SOLUTIONS MANUAL for Microeconomics 3rd Edition by Daron Acemoglu; David Laibson; John List by StudyGuide

SOLUTION’S MANUAL Microeconomics 3rd Edition by Daron Acemoglu; David Laibson; John List

TABLE OF CONTENTS Chapter 1: The Principles and Practice of Economics Chapter 2: Economic Science: Using Data and Models to Understand the World Chapter 3: Optimization: Trying to Do the Best You Can Chapter 4: Demand, Supply, and Equilibrium Chapter 5: Consumers and Incentives Chapter 6: Sellers and Incentives Chapter 7: Perfect Competition and the Invisible Hand Chapter 8: Trade Chapter 9: Externalities and Public Goods Chapter 10: The Government in the Economy: Taxation and Regulation Chapter 11: Markets for Factors of Production Chapter 12: Monopoly Chapter 13: Game Theory and Strategic Play Chapter 14: Oligopoly and Monopolistic Competition Chapter 15: Trade-offs Involving Time and Risk Chapter 16: The Economics of Information Chapter 17: Auctions and Bargaining Chapter 18: Social Economics

Chapter 19: The Wealth of Nations: Defining and Measuring Macroeconomic Aggregates Chapter 20: Aggregate Incomes Chapter 21: Economic Growth Chapter 22: Why Isn't the Whole World Developed? Chapter 23: Employment and Unemployment Chapter 24: Credit Markets Chapter 25: The Monetary System Chapter 26: Economic Fluctuations Chapter 27: Macroeconomic Policy Chapter 28: Macroeconomics and International Trade Chapter 29: Open Economy Macroeconomics

Chapter 1: The Principles and Practice of Economics Questions 1. Give examples to explain how economic analysis can be positive and normative. Answer: Positive economics is objective and based on facts. However, normative economics is subjective and opinion-based. For example, Positive economics: The mismatch between students’ knowledge and market requirements is afactor that underlies low employability. Normative economics: The government should increase the minimum wage earned by each employee. 2.

Economists think of almost all human behavior as the outcome of choices. Do you agree with this statement? Based on your reading of the chapter, how would you define economics?

Answer: Scarcity of resources for individuals, firms, and nations in the situation of having unlimited wants pushes them to make choices by allocating scarce resources to their wants. Individuals have limited budgets (scarce resources) compared to the unlimited wants that they wish to satisfy. Firms have unlimited investment projects as compared to their limited budgets.Nations may have many areas—growth, human development, healthcare, legislature, and education—that require expenditure, but due to limited budgets, governments need to prioritizeareas for spending. Economics is a science that helps in performing this allocation. 3.

Examine the following statements and determine if they are examples of normative economics or positive economics. Explain your answer. a. According to the World Economic Outlook Update released by the International Monetary Fund in January 2021, the global economy is projected to grow 5.5 percent in 2021 and 4.2 percent in 2022. b. According to an article published in the European Central Bank (ECB) Economic Bulletin in January 2021, government spending on investment should be a priority duringthe interim phase in the run-up to the economic recovery in the euro area.

Answer: a. This is an objective prediction released by the IMF about growth in the global economy. Positive economics is analysis that generates objective descriptions or predictions about the world, which can be substantiated with data. Since data can be used to underline why the IMF believes that growth will be 5.5 percent in 2021 and 4.2 percent in 2022, this is an example of positive economic analysis. However, students should note that different organizations may have different growth predictions about the global economy and that the IMF itself will revise these calculations every quarter. b. The statement that government spending on investment should be a priority is normative since it states what governments ought to do. Normative economics prescribes what an

Chapter 1 | The Principles and Practice of Economics

individual or society should do. Source: Stephan Haroutunian, Steffen Osterloh, and Kamila Sławińska,“The Initial Fiscal Policy Responses of Euro Area Countries to the Covid-19 Crisis,” ECB Economic Bulletin, January 2021, https://www.ecb.europa.eu/pub/economicbulletin/articles/2021/html/ecb.ebart202101_03 ~c5595cd291.en.html. 4.

How does microeconomics differ from macroeconomics? Would the supply of iPhones in the United States be studied under microeconomics or macroeconomics? What about the growth rate of total economic output in the national economy?

Answer: Microeconomics is the study of how individuals, households, firms, and governments make choices, and how those choices affect prices, the allocation of resources, and the well-being of other agents. Macroeconomics is the study of the economy as a whole. Macroeconomists study factors that affect overall – in other words, aggregate – economic performance. The supply of iPhones refers to the supply of a good by an individual firm, Apple. The iPhone market will be studied under microeconomics. Microeconomics studies how individuals, households, firms and governments make choices, and how those choices affect prices and the allocation of resources. The growth rate of total economic output, on the other hand, refers to the aggregate American economy, and is therefore studied under macroeconomics. 5.

Why do economic agents have to make trade-offs on any given day of their lives? What kind of non-monetary budget constraints do agents face?

Answer: An economic agent faces the prospect of a trade-off when the agent needs to give up one thing to get something else. For instance, an agent faces a trade-off when organizing their daily schedule. Should they go to work, or stay at home and watch a TV series? Should they spend an extra hour at work or hang out with friends? Should they spend their free time focusing on getting an extra degree in legal studies or be happy with the current work position they are in? An example of a non-monetary budget constraint is that of time. All economic agents have 24 hours in their day. Therefore, based on their utilities, agents optimize by making trade-offs on the type of activity that they take part in. 6.

This chapter introduces the idea of opportunity cost. a. What is meant by opportunity cost? b. What is the opportunity cost of taking a year after graduating from high school and backpacking across Europe? Are people who do so being irrational?

Answer: a. Opportunity cost is the best alternative use of a resource. The opportunity cost of a particular choice is measured in terms of the benefit foregone from the next best alternative. To facilitate comparison, the benefits and costs of various choices are translated into monetary units like dollars. b. The opportunity cost of backpacking across Europe, for a particular person, is the cost of anything else that could have been done in that year. The backpacker could have attended college or started working. These costs are the opportunity costs of the gap year. This, however, does not mean that backpackers are irrational, because the benefits may exceed the cost. Every action has an opportunity cost. The choices that people make are optimal based on their perceived costs and benefits. 7.

Suppose you wish to take out a mortgage to buy a new house for your family. However, the houses you like exceed your budget. You are considering three options: choose a neighborhood that is less fashionable and, therefore, the prices are lower; take out a mortgage

Chapter 1 | The Principles and Practice of Economics

with a longer maturity period; or instead of buying a house, buy a larger apartment in your current neighborhood. How would you evaluate these options and choose the optimal one? Answer: You can use cost-benefit analysis to compare the various feasible alternatives and pick the best one. Cost-benefit analysis is a calculation that adds up costs and benefits using a common unit of measurement, such as euros. Buying a house in a less fashionable neighborhood would give you a larger space and your family a garden to enjoy; however, it might take longer to commute to work, or the schools in the locality might be of a lower quality. The mortgage with a longer maturity period allows you to buy your dream house, but you will be opening yourself up to a greater risk of default should you, or your partner, face job loss. Buying a larger apartment instead of a house gives you enough room for an expanding family, but not a garden. All these options need to be converted into values in euros. This will include monetary as well as opportunity costs. You can then choose the option that offers you the greatest net benefit. 8.

Suppose the market price of the latest model of iPhone is €759 in Germany. What are the three conditions that will need to be satisfied for the iPhone market to be in equilibrium at this price?

Answer: For the market to be in equilibrium, three conditions will need to be satisfied:

•

At the price of €759 per unit, the number of iPhones supplied by Apple should be equal to the number of iPhones purchased by buyers in the market.

•

Apple has chosen the optimal quantity of iPhones to supply, given the price of €759 per unit.

•

Consumers have chosen the optimal quantity of iPhones to buy, given the price of €759 per unit.

Suppose you are living in a housing project that has 100 apartments. The housing project has its own garden, swimming pool, library, and community center. To be able to utilize the available amenities, residents must contribute €50 a month towards the upkeep while also taking turns keep it clean. In this context, answer the following questions. a. What is meant by free riding? b. How would you define a free-riding resident? Why would it be a problem for the housing project?

Answer: a. A free rider is a person who receives the benefit of a good but avoids paying for it. People tend to pursue their own private interests and usually don’t contribute voluntarily to the public interest. For example, watching a pirated copy of a movie is cheaper than buying one. Those who watch the pirated version are free riders because there are others who buy the movie or pay for movie tickets. If everyone watched pirated copies, making movies would not be profitable and the industry would not function. b. In the situation described in the question, a free-riding resident would be a person or family that does not contribute in terms of money and commitment to maintain the housing project and keep it clean. In a way, this person is using the services being offered by the housing project for free and is taking advantage of the other contributing residents. This is a problem for the housing project because it will compel the paying residents to either eventually pay more money for the upkeep of the garden, swimming pool, and other amenities, or they will have to work more in any given week to keep it clean.

Chapter 1 | The Principles and Practice of Economics

10. “Scarcity exists because people have unlimited wants in a world of limited resources.” Explain this statement using a real-life example. Answer: Since the world has limited resources, no one can have everything they want. Scarce resources are things that people want, where the quantity desired exceeds the quantity that is available. For example, emerging viral pandemics, such as the COVID-19 pandemic, may place unexpectedly high and sustained demands on public healthcare systems and on various essential services. However, certain regions with large outbreaks may have fewer hospital beds and ventilators, or smaller hospitals in rural areas may have less space and supplies to offer. Thus, the demand for such items in these regions, especially during a pandemic, may exceed the resources available, causing scarcity. These situations will create the need to ration supplies and interventions. 11. Identify the cause and the effect in the following phenomena in a hypothetical country: a. A surge in the price of goods and an increase in the workers’ income. b. A rise in GDP and an increase in the number of university graduates. Answer: a. The increase in income is likely to induce people to spend more, thus leading to a surge in prices. b. The increase in the number of university graduates in the country is likely to lead to higher productivity, resulting in a rise in GDP.

Problems 1.

You have purchased a non-refundable ticket to the Maldives with an early morning departure scheduled for Saturday. You receive a call notifying you about an interview for a job that may be scheduled around the same time. While you really wanted this job, you think that going on the trip is more important for your mental wellbeing as you have been planning this trip for a year now. a. The human resources department from the company you applied to informs you that there is only one slot available for the interview, which clashes with your flight. Should this affect your decision to go on the trip? Explain by using the term “opportunity cost. b. Suppose instead that you realize that the non-refundable travel ticket, which you already purchased, cost you €100; previously you had mistakenly believed the price was €250. Should learning this information affect your decision to go to the Maldives trip?

Answer: a. This should affect your decision, or at least make you reconsider. The explicit cost of the trip has not changed, nor has the benefit of the trip itself. However, the opportunity cost of not making it to the interview is now higher than you previously thought. b. This should not affect your decision. Whether you paid €100 or €250 in the past is irrelevant to the costs and benefits that you can affect by going (or not going) on the trip. 2.

You are thinking about buying a house in London. You find one you like that costs £1,000,000. You learn that, based on the value of the house and your wages, your bank will give you a mortgage for 20 years in the region of £600,000. This means that you must make a down payment of £400,000. What are some of the monetary and non-monetary opportunity costs of this purchase?

Chapter 1 | The Principles and Practice of Economics

Answer: By using your £400,000 to buy the house, you give up the opportunity to earn interest on that money. If you could earn 4% interest, then the opportunity cost is 0.04 × £400,000 = £16,000 per year. Also, if the value of the house increases (real increase) by 2% per annum, then the value of your property will have increased by £20,000 a year (£1,000,000 × 1.02 = £1,020,000). Subtracting the opportunity cost of £16,000, this indicates a gain of £4,000. However, you will also have to pay mortgage. At a 4% mortgage, you will be paying £24,000 per annum. Under these conditions, you will have to decide whether it makes sense for you to buy the house. Some of the non-monetary opportunity costs include the benefits associated with a better neighborhood, such as accessibility to public transport, shops, and schools. 3.

Your local coffee shop used to be the best in the neighborhood; however, due to a recent change in ownership the quality of the service and products offered has been steadily decreasing. Nevertheless, you have some fond memories of the place and it is also quite conveniently located—on the way to the train station that you use to get to work.

a. What is the opportunity cost of searching for a new coffee shop? b. You have found a new coffee shop, but to get there you have to take a longer route to the train station. How would you determine, every morning, which coffee shop to visit? The old one or the new one? Answer: a. You have to invest time and effort in finding a new coffee shop. You will also have to leave your apartment (flat) earlier or spend some extra time after work to find the optimal one. Instead, this time could be spent in relaxing or meeting with friends. b. You will have to factor in whether the longer walk to get to the train station is worthwhile to visit your new coffee shop. If you were able to leave your flat on time, or if there are trains every five minutes from your local station, then the opportunity cost of visiting your new coffee shop will be presumably low. However, if you are late, if it is raining, or if your old coffee shop holds some sentimental value for you, you might stick to the old one. 4.

You have decided that you are going to consume 600 calories of beer and snacks at a party Saturday night. A beer has 150 calories and a snack has 75 calories. a. Create a table that shows the various combinations of beer and snacks you can consume. To keep things simple, use only round numbers (e.g., you could choose 1 or 2 beers but not 1.5 beers). b. What is the opportunity cost of a beer?

Answer: a. Suppose you choose to consume 0 beers. Then you could use all 600 calories on snacks. Since snacks have 75 calories you could consume 600 / 75 = 8 snacks. Now suppose you choose 1 beer. A beer has 150 calories and so you would be left with 600 – 150 = 450 calories for snacks. You could therefore consume 450 / 75 = 6 snacks if you choose 1 beer. You can use the same logic to complete the table below.

Chapter 1 | The Principles and Practice of Economics

Beer

Snacks

b. If you consume 1 more beer you will have 150 fewer calories for snacks. Since a snack has 75 calories, consuming one more beer means that you will have to give up 150 / 75 = 2 snacks. The opportunity cost of a beer is therefore 2 snacks. 5.

Consider the following three statements : a. You are planning a conference in St. Petersburg, Russia, and your closing gala will be on a cruise boat in November. Do you think hosting the event on a boat is a rational choice? b. You have to reach the airport during rush hour to catch your flight to St. Petersburg. You have two options: take the underground or take a taxi. Although you have an hour to get there, traffic most of the time is heavy during rush hour. Which option would be the rational choice? c. Suppose you decided to take a taxi to the airport and made it to the airport in time. Once you landed in St. Petersburg, you noticed that the temperature was surprisingly mild, making the cruise boat experience comfortable. Do these outcomes mean that the decisions to host an event on a cruise boat in November and take a taxi to the airport were rational?

Answer: a. Considering the low average temperature in St. Petersburg in November, if the boat does not have heating or paneling, or is not made for the Russian winter, hosting the event on a cruise boat is likely to be an irrational decision. b. If the traffic is heavy during rush hour, the rational choice would be to take the underground to the airport and avoid traveling by road. c. It is possible to beat the odds despite making an irrational decision. The probable temperature in November in St. Petersburg and the time taken to get to the airport by taxi are estimated as averages; there can always be some deviation from the mean. 6.

Consider the following three statements: a. “Your friends are coming over for lunch and you realize you have forgotten to get groceries. You go to the local market, where there are about 50 stalls. You are in a hurry, so you decide to do all of your shopping at the first two stalls. b. You find a stall that sells good quality vegetables and fruit. However, you do not have enough money on you. You start to haggle and agree on a 15 percent discount for the products you are buying. c. “Despite being in a hurry, you now decide to go around the market to check the prices and quality at all stalls.

Chapter 1 | The Principles and Practice of Economics

Which of these statements deals with optimization, which deals with equilibrium, and which deals with empiricism? Explain. Answer: The first statement involves optimization. You believe that you will be better off by making all your purchases quickly to get home in time to do the cooking. The second statement involves equilibrium. The shopkeeper may have been in a hurry to make the sale, or the fruits and vegetables might have been nearing their expiry date. Therefore, you settled on a price that is acceptable to both parties. In other words, supply met demand at an agreed-on price. The third statement involves empiricism. You decided to obtain data on price and quality through observation in order to make an informed purchase. 7.

In 2014, California was in its third year of a major drought. With water supplies dwindling, Governor Brown issued a plea for a voluntary 20 percent reduction in water use. This target was not reached. In early 2015 Governor Brown issued an executive order requiring local water agencies to reduce water use by 25 percent, but no enforcement mechanism was specified. No taxes or fines were in the executive order. State officials hoped that they could achieve compliance without resorting to fines. a. From an individual homeowner’s perspective, what are the costs and benefits of using water during a drought? Why do you think that the voluntary reduction order in 2014 didn’t work? b. Using concepts from this chapter, explain how you might get individual homeowners to reduce water use during a drought. c. Eventually, many communities began levying fines on water use. However, while many middle income families dramatically cut water use, wealthy households cut back their water use relatively little. How can you explain this phenomenon from an economic perspective?

Answers: a. With no specific enforcement mechanism, there is low cost to using water. Water bills are not zero, but these prices were low enough in the past to create a water shortage, so clearly the financial cost is not high enough to prevent a shortage. There may be some social stigma attached to watering a lawn, though this cost varies for each person and depends on their sense of civic responsibility. On the flip side, the benefits of using water are quite clear: Green lawns, pleasant showers, and odorless toilets. The fact that the 2014 plea did not work is because the cost of violating a call for civic responsibility is not very high for most people. b. Charging a higher price for water than in 2014 would likely result in a reduction in water usage. When the price goes up, people would discover that some of their usage is actually not that important. c. Fines are equivalent to a higher price for water. In this case, lower income individuals were more price elastic; they responded more sharply to a price change. This implies that the willingness to pay for the last gallon of water in a low-income household is less than the willingness to pay in a high-income household. 8.

Use the concepts discussed in this chapter to answer the following problems: a. Oskar is about to join a new factory where he has the option of joining a trade union. Being a part of the trade union means that he will have to pay 5 percent of his wages to the union. Why do you think some workers decide not to join a trade union?

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b. You are living in a semi-detached house with a common garden. This means that both families living in the house can use it while being jointly responsible for its maintenance and upkeep. However, you decide that you cannot spare any time to maintain the garden. How can the other family get you to do your share of the maintenance? Answer: a. The free-rider problem explains why some workers decide not to join a trade union. On the one hand, they hope that they will not need the services provided by the trade union, such as legal assistance. On the other hand, they know that even if such a need arises, the services will be available to everyone, irrespective of whether they have paid a membership fee or not. b. The other family can insist on signing a joint usage-of-the-garden contract that states the responsibilities shared by the two families. It can also state the consequences of failing to share those responsibilities. Alternatively, they can decide to maintain only the half that is closer to them. 9. It is the night before your trip to Spain and you must decide how many hours to spend on expanding your vocabulary. The total benefits column shows how many more Spanish words you expect to learn. The cost column shows how many Spanish words you will mispronounce because of the increased fast learning. (The “marginal” columns show the effect of each additional hour spent studying. These marginal numbers are calculated by taking the difference within a column from one row to the next row.) Hours Spent Learning

Total Benefit

Marginal Benefit

Total Cost

Marginal Cost

a. If you study in an optimal way, how many more Spanish words will you learn? b. Explain how you can find the optimal number of hours by using the marginal benefits and marginal costs columns. Answer: a. Total benefit minus total cost is maximized at 13 − 2 = 11 when you study for two hours. This difference is lower in all other rows. b. You can arrive at the answer of two hours by noticing that the first hour is well worth it since the marginal benefit of 8 is greater than the marginal cost of 0. The second hour is also worth it since 5 > 2. However, the third hour is not worth it since 3 < 4; thus, you will gain fewer points than you will lose. (This sort of “marginal analysis” is a recurrent theme in economics.)

Chapter 2

Economic Science: Using Data and Models to Understand the World Questions 1.

Why do economists use the scientific method? Explain your answer by arguing for and against the use of this method.

Answer: The scientific method is the name for the process that economists and other scientists use to develop models of the world, test them with data, and evaluate how well they predict or describe behavior. Data are needed to know what is happening, and models are needed to know what the interaction is between different sets of data. When arguing for the usage of the scientific method, imagine a situation where you are responsible for the production of cars. Your task is to know, in advance, what colors customers will want their cars to have. Using empiricism, you can collect data on consumer preferences in advance and thus know what percentage of consumers prefer black, white, or blue cars. You can also create a model based on your collection of data in addition to other data such as previous purchases, social background, and wages to extrapolate which car color will be more popular with consumers. The difficulties of obtaining data, the expenses involved, and the challenges of statistical analysis may be put forth as arguments against the use of the scientific method. However, all these arguments are outweighed by arguments in favor of the use of scientific methods. We simply cannot make well-grounded, general observations about our world without having models that are backed by data. 2.

Explain how economists study the economic behavior of a society empirically. By using hypotheses, confirmed by empirical evidence, how do the economists and the empirical evidence contribute to the welfare of the society?

Answer: Economic behaviors and patterns help economists to study (a) the effects of psychological, cognitive, social, emotional, and other factors on economic decisions made by individuals and institutions; and (b) the consequences of market prices, returns, and resource allocation. These studies are mostly confirmed by empirical data collected by the economists themselves or by other individuals and organizations. Suppose economists study the amount of tax (10 percent) that will need to be paid by citizens of two states in order to construct a bridge that will connect the two states, which are divided by a river. For this purpose, they gather data on the income of the citizens (based on which the 10 percent tax will be calculated), how much the government should receive, how much tax will be evaded, and what is the estimated cost of building the bridge versus the actual cost. Such empirical data on constructing a bridge helps economists plan better when creating a good that contributes to public welfare. 3.

Are economic models detailed or simplified versions of reality? Could economists build perfect economic models? Why?

Chapter 2 | Economic Methods and Economic Questions

Answer: Economists create simplified descriptions that enhance an individual’s understanding of how things work, based on which economic models are built. Such economic models are designed to yield hypotheses about economic behavior that can be tested. Because they are built on assumptions, they have no objective measure of economic outcomes and are mostly subjective in nature. Different economists will draw different conclusions to explain their interpretations of reality. Because economics models are based on real-world factors that are hard to control, condition, or simulate due to complex and dynamic variables, they cannot be perfect representations of reality. Consider macroeconomic models used by central banks. These are approximations and simplifications of the economy, but usually correct in their predictions. 4.

How is the mean calculated from a series of observations? Suppose a supermarket near you sells 4 types of fruit juice (apple, orange, lemon, and grape). The price of the apple juice is €3, the price of the orange juice is €5, the lemon juice is €6, and the grape juice is €4. What is the average price of juice in the supermarket?

Answer: The mean is the average value of a set of observations. It is calculated as the sum of all the different items divided by the number of items. The average value is the sum of the prices of all the types of fruit juice divided by, in this case, four. Therefore, (3 + 5 + 6 + 4) / 4 = €4.50. This means that the average price of fruit juice is €4.50. 5.

Why does the size of the sample matter in an empirical argument?

Answer: The size of the sample used to test the argument can affect the results. A small sample may bias the results of a study. Bias means that the sample will not accurately reflect the entire population for which you were trying to obtain information. For example, you wish to obtain information on the consumption habits of European Union (EU) citizens. If you are using a small sample of 50 people, it might be possible that all of them are only from Germany and France, and the other EU member countries are not represented. However, if a random sample of 1,000 people is used, you will get a representative result. For details on minimal acceptable sample sizes, you can check with your statistics tutor or use the following website: https://www.surveysystem.com/sscalc.htm 6.

Explain why correlation does not equal causation. Give examples where the cause and effect relationship between events is not necessarily clear.

Answer: Correlation means that there is a relationship between two variables; as one variable changes, another variable also changes. Causation occurs when one variable directly affects another through a cause-and-effect relationship. Correlation suggests that there is some connection but not necessarily one of cause and effect. You bought a very fast sports car, which you use for getting to work. You are always on time. Your neighbor has a slow car and works at the same place as you do. He is always late for work. Is it because your car is faster? Not necessarily. In most countries there are speed limits; thus, your sports car probably cannot go any faster than your neighbor’s car. Presumably, your neighbor is either taking a longer route to get to work, or getting bogged down in traffic. One of your classmates attended all the classes in the statistics module the previous semester and received an A. Does this mean that if you attend all the classes, you will also receive an A? Not necessarily. You will also have to study for the class; otherwise, it is unlikely that you will get good grades.

Chapter 2 | Economic Methods and Economic Questions

The newest superhero movie has been released, and it is a major financial success. Does this mean that the film is actually good? Once again, not necessarily, as the cartoon characters featured in the movie may have such a large fandom that people would be eager to see them on the big screen. 7. Consider the following examples and state whether there is positive correlation, negative correlation, or zero correlation between the variables. a. A person’s gender and how well they drive a car. b. The number of sunglasses sold and the number of sunny days. c. The amount of gas (petrol) sold and its price. Answer: a. This is an instance of stereotyping. A person’s gender is unlikely to influence how well they can drive a car. The best drivers are typically the ones who practice a lot. Therefore, this is an example of zero correlation. b. The more the number of sunny days a region has, the more likely it is for people to wear sunglasses; therefore, there is positive correlation. c. If the price of gas drops, people will be more likely to use their cars frequently. As opposed to this, when the price of gas increases, fewer people will use cars. The frequency of usage will also drop. Therefore, this is an example of negative correlation. 8.

What is data? Is it always numerical? How is data used in empirical analysis? Give an example.

Answer: Data refers to facts that can be observed or measured. It is also referred to as empirical evidence. Data can be either numerical (quantitative) or qualitative in nature. For example, Mia paid €200 in taxes in the year 2017 is numerical data. On the other hand, Mia prefers to pay by credit card over check is qualitative data. Data can be collected and organized for empirical analysis in order to establish facts or truths about various phenomena. For example, if you survey your classmates about their incomes from part-time jobs, you can analyze those data to determine their average income. 9.

Why is it necessary to conduct experiments before releasing new drugs in a market? Why is randomization needed for experiments?

Answer: In order to know whether a drug works on people, it has to be tested. The best way to test it is to administer the drug to a treatment group (those who receive the drug) and to a control group (those who receive a placebo). If there is a significant improvement of health in the treatment group vis-à-vis the control group, the drug could be working. However, the drug may have side effects; therefore, a large pool of people should be tested. The best results are obtained when a large sample is selected randomly. 10. Suppose you had to find the effect of smoking on cancer. Would you choose to run a randomized experiment or would it make sense to use natural experiments here? Explain. Answer: It would be unethical to conduct a randomized experiment and ask people to smoke cigarettes, in order to test whether they might contract lung cancer or not. It makes more sense to conduct surveys or analyze medical records to find the linkage between smoking and cancer. Thus, the use of a natural experiment is the way forward.

Chapter 2 | Economic Methods and Economic Questions

Problems 1.

Some studies have found that people who owned guns were more likely to be killed with a gun. Do you think this study is strong evidence in favor of stricter gun control laws? Explain.

Answer: Not necessarily. It is quite possible that people who thought they were at risk (perhaps because they live in dangerous neighborhoods) were more likely to buy a gun for self-protection. This is an example of a case where correlation may not imply causation. There has been a good deal of research on this question. See, for example, a Harvard School of Public Health 2011 interview with David Hemenway: http://www.hsph.harvard.edu/news/features/review-gunspolitics-hemenway 2.

The average score for a class of 30 students is 70. The score for the top 20 students in the class averaged at 75. What is the average score of the remaining 10 students in the class?

Answer: The total score of 30 students = 30 × 70 = 2,100. The total score of 20 students = 75 × 20 = 1,500. Thus, the total score for the remaining 10 students = 2,100 − 1,500 = 600. Therefore, the average score of the remaining 10 students is 600 / 10 = 60. 3.

This chapter stressed the importance of using appropriate samples for empirical studies. Consider the following two problems in that light. a. Imagine you are a sociologist and your task is to find out the average wage in a small town in rural Europe. Since you are short on time you travel to the city and ask 10 random people waiting at the train station about their wages, then travel back and report on the data. Are you going to get an accurate number? b. Your friend was visiting a European capital city for two days and comes home saying that this city has the best restaurants in the world. Do you think his/her conclusion is justified?

Answer:

Even though an attempt at randomization has been made, there are different types of bias in the sample. First, your sample is small; second, you are interviewing people at a special place and time, which may not provide accurate reflections about the whole small town. Let us consider that the interviews are conducted in the morning and perhaps the interviewed people are commuters to the capital city nearby where wages are higher. Thus, you will be reporting on the wages in the city and not those in your small town.

No, as the sample that your friend was using was more than likely limited to a couple of experiments with restaurants. Again, they could have got lucky and tried only the good ones.

A study in 1991 have found that hormone replacement therapy (HRT), used to treat symptoms of menopause, reduces coronary heart disease risk. Do you think this study is strong evidence in favor of HRT? Explain.

Answer: Not necessarily. It is quite possible that women who resort to HRT are also financially better-off and, hence, lead healthier lives in terms of physical exercise and diet. This is an example of a case in which correlation may not imply causation. This question has been explored by several studies. Refer, for example, to the following 2004 article in the International Journal of Epidemiology: https://academic.oup.com/ije/article/33/3/464/716652. Source: https://science.howstuffworks.com/innovation/science-questions/10-correlations-that-arenot-causations4.htm (original sources within) (Retrieval Date: May 26, 2020).

Chapter 2 | Economic Methods and Economic Questions

As the text explains, it can sometimes be very difficult to sort out the direction of causality. a. As opposed to the United States, which has serious speed limits, in Germany, many places have no speed limits on the motorway. This means that you can easily travel at 200 kilometers per hour. Does the lack of a speed limit on the motorway mean that there are likely to be more fatalities due to car accidents in Germany? b. In 2017, Europe experienced the hottest summer since 2003. The heatwave was aptly named Lucifer. Temperatures crossed 40°C. Do you think it is likely that more people would have bought an air-conditioning device for their home?

Answer: a. Essentially, it should. However, the better roads, the skill and training of the drivers, the better quality of the cars, and strict penalties for tailgating ensure that fatalities are lower in, Germany than in the United States. b. Probably yes. If they had experienced high temperatures and could not tolerate the heat, it is likely that they bought air-conditioners to mitigate the discomfort. For further reference, students may refer to the following: Leonard Evans, “Traffic Fatality Reductions: United States Compared With 25 Other Countries,” American Journal of Public Health, August 2014, 104(8): 1501–1507, https://www.ncbi.nlm.nih.gov/pmc/articles/PMC4103211/; Aaron Brown, “8 Reasons That Germany's Autobahn Is so Much Better than US Highways,” Business Insider, March 31, 2016; and Stan Cox, “Climate Risks Heat up as World Switches on to Air Conditioning,” The Guardian, July 10, 2012. 6.

During the summer of 2015, the European Union (EU) experienced a record number of applications from asylum seekers. Some said they are economic migrants who just want to take advantage of the relatively good social protection system of the EU, whereas others pointed out that most asylum applications come from countries experiencing civil war. Why do you think asylum seekers were trying to get into the EU? List at least 5 possible explanations.

Answer: Migration can be best analyzed by looking at push and pull factors. Push factors are the factors that push people from their home country. These can include intensity of civil war; political, sexual, or religious repression; climate change; and a lack of job opportunities. Pull factors are those that draw migrants to a new country, such as safety, tolerance, job prospects, higher wages, minorities from the same country of origin, and common spoken language. (For further reading, students may refer to the following article: Timothy Hatton, “Refugees, Asylum Seekers, and Policy in OECD Countries,” American Economic Review: Papers & Proceedings, 106(5): 441–445, 2016.). 7.

An independent variable is a variable whose value does not depend on another variable, whereas a dependent variable is a variable whose value depends on another variable. Assume that ACT scores obtained by the students is the dependent variable. a. What kind of independent variables might we use in order to predict how a student might perform in secondary school? b. Assuming that in order to pass their calculus module students on average have to spend 100 hours studying. If they study more, they will of course improve on their ACT score. If someone i) has a higher IQ ii) has better teachers iii) has more committed classmates iv) has to work part time, will they have to spend more or less hours on average to pass calculus?

Chapter 2 | Economic Methods and Economic Questions

Answer: a. ACT scores are a measure of a student’s performance. In this case, the possible independent variables could be: IQ level, number of hours spent studying, family income, number of students in the classroom, qualification of teaching staff, etc. b. i) If someone has a higher IQ, they might have to study less. ii) Having better teachers means that students might understand the topic in class; thus, they might have to study less at home. iii) Peer pressure can be a highly influential factor in improving grades, although it does not mean that students will have to study less. iv) If someone has to work part-time, it means that they will have less time to spare for studies; however, they will have to spend, on average, at least 100 hours studying in order to pass the course. 8.

In 2016, most British voters decided that the United Kingdom should exit the European Union (EU). This withdrawal is popularly known as Brexit. How can we use this to demonstrate the effects of EU membership? Is this a natural experiment? What economic impact will this have on the United Kingdom?

Answer: Brexit, in a way, is a natural experiment. This is the first time that a country has decided to voluntarily exit the EU, and, so far, we have no experience in what happens to the economy of a country that does exit. We can analyze how the British economic growth will unfold in the future and compare it to that of the larger countries in the EU, such as France, Germany, or Italy. It is difficult to predict the economic impact of Brexit; however, growth is estimated to be less dynamic. Another consequence of Brexit was the illustration of how difficult it is to leave the EU to other member states. Source: Larry Elliott and Phillip Inman, “Gloomy Brexit Forecasts for UK are Coming True, Says IMF,” The Guardian, December 20, 2017, https://www.theguardian.com/. 9.

An economist believes that the consumption patterns of a household can be determined by using the equation C = a + bI, where I is the income, a denotes a positive number, and b a percentage. a. Is the economist using a model? b. would you test this it?

Answer: a. Yes, the economist is using a model. A model is a simplified version of the economic reality. This equation simplifies a household’s consumption behavior. So, we can consider it to be a model. b. The consumption is simplified by a model with two main variables. The first variable denotes the irreducible consumption: We consume even when we don’t have an income. The second set of variables denotes that a certain proportion (b) of the income (I) is devoted to consumption. A1. How would you represent the following graphically? a. Income inequality in the U.S. has increased over the past 10 years. b. All the workers in the manufacturing sector in a particular country fit into one (and only one) of the following categories: 31.5 percent are high school dropouts, 63.5 percent have a high school diploma, and the rest have vocational training certificates. c. The median income of a household in Alabama was $43,464 in 2012, and the median income of a household in Connecticut was $64,247 in 2012.

Chapter 2 | Economic Methods and Economic Questions

Answer: a. Since the graph needs to show how income inequality increases over a period of time, a time-series graph needs to be used here. b. A pie chart is a circular chart split into segments to show the percentages of parts to the whole. Since the given data is in percentages, a pie-chart can be used to represent each category of workers. c. A bar chart would be a good way to compare income in Alabama and Connecticut. The height of each bar would represent the income in each one of the states. A2. Consider the following data that shows the quantity of coffee produced in Brazil from 20042012. Year

Production (in tons)

2004

2,465,710

2005

2,140,169

2006

2,573,368

2007

2,249,011

2008

2,796,927

2009

2,440,056

2010

2,907,265

2011

2,700,440

2012

3,037,534

a. Plot the data in a time series graph. b. What is the mean quantity of coffee that Brazil produced from 2009 to 2011? c. In percentage terms, how much has the 2012 crop increased over the 2009-2011 mean? Answer: a. A time-series graph can be used to represent the quantity of coffee produced from 2004 to 2012.

b. The average quantity of coffee that Brazil produced during the 2009-11 period is 2,682,589 587 tons. This is the sum of the total quantity produced divided by the number of years.

Chapter 2 | Economic Methods and Economic Questions

c. The coffee crop in 2012 is 14.6% larger than the average coffee crop in 2009-2011. The increase in production is 3,073,534 – 2,682,589 = 390,945. In percentage terms, the change is 390,945 / 2,682,589 587 = 14.6%. Data taken from: http://faostat.fao.org/site/567/default.aspx#ancor A3. Suppose the following table shows the relationship between revenue that the Girl Scouts earn and the number of cookie boxes that they sell. Number of cookie boxes

Revenue ($)

200

150

600

250

1,000

350

1,400

450

1,800

550

2,200

a. Present the data in a scatter plot. b. Do the two variables have a positive relationship or do they have a negative relationship? Explain. c. What is the slope of the line that you get in the scatter plot? What does the slope imply about the price of a box of Girl Scout cookies? Answer: a. The following line chart shows the relationship between the Girl Scouts’ revenue and the number of cookie boxes that they sell:

b. Since the values of both variables increase together in the same direction, they have a positive relationship. This means that as more cookie boxes are sold, the revenue earned increases. c. The slope is constant in this problem and so we can choose any two points to calculate the slope. Suppose we use the first and last data points. The slope is calculated as

Chapter 2 | Economic Methods and Economic Questions

. The slope implies that one extra box of cookies sold is associated with $4 more in revenue.

Chapter 3

Optimization: Trying to Do the Best You Can Questions 1.

Are people, households, businesses, and governments always exercising their optimal choice when making decisions?

Answer: Economists don’t assume that people are always successfully optimizing. However, they believe that economic agents try to optimize, given the available information. These economic agents are not perfect optimizers and their decisions are not always optimal, because optimization is usually not easy. For example, a student has one week to prepare for two exams. He decides to allocate 3 days to preparation for the first exam and 4 days to preparation for the second exam. According to the student, this is the best allocation of time, which may or may not be the optimal choice. 2.

How is optimization used to predict economic or business outcomes?

Answer: As stated in the chapter, “whatever choices people face, economists believe that they will choose optimally.” When presented with the same set of available information, optimization means that different economic agents will make the same (or a similar) choice. Hence, businesses can predict the optimal economic or business decisions of their rivals, customers, and suppliers. Through seeking and providing advice, economists and business leaders can attempt to make optimal decisions by quantifying the effect of future decisions to gauge possible outcomes before the decision is finalized. With the help of optimization, they can not only predict what might happen but also analyze why it will happen. Using input from various data sets, optimization, when implemented correctly, can have a large impact on how businesses make decisions. This is done by providing scope for analysis of several areas—production, schedules, and inventory— and ensuring that the right products and services are put out in the market at the right time, which in turn will help optimize the experience of the consumers. This is the reason behind the success of websites that are used to compare identical or similar products and their prices, since they help economic agents make informed decisions regarding what to consume. Economic and business decision makers certainly hope that consumers do use optimization when consuming; therefore, when a product (such as an iPhone) is more expensive, people can be convinced that it offers more or better services. Students should note that efficient optimization requires time—initially, people will struggle to choose the best products; however, with time, they will learn from their mistakes and optimize better. 3.

Suppose your workplace does not have a cafeteria and you have to go out during your lunch break to grab a bite to eat. You have two options: an expensive restaurant that is two minutes away or a cheaper one that is ten minutes away. Does picking the one that is ten minutes away necessarily imply that you are optimizing?

Answer: Not necessarily. You only have a 30-minute lunch break, and you are spending 20 minutes of this time in getting to the restaurant, almost devouring your food because of lack of

Chapter 3 | Optimization: Doing the Best You Can

time, which, in turn, impacts your health. Also, if the opportunity cost of not working but eating is high (for instance, because you need the money, or you are closing in on a deadline, or you have a meeting coming up soon), then the optimal decision may be to save some time and eat at a location that is closer to your office. 4.

Why does a change in one’s opportunity cost of time imply a change in one’s optimal apartment location?

Answer: When the opportunity cost of time is lower there is a lower cost to traveling a large distance to get to work and social activities. Thus somebody with a lower opportunity cost of time is likely to care less about where they live, and thus probably live farther from the places that he or she frequently visits. On the flip side, people who value their time greatly are more likely to pay a premium to live close to work. 5.

Suppose you are trying to open a store at a local shopping mall. There are two open spaces: one is on the ground floor near the entrance; the other is on the topmost floor. Both spaces are identical in size, but the rent for the ground floor space is almost twice the rent for the top floor space. You choose the top floor. Is your decision optimal? Explain.

Answer: The answer depends on several factors which include the following: How frequented is the shopping mall? If this is the only one in your city, then you can presume that there will be as many customers visiting stores on the top floor as there would be on the other floors. Are you selling (luxury) goods that no one else sells in the mall? If your answer is yes, then it does not really matter where you are located. If you are selling a product that is in demand, it does not matter where you are located. Is there a food court or a multiplex next to your store? If yes, once again, you have made an optimal decision by choosing to be located on the top floor. Otherwise, you might have to make careful calculations to determine whether the extra rent that you have to pay on the ground floor can be offset by your increased sales. Consider the example summarized in the table below. The shop did not lose too many customers because of not being located on the ground floor; thus, it makes sense to have saved on the rent.

Floor

Rent/Month

Top floor Ground floor

$20,000 $40,000

Average Spend by Customers $100 $100

Average Number of Customers 800 900

Total Revenue

Total Profit

$80,000 $90,000

$60,000 $50,000

There is a proverb “anything worth doing is worth doing well.” Do you think an economist would agree with this proverb?

Answer: Probably not (unless this economist is one of your parents). An economist is likely to tell you that you should follow the Principle of Optimization at the Margin and that you should do something well only if the marginal benefits of doing it well are at least as large as the marginal costs. Suppose you are thinking of painting your room and you have three options: decide not to paint, paint but do a sloppy job, or paint and be meticulously careful. An economist would tell you to paint your room carefully if the marginal benefit of being careful (i.e., the difference between how your room would look if you are careful and how it would look if you are sloppy) is at least as large as the additional cost of painting carefully. Remember that because of scarcity,

Chapter 3 | Optimization: Doing the Best You Can

we cannot have everything we want. Suppose you get 95% of the benefit from painting your room to perfection while doing a sloppy job. The additional 5% in benefits from striving for perfection may well cost more than it is worth, in terms of alternative uses for your time. 7.

Economists like using marginal analysis to illustrate a point. Suppose you have been working very hard and are considering taking a vacation. Use marginal analysis to illustrate how you would approach taking (i) one additional day and (ii) one additional week of vacation.

Answer: (i) Suppose that you have been working hard and you need a vacation, but you cannot decide whether to go for 3 or 4 days. By using marginal analysis, you can get an approximation on whether that extra day of vacation is going to make you more relaxed and ready to work. (ii) However, if you are overworked, it probably does not make any difference whether you take 3 or 4 days of vacation—the question should be whether to take 1 or 2 weeks of vacation instead. Using our previous analysis, we can also calculate whether an extra week of holiday is going to make us more relaxed. The answer is still yes, but by a far smaller margin than in the case of a 3-day versus a 4-day holiday. The textbook will refer to similar examples as diminishing marginal returns. 8.

Identify the distinction between optimization in levels and optimization in differences. Do they yield the same result?

Answer: Optimization in levels calculates the total net benefit of different alternatives and chooses the best one. Optimization in differences calculates the change in net benefits when a person switches from one alternative to another, and then uses these marginal comparisons to choose the best alternative. Optimization in difference and optimization in level give identical results. 9.

A normative model answers optimization questions like what the optimal way of solving things is. Why do you think economists are being taught early on about normative models and optimization?

Answer: Economics and business are about not having infinite resources. This means that to maximize our benefits (such as utility, income, and happiness), we have to give up some of our goods. For instance, the textbook mentions the trade-off in terms of rent and traveling time between the city center and the outskirts. Economics is about choices and decisions. Economic agents are rational (or bounded rationality), and they pursue optimization of particular objectives. This sometimes involves subjective judgments. Economists are taught about these because some decisions (especially those in the public domain) require a balance between different views, and economists specialize in offering advice on such decisions. The sooner we start thinking in terms of “what could be the benefit of an extra unit of investment or expenditure,” the easier it will become to make optimal decisions in terms of cutting back on investments in an industry if there are no more benefits to be obtained, or increasing investment if there is still an option for extra income. Problems 1.

Suppose you are making two different decisions: the first decision is to buy a financial stock. The second decision is to buy a good to consume. Identify how you would behave in each

Chapter 3 | Optimization: Doing the Best You Can

decision to optimize your choice. Does optimal choice always mean obtaining the highest

values? Answer: When you buy a financial stock, you optimize your choice by balancing the risk of the stock with its benefits. When you buy a good for consumption purposes, you optimize your choice by maximizing your satisfaction from this consumption. In both cases, you are optimizing. Optimizing does not mean obtaining the highest values at all times. In the first decision, minimizing the risk means that you are buying the stock with the lowest value of risk relative to a given level of benefit. However, in the second decision, you are seeking highest value of utility. 2.

Suppose you applied to three jobs and are accepted for all three. Considering all factors: a. How would you make an optimal decision on which job to choose? b. The jobs that you have applied for only require a bachelor’s degree; however, you may wish to pursue your Masters. How can you make an optimal decision on whether to work or continue your studies?

Answer: a.

Some of the factors to consider are: • Wages paid by the employer • Working conditions, such as whether the office space is clean or not • Number of vacation days being offered • Offer of health insurance or pension contribution from the employer • Potential job satisfaction and growth • Potential difficulty of the job and the amount of work expected from you To make an optimal choice, you need to consider the total benefit from each of the three jobs. You also need to calculate the amount of commitment that is required from you and whether it aligns with the compensation. You should then choose the job that offers you the maximum net benefit.

This partially depends on your opportunity costs as well as on how you envision your future. For instance, you will have to decide which option has a higher opportunity cost for you: Having a job and not studying, or studying but not having a job. Your opportunity cost can depend on, for instance, whether you are being financially supported by your family, or whether you wish to incur a debt through a student loan. There is a third option: Many universities offer part-time master’s degrees, which would enable you to study and work at the same time. In this case, you are sacrificing your free time to get a better education.

Determine if the following statements use optimization by total values or optimization by marginal analysis. a. Kelly is working as an administrator at a university. The university is now facing the decision whether to launch a new bachelor’s and a new master’s program. The expected net benefit of the bachelor’s program is €100 thousand, whereas that of the master’s program is €80 thousand. b. Jan is living in New Jersey but frequently travels to Europe for work. He has three major airline loyalty schemes to choose from: Star Alliance, Sky Team, and One World. Assuming that Star Alliance offers the best services onboard (net benefit is $100 per trip), Sky Team the best prices (net benefit is $80 per trip), and One World the fastest planes (net benefit is $60 per trip), which option should Jan pick? Which optimization strategy is he using?

Chapter 3 | Optimization: Doing the Best You Can

c. Megan is thinking about buying a car. She likes fast sports cars and is considering buying either a Nissan Skyline or a BMW M3. The Nissan Skyline was featured in many movies and, should she drive it, she hopes that everyone will think of her as being cool. On the other hand, buying a BMW M3 is probably going to be less expensive. She also assigns net benefits to both cars: $1,500 for the Nissan and $1,200 for the BMW. Which strategy is she using? d. Justin is thinking about buying a yacht for one of the Great Lakes in Canada. One of the biggest decisions when selecting yachts for purchase is how large the cabin area is. An extra 5 square meters would mean two additional bunk spaces and an extra cost of $5,000. Which strategy is in use? Answers: a. This is an example of optimization by marginal analysis. The net benefit of having one or two new educational programs is being considered here. b. Jan should take the flight operated by Star Alliance as this has the highest net benefit for him. He is using optimization by total value. c. This is an example of optimization by total value. For Megan, the benefit of driving a car that is famous is higher than the cost of purchase.

d. Justin is using marginal analysis by considering the increase in square meters. An extra square meter on the boat will cost an additional $1,000. 4.

Pascal is taking three courses this semester: economics, calculus, and statistics. Pascal’s goal is to maximize his average grade on the three term exams. Using optimization in marginal analysis, help Pascal decide how much time to spend studying for each exam if he has only one day in total to prepare for the three exams. How should he allocate that day across the three subjects? Repeat the analysis assuming he has two days in total to prepare. Finally, repeat the analysis assuming he has three days. Note: Pascal can only choose to study in increments of one day. Results are given from 0 to 100, where 0 is the worst and 100 is the best grade. He must achieve at least 50 to pass an exam, and he must pass all exams. Days of Study

Economics

Calculus

Statistics

0 1 2 3

60 65 69 75

45 50 52 60

50 52 57 62

Days of Study 0 to 1 1 to 2 2 to 3

Economics 5 4 6

Calculus 5 2 8

Statistics 2 5 5

Answers:

The table above contains the marginal differences for every extra day of study. If Pascal had just one day, it might seem that he would have an option from among the three subjects; however, in reality, without studying, he would fail in calculus. Therefore, his first day of study should be allocated to calculus. Now that Pascal would pass all the exams, you can decide on maximizing the average grade. The options are: study economics for 1 day (grade change by 5), study calculus for 1 extra day (grade change by 2), or study statistics for 1 day (grade change by 2). The greatest improvement can be achieved by studying economics.

