch. D. If this community produces 3 pounds of fish and 22 pounds of berries, production is efficient but to produce more fish it faces a tradeoff. Answer: D Production of 3 pounds of fish and 22 pounds of berries is on the PPF and therefore efficient. To produce more fish, the community moves along its PPF, increasing production of fish and decreasing production of berries. The community faces a tradeoff. .

Part 1 . INTRODUCTION

The table above shows the production possibilities of an island community. This community’s opportunity cost of producing 1 pound of fish ______. A. is the increase in the quantity of berries gathered as the quantity of fish increases by 1 pound B. increases as the quantity of berries gathered increases C. is 10 pounds of berries if the quantity of fish increases from 2 to 3 pounds D. increases as the quantity of fish caught increases Answer: D Page 70 discusses why opportunity increases as production of the good increases. 4.

The table above shows the production possibilities of an island community. Choose the best statement. A. When a drought hits the island, its PPF shifts outward. B. When the islanders discover a better way of catching fish, the island’s PPF shifts outward. C. When islanders reduce the time they spend gathering berries, the PPF shifts inward. D. If the islanders decide to spend more time gathering berries but continue to spend the same amount of time fishing, they face a tradeoff. Answer: B Page 72 shows that technological progress, such as exemplified in answer B, shifts the PPF outward. 5.

Mary makes 10 pies and 20 cakes a day and her opportunity cost of producing a cake is 2 pies. Tim makes 20 pies and 10 cakes a day and his opportunity cost of producing a cake is 4 pies. If Mary and Tim specialize in the good in which they have a comparative advantage ______. A. Mary produces only pies B. Tim produces both pies and cakes C. Mary produces only cakes while Tim produces only pies D. Tim produces only cakes while Mary produces only pies Answer: C Answer C is correct because Mary has the lower opportunity cost of making a cake.

Chapter

Demand and Supply ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications 1.

Explain how each of the following events changes the demand for or supply of air travel. • Airfares tumble, while long-distance bus fares don’t change. A change in the price of airfares does not change either the demand for or the supply of air travel. (It changes the quantity demanded and the quantity supplied of air travel.) •

The price of jet fuel rises. The rise in the price of jet fuel decreases the supply of air travel because it raises the cost of producing air travel.

•

Airlines reduce the number of flights each day. The reduction in the number of flights decreases the supply of air travel.

•

People expect airfares to increase next summer. The current demand for air travel increases when people expect airfares to increase next summer because people fly now, when airfares are relatively cheaper, rather than next summer.

•

The price of train travel falls. Train travel is a substitute for air travel. So a fall in the price of train travel decreases the demand for air travel.

•

The price of a pound of air cargo increases. Transporting cargo by air is a substitute in production for transporting people by air. So the rise in the price of air cargo decreases the supply of air travel for people.

Use the laws of demand and supply to explain whether the statements in Problems 2 and 3 are true or false. In your explanation, distinguish between a change in demand and a change in the quantity demanded and between a change in supply and a change in the quantity supplied. 2. The United States does not allow oranges from Brazil (the world’s largest

Part 1 . INTRODUCTION

producer of oranges) to enter the United States. If Brazilian oranges were sold in the United States, oranges and orange juice would be cheaper. The statement is true. Allowing Brazilian oranges into the United States increases the supply of oranges and the supply curve shifts rightward. The equilibrium price of an orange falls and the equilibrium quantity increases. The quantity of oranges demanded increases and there is a movement down along the demand curve. Oranges are a resource used in the production of orange juice. When the price of an orange falls, it costs less to produce orange juice and the supply of orange juice increases. The quantity of orange juice demanded increases and there is a movement down along the demand curve. The equilibrium price of orange juice falls and the equilibrium quantity increases. 3.

If the price of frozen yogurt falls, the quantity of ice cream consumed will decrease and the price of ice cream will rise. The statement is false. Frozen yogurt and ice cream are substitutes for consumers. When the price of frozen yogurt falls, people substitute frozen yogurt for ice cream. The demand for ice cream decreases and the demand curve shifts leftward. The equilibrium quantity of ice cream decreases but the equilibrium price of ice cream falls. There is a change in the quantity of ice cream supplied and a movement down along the supply curve.

The table shows the demand and supPrice Quantity Quantity ply schedules for running shoes. What (dollars demanded supplied per pair) is the market equilibrium? If the price (pairs per day) 60 1,000 400 is $70 a pair, describe the situation in 70 900 500 the market. Explain how market equi80 800 600 librium is restored. If a rise in income 90 700 700 increases the demand for running 100 600 800 shoes by 100 pairs a day at each price, 110 500 900 explain how the market adjusts to its new equilibrium. The market equilibrium occurs at a price of $90 a pair and 700 pairs of running shoes a day. At the price of $90 a pair, the quantity demanded equals the quantity supplied. If the price is $70 a pair, the quantity demanded is 900 pairs and the quantity supplied is 500 pairs. There is a shortage of 400 pairs a day and the price rises. As the price rises, the quantity demanded decreases, the quantity supplied increases, and the shortage decreases. The price rises until the shortage disappears. The table (on the next page) shows the new demand schedule after the increase in income has increased the quantity demanded by 100 pairs of shoes at each price. At the original equilibrium price of $90 a pair, there is a shortage and the price rises. As the price rises, the quantity demanded de-

Chapter 4 . Demand and Supply

creases, the quantity supplied increases, and the shortage decreases. The price rises until the shortage disappears. The price rises to $95 a pair and the quantity increases to 750 pairs of running shoes.

Price (dollars per pair) 60 70 80 90 100 110

New Quantity Quantity demanded supplied (pairs per day) 1,100 400 1,000 500 900 600 800 700 700 800 600 900

“As more people buy fuel-efficient hybrid cars, the demand for gasoline will decrease and the price of gasoline will fall. The fall in the price of gasoline will decrease the supply of gasoline.” Is this statement true? Explain. The first statement is correct. As more people buy fuel-efficient cars, the demand for gasoline will decrease. The price of gasoline will fall. The second statement is false. The demand for gasoline decreases and the demand curve shifts leftward. There is a movement along the supply curve and a decrease in the quantity of gasoline supplied but no change in supply.

OPEC and allies agree to cut oil production With oil prices stuck at a low of $60-a-barrel , major oil producers agree to cut crude production. Source: CNBC, December 7, 2018 Explain and illustrate on a graph of the oil market the effect of this decision on the market equilibrium. The market initially is in equilibrium in Figure 4.1 with demand curve D and supply curve S0. The initial equilibrium price is $60 per barrel of oil and the initial equilibrium quantity is 100 million barrels per day. When OPEC agreed to decrease the supply, the supply curve shifts leftward, as illustrated in Figure 4.1 by the shift

from S0 to S1. In the figure the price of a barrel of oil rises from $60 per barrel to $63 per barrel and the quantity decreases by 1.2 million barrels, from 100 million barrels per day to 98.8 million barrels per day. Use the following information to work Problems 7 and 8. Chinese hog farms ‘panic’ as swine virus shrinks herds China produces half the world’s pork, but 80 percent of China’s hog farms are not going to restock as a swine fever spreads. Farmers fatten hogs with soybean, so imports of soybeans are expected to fall by 85 million tons by September. Source: Bloomberg, April 22, 2019

Part 1 . INTRODUCTION

Explain how the virus will change the prices of hogs, soybean, and pork. The virus decreases the supply of hogs and pork, so their prices will rise. Because farmers use soybeans to feed their hogs, fewer hogs decreases the demand for soybeans decreases, so the price of soybeans falls.

Use graphs to show how supply and demand will change in the markets for corn, soybean, and wheat.

The effect in the market for hogs and pork is similar, so Figure 4.2(a) uses pork as the example. The virus decreases the supply of pork, thereby shifting the supply curve leftward from S0 to S1. The price of pork rises, in the figure from $2.50 per pound to $3.00 per pound, and the equilibrium quantity decreases, from 600 million pounds to 400 million pounds. Figure 4.2(b) shows the effect in the market for soybeans. The decrease in demand for soybeans shifts the demand curve leftward from D0 to D1. The price of soybeans falls, in the figure from $5.90 per bushel to $5.70 per bushel, and the equilibrium quantity decreases, from 800 million bushels to 700 million bushels. 9.

Read Eye on the Price of Avocados on p. 105 and explain how we know that the price increased during August 2018 because the supply of avocados decreased and not because the demand for avocados increased. When the supply decreases, the price rises and the quantity decreases and when the demand increases the price also rises but the quantity increases. .The table shows that when the equilibrium price of an avocado rose during August, the equilibrium quantity decreased, so the price rise had to be the result of a decrease in supply rather than an increase in demand.

Chapter 4 . Demand and Supply

 Additional Problems and Applications 1.

Read Eye on the Price of Avocados on p. 105. Why can we be confident that the market for avocados is competitive and that a decrease in supply rather than the greed of avocado growers is the reason for the August 2018 rise in price? There are thousands of avocado growers and buyers, so the market for avocados is competitive—no one buyer or seller can influence the price. Greedy growers cannot successfully raise the price above its equilibrium. If greedy growers raised their price, there would be movements up along the demand curve, reducing the quantity demanded, and up along the supply curve, increasing the quantity supplied. The result would be a surplus of avocados, which would force the price to fall back to its equilibrium. What is the effect on the equilibrium price and equilibrium quantity of orange juice if the price of apple juice decreases and the wage rate paid to orange grove workers increases? Apple juice and orange juice are substitutes for consumers, so the fall in the price of apple juice decreases the demand for orange juice. The demand curve for orange juice shifts leftward. The increase in the wage rate paid to orange grove workers raises the cost of producing oranges and thereby boosts the cost of producing orange juice. The supply of orange juice decreases and the supply curve of orange juice shifts leftward. The net effect of these events decreases the equilibrium quantity but has an undetermined effect on equilibrium price. If supply decreases by more than the demand decreases, the equilibrium price rises. If demand decreases more than the supply decreases, the equilibrium price falls. And if they decrease by the same amount, the equilibrium price does not change. What is the effect on the equilibrium in the orange juice market if orange juice becomes more popular and a cheaper robot is used to pick oranges? Because orange juice becomes more popular, demand increases and the demand curve for orange juice shifts rightward. The cheaper picking robot lowers the production costs of orange juice, so the supply of orange juice increases and the supply curve of orange juice shifts rightward. The equilibrium quantity increases. But the effect on the equilibrium price is ambiguous. If the increase in supply is greater than the increase in demand, the equilibrium price falls. If the increase in demand is greater than the increase in supply, the equilibrium price rises. And if the increase is the same size, then the equilibrium price does not change. Why oil and gasoline prices are rising faster than expected The oil price has risen faster than expected because demand has been stronger than expected and U.S. sanctions on Iran and Venezuela have removed a cushion to absorb oil supply disruptions. Source: CNBC, April 3, 2019

Part 1 . INTRODUCTION

Using the information in the news clip, what can you say about the equilibrium quantities of oil and gasoline? In the market for oil, demand increased. By itself, an increase in demand increases the equilibrium quantity. The sanctions on Iran and Venezuela, however, decrease the supply of oil, which, by itself, decreases the equilibrium quantity. The effect on the equilibrium quantity of oil is ambiguous because we do not know if the demand effect is larger or if the supply effect is stronger. The news clip says that the price of oil rose. Because oil is a resource used to produce gasoline, the higher price of this factor of production decreases the supply of gasoline, so the equilibrium quantity of gasoline decreases. The table shows the demand and supply Price Quantity Quantity schedules for boxes of chocolates in an av(dollars demanded supplied per box) erage week. Use this information to work (boxes per week) 13.00 1,600 1,200 Problems 5 and 6. 14.00 1,500 1,300 5. If the price of chocolates is $17.00 a 15.00 1,400 1,400 box, describe the situation in the mar16.00 1,300 1,500 ket. Explain how market equilibrium 17.00 1,200 1,600 is restored. 18.00 1,100 1,700 At the price of $15.00 a box, the quantity supplied equals the quantity demanded. At a price of $17.00 a box, the quantity demanded is 1,200 boxes and the quantity supplied is 1,600 boxes. There is a surplus of 400 boxes a week and the price falls. As the price falls, the quantity demanded increases, the quantity supplied decreases, and the surplus decreases. The price falls until the surplus disappears. The market equilibrium occurs at a price of $15.00 a box and 1,400 boxes a week so the price falls to $15.00 a box. 6.

During Valentine’s week, more people buy chocolates and chocolatiers offer their chocolates in special red boxes, which cost more to produce than the everyday box. Set out the three-step process of analysis and show on a graph the adjustment process to the new equilibrium. Describe the changes in the equilibrium price and the equilibrium quantity. Starting with the demand side, Valentine’s week increases people’s preferences for boxes of chocolate so the demand for boxes of chocolate increases. The demand curve for chocolates shifts rightward, from D0 to D1 in Figure 4.4 (on the next page). Moving to the supply side, the fancy red box raises the cost of producing boxes of chocolate, which decreases the supply. The rise in the cost of producing boxes of chocolates shifts the supply curve leftward, from S0 to S1 in Figure 4.4. After these changes, at the initial price of a box of chocolate, $15.00, in Figure 4.4 there is a shortage of 600 boxes of chocolate per week. The shortage forces the price higher,

Chapter 4 . Demand and Supply

so the equilibrium price of a box of chocolate rises, to $18.00 in the figure. The problem points out that people buy more boxes of chocolate during Valentine’s week. This result means that the change in demand exceeds the change in the supply, that is, the magnitude of the increase in demand exceeds that of the decrease in supply. Figure 4.4 illustrates this situation and in the figure the equilibrium quantity increases from 1,400 boxes per week to 1,500 boxes per week. 7.

After a severe bout of foreclosures and defaults on home loans, banks made it harder for people to borrow. How does this change influence the demand for new homes, the supply of new homes, and the price of a new home? Illustrate your answer with a graphical analysis. The demand for homes decreases, the supply of new homes does not change, and the price of new homes falls. Figure 4.5 shows the effect of making home loans more difficult to obtain. Before the change in difficulty, the demand curve is D0. In the figure the price of a new home is $350,000. After the increase in difficulty, the demand decreases and the demand curve shifts leftward, in the figure from D0 to D1. The supply curve does not shift. The price of a new home falls, in the figure from $350,000 to $275,000.

China turns caviar into a cheap snack The price of caviar crashed from $24 an ounce in January 2012 to a bit less than $10 an ounce in November 2018. China has become a big producer and from 2012 to 2017, U.S. imports of Chinese caviar increased fivefold. Source: The Washington Post, April 22, 2018 Use the demand and supply model to explain why the quantity of caviar consumed has increased and the price of caviar has fallen. What most likely happened to the demand for caviar and the quantity of caviar demanded?

Part 1 . INTRODUCTION

The increase in Chinese production of caviar increased the supply of caviar. Consequently, the price of caviar fell and the quantity sold increased. It is likely that the demand for caviar did not change. Instead, as Figure 4.6 illustrates, there is a movement down along the demand curve, which reflects in an increase in the quantity of caviar demanded. 9.

“As more people buy smartphones, the demand for smartphone service increases and the price of smartphone service falls, which decreases the supply of smartphone service.” Is this statement true or false? Explain. The assertion that the demand for smartphone service increases as more people buy smartphones is true. However the claim that the increase in demand reduces the price of smartphone service is false; the increase in demand raises the price of smartphone services. The second sentence is false. Regardless of whether the price of smartphone service rises or falls, the supply of smartphone service does not change. Rather the change in price changes the quantity of smartphone service supplied.

10. Record number waiting to upgrade cell phones Faced with a $1,000 price tag for an old-tech phone, consumers may be waiting for the new 5G technology coming before buying a replacement phone. Source: Bloomberg, April 24, 2019 Explain how the expected arrival in 2020 of a new technology cell-phone service might influence the equilibrium price and quantity of cell phones in 2019 and 2020. Source: The Wall Street Journal, September 8, 2015 In 2019, the expected arrival of new technology cell-phone service might lead consumers to decrease their demand for phones in order to wait for new phones that they are certain can use the new technology. The decrease in the demand shifts the demand curve leftward, so the equilibrium price of a cell phone falls and the equilibrium quantity decreases. In 2020, new 5G compatible cell phones become available. For a given supply, if the demand for cell phones increases, the equilibrium price of a cell phone rises and the equilibrium quantity of cell phones increases.

Chapter 4 . Demand and Supply

 Multiple Choice Quiz 1.

Which of the following events illustrates the law of demand: Other things remaining the same, a rise in the price of a good will ________ . A. decrease the quantity demanded of that good B. increase the demand for a substitute of that good C. decrease the demand for the good D. increase the demand for a complement of that good Answer: A The law of demand is the inverse relationship between the price of a good and the quantity demanded. 2.

In the market for jeans, which of the following events increases the demand for a pair of jeans? A. The wage rate paid to garment workers rises. B. The price of a denim skirt (a substitute for jeans) rises. C. The price of denim cloth falls. D. New technology reduces the time it takes to make a pair of jeans. Answer: B The other factors listed change the supply; only answer B increases the demand.

Other things remaining the same, a fall in the price of peanuts will ________. A. increase the supply of peanuts B. decrease the supply of peanut butter C. decrease the quantity supplied of peanuts D. decrease the supply of peanuts Answer: C A fall in the price of the good creates a movement along the supply curve and decreases the quantity supplied.

In the market for smartphones, which of the following events increases the supply of smartphones? A. New technology lowers the cost of making a smartphone B. Rise in the price of an e-book reader (a substitute in production) C. An increase in people’s incomes D. A rise in the wage rate paid to electronics workers Answer: A Answers B and D decrease the supply of smartphones; answer C affects the demand for smartphones.

Part 1 . INTRODUCTION

When floods wiped out the banana crop in Central America, the equilibrium price of bananas ________ and the equilibrium quantity of bananas ________. A. rose; increased B. rose; decreased C. fell; increased D. fell; decreased Answer: B Figure 4.12(b) illustrates this case of a decrease in supply. 6.

A decrease in the demand for chocolate with no change in supply will create a ________ of chocolate at today’s price, but gradually the price will ________. A. surplus; fall B. shortage; fall C. surplus; rise D. shortage; rise Answer: A Figure 4.11(b) illustrates this case of a decrease in demand. 7.

Many Americans are selling their used cars and buying new fuel-efficient hybrids. Other things remaining the same, in the market for used cars, ________ and in the market for hybrids ________. A. supply increases and the price falls; demand increases and the price rises B. demand decreases and the price rises; supply increases and the price falls C. both demand and supply decrease and the price might rise, fall, or not change; demand increases and the price rises D. demand decreases, supply increases, and the price falls; supply increases and the price falls Answer: A Selling their used cars increases the supply of used cars. Buying new hybrids increases the demand for hybrids.

GDP: A Measure of Total Production and Income ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications 1.

Figure 21.1 shows the flows of income and expenditure in an economy. In 2013, U was $2 trillion, V was $1.5 trillion, W was $7 trillion, J was $1.5 trillion, and Z was zero. Calculate total income, net taxes, and GDP. Total income (which is flow Q) equals total expenditure, the sum of consumption expenditure, investment, government expenditure on goods and services, and net exports of goods and services. Flow U is government expenditure on goods and services, G; flow W is consumption expenditure, C; flow J is investment, I; and flow Z is net exports of goods and services, NX. Total expenditure equals $7 trillion + $1.5 trillion + $2 trillion + $0, which is $10.5 trillion, so total income also equals $10.5 trillion. Net taxes equal total income minus consumption expenditure and saving. Total income is $10.5 trillion. Consumption expenditure is $7 trillion. Saving is the flow into the financial markets (flow V) and equals $1.5 trillion. So net taxes equal $10.5 trillion − $7 trillion − $1.5 trillion, which is $2 trillion. Total income equals total expenditure which equals GDP, so GDP equals $10.5 trillion.

Use the following information to work Problems 2 and 3. The national accounts of Parchment Paradise are kept on (you guessed it) parchment. A fire in the statistics office destroys some accounts, leaving only the following data: • GDP (income approach) $2,900

Chapter

240

Part 8 . MONITORING THE MACROECONOMY

• Consumption expenditure $2,000 • Indirect taxes less subsidies $100 • Interest, rent, and profit $500 • Investment $800 • Government expenditure $400 • Wages $2,000 • Net factor income from abroad $50 • Net exports –$200 2. Calculate GDP (expenditure approach) and depreciation. For the expenditure approach, GDP equals the sum of consumption expenditure, investment, government expenditure on goods and services, and net exports. Fortunately, these data were saved from the fire. Hence GDP = C + I + G + NX = $2,000 + $800 + $400 − $200 = $3,000. From the income approach, GDP equals the sum of wages plus interest, rent, and profit plus indirect taxes less subsidies plus depreciation. The value of the income approach GDP survived the fire and is $2,900. The sum of wages plus interest, rent, and profit plus indirect taxes less subsidies equals $2,000 + $500 + $100 = $2,600. So depreciation equals $2,900 − $2,600 = $300. 3.

Calculate net domestic product at factor cost, the statistical discrepancy, and GNP. Net domestic product at factor cost equals the sum of wages, interest, rent, and profit. Once again, all these data were fortunately saved from the fire, so net domestic product at factor cost = $2,000 + $500 = $2,500. The statistical discrepancy equals GDP from the expenditure approach, $3,000 from problem 2, minus GDP from the income approach, $2,900. So the statistical discrepancy is $100. GNP equals GDP plus net factor income from abroad. From problem 2, GDP is $3,000. Net factor income from abroad is $50. So GNP equals $3,000 + $50 = $3,050.

Use the following information to work Problems 4 to 6. An economy produces only fun and food. The table shows the prices and the quantities of fun and food produced in 2020 and 2021. The base year is 2020. 4. Calculate nominal GDP in 2020 and 2021. Nominal GDP in 2020 is equal to (40 units of fun × $2) + (60 units of food × $3) = $260. Nominal GDP in 2021 is equal to (35 units of fun × $3) + (65 units of food × $2) = $235.

GDP data for 2020 Item Quantity Price Fun 40 $2 Food 60 $3 GDP data for 2021 Item Quantity Price Fun 35 $3 Food 65 $2

Chapter 21 . GDP: A Measure of Total Production and Income

Calculate the percentage increase in real GDP in 2021. In the base year, real GDP equals nominal GDP, so real GDP in 2020 is $260. Using prices from 2020, real GDP in 2020 is $260 and real GDP in 2021 is $265. Using 2020 prices, real GDP grew [($265 − $260)/$260] x 100, or 1.9 percent.

If potential GDP was $270 in 2020 and it grew by 1 percent in 2021, in which phase of the business cycle is the economy? Explain. Real GDP in 2020 is $260 and in 2021 is $265. Between 2020 and 2021, real GDP grew so the economy is in the expansion phase of the business cycle.

Use the following information to work Problems 7 to 9. The Commerce Department reported that in December 2015, retail sales rose by 0.2, net exports decreased, inventories held by businesses rose by 0.1 percent, and total sales by businesses fell by 0.6 percent. Source: Commerce Department, February 2016 7. Which component of GDP changed because retail sales increased? Which component of GDP changed because business inventories increased? The increase in retail sales means that consumption expenditure on goods and services increased. The increase in inventories held by businesses means that investment increased. 8.

Explain the effect of the fall in net exports on GDP. Because net exports is part of GDP, the fall in net exports means that GDP decreases.

Does the statement that total sales by businesses fell by 0.6 percent mean that GDP decreased by 0.6 percent? Explain your answer. The statement “total sales by businesses” does not specify whether these sales include final goods and intermediate goods or just final goods. If it includes intermediate goods, then GDP did not necessarily fall by 0.6 percent. In this case GDP might actually rise because some components of GDP—retail sales—increased.

10. Read Eye on the Booms and Busts on p. 556 and explain why the NBER reported that the 2008 recession began before real GDP had fallen for two successive quarters. The NBER dated the start of the 2008 recession before real GDP had fallen for two consecutive quarters because other relevant data, such as real personal income, real manufacturing, wholesale and retail sales, industrial production, and employment all peaked before real GDP had fallen for two successive quarters.

241

Part 8 . MONITORING THE MACROECONOMY

242

 Additional Problems and Applications 1.

Read Eye on Booms and Busts on p. 556 and work the following exercise: In Brazil, real GDP in the first quarter of 2019 was lower than in the fourth quarter of 2018 and was lower in the second quarter of 2019 than in the first quarter. In the United States, real GDP increased during the first two quarters of 2018. Based on this information, which country was in a recession in 2019? What features of the information provided led you to your conclusion? Brazil was in a recession because Brazil’s real GDP had decreased for two successive quarters.

Classify each of the following items as a final good or service or an intermediate good or service and identify it as a component of consumption expenditure, investment, or government expenditure on goods and services: • Banking services bought by Target Banking services purchased by Target is an intermediate service. •

Security system bought by the White House The security system purchased by the White House is a final good. It is part of government expenditure on goods and services.

•

Coffee beans bought by Starbucks Coffee beans purchased by Starbucks are an intermediate good.

•

New coffee machines bought by Starbucks New coffee machines purchased by Starbucks are final goods. They are part of investment.

•

Starbuck’s grande mocha frappuccino bought by a student The student’s purchase is a final good. It is part of consumption expenditure on goods and services.

•

New battle ship bought by the U.S. navy The new battle ship purchased by the U.S. navy is a final good. It is part of government expenditure on goods and services.

Use the following information to work Problems 3 and 4. Mitsubishi Heavy Industries makes the wings of the new Boeing 787 Dreamliner in Japan. Toyota assembles cars for the U.S. market in Kentucky. 3. Explain where these activities appear in the National Income and Product Accounts of the United States. When the Dreamliner wings are sent from Japan to the United States, they are counted in the U.S. National Income and Product Accounts as imports, which is a negative entry in the expenditure approach to U.S. GDP. If any U.S. factors of production are employed in Japan making these

Chapter 21 . GDP: A Measure of Total Production and Income

wings (say, a supervisor from Boeing or a Boeing engineer), their income is part of “net factor income from abroad” and will be counted as part of U.S. GNP but not U.S. GDP. Toyota’s production of cars in Kentucky is included in U.S. GDP because it represents production within the United States. Expenditure on the cars is counted as part of consumption expenditure (if the cars are purchased by U.S. consumers) or investment (if the cars are purchased by U.S. firms) or government expenditure (if the cars are purchased by a government) in the expenditure approach to GDP. If any of the parts of the cars are imported from Japan, the value of these parts is included among U.S. imports. The incomes earned by the factors of production that produce the cars are part of the wages, interest, rent, and profit income that are used in the income approach to GDP. Finally, if any of the factors of production are foreign—say a Japanese citizen who supervises the production—the income of that factor is part of U.S. GDP but not part of U.S. GNP. 4.

Explain where these activities appear in the National Income and Product Accounts of Japan. Mitsubishi Heavy Industries’ production of Dreamliner wings in Japan is included in Japanese GDP because it represents production within Japan. When these wings are sent to the United States, they are counted in the National Income and Product Accounts as part of Japanese exports. If any of the parts of wings are imported into Japan, the value of these parts is included among Japanese imports. The incomes earned by the factors of production that produce the wings are part of the wages, interest, rent, and profit income that are used in the income approach to GDP. Finally, if any of the factors of production are foreign—say a U.S. citizen who supervises the production—the income of that factor is part of Japan’s GDP but not part of Japan’s GNP. Toyota’s production of cars in Kentucky is not directly included in Japan’s GDP unless some of the parts for these cars are exported from Japan to the United States. In that case the value of the parts are included in Japan’s GDP as exports. The production of these cars is included in Japan’s GNP if any Japanese-owned factors of production are used to produce the cars, such as a Japanese engineer sent from Japan to the United States to supervise the production. The income of these factors appears in the Japanese National Income and Product Accounts as “net factor income from abroad.”

Use the following data on the economy of Iberia to work Problems 5 and 6. • Net taxes $18 billion • Government expenditure $20 billion • Saving $15 billion

243

244

Part 8 . MONITORING THE MACROECONOMY

• Consumption expenditure $67 billion • Investment $21 billion • Exports $30 billion 5. Calculate Iberia’s GDP. Because the value of income equals the value of production, that is, the value of income equals GDP, Y = C + S + NT = GDP. So for Iberia, GDP = $67 billion + $15 billion + $18 billion, which is $100 billion. 6. Calculate Iberia’s imports of goods and services. GDP equals C +I +G +NX. Rearranging, NX = GDP − C − I − G. So Iberia’s net exports equal $100 billion − $67 billion − $21 billion − $20 billion, which is −$8 billion. Net exports equal exports − imports, so imports equal exports minus net exports. Iberia’s imports equal $30 billion − (−$8 billion), which is $38 billion. Use the table, which shows an economy’s total production and the prices of the final goods it produced in 2020 and 2021, to work Problems 7 to 9. 7. Calculate nominal GDP in 2020 and 2021. Nominal GDP in 2020 is equal to (100 fish × $2) + (50 berries × $6) = $500. Nominal GDP in 2021 is equal to (75 fish × $5) + (65 GDP data for 2020 berries × $10) = $1,025. Item Quantity Price 8. The base year is 2020. Calculate real GDP in 2020 Fish 100 $2 and 2021. Berries 50 $6 In the base year, real GDP equals nominal GDP, so real GDP in 2020 is $500. Real GDP in 2021 uses GDP data for 2021 2021 quantities and 2020 prices and so equals (75 Quantity Price Item fish × $2) + (65 berries × $6) = $540. Fish 75 $5 Berries 65 $10 9. Calculate the percentage increase in real GDP in 2021. The percentage increase in real GDP equals [($540 − $500)/$500] x 100, or 8.0 percent. Use the following information to work Problems 10 and 11. Investors snapping up US homes at record levels With confidence in the housing market and low mortgage interest rates, U.S. investors are buying new and existing homes at a record high rate. Source: Fox News, August 8, 2019 10. Where do new-home sales appear in the circular flow of expenditure and income? Explain how a surge in new home sales affects real GDP. The purchase of a new home is counted as investment and so it appears with the rest of investment. An increase in new home sales increases real GDP.

Chapter 21 . GDP: A Measure of Total Production and Income

11. Where do sales and inventories of existing homes appear in the circular flow of expenditure and income? Explain how an increase in sales of existing homes and a low inventory of existing homes affects real GDP. Sales of previously owned homes are sales of used goods; they were not produced in the current time period. For that reason they also do not appear in the circular flow of expenditure and income. Just as a sale of a used good does not add to GDP, an increase in sales of previously owned homes have no direct impact on real GDP. (A real estate commission paid to sell a used home, however, does add to GDP because it is a part of current production.) 12. China GDP growth slows to 27-year low China’s economic growth slowed to 6.2% in the second quarter, its weakest pace in at least 27 years, as demand at home and abroad faltered in the face of mounting U.S. trade pressure. Source: Reuters, July 15, 2019 How does China’s real GDP growth compare with that of the United States? If China’s growth slows further, would that mean it was in a recession? Even at 6.2 percent, China’s real GDP is much higher than that of the United States. If China’s growth rate falls further, it is not in a recession. To be in a recession, the growth rate must be negative for at least two successive, not just falling for two successive quarters.

245

246

Part 8 . MONITORING THE MACROECONOMY

 Multiple Choice Quiz 1.

Gross domestic product is the market value of all the _______ in a given time period. A. goods and services bought by Americans B. goods and services produced by American companies in all countries C. final goods and services produced by all firms located in the United States D. U.S.-produced goods and services bought in the United States Answer: C Answer C is the definition of GDP. 2.