Chapter 3 | Optimization: Doing the Best You Can

So, the first day is being spent on calculus, the second on economics. The options and corresponding marginal improvements for the third day are as follows: an extra day of economics (grade change by 4), an extra day of calculus (grade change by 2), or an extra day of statistics (grade change by 2). Once again, Pascal’s best option would be to study economics. Therefore, Pascal’s results would be as follows: 69 in economics, 50 in calculus, and 50 in statistics. His grade average would be 56.3, which is quite low. Perhaps Pascal should have spent more time studying at university than engaging in personal activities. 5.

Richard has begun running to improve his health. The first column lists the distance he is jogging in meters, the second column the total benefits in U.S. dollars. Meters run 0 500 1000 2000 3000 4000 5000 6000 7000

Total Benefit 0 40 100 200 320 420 490 540 550

a. Find the marginal benefit, the opportunity cost, and the net benefit for each distance. b. Being a busy lawyer, Richard cannot run as much as he would like to every day. He can run 1,000 meters in 10 minutes and the opportunity cost of an hour spent running is $600. What is the optimal distance for him to run? Answer: a. The marginal benefits of running each week are shown in the table below: Meters Total Benefit Marginal Opportunity Net Benefit Run ($) Benefit ($) Cost ($) 0 0 X 0 500 40 40 50 −10 1,000 100 60 100 0 2,000 200 100 200 0 3,000 320 120 300 20 4,000 420 100 400 20 5,000 490 70 500 −10 6,000 540 50 600 −60 7,000 550 10 700 −150 b. 1) Marginal benefit approach: If Richard runs 1,000 meters in 10 minutes, then the opportunity cost of 1,000 meters of running is $100. His marginal benefits are low at the beginning, which means that if he stopped running after 500 meters, then it would not be worthwhile and he should not have even started. The marginal benefits will equal the opportunity cost at 2,000 meters and 4,000 meters. However, running an extra kilometer

Chapter 3 | Optimization: Doing the Best You Can

can provide higher benefits than the costs for 2,000 meters. Therefore, optimal distance should be 4 kilometers. After that, the benefits will diminish and the costs will increase. 2) Net benefit approach: Net benefits are +20 at both 3,000 and 4,000 meters of running; thus, it is up to you to choose what distance you prefer 6.

Viktoria, a business consultant, has to travel quite frequently from Singapore to other parts of Asia. She has a frequent flyer card with Singapore Airlines and can choose from four different classes—First Class, Business Class, Premium Economy, and Economy. The following table provides the price of the seats and Viktoria’s valuation of each. All else equal, she likes to choose a class that offers comfort and allows her to work. What is the optimal seat allocation? Class First Class Business Class Premium Economy Economy

Price $2000 $1100 $750 $500

Viktoria’s Value of Seat $1600 $1200 $700 $400

For a trip to Hong Kong, Viktoria has four options to reach the city—a chauffeur-driven car, a taxi, a bus, or a train. The following table contains the prices of each service and the duration. Viktoria prefers one that is fast and clean. Which mode of transportation would she choose? Mode Cost Duration Total Benefit Chauffeur $950 40 min $450 Taxi $370 40 min $300 Train $110 24 min $400 Bus $48 67 min $60 Answers: Viktoria would choose the Business Class seat as that option maximizes comfort but is not overpriced. The marginal cost increase from Business to First Class is $900, whereas the marginal benefit is only $400. Therefore, this improvement in seating is at a net loss of $500. Upgrading from Economy to Premium Economy has a net benefit of $300 − $250 = $50, and from Premium Economy to Business Class $500 − $350 = $150. Therefore, the best option for her is to travel Business Class. Viktoria would choose the train as it maximizes arrival time, comfort, and price. Traveling by bus is at a small gain of 60 HKD − 48 HKD = 12 HKD (Hong Kong Dollar). Switching to the train has a marginal benefit of 340 HKD and a marginal cost of 62 HKD, which is a net gain of 278 HKD. Switching from the train to the taxi has a marginal benefit of −100 HKD and a marginal cost increase of 260 HKD, which is a net loss of 360 HKD. Switching from the taxi to the chauffeur-driven car has a marginal benefit of 150 HKD and a marginal cost of 580 HKD, which is a net loss of 430 HKD. This proves that Hong Kong has a very cost-efficient railway connection to the airport. 7.

Scott is planning on buying a car. He can choose between six types of powering: petrol, diesel, gas, hybrid, electric, or hydrogen. Being environmentally conscious, his total benefit will reflect the amount of greenhouse gases a car releases. The total cost is the price and upkeep of the car. He has a seventh option, using public transport. Assume Scott has been using public transport and has received 0 total benefits and costs.

Chapter 3 | Optimization: Doing the Best You Can

Type of Car Public transport Petrol Diesel Gas Hybrid Electric

Total Benefit 0 15 16 18 30 40

Total Cost 0 10 12 12 25 36

Hydrogen

a. Find the total net benefit for each. b. Use optimization in total value to determine the best option for Scott when he is trying to be conscious of the environment and save some money at the same time. c. Find the marginal benefit and the marginal cost for each.

d. Show that marginal analysis would also make him buy a gas-powered car. Answer:

a. (1) Type of Car Public transport Petrol Diesel Gas Hybrid Electric Hydrogen

(2) Total Benefit

(3) Total Cost

(4) Total Net Benefit

(5) Marginal Benefit

(6) Marginal Cost

15 16 18 30 40 60

10 12 12 25 36 58

5 4 6 5 4 2

b. Scott should buy a gas-powered car, which is probably not the best in terms of performance or for the environment, but it provides the highest net benefit. c. The table below shows the marginal benefits and costs for Scott’s choices. (1) Type of Car Public transport Petrol Diesel Gas Hybrid Electric Hydrogen

(2) Total Benefit

(3) Total Cost

(4) Total Net Benefit

(5) Marginal Benefit

(6) Marginal Cost

15 16 18 30 40 60

10 12 12 25 36 58

5 4 6 5 4 2

15 1 2 12 10 20

10 2 0 13 11 22

d. Scott should seek improvement in cars until the net marginal benefit continues to outweigh the net marginal cost. In this case, the gas-powered car is such a choice 8. It is possible to use equations to do marginal analysis. Suppose your firm has a marginal revenue given by MR = 21 - 2Q. This means that the fifth unit of output brings in 21 – 2(5) =

Chapter 3 | Optimization: Doing the Best You Can

$11 of additional revenue. The marginal cost for your firm is MC = 3 + Q. This means that the fifth unit of output increases cost by 3+ 5 = $8. a.

Is it a good idea to produce the fifth unit of output? Why or why not?

b. Find the Q that sets marginal cost equal to marginal revenue (MC=MR). As a preview of upcoming chapters, try to explain why this value maximizes profit. Answers: a. At Q = 5, the marginal revenue is 21 – 2(5) = $11; the marginal cost is 3 + 5 = $8. Therefore, not producing the fifth unit is a bad idea as the additional revenue is greater than the additional cost. The firm should produce the fifth unit of output.

b. 21 − 2Q = 3 + Q implies 18 = 3 × Q; therefore, Q = 6. At Q = 6, profit will be maximized

as the marginal revenue equals the marginal cost. At lower output levels, MR will exceed MC, as we saw in part (a). At higher output levels, MR will be lower than MC. For example, at Q = 7, MR = 21 – 2(7) = 7, while MC = 3 + 7 = 10, so the firm would not want to produce a seventh unit as its profit will be lower.

Your firm has a marginal revenue given by the equation MR = 24 – Q. This means that the 3rd unit of output brings in 24 – 3 = $21 of additional revenue. The marginal cost for your firm is MC = 4 + Q, thus the 3rd unit increases cost by 4 + 3 = $7. a. If you are currently producing two units, is it a good idea to increase production so that you produce a 3rd unit? Why or why not? b. As a preview of upcoming chapters, find a value for Q such that MR equals MC. Try to explain why this maximizes profit.

Answers: a. Yes, you should increase production since a third unit generates additional (“marginal”) revenue of $21 but has a marginal cost of only $7, so profit will increase by $14. b. 24 – Q = 4 + Q implies Q = 10. For any Q less than 10, the marginal revenue is greater than marginal cost, thus more is better. For any Q more than 10, the marginal revenue is less than marginal cost, so more is worse. Q = 10 is thus the sweet spot where profits are highest.

Chapter 4

Demand, Supply, and Equilibrium Questions 1.

How would you define a perfectly competitive market? Use an example to explain how you would apply the concept of ceteris paribus (holding all else equal) in such a market.

Answer: When defining a perfectly competitive market, we should consider the vast number of firms in the market, the absence of barriers to entry and exit, and the availability of complete information. In a perfectly competitive market, sellers sell identical goods and services, and individual buyers and sellers are not powerful enough to influence the market price. The demand and supply of a good may be influenced by multiple factors acting simultaneously. We use the concept of ceteris paribus to understand the impact of only one factor (usually price) on the demand and supply of the good, keeping all other factors unchanged or constant. For instance, one question could be—what is the impact of increasing the minimum earnings on the demand for inferior products? 2.

How would you define diminishing marginal benefits? Using the examples below, explain if it is possible to experience diminishing marginal benefits. a. You are an ardent fan of animated movies. Are you going to be as excited for the eighth animated movie released in a given year (such as Wonder Woman or Spiderman) as you are when the first is released in the same year? b. You are a foodie (a person who loves eating quality food), and in your spare time you blog about new restaurants opening in localities near you. If 10 new places open up in a short period around your block, what is your possible level of enthusiasm for it? c. You love driving and owning fast sports cars. Will buying an extra unit of such cars have increasing or diminishing returns for you?

Answer: Diminishing marginal benefit from a good suggests that the willingness to pay for an additional unit of a good declines as more of the good is consumed. a. The level of excitement decreases somewhat as each new animated movie is released. You may still watch them, but with decreasing anticipation. b. As in the previous answer, you may like to check out new restaurants; however, it becomes more of a chore than a passion if there are too many restaurants opening in too short a time, and your enthusiasm will probably decline. c. Since you are more than just a fan¾you are an enthusiast who loves collecting different models of fast sports cars¾the more expensive a car is, the more likely you are to buy it, assuming you have unlimited financial resources. With this mindset, the more cars you have, the more you crave, which means increasing marginal returns. (Note that purchasing additional units of sports cars may yield increasing returns only when they have different characteristics; buying more than one unit of the same car might not really provide any additional return.) 3.

How is the market demand schedule derived from individual demand schedules? How does

Chapter 4 | Demand, Supply, and Equilibrium

the market demand curve differ from an individual demand curve? Answer: We would derive the market demand schedule by summing the individual demands at every possible price. So, for example, if Consumer 1 would buy 6 units of a good when the price is $5 and Consumer 2 would buy 4 units, then the market demand at $5 is 10 units. The market demand curve is the sum of the individual demand curves of all the potential buyers. The market demand curve plots the relationship between the total quantity demanded and the market price, holding all else equal. 4.

Explain how the following factors will affect the demand curve for houses in an economy. a. Commercial banks raise the housing loan rate. b. An increase in immigration results in a large increase in population in the economy. c. An increase in the income of people in the economy.

Answer: a. Since people usually borrow from banks to finance the purchase of houses, we can consider housing loans and houses as complementary to each other. A higher interest rate will increase the cost of owning a house, leading to a decrease in the demand for houses. The demand curve for houses will shift to the left. b. The large increase in population will lead to an increase in the demand for houses. The demand curve for houses will shift to the right. c. Houses are considered as normal goods; in the case of a normal good, people will buy more of the good when their income increases. Hence, higher income will lead to an increase in the demand for houses. The demand curve for houses will shift to the right. 5.

In what ways do you think renewable energy is affecting the demand curve of oil?

Answer: Renewable energy is more sustainable than oil. Thus, because of global warming, people are more likely to favor the use of renewable energy over oil, which releases a substantial amount of greenhouse gases. It is, therefore, likely that the demand curve for oil will shift to the left, resulting in lower prices of oil. 6.

Suppose the price of crude oil rises from $55.66 per barrel in February 2020 to $62.28 per barrel in February 2021. The quantity supplied increases from 500 gallons to 720 gallons. What does this imply about the relationship between the price and the supply? Does the Law of Supply hold true in this situation?

Answer: Since the two variables move in the same direction—when the price of crude oil goes up, the supply also increases—we can say that the price of crude oil and the quantity supplied are positively related. Yes, the Law of Supply holds true, as it states that the quantity supplied rises when the price rises (holding all else equal), which is the scenario in the situation presented. 7.

What is the difference between willingness to accept and willingness to pay? For a trade to take place, does the willingness to accept have to be lower, higher, or equal to the willingness to pay?

Answer: Willingness to accept is the lowest price that a seller is willing to receive to sell an extra unit of a good, while willingness to pay is the highest price that a buyer is willing to pay for an extra unit of a good. For a trade to take place, the buyer’s willingness to pay must be greater than or equal to the seller’s willingness to accept. 8.

Explain how the following factors will affect the supply curve for cars. a. An increase in the working age population of a country.

Chapter 4 | Demand, Supply, and Equilibrium

b. A restriction on the inflow of foreign labor employed in the car industry. c. More companies are producing cars. Answer: a. The growth in the working age population increases the pool of workers in the car production industry. This will increase the supply of cars. Therefore, the supply curve will shift rightward. b. The restriction on foreign labor employed in the car industry will increase wages in the car industry, thus increasing the cost of production of cars. The supply curve will shift to the left. c. As more companies start producing cars, the supply of cars will increase. Therefore, the supply curve will shift rightward 9.

How do the following affect the equilibrium price in a market? a. A rightward shift in demand b. A leftward shift in supply c. A leftward shift in supply and a rightward shift in demand of the same magnitude d. A small rightward shift in supply and a large leftward shift in demand

Answers: a. Everything else remaining unchanged, a rightward shift in demand will increase the equilibrium price in the market. b. Everything else remaining unchanged, a leftward shift in supply will increase the equilibrium price in the market. c. Everything else remaining unchanged, a leftward shift in supply together with a rightward shift in demand of the same magnitude will increase the equilibrium price in the market. d. Everything else remaining unchanged, a small rightward shift in supply and a large leftward shift in demand will decrease the equilibrium price in the market. 10. Assume a shipping company is offering a Mediterranean cruise along Greece for anyone who lives in your city at the fixed price of €200 (the normal price is around €2,000). However, only a hundred people can take advantage of this offer. What would be the optimal way of distributing these tickets? Answer: At €200, it is quite probable that demand will exceed supply. This might lead to long queues or even riots to obtain these tickets. A more optimal option would be to host a public auction where people would be allowed to bid on these tickets. Although this would not lead to a 100 lucky people getting tickets for a cruise at a 90% discount, people would not have to stand in a queue and spend a large amount of time to purchase cruise tickets. The mechanism of an auction would ensure that the people who are interested, consider the ticket to be of value, and are able to pay for the ticket will get tickets. Problems 1. Suppose the following table shows the quantity of glitter that is demanded and supplied at various prices in European Country A.

Chapter 4 | Demand, Supply, and Equilibrium

P (€)

Quantity Demanded (thousand liters)

Quantity Supplied (thousand liters)

160

140

120

100

120

140

160

Use the data in the table to draw the demand and supply curves in the market for glitter.

What is the equilibrium price and quantity in the market?

The following tables give the demand and supply schedules for two of its neighboring European countries, Country B and Country C. Suppose these three countries decide to form an economic union and integrate their markets. Use the data in the table to plot the market demand and supply curves in the newly formed economic union. What is the equilibrium price and quantity in the market? Country B:

P (€)

Quantity Demanded (thousand liters)

Quantity Supplied (thousand liters)

140

120

100

120

140

Chapter 4 | Demand, Supply, and Equilibrium

Country C:

P (€)

Quantity Demanded (thousand liters)

Quantity Supplied (thousand liters)

180

160

140

100

120

100

140

160

180

Answers: a. The following figure shows the domestic market for glitter:

b. The equilibrium price in the market is €4, and the equilibrium quantity is 100,000 liters. c. If the three countries decide to integrate, the individual country demand and supply curves need to be aggregated to arrive at the demand and supply curves in the economic union. The quantities demanded and the quantities supplied by the three countries are each summed up for every price.

Chapter 4 | Demand, Supply, and Equilibrium

P (€)

Quantity Demanded Quantity Supplied (thousand liters) (thousand liters)

480

120

420

180

360

240

300

240

360

180

420

120

480

The following figure shows the demand (DM) and supply (SM) curves in the economic union:

As can be seen in the figure, the equilibrium price remains €4, while the total quantity sold is equal to 300,000 liters. 2.

Suppose your country has been doing well since the end of the global financial crisis and, therefore, the wages have increased by 30 percent since 2008. In parallel, active workers represent 75 percent of the population. Using a generic supply curve and assuming steak is a normal commodity, show the impact on the price and quantity of steaks sold.

Answers: When wages increase, the demand curve shifts (in this case, to the right; see textbook, p. 65). With a higher disposable income, it is logical that people will be able and willing to pay more for steaks. Thus, in this situation, the equilibrium price and the equilibrium quantity increase. For further details, see the graph below.

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The following two incidents involve simultaneous shifts in the demand and the supply curves. Analyze the final effects on the equilibrium price and quantity after the changes. Explain your answers. a. Severe drought at the peak of summer reduces the production of watermelons. With more people consuming the fruit to quench their thirst, the equilibrium quantity is unchanged. b. The government allocates land to build more houses in the country. At the same time, it relaxes the criteria of citizenship to entice more foreigners to settle down in the country. The price of house increases

Answers: a. The hot weather reduces the watermelon crop, and thus, for a given price, supply decreases. This will increase the equilibrium price and decrease the equilibrium quantity of the fruit. At the same time, when more people consume watermelons, for a given price, the demand for watermelon increases. This will lead to a higher equilibrium price and higher equilibrium quantity of watermelons. Since the equilibrium quantity of watermelons ultimately remains unchanged, the supply curve shifts by the same magnitude as the demand curve. b. With more land available to build houses, for a given price, the supply of houses increases. This results in a lower equilibrium price and a higher equilibrium quantity in the housing market. As more people take up citizenship in the country, for a given price, the demand for houses increases. This will lead to a higher equilibrium price and a higher equilibrium quantity. Since the price of houses ultimately increases, the demand curve shifts by a larger magnitude than the supply curve. 4.

Sketch generic supply and demand curves for the housing market and label the equilibrium price and quantity. a. A booming economy increases the demand for housing. Show the shift in the demand curve on your graph. What does this do to the price and quantity in the market? b. You and a friend both notice that more houses are built in response to this change. Your friend says, “this is a sign that the supply curve is shifting as well.” You respond, “no,

Chapter 4 | Demand, Supply, and Equilibrium

this is actually just a shift along the supply curve.” To help your friend understand, demonstrate what you mean on your graph. c. As it turns out, there actually is a shift in the supply curve due to an unrelated breakthrough in construction that lowers the cost of building houses. In what direction does the supply curve shift? Show this on your graph. d. Relative to the original price and quantity, what is the overall effect of both shifts on price and quantity? Answers: a. The price increases and the quantity increases. See first diagram. b. See the two red arrows on the supply curve; this represents a shift along the supply curve, which is different from a shift of the supply curve. c. A reduction in cost lowers the supply curve vertically, which is the same as a shift to the right, or an increase in the supply. See second diagram below. d. Quantity increases unambiguously. The overall effect on price is ambiguous as it depends on the size of the supply shift relative to the demand shift. As drawn, there is a slight increase in price, but with a slightly larger supply shift, price could remain the same or be even lower.

Thailand is the world’s second-largest producer of hard drives after China. In 2011, there were severe floods in Thailand. Because the hard drive manufacturing factories had to shut down due to the flood, the cost of hard drives increased significantly. a. Draw and discuss a supply and demand diagram to explain the increase in hard drive prices. b. Are computers and hard drives substitutes or complements? Explain. c. What do you think the impact of this flood has been on the equilibrium price and quantity of computers? Draw a supply and demand diagram for the computer market to explain your answer

Answers: a. Owing to the flood, the supply curve shifted to the left, which made the price of hard drives increase and the quantity decrease.

Chapter 4 | Demand, Supply, and Equilibrium

b. Computers and hard drives are complementary products: one cannot function without the other. In addition, there is no substitute product for a hard drive. c. Since the two products are complementary, the increase in the price of one will lead to an increase in the price of the other. Hence, the price of computers will increase, and the quantity produced will decrease simultaneously, as you cannot create functioning computers without hard drives. Thus, the computer supply curve shifts to the left.

Suppose nuclear reactors primarily provide the energy supply in your country. Your country is both sunny and windy at the same time and, therefore, many people have decided to set up

Chapter 4 | Demand, Supply, and Equilibrium

sun collectors and wind farms as a cheaper alternative to obtaining electricity. Explain how this might affect the price of electricity in the country with the help of a graph. Would it still be feasible to create new nuclear reactors? Answer: The supply curve for electricity would shift to the right, as new technology that makes electricity cheaper has been installed. Therefore, while the price of electricity decreases, the quantity of electricity increases. To answer the second question: No, it would not be feasible to open up new nuclear reactors since these are the most expensive options for the production of electricity.

For each of the following situations, sketch the demand curve as accurately as possible. a. There are 2 buyers of ostrich feathers. For any price above £6, these two buyers want nothing. For any price at or below £6 these buyers want a total of exactly 40 feathers. b. Insulin is a medicine needed by diabetics. If its price rises or falls, people would still need to get the exact same dosage prescribed to them, say 1 ml per day. c. You used to sell fresh orange juice in front of your house during summer, and all the neighboring kids used to do the same. You found out that if the price is £3 or below, you are able to sell all that you have, but you’d sell none if the price is above £3Answers:

Answer: a. This is a step “function” that jumps at the price of £6. At a price of exactly £6, the buyers are willing to buy any number of units, so it is actually preferable—not just permissible—to fill in this region with a horizontal line. (Also, technically speaking, the demand is not a “function” in the mathematical sense, because the price of £6 maps into multiple quantities demanded.) b. A vertical (“perfectly inelastic”) demand curve.

c. A horizontal (“perfectly elastic”) demand curve. Note that above £3, the quantity

demanded is zero (drawn explicitly in the graph, but often only implied in other graphs).

Chapter 4 | Demand, Supply, and Equilibrium

A freshwater aqua farm in Singapore can breed tiger prawns and tilapia. Recently, it was found that there may be a risk of contracting a type of disease from the consumption of tiger prawns—this discovery has led to fear among its consumers. How will this affect the equilibrium price and quantity of tilapia in Singapore?

Answer: The fear of contracting a disease from the consumption of tiger prawns decreases the demand for tiger prawns. This will lead to a lower equilibrium price, thereby reducing profit in

Chapter 4 | Demand, Supply, and Equilibrium

breeding tiger prawns. This, in turn, will decrease the demand for breeding tiger prawns at the freshwater aqua farm in Singapore. The consequent fall in the equilibrium price of conducting aquaculture leads to an increase in the supply of tilapia. Thus, the supply curve for tilapia will shift to the right. In the diagram below, the equilibrium price falls from P1 to P2 and the equilibrium quantity increases from Q1 to Q2. Market for Tilapia

Suppose that while explaining this chapter to your classmate, she tells you that when the supply curve shifts to the left, the price will increase. This increase in price will lead to an increase in supply leading to a rightward shift in the supply curve. Therefore, the supply curve will be back at its original position. Explain whether her explanation correct.

Answer: Her explanation is flawed because it claims that “an increase in price will cause an increase in supply and hence a shift of the supply curve...”; she may have mixed up shift of a supply curve and movement along a supply curve. The increase in price will cause an increase in the quantity supplied and, hence, movement along the supply. 10 Paris decides to increase the consumption of natural juices by imposing a maximum price of €3 per glass. The current equilibrium price is €4. Sketch the supply and demand for natural juice glasses and show the effect of this policy. Clearly label the excess demand/supply in your diagram.

Chapter 4 | Demand, Supply, and Equilibrium

Answer:

11. Lobsters are plentiful and easy to catch in August but scarce and difficult to catch in November. In addition, vacationers shift the demand for lobsters further to the right in August than in any other month. Compare the equilibrium price and quantity of lobsters in August to the equilibrium price and quantity of lobsters in November. Present and discuss a supply-and-demand diagram to explain your answers. Answer: The August demand and supply curves are DA and SA and therefore the August equilibrium price and quantity are PA and QA. As we move to November, the demand curve shifts to the left to DN and the supply curve shifts to the left to SN. The decrease in demand and decrease in supply both decrease the equilibrium quantity and therefore the November quantity QN is definitely less than QA. The decrease in demand decreases the equilibrium price but the decrease in supply increases the equilibrium price. Therefore, in general, we cannot know if the November price PN is less than, equal to, or greater than PA. In the diagram above, PN is less than PA but if the decrease in demand were small relative to the increase in supply we would have found that PN is greater than PA.

Chapter 4 | Demand, Supply, and Equilibrium

12. As part of U.S. sugar policy (in 2013), the government offered to buy raw sugar from domestic sugarcane mills at an average price of 18.75 cents per pound. The government offer was made for as much raw sugar as sugar mills produced. Any raw sugar purchased by the government was not sold in the domestic market, as this might have caused raw sugar prices to fall. The price of 18.75 cents per pound was above the equilibrium price. a. Under this policy, what do you think the government’s demand curve for sugar looks like? b. What impact does this policy likely have on domestic sugar prices? Answers: a. Since the government is willing to buy any quantity of raw sugar at the 18.75 cents per pound, the demand curve is horizontal at that price. The government’s demand curve is shown in the following figure:

b. Since the government guarantees that mills will get 18.75 cents per pound of raw sugar, they do not have an incentive to sell sugar to any buyer who offers less than that price. In effect, the government is raising the price of raw sugar to 18.75 cents per pounds. Also note that when the price falls below 18.75 cents, the millers sell the sugar to the government. Since the government does not re-sell this sugar in the open market, the domestic market price is very likely to increase. See http://www.npr.org/2013/03/28/175569499/farm-bills-sugar-subsidy-more-taxingthan-sweet-critics-say 13. The equilibrium price of coffee in an economy, measured in dollars, is about $2,000 per ton. To help the coffee farmers earn a higher income, the government set the price to $2,500 per ton. a. How will this affect the demand and supply of coffee in the coffee market? b. Construct a diagram for coffee to show the effect of the government action. Will the coffee farmers be better off? Answers: a. The price set above the market equilibrium level will lead to an increase in the quantity of coffee supplied but a decrease in the quantity of coffee demanded in the coffee market. b. At a market price of $2,500 per ton, the quantity supplied will exceed the quantity demanded. There will be an excess supply of coffee in the market. Only those farmers

Chapter 4 | Demand, Supply, and Equilibrium

who are able to sell their product at the higher price of $2,500 will be better off. Those who are unable to do so will be worse off.

14. Suppose the demand for hand sanitizer is QD = 70 − 4P, and the supply of hand sanitizers is QS = 10 + 2P, where P is the price of a unit of hand sanitizer. a. Find the equilibrium price and quantity of hand sanitizers. b. Suppose consumers’ income increases and hand sanitizers are considered as normal goods. As a result, the demand curve for hand sanitizers becomes QD = 100 − 4P. Find the new equilibrium price and quantity of hand sanitizers. Answers: Note: This problem requires some basic algebra. a. At equilibrium, the quantity demanded must be equal to the quantity supplied. Thus, we have 70 − 4P = 10 + 2P. Solving for P, we have 60 = 6P, and hence, P = 10. Substituting P = 10 into the demand or supply equation, we have Q = 70 – 4(10) or 10 + 2(10) = 30. The equilibrium price is $10, and the equilibrium quantity is 30 units. b. Equating the new QD with QS, we have 100 − 4P = 10 + 2P. Solving for P, we have 90 = 6P, and hence, P = 15. Substituting P = 15 into the demand or supply equation, we have Q = 100 − 4(15) or 10 + 2(15) = 40. The new equilibrium price of hand sanitizers is $15, and the equilibrium quantity is 40 units. 15. Draw the demand curve and the supply curve for a market in which the equilibrium price is negative. (Hint: Reread the discussion – Letting the Data Speak – of the crude oil market in Cushing Oklahoma on April 20, 2020.) Answer: The following diagram shows very low demand (due to the coronavirus shutdown of the economy). It also shows a supply curve in which it is costly to not sell (because of the cost of storage – space to store oil was running out in Cushing Oklahoma). The result is a negative price, in which people were willing pay to get rid of oil.

Chapter 4 | Demand, Supply, and Equilibrium

Chapter 19

The Wealth of Nations: Defining and Measuring Macroeconomic Aggregates Questions 1. Find and list three recent stories in the media that would typically be studied in macroeconomics. (Cite the date and source of the stories you choose.) Discuss why they would fall within the subject matter of macroeconomics. Answer: Solutions may vary. 2. How is gross domestic product defined? Answer: Gross domestic product is defined as the market value of the final goods and services produced within the borders of a country during a particular period. 3. What is an accounting identity? Explain the accounting identity Production = Expenditure = Income. Answer: Variables are related by an accounting identity when they are defined in a way that makes them mathematically identical. The circular flow diagram demonstrates that total production in the economy in a given year, total expenditure on goods and services over the year, and the total income received by all factors of production, will always be equal. Hence, GDP can be measured by any of the three. 4. Use the circular flow diagram to show how expenditure, production, and income relate to one another.

Answer: The concept of the circular flow between households and firms highlights the four kinds of flows that connect households and firms—production, factors of production, expenditure, and income. Households provide the factors of production that firms need—labor and capital. In turn, firms supply households with goods and services.

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These flows of goods and services are balanced by reverse flows of payments. Firms make factor payments to households for their labor and capital, which constitutes households’ incomes. The households use this income to make payments for the goods and services purchased from the firms, which constitutes aggregate expenditure on goods and services. Therefore, the value of production is equal to the value of expenditure, which is equal to the value of income. This means that GDP estimated using the income-based accounting approach will be equal to the estimate calculated using the expenditure-based accounting approach, which will also be equal to the estimate of GDP calculated using the production-based accounting approach. 5. How is production-based accounting used to estimate GDP? Discuss the role of value-added. Answer: Production-based accounting sums up the value that is added by each domestic firm in the production process. From the total revenue earned by a firm from the sale of a good, all of the productive activity of other firms in the supply chain is deducted to arrive at the value added by the firm. 6. How is GDP calculated using expenditure-based accounting? Answer: Expenditure-based accounting tracks the purchases of the goods and services produced in the economy. These purchases come in three key categories: goods and services that are bought by households (C); investment goods that are bought by households and firms (I); goods and services that are purchased by the government (G); and the expenditure of foreign agents on exports minus the value of domestic expenditure on imported goods (X – M). GDP can be calculated as the sum of these components: Y = C + I + G + (X – M). 7. Which category of expenditure accounts for the highest share of GDP in the United States? Answer: Consumption expenditure has consistently represented about two thirds of economic activity. In 2019, consumption represented 68 percent of U.S. GDP. 8. How is the level of economic activity calculated using the income method? Answer: The income-based accounting system calculates the aggregate level of economic activity in an economy by measuring the income generated as a result of such activity. Income payments come in two key categories: labor income and capital income. Labor income includes wages, salary, workers’ health insurance, and workers’ retirement benefits. It also includes every other way that people are explicitly or implicitly paid for their labor. Capital income includes dividends paid to shareholders, interest paid to lenders, earnings retained by corporations, rent payments made to landlords, and the benefits of living in one’s own house. 9. Why is owning a home an important source of capital income? Answer: Homeownership is an important source of (implicit) capital income as a person who owns a home does not need to pay rent. Economists consider this "non-payment" to be a form of capital income. The income from homeownership is the amount of money the owner would have needed to spend had they been renting the same kind of home or apartment. 10. What is meant by capital depreciation?

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Answer: Capital depreciation refers to the loss in value of capital over time due to wear and tear on capital equipment and structures. 11. How might more rapid income per capita growth in a country with low income like Zimbabwe improve well-being of the citizens of the United States in ways that are both measured and not measured in U.S. GDP calculations? Answer: Typically, as a country’s GDP per capita expands, its citizens import and export more goods and services. The U.S. would benefit by exporting more to supply Zimbabwe’s increased demand for imports. Likewise, U.S. citizens would benefit from importing more goods and services exported by Zimbabwe. As an example of a benefit not calculated in GDP, most U.S. citizens would be happy knowing that fewer people in the world were experiencing severe poverty. Wouldn’t you be happier seeing fewer commercials with starving children? 12. Explain three important factors that GDP leaves out. Answer: The text lists four important factors that GDP leaves out so student will select a different set of three. GDP does not account for capital depreciation, which is the loss in the value of capital over time as it gets used. It also excludes the value of home production. Activities like cooking your own meals, doing your laundry, or cleaning your house are not accounted for. Economic transactions that take place in the black market are also excluded from GDP estimates. Negative externalities, such as pollution, are not accounted for. The value of leisure is also not included in the estimates of a country’s national income, although leisure is a key ingredient in human well-being. 13. You decide to cook your own meal rather than eat in a restaurant. How will this affect GDP? Answer: GDP does not include home production because there is no market transaction, market price, or measurable quantity that accompanies home production. Therefore, if you cook your own meal rather than eating in a restaurant, it will not be included in GDP. GDP would thus be lower than if you ate in a restaurant. 14. When would a country’s gross domestic product exceed its gross national product? Answer: Although gross domestic product includes the market value of everything produced within the borders of a country, gross national product includes the market value of production generated by the factors of production possessed or owned by the residents of a particular nation. Domestic Gross National Product (GNP) = GDP + production of domestic country-owned capital/labor within the borders of foreign countries – production of foreign country-owned capital/labor within the domestic country’s borders. GDP is likely to exceed GNP when production by domestic factors within the borders of foreign countries is lower than production by foreign factors within domestic borders. 15. Nobel laureate Simon Kuznets, who did significant work on national income accounts in the 1930s, said that the welfare of a nation can scarcely be inferred from a measurement of national income. Would you agree with him? Why or why not?

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Answer: GDP is a summary figure of the level of economic activity in the economy, but per capita GDP is often used as a proxy for determining the well-being of a society. This is because per capita GDP shows a strong positive correlation with life satisfaction; countries with higher levels of per capita GDP report higher levels of life satisfaction. The same relationship also shows up within each country. In other words, low-income households report substantially lower life satisfaction than high-income households. 16. In 1968, Robert F. Kennedy gave an address in which he criticized the usefulness of GDP. His key observations are quoted here: “our Gross National Product, now, is over $800 billion dollars a year, but that Gross National Product—if we judge the United States of American by that—that Gross National Product counts air pollution and cigarette advertising, and ambulances to clear our highways of carnage. It counts special locks for our doors and the jails for the people who break them. It counts the destruction of the redwood and the loss of our natural wonder in chaotic sprawl. It counts napalm and counts nuclear warheads and armored cars for the police to fight the riots in our cities. It counts Whitman’s rifle and Speck’s knife, and the television programs which glorify violence in order to sell toys to our children. Yet the gross national product does not allow for the health of our children, the quality of their education or the joy of their play. It does not include the beauty of our poetry or the strength of our marriages, the intelligence of our public debate or the integrity of our public officials. It measures neither our wit nor our courage, neither our wisdom nor our learning, neither our compassion nor our devotion to our country, it measures everything in short, except that which makes life worthwhile.” Would you agree with him? Why or why not? Answer: Robert F. Kennedy’s words are moving and make the important point that our goal is not to achieve the highest GNP possible but the highest level of wellbeing. He does this by noting that GNP does not add value for positive externalities like the beauty of our poetry nor subtract value for negative externalities like the destruction of the redwood, and a reminder of this fact is important (and that is why it is included in the text). GNP remains a good measure for the quality of life because positive externalities tend to increase as GNP increases (positive correlation), and negative externalities tend to decrease as GNP increases (negative correlation). In chapter 8, we will learn of something about else that is not included in GDP, the quality of our institutions. Good institutions cause economic growth and wellbeing and bad institutions, the opposite.

17. Why is it essential to differentiate between real and nominal growth rates of GDP? Answer: It is essential to differentiate between real and nominal growth rates of GDP in order to understand whether output has actually grown from one year to the next. An increase in the nominal value of GDP could have been due to an increase in prices rather than an increase in output. The growth rate of real GDP, however, shows the increase in the actual quantity of goods and services produced. 18. What are the key differences between the Consumer Price Index (CPI) and the GDP deflator? Answer: The main difference between the CPI and the GDP deflator is the basket of goods that each formula considers. The GDP deflator is based on a country’s total GDP, the basket of goods that is produced domestically. In other words, the GDP deflator utilizes the basket of goods that represents the total output of the domestic economy. Therefore, it includes many goods not ordinarily purchased by consumers. In contrast, the CPI is based on the basket of goods and services that an “average” consumer

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typically buys. This basket is constructed to reflect the types and quantities of goods that are purchased by a typical household. As a result, the CPI includes items that are purchased by households—like imported goods—that are not included in GDP. And because they are not included in GDP, their prices are not reflected in the GDP deflator. Another difference involves the weighting of goods in the two indices. Housing, for example, represents a major portion of a typical household’s budget; hence, it has a high weighting in the calculation of the CPI. However, it has a much smaller weighting in the calculation of the deflator. A final difference is that the CPI is announced monthly, whereas the GDP deflator is only released quarterly. Hence, the CPI is more timely. 19. How is the Consumer Price Index similar to the GDP Deflator? Answer: Both the CPI and the GDP deflator use current prices in the numerator and base-year prices in the denominator. The formulas for the CPI and the GDP deflator both contain a ratio that compares what it would cost to buy goods in the current year (in the numerator) to what it would have cost to buy the same goods using base-year prices (in the denominator). Both formulas also have the same interpretation: A higher ratio implies a greater price increase from the base-year to the current year.

Problems 1. Which of the following would be considered a final good in the calculation of Armenian GDP? Explain your answers. a. All the actors and members of staff employed for a popular TV show, produced by Armenia TV, are citizens of the country. b. The Armenian government approved a stimulus package in March 2020 for those who were negatively impacted by the COVID-19 pandemic. c. Lavash bread, which in 2014 was placed on UNESCO's list of Intangible Cultural Heritage, is produced in Armenia but is sold globally. Answer: a. The TV series is an all-Armenian final good, so it would be included in the GDP estimates of Armenia. b. While this is government expenditure, since it is aid money, it is considered a transfer payment. Transfer payments are not to be included in the computation of GDP. c. Lavash bread would be included in the computation of Armenia’s GDP as it is produced in the country. If it is sold in Armenia, it will be considered under the consumption category and if sold abroad, it will be considered as an export. 2. By how much would GDP change as a result of each of the following changes? Briefly explain your answers. Copyright © 2022 Pearson Education Ltd.

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a. A couple decides that their child should visit a private language tutor as opposed to attending a language school. The cost of the private language teacher is €10 per session, whereas the language school costs €8 per session. If the private language tutor does not report the income to the tax authorities, what would be the impact on the calculation of GDP? b. A couple moves to the countryside from Rome, Italy, for health reasons. They have a small garden, where they grow vegetables for home use. While they were living in Rome, they spent €2,000 annually on vegetables, but now they spend only €500. c. Part of a bridge built by the South Korean government collapsed in the same year it was constructed. The total cost of building the bridge was ₩4,458,400,000 (approximately $4 million), and then it costs ₩ 2,229,200,000 (approximately $2 million) to repair it. d. India produced 8 million tons of rice in a particular year. Of this, 0.5 million tons had to be discarded due to a pest infestation. Answer: a. Attending the language school would add €8 to GDP. Since the child has a private tutor who does not declare this “produced service” to the tax authorities, the service produced would not manifest itself in the production-based GDP. Therefore, the GDP would decrease by €8 because of the increase in the underground economy. b. In this case, Italy’s GDP would decrease by €1,500 as the couple is no longer buying vegetables worth €2,000 from the supermarket and instead only spending €500 on what they cannot grow themselves. c.

South Korea’s GDP would increase by ₩2,229,200,000.

d. India’s GDP would remain unchanged. The quantity of rice that was discarded would not affect the calculation of GDP as depreciation is not included in the calculation of GDP. 3. In order to generate estimates of GDP, the Bureau of Economic Activity must aggregate a variety of data sources, such as expenditure surveys. a. What measurement problems might the government face in trying to estimate GDP? Consider the three accounting methods we discussed in this chapter; what kinds of information would you need for each? b. In its quarterly estimates, the BEA uses both expenditures-based and income-based accounting; in order to differentiate between the two, it refers to the expenditures-based estimate as GDP and the income-based estimate as GDI. What would we expect the relationship between GDP and GDI to be? c. Now, go to the BEA NIPA tables (https://www.bea.gov/iTable/index_nipa.cfm), and compare the actual estimates for GDP (table 1.1.5) and GDI (table 1.10). What are the estimates for GDP and GNI in the first quarter of 2020? What factors could explain any differences you notice? Answer: a. Solutions may vary but should touch on the concepts introduced in the chapter. For example, the government may have trouble measuring informal or black-market production. The three accounting methods should be listed: production-based accounting, income-based accounting, Copyright © 2022 Pearson Education Ltd.

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and expenditure-based accounting. To measure production, the government would need information on both quantities produced and market prices, for every good produced in the U.S. economy. To measure income, the government would need all investment and labor income (including, for an accurate estimate, any wages paid in cash). Finally, to measure expenditure, the government would need information on all sales, including the size of all inventories in every company. b. Although, in theory, we would expect them to be equal, in practice they likely vary due to the measurement issues discussed in part a. c. GDI is around 100-300 billion dollars higher than GDP, at least in the last few years. This discrepancy could be due to limitations in, for example, measuring company inventories or certain kinds. (solutions may vary) 4. Suppose there are two neighboring countries in a multi-country world: Plastakia and Recylopia. Both countries have the same currency, Bogs. Plastakia’s GDP per capita is 5,380 Bogs, its GDP is 400 million Bogs, and its GNP is 432 million Bogs. Recyclopia has a population of 40,000 people and its GNP is 350 million Bogs. Use this information to calculate Recyclopia’s GDP. What is the Plastakia’s population and what is Recyclopia GNP per capita? Answer: Since there are more than two countries, the total GDP of the two countries cannot be equal to their total GNP. In addition, the problem does not specify the components of either countries’ GDP or the value of the final goods produced in Recyclopia. Thus, we cannot calculate Recyclopia’s GDP. Plastakia’s GDP per capita = GDP / Plastakia’s population So Plastakia’s population = GDP / Plastakia’s GDP per capita = 400,000,000 Bogs / 5,380 Bogs = 74,349.44 people Recyclopia’s GNP per capita = 350,000,000 Bogs / 40,000 people = 8,750 Bogs. 5. The following table gives data for a small country, Barboras. Component Interest paid on government debt Depreciation Households purchase of stocks and bonds Net private investment Gross private investment Exports Households’ consumption of domestic produce Imports Salaries earned by foreigners working in Barboras Household consumption Purchases of raw materials Government purchases Capital income Salaries earned by Barborasians working abroad

Expenditure (in thousands) £180 £25 £280 £525 £550 £230 £100 £290 £185 £1,000 £205 £800 £310 £420

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a. Use the data to calculate GDP for this economy using the expenditure method. b. Calculate the value of Barboras’ GNP. Does Barboras’ GDP differ from its GNP? Why or why not? Answer: a. According to the expenditure approach, GDP = C + G + I + (X – M). Here, C represents household consumption expenditure (excluding purchases of stocks and bonds and consumption of home production), G represents government expenditure on goods and services (excluding transfer payments and interest on public debt), I represents investment (gross not net), and (X – M) represents net exports. The value of Barboras’ GDP = household consumption + gross private investment + government purchases + (exports – imports). Barboras’ GDP = 1,000,000 + 550,000 + 800,000 + (230,000 – 290,000) = £2,290,000. b. Gross National Product (GNP) is the market value of production generated by the factors of production – both capital and labor − possessed or owned by the citizens of a particular nation. Therefore, Barboras’ GNP = Barboras’ GDP + salaries earned by Barborasians working abroad – salaries earned by foreigners working in Barboras Barboras’ GNP = 2,290,000 + 420,000 – 475,000 = £2,235,000. Barboras’ GNP is slightly lower than its GDP because the production of goods in Barboras exceeds the production of Barborasian factors of production within the borders of foreign countries. 6. Most products we buy go through several intermediate processes before we can purchase them. Suppose the stages and the associated transaction values involved in the production of a tin of coffee are as follows: Stage Factory buys beans from farmers Factory buys tin box Factory sells product to a wholesaler Wholesaler sells product to a retail chain Retail chain starts a marketing campaign Retail chain sells product to the public

Value € 2 € 1 € 8 €11 € 1 €15

By how much would GDP change as a result of this tin of coffee? Use the following: a. Expenditure-based accounting b. Income-based national accounting c. Production-based accounting Answer: a. A consumer buys the tin of coffee for €15, so consumption and GDP increase by €15. b. Farmer’s income €2 + tin box maker’s income €1 + factory’s income €5 + wholesaler’s income €3 + marketing consultant’s income €1 + retail chain’s income €3 = total addition to GDP = €15. Copyright © 2022 Pearson Education Ltd.

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c. Value added by (farmer €2 + tin box maker €1 + factory €5 + wholesaler €3 + marketing consultant €1 + retailer €3 = total value added = total addition to GDP = €15. 7. In 1966, two of baseball’s best pitchers, both playing for the Los Angeles Dodgers, formed a twoplayer union. They demanded a $1 million 3-year contract to be split equally. They eventually signed 1-year contracts of $125,000 for Koufax and $110,000 for Drysdale. A short time later, baseball players formed a union and won an end to the reserve clause, which forced a player to play for a team as long as the team wanted the player. In 2018, Kershaw, another outstanding Dodger pitcher, signed a $93 million 3-year deal. a. In 1966, the CPI was 32.5. In 2018, it had risen to 251.1. Calculate the value in 2018 dollars of the contracts signed by Koufax and Drysdale. Compare the three contracts (annualizing Kershaw’s contract). b. How did the elimination of the reserve clause change the bargaining power of players? c. Speculate as to how the end of the reserve clause, a change in the rules of the game, might have influenced ticket prices. Answer: a. Koufax’s 1966 contract, using 2018 as the base year =

251.1

($125,000) 32.5 = $965,769 Drysdale’s 1966 contract, using 2018 as the base year was =

251.1

($110,000) 32.5 = $849,877 Kershaw’s contract can be annualized by dividing the $93,000,000 by 3 or $31,000,000 per year. b. When the reserve clause was eliminated, a player could negotiate with many other owners who would bid up the value of the contract. Indeed, this is just what happened. c. Owners maximized revenues both before and after the elimination of the reserve clause. In both cases, players are paid from these revenues. This implies that the higher contracts paid to players would not change ticket prices. Eliminating the reserve clause did dramatically change how revenues were divided between owners and players. Copyright © 2022 Pearson Education Ltd.