A ________ is a final good and ________ is an intermediate good. A. new car bought by a student; a used SUV bought by a dealer B. new textbook; a used textbook C. new iPhone bought by a student; a new computer bought by WalMart to manage its inventories D. tank of gasoline bought by you; jet fuel bought by Southwest Airlines Answer: D The gasoline has been purchased by its ultimate user, so it is a final good; the jet fuel purchased by Southwest Airlines will be used to help produce an service, airline flights, so it is an intermediate good. 3.

Saving equals ________. A. income minus consumption expenditure minus net taxes B. income minus net taxes C. total income minus total expenditure D. net taxes minus government expenditure Answer: A Saving is what is left from income after consumption expenditure and net taxes are paid. 4.

The expenditure approach to measuring U.S. GDP equals _________. A. the sum of U.S. consumption expenditure and U.S. investment B. U.S. government expenditure minus taxes paid by Americans C. all expenditure on final goods and services produced in the United States in a given time period D. all expenditure by Americans on goods and services produced in the United States in a given time period Answer: D Answer D is effectively the definition of the expenditure approach.

Chapter 21 . GDP: A Measure of Total Production and Income

When using the income approach to measure GDP at market prices, in addition to summing all factor incomes it is necessary to ________. A. subtract depreciation because profit is not reported as net profit B. add depreciation because capital depreciates when goods are manufactured C. add indirect taxes less subsidies to convert aggregate income from factor cost to market prices D. add a statistical discrepancy which is the sum of depreciation and indirect taxes less subsidies Answer: C Because factor cost does not include indirect taxes but does include subsidies, it is necessary to add indirect taxes and subtract subsidies to change the factor cost to the market prices. 6.

The following statements about the business cycle are correct except ______. A. it is a regular predictable cycle in real GDP around potential GDP B. from the peak to the trough, the economy is in a recession C. from the trough to the peak, the economy is in an expansion D. it is a periodic movement in economic activity including employment Answer: A The business cycle fluctuations around potential GDP are irregular and difficult to predict. 7.

Real GDP per person is not an accurate measure of the standard of living because it ______. A. includes the goods and services that governments buy B. omits the goods and services that people produce for themselves C. includes goods and services bought by firms D. omits the goods and services imported from other countries Answer: B In less developed nations, GDP is a poor measure of the standard of living because much of a person’s consumption is produced by the person themself.

247

Chapter

Appendix: Measuring Real GDP ANSWERS TO APPENDIX CHECKPOINTS

 Problems and Applications An island economy produces 2018 2019 only bananas and coconuts. The Item Quantity Price Quantity Price table gives the quantities produced and prices in 2018 and Bananas 100 $10 110 $15 in 2019. The base year is 2018. Coconuts 50 $12 60 $10 1. Calculate nominal GDP in 2018 and nominal GDP in 2019. Nominal GDP in 2018 = ($10 × 100) + ($12 × 50) = $1,000 + $600 = $1,600. Nominal GDP in 2019 = ($15 × 110) + ($10 × 60) = $1,650 + $600 = $2,250. 2.

Calculate the value of 2019 production in 2018 prices and the percentage increase in production when valued at 2018 prices. Using 2018 prices, the value of 2019 production is ($10 × 110) + ($12 × 60) = $1,100 + $720 = $1,820. In 2018 prices, GDP in 2018 is $1,600 so the value of production increased from $1,600 to $1,820, an increase of $220. The percentage increase is equal to ($220 ÷ $1,600) × 100, which is 13.75 percent.

Calculate the value of 2018 production in 2019 prices and the percentage increase in production when valued at 2019 prices. Using 2019 prices, the value of 2018 production is ($15 × 100) + ($10 × 50) = $1,500 + $500 = $2,000. In 2019 prices, GDP in 2019 is $2,250 so the value of production increased from $2,000 to $2,250, an increase of $250. The percentage increase is equal to ($250 ÷ $2,000) × 100, which is 12.5 percent.

Use the chained-dollar method to calculate real GDP in 2018 and 2019. In terms of what dollars is each of these two real GDPs measured? Real GDP in 2018 = $1,600. It is equal to nominal GDP because 2018 is the base year. To calculate real GDP in 2019 compute the growth rate of real GDP between 2018 and 2019. That growth rate is the average of the growth rates

250

Part 8 . MONITORING THE MACROECONOMY

between 2018 and 2019 using prices from 2018 and using prices from 2019. Taking the average of the answers to Problems 2 and 3 gives an average percentage increase of 13.13 percent. This result means that real GDP in 2019 is 13.13 percent greater than real GDP in 2018. Real GDP in 2018 was $1,600, so real GDP in 2019 equals ($1,600) × (1.1313), which is $1,810.08. These real GDPs are in terms of 2018 dollars. 5.

Using the chained-dollar method, compare the growth rates of nominal GDP and real GDP in 2019. Between 2018 and 2019, nominal GDP increased from $1,600 to $2,250, an increase of $650. The growth rate of nominal GDP is ($650 ÷ $1,600) × 100, which is 40.6 percent. The growth rate of real GDP is 13.13 percent, so nominal GDP grew much more rapidly than did real GDP.

If the base year is 2019, use the chained-dollar method to calculate real GDP in 2018 and 2019. In terms of what dollars is each of these two real GDPs measured? Real GDP in 2019 = $2,250. It is equal to nominal GDP because 2019 is the base year. To calculate real GDP in 2018 compute the growth rate of real GDP between 2018 and 2019. That growth rate is the average of the growth rates between 2018 and 2019 using prices from 2018 and using prices from 2019. Taking the average of the answers to Problems 2 and 3 gives an average percentage increase of 13.13 percent. This result means that real GDP in 2019 is 13.13 percent greater than real GDP in 2018 so real GDP in 2018 equals ($2,250) ÷ (1.1313), which is $1,988.86. These real GDPs are in terms of 2019 dollars.

If the base year is 2019, compare the growth rates of nominal GDP and real GDP in 2019. From Problem 5, the growth rate of nominal GDP is 40.6 percent. From Problem 6, the growth rate of real GDP in 2019 dollars is 13.13 percent.

Appendix 21 . Measuring Real GDP

251

 Additional Problems and Applications An economy produces only 2018 2019 food and fun. The table Item Quantity Price Quantity Price shows the quantities produced and prices in 2018 and Food 100 $2 75 $5 2019. The base year is 2019. Fun 50 $6 65 $10 1. Calculate nominal GDP in 2018 and nominal GDP in 2019. Nominal GDP in 2018= ($2 × 100) + ($6 × 50) = $200 + $300 = $500. Nominal GDP in 2019 = ($5 × 75) + ($10 × 65) = $375 + $650 = $1,025. 2.

Calculate the value of 2019 production in 2018 prices and the percentage increase in production when valued at 2018 prices. Using 2018 prices, the value of 2019 production is ($2 × 75) + ($6 × 65) = $150 + $390 = $540. In 2018 prices, GDP in 2018 is $500 so the value of production increased from $500 to $540, an increase of $40. The percentage increase is equal to ($40 ÷ $500) × 100, which is 8.00 percent.

Calculate the value of 2018 production in 2019 prices and the percentage increase in production when valued at 2019 prices. Using 2019 prices, the value of 2018 production is ($5 × 100) + ($10 × 50) = $500 + $500 = $1,000. In 2019 prices, GDP in 2019 is $1,025 so the value of production increased from $1,000 to $1,025, an increase of $25. The percentage increase is equal to ($25 ÷ $1,000) × 100, which is 2.50 percent.

Using the chained-dollar method, calculate real GDP in 2018 and 2019. In terms of what dollars is each of these two real GDPs measured? Real GDP in 2019 = $1,025. It is equal to nominal GDP because 2019 is the base year. To calculate real GDP in 2018 compute the growth rate of real GDP between 2018 and 2019. That growth rate is the average of the growth rates between 2018 and 2019 using prices from 2018 and using prices from 2019. Taking the average of the answers to Problems 2 and 3 gives an average percentage increase of 5.25 percent. This result means that real GDP in 2019 is 5.25 percent larger than real GDP in 2018 so real GDP in 2018 equals ($1,025) ÷ (1.0525), which is $973.87. These real GDPs are in terms of 2019 dollars.

Using the chained-dollar method, compare the growth rates of nominal GDP and real GDP in 2019. Between 2018 and 2019, nominal GDP increased from $500 to $1,025, an increase of $525. The growth rate of nominal GDP is ($525 ÷ $500) × 100, which is 105 percent. The growth rate of real GDP is 5.25 percent, so nominal GDP grew much more rapidly than did real GDP.

252

Part 8 . MONITORING THE MACROECONOMY

If the base year is 2018, use the chained-dollar method to calculate real GDP in 2018 and 2019. In terms of what dollars is each of these two real GDPs measured? Real GDP in 2018 = $500. It is equal to nominal GDP because 2018 is the base year. To calculate real GDP in 2019 compute the growth rate of real GDP between 2018 and 2019. That growth rate is the average of the growth rates between 2018 and 2019 using prices from 2018 and using prices from 2019. Taking the average of the answers to Problems 2 and 3 gives an average percentage increase of 5.25 percent. This result means that real GDP in 2019 is 5.25 percent larger than real GDP in 2018. Based on this percentage growth rate, real GDP in 2019 equals ($500) × (1.0525), which is $526.25. These real GDPs are in terms of 2018 dollars.

If the base year is 2018, compare the growth rates of nominal GDP and real GDP in 2019. From Problem 5, the growth rate of nominal GDP is 105 percent. From Problem 6, the growth rate of real GDP in 2018 dollars is 5.25 percent. Nominal GDP (still) grew much more rapidly than did real GDP.

Chapter

Jobs and Unemployment ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications Use the following information gathered by a BLS labor market survey of four households to work Problems 1 and 2. • Household 1: Candy worked 20 hours last week setting up her Internet shopping business. The rest of the week, she completed application forms and attended two job interviews. Husband Jerry worked 40 hours at his job at GM. Daughter Meg, a student, worked 10 hours at her weekend job at Starbucks.

•

Household 2: Joey, a full-time bank clerk, was on vacation. Wife, Serena, who wants a full-time job, worked 10 hours as a part-time checkout clerk.

•

Household 3: Ari had no work last week but was going to be recalled to his regular job in two weeks. Partner Kosta, after months of searching for a job and not being able to find one, has stopped looking and will go back to school.

•

Household 4: Mimi and Henry are retired. Son Hank is a professional artist, who painted for 12 hours last week and sold one picture. Classify each of the 10 people into the labor market category used by the BLS. Who are part-time workers and who are full-time workers? Of the part-time workers, who works part time for economic reasons? Candy is employed because she worked for more than 15 hours at her family business. Jerry is employed because he worked full time at General Motors. Their 17-year old daughter, Meg, is employed because she worked for more than 1 hour as a paid employee. All three are in the labor force and in the working-age population. Joey is employed because he is temporarily absent from his job. Serena is employed because she worked for more than 1 hour as a paid employee. Both are in the labor force and in the working-age population.

254

Part 8 . MONITORING THE MACROECONOMY

Ari is unemployed because he is waiting to be recalled to his job. Ari is in the labor force and in the working-age population. Kosta is in the working age population but is not in the labor force so Kosta is a marginally attached worker. Mimi and Henry are both in the working-age population. Mimi is not in the labor force. Hank is employed because he worked for more than 1 hour in his own business. He is in the labor force. Candy, Meg, and Serena are part-time workers. Jerry and Joey are fulltime workers. Candy and Serena are part time for economic reasons. 2.

Calculate the unemployment rate and the labor force participation rate, and compare these rates with those in the United States in 2019. The labor force is 7 people and 1 of the people is unemployed. The U-3 unemployment rate is (1 ÷ 7) × 100, which is 14.2 percent. The unemployment rate is higher than the U.S. unemployment rate, which was 3.7 percent in July, 2019. The labor force is 7 people and the working age population is 10 people. The labor force participation rate is (7 ÷ 10) × 10, which is 70 percent. The labor force participation rate is more than the U.S. labor force participation rate, which was 63.0 percent in July, 2019.

Describe two examples of people who work part time for economic reasons and two examples of people who work part time for noneconomic reasons. Sam is an associate at JCPenney and would like to work 40 hours per week. However sales at JCPenney are slow and so he is scheduled to work only 25 hours per week. Maria is a server at Olive Garden and would like to work at least 40 hours per week. But Maria is scheduled for only 20 hours per week because Olive Garden’s sales are down. Both Sam and Maria work part time for economic reasons. Mike is a student who wants to work 20 hours per week at Cost Cutters hair styling so that he can attend class and study. Cost Cutters schedules him for 20 hours per week. Lorri is partially retired and wants to work only 15 hours per week at Walgreens so that she may spend most of her time with her spouse. Walgreens schedules Lorri for 15 hours per week. Both Mike and Lorri work part time for noneconomic reasons.

Explain the relationship between the percentage of employed workers who have part-time jobs and the business cycle. When the economy goes into a recession, the percentage of workers who have part-time jobs for economic reasons rises. When the economy goes into an expansion, the percentage of workers who have part-time jobs for economic reasons falls. The percentage of workers who have part-time

Chapter 22 . Jobs and Unemployment

jobs for noneconomic reasons does not change through the business cycle. Because one component of part-time workers rises in a recession and falls in an expansion, the total percentage of workers who have part-time jobs rises in a recession and falls in an expansion. 5.

Distinguish among the three types of unemployment: frictional, structural, and cyclical. Provide an example of each type of unemployment in the United States today. Frictional unemployment is unemployment that arises from normal labor turnover—from people entering and leaving the labor force and from the ongoing creation and destruction of jobs. Structural unemployment is unemployment that arises when changes in technology or international competition change the skills needed to perform jobs or change the locations of jobs. And cyclical unemployment is the fluctuating unemployment over the business cycle that increases during a recession and decreases during an expansion. A college student graduating and entering the labor force to look for a job is frictionally unemployed. An assembly worker who is fired when the company moves production to Singapore is structurally unemployed. And an autoworker who is laid off when the economy contracts and Ford’s sales slump is cyclically unemployed.

Describe the relationship between the unemployment rate and the natural unemployment rate as the output gap fluctuates between being positive and being negative. When real GDP is less than potential GDP so that the output gap is negative, the unemployment rate is above the natural unemployment rate. When real GDP is greater than potential GDP so that the output gap is positive, the unemployment rate is below the natural unemployment rate. And, when real GDP equals potential GDP so that the output gap is zero, the unemployment rate equals the natural unemployment rate.

Use the following information to work Problems 7 and 8. US jobless rate at lowest since 1969 The U.S. unemployment rate fell from 3.8 percent to 3.6 percent in April, its lowest level for more than 49 years. The economy added jobs in construction and professional and healthcare services. But jobs in retailing shrank by 12,000 as shoppers moved online. Source: BBC News and careerbuilder.com, May 3, 2019 7. Using the information provided in the news clip, which types of unemployment were present in the U.S. economy in April 2019? The clip says that the United States is at the lowest unemployment rate in almost 50 years, so the only types of unemployment are structural and frictional unemployment.

255

256

Part 8 . MONITORING THE MACROECONOMY

How would you expect construction and professional and healthcare services to influence the actual and natural unemployment rates? If people who were previously unemployed fill the additional jobs in construction and professional and healthcare services or if new entrants to the labor force fill these jobs, the actual unemployment rate falls. Because the change in employment in the construction and professional and healthcare services is just normal labor turnover, the natural unemployment rate does not change.

Read Eye on Full Employment on pp. 582-583. In which year, 2010 or 2019, was real GDP below potential GDP? How can you tell from the graph on p. 584? The Z-Pop ratio shows that real GDP was below potential GDP. The ZPop ratio is the percentage of the working-age population that is fully utilized. The figure shows that before the 2008-2009 recession, 95.2 percent of the working-age population was fully utilized but in 2010, the Z-Pop ratio fell to 89.7 percent. Because the Z-Pop ratio in 2010 that is less than the ZPop ratio prior to the 2008-2009 recession, the economy is producing less than potential GDP. Real GDP is less than potential GDP. Additionally, the graph on page 584 shows that in 2010, the output gap was negative, which means that real GDP is below potential GDP.

Chapter 22 . Jobs and Unemployment

 Additional Problems and Applications 1.

Read Eye on Full Employment on pp. 582–583, then work the following exercises. • Compare the duration of unemployment in 2019 with that in 2000 and explain whether the difference was most likely the result of frictions, structural change, or the business cycle. The duration of unemployment was longer in 2019 than in 2000. In 2000, the business cycle was at a peak. In 2019, the economy is in a slow expansion, with the unemployment rate lower than the natural unemployment rate and the economy is at more than full employment. So it is most likely that the differences in the duration of unemployment is due to structural change. Structural unemployment fluctuates with the pace of technological change, and that change is driven by fierce international competition. • How does the unemployment of marginally attached workers influence the duration of unemployment in 2019 compared with that in 2000? U3 is the official measure of unemployment. U5 measures unemployment by including discouraged workers and other marginally attached workers. When the economy moves into a recession, both the official number of unemployed workers and the number of marginally attached workers increase. And, when the economy moves into an expansion, both the official number of unemployed workers and the number of marginally attached workers decrease. Because U5 and U3 fluctuate together and the number of marginally attached workers has no effect on the duration of unemployment.

The Bureau of Labor Statistics reported that in the second quarter of 2008 the working-age population was 233,410,000, the labor force was 154,294,000, and employment was 146,089,000. Calculate for that quarter the labor force participation rate and the unemployment rate. The labor force participation rate equals the number of people in the labor force divided by the working-age population, then multiplied by 100. (154,294,000 ÷ 233,410,000) × 100, which is 66.1 percent. The unemployment rate equals the number of unemployed workers divided by the labor force, then multiplied by 100. The number of unemployed workers equals the labor force minus the employment. So in the second quarter of 2008 the number of unemployed workers equaled 154,294,000 – 146,089,000, which is 8,205,000. Thus the unemployment rate equals (8,205,000 ÷ 154,294,000) × 100, which is 5.3 percent.

In July 2020, in the economy of Sandy Island, 10,000 people were employed and 1,000 were unemployed. During August 2020, 80 people lost

257

258

Part 8 . MONITORING THE MACROECONOMY

their jobs and didn’t look for new ones, 20 people quit their jobs and retired, 150 people who had looked for work were hired, 50 people became discouraged workers, and 40 new graduates looked for work. Calculate the change in the unemployment rate from July 2020 to August 2020. The unemployment rate in July is 9.1 percent. The unemployment rate is the number unemployed as a percentage of the labor force. The number of unemployed workers is 1,000. The labor force is the number employed plus the number unemployed so in July it is 11,000. The unemployment rate equals (1,000 ÷ 11,000) × 100, which is 9.1 percent. To calculate the unemployment rate, the number of people unemployed and the number employed are needed. The number of people who are unemployed at the end of August equals the number unemployed in July plus people who lost their jobs and who stayed in the labor market, plus new workers entering the labor market, such as new graduates, minus people who were hired and people who stopped looking for work, that is, became discouraged workers. So the number of people unemployed equals 1,000 + 40 − 150 − 50, which is 840. Next the number of people who are employed at the end of August equals the number employed in July minus people who lost jobs plus people who were hired, so the number employed is 10,050. The unemployment rate equals the number unemployed expressed as a percentage of the labor force. The labor force equals the number employed plus the number unemployed, so at the end of August it is 10,890. The unemployment rate at the end of August equals (840 ÷ 10,890) × 100, which is 7.7 percent. Between July and August, the unemployment rate fell by 1.4 percent from 9.1 percent to 7.7 percent. 4.

The BLS survey reported the following data in a community of 320 people: 200 worked at least 1 hour as paid employees; 20 did not work but were temporarily absent from their jobs; 40 did not have jobs and didn’t want to work; 10 were available for work and last week they had looked for work; and 6 were available for work and were waiting to be recalled to their previous job. Calculate the unemployment rate and the labor force participation rate. The number of employed people is 200 + 20, which is 220. The number of unemployed people is 10 + 6, which is 16. The labor force is 220 + 16, which is 236. So the unemployment rate is (16 ÷ 236) × 100, which is 6.8 percent. The total working age population is 200 + 20 + 40 + 10 + 6, which is 276. The labor force is 236. So the labor force participation rate is (236 ÷ 276) × 100, which is 85.5 percent.

Chapter 22 . Jobs and Unemployment

Describe the trends and fluctuations in the unemployment rate in the United States from 1949 through 2019. In which periods was the unemployment rate above average and in which periods was it below average? Between 1949 and 2019, the unemployment rate has fluctuated, falling in expansions and rising in recessions. It was generally lower than average from 1949 to 1958, though during recessions it rose. The unemployment rate fell again to below its average during the late 1960s but then generally rose above average in the 1970s and hit its post World War II peak, near 10 percent, in the 1982 recession. The unemployment rate, while falling through the 1980s, was generally above average. It rose again during the 1990-1991 recession but by the middle of the 1990s expansion it had fallen below its average. There was a slight rise around 2000, but the unemployment rate generally stayed near or a little below its average for most of the 2000s until 2008 when it rose well above its average during the most recent recession. Since 2009 the unemployment rate has fallen as the economy emerged from the 2008-2009 recession.

Describe how the labor force participation rate in the United States changed between 1960 and 2019. Contrast and explain the different trends in the labor force participation rates of women and men. Between 1960 through 2019, the labor force participation rate for men trended downward, from 83 percent to about 70 percent. The labor force participation rate for women trended upward, from 37 percent to 60 percent in about 1999 and has fallen slightly since then. The overall labor force participation rate trended slowly upward, from 59 percent to about 67 percent in 1999 and has fallen a little since then. The female participation rate increased for four reasons: more women pursued a college education and so increased their potential wages in the job market; technological change in the work place created a large number of white-collar jobs with flexible hours that women found attractive; technological change in the home increased the time available for paid employment; and, families wanted two incomes to balance tight budgets. The male labor force participation rate decreased for three reasons: some men retired early because of an increase in wealth; some men left the labor force because they lost jobs when they were older and finding a new job was difficult; and, more men remained in full-time education.

Explain why the natural unemployment rate is not zero and why the unemployment rate fluctuates around the natural unemployment rate. The natural unemployment rate includes frictional unemployment and structural unemployment. There are always people looking for work from just normal labor market turnover, so fictional unemployment is never zero. Similarly technological change and/or changes in international competition will always create some unemployment, so structural

259

260

Part 8 . MONITORING THE MACROECONOMY

unemployment is never zero. Because its components are never zero, the natural unemployment rate is never zero. Unemployment fluctuates around the natural unemployment because cyclical unemployment, which is included in the total unemployment but not in natural unemployment, fluctuates during the business cycle. Cyclical unemployment is negative during strong expansions and positive during recessions, so unemployment will sometimes be less than natural unemployment and sometimes more than natural unemployment. Use the following information to work Problems 8 and 9. The metro areas with the lowest and highest unemployment In June 2019, Ames, Iowa, had one of the lowest unemployment in the United States at 2.3 percent of the workforce. At the other end of the scale was El Centro, California, with 18.6 percent of its workforce unemployed. Source: Bureau pf Labor Statistics, August 1, 2019 In the depth of the 2008–2009 recession, the unemployment rate in Ames peaked at 5.7 percent. In El Centro, it peaked at 30.3 percent. 8. Use the information provided to estimate how much of the unemployment in Ames and El Centro in 2009 was cyclical and how much was natural. Explain your assumptions in arriving at your estimates. At full employment, the unemployment rate equals the natural unemployment rate. So, assuming that the unemployment rates in both Ames and El Centro are their natural unemployment rates, that means that the natural unemployment rates are 2.3 percent and 18.6 percent, respectively. Then in 2009 Ames’ natural unemployment rate was 2.3 percent, so that Ames’ cyclical unemployment rate equaled 5.7 percent – 2.3 percent, or 3.4 percent. And in El Centro in 2009, the natural unemployment rate was 18.6 percent so that El Centro’s cyclical unemployment rate equaled 30.3 percent – 18.6 percent = 11.7 percent. 9.

How would you explain the difference in the unemployment rates in Ames and El Centro in June 2019? Why is the difference almost certainly not explained by different cyclical unemployment rates? Because the U.S. economy was above full employment, there was no cyclical unemployment so the difference in the unemployment rates is surely the result of a difference in the natural unemployment rates.

Chapter 22 . Jobs and Unemployment

 Multiple Choice Quiz 1.

The BLS count Jody as being unemployed if she _______. A. had a job last month but not this month B. doesn’t have a job because the U.S. factory where she worked cannot compete with cheap Chinese imports C. wants a job and looked for a job last year but has now stopped looking D. wants a job and is willing to take a job but after searching last week cannot find a job Answer: D To be counted as unemployed, a person must be without a job, available for work, and made specific efforts to find a job within the past 4 weeks. 2.

A marginally attached worker is a person who ________. A. works part time for economic reasons B. works part time for noneconomic reasons C. doesn’t work, is available and willing to work, but hasn’t looked for job recently D. has no job but would like one and has gone back to school to retrain Answer: C Answer C is essentially the definition of a marginally attached worker. 3.

If the BLS included all marginally attached workers as being unemployed, the ________ would be __________. A. unemployment rate; higher B. labor force; unchanged C. labor force participation rate; lower D. unemployment rate; lower Answer: A Marginally attached workers are unemployed, so the unemployment rate would be higher. 4.

When the economy goes into recession, the biggest increase in unemployment is _________. A. structural because jobs are lost in most states B. cyclical because jobs are lost in many industries as they cut production C. frictional because the creation of jobs slows D. the combination of structural and frictional as few new jobs are created. Answer: B Cyclical unemployment is the unemployment resulting from a recession.

261

262

Part 8 . MONITORING THE MACROECONOMY

The economy is at full employment when all unemployment is ________. A. structural B. cyclical C. structural and cyclical D. structural and frictional Answer: D Answer D is the definition of when the economy is at full employment. 6.

Potential GDP is the value of real GDP when ______. A. the unemployment rate equals the natural unemployment rate B. there is no frictional unemployment C. there is no structural unemployment D. the unemployment rate is zero Answer: A When real GDP equals potential GDP, the unemployment rate equals the natural unemployment rate. 7.

When the unemployment rate _________ the natural unemployment rate, real GDP is _________ potential GDP and the output gap is _________. A. exceeds; below; negative B. is below; below; negative C. exceeds; above; positive D. is below; above; negative Answer: A When the unemployment rate exceeds the natural unemployment rate, the economy is in a recession with real GDP is less than potential GDP so the output gap is negative.

Chapter

The CPI and the Cost of Living ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications 1.

In Canada, the reference base period for the CPI is 2002. By 2017, prices had risen by 29.9 percent since the base period. The inflation rate in Canada in 2018 was 2.1 percent. Calculate the CPI in Canada in 2018. Because 2002 is the reference base period in Canada, in 2002 the CPI equaled 100. Between 2002 and 2017 prices rose by 29.9 percent. The formula for the percentage rise in prices is [(CPI in 2017 − 100) ÷ 100] × 100. So, [(CPI in 2017 − 100)] = 29.9 percent. Solving the formula for the CPI in 2017 shows that the CPI in 2017 is 129.9. Finally, with an inflation rate of 2.1 percent in 2018, the CPI in 2018 equals 129.9 × (1.021) = 132.6. In Brazil, the reference base period for the CPI is 2000. By 2016, prices had risen by 187 percent since the base period. The inflation rate in Brazil in 2017 was 3.4 percent, and in 2018, the inflation rate was 3.7 percent. Calculate the CPI in Brazil in 2017 and 2018. Brazil’s CPI in 2019 was 318. Did Brazil’s inflation rate increase or decrease 2019? Because 2000 is the reference base period for Brazil, the CPI in that year is 100. Between 2000 and 2016 prices rose by 187 percent. Over this period, the formula for the percentage rise in prices is [(CPI in 2016 − 100) ÷ 100] × 100. So, [(CPI in 2016 − 100)] = 187 percent. Solving the formula for the CPI in 2016 shows that the CPI in 2016 is 287. The price level in 2017 equals the price level in 2016, 287, multiplied by 1.034. (The 1.034 comes from the observation that the price level in 2017 equals the price level in 2016, which accounts for the “1,” plus the inflationary increase of 3.4 percent, which accounts for the “0.034.”) So the price level in 2017 equals (287 × 1.034), which is 297. The price level in 2018 equals the price level in 2017, 297, multiplied by 1.037. So the price level in 2018 equals (297 × 1.037), which is 308. The inflation rate in Brazil in 2019 equals [(318 − 308) ÷ 308] × 100, which is 3.2 percent. Brazil’s inflation rate decreased in 2019.

264

Part 8 . MONITORING THE MACROECONOMY

The table shows the Week 1 Week 2 quantities of the goods Price Price that Suzie bought and the Item Quantity (per unit) Quantity (per unit) prices she paid during Coffee 11 cups $3.25 11 cups $3.25 two consecutive weeks. Suzie’s CPI market DVDs 1 $25.00 3 $12.50 basket contains the goods Gasoline 15 gallons $2.50 5 gallons $3.00 she bought in Week 1. 1 ticket $95.00 Calculate the cost of Concert Suzie’s CPI market basket in Week 1 and in Week 2. What percentage of the CPI market basket is gasoline? Calculate the value of Suzie’s CPI in Week 2 and her inflation rate in Week 2. Susie’s CPI market basket contains 11 cups of coffee, 1 DVD, and 15 gallons of gasoline. The cost of her market basket in Week 1 is (11 cups × $3.25 a cup) + (1 DVD × $25 each) + (15 gallons of gasoline × $2.50 a gallon), which is $35.75 + $25.00 + $37.50, or $98.25. The cost of her market basket in Week 2 is (11 cups × $3.25 a cup) + (1 DVD × $12.50 each) + (15 gallons of gasoline × $3.00 a gallon), which is $35.75 + $12.50 + $45.00, or $93.25. Her market basket in Week 2 does not include concert tickets because she purchased no tickets in the base week. Gasoline accounted for $37.50 of her $98.25 market basket, which is ($37.50 ÷ $98.25) × 100 or 38.2 percent. Her CPI in Week 2 is equal to [$93.25 ÷ $98.25] × 100, which is equal to 94.9. The CPI in the base week is 100, so the inflation rate in week 2 equals ([94.9 − 100.0] ÷ 100) × 100, which is −5.1 percent.

Use the following information to work Problems 4 and 5. The GDP price index in the United States in 2014 was about 104, and real GDP in 2014 was $16.2 trillion (2012 dollars). The GDP price index in 2019 was about 112, and real GDP in 2019 was $19 trillion (2012 dollars). 4. Calculate nominal GDP in 2014 and in 2019 and the percentage increase in nominal GDP between 2014 and 2019. Nominal GDP in 2014 equals $16.2 trillion × 104 ÷ 100, which is $16.8 trillion. Nominal GDP in 2019 equals $19 trillion × 112 ÷ 100, which is $21.3 trillion. The percentage increase in nominal GDP is equal to ([$21.3 trillion − $16.8 trillion] ÷ $16.8 trillion) × 100, which is 26.8 percent. 5.

What was the percentage increase in production between 2014 and 2019, and by what percentage did the price level rise between 2014 and 2019? The percentage increase in production is equal to the percentage increase in real GDP. That percentage is {[$19 trillion − $16.2 trillion] ÷ $16.2 trillion} × 100, or 17.3 percent. The percentage increase price level is equal to ([112 − 104] ÷ 104) × 100, or 7.7 percent.