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8. With the rise of globalization, supply chains are spread across the world. Suppose the following are the stages of producing pencils in Germany: • A German-based pencil company develops the designs for the pencil. It’s a ground-breaking design that is ergonomic, easy to carry, and doesn’t roll when left on a table. • Graphite, which is the writing core of the pencil, is a mineral mined in Brazil and €10 billion worth of graphite is sold to China. • Softwood, which encases the graphite, is imported from South Africa to China where a Chinese plant manufactures the body of the pencils along with the graphite inside. These are then exported to Kazakhstan for €16 billion. • Kazakhstan produces a non-toxic paint. A factory in Kazakhstan paints the pencils and sells them to Germany for €18 billion. • The rubber that is used to produce the eraser on top of the pencil is derived from tropical plants grown in Malaysia. • The aluminum that goes into the production of the ferrule that encases the eraser is produced in Mozambique. • The German company imports rubber and graphite for a total of €7 billion and manufactures the eraser tips, which it then adds to the rest of the pencil. • The company sells the finished pencils to German retailers for €33 billion. • The retailers sell the pencils within Germany, for a total of €39 billion in revenue. a. Calculate how much this process contributes to German GDP. Explain your calculation. b. What sources of value might not be captured in your calculation in part (a)? Answer: a. To calculate this number, we have to look at the value added by the German firm. The German firms buy the pencils bodies for €18 billion and the rubber and aluminum for €7 billion and produce €33 billion worth of value = €8 billion of value added. Finally, the German retailers buy €33 billion worth of pencils and sell €39 billion = €6 billion of value added. Total value added = 8 + 6 = €14 billion in value added to German GDP. b. Primarily, we’re missing any added value from the ground-breaking design creation. Ideally, this should have been captured in the GDP. 9. The country of Francania produces and consumes only three goods: lemonade, croissants, and blouses. The quantity produced and price of each good in 2020 and 2021 are given in the following table: 2020 Blouses Lemonade (bottles) Croissant

Quantity 90 650 1,200

2021 Price €30 €1.5 €1.5

Quantity 120 500 800

Price €35 €2.50 €3

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c. Based on your answer from part (b), by what percentage did real GDP grow between 2020 and 2021? d. Now calculate real GDP for 2020 and 2021 using 2021 as the base year. e. Based on your answer from part (d), by what percentage did real GDP grow between 2020 and 2021? f.

Using 2020 as the base year, what was the GDP deflator in 2020 and 2021?

g. Based on your answer from part (f), by what percentage did prices change between 2020 and 2021? Answer: a. For 2020: Nominal GDP = (90 blouses) × (€30) + (650 bottles of lemonade) × (€1.5) + (1,200 croissants) × (€1.5) = €5,475 For 2021: Nominal GDP = (120 blouses) × (€35) + (500 bottles of lemonade) × (€2.50) + (800 croissants) × (€3) = €7,850 b. Base year = 2020 For 2020: Real GDP = (90 blouses) × (€30) + (650 bottles of lemonade) × (€1.5) + (1,200 croissants) × (€1.5) = €5,475 = 2020 Nominal GDP (because 2020 is the base year) For 2021: Real GDP = (120 blouses) × (€30) + (500 bottles of lemonade) × (€1.50) + (800 croissants) × (€1.5) = €5,550 c. To calculate the percentage change, or growth rate, between 2020 and 2021, we simply take: [(Real GDP in 2021 – Real GDP in 2020) / Real GDP in 2020] × 100 = [(€5,550 − €5,475)/ €5,475] × 100 = 1.37 percent So, real GDP grew by 1.37 percent from 2020 to 2021. d. For this exercise, the base year has been switched. Now, the real GDP calculation for 2021 is simply the calculation of 2021 nominal GDP, which is €7,850. The calculation of 2020 real GDP, using 2021 as a base, is as follows: Base year = 2021 For 2020: Copyright © 2022 Pearson Education Ltd.

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Real GDP = (90 blouses) × (€35) + (650 bottles of lemonade) × (€2.5) + (1,200 croissants) × (€3) = € 8,375 For 2021: Real GDP = (120 blouses) × (€35) + (500 bottles of lemonade) × (€2.50) + (800 croissants) × (€3) = €7,850 = 2021 nominal GDP (because 2021 is the base year) Notice how sensitive these calculations are to what year is chosen as the base. e. The calculation is now: [(Real GDP in 2021 – Real GDP in 2020) / Real GDP in 2020] × 100 = [(€7,850 €8,375)/ €8,375] × 100 = −6.27 percent Because the base year on which our calculations are based has changed, we get a very different picture of the performance of Francania’s economy between 2020 and 2021. f.

The GDP deflator is calculated as follows:

Thus, the deflator for 2020 is: Nominal GDP in 2020 / Real GDP in 2020 (using 2020 as base) = €5,475 / €5,475 = 1 × 100 = 100 (This will always be the case when calculating the deflator for the base year, i.e., the deflator will always be 100.) The GDP deflator for 2021 is: 𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃 𝑖𝑛 2021 𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 𝑖𝑛 2021 (𝑢𝑠𝑖𝑛𝑔 2020 𝑎𝑠 𝑎 𝑏𝑎𝑠𝑒)

€7,850 €5,550

× 100 = 141.44

g. The percentage change in prices between 2020 and 2021 can be calculated just like any other percentage change: 𝐷𝑒𝑓𝑙𝑎𝑡𝑜𝑟 𝑖𝑛 2021−𝐷𝑒𝑓𝑙𝑎𝑡𝑜𝑟 𝑖𝑛 2020 141.44−100 = = 0.4144 = 41.44 percent 𝐷𝑒𝑓𝑙𝑎𝑡𝑜𝑟 𝑖𝑛 2020 100

Hence, prices changed by 41.44 percent from 2020 to 2021. This is one measure of the inflation rate over the year. 10. The following table contains some of the CPI components for the United Kingdom between 2009 and 2016. Every component is a part per 1,000. 1 3 4 5 6

CPI Components Food and non-alcoholic beverages Clothing and footwear Housing, water, electricity, gas and other fuels Furniture, household equipment and maintenance Health Copyright © 2022 Pearson Education Ltd.

2009 118 57 126 66 22

2016 103 71 120 59 28

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7 8 9 10 11 12

Transport Communication Recreation and culture Education Restaurants and hotels Miscellaneous goods and services

151 23 145 21 128 99

226

153 32 148 25 123 96

What are the reasons for the changes in average spending in the following components? a. Food and non-alcoholic beverages, which fell by 13 percent. b. Clothing and footwear, which increased by 24.5 percent. c. Communications, which increased by 39 percent. Answer: a. People in the United Kingdom may have started spending less on food and beverages because they may have realized that a reduction in food consumption could lead to a healthier lifestyle. Alternatively, the share of this component may have decreased automatically because of an increase in the share of other components. b. As 2009 was the year of the global financial crisis, people would have cut back on unnecessary expenditures such as clothing, hence the lower representation of clothing and footwear in the consumption basket. By 2016, it became trendy to spend more on clothing and dress fashionably, hence the increase in spending on clothing and footwear. c. Due to advancements in communication technology and tastes, people are spending an increased amount of money on anything that has smart technology – from expensive phones to watches and glasses. The mobile services for such gadgets are more expensive and consequently an increase in spending. In addition, in 2009, there were fewer affordable smart items available; therefore, the quantities of these products sold were lower. Source: https://www.ons.gov.uk/economy/inflationandpriceindices/datasets/w1tow3tablesannexa 11. Social Security payments in the United States are currently linked to the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). This means that as the CPI-W shows an increase in the price level, Social Security payments will also increase, keeping the real value of the payment constant. The following table shows the weighting given to the different components in the CPI-W consumption basket. Item

Weight

Food and Beverages

15.948

Housing

39.867

Apparel

3.623

Transportation

18.991

Medical care

5.767

Recreation

5.528

Chapter 19 | The Wealth of Nations: Defining and Measuring Macroeconomic Aggregates

Education and communication

6.766

Other goods and services

3.510

Total

100.000

227

It has been suggested that using the CPI-W to adjust Social Security payments understates inflation for seniors. Do you agree? Why might this be the case? Answer: Yes, it is possible that using the CPI-W understates inflation for senior citizens. The CPI studies a particular basket of consumer goods that a typical household purchases. Each item in this basket is given a certain weighting depending on its relative importance in consumption. As can be seen from the table given in the question, medical care is given a relatively low weighting in the CPI-W. However, most seniors are likely to spend a substantial amount on medical care and perhaps lower amounts on the other categories in the basket. So if the rate of health care inflation is higher than the rate of inflation for the other items in the basket, the CPI-W would understate inflation for seniors. Based on: http://www.economist.com/blogs/democracyinamerica/2013/04/barack-obamas-budget Data taken from: https://www.bls.gov/cpi/tables/relative-importance/2012.pdf 12. As of September 25, 2020, Jeff Bezos (the CEO of Amazon) had an estimated net worth of $182 billion (https://www.forbes.com/billionaires/). But does this make Bezos the richest person who ever lived? John D. Rockefeller, the founder of Standard Oil, is often credited with this distinction. At the time of his death in 1937, Rockefeller had an estimated net worth of $1.4 billion. a. Go to the U.S. Bureau of Labor Statistics CPI site at http://data.bls.gov/cgi-bin/surveymost?cu. Under “Consumer Price Index—All Urban Consumers,” select “US All Items, 1982 - 84 = 100,” and click the “Retrieve data” button at the bottom of the page. Adjust the years to retrieve data from 1937 through 2020. Use the data under the “Annual” column to calculate Bezos’s net worth measured in 1937 dollars. You should find that Bezos’s wealth does have more buying power than Rockefeller’s wealth did. b. Some analysts say that Rockefeller’s net worth was economically equivalent to over $250 billion today. However, this figure is arrived at in a particular way. First, his net worth in 1937 is calculated as a percentage of total U.S. GDP in 1937. That percentage is then multiplied by the current level of GDP to arrive at the equivalent figure in current dollars. See if you can approximate the $250 billion figure. You can find the relevant GDP figures at http://research.stlouisfed. org/fred2/data/GDPA.txt. c. What are the pros and cons of the two different methods of adjusting Rockefeller’s net worth to make it comparable to the wealth of business leaders today? Answer: a. Bezos’ net worth = $182B in 2020. 1937 CPI = 14.4. March 2020 CPI = 258.115. Adjustment factor = 14.4/258.115 = 0.056. So, Bezos’ 2020 fortune in 1937 = $182B × 0.056 = $10.2B. Copyright © 2022 Pearson Education Ltd.

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b. Rockefeller’s net worth in 1937 = $1.4B. 1937 GDP = $93B. Percentage of GDP represented by Rockefeller’s net worth = 1.4/93 × 100 = 0.015 = 1.5%. 2020 GDP was equal to $20,937 billion. 1.5% of $20,937 billion is $314 billion. So, if Rockefeller was alive in 2020, and his net worth was 1.5% of 2020 GDP, he would be worth $314 billion. c. The main advantage to this method of updating Rockefeller’s net worth is that it expresses it relative to the economy as a whole. In other words, given that Rockefeller’s wealth was 1.5 percent of 1937 GDP, a net worth today that represented an equivalent percentage of GDP would be around $314 billion. However, a disadvantage is that this method might actually overstate Rockefeller’s standard of living in 1937 compared to the present. Even someone with his resources did not have such modern essentials as air conditioning, computers, the Internet, or a host of life-saving drugs and medical procedures. So while his net worth was extraordinary when translated to a comparable contemporary figure, it is important to remember that people’s lives have been transformed by the progress of technology unavailable even to the wealthiest individuals in Rockefeller’s time. This is not accounted for in a simple numerical calculation of dollar values.

13. Recall the method of calculating real GDP detailed in the chapter. As you may already have noticed, this method has a problem: In calculating aggregate output, this method weights the output of the various goods and services by their relative prices in the base year. Say, for example, a textbook cost $100 in the base year, and a laptop cost $2,000. This means that the laptop would have 20 times the weight of a book in calculating aggregate output. But what happens when relative prices change? As you know, the prices of most high-tech items, including laptops, have generally been decreasing over time. Suppose the price of a laptop declined from $2,000 to $1,000 in the period from the base year to the current year. Now a laptop only costs 10 times as much as the book. So, using base-year relative prices would overweight laptops in calculating real GDP in the current year. In response to this problem, in 1996 the BEA switched to what is called a chain-weighted method of calculating real GDP. Say the base year is 2008. To calculate the growth rate of real GDP between 2008 and 2009, for example, the BEA calculates real GDP for 2008 using 2008 as the base, and then real GDP for 2008 using 2009 as the base. Then, the Bureau calculates real GDP for 2009 using 2009 as the base, and real GDP for 2009 using 2008 as the base. For each base, the growth rate is then calculated as: 2009 GDP2008 Base − 2008 GDP2008 Base 2009 GDP2009 Base − 2008 GDP2009Base , 2008 GDP2008 Base 2008 GDP2009 Base

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So, they end up with two different growth rates, which are then averaged. Given this averaged growth rate, and the level of GDP in 2008 at 2008 prices, the Bureau then calculates real GDP for 2009 as one plus the average growth rate previously calculated, times 2008 output in 2008 dollars. The growth rate between 2009 and 2010 is then calculated similarly. Suppose that laptops, economics textbooks, and energy drinks are the only three goods produced in the United States. The following table gives the quantity of each produced (in millions) and their price in the years from 2018 to 2020: PLaptops

QLaptops

PTexts

QTexts

PEng. Drnk

QEng. Drnk

2018

1500

100

2019

1200

110

2020

1000

120

a. Calculate nominal GDP and real GDP (using 2014 as the base year) for each year. b. Calculate real GDP for 2019 and 2020 using the chain-weighted method outlined above. Answer: a. Year

Price Laptops

Quantity Laptops

Price Texts

Quantity Texts

Price En. Drk

Quantity En. Drk

Nom GDP

Real w/ 2018 P

2018

1500

100

11250

2019

1200

110

11910

14460

2020

1000

120

10340

14570

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Table continued from part a.

Year

Nom GDP

Real w/ 2018 P

Real w/ 2019 P

Growth w/ 2018 P

Growth w/ 2019 P

Growth Average

Chain Wtd GDP

2018

11250

9270

2019

11910

14460

11910

28.5%

28.51%

14456.94

2020

10340

14570

12040

0.8%

1.01%

0.93%

14593.92

230

Chapter 20

Aggregate Incomes Questions 1. Suppose you are comparing per capita income in Germany and Hungary. According to the International Monetary Fund’s World Economic Outlook Database (April 2017), Hungary’s GDP per capita in 2015, using exchange rates and current prices, was Intl$ 12,344, and its PPP-based GDP per capita was Intl$ 26,536. Germany’s GDP per capita based on the exchange rate was Intl$ 41,197 and its PPP-based GDP per capita was Intl$ 47,254. Which measure is likely to give you a more accurate picture of the differences in living standards between the two countries? Explain your answer. [Note: An international dollar (Intl$) has the same purchasing power as the U.S. dollar has in the United States in that given year. It is mainly used for comparison purposes.] Answer: The exchange rate-based calculation of the Hungarian GDP is dependent on the annual fluctuations between the U.S. dollar and the Hungarian forint. Thus, in theory, Hungary’s GDP per capita can increase if the U.S. dollar weakens vis-à-vis the Hungarian forint, but this might not be represented in actual changes in terms of production. The PPP-based GDP per capita is estimated by calculating how much a representative bundle of commodities costs in various countries. So, the PPP adjusted exchange rate will show how much it will cost residents of Hungary and Germany to purchase the same bundle of goods. Therefore, while the difference between Germany and Hungary was 3.33 using the exchange rate per capita GDP, based on the PPP approximation of GDP per capita, the difference was 1.78. 2. What are the disadvantages of using Big Macs to measure PPP? Answer: The price of a Big Mac is used as an alternative measure of the exchange rate between two countries. One of the problems with using Big Macs to measure purchasing power parity is that, instead of a bundle of diverse goods, this index compares a bundle consisting of just one good. Also, Big Macs are only a very small fraction of people’s consumption, so their prices will not reflect true cost-of-living differences across countries. 3. Suppose that country A has higher income per capita than country B. Explain why this does not imply that most citizens of country A have higher income than most citizens of country B. Construct an example in which both countries have ten citizens to demonstrate this point. Answer: Although income per capita does correlate strongly with various measures of the quality of life, it does not give a complete picture of the standard of living of all of a country’s citizens. Income inequality can make income per capita a deceptive measure of economic well-being. Individual incomes can vary widely within a country and may not be reflected in a simple measure of income per capita.

Person

Country A Income

Country B Income

$ 1,000

$ 5,000

$ 1,500

$ 6,000

Chapter 20 | Aggregate Incomes

$ 2,000

$ 7,000

$ 2,500

$ 9,000

$ 3,000

$ 9,500

$ 3,500

$10,000

$ 4,000

$11,000

$15,000

$12,000

$30,000

$14,000

$45,000

$15,000

232

Imagine that countries A and B each have ten people (or ten equally large groups of people) with incomes distributed as follows: Country A’s GDP per capita is $10,750, while country B’s is only $9,850. But notice that GDP appears to be much more equally distributed in country B than in country A. The median income in country A is $3,250, whereas the median in country B is $9,750. Hence, most of the citizens in country B have a higher income than most citizens in country A. 4. Is GDP per capita more relevant in understanding differences in international living standards than GDP per worker? Answer: Yes, GDP per capita is likely to be a better measure of differences in living standards. GDP per capita is estimated by dividing the country’s aggregate output by the total population, while GDP per worker divides aggregate output by the number of people in employment. GDP per worker is a good measure of how productive an economy is as it considers the average output produced by the workforce. GDP per capita, however, might be a better measure of welfare as it considers the conditions of the whole population, including children and the elderly. 5. What is the correlation between GDP per capita and welfare measures like absolute poverty and life expectancy? What does this suggest about GDP per capita as a measure of welfare? Answer: GDP per capita shows a strong correlation with measures like absolute poverty and life expectancy. GDP per capita does have weaknesses as a measure of welfare. It might hide inequalities between countries and within countries. It doesn’t take into account factors like the quality of health care, the environment, and public safety. Although GDP per capita is by itself not a perfect measure of welfare, it does give us a lot of information about the living standards in a country. Therefore, it makes sense to first focus on GDP per capita and then look more deeply into data on health, education, poverty, and inequality within and across countries. 6. What does the Human Development Index measure? What is the correlation between this index and PPP-adjusted GDP per capita in a country? Answer: The Human Development Index was developed by the United Nations to measure living standards across various countries. It combines GDP per capita, life expectancy, and measures of education (the mean of years of schooling for adults aged 25 years and expected years of schooling for children of school-entering age). Data on GDP per capita and HDI of various countries show a strong positive correlation between HDI and income per capita.

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7. What is productivity? Why does it vary across countries? Answer: Productivity refers to the value of goods and services that a worker generates for each hour of labor. There are three main reasons why productivity differs across countries: i. Human capital: Workers differ in terms of human capital, which is their stock of skills to produce output or economic value. Differences in human capital across countries result in differences in productivity. ii. Physical capital: Physical capital is any good, including machines (equipment) and buildings (structures) used for production. Workers will be more productive when the economy has a bigger physical capital stock, enabling each worker to work with more (or better) equipment and structures. iii. Technology: An economy with better technology uses its labor and capital more efficiently and thus achieves higher productivity 8. What are the two components of technology? Answer: Technology has two very distinct components: the first is knowledge that society has acquired and applied to its production process. This knowledge is embedded partly in the capital stock of firms. The second component has to do with the efficiency of production. The efficiency of production refers to the ability of society to produce the maximal amount of output at a given cost or for given levels of factors of production. 9. What are factors of production? What does the aggregate production function describe? Answer: A factor of production is an input used in producing output in an economy. An aggregate production function describes the relationship between a nation’s GDP (Y) and its factors of production, such as physical capital (K) and total efficiency units of labor (H). It is written as follows: A is an index of technology. A higher level of A implies that the economy produces more GDP with the same level of physical capital stock and total efficiency units of labor. 10. What are the total efficiency units of labor? What is the relationship between this concept and human capital? Answer: Because the workers in an economy have different levels of human capital, we would not be able to gauge how much the economy can produce only by looking at the number of workers it has. Total efficiency units of labor accounts for the number of workers as well as the average level of human capital. Denoting total efficiency units by H, the total number of workers in the economy by L, and the average efficiency or human capital of workers by h, total efficiency units of labor is calculated using the formula:

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11. Use the following diagram to explain the relationship between a country’s physical capital stock and GDP, holding all else constant.

Answer: The diagram shows the aggregate production function, holding total efficiency units of labor constant. This graph shows both the positive relationship between capital and output as well as the law of diminishing marginal product. Holding labor constant, if capital stock increases, the level of output produced also increases. However, the marginal contribution of an additional unit of capital to output— how much output increases as a result of a unit increase in the capital stock—decreases. This can be seen by comparing a unit increase in output at two different points on the aggregate production function. At a point closer to the origin, when there is less capital in the economy, an increase in capital stock will lead to a relatively large increase in output. When we have the same unit increase starting with a larger capital stock—farther to the right on the horizontal axis—the corresponding increase in output is smaller. 12. Explain the difference between “physical capital” and “human capital.” Answer: Physical capital is any good, including machines (equipment) and buildings (structures), used for production. Human capital refers to workers’ skills that enable them to produce output or economic value. 13. Explain what distinguishes physical capital from natural resources. Answer: Physical capital is not given to a country by nature; it must be produced. In fact, it is sometimes called “produced means of production.” This is what the authors mean when they say that capital is not given to us as an “endowment,” as are natural resources. 14. How do increases in technology affect the aggregate production function? Answer: An increase in technology means that the economy can generate more output from the same set of inputs. Exhibit 20.9 shows the implications of better technology for the aggregate production function: Again holding the efficiency units of labor, H, constant, the relationship between GDP and the physical capital stock shifts upward. Therefore, for every level of K, the physical capital stock, a better technology implies that the economy will be able to produce more GDP. 15. What does Moore’s Law state? Is Moore’s Law borne out by historical data? Answer: Moore’s Law, named after Intel cofounder Gordon Moore, predicts that the number of transistors on a chip will double approximately every two years. The number of transistors is a key determinant of Copyright © 2022 Pearson Education Ltd.

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how fast a computer processor is. So Moore’s Law implies that computer processor power should double approximately every two years. Gordon Moore made this prediction in 1965. Moore’s Law has turned out to be fairly accurate, with the number of transistors packed in a computer chip doubling approximately every two years. Several other measures of technological advances in computing have also behaved according to Moore’s Law. 16. Why is the average American so much richer than the average Indian? Answer: The difference between the average income of an American and an Indian can be explained by differences in physical capital stock per worker, total efficiency units of labor, and technology in the United States and in India. Compared to the United States, India’s aggregate production function shows that India has significantly lower levels of capital stock per worker, human capital, and technology. If an Indian had access to the same level of technology as an American does, the average income level in India would more than double. 17. What policies can be used to raise GDP in a country? Answer: Four types of policies can be used to raise a country’s GDP: i.

Increasing physical capital: Countries can increase their capital stock by increasing their savings rate.

ii. Raising efficiency units of labor: Increasing the levels of schooling and education would help countries increase their levels of human capital thus their efficiency units of labor. iii. Improving efficiency in the allocation of resources to improve the efficiency of production: By increasing the competitiveness of markets, countries can make resource allocation more efficient. iv. Improving technology: Investing in research and development as well as using technology transfers can improve the technology that is used in the production process.

Problems 1. Shutterstock is a photo library and one of the leaders in the microstock industry. Photographers and videographers from around the world upload their files to the site, knowing that each file can be sold multiple times. When a file is sold, the artist receives a royalty. In the last week of May 2020, Shutterstock announced it would slash the royalties, in addition to other changes. This meant that a top contributor might get only 10 cents instead of 36 cents per subscription sale. Many contributors started protesting, deactivating, and even deleting their portfolios, and joined a then newly-formed coalition. Yet, there were many contributors who did not protest and accepted the 10 cents royalty fee for their art and continued to upload their work. Why do you think the strike-breakers, as they were referred to by the coalition members, didn’t protest? Answer: While 10 cents may not make a difference to artists in countries with a high cost of living, it may not be considered as extremely low or exploitative of the artist’s time and effort in countries with a low cost of living. New contributors on Shutterstock are from countries like Pakistan, India, and Vietnam, where accumulated 10 cents payments can contribute to a good income for the artists. Based on: https://forums.submit.shutterstock.com/topic/100133-new-earnings-structure-for-contributors/; and https://stockcoalition.org/, Retrieval Date: July 21,2020.

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2. The following table lists 2014 PPP GDP per capita for four countries in $. It also lists the price of a Levi’s 501 jeans in local currency in each country in 2014. The price of the Levi’s 501 in the United states was $40.58 in 2014.

Country (Local Currency)

2014 PPP GDP per Capita

2014 Levi’s 501 Price (in Local Currency)

Switzerland (Swiss franc)

$66,038.70

120.54

Argentina (Argentine peso)

$23,550.31

766.52

Australia (Australian dollar)

$47,671.10

102.23

Malaysia (Malaysian ringgit)

$23,910.80

229.36

Sources for Levi's prices: https://www.nationmaster.com/country-info/stats/Cost-of-living/Clothing-and-shoe-prices/Jeans/1-pair-of-Levi-501s-orequivalent Source for currency conversion (USD to local currencies) using the average exchange rates: https://www.xrates.com/average/?from=USD&to=EUR&amount=1&year=2021 Source for PPP GDP per capita: https://tradingeconomics.com/

Using the Levi’s 501 jeans as a representative commodity common to the countries, calculate the PPP-adjustment factor for each country, and then the GDP per capita for each country in the local currency. Answer: Following the procedure given in the text, we first calculate the ratio of the price of the U.S. Levi’s 501 and the Levi’s 501 in the country in question. For example, for Argentina, the calculation would be $40.58/766.52 Argentine pesos = 0.05294. This is the PPP adjustment factor, which we use to divide by the PPP GDP per capita to get the GDP per capita stated in the local currency. For Argentina, the calculation is 23,550.31/0.05294 = 444,849.07 Argentine Pesos. Here is the table showing the results for all the countries: PPP GDP/Capita in $

2014 Levi’s 501 Price (Local Currency)

PPP Adjustment Factor

2012 GDP per Capita (Local Currency)

Switzerland (Swiss Franc)

66,038.7

120.54

0.336651734

196,163.26

Argentina (Argentine Peso)

23,550.31

766.52

0.052940563

444,844.35

Australia (Australian Dollar)

47,671.1

102.23

0.396948058

120,094.05

Malaysia (Malaysian Ringgit)

23,910.8

229.36

0.176927101

135,144.93

Country (currency)

3. Let us use what we have learned in the first part of the chapter to compare living standards in the United States and Germany in 2015. a. The U.S. GDP in 2015 was approximately $18,120 billion, and the U.S. population was approximately 321.08 million. What was the per capita GDP in U.S. in 2015? b. Suppose that Germany’s GDP in 2015 was €3,082 billion, and Germany’s population was approximately 81.7 million. What was Germany’s per capita GDP in euros? What problems do Copyright © 2022 Pearson Education Ltd.

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you foresee in comparing this number to the United States’ GDP per capita in U.S. dollars computed in part (a)? c. On January 3, 2015, the €/$ exchange rate was 1.2 (meaning that €1 was worth $1.2), and on March 15, 2015, the exchange rate changed to 1.05. Calculate an exchange-rate-based measure of GDP per capita in Germany, in U.S. dollars, on these two dates. Do you think the change in Germany’s exchange-rate-based measure of GDP per capita between these two dates reflects a true change in living standards? d. McDonald’s has a thriving business in Germany and sold a Big Mac for €3.65 in 2015, while at the same time, a Big Mac sold for $5 in the United States. Using this information, provide an alternative estimate of GDP per capita in Germany. Would you trust this estimate better than the one based on exchange rates? Why or why not? Answer: Aggregate income or GDP 18,120,000 = 321.08 = $56,434.53 Total population Aggregate income or GDP 3,082,000 Per capita GDP = = = $37,121 Total population 81.7

a. Per capita GDP = b.

The U.S. per capita GDP, which is in dollars, cannot be compared to the per capita GDP in Germany, which is in euros. To facilitate comparison, we would have to convert both values into a common unit of measurement – either the German GDP into dollars or the American GDP into euros. c. January 3, 2015: Germany’s per capita GDP in U.S. dollars= 37,121 × 1.2 = $44,545 March 15, 2015: Germany’s per capita GDP in U.S. dollars = 37,121 × 1.05 = $38,977 No, the change in Germany’s exchange-rate-based measure of per capita GDP is unlikely to reflect a change in living standards. However, if Germans decide to import more goods from the United States in the long run, they would have to pay more for those goods and even though they are producing the same amount of goods, they would have to slightly adjust their consumption habits. d. This information can be used to arrive at a PPP-adjusted exchange rate between the United States and Germany. If a Big Mac costs €3.65 in Germany and $5.00 in the United States, then €1 = $1.37. It follows that the per capita GDP in Germany in U.S. dollars = 37,121 × 1.37 = $50,850. Yes. The Big Mac index is commonly used as an alternative measure of exchange rates. It is a very simple example of PPP adjustment. PPP adjustments account for the relative differences in the cost of living in various countries. Because it involves the prices of actual goods in the two countries, it is more reliable than an estimate based on exchange rates. Of course, in reality, the Big Mac index is not an accurate approximation of PPP because people consume other products as well in a given year.

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4. Suppose you are given the following information for the country Poldan: Characteristic Total population GDP per worker GDP per capita

Value in Poldan 175 million €29,166.667 €15,500

a. What is Poldan’s GDP? b. What is the number of employed people in Poldan? The following table gives you the same information for the country, Manyger. Characteristic

Value for Manyger 89 million 51 million €2,200 billion

Total population Employment GDP c. What is Manyger’s GDP per capita?

d. What is Manyger’s GDP per worker? e. Based on the given information, which country would be considered more productive? Explain your answer. f.

Which country do you think has higher living standards?

Answer: a. GDP per capita = GDP/Total Population. So, GDP = GDP per capita × Total Population = 15,500 × 175 million = €2,712.5 billion. b. GDP per worker = GDP / number of employed people, so number of employed people = GDP / GDP per worker = €2,712,500,000,000 / €29,166.67 = 93 million people (approx.). c. GDP per capita in Manyger = GDP/Total Population = 2,200,000,000,000/89,000,000 = € 24,719 (approx.). d. GDP per worker in Manyger = GDP / number of employed people = 2,200,000,000/50,000,000 = €44,000. e. The GDP per worker in Manyger is much higher than Poldan. Therefore, it can be concluded that workers in Manyger are more productive than workers in Poldan. f.

GDP per capita should be used to compare living standards. The GDP per capita in Manyger is higher than that in Poldan. This implies that the standard of living in Manyger is higher than that in Poldan.

5. Suppose that the GDP in current dollars for Spectrania is lower than Meleda’s GDP. In addition, using PPP-adjusted dollars, Meleda’s GDP is higher than Spectrania’s GDP. Based on this information, what would you conclude about the living standards in Polonia and Ruritania? Copyright © 2022 Pearson Education Ltd.

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Answer: Both measures are higher in Meleda compared to Spectrania. However, the GDP in current dollars should not be used to compare standards of living; PPP-adjusted GDP should be used instead because it constructs the cost of a representative bundle of commodities in each country and uses these relative costs to compare income across the countries. Given that Meleda’s PPP-adjusted GDP is higher than Spectrania’s, the standard of living in Meleda is likely to be higher than that in Spectrania. 6. In 2011, China revised its poverty line upward to 2,300 yuan per year, or 6.3 yuan per day. At the prevailing exchange rate, this was equal to a little less than a single U.S. dollar. Some commentators felt that China’s poverty line fell short of the World Bank’s poverty line of $1.25 per day in 2005 PPP-adjusted U.S. dollars. Would you agree? What other information would you need to evaluate this claim? Answer: The World Bank’s poverty line is based on PPP-adjusted U.S. dollars. This means that people whose purchasing power is so low that they cannot afford to buy the same goods and services that could be bought in the United States in 2005 for $1.25 are considered to be below the poverty line. To check whether China’s poverty line falls below the World Bank’s poverty line, we need to use the PPP-adjusted exchange rate for Chinese yuan and the U.S. dollar. Based on http://www.economist.com/blogs/freeexchange/2011/12/chinas-poverty-line 7. In this question, we will use what you learned in the second part of the chapter to compare the performance of an economy in two different time periods, as its physical capital stock and efficiency units of labor change. a. Suppose that from period 1 to period 2, the unemployment rate in the economy decreases. Everything else remains unchanged. What happens to the total efficiency units of labor? Express your results formally as an inequality, using the formula for total efficiency units of labor presented in the chapter (in particular, recall that total efficiency units of labor in two periods can be written as H1 = L1 × h1 and H2 = L2 × h2; where L is the total number of employed workers). b. What are the consequences of this decrease in unemployment for GDP? Express your results formally as an inequality, using the aggregate production function presented in the chapter. c. What are the consequences for GDP per capita and GDP per worker? d. Suppose that there is a technological advance from period 1 to period 2 and, at the same time, an increase in physical capital stock? Can you say whether GDP will increase or decrease? Why or why not? Answer: a. The total efficiency units of labor is the product of the average efficiency units of workers and the total number of workers in the economy. A decrease in unemployment implies an increase in the number of workers. Everything else remaining unchanged, an increase in the number of workers increases the total efficiency units of workers. This can be expressed formally as follows: L1 < L2 implies H1 = L1 × h1 < H2 = L2 × h2 b. The aggregate production function is expressed as Y =A × F (K, H), where Y stands for GDP, K is capital stock, H is efficiency units of labor, and A is a technology index. With a decrease in unemployment in period 2, the efficiency units of labor will rise. This means that GDP will also rise as there is a direct relationship between capital, labor, and aggregate output. Formally, this Copyright © 2022 Pearson Education Ltd.

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can be expressed as follows: H2 > H1 implies F(K, H2) > F(K, H1), which implies A × F(K, H2) > A × F(K, H1), which implies Y2 > Y1. c. Other things remaining the same, the rise in GDP will increase GDP per capita. The effect on GDP per worker is harder to determine because both GDP and the number of workers are increasing, so the change in the GDP per worker depends on the magnitude of these changes. d. Technological progress means that the economy can generate more output from the same set of inputs. An increase in physical capital will also affect GDP positively. Therefore, we can say for sure that due to the increase in capital stock and the technological advance, GDP will increase. 8. Assume that the country Lusitania has two industries, clothing production and computer chip production. At first, both industries have identical aggregate production functions: the following table shows how the output of each industry is affected by a change in efficiency units of labor.

Y (in Millions of Dollars)

Stock of Physical Capital (Units)

Efficiency Units of labor

100

15,000

16,000

150

15,000

20,000

180

15,000

24,000

200

15,000

28,000

210

15,000

32,000

a. Using the data in the table, draw a graph showing how output (on the y-axis) changes with efficiency units of labor (on the x-axis). What explains the shape of the graph? Why is it valid in this case to plot output against the efficiency units of labor and leave the stock of physical capital in the background? b. A Lusitanian inventor has produced a new technology that doubles the output of computer chips for any combination of capital and labor. Explain, using an equation, how this invention affects the production of computer chips. Create a new table for computer chip production and compare it to the (unchanged) table for clothing production. c. If you were a central planner, would you make any changes to the allocation of labor, holding capital fixed? If so, what factors might prevent you from implementing your policy? Answer: a. The graph should look approximately like the figure below:

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GDP increases with an increase in the efficiency units of labor. However, the rate of increase in GDP gradually decreases as the efficiency units of labor increase. The student should explain that this shape is due to the decreasing marginal product: holding the stock of physical capital constant, the relationship between aggregate product and efficiency units of labor becomes less and less steep as the total efficiency units of labor increases. b. Here, in effect, we’re multiplying column A by 2. So now, any combination of labor and capital produces double the output it did before. We show this in the table below: Y (in Millions of Dollars)

Stock of Physical Capital (Units)

Efficiency Units of labor

200

15,000

16,000

300

15,000

20,000

360

15,000

24,000

400

15,000

28,000

420

15,000

32,000

c. A central planner would re-allocate workers to computer chips—because now marginal product of labor has increased at each level. We’ll be able to get more bang for our buck with workers in computer chip industry. However, it may be that higher training is required for workers to produce computer chip, so it might not be possible to simply re-allocate employees. 9. An economy has two types of workers, economics professors and basketball players, and two types of tasks, teaching and playing basketball. Efficiency for each worker is measured in the value of hourly production as shown in the following table. Adam

Kevin Thomas

Elena

Candace

Elinor

Steph

Joseph

$/hr teaching

$/hr basketball

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A worker can only be assigned to one task. Initially, the first four workers are assigned to teaching, and the second four to playing basketball. What are the levels of production value per hour for teaching and basketball? New leaders take over the management of the economy and assign workers to the task in which they have the highest efficiency. What are the new levels of value per hour? We know that income differences between countries are large and are in part due to efficiency of production. In light of your answer to this question, discuss whether misallocation of talent could be related to differences in efficiency of production. Then speculate briefly as to why a country’s leaders might prefer inefficiency of production.

Answer: The table calculates the value of output if the first four individuals are assigned to teaching, and the second four, to basketball. Adam

Kevin

Thomas

Elena

Candace

Elinor

Steph

Joseph

Contribution to GDP

$/hr teaching

$31

$/hr basketball

$47

The value of production or GDP, the sum of the value of production from teaching and basketball, equals $78/hr. The second question is a reminder of the optimization process and anticipates comparative advantage. The individuals should be sorted based on how much value in teaching must be sacrificed to get an additional dollar of value in basketball. Those with the highest opportunity costs (OC) should teach. The opportunity cost for each individual is shown in the last row of the next table but the differences in ability are great enough that students should be able to sort the individuals without the mathematical explanation of the economic insight.

Adam

Kevin

Thomas

Elena

Candace

Elinor

Steph

Joseph

Contribution to GDP

$/hr teaching

$47

$/hr basketball

$62

3.00

0.07

6.00

0.17

0.13

0.44

4.67

1.18

Adam, Thomas, Elinor and Joseph should teach because the amount of teaching value sacrificed is relatively large compared to the remaining individuals. The sorting based on efficiency increased the total value of teaching/hr to $47 from $31. Kevin, Elena, Candace and Steph should play basketball because their opportunity cost, the value teaching/hr, is low relative to their value playing basketball. The sorting based on efficiency increased the value of basketball/hr from $47 to $62. GDP/hr increased from $78/hr to $109/hr.

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The gain in GDP/hr is due the increase in the efficiency of production. It is the allocation that competitive markets produce and illustrates the value of markets in this function. Less clearly seen, is the role of government in establishing rules that maintain competitive markets. Leaders might prefer inefficient production if it increased their political power or wealth. Positions might be allocated based on political support individuals could provide government officials or the willingness of individuals to pay bribes, Government officials might also distribute positions on non-economic factors such as race, religion, or family relationship.

10. According to Central Intelligence Agency data, in 2017, Angola ranked first in a list of countries ranked from highest to lowest birth rates. In the same year, it ranked twentieth in a list of countries ranked from lowest to highest life expectancy in years. It means that Angola has both a high fertility rate and low life expectancy. Suppose that this trend continues in Angola, what can you deduce about the future productivity in this country? Answer: Productivity will likely increase – the workforce is young, which usually implies high productivity. However, students might answer that they need more information concerning details about life expectancy: is it low because infant mortality is high or because of inadequate healthcare? So, students could argue that there are ambiguous effects. Multiple, well-reasoned answers are acceptable. Sources: https://www.cia.gov/library/publications/the-world-factbook/rankorder/2054rank.html, https://www.cia.gov/library/publications/the-world-factbook/rankorder/2102rank.html, 2017; Retrieval Date: July 21, 2020. 11. In “Dead Aid,” economist Dambisa Moyo argues that humanitarian aid—provision of food or medicine to poor families, for example—is an ineffective tool for promoting growth in the developing world. Instead, she argues in favor of foreign aid policies that encourage or subsidize foreign investment in the businesses of developing countries. Using the concepts in this chapter, evaluate her approach. Your answer should consider the short-term and long-term effects of such policies on both poverty rates and aggregate growth. If you were trying to improve macroeconomic growth and lower poverty rates in the developing world, what kind of programs would you encourage the U.S. government to fund? What tradeoffs would you weigh in making your recommendation? Answer: In the short term, any infusion of capital will boost GDP mechanically—we should see, then, an increase in GDP and GDP per capita, all else equal. Perhaps more importantly, if these investments enhance productivity, then they will, as we’ve seen in this chapter, boost GDP in the long run (and GDP per capita, all else equal). However, it’s not clear how these increases will affect the poorest segments of the population—while GDP will increase, poverty rates may stay the same (or even potentially increase, if the investments come at the expense of aid). This persistence of poverty will be particularly likely in countries without mechanisms for redistribution (like any kind of government-run welfare programs). In the long run, high poverty rates may actually hamper the growth of GDP—a starving, sick population may be unable to work or innovate. The second part of this answer may vary—multiple well-reasoned arguments are acceptable. For example: In developing programs, then, we may, based on funding constraints, face a short-term trade-off between alleviating poverty and increasing GDP. Ideally, a mix of well-targeted programs would bolster productivity—perhaps partially through training programs and improved technology, and partially through aid to poor segments of the population.

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12. Give an algebraic and an intuitive explanation of the concept of “efficiency of production.” Why is efficiency of production so important to GDP? Answer: Given the aggregate production, function Y=A×F(K,H), higher productive efficiency implies that A is higher. Therefore, for a given level of K and H, a higher level of A implies a higher level of Y, or GDP. “Efficiency of production” is defined as the ability of an economy to produce the maximal amount of output at a given cost or from a given amount of factors of production. This is important for GDP because the greater productive efficiency in an economy, the more goods and services that can be produced from a given input, or combination of inputs. For example, with a given labor force, a country with greater efficiency will be able to produce more goods and services than a country with lower efficiency and, therefore, will have a larger GDP than a country where such efficiency remains low. When a nation’s workers are more productive, real GDP (Y) is larger, and therefore incomes are higher than they would otherwise have been. Higher incomes mean higher living standards. So, when the efficiency of production grows rapidly, so do living standards.

Chapter 21

Economic Growth Questions 1. What is meant by economic growth? How has the U.S. economy grown over the past 200 years? Answer: Economic growth refers to an increase in real GDP per capita in a country. Over the last 200 years, there has been a marked increase in real GDP per capita in the United States, though the increase is not entirely steady. One of the major economic fluctuations in the United States was the Great Depression, which started in 1929 and recorded a major contraction in real U.S. GDP per capita. However, this was a temporary event, and the sustained and steady growth of real GDP per capita characterizes the U.S. economy both before and after it. 2. What are catch-up growth and sustained growth? Explain with examples. Answer: Catch-up growth refers to a growth process whereby relatively poorer nations increase their incomes by taking advantage of knowledge and technologies already invented in other, technologically more advanced countries. For example, South Korea, Spain, and China were poorer relative to the United States in 1970. But over the last 40 years, these countries grew faster than the United States, closing the gap that had opened up previously. Sustained growth refers to a growth process in which real GDP per capita grows at a positive and relatively steady rate for long periods. For example, the United States demonstrated sustained growth between 1820 and 2007. This means that there was a positive and relatively steady growth rate in every 50-year period, and the growth rate for the entire period was significantly positive. 3. According to the aggregate production function, how does real GDP increase? Answer: The aggregate production function Y = A × F(K,H) links aggregate output to physical capital (K), total efficiency units of labor (H), and technology (A). To increase GDP, a nation can increase its stock of physical capital, K; increase the human capital of its workers, H (so that it has greater efficiency units of labor for the same workforce); or improve its technology, A. 4. The chapter emphasizes the importance of saving in economic growth. a. How is the saving rate in an economy defined? b. What factors help households decide whether to consume or save their income? c. How do household saving decisions impact investment in the economy? Answer: a. The saving rate is the fraction of total income that households save (Total saving divided by GDP). b. Saving is a way of allocating some of today’s resources for consumption tomorrow. So, in deciding how much to save, households are trading off consumption today for consumption tomorrow. These choices are affected by several factors: Copyright © 2022 Pearson Education Ltd.

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The first one is the interest rate. The interest rate determines how much households will earn on their savings. Higher interest rates typically encourage more saving. Second, expectations about future income will affect savings: Households that expect rapid income growth in the future will have less reason to save to finance future consumption (because future income growth will enable them to do this). Third, expectations about taxes will also impact saving decisions: If households expect high taxes in the future, they may save more to be able to pay these taxes without reducing future consumption. c. An increase in the saving in an economy facilitates an increase in investment. This, in turn, can lead to an increase in the economy’s stock of physical capital, which we have seen is a key to economic growth. 5. Holding all else equal, will increasing the efficiency units of labor lead to sustained growth? Why or why not? Answer: Increasing the efficiency units of labor by itself is not likely to lead to sustained growth. Efficiency units of labor are calculated as the product of the number of workers and the level of human capital in the economy. Suppose the number of workers in the economy increases. Holding other factors constant, every additional worker will increase output by less and less because of the diminishing marginal product of labor. Likewise, increasing only the level of human capital will not achieve sustained growth. Because each individual has a finite life, there is a limit to how many years of schooling he or she can obtain. Thus, achieving greater levels of efficiency units by continuously increasing the years of schooling of the workforce does not appear feasible. 6. What explains economic growth in the United States over the past few decades? Answer: Data on the contribution of physical capital, human capital, and technology to the growth of output per hours worked shows that technology is the single most important contributor to economic growth in the United States. Although physical and human capital did contribute to growth, technology played a central role in U.S. economic growth. 7. Why was there no sustained economic growth before modern times, that is, before 1800? Answer: The period before modern times was not stagnant, but it was not characterized by sustained growth. One of the possible explanations is that the pace of technological change was much slower than in more recent times. Also, any increases in aggregate income were offset by increases in population, keeping per capita income low. 8. What did Malthus predict about economic growth? Did his predictions come true? Why or why not? Answer: According to Thomas Malthus, the number of children per woman or per family would always adjust so that income remained close to a subsistence level. Whenever living standards were above this subsistence level, couples would increase their number of children, and this, in turn, would push incomes down toward the subsistence level. When population increases too much, income per capita falls below subsistence and induces famines and/or wars that kill a large fraction of the population. This cycle would then repeat to ensure that incomes always remained close to subsistence. Malthus’ predictions failed to come true. Although the Malthusian model was a good representation of

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how the world was before 1800, it failed to account for the demographic transition. In several countries, population growth rapidly increased due to increased life expectancy and migration. Around the same time, fertility declined, with families having fewer children. This process, which has both economic and social causes, is referred to as the demographic transition. The demographic transition, combined with the Industrial Revolution, enabled economies to break away from the Malthusian cycle. This led to relatively sustained growth in income per capita in many economies, particularly in the Western world. 9. How did the Industrial Revolution affect economic growth? Answer: The Industrial Revolution is the term given to the series of innovations and their implementation in the production process that started to take place at the end of the eighteenth century in Britain. The Industrial Revolution is important both as an event in itself (because it was the first time technology and scientific methods were used in production in such a coordinated manner) and also as heralding the wave of industrialization that affected many other countries around the world. It was the Industrial Revolution that opened the way for steady and rapid technological changes that have underpinned modern economic growth. 10. Suppose Italy has experienced a greater average growth rate in GDP per capita than has Greece. Based only on this, what would you predict about how the poverty rates changed in the two countries? Answer: Based on the information provided, we could assume that the poverty rate in Italy has decreased faster than that of Greece. 11. Based on your understanding of the chapter, how can poverty best be reduced? Answer: Economic analysis suggests several potentially useful approaches to reducing poverty. For poor countries that have natural resources and agricultural sectors, international trade could help raise aggregate incomes. Trade does create certain distributional conflicts, but the overall benefit is positive. Improvements in knowledge and the technologies available in the world economy will also help in raising living standards around the world. 12. What factors explain the dramatic increases in life expectancy that we saw in most countries in the twentieth century? Answer: Scientific advances in the United States and Western Europe were primarily responsible for the increase in life expectancy throughout the world in the last century. Three were highlighted in the chapter: (1) the development of new drugs, especially antibiotics; (2) the discovery of DDT, which was very effective in attempts to control malaria; and (3) the proliferation of basic but effective medical and public health practices, like boiling water, in poor countries.

Problems 1.

Having experienced an exponential growth in the past few decades due to economic reforms it initiated in the late 1970's, China had a GDP of $305.35 billion in 1980. It witnessed a 10 percent average annual growth rate after initiating the reforms. This growth slowed down in later years, and the IMF projected it to become 5.8 percent in 2020 and 5.6 percent in 2023 (Source: Caleb Silver, “The Top 25 Economies in the World,” Investopedia.com, December 24, 2020). a. Assuming the 10 percent exponential annual growth rate did not fall, calculate China’s projected GDP in 2020. Copyright © 2022 Pearson Education Ltd.