Chapter 23 . The CPI and the Cost of Living

The table shows the prices that Terry paid for some of his expenditures in June and July 2019. Explain and discuss why these prices might have led to commodity substitution or outlet substitution.

Item

Price in Price in June July (dollars per unit)

Steak Bread Bacon Milk Tomatoes Apples Bananas Chicken Lettuce

4.11 3.25 3.62 2.62 1.60 1.18 0.62 1.28 1.64

4.01 3.12 3.64 2.62 1.62 1.19 0.66 1.26 1.68

Terry will substitute other products, commodity substitution, or other locations to buy a product, outlet substitution, if the price rises. The larger the price increase, the greater the incentive for these substitutions. Bananas had the largest percentage price hike, so Terry could well have substituted other products (say apples, for which the price rise was a smaller amount) or have purchased his bananas at a different location to save on the price paid. Tomatoes and lettuce also had a large price hike. Terry might substitute apples for these (commodity substitution) or else purchased them at a less expensive location (outlet substitution). Steak and, to a lesser extent, chicken fell in price. Terry might have substituted these for bacon, which rose in price. 7.

In 2019, Annie, an 80-year-old, is telling her granddaughter Mary about the good old days. Annie says that in 1935, you could buy a nice house for $15,000 and a jacket for $5. Mary says that in 2019 such a house costs $250,000 and such a jacket costs $80. The CPI in 1935 was 16.7 and in 2019 it was 250.1. Which house and which jacket have the lower prices? The 2019 house price that is equivalent to $15,000 price in 1935 equals the CPI in 2019 divided by the CPI in 1935 and then multiplied by $15,000. So the 2019 house price is (250.1 ÷ 16.7) × $15,000, which is $224,641. The price for a house of $15,000 in 1935 is lower than its price in 2019. The 2019 jacket price that is equivalent to $5 in 1935 equals the CPI in 2019 divided by the CPI in 1935 and then multiplied by $5. So the 2019 jacket price is (250.1 ÷ 16.7) × $5, which is $75. So the $5 for a jacket in 1935 is the lower priced jacket.

265

266

Part 8 . MONITORING THE MACROECONOMY

Use the following information to work Problems 8 and 9. A news report says that falling oil prices pushed the CPI down 0.1 percent in a month in which energy prices fell 2.4 percent and the price of gasoline fell by 3.9 percent. 8. Given the further information that the weight on energy prices in the CPI is 8 percent, by how much would the CPI have changed in the month if energy prices had not changed? Because energy accounts for 8 percent of the CPI basket, its fall of 2.4 percent contributes (8 percent) × (−2.4 percent) = −0.19 percentage points toward the change in the CPI. Consequently, if energy prices had not changed, the CPI would have been 0.19 percent higher, that is, rather than falling 0.1 percent, it would have risen 0.09 percent. 9.

By what percentage did the prices of other items in the CPI basket change? The price of energy fell 2.4 percent, so the change in the CPI contributed by the fall in the price of energy is 2.4 percent × 8 percent, which is −0.19 percent. The overall change in the CPI is −0.1 percent, so the remaining factors must have contributed a rise of 0.09 percent. The remaining factors are 92 percent of the market basket, so they must have risen by (0.09/92) × 100, or 0.098 percent.

10. Read Eye on Box Office Hits on p. 608 and using BLS data for the CPI in 1982 and 1997, determine which movie had the greater real box office revenues, E.T.: The Extra-Terrestrial, which earned $435 million in 1982 or Titanic, which earned $601 million in 1997. From the BLS, the CPI in 1982 = 96.5 and the CPI in 1997 = 160.5. To convert the dollars earned by E.T.: The Extra-Terrestrial into 1997 dollars, multiply the 1982 dollars, $435 million, by the 1997 CPI and divide by the 1982 CPI. This procedure gives $435 million × 160.5 ÷ 96.5, which is $723 million. This result shows that E.T.: The Extra-Terrestrial had greater real box office than Titanic.

Chapter 23 . The CPI and the Cost of Living

 Additional Problems and Applications 1.

Read Eye on Box Office Hits on p. 608 and then compare the method used by Box-Office Mojo on p. 608 to calculate real box-office receipts with the method used on p. 604 to calculate the real price of a postage stamp. Compare and contrast the real variables that each method calculates. The real price of a stamp was calculated using the CPI; Box-Office Mojo calculated the real box office receipts using the price of movie tickets. The formulas used are effectively the same: Multiply the product, the stamp price or box office revenue, by the current period price index and divide by the price index for the relevant period, that is, the period of the stamp price or box office revenue. The difference between the two methods revolves around what price index is used. Box-Office Mojo uses each year’s price of a movie ticket; that is, this calculation uses the price of one good. The textbook used the CPI, which incorporates the prices of 80,000 goods consumers purchase.

Pete is a student who spends 10 perItem Price in cent of his expenditure on books and Books and supplies 172.6 supplies, 30 percent on tuition, 30 Tuition 169.0 159.0 percent on rent, 10 percent on food Rent Food and drink 129.8 and drink, 10 percent on transporta115.4 tion, and the rest on clothing. The Transportation 92.9 Clothing price index for each item was 100 in 2009. The table shows the prices in 2019. What is Pete’s CPI in 2019? (Hint: The contribution of each item to the CPI is its price weighted by its share of total expenditure.) Did Pete experience a higher or lower inflation rate between 2009 and 2019 than the student whose CPI is shown on p. 609? Pete’s CPI in 2019 equals (0.10 × 172.6) + (0.30 × 169.0) + (0.30 × 159.0) + (0.10 × 129.8) + (0.10 × 115.4) + (0.10 × 92.9) = 149.5. Pete’s inflation is slightly lower than the inflation for the student on page 609. Pete spends less in sum on the items that have risen most rapidly—books and supplies, tuition, and rent—and more on the item that rose much less rapidly than inflation—clothing. Pete’s inflation rate has averaged about 3.7 percent per year, which the figure on page 609 shows is a bit less than the average inflation rate over the years of the student whose CPI is on page 609. The people on Coral Island buy only juice and cloth. The CPI market basket contains the quantities bought in 2019. The average household spent $60 on juice and $30 on cloth in 2019 when the price of juice was $2 a bottle and the price of cloth was $5 a yard. In the current year, 2020,

267

268

Part 8 . MONITORING THE MACROECONOMY

juice is $4 a bottle and cloth is $6 a yard. Calculate the CPI and the inflation rate in 2020. The average household on Coral Island spent $60 on juice and $30 on cloth. The price of juice was $2 a bottle, so the average household purchased 30 bottles of juice. The price of cloth was $5 a yard, so the average household purchased 6 yards. Hence the CPI market basket is 30 bottles of juice and 5 yards of cloth. In 2019, the CPI market basket cost $90 ($60 on juice and $30 on cloth). In 2020, the CPI market basket cost (30 bottles of juice × $4 a bottle) + (6 yards of cloth × $6 a yard) = $120 + $36 = $156. So the CPI in 2020 equals ($156 ÷ $90) × 100, which is 173.3. The inflation rate on Coral Island between 2020 and 2019 is equal to [(173.3 − 100) ÷ 100] × 100, which is 73.3 percent. 4.

The table shows the Week 1 Week 2 quantities of the goods Price Price Item that Harry bought and the Quantity (per unit) Quantity (per unit) prices he paid during two Coffee 5 cups $3.00 4 cups $3.25 consecutive weeks. 5 $1.00 10 $1.00 Harry’s CPI market basket iTune songs contains the goods he Gasoline 10 gallons $2.00 10 gallons $3.00 bought in Week 1. Calculate Harry’s CPI in Week 2. What was his inflation rate in Week 2? Harry’s CPI market basket contains 5 cups of coffee, 5 iTunes songs, and 10 gallons of gasoline. The cost of his market basket in Week 1 is (5 cups × $3.00 a cup) + (5 songs × $1.00 each) + (10 gallons of gasoline × $2.00 a gallon), which is $15.00 + $5.00 + $20.00, or $40.00. The cost of his market basket in Week 2 is (5 cups × $3.25 a cup) + (5 songs × $1.00 each) + (10 gallons of gasoline × $3.00 a gallon), which is $16.25 + $5.00 + $30.00, or $51.25. His CPI in Week 2 is equal to [($51.25) ÷ ($40.00)] × 100, which is 128.1. The CPI in the base week is 100, so the inflation rate equals ([128.1 − 100.0] ÷ 100) × 100, which is 28.1 percent.

Use the following information to work Problems 5 and 6. The base year is 2012. Real GDP in 2012 was $15 trillion. The GDP price index in 2019 was 105, and real GDP in 2019 was $16 trillion. 5. Calculate nominal GDP in 2012 and in 2019 and the percentage increase in nominal GDP from 2012 to 2019. In the base year, nominal GDP equals real GDP. So in the base year of 2012, nominal GDP = $15 trillion. In general, nominal GDP = real GDP × price level ÷ 100. So in 2019, nominal GDP = $16 trillion × 105 ÷ 100, which is $16.8 trillion. The percentage increase in nominal GDP is equal to [($16.8 trillion − $15 trillion) ÷ $15 trillion] × 100, which is 12 percent.

Chapter 23 . The CPI and the Cost of Living

What was the percentage increase in production from 2012 to 2019, and by what percentage did the price level rise from 2012 to 2019? The percentage increase in production equals the percentage increase in real GDP, [($16 trillion − $15 trillion) ÷ $15 trillion] × 100, which is 6.7 percent. In the base year, the GDP price index equals 100. So the percentage increase in the GDP price index equals [(105 − 100) ÷ 100] × 100, which is 5 percent.

In 1988, the average wage rate was $9.45 an hour and in 2018 the average wage rate was $22.67 an hour. The CPI in 1988 was 118.3 and in 2018 it was 251.1. Which real wage rate is higher? The 2018 wage rate that is equivalent to $9.45 in 1988 equals the CPI in 2018 divided by the CPI in 1988 and then multiplied by $9.45. So the 2018 wage rate is (251.1 ÷ 118.3) × $9.45, which is $20.06. The wage rate of $22.67 in 2018 is the higher wage rate.

Imagine that you are given $1,000 to spend and told that you must spend it all buying items from a Sears catalog. But you do have a choice of catalog. You may select from the 1903 catalog or today’s catalog from Sears.com. You will pay the prices quoted in the catalog that you choose. Which catalog will you choose and why? Refer to any biases in the CPI that might be relevant to your choice. The 1903 catalog is attractive because prices quoted in the 1903 catalog are much lower than the prices quoted on Sears.com today. So the $1,000 buys more goods from the 1903 Sears catalog. Sears.com is attractive because the goods available on Sears.com are vastly improved and different from those available in the 1903 Sears catalog. The choice of whether to buy from the 1903 Sears catalog or from Sears.com will differ among students. However, two factors that play a role in this choice are, first, the quality of most goods today is higher than in 1903 and, second, the presence of a huge number of new goods available on Sears.com compared to the 1903 Sears catalog. These last two factors are the same as the corresponding two biases in the CPI: the quality change bias and the new goods bias.

269

270

Part 8 . MONITORING THE MACROECONOMY

Use the following information to work Problems 9 and 10. Zimbabwe central bank hikes interest rate to 50 percent In an attempt to lower inflation, the Reserve Bank of Zimbabwe has raised its interest rate to 50 percent a year. Steve H. Hanke, an economics professor at Johns Hopkins University estimates Zimbabwe's inflation rate is 570 percent per year. Sources: Bloomberg, August 16, 2019 and chronicle.co.zw, August 19, 2019 9. Calculate the real interest rate in Zimbabwe. The real interest rate equals the nominal interest rate minus the inflation rate. So the real interest rate was (50 percent) − (570 percent), which is −520 percent. 10. To achieve a real interest rate above zero, how must the Reserve Bank of Zimbabwe change the nominal interest rate? To achieve a positive real interest rate, the Reserve Bank of Zimbabwe must raise the nominal interest rate so it exceeds 570 percent per year.

Chapter 23 . The CPI and the Cost of Living

 Multiple Choice Quiz 1.

The CPI measures the average prices paid by __________ for _________. A. urban consumers; a fixed basket of consumption goods and services B. urban consumers; the average basket of goods and services they buy C. all consumers; housing, transportation, and food D. everyone who earns an income; the necessities of life Answer: A Answer A is the definition of the CPI. 2.

The BLS reported that the CPI in July 2010 was 226. This news tells you that _______. A. consumer prices during July were 226 percent higher than they were during the base year B. the CPI inflation rate in July was 26 percent a year C. consumer prices rose by 26 percent during the month of July D. the prices of consumption goods and services have risen, on average, by 126 percent since the base year Answer: D In the reference base period the CPI equals 100, so if it is 226 in July 2010, prices have risen, on average, 226 – 100, or 126 percent.

When the price level_______, the inflation rate ______. A. rises rapidly; increases B. rises rapidly; is high C. falls; is zero D. rises slowly; falls Answer: B When the price level rises rapidly, the inflation rate, which is the growth rate of the price level, is high. 4.

The CPI bias arises from all of the following items except ________. A. the introduction of new goods and services B. the improved quality of goods C. the goods and services bought by poor people D. consumers’ responses to price changes Answer: C The CPI’s biases do not include anything specific to the goods and services purchased by poor people.

271

272

Part 8 . MONITORING THE MACROECONOMY

Of the alternative measures of the price level, _________ overcomes the bias of the CPI and is a better measure of the cost of living because it _________. A. GDP price index; uses a current basket B. PCEPI; uses a current basket of all consumption goods C. PCEPI excluding food and energy; is less volatile D. GDP price index; includes all goods and services bought by Americans Answer: B The PCEPI is based on the current consumption bundle and thereby avoids the biases in the CPI. 6.

If nominal GDP increases by 5 percent a year and the GDP price index rises by 2 percent a year, then real GDP increases by ________. A. 7 percent a year B. 3 percent a year C. 2.5 percent a year D. 10 percent a year Answer: B Growth in nominal GDP can be separated into growth in the GPD price index plus growth in real GDP. 7.

When the CPI increases from 200 in 2016 to 210 in 2017 and the nominal wage rate is constant at $10 an hour, the real wage rate ______. A. increases by 10 percent B. increases to $15 an hour C. decreases by 5 percent D. is $10 an hour Answer: C The nominal wage rate falls from [($10 ÷ 200) × 100], which is $5.00, to [($10 ÷ 210) × 100], which is $4.76, a fall of 5 percent. 8.

When the price level is rising at ______ and the real interest rate is 1 percent a year, the nominal interest rate is 3 percent a year. A. 4 percent a year B. 3 percent a year C. 2 percent a year D. 1 percent a year Answer: C The nominal interest rate equals the real interest rate plus the inflation rate, so if the nominal interest rate is 3 percent a year and the real interest rate is 1 percent a year, the inflation rate must be 2 percent a year.

Potential GDP and the Natural Unemployment Rate

Chapter

ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications Use the following list of events, which occur in the United States one at a time, to work Problems 1 to 4. • Dell introduces a new supercomputer that everyone can afford. • A major hurricane hits Florida. • More high school graduates go to college. • The CPI rises. • An economic slump in the rest of the world decreases U.S. exports. 1. Sort the items into four groups: those that change the production function, those that change the demand for labor, those that change the supply of labor, and those that do not change the production function, the demand for labor, or the supply of labor. Say in which direction any changes occur. • The new supercomputers change the production function by shifting it upward. The hurricane changes the production function by shifting it (at least in Florida) downward. • The hurricane decreases the capital stock and thereby decreases the demand for labor. • If the new supercomputers increase workers’ productivity, the demand for labor increases. • The increased number of teenagers going to college has the immediate effect of changing the supply of labor by decreasing the supply of labor. • The CPI rising does not change the production function, the supply of labor, or the demand for labor. Similarly, the economic slump in the rest of the world does not change the production function, the supply of labor, or the demand for labor.

274

Part 9 . THE REAL ECONOMY

Which of the events increase the equilibrium quantity of labor and which decrease it? If the new supercomputers increase the demand for labor, the equilibrium quantity of labor increases. The increased number of teenagers in college has the immediate effect of decreasing the equilibrium quantity of labor. When a major hurricane hits Florida, the destruction of the capital stock decreases the demand for labor and decreases the equilibrium quantity of employment.

Which of the events raise the real wage rate and which lower it? If the new supercomputers increase the demand for labor, the equilibrium real wage rate rises. The increased number of teenagers in college has the immediate effect of increasing the equilibrium real wage rate. The hurricane decreases the demand for labor and thereby lowers the real wage rate.

Which of the events increase potential GDP and which decrease it? The new supercomputers increase potential GDP. The hurricane and the direct impact of more teenagers attending college decrease potential GDP. Production function Labor Real GDP hours (millions of (millions) 2012 dollars) 0 0 1 10 2 19 3 27 4 34 5 40

Labor market Real wage rate Quantity of Quantity of (2012 dollars labor demanded labor supplied per hour) (millions of hours per year) 10 1 5 9 2 4 8 3 3 7 4 2 6 5 1

Use the information set out in the tables above about the economy of Athabasca to work Problems 5 and 6. 5. Calculate the quantity of labor employed, the real wage rate, and potential GDP. The real wage rate is $8 per hour, because that is the real wage that sets the quantity of labor demanded equal to the quantity of labor supplied. The equilibrium quantity of labor is 3 million hours per year. The production function shows that the potential GDP is $27 million. 6.

If the labor force participation increases, explain how employment, the real wage rate, and potential GDP change. If the labor force participation increases, the supply of labor increases. The increase in the supply of labor lowers the real wage and increases employment. The increase in employment increases potential GDP.

Chapter 24 . Potential GDP and the Natural Unemployment Rate

Use the following information to work Problems 7 and 8. Suppose that the United States cracks down on illegal immigrants and returns millions of workers to their home countries. 7. Explain how the U.S. real wage rate, U.S. employment, and U.S. potential GDP would change. The supply of labor in the United States decreases, which decreases equilibrium U.S. employment and raises the U.S. real wage rate. U.S. potential GDP decreases. The U.S. production function is unchanged, but equilibrium employment decreases in the United States so that U.S. potential GDP decreases. 8. In the countries to which the immigrants return, explain how employment, the real wage rate, and potential GDP would change. In the countries to which the immigrants return, the supply of labor increases, which increases equilibrium employment. The supply of labor increases, which lowers the equilibrium real wage rate. Potential GDP increases. The production function is unaffected, but equilibrium employment increases in those countries so that potential GDP increases. 9. Two island economies, Cocoa Island and Plantation Island, are identical in every respect except one. A survey tells us that at full employment, people on Cocoa Island spend 1,000 hours a day on job search, while the people on Plantation Island spend 2,000 hours a day on job search. Which economy has the greater level of potential GDP? Which has the higher real wage rate? And which has the higher natural unemployment rate? Cocoa Island has the greater level of potential GDP because its labor force spends less time searching and more time employed. Plantation Island has the higher real wage rate. We know that Plantation Island has the higher real wage rate because the supply of labor is less on Plantation Island since workers spend more time searching for jobs. As the supply of labor decreases, the real wage rate rises. The increased search on Plantation Island means that Plantation Island has the higher natural unemployment rate. 10. What retiring baby boomers mean for the economy Almost 10,000 baby boomers—those born between 1946 and 1964—turn 65 every day and leave the labor force. In 2031, 75 million Americans will be over the age of 65, almost double the number in 2008. Source: smartasset.com, April 1, 2019 How would you expect the change in the labor force described in the news clip to affect potential GDP and the natural unemployment rate? The retirement of baby boomers as well as fewer young people joining the labor force decreases the supply of labor. The decrease in the supply of

275

276

Part 9 . THE REAL ECONOMY

labor decreases full employment. There is a movement down along the production function so that potential GDP decreases. With fewer young people entering the labor force and more employers looking for workers, frictional unemployment decreases. Natural unemployment is the sum of frictional unemployment and structural unemployment, so natural unemployment decreases. But the natural unemployment rate equals the natural unemployment divided by the labor force, all multiplied by 100. Because the labor force is decreasing and we don't know if the percentage decrease in natural unemployment is less than, greater than, or equal to the percentage decrease in the labor force, the natural unemployment rate might rise, fall, or remain the same.. 11. Read Eye on U.S. Potential GDP on p. 626 and then explain why U.S. potential GDP per worker per week is greater than that in Europe. What could induce Europeans to work the same hours as Americans and would that close the gap between potential GPD per worker in the two economies? U.S. potential GDP is higher than European potential GDP for two reasons: First, U.S. capital per worker and U.S. technology exceed those in Europe. Consequently, the U.S. production function lies above the European production function. Second, U.S. workers work more hours than do European workers. Both these differences mean that U.S. potential GDP exceeds European potential GDP. European workers would work more hours if taxes and unemployment benefits were lower in Europe. These changes would help close the gap between U.S. potential GDP and European potential GDP but would not eliminate it.

Chapter 24 . Potential GDP and the Natural Unemployment Rate

 Additional Problems and Applications Read Eye on Potential GDP on p. 626 and then use the following information to work Problems 1 and 2. In South Korea, real GDP per hour of labor is $22, the real wage rate is $15 per hour, and people work an average of 46 hours per week. 1. Draw a graph of the demand for and supply of labor in South Korea and the United States. Mark a point at the equilibrium quantity of labor per person per week and the real wage rate in each economy. Explain the difference in the two labor markets. Figure 24.1 shows the labor market in South Korea and also, based on data from page 626 of the text, in the United States. The demand for labor in the United States exceeds the demand for labor in Korea because the quantity of capital per worker in the United States exceeds that in Korea and U.S. technology is generally more productive than Korean technology. The U.S. supply of labor is less than the Korean supply of labor because of the income effect: U.S. income is higher than income in Korea, which increases the demand for leisure in the United States and thereby decreases the supply of labor in the United States. 2. Draw a graph of the production functions in Korea and the United States. Mark a point on each production function that shows potential GDP per hour of work in each economy. Explain the difference in the two production functions. Figure 24.2 shows the two production functions. The information used for the U.S. production function is based on the data from page 626 of the text. The U.S. production function is higher than the production function in Korea because the United States has more capital per worker than Korea and because U.S. technology is generally more advanced that Korean technology.

277

278

Part 9 . THE REAL ECONOMY

Use the following list of events that occur one at a time to work Problems 3 to 6. • The Middle East cuts supplies of oil to the United States. • The New York Yankees win the World Series. • U.S. labor unions negotiate wage hikes that affect all workers. • A huge scientific breakthrough doubles the output that an additional hour of U.S. labor can produce. • Migration to the United States increases the working-age population. 3. Sort the items into four groups: those that change the production function, those that change the demand for labor, those that change the supply of labor, and those that do not change the production function, the demand for labor, or the supply of labor. Say in which direction each change occurs. The decrease in the supply of oil changes the production function by shifting it downward. The scientific breakthrough changes the production function by shifting it upward. The decrease in the supply of oil decreases the demand for labor. The scientific breakthrough increase workers’ productivity so the demand for labor increases. The increased migration increases the supply of labor. The New York Yankees winning the World Series has no effect on the production function, the supply of labor, or the demand for labor. The union negotiation has no effect on the production function, the supply of labor, or the demand for labor. However it does increase the quantity of labor supplied and decrease the quantity of labor demanded. But these are movements along the curves and not shifts in the curves. 4. Which of the events increase the equilibrium quantity of labor and which decrease the equilibrium quantity of labor? The scientific breakthrough and the increased migration increase the equilibrium quantity of labor. The union negotiated higher wage rate decreases the equilibrium quantity of labor. 5. Which of the events raise the real wage rate and which of the events lower the real wage rate? The scientific breakthrough and the union negotiated wage hike increase the equilibrium real wage rate. The increased migration decreases the equilibrium real wage rate. 6. Which of the events increase potential GDP and which decrease potential GDP? The scientific breakthrough and the increased migration increase potential GDP. The cut in the supply of oil and the union negotiated wage hike decrease potential GDP.

Chapter 24 . Potential GDP and the Natural Unemployment Rate

Production function Labor Real GDP hours (2012 dollars (per day) per year) 0 0 10 100 20 180 30 240 40 280

Labor market Real wage rate Quantity of Quantity of (2012 dollars labor demanded labor supplied per hour) (hours per day) 1.00 10 50 0.80 20 40 0.60 30 30 0.40 40 20

Use the two tables above about the economy of Nautica to work Problems 7 and 8. 7. What is the quantity of labor employed, potential GDP, the real wage rate, and total labor income? The real wage rate is $0.60 per hour, because that is the real wage that sets the quantity of labor demanded equal to the quantity of labor supplied. The equilibrium quantity of labor is 30 hours per day. The production function shows that the potential GDP with this amount of employment is $240 per year. Total labor income is $0.60 × 30 hours = $18 per week. 8.

279

Suppose that the government introduces a minimum wage of $0.80 an hour. What is the real wage rate, the quantity of labor employed, potential GDP, and unemployment? Does the unemployment arise from job search or job rationing? Is the unemployment cyclical? Explain. The minimum wage of $0.80 an hour is greater than the equilibrium real wage rate, so the real wage rate equals the minimum wage, $0.80 an hour. At this wage rate the quantity of labor supplied is 40 hours per day but the quantity of labor demanded is 20 hours per day. Hence employment is 20 hours per day. At this level of employment, potential GDP is $180 per year. Unemployment equals the difference between the quantity of hours supplied, 40 per day, and the quantity of hours demanded, 20 per day, or 20 hours per day of unemployment. This unemployment reflects job rationing from the minimum wage. It is not cyclical.

280

Part 9 . THE REAL ECONOMY

Blizzard conditions shut down stretch of I-90 in Washington A potent winter storm is causing major disruptions to travel and daily routines across the Northwest. Heavy snow can be expected through Saturday morning as a storm continues to dive southward through Washington and Oregon. The Washington State Governor declared a state of emergency. Source: AccuWeather.com, February 9, 2019 Explain the effect of the Blizzard of 2019 on the economy of the Northwest states. How did it impact the production function, the labor market, and potential GDP? The blizzard damaged many businesses and damaged infrastructure, both of which are part of the nation’s capital. So the quantity of capital decreased, which shifted the production function downward. The blizzard closed many businesses, so the demand for labor from these businesses decreased. This decrease in the demand for labor was partially offset by an increase in the demand for labor for snow removal and other activities related to the blizzard increased. The supply of labor decreased because many people could not travel to work. The overall net decrease in the demand for labor and the supply of labor resulted in a decrease in the full-employment quantity of labor. The decrease in the employment led to a movement down along the production function. This change, combined with the downward shift in the production shift in the production function itself, decreased potential GDP.

Chapter 24 . Potential GDP and the Natural Unemployment Rate

 Multiple Choice Quiz 1.

U.S. potential GDP is the value of the goods and services produced in the United States ________. A. in the reference base year B. when the U.S. unemployment rate is zero C. when the U.S. economy is at full employment D. when the U.S. inflation rate is zero Answer: C Answer C is correct because it is the definition of potential GDP. 2.

The demand for labor curve shows the relationship between _________. A. the quantity of labor employed and firms’ profits B. all households’ willingness to work and the real wage rate C. the quantity of labor businesses are willing to hire and the real wage rate D. the labor force and the real wage rate Answer: C Answer C is the definition of the demand for labor curve. 3.

The supply of labor is the relationship between __________. A. the quantity of labor supplied and leisure time forgone B. the real wage rate and the quantity of labor supplied C. firms’ willingness to supply jobs and the real wage rate D. the labor force participation rate and the real wage rate Answer: B Answer B defines the supply of labor. 4.

Households’ labor supply decisions are influenced by all of the following except _______. A. the opportunity cost of taking leisure and not working B. the after-tax wage rate C. unemployment benefits D. the number of full-time jobs available Answer: D The number of full-time jobs available reflects firms’ demand for labor not households’ supply of labor.

281

282

Part 9 . THE REAL ECONOMY

The full-employment quantity of labor _______. A. increases if labor becomes more productive B. cannot increase because everyone who wants a job has one C. increases as the economy moves along its production function D. decreases if the income tax rates decrease Answer: A The increase in the productivity of labor increases the demand for labor, thereby raising the full-employment quantity of labor. 6.

The natural unemployment rate _______. A. increases if unemployment benefits become more generous B. increases in a recession C. increases as the average age of the labor force rises D. decreases as firms outsource manufacturing jobs Answer: A More generous unemployment benefits decrease the cost of searching for a job and thereby increase the amount of job search. 7.

Job rationing ________. A. increases the natural unemployment rate B. has no effect on the natural unemployment rate C. increases labor turnover as firms compete for high quality labor D. decreases the demand for labor, which lowers the real wage rate Answer: A Job rationing decreases the quantity of labor demanded and thereby raises the natural unemployment rate. 8.

An efficiency wage results in all of the following except _________. A. a decrease in the rate of labor turnover B. an increase in the full-employment quantity of labor C. greater work effort D. an increase in the cost of monitoring work effort Answer: B An efficiency wage decreases employment.

Chapter

Economic Growth ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications 1.

Explain why sustained growth of real GDP per person can transform a poor country into a wealthy one. The reason that sustained growth of real GDP per person can transform a poor country into a wealthy one is that economic growth is like compound interest. In other words, as the economy grows, in future years the growth rate is applied to a larger and larger real GDP per person and so the gain is larger and larger.

In 2018, India’s real GDP grew by 7.1 percent a year and its population grew by 1.1 percent a year. If these growth rates are sustained, in what years would • Real GDP be twice what it was in 2018? Using the Rule of 70, India’s real GDP doubles in 70 ÷ 7.1 = 9.9 years. So starting from January 1, 2018 real GDP would be twice what it was on January 1, 2018 close to the end of the year 2028. •

Real GDP per person be twice what it was in 2018? The growth rate of India’s real GDP per person equals 7.1 percent − 1.1 percent = 6.0 percent. Using the Rule of 70, India’s real GDP per person doubles in 70 ÷ 6.0 = 11.7 years. So starting from January 1, 2018 real GDP would be twice what it was on that date two-thirds of the way through the year 2030.

Describe how potential GDP per person has grown since 1960. Since 1960, U.S. potential GDP per person has grown but the growth rate has slowed in every decade. In the 1960s the annual growth rate of potential GDP per person was a little under 3.0 percent. By the 1990s it was 1.75 percent and by the 2010s had slowed still further to around 0.85 percent. As a result, the number of years it takes for U.S. potential GDP to double has risen from 24 years to 82 years.

284

Part 9 . THE REAL ECONOMY

Explain the link between labor hours, labor productivity, and real GDP. Labor productivity = (Real GDP) ÷ (Aggregate hours). So, Real GDP = (Labor productivity) × (Aggregate hours). Real GDP grows when labor productivity increases or when aggregate labor hours increase.

Explain how saving and investment in capital change labor productivity. Why do diminishing returns arise? Provide an example of diminishing returns. Use a graph of the productivity curve to illustrate your answer. Saving and investment in new physical capital increase labor productivity. Diminishing returns, however, occur: as capital per hour of labor rises, additional increases in capital per hour of labor raise labor productivity by smaller amounts. Diminishing returns arise because the first increases in capital boost labor productivity tremendously while, once more capital is accumulated, later increases have a smaller effect on labor productivity. For instance, when a wheat farm acquires its first combine, the workers’ productivity skyrockets higher because the wheat can be harvested in a much shorter time. But when the farm acquires its second combine, the increase in labor productivity is much smaller because the wheat already is being harvested efficiently. An increase in physical capital, which is the result of saving and investment, results in a movement along the productivity curve, as illustrated in Figure 25.1 by the arrow. The savings and investment has increased capital per hour of labor so there has been a movement along the productivity curve to a higher level of labor productivity.

Explain how advances in technology change labor productivity. Do diminishing returns arise? Provide an example of an advance in technology. Use a graph of the productivity curve to illustrate your answer. Advances in technology increase labor productivity. Technological advances allow producers to produce more goods and services without changing the quantity of resources utilized. Labor productivity is equal to (real GDP) ÷ (aggregate hours), so the technological advance that boosts real GDP without changing aggregate hours boosts labor productivity. Technological change is not subject to diminishing returns. For instance, the technological change in the production of computer chips has boosted the productivity of millions. An advance in technology results in an upward shift of the productivity curve, as illustrated in Figure 25.2 where

Chapter 25 . Economic Growth

the productivity curve shifts from PC0 to PC1. At any amount of capital per hour of labor, labor productivity PC1 is greater than labor productivity along PC0. Of course, along both productivity curves, increases in capital remain subject to diminishing returns.

Explain how an increase in human capital changes labor productivity. Do diminishing returns arise? Provide an example of an increase in human capital. Use a graph of the productivity curve to illustrate your answer. Increases in human capital increase labor productivity. Moreover, human capital is not subject to diminishing returns. When workers’ human capital increases, they become more productive. For example, as more students graduate from college with advanced knowledge of DNA, the development and production of new, DNA-based drugs increases. An increase in human capital results in an upward shift of the productivity curve, as illustrated in Figure 25.3 where the productivity curve shifts from PC0 to PC1. At any amount of capital per hour of labor, labor productivity PC1 is greater than labor productivity along PC0. Of course, along both productivity curves, increases in capital remain subject to diminishing returns.

285

286

Part 9 . THE REAL ECONOMY

What were the sources of labor productivity growth in the U.S. economy during the fifty years since 1960? How did the 1960s differ from the more recent decades? Labor productivity has grown because of capital accumulation, (rapid) human capital growth, and technological change. The 1960s differ from other decades because labor productivity growth was most rapid in that decade. Labor productivity growth slowed dramatically in the 1970s because technology and capital growth during that decade was devoted to offsetting high oil prices and because of increasing taxes and government regulation. Labor productivity growth rose in the 1990s with the widespread adoption of computers and dramatic health-care advances.

Draw productivity curves to illustrate the changes in labor productivity that occurred in the U.S. economy in the 1960s and contrast the change with that after 2007. What were the new technologies that arrived in the 1960s?

Figure 25.4 illustrates the 1960s and Figure 25.5 illustrates the period after 2007. The growth rate of physical capital and human capital growth in the 1960s was about 2 percent, which is twice that after 2007. The growth rate of technological change in the 1960s was about 0.8 percent, also about twice that after 2007. Technologies associated with transistors, computers, the laser, plastics, passenger jets, the interstate highway system, and shopping malls grew rapidly in the 1960s.

Chapter 25 . Economic Growth

10. What can governments in Africa do to encourage economic growth and raise the standard of living in their countries? Governments in Africa have to focus on increasing economic freedom within their countries. They need to end any wars in which they are involved to return to the rule of law and provide secure property rights. They also need to provide greater access to education to improve their citizens’ human capital as well as establish truly free markets. 11. As China’s growth slows, income inequality speeds up China’s real GDP growth rate has fallen from 10 percent a year to 6.8 percent a year. At the same time, the distribution of income has become more unequal. Suggestions for dealing with these problems include encouraging the growth of small firms, expanding the services sector, and investing more in human capital and research. Source: Economywatch.com, June 16, 2016 Compare China’s growth slowdown and increased inequality with that of the United States. Would the suggestions for dealing with these problems work? China’s growth slowdown of 3.2 percent a year is larger than the U.S. slowdown but China’s economic growth remains much higher than U.S. economic growth. In both China and the United States, the distribution of income has become less equal. Of the suggestions offered, investing in more human capital would speed both economic growth and reduce inequality. Investing more in research would increase economic growth but probably have a minimal effect on the distribution of income. Encouraging the growth of small firms and expanding the services sector might have a small positive effect on economic growth and on increasing the equality of income. 12. Read Eye on Rich and Poor Nations on p. 661. Which nations are the richest and which are growing the fastest? What are the conditions that lead to higher incomes and faster growing incomes? The richest nations are the United States, Europe’s “Big 4” nations, Hong Kong, and Taiwan. The nation growing the most rapidly is China, though Hong Kong and Taiwan have also grown rapidly in the recent past. Rapid economic growth requires three key factors: Economic freedom, secure property rights, and reliance upon free markets. Once these factors are in place, good incentives to save, invest, and innovate are important for speeding economic growth. Allowing for free international trade and creating a sound education system also help bring more rapid economic growth.

287

288

Part 9 . THE REAL ECONOMY

 Additional Problems and Applications 1.

Read Eye on Rich and Poor Nations on p. 661 and distinguish between a low and high incomes and a low and high economic growth rates. What are the key features of an economy that are present when incomes are high or fast growing and absent when incomes are low and stagnating or growing slowly? Provide an example of an economy with • Low income and slow growth rate • Low income and rapid growth rate • High income with sustained growth over many decades. The difference between low and high incomes versus low and high economic growth rates is important. A nation’s current income tells where it is now while the growth rate tells how rapidly its current income is changing. A nation with a high income or a fast-growing income will have met the preconditions for economic growth: economic freedom, secure property rights, and markets. These nations also frequently will have good incentive mechanisms to save, invest and innovate; government policies that encourage saving and research and development; free international trade; and, a high quality of education. Nations with low income or slow growth often need some of the necessary preconditions for growth. They also tend to lack good incentives to save, invest, and innovate; no government policies to encourage saving and research and development; restricted international trade; and poor schooling. Currently Zimbabwe is an economy with an extremely low income and an extremely slow growth rate; China is an economy with a relatively low income and a very high growth rate; and the United States is an economy that has enjoyed sustained growth over many decades.

Use the following information to work Problems 2 and 3. China’s growth rate of real GDP in 2005 and 2006 was 10.5 percent a year and its population growth rate was 0.5 percent a year. 2. If these growth rates continue, in what year would real GDP be twice what it was in 2006? Using the Rule of 70, China’s real GDP doubles in 70 ÷ 10.5 = 6.7 years. So starting from January 1, 2006, real GDP would be twice what it was on that date about two thirds of the way through the year 2012. 3.

If these growth rates continue, in what year would real GDP per person be twice what it was in 2006? The growth rate of China’s real GDP per person equals 10.5 percent − 0.5 percent = 10.0 percent. Using the Rule of 70, China’s real GDP per person doubles in 70 ÷ 10.0 = 7.0 years. So starting from January 1, 2006, real GDP would be twice what it was in 2006 in 2013.

Explain how an increase in physical capital and an increase in human

Chapter 25 . Economic Growth

289

capital change labor productivity. Use a graph to illustrate your answer. Saving and investment increase the amount of capital. The increase in the physical capital leads to an increase in labor productivity and a movement along a productivity curve. Formal education and training, as well as job experience, increase human capital. An increase in human capital increases labor productivity and shifts the productivity curve. Figure 25.6 illustrates this outcome by the shift in the productivity curve from PC0 to PC1. At any amount of capital per hours of labor, labor productivity (real GDP per hour of labor) is greater along productivity curve PC1 than along productivity curve PC0. 5.

The table describes labor productivity in an economy. What must have occurred in this economy during year 1? Between year 1 and year 2, the output per hour of labor (labor productivity) increased for every level of capital per hour of labor. There was either technological advances and/or growth in human capital.

Describe and illustrate in a graph what happened in the economy in the table if in year 1, capital per hour of labor was 30 and in year 2 it was 40. Figure 25.7 shows the productivity curves for the two years. PC1 is the productivity curve for year 1 and PC2 is the curve for year 2. The productivity curve shifted higher, as illustrated in the figure. This upward shift was the result of either technological advances and/or growth in human capital. The quantity of capital per hour of labor also increased because of saving and investment in new capital. With these changes the economy moved from point A in year 1 to point B in year 2.

Capital per hour of labor 10 20 30 40 50 60 70

Real GDP per hour of labor In year 1 In year 2 7 9 13 17 18 24 22 30 25 35 27 39 28 42

290

Part 9 . THE REAL ECONOMY

China invests almost 50 percent of its annual production in new capital compared to 15 percent in the United States. Capital per hour of labor in China is about 25 percent of that in the United States. Explain which economy has the higher real GDP per hour of labor, the faster growth rate of labor productivity, and which experiences the more severe diminishing returns. The United States has the higher real GDP per hour of labor because the U.S. productivity curve lies above the Chinese productivity curve and the United States has more capital per hour of labor than does China. China’s growth of productivity exceeds U.S. growth of productivity because China is increasing its capital per hour of labor more rapidly that the United States. The United States experiences more severe diminishing returns because the U.S. capital per hour of labor exceeds that in China.

Use the following information to work Problems 8, 9, and 10. Dear Silicon Valley: Forget flying cars, give us economic growth We have made enormous advances in computing technology. In Silicon Valley at Alphabet’s X labs, people are working on transformative technologies that include driverless cars, high-altitude balloons that deliver the Internet to remote regions of the world, self-navigating drones, and flying wind turbines tethered to a ground station. But despite today’s advances in technology, our economic growth rate has slowed. Source: MIT Technology Review, June 21, 2016 8. How would you explain the disconnect between the advances in technology described in the news clip and the pace of real GDP growth? Advances in technology shift the productivity curve upward and increase real GDP per hour of labor. But the advances described in the clip— driverless cars, high-altitude balloons, self-navigating drones, and flying wind turbines—have not yet been completely perfected and so have not yet left the labs in their finished forms. We can see these technologies on the horizon but many sectors have to benefit from these technologies. 9.

Thinking about the perpetual motion machine of economic growth (Figure 25.5 on p. 652), what are the missing ingredients that make some of today’s amazing technologies fail to deliver faster economic growth? Some of these technologies—high-altitude balloons and flying wind turbines—appear to be similar to the technologies developed on the 1970s insofar as they are dealing with problems—lack of Internet access, pollution from exploiting energy resources—that do not lead to new and better jobs. Consequently, in spite of technological advances, job creation has been slow.

10. Of the preconditions for economic growth and the policies that might achieve faster growth, which are already present in Silicon Valley (and

Chapter 25 . Economic Growth

the rest of the U.S. economy), and which, if any, might need to be strengthened? All of the preconditions are present in Silicon Valley. Allowing for additional free trade and perhaps relaxing some business regulations that make it difficult to hire the best person for the job, even if that person is an immigrant, might help speed economic growth. The United States could also encourage saving, which would increase the growth of capital and boost economic growth.

291

292

Part 9 . THE REAL ECONOMY

 Multiple Choice Quiz 1.

If real GDP increases from $5 billion to $5.25 billion and the population increases from 2 million to 2.02 million, real GDP per person increases by ___ percent. A. 5.0 B. 1.0 C. 2.5 D. 4.0 Answer: D Real GDP grows by 5 percent and the population grows by 1 percent, so real GDP per person grows by 4 percent. 2.

If the population growth rate is 2 percent, real GDP per person will double in 7 years if real GDP grows by ______ percent per year. A. 7 B. 10 C. 12 D. 14 Answer: C For real GDP per person to double in 7 years, the growth rate of real GDP per person must be 10 percent. If the population growth rate is 2 percent, then real GDP must grow at 12 percent. 3.

All of the following increase labor productivity except _________. A. the accumulation of skill and knowledge B. an increase in capital per hour of labor C. an increase in consumption D. the employment of a new technology Answer: C An increase in consumption has nothing to do with changing labor productivity.

The increase in real GDP per hour of labor that results from an increase in capital per hour of labor ________. A. is constant and independent of the quantity of capital B. is larger at a small quantity of capital than at a large quantity of capital C. is smaller at a small quantity of capital than at a large quantity of capital D. decreases as technology advances Answer: B Answer B describes the law of diminishing returns.

Chapter 25 . Economic Growth

The increase in real GDP per hour of labor that results from an advance in technology makes labor _______ productive ________. A. more; at all quantities of capital B. less; and capital more productive C. more; only at a large quantity of capital D. more; and capital less productive Answer: A Figure 25.2 in the book shows that answer A is correct. 6.

The classical growth theory is that real GDP per person ______. A. only temporarily rises and then returns to the subsistence level B. grows forever C. is constant and does not change D. increases as the population grows Answer: A If real GDP per person rises above the subsistence level, a population explosion occurs that drives it back down to the subsistence level. 7.

In new growth theory, the source of economic growth is ______. A. more leisure B. new and better jobs C. the persistent want for a higher standard of living D. an ever increasing growth rate of capital per hour of labor Answer: C The persistent drive for a higher standard of living leads to persistent innovations and technological advances that create persistent economic growth. 8.

An economy can achieve faster economic growth without ______. A. markets and property rights B. people being willing to save and invest C. incentives to encourage the research for new technologies D. an increase in the population growth rate Answer: D The other answers are necessary conditions for economic growth.

293

Finance, Saving, and Investment ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications 1.

On January 1, 2020, Terry’s Towing Service owned 4 tow trucks valued at $300,000. During 2020, Terry’s bought 2 new trucks for a total of $180,000. At the end of 2020, the market value of all of the firm’s trucks was $400,000. What was Terry’s gross investment? Calculate Terry’s depreciation and net investment. His gross investment was $180,000. His depreciation, which equals the initial market value of the trucks plus gross investment minus the ending market value of the trucks, was $80,000. His net investment, equal to gross investment minus depreciation, was $100,000.

Use the following information to work Problems 2 and 3. The Bureau of Economic Analysis reported that the U.S. capital stock was $57.3 trillion at the end of 2016, $59.8 trillion at the end of 2017, and $62.9 trillion at the end of 2018. Depreciation in 2017 was $3.2 trillion, and gross investment during 2018 was $3.8 trillion. 2. Calculate U. S. net investment and gross investment during 2017. Net investment equals the change in the quantity of capital. So in 2017, U.S. net investment was $59.8 trillion − $57.3 trillion, which is $2.5 trillion. Gross investment equals net investment plus depreciation. So in 2017, U.S. gross investment was $2.5 trillion + $3.2 trillion, which is $5.7 trillion. 3.

Calculate U.S. depreciation and net investment during 2018. Net investment equals the change in the quantity of capital. So in 2018, U.S. net investment was $62.9 trillion − $59.8 trillion, which is $3.1 trillion. Depreciation equals gross investment minus net investment. So in 2018, U.S. depreciation was $3.8 trillion − $3.1 trillion, which is $0.7 trillion.

Mike takes a summer job washing cars. During the summer, he earns an after-tax income of $3,000 and he spends $1,000 on goods and services.

Chapter

296

Part 9 . THE REAL ECONOMY

What was Mike’s saving during the summer and the change, if any, in his wealth? Mike’s saving is equal to his after-tax income minus his consumption expenditure, which is $3,000 − $1,000 = $2,000. Mike’s wealth increased by the amount of his saving, $2,000. 5.

What is the market for financial capital? What is financial capital? Explain why, when the real interest rate rises, the demand for loanable funds does not change but the quantity of funds demanded decreases. Financial markets are where savers and borrowers transact their business. Financial markets include loan markets, bond markets, and stock markets. Financial assets, such as stocks and bonds, are traded in financial markets. Financial capital is the funds that firms use to buy their (physical) capital. An increase in the real interest rate decreases the quantity of loanable funds demanded and results in a movement upward along the demand for loanable funds curve. The demand for loanable funds curve does not shift. The factor that changes the demand for loanable funds, that is, changes the entire relationship between the real interest rate and the quantity of loanable funds demanded is the expected rate of profit. When the expected profit changes, the demand for loanable funds changes and the loanable funds demand curve shifts.

With an increase in political tension, many governments increased defense spending, which decreased government budget surpluses. Show, on a graph, the effects of a decrease in government budget surpluses if there is no Ricardo-Barro effect. Explain how the effects differ if there is a partial Ricardo-Barro effect. Figure 26.1 shows the initial private supply of loanable funds curve, PSLF0 and the initial total supply of loanable funds curve, SLF0. The horizontal difference between the two curves, indicated by the long grey arrow, is the amount of the initial government budget surpluses. If the governments begin to run smaller budget surpluses and there is no RicardoBarro effect, the private supply of loanable funds curve remains the same, PSLF0. The total supply of loanable funds curve shifts leftward, in the figure to SLF1. In the figure, the decrease in the government surpluses equals the length of the short grey arrow facing left. If the governments begin to run smaller

Chapter 26 . Finance, Saving, and Investment

budget surpluses and there is a full Ricardo-Barro effect, the total supply of loanable funds curve remains the same, SLF0. The private supply of loanable funds curve shifts rightward to PSLF1 because households increase their saving to exactly offset the lessened government surplus. The shift is equal to the reduction in the government surplus and equals the length of the short grey arrow facing right (which is the same amount as the short, leftward facing arrow). If there is a partial Ricardo-Barro effect, the effects are partway between those with no Ricardo-Barro effect and a full Ricardo-Barro effect. The private supply of loanable funds curve shifts rightward but not all the way to PSLF1 and the total supply of loanable funds curve shifts leftward but not all the way SLF1. 7.

It’s time to start worrying about the National Debt The budget deficit this year is expected to reach $1 trillion. The government is financing this gap between its outlays and tax revenue by selling Treasury bills and bonds to American and international investors. Source: Valerie Ramey, The Wall Street Journal, August 23, 2019 Draw a graph of the loanable funds market to illustrate the situation described in the article. How will selling Treasury bills and bonds to American and international investors change the real interest rate and the quantity of saving in the United States? Selling Treasury bills and bonds increases the demand for loanable funds. As a result, the demand for loanable funds curve shifts rightward. Figure 26.2 shows this change as the shift in the demand for loanable funds curve from DLF0 to DLF1. The increase in the demand for loanable funds raises the real interest rate, in Figure 26.2 from 5 percent to 6 percent. Figure 26.2 also shows that the increase in the demand for loanable funds increases the equilibrium amount of loanable funds, in the figure from $1.0 trillion to $2.0 trillion. Equivalently, the equilibrium quantity of saving increases from $1.0 trillion to $2.0 trillion.

Saudi Arabia posts $7.4 billion budget surplus The Saudi Finance Minister said that higher oil revenue and the introduction of value-added taxation and subsidy cuts have moved the coun-

297

298

Part 9 . THE REAL ECONOMY

try's budget from a deficit to a surplus. Source: islamicbusinessandfinance.net, April 24, 2019 Explain the effect of Saudi Arabia’s budget surplus on the loanable funds market in Saudi Arabia. How will the budget surplus influence economic growth? The budget surplus increases the supply of loanable funds. The supply curve of loanable funds shifts rightward and the real interest rate falls. Saudi Arabia’s economy will grow more rapidly because the fall in the real interest rate increases investment and consumption expenditures on big ticket items. 9.

Read Eye on Financial Markets on p. 687. Describe some of the financial services provided by fintech firms. How has fintech changed the quantity of personal loans? How has crowdfunding changed the interest rate on personal loans? Fintech firms provide several financial services. Some fintech firms have created apps that allow payments to be made via a smartphone or online. Others make personal loans available online. Some fintech firms allow crowdfunding of entrepreneurs and businesses. Fintech has increased the quantity of personal loans. In 2018, fintech accounted for almost 40 percent of personal loans made in the United States. The share of fintech personal loans has grown quickly because they are often easier and cheaper to obtain than traditional loans and the interest rate they charge is lower than that charged by traditional lenders. Crowdsourcing has increased the supply of loanable funds. The increase in the supply of loanable funds lowered the interest rate.

Chapter 26 . Finance, Saving, and Investment

299

 Additional Problems and Applications 1.

Read Eye on Fintech on p. 687. Explain how fintech has changed the loanable funds market. Using data and making assumptions, draw a graph of the loanable funds market to illustrate the effects of fintech on the interest rate. Fintech increased the supply of loanable funds. Fintech increased the supply of loanable funds by giving individuals the ability to fund startups and entrepreneurs via avenues such as Kickstarter. From 2013 to 2018, fintech personal loans increased by approximately $50 billion, or about one third of all personal loans. Figure 26.3 shows the effect of fintech in the market for loanable funds. DLF and SLF0 show the market for loanable funds in the absence of fintech and SLF1 shows the supply curve in the market for loanable funds with fintech. The presence of fintech increased the equilibrium quantity of loanable funds by one third, from $1.2 trillion to $1.6 trillion, and lowered the real interest rate, from 4 percent to 3 percent.

On January 1, 2020, Sophie’s Internet Cafe owned 10 computer terminals valued at $8,000. During 2020, Sophie’s bought 5 new computer terminals at a cost of $1,000 each, and at the end of the year, the market value of all of Sophie’s computer terminals was $11,000. What was Sophie’s gross investment, depreciation, and net investment? Her gross investment was $5,000 for the new computers. Her net investment is the difference in the value of the capital over the year and is $3,000. Depreciation equals gross investment minus net investment, so her depreciation was $2,000.

The numbers in the second column of the table are the Federal Reserve’s estimates of personal wealth at the end of each year. The numbers in the third column are the Bureau of Economic Analysis’s estimates of personal saving each year. In which years did the change in

Year 2015 2016 2017 2018

Wealth (billions of dollars) 177,400 185,200 198,400 189,900

Saving (billions of dollars) 1,049 959 1,031 1,210

300

Part 9 . THE REAL ECONOMY

wealth exceed saving? In which years did saving exceed the change in wealth? Given the definitions of saving and wealth, how can the change in wealth differ from saving? The change in wealth exceeded saving in 2016 and 2017. In 2018, wealth decreased, so in that year the change in wealth was less than saving. The change in wealth can exceed saving if the prices of the assets included in wealth increase during the year and the change in wealth can be less than the change in saving if the prices of the assets included in wealth decrease during the year. 4.

Cindy takes a summer job and earns an after-tax income of $8,000. Her living expenses during the summer were $2,000. What was Cindy’s saving during the summer and the change, if any, in her wealth? Cindy’s saving is equal to her after-tax income minus her consumption expenditure, which is $8,000 − $2,000 = $6,000. Cindy’s wealth increased by the amount of her saving, $6,000.

A stock market boom of 2019 increased wealth by trillions of dollars. Explain the effect of this increase in wealth on the equilibrium real interest rate, investment, and saving. The increase in wealth decreased people’s saving and thereby decreased the supply of loanable funds. The decrease in the supply of loanable funds raised the equilibrium real interest and decreased the equilibrium quantity of loanable funds. The equilibrium quantity of investment and saving also decreased.

Use the following information to work Problems 6 and 7. An economy’s saving rate increased from –0.1 percent in 2015 to 2.0 percent in 2016, to 2.4 percent in 2017, to 2.9 percent in 2018, and to 3.0 percent in 2019. 6. How can the saving rate be negative? Why might a negative saving rate be something to worry about? How might a country’s saving be increased? Saving can be negative if consumption expenditure exceeds disposable income. For the macroeconomy, a negative saving rate means that people, on net, are borrowing, possibly from foreigners. A negative saving rate can be worrisome because at some point the borrowing must be repaid. If the borrowing is used to finance consumption expenditure, it will be more difficult to repay the loans. Saving can be stimulated using government policies. For instance, the government could decrease or eliminate taxes on interest income or gains in the stock market. 7.

Explain why the saving rate might have increased and its effect on the supply of loanable funds. On reason why the saving rate might have increased is a stock market crash. A stock market crash decreases people’s wealth. A decrease in

Chapter 26 . Finance, Saving, and Investment

wealth increases the saving rate and increases the supply of loanable funds. Use the following information to work Problems 8 and 9. IMF says it battled crisis well The International Monetary Fund (IMF) reported that it acted effectively in combating the global recession, especially in Eastern Europe. The IMF made $163 billion available to developing countries. The IMF required countries with large deficits to cut spending or not increase it, but it urged the United States, Western European countries, and China to run deficits to stimulate their economies. Source: The Wall Street Journal, September 29, 2009 8. Explain how an increase in government expenditure will change the government’s budget balance and the loanable funds market. An increase in government expenditure increases a budget deficit or decreases a budget surplus. In the absence of a Ricardo-Barro effect, the increase in a budget deficit increases the demand for loanable funds while a decrease in budget surplus decreases the supply of loanable funds. On both counts the real interest rate rises and investment is crowded out. 9.

Why do you think the IMF required countries with large deficits, like those in Eastern Europe, to cut spending rather than increase it? The IMF was probably concerned that further increases in these nations’ budget deficits might have caused potential lenders to the nations to worry that the default risk on those nations’ debts was becoming quite high. Such a concern would have decreased the supply of loanable funds to those nations and possibly raised the real interest they must pay quite substantially.

Present Value Appendix Exercise 10. With an interest rate of 20 percent, what is the present value on December 31, 2020 of payments of $400 on December 31 each year for the next 3 years starting in 2021? The present value of the payment 1 year in the future is ($400)/(1 + 0.20) = $333.33. The present value of the payment 2 years in the future is ($400)/(1 + 0.20)2 = $277.78. The present value of the payment 3 years in the future is ($400)/(1 + 0.20)3 = $231.48. The present value of all three payments is the sum of each individual present value, or $333.33 + $277.78 + $231.48 = $842.59.

301

302

Part 9 . THE REAL ECONOMY

 Multiple Choice Quiz 1.

Financial capital is the ___________. A. money used to buy stocks and bonds B. money used to buy physical capital C. funds that savers supply and buyers of physical capital borrow D. money in the bank Answer: B Answer B is essentially the definition of financial capital. 2.

If the price of a U.S. government bond is $50 and the owner of the bond is entitled to $2.50 income each year, then the interest rate on the bond is ____. A. 0.2 percent B. 5 percent C. 10 percent D. 20 percent Answer: B The interest rate on an asset is equal to the interest paid divided by the price, then multiplied by 100. 3.

In the loanable funds market, an increase in ________. A. the real interest rate increases the demand for loanable funds B. expected profit increases the demand for loanable funds C. expected profit doesn’t change the demand for loanable funds, but the quantity of loanable funds demanded increases D. the real interest rate doesn’t change the demand for loanable funds, but the quantity of loanable funds demanded increases Answer: B The increase in expected profit increases the demand for loanable capital, which means the demand curve for loanable capital shifts rightward. 4.

The supply of loanable funds increases ________. A. when the demand for loanable funds increases B. when people increase saving as the real interest rate rises C. when disposable income increases or wealth decreases D. if net taxes decrease or expected future income increases Answer: C An increase in disposable income or decrease in wealth influence people to increase their saving, which increases the supply of loanable funds.

Chapter 26 . Finance, Saving, and Investment

An increase in expected profit _______ the real interest rate and ________ the quantity of loanable funds. A. decreases; decreases B. increases; decreases C. decreases; increases D. increases; increases Answer: D An increase in expected profit increases the demand for loanable funds, which increases the real interest rate and the quantity of loanable funds. 6.

A government budget surplus _______. A. increases the supply of loanable funds B. raises the real interest rate C. decreases the demand for loanable funds and lowers the real interest rate D. decreases net taxes, increases disposable income, and increases saving Answer: A A government budget surplus is a source of loanable funds and so increases the supply of saving.

Crowding out occurs when ______. A. households’ budgets are in deficit and saving decreases B. the government budget is in surplus, so people have paid too much tax C. the government budget is in deficit and the real interest rate rises D. the government budget is in deficit but taxpayers are rational and the Ricardo-Barro effect operates Answer: C When the government budget is in deficit, the demand for loanable funds increases, thereby raising the real interest rate. The higher real interest rate decreases—crowds out—private investment. 8.

An increase in the government budget deficit _______. A. increases private saving and investment B. increases private saving and decreases investment C. increases the supply of private saving and decreases investment D. decreases private saving and investment Answer: B The increase in the budget deficit raises the real interest rate, which increases private saving and decreases investment.

303

Chapter

The Monetary System ANSWERS TO CHAPTER CHECKPOINT

 Problems and Applications 1.

What is money? Would you classify any of the following items as money? Money is any commodity or token that is generally accepted as a means of payment. • Store coupons for noodles Store coupons for noodles can act as a store of value but only at the store which honors them and usually only when presented with cash. They are not a widespread medium of exchange (only for noodles!) but if they are in dollars, the coupons are a unit of account. Store coupons are not money. •

A $100 Amazon.com gift certificate The $100 Amazon.com gift certificate acts as a store of value and a unit of account. It is a medium of exchange only at Amazon.com. The gift certificate is not money.

•

Frequent flier miles The frequent flier miles act as a unit of account. However, they might not serve as a store of value because they often have expiration dates. They are not money.

•

Credit available on your Visa card Credit available on your Visa card represents ability to borrow. It doesn’t share any of the characteristics of money, so it is not money.

•

The dollar coins that a coin collector owns The dollar coins that a coin collector owns are worth more than their face value of one dollar. Hence they will not be used as a means of payment so they are not money.

Part 10 . THE MONEY ECONOMY

306

What are the three functions that money performs? Which of the following items perform some but not all of these functions, and which perform all of these functions? Which of the items are money? Money acts as a medium of exchange; is a unit of account; and is a store of value. • A checking account at the Bank of America A checkable deposit at the Bank of America performs all three functions of money. It is money. •

A dime A dime performs all three functions of money. It is money.

•

A debit card A debit card represents a convenient way to access funds in account. The debit card is not a medium of exchange, a unit of account, or a store of value. (The funds in the account are the medium of exchange, unit of account, and store of value.) A debit card is not money.

Monica transfers $10,000 from her savings account at the Bank of Alaska to her money market fund. What is the immediate change in M1 and M2? M1 and M2 are left unchanged. The reason is that only the composition of M2 has changed but not the total amount of M2. M1 does not change because none of the components of M1 are affected.

Terry takes $100 from his checking account and deposits the $100 in his savings account. What is the immediate change in M1 and M2? M1 decreases by $100 and M2 remains unchanged.

Suppose that banks had deposits of $500 billion, a desired reserve ratio of 4 percent and no excess reserves. The banks had $15 billion in notes and coins. Calculate the banks’ reserves at the central bank. The banks’ total desired reserves equal $500 billion × 0.04, which is $20 billion. Of these $20 billion in desired reserves, banks have $15 billion in notes and coins, leaving $5 billion at the central bank.

Explain the Fed’s policy tools and briefly describe how each works. The Federal Reserve has four policy tools: changing the required reserve ratio, changing the discount rate, open market operations, and extraordinary crisis measures. The Fed can set the required reserve ratio, the fraction of deposits that banks must keep as reserves. If the Fed raises the required reserve ratio, banks are unable to make as many loans because they must keep more of their deposits as reserves. The Fed can change the discount rate, the interest rate it charges banks for loans of reserves. If the Fed raises the discount rate, banks will borrow fewer reserves. Open market operations are the purchase or sale by the Fed of government securities. If the Fed sells government securities, banks will have fewer re-

Chapter 27 . The Monetary System

307

serves. Extraordinary crisis measures include quantitative easing, when the Fed increases banks’ reserves by large-scale open market operations, credit easing, when the Fed buys private securities or makes loans to financial institutions, and Operation Twist, when the Fed buys long-term government securities and sells short-term government securities in an effort to lower the long-term interest rate. 7.