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b. Why do you think the actual growth rate slowed down with passing years and did not remain at 10 percent? Answer: a. Every year, between 1980 and 2020, China’s GDP grows by 10 percent. If we write down the equations for every year, we get: Year 1 (1980) = 305.35 billion × 1.1 Year 2 (1987) = 305.35 billion × 1.1 × 1.1 Year 3 (1988) = 305.35 billion × 1.1 × 1.1 × 1.1 and so on. We see a pattern – every year, we multiply by an additional 1.1. In year x, then, the GDP will be: 305.35 billion × (1.1)𝑥 In 2020 (or year 40 = 2020 – 1980), GDP will be equal to: 305.35 × 1.140 = $13,819,913,687,742.53. b. Countries experiencing catch-up growth because of reforms that freed the economy, as in this case, often experience high and then declining growth rates. 2. Currently, some of the fastest growing countries in the world remain desperately poor. For example, of the top five fastest-growing economies in 2016, three—Iraq, Burma, and Nauru—had real per capita GDP that were 101st, 162nd and 112th in the world, respectively. (Source: CIA Factbook estimates for 2016, PPP basis.) This seems like something of a contradiction. Using the equations for growth given in the chapter, explain why a country that has a very low real per capita GDP can also have a very high growth rate. Answer: Recall that the equation for growth from year t to year t +1 is Growth𝑡,𝑡+1 =

Yt+1 − Yt Yt

So a lower number in the denominator means that even a small figure in the numerator will result in a large growth rate. For example, in 2016, Burma had a GDP of only $311 billion and a population of 56.9 million, resulting in a GDP per capita of around $5,466. However, an increase in GDP per capita of just $100 (which hardly makes Niger a rich country) would result in a GDP figure of $316.69 billion, and a GDP growth rate of $316.69 billion − $311.00 billion = 0.018 or 1.8% $311.00 billion By contrast, a $100 increase in U.S. GDP per capita (from $57,300 to $57,400) reflects a GDP growth rate of only 0.2 percent. Mathematically, these results are due to the much larger base in the United States compared to the much smaller one in Niger. 3. The following table lists GDP per capita from 1970 to 2010 for South Korea and the United States. As you can see, both grew substantially over that 40-year period.

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Year

South Korea GDP per Capita

U.S. GDP per Capita

1970

$317

$5,247

1980

$1,778

$12,598

1990

$6,642

$23,955

2000

$11,948

$36,467

2010

$22,151

$48,358

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[Data from the World Bank, World Development Indicators] a. Plot the five data points for each country on a graph using a nonproportional scale, as in Exhibit 21.3 in the chapter. Connect the points to create a line graph. b. Plot the five data points for each country on a graph using a proportional scale, that is, a scale where equal distances represent equal percentage changes. Connect the points to create a line graph. c. Using Exhibit 21.5 and the production function, Y = A × F(K,H), with reference to South Korea, explain how the Korean War might have reduced catch-up growth prior to 1966 and how recovery from the war might have affected catch-up growth after 1966. Answer: a. Comparison using nonproportional scale. Nonproportional Scale

b. Comparison using proportional scale Proportional Scale

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It is impossible to describe the history of a nation with a graph and an equation, but they can give us insights to direct inquiry. U.S. involvement with South Korea began with the Korean War (1950-53). Exhibit 21.5 shows that, as the war began, China and South Korea had about 7% of the GDP per capita of the United States. Beginning in the late 1960s, the South Korean economy began to grow as shown in the two graphs produced in parts (a) and (b) of the problem. Both the nonproportional and proportional graphs show that U.S. and South Korea experienced significant growth as seen by the positive slope of the curves. The graph with proportional scale is the more important. On a proportional scale axis, equal vertical distances represent equal percentage changes. In the graph from part b, this means that the distance from 300 to 3,000 (a ten-fold increase) is the same as the distance from 3,000 to 30,000. This in turn implies that the slope of the line indicates that rate at which a given quantity is growing. So, for both South Korea and the United States, the rate of growth slowed over the 40-year period, shown by the flatter slopes of the lines in the later years. It is significant that South Korean GDP per capita began to catch-up with the U.S., but why didn’t this trend begin with the end of the war? War is destructive. The production function, Y = A × F(K,H), illustrates where and how that destruction might have occurred. Because South Korea had a low level of technology prior to the war, it is unlikely that technology was lowered. Capital, K, although at low levels, was destroyed. A great many people died implying that human capital was destroyed. The economy had fewer resources available to begin to grow. Disruption from the war caused disruption in the production function. The economy did not immediately combine capital and labor efficiently. Finally, to experience catch-up growth, private and public sector South Koreans must attract foreign capital and technology. They needed to convince foreign investors that profits would be high relative to risk. It takes time to establish these conditions. The data clearly show that once these conditions were established, the South Korean economy experienced rapid growth. Note also that the line is steeper for South Korea than the United States, especially in earlier years. This shows that South Korea was growing more rapidly than the United States, that is, at a higher rate. And this explains why South Korean GDP per capita was only 6 percent of the U.S. level in 1970, but by 2010 had grown to be 46 percent of the U.S. level.

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4. Economists Andrew McAfee and Erik Brynjolfsson have written about “The Great Decoupling”—the divergence between productivity growth and employment. Since the mid-1990’s, labor productivity and real GDP have continued to increase, while employment and wages have remained stagnant. Use the concepts from this chapter to explain how this “Decoupling” might work; how could productivity and real GDP continue to increase, even with the declining employment? Why might it be the case that employment has not increased while real GDP has continued to grow? How might this dynamic influence inequality? Answer: As we saw in the chapter, technology can improve productivity at any level of employment (by increasing A in the production function); the rise in technology, then, is likely responsible for this phenomenon. Indeed, if labor allows for capital to substitute for labor, then we would expect unemployment to remain stable or even increase. Ultimately, this dynamic will likely increase inequality, particularly if the jobs lost to technology are lower skill jobs; the owners of capital will benefit of the substitution toward capital, and the employed will make more money while the unemployed rely on transfers. 5. The graph below shows an index of world GDP per capita from 1000 B.C. to the year 2000.

Source: Jeff Speakes, “Economic History of the World,” Center for Economic Research and Forecasting, California Lutheran University As you can see, over most of that period, global economic growth was virtually nonexistent. While there were periods that experienced some increase in per capita income, sustained growth begins only in the mid-eighteenth century, and explodes after that—by the year 2000, income per capita is 12 times what it had been 250 years before. Explain what accounts for such a dramatic change in economic change beginning in the 18th century. Answer: As detailed in the chapter, the development of technology is crucial for economic growth. For centuries, technology did not change much. The main source of power was human or animal muscle, Copyright © 2022 Pearson Education Ltd.

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which severely constrains the ability to build, transport, and manufacture. People in this era lived in much the same way as their ancestors had. However, beginning with the Industrial Revolution in England in the mid-eighteenth century, other sources of power were harnessed—first steam and then electricity. Humankind’s power was magnified many times over in a relatively brief time. Moreover, these changes affected almost every dimension of life and led to still more powerful technology and still faster growth. 6. Labor productivity (GDP per hour worked) in the United States increased significantly in the 1990s and 2000s. This can be clearly seen in Exhibits 21.10 and 21.11. a. Based on Exhibit 21.10, is it physical capital, human capital, or technology that is most responsible for the overall increase in the annual growth rate of GDP per hour worked in these two decades? Explain your answer with reference to the exhibit. b. When focusing on productivity increase in the 2000s, what technologies may have contributed most to the increased productivity? Answer: a. Since 1950, growth that resulted from physical capital (column 4) has been relatively constant until 1999. In the 2000s, there was a 17 percent increase in growth from physical capital. Growth from human capital declined between the 1990s and 2000s, whereas there seems to be a marked increase resulting from the use of technology – there was a 93 percent increase in returns from technology in the 1990s and a further 48 percent increase in the 2000s. We can also see that 42 percent of growth comes from technology in the 1990s and 52 percent growth in the 2000s. This is opposed to the mere 28 percent growth stemming from technological advancements in the 1980s. b. We can safely assume that it is due to the spread of the usage of computer and Internet-based technologies. 7. The concept of diminishing returns to a factor of production applies not only to physical capital but to labor as well. Use the concept of diminishing returns to labor to explain and illustrate why there was no sustained growth in living standards prior to the Industrial Revolution. Draw a graph to illustrate the relationship between population and real GDP, where population is measured on the x- axis. Explain how your graph changes after the Industrial Revolution. Answer: The relevant graph is below:

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Note that real GDP increases at a decreasing rate, as is also the case with capital. Barring technological change, this does not allow for an increase in living standards, especially as the population continues to grow. The Industrial Revolution led to the invention of capital and technology that shifted the production function upward in terms of both labor and capital.

8. In Question 8, we discussed the Malthusian cycle prediction. Under what conditions might the Malthusian cycle be a reality as it was in the preindustrial age? Answer: As long as technological advancements in agriculture can keep up with population growth on the one hand and increased food consumption due to increased wealth in developing countries on the other, the Malthusian cycle is unlikely to become a problem. However, should climate change destroy mass amounts of previously arable land, freshwater supplies run out, technological advancements slow down, and population growth remain constant, the Malthusian cycle may very well be a problem in the future. 9. The “Letting the Data Speak” box on levels versus growth points out how one important index of health—life expectancy—has changed in various countries over time. To see a dramatic animation of the data mentioned in the box, go to https://www.gapminder.org/videos/200-years-that-changed-theworld/. Hans Rosling is an expert in global health and is known for his creative presentation of statistics. Watch the brief video and answer the following questions. a. What was the upper limit on life expectancy in almost all countries in 1810? Which two countries were slightly better off? b. Which countries failed to improve much in life expectancy and income as a result of the Industrial Revolution? c. As of 1948, had disparities in life expectancy and income between countries narrowed or widened? Which were some of the countries that had not made much improvement in either measure by 1948?

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d. As of 2009, what was the general situation regarding the distribution of countries in terms of health and income? What countries still lagged behind? e. Based on the video, how can country averages disguise the wide variation in living standards within a country? Give an example from the video. Answer: a. The upper limit on life expectancy in almost all countries in 1810 was 40. Only Britain and the Netherlands were slightly better off. b. Countries in Asia and Africa did not realize much improvement in either life expectancy or income during the Industrial Revolution. The benefits of that period were confined mostly to European nations. c. By 1948, the differences in life expectancy and income between countries were higher than ever. Europe and North America, followed by Japan, had made great strides on both measures, while such countries as China, India, Indonesia, Bangladesh, and most of the African countries were still characterized by short life expectancies and poverty. d. By 2009, most Asian and some African countries had made great improvements in life expectancy and income. Rosling comments that by then, most people in the world were “in the middle” between the richest countries with the highest life expectancy (Europe, North America, and Japan) and the poorest countries, like many in sub-Saharan Africa that had endured civil strife or the HIV epidemic (Congo and South Africa). e. When the data are examined in more detail, significant differences emerge within countries. For example, life expectancy and income in China range all the way from the situation in Shanghai, which has figures comparable to those of Italy, and the poor inland province of Guizhou, whose rural areas have the same health and wealth as Ghana, a very poor country. Hence, although taken as a whole, China has made great strides in living standards, there are still enormous regional disparities that are hidden in the countrywide data. 10. Increasingly, independent programmers are making their code “open source.” The statistical programming language “R,” for example, is completely free and open; anyone can submit a new “package” of specialized functions. How might open source technology affect growth in developing countries? Imagine every technology company in the United States suddenly made their code open source; would this increase growth in developing countries? Explain. Answer: Open source technology likely has the potential to boost growth in developing countries—it makes productivity-enhancing tools available to a broader group of people, increasing A, technology, in countries around the world. Indeed, the chapter discussed the importance of infusing technology in stimulating growth. However, suddenly making all code open sourced wouldn’t necessarily boost growth immediately in developing countries—software, in particular, needs the appropriate hardware. The technologies of foreign economies may not be immediately useful. In addition, any code that’s open sourced and available off-the-shelf could go directly to consumers with technology—and wouldn’t be counted in GDP. 11. Suppose that a 20 percent increase in the physical capital stock increases GDP by 20 percent. By how much should the capital stock increase next to cause another 20 percent increase in GDP. Answer: The second increase in the physical capital stock should be higher than the initial 20 percent for it to result in another equal increase of 20 percent in the GDP. This is due to the diminishing marginal

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product of physical capital. Each additional increment in the stock of physical capital leads to smaller and smaller increases in GDP. 12. Challenge Problem: Refer to Exhibit 21.4. If the United States, Guatemala, Haiti, Rwanda, Ghana, Kenya, and India continue to grow at the rates given in the exhibit, how many years (starting from 2010) would it take for each to catch up to the United States in terms of per capita GDP? Why might these calculations be less reliable? (Hint: If a country’s GDP per capita is growing at a constant rate, g, then the natural log of GDP per capita t years into the future is: ln 𝑦(𝑡) = ln 𝑦(0) + 𝑔𝑡, where y(0) is GDP per capita in the initial year.) Answer: Look carefully at the table (Exhibit 21.4). The U.S. per capita GDP is growing at 2 percent per year. Hence, any country that starts from a lower GDP per capita and has a growth rate of 2 percent or less will never catch up – it is simply mathematically impossible. This means that, if the growth rates listed continue to prevail, Guatemala, Haiti, Rwanda, Ghana, and Kenya will never catch up to the United States in terms of per capita GDP. Therefore, that leaves India, whose per capita GDP is growing at 3.20 percent. To see how long it will take India to catch up to the United States, we can use the formula provided in the hint: ln y(t) = ln y(0) + gt, where y(0) is GDP per capita in 2010. Substituting in the 2010 value for y(0) and the value for g in the United States gives the following: ln yUS(t) = ln 41,365 + 0.02t The comparable equation for India is as follows: ln yIndia(t) = ln 3,477 + 0.032t We want to find how many years (t) it will take India to catch up to the United States in terms of per capita GDP. We must keep in mind that U.S. per capita GDP is continuing to grow, just not as fast as India’s. To find how long it will take India to catch up, we simply set the above equation for the United States equal to the equation for India: ln 41,365 + 0.02t = ln 3,477 + 0.032t Solving this equation for t: tIndia = (ln 41,365 – ln 3,477)/0.012 = approximately 206 years. Therefore, if the rates of growth of GDP per capita listed in the table persist from 2010 on, India would catch up with the United States in around 206 years. The problem with these calculations is that many factors can influence growth: this means that due to technological discoveries in India its growth might increase, whereas if the United States does not invest in technology, its growth can decline. It is difficult to predict the GDP growth for the next 5 years with certainty and doing it for longer than that is even more unreliable.

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Appendix to Chapter 7 Problems A1. Use a diagram to represent the Solow growth model using the aggregate production function and the relationship between the physical capital stock and aggregate saving. a. Which point in the figure represents the steady-state equilibrium? Why? b. Use the diagram to show the impact of an increase in human capital on GDP. Answer: The following figure represents the Solow growth model. The straight line represents the value of depreciated capital, d × K. The curve labeled Y = A × F(K,H) represents the aggregate production function, or more specifically, the relationship between aggregate incomes and the (physical) capital stock, for a given level of efficiency units of labor (and for a given technology). The curve labeled s × A × F(K, H) shows the relationship between the level of investment and the capital stock given the saving rate of households, s. The distance between this curve and the horizontal axis at a given level of capital stock corresponds to aggregate saving or investment, while the distance between the curve labeled s × A × F(K, H) and the curve labeled Y = A × F(K, H) represents consumption.

a. In the figure, there is a unique point where the straight line labeled (d × k) intersects the curve labeled s × A × F(K,H), representing investment. This intersection gives the steady-state equilibrium capital level on the horizontal axis, marked as K*, and the steady-state equilibrium output level on the vertical axis is Y*. When the economy is in steady-state equilibrium, the level of investment (saving) and the value of depreciated capital are equal.

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b. The following figure shows the effect of an increase in human capital on aggregate output.

When the human capital of workers increases, the total efficiency units of labor also increases. This implies that the economy can produce more with the same capital stock and technology, so the curve for the aggregate production function shifts up. This leads to a new steady-state equilibrium with higher capital stock and aggregate income. In particular, the capital stock increases from K* to K** and aggregate income from Y* to Y**. A2. In 2016, Guinea topped the list of countries registering the lowest national savings, with savings forming −14.9 percent of GDP. This, however, does not mean that the economy doesn't have good prospects of potential growth given various internal positive components. Does this logic fit the Solow model? (Source: World Atlas, https://www.worldatlas.com/articles/countries-with-the-leastsavings-in-the-world.html, April 25, 2017) Answer:

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In the figure, the Solow model shows that economies with higher saving rates have higher aggregate incomes but an increase in the saving rate cannot be the only source of sustained growth. Following the same line of thought, if a country suffers from low saving rates, it does not mean that it cannot witness growth. A3. Switzerland’s GDP per capita increased from $30,401.892 in 1989 to $81,993.727 in 2019. (Source: World Bank, https://data.worldbank.org/indicator/NY.GDP.PCAP.CD?end=2019&locations=CH&start=1973.) a. Calculate the arithmetic average annual rate of growth of the Swiss economy during this period using the arithmetic average. b. Calculate the geometric average annual growth rate of Switzerland during this period. Does the number you got mean that every year the Swiss GDP per capita increased by this percentage? Refer to the data in the source link provided to prove your answer. Answer: a. Switzerland’s growth between 1989 and 2019 = [GDP per capita (2019) – GDP per capita (1989)] / GDP per capita (1989) = ($81,993.727 $30,401.892) / $30,401.892 = 1.6969 = 169.69%. Switzerland’s average annual growth rate = 169.69% / 30 = 5.656%. b. Recall the formula for a geometric average: [GDP per capita in the later year / GDP per capita in the earlier year]1/# of years – 1 In this case, the Swiss GDP per capita in the later year (2019) was $81,993.727 and that in the earlier year (1989) was $30,401.892. Plugging in these numbers: [GDP per capita (2019) / GDP per capita (1989)]1/30 – 1 = ($81,993.727/$30,401.892) 1/30 – 1 = 0.0336 = 3.36% This number certainly does not mean that every year for 30 years, the Swiss economy grew by 3.36 percent. It is an average determined by lumping together the years in consideration and giving a number that’s representative of the growth rate during this period; some years may have had a high growth rate, others a low one, and some even a negative rate. In fact, checking the data provided, we can notice that although the trend is a general increase, the Swiss GDP per capita decreased from $88,415.628 in 2011 to $81,993.727 in 2019. A4. The appendix details the important distinction between arithmetic and geometric averages in determining growth rates. Consider Exhibit 21.4. a. Using the procedure outlined in the Appendix for geometric average growth rates (in the section titled “Calculating Average (Compound) Growth Rates,” see if you can reproduce the “Implied (average) annual growth” figures given in the last column of the exhibit for the following countries: Mexico, Guatemala, South Korea, Ghana, and Rwanda. b. Using the procedure outlined in the Appendix for finding arithmetic average growth rates, calculate the arithmetic average growth rate for the five countries. Compare these with the rates you obtained in part (a). Does the arithmetic average understate or overstate the actual growth rate? Explain. Answer:

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a. From the formula in the Appendix, we know that to find the geometric average growth rate (g) over the 57-year period displayed in the table, we start by finding the ratio of the GDP per capita in 2017 to the GDP per capita in 1960. We then plug that ratio into the following equation: [GDP per capita (2017)/ GDP per capita (1960)]1/57 – 1 Below are the calculations for the five countries given in the problem: GDP per Capita GDP per capita [GDP per capita (2017)/ (2017)/ GDP per GDP per capita (1960)]1/57 capita (1960) –1 = Geometric average annual growth 1960 2017 Mexico $5,741.75 $18,360.42 2.06% 3.19770453259 Guatemala $2,418.48 $7,473.34 3.09009791274 2.00% South $1,175.10 $37,725.07 32.1037103225 6.28% Korea Ghana $2,816.50 $5,153.55 1.82977099237 1.07% Rwanda $962.58 $1,948.49 2.02423694654 1.25% b. From the formula in the Appendix, we know that to find the arithmetic average growth rate over the 57-year period displayed in the table is to use the following equation: {[GDP per capita (2017) – GDP per capita (1960)]/ GDP per capita (1960)} / 57 Using this formula yields the following arithmetic growth rates: GDP per Capita

Mexico Guatemala South Korea Ghana Rwanda

1960 $5,741.75 $2,418.48 $1,175.10

2017 $18,360.42 $7,473.34 $37,725.07

$2,816.50 $962.58

$5,153.55 $1,948.49

[GDP per capita (2017) – GDP per capita (1960)] / GDP per capita (1960)

{[GDP per capita (2017) – GDP per capita (1960)]/ GDP per capita (1960)} / 57 = Arithmetic average annual growth

2.197704532 2.090097912

3.86% 3.67%

31.103710322 0.829770992 1.024236946

54.57% 1.46% 1.80%

In each case, the calculated arithmetic average growth rate overstates the actual growth rate that is consistent with the observed data for per capita GDP in 2017. This is because using the arithmetic average does not account for compounding and therefore ignores the cumulative effects of growth.

Chapter 22

Why Isn't the Whole World Developed? Questions 1. How are the proximate causes of prosperity different from the fundamental causes of prosperity? Answer: Proximate causes link high levels of prosperity to high levels of factors such as physical capital, human capital, and technology but don’t provide an explanation for why the levels of these inputs are high. On the other hand, the underlying factors that explain the proximate causes of prosperity are known as the fundamental causes of prosperity. Fundamental causes of prosperity explain why some countries are either unable or unwilling to invest in different amounts of physical capital, human capital, and technology. 2. What does the geography hypothesis state? Answer: The geography hypothesis states that differences in geography, climate, and ecology are ultimately responsible for the differences in prosperity observed across the world. According to this hypothesis, some countries have highly unfavorable geographical, climatic, or ecological circumstances that are outside of their control. These conditions make it impossible or unlikely for such countries to accumulate or effectively use the factors of production. 3. According to the geography hypothesis, what could be done to improve incomes in poor countries? Explain. Answer: If geography is the major fundamental basis of prosperity, then the poor nations of the world have little reason to expect much improvement in living standards. They are permanently disadvantaged and would not be expected to catch up with the rest of the world and become economically developed anytime soon. However, some variations of the geography hypothesis stipulate that large-scale investments in transport technology or disease eradication may partially redress these geographic disadvantages. 4. What does the culture hypothesis state? Answer: According to the culture hypothesis, different societies respond differently to incentives because of specific shared experiences, religious teachings, the strength of family ties, or unspoken social norms. For example, some societies may have values that encourage investment, hard work, and the adoption of new technologies, while other societies may encourage creative tactics to avoid work or nurture suspicion of new inventions. Because culture is viewed as a key determinant of the values, preferences, and beliefs of individuals and societies, the culture hypothesis maintains that these differences play a key role in shaping economic performance. 5. In the context of this chapter, what is meant by the term institution? What are the three important elements that define institutions?

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Answer: As defined by economic historian Douglass North, institutions are the rules of the game in a society or, more formally, are the humanly devised constraints that shape human interaction. This definition captures three important elements that define institutions: ●

They are determined by individuals as members of a society. In contrast to geography, which is largely outside of human control, and culture, which changes very slowly, institutions are determined by man-made factors.

●

They place constraints on behavior. The “rules of the game” determine people’s behavior. Policies, regulations, and laws that punish or reward certain types of behavior will naturally have an effect on behavior.

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They affect incentives. The constraints that institutions place on individuals—whether formal constraints, such as banning certain activities, or informal ones, such as discouraging certain types of behavior through customs and social norms—shape human interaction and affect incentives.

6. How does the institutions hypothesis explain the difference in prosperity among nations? Answer: The institutions hypothesis claims that differences in institutions—how societies have organized themselves and shaped the incentives of individuals and businesses—are at the root of the differences in prosperity across the world. In other words, the institutions hypothesis is based on the notion that it is the way that humans themselves decide to organize their societies that determines whether or not they prosper. Some ways of organizing societies encourage people to innovate, to take risks, to save for the future, to find better ways of doing things, to learn and educate themselves, to solve problems of collective action, and to provide public goods. 7. What does it mean to say that private property rights are well-enforced in an economy? How does enforcement of these rights foster economic development? Answer: Secure private property rights means that a country’s citizens can hold property like businesses, houses, cars, and many other things without fearing that the government or anyone else will arbitrarily take them away. Well-enforced property rights help economic development by encouraging entrepreneurship. Entrepreneurs know that the income they generate belongs to them. This gives them the incentive to borrow money, invest, and start businesses. When property is well-protected, law and order are buttressed and contracts are enforced. All of these factors promote economic activity and development. 8. How do inclusive economic institutions differ from extractive economic institutions? Answer: Inclusive economic institutions provide secure property rights, set up a judicial system that enforces contracts and upholds the law, allow private parties to sign contracts for economic or financial transactions, and maintain relatively open and free entry into different businesses and occupations. Such institutions are said to be inclusive because they encourage the participation of a majority of the population in economic activities in a way that makes an efficient use of their talents and skills. On the other hand, extractive economic institutions fail to ensure protection of property rights, create barriers to entry in an industry, and restrict the free functioning of markets. Such institutions are often controlled by those who wield political power and extract resources from the rest of the society. 9. What does the return-to-entrepreneurship curve show? What is meant by the opportunity cost of entrepreneurship? Copyright © 2022 Pearson Education Ltd.

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Answer: The return-to-entrepreneurship curve ranks potential entrepreneurs in descending order according to the return they will make if they enter into the business for which they have a comparative advantage. The opportunity cost of entrepreneurship indicates the value to a potential entrepreneur of her best alternative activity. 10. In what ways should extractive economic institutions be changed to encourage economic development? Answer: A major problem with extractive economic institutions is that they do not guarantee property rights. This means that entrepreneurs are discouraged from investing as their investment or profits are not guaranteed. Therefore, a primary area of change is to provide guarantees to firms that they will not be taxed unfairly, their profits will not be taken away, and they will not be nationalized. New market entries should also be encouraged and protected. 11. Suppose a country has well-enforced private property rights for entrepreneurs, but a large fraction of the population does not have access to education and thus cannot become entrepreneurs. Moreover, their productivity as workers is low. Would you say that this country has inclusive economic institutions? Is it likely to achieve a high level of economic development? Answer: Well-enforced property rights are only one element, although a very important one, of inclusive economic institutions. Other components include a disinterested and efficient judiciary and accessibility of businesses and occupations to a wide variety of citizens. However, almost a prerequisite of this accessibility is an educational system that allows people to acquire the training and skills necessary to found and manage businesses successfully. Without this vital element, low productivity and the squandering of entrepreneurial talent are inevitable, and a country’s institutions cannot be called fully inclusive. And in the absence of truly inclusive institutions, economic growth and development might be substantially impeded. 12. What is meant by political creative destruction? How would this concept explain the existence of extractive institutions? Answer: Political creative destruction refers to the process in which economic growth destabilizes existing regimes and reduces the political power of rulers and monarchs. This would explain why a society adopts extractive institutions even though it seems to lead to relative poverty and a lack of economic development. New technology and economic growth may bring new actors on the scene who may make political demands. New economic activities may fall outside of the control of existing rulers. If the process of economic growth is also associated with political creative destruction, then the politically powerful, who fear losing their privileged positions, will be opposed to this process. This would ensure that extractive institutions remain in place. 13. Parts of the world that were relatively more prosperous 500 years ago have experienced a reversal of fortune and are relatively poorer today. What factors could explain this? Answer: Taking data on urbanization as a proxy for the prosperity of a nation, we can see that, in 1500, places like Mexico, Peru, North Africa, and India were relatively more prosperous than places such as the United States, Canada, Australia, New Zealand, and Argentina. The areas that were relatively more prosperous have experienced a reversal of fortune and are generally poorer today. This reversal of fortune can be seen as the consequence of an “institutional reversal” attributed to European colonization. The Europeans established more extractive institutions in places that were previously more developed and set up more inclusive institutions in places that were previously less developed. As a result, the lands of the former Aztecs and Inca Empires—Mexico, Peru, and their surroundings—ended up with extractive Copyright © 2022 Pearson Education Ltd.

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institutions, while Europeans who settled in the lands that were later to become the United States and Canada ended up with more inclusive institutions. This institutional reversal then led to the reversal of prosperity.

Problems 1. A mission "to expand financial access to help underserved communities thrive" is the raison-d'etre of Kiva, a nonprofit organization founded in San Francisco in 2005. It serves as a platform to help small businesses and low-income entrepreneurs in 77 countries. Financing the businesses come from lenders around the world, repayment level is between 95 and 96 percent. Go to Kiva’s website, look at the numbers, and discuss how this effort might impact sources of growth. Answer: The numbers published on the website are impressive: there were 3.6 million borrowers, most of whom were women, from 77 countries, with a total of $1.46 billion loans given. The loans given by lenders in developed countries contribute to enhancing the development efforts and growing small businesses that otherwise would have no access to funding. Kiva loans are proving to be life changers for individual entrepreneurs and their close communities. Additionally, due to the personal relationships that may form between borrowers and lenders, there can be cultural exchanges, which can enhance their lives. 2. In 1974, Cyprus got divided into two parts, the Northern part that got invaded by Turkey and the Southern part that is internationally recognized and a member of the European Union. The Southern or the Greek Cypriot part has a free-market economy mostly based on services, especially the tourism industry, it was affected by the Greek crisis but has since recovered at a fast pace registering a 4 percent growth rate in 2018 and continuing at a healthy pace. Whereas, the Turkish Cypriot part, which also has a big services sector but depends on agriculture as well, has a GDP per capita around half of the Southern part and gets extensive financial help from Turkey. Based on the information given in the question and your own research, do you think the case of Cyprus is similar to the case of Germany and of Korea when each of these countries got divided? Answer: Answers should be along the lines of: The case of Cyprus is about a country that got split into two parts with a resulting big difference in economic performance. Even if Cyprus does not represent a pure natural experiment (because in natural experiments, the geography and culture should be more or less identical, while the institutions are the only different factor) it’s still similar to the cases of East and West Germany and of North and South Korea. Indeed, Cyprus did not start as a unified body of culture and beliefs – after gaining independence from Great Britain, there were always political instabilities and intercommunal violence between the Greek Cypriot majority and the Turkish Cypriots. This eventually led to a coup and then to Turkey taking over Northern Cyprus and declaring that part independent, though only recognized by Turkey. However, what accounts for the differences in economic performance and standards of living between the two parts following this division and what serves as the key explanation for the divergence in growth paths, is the difference in economic and political institutions. Sources: https://fas.org/sgp/crs/row/IF10749.pdf, https://www.cyprusprofile.com/page/economy, http://txs.it/docs/hm2gd3.php?9e5fe6=cyprus-gdp-by-sector; retrieval Date: August 9, 2020.

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3. Suppose the country of Temria has an abundance of oil and gas. These natural resources were discovered about 40 years ago. Before this discovery was made, the country was a middle-income country with relatively productive industrial and service sectors. However, with exceptional profits due to its efficient extraction of oil and gas, the country gained access to a huge amount of capital. Since Temria is a democracy where people prefer planning ahead, this capital was reinvested into improving education and research and development. Now, due to sound planning, Temria is one of the richest countries in the world. Using the information given, distinguish between the fundamental and proximate causes of prosperity (or its absence) in Temria. Answer: The proximate causes of prosperity are high levels of factors such as physical capital, human capital, and technology, which result in a high level of GDP per capita. The underlying factors that explain the proximate causes of prosperity are known as the fundamental causes of prosperity. In other words, fundamental causes explain why some countries have accumulated more physical capital, invested more in human capital, and developed and adopted better technologies than other countries. In the case of Temria, three of the proximate causes for prosperity that could be cited are the following: • • •

The oil extraction process is efficient and waste is presumably not tolerated. Earnings from the oil sector are reinvested into education and R&D that can make growth sustainable. The local industry has not been destroyed by capital flowing into the oil and gas sector instead of traditional industries, keeping the growth balanced.

The fundamental causes that could explain the proximate causes are as follows: • •

From the given information, it seems that Temria’s government and people prefer planning ahead as opposed to spending wealth just to buy expensive cars and build “prestige investments.” There was a relatively developed industry in the country, and instead of letting all resources go into the oil sector, the extra inflow of capital was used to regain a competitive edge in the traditional industry in the country.

4. Look at the following map of Nogales, a twin city that is divided by the U.S. border.

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One part of Nogales lies in the United States, in Arizona, and the other part lies in Sonora, Mexico. Life in Nogales, Mexico is very different from life in Nogales, Arizona. The average income in Nogales, Mexico is about one-third the average income in Nogales, Arizona. Education levels, life expectancy, and health conditions are better in Nogales, Arizona than in Nogales, Mexico. Unlike the city in Arizona, Nogales in Mexico has only recently adopted political reforms, bringing it closer to functioning as a democracy. Crime rates are also lower in Nogales, Arizona than in Nogales, Mexico. Since both cities are located so close to each other, they share similar geographical conditions and climate. The inhabitants of both cities also share a common ancestry and enjoy the same types of food and music. Based on this information and your own research, what factors do you think can explain why Nogales, Arizona is so much more prosperous than Nogales, Mexico? Answer: One of the obvious reasons for the difference in prosperity between the two cities divided by the border is the border itself. Nogales, Arizona, is a part of the United States, which has very different institutions compared to those in Mexico. The United States generally has inclusive economic institutions that promote economic activity and development. U.S. citizens can take part in elections that allow them to elect their government democratically and hold it responsible for its actions. Much of the important infrastructure, as well as key public services, are provided by the government. Economic institutions encourage employers in the United States to invest in technology, hire the best talent, and contribute to economic growth in the country. Citizens acquire education and are free to work in occupations to which they are best suited. Unlike the United States, Mexico does not have many of these inclusive institutions; even where they are present, they are often incomplete or compromised by political factors. It is these institutional factors that could explain why life is so different for people who live in two areas that are otherwise very similar. Map credit: http://www.nytimes.com/2012/02/26/travel/nogales-mexico-a-few-steps-and-a-whole-worldaway.html?_r=0 Adapted from: Why Nations Fail: The Origins of Power, Prosperity and Poverty (James A. Robinson, Daron Acemoglu). 5. The latest OECD Economic Survey of Germany projected growth to top 2 percent for the 2018–19 period. To sustain the remarkable growth of the German economy, OECD Secretary-General Angel Gurría suggested, among other improvements, decreasing the government involvement and ownership of various sectors in the economy: Landesbanken (group of state-owned banks), car manufacturing, telecommunications, and postal services. a. Would Germany be considered to have extractive or inclusive institutions? Explain your answer. b. Why is it that countries supporting inclusive institutions, as opposed to predatory governments, are not afraid of the loss of political power reduction that results from economic growth? Answer: a. German economy has inclusive institutions that protect private property, uphold law and order, allow and enforce private contracts, and allow free entry into new lines of business and occupations. According to the suggestions of the OECD Secretary-General, it will move towards decreasing government ownership and, thus, further efficiency in allocating resources. Extractive institutions, on the other hand, do not protect private property rights, do not uphold contracts, interfere with markets, and erect significant entry barriers into businesses and occupations.

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b. This is because under non-totalitarian systems, the rulers’ objective is not to rule for a lifetime, so there should not be a conflict of interest between doing what is best for the economy in terms of human capital development, enhancing education, and technological progress as all of these can raise living standards in a country. On the other hand, the politically powerful in countries that have extractive institutions would prefer holding power in a stagnant economy to losing power by reforming institutions and enhancing growth. Source: https://www.oecd.org/newsroom/deeper-reforms-in-germany-will-ensure-more-inclusive-andsustainable-growth.htm, retrieval Date: August 8, 2020 6. Since gaining independence from Malaysia in 1965, Singapore has had impressive growth performance, achieving an average annual growth rate of GDP per capita of 7.46 percent. Stateowned Enterprises (SOEs) have featured prominently in its burgeoning economy; even today, many of its powerful companies are partially controlled by the highly centralized government. a. Based on what you have learned in this chapter, how would you expect the presence of SOEs to affect the returns to and opportunity cost of entrepreneurship? Use the curves developed in Exhibit 22.5 to explain. b. Some of Singapore’s SOEs have focused on developing shipping and transportation infrastructure. How might this fact change your answer to part a? c. Does the example of Singapore contradict what you learned in this chapter about institutions and growth? Explain. Answers: a. As we learned about extractive economic institutions in the Exhibit 22.5, we’d expect SOEs to push up the opportunity cost of entrepreneurship; new entrepreneurs would have trouble competing against powerful, state-supported companies. In addition, we might expect the returnto-entrepreneurship curve to shift to the left; it might be more expensive to conduct business with state-supported monopolies, and, if the state absorbed some of the profits from business ventures, entrepreneurs would not reap all of the returns. b. While we could still see the same effects for would-be shipping and transportation entrepreneurs, these infrastructure projects could actually reduce the costs of entrepreneurship in other industries—by easing exporting or the integration of supply chains. Thus, we could actually see a reduction in the opportunity cost of entrepreneurship. c. No—we saw that good institutions can encourage growth. While, as we discussed in this chapter, too much state interference can stymie growth, well-managed, productivity-enhancing SOEs could actually facilitate the development of entrepreneurship. 7. Using a graph like that displayed in Exhibit 22.5, which show returns to entrepreneurship and the opportunity cost of entrepreneurship, illustrate how each of the following historical events shifted one (or both) of the curves. a. The Lebanese Company for the Development and Reconstruction of Beirut Central District known as Solidere, is a controversial entity granted expropriation rights over the Beirut Central District area (approximately 150 hectares) in order to reconstruct it after the ravaging civil war ended in the 1990's. It's a private company that was operating under the authority of the government, which makes the expropriation of property, either compensated for with controversial undervaluation of estate or forced, private-to-private. b. In the World Bank Group's 2020 Ease of Doing Business, Egypt moved six positions up from the 120th position of the prior year thanks to improvements in four areas: Copyright © 2022 Pearson Education Ltd.

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Starting a new business got simplified in addition to enhancing the one-stop shop system. Tax collection can now be done online. The country increased minority investors protections. The improved reliability of electricity supply.

c. Abu Dhabi, being the second largest economy in the Arab world and ranked 16th in the World Bank's Ease of Doing Business Report 2020, is a good destination for new firms or expanding firms. The Abu Dhabi Investment Office (ADIO) encourages private sector involvement in major infrastructure projects with the objective of strengthening public-private collaborations, and it offers a Ventures Fund that backs up startups by increasing their access to capital. In addition, the ADIO gives many incentives for foreign or local investors such as low tax rates, up to 100 percent profit repatriation in Special Economic Zones, ease of obtaining capital, state of-the-art technology, and high connectivity. Answer: a. The expropriation actions taken by Solidere reduced returns to independent entrepreneurs. But this firm reconstructed the Beirut Souks itself, which led to a leftward shift in the return-toentrepreneurship curve, as shown below.

b. The various positive actions taken by Egypt to simplify conducting business would certainly lead to an increase in the number of business people, and therefore the number of businesses because the opportunity cost of doing business is now lower. The opportunity cost curve was shifted down, as shown in the graph below.

c. The ADIO’s incentives simultaneously increased returns to entrepreneurship (reflected in a rightward shift of the returns-to-entrepreneurship curve) and decreased the cost of doing business Copyright © 2022 Pearson Education Ltd.

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(resulting in a downward shift of the opportunity cost curve), changing the equilibrium from E1 to E2.

8. Suppose the returns-to and cost-of entrepreneurship curves are described by the following equations (with numbers measured in the thousands): R = 520,000 – 140,000 N C = 120,000 + 180,000 N where R = returns to entrepreneurship, C = cost of entrepreneurship, N = number of entrepreneurs a. How would the cost of entrepreneurship function mentioned in the chapter be written? Which form you think is more reflective of real life, the one discussed in the chapter or the one in this problem? b. Find the equilibrium number of entrepreneurs in this economy and the equilibrium returns to entrepreneurship. c. The government now enacts a license fee of £20,000 to file the paperwork necessary to start a firm. What is now the equilibrium number of entrepreneurs and the equilibrium returns to entrepreneurship? Answer: a. The opportunity cost line in the chapter was horizontal, so as a function, it would have been C = a constant numerical value. In this problem, it is upward sloping – there is a positive relationship between the number of entrepreneurs and the opportunity cost of entrepreneurship. This positive relationship, as opposed to the two variables being independent, is more reflective of real life for several reasons. For example, it might be that the greater the number of entrepreneurs in an economy, the greater the opportunities for the employment of additional entrepreneurs, and hence the greater the opportunity cost. b. To find equilibrium, you should equalize the two functions, so 520,000 – 140,000 N = 120,000 + 180,000 N Therefore, N* = 1,250 and R* = £345,000 c. The new opportunity cost line is described by C = 140,000 + 180,000 N. Hence, it has shifted upward by 20,000. Setting this equal to the equation for returns: N* = 1,187.5 R* = £353,750.

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9. Jointly published by the Wall Street Journal and The Heritage Foundation, “The Freedom Index” gives an annual ranking of most of the countries of the world based on their level of economic freedom. Factors considered in the rankings include the status of property rights, extent of corruption, and ease of starting and running a business. The Index can be found at http://www.heritage.org/index/. a. Go to http://www.heritage.org/index/ranking and find three countries in each of the freedom categories (“Free,” “Mostly Free,” and so forth.). Click on the country name in the table for each country you select, and read about the rationale for their ranking. Provide a summary for the nations you selected. b. Now go to http://www.heritage.org/index/explore?view=by-variables. Note the per capita GDP of the three countries you selected in each category, and calculate the average of the three you selected in each category. What pattern do you notice? What preliminary conclusions can you draw concerning the relationship between economic freedom and economic development? Which of the three hypotheses mentioned in the chapter do your results tend to support? Explain. c. Sub-Saharan Africa is known to be one of the poorest regions of the world. Go to the “Interactive Freedom Heat Map” at http://www.heritage.org/index/heatmap. Into which freedom categories do the majority of countries of the region fall? Which countries are the exceptions to the overall pattern? Answer: a. Students will select three countries in each of the five categories: “Free,” “Mostly Free,” “Moderately Free,” “Mostly Unfree,” and “Repressed.” The summary should include the salient characteristics mentioned in the write-up on each country. b. Students should notice the positive correlation between economic freedom and per capita GDP. This supports the institutional hypothesis, which posits the importance of such indicators of freedom as protection of property rights and the rule of law, open markets, and regulatory efficiency. c. The vast majority of the countries fall into either the “Mostly Unfree” or “Repressed” categories. As of the time of this writing, Mauritius has the highest ranking at “Mostly Free.” Botswana, Namibia, Seychelles, Cape Verde, and Cote d’Ivoire are “Moderately Free.” Mauritius and Botswana (which in the past has been “Mostly Free”) have experienced rapid economic growth). 10. The process of Schumpeter’s creative destruction creates winners and losers in economies. What are some of the options to limit the negative effects on the losers? Why is it imperative to minimize these negative effects? Answer: The process that Schumpeter called “creative destruction,” which is fundamental to growth, is one that inevitably creates winners and losers in an economy. As new technologies replace older ones, new businesses and new sectors replace existing firms and sectors. Likewise, skills consistent with the new technologies are in higher demand, which results in a disproportionate increase in the rewards to the people possessing those skills. It should be noted that those who are losers are people and that some may not be able to change the way they operate/live/work without outside assistance. This means that retraining and assistance programs should be provided for those who would not be able to change on their own. If people are left to the forces of the market, they could be dissatisfied with how things have turned out for them in their career and could be radicalized and participate in violent action against their compatriots.

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11. In what situation would foreign aid be not only insufficient but also detrimental to an economy? Answer: If there is no control over who is benefitting from aid, if the government is corrupt, and if there are extractive economic institutions, foreign aid will not be used efficiently to develop the economy. It is often distributed to corrupt officials and consolidates the position of the corrupt government controlling the extractive economic institutions. 12. Based on the discussions in this chapter, the preceding chapters, and your own readings, what could be some of the conditions under which aid works and can assist the development of the countries of the Global South? Answer: For aid to be efficient, some of the basic economic and political institutions in the country must be present. If we look at the economic miracles of Western Germany and Japan after the Second World War, their success was partially built around the fact that these countries mainly lost human and physical capital during the war but not their institutional setups. Creating an efficient institutional setting can be virtually impossible. Second, aid should be protected from falling into the hands of corrupt officials. Third, the country itself and citizens should also be made “owners” of the development projects that are financed through aid to make them complicit in the success.

Chapter 23

Employment and Unemployment Questions 1. Unemployment statistics are measured and released by the Bureau of Labor Statistics, a division of the U.S. Department of Labor. a. When does the Bureau of Labor Statistics officially classify a person as being employed? When are potential workers classified as being unemployed? b. What do the following terms mean and how are they calculated? i.

The unemployment rate

ii.

The labor force participation rate

Answer: a. According to the BLS, a person who is a part of the civilian non-institutional population aged 16 and over and holds a full-time or part-time paid job is considered employed. A potential worker is considered unemployed if he or she does not have a paid job, has actively looked for work in the prior four weeks, and is currently available for work. b. i.

The unemployment rate is defined as the percentage of the labor force that is unemployed:

Unemployed Labor force ii. The labor force participation rate is defined as the percentage of the population of potential workers that is in the labor force: Unemployment rate = 100% ×

Labor force Potential workers 2. Explain whether each of these individuals will be counted as a part of the labor force. Labor force particpation rate = 100% ×

a. Chiara is a part-time university lecturer who is raising her daughter by herself. b. Jan recently quit his job and has not applied for any jobs in the last four weeks because he is still trying to decide which job would best suit him. c. Aron is volunteering at a nonprofit to gain experience as a lawyer and build his career. Answer: a. Chiara will be included in the labor force because she is working part-time and is getting paid for her work. Copyright © 2022 Pearson Education Ltd.

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b. Jan will not be included in the labor force because neither is he working nor applying for a job. c. Since Aron is doing unpaid volunteer work, he will not be included in the labor force. 3. Consider Exhibit 23.2. What were the two highest rates of unemployment since 1948? When did they occur? Answer: The two highest rates of unemployment since 1948 were 10.8 percent, which occurred during the 1981–1982 recession, and 10.0 percent, which occurred during the 2007–2009 recession. (Note: Student answers may be somewhat inexact because the exhibit is such that precise rates and times are difficult to determine. However, students should still see the peaks around the times indicated in the answer.) 4. What could explain why unemployment is lower among workers with a relatively higher level of education? Answer: As the chapter points out, multiple factors explain why more educated workers have lower rates of unemployment. One such factor is the fact that unemployment is lower among workers with a higher level of education is consistent with the principle of optimization. More educated workers tend to earn higher wages than less educated workers when working outside the home. More educated workers, therefore, have a much higher opportunity cost of time. An unskilled worker who is unemployed is more likely to be indifferent between staying at home or working at a low-paying job. But for a skilled worker, the opportunity cost of staying at home is much higher. He or she would be better off getting back to work as quickly as possible. This is because higher wages make the opportunity cost of unemployment much higher for workers with more education. 5. What is the value of the marginal product of labor? Explain how it is computed with an example. Answer: The value of a worker’s marginal product is the additional revenue that a worker will generate for the firm by working one additional unit of time. In a competitive market, it is calculated as the marginal product of labor multiplied by the market price of the product. In a competitive equilibrium, a profit-maximizing firm will pay a worker a wage that is equal to the value of his or her marginal product. Consider a tailor, who makes $4,000 in revenues when he works alone. Suppose the tailor hires a new worker and this increases the tailor’s total revenue to $5,300. He then hires a second worker and his total revenue increases to $6,000. This means that the value of the marginal product of the first worker is $1,300, and the value of the marginal product of the second worker is $700. 6. List two factors that can cause a shift in the labor demand curve. Explain why a change in each factor can lead to a shift of the curve. Answer: Each of the following factors affects the entire schedule relating the quantity of labor demanded to the wage, which is equal to the value of the marginal product of labor. Hence a change in any of these factors will shift the labor demand curve. ●

Changing output prices: When the price of a final good increases, the value of the marginal product of labor also increases for every quantity of labor demanded. This shifts the labor demand curve to the right. Similarly, when the price of a final good falls, the demand for labor curve shifts to the left.