The table shows a bank’s balance Assets Liabilities sheet. The bank has no excess re(millions of dollars) serves and there is no currency Reserves at the Fed 20 Checkable deposits 5 Savings deposits drain. Calculate the bank’s desired Cash in vault Securities 75 reserve ratio. Loans 100 The bank’s deposits are $200 million and its reserves, which are composed of the reserves at the Fed plus the cash in its vault, are $25 million. Therefore the desired reserve ratio equals ($25 million) ÷ ($200 million) = 0.125 or 12.5 percent. The Fed buys $2 million of securities from AIG. If AIG’s bank has a desired reserve ratio of 0.1 and there is no currency drain, calculate the bank’s excess reserves as soon as the open market purchase is made, the maximum amount of loans that the banking system can make, and the maximum amount of new money that the banking system can create. Excess reserves = actual reserves − desired reserves. The new reserves created by the Fed’s purchase are $2 million. Desired reserves have not changed, so the excess reserves are $2 million − $0.0 million, which is = $2.0 million. The maximum amount of loans that the banking system can make is equal to the increase in the quantity of money. To calculate the increase in the (1 + C / D) quantity of money, use the money multiplier, , where C/D ( R / D + C/D) is the currency drain ratio and R/D is the desired reserve ratio. In this case, the currency drain equals 0, so the money multiplier is 1 ÷ 0.10, or 10.0. So the total increase in the quantity of money is $2 million × 10.0, which is $20 million. Given the $20 million increase in the quantity of money, the total increase in loans is $20 million.

Use the following information to work Problems 9 and 10. If the desired reserve ratio is 5 percent, the currency drain ratio is 20 percent of deposits, and the central bank makes an open market purchase of $1 million of securities, calculate the change in 9. The monetary base and the change in its components. With the $1 million purchase of government securities, the monetary base increases by $1 million. Initially the component of the monetary base that

80 120

308

Part 10 . THE MONEY ECONOMY

changes is banks’ deposits at the Fed, that is, banks reserves held at the Fed, increase. 10. The quantity of money, and how much of the new money is currency and how much is bank deposits. The change in the quantity of money equals (money multiplier) × (change (1 + C / D) in the monetary base). The money multiplier is , where C/D ( R / D + C/D) is the currency drain ratio and R/D is the desired reserve ratio. The money multiplier equals (1 + 0.2) ÷ (0.05 + 0.2) = 1.2 ÷ 0.25 = 4.8. So the change in the quantity of money equals (4.8) × ($1 million) = $4.8 million. One way to determine how much of the increase in money is in currency and how much is in deposits relies on two observations. First, note that c + d = $4.8 million, where c is currency and d is deposits. Then by rearranging, d = $4.8 million − c. Next, note that the entire $1 million increase in the monetary base must be held as either currency or reserves. Reserves equal the desired reserve ratio multiplied by the amount of deposits, or (0.05) × d. Thus $1 million = c + (0.05) × d. Now, use the first formula for d, namely d = $4.8 million − c, in the second formula to give $1 million = c + (0.05) × [($4.8 million) − c]. Multiply through by 0.05 to get $1 million = c + (0.05) × ($4.8 million) − (0.05) × (c). Simplify to obtain $1 million = 0.95 × c + $0.24 million. Solve this last formula for c and the result is c = $0.80 million. Because d = $4.8 million − c, with c = $0.8 million, d equals $4.0 million. Use this information to work Problems 11 and 12. People’s Bank of China boosts liquidity with open market operations The People's Bank of China, China's central bank, pumped 270 billion yuan ($39 billion) into the financial system through an open market operation. Source: www.chinadaily.com.cn, October 8, 2018. 11. In the open market operation described in the news clip, explain whether the People’s Bank of China buys or sells securities. Illustrate the effects of the open market operation on the balance sheets of the banks and the central bank. The People’s Bank of China is buying securities. For simplicity, presume that the People’s Bank of China buys the securities directly from banks. The, as the balance sheets on the next page show, the open market operation increases the reserves the banking system has at the People’s Bank of China (PBC) by 270 billion yuan while simultaneously decreasing the securities held by the banking system by the same amount, 270 billion yuan. The liabilities of the banking system do not change. For the People’s Bank of China, the open market operation increases the Bank’s securities by 270 billion yuan. It also simultaneously

Chapter 27 . The Monetary System

increases the reserves held by the banking system by the same amount, 270 billion yuan.

309

Change in Banking System Balance Sheet Assets

Liabilities (billions of yuan)

Reserves at the PBC Securities Loans

270 −270 0

Checkable deposits

Savings deposits

Change in People’s Bank of China Balance Sheet Assets

Liabilities (billions of yuan)

Securities

270

Reserves of banking system

12. Explain how the open market operation described in the news clip will change the quantity of money in China. The open market operation will increase China’s monetary base and thereby increase the quantity of money in China. 13. Read Eye on Creating Money on pp. 718 –719. Why didn't M2 increase by the same percentage as the increase in the monetary base? The monetary based increased to four times its original amount, which means it increased by 300 percent. M2 did not increase by anywhere near the same amount because banks’ desired holdings of reserves relative to M2 deposits skyrocketed. The huge increase in the ratio of reserves to M2 deposits more than halved the M2 money multiplier so it fell from about 9 to 5 and ultimately bottomed out at a little more than 3. The drastic fall in the M2 money multiplier means that the rapid growth in the monetary base lead to much smaller growth in M2. Banks’ desired reserves increased so dramatically because of the significant increase in risk they perceived during and after the financial crisis.

270

Part 10 . THE MONEY ECONOMY

310

 Additional Problems and Applications 1.

Read Eye on Creating Money on pp. 718–719. When the Fed engaged in QE between 2008 and 2014, by how much did the monetary base increase? Which component of the monetary base increased most, currency or bank reserves? In the fall of 2008, the Fed doubled the monetary base in QE1. In 2010 and 2011, the Fed's actions in QE2 increased by monetary base to more than three times its pre-crisis level. And in 2012 and 2013, a further gradual QE3 raised the monetary base to four times its normal level. Banks’ reserves increased dramatically. There was a much smaller increase in currency. 2. What happened to the money multiplier between 2008 and 2014? What would the money multiplier have been if the currency drain ratio had increased? What would the money multiplier have been if the banks’ desired reserve ratio had not changed? The money multiplier fell by an unprecedented amount. The money multiplier is (1 + C/D)/(R/D + C/D), where C/D is the currency drain ratio and R/D is the desired reserve ratio. Typically C/D is about 0.11 and R/D is about 0.01 so the money multiplier is 1.11/0.12, which is approximately 9. In 2008 the currency ratio hardly changed but the desired reserve ratio skyrocketed over 0.10 and still higher to about 0.20 in recent years. This drastic increase in banks’ desired reserve ratio lead to a huge fall in the money multiplier to less than 4.0. If the currency drain ratio had increased, the money multiplier would have fallen even more. If the desired reserve ratio had not changed, then because the desired reserve ratio has hardly changed, the money multiplier would not have changed; it would have remained equal to about 9. 3. What are the three functions that money performs? Which of the following items perform some but not all of these functions and which of the items are money? Money acts as a medium of exchange; is a unit of account; and is a store of value. • An antique clock An antique clock can serve as a store of value. But it is not a medium of exchange nor a unit of account, so it is not money. •

An S&L savings deposit The S&L saving deposit acts as a unit of account and a store of value. It is counted as part of M2 money.

Chapter 27 . The Monetary System

•

Your credit card A credit card represents a convenient way to access an immediate loan. The credit card is not a medium of exchange, a unit of account, or a store of value, so a credit card is not money.

•

The coins in the Fed’s museum The coins in the Fed’s museum are worth more than their face value of one dollar. Hence they will not be used as a means of payment so they are not money. They are, however, a unit of account and a store of value.

•

Government securities Government securities can serve as a store of value. But they are not a medium of exchange nor a unit of account, so they are not money.

Naomi buys $1,000 worth of American Express travelers’ checks and charges the purchase to her American Express card. What is the immediate change in M1 and M2? M1 and M2 both rise by $1,000.

A bank has $500 million in checkable deposits, $600 million in savings deposits, $400 million in small time deposits, $950 million in loans to businesses, $500 million in government securities, $20 million in currency, and $30 million in its reserve account at the Fed. Calculate the bank’s deposits that are part of M1, deposits that are part of M2, the bank’s loans, securities, and reserves. The only deposits that are part of M1 are the checkable deposits of $500 million. The entire $1,500 million of deposits is part of M2. Total loans are $950 million. Reserves are deposits at the Fed plus currency = $30 million + $20 million = $50 million. Securities are $500 million.

What can the Fed do to increase the quantity of money and keep the monetary base constant? Explain why the Fed would or would not If the Fed decreases the required reserve ratio, banks can increase their lending, which increases the quantity of money. Reserves do not change and so the monetary base does not change. •

Change the currency drain ratio. The Fed has no control over currency drains.

•

Change the required reserve ratio. As outlined above, if the Fed lowers the required reserve ratio, the quantity of money increases and the monetary base does not change.

•

Change the discount rate. If the Fed decreases the discount rate, the banks pay a lower price for reserves that they borrow from the Fed. So banks are more willing to borrow reserves and increase their lending. The Fed would not do this action because it increases the monetary base.

311

Part 10 . THE MONEY ECONOMY

312

•

Conduct an open market operation. The Fed cannot conduct an open market operation and increase the quantity of money while keeping the monetary base constant. Open market operations change the quantity of money by changing the monetary base. It is impossible to use an open market operation to change the quantity of money while keeping the monetary base constant.

Use the table, which shows commercial Assets Liabilities bank’s balance sheet, to work Problems 7 (millions of dollars) and 8. The commercial banks’ desired reReserves at central 25 Checkable deposits serve ratio on all deposits is 5 percent bank Cash in vault 15 Savings deposits and there is no currency drain. Securities 60 7. Calculate the banks’ excess reLoans 100 serves. If the banks use all these excess reserves to make loans, what is the quantity of loans made and the quantity of total deposits after the loans have been made? The banks’ total deposits are $200 million, so the banks’ desired reserves are 0.05 × $200 million, which is $10 million. The banks’ reserves are the sum of the reserves at the central bank plus the cash in their vaults, so the banks have $40 million in reserves. The banks’ excess reserves are $40 million − $10 million = $30 million. The banks can loan $30 million. When the banks have made the loans, the banks’ total deposits are $230 million, the sum of the initial demand deposits ($90 million) plus the deposits created by the loans ($30 million) plus the initial savings deposits ($110 million). 8.

Calculate the quantity of bank loans and the quantity of total deposits when the banks have no excess reserves? The banks increase their loans by $30 million, so the total will be $130 million. Until the loans are spent, the banks’ total deposits are $230 million; after the loans are spent, the banks’ deposits are $200 million. The money multiplier is 20, so the total increase in deposits and loans is 20 × $30 million = $600 million.

Use the following information to work Problems 9, 10, and 11. China lowers reserve requirements The People’s Bank of China lowered the required reserve ratio from 13.5 percent to 13 percent but it remained much higher than in other countries. Source: Bloomberg News, September 6, 2019 9. Compare the required reserve ratio in China and the required reserve ratio on checkable deposits in the United States today. The required reserve ratio is higher in China, 13 percent, then in the United States, where it is 3 percent on checkable deposits below a specified amount and 10 percent on checkable deposits above the amount.

90 110

Chapter 27 . The Monetary System

10. If the currency drain ratio in China is 10 percent of deposits and the desired reserve ratio equals the required reserve ratio, calculate the money multipliers in China and compare it with the U.S. money multiplier. (1 + C / D) The money multiplier is , where C/D is the currency drain ( R / D + C/D) ratio and R/D is the desired reserve ratio. In China, the money multiplier equals (1 + 0.10) ÷ (0.13 + 0.10), or 4.78. In the United States, using the higher required reserve ratio (that is, 10 percent on deposits) the money multiplier (1 + 0.10) ÷ (0.10 + 0.10), or 5.5. The higher required reserve ratio in China makes the Chinese money multiplier smaller than the U.S. money multiplier. 11. If the currency drain ratio in China is 10 percent of deposits, by how much did the money multiplier change when the required reserve ratio changed as described in the news clip? (1 + C / D) The money multiplier is , where C/D is the currency drain ( R / D + C/D) ratio and R/D is the desired reserve ratio. In China, before the change the money multiplier equals (1 + 0.10) ÷ (0.135 + 0.10), or 4.68. After the change, the money multiplier equals (1 + 0.10) ÷ (0.13 + 0.10), or 4.78. The (small) decrease in the required reserve ratio creates a (small) increase in the money multiplier.

313

314

Part 10 . THE MONEY ECONOMY

 Multiple Choice Quiz 1.

A commodity or token is money if it is ________. A. generally accepted as means of payment B. a store of value C. used in a barter transaction D. completely safe as a store of value Answer: A Answer A is the definition of money. 2.

Money in the United States today includes _______. A. currency and deposits at both banks and the Fed B. the currency in people’s wallets, stores’ tills, and the bank deposits that people and businesses own C. currency in ATMs and people’s bank deposits D. the banks’ reserves and bank deposits owned by individuals and businesses Answer: B Only currency outside of banks is part of money. 3.

Rick withdraws $500 from his savings account, keeps $100 as currency, and deposits $400 in his checking account. A. M1 increases by $400 and M2 decreases by $500. B. M1 does not change, but M2 decreases by $500. C. M1 does not change, but M2 decreases by $400. D. M1 increases by $500 and M2 does not change. Answer: D When the $500 was in the savings account, none of it was counted as M1 although all was counted as M2. When the funds are changed to currency and checkable deposits, all of it becomes part of M1 and hence all of it remains as M2. 4.

Commercial banks’ assets include ________. A. bank deposits of individuals and businesses and bank reserves B. loans to individuals and businesses and government securities C. bank reserves and the deposits in M2 D. government securities and borrowed funds Answer: B The discussion in the text about banks’ assets shows that banks’ assets include securities and loans.

Chapter 27 . The Monetary System

The Fed’s policy tools include all the following except _______. A. required reserve ratio and open market operations B. quantitative easing C. discount rate D. taxing banks’ deposits at the Fed Answer: D Answer D is not a Fed policy tool. 6.

A commercial bank creates money when it does all the following except ______. A. decreases its excess reserves B. makes loans C. creates deposits D. puts cash in its ATMs Answer: D Currency inside of a bank is not money, regardless of whether the currency is in a teller’s till or is in an ATM. 7.

An open market _______ of $100 million of securities ______. A. purchase; increases bank reserves B. sale; increases bank reserves C. purchase; decreases the Fed’s liabilities D. sale; increases the Fed’s liabilities Answer: A When the Fed purchases government securities, it effectively pays for (at least part of) the purchasing by increasing banks’ reserves. 8.

The money multiplier _______. A. increases if banks increase their desired reserve ratio B. increases if the currency drain ratio increases C. is 1 if the desired reserve ratio equals the currency drain ratio D. decreases if banks increase their desired reserve ratio Answer: D If banks increase their desired reserve ratio, they will make fewer loans, which decreases the size of the money multiplier.

315

Chapter

Money, Interest, and Inflation ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications 1.

Draw a graph to illustrate the demand for money. On the graph show the effect of an increase in real GDP and the effect of an increase in the number of families that have a credit card. A demand for money curve is illustrated as MD0 in Figure 28.1. An increase in real GDP increases the demand for money and the demand for money curve shifts rightward. Figure 28.1 illustrates this change as the shift from MD0 to MD1. An increase in the number of families with credit cards decreases the demand for money. The demand for money curve shifts leftward, from MD0 to MD2 in Figure 28.1

If the Fed makes a decision to cut the quantity of money, explain the short-run effects on the quantity of money demanded and the nominal interest rate. In the short run, the decrease in the quantity of money raises the nominal interest rate, so the quantity of money demanded decreases.

318

Part 10 . THE MONEY ECONOMY

The Fed conducts an open market purchase of securities. Explain the effects of this action on the nominal interest rate in the short run and the value of money in the long run. If the Fed conducts an open market purchase of securities, the quantity of money increases in both the short run and long run. In the short run, the increase in the quantity of money lowers the nominal interest rate. In the long run, the price level rises which lowers the value of money.

In 2007, the United States was at full employment. The quantity of money was growing at 6.4 percent a year, the nominal interest rate was 4.4 percent a year, real GDP grew at 1.9 percent a year, and the inflation rate was 2.9 percent a year. Use this information to work Problems 4 and 5. 4. Calculate the real interest rate. The real interest rate equals the nominal interest rate minus the inflation rate, so it is equal to 4.4 percent a year minus 2.9 percent a year, which is 1.5 percent a year. 5.

Was the velocity of circulation constant? (Hint: Use the quantity theory of money.) If the velocity of circulation was not constant, how did it change and why might it have changed? Velocity was not constant. Its growth rate equals inflation (2.9 percent a year) plus real GDP growth (1.9 percent a year) minus money growth (6.4 percent a year), which is −1.6 percent a year; that is, its growth rate was negative. The growth rate was negative, which means that people were spending their money at a lower rate than previously, perhaps because they expected inflation would slow in the future.

If the quantity of money is $3 trillion, real GDP is $10 trillion, the price level is 0.9, the real interest rate is 2 percent a year, and the nominal interest rate is 7 percent a year, calculate the velocity of circulation, the value of M × V, and nominal GDP. The velocity of circulation, V is equal to (P × Y) ÷ M, where P is the price level, Y is real GDP and M is the quantity of money. Using this formula gives V = (0.9 × $10 trillion) ÷ $3 trillion, which equals 3. M × V is equal to $3 trillion × 3, or $9 trillion. Nominal GDP is P × Y, where P is the price level and Y is real GDP. So, nominal GDP equals 0.9 × $10 trillion, which is $9 trillion. Nominal GDP also equals M × V.

Chapter 28 . Money, Interest, and Inflation

If the velocity of circulation is growing at 1 percent a year, the real interest rate is 2 percent a year, the nominal interest rate is 7 percent a year, and the growth rate of real GDP is 3 percent a year, calculate the inflation rate, the growth rate of money, and the growth rate of nominal GDP. The inflation rate is the difference between the nominal interest rate and the real interest rate. So the inflation rate is 7 percent a year − 2 percent a year, which is 5 percent a year. Money growth + Velocity growth = Inflation + Real GDP growth. Rearranging this formula gives Money growth = Inflation + Real GDP − Velocity. Inflation is 5 percent, real GDP growth is 3 percent, and velocity growth is 1 percent, so money growth equals 5 percent + 3 percent − 1 percent, which is 7 percent a year. The growth rate of nominal GDP is the sum of the inflation rate plus the growth rate of real GDP. So the growth rate of nominal GDP is 5 percent a year + 3 percent a year, which is 8 percent a year.

Suppose that the government passes a new law that sets a limit on the interest rate that credit card companies can charge on overdue balances. As a result, the nominal interest rate charged by credit card companies falls from 15 percent a year to 7 percent a year. If the average income tax rate is 30 percent, explain how the after-tax real interest rate on overdue credit card balances changes. The fall in the nominal interest rate lowers the real after-tax interest rate on credit cards. The after-tax real interest rate equals the after-tax nominal interest rate minus the inflation rate. Before the government’s new law, the after-tax nominal interest rate is equal to (15 percent) – (0.30) × (15 percent), which is 10.5 percent. With the new law, the after-tax nominal interest rate is equal to (7 percent) – (0.30) × (7 percent), which is 4.9 percent. So with no change in the inflation rate, the government has decreased the after-tax real interest rate by 5.6 percentage points.

Annualized inflation in Venezuela soars to 1,000 percent Inflation in Venezuela hit a monthly rate of 23.3 percent in June and it was feared that it would soon move into unstoppable hyperinflation. The country faced constant looting and social unrest. Source: PanAm Post, July 15, 2016 9. What is hyperinflation? Is Venezuela in a hyperinflation? A hyperinflation occurs when the inflation rate exceeds 50 percent per month. While close, Venezuela is not in a hyperinflation because the inflation rate is less than 50 percent per month. 10. Compare inflation in Venezuela in 2016 with that in Germany in 1923. Why did Germany print money in 1923 and create hyperinflation? Why is

319

320

Part 10 . THE MONEY ECONOMY

Venezuela printing money today? Why does a high inflation rate bring looting and social unrest? Inflation in Venezuela in 2016, while high, was significantly less than it was in Germany in 1923. Germany printed trillions of German marks to help pay reparations that were imposed on it after World War I. Venezuela is printing money to help pay for its government spending. High inflation brings looting and unrest because of the costs it creates. High inflation increases the tax on interest income and leads to very large shoeleather costs. It also leads to very high confusion costs and uncertainty costs, which decrease the nation’s real GDP. 11. Read Eye on Inflation on p. 742. Why did inflation increase during the 1970s? In which decades did velocity growth break the link between money growth and inflation? Inflation increased in the 1970s because the growth rate of the quantity of money increased. Velocity broke the link between money growth and inflation in the 1990s and after 2000. In the 1990s, velocity increased, which increased the inflation rate above what it otherwise would have equaled. After 2000 and particularly after 2010, however, velocity decreased, which lowered the inflation rate from what it otherwise would have equaled.

Chapter 28 . Money, Interest, and Inflation

 Additional Problems and Applications 1.

Read Eye on Inflation on p. 742 and explain what causes inflation. Why is it easier to predict the decade-average inflation rate than the inflation rate in a single year? Inflation is the result of growth in the quantity of money that is faster than growth in real GDP. It is easier to predict decade-average inflation rates rather than single-year inflation rates because during a single year factors other than the growth rate of money can change and these factors can affect the single-year inflation rate. In particular, in any given year velocity and real GDP can have large changes, which have large effects on that year’s inflation rate. But over a decade, these changes “cancel out” so that over a decade the primary factor driving changes in the inflation rate is changes in the monetary growth rate.

If the Fed doubled the quantity of money and nothing else changed, what would happen to the price level in the short run and the long run? What would happen to the inflation rate? If the Fed doubled the quantity of money, in the short run the nominal interest rate falls so investment and consumption increase. This increase in demand starts to raise the price level. In the long run, the price level changes by the same percentage change in the quantity of money. So in the long run, the price level will double. The inflation rate rises while the price level was rising but after the price level had reached its new equilibrium, the inflation rate would fall to zero (unless the Fed continued to increase the quantity of money).

Suppose that banks launch an aggressive marketing campaign to get everyone to use debit cards for every conceivable transaction. They offer prizes to new debit card holders and introduce a charge on using a credit card. How would the demand for money and the nominal interest rate change? The demand for money increases as people use their debit cards more often and use money (rather than credit cards) more often for transactions. Because the demand for money increases, the nominal interest rate rises.

321

322

Part 10 . THE MONEY ECONOMY

Draw a graph of the money market to illustrate equilibrium in the short run. If the growth rate of the quantity of money increases, explain what happens to the real interest rate and the nominal interest rate in the short run. Figure 28.2 shows the money market in the short run. In the short run, the increase in the growth rate of the quantity of money lowers the nominal interest rate. In Figure 28.2, the increase in the growth rate of the quantity of money increases the quantity of money from $0.98 trillion to $1.02 trillion and lowers the nominal interest rate from 5 percent to 3 percent. Because the inflation rate does not change in the short run, the real interest rate also falls.

The Fed conducts an open market sale of securities. Explain the effects of this action in the short run on the nominal interest rate and in the long run on the value of money and the price level. The sale of securities decreases the quantity of money. In the short run, the nominal interest rate rises. In the long run, the price level falls, which raises the value of money.

What is the quantity theory of money? Define the velocity of circulation and explain how it is measured. The quantity theory of money is the proposition that when real GDP equals potential GDP, an increase in the quantity of money brings an equal percentage increase in the price level. The velocity of circulation is the average number of times in a year that the each dollar of money gets used to buy final goods and services. The formula used to measure the velocity of circulation is V = (P × Y) ÷ M, where P is the price level, Y is real GDP, and M is the quantity of money.

If the velocity of circulation is constant, real GDP is growing at 3 percent a year, the real interest rate is 2 percent a year, and the nominal interest rate is 7 percent a year, calculate the inflation rate, the growth rate of money, and the growth rate of nominal GDP. The inflation rate is the difference between the nominal interest rate and the real interest rate. So the inflation rate is 7 percent a year − 2 percent a year, which is 5 percent a year. Because the velocity of circulation is constant, its growth rate is zero. Then, Money growth + Velocity growth = Inflation + Real GDP growth. Rearranging, Money growth = Inflation + Real

Chapter 28 . Money, Interest, and Inflation

323

GDP growth − Velocity, which is 5 percent a year + 3 percent a year − 0 percent a year = 8 percent a year. The growth rate of nominal GDP is the sum of the inflation rate plus the growth rate of real GDP. So the growth rate of nominal GDP is 5 percent a year + 3 percent a year, which is 8 percent a year. Sara has $200 in currency and $2,000 in a bank account on which the bank pays no interest. The inflation rate is 2 percent a year. Calculate the amount of inflation tax that Sara pays in a year. Sara has $2,200 of money. With inflation at 2 percent per year, Sara “pays” an inflation tax of 2 percent per year on the money she holds. So Sara pays an inflation tax of 0.02 × $2,200, or $44 per year.

Use the following information to work Problems 9 to 12. Fed’s easy money can’t control price level Robert F. Stauffer, Emeritus Professor of Economics at Roanoke College, Salem, Virginia, argues that the Fed’s monetary policy cannot closely control the price level, and an inflation target can be achieved only by chance. He takes issue with Harvard economist Martin Feldstein, who argues that the Fed’s easy money policy will eventually raise the inflation rate to more than 3 percent. Source: The Wall Street Journal, July 14, 2016 9. Why might Robert Stauffer be right? If he is right, what is he implying about the equation of exchange and the quantity theory of money? Mr. Stauffer might be correct if the velocity of circulation continues to fall. In this case, there will be no close tie between the growth rate of the quantity of money and the inflation rate. The equation of exchange is always correct because it is an identity that defines the velocity of circulation. But the quantity theory of money assumes that the velocity of circulation is stable and predictable. If the velocity of circulation is neither stable nor predicable, then the quantity theory is not useful because it cannot predict the relationship between monetary growth and inflation. 10. Why might Martin Feldstein be right? If he is right, what is he implying about the equation of exchange and the quantity theory of money? Mr. Feldstein might be correct if the velocity of circulation stops falling. If velocity growth stops falling and becomes more constant, then the quantity theory of money predicts that higher monetary growth will lead to a higher inflation rate. But the stable relationship between the growth rate of the quantity of money and the inflation rate (alternatively, between the percentage change in the quantity of money and the percentage change in the price level) requires a stable velocity of circulation. Mr. Feldstein is implying that the equation of exchange and the quantity theory of money are useful tools to help predict the inflation rate.

324

Part 10 . THE MONEY ECONOMY

11. When Martin Feldstein describes the Fed’s monetary policy as “easy,” he means that the Fed has created a lot of money, has made money grow at a fast rate, and has pushed interest rates down. Looking at the graph in Eye on Inflation (p. 742), has money been “easy” during the 2010s? In which decade was it most “easy”? Looking at the M2 growth rate from the decade of the 1960s, 1970s, 1980s, 1990s, 2000s, and 2010s, the M2 growth rate in the 2010s was about equal to about the average growth rate for these 6 decades. The M2 growth rate was highest—most easy—in the decade of the 1970s. 12. If the money growth rate and real GDP growth rate of the 2010s are maintained and if the velocity growth rate is zero, will the inflation rate rise to 3 percent as predicted by Martin Feldstein? The inflation rate will rise a little beyond Mr. Feldstein’s prediction, to about 4 percent. The figure shows that in the 2010s, the money growth rate is approximately 6.5 percent a year and the real GDP growth rate is approximately 1.75 percent a year. If the velocity growth rate is zero, the inflation rate is equal to the money growth rate minus the real GDP growth rate, which is 6.5 percent-1.75 percent, which is 4.75 percent a year.

Chapter 28 . Money, Interest, and Inflation

 Multiple Choice Quiz 1.

Holding money provides a benefit ________. A. because it is a means of payment B. because its opportunity cost is low C. which is constant no matter how much money is held D. because most money is in bank deposits Answer: A Answer A describes the benefit from holding money. 2.

The opportunity cost of holding money _______. A. is determined by the inflation rate B. is zero because money earns no interest C. equals the nominal interest rate on bonds D. equals the real interest rate on bonds Answer: C By holding money rather than bonds, the holder loses the return on the bonds, which is the nominal interest rate. 3.

The quantity of money demanded increases if _______. A. the supply of money increases B. the nominal interest rate falls C. banks increase the interest rate on deposits D. the price of a bond falls Answer: B The nominal interest rate is the opportunity cost of holding money, so a decrease in the nominal interest rate increases the quantity of money demanded. 4.

If the Fed increases the quantity of money, people will be holding ________. A. too much money, so they buy bonds and the interest rate rises B. too much money, so they buy bonds and the interest rate falls C. the quantity of money they demand and banks will hold more money D. more money and will increase their demand for money Answer: B People initially are holding more money than they want, so they buy bonds in order to hold less money, which raises the price of bonds and lowers their interest rate.

325

326

Part 10 . THE MONEY ECONOMY

In the long run, money market equilibrium determines the _______. A. real interest rate B. price level C. nominal interest rate D. economic growth rate Answer: B In the long run, money market equilibrium determines the value of money, 1/P. 6.

If the quantity theory of money is correct and other things remain the same, an increase in the quantity of money increases _______. A. nominal GDP and the velocity of circulation B. the price level and potential GDP C. real GDP D. nominal GDP and the price level Answer: D An increase in the quantity of money has no effect on real GDP or velocity, so an increase in the quantity of money raises the price level and hence also raises nominal GDP. 7.

In the long run with a constant velocity of circulation, the inflation rate ______. A. is constant and equals the money growth rate B. equals the money growth rate minus the growth rate of real GDP C. equals the growth rate of real GDP minus the growth rate of money D. is positive if the economic growth rate is positive Answer: B If velocity is constant, the growth rate of velocity is 0 percent, so the equation of exchange demonstrates that answer B is correct. 8.

The costs of inflation do not include _______. A. the cost of running around to compare prices at different outlets B. the increased opportunity cost of holding money C. the tax on money held by individuals and businesses D. an increase in saving and investment Answer: D Answer D is incorrect because inflation decreases saving and investment.

Aggregate Supply and Aggregate Demand ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications 1.

As more people in India have access to higher education, explain how potential GDP and aggregate supply will change in the long run. Increased access to higher education means that India’s labor force will be more highly educated and have more human capital. In the long run, this change will increase both India’s potential GDP and aggregate supply.

Explain the effect of each of the following events on the quantity of U.S. real GDP demanded and the demand for U.S. real GDP: • The world economy goes into a strong expansion. As the world economy goes into a strong expansion, U.S. exports increase. As a result, U.S. aggregate demand increases and the U.S. AD curve shifts rightward.

•

The U.S. price level rises. The rise in the U.S. price level decreases the quantity of U.S. real GDP demanded. There is a movement upward along the U.S. AD curve.

•

Congress raises income taxes. The tax hike decreases aggregate demand and shifts the AD curve leftward.

The United States is at full employment when the Fed cuts the quantity of money, other things remaining the same. Explain the effect of the cut in the quantity of money on aggregate demand in the short run. A decrease in the quantity of money decreases aggregate demand and shifts the AD curve leftward.

Chapter

328

Part 11 . ECONOMIC FLUCTUATIONS

The table sets out an economy’s aggrePrice level Real GDP Real GDP gate demand and aggregate supply (GDP demanded supplied price index) (billions of 2012 dollars) schedules. What is the macroeconomic 90 900 600 equilibrium? If potential GDP is $600 100 850 700 billion, what is the type of macroeco110 800 800 nomic equilibrium? Explain how real 120 750 900 GDP and the price level will adjust in 130 700 1,000 the long run. The macroeconomic equilibrium occurs at real GDP of $800 billion and a price level of 110. This price level is the only price level at which the quantity of real GDP demanded equals the quantity of real GDP supplied. If potential GDP is $600 billion, real GDP exceeds potential GDP. There is an inflationary gap. In the long run, the money wage rate rises. As the money wage rate rises, aggregate supply decreases so that real GDP decreases and the price level rises. Eventually aggregate supply decreases enough so that real GDP equals potential GDP, at which point adjustment stops.

Suppose that the U.S. economy has a recessionary gap and the world economy goes into an expansion. Explain the effect of the expansion on U.S. real GDP and unemployment in the short run. A global expansion increases exports and thereby increases U.S. aggregate demand so that the U.S. AD curve shifts rightward. In the short run, the increase in aggregate demand increases U.S. real GDP and lowers U.S. unemployment.

The U.S. economy is close to full employment when the Fed increases the quantity of money. Explain the effect of the Fed's action on the macroeconomic equilibrium in the short run. Explain the adjustment process that returns the economy to full employment. An increase in the quantity of money increases aggregate demand. As shown in Figure 29.1, the AD curve shifts rightward from AD0 to AD1. The new short-run equilibrium occurs where the AS curve intersects the AD1 curve. The price level rises and real GDP increases. In Figure 29.1, the new short-run equilibrium occurs at the price level of 120 and real GDP of $20.5 trillion. This equilibrium reflects an inflationary gap. Full employment is restored as the money wage rate rises. Aggregate supply decreases and the AS curve shifts leftward. Even© 2021 Pearson Education, Inc.

Chapter 29 . Aggregate Supply and Aggregate Demand

tually aggregate supply decreases enough so that that real GDP returns to potential GDP and the economy is back at full employment. Use Figure 29.2 to work Problems 7 to 9. Initially, the economy is at point B. 7. Some events change aggregate demand from AD0 to AD1. Describe two possible events. What is the new equilibrium point? If potential GDP is $1 trillion, describe the type of macroeconomic equilibrium. Aggregate demand increases when the aggre-

gate demand curve shifts from AD0 to AD1. Aggregate demand increases if expected future income, expected future inflation, or expected future profit increases; if the government cuts taxes, increases its expenditure on goods and services, or increases its transfer payments; if the Fed increases the quantity of money and lowers the interest rate; or if the U.S. foreign exchange rate falls or foreign income increases. After the change in aggregate demand, equilibrium real GDP is $1.1 trillion and the equilibrium price level is 105. The economy has an inflationary gap. Some events change aggregate supply from AS0 to AS1. Describe two possible events. What is the new equilibrium point? If potential GDP is $1 trillion, does the economy have an inflationary gap, a recessionary gap, or no gap? Aggregate supply decreases when the aggregate supply curve shifts from AS0 to AS1. Aggregate supply decreases if potential GDP decreases; if the money wage rate rises; or if the money prices of other resources rise. After the change, equilibrium real GDP is $0.9 trillion and the equilibrium price level is 105. The economy is at an equilibrium with a recessionary gap. Some events change aggregate demand from AD0 to AD1 and aggregate supply from AS0 to AS1. What is the new macroeconomic equilibrium? After the changes, equilibrium real GDP is $1.0 trillion and the equilibrium price level is 110. The economy is at a full-employment equilibrium.

329

330

Part 11 . ECONOMIC FLUCTUATIONS

Use the following information to work Problems 10 and 11. “Brexit” expected to rattle U.S. economy The United Kingdom vote to leave the European Union (known as Brexit) is expected to affect the U.S. economy by driving up the value of the dollar. Source: The Wall Street Journal, June 24, 2016 10. Explain the effect of a high value of the U.S. dollar on U.S. aggregate demand and aggregate supply. A higher exchange rate makes U.S. exports more expensive abroad, and so decreases U.S. exports. It also lowers the price of U.S. imports, thereby increasing U.S. imports. The decrease in U.S. exports and the increase in U.S. imports both decrease U.S. aggregate demand and shift the AD curve leftward. Aggregate supply does not change. 11. Explain the effect of a high value of the U.S. dollar on U.S. real GDP and the price level. Use an AS-AD graph to illustrate your answer. The high value of the dollar decreases aggregate demand but it does not change aggregate supply. Figure 29.3 illustrates this change. Without the effects from Brexit, the aggregate demand curve would be AD0 and U.S. real GDP would equal $20.5 trillion. Brexit shifts the aggregate demand curve to AD1 and decreases U.S. GDP to $20.3 trillion. 12. Read Eye on Recession on p. 773. What caused the 2008–2009 recession and how do we know that a decrease in aggregate supply played a role? The financial crisis decreased the supply of loanable funds so that investment, particularly construction, decreased. The decrease in investment decreased aggregate demand. The decrease in aggregate demand was partially offset by an increase in government spending. Simultaneously, the rise in oil prices and in the money wage rate decreased aggregate supply. Accordingly, the recession was caused by the financial crisis, an increase in oil prices, and an increase in the money wage rate. We know that the recession involved a decrease in aggregate supply because if only aggregate demand decreased, the price level would have fallen. But the price level rose. The rise in the price level requires a decrease in aggregate supply.

Chapter 29 . Aggregate Supply and Aggregate Demand

 Additional Problems and Applications 1.

Read Eye on Recession on p. 773. What, according to the mainstream theory of the business cycle, is the most common source of recession: a decrease in aggregate demand, a decrease in aggregate supply, or both? Which is the most likely component of aggregate demand to start a recession? How does the aggregate demand multiplier influence a recession? According to mainstream theory, fluctuations in aggregate demand are the major source of recessions. Investment is the component of aggregate demand whose decrease starts recessions. The aggregate demand multiplier means that recessions will be deeper. An initial decrease in aggregate demand is reinforced by the aggregate demand multiplier so that the resulting decrease in real GDP (and increase in unemployment) is larger than would otherwise be the case.

Suppose that the United States is at full employment. Explain the effect of each of the following events on aggregate supply: • Union wage settlements push the money wage rate up by 10 percent. The higher money wage rate decreases U.S. aggregate supply and the U.S. AS curve shifts leftward.

•

The price level increases. The higher price level increases the quantity of real GDP supplied and there is a movement upward along the U.S. AS curve.

•

Potential GDP increases. The increase in potential GDP increases U.S. aggregate supply and the U.S. AS curve shifts rightward.

The U.S. economy is at full employment. If the federal government cuts taxes, and all other influences on aggregate demand remain the same, explain how aggregate demand will change in the short run. The tax cut increases aggregate demand and shifts the AD curve rightward. Aggregate supply does not change.

Use the following information to work Problems 4 and 5. Because fluctuations in the world oil price make the U.S. short-run macroeconomic equilibrium fluctuate, someone suggests that the government should vary the tax rate on oil, lowering the tax when the world oil price rises and increasing the tax when the world oil price falls, to stabilize the oil price in the U.S. market. 4. How would such an action influence aggregate demand? Raising the tax decreases disposable income, decreases consumption, and decreases aggregate demand. Lowering the tax has the opposite effects.

331

332

Part 11 . ECONOMIC FLUCTUATIONS

How would such an action influence aggregate supply? If the tax successfully stabilizes the price of oil, it would stabilize aggregate supply. If the tax does not fully stabilize but instead moderates fluctuations in the price of oil, then it would moderate fluctuations in aggregate supply.

The table sets out the aggregate dePrice level Real GDP Real GDP (GDP demanded supplied mand and aggregate supply schedules price index) (trillions of 2005 yen) in Japan. Potential GDP is 600 trillion 75 600 400 yen. What is the short-run macroeco85 550 450 nomic equilibrium? Does Japan have 95 500 500 an inflationary gap or a recessionary 105 450 550 gap and what is its magnitude? 115 400 600 125 350 650 The macroeconomic equilibrium oc135 300 700 curs at real GDP of ¥500 trillion and a price level of 95. This price level is the only price level at which the quantity of real GDP demanded equals the quantity of real GDP supplied Because potential GDP is ¥600 trillion, real GDP is less than potential GDP. There is a recessionary gap equal to real GDP minus potential GDP, which is ¥100 trillion.

The U.S. economy is at full employment when the world price of oil rises. On an AS–AD graph, show the effect of the world oil price rise on U.S. macroeconomic equilibrium in the short run. Explain the adjustment process that restores the economy to full employment. A rise in the world price of oil decreases aggregate supply. As Figure 29.4 shows, the AS curve shifts leftward from AS0 to AS1. The new short-run equilibrium occurs where the AS1 curve intersects the AD curve, at the price level of 120 and real GDP of $19.75 trillion. The economy is in an equilibrium with a recessionary gap. There is a surplus of labor because employment has decreased. This surplus gradually lowers the money wage rate. Full employment is restored as the money wage rate falls. Aggregate supply increases and the AS curve shifts rightward.

The U.S. economy is at full employment when the global economy goes into recession. Explain the effects of the global recession on the U.S. macroeconomic equilibrium in the short

Chapter 29 . Aggregate Supply and Aggregate Demand

run. Explain the adjustment process that restores the economy to full employment. As the world economy goes into recession, U.S. exports decrease so the U.S. aggregate demand decreases and the U.S. AD curve shifts leftward. Figure 29.5 illustrates this change, with the AD curve shifting leftward from AD0 to AD1. The new short-run equilibrium occurs where the AS curve intersects the AD1 curve. The price level falls and real GDP decreases. In Figure 29.5, the new short-run equilibrium occurs at the price level of 100 and real GDP of $19.5 trillion. The economy is in an equilibrium with a recessionary gap. There is a surplus of labor because employment has decreased. This surplus gradually lowers the money wage rate. In the long run, full employment is restored as the money wage rate falls. Aggregate supply increases and the AS curve shifts rightward. The increase in aggregate supply raises real GDP and employment so that the economy ultimately returns to potential GDP and full employment. Use the following information to work Problems 9 and 10. Brexit means a bumpy road ahead for the U.K. economy The decision by the U.K. people to leave the European Union has already brought a sharp fall in the value of the pound and is expected to lower business and household spending. Source: Financial Times, June 24, 2016 9. Explain the effects of a fall in the value of the U.K. pound and lower spending by businesses and households on U.K. aggregate demand and aggregate supply. The fall in the value of the pound makes U.K. imports less expensive to foreigners and U.K. imports more expensive to U.K. citizens. Both effects increase U.K. aggregate demand. However, lower spending by businesses and households both decrease U.K. aggregate demand. Consequently, the net effect on U.K. aggregate demand is ambiguous.

333

334

Part 11 . ECONOMIC FLUCTUATIONS

10. The U.K. economy in 2016 was close to full employment. Use the AS-AD model to show the effect on U.K. real GDP of the effects of Brexit described in the news clip. Although the effect of brexit on U.K. aggregate demand is ambiguous, most observers expect it to decrease. Indeed, the conclusion that it will decrease is why Brexit means a “bumpy road ahead for the U.K. economy.” Figure 29.6 illustrates the effect of the decrease in aggregate demand. Brexit lowers U.K. real GDP from ₤4.4 trillion to ₤4.2 trillion.

Chapter 29 . Aggregate Supply and Aggregate Demand

 Multiple Choice Quiz 1.

Aggregate supply increases when ________. A. the price level rises B. the money wage rate falls C. consumption increases D. the money price of oil increases

Answer: B

A fall in the money wage rate increases aggregate supply and shifts the AS curve rightward.

When potential GDP increases, _______. A. aggregate demand increases B. aggregate supply increases C. both aggregate demand and aggregate supply increase D. the price level rises

Answer: B

As Figure 29.2 in the text shows, an increase in potential GDP increases aggregate supply.

The quantity of real GDP demanded increases if _______. A. the buying power of money increases B. the money wage rate rises C. the price level falls D. the nominal interest rate falls

Answer: C

Changes in the price level bring movements along the AD curve and change the quantity of real GDP demanded.

An increase in expected future income increases ________. A. consumption expenditure, which increases current aggregate demand B. investment, which increases current aggregate supply C. the demand for money, which decreases current aggregate demand D. future consumption expenditure and has no effect on current aggregate demand

Answer: A

Consumption expenditure increases as consumers buy bigticket items now with the idea of paying for them in the future.

335

336

Part 11 . ECONOMIC FLUCTUATIONS

Macroeconomic equilibrium occurs when the quantity of real GDP _______ equals the quantity of _______. A. demanded; real GDP supplied B. demanded; potential GDP C. supplied; potential GDP D. demanded; real GDP supplied and potential GDP

Answer: A

Macroeconomic equilibrium occurs where the AD curve intersects the AS curve, which is the point at which the quantity of real GDP demanded equals the quantity of real GDP supplied.

If the economy is at full employment and the Fed increases the quantity of money, _______. A. aggregate demand increases, a recessionary gap appears, and the money wage rate starts to rise B. aggregate supply increases, the price level starts to fall, and an expansion begins C. aggregate demand increases, an inflationary gap appears, and the money wage rate starts to rise D. potential GDP and aggregate supply increase together and the price level does not change

Answer: C

An increase in the quantity of money can set off a demandpull inflation by increasing aggregate demand, thereby creating an inflationary gap.

Over the past decade, the demand for goods produced in China has brought a sustained increase in demand for China’s exports that has outstripped the growth of supply. As a result, China has experienced a _______. A. period of stable prices and sustained economic growth B. rising price level and demand-pull inflation C. rising price level and cost-push inflation D. rising price level and a falling real wage rate

Answer: B

Aggregate demand has increased far more than aggregate supply, so the price level has risen and the economy has had a demand-pull inflation.

Aggregate Expenditure Multiplier

Chapter

ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications The table shows disposable income and saving in an economy. Disposable Use the table to answer Problems 1 and 2. income Saving (trillions of dollars) 1. Calculate consumption expenditure at each level of dis0 −5 posable income. Over what range of disposable income is 10 −3 there dissaving? Estimate the level of disposable income at 20 −1 which saving is zero. 30 1 When disposable income is $0, consumption expenditure 40 3 is $5 trillion; when disposable income is $10 trillion, con50 5 sumption expenditure is $13 trillion; when disposable income is $20 trillion, consumption expenditure is $21 trillion; when disposable income is $30 trillion, consumption expenditure is $29 trillion; when disposable income is $40 trillion, consumption expenditure is $37 trillion; when disposable income is $50 trillion, consumption expenditure is $45 trillion. Saving is zero when disposable income is $25 trillion. 2.

Calculate the marginal propensity to consume. If wealth increases by $10 trillion, in which direction will the consumption function change? The marginal propensity to consume is the change in consumption expenditure divided by the change in disposable income. When disposable income increases by $10 trillion from $40 trillion to $50 trillion, consumption expenditure increases from $37 trillion to $45 trillion, an increase of $8 trillion. So the MPC equals $8 trillion ÷ $10 trillion, 0.80. If wealth increases by $10 trillion, the consumption function shifts upward.

338

Part 11 . ECONOMIC FLUCTUATIONS

Use the table to work Problems 3, 4, and 5. The table shows real GDP, Y, the components of planned expenditure, and aggregate planned expenditure (in millions of dollars) in an economy in which taxes are constant. Planned expenditure Y

0 2 4 6 8 10 12

2.0 Q 4.4 5.6 6.8 8.0 9.2

1.75 1.75 R 1.75 1.75 1.75 1.75

1.0 1.0 1.0 S 1.0 1.0 1.0

1.25 1.25 1.25 1.25 T 1.25 1.25

0 0.4 0.8 1.2 1.6 U 2.4

6.0 6.8 7.6 8.4 9.2 10.0 V

Find the value of Q, R, S, T, U, and V. Q = 3.2; R = 1.75; S = 1.0; T = 1.25; U= 2.0; V = 10.8. All of the answers are calculated using the formula AE = C + I + G + X − M.

Calculate the marginal propensity to consume and the marginal propensity to import. What is equilibrium expenditure? The marginal propensity to consume equals the change in consumption expenditure divided by the change in disposable income. Because taxes are constant, the change in real GDP equals the change in disposable income. When real GDP increases from $4 million to $6 million, consumption expenditure increases from $4.4 million to $5.6 million. MPC equals the change in consumption, $1.2 million, divided by the change in real GDP, $2.0 million, which is 0.60. The marginal propensity to import equals the change in imports divided by the change in real GDP. When real GDP increase from $4 million to $6 million, imports increase from $0.8 million to $1.2 million. The marginal propensity to import equals the change in imports, $0.4 million, divided by the change in real GDP, $2.0 million, which is 0.20. Equilibrium expenditure is $10 million because this is the level of real GDP at which aggregate expenditure equals real GDP.

If investment crashes to $0.55 million but nothing else changes, what is equilibrium expenditure and what is the multiplier? Equilibrium expenditure becomes $8 million because when real GDP equals $8 million, (the new) aggregate expenditure equals real GDP. The $1.20 million decrease in investment lead to a $2.0 million decrease in real GDP. So the multiplier is $2.00 million ÷ $1.20 million, which is 1.67.

Chapter 30 . Aggregate Expenditure Multiplier

Figure 30.1 shows aggregate planned expenditure when the price level is 100. When the price level increases to 110, aggregate planned expenditure changes by $0.5 trillion. What is the quantity of real GDP demanded when the price level is 100 and 110? When the price level is 100, the AE curve in Figure 30.1 is the relevant aggregate expenditure curve. The equilibrium real GDP is then $5 trillion, so when the price is 100, the quantity of real GDP demanded is $5 trillion. When the price level increases to 110, aggregate expenditure falls by $0.5 trillion so the aggregate expenditure curve in Figure 30.1 would shift downward by $0.5 trillion. The new AE curve shows that equilibrium real GDP is $3 trillion. So when the price level is 110, the quantity of real GDP demanded is $3 trillion.

Use this information to work Problems 7 and 8. U.S. durable goods orders rebound strongly The Commerce Department reported that orders for durable goods increased 2.1 percent in July. Orders for Boeing aircraft rebounded. Source: Financial Times, August 26, 2019 7.

Explain the process by which an increase in durable goods orders at a constant price level changes equilibrium expenditure and real GDP. The increase in planned investment has a multiplied effect on equilibrium expenditure. The initial increase in investment increases expenditure by a like amount. But the workers employed constructing the new investment goods have higher disposable incomes and, as a result, increase their consumption expenditure, thereby adding to equilibrium expenditure. And the workers producing the additional consumption goods and services have higher disposable income and therefore higher consumption expenditure. The induced consumption expenditure is why the increase in investment has a multiplier effect on equilibrium expenditure.

What determines the increase in aggregate demand resulting from an increase in durable goods orders? The increase in aggregate demand is determined by the multiplier. The larger the multiplier, the larger the increase in aggregate demand.

Read Eye on the Multiplier on p. 796. Why do multiplier estimates differ? What conditions would be consistent with a large multiplier? Multiplier estimates differ because there is disagreement among econo© 2021 Pearson Education, Inc.

339

340

Part 11 . ECONOMIC FLUCTUATIONS

mists about the crowding out effect on investment. Barro says the multiplier is only 0,.8 because private expenditure is crowded out by government expenditure, while the Council of Economic Advisers thinks there is less crowding out so they estimate the multiplier to be 1.6. The multiplier estimates also differ because of differences in how they are estimated. Barro, for instance, used the large increases in government expenditure during wars to construct his estimate of the multiplier. For the multiplier to be large requires that the economy has a large recessionary gap.

Chapter 30 . Aggregate Expenditure Multiplier

 Additional Problems and Applications 1.

Read Eye on the Multiplier on p. 796. The output gap in the second quarter of 2009 was $0.8 trillion. How much fiscal stimulus would have been required to close the output gap if the multiplier was as large as the President’s Council of Economic Advisers believe? How much fiscal stimulus would have been required if the multiplier was a large as Robert Barro believes? The President’s Council of Economic Advisers believes the multiplier is 1.6. With this sized multiplier, to close an output gap of $0.8 trillion requires government expenditure of ($0.8 trillion) ÷ 1.6 or $0.5 trillion. Robert Barro believes the multiplier is 0.8. With this sized multiplier, to close an output gap of $0.8 trillion requires government expenditure of ($0.8 trillion) ÷ 0.8 or $1.0 trillion.

The table shows disposable income and consumpDisposable Consumption income expenditure tion expenditure in an economy. Use the table to (billions of dollars) work Problems 2 and 3. 200 350 2. Calculate saving at each level of disposable 400 500 income. Over what range of disposable income 600 650 does consumption expenditure exceed 800 800 disposable income? Calculate autonomous 1,000 950 consumption expenditure. When disposable income is $200 billion, saving is −$150 billion; when disposable income is $400 billion, saving is −$100 billion; when disposable income is $600 billion, saving is −$50 billion; when disposable income is $800 billion, saving is $0; and, when disposable income is $1,000 billion, saving is $50 billion. Consumption expenditure exceeds disposable income when disposable income is less than $800 billion. Autonomous consumption expenditure is consumption expenditure when disposable income is $0. Extrapolating from the table above, autonomous consumption expenditure is $200 billion. 3.

Calculate the marginal propensity to consume. At what level of disposable income will saving be zero? If expected future income increases, in which direction will the consumption function change? The marginal propensity to consume equals the change in consumption expenditure divided by the change in disposable income. Because the consumption function is linear, the MPC is the same at all levels of disposable income. So the MPC = ($500 billion − $350 billion) ÷ ($400 billion − $200 billion) = ($150 billion) ÷ ($200 billion), which is 0.75. Saving is equal to zero when disposable income equals $800 billion. If expected future income increases, consumption increases and the consumption function shifts upward. © 2021 Pearson Education, Inc.

341

342

Part 11 . ECONOMIC FLUCTUATIONS

Use the following information to work Problems 4 to 6. In an economy with no exports and no imports, autonomous consumption is $1 trillion, the marginal propensity to consume is 0.8, investment is $5 trillion, and government expenditure on goods and services is $4 trillion. Taxes are $4 trillion and do not vary with real GDP. 4. If real GDP is $30 trillion, calculate disposable income, consumption expenditure, and aggregate planned expenditure. What is equilibrium expenditure? Disposable income equals GDP minus net taxes. GDP is $30 trillion, taxes are $4 trillion, so disposable income is $30 trillion − $4 trillion, which is $26 trillion. Consumption expenditure equals the sum of autonomous consumption expenditure plus induced consumption expenditure. Induced consumption expenditure equals MPC times disposable income, so induced consumption expenditure equals (0.8) × ($26 trillion), which is $20.8 trillion. Autonomous consumption is given as $1 trillion, so total consumption expenditure equals $1 trillion + $20.8 trillion, which is $21.8 trillion. Aggregate planned expenditure equals the sum of consumption expenditure plus investment plus government expenditures (plus exports and minus imports if there is international trade). Aggregate planned expenditure equals $21.8 trillion + $5 trillion + $4 trillion, which is $30.8 trillion. Equilibrium expenditure equals $34 trillion. To check this answer, note that when expenditure is $34 trillion, real GDP equals $34 trillion so disposable income equals $30 trillion. Therefore consumption expenditure is $25 trillion. Aggregate planned expenditure equals consumption expenditure, $25 trillion, plus investment, $5 trillion, plus government expenditure on goods and services, $4 trillion, which is $34 trillion and equals real GDP. 5.

If real GDP is $30 trillion, explain the process that takes the economy to equilibrium expenditure. If real GDP is $40 trillion, explain the process that takes the economy to equilibrium expenditure. If real GDP is $30 trillion, aggregate expenditure exceeds real GDP. Firms find their inventories falling below their target levels, and in response, they increase production to restore inventories to their target levels. As firms increase production, real GDP increases and the economy moves toward its equilibrium expenditure of $34 trillion. If real GDP is $40 trillion, real GDP exceeds aggregate planned expenditure. Inventories rise above their target levels. Firms slash production to drive inventories back to their target levels and so real GDP decreases. The economy moves toward its equilibrium expenditure of $34 trillion.

If investment increases by $0.5 trillion, calculate the change in equilibrium expenditure and the multiplier. If investment increases by $0.5 trillion, the AE curve shifts upward by $0.5 © 2021 Pearson Education, Inc.

Chapter 30 . Aggregate Expenditure Multiplier

trillion. Since there are no income taxes (taxes are fixed at $4 trillion) and 1 because there are no imports or exports, the multiplier equals . (1 − MPC ) With the MPC equal to 0.8, the multiplier equals 5.0. The change in equilibrium expenditure equals the change in autonomous expenditure times the multiplier. The change in autonomous expenditure is the change in investment, which is $0.5 trillion. The multiplier is 5.0. So the change in equilibrium expenditure is equal to ($0.5 trillion ) × (5.0), which is $2.5 trillion. Use the following information to work Problems 7 and 8. The figure shows the aggregate demand curve in an economy. Suppose that aggregate planned expenditure increases by $0.75 trillion for each $1 trillion increase in real GDP. 7. If investment increases by $1 trillion, calculate the change in the quantity of real GDP demanded if the price level is constant at 105. Because aggregate planned expenditure increases by 0.75 of any change in real GDP, the multiplier for the change in real GDP is equal to 1/(1 − 0.75), which is 4.0. Hence a $1 trillion increase in investment increases the quantity of real GDP demanded by $4 trillion when the price level is constant at 105. 8.

Compare the shift of the AD curve with the $1 trillion increase in investment. Explain the magnitude of the shift of the AD curve. The AD curve shifts rightward by $4 trillion dollars. The overall increase in aggregate demand exceeds the initial increase in investment because of the multiplier. The increase in investment increases people’s disposable income, which leads to still further increases in consumption expenditure.

Use the following information to work Problems 9 and 10. Durable goods orders slump Orders for Boeing planes almost dried up in April following the grounding of its 737 Max jet, triggering a decline in U.S. orders for durable goods. Source: Bloomberg, May 24, 2019 Source: Bloomberg, February 29, 2012 9.

Explain the process by which a decrease in durable goods orders at a constant price level changes equilibrium expenditure and real GDP. The decrease in planned investment in durable goods has a multiplier ef© 2021 Pearson Education, Inc.

343

344

Part 11 . ECONOMIC FLUCTUATIONS

fect on equilibrium expenditure. The initial decrease in investment decreases GDP by the same amount. But some workers are made unemployed as a result of the decrease in the production of investment goods. These workers have lower disposable incomes and, as a result, decrease their consumption expenditure, thereby reducing equilibrium expenditure even more. And the decrease in consumption expenditure means that some workers producing consumption goods and services have lower disposable income as they are fired or work fewer hours. Consequently their consumption expenditure also falls. The induced decrease in consumption expenditure is why the decrease in investment has a multiplier effect on equilibrium expenditure. In terms of the aggregate planned expenditure curve, it shifts downward by an amount equal to the decrease in planned investment. Equilibrium expenditure and real GDP, which are determined at the intersection of the aggregate expenditure curve and the 45-degree line, decrease by more than the initial fall in planned investment. 10. What determines the decrease in aggregate demand resulting from a decrease in durable goods orders? The decrease in aggregate demand is determined by the multiplier. The larger the multiplier, the larger the decrease in aggregate demand.

Chapter 30 . Aggregate Expenditure Multiplier

 Multiple Choice Quiz 1.

The consumption function shows how an increase in _______ influences _________. A. income; households’ aggregate planned expenditure B. nominal GDP; consumption expenditure C. disposable income; consumption expenditure D. consumption as a fraction of income; real GDP Answer: C Answer C is the definition of the consumption function. 2.

The marginal propensity to consume tells us by how much _______ changes when _______ changes. A. consumption expenditure; wealth B. the real interest rate; planned consumption C. expected future income; the percentage of income spent D. consumption expenditure; disposable income Answer: D Answer D explains what the marginal propensity to consume measures. 3.

Induced expenditure includes ________ . A. consumption expenditure, government expenditure, and exports B. investment, exports, and imports C. consumption expenditure and imports D. consumption expenditure, investment, and government expenditure Answer: C Consumption expenditure and imports both change when real GDP changes, so both are induced expenditure.

The aggregate planned expenditure curve ________ increases. A. slopes upward because induced expenditure increases as income B. is horizontal because autonomous expenditure is constant when income C. shifts upward if induced expenditure increases as income D. slopes upward because autonomous expenditure Answer: A Aggregate expenditure increases when real GDP increases because induced expenditure increases when real GDP increases.

345

346

Part 11 . ECONOMIC FLUCTUATIONS

If real GDP _______ planned expenditure, the economy converges to equilibrium expenditure because inventories _________ and firms increase production. A. exceeds; pile up B. exceeds; are run down C. is less than; are run down D. is less than; pile up Answer: C If real GDP is less than planned expenditure, the difference is made up by unplanned decreases in inventories which leads firms to boost their production. 6.

The multiplier equals ____________ divided by _________. A. the marginal propensity to consume; autonomous expenditure B. 1; (1 – Slope of the AE curve) C. 1; Slope of the AE curve D. Slope of the AE curve; the marginal propensity to consume Answer: B Answer B correctly gives the formula for the multiplier. 7.

The multiplier will increase if the marginal propensity to consume ______ or the marginal tax rate ______. A. increases; decreases B. increases; increases C. decreases; increases D. decreases; decreases Answer: A Both an increase in the marginal propensity to consume and a decrease in the marginal tax rate increase the amount of spending from an increase in income, thereby increasing the size of the multiplier. 8.

A rise in the price level shifts the AE curve ______. A. upward and creates a movement up along the AD curve B. downward and creates a movement up along the AD curve C. upward and shifts the AD curve rightward D. downward and shifts the AD curve leftward Answer: B The AE curve shifts downward because real wealth decreases; there is movement along the AD curve because a change in the price changes the aggregate quantity of real GDP demanded.

The Short-Run Policy Tradeoff

Chapter

ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications Data 2020 Data 2021 Price Real GDP Unemployment Price Real GDP Unemployment level (trillions of rate level (trillions of rate (2019 = 100) 2019 dollars) (percent) (2019 = 100) 2019 dollars) (Percent) A 102 11.0 9 A 108 11.1 9 B 104 11.1 7 B 110 11.2 7 C 106 11.2 5 C 112 11.3 5 D 110 11.4 3 D 116 11.5 3 The left part of the table describes four situations that might arise in 2020, depending on the level of aggregate demand. The right part of the table describes four situations that might arise in 2021. Use the table to work Problems 1 to 4. 1. Plot the short-run Phillips curve and aggregate supply curve for 2020 and mark the points A, B, C, and D on each curve that correspond to the data in the left part of the table. Inflation rate Unemployment rate Price level Real GDP (percent per year) (percentage) (2019 = 100) (trillions of 2019 dollars) A 2 9 102 11.0 B 4 7 104 11.1 C 6 5 106 11.2 110 11.4 3 D 10 Use the data in the table above to plot the Phillips curve and the aggregate supply curve. In the table the inflation rates are calculated as the change in the price level divided by the initial price, all multiplied by 100. Then the inflation rates and unemployment rates are plotted as the Phillips curve in Figure 31.1 (on the next page). The aggregate supply curve is plotted in Figure 31.2 (on the next page) using the data in the problem, which is reproduced in the table above.

348

Part 11 . ECONOMIC FLUCTUATIONS

In 2020, the outcome turned out to be row C of the left side of the table. Plot the short-run Phillips curve for 2021 and mark the points A, B, C, and D that correspond to the data in the right side of the table.