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Changing technology and productivity: Technology used in production can increase productivity and the marginal product of labor, increasing the value of that marginal product, and shifting the labor demand curve to the right. In rare cases, technological progress can shift labor demand to the left; for example, technological progress can result in machines replacing labor. Similarly, a decline in productivity can shift the labor demand curve to the left. Copyright © 2022 Pearson Education Ltd.

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Changing input prices: Firms use labor and other factors of production, like machines and tools, to produce goods and services. When the prices of these other factors fall, businesses purchase more of these other factors. This usually increases the marginal product of labor, shifting the labor demand curve to the right. Conversely, if the prices of other factors rise, the marginal product of labor falls, shifting the labor demand curve to the left.

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Changing demand for the output good or service: For example, if the demand for a product or service declines, the value of the marginal product of labor declines. This will shift the labor demand curve to the left.

7. Why does the labor supply curve slope upward, and what can cause the labor supply curve to shift? Answer: The labor supply curve represents the relationship between the quantity of labor supplied and the wage. As the wage increases, the quantity of labor (hours) supplied rises: The opportunity cost of activities other than paid employment increases when the wage increases. So, workers have an incentive to work more hours as their wage increases. Accordingly, the labor supply curve is upward sloping. Each of the following factors affects the entire schedule relating the quantity of labor supplied to the wage and will therefore shift the labor supply curve. ●

Changing tastes and social norms: Changing social norms affect people’s willingness to take a paid job. For example, factory work during the Second World War was one early step in a worldwide shift toward acceptance of female labor force participation. This increase in the number of workers shifts the labor supply curve to the right.

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Changing opportunity cost of time: Household appliances, like dishwashers and vacuum cleaners, lower the opportunity cost of working outside the home. This encourages people to shift more time out of home production into paid employment, generating a rightward shift in the labor supply curve.

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Changes in population: For example, the influx of immigrants to a country will increase a country’s population and shift the labor supply curve to the right.

8. Would a country with a healthy economy have a zero unemployment rate? Answer: The process of matching jobs and workers is time-consuming and results in frictional unemployment being present in any economy at any point of time. Therefore, a zero unemployment rate is impractical as a policy goal. 9. What is meant by job search? How does it lead to frictional unemployment? Answer: Finding the right job is not easy; a job seeker would need to determine which firms are hiring and learn how pay, benefits, and other job characteristics vary among them. He or she would also have to line up references and send out resumes. Interviews will need to be set up, but in most cases, someone else gets chosen, and then the job candidate needs to start all over again. These job-hunting activities are referred to as job search. Unemployment arising from job search is called frictional unemployment. Frictional unemployment arises because it takes time for an unemployed worker to find a firm with a well-matched job vacancy. 10. What is the difference between frictional and structural unemployment? Answer: When firms and workers lack important information about the labor market, workers cannot always be quickly matched to open jobs, which will cause unemployment. This type of unemployment is called frictional unemployment. On the other hand, structural unemployment arises when the quantity of labor supplied is persistently higher than the quantity of labor demanded. This is often due to institutional Copyright © 2022 Pearson Education Ltd.

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factors (e.g., minimum-wage laws, collective bargaining, and efficiency wages) that result in wage rigidity, thus preventing the market wage from adjusting to bring the market to equilibrium. 11. Sometimes new technology in production reduces the time that a worker takes to complete a task. Technological innovations can also completely replace a factory worker. Does this mean that technological progress will lead to large-scale unemployment? Explain your answer. Answer: New technology can replace factory workers and make jobs redundant in a certain industry. However, historical evidence shows that technological progress does not produce unemployment in a country as a whole. Technological progress increases productivity and incomes in the overall economy. Higher incomes lead to higher demand for goods and labor. As a result, workers who lose jobs in one industry will be able to find jobs in others, though for many of them this might take time and some of them will have to accept lower wages in their new jobs. 12. What is wage rigidity? List and explain two factors that can increase wage rigidity in the labor market. Answer: Wage rigidity refers to the situation in which wages are held above the level that clears the labor market. Because firms will not be able to hire workers who would have been willing to work at the equilibrium wage, wage rigidity leads to unemployment. Some of the factors that increase wage rigidity are the following: ●

Minimum-wage legislation: The minimum wage is a legislated price floor that prevents the market price from falling to the equilibrium price. Minimum-wage legislation prevents employers from hiring workers at wages that would equalize the quantity supplied and demanded, leading to unemployment in the market.

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Collective bargaining: Collective bargaining refers to contract negotiations between an employer and a labor union representing workers. Collective bargaining agreements between unions and employers often result in wages that are above equilibrium.

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Efficiency wages: Efficiency wages are set above the market wage in order to increase worker productivity. Firms might find it profitable to pay a higher wage than the market clearing wage in order to boost productivity, lower absenteeism and turnover, boost worker morale, etc. Moreover, paying efficiency wages may well attract higher quality applicants for the available positions.

●

Downward wage rigidity: Workers tend to resist a decline in their wage. In order to maintain productivity and morale, firms often prefer to fire workers than try to cut everyone’s wages. This leads to downward wage rigidity.

Problems 1. The following table shows the employment level, unemployment level, and the labor force participation rate in Greece for the month of March of every year from 2008 to 2020. Use the given data to complete the table and answer the following questions. (Note: All rates are in percent.)

Chapter 23 | Employment and Unemployment

Year

Number Unemployed (in thousands)

Number Employed (in thousands)

Labor Force Participation Rate

2008

454.1

4537.4

52.9%

2009

475.1

4535.5

53.2%

2010

594.9

4432.1

53.6%

2011

828.3

4126

53%

2012

1130.4

3745.6

52.4%

2013

1302.8

3491

52%

2014

1343.4

3495.6

51.9%

2015

1299.4

3438.1

51.6%

2016

1189.9

3600.7

52.04%

2017

1079.717

3669.1972

51.9%

2018

973.5729

3768.629

51.6%

2019

844.038

3846.3319

51.8%

2020

665.3619

3813.0379

50.6%

Employment Rate

Unemployme nt Rate

Labor Force

274

Adult Population

Source: Based on 2020 data extracted from the Trading Economics website (Greece: unemployed persons, employed persons, and labor force participation rate) a. In which years did the economy witness increases in the unemployment rate? What could possibly explain this? b. Use the data on the size of the labor force and potential workers to compute the percentage of adults out of the labor force for the year 2017. Verify that your calculation is equal to one minus the labor force participation rate. c. What are the general trends that you observe in the data? Answer: The completed table is given below. Year

Number Unemployed

Number Employe d

Labor Force Participatio n Rate

Employmen t Rate

Unemployme nt Rate

Labor Force

2008

454,100

4,537,400

52.9%

90.9%

9.1%

4,991,500

2009

475,100

4,535,500

53.2%

90.5%

9.5%

5,010,600

2010

594,900

4,432,100

53.6%

88.2%

11.8%

5,027,000

2011

828,300

4,126,000

53%

83.3%

16.7%

4,954,300

2012

1,130,400

3,745,600

52.4%

76.8%

23.2%

4,876,000

Adult Population 9,435,727.7 88 9,418,421.0 53 9,378,731.3 43 9,347,735.8 49 9,305,343.5 11

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2013

1,302,800

3,491,000

52%

72.8%

27.2%

4,793,800

2014

1,343,400

3,495,600

51.9%

72.2%

27.8%

4,839,000

2015

1,299,400

3,438,100

51.6%

72.6%

27.4%

4,737,500

2016

1,189,900

52.04%

75.2%

24.8%

4,790,600

2017

1,079,717

3,600,700 3,669,197 .2

51.9%

77.3%

22.7%

4,748,914.2

2018

973,572.9

51.6%

79.5%

20.5%

4,742,201.9

2019

844,038

51.8%

82%

18%

4,690,369.9

2020

665,361.9

3,768,629 3,846,331 .9 3,813,037 .9

50.6%

85.1%

14.9%

4,478,399.8

275

9,218,846.1 54 9,323,699.4 22 9,181,201.5 5 9,205,611.0 68 9,150,123.6 99 9,190,313.7 6 9,054,768.1 47 8,850,592.4 9

Source: https://tradingeconomics.com/greece/unemployed-persons; https://tradingeconomics.com/greece/employed-persons; https://tradingeconomics.com/greece/laborforce-participation-rate, 2020; retrieval Date: July 28, 2020 To calculate the employment and unemployment rate, the size of the labor force needs to be computed. The total number of employed and unemployed constitutes the labor force. The percentage of the population of potential workers that is in the labor force gives the labor force participation rate. Using the data on the labor force participation rate and the size of the labor force, the total population aged 16 years and above can be calculated. The number of unemployed people as a percentage of the labor force gives the unemployment rate. Similarly, the number of employed people as a percentage of the labor force gives the employment rate. A simpler method in this case would be to subtract the unemployment rate from 100 to obtain the employment rate. a. The economy recorded a continuous increase in the unemployment rate from 2009 to 2015. This observation is logical because this was the period when the Greek economic crisis, which started in 2009 and lasted until 2018, was at its height. b. The percentage of adults not in the labor force is given by the following: [(Potential workers – Labor force) / Potential workers] × 100 For 2002, the percentage of adults not in the labor force can be calculated as: [(9,150,123.699 – 4,748,914.2) / 9,150,123.699] × 100 = 48.1% This answer can be checked by subtracting the labor force participation rate (as a decimal) from 1, which also gives the percentage of adults not in the labor force: c – 0.519 = 0.481 = 48.1% c. Student answers may vary, but some of the general trends are as follows: • Despite some increases, the total adult population has decreased from 2008 to 2020 following a downturn trend. • The unemployment rate was on a steady increase from 2008 to 2015, when it started steadily going down, while still being higher than 2008. • The increases and decreases between the total adult population and the labor force participation rate do not always match. • The labor force participation rate in 2020 is still lower than the rate in 2008. Copyright © 2022 Pearson Education Ltd.

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276

Assume that 1 million immigrants enter the United States this year and that some of these immigrants work in the home construction industry. a. Graph the impact of immigration on the supply of labor and the resulting new equilibrium wage and quantity. b. These new immigrants also increase the demand for housing. Graph the change in the demand for labor in the home construction industry due to the increased demand for housing. Without considering the increase in the supply of labor, how does the equilibrium wage and quantity of workers hired change? c. Considering both the change in the supply and the demand for labor in the home construction

industry, what can you conclude about the change in the equilibrium wage and quantity of workers hired?

Answer: a

The graph show the original equilibrium at E1. As supply increases due to the immigration of new workers, the supply shifts to the right as indicated by the arrow. As supply increases, the equilibrium number of workers increase and the wage decreases as indicated by the new equilibrium point E2. b.

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As the demand for housing increases due to the immigration, the demand for homes increases as indicated by the upper arrow showing the movement to the right of the demand curve. The equilibrium quantity of workers and wage increase as demand for workers increases. The new equilibrium, E2, is higher than the original equilibrium wage, E1. c.

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The third graph depicts an equilibrium wage, E3, that is identical the original equilibrium, E1 and between the two intermediate equilibriums that were both labeled, E2. Depending on the shape of the supply and demand curve, and the relative shifts in supply and demand, the equilibrium wage might increase or decrease a bit, but it will be between the two intermediate equilibriums. The equilibrium for new workers unambiguously increases. 3.

In April 2012, the Bazanian Daily, a leading newspaper in the country of Bazania, carried a report titled “20,000 jobs Added in the Last Quarter; Unemployment Rate Shoots Up from 5 Percent to 6.7 Percent.” How could the unemployment rate in Bazania increase even when new jobs were created?

Answer: A rapidly expanding economy creates new jobs and also draws discouraged workers back into the labor force. The unemployment rate is equal to the number of people who are unemployed divided by the labor force. Both the numerator and the denominator are increasing. If the reentry of discouraged workers is sufficiently large, the unemployment rate will increase. A second statistic, the labor force participation rate would help Bazanians better understand the situation. It is the labor force divided by the adult population. The labor force is increasing while the adult population is constant. By looking at the two statistics simultaneously, observers should reach the proper conclusion that the labor market is improving

4. A new study suggests that technology might provide improved leisure options, like video games, to potential workers, and that young men with low levels of education are increasingly staying home and playing video games instead of working. There has also been a concurrent decline in the labor force participation of young men with low levels of education. a. Could the rapid rise in video game playing be a cause of the decreased labor force participation of low-education young men? What other factors might explain these two simultaneous trends? In your response, you should use the labor market equilibrium figure (e.g., Exhibit 23 .8) and also utilize the concepts of voluntary and involuntary unemployment. Copyright © 2022 Pearson Education Ltd.

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b. The authors of this new study also find that these young men, as a group, have experienced an increase in self-reported happiness through the 2000s (according to the General Social Survey). How does this factor into your explanations in part a? Answer: a. Certainly, improved leisure options could change individual preferences, tilting them from work to leisure; this could, in turn, increase voluntary unemployment. However, it could be that involuntarily unemployed young men are simply playing video games instead of idling; that is, the increase in video games could be an effect, rather than a cause, of unemployment. As the problem directs, students should also provide at least one chart showing the possible decrease in labor supply due to improved video game technology (see example below). Ideally, they will provide an additional chart showing the alternative explanation; a shock, for example, to demand for young workers, leading to involuntary unemployment.

b. This fact could perhaps support the authors’ contention that these individuals are voluntarily unemployed. However, it could also simply be the case that overall happiness has been improving in this age group, for reasons unrelated to employment. Alternatively, this average trend could be driven by a small group of super-happy, super-successful young men. Overall, then, this fact doesn’t necessarily help us pick between the explanations in part a. 5. Suppose Construire Construction Firm makes a special window frame that it sells for €20. The following table shows the number of window frames that can be produced from a given number of labor hours. Assume that the company cannot hire labor for a fraction of an hour.

Chapter 23 | Employment and Unemployment

Hours of Labor 0

Quantity 0

100

120

145

150

152

280

a. Find the marginal product (in window frames) and the value of the marginal product (in euros), of each hour of labor. b. If the wage paid to workers in Construire Construction’s plant is €450/hour, how many hours of labor should the firm employ? How many hours will be employed if the wage decreases to €350/hour? Explain. c. How many hours will be employed if the wage is €450/hour, but the price of a bracket rises to €25? Answer: a. The relevant figures are provided in the following table: Labor Hours 0 1 2 3 4 5 6 7

Quantity 0 40 75 100 120 135 140 142

MPL

VMPL

40 35 25 20 15 5 2

800 700 500 400 300 100 40

b. Recall that a firm will keep hiring hours of labor as long as the additional revenue that an additional hour produces is at least as great as the wage the additional hour earns. If the wage paid for each hour of labor is €450, then the firm will hire 3 hours of labor to make the window frames. The fourth hour generates €400 in additional revenue (VMPL) but costs the firm €450. If the firm hires a fourth hour, Construire Construction would lose €50 on that hour. However, if the wage decreases to €350/hr., then Construire Construction will hire for 4 hours. The fifth hour generates €300 in additional revenue but costs the firm €350, so the firm will not hire that fifth hour. c. If the price of a bracket is now €25 instead of €20, the value of the marginal product of labor must be recalculated. The results are shown below:

Chapter 23 | Employment and Unemployment

Hours of Labor 0 1 2 3 4 5 6 7

Quantity 0 40 75 100 120 135 140 142

MPL

VMPL

40 35 25 20 15 5 2

1000 875 625 500 375 125 50

281

Given the higher values for the value of the marginal product of labor, four hours will be employed. The fifth hour now generates €375 in additional revenue but will cost the firm €450. Hence, it will not be hired. 6. Following are the durations of unemployment in Italy during 2018: • • • • •

Less than 1 month: 5.7 percent More than 1 month and less than 3 months: 10.7 percent More than 3 months and less than 6 months: 12.1 percent More than 6 months and less than 1 year: 12.6 percent More than 1 year: 59 percent

Source: https://www.statista.com/statistics/785245/duration-of-unemployment-in-italy/, 2020. a. Suppose you are an Italian fresh graduate, you searched for work for 5 months until you finally found work that you like. Should you consider yourself lucky? b. When you were unemployed, did you classify yourself as frictionally unemployed? Do you think those who are unemployed for more than 1 year are also frictionally unemployed? Answer: a. Yes, I should consider myself lucky because I am better off than 12.6% + 59% = 71.6% of the unemployed people in Italy who spend more than 6 months trying to find work. b. Yes, I was frictionally unemployed because I was searching for a job that I like and not just any job. It depends on the reason people are unemployed – if they’re unemployed because they’re not well informed about the job opportunities where they are sending their resumes or if there is tough competition for the positions they’re applying to, they would be considered as frictionally unemployed. Otherwise, they may be structurally or cyclically unemployed. 7. Every month, statistics on employment and unemployment are compiled by the Bureau of Labor Statistics. a. The unemployed worker whose frustration was discussed at the beginning of section 9.1 had been unemployed for 17 months. Go to www.bls.gov and consult Table A-12. Find the average (mean) duration of unemployment (seasonally adjusted) in the most recent month. Based on what you find, is 17 months higher or lower than average? b. List some possible reasons for the quoted worker’s unemployment that would make his joblessness qualify as frictional unemployment. List reasons that would fall in the category of structural unemployment. Copyright © 2022 Pearson Education Ltd.

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Answer: a. The answer will depend on when the table is consulted, but a typical seasonally adjusted duration is around 33 weeks, or a bit longer than 8 months. So the worker quoted had been unemployed about twice as long as the average. b. (Various scenarios are possible. The following are examples of issues that would fall into the two categories.) Frictional Unemployment ●

The worker’s job search has been protracted due to insufficient or faulty information about job opportunities in her area.

●

The worker has not been proactive about sending out resumes, gathering references, lining up interviews, networking, or following up on all opportunities.

●

The positions for which the worker has applied have received multiple applications, and it is taking the employers longer than usual to process all of the applications.

Structural Unemployment ●

The worker has applied for jobs in a region that has a high minimum wage—one that is set above the equilibrium wage for the labor market in which she is applying.

●

Wages in the labor market in which the worker is applying are above equilibrium and downwardly rigid due to the fact that many employers in that market pay efficiency wages.

●

The industry in which the worker is applying is heavily unionized, and wages are kept consistently above equilibrium.

7. In recent years, countries around the world have faced a youth unemployment crisis. According to a report by the International Labour Organization, the global youth unemployment rate in 2016 was 2.9 times higher than the global adult rate. a. In Exhibit 23.5, we compared the curves for two types of labor, low-skill and high-skill. Suppose that the curves show the labor market for workers over the age of 22, with a minimum wage of $10. Use new charts to demonstrate two ways in which the youth labor market might feature greater structural unemployment at the same minimum wage. b. How would you distinguish between the two different explanations you proposed in part a: what kind of data would you need to test these different explanations? c. Some countries, like the UK, have attempted to reduce youth unemployment by implementing a lower minimum wage for workers under the age of 20. Discuss how this might influence youth unemployment, linking your answer to the two explanations discussed in parts a and b as well as to the different types of unemployment discussed in this chapter. Do you think efforts to reduce youth unemployment by setting lower minimum wages for young workers is likely to be effective? Answer: a.

There are a few options here. For example, the student could, as in exhibit 23.5, change the elasticity of supply for the youth labor market—the youth labor market could be more elastic because young people have fewer job options. They could also shift the labor supply for the youth

Chapter 23 | Employment and Unemployment

283

labor to the right, reflecting an influx of young workers; or they could shift the labor demand for the youth labor to the left, suggesting that fewer employers want to hire unskilled workers. b. Again, this depends on the answers given in part a. A great answer will distinguish between supply-side/demand-side effects (and perhaps give some of the explanations offered in the part a. answer here, instead). The data sources should be, for example, data on how many youths are hired across industries and the associated wages—or data on wages for jobs that youth accept. Ideally, hourly wage data could give a disaggregated look at the willingness of youth to substitute work for leisure. c. Given the features of the market discussed in a. and b. (specific answer here will depend on student’s answer to a/b), the adult minimum wage seems to generate particularly high unemployment for young people. A lower minimum wage would address structural unemployment, as we saw in this chapter, by coming closer to the equilibrium wage; we would also expect it to slightly increase voluntary unemployment, as some people wouldn’t want to work for the lower wage (because they find leisure more valuable). It’s hard to say whether it will be effective—the amount of employment generated will depend somewhat on the elasticities of supply and demand. If both are extremely elastic, then we could see a large effect of even a small decrease in minimum wage (particularly if firms are simply hiring the cheapest labor, with no preference for age/experience). However, if young people are not good substitutes for older, more experienced, workers, then the minimum wage decrease may not make a big difference. 8. Countries around the world have faced a youth unemployment crisis in recent decades. According to a report by the International Labour Organization, the global youth unemployment rate in 2016 was 2.9 times higher than the global adult rate a. In Exhibit 23.10 we compared the curves for two types of labor, low-skill and high-skill. Suppose that the curves show the labor market for workers over the age of 22, with a minimum wage of $10. Use new graphs to demonstrate two ways in which the youth labor market might feature greater structural unemployment at the same minimum wage. b. How would you distinguish between the two different explanations you proposed in part a: what kind of data would you need to test these different explanations? c. Some countries, like the UK, have attempted to reduce youth unemployment by implementing a lower minimum wage for workers under the age of 20. Discuss how this might influence youth unemployment, linking your answer to the two explanations discussed in parts a and b as well as to the different types of unemployment discussed in this chapter. Do you think efforts to reduce youth unemployment by setting lower minimum wages for young workers is likely to be effective? Answer: a.

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The graph was drawn so that the $10 minimum wage would be binding in the teen labor market but not the 22-year-old labor market. At this level, only teen workers experience structural unemployment due to the minimum wage. At that wage, 300,000 teen workers wish to work, but employers will hire only 150,000. Because the labor supplied at the minimum wage is greater than the demand, structural employment exists. At $10, the minimum wage is not binding on 22year-old workers. All of these workers have acquired skills sufficient to earn $10 or more. There is no structural unemployment in this market. If the wage increases to $12 per hour, no additional teen workers enter the market because all the workers who wish to work are already employed. As the minimum wage increase, the demand for teen workers continues to fall. The higher minimum wage at $12 is binding in the market for 22-year-old labor. Structural unemployment has entered a new market. b. A researcher might conduct a natural experiment such as that conducted by Card and Kreuger, but using data on the minimum wage experienced by workers, their age, and unemployment rates, again by age. High levels of unemployment among teens relative to 22-year-olds suggests that the minimum wage is more binding. Similar rates of unemployment generated by higher minimum wages, say $10 vs. $15, suggest that the minimum wage is on the vertical portion of the supply curve. c. If the minimum wage were on the vertical portion of the teen labor supply curve, a lower minimum wage might move down the supply curve to the positively sloped portion. It would also reduce the gap between the supply of labor and the demand, which is the structural unemployment. There is a danger. Because teens have few skills and experience low wages, their wage is closer to their opportunity cost of not working than a highly skilled worker who would have a higher wage. Reducing the minimum wage would increase the demand for teen labor but teens might not wish to work at the lower wage. 9. The following graph shows the demand for and supply of labor in a market with a minimum wage set at €125 per month. Use the graph to answer the following questions.

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a. How many workers will be unemployed due to the minimum wage? What kind of unemployment is this? b. Give an example of a minimum wage rate that would not affect the quantity of labor demanded nor supplied. Explain. c. Do you think all current employed people would benefit from the minimum wage rate? d. What is the difference of the impact of the minimum wage rate on unemployment between developed and developing countries? Answer: a. At a wage of €125 per month, the quantity of labor supplied is 600, but the quantity of labor demanded is only 300. Hence, there will be structural unemployment of 300 workers in this market as a result of the minimum wage. b. Any minimum wage that is set below the equilibrium wage in the market, which is €75 per month, will not affect the quantity of labor demanded and supplied. For example, if the minimum wage rate is set at €50 per month because the market is already paying wages that are higher than the minimum wage, the minimum wage law will have no impact on the labor market. c. Currently employed workers who keep their jobs would benefit from the minimum wage rate if that is what they are being paid and if these are the workers who would have been willing to work at the lower market-clearing wage. On the other hand, many workers could lose their jobs due to the lower demand from firms, which would now have to pay higher wages. Therefore, not all current employees would benefit and many could become unemployed as a result of the minimum wage rate. d. Most likely, in developed countries, the minimum wage rate would not have an impact on unemployment as the majority of workers already make more than the minimum wage. However, it would be a different story in developing countries, where the vast majority get paid less than a newly implemented minimum wage rate. As a result, the unemployment rate would increase. 10. In response to the financial crisis of 2007, the government of Hungary, in 2012, reduced the number of days for which unemployment benefit can be provided to 90 days from 270 days. What could have been the rationale behind this? What are some of the potential effects of such a policy? Copyright © 2022 Pearson Education Ltd.

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Answer: The idea might have been that people would look for a job far more intensively. Unfortunately, at that time, Hungary had a scarcity of jobs; therefore, on average, it took job seekers significantly more time to find a job than the 90 day-timeframe. Despite their efforts, it was unlikely that a job seeker would find employment and hence, would probably have to ask family and friends to support them financially. This had an additional effect on wages. In such cases, an individual being interviewed for a job could not negotiate an appropriate wage rate and would take whatever was offered to them. 11. Assume that half of all workers are White and the other half Black. All workers are equally productive. Draw a graph of the labor market for White and then Black workers. Include the equilibrium wage and quantity of workers hired. How do the equilibrium wage and quantity compare in each market? a. Now assume that employers believe that Black workers are less productive than White workers. Add a new demand curve to the market for Black labor that reflects the belief. How does it affect the demand for labor for both White and Black workers? What happens to the equilibrium wage and quantity hired? b. Does discrimination affect structural unemployment? c. Assume that some employers correctly measure the productivity of Black workers and some do not. If you are a Black worker, how can you avoid a lower wage from discrimination? d. Why is the added job search still a cost of discrimination? Answer:

Chapter 23 | Employment and Unemployment

It may be able to precisely read points off the axes. Answers may vary. At the equilibrium point, 440,000 workers will be hired at $11.20 per hour. Half of the workers will be White, and half, Black. a.

287

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288

The demand for White labor is half the original demand. The equilibrium is 220,000 White workers are hired at $11.20 per hour; the employment of White workers and their wage has not changed. The Black demand will have a more steep slope and will lie under the White demand. In equilibrium, 157,150 Black workers are hired at a wage of $7.42 per hour. The number of Black workers has fallen by 62,850 and their wage by $3.78. b. In equilibrium, structural unemployment has increased to 62,850 workers, all Black. The direct cost of discrimination can be measured on an hourly basis. The workers who would have been employed if discrimination did not exist lost $11.20 per hour. The remaining Black workers still are employed so they are not structurally unemployed, but they do earn $3.78 per hour less than they would in a world without discrimination. c. Black workers can avoid lower wages by seeking out employers who correctly measure productivity. The avoidance is not free. Black workers will have to search for nondiscriminating employers. Note that the cost of incorrectly measuring productivity has reduced the profits of these employers. d. Search takes time and time is money as measured by forgone wages. 12. Metro Cheese Steaks prepares meals from outlets in major cities across the country. Assume that some outlets can hire only White workers and others only Black workers. Productivity of all workers is the same. The market price for a lunch is $10. The table shows the number of lunches that can be served given the number of workers on duty per hour.

Chapter 23 | Employment and Unemployment

Workers/ Hour 1 2 3 4 5

Output/ Hour 25 45 60 70 75

Perceived Output/Hour 20 35 45 50 53

MPL/ Hour

289

VMPL/ Hour

a. Calculate the MPL/hour, and then the VMPL/hour. How many workers per hour does each Metro hire? b. Assume the perceived output/hour for Black workers is given in the third column. Calculate the MPL/hour and the VMPL/hour assuming the misperception. In outlets with only Black workers, how many Black workers are now hired? How does this compare to the number hired when there are no misperceptions? c. How does discrimination lead to structural unemployment? Answer: a. Workers/ Hour 1 2 3 4 5

Output/ Hour 25 45 60 70 75

Perceived Output/Hour 20 35 45 50 53

MPL/ Hour 25 20 15 10 5

VMPL/ Hour 250 200 150 100 50

At a wage of $50/hour, Metro Cheese Stakes hires five workers if they are measuring MPL correctly b. Workers/ Hour 1 2 3 4 5

Perceived Output/Hour 20 35 45 50 53

Perceived MPL/Hour 20 15 10 5 3

Perceived VPML/Hour 200 150 100 50 30

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The inability to correctly measure the MPL/hour results in lower perceived VMPL/hour. For one worker, the underestimate is $50/hour; for two, $50/hour, etc. The undervaluation is seen in the graph that shows both the actual VMPL/hr. and the perceived VMPL/hr. for Black workers. The perceived VMPL/hr. is to the left of the VMPL/hr. curve. The graph shows that at a wage of $100/hr. Metro hires one Black worker too few. The same is true for any other wage chosen. b. Many fewer Black workers are on duty, one less worker per hour times the number of outlets in cities hiring only Black workers at all relevant wages. c. Metro Cheese Steaks will hire fewer Black workers; its profits will be lower because it is not exploiting all profit-making opportunities, harming its owners; and it is creating structural unemployment because it is hiring too few Black workers. 13. According to salary.com, the average salary for an Art and Creative Director in the United States is $99,700 as of 2020. A new company decided to take the advertising industry by storm and so it needs to hire and retain high-level creative directors. How much do you advise it to pay as a salary for its Art and Creative Directors? Answer: For this new company to attract and retain high-level creative directors, it should pay them a salary well higher than the industry average. This salary differential can be explained using the concept of efficiency wages – the higher-than-average wage will serve to increase the productivity of workers by reducing worker turnover and enhancing worker morale, all of which will increase the firm’s profitability. Source: https://www.salary.com/research/salary/alternate/art-and-creative-director-salary, June 28, 2020; retrieval Date: July 27, 2020. 14. The following figure shows the demand and supply curves in the market for workers (called “baristas”) in Starbucks coffee shops, (called “baristas”). The hourly wage in this market has been fixed at $7.25 and cannot be changed.

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a. Suppose that, due to concerns about the high number of calories in many Starbucks drinks, the demand for Starbucks products declines. Use a graph to explain what will happen to employment in the market for baristas. b. Now suppose the wage is flexible. How would your answer to part (a) change? Answer: a. A fall in demand for Starbucks coffee will reduce the demand for labor by coffee shops. The demand for labor curve will shift to the left, as illustrated below. Because the wage in the market is fixed at $6 per hour, the quantity of labor supplied at that wage will exceed the quantity demanded, leading to unemployment. For example, in the graph below, 100,000 workers would be unemployed as a result of the inflexible wage.

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b. With flexible wages, a shift to the left in the demand for labor reduces the equilibrium wage and employment but does not cause unemployment. The demand curve will shift to the left, the wage will fall—say, to $5 per hour as illustrated above—and the level of employment will be equal to 250,000 baristas. But at this lower wage, the number of baristas demanded will be equal to the number of baristas supplied; there will be no unemployment in the market.

Chapter 24

Credit Markets Questions 1. What is the difference between nominal and real interest rates? Answer: The nominal interest rate is the interest rate you pay on a loan or receive on a savings account, while the real interest rate is the nominal interest rate adjusted for inflation. Real interest rate = Nominal interest rate – Inflation rate Or using symbols, r = i – π, where r is the real interest rate, i is the nominal interest rate, and π stands for the inflation rate. 2. The credit demand curve shows the relationship between the quantity of credit demanded and the real interest rate. If everything else remaining unchanged, what is likely to happen to the credit demand curve of a semiconductor multinational company like Intel if: a. there is an increase in the real interest rate? b. it plans to expand production in the future? Answer: a. If there is an increase in the real interest rate, there will be an upward movement along the credit demand curve of the multinational company. b. If a company like Intel plans to expand its production in the near future, its credit demand curve is likely to shift to the right. 3. What factors explain why people save for the future? Answer: People save for many reasons, some of which are listed below: ●

Retirement: Because the Social Security program pays the typical U.S. household a bit less than half of the household’s pre-retirement income, most people save some of their pre-retirement income to keep consumption levels more or less the same after retirement as before retirement.

●

Bequests: Some parents save to leave money for their children. These inter-generational transfers are called bequests. Parents may also save money for their kids’ college education, etc.

●

Homes and durable goods: People save to buy a home or to buy durable goods, like a new washing machine or a car.

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Starting a business: In cases where outside funding can’t be obtained, small business owners need to use their own savings to fund their business ideas.

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Saving for a rainy day: People save for unexpected events—they may lose their jobs or need money for a medical expense.

4. Households and firms with savings lend money to banks and other financial institutions. The credit supply curve shows the relationship between the quantity of credit supplied and the real interest rate. a. Why does the credit supply curve slope upward? Copyright © 2022 Pearson Education Ltd.

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b. What can cause a shift in the credit supply curve? Answer: a. The credit supply curve is upward sloping because a higher real interest rate encourages more saving, increasing the amount of funds that banks can lend, and thereby increasing the quantity of credit supplied. b. Although a change in the real interest rate will lead to a movement along the credit supply curve, the following factors will lead to a shift of the curve: ●

Changes in the saving motives of households: Households save for many reasons, but these motives change over time, shifting the credit supply curve. For example, if households are generally optimistic about their future income, they may spend more now and save less, shifting the credit supply curve to the left. Conversely, if households decide that they want to increase the amount that they leave to their children, the credit supply curve will shift to the right.

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Changes in the saving motives of firms: When firms distribute part of their earnings back to shareholders through dividends, the credit supply curve shifts to the left because passing earnings back to shareholders can be thought of as dissaving. On the other hand, when firms are at all nervous about their ability to fund their business in the future, they tend to hold on to, or retain, any earnings. In this case, the credit supply curve shifts to the right. This is much the same as when households save for a rainy day.

5. What are the key categories on a bank’s balance sheet? Illustrate using a table with assets on the left and liabilities and stockholders’ equity on the right. Answer: A bank’s balance sheet has the following categories of assets and liabilities: Balance Sheet Assets

Liabilities and Stockholders' Equity

Reserves

Demand deposits

Cash equivalents

Short-term borrowing

Long-term investments

Long-term debt Total Liabilities Stockholders' Equity

Total Assets

Total Liabilities + Stockholders' Equity

6. What is the shadow banking system? Answer: The shadow banking system is made up of financial institutions, such as investment banks, that do not fulfill traditional banking functions: They don’t accept deposits from the public. Nevertheless, they act like banks in the sense that these firms raise money and then make loans with the funds. Lehman Brothers, an investment bank whose bankruptcy fueled the 2008 financial crisis, was one example of a shadow bank. Instead of taking common deposits, Lehman would take loans from large investors, like insurance companies, and use the money to trade stocks, bonds, and derivatives based on those securities. Institutions in the shadow banking system also make loans to businesses and devise new financial products that they can sell to other institutions and wealthy investors. 7. What functions do banks perform as financial intermediaries in the economy? Copyright © 2022 Pearson Education Ltd.

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Answer: Banks perform three interrelated functions as financial intermediaries: ●

Banks identify profitable investment opportunities by bringing together credit-worthy borrowers and depositors and channeling depositors’ savings to borrowers.

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Banks transform short-term liabilities, like deposits, into long-term investments in a process called maturity transformation. Maturity transformation allows the economy to undertake significant long-term investments.

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Banks transfer risk from depositors to the bank’s stockholders and, in severe financial crises, to the U.S. government.

8. What is maturity transformation? Answer: The process by which banks take short-term liabilities, such as demand deposits, and use them to invest in long-term assets, like loans, is called maturity transformation. Demand deposits have a 0-year maturity because the depositor can take back his or her money at any time. In contrast, when banks lend to borrowers, such loans usually have a maturity of 5–30 years. 9. What is stockholders’ equity? Who bears the risk that a bank faces when stockholders’ equity is greater than zero? Answer: Stockholders’ equity is defined as the difference between a bank’s total assets and total liabilities. Stockholders are the primary risk takers, but it should be noted that if their equity is wiped out, any losses cascade down to either lenders or the government. Hence, undercapitalized banks, that is, banks whose stockholder equity is a very small proportion of assets, run a significant risk that a decline in asset values could not only wipe out stockholders, but also impact others. 10. What is a bank run? Answer: A bank run is a situation where a large proportion of a bank’s depositors try to withdraw their money at the same time. If the bank has mostly long-term, illiquid assets, it may not be able to pay out all the withdrawals. As word gets out that the bank’s cash is running low, more depositors will try to make withdrawals in the hope that they can get what little cash remains. 11. What is deposit insurance? Is deposit insurance successful in preventing bank runs? Answer: Deposit insurance is offered by the government and protects depositors’ balances up to a certain amount. All deposits at or below the cap are paid out in full by the government in the event that a bank cannot meet its obligations. In the United States, bank runs have been relatively rare since the 1930s because of the deposit insurance provided by the Federal Deposit Insurance Corporation (FDIC). However, institutional bank runs—where large lenders fear default by their borrowers and cut short-term lending as a result—did occur during the financial crisis of 2007–2009. Unlike households, institutions make deposits and short-term loans that are far too large to be insured fully by the FDIC. 12. As the Choice and Consequence box on “Too Big to Fail” notes, bank regulators worry about the prospect of the failure of large financial institutions, dubbed “systemically important financial institutions” (SIFIs). a. How would the failure of a SIFI affect the economy? b. What steps do bank regulators take to prevent SIFIs from failing or to minimize the effect of such failures? Answer: Copyright © 2022 Pearson Education Ltd.

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a. A SIFI’s failure could have repercussions for the entire banking sector and the economy as a whole. All of the banks to which the failed bank owes money will suffer losses. In turn, these losses can cause runs on the banks involved or wipe out the capital (stockholders’ equity) of these banks, leading to bankruptcy. As one bank after another fails, the ripple effects of financial losses keep spreading through more and more banks. In theory, the failure of one SIFI could bring down the whole financial system. b. To protect the economy from the effects of the failure of a SIFI, bank regulators have adopted two strategies. First, they now require large banks to set up “living wills” that spell out how the bank would sell its assets and pay off its creditors in the event that it needed to end its business operations. Such living wills are designed to make it more credible and easier for a government to shut down a failing bank, including a failing mega-bank. Second, regulators are now requiring banks to take on less risk and hold more stockholders’ equity, reducing the likelihood that a large bank will get into trouble in the first place. 13. Banks fail when they invest in long-term assets that subsequently fall in price. What are the two views on why asset prices fluctuate so much that they lead to financial crises and bank failures? Answer: The theory of efficient markets asserts that asset prices are based exclusively on fundamentals. This theory implies that all movements in asset prices reflect a rational appraisal of new information, not a tendency for investors to let their emotions get in the way. In this view, fluctuations in asset prices are interpreted as episodes in which important new information becomes available to investors. An alternative view links asset price fluctuations to bubbles in asset prices, which occur when asset prices depart from fundamentals. In this view, substantial asset price bubbles can arise, partly driven by psychological factors and biases, particularly during specific episodes such as extended economic and stock market booms.

Problems 1. Optimizing economic agents use the real interest rate when thinking about the economic costs and returns of a loan. a. In a given year, the average rate paid by banks on savings accounts was 3.85 percent. The subsequent year, it was found that the average saver’s real rate of interest received on bank deposits was 2.29 percent. Can you guess what was the inflation rate during that period? b. Banks expect that the rate of inflation in the coming year will be −2.9 percent, in other words, a deflation is expected. They want a real return of 6 percent. What nominal rate should they charge borrowers? Explain, using the Fisher equation. Answer: a. Recall that the real rate of interest is defined as: where r is the real interest rate, i is the nominal interest rate, and π is the rate of inflation. Substituting the values in the problem, i = 3.85% and r = 2.29%, which implies that π = 3.85% – 2.29% = 1.56%. b. In this question, r = 6% and πe = –2.9%, where πe stands for the expected inflation rate. Rearranging the equation for the real interest rate, banks should set the nominal rate they charge on loans at: 𝑖 = 𝑟 + 𝜋𝑒 = 6% + (−2.9%) = 3.1% Copyright © 2022 Pearson Education Ltd.

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2. The 1970s was a period of high inflation in many industrialized countries, including the United States. a. Due to the increase in the inflation rate, lenders, including credit card companies, revised their nominal interest rates upward. How is the inflation rate related to the nominal interest rate that credit card companies charge? Why would lenders need to increase the nominal interest rate when the inflation rate increases? b. Usury laws place an upper limit on the nominal rate of interest that lenders can charge on their loans. In the 1970s, in order to avoid usury laws, some credit card companies moved to states where there were no ceilings on interest rates. Why would credit card companies move to states without usury laws during a period of high inflation like the 1970s? Answer: a. It is the real rate of interest that matters to lenders and borrowers. The real interest rate is calculated by subtracting the inflation rate from the nominal interest rate. When the rate of inflation increases, the nominal interest rate needs to increase to keep the real interest rate constant. b. Usury laws do not constrain lenders when the inflation rate is low because a reasonable real interest rate does not require a high nominal interest rate in a low-inflation environment. However, as the inflation rate rises, it is necessary to increase the nominal interest rate one-forone to maintain the real interest rate. In such a situation, an upper limit on the nominal interest rate could constrain a lender. Adapted from an article by the Federal Reserve Bank of Chicago found here: http://www.math.utah.edu/~zobitz/pdf_files/Fall04_teaching/interest_rate.pdf 3. The average annual inflation rate in Canada was 12.47 percent, in 1981 and became 1.78 percent in 2010. The Canadian short-term nominal interest rate was 17.78 percent in 1981 and it also fell to 0.58 percent in 2010. How has the real short-term interest rate changed from 1981 to 2010 in Canada? Come to a conclusion about the magnitude of the changes in the inflation and nominal interest from your findings regarding the real interest rate. Answer: Recall that the relationship between the real interest rate, the nominal interest rate, and the rate of inflation is given by: where r = the real interest rate, i = the nominal interest rate, and π = the rate of inflation. Substituting values from 1981, 𝑟 = 17.78% − 12.47% = 5.31%. For 2010, 𝑟 = 0.58% − 1.78% = −1.2%. As both inflation and nominal interest rates fell from 1981 to 2010, and as the real interest rate fell from 5.31% to −1.2%, the nominal interest rate fell more than the inflation rate did in the same period. Source: inflation: https://www.macrotrends.net/countries/CAN/canada/inflation-rate-cpi; interest rates: https://www150.statcan.gc.ca/n1/pub/11-210-x/2010000/t098-eng.htm; retrieval Date: July 30, 2020 4. Many kinds of loans, like student loans and mortgages, can be taken out at either a fixed or variable rate. A fixed rate loan allows the borrower to pay the same nominal interest rate for the entire lifetime of the loan, while a variable rate loan may experience changes in in the nominal interest rate as the rate that banks charge each other for overnight loans changes. For this problem, assume that this variable nominal interest rate adjusts such that the associated real interest rate remains constant over time. Copyright © 2022 Pearson Education Ltd.

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a. In the first year, inflation is 2.75 percent and the nominal interest rate for both the fixed and variable rate loans is 5 percent. What is the real interest rate for the fixed rate loan? What about for the variable rate loan? b. In the second year, inflation rises to 3 percent. Calculate the nominal and real interest rates for the fixed rate and the variable rate loans described in part a. c. What happens if the inflation rate falls? Could a borrower end up facing a much higher real interest rate with a variable rate loan? With a fixed rate loan? d. Suppose you are deciding between a fixed rate and a variable rate loan and that you dislike risk (variability) in the real interest rate you pay. Should you opt for a fixed rate or a variable rate loan? Are there any reasons for a borrower to dislike variability in the nominal interest rate rather than the real interest rate she faces? Answer: a. The real interest rate for the fixed rate loan is given by where r = the real interest rate, i = the nominal interest rate, and π = the rate of inflation. Plugging in, then, we get that the real interest rate for both the fixed and variable rate loans is 2.25 percent. b. Again, we use the equation from above. The fixed rate loan is simple—the nominal rate is still 5 percent, so the real interest rate is 2 percent. For the variable rate loan, the nominal rate should adjust so that the real interest rate remains at 2.25 percent. Rearranging the equation above, we get that the nominal rate for the variable rate loan should be at 5.25 percent. c. The real interest rate could, indeed, go up with a fixed rate loan (particularly with deflation, when inflation would be negative, and the real interest rate would be higher than the nominal interest rate). With a variable interest rate, however, the real interest rate will always remain the same. d. If you dislike variability in the real interest rate, then you’re better off choosing the variable rate loan, because it will adjust to keep the real interest rate constant. It’s possible, though, that you want to keep the nominal interest rate constant, perhaps because you get paid in nominal dollars and like the predictability of paying a certain percentage of your wage each month. 5. Explain how the equilibrium real interest rate and the equilibrium quantity of credit would change in each of the following scenarios and illustrate your answer with a well-labeled graph of the credit market. a. As the real estate market recovers from the 2007 – 2009 financial crisis, households begin to buy more houses and condominiums, and they apply for more mortgages to enable those purchases. b. Congress agrees to a large tax cut which increases the level of the government deficit.

c. Households begin to fear that a growing pandemic may cause them to lose their jobs and they increase their savings for a rainy day. d. Businesses become more optimistic about the future of the economy and decide to distribute more of their earnings as dividends to their shareholders. Answer: Copyright © 2022 Pearson Education Ltd.

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a. As households apply for more mortgages to purchase real estate, the demand for credit increases, and the credit demand curve shifts to the right. This increases the equilibrium real interest rate as well as the quantity of credit, as shown in the graph below.

b. As government borrowing increases, there is a consequent increase in the demand for credit. The credit demand curve shifts to the right, raising the equilibrium interest rate and the equilibrium quantity of credit. This is illustrated in the graph below.

c. The increase in household pessimism would result in a decline in borrowing by households, reflected in a leftward shift in the credit demand curve. By itself, this would lower the equilibrium real interest rate and the equilibrium quantity of credit. However, households would also tend to increase their saving, thus shifting the credit supply curve to the right. This action further lowers the real interest rate but increases the quantity of credit. Hence, the combination of a decrease in credit demand and an increase in credit supply would definitely lower the equilibrium real interest rate but have an ambiguous effect on the quantity of credit. (Note: The graph below shows a small decrease in the equilibrium quantity of credit because the credit demand curve shifted to the left by a greater horizontal distance than the credit supply curve shifted to the right.) Copyright © 2022 Pearson Education Ltd.

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d. If the business community becomes more optimistic about the economy, they will tend to increase their borrowing to fund investment and expansion. This will shift the credit demand curve to the right. At the same time, distributing more of their earnings to shareholders as dividends will decrease the supply of credit (assuming that the shareholders spend those dividends), shifting the credit supply curve to the left. The net result of these two effects is shown in the graph below. The equilibrium real interest rate will definitely increase, but the effect on the equilibrium quantity of credit is ambiguous and depends on which curve shifts by the greater horizontal distance. (Note: The graph below shows a situation where the leftward shift in the credit supply curve is exactly offset by the rightward shift in credit demand, resulting in no change in the equilibrium quantity of credit.)

6. Households, like banks, have balance sheets. Although these assets and liabilities may not be written down in a neat table, they still influence household decision making. a. We saw in this chapter that for banks, assets are equal to liabilities plus stockholders’ equity. In what sense is this also true for a household? Explain. b. What kinds of assets might the average household have? Of these, which do you think are the most liquid? c. How would a one-time loan made to a relative affect a household’s annual balance sheet? What about purchasing a car with cash? Copyright © 2022 Pearson Education Ltd.

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Answer: a. The comparison between banks and households is similar but not identical. Shareholder’s equity makes up the difference between assets and liabilities for the bank. Household wealthy can be defined in the difference between assets owned by households and liabilities owed. Many American households face large debts (e.g. credit card debt, student loans) and likely have liabilities greater than assets. Other households—older homeowners, for example—may have assets greater than liabilities. b. Households can have cash, investments (e.g. equities, bonds, retirement accounts), physical investments like cars or jewelry, or houses. Cash and checking accounts are the easiest to use quickly, which makes them the most liquid. c. A one-time loan would decrease available cash on the lender’s asset side and replace it with a loan on the asset side (representing the expectation of future payment). This loan, of course, is much less liquid than the cash. Purchasing a car with cash would have a similar effect; a decrease in cash on the asset side, replaced with the long-term physical asset of the car. 7. Banks that practice narrow banking match the maturity of their investments with the term of the deposits that they collect from the public. In other words, narrow banks take short-maturity deposits and invest in assets that carry a low level of risk and are also of short-term maturity, like short-term government debt. a. Suppose that all FDIC-insured banks decide to adopt narrow banking. How would narrow banking reduce the level of risk in the banking system? b. If narrow banking would reduce systemic risk, why does society allow banks to practice maturity transformation? Answer: a. Narrow banking would reduce the level of risk in the banking system by reducing the likelihood of bank runs and liquidity problems for banks. Narrow banks match the maturity of their deposits with that of their investments. Because depositors’ money is in the form of short-term, liquid investments, banks will be able to convert these investments into cash easily and return money to their depositors when they ask for it. b. Banks take short-term deposits from savers and make long-term loans to investors. This crucial function allows the economy to undertake significant long-term investments. Maturity transformation allows banks to match savers with investors. 8. If you have studied microeconomics, you may recall a concept called “moral hazard.” Moral hazard occurs when an economic agent is incentivized to take risks because some (or all) of the losses that might result will be borne by other economic agents. Discuss how federal deposit insurance, administered by the FDIC as described in the chapter, might lead to moral hazard. Answer: Moral hazard occurs whenever a policy changes incentives, which in turn changes behavior. Because of federal deposit insurance, the majority of depositors need not pay any attention to the lending practices of their bank. Depositors are more likely to decide where to bank based on the interest rate offered, or on convenience. Consequently, a bank’s customers won’t worry about whether a bank is badly run, nor will they worry about whether a bank is making unprofitable long-term investments. The depositors will get their deposits back in any case because of deposit insurance. Likewise, knowing that their depositors’ funds are covered gives banks’ management more incentive to acquire riskier assets, e.g., to make riskier loans than they otherwise would. If the assets perform well, the Copyright © 2022 Pearson Education Ltd.

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bank will earn higher profits. If the assets decline in value, and lead to losses, the bank’s depositors are still covered. 9. In this problem, consider a simple mutual fund. Households and businesses invest in the fund by buying shares; the fund uses this money, in turn, to invest in a range of assets, including equities and bonds. If an investor wishes to divest from the fund, she can “redeem” her shares. Redeeming involves selling the shares back to the mutual fund for a price called the “net asset value” (NAV). The NAV is equal to the difference between assets and liabilities, divided by the total number of investors in the fund (similar to the shareholders’ equity discussed in this chapter). The NAV is updated at the end of each day. Thus every investor who redeems on a given day will get the same price. a. What does this fund’s balance sheet look like? b. Suppose several large investors in the mutual fund start getting nervous about market conditions and decide to redeem, all on the same day. How will these redemptions affect the fund’s balance sheet? c. Suppose now that investors anticipate that other (large) investors will redeem. How will this affect their incentives to redeem? Link your answers to the notion of bank runs discussed in this chapter. d. Assume that the economy has 15 other, identical mutual funds. As the fund in part b begins selling assets to pay back investors, the market price of those assets drops. How would this price drop affect the balance sheets of the other mutual funds that invest in those assets? Does this also relate to bank runs? Clarify the differences between your answers to this part and part c. Answer: a. On the liabilities side, we have the money given by the individual investors—they can redeem at any point, so it becomes a liability. On the assets side, we have all of investments that the manager has chosen; the difference between the two sides is the NAV. (It’s also acceptable if students put different, more traditional liabilities, and say that the NAV is the only place where the investors in the fund enter in—which is closer to how mutual funds actually work). b. Now, the fund will have to get the money to pay its investors. Thus, it will need to sell some of the assets side; it may have some cash on hand to pay investors, but, if enough people redeem, it will need to sell off more. c. As the problem describes, anyone who redeems on a given day will get the Net Asset Value from the night before. However, as we saw in part b, redemptions will actually pull down the NAV because of reductions in the assets; at the end of a day with many redemptions, the NAV will be lower than the day before. An investor, then, who expects a large number of redemptions in a day, will also want to redeem on that day, particularly if she thinks that the redemptions are occurring because of negative sentiment about the fund. As we saw in the chapter with bank runs, individuals can seek to take their money away if they believe that everyone else is—and if they think their investments might not be safe tomorrow. d. Now, we’ll see the value of the assets of those other mutual funds go down—leading to a decrease in their NAVs. This effect, itself, does not relate to bank runs—this is more of an example of systemic risk, in that an event at one institution has impacts that reverberate throughout the system. In part c, sentiment played a primary role in pushing investors to redeem, leading to a downward spiral. Here, while the systemic decrease in NAV could generate negative sentiment, the primary phenomenon of interest is the systemic impact of a price decrease on the assets of similar financial institutions. Copyright © 2022 Pearson Education Ltd.

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10. The “Choice and Consequence” box on “Asset Price Fluctuations and Bank Failures” discusses the relationship between the prices of things like oil and real estate, and the solvency of lending institutions like banks. Consider the following two scenarios. Supply the missing entries and answer the questions that follow. Assume that Securitas Bank is a large bank in the country of Hyponatremia. The bank’s only assets and liabilities at the beginning of the year are given in the following balance sheet: Securitas Bank Balance Sheet Assets

Liabilities

Reserves and Cash Equivalents

$ 20 Billion Demand Deposits

$200 Billion

Long-term investments

$330 Billion Borrowing from Other Banks

$ 50 Billion

Total Assets

Stockholders’ Equity ?

Philopericulum Bank is another large bank whose only assets and liabilities are summarized in its balance sheet: Philopericulum Bank Balance Sheet Assets

Liabilities

Reserves and Cash Equivalents

$ 10 Billion Demand Deposits

$450 Billion

Long-term investments

$650 Billion Borrowing from Other Banks

$200 Billion

Total Assets

Stockholders’ Equity ?

Assume now that due to an economic downturn, the value of each bank’s long-term investments declines by 10 percent. Show the resulting situation on each bank’s balance sheet. How would you describe the resulting situation for each bank? Relate your answer to the discussion in the chapter of the concept of “too big to fail.”

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Answer: Before the decline in the banks’ investments, these were the complete balance sheets: Securitas Bank Balance Sheet Assets

Liabilities

Reserves and Cash Equivalents

$ 20 Billion

Demand Deposits

$200 Billion

Long-term investments

$330 Billion

Borrowing from Other Banks

$ 50 Billion

Total Assets

$350 Billion

Stockholders’ Equity $100 Billion

Philopericulum Bank Balance Sheet Assets

Liabilities

Reserves and Cash Equivalents

$ 10 Billion

Demand Deposits

$450 Billion

Long-term investments

$650 Billion

Borrowing from Other Banks

$200 Billion

Total Assets

$660 Billion

Stockholders’ Equity $10 Billion

After a 10 percent decline in each bank’s long-term investments, here are the resulting balance sheets: Securitas Bank Balance Sheet Assets

Liabilities

Reserves and Cash Equivalents

$ 20 Billion

Demand Deposits

$200 Billion

Long-term investments

$297 Billion

Borrowing from Other Banks

$ 50 Billion

Total Assets

$317 Billion

Stockholders’ Equity $67 Billion

Philopericulum Bank Balance Sheet Assets

Liabilities

Reserves and Cash Equivalents

$ 10 Billion

Demand Deposits

$450 Billion

Long-term investments

$585 Billion

Borrowing from Other Banks

$200 Billion

Total Assets

$595 Billion

Stockholders’ Equity –$55 Billion

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Securitas Bank is still solvent, with stockholders’ equity at $67 Billion. This is because the ratio of their assets to equity started at $350 Billion / $100 Billion = 3.5:1; it had $1 of equity for each $3.50 worth of assets. Philopericulum Bank, on the other hand, started with a ratio of assets to equity of $660 Billion / $10 Billion, or 66:1; each dollar of equity supported $66 worth of assets. In other words, Philopericulum Bank had borrowed a much larger proportion of the funds it used to make its investments. In finance jargon, we would say that it had much higher “leverage.” As discussed in the chapter, any loss of value in assets comes right out of the equity portion of a bank’s balance sheet. And when equity falls to zero or below, it means that the bank is insolvent, or has failed. As seen in the balance sheets above, the 10 percent decline in the value of Philopericulum’s investments resulted in the bank’s failure; it now has negative stockholders’ equity. This illustrates the danger involved in high leverage. Furthermore, it provides the rationale behind regulatory requirements regarding the amount of stockholders’ equity that a bank must have as a proportion of its total assets. 12. The sharpest one-day percentage decline in the Dow Jones Industrial Average (DJIA) took place on October 19, 1987. The DJIA fell 23 percent on this one day. Foreign exchange markets and other asset markets also exhibit large fluctuations on a daily basis. Based on the information given in this chapter, discuss some factors that could explain why asset prices fluctuate. Answer: According to theory of efficient markets, asset prices are based exclusively on fundamentals. In this view, any fluctuation in a stock price is attributed to a rational appraisal of new information about the profitability of the company, not a tendency for investors to let their emotions get in the way. On the other hand, another view has been gaining traction in recent decades. Asset bubbles occur when asset prices deviate from their fundamental value. This can occur due to a herd effect, limited investor rationality, or other psychological factors or biases. Bubbles are also likely to be followed by a market crash. This can be another source of fluctuations in asset prices. Based on: https://www.philadelphiafed.org/-/media/frbp/assets/economy/articles/businessreview/1996/january-february/brjf96lo.pdf

Chapter 25

The Monetary System Questions 1. List and explain the three functions of money in a modern economy. Answer: Money is used to conduct market transactions in a modern economy. Money is what people usually use to make and receive payments when buying and selling goods and services. Specifically, money serves three functions: ●

Money is a medium of exchange. Money is the most common medium of exchange. The use of money allows for a convenient, universally acceptable way of buying and selling goods.

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Money is a store of value. A store of value is an asset that enables people to transfer purchasing power into the future. Money that is received today will be accepted as a form of payment even a decade from now.

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Money is a unit of account. Money is a universal yardstick that is used for expressing the worth (price) of different goods and services. The cost of a good is measured by the number of dollars it takes to buy the good.

2. How does fiat money differ from commodities like gold and silver that have been used as money? Answer: Fiat money is intrinsically worthless but is used as legal tender by government decree. Whereas gold and silver have intrinsic value, fiat or paper money is valuable only because other people will accept it as money. 3. How is the M2 money supply defined? Does the definition of M2 include currency in bank vaults? Does the definition of M2 include reserves on deposit at the Fed? Explain why it is important to be able to measure inflation when calculating real GDP. Answer: The money supply or M2 adds together currency in circulation, checking accounts, travelers’ checks, savings accounts, and money market accounts. M2 does not include currency in bank vaults nor reserves on deposit at the Fed because these assets are not in circulation but have been set aside to meet regulatory requirements. When measured correctly, the growth of an economy is a starting point of measuring wellbeing. Inflation distorts the measurement of growth by conflating the growth of GDP with the devaluation of money. To resolve this problem, economist separate the growth of nominal GDP and real GDP by subtracting the growth rate of prices (inflation rate) from the growth of nominal GDP. 4. Recall the discussion in the chapter about the “quantity theory of money.” a. Explain the quantity theory of money. b. Explain how the predictions of the quantity theory of money are borne out by historical data. Answer:

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a. The quantity theory of money assumes that the ratio of money supply to nominal GDP is constant. This implies that, if money supply grows by 10 percent, then nominal GDP also needs to grow by 10 percent to keep the ratio of money supply divided by nominal GDP constant. It follows that the growth rate of money supply and the growth rate of nominal GDP will be the same. Growth Rate of Money Supply = Growth Rate of Nominal GDP Substituting the growth rate of money supply for the growth rate of nominal GDP, we find that: Growth Rate of Money Supply = Inflation Rate + Growth Rate of Real GDP Rearranging this equation, Rate= Growth Rate of Money Supply – Growth Rate of Real GDP So, according to the quantity theory of money, inflation is equal to the gap between the growth rate of the money supply and the growth rate of real GDP. When this gap widens, the inflation rate increases. b. Exhibit 25.2 in the text examines data on inflation and the value of the growth rate of money supply minus the growth rate of real GDP from 110 countries over the period 1960–1990. The exhibit shows that a 45-degree line passes through the inflation rate and the value of the growth rate of money supply minus the growth rate of real GDP. The quantity theory of money predicts that inflation should rise one-for-one with the growth rate of money supply minus the growth rate of real GDP. The fact that the data points lie approximately along a 45-degree line with a slope of one confirms the key long-run prediction generated by the quantity theory of money. 5. What are the differences among inflation, deflation, and hyperinflation? Answer: Inflation refers to an increase in an economy’s overall price level, whereas deflation is a decrease of an economy’s overall price level. Hyperinflation refers to a level of inflation so high that a country’s price level doubles within three years. 6. What is the most common cause of hyperinflation? Answer: Hyperinflation is always related to extremely rapid growth of the money supply. In almost all cases, such extreme monetary growth is brought about by large government budget deficits. If a government’s tax revenues fall short of its expenditures, it meets its obligations by borrowing more from the public or printing money. Printing more money and using it to buy goods and services increases the money supply in the economy, leading to rapid increases in the price level. 7. What are the costs associated with inflation? Answer: Inflation imposes the following types of costs on consumers and firms. ●

High rates of inflation create logistical costs: Even moderate rates of inflation will necessitate multiple changes to price lists, price tags, and so on over the course of the year. The costs associated with such changes are referred to as “menu costs.”

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Higher inflation distorts relative prices, reducing economic efficiency: As a consequence of volatile inflation, firms may adjust their prices differently, causing relative prices to fall out of alignment. Distortion of relative prices leads to economic inefficiencies.

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Inflation often leads to counterproductive policies like price controls: High rates of inflation are a politically sensitive issue, which may prompt governments to enact economically destructive policies such as price controls. As discussed in earlier chapters, price controls can result in supply disruptions, long lines, and expansion of the underground economy.

8. Does inflation have any benefits? Explain. Answer: Yes, inflation does have certain benefits. ●

Government revenue is generated when the government prints money. The government revenue that is obtained from money creation is called seignorage which is the difference between the cost of printing paper money and the value of the goods and services that the government can purchase with the newly printed money.

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Inflation can sometimes stimulate economic activity. If inflation increases when the nominal wage is fixed, a worker’s real wage falls. This increases firms’ willingness to hire more workers. Inflation may therefore give the government a way to stimulate the economy temporarily, which is a useful policy lever during economic slowdowns. In addition, inflation lowers the real interest rate, which increases consumption and investment.

9. What is the federal funds rate? What are the factors that would shift the demand curve for reserves? Answer: The federal funds rate is the interest rate in the federal funds market where banks borrow and lend reserves to one another. The loans are typically from one morning to the next explaining their name of overnight loans. The funds that are lent in this market are reserves at the Federal Reserve Bank. The demand curve for reserves plots the net quantity of reserves held by private banks. Because the demand curve relates the quantity of reserves demanded by private banks for each level of the federal funds rate, if some factor other than the federal funds rate changes, the entire demand curve shifts. There are five such factors that can shift the curve: ●

An economic expansion or contraction: The value of reserves will rise in a booming economy because banks will need to make more loans to their customers. This will shift the demand curve to the right. Similarly, in a contracting economy, the demand curve will shift to the left.

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Changing liquidity needs: If the deposit base is expected to fall very quickly in the near future, for example due to a substantial increase in withdrawals, this will increase the demand for reserves and shift the demand curve to the right.

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Changing deposit base: A bank in the United States needs to hold 10 percent of its deposits as reserves. So as deposits increase, the demand curve for reserves will shift to the right. Similarly, as the deposit base shrinks, the demand curve for reserves will shift to the left.

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Changing reserve requirement: In the rare event that the Fed raises the reserve requirement, demand for reserves would increase, and the demand curve for reserves would shift to the right. Conversely, if the Fed lowered the reserve requirement, the demand curve for reserves would shift to the left.

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Changing interest rate paid by the Fed for having reserves on deposit at the Fed: A change in the modest interest rate that the Fed pays banks on reserves held at the Fed (interest on reserves or IOR) could change the demand for reserves. For example, if the Fed raises this rate, reserves become more beneficial to private banks, shifting the demand curve for reserves to the right. If the Fed lowers this rate, reserves become less valuable, shifting the demand curve for reserves to the left.

10. What is an open market operation? Why does the Federal Reserve conduct open market operations?

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Answer: An open market operation is an exchange between a private bank and the Federal Reserve. The Fed buys or sells government bonds to private banks in exchange for reserves held by those private banks at the Fed. The Fed uses open market operations when it wants to influence the federal funds rate. Banks need to give the Fed assets in exchange for the reserves held at the Fed. These assets are usually government bonds. When the Fed offers to buy government bonds from private banks, it gives banks more electronic reserves. Similarly, when the Fed sells government bonds to private banks, it reduces the level of electronic reserves that banks hold. Suppose the Fed wants to obtain a particular value for the federal funds rate. It first chooses the federal funds rate and then finds that point on the demand curve that corresponds to that federal funds rate. The Fed makes available the exact level of reserves associated with that point on the demand curve. 11. What is interest on reserves (IOR)? Does a change in interest on reserves affect the demand curve for reserves or the supply curve for reserves? Answer: Interest on reserves is the rate paid by the Fed to banks for having reserves on deposit with the Fed. When the Fed increases the IOR, the demand curve for reserves shifts to the right, and when it decreases, the curve shifts to the left. 12. How does a change in interest on reserves (IOR) effect equilibrium in the federal funds market, including the federal funds rate? Answer: As depicted in Exhibit 25.5, when the Fed increases IOR, the demand for reserves shifts to the right and the equilibrium federal funds rate increases. When the Fed decreases IOR, the demand shifts to the left and the equilibrium rate decreases. 13. Why is the Federal Reserve referred to as the “lender of last resort”? Answer: Banks usually meet their liquidity needs by borrowing from each other in the federal funds market. Every morning, the banks assess their liquidity needs for the coming business day and borrow or lend accordingly. During extraordinary times, say during a financial crisis, the federal funds market can “freeze” or break down. Banks with excess reserves may be unwilling to lend out these reserves. When this happens, banks can borrow from the Federal Reserve instead. Banks borrow reserves from the Fed at the “discount window.” Since borrowing from the Fed is more costly than borrowing on the federal funds market, it is a bank’s last resort for borrowing reserves. 14. How does the Federal Reserve influence the long-term real interest rate? Answer: The long-term real interest rate is defined as the long-term nominal interest rate minus the longterm inflation rate. The Fed influences the long-term nominal interest rate through the short-term federal funds rate. A longterm loan is effectively made up of many short-term loans. The nominal interest rate for the long-term loan can be seen as the average of these short-term loans. Because several of the short-term loans are affected by a change in the federal funds rate, the long-term nominal rate moves in the same direction. The long-term expected inflation rate depends on the effect of monetary policy on inflationary expectations. If the inflation expectations don’t change and nominal interest rates fall, then the expected real interest rate falls. Therefore, a fall in the federal funds rate lowers the long-term nominal interest rate and lowers

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the expected long-term real interest rate. Even when inflation expectations do change, the long-term expected real interest rate often falls in response to a reduction in the federal funds rate. 15. What are the two models that are used to describe inflationary expectations? Answer: Adaptive expectations and rational expectations are the two models that are used to describe inflationary expectations. The adaptive expectations model assumes that inflationary expectations are determined by the level of inflation in the recent past. Adaptive expectations are a backward-looking way of describing how inflationary expectations are formed. The rational expectations approach, on the other hand, assumes that people have inflation expectations that incorporate all of the information that is available when the inflation expectations are being formed and use that information in the most sophisticated way possible. If agents have rational expectations, they are masterful forecasters who make the best possible forecast using a sophisticated understanding of the workings of the economy.

Problems 1. Barter is a method of exchange whereby goods or services are traded directly for other goods or services without the use of money or any other medium of exchange. a. Due to the economic collapse of the Lebanese economy in 2020, many Facebook pages and Instagram accounts are being set up as platforms for barter. The posts usually follow the format of someone putting product A for barter against a desired product B. You notice that these requests remain unanswered for a long time even though products A and B are neither unique nor hard to find. Why do you think it is the case? b. Suggest a way to avoid the problem you discussed above. Answer: a. Many people might want product A, but they might not have product B to exchange for it. Many people might also want to give away product B but not in exchange for product A. It might take a while to find someone who has product B and wants product A, making barter difficult. b. One possible way to simplify transactions is for the admins of the page to take it upon themselves to create “barter credit” that could act as a currency. If you offer product A for barter, instead of giving you product B, the buyer would give you barter credit. You’d then be able to use the barter credits to buy product B. 2. Money makes a variety of economic transactions possible. In the following three situations, determine whether money is involved in the transaction. a. On the island of Yap, exchanges were made by using large circular stone discs carved out of

limestone. Since these stones were too large to move, when an exchange occurred, a stone stayed in its place but its ownership would change. Can these stone discs be termed as money? b. In recent years it has become increasingly common to pay with your smartphone. Is your smartphone money? Explain your reasoning. c. In food courts at several malls, it is quite common to use coupons instead of money. This means that you exchange your currency notes for coupons and use them to purchase meals. Can such coupons be considered money? Answer:

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a. The three key functions of money are medium of exchange, store of value, and unit of account. Even though these stone discs were large, you could use them for exchange. The ownership of these discs was recorded in oral history, thus fulfilling the first and third components of the exchange. The discs also possessed inner value as they were made from limestone that was apparently difficult to access on the island of Yap. b. Smartphones are not money. They are a vehicle of transfer. Your smartphone is connected to an online account (typically your credit or debit card). If it is connected to your debit card, when you pay, you are directly transferring money from your bank account to the seller’s account. However, when you are using your credit card, you are borrowing from your bank to pay the seller and will have to repay this debt later. Thus, when you settle your debt, you will be transferring money. c. Yes, in a food court, coupons do constitute real money. They are transferrable between consumers and are not false. However, these can only be exchanged for real money within the confines of the food court within that specific mall, so a consumer cannot buy goods or services using the coupons outside the food court. 3. In some parts of the world, salt—the stuff sitting on your kitchen table—was once used as currency. In ancient Ethiopia, for example, blocks of salt were used to purchase goods and pay salaries. The value of the salt block was based on weight, and it was physically transferred as part of the transaction. In part, salt was valuable because of its scarcity and its usefulness: before the introduction of refrigeration, many civilizations used salt to preserve food. a. Discuss how salt did or did not fulfill the three roles of currency. b. Suppose several new salt mines opened in ancient Ethiopia. How would you expect the rapid infusion of currency into society to affect the economy? Explain. c. How might the use of salt as a commodity affect the value of salt as money? As an example, would you need more or less salt to buy a pound of meat? Answer: a. As the problem describes it, salt was a medium of exchange. However, it’s not clear to what degree it was a store of value or a unit of account. Since it could be used and, thus, depleted, the student could argue that it did not store a fixed amount of value. In addition, we don’t know whether it really served as a unit of account; if it was primarily a valuable commodity that everyone wanted, then it was, perhaps, the centerpiece of a barter-based system rather than a true currency. b. If we viewed this as a traditional currency, then we could characterize the opening of new mines as a potential source of hyper-inflation; the value of a given amount of salt would weaken, leading to rising “prices” in salt. Given the context, however, the opening of new mines could make salt useless as a currency—given a new abundance of salt, it may lose almost all of its value in a barter-based system. Either way, the value of salt would be severely weakened—leading, likely, to its abandonment as a currency. c. Consumption of salt reduces the supply of salt as money, increasing its value. This implies that you would need less salt to buy a pound of meat. 4. Bitcoins are defined as a “peer-to-peer decentralized digital currency.” The supply of bitcoins is not controlled by the government or any other central agency. The value of each bitcoin is determined on the basis of supply and demand and is defined in terms of dollars. New bitcoins can be generated

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through a process called “mining.” However, new bitcoins will not be created once there are a total of 21 million bitcoins in existence. Some commentators feel that bitcoins can eventually replace most of the major currencies in the world. Would you agree? Explain your answer. Answer: The bitcoin in its present form is not likely to replace any of the major currencies of the world. Bitcoin deposits, unlike bank deposits, are not insured by the government. Also, the value of a bitcoin is highly volatile, so bitcoins may not serve as a reliable store of value. Source: http://bitcoin.org/en/ and http://www.livemint.com/Opinion/fEXo8r2OcAIZHWOMbZmmfO/Investors-beware-of-Bitcoin.html 5. Imagine that the central bank of the island economy you live in announced this morning that every denomination of the currency in circulation would be worth half of what it was yesterday. For example, a 20 Tutu bill would be worth 10 Tutus, the balances in all checking and savings accounts are to be halved, and so forth. Islanders panic as they think they became two times as poorer as they were yesterday, they are planning for the revolution to topple the system. Would you actually be two times poorer on the day the announcement took effect? Why or why not? Answer: You should not join the public panic because you know that eventually prices on the island will be halved or almost halved. Money’s ultimate value is the goods and services for which it can be exchanged. If prices will get eventually halved, the money’s value is approximately the same as before the announcement. However, this does not mean that all people will be unaffected by the change. If the prices of some of the goods people buy cannot decrease in response to the announcement, then they are poorer, and the seller of the goods is definitely richer. This would be especially true regarding some loan arrangements. For example, if you owe someone 20,000 Tutus as per a written contract, this amount cannot change in response to the central bank’s announcement, so the lender is richer, while the borrower is poorer. However, the prices of a majority of goods and services will be halved quickly, and eventually, the prices of all goods and services will also be halved. There is no need for citizens to panic about this announcement. 6. According to the BBC, inflation in the country of Zimbabwe reached an annualized rate of 231,000,000 percent in October 2008. Prices got so high that in January 2009, the country’s central bank—the Reserve Bank of Zimbabwe—introduced a $100 trillion bill. (Sources: http://news.bbc.co.uk/2/hi/africa/7660569.stm; http://news.bbc.co.uk/2/hi/africa/7832601.stm) Read the summary of Zimbabwe’s experience with hyperinflation in Wikipedia (http://en.wikipedia.org/wiki/Hyperinflation_in_Zimbabwe). How does the history of hyperinflation in the country illustrate the points made in the chapter regarding the root causes, costs, and benefits of inflation? What were some of the adaptations that citizens of the country used to cope with the situation? We learned that the collapse of the German economy set the stage for the ascent of the Nazi Party. Hyperinflations also occurred in the Confederacy, the end of the Chinese Civil War prior to communist rule, and other periods of social unrest. Using your knowledge of the creation of money to determine if the hyperinflation itself is a cause of turmoil, or if the hyperinflation, like the turmoil, is the result of some other challenge faced by the government. Explain how you reached your conclusion. Answer: The chapter stresses that, in accordance with the quantity theory of money, the root cause of inflation is a rate of increase in the money supply that exceeds the rate of growth of real GDP. This was certainly the case in Zimbabwe. According to the article, Zimbabwe was printing money aggressively in order to fund its involvement in foreign wars, as well as to pay higher salaries to military and political officials.

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Costs to the Zimbabwe economy were also in line with those detailed in the chapter. Businesses faced such severe logistical problems and uncertainty that many ceased to function. People were forced to spend significant time and effort simply to carry out routine errands. Basically, the country’s economy faced such chaos that it simply collapsed. Also mentioned in the chapter are the undesirable political consequences that can follow from inflation, as the government introduces counterproductive policies to cope with the situation. These reached an extreme in Zimbabwe, where the government introduced higher and higher denomination banknotes, stifled political opponents, and tried to declare price increases “illegal,” the ultimate form of price controls! The only beneficiary of Zimbabwe’s hyperinflation (temporarily, at least) was the government of dictator Robert Mugabe, which did reap the seignorage mentioned in the chapter. Wikipedia mentions several of the adaptations that evolved to meet the crisis: initially, redenomination of the currency; later, the use of foreign currencies—especially the U.S. dollar; and the flourishing of an underground economy in U.S. dollars. In the cases of Zimbabwe, the Weimar Republic, the American Confederacy, and the Chinese Civil War, the hyperinflations were caused by war or its aftermath. Each country printed money to pay its financial obligations. Using the vocabulary learned in chapter 8, printing money was the proximate cause of the hyperinflation, but the financial consequences of war were the fundamental causes. 7. The following table shows the cost of producing dollar notes of various denominations. As you can see in the table, it costs only 15.5 cents to produce a $100 bill. Suppose the government decides that it will print new notes to fund its fiscal deficit as well as all its ongoing expenditures. What would be the effects of such a policy? Note Denomination

Cost of Production

$1 and $2

5.4 cents per note

11.5 cents per note

$10

10.9 cents per note

$20

12.2 cents per note 19.4 cents per note

$50 $100

15.5 cents per note

Answer: Printing paper money has small direct cost to the Bureau of Engraving and Printing and gives the government money to spend. But printing too much money can backfire. If a currency has a very high rate of inflation, nobody will want to hold it, not even the country’s own citizens. People will start to switch to other less inflationary currencies. Consequently, printing too much money will cause a currency to lose value sharply. However, there may a lag between when a government prints and spends the money, and when inflation becomes a serious problem. So initially at least, government benefits, but eventually, everyone, including the government, won’t be able to get many goods and services in exchange for the newly printed currency. Data taken from: http://www.federalreserve.gov/faqs/currency_12771.htm

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8. On March 15, 2020, the Federal Reserve Board held an emergency meeting in response to the large economic contraction caused by the coronavirus pandemic. After the meeting, the Fed released a press statement that included this paragraph: “Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The effects of the coronavirus will weigh on economic activity in the near term and pose risks to the economic outlook. In light of these developments, the Committee decided to lower the target range for the federal funds rate to 0 to 1/4 percent. The Committee expects to maintain this target range until it is confident that the economy has weathered recent events and is on track to achieve its maximum employment and price stability goals.” This action will help support economic activity, strong labor market conditions, and inflation returning to the Committee’s symmetric 2 percent objective.

a. What is the Federal Reserve’s statutory mandate, and how is it reflected in this statement? b. What decision did the committee reach in this meeting? c. The committee used open market operations and a change in interest on reserves (IOR) to lower the target range of the federal funds rate from 1 to 1.25 percent to 0 to .25 percent. What kind of open market operations would lower the target range of federal funds rate in the desired direction? d. Ultimately, how would you expect this change in the federal funds rate to affect the long-term real interest rate, employment, and the money supply? Walk through the steps, as in Exhibit 25.11. Answers: a. The Federal Reserve has the dual statutory mandate of maintaining low inflation and maximum employment. The statement begins by repeating the mandate, “Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.” The committee ends the first paragraph of its press release reiterating the mandate, “The Committee…is confident that the economy…is on track to achieve its maximum employment and price stability goals.” b. The committee decided to lower the target range of the federal funds rate range from 1 to 1.25 percent to 0 to .25 percent. c. In order to lower the federal funds rate using open market operations, the fed must increase the supply of reserves by buying bonds from private banks. This increases the supply from S1 to S2 and reduces the interest rate from r1 to r2 as seen in the following graph. In return, they give up some of their investments in bonds. The following chart shows the resulting shift in the supply of reserves and increase in the federal funds rate.

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d. First, the Fed uses open market operations (in this case, buying bonds) to increase the supply of reserves and lower the federal funds rate. This causes a decrease in the federal funds rate (S2,r2). Now, it costs banks less to borrow money, leading them to offer their loans at lower interest rates. Thus, the long-term nominal interest rate decreases because it’s effectively made up of shorterterm loans. Assuming long-term expected inflation remains the same, we’ll also see a decrease in the long-term real interest rate. This decrease in borrowing costs will fuel investment, leading to an increase in the growth rate of employment. In addition, the lower interest rates will increase loan origination, increase the growth rate of deposits and thus, ultimately, lead to an increase in the growth rate of the money supply. 9. From 2001 to 2006, Japan’s central bank, the Bank of Japan (BOJ), engaged in a monetary policy program called quantitative easing. The BOJ increased the quantity of reserves that commercial banks held with the central bank by buying assets from these commercial banks. Use a graph to show how this policy is likely to have affected the overnight call rate. The overnight call rate in Japan is similar to the federal funds rate in the United States. Answer: The federal funds rate is a short-term nominal interest rate at which banks lend to each other in the federal funds market. The overnight call rate is Japan’s federal funds rate. When the BOJ increases the level of reserves held at commercial banks, it buys assets like government bonds from these banks. In turn, it gives private banks electronic reserves. This shifts the supply curve for reserves from S1 to S2. Assuming that the demand for reserves remains the same, the overnight call rate will fall from R1 to R2. Through its quantitative easing program, the BOJ had intended to lower the overnight call rate to close to 0 percent.

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10. Till the late nineteenth century, it was common for gold and silver coins to be used as a medium of exchange. When it required money, governments would often mint more coins and replace some quantities of the gold or silver with iron. What would be the effect of such a policy? Answer: Eventually, this would lead to inflation. People would soon find out that the amount of gold in each coin was lesser than it used to be, and therefore prices would increase proportionately. However, by that time, typically, the government that required the money would have already used those funds to purchase the goods it needed. If a government did this too often, people would become less trusting of the coins in circulation and may resort to purchasing/acquiring gold coins minted by a country where the coins are more stable. 11. As the U.S. economy recovers from the effects of the coronavirus recession, it is anticipated that the Fed will raise the federal funds rate. Suppose the current federal funds rate is 0 percent and that this rate is expected to prevail for 2 years. Then the expectation is that the Fed will raise the federal funds rate by 0.5 percentage points each year thereafter. What will be the 10-year nominal interest rate as a result of these expectations? Explain and show your work. Answer: Recall from the chapter that a long-term nominal interest rate can be thought of as the average of the one-year interest rates, which are expected to prevail over a given long-run period. In this question, the short-term (one-year) rates are as follows: Year

Rate

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

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Calculating the 10-year average using these numbers, we get the 10-year nominal rate: 0.0% + 0.0% + 1.5% + 1.0% + 1.5% + 2.0% + 2.5% + 3.0% + 3.5% + 4.0% = 1.8% 10 Hence, even though the current short-term nominal rate is only 0.0 percent, the expectation of higher short-term rates to come will result in a higher long-term nominal rate. 12. The chapter discusses different models of how people form their expectations regarding inflation. Consider the following two investors, who are trying to forecast what inflation will be for next year. Sean reasons as follows: “Inflation was 2 percent last year. Therefore, I think it is likely to be 2 percent this year.” In contrast, River thinks this way: “The economy has recovered from recession sufficiently that inflationary pressures are likely to build. Likewise, a weaker dollar means that imports are going to be more expensive. I don’t think the Fed will risk slowing the recovery and raising unemployment by raising interest rates to fight inflation. So, in light of all these factors, I expect inflation to increase to 3 percent this year.” Using the terminology mentioned in the chapter, explain how you would best describe how each investor is forming his expectations of inflation. Which description better fits your own forecasts of inflation? Answer: Sean is typical of those who formulate their forecasts using adaptive expectations. This involves using past patterns or trends to project what is likely to happen in the future. Carlos, however, is forming his opinion based on what economists call rational expectations. In this approach, expectations are formed not just based on the past, but on all information available at the time. This implies that investors consider such things as the state of the macroeconomy as a whole, various monetary policies, the behavior of exchange rates, etc. when forming their expectations. Adaptive expectations are necessarily backward looking. They assume that the past is the best guide to the future. Economic history is replete with examples where this has not been the case. Dramatic unexpected events can occur, past trends abruptly reverse, and patterns that have been reliable guides in the past can suddenly disappear. All of this makes adaptive expectations a problematic way to formulate forecasts. Rational expectations, on the other hand, require a level of rationality and objectivity that few people can actually achieve. Moreover, the sheer volume of information involved and the degree of sophistication necessary to understand and process that information are beyond the ability of most people. Of course, student answers to the last part of the question will vary.

Chapter 26

Economic Fluctuations Questions 1. What are economic fluctuations? What is the difference between an economic expansion and a recession? Answer: Short-run changes in the growth of GDP are referred to as economic fluctuations or business cycles. Recessions are periods in which the economy contracts, while economic expansions are defined as the periods between recessions, characterized by positive growth in GDP. Accordingly, an economic expansion begins at the end of one recession and continues until the start of the next recession. In the United States, recessions are informally defined as two consecutive quarters of negative growth in real GDP. (The term depression is used for a prolonged recession that features unemployment in excess of 20 percent of the labor force.) 2. What does it mean to say that an economic fluctuation involves the co-movement of many aggregate macroeconomic variables? Name four variables that exhibit co-movement during an economic expansion. Answer: Co-movement of aggregate macroeconomic variables implies that these variables grow or contract together during booms and recessions. Employment and GDP move together with consumption and investment, while unemployment varies inversely with GDP. Thus, during an expansion, consumption, investment, employment and GDP all rise, while unemployment falls. 3. Does the Great Depression illustrate the three characteristics of economic fluctuations? Explain your answer.

Answer: The Great Depression does illustrate the three key properties of economic fluctuations. • • •

It featured strong co-movement in economic aggregates. Exhibit 26.5 in the chapter shows that real GDP, real consumption, and real investment started to fall in 1929 and bottomed out in 1932 and 1933. Simultaneously, unemployment moved in the opposite direction. It featured limited predictability. The Great Depression came as a surprise to leading economists, policymakers, and business leaders, none of whom foresaw this event. It featured a great deal of persistence. The period of negative growth in real GDP lasted for four years, starting in 1929 and ending in 1933.

4. How do wage flexibility and downward wage rigidity affect the extent of unemployment in the economy when the demand for labor shifts to the left? Answer: Suppose the labor demand curve shifts to the left when wages are flexible. A new equilibrium will be established at a lower wage (assuming a downward-sloping labor demand curve). Although the level of employment will have declined, everyone who wants to work at the new, lower wage will be able to find a job, so there is no unemployment. However, if wages are downwardly rigid, a shift to the left of the labor demand curve has an amplified effect, as shown in Exhibit 26.6(c) in the chapter. The overall level of employment declines more than if wages had been able to adjust. Moreover, the quantity of labor supplied at the rigid wage is now higher than the quantity of labor demanded. Hence, there is now unemployment. 5. How does real business cycle theory explain economic fluctuations?

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Answer: Real business cycle theory emphasizes the effect of changing productivity and technology on economic fluctuations. Certain types of technological improvements can lead to increases in investment and consumption. Although technological regress seems an unlikely explanation for recessions, the rate of technological progress is believed to play a key role in long-run variation in economic growth. Real business cycle theory also emphasizes the importance of changing input prices—especially the price of oil. Because oil price changes can be abrupt, this factor does help to explain recessions. 6. How did John Maynard Keynes use the concepts of animal spirits and sentiments to explain economic fluctuations? Answer: Animal spirits are what Keynes called the psychological factors that lead to changes in the mood of consumers or businesses and affect consumption, investment, and GDP. Animal spirits represent the overall level of optimism or pessimism in the economy and affect expectations of how future events will play out. For example, suppose firms are pessimistic about the future and cut back employment and investment. Households will face a heightened risk of losing their jobs because of the fall in investment and are likely to decrease their consumption and save for a rainy day. This translates into a decline in the current demand for the products of many firms, shifting the labor demand curve at those firms to the left, thereby reducing production and employment. Animal spirits are an example of changing sentiments, which include changes in expectations and changes in the (real or perceived) uncertainty facing firms and households. Changes in sentiments lead to changes in household consumption and firm investment, which affect aggregate expenditure and output. 7. The concept of multipliers was one of the key elements of John Maynard Keynes’s theory of fluctuations. What is a multiplier? Explain with an example. Answer: The working of a multiplier magnifies a modest negative or positive shock to the economy and generates a cascade of follow-on effects that ultimately causes a larger contraction or expansion, respectively. Multipliers are the economic mechanisms that cause an initial shock to be amplified by follow-on effects. For example, suppose a drop in consumer confidence reduces households’ willingness to spend. Firms will cut back production and lay off employees. Those newly unemployed workers will be unable to buy goods and services, leading firms that previously sold goods to these consumers to scale back production even more. Such cascades of effects will amplify the impact of the initial shock. 8. How can contractionary monetary policy lead to an economy-wide recession? Why do policymakers generally prefer to target low levels of inflation (e.g., 2%) rather than zero inflation? Answer: Contractionary monetary policy causes the money supply to fall. A decline in the money supply causes the price level to fall. Wages will be downwardly rigid because firms typically avoid cutting wages to prevent morale problems at work. So when the aggregate price level falls, firms will cut their output prices but won’t cut the wages that they pay their workers. Firms will reduce employment, as the fall in their output prices causes their labor demand curve to shift to the left. Contractionary monetary policy also causes the real interest rate to rise. This increases production costs for firms and also causes a leftward shift in the demand for labor, lowering the quantity of labor hired at the downward rigid wage. These effects put together cause a fall in employment and GDP, leading to a recession.

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Low levels of inflation can create fluidity in labor markets decreasing downward rigidity of wages. Inflation can cause real wages to fall even if nominal wages are fixed by reducing the purchasing power of the real wage (the ratio of the nominal wage to a price index is falling), but an equally important change is happening to the demand for labor. Because nominal output prices are rising while nominal wages are fixed, the ratio of nominal profits to a price index is rising, pushing the labor demand to the right. If an economy is operating on the horizontal portion of its labor supply curve as in Exhibit 26.2, the low level of inflation pushes the labor demand curve close to the vertical portion of the labor supply, increasing the equilibrium quantity of labor hired up. If low levels of inflation keep the equilibrium in the labor market on the vertical portion of the labor supply curve, labor markets remain fluid and inflation at a manageable level. 9. What are two important mechanisms that reverse the effects of a recession in a modern economy? Answer: In the medium run, two factors tend to reverse the effects of a recession. •

The labor demand curve shifts back to the right.

This can happen for several reasons: Excess inventory has been sold off in the course of the recession; technological advances create new business opportunities that enable firms to expand their activities; or the banking system and other financial intermediaries recuperate, increasing the credit available to finance expanded business operations. •

Government pursues expansionary monetary and fiscal policies to stimulate the economy.

Expansionary monetary policy can be used to lower interest rates, stimulating both consumption and investment. Likewise, government spending can be increased, or taxes reduced, as part of expansionary fiscal policy. The inflationary pressures that can result from either of these policies serve to raise the prices for firms’ products, thus making their operations more profitable at a given wage. This also acts as a stimulus to increased employment.

Problems 1. Consider the data in Exhibit 26.3. a. List the recessions since 1929 by duration, with the longest recession first and the shortest last. b. List the recessions since 1929 according to decline in real GDP from peak to trough, with the greatest decline first and the smallest decline last. Note which recessions are first and second on your list from part (a) and first and third on your list from part (b). Can you think of a reason why the fall in real GDP at the end of World War II (1945; second recession on your list from part (b)) was so deep even though that recession was very short? Answer: a. Starting Month

Ending Month

Duration

Decline in Real GDP

August 1929

March 1933

43 Months

26.7%

December 2007

June 2009

18 Months

4.3%

November 1973

March 1975

16 Months

3.1%

July 1981

November 1982

16 Months

2.5%

May 1937

June 1938

13 Months

3.3%

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November 1948

October 1949

11 Months

1.5%

December 1969

November 1970

11 Months

0.2%

July 1953

May 1954

10 Months

1.9%

April 1960

February 1961

10 Months

0.3%

February 1945

October 1945

8 Months

12.7%

August 1957

April 1958

8 Months

3.0%

July 1990

March 1991

8 Months

1.3%

March 2001

November 2001

8 Months

0.3%

January 1980

July 1980

6 Months

2.2%

Starting Month

Ending Month

Duration

Decline in Real GDP

August 1929

March 1933

43 Months

26.3%

February 1945

October 1945

8 Months

12.7%

December 2007

June 2009

18 Months

4.3%

May 1937

June 1938

13 Months

3.3%

November 1973

March 1975

16 Months

3.1%

August 1957

April 1958

8 Months

3.0%

July 1981

November 1982

16 Months

2.5%

January 1980

July 1980

6 Months

2.2%

July 1953

May 1954

10 Months

1.9%

November 1948

October 1949

11 Months

1.5%

July 1990

March 1991

8 Months

1.3%

April 1960

February 1961

10 Months

0.3%

March 2001

November 2001

8 Months

0.3%

December 1969

November 1970

11 Months

0.2%

321

After almost every war, there is usually a sharp recession. This was especially true of World War II. During the conflict, production went into overdrive. Workers worked double shifts, and factories sometimes stayed busy 24 hours a day. With the end of the war, however, the surge of output abruptly diminished. There was no longer demand for war materiel, and the government spending that paid for it quickly dried up. The economy eventually transitions to normal, peacetime production, but that takes a bit of time. In the interim, there can be a deep, if brief, recession, as output and employment drop. Although the United States economy entered a recession in February 2020, as shown in Exhibit 26.3, data on its length and depth are not yet available. 2. Go to the Trading Economics website and view the unemployment rate section. Click on the max button, and a graph will show the unemployment rate in the European Union (EU) since 2000. To check GDP growth rates, select GDP from the column on the right-hand side.

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a. Does the behavior of the unemployment rate illustrate the principle of co-movement discussed in the chapter? Why or why not? b. Economic variables are sometimes divided into “leading indicators” and “lagging indicators.” Leading indicators are variables that start to change before an economic expansion or contraction. Lagging indicators change only when an expansion or contraction is well underway. Based on the graph of the unemployment rate, is unemployment a leading or lagging indicator of recessions? Explain. Answer: a. When unemployment declines, the disposable income of people increases; people spend more, which in turn can cause inflation. b. The unemployment rate is typically a “lagging indicator.” If you look closely at the graph, unemployment only begins to increase after a recession is underway. Moreover, in the last few recessions, unemployment has tended to keep rising after the official end of the recession, peaking after the recovery in real GDP has already begun. This is typical of a “lagging” economic indicator. Furthermore, unemployment will increase if the growth prospects within an economy decline. Business owners may feel a need to lay off workers to stay competitive. 3. The Conference Board publishes data on Business Cycle Indicators (BCI). The Composite Index of Leading Economic Indicators is one of the three components of the BCI. Changes in leading economic indicators usually precede changes in GDP. Some of the variables tracked by the index are listed below. i.

The average weekly hours worked by manufacturing workers

ii. The average number of initial applications for unemployment insurance iii. The amount of new orders for capital goods unrelated to defense iv. The number of new building permits for residential buildings v. The S&P 500 stock index vi. Consumer sentiment Consider each variable and explain whether it is likely to be positively or negatively correlated with real GDP. Answer: All of the variables that are listed are likely to be positively correlated with GDP except the average number of initial applications for unemployment insurance. i.

The average weekly hours worked by manufacturing workers depends on the quantity of goods that are being manufactured. This is likely to be low in a recession and high during a boom or expansion, when output is high. ii. Unemployment is negatively correlated with real GDP. Unemployment falls when GDP rises, and unemployment rises when GDP falls. The number of applications for unemployment insurance will rise when unemployment rises. Therefore, the average number of initial applications for unemployment insurance is negatively correlated with real GDP. iii. An increase in the amount of orders for capital goods unrelated to defense indicates an increase in investment and is usually undertaken when firms are optimistic about future demand for the goods and services that they produce. As real GDP rises, firms will increase capital investment in anticipation of future sales and revenue. Defense is excluded from this indicator as defense orders are usually undertaken by the government irrespective of changes in real GDP.

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iv. Firms that construct residential buildings are likely to request new building permits when they expect demand for housing to be strong. The demand for housing is usually strong in a growing economy in which increasing incomes allow consumers to invest in residential housing. Therefore, this variable moves positively with real GDP. v. Stock prices tend to move positively with other measures of economic activity. Therefore, the S&P 500 stock index is also likely to be positively correlated with real GDP. vi. Consumer sentiment is likely to be positively correlated with real GDP. When real GDP and incomes are rising, consumers are optimistic about the prospects of the economy. Data on BCI taken from: http://www.investopedia.com/university/conferenceboard/conferenceboard2.asp 4. Suppose that the mythical country Moricana has a downward rigid wage. Moricana is in a recession; capacity utilization in the economy is at an all-time low, and surveys show that firms do not expect economic conditions to improve in the coming year. a. Firms in the country are cutting back on capital spending and investment. Use a graph to show how this would affect the labor demand curve (ignore the effects of multipliers). b. Is unemployment in Moricana likely to be classified as voluntary or involuntary? Explain your answer. Answer: a. Given the information in the question, wages in Moricana are likely to be rigid. When firms cut back on capital spending and investment, the demand for labor will fall. This shifts the labor demand curve to the left. As shown in the following graph, the economy is initially in equilibrium at point 1, where the level of employment is L. The demand curve for labor shifts from D1 to D2. Because wages are rigid and cannot adjust, the economy moves to point 2 on D2. The level of employment falls from L to L". Had wages been flexible, employment would have only fallen to L'.

b. When wages are rigid, a left shift of the demand curve leads to involuntary unemployment. At the going wage W in the graph, the number of workers who are willing to work at the going wage exceeds the number of jobs that firms are willing to fill. The number of workers who would like to work at the market wage but can’t find a job is equal to the gap between L and L" in the graph from part a.