A B C D

Inflation rate (percent per year) 1.9 3.8 5.7 9.4

Unemployment rate (percentage) 9 7 5 3

Use the table above to plot the Phillips curve. The table and inflation rates are constructed similarly to that in Problem 1. The inflation rates and unemployment rates are plotted as the Phillips curve in Figure 31.3. 3.

Compare the short-run Phillips curve of 2021 with that of 2020. The Phillips curve shifted slightly downward.

What is Okun’s Law? If the natural unemployment rate is 6 percent, does this economy behave in accordance with Okun’s Law? Okun’s law is a relationship between unemployment and GDP. Okun’s law states that for each percentage point that the unemployment rate is above (below) the natu-

Chapter 31 . The Short-Run Policy Tradeoff

ral unemployment rate, real GDP is 2 percentage points below (above) potential GDP. The economy in the two tables does not behave in accordance with Okun’s law. For instance, in 2020, because the natural unemployment rate is 6 percent, potential GDP is $11.15 trillion. When the unemployment rate is 7 percent, according to Okun’s law real GDP should be $10.9 trillion, 2 percent lower. But the table shows that when the unemployment rate is 7 percent, real GDP is $11.1 trillion. Similar calculations show that Okun’s law also fails to hold for the 2021 data. 5.

Suppose that the natural unemployment rate is 7 percent in 2019 and it decreases to 6 percent in 2020 with no change in expected inflation. Explain how the short-run and long-run tradeoffs change. A decrease in the natural unemployment rate means that both the shortrun and long-run Phillips curves shift leftward.

Suppose that the natural unemployment rate is 7 percent and the expected inflation rate in 2020 is 3 percent a year. If the inflation rate is expected to rise to 5 percent a year in 2021, explain how the short-run and the long-run Phillips curves will change. The short-run Phillips curve shifts upward because there is a rise in the expected inflation rate. There is no change to the long-run Phillips curve.

The inflation rate is 2 percent a year, and the quantity of money is growing at a pace that will maintain that inflation rate. The natural unemployment rate is 7 percent, and the current unemployment rate is 9 percent. In what direction will the unemployment rate change? How will the short-run Phillips curve and the long-run Phillips curve shift? The current unemployment rate is greater than the natural unemployment rate. So, over time, the unemployment rate decreases until it equals the natural unemployment rate. Because the current unemployment rate is greater than the natural unemployment rate, the economy has moved along its SRPC to a point to the right of the LRPC. At this point, the current inflation rate is less than the expected inflation rate. So, over time, people revise downward their expected inflation rate and the short-run Phillips curve shifts downward. The long-run Phillips curve does not shift.

From 1991 until 2018, the average inflation rate in Russia was 11 percent. Explain how a history of high inflation might influence the short-run and long-run Phillips curves in Russia. The history of high inflation means that people are very cautious about being caught unawares by another outburst of inflation. Their expected inflation rates change rapidly, which means the short-run Phillips curve shifts rapidly. As a result, any higher inflation rate is unlikely to be unexpected for long because people rapidly revise their expected inflation rate,

349

350

Part 11 . ECONOMIC FLUCTUATIONS

which means that any decrease in unemployment from the higher inflation is short-lived. Use the following information to work Problems 9 and 10. India seeks more reserved central bank There is a conflict in India between politicians who want faster growth and lower unemployment, and the central bank governor who wants price stability. The government is replacing the central bank governor and possibly increasing its inflation target. Source: The Wall Street Journal, July 5, 2016 9. Sketch India’s short-run and long-run Phillips curves if the expected inflation rate rises from 5 percent per year to 7 percent per year and the natural unemployment rate is constant at 8 percent. Figure 31.4 shows the long-run Phillips curve, LRPC, which is vertical at the natural unemployment rate of 8 percent. The increase in the expected inflation rate shifts the short-run Phillips curve upward. The figure shows this shift, with the short-run Phillips curves, SRPC5 (the Phillips curve when the expected inflation rate is 5 percent) and SRPC7, (the Phillips curve when the expected inflation rate is 5 percent) which both intersect the long-run Phillips curve at their respective expected inflation rates. 10. If the government replaces the central bank governor and pursues faster growth by increasing aggregate demand, how will inflation and unemployment change? How will India’s Phillips curves change? If the actual inflation rate rises and the expected inflation rate does not change, there is a movement upward along the (unchanged) short-run Phillips curve. The unemployment rate decreases and the inflation rate rises. The short-run tradeoff between inflation and unemployment does not change, that is, the short-run Phillips curve does not shift. If the actual inflation rate rises and the expected inflation rate also rises by the same amount, the long-run Phillips curve does not change. The shortrun Phillips curve shifts upward by the amount of the increase in the expected inflation rate, so the short-run tradeoff between inflation and unemployment worsens. The inflation rate rises and the unemployment rate does not change.

Chapter 31 . The Short-Run Policy Tradeoff

11. Read Eye on the Tradeoff on p. 817. How can the Phillips curve account for the combination of inflation and unemployment in 2018? Do the data for that year mean that there is no tradeoff? In 2018 the inflation rate increased slightly and the unemployment rate fell. There was a tradeoff between inflation and unemployment for that year along a short-run Phillips curve that did not change.

351

352

Part 11 . ECONOMIC FLUCTUATIONS

 Additional Problems and Applications 1.

Read Eye on the Tradeoff on p. 817. Suppose that the U.S. economy has fully recovered from the 2008–2009 recession. The natural unemployment rate has fallen to 4 percent and the expected inflation rate is zero. How would the short-run and long-run Phillips curves change? Would the tradeoff be more or less favorable than that of 2018? Draw a graph to illustrate your answer. A decrease in the natural unemployment rate shifts the long-run and short-run Phillips curve leftward. This change makes the tradeoff between inflation and unemployment more favorable. The fall in the expected inflation rate shifts the short-run Phillips curve downward but has no effect on the long-run Phillips curve. This change makes the tradeoff between inflation and unemployment more favorable. These changes are illustrated in Figure 31.5. The long-run Phillips curve shifts from LRPC0 to LRPC1 and the short-run Phillips curve shifts from SRPC0 to SRPC1. As illustrated in the figure, the new short-run Phillips curve has a more favorable tradeoff.

In an economy, the natural unemployment rate is 4 percent and the expected inflation rate is 3 percent a year. Draw a graph of the short-run and long-run Phillips curves that display this information. Label each curve. Figure 31.6 shows the short-run and long-run Phillips curves. The long-run Phillips curve, LRPC, is vertical at the natural unemployment rate of 4 percent. The short-run Phillips curve, SRPC, intersects the long-run Phillips curve at the expected inflation rate, 3 percent.

Chapter 31 . The Short-Run Policy Tradeoff

353

Data 2020 Data 2021 Price Real GDP Unemployment Price Real GDP Unemployment level (trillions of rate level (trillions of rate (2019 = 100) 2019 dollars) (percent) (2019 = 100) 2019 dollars) (Percent) A 102 10.0 8 A 108 10.3 8 B 104 10.1 6 B 110 10.4 6 C 106 10.2 4 C 112 10.5 4 D 110 10.4 2 D 116 10.7 2 The left part of the table describes four possible situations that might arise in 2020, depending on the level of aggregate demand in 2020. The right part of the table describes four possible situations that might arise in 2021. Use the table to work Problems 3 and 4. 3. Plot the short-run Phillips curve and aggregate supply curve for 2020 and mark the points A, B, C, and D on each that correspond to the data in the left part of the table.

A B C D

Inflation rate (percent per year) 2 4 6 10

Unemployment rate (percentage) 8 6 4 2

Price level (2019 = 100) 102 104 106 110

Real GDP (trillions of 2019 dollars) 10.0 10.1 10.2 10.4

The figures are above. Also above is a table with the data necessary to plot the Phillips curve and the aggregate supply curve. In the table the

354

Part 11 . ECONOMIC FLUCTUATIONS

inflation rates are calculated as the change in the price level divided by the initial price, all multiplied by 100. Then the inflation rates and unemployment rates are plotted as the Phillips curve in Figure 31.7. The aggregate supply curve is plotted in Figure 31.8 using the data in the problem, which is reproduced in the table above. 4.

In 2020, the outcome turned out to be row D of the left side table. Plot the short-run Phillips curve for 2021 and mark the points A, B, C, and D that correspond to the data in the right part of the table.

A B C D

Inflation rate (percent per year) −1.8 0 1.8 5.5

Unemployment rate (percentage) 8 6 4 2

Use the table above to plot the Phillips curve. The table is constructed similarly to that in Problem 3. The inflation rates and unemployment rates are plotted as the Phillips curve in Figure 31.9.

Explain the relationship between the long-run Phillips curve and potential GDP and the short-run Phillips curve and the aggregate supply curve. The long-run Phillips curve and potential GDP are closely related. When the economy is producing at potential GDP, the unemployment rate is the natural unemployment rate and the economy is on its long-run Phillips curve. Potential GDP does not change when the price level changes, so the natural unemployment rate does not change when the price level or the inflation rate changes. The short-run Phillips curve and the aggregate supply curve also are related. The inflation rate is defined as the percentage change in the price

Chapter 31 . The Short-Run Policy Tradeoff

level. So, starting from any given price level last period, the higher the inflation rate, the higher is the current period’s price level. With this in mind, moving upward along the AS curve, the price level rises and real GDP increases. So, moving upward along the AS curve, as the price level rises, the inflation rate also increases. And as real GDP increases, unemployment decreases. So, a movement up along the AS curve corresponds to a movement up along the short-run Phillips curve, in which the inflation rate rises and the unemployment rate decreases. 6.

The inflation rate is 3 percent a year, and the quantity of money is growing at a pace that will maintain the inflation rate at 3 percent a year. The natural unemployment rate is 4 percent, and the current unemployment rate is 3 percent. In what direction will the unemployment rate change? How will the short-run Phillips curve and the long-run Phillips curve shift? The current unemployment rate is less than the natural unemployment rate. So, over time, the unemployment rate increases until it equals the natural unemployment rate. Because the current unemployment rate is less than the natural unemployment rate, the economy has moved along its SRPC to a point to the left of the LRPC. At this point, the current inflation rate is greater than the expected inflation rate. So, over time, people revise upward their expected inflation rate and the short-run Phillips curve shifts upward. The long-run Phillips curve does not shift.

The inflation rate is 6 percent a year, the unemployment rate is 4 percent, and the economy is at full employment. The Fed announces that it intends to slow the money growth rate to keep the inflation rate at 3 percent a year for the foreseeable future. People believe the Fed. Explain how unemployment and inflation change in the short run and in the long run. Because people believe the Fed, they immediately adjust their expected inflation rate downward to 3 percent, which shifts the short-run Phillips curve downward. Then, in both the short run and the long run, when the inflation rate falls to 3 percent, the unemployment rate remains at 4 percent.

Use the following information to work Problems 8 to 10. Brazilian inflation and growth get worse Brazil’s central bank has increased its inflation forecast to 9 percent and cut its forecast for real GDP growth, which it now says will be minus 1.1 percent. Source: The Wall Street Journal, June 24, 2015 8. According to Okun’s Law, how would you expect Brazil’s fall in real GDP (negative growth rate) to change the unemployment rate? According to Okun’s Law, the unemployment rate will rise. Okun's Law concludes that for each percentage point that the unemployment rate is

355

356

Part 11 . ECONOMIC FLUCTUATIONS

above the natural unemployment rate, real GDP is 2 percent below potential GDP. So if the real GDP growth rate decreases by 1.1 percentage points, then the unemployment rate rises by 1.1/2.0 or 0.55 percent. 9.

Draw two short-run Phillips curves and a long-run Phillips curve for Brazil. On your graph, place two points, one for Brazil in 2014 and one for the central bank’s expectations about the outcome in 2015. Explain any assumptions you make. In Figure 31.10, we assume that the expected inflation rate increases along with the inflation rate, so the short-run Phillips curve shifts upward from SRPC1 to SRPC2. We also assume that the fall in the real GDP growth rate increases unemployment by 0.55 percentage points, as calculated above. The economy moves from point A, with an unemployment rate of 8.45 percent and an inflation rate of 8.5 percent, to point B, with an unemployment rate of 9 percent and an inflation rate of 9 percent.

10. Explain and illustrate with a graph the effects of the central bank of Brazil trying to lower the inflation rate by unexpectedly slowing the money growth rate. Explain how the unemployment rate will change in the short run and in the long run if the central bank persists with a lower money growth rate. Contrast the outcome with that for an expected slowing of money growth. The economy starts at point A. When the central bank unexpectedly lowers the monetary growth rate and thereby the inflation rate, the economy moves down along the short-run Phillips curve SRPC1 to point B. Eventually the expected inflation rate falls, which shifts the short-run Phillips curve downward to SRPC2. The economy moves to point C. If the public expects the lower monetary growth rate and inflation rate, the short-run Phillips curve immediately shifts downward to SRPC2 and the economy moves from point A to point C.

Chapter 31 . The Short-Run Policy Tradeoff

 Multiple Choice Quiz 1.

The short-run Phillips curve shows that, other things remaining the same, ________. A. an increase in expected inflation will lower the unemployment rate B. a fall in unemployment will lower the inflation rate C. the inflation rate rises by 1 percent when unemployment falls by 1 percent D. a rise in the inflation rate and a fall in the unemployment rate occur together Answer: D The short-run Phillips curve shows a tradeoff between higher inflation and lower unemployment.

The long-run Phillips curve _______. A. is a horizontal curve at the expected inflation rate B. is a vertical curve at the natural unemployment rate C. slopes downward as the inflation rate falls D. slopes upward as the unemployment rate falls Answer: B Figure 31.3 in the text illustrates that Answer B is correct. 3.

The short-run Phillips curve intersects the long-run Phillips curve at _______. A. the expected inflation rate and the current unemployment rate B. the current inflation rate and the natural unemployment rate C. the expected inflation rate and the natural unemployment rate D. the current inflation rate and the current unemployment rate Answer: C Figure 31.4 in the text illustrates that Answer C is correct. 4.

An increase in the expected inflation rate, other things remaining the same, ________. A. shifts the short-run Phillips curve upward B. creates a movement up along the short-run Phillips curve C. decreases the natural unemployment rate and shifts the long-run Phillips curve leftward D. creates a movement up along the long-run Phillips curve with no change in the short-run Phillips curve Answer: A Figure 31.4 in the text illustrates that Answer A is correct.

357

358

Part 11 . ECONOMIC FLUCTUATIONS

A decrease in the natural unemployment rate _______. A. shifts both the short-run and the long-run Phillips curves leftward B. shifts the short-run Phillips curve leftward but the long-run Phillips curve does not change C. creates a movement along the short-run Phillips curve D. increases the expected inflation rate and shifts the short-run Phillips curve upward Answer: A Figure 31.6 in the text illustrates that Answer A is correct. 6.

Suppose that the unemployment rate exceeds the natural unemployment rate and the Fed increases the money growth rate. If the Fed’s action is _______. A. unexpected, the unemployment rate falls but the inflation rate rises B. unexpected, the inflation rate doesn’t change but the unemployment rate falls C. expected, the inflation rate rises but the unemployment rate doesn’t change D. expected, the unemployment rate doesn’t change and the inflation rate equals the expected inflation rate Answer: A Because the expected inflation rate does not change, the rise in the inflation rate moves the economy upward along its short-run Phillips curve and leads to a fall in the unemployment rate and a rise in the inflation rate.

Fiscal Policy ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications 1.

Suppose that in an economy, investment is $400 billion, saving is $400 billion, tax revenues are $500 billion, exports are $300 billion, and imports are $200 billion. Calculate government expenditure and the government’s budget balance. The circular flow shows that GDP = C + I + G + X − M. The circular flow also shows that Y = C + S + T. Because GDP = Y, these two equalities can be combined to give C + I + G + X − M = C + S + T. Rearranging this equality gives G = S – I + T + M – X. Using this formula shows G = $400 billion − $400 billion + $500 billion + $200 billion − $300 billion, or government expenditure = $400 billion. The government’s budget balance equals T − G, so the budget balance is $500 billion − $400 billion, or a $100 billion budget surplus. 2. Classify the following items as automatic fiscal policy actions, discretionary fiscal policy actions, or neither. • An increase in expenditure on homeland security Discretionary fiscal policy because the spending must be approved by an act of Congress. • An increase in unemployment benefits paid during a recession Automatic fiscal policy because no action of Congress was necessary for this increase to occur. • Decreased expenditures on national defense during peace time Discretionary fiscal policy because the spending change must be approved by an act of Congress. • An increase in Medicaid expenditure brought about by a flu epidemic Automatic fiscal policy because no action of Congress was necessary for this increase to occur.

Chapter

Part 12 . MACROECONOMIC POLICY

360

• 3.

A cut in farm subsidies Discretionary fiscal policy because an act of Congress was required. The U.S. economy is in recession and has a large recessionary gap. Describe what automatic fiscal policy might occur. Describe a fiscal stimulus that could be used that would not increase the budget deficit. One automatic fiscal policy that kicks in results from the point that the recession lowers people’s incomes, so induced taxes decrease. The other automatic stabilizer occurs because lower incomes increase needs-tested spending, such as unemployment benefits and food stamps. Both automatic stabilizers help to stabilize aggregate demand by decreasing the multiplier effect. A fiscal stimulus that could be used and that does not increase the budget deficit is a balanced budget increase in government expenditure and taxes. The balanced budget multiplier shows that when both government expenditure and taxes increase by the same amount, aggregate demand increases. The increase in aggregate demand can help decrease the recessionary gap.

Labor market Real wage rate (dollars per hour)

Quantity of labor demanded (thousands of hours)

Quantity of labor supplied (thousands of hours)

10 11 12 13 14 15

6 5 4 3 2 1

2 3 4 5 6 7

Production function Employment Real GDP (thousands (millions of of hours) dollars)

2 3 4 5 6 7

OilPatch is a mineral rich economy in which the government gets most of its tax revenue from oil royalties. But OilPatch has an income tax. The left table above describes the labor market in OilPatch and the right table above describes the economy’s production function. The government introduces an income tax of $2 per hour worked. Use the tables to work Problems 4 to 6. 4. What are the levels of employment and potential GDP in OilPatch, what is the real wage rate paid by employers, and what is the after-tax real wage rate received by workers? The equilibrium quantity of employment is 3,000 hours. Firms pay a before-tax wage rate of $13 an hour (so the quantity of labor firms demand is 3,000 hours). Households receive an after-tax wage rate of $11 an hour (so the quantity of labor households supply is 3,000 hours). Employment of 3,000 means that potential GDP is $11 million.

6 11 15 18 20 21

Chapter 32 . Fiscal Policy

If OilPatch eliminates its income tax, what then are the levels of employment and potential GDP and what is the real wage rate in OilPatch? If OilPatch removes its income tax, the equilibrium quantity of employment is 4,000 hours. The real wage rate is $12 an hour and potential GDP is $15 million.

If OilPatch doubles its income tax to $4 an hour, what then are the levels of employment and potential GDP? What is the real wage rate paid by employers and the after-tax real wage rate received by workers? If oil patch doubles its income tax to $4 an hour, the equilibrium quantity of employment is 2,000 hours. Firms pay a before-tax wage rate of $14 an hour (so the quantity of labor firms demand is 2,000 hours). Households receive an after-tax wage rate of $10 an hour (so the quantity of labor households supply is 2,000 hours). Employment of 2,000 means that potential GDP is $6 million.

The income tax rate on all forms of income is 40 percent and there is a tax of 10 percent on all consumption expenditure. The nominal interest rate is 7 percent a year and the inflation rate is 5 percent a year. What is the size of the tax wedge on wages and what is the true tax rate on interest? The tax wedge on wages is the sum of the income tax rate and the tax rate on consumption. So the tax wedge is 40 percent + 10 percent, or 50 percent. The tax on interest income is applied to the nominal interest rate. So the after-tax real interest rate equals the nominal interest rate minus the inflation rate (which equals the before-tax real interest rate) minus the tax paid on the interest income. When the inflation rate rises, the nominal interest rate rises. The higher nominal interest rate increases the tax paid on the interest rate, which decreases the after-tax real interest rate and thereby increases the true tax rate on interest income. If the tax rate on all forms of income, including interest income, is 40 percent and the nominal interest rate is 7 percent, then of the 7 percent nominal interest rate, 2.80 percent is paid as taxes. The real interest rate equals the nominal interest rate, 7 percent, minus the inflation rate, 5 percent, so the real interest rate is 2 percent. Of this amount, 2.8 percent must be paid as taxes, so the after-tax real interest rate is 2 percent – 2.8 percent, or –0.8 percent. The tax lowers the real interest rate from 2 percentage points to −0.8 percentage points, which is a fall of 2.8 percentage points for a true tax rate on interest income of 140 percent (from (2.8 ÷ 2.0) × 100).

China’s power to boost global economy is fading Whenever global growth faltered, Beijing splurged on roads, airports, and housing developments that fed companies and their employees

361

362

Part 12 . MACROECONOMIC POLICY

across the globe. Worryingly, trade restrictions that limit China’s exports are making this secret weapon lose some of its force. Source: The Wall Street Journal, September 17, 2019 Explain the effect of China’s fiscal stimulus on global aggregate demand and why it might have lost some of its force. Public investment, such as that undertaken by the Chinese government in different countries, increases Chinese exports and Chinese real GDP. The higher Chinese GDP increases China’s demand for imports, which are exports of other countries. The increase in exports increases world aggregate demand and shifts the world aggregate demand curve rightward. If trade restrictions decrease Chinese imports, China’s fiscal stimulus from the public investment is partially offset, thereby increase global aggregate demand less than before. 9.

Former Canadian Prime Minister Stephen Harper warns that if policy makers adopt too strong a fiscal stimulus, then long-term growth might be jeopardized. Explain what he meant. Mr. Harper was concerned about the supply-side effects of the fiscal stimulus. If the fiscal stimulus consists of government expenditure increases that are large and permanent, then government tax revenues would need to increase to keep the budget deficit from rising and crowding out investment. If investment decreases, then the economic growth rate slows.

10. Read Eye on Fiscal Stimulus on p. 839. How big was the fiscal stimulus package of 2008–2009, how many jobs was it expected to create, and how large was the multiplier implied by that expectation? Did the stimulus work? In February 2009, the total fiscal stimulus package passed by the Congress was $787 billion, though in the first year only about 20 percent of the stimulus, or $160 billion, had been spent. The stimulus was expected to save or create 650,000 jobs by the summer of 2009. Government economists asserted that 650,000 jobs had been saved or created. Accordingly, $160 billion in fiscal stimulus created 650,000 jobs. The implied multiplier was only 0.4, far smaller than the administration predictions that the multiplier was 1.6.

Chapter 32 . Fiscal Policy

 Additional Problems and Applications 1.

Read Eye on Fiscal Stimulus on p. 839. From the peak in 1929 to the Great Depression trough in 1933, government tax revenues fell by 1.9 percent of GDP and government expenditures increased by 0.3 percent. Real GDP fell by 25 percent. Compare and contrast this experience with the fiscal policy that accompanied the 2008-2009 recession. What did fiscal policy do to moderate the last recession that was largely absent during the Great Depression? In the 2008-2009, fiscal policy was used extensively to moderate the recession. During the Great Depression, however, fiscal policy was virtually not used. For instance, during the Great Depression, government expenditure increased by only 0.3 percent of GDP but during the recent recession government expenditure (including both automatic and discretionary expenditure) increased by 5 percent of GDP. Similarly during the Great Depression government tax revenues fell by only 1.9 percent of GDP while during the recent recession tax revenues (both automatic and discretionary) fell by 3.0 percent of GDP. The scale of the fiscal stimulus was much greater during the last recession and this fact might be a point why the recession was much less severe than the Great Depression.

Suppose that the U.S. government increases its expenditure on highways and bridges by $100 billion. Explain the effect that this expenditure would have on aggregate demand and real GDP. Government expenditure is autonomous expenditure, so the increase in government expenditure increases autonomous expenditure. As a result, aggregate demand increases. The multiplier effect means that aggregate demand increases by more than the $100 billion increase in government expenditure. Real GDP increases because aggregate demand increases.

Suppose that the U.S. government increases its expenditure on highways and bridges by $100 billion. Explain the effect that this expenditure would have on needs-tested spending and the government’s budget surplus. Needs-tested spending decreases as the economy expands. The budget surplus will fall but by less than the increase in expenditure because the increase in GDP will induce some additional taxes and decrease needstested spending.

363

364

Part 12 . MACROECONOMIC POLICY

Labor market Real wage rate (dollars per hour)

Quantity of labor demanded (thousands of hours)

Quantity of labor supplied (thousands of hours)

10.00 10.50 11.00 11.50 12.00 12.50

18 15 12 9 6 3

6 9 12 15 18 21

Production function Employment Real GDP (thousands (millions of of hours) dollars)

6 9 12 15 18 21

The first table to the left describes the labor market in LowTaxLand and the second table to the right describes the economy’s production function. LowTaxLand introduces an income tax of $1 per hour worked. Use the tables to work Problems 4 to 6. 4. What are the levels of employment and potential GDP in LowTaxLand, what is the real wage rate paid by employers, and what is the after-tax real wage rate received by workers? Employment equals 9,000 hours. At this level of employment, potential GDP equals $12 million. The before-tax wage rate is $11.50 per hour and the after-tax wage rate is $10.50 per hour. 5.

If LowTaxLand eliminates its income tax, what then are the levels of employment and potential GDP and what is the real wage rate in LowTaxLand? If LowTaxLand eliminates its income tax, employment equals 12,000 hours. At this level of employment, potential GDP equals $16 million. The real wage rate is $11.00 per hour.

If LowTaxLand doubles its income tax to $2 an hour, what then are the levels of employment and potential GDP? What is the real wage rate paid by employers and the after-tax real wage rate received by workers? If LowTaxLand doubles its income tax to $2 an hour, employment equals 6,000 hours. At this level of employment, potential GDP is $7 million. The before-tax wage rate is $12.00 per hour and the after-tax wage rate is $10.00 per hour.

Describe the supply-side effects of a fiscal stimulus and explain how a tax cut will influence potential GDP. A tax cut increases people’s incentives to work and to save. Therefore a tax cut increases employment and investment in new capital. The increase in employment and capital increase potential GDP.

7 12 16 19 21 22

Chapter 32 . Fiscal Policy

Use an aggregate supply–aggregate demand graph to illustrate the effects on real GDP and the price level of a fiscal stimulus when the economy is in recession. The fiscal stimulus increases aggregate demand and shifts the aggregate demand curve rightward, as illustrated in Figure 32.1. The increase in aggregate demand raises the price level, in Figure 32.1 from 110 to 115, and increases real GDP, in Figure 32.1 from $19 trillion to $20 trillion. The recessionary gap is decreased; indeed, in Figure 32.1, the recessionary gap is completely eliminated.

Use the following information to work Problems 9 to 11. CBO expects deficit to grow more than projected Federal deficits are expected to swell to higher levels over the next decade than previously expected. The U.S. budget deficit is expected to average a whopping $1.2 trillion per year between 2020 and 2029. The aging of the U.S. population and growth in health-care spending are the main drivers of the large deficit. Source: CNBC, August 21, 2019 9. Explain why the national debt does not measure the federal government’s true indebtedness. How does the nation’s fiscal imbalance provide a more accurate account of government’s debt? The national debt does not measure the federal government’s true indebtedness because it does not measure the present value of the government’s commitments to pay future benefits minus the present value of the government’s future tax revenues. For example, the government has made promises to pay certain amounts as Social Security benefits in the future and has set tax rates that will collect certain tax revenues in the future. The national debt omits these sorts of future spending and revenues. The fiscal imbalance, however, includes these future commitments because it equals the present value of the government’s future commitments to pay future benefits minus the present value of the government’s future tax

365

366

Part 12 . MACROECONOMIC POLICY

revenues. Consequently, the fiscal imbalance is a measure of the government’s true indebtedness. 10. If the government decided to slow the growth of debt by cutting transfer payments and raising taxes by the same amount, how would this fiscal policy influence the budget deficit and real GDP? By cutting transfer payments and raising taxes, the government will decrease the budget deficit. Cutting transfer payments and increasing taxes decrease aggregate demand, which decreases real GDP. A higher tax rate also increases the tax wedge, which in turn decreases employment, saving, and investment and thereby decreases potential GDP and aggregate supply. The decrease in aggregate supply also decreases real GDP. The lower budget deficit, however, lowers the real interest rate which increases investment and, through this channel, increases real GDP. This effect on real GDP, though, is smaller than the others, so on net real GDP decreases. 11. How do an aging population and healthcare programs drive spending and the deficit and how do they create fiscal imbalance and generational imbalance? Spending on an aging population is largely spending on Social Security. Social Security and healthcare are major drivers of government spending. Consequently, they are also major drivers of the deficit. In addition, because they represent future government obligations, they also create fiscal imbalance as well as being the prime source of the generational imbalance. For example, the Social Security and Medicare fiscal imbalance is $68 trillion in 2014, about four times U.S. GDP. The current generation and the future generation each pay some of the fiscal imbalance. Presently the current generation will pay 83 percent of the fiscal imbalance and the future generation will pay 17 percent.

Chapter 32 . Fiscal Policy

 Multiple Choice Quiz 1.

The federal government’s major outlay in its budget is_______ and its major source of revenue is _______. A. debt interest; sales of government bonds B. expenditure on goods and services; taxes on goods and services C. Social Security and other benefits; personal income taxes D. subsidies to farmers; corporate taxes Answer: C Social Security payments are the major part of the government’s transfer payments, which is the largest outlay item. On the revenue side, personal income taxes exceed Social Security taxes in revenue collected. 2.

U.S. national debt _______ when the federal government’s _______. A. increases; outlays exceed tax revenue B. decreases; outlays exceed tax revenue C. increases; tax revenue rises faster than outlays D. decreases; tax revenue rises faster than outlays Answer: A The national debt increases whenever the government’s outlays exceeds its tax revenues. 3.

Discretionary fiscal policy to stimulate the economy includes ________. A. lowering the tax rate paid by households with middle incomes B. raising the tax on gasoline C. the fall in tax revenue as the economy goes into recession D. the rise in tax revenue collected from businesses as their profits increase Answer: A Answer A is discretionary fiscal policy because it requires an act of Congress. It is an expansionary policy because it is designed to increase consumption expenditure and hence aggregate demand. 4.

Automatic fiscal policy ________. A. requires an action of the government B. is weak unless the government cuts its outlays to reduce the deficit C. operates as the economy moves along its business cycle D. reduces the deficit as the economy goes into recession Answer: C Answer C is essentially the definition of automatic fiscal policy.

367

368

Part 12 . MACROECONOMIC POLICY

Needs-tested spending is _______ fiscal policy because it _______. A. automatic; increases in recession and decreases in expansion B. discretionary; increases when tax revenue increases C. automatic; increases when the government’s budget deficit falls D. discretionary; is determined by economic hardship Answer: A Needs tested spending automatically increases in recessions and decreases in expansions without need for any government action. 6.

A government expenditure multiplier _______. A. equals 1 B. is less than the tax multiplier C. exceeds 1 D. equals the tax multiplier Answer: C The expenditure tax multiplier exceeds 1 because an increase in government expenditure induces additional increases in expenditure. 7.