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5. Answer the following and illustrate your answers on a graph. a. Assuming flexible wages, how will wages react to a fall in labor demand? b. What options do workers have in this case? Answer: a. Labor demand can fall significantly during a period of recession. There is a decreased demand for workers, and companies can choose among the best workers. Therefore, companies are in a good negotiating position to lower wages. b. The choices for workers are limited. They can remain unemployed, or they can retrain themselves if they have money to spare. If workers decide to increase their labor supply, for instance, by working extra hours, that will further reduce the wages. However, if workers can go on strike effectively and threaten to decrease their labor supply, which on its own might increase wages, then companies will be forced to reconsider their labor demand and increase wages for more people. 6. Assume that labor supply and labor demand are described by the following equations: Labor Supply:

LS = 5 × w

Labor Demand:

LD = 110 – 0.5 × w

where w = wage expressed in dollars per hour, and LS and LD are expressed in millions of workers. a. Find the equilibrium wage and the equilibrium level of employment. b. Assume that there is a shock to the economy, such that the labor demand curve is now described by the equation: LD = 55 – 0.5 ×w. If wages are flexible, what will be the new equilibrium wage and level of employment? Show your work. c. Now assume that wages are rigid at the level you found in part (a). What will employment be at this wage? How many workers will be unemployed? Answer: a. LS = 5w LD = 110 – 0.5 × w In equilibrium: LS = LD 5 × w = 110 – 0.5 × w Solving for the equilibrium wage, w*: 5.5 × w = 110 w* = 20 Plug in w* to find L* using either LS or LD: LS = 5w* = 5 × 20 = 100 = L* LD = 110 – 0.5 × w = 110 – 0.5 × 20 = 100

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= L* S

b. L = L

5 × w = 55 – 0.5 × w Solving for the equilibrium wage, w*, assuming the wage is flexible: 5.5 × w = 55 w* = 10 Plug in w* to find L* using either LS or LD: LS = 5 × w* = 5 × 10 = 50 = L* LD = 55 – 0.5 × w = 55 – 0.5 × 10 = 50 = L* c. From part (a), we already know that the wage will be 20, and LS at 20 = 100. However, labor demand at the previous wage of w = 20 will be: LD = 55 – 0.5 × 20 = 55 – 10 = 45 S

Given that L = 100, unemployment will be: LS – LD = 100 – 45 = 55 7. In 1973, the major oil-producing nations of the world declared an oil embargo. The price of oil, a key source of energy, increased. In many countries, this led to a fall in real GDP and employment. Which of the three business cycle theories explained in the chapter – real business cycle theory, Keynesian theory, and monetary theory – would best fit this explanation of the 1973 recession? Answer: Real business cycle theory emphasizes the role of technology in causing economic fluctuations. Proponents of real business cycle theory tend to emphasize the importance of changing input prices on aggregate output. Because almost all firms use oil in one form or another, oil price changes function like technology changes. An increase in the price of oil in 1973 led to a decrease in the productivity of firms that used oil. Large and abrupt increases in oil prices can cause a recession. Thus, the real business cycle theory best fits the explanation given in the problem. 8. Proponents of the real business cycle theory emphasize the importance of input prices, especially oil, a nonrenewable energy source that is subject to abrupt price changes. How might the development of wind and solar power, both renewable energy sources, challenge the usefulness of the theory to explain recessions? Answer: Wind and solar power could allow power companies to diversify away from oil, reducing the variability of energy prices. If oil is no longer as important as a source of energy, and overall energy prices change less abruptly, then oil price swings are less likely to cause recessions, and the real business cycle theory becomes less important as an explication of recessions. 9. An old saying goes: “Nothing succeeds like success.” Explain how this could relate to Keynes’s animal spirits view of economic fluctuations and the concept of a self-fulfilling prophecy.

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Answer: Keynes’s theory of animal spirits highlights the psychological elements that are important determinants of everyone’s decisions, including their economic and financial decisions. Optimism and pessimism are inevitable components of our thinking and, in the aggregate, can affect the macroeconomy. In periods when a majority of consumers and business people are optimistic about the economy, their actions will reflect that optimism. Consumers increase their spending, businesses increase their investment, and this, in turn, stimulates the economy. This is the “self-fulfilling prophecy” phenomenon mentioned in the chapter. Furthermore, this success can stimulate further success. As the chapter points out, the multiplier process can be linked to this interplay of attitudes and results. Optimism about the economy leads businesses to increase output and thus their demand for labor. Wages rise, and employment increases, which increases workers’ incomes. As workers spend their increased income on consumption goods, demand rises further and feeds back into another round of increases in labor demand. The initial boost to the economy resulting from a more optimistic view of the future spurs further optimism and, via the multiplier, a further boost to the economy. Success stimulates further success. 10. Suppose that after a negative shock on the labor demand curve in an economy, the government interfered and implemented an expansionary policy by decreasing taxes and increasing spending simultaneously. Use a detailed graph to show the effect of such a policy given rigid wages. If wages were flexible, would the changes have led to more positive effects on the employment level? Answer: The following graph illustrates the answer. The initial labor demand curve is D1. As a result of the negative shock, it moved to D3 after the amplifications by multiplier effects. If wages are rigid, the economy would move from point 1 to point 3, with wages remaining the same but the level of employment falling from L to L''. After the government expansionary policy and the accompanying multipliers’ magnifications, the labor demand curve moves from D3 to D2. If wages are rigid, the economy moves from point 3 to point 2 with constant wages but a higher level of employment at L'. If wages are flexible, the negative shock would have moved the economy to point B which shows a higher level of employment compared to L''. After the government’s interference, the economy moves to point A, which is also better than L'. Therefore, with regard to the employment level, flexible wages are better than rigid wages.

11. The global outbreak of COVID-19 in 2020 wreaked havoc on most economies. The containment efforts of the pandemic were proving to be detrimental to economic activity leading many countries to relax the lockdown even when the objective of the containment was not reached. How do you think the labor demand curve was affected because of the pandemic? How do you imagine countries are reacting to cushion the effect of the fall in economic activity on businesses and household incomes? Use a graph to illustrate your answer. Answer: The COVID-19 outbreak constituted a negative shock on the labor demand curve in any economy that was affected by this virus. Many lost their jobs due to the pandemic. As shown in the figure, the labor demand curve moved from D1 to D3, and employment accordingly decreased from L to

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L'' (if wages are assumed to be rigid) or to LB (if wages are flexible). To counter the ensuing unemployment and business closures, governments should implement expansionary fiscal policies like tax exemption, fiscal packages to failing businesses, and targeted support to families. Monetary policies should also support the fiscal policies. If successful and if the negative effects of the pandemic stabilize, such policies would move the employment from L'' to L' (if wages are rigid) or from LB to LA (if wages are flexible); if not, then the magnitude of the negative shock will be more severe, which governments can combat by implementing more acute expansionary measures.

12. In the early 1980s, the unemployment rate in the United States rose above 10 percent. The United States was in a severe recession. Both fiscal and monetary policies were used to stimulate the economy. Government spending increased by 18.9 percent, while the Federal Reserve cut interest rates by nearly 11 percentage points. How would these policies affect the labor demand curve and the overall labor market? Assuming wages are rigid, use a graph to explain your answer. Be sure to show the pre-recession equilibrium, the situation at the trough of the recession, and the effect of the government policies. Answer: Both policies will shift the labor demand curve to the right, leading to higher equilibrium employment and wage. As shown in the following figure, the economy is initially in equilibrium at L level of employment where the labor demand curve, D1, intersects the labor supply curve, S. A shock to the economy moves the labor demand curve from D1 to D2, reducing employment to L". Because wages are rigid, the D2 curve intersects S at point 2. L" is the level of trough employment. Policy interventions by the government and the Federal Reserve shift the labor demand curve from D2 to D3, partially reversing the impact of the shock. Although the employment level is not fully restored, the partial recovery in the labor demand curve takes the economy from point 2 to point 3, where employment is at L'.

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Data from: http://www.epi.org/publication/bp355-five-years-after-start-of-great-recession/ 13. The first Evidence-Based Economics feature in the chapter identifies three key factors that caused the recession of 2007–2009. a. How would Keynes’ concept of animal spirits explain the creation of a housing bubble? b. Explain how the 2007–2009 recession affected the consumption and investment components of the national income identity. Answer: a. According to Keynes, animal spirits is a psychological phenomenon. It represents the overall level of optimism or pessimism in the economy. In the book Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism, George Akerlof and Robert J. Shiller (Nobel Prize laureates in economics in 2001, and 2013) explain that the idea that everyone should own a house and that a house is a worthwhile investment played a part in creating a bubble. This belief, which gained momentum in the 1990s and the early 2000s, pushed housing prices up and also led many to ignore the possibility of a decline in housing prices. The housing bubble showed that animal spirits in an economy can fluctuate sharply even as the underlying fundamental features of the economy change relatively little. b. The national income identity is: Y = C + I + G + NX. The Great Recession primarily affected the C and I components of the national income identity. The fall in housing prices reduced consumers’ wealth and led to a drop in consumption. Because falling prices made new construction unprofitable, construction of new houses dropped, which reduced I. The decline in housing prices also led to millions of mortgage defaults. These mortgage defaults led to bank failures. Bank lending fell sharply, causing further reductions in C and I. Based on: http://chronicle.com/article/How-Animal-Spirits-Wrecked/15656 14. Some economists stress the role of monetary policy in the period leading up to the 2007–2009 recession. Between 2001 and 2003, the Federal Reserve lowered the target Fed Funds rate from 6.5 percent to 1 percent and kept it there through much of 2004. This resulted in a substantial decline in real interest rates throughout the economy, including mortgage rates. Based on the chapter’s discussion of monetary and financial factors, explain how the Federal Reserve’s policies could have contributed to the economic “bubble” of the pre-recession years of 2000–2006. Answer: The historically low interest rates that resulted from Fed policy from 2000 –2004 were mirrored by very low mortgage rates. This, in turn, stimulated the housing market as families took advantage of low rates to finance home purchases. Demand for real estate increased, which drove up real estate prices throughout the United States. Moreover, partially in response to government initiatives to increase home ownership, mortgage lending standards were relaxed, which, coupled with the very low rates on mortgages, contributed to the “bubble” mentioned in the chapter. 15. The pandemic of 2020 affected firms’ willingness to hire workers, initially shifting the labor demand curve sharply to the left.

a. Work out the consequences of this labor demand shift on an economy with a downward rigid wage.

Use your graphical analysis to describe the change in equilibrium employment and the change in the number of unemployed workers.

b. What happens when the labor demand curve eventually shifts back out to the right as the economy starts to recover? Does the rightward shift in the labor demand curve raise wages?

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Answer:

a. A supply curve in an industry with downwardly rigid wages, LS, will have a horizontal portion denoting that wages will not fall below the point of rigidity, W*. The labor demand shifts inward from LD1 to LD2 due to the pandemic. The equilibrium moves from point 1 to point 2 (QL2, W*); wages remain at the point of rigidity. Employment, the quantity of labor hired, falls from QL1 to QL2, and unemployment increases from zero to QL1-QL2. Multiplier effects push the labor demand to LD3, and a new equilibrium at point 3 (QL3, W*) ensues. At this point, unemployment has increased to QL1-QL3.

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b. Recovery from a recession looks something like the reserve of a recession. Due to combination of changes in labor demand due to market forces or government policy, labor demand shifts from LD1 to LD2 and the equilibrium from point 1 to point 2. Because the new equilibrium is still on the horizontal portion of the labor supply curve that represents the rigid wage, wages do no change but the new equilibrium (QL2, W*) does represent a higher level of employment. Multiplier effects push labor demand, LD3 further to the right. There is no guarantee that shift in labor demand will deliver a complete recover with full employment, QL3 at W*. The new equilibrium might be short of full employment at QL3 or it might be at a point like point 3 with a wage of W** which is above the downward rigid wage.

Chapter 27

Macroeconomic Policy Questions 1. What are the similarities and the differences between monetary and fiscal policies? Answer: Monetary policy is conducted by the central bank, whereas fiscal policy is undertaken by the legislative and executive branches of government. Monetary policy manipulates monetary aggregates (such as bank reserves and M2), credit access, and interest rates, while fiscal policy adjusts government spending and taxes. Though monetary and fiscal policies work differently in different situations, both sets of policies cause shifts in the labor demand curve. 2. How do expansionary policies differ from contractionary policies? Answer: During a recession, expansionary policy aims to reduce the severity of the downturn by shifting labor demand to the right and “expanding” economic activity. Contractionary policy, on the other hand, shifts the labor demand curve to the left and sometimes is used to reduce the rate of inflation or slow down the economy when it grows too fast or “overheats.” 3. How does an increase in interest on reserves (IOR) effect the federal funds rate? Answer: An increase in the IOR shifts the demand curve for reserves to the right, increasing the equilibrium interest rate in the federal funds market thereby increasing the federal funds rate. Increasing the IOR is contractionary monetary policy because it increases incentives for banks to hold funds as reserves rather than to make loans. 4. Briefly explain how expansionary monetary policy shifts the labor demand curve to the right. Answer: Expansionary monetary policy lowers short-run interest rates and increases access to credit in order to stimulate economic activity. The fall in short-run interest rates usually causes the long-term expected real interest rate to fall. A fall in the long-term expected real interest rate encourages households and firms to make more investments (such as building new homes and factories) because a lower real interest rate implies that the cost of a loan has fallen. Lower interest rates also stimulate consumption spending, especially on durable goods, because loans to finance those purchases cost consumers less. To satisfy an increase in demand for investment and consumption goods, firms seek to hire more workers, shifting the labor demand curve to the right. 5. What is quantitative easing? Why do central banks undertake quantitative easing programs? Answer: Quantitative easing involves primarily a change in the way that the Fed conducts open market operations. Rather than buying just short-term Treasury bonds, which is the usual way that the Fed increases bank reserves in a standard open market operation, the Fed buys other assets as well, including long-term bonds and mortgage-backed securities. This pushes up the price on the long-term bonds and thereby drives down long-term interest rates. Such purchases also increase the quantity of bank reserves, with the goal of increasing bank lending, and ultimately, stimulating the economy. Quantitative easing is one of the major factors behind the significant increase in bank reserves that occurred from 2008 to 2015 and during and after the 2020 recession.

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6. A successful campaign of quantitative easing increases bond prices and decreases interest rates. Lower interest rates increase the value of real estate and stocks as well as bonds. Given that the wealthy own real estate, stocks, and bonds, how might quantitative easing worsen income inequality? Answer: Quantitative easing is designed to increase economic activity, including employment, by lowering interest rates through purchases of long-term treasury bonds and mortgage backed securities. Because asset values tend to move together, the values of other assets, such as stocks, increase as well Imagine a country with two groups: the haves constituting 10 percent of the population and $100 billion in net worth through investments, and the have-nots constituting 90 percent of the population and zero dollars in net worth. If quantitative easing increases asset values by 50 percent, the haves now have a net worth of $150 billion and the have-nots still have a net worth of zero dollars. The increase in net worth is income at the time that it occurs. Income to the haves increased by $50 billion. If this increase in income was greater than the increase in income through new employment, then the haves benefited relative to the have-nots. 7. Other than interest on reserves (IOR), open market operations, and quantitative easing, what tools does the Federal Reserve use to manipulate interest rates in the economy? Answer: The Federal Reserve has several tools in addition to open market operations to affect interest rates. First, it can change the reserve requirement, the percentage of checking deposits that banks are required to keep on reserve. If the requirement is increased, banks must keep more in reserves, and the demand for reserves curve shifts to the right, increasing the fed funds rate. Conversely, if the requirement is decreased, the reserves demand curve shifts to the left, decreasing the fed funds rate. Second, the Fed can change the interest rate it pays banks on the reserves banks hold at the Fed. A decrease in that rate lowers the demand for reserves and shifts the reserves demand curve to the left, thus lowering the fed funds rate. An increase in the rate paid would have the opposite effect. Third, the Federal Reserve can change interest rates by using the discount window through which it can provide short-term liquidity to banks. Banks use the discount window when they can’t find a lender in the federal funds market. Such lending occurs frequently during financial crises. 8. Does the effectiveness of monetary policy depend on inflation expectations? Explain. Answer: Yes, inflation expectations are linked closely with the long-term expected real interest rate. The federal funds rate, which is the annualized interest rate on overnight loans between banks, is a short-term nominal interest rate that the Fed directly controls using monetary policy. However, the interest rate that is relevant for consumers’ and firms’ investment decisions—for instance, the mortgage interest rate—is the long-term expected real interest rate. Long-term expected real interest rate = Long-term nominal interest rate – Long-term expected inflation rate. For the Fed to lower the long-term expected real interest rate, it has to either lower the long-term nominal interest rate or raise long-term expectations of the inflation rate (or both). To do this, the Fed can communicate that it will maintain an expansionary monetary policy, holding down the federal funds rate and increasing the money supply, for a long period of time. If the Fed promises to keep the federal funds rate low and households and firms believe that the federal funds rate will remain low for several years, then the long-term nominal interest rate will also be low. Inflation expectations are likely to be high when the Fed creates expectations of inflation by promising to conduct expansionary monetary policy for several years. High inflation expectations will then lower the long-term expected real interest rate. 9. Briefly explain how an increase in the quantity of reserves that commercial banks hold at the Federal Reserve could lead to inflation.

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Answer: The Federal Reserve buys government bonds from commercial banks and electronically increases the quantity of reserves held by these commercial banks. Because banks now have a higher quantity of reserves, they can create more loans. Those loans circulate through the economy and return to the banking system as deposits. Rising bank deposits enable banks to make even more loans. The resulting total increase in deposits generates an increase in monetary aggregates like M2. If the stock of money grows faster than the real level of GDP, the aggregate price level will rise, generating inflation. 10. How does the zero lower bound on interest rates affect the working of monetary policy? Answer: The zero lower bound is a barrier that nominal interest rates cannot cross; when nominal interest rates have been lowered to zero, the central bank cannot lower rates any further. When the rate of inflation is low or negative, the zero lower bound is a problem for the working of monetary policy. When the nominal interest rate is stuck at or above zero and the inflation rate is negative, the real interest rate will be positive. If the inflation rate keeps falling, the real interest rate will rise, reducing investment and shifting the labor demand curve to the left. 11. When nominal interest rates have hit the zero lower bound, can central banks use interest rates to stimulate the economy? Explain. Answer: Yes, the central bank can try to influence expectations of future nominal interest rates and future inflation. By promising to keep nominal interest rates low for many years and promising to keep inflation low in the long term, the central bank can influence the long-term expected real rate of interest, even if the current interest rate is at zero and can’t be lowered any further. 12. What does the Taylor rule state? Answer: The Taylor rule shows that the federal funds rate should be set at the level where: Federal funds rate = Long-run federal funds rate target + 1.5[inflation rate –Inflation rate target] + 0.5[Output gap in percentage points] 13. According to the Taylor rule, when should the Federal Reserve lower or raise the federal funds rate? Answer: The Taylor rule contains two relationships: ●

The Fed should raise the federal funds rate as the inflation rate rises. A larger inflation rate leads the Fed to engage in less stimulus by raising the federal funds rate. Specifically, the formula says that every percentage point increase in the inflation rate should translate into a 1.5 percentage point increase in the federal funds rate.

●

The Fed should set a higher federal funds rate the higher the output gap. A larger output gap leads the Fed to engage in more contractionary monetary policy by raising the federal funds rate. Specifically, the formula says that every percentage point increase in the output gap should translate into a 0.5 percentage point increase in the federal funds rate.

14. What are the automatic and discretionary components of fiscal policy? Answer: Fiscal policy can be divided into automatic and discretionary components. ●

Automatic components are aspects of fiscal policy that automatically partially offset fluctuations in economic activity. These automatic components do not require deliberate action on the part of the government. For example, tax collection falls automatically during a recession because unemployed workers don’t owe income tax.

●

Discretionary components are aspects of fiscal policy that policymakers deliberately enact in response to economic fluctuations. In most cases, these new policies introduce a package of

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specific, temporary tax cuts or spending increases to reduce economic hardship and stimulate aggregate economic activity. 15. Why do governments, in most cases, not follow countercyclical fiscal policy? How can the need for discretionary fiscal policies be decreased? Answer: Government leaders typically have two goals: to assist and lead their countries and to stay in power. In most cases, it is possible to stay in power by providing funds for those voting groups who can be convinced to vote for you. This makes it difficult to follow prudent fiscal choices, as that would mean saving when the economy is booming and spending when the economy is in a downturn. Most governments do not save enough during boom years and are therefore not able to spend enough during a crisis. 16. Why might the fiscal multipliers be lower during a pandemic? Answer: The administrations of Trump and Bidden passed three pieces of legislation authorizing combined payments of up to $3,200 per person. During the pandemic, people who attempted to avoid catching the coronavirus practiced social distancing, traveled less, and avoided large gatherings even when they were held. In addition to lower demand for goods and services, state and local governments ordered mandatory lockdowns of some types of businesses. The reduced social interaction lowered consumption, even of people who did not experience a reduction of income. Because many people saved high portions of their payments, fiscal multipliers were low. 17. The CARES Act (2020) financed government spending and transfers to firms and households that occurred primarily in 2020, whereas the American Recovery and Reinvestment Act (2009) financed fiscal spending that was spread out over many years. Why did the rapid spending associated with the CARES Act represent an advantage over the slow spending in the American Recovery and Reinvestment Act? Answer: Taxation-based fiscal policy, like the CARES Act, can quickly put money in the hands of households, and households spend the money on goods and services that they value. The American Recovery and Reinvestment Act authorized expenditures of $230 billion in infrastructure spending. Ignoring the problem of pork barrel spending, it takes time to identify, authorize and begin these projects. The 2007-2009 recession ended in June 2009. As of February 2009, only a small portion of the funds had been spent. A year later, almost a year after the recession had ended, only a quarter of the infrastructure budget had been spent. Lags between the authorization of spending and the actual spending reduce the effectiveness of fiscal policy. 18. What could explain why a decrease in taxes could lead to a less than one-for-one increase in output? Answer: Expansionary fiscal policy is implemented by increasing government spending or by cutting taxes. A decrease in taxes could lead to a less than one-for-one increase in output for the following reasons. ●

Tax cuts might generate crowding out effects. As consumers try to spend more, resources that would have previously gone to investment may now be redirected to consumption. The extra goods might be provided by an increase in imports, lowering net exports.

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Consumers may not actually spend much of their tax cut right away and may choose to save instead. Consumers may try to smooth their consumption by spreading the “extra” spending over the long term rather than consuming the proceeds of a tax cut all at once. They may also recognize that the government will eventually have to raise taxes in the future to pay for the current tax cut. This may lead them to save the tax cut now to pay for the tax raise later.

19. Why is the Troubled Asset Relief Program (TARP) considered an example of a countercyclical policy that represents a mix of fiscal and monetary effects?

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Answer: A program like TARP is an example of a policy that includes both fiscal and monetary effects. The TARP was developed jointly by the Federal Reserve and the Treasury Department. The TARP legislation required that the Fed Chairman be consulted during TARP’s implementation. The U.S. Congress passed the legislation authorizing the Treasury Department to spend $700 billion to stabilize the financial system. This money was used to infuse capital into the banking system. The increase in capital stabilized banks that were close to bankruptcy and prevented financial contagion. Therefore, the fiscal component of TARP involved the increase in government expenditure, while the monetary component was the fact that banks and the financial system were affected by this program. 20. What aspect of the CARES Act represented a mix of fiscal and monetary policy? Answer: Like TARP, the CARES Act includes both fiscal and monetary effects. The CARES Act funded $454 billion of collateral controlled by the Treasury (fiscal policy) and used by the Fed to support new loans (monetary policy). Beneficiaries of these loans included financial institutions, other corporations, and state and local governments.

Problems 1. Former chairman of the Federal Reserve Alan Greenspan used the term “irrational exuberance” in 1996 to describe the high levels of optimism among stock market investors at the time. Stock market indexes, such as the S&P Composite Price Index, were at an all-time high, and the stock market kept rapidly rising in the late 1990s, generating what came to be recognized as a bubble in technology stocks. Some commentators believed that the Fed should have intervened to slow the expansion of the economy at that time. Why would central banks ever want to clamp down when the economy is growing rapidly? What policies could the government and the central bank use to slow down an economic expansion? Answer: To quote Greenspan, “But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?” Policymakers may want to limit growth because factors such as irrational optimism about the economy can result in unsustainable increases in asset values. Bubbles or irrational increases in asset prices are usually not supported by corresponding changes in fundamentals. Unsustainable expansions can subsequently lead to very severe downturns because irrational optimism can implode suddenly and severely (due to multiplier effects). The government and the central bank can use contractionary policies to slow or even reverse an economic expansion. Contractionary monetary policy can be implemented to raise interest rates, thereby increasing the cost of borrowing and reducing investment and consumer spending. Contractionary fiscal policy, such as tax increases or reductions in government spending, could also be employed to dampen aggregate economic activity. Either of these policies will serve to slow an economic expansion and avoid the dangers of unsustainable increases in asset prices Alan Greenspan’s speech: http://www.federalreserve.gov/boarddocs/speeches/1996/19961205.htm 2. The following figures show the European Central Bank’s (ECB) balance sheet as well as the balance sheet of a commercial bank in France, Crédit Paribas Bank. Suppose the ECB wants to raise bank reserves by €2 billion. Assuming that Crédit Paribas Bank is the only bank that is going to undertake these transactions with the ECB, show how ECB’s as well as Crédit Paribas Bank’s balance sheet will change. Assets Treasury Bonds

The European Central Bank Liabilities and Shareholders' Equity €3,000 billion Reserves €1,700 billion

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€1,000 billion Currency €3,000 billion Total liabilities

336

€1,300 billion €3,000 billion

Crédit Paribas Bank Assets Reserves

Liabilities and Shareholders' equity €300 billion

Deposits and other liabilities

€1,100 billion

Bonds and other investments

€1,000 billion

Shareholders' equity

€200 billion

Total assets

€1,300 billion

Liabilities + shareholders' equity

€1,300 billion

Answer: To raise bank reserves by €2 billion, the ECB engages in an open market operation with Crédit Paribas Bank. The ECB adds €2 billion to the reserves that Crédit Paribas Bank holds with the ECB and takes €2 billion in bonds from Crédit Paribas Bank in return. On the liability side of the ECB’s balance sheet, the reserves (held by Crédit Paribas Bank) rise by €2 billion. On the asset side, the ECB has €2 billion more in bonds (bought from Crédit Paribas Bank). The European Central Bank Assets

Liabilities and Shareholders' Equity

Treasury Bonds

€3,002 billion

Reserves

€1,702 billion

Other bonds

€1,000 billion

Currency

€1,300 billion

Total assets

€3,002 billion Total liabilities

€3,002 billion

Crédit Paribas Bank sells €2 billion in bonds to the ECB and is paid for them by an increase of €2 billion in the bank’s reserve account at the ECB. Nothing changes on the liability (and shareholders’ equity) side of Crédit Paribas Bank’s balance sheet. On the asset side, total assets don’t change, but the composition of assets does. After the trade, Crédit Paribas Bank has €2 billion less in bonds and €2 billion more in reserves. Crédit Paribas Bank Assets

Liabilities and Shareholders' equity

Reserves Bonds and other investments

€302 billion

Deposits and other liabilities

€1,100 billion

€998 billion

Shareholders' equity

€200 billion

Total assets

€1,300 billion

Liabilities + shareholders' equity

€1,300 billion

Indicate whether the following phenomena will lead to a shift in the reserves supply and demand curve for the Bank of England (BoE), where the horizontal axis indicates the quantity of reserves and the vertical axis the interest rate of the Bank of England. In your answer, use a graph of the money market to show how the Bank of England’s action translates into a higher interest rate. a. Economic contraction. b. Increasing deposit base.

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c. Selling governmental bonds. d. If the demand curve shifts to the left, how should the BoE respond to keep the interest rate constant? Answer: a. In case of an economic contraction, firms are in less need of loans. Therefore, we will witness a shift to the left in the demand curve. b. Banks are required to hold a certain amount of their customers’ bank accounts in reserve deposits at the Fed. If the deposit base is increased (the Fed might do this to increase the safety of banks during a potential crisis), then banks will have to increase their holdings at the Fed. Therefore, the demand curve will shift to the right. c. If the Fed decides to sell government bonds, then it is decreasing its reserves, moving the supply curve to the left. d. If the demand curve shifts to the left, then the Fed should consider shifting its own supply curve to the left as well. As we have seen from the previous example, this can be done by selling government bonds, for instance. 4. You and a friend are debating the merits of using monetary policy during a severe recession. Your friend says that the central bank needs to lower interest rates all the way down to zero. According to your friend, zero nominal interest rates will boost lending and investment; consumers and firms will surely borrow and spend when interest rates are zero. Would you agree with his reasoning? How does the level of inflation affect your answer? Explain your conclusions. Answer: Yes, zero nominal interest rates could boost spending and act as an economic stimulus. Households and firms make investment decisions based on the real interest rate. When the nominal interest rate is zero and the inflation rate is positive, the real interest rate will be negative. Suppose the inflation rate is 2 percent. The real interest rate would be equal to 0 percent – (2 percent) = –2 percent. This provides a significant incentive for consumers and firms to borrow, which stimulates consumption expenditure and investment expenditure. 5. Why is observing the Taylor rule important in ensuring macroeconomic stability? What are the potential effects of not taking it into consideration? Visit http://www.global-rates.com and check the following pages. a. The ECB refi rate, European central bank’s interest rate b. Inflation Europe (HICP) Can you see the Taylor effect in practice with the ECB? Answer: a. The Taylor rule states that the federal funds rate should be increased if inflation increases. If the federal funds rate is higher, then the degree of stimulus being provided by inflation is lower. The Taylor rule even states that a single percentage point increase in the interest rate will have to lead to a 1.5 percentage increase in the federal funds rate. In addition, a stronger output gap (stronger economy) should also lead to a higher federal funds rate. b. If the Taylor rule is not observed, that is, the federal funds rate is not increased in parallel with inflation or economic growth, the economy of the country can very easily overheat. This can be partially observed by looking at the graph (in relation to inflation Europe HICP available at http://www.global-rates.com). The Fed started to increase its federal funds rate only from 2004

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Q1 onward, which was probably too late. This led to two years in which inflation and economic growth were uncontrolled and may have contributed to the financial crisis of 2008–2009. 6.

According to the Taylor rule, how should a negative output gap affect the federal funds interest rate?

Answer: The Taylor rule states that the federal funds rate should be set at the level where: Federal funds rate = Long-run federal funds rate target + 1.5[inflation rate –Inflation rate target] + 0.5[Output gap in percentage points] The relevant portion is that a negative output gap measured in percentage points should decrease the federal funds rate by half the gap. For example, a -1 percent gap should reduce the federal funds rate by .5 points. 7. According to the Taylor rule, how should an inflation rate above 2 percent affect the federal funds rate? Answer: The relevant portion of the Taylor rule states that the federal funds rate should change by 1.5 times the difference between the inflation rate and the target of 2 percent. An inflation rate above the target, say of 4 percent, would increase the federal funds rate 1.5×[4-2] = 3 percent. 8. Two economists estimate the government taxation multiplier and come up with different results. One estimates the multiplier at 0.75, while the other comes up with an estimate of 1.25. a. What do these different estimates imply about the consequences of government taxation (or transfers)? b. If the current value of GDP is $20 trillion and the government is planning to make transfers to people of $1 trillion, what is the percentage increase in GDP for each of the two estimates for the multiplier? Assume the increase in spending occurs all in 1 year. Answer: a. The economist who estimates the multiplier at 1.25 is likely to be assuming that the increased government spending will lead to an increase in consumption. The increase in government spending can stimulate business activity, which will increase the income of workers and hence consumption spending in the economy. The other economist is likely to be assuming that the increase in government spending will lead to more government borrowing, which will divert resources away from consumption and investment. The resulting higher interest rates dampen consumption and investment spending. According to the economist who estimates the multiplier at 0.75, a $1 increase in government spending will not even generate a $1 increase in equilibrium GDP. b. 3.75 percent, 6.25 percent If the multiplier is 0.75, an $1 trillion increase in government spending will result in an increase in GDP of 0.75 × $1 trillion ($1,000 billion) = $750 billion. GDP would increase from $20 trillion to $20.750 trillion, an increase of 3.75 percent. If the multiplier is 1.25, then an $1 trillion increase in government spending will result in a 1.25 × $1,000 billion = $1,250 billion increase in GDP. GDP would increase from $20 trillion to $21.250 trillion, which is an increase of 6.25 percent. 9. According to the article “Politics and investment: Examining the territorial allocation of public investment in Greece,” in the 34 years before the 2008 financial crisis, public expenditure in various constituencies in Greece was closely correlated with electoral results. The regions that voted a party back to office were rewarded, whereas contested and opposition areas were not supported.

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a. What is this type of attitude or spending called? Explain your answer. b. What are the problems with heavy government investment in this type of spending? Answer: a. Rewarding your loyal supporters and spending for popularity purposes is called pork-barrel spending. This is an inefficient use of funds as the benefits will be provided to a small group of people, whereas the costs will be paid by many. b. Government expenditure in healthcare, education, and infrastructural investment can be quite important to maintain the competitiveness of the given country. However, resources should be allocated in a way that supports those regions of a country where there is a real need. Otherwise, the investment will not be sustainable and will have a government expenditure multiplier close to zero. Furthermore, if a government decides to spend during the peak of the boom period, the positive impact will be close to zero. In fact, it might crowd out perfectly good investments, increasing the economy’s dependence on government investments as opposed to market-based investments. 10. Milton Friedman, the renowned monetary economist, gave the following analogy about the Fed: “Imagine your house is being heated by a heater. The heater is controlled by a thermostat. The way it’s set up, when the house gets a little too warm, the thermostat turns off the heater; if it gets too cold, the thermostat turns the heater back on. If everything works as planned, the room temperature in the house should roughly be the targeted temperature all the time. Now suppose the thermostat is not in the same room as the heater. In fact, it’s in the last room that is affected by the heater. Say, the attic. And the radiators through which the heater works are really old, and it takes them at least twenty minutes to react. Then, instead of making the temperature more stable, the thermostat would make the temperature swing wildly. For example, if the house is cold, then the thermostat will turn the heater on. But it will turn the heater off only when the attic is warm. By then, the entire house will be scorching hot. When it turns the heater off, it will not turn it back on until the attic is cooler. By then, the house will be freezing.” (In this analogy, the thermostat is the Fed; the house is the entire economy.) a. What do you think Milton Friedman was trying to say about monetary policy? (Hint: you do not need to draw any graphs for this question.) b. As in the thermostat analogy, what might be some possible unintended consequences of monetary policy? Might there be a similar effect for fiscal policy? If yes, how does the effect differ from that of monetary policy? Answers: a. Milton Friedman is referring to lags in monetary policy, more specifically, what are called impact lags. This is the time that elapses between when a policy is decided, when it is implemented, and when it has an impact. The impact may occur when the economy has already begun to move by itself in the desired direction. Thus, monetary policy can exaggerate a swing in the business cycle instead of dampening it. b. Due to lags in monetary policy, the danger is that any action, such as expansionary monetary policy, will have an effect when the economy is already climbing out of recession. The effect of monetary policy will then overheat the economy. Conversely, if the Fed moves to raise interest rates and “tighten” the availability of credit, the policy may have its greatest effect when the economy is already cooling and thus cause a more pronounced recession than had been planned.

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The impact of fiscal policy tends to be more immediate than that of monetary policy. However, fiscal policy often involves a considerable delay in its formulation and implementation. This is sometimes called a “decision lag.” As is the case with monetary policy, the effect on the economy might occur when it is no longer needed. 11. The European Central Bank (ECB) manages monetary policy for the eurozone. In 2019, the ECB’s policy rate (the ECB’s version of the federal funds rate) was already at 0 percent, before the start of the 2020 recession. a. Using the concept of the zero lower bound, explain how low interest rates (before a recession starts) could constrain countercyclical monetary policy. b. Though fiscal policies are controlled by individual governments in the eurozone, the European Union’s Stability and Growth Pact places strict limits on country-level deficit spending. Explain how the confluence of the zero lower bound and restrictions on the fiscal deficit might be problematic for countercyclical macroeconomic policy. Answer: a. As interest rates approach the zero lower bound, central banks become limited in their options. If the economy is in a recession, the bank would, ideally, want to lower the interest rate more to mitigate unemployment and deflation during the recession. However, because of the zero lower bound, that policy has a limit—at some point, the central bank will be unable to further lower the federal funds rate equivalent. b. As we saw in part a, the zero lower bound limits countercyclical monetary policy during a recession. The alternative, generally, might be countercyclical fiscal policy—during a recession, that might include tax cuts or increased government spending. However, both of these policies increase spending without a compensating increase in government income. Deficit restrictions, then, could prevent central governments from enacting the appropriate countercyclical policies. Combined, then, deficit restrictions and interest rates close to the ZLB could severely limit a country’s options during a recession.

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Macroeconomics and International Trade Questions 1. How does comparative advantage differ from absolute advantage? Answer: Although absolute advantage refers to the actual number of goods or services that a seller can produce, comparative advantage looks at the opportunity cost of the goods and services that a seller can produce. A seller has an absolute advantage in producing a good if he can produce more units of a good or service per hour than other sellers. A seller has a comparative advantage in the production of a good or service when he has a lower opportunity cost compared to that of another seller. 2. How does trade allow buyers and sellers to exploit gains from specialization? Answer: Gains from specialization are the economic gains that the society can obtain by having some individuals, regions, or countries specialize in the production of certain goods and services. Trade enables sellers to specialize in the production of the good or service for which they have a comparative advantage. Through trade, individuals acting as consumers, buy goods and services produced by sellers with the comparative advantage; their overall level of consumption increases. 3. Engaging in trade increases overall economic efficiency. Does this also imply that everyone in an economy gains from trade equally? Answer: Although trade does generate substantial benefits to both trading partners, everyone does not gain equally from it. Trade produces some winners and some losers. For example, international trade may cause routine assembly jobs to move to developing countries like Taiwan, and, as a result, fewer assembly jobs are left in the United States. As a consequence, workers previously working in assembly jobs are typically worse off. However, the efficiencies created from trade are so great that the winners will be far more numerous than the losers. In principle, the winners could compensate the losers, so that everyone— both the winners and losers—would be better off as a result of free trade. 4. Explain the following terms: a. Open economy b. Closed economy c. Imports d. Exports e. Tariffs Answer: a. An open economy exists when a country trades freely with other countries. b. A closed economy exists when a country doesn’t trade with other countries—that is, does not have any imports or export. c. Imports are the goods and services that are produced abroad and consumed domestically. d. Exports are the goods and services that are produced domestically and consumed abroad.

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e. Tariffs are taxes levied only on imports. They are an example of a trade restrictions. 5. How is trade between Mexico and the United States theoretically different from trade between California and Texas? Are there practical differences? Answer: Theoretically, there is no difference in the advantages of trade between countries and the advantages of trade between states. Trade between both would be based on comparative advantage. Practical differences exist and have been discussed previously; these differences can create obstacles to trade. Trade between countries generally involves purchases in different currencies (see chapter 6). Trade may take place between countries with higher and lower levels of inclusive economic and political institutions. As noted in chapter 8, the level of inclusive institutions over time explains the wealth of nations today. Trade with countries that have low levels of inclusive institutions has more political and economic risk than trade with countries with high levels. 6. Has trade been increasing or decreasing over the past few decades as a fraction of GDP? What could explain why the ratio of imports to GDP in the United States fell sharply in the 1930s? Hint Read the Wikipedia entry about the Smoot-Hawley Tariff Act. Answer: Global trade has been increasing over the past few decades. As Exhibit 28.6 in the chapter shows, the ratio of imports to GDP has risen sharply in some of the largest economies in the world. Almost every country in the world is much more open today than it was 60 years ago. With the onset of the Great Depression in 1929, trade collapsed. Tradable goods are disproportionately comprised of luxury goods, and luxury goods are the first to be cut when a household’s income falls. Also, at the outset of the Great Depression, many countries passed legislation restricting imports in an effort to increase demand for domestic production. Tariffs imposed by one country led to a non-cooperative “trade war” between countries, and trade collapsed further. The Smoot-Hawley Tariff Act passed by the United States Congress in 1930 explains part of the decline in trade. The Act made it more expensive for the United States to import goods and services from other countries, explaining the decline in imports. Canada and other countries retaliated by passing similar legislation making U.S. exports more expensive in these countries explaining the decline in U.S. exports. 7. Why is it a problem if a country is running a current account deficit? How can this be balanced out? Answer: If a country is running a trade deficit, it is importing more than it is exporting. This is analogous to a household spending more than it earns. Running a trade deficit means the country will eventually have to borrow to repay the debt. This borrowing is represented in the financial account. If the country continuously runs a trade deficit and overspends, it will eventually run up its debt to an unsustainable degree and the trade deficit will have to be decreased. 8. The international accounting system maintains a clear distinction between residency and citizenship. a. Who would be considered a domestic resident of the United States, according to the international accounting system? b. Suppose a U.S. citizen lives and works in Nigeria. Would they be considered a “foreigner” or a domestic resident in the U.S. international transactions accounts? Answer: a. The international accounting system is built upon the concept of residency, not the concept of citizenship, so domestic residents are people who reside in the United States whether or not they are U.S. citizens. In the same way, an immigrant Australian citizen living in the United States is defined as a domestic resident of the United States in the official international trade accounts. b. Residents of foreign countries—“foreigners”—are people who reside outside the United States, whether or not they are actually citizens of foreign countries. So a U.S. citizen who resides in

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Nigeria is counted as a “foreigner” with respect to the United States as far as the international trade accounts are concerned. 8. List the sources of income-based payments that domestic residents make to foreigners and the ways that domestic residents can receive income-based payments from foreigners. Answer: There are three ways that domestic residents can receive income-based payments from foreigners. ●

Receiving payments from the sale of goods and services to foreigners—exports. Exports are the goods and services that domestic residents produce and then sell in foreign countries.

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Receiving income from assets that the domestic resident owns in foreign countries—factor payments from foreigners.

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Receiving transfers from individuals who reside abroad or from foreign governments—transfers from foreigners. These transfers are “gifts” like aid or remittances from foreign residents or foreign governments.

There are also similar types of financial flows that move in the opposite direction. ●

Making payments to foreigners in return for their goods and services—imports. Imports are the goods and services that foreigners produce and then sell to domestic agents.

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Paying income on assets that foreign residents own in the domestic economy—factor payments to foreigners.

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Making transfers to individuals who reside abroad or to foreign governments—transfers to foreigners. Transfers to foreigners are “gifts,” which include foreign aid from the U.S. government, donations from U.S. citizens to foreign charitable organizations, and remittances from legal and illegal residents of the United States.

10. What does the current account include? Describe each of its components. Are all of these components included in GDP? Explain. Answer: The current account adds together the different sources of payments into and out of a country. It consists of the sum of net exports, net factor payments from abroad, and net transfers from abroad. Current Account = Net exports + Net factor payments from abroad + Net transfers from abroad. Net exports are the value of the country’s exports minus the value of its imports. Net factor payments from abroad = Factor payments from abroad – Factor payments to foreigners. Factor payments from abroad = Income received from assets that the domestic resident owns in foreign countries. Factor payments to foreigners = Income paid on assets that foreign residents own in the domestic economy. Net transfers from abroad = Transfers from abroad – Transfers to foreigners. Transfers from abroad = Transfers received from individuals who reside abroad or from foreign governments. Transfers to foreigners = Transfers made to individuals who reside abroad or to foreign governments. Not all of these components are included in GDP. Specifically, transfers and factor payments won’t be captured in GDP which, as we saw in earlier chapters, focuses on domestic production. While net

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exports will be included, then, payments made to U.S. citizens from foreign assets should not be included in GDP. 11. What is included in a country’s financial account? How is the financial account related to the current account? Answer: Financial Account = Increase in domestic assets held by foreigners – Increase in foreign assets held domestically The financial account is defined so that the net flows in the financial account exactly offset the net flows in the current account. Current Account + Financial Account = 0 This means that if foreigners receive net payments in the current account, then they must do something with those funds. They use the dollars that they received to make dollar deposits in banks, or to buy assets from U.S. residents, including U.S. Treasury bonds, shares in U.S. companies, or other U.S. assets, all of which are recorded in the financial account. 12. What are net capital outflows? Use an example to explain how they are related to net exports. Answer: Net capital outflows are the net investments flowing from one country to another; that is, they are the difference between the amount that the home country invests in foreign countries and the amount that foreign countries invest in the home country. They are equal to net exports because any foreign exchange in goods or services involves an exchange in capital, as well. For example, suppose Mexico exports avocados to a United States grocery store chain. The grocery store, in return, will pay Mexico— perhaps in USD, perhaps with an IOU. Either way, Mexico now effectively holds an “investment” in the United States. An increase in net exports for Mexico, then, is accompanied by an equal increase in net capital outflows. 13. What is foreign direct investment? Explain with an example. How does foreign direct investment benefit the recipient country? Answer: Foreign direct investment refers to investments by foreign individuals and companies in domestic firms and businesses. Foreign direct investment must generate an ownership stake in a local firm for the foreign investors. For example, foreign direct investment in India occurs when a foreign company opens a factory in India. Foreign direct investment enables technology transfer. Although technology transfer may not be the intended purpose of investment, when a foreign firm opens a factory in a country, it brings its know-how and technology to the country. Both countries are not only trading goods and services and having their firms and banks borrow from and lend to each other, but they are also technologically interlinked. Innovations and technological improvements in one country can ultimately improve productivity in many countries. 14. Are multinational companies harming factory workers in the developing world by hiring them at low wages? Answer: For many workers in developing countries, working in a factory is a better alternative to working in jobs like those in the agricultural sector. Most factory jobs pay twice as much as agriculture jobs and have moved many workers out of poverty. However, working conditions in a factory are not anywhere close to U.S. safety standards, and many factory workers are underage. Even then, employment by multinational firms appears to contribute to an increase in employment, wages, and living standards in most countries.