When the government lowers the income tax rate, ______. A. employment increases and potential GDP increases B. employment does not change but labor productivity falls C. labor productivity rises and employment decreases D. both labor productivity and potential GDP increase Answer: A Lowering the income tax rate increases the supply of labor, thereby raising both employment and potential GDP. 8.

A tax cut increases _______. A. aggregate demand but has no effect on aggregate supply B. aggregate demand because it increases disposable income and increases aggregate supply because it is an incentive to supply more labor C. aggregate demand because it increases consumption expenditure and decreases aggregate supply because labor productivity falls D. aggregate supply but has no effect on aggregate demand Answer: B A tax cut increases both aggregate demand and aggregate supply.

Chapter

Monetary Policy ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications 1.

A $1 trillion U.S. budget deficit is one big reason the Fed may have to cut rates The recent debt deal between the White House and Congress virtually guarantees trillion-dollar deficits well into the future and the rising debt calls for the Federal Reserve to lower interest rates. Source: CNBC, August 13, 2019 Explain why a large government budget deficit might call for lower interest rates and why the newsclip might be wrong and higher rates needed? A large budget deficit means that the government debt increases. One of the expenditures of the federal government is interest payments on its debt. To lower these expenditures, the government would prefer lower nominal interest rates. A large budget deficit also means that the government must borrow in the loanable funds market. An increase in the demand for loanable funds leads to a rise in the real interest rate. The nominal interest rate equals the real interest rate plus the inflation rate, so an increase in the real interest rate means that higher nominal interest rates are needed.

Use the following information to work Problems 2 to 4. Suppose that the U.S. economy is at full employment when strong economic growth in Asia increases the demand for U.S.-produced goods and services. 2. Explain how the U.S. price level and real GDP will change in the short run. The increase in Asian demand for U.S.-produced goods and services will increase net exports and therefore increase aggregate expenditure and aggregate demand. The increase in aggregate demand will lead to increases in the U.S. price level and real GDP.

370

Part 12 . MACROECONOMIC POLICY

Explain how the U.S. price level and real GDP will change in the long run if the Fed takes monetary policy actions that are consistent with its objectives as set out in the Federal Reserve Act of 2000. If the Fed takes the monetary policy action consistent with its objectives, it will raise the federal funds rate to offset the increase in aggregate demand. If the Fed’s actions perfectly offset aggregate demand, then neither the price level nor real GDP change. Even if the actions are not perfect, the Fed will moderate the rise in the price level and real GDP.

Explain whether the Fed faces a tradeoff in the short run. The Fed does not face a tradeoff. Its actions move both real GDP (and hence employment) and the price level back to their desired levels.

What is the Fed’s “dual mandate” for the conduct of monetary policy? What are the means to achieving the goals of the dual mandate? The Fed has two goals for its monetary policy. These two goals—the Fed’s dual mandate—are to achieve a stable price level, that is, keep the inflation rate low and predictable, and to achieve maximum employment, that is, keep real GDP close to potential GDP. To achieve these goals the Fed has been instructed to maintain growth in the monetary and credit aggregates that are consistent with the economy’s production potential. In other words, the Fed has been instructed to keep the growth of the quantity of money in line with the growth in potential GDP.

What is financial stability? What actions has the Fed taken since 2007 in pursuit of financial stability? Use a graph to illustrate the effects of the Fed’s actions. Financial stability is the situation in which the nation’s financial markets and institutions are working normally to allocate capital and risk. The financial crisis that started in 2007 has caused the Fed to focus more than normal on financial stability. With the crisis in the nation’s financial markets, banks faced significantly more risk than normal and responded by drastically increasing their demand for (safe) reserves. In Figure 33.1, the demand curve for reserves shifted right from RD0 to RD1. In the absence of Fed action, the federal funds rate would have skyrocketed from 5 percent to 9 percent. But the Fed engaged in quantitative easing by increasing the supply of reserves from RS0 to RS1. The Fed’s actions drove

Chapter 33 . Monetary Policy

the federal funds rate to 0 percent and helped maintain financial stability by giving banks reserves with which they could make loans. Use the following information to work Problems 7 to 9. Figure 33.2 shows the aggregate demand curve, AD, and the short-run aggregate supply curve, AS, in the economy of Artica. Potential GDP is $300 billion. 7. What are the price level and real GDP? Does Artica have an unemployment problem or an inflation problem? Why? The price level is 130 and real GDP is $200 billion. Artica has an unemployment problem because real GDP is less than potential GDP. 8.

What do you predict will happen if the central bank takes no monetary policy actions? What monetary policy action would you advise the central bank to take and what do you predict will be the effect of that action? If the central bank takes no action, then in the long run the money wage rate falls. Aggregate supply increases so that the AS curve shifts rightward. In the long run, the economy returns to potential GDP of $300 billion and the price level falls to 120. If the central bank undertakes a policy action, the central bank should lower the federal funds interest rate and thereby increase aggregate demand. If the central bank did so and was totally accurate, then real GDP would return to potential GDP of $300 billion and the price level would rise to 140.

Suppose that a drought decreases potential GDP in Artica to $250 billion. Explain what happens if the central bank lowers the federal funds rate. Do you recommend that the central bank lower the interest rate? Why? The central bank should lower the interest rate. If the central bank lowers the federal funds rate, aggregate demand increases. The price level rises. Real GDP increases and moves closer to potential GDP. Lowering the interest rate can move real GDP back to potential GDP. But if the central bank does not realize that potential GDP has decreased to $250 billion, it might lower the interest rate by too much and increase real GDP well beyond potential GDP. In that case inflation would result. 10. Fed cuts interest rates again but future drops this year are in doubt Fed policymakers cut rates but were divided about their future path. A majority projected no more cuts in the foreseeable future with the

371

372

Part 12 . MACROECONOMIC POLICY

unemployment rate expected to remain at a very low 3.7% this year and next, and inflation to stay at about 1.5% this year and rise to 1.9% in 2020. Source: Los Angeles Times, September 18, 2019 What are some of the problems that could arise if the Fed cuts interest rates too soon by too much or too late by too little? When the Fed lowers the interest rate, the lower interest rate leads to an increase in aggregate demand and more rapid growth in real GDP. If the Fed lowers the interest rate by too much or for too long, the rapid growth in aggregate demand will open an inflationary gap. In this situation, inflation will rise more than otherwise and could rise above the desired level. However, if the Fed lowers the interest rate by too little or for not long enough, growth in aggregate demand will slow and unemployment will be higher than otherwise. 11. Read Eye on the Fed in a Crisis on p. 860. What are the key differences in monetary policy between the Great Depression and the slow recovery from the 2008–2009 recession? The major difference in the Fed’s behavior between the Great Depression and the 2008-2009 recession was the vast increase in reserves in 2008-2009 and the following increase in the quantity of money. In the Great Depression, the Fed allowed the quantity of money to decrease by 35 percent; in the 2008-2009 recession, the Fed engineered an increase in the quantity of money of 37.5 percent.

Chapter 33 . Monetary Policy

 Additional Problems and Applications 1.

Read Eye on the Fed in a Crisis on p. 860. In which episode, the Great Depression or the 2008–2009 recession, did the banks’ desired reserve ratio and the currency drain ratio increase by the larger amount and the money multiplier fall by the larger amount? Banks’ desired reserve ratio increased by much more in the 2008-2009 recession than during the Great Depression. The currency drain ratio increased by more during the Great Depression. The fall in the money multiplier was much larger during the 2008-2009 recession.

Compare and contrast the Fed’s monetary policy response to the surge in desired reserves and currency holdings in the Great Depression and the 2008–2009 recession. The Fed in the 2008-2009 recession attempted to avert the collapse in lending that occurred during the Great Depression by making its monetary policy much more accommodative than during the Great Depression. That is, the Fed met the increased demand for reserves in 2008-2009 by vastly increasing the quantity of reserves while in the Great Depression the Fed did very little. During the Great Depression M2 decreased by more than 30 percent while during the recent recession M2 grew by 8 percent.

Use the following information to work Problems 3 to 5. The U.S. economy is at full employment when the world price of oil begins to rise sharply. Short-run aggregate supply decreases. 3. Explain how the U.S. price level and real GDP will change in the short run. The increase in the price of oil decreases aggregate supply so that the price level rises and real GDP decreases. 4.

Explain how the U.S. price level and real GDP will change in the long run if the Fed takes monetary policy actions that are consistent with its objectives as set out in the Federal Reserve Act of 2000. The Fed faces a quandary. It is charged with keeping stable prices and maximum employment. If the Fed raises the federal funds rate, it will decrease aggregate demand and thereby offset the rise in the price level. But this policy also decreases real GDP, which worsens the effect of the oil price hike on employment. However, if the Fed lowers the federal funds rate, it will increase aggregate demand and thereby offset the fall in real GDP (and employment). But this policy also increases the price level, which worsens the effect of the oil price hike on inflation.

373

374

Part 12 . MACROECONOMIC POLICY

Does the Fed face a tradeoff in the short run? Explain why or why not. The Fed definitely faces a tradeoff. With the change in aggregate supply, the Fed can either stabilize the price level or real GDP (and employment) but not both.

Use the following information to work Problems 6 to 9. Figure 33.3 shows the aggregate demand curve, AD, and the short-run aggregate supply curve, AS, in the economy of Freezone. Potential GDP is $300 billion. 6. What are the price level and real GDP? Does Freezone have an unemployment problem or an inflation problem? Why? The price level is 110 and real GDP is $400 billion. Freezone has an inflation problem because real GDP exceeds potential GDP. 7.

What do you predict will happen in Freezone if the central bank takes no monetary policy actions? What monetary policy action would you advise the central bank to take and what do you predict will be the effect of that action? If the central bank takes no action, then in the long run the money wage rate rises. Aggregate supply decreases so that the AS curve shifts leftward. In the long run, the economy returns to potential GDP of $300 billion and the price level rises to 120. If the central bank undertakes a policy action, the central bank should raise the federal funds rate and thereby decrease aggregate demand. If the central bank did so and was totally accurate, then real GDP would return to potential GDP of $300 billion and the price level would fall to 100.

What happens in Freezone if the central bank lowers the federal funds rate? Do you recommend that the central bank lower the interest rate? Why? If the central bank lowers the federal funds rate, aggregate demand increases. The price level rises. Real GDP increases and moves farther away from potential GDP. Lowering the interest rate moves real GDP farther away from potential GDP and so is an incorrect policy to pursue.

What happens in Freezone if the central bank conducts an open market sale of securities? How will the interest rate change? Do you recommend that the central bank conduct an open market sale of securities? Why? If the central bank conducts an open market sale of securities, the federal funds interest rate rises. With the rise in the federal funds rate, aggregate

Chapter 33 . Monetary Policy

demand decreases. The price level falls. Real GDP decreases and moves closer to potential GDP. Because real GDP moves closer to potential GDP, it is reasonable to recommend that the central bank conduct an open market sale of securities. 10. Suppose that inflation is rising toward 5 percent a year, and the Fed, Congress, and the White House are discussing ways of containing inflation without damaging employment and output. The President wants to cut aggregate demand but to do so in a way that will give the best chance of keeping investment high to encourage long-term economic growth. Explain the Fed’s best action for meeting the President’s objectives. The Fed really cannot meet both the President’s objectives. On the one hand, to keep investment high, the policy must lower, or at the least, not raise the real interest rate. So the President’s goal is to decrease aggregate demand and lower (or not raise) the real interest rate. The rise in the federal funds rate means that the real interest rate rises. The rise in the real interest rate decreases aggregate demand, which is what the President wants. But it also decreases investment, which is incompatible with the President’s other goal. On the other hand, cutting the funds rate means that the real interest rate falls. The fall in the real interest rate increases investment, which is what the President wants. But it also increases aggregate demand, which is incompatible with the President’s other goal. Use the following information to work Problems 11 and 12. U.S. job growth rebounds in June, lowering Fed’s incentive to cut interest rates U.S. employers added 224,000 jobs last month, an indication of the economy’s durability after more than a decade of expansion. The strength of the jobs report complicates the Federal Reserve’s decision on whether to cut interest rates. Source: Los Angeles Times, July 5, 2019 11. Explain why a strong jobs report complicates the Fed's decision about cutting interest rates. The Fed is concerned about weak employment growth. If the Fed believes employment growth will continue to be weak, the Fed will lower the interest rate. This will increase the growth rate of the quantity of money and raise employment. But if employment growth is strong and the Fed lowers the interest rate, the increase in the growth rate of the quantity of money will result in a higher inflation rate. The stronger-than-expected jobs report increased the Fed’s uncertainty about the path of future employment growth. Consequently, it increased the Fed’s uncertainty about whether to cut interest rates.

375

376

Part 12 . MACROECONOMIC POLICY

12. What is the problem that might arise if the Fed keeps the interest rate too high for too long? If the Fed waits too long to lower the interest rate, the Fed’s decision will lead to lower employment. By keeping the interest rate high too long, the Fed has kept the growth rate of the quantity of money lower too long, which leads to less economic growth and lower employment.

Chapter 33 . Monetary Policy

 Multiple Choice Quiz 1.

The Fed’s “dual mandate” is to achieve ________. A. a government budget surplus and low interest rates B. low inflation and maximum employment C. a stable quantity of money and stable prices D. zero unemployment and a stable means of payment Answer: B The Fed’s dual mandate reflects its major goals. 2.

The Fed’s operational goals include ________. A. a core inflation rate of 2 percent a year and an output gap as small as possible B. an economic growth rate of 3 percent a year and an unemployment rate equal to the natural unemployment rate C. a strong U.S. dollar on foreign exchange markets and a positive output gap D. maximum growth of stock prices and a low core inflation rate Answer: A Answer A accurately describes the Fed’s operational goals for its dual mandate to achieve stable prices and maximum unemployment. 3.

The Fed’s monetary policy instrument is the ________. A. inflation rate B. federal funds rate C. long-term interest rate D. monetary base Answer: B The Fed uses the federal funds rate as its monetary policy instrument. 4.

The Fed fights inflation by _______. A. lowering the federal funds rate, which lowers interest rates and decreases aggregate demand B. raising the federal funds rate, which raises interest rates and decreases aggregate demand C. decreasing the monetary base, which raises the interest rate and increases saving D. lowering the long-term real interest rate, which increases investment and spurs economic growth Answer: B By raising the federal funds rate, the Fed ultimately decreases aggregate demand, which slows the inflation rate.

377

378

Part 12 . MACROECONOMIC POLICY

To fight unemployment and close a recessionary gap, the Fed ______. A. stimulates aggregate demand by lowering the federal funds rate, which increases the quantity of money B. stimulates aggregate supply by lowering the federal funds rate, which increases potential GDP C. increase employment, which increases real GDP D. increases bank reserves, which banks use to make new loans to businesses, which increases aggregate supply Answer: A By lowering the federal funds rate, the Fed ultimately increases aggregate demand, which increases real GDP and lowers unemployment. 6.

The Fed’s choice of monetary policy strategy is ______. A. discretionary monetary policy B. the k-percent rule for money growth C. adjusting the federal funds rate to best fulfill its dual mandate D. setting the foreign exchange rate of the dollar Answer: C The Fed changes the federal funds rate to hit its target federal funds rate, the federal funds rate it believes will enable it to meet its dual mandate of price stability and maximum employment. 7.

A monetary policy rule is ______ to discretionary monetary policy because______. A. superior; discretion limits what the Fed can do in a financial crisis B. inferior; a rule makes it harder for people to forecast the inflation rate C. superior; a rule keeps inflation expectations anchored D. equivalent; the Fed uses its discretion to set the rule Answer: C By stabilizing inflation expectations, the Fed helps keep the financial markets and labor markets working well by enabling people to make safer long-term commitments.

International Finance ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications The table gives some data that describe the economy of Antarctica in 2050: Item

(billions of dollars)

Imports Exports of goods and services Net interest Net transfers Foreign investment in Antarctica Antarctica’s investment abroad

150 50 −10 35 125 55

Use the table to answer Problems 1 and 2. 1.

Calculate Antarctica’s current account balance, capital and financial account balance, and the increase in Antarctica’s official reserves. For the current account balance, use the definition that CAB = NX + Net interest and transfers from abroad. CAB = −$100 billion + (–$10 billion) + $35 billion = −$75 billion. The capital and financial account balance equals foreign investment in Antarctica minus Antarctica’s investment abroad, which is $125 billion − $55 billion = $70 billion. Use the formula current account + capital account + official settlements account = 0. So, (−$75 billion) + ($70 billion) +(official settlements account) = 0, The official settlements account balance is $5 billion. Antarctica’s official reserves decreased by $5 billion.

Is Antarctica a debtor nation or a creditor nation? Are its international assets increasing or decreasing? Is Antarctica borrowing to finance investment or consumption? Explain. Antarctica is a debtor nation because its net interest payment is negative.

Chapter

Part 12 . MACROECONOMIC POLICY

380

Antarctica’s net international assets are decreasing because foreign investment in Antarctica is increasing more than is Antarctica’s investment abroad. The value of Antarctica’s imports is $100 billion Antarctica dollars more than the value of its exports. So Antarctica is borrowing these funds. But we have no information about what Antarctica is doing with these funds so we cannot tell if Antarctica is borrowing for consumption or investment. For instance, if Antarctica has no private investment and government spending is not on capital goods, then Antarctica is borrowing for consumption. 3.

U.S. trade gap widened in May despite tariff moves The U.S. trade gap widened sharply in May despite a new round of tariffs on Chinese goods that took effect in the first half of the month. Source: Wall Street Journal, July 3, 2019 Explain how the United States pays for its international trade deficit and why tariffs don’t lower the deficit. The United States pays for its international trade deficit by borrowing from abroad. Indeed, the United States is a net borrower and has been since 1983. The U.S. trade balance is equal to the sum of the private sector balance plus the government sector balance, or (S – I) + (NT – G), where S is saving, I is investment, NT is net taxes, and G is government expenditure on goods and services. Because tariffs have no effect on these variables, they will not change the overall U.S. trade balance.

The U.S. dollar depreciates. Explain which of the following events could have caused the depreciation and why. • The Fed intervened in the foreign exchange market. Did the Fed buy or sell U.S. dollars? If the Fed intervenes in the foreign exchange market by selling dollars, it increases the supply of dollars and the exchange rate depreciates. However, if the Fed intervenes in the foreign exchange market by buying dollars, it decreases the supply of dollars and the exchange rate appreciates. •

People began to expect that the U.S. dollar would depreciate. If people expect the dollar to depreciate, the demand for dollars decreases and the supply increases, which leads to an immediate depreciation of the U.S. dollar exchange rate.

•

The U.S. interest rate differential increased. If the U.S. interest rate differential increases, the demand for U.S. dollars increases and the supply decreases, and the exchange rate appreciates.

Chapter 34 . International Finance

•

Foreign investment in the United States increased. If foreign investment in the United States increases, foreigners need U.S. dollars to make the investment. The demand for dollars increases, and the exchange rate appreciates.

Suppose that the inflation rate is lower in Japan than it is in the United States, and that the difference in the inflation rates persists for some years. Use this information to work Problems 5 to 7. 5. Will the U.S. dollar appreciate or depreciate against the yen and will purchasing power parity be violated? Why or why not? The dollar will depreciate. Purchasing power parity might be violated for a while, but ultimately it is purchasing power parity that depreciates the dollar and appreciates the yen. 6.

Will U.S. interest rates be higher or lower than Japanese interest rates and will interest rate parity hold? Why or why not? The U.S. interest rate will be higher than the Japanese interest rate. The higher U.S. interest rate will compensate people who buy U.S. assets for the depreciation of the U.S. dollar. Interest rate parity will continue to hold regardless of any difference in the inflation rates. The exchange rate changes so that interest rate parity always holds

Explain how the expected future exchange rate will change. The inflation difference will influence the expected future exchange rate. Because the U.S. dollar eventually will fall in value, the expected future U.S. exchange rate will be lower than otherwise.

Suppose that the U.K. pound is trading at 1.82 U.S. dollars per U.K. pound and at this exchange rate purchasing power parity holds. The U.S. interest rate is 2 percent a year and the U.K. interest rate is 4 percent a year. Calculate the U.S. interest rate differential. What is the U.K. pound expected to be worth in terms of U.S. dollars one year from now? The U.S. interest rate differential equals 2 percent minus 4 percent, or −2 percent per year. For interest rate parity to hold, the U.K. pound must be expected to depreciate 2 percent over the year, so next year it is expected to be 0.98 × 1.82 U.S. dollars per U.K. pound, or 1.78 U.S. dollars per U.K. pound.

381

382

Part 12 . MACROECONOMIC POLICY

Pound plunges on U.K. vote to leave the European Union Britain’s vote to leave the European Union lowered the pound from $1.50 to $1.32 in tumultuous hours of foreign exchange trading. Source: Wall Street Journal, June 24, 2016 Which of the influences on demand and supply in the foreign exchange market most likely changed to bring this rapid and large change in the dollar-pound exchange rate? The vote to leave the European Union made the British pound depreciate against the U.S. dollar. The vote to exit the European Union created significant uncertainty about future British economic growth and policy. There is concern that the departure will harm future British economic growth because British firms will no longer have free access to the countries in the European Union, so that British exports decrease. If British growth slows and the economy plunges into a recession, Britain’s central bank, the Bank of England, will lower British interest rates. U.S. interest rates are expected to rise, so with British interest rates expected to fall and U.S. interest rates expected to rise, the dollar-pound exchange rate is expected to depreciate in the future. The expected future depreciation of the British exchange rate is the primary factor that lead to the rapid and large change in the dollar-pound exchange rate.

10. Read Eye on the Dollar on p. 897. When and why did the dollar rise against the euro and when and why did it fall? The dollar rose in 2014 and 2015. During that time, the dollar was expected to appreciate, that is, rise in value relative to the euro. The expected appreciation increased the demand for dollars and decreased the supply of dollars. The demand curve for U.S. dollars shifted rightward, the supply curve of U.S. dollars shifted leftward; consequently the U.S. exchange rate rose. The dollar fell between 2001 and 2008. Between those years, U.S. economic growth fell beneath economic growth in Europe, interest rates in Europe exceeded those in the United States, and the dollar was expected to depreciate. The negative U.S. interest rate differential and expected depreciation decreased the demand for dollars and increased the supply of dollars. The demand curve for U.S. dollars shifted leftward, the supply curve of U.S. dollars shifted rightward; consequently the U.S. exchange rate fell.

Chapter 34 . International Finance

 Additional Problems and Applications 1.

Read Eye on the Dollar on p. 897. If the European Central Bank starts to raise its policy interest rate before the Fed starts to raise the federal funds rate target, what do you predict will happen to the dollar/euro exchange rate? Illustrate your answer with an appropriate graphical analysis. If the European Central Bank starts to raise its interest rate before the Fed raises U.S. interest rates, the U.S. interest rate differential will shrink. The fall in the U.S. interest rate differential decreases the demand for U.S. dollars and increases the supply of U.S. dollars. As Figure 34.1 illustrates, the demand curve for U.S. dollars shifts leftward from D0 to D1 and the supply curve of U.S. dollars shifts rightward from S0 to S1. These changes lower the U.S. exchange rate, in the figure from 0.90 euros per dollar to 0.70 euros per dollar.

The table gives some data that describe the economy of Atlantis in 2020: Item

(billions of dollars)

Government expenditure Saving Increase in official reserves of Atlantis Net foreign investment in Atlantis Net taxes Investment

200 100 5 50 150 125

Calculate the current account balance, the capital and financial account balance, the government sector balance, and the private sector balance. The current account balance equals the sum of the private sector balance, saving minus investment, plus the government sector balance, net taxes minus government expenditures. In this case, the current account balance equals ($100 billion − $125 billion) + ($150 billion − $200), which is −$75 billion. The capital and financial account balance plus the current account balance plus the official settlements account equals zero. So the capital account balance equals − (−$75 billion) − (−$5 billion), which is $80 billion.

383

Part 12 . MACROECONOMIC POLICY

384

The government budget balance is equal to net taxes minus government expenditures, which is $150 billion − $200 billion, or −$50 billion. The private sector balance is equal to saving minus investment, which is $100 billion − $125 billion, or −$25 billion. 3.

The U.S. dollar appreciates, and U.S. official reserves increase. Explain which of the following events might have caused these changes to occur and why. • The Fed intervened in the foreign exchange market and sold U.S. dollars. If the Fed intervenes in the foreign exchange market by selling dollars, it increases the supply of dollars and the exchange rate depreciates. In this case, official holdings of foreign currency increase. •

The Fed conducted an open market operation and sold U.S. bonds. If the Fed sells bonds in an open market operation, the interest rate rises. The demand for dollars increases and the exchange rate rises. The U.S. dollar appreciates but there is no change in the nation’s official holdings of foreign currency.

•

People began to expect that the U.S. dollar would appreciate. If people expect the dollar to appreciate, the demand for dollars increases and the supply decreases, which leads to an appreciation of the U.S. dollar exchange rate. There is no direct effect on official holdings of foreign currency.

•

The U.S. interest rate differential narrowed. If the U.S. interest rate differential narrows, the demand for U.S. dollars decreases and the supply increases. The U.S. dollar depreciates. There is no direct effect on official holdings of foreign currency.

Which of the following events might have caused the euro to appreciate and why? • The European Central Bank sold euros in the foreign exchange market. If the ECB intervenes in the foreign exchange market by selling euros, the supply of euros increases. When the supply of euros increases, the euro depreciates. •

The Fed intervened in the foreign exchange market and bought U.S. dollars. If the Fed intervenes in the foreign exchange market by buying dollars, it is selling euros, which increases the supply of euros. When the supply of euros increases, the euro depreciates.

•

The EU interest rate differential increased. If the EU interest rate differential increases, the demand for euros increases, the supply decreases, and the euro appreciates.

Chapter 34 . International Finance

•

Profits increased in Europe, and U.S. investment in Europe surged. If foreign investment in Europe increases, foreigners, such as U.S. citizens, need euros to make their investments. The demand for euros increases, and the euro appreciates.

Use the following information to work Problems 5 and 6. Suppose that the euro keeps appreciating against the U.S. dollar. The Fed decides to stop the euro from appreciating (stop the U.S. dollar from depreciating) and intervenes in the foreign exchange market. 5. What actions might the Fed take in the foreign exchange market? Could these actions persist in the long run? Would the Fed’s actions prevent interest rate parity from being achieved? Why or why not? The Fed can buy U.S. dollars and sell euros. The Fed increases the demand for U.S. dollars and increases the supply of euros. The Fed cannot take these actions forever because eventually the Fed would run out of euros to sell. The Fed’s actions would not keep interest rate parity from being achieved. If the Fed is able to influence the exchange rate, interest rates in the nations would adjust so that, adjusted for risk, interest rate parity holds. 6.

Are there any other actions that the Fed could take to raise the foreign exchange value of the dollar? Explain your answer. The Fed can make an open market sale of bonds. An open market sale decreases the quantity of money. At least in the short run, when the quantity of money decreases the interest rate rises so that the U.S. dollar exchange rate would rise.

Use the following information to work Problems 7 and 8. In June 2019, the exchange rate between the U.S. dollar and the Brazilian real was 3.81 real per dollar. In the same month, the price of a Big Max was 17.5 real in Sao Paulo and $5.74 in New York. Brazil’s interest rate was 5.5 percent per year and the U.S. interest rate was 2 percent per year. Source: Pacific Exchange Rate Service and The Economist 7. Does purchasing power parity (PPP) hold between Brazil and the United States? If not, does PPP predict that the real will appreciate or depreciate against the U.S. dollar? The price of the Big Mac converted to U.S. dollars equals 17.5 real ÷ 3.81 real per dollar, which is $4.59. Purchasing power parity does not hold because a dollar buys less in New York than in Brazil. PPP predicts that Brazil’s exchange rate will appreciate (alternatively phrased, the U.S. exchange rate will depreciate). 8.

Does interest rate parity hold between Brazil and the United States? If interest rate parity does hold, what is the expected rate of appreciation or

385

386

Part 12 . MACROECONOMIC POLICY

depreciation of the Brazilian real against the U.S. dollar? If the Fed lowered the interest rate while the Brazilian interest rate remained at 5.5 percent a year, how would the expected appreciation or depreciation of the real change? Interest rate parity holds. The difference in the interest rates is offset by the expected depreciation of the Brazilian real, so the real is expected to depreciate by 3.5 percent a year. If the Fed lowered the U.S. interest rate, interest rate parity will continue to hold. Because the U.S. interest rate is now lower, the expected depreciation of the real is greater. (The lower U.S. interest rate means that the U.S. interest rate differential decreases. The demand for dollars decreases and the supply increases, so the dollar immediately depreciates which means the real immediately appreciates. From this immediately higher real/dollar exchange rate, the expected depreciation in the future is larger.)

Chapter 34 . International Finance

 Multiple Choice Quiz 1.

The current account balance equals ______. A. exports minus imports plus net interest and net transfers B. net exports plus net foreign investment in the United States C. capital and financial account balance minus the official settlements account balance D. net exports plus the official settlements balance Answer: A Answer A is the definition of the current account balance.

China’s official reserves have ballooned, fueled by strong foreign investment and large trade surpluses. China is a net ______ and a ______ nation. A. lender; debtor B. borrower; debtor C. lender; creditor D. borrower; creditor Answer: C China is using its large trade surpluses to lend to other nations. 3.

Net exports equal the ______. A. private sector balance plus the government sector balance B. private sector balance minus the government sector balance C. government sector balance minus the private sector balance D. private sector balance plus the government’s budget deficit Answer: A Table 34.3 shows that answer A is correct and contains recent U.S. data. 4.

A net exports deficit will become a surplus if ______. A. the government budget deficit is turned into a surplus and the private sector has a surplus B. the private sector surplus adjusts to equal the government sector deficit C. private saving and government saving exceed private investment D. the country appreciates its currency Answer: A If both the government sector and the private sector have surpluses, the country lends these surpluses abroad and has a net exports surplus.

387

388

Part 12 . MACROECONOMIC POLICY

The quantity of U.S. dollars demanded in the foreign exchange market increases if ______. A. the value of U.S. imports increases B. traders expect the future exchange rate to rise C. the U.S. interest rate rises relative to those in other countries D. the U.S. dollar depreciates against other currencies Answer: D The depreciation of the U.S. dollar increases the quantity of U.S. dollars demanded and results in a movement downward along the demand curve for U.S. dollars. 6.

The supply of U.S. dollars in the foreign exchange market increases if ______. A. the value of U.S. imports increases B. the U.S. interest rate differential decreases C. the U.S. dollar depreciates against other currencies D. the U.S. dollar is expected to appreciate against other currencies in the future Answer: B The decrease in the U.S. interest rate differential leads U.S. investors to demand more foreign assets, which increases the supply of U.S. dollars. 7.

Purchasing power parity between euros and U.S. dollars ______. A. holds if the price of a good is the same number of euros or dollars B. means that the value of the euro and the dollar are equal C. always holds because exchange rates adjust automatically D. implies that international trade is competitive Answer: B The value of the currencies being equal means that these monies buy the same amounts of goods and services. 8.

The free floating yuan-U.S. dollar exchange rate will rise if ________ in the foreign exchange market. A. the Fed agrees not to sell U.S. dollars B. the People’s Bank of China buys U.S. dollars C. the People’s Bank sells U.S. dollars that it holds on reserve D. the Fed does not buy yuan Answer: B If the People’s Bank of China did not buy U.S. dollars, the yuan would appreciate. By purchasing U.S. dollars, the People’s Bank of China can keep the exchange rate stationary.