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Problems 1. Nobel laureate Paul Samuelson (1969) once said of the concept of comparative advantage: "That it is logically true need not be argued before a mathematician; that it is not trivial is attested by the thousands of important and intelligent men who have never been able to grasp the doctrine for themselves or to believe it after it was explained to them." (Source: World Trade Organization, https://www.wto.org/english/res_e/reser_e/cadv_e.htm.) In what way do you think that comparative advantage is counterintuitive? Answer: Absolute advantage is very straightforward in that if you are good at something and your friend is good at something that you do badly, you both do what each is good at. However, comparative advantage may be counterintuitive in that if you are good at both things and your friend is bad at both things, you would not end up doing both things and your friend would do neither. 2. You and your roommate are enrolled in the same course: Postmodern Deconstruction of Postmodern Deconstructionism. The course requires a term paper. Since the professor encourages collaboration on the paper, you decide to work on it together, “trading” tasks. In 8 hours, you can type 18 pages, whereas your roommate can type only 10. If you do outlining instead of typing, in the same 8 hours you could produce 6 summary outlines of the course readings, while your roommate could produce only 2. a. Who has the absolute advantage in typing? In outlining? Explain your answers. b. Who should do the typing, and who should do the outlining? Explain. Answer: a. Because you are more productive in both typing (18 pages per 8 hours vs 10) and outlining (6 outlines per 8 hours vs 2), you have the absolute advantage in both. b. The comparative advantage can be determined by using the following table showing the opportunity cost of typing and outlining for you and your roommate: Opportunity Cost of 1 Page of Typing (in terms of outlines)

Opportunity Cost of 1 Outline (in terms of typed pages)

You

1/3 outline

3 typed pages

Roomie

1/5 outline

5 typed pages

You have a lower opportunity cost of outlining (3 typed pages per outline vs 5), and your roommate has a lower opportunity cost of typing (1/5 outlines per typed page vs 1/3). Therefore, you should outline, and your roommate should type. You can trade outlines for typing, and your roommate can trade typed pages for outlines. 3. In India, an acre of land can produce 40 tons of sugar cane or 65 bushels of corn per season, while in the United States, an acre of land can produce 20 tons of sugarcane or 150 bushels of corn per season. a. Which country has the absolute advantage in the production of sugar cane? Of corn? Explain. b. Explain the concept of comparative advantage. What is India’s comparative advantage in this case? What about the United States? c. Suppose U.S. scientists have developed a groundbreaking new technology that increases the productivity of sugarcane in the United States to 75 tons of sugarcane per acre (and has no effect

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on U.S. corn productivity or Indian productivity in sugarcane or corn). How does this change India’s comparative advantage? Answer: a. Because the United States has higher productivity (output per acre of land) in corn (i.e., American land can produce more corn per acre in a season than Indian land), the United States has an absolute advantage in corn. India, however, has absolute advantage in producing sugar: it has higher productivity in sugar than the United States. b. A country has a comparative advantage in a good if it has a lower opportunity cost of producing that good. Thus, a country has a comparative advantage in producing good X if its relative productivity (relative to good Y) is higher in the production of good X. Opportunity Cost of Corn

Opportunity Cost of Sugar

United States

2/15 ton

15/2 bushels

India

8/13 ton

13/8 bushels

The United States has the comparative advantage in corn. India has the comparative advantage in sugar. c. It doesn’t change—India still has comparative advantage in sugar. Although the opportunity cost of sugar has decreased to 2 for the United States, the opportunity cost of sugar in India is still lower (13/8 < 2). Thus, the comparative advantage of India is still in sugar. 4. Assume that an American worker can produce 5 cars per year or 10 tons of grain per year, whereas a Japanese worker can produce 15 cars per year or 5 tons of grain per year. Assume for this exercise that labor is the only input used in car and grain production. a. Which country has the absolute advantage in producing cars? In producing grain? b. For the United States, what is the opportunity cost of producing a car? What is the opportunity cost of producing a ton of grain? Show how you arrived at your numbers. c. For Japan, what is the opportunity cost of producing a car? What is the opportunity cost of producing a ton of grain? Show how you arrived at your numbers. d. If free trade is allowed, which country will import cars? Which country will import grain? Explain. Answer: a. The following table summarizes the numbers given in the problem. Cars

Grain (tons)

United States

Japan

Because Japanese workers can produce 15 cars in a year versus only 5 for a U.S. worker, Japan has an absolute advantage in auto production. An American worker can produce 10 tons of grain,

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while a Japanese worker can produce only 5. So the United States has an absolute advantage in producing grain. (For b. and c., students should have made calculations of the opportunity cost for each country and each good, which result in the numbers in the following table.)

Opportunity Cost of Cars

Opportunity Cost of Grain

U.S.

2 tons of grain

1/2 car

Japan

1/3 ton of grain

3 cars

b. Based on the productivity numbers given in the problem, the opportunity cost of a car in the United States is found by simply calculating the number of tons of grain that could have been produced in the United States with the labor used to produce one car. Likewise, the opportunity cost of a ton of grain in the United States is found by calculating the number of cars that could have been produced in the United States with the labor used to produce one ton of grain. These calculations result in the numbers for the United States shown in the previous table. The opportunity cost of a car in the United States is 2 tons of grain, and the opportunity cost of a ton of grain is 1/2 car. c. Based on the productivity numbers given in the problem, the opportunity cost of a car in Japan is found by simply calculating the number of tons of grain that could have been produced in Japan with the labor used to produce one car. Likewise, the opportunity cost of a ton of grain in Japan is found by calculating the number of cars that could have been produced in Japan with the labor used to produce one ton of grain. These calculations result in the numbers for Japan shown in the previous table. The opportunity cost of a car in Japan is 1/3 ton of grain, and the opportunity cost of a ton of grain is 3 cars. d. Under free trade, a country will specialize in the good in which it has a comparative advantage, defined as lower opportunity cost. The United States has a lower opportunity cost of grain production (1/2 car versus 3 cars for Japan), so it will specialize in grain production and import cars. Conversely, Japan has a lower opportunity cost of car production (1/3 ton of grain versus 2 tons in the United States), so it will specialize in car production and import grain. 5. Use the information below to answer the questions that follow. Production per Unit of Labor The United States Germany Wheat (tons) 120 200 Cars 200 400 a. Which country has the absolute advantage in producing cars? In producing wheat? b. For the United States, what is the opportunity cost of producing a car? What is the opportunity cost of producing a ton of wheat?

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c. For Germany, what is the opportunity cost of producing a car? What is the opportunity cost of producing a ton of wheat? d. If free trade is allowed, which country will export cars? Which country will export wheat? Explain. Answer: a. Every German worker can produce more goods individually than its American counterpart can. This means that Germans enjoy an absolute advantage in the production of cars and wheat. b. For the United States, the opportunity cost of producing a car is 120/200 = 0.6, and the opportunity cost of producing a ton of wheat is 200/120 = 1.67. c. For Germany, the opportunity cost of producing a car is 200/400 = 0.5, and the opportunity cost of producing a ton of wheat is 400/200 = 2. d. Under free trade, a country will specialize in producing the good in which it has a comparative advantage, defined as lower opportunity cost. Germany has a lower opportunity cost of producing cars, and the United States has a lower opportunity cost of producing wheat. Therefore, Germany will export cars, and the US will export wheat. 6. The United States has maintained a free trade policy since World War II. However, since the election of President Trump, there is growing discourse that tariffs should be imposed to save American industries and jobs. According to CNBC, in 2015, China was the United States’ largest import partner with $479.1 billion worth of goods being imported. The average rate of tariffs toward China was 3 percent. What do you think would be the effects of increasing the average tariff rate for China to 8 percent? Answer: In the short run, the American treasury would win by collecting more tariff revenues. However, consumers would lose in the short run, as they would have to pay a higher price for their favorite Chinese products. Eventually, consumers will switch to a less expensive import product not from China if it is a near-perfect substitute. Therefore, countries that can produce substitute products will gain. In the long run, Chinese companies will move their production to countries from which it is easier to export to the United States. 7.

Former President Donald Trump argued that China was exploiting the United States. In particular, he decried the large trade deficit with China—he often said that that China was “killing” the United States on trade. Is having a trade deficit with another country inherently bad? Explain why a trade deficit may not be a bad thing for the United States. What are the scenarios under which a trade deficit may be a problem?

Answer: No, having a trade deficit with another country is not inherently bad—that is, trade is not a zerosum game. It is not necessary for the United States and China to buy exactly the same quantity of goods and services from each other, just as it is not necessary for a grocer to buy the same quantity of goods from you that you buy from him. There are other countries, like Brazil, to which the United States sells goods and services and from which the United States buys relatively little. In addition, the trade deficit is balanced out by capital inflows, which could be beneficial to a country’s economy, as well. A trade deficit could be an issue if, as we discussed in this chapter, gains from trade are not distributed equally. If the U.S. loses exporting industry jobs, groups of workers—perhaps concentrated in certain states—may lose their jobs. In the absence of national redistribution, these individuals may suffer. Ultimately, they may also negatively impact national trade policy. As we saw in the 2016 election, groups of disgruntled workers supported anti-trade candidates, even pushing Hillary Clinton to renounce the TPP. Stringently anti-trade policies may, in turn, harm even broader swaths of the U.S. population. Adapted from: http://archive.mises.org/2408/do-only-sellers-benefit-from-exchange/

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8. Suppose the following table shows data on transactions between Hungary and the rest of the world for the second quarter of 2017. Assuming the list is exhaustive, use the information given to fill in the table showing the current and financial accounts for the second quarter of 2017. Transaction A Hungarian citizen buys German state bonds Dividends received by Hungarian investors from foreign investments The Hungarian government provides tied aid to Sri Lanka Expenditure incurred by Mercedes to expand its capacity to build cars in Hungary Payments made by British citizens for medical services availed in Hungary Payment made by a Hungarian to rent a boat in Croatia Entry fees paid by French citizens to the National Museum in Budapest Receipt of cohesion funds from the European Union Salary earned by American citizens pursuing a temporary job in Hungary Current and Financial Accounts for Second Quarter, 2017 Payments from Foreigners Payments to Foreigners

Amount €10,200,500 €10,000 €500,000 €1,000,000 €20,000 €30,000 €500 €10,000,000 €300,000

Net Payments

Trade in goods and services Factor payments Net transfer payments Current account Change in domestic assets held by foreigners

Change in foreign assets held domestically

Net sales to foreigners Financial account Answer: • • • • • • • • •

A Hungarian citizen buys German state bonds: This leads to an increase in foreign assets held domestically—financial account. Hungarian investors receive dividends from their foreign investment: This is an example of income earned from assets that a domestic resident owns in a foreign country. The Hungarian state provides tied aid to Sri Lanka: This is an example of a transfer made to a foreign government. Mercedes in Hungary is expanding its capacity to build cars: This leads to an increase in domestic assets held by foreigners. British people go to the dentist in Hungary: This is an example of a service export. A Hungarian citizen rents a boat in Croatia: This is an example of a service import. French citizens visit the National Museum in Budapest: This is an example of a service export. Hungary receives cohesion funds from the EU: This is an example of a unilateral transfer. Americans come to Hungary to consult on a temporary job: This is an example of factor payment made to foreigners.

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Current and Financial Accounts for Q2 2017 Payments from Foreigners

Payments to Foreigners

Net Payments

Trade in goods and services

British people go to the dentist in Hungary, and French citizens visit the National Museum in Budapest

A Hungarian citizen rents a boat in Croatia

= 20,000 + 500 – 30,000 = –9,500

Factor payments

Hungarian investors receive dividends from their foreign investment

Americans come to Hungary to consult on a temporary job

= 10,000 –300,000 = –290,000

Net transfer payments

Hungary receives cohesion funds from the EU

The Hungarian state provides tied aid to Sri Lanka

= 10,000,000 – 500,000 = 9,500,000

Current account

Net sales to foreigners

9,200,500 Increase in domestic assets held by foreigners

Increase in foreign assets held domestically

Mercedes in Hungary is expanding its capacity to build cars

A Hungarian citizen buys German state bonds

Financial account

= 1,000,000 –10,200,500 = –9,200,500

In 2019, the U.S. current account deficit was $480 billion, while the trade deficit was $577 billion. a. Why are the trade deficit and the current account deficit different? b. Based on the information in this problem, what were U.S. net capital outflows in the second quarter of 2020? Carefully show how you got your answer and explain, in words, the concept of net capital outflows. c. Suppose Apple (based in the United States) sold an additional $0.5 billion in iPhones to retailers in Spain. How would this transaction affect the trade deficit? What about net capital outflows? Explain. d. How would an increase in the U.S. real interest rate affect the trade deficit? Net capital outflows? Explain.

Answer: a. You will remember from the chapter that the current account is composed of the trade balance (net exports) as well as factor payments and international transfers. Thus, trade is only one component of the current account. It is possible, for example, to have a trade deficit but a current account surplus, if surpluses in factor payments and international transfers outweigh the trade deficit. b. Based on this problem, U.S. net capital outflows were -$577 billion dollars (that is, more capital was flowing in than out). As we saw in this chapter, we can re-arrange the National Income

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Identity (Y = C + I + G + X – M), so that we get (Y – C – G ) – I = X – M, or, if we substitute in savings, S – I = X – M. X – M, here, is net exports; we defined S – I as net capital outflows. Net capital outflows tell us how much money, on net, is flowing out of the country—this money could be in the form of investments, for example. The intuition behind the equality between NCOs and net exports is that the money obtained during a trade exchange constitutes, on its own, an investment in the foreign country. This investment could simply be an IOU, as we saw in the chapter; it could also, more tangibly, be a range of foreign assets. Either way, the exporting country is now investing in its trade partner. c. An additional .5 billion in exports to Spain, all else equal, would reduce the deficit by .5 billion— using the number given in the problem, it would now be at 576.5 billion dollars. The money used by Spain to purchase the iPhones would represent an increase in U.S. net capital outflows (e.g. Spain might issue an IOU to the United States); now, the NCOs would be -576.5 billion dollars for the United States. d. An increase in the U.S. real interest rate would attract more foreign investors, decreasing Net Capital Outflows. Because of the relationship we derived in part b., net exports would also decrease (deepening any existing trade deficit). 10. Throughout the 1950s and 1960s, many countries with low income per capita pursued a policy called “import-substituting industrialization,” or ISI for short. India, and many nations in Africa and Latin America, closed themselves off to trade in order to promote the development of domestic industries. As noted in the Economist article “Grinding the Poor,” (September 27, 2001), “(o)n the whole, ISI failed; almost everywhere, trade has been good for growth.” The article discusses how growth was disappointing in countries that pursued ISI. Nations that were open to trade—primarily in Asia—grew much more rapidly. Based on the discussion in the chapter, speculate on why ISI was ultimately a failure and why integration with the global economy promotes economic growth and development. Answer: The chapter highlights the benefits of specialization and its corollary, trade. Exploiting a comparative advantage allows a country to produce those goods or services in which it is most efficient. Scarce resources are directed to their most productive uses. Moreover, openness to the global economy facilitates flows of capital into poorer regions. Domestic businesses in developing regions have access to the financing they need to expand. Capital can flow from countries in which investment opportunities are more limited, to countries where such opportunities abound. Foreign direct investment (FDI) can boost a poor nation’s development, employment, and urbanization. As the chapter notes, FDI is a major conduit for technology transfer. Developing countries don’t have to invest in the R&D necessary to invent new products or processes. They can adopt and adapt technologies that were developed elsewhere. The resulting boost to productivity is instrumental in promoting economic growth. Restricting or prohibiting trade denies a country these benefits. Inefficient domestic producers are protected from competition, and resources are not directed to their most productive uses. Failure to integrate a nation into the broader world economy inevitably retards economic growth and usually does not even achieve the immediate objective of fostering the development of particular industries. 11. Foreign direct investment in several sectors in India is still heavily regulated. After much debate, the government of India recently relaxed restrictions on foreign direct investment in the retail sector. Purportedly for reasons like national security and possible job losses, many sectors of the economy (such as defense, nuclear power, and oil refining) are not fully open to foreign direct investment. Suppose you are hired to serve on the government’s Working Group on Foreign Direct Investment. What would you suggest to the government? Defend your position.

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Answer: [Student answers will vary because they are asked to render an opinion on the question. However, a good answer should clearly use concepts from the chapter in support of whatever position they state. The following answer is an example that takes the position in favor of foreign direct investment (FDI), but a more contrary argument is certainly possible.] One of the biggest arguments in support of FDI is that it is a major conduit for technology transfer, though in most cases this transfer is not the goal of the foreign firm that is making the investment. A company that owns a factory or a retail outlet in India would also bring its technical know-how and business practices to the country. For example, suppose Walmart decides to open stores in India. To ensure that its operations run smoothly, Walmart would bring in its own expertise in supply chain management and operations. This would increase overall efficiency and benefit the host country. FDI is a method to ensure that innovations and technological improvements are transferred between countries. Even in sensitive industries like those connected with national defense, technology transfer can provide a compelling rationale to be more open to FDI. Moreover, employment losses in one industry due to trade are almost always made up by the addition of new jobs in other industries in which a country has a comparative advantage, so the jobs issue does not constitute a sufficient reason to curtail foreign direct investment. 12. The coffee market is one of the most globalized and volatile commodity markets in existence. In terms of the value of trade, it is second only to oil. Coffee is produced in over seventy countries, primarily lower-income nations in Latin American, Africa, and Asia. In recent years, a movement has developed supporting “fair trade coffee,” which seeks to better the conditions and increase the incomes of coffee producers. Read the following sources and list the main arguments for and against the fair trade coffee movement, as delineated in the articles. Comment on any similarities you see between fair trade coffee policy and the case of Nike in Vietnam (as discussed in the chapter’s Evidence-Based Economics feature). “The Fair Trade Debate,” in Wikipedia: http://en.wikipedia.org/wiki/Fair_trade_debate “Coffee,” from Fair Trade International: http://www.fairtrade.net/coffee.html Answer: Obviously, student answers will vary depending on how carefully they read the articles, which points they see as important, and perhaps even their prior attitudes or commitments. However, some of the salient points they should mention include the following: Arguments in Favor of the Fair Trade Coffee Movement ●

Fair trade coffee ensures that poor coffee farmers will have enough income to provide for their families and have a decent standard of living.

●

Coffee produced under fair-trade certification or licensing helps to ensure safer working conditions for those working in the coffee industry.

●

Volatility in the market is dampened by putting a price floor under world coffee prices and by reducing the opportunity for speculation.

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The higher price offered for fair trade products allows farmers and their descendants to stay on their traditional land and continue to produce, rather than seek better paid jobs in urban areas.

Criticisms of the Fair Trade Coffee Movement ●

The amount that growers are paid for their coffee is only slightly higher than the free market price. Growers can often sell their coffee for higher prices if they don’t honor their contracts with fair trade organizations.

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Very little of the higher prices consumers pay for fair trade coffee actually ends up with coffee growers.

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There is insufficient and ineffective monitoring of the cooperatives that sell fair trade coffee.

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The fair trade marketing system is riddled with inefficiency and corruption.

●

Fair-trade agreements can hurt other coffee farmers not covered by the agreements.

353

The section of the chapter that is most relevant to student answers is the discussion of the role of Nike in Vietnam. They should relate the fair trade movement to the criticisms of multinational firms like Nike operating in developing countries. In particular, students should be alert to the idea that when it comes to international commerce, well-intentioned policies might have unintended negative consequences for the very people the policies are designed to help.

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Open Economy Macroeconomics Questions 1. How is the nominal exchange rate between two currencies defined? Answer: The nominal exchange rate is the price of one country’s currency in units of another country’s currency. Specifically, the nominal exchange rate is the number of units of foreign currency that can be purchased with one unit of domestic currency.

The nominal exchange rate (e) is calculated as 2. When is a currency said to appreciate or depreciate? Answer: When the nominal exchange rate goes up, the domestic currency appreciates against the foreign currency, and the domestic currency is said to be strong. When the nominal exchange rate goes down, the domestic currency depreciates against the foreign currency, and the domestic currency is said to be weak. The appreciation of one currency implies the depreciation of the other. For example, suppose the nominal exchange rate between the U.S. dollar and the Chinese yuan changes from10 yuan to 1 U.S. dollar to 8 yuan to the dollar. Each dollar buys fewer yuan, 8 instead of 10. The yuan has become costlier for buyers using the dollar. Reciprocally (literally), the yuan has appreciated. A yuan originally could only buy .1 U.S. dollars; now it can buy .125. The dollar has become “cheaper” in terms of yuan; it takes fewer yuan to “buy” one dollar. The yuan is said to have appreciated against the U.S. dollar, and conversely, the dollar has depreciated against the yuan. 3. Distinguish among flexible, fixed, and managed exchange rates. Answer: If the government does not intervene in the foreign exchange market, then the country has a flexible exchange rate, which is also referred to as a floating exchange rate. If the government sets a longrun value for the exchange rate and intervenes to defend that value, then the country has a fixed exchange rate. If the government intervenes actively in the foreign exchange market without setting a particular value for the exchange rate, then the country has a managed exchange rate. The values of managed exchange rates do change, but the fluctuations are relatively smooth when they occur. 4. What are the advantages of undervaluation and overvaluation of a currency to an economy? What are the disadvantage of each? Answer:

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Students benefit from a graphic description of the process of undervaluation of the domestic currency (overvaluation of the dollar). Continuing with the example of the yuan, Chinese authorities desire to establish a weak yuan by pegging an exchange rate at ePegged (the solid purple line) which is above the equilibrium exchange rate e*. This means that a dollar at the pegged exchange rate can buy more yuan at the pegged rate than the equilibrium rate. If the pegged rate is effective (binding) the supply of dollars in China will be greater than the demand implying that Chinese authorities must buy the surplus dollars equal to the distance between the supply and demand curves (the black arrow at the bottom of the graph). This process increases foreign reserves, in this case dollars, by Chinese authorities. We will continue with the example of the Mexican peso to describe the consequences of overvaluation of the domestic currency (undervaluation of the dollar). By pegging an exchange rate at ePegged (the solid purple line) which is below the equilibrium exchange rate e*, a dollar can buy fewer pesos. If the pegged rate is effective (binding) the demand for dollars in Mexico will be greater than the supply implying that Mexican authorities must sell dollars and purchase pesos in a quantity equal to the distance between the demand and supply curves (the black arrow at the bottom of the graph). This process decreases foreign reserves, in this case dollars, by Mexican authorities. Producers in countries with undervalued domestic currencies, ePegged find it easier to export their goods and services because the pegged exchange rate is above the flexible rate e* meaning that the foreign buyers face a lower price. Foreign lenders often prefer to make loans denominated in dollars to countries histories of inflation and debt crises. Borrowers, both public and private in foreign countries like Mexico benefit if they can borrow at the flexible rate e* and repay at the undervalued dollar rate of ePegged.. Overvaluation also keeps the prices of consumer goods low for domestic buyers. Finally, in a country may associate a strong or appreciating currency with a strong country creating support for political leaders. The disadvantages of an undervalued domestic currency and overvalued domestic currency are the flip side of the advantages. Consumers in countries like China, which maintained an undervalued domestic currency, will pay higher prices, reducing their standard of living. Producers in countries like Mexico, which maintained an overvalued domestic currency, will find it harder to export. A country forced to

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move toward the flexible exchange rate may face a political backlash from groups that benefited from the pegged rate. A floating exchange rate (the equilibrium, e*), is the easiest to maintain. However, because a country defending an undervalued domestic currency can do so more easily than a country defending an overvalued domestic currency. It can buy excess dollars or some other foreign currency with printed local currency. A country defending an overvalued currency must do so by using reserves of the undervalued foreign currency to purchase the excess supply of the domestic currency and thus supplying the excess demand for the foreign currency. 5. What does the demand curve for dollars show? Why does the demand curve for dollars slope downward? Answer: The demand curve for dollars represents the relationship between the quantity of dollars demanded and the nominal exchange rate between the dollar and another currency—say, the euro. The demand for dollars in exchange for euros is downward sloping because a higher exchange rate increases the price of U.S. goods faced by European firms and consumers, reducing their quantity of goods demanded and thus the quantity of dollars demanded. 6. What does the supply curve for dollars show? Why does the supply curve for dollars slope upward? Answer: The dollar supply curve represents the relationship between the quantity of dollars supplied and the nominal exchange rate between the dollar and another currency—say, the euro. The supply of dollars in exchange for euros is upward sloping because a higher exchange rate increases the quantity of goods supplied by European firms to the U.S. market, thus raising their dollar earnings and the quantity of dollars supplied to the foreign exchange market. 7. What does it mean to say that, at an exchange rate of $1 = 70 INR, the U.S. dollar is overvalued and the Indian rupee (INR) is undervalued? Answer: When we say that the dollar is overvalued with respect to the rupee, we mean that the dollar is worth more rupees than it would have been under a flexible exchange rate regime. Currencies may be overvalued or undervalued in a fixed or managed exchange rate regime. Suppose the Indian central bank pegs the rupee to the dollar. An undervalued rupee means that the exchange rate (rupee per dollar) at this peg is higher than the exchange rate that would have prevailed under a flexible exchange rate regime. When the price in the foreign exchange market is higher than the equilibrium price, the quantity of dollars supplied to the market is greater than the quantity demanded in exchange for rupees. In order to maintain the peg, the Indian authorities need to buy up these surplus dollars in exchange for rupees. 8. Why might a country peg its exchange rate at a level that overvalues its own currency? Answer: In many cases, countries maintain overvalued exchange rates. There are several reasons for this: ●

Most countries regularly borrow from foreign lenders. In developing countries like Mexico, these loans are typically denominated in dollars. Thus, Mexican borrowers receive dollars when they take out their loan and pay back dollars, not pesos, at the end of the loan period. If the peso appreciates after the loan is made, the number of pesos that are needed to pay back dollardenominated debts will decrease.

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An undervalued dollar—and by implication, an overvalued peso—lowers the cost that Mexican consumers pay in pesos to import goods from the United States. Consequently, the Mexican government can keep prices and inflation low by keeping the dollar undervalued and the peso overvalued.

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Another reason why countries maintain an overvalued fixed exchange rate is because a fall in the value of a currency is often perceived as a failure of government policies. This perception can be a problem for incumbent politicians in democratic countries.

9. How is the real exchange rate for the United States calculated? Answer: The real exchange rate for the United States is defined as the ratio of the dollar price of a basket of goods and services in the United States divided by the dollar price of the same basket of goods and services in a foreign country. The real exchange rate between the U.S. dollar and the Indonesian rupiah is calculated as follows:

10. How does a change in a country’s real exchange rate affect its net exports? Answer: When the real exchange rate increases, a country imports more from and exports less to foreign economies, reducing its net exports. Conversely, when the real exchange rate depreciates, a country imports less from and exports more to foreign economies, increasing its net exports. For example, when the U.S. dollar appreciates against the Chinese yuan, the United States imports more from China and exports less to China. 11. All else being equal, explain how an increase in the real interest rate is likely to affect a country’s net exports, labor demand, and level of employment. Answer: An increase in interest rates in the United States, relative to rates in other countries, implies that foreign investors will receive higher returns on their investments than they could elsewhere. Hence, with the increase in interest rates, foreigners will increase their demand for U.S. assets. Because assets in the United States are denominated in U.S. dollars, the demand for dollars will increase. This will shift the demand curve for dollars to the right. Given flexible exchange rates, this leads to an appreciation of the dollar relative to other currencies. An appreciation of the U.S. dollar means that American goods are more expensive for foreigners to buy, so exports will decline. Conversely, foreign goods are cheaper for Americans to buy, so imports increase. An increase in imports coupled with a decrease in exports means that net exports decline. The decrease in demand for U.S. products due to lower exports results in a decrease in demand for the labor to produce those products. This is reflected in a leftward shift of the labor demand curve, and the new equilibrium level of employment will thus be lower. 12. The economy of Freedonia is currently faced with high unemployment. Explain how the Freedonian central bank could increase net exports and lower unemployment. Answer: Two measures the bank could pursue are as follows: ●

Enact expansionary monetary policy to lower interest rates. The overall stimulatory effects of this policy were discussed in previous chapters but also relate to the open economy issues that are the subject of the present chapter. Lower rates mean a decreased demand for domestic assets and therefore a decreased demand for domestic currency. This, in turn, leads to a decline in the nominal exchange rate and thus a decline in the real exchange rate. The decline in the real

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exchange rate means that domestic goods are cheaper for foreigners to buy and that foreign goods are more expensive for domestic purchasers to buy. Exports will increase, imports decline, so net exports go up. As net exports increase, demand for domestic goods increases, and so the demand for labor to produce those goods increases. This results in an increase in employment as the labor demand curve shifts to the right. ●

Intervene in the foreign exchange market so as to depreciate the Freedonian currency. The chapter discussed such interventions on the part of the Chinese central bank in recent years. Domestic currency is supplied to the market by the central bank, which increases its holdings of foreign reserves by buying foreign currency and selling domestic currency. The result of such policies is to depress the nominal exchange rate and thereby decrease the real exchange rate. As the real exchange rate declines, the same consequences for GDP and unemployment described in the previous paragraph come into play.

Problems 1. Suppose that the European Union follows a flexible exchange rate regime. The exchange rate between the euro (EUR) and the U.S. dollar (USD) is currently 1 EUR = 1.17 USD. a. Use a graph to show the equilibrium in the foreign exchange market with the U.S.-dollar-per-euro exchange rate on the y-axis and the quantity of euros on the x-axis. b. Suppose that due to challenges in the eurozone economic environment, the cost of producing goods in the Eurozone increases sharply. What effect will this have on the exchange rate? Use a graph to explain. Answer: a. The following graph shows the foreign exchange market in the Eurozone. The supply curve for EURs in exchange for USDs is shown as an upward-sloping curve. The demand curve for EURs in exchange for USDs is shown as a downward-sloping curve. The y-axis shows how many USDs can be exchanged per EURs, while the x-axis shows the quantity of EURs traded in the foreign exchange market. As the Eurozone follows a flexible exchange rate regime, the market is in equilibrium at the point where the supply and demand curves intersect at an exchange rate of 1 EUR = 1.17 USD.

b. As the Eurozone production has become less competitive, the prices have increased. As a result of the price increase, there will be less demand for products from the Eurozone, and the demand curve will therefore shift to the left. As opposed to 1 EUR = 1.17 USD, the EUR will depreciate, for example, to a level of 1 EUR = 1 USD.

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2. Recall from Chapter 6 that the Big Mac index is used as a rough measure of purchasing power parity across countries. In January 2021, The Economist magazine reported: “A Big Mac costs 66,000 dong in Vietnam and US$5.66 in the United States. The implied exchange rate is 11,660.78. The difference between this and the actual exchange rate, 23,064.00, suggests the Vietnamese dong is 49.4% undervalued.” What The Economist refers to as the implied exchange rate is the hypothetical exchange rate that would make the real exchange rate 1. The actual exchange rate was 23,064.00 dong per U.S. dollar. Explain why this analysis led The Economist to suggest that “the Vietnamese dong is 49.4% undervalued.” Answer: The answer can be computed directly from the implied exchange rate (hypothetical rate that would make the real exchange rate 1) and the actual exchange rate. 𝑅𝑒𝑎𝑙 𝑒𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑒 − 𝐴𝑐𝑡𝑢𝑎𝑙 𝑒𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑒 11,660.78 − 23,064 ( ) ∗ 100 = −49.44% ) × 100 = ( 𝐴𝑐𝑡𝑢𝑎𝑙 𝑒𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑒 23,064 The negative sign implies that the Vietnamese dong is undervalued by 49.44%. A student could derive the same number by calculating the actual price of the Big Mac in Vietnam derived from the actual exchange rate (23,064 VND/USD × 5.66US = 130,542.2 and calculating the undervaluation by using the hypothetical Big Mac Price and the actual Big Mac Price. 66,000 − 130,542 ( ) ∗ 100 = −49.44% 130,542 Adapted from: http://www.economist.com/blogs/graphicdetail/2014/02/big-mac-index 3. In 2011, the government of Argentina developed a new policy (sometimes called the “dollar clamp”) to prevent Argentines from exchanging pesos, the local currency, for U.S. dollars. New restrictions hampered currency exchange: for example, buying dollars required advance approval from the national tax authority. a. Consider that Argentina has had a tumultuous economic history, with periods of high inflation and economic volatility. In particular, right before the restrictions were put in place, foreign investors (who were holding Argentinian assets) were starting to get skittish. Given this environment, why might the government put these exchange restrictions in place? b. Even with the restrictions in place, dollars were still available in the flourishing underground market (if you’re interested, the twitter feed @dolarblue posts the daily underground market exchange rate in Argentina). In these circumstances, would you expect the underground market exchange rate (pesos per dollar) to be higher or lower than the official exchange rate? Explain. c. At the end of 2015, the new President of Argentina, Mauricio Macri, eliminated the restrictions. Examine a five year chart of the Peso-dollar exchange rate here:

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https://fred.stlouisfed.org/series/ARGCCUSMA02STM . What happened to the official exchange rate when Macri enacted his policy of unrestricted foreign exchange transactions? Explain. Answer: a. As we saw in this chapter, currency appreciation increases the value of a country’s assets, leading to increased foreign investment. If the government was worried about investors selling off their assets, it might want to appreciate the currency. In addition, nervous Argentinian citizens might also, in volatile times, want to exchange pesos for the more stable USDs. This increase in demand would cause a devaluation—and, if the devaluation sparked more concerns, a downward spiral of continued devaluation. By restricting exchange, the government can stymie this channel for devaluation. b. We would expect the underground market exchange rate to be higher (pesos per dollar) than the official exchange rate—because the government is stifling demand, we expect demand to be at its normal, unimpeded level in the underground market. Thus, it should take more pesos to buy one dollar in the underground market. c. When Macri eliminated the restrictions, the peso-dollar exchange rate shot upwards. This makes sense, because we would expect the elimination of the restrictions to cause the demand for dollars to shift back to its initial level, leading to a depreciation of pesos.

4. Using the net exports curve and the labor demand and labor supply curve, explain how a rise in the real exchange rate can lead to a decrease in employment in a country.

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Answer: The net exports curve shows the relationship between the real exchange rate and net exports. When the real exchange rate between, say, the EUR and the USD, rises to R", Europe will export less to the U.S. as European goods are now more expensive to Americans and import more because American goods are now cheaper to Europeans. ‘Net exports’ is defined as the difference between a country’s exports and imports. As exports decrease and imports increase, the value of European net exports will also decrease. The economy moves to point A' in the following graph, which happens to show negative net exports.

As the foreign demand for European goods and services decreases, producers in European countries will decrease employment in the face of lower demand for their products. The demand for labor curve will shift to the left from D to D'. Assuming that wages are flexible, the real wage and level of employment in Europe will decrease to W' and L', respectively.

5. Econia trades with its neighbors, the countries of Governmentia and Sociologia. In Econia, the currency is called the econ; in Governmentia, the currency is called the gov; and in Sociologia, the currency is the soc. Nominal exchange rates follow: 200 econ = 1 gov, 4 socs = 1 gov, 100 econ = 1 soc A good that is produced and consumed in all three countries is the Mack Burger. The price of Macks in the three countries is as follows: one Mack costs 2 govs in Governmentia, 16 socs in Sociologia, and 600 econs in Econia.

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a. From the perspective of Governmentia, calculate the real exchange rate in Mack between Governmentia and Sociologia, using the nominal exchange rate (4 socs per gov) and prices listed above. Explain in words what the number you calculated means. b. If these three currencies can be freely traded so that their exchange rates are flexible or floating, can the nominal exchange rates listed above persist over time? Why or why not? (Hint: Show that currency traders could make unlimited profits if they could persistently trade at these exchange rates.) Answer: a. The equation for the real exchange rate (denoted by E) is as follows:

Where Domestic price = the domestic price of the Mack Burger e = Nominal Exchange Rate, expressed in units of foreign currency per unit of domestic currency Foreign price = the foreign price of the Mack Burger Governmentia is the domestic country, and Sociologia is the foreign country, as stated in the question. We know that the PDom is equal to 2 govs and that the PFor is equal to 16 socs. The nominal exchange rate is 4 socs/gov. Substituting these values into the real exchange rate equation yields: R = (2 × 4) / 16 = ½ We find the real exchange rate is equal to ½, which is the price of goods in Governmentia in terms of the price of goods in Sociologia. In other words, the real exchange rate is the relative price of goods in the two countries, or it is the rate at which we can trade goods in Governmentia for goods in Sociologia: A Governmentia Mack costs ½ of a Sociologia Mack. b. No, in a freely traded market currency traders have an opportunity to conduct arbitrage trades. (Arbitrage means that a trader can lock in a price differential for the same asset and make a profit without taking any risk.) The exchange rates as given allow for arbitrageurs to make money. For instance, starting with 1 gov, you could first trade the 1 gov for socs in the currency markets and receive 4 socs. Next, you could trade the 4 socs in the currency markets for 400 econs. Lastly, you could trade the 400 econs in the currency markets for 2 govs. There is an arbitrage opportunity to make a 1 gov profit by trading govs into socs into econs and then back into govs. For floating currencies, arbitrageurs will capitalize on the market inefficiencies and drive all nominal exchange rates to a consistent level; thus, the exchange rates as listed cannot persist over time. If they did, traders could continue the arbitrage trading given previously, turning 2 govs into 4, then 4 into 8, repeating the trade an infinite number of times and make unlimited profits. They would have discovered a money machine! 6. Challenge Problem: The beautiful, mythical country of Coloradial uses the teo as its currency, and the gritty, post-industrial country of Oheo uses the eren. Exactly 1 year ago, you could get 100 teos in exchange for 5 erens in the foreign exchange market. Since then, though, the real interest rate in Coloradial has increased, while staying constant in Oheo.

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a. All other things being equal, would you expect the eren to have appreciated or depreciated with respect to the teo? In other words, what would you expect to happen to the exchange rate of teo per eren? Explain your reasoning. b. Assume that the change in the value of the eren with respect to the teo (appreciation or depreciation depending on your previous answer) was 50 percent. What is the current nominal exchange rate expressed in teos per eren? c. One year ago, you borrowed 100,000 teos from a Coloradial bank at a rate of 3 percent per year. You then traded the 100,000 teos for erens at the nominal exchange rate that prevailed at the time (100 teos = 5 erens), and invested those erens in Oheo at 5 percent interest. After the year was over, your intention was to exchange the erens back for teos, repay the loan to the Coloradial bank, and keep a tidy profit. (This strategy is called a “carry trade” and is often popular with foreign exchange traders.) i.

How much would you have made on this strategy if the interest rates did not change and if the exchange rate had not changed from 100 teos = 5 erens? ii. What will be your profit (or loss) on the trade given the changes in the exchange rate you found in parts (a) and (b)? (Assume the interest rate you paid to the Coloradial bank was fixed in your loan agreement, and so did not change.) Answer: a. Because the real interest rate in Coloradial has increased, Coloradian assets, denominated in teos, become more attractive relative to Oheoan assets denominated in erens. Investors will want to buy Coloradian assets and therefore need teos. The increased demand for teos will increase their price in terms of erens. Hence, the teo will appreciate, and the eren will depreciate. That is, the exchange rate of teo per eren will decrease. b. The fact that you could exchange 5 erens for 100 teos implies that the nominal exchange rate last year was 1 eren = 20 teos. After a 50 percent depreciation, the value of the eren is half its original value; thus, 1 eren buys 50 percent fewer teos. Therefore, the new nominal exchange rate is 1 eren = 10 teos; i.e., E = 10 teos/eren. c. i.

If the exchange rate had remained unchanged at 20 teos per eren, you would have made 2,000 teos (= 100 erens) on the trade. You borrow 100,000 teos from a Coloradial bank at 3 percent; in one year you will owe 103,000 teos. You convert the 100,000 teos you borrowed into 5,000 erens, and invest that sum in Oheo at 5 percent. In one year’s time you will have a total of (1.05)(5,000) = 5,250 erens. If the exchange rate were still 20 teos per eren, you could convert the 5,250 erens into 105,000 teos. You owe the Coloradial bank 103,000 teos, and after you repay your loan, you are left with a profit of 2,000 teos, or 100 erens. Alternatively, you may calculate your profit by focusing on the difference between the interest rates in the two countries. You make a profit of 5 percent – 3 percent = 2 percent on the 100,000 teos you borrowed. This yields a profit of 2,000 teos, which, if the exchange rate is still 20 teos per eren, is equal to 100 erens.

ii. This part of the question illustrates the great risks inherent in any carry trade. If the eren depreciates by 50 percent−from 20 teos per eren to 10 teos per eren,then when you go to change your 5,250 erens into teos at the end of the year, you only get 52,500 teos for your

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5,250 erens. However, remember that you owe the Coloradial bank 103,000 teos. Hence, you lose 103,000 teos – 52,500 teos = 50,500 teos, or 5,050 erens. 7. The following graph shows the Hungarian forint (HUF) per U.S. dollar (USD) exchange rate for 2008–2017.

The table that follows shows the real interest rates in the United States and Hungary during the same period. Year United States Hungary

2008 3.08 5.15

2009 2.47 6.57

2010 2.06 4.93

2011 1.14 6.27

2012 1.31 5.94

2013 1.47 3.38

2014 1.37 0.71

2015 2.20 0.12

2016 2.45 0.73

2017 2.17 -2.41

Source: The World Bank, Real Interest Rate (%) Hungary and The United States, https://data.worldbank.org/indicator/FR.INR.RINR?end=2016&locations=HU&start=2008

What could explain why the Hungarian forint depreciated between 2008 and 2017 with respect to the U.S. dollar? Explain your answer with the help of the information given in the table. Answer: In this case, despite interest rates being higher in Hungary between 2008 and 2014, investors were selling the Hungarian forint (HUF) and buying the U.S. dollar (USD). This could have partially been due to fears of the Hungarian economy collapsing during this period, whereas the U.S. economy was thought to be relatively more stable. In fact, Hungary had to turn to the IMF and the EU for a stand-by loan agreement in October 2008. This was when the HUF depreciated around 60% against the USD as seen on the graph. Once the Hungarian economy normalized around 2013–2014, the interest rate also decreased and the exchange rate stayed in the band between 250–300 HUF per USD. Graph source: https://www.xe.com/currencycharts/?from=USD&to=HUF&view=10Y 8. Since 2008, the dollar has generally appreciated against the euro. a. Suppose that in the short run the Fed wanted both to weaken the dollar (that is, stop its appreciation and/or cause it to depreciate) and stimulate investment. Based on what you have learned in this chapter and in Chapter 13, discuss whether the Fed can achieve both of these goals simultaneously through monetary policy. b. Suppose instead that the European Central Bank conducts contractionary monetary policy. What is the short-run effect, if any, of this policy on the euro-per-dollar nominal exchange rate and on the real exchange rate between the United States and the eurozone? In your answer regarding the real exchange rate, state any assumptions you are making. Answer:

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a. We are told that the dollar has depreciated relative to the euro. Facing this situation, the Federal Reserve wants both to weaken the dollar and to stimulate investment. To weaken the dollar, the Fed must conduct expansionary monetary policy—e.g., buy bonds in an open-market operation, which would increase reserves in the banking system and thereby increase the money supply. The supply of reserves would shift to the right, resulting in a lower equilibrium fed funds rate, and lower interest rates in general, in the United States. Holding everything else constant, a] decrease in the U.S. real interest rate makes investment in U.S. financial markets a less attractive opportunity than investment Europe, and thus leads to capital flowing out of the United States and into Europe. As investors abandon dollardenominated assets for those denominated in the euro, they sell dollars and buy euros, thus causing the dollar to depreciate (and the euro to appreciate). In addition, the decrease in interest rates necessary to defend the dollar is consistent with the Fed’s second goal of stimulating investment. Investment is, among other things, negatively related to the real interest rate. Therefore, the Fed can achieve both goals simultaneously through expansionary monetary policy. b. Contractionary monetary policy carried out by the European Central Bank (ECB) will raise interest rates in those European countries over which the ECB has jurisdiction—that is, the countries that belong to the European Monetary Union (EMU). These are the countries that use the euro. An increase in EMU interest rates will lead to capital flowing into EMU countries from the United States. Because euro-denominated assets will become more attractive relative to dollardenominated assets, investors will demand more euro-denominated assets, and hence demand more euros to buy those assets. This will cause an appreciation of the euro, and a depreciation of the dollar. The euro/dollar nominal exchange rate will decrease—it will take fewer euros to buy one dollar. From the standpoint of the United States, the real exchange rate is equal to , where e is equal to the nominal exchange rate (the number of euros per dollar). A decrease in e will lead to a decrease in the real exchange rate, assuming no increase in relative prices in the United States and European Monetary Union, i.e., assuming that does not increase, or if it does increase, it does not do so enough to offset the decrease in e. 9. Thailand and Taiwan are both rapidly growing Asian economies that trade actively with other countries. a. Suppose a computer circuit board is the only good produced in Thailand and Taiwan. The circuit board costs 100 baht in Thailand and 200 NT (New Taiwan dollars) in Taiwan. The nominal exchange rate is 2 NT per baht.. Calculate the real exchange rate from Thailand’s perspective (that is, using Thailand as the domestic economy, so the nominal exchange rate is 2 NT per baht). Show your work. Intuitively, what does this number represent? b. The Taiwanese current account with the rest of the world is initially balanced –in other words, it is running neither a deficit nor a surplus. Taiwan alone experiences an economic boom and its real interest rate rises at the same time. Explain the mechanisms by which the Taiwanese current account is affected by its boom and the increase in its real interest rate.

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c. Assume that the change in the value of the NT-per-baht exchange rate was 50 percent, which, depending on your answer in part (b), was either appreciation or depreciation. What is the current nominal exchange rate expressed in NT per baht? Show your work. Answer: a. The real exchange rate is 1 Taiwanese computer circuit board per Thai computer circuit board.

The real exchange rate formula is where e is the nominal exchange rate and E is the real exchange rate. The nominal exchange rate from the Thai perspective is 2 NT per bhat. Therefore, E = [(100 bhat) × (2 NT per bhat)] / 200 NT = 1. This represents the number of Taiwanese computer circuit boards it takes to buy one Thai computer circuit board. b. Both the economic boom and the rise in the real interest rate cause a current account deficit in Taiwan. The economic boom raises domestic income or output, which increases imports because domestic income is one of the determinants of import demand. Since NX = X – IM, an increase in imports decreases net exports, which leads to a current account deficit (or negative current account). The rising Taiwanese interest rates increase the attractiveness of Taiwanese or NTdenominated assets compared to foreign assets. The NT appreciates relative to other currencies, causing a rise in the nominal exchange rate. Therefore, the real exchange rate also rises according to the exchange rate formula. An increase in the real exchange rate makes Taiwanese exports relatively more expensive to foreigners and makes foreign imports relatively less expensive to the Taiwanese. This decreases exports and increases imports, which decreases net exports. Thus, the rise in interest rates also contributes to a Taiwanese current account deficit. c. From (b) we know that the NT appreciates. In part (a) you could exchange 2 NT for 1 baht. After the 50 percent appreciation of the NT, the value of the nominal exchange rate is 4/3 bhat per NT (e = 4/3 NT per baht). You can now exchange 4/3 NT for one baht. 10. You may have seen the term “capital flight” in news articles about developing countries. Capital flight occurs when foreign investors, often spooked by political instability, lose confidence in a country’s assets and decide to sell them. This phenomenon is particularly concerning to the many developing countries that rely on foreign direct investment, which we discussed in Chapter 214 a. Using Exhibit 29.13, show how capital flight—a reduction of demand for a country’s assets at every interest rate—would affect the real exchange rate. Assume that the domestic credit market (panel (a)) doesn’t change, so that the real interest rate is held fixed (for example, the capital flight is caused by political instability). Explain why capital flight is represented by a rightward shift of the curve in panel (b). Then explain how this rightward shift in panel (b) coincides with a movement along the curve in panel (c) and, therefore, a fall in the real exchange rate. b. Suppose the local government maintains a fixed exchange rate by changing the domestic interest rate. Faced with capital flight, how would the government need to change the interest rate to maintain its exchange rate? Explain using the charts from part (a) of this problem. Answer: a. Capital Flight first causes a rightward shift of the panel (b) curve. This shift occurs because now, at every interest rate, foreign investors will be less likely to invest in the home country. Thus, the country will have increased net capital outflows which, as we’ve seen in the previous chapter, is equal to net exports. As we can see in the chart below, net exports/NCOs will now increase at the equilibrium interest rate. As foreign investors transition their investments outside of the home country, they sell the home currency, leading to a depreciation of the home currency. We see this

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in panel (c) of the chart: the exchange rate decreases from 𝐸1 to E*.

b. In order to counteract the depreciation caused by capital flight, the home country now needs to cause appreciation. They can achieve this appreciation by increasing domestic interest rates through, for example, contractionary monetary policy. We can see this in the charts below: the real interest rate increases from r* to 𝑟1, ultimately causing the real exchange rate to return to 𝐸1.

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11. Imagine that there are two economies in the world: Bostonia and New Yorkland. Bostonia’s currency is the sock and New Yorkland’s is the yank. Despite the longstanding rivalry between their citizens, Bostonia and New Yorkland are trading partners. a. The Central Bank of New Yorkland decides to conduct contractionary monetary policy. Explain the short-run effect, if any, on the following: i. . The sock/yank nominal exchange rate ii. New Yorkland’s net exports iii. Bostonia’s net exports b. GDP in New Yorkland recently plummeted. At first, the citizens in Bostonia cheered, happy to see their rivals taken down a notch. But then an economist (always a killjoy) asserts that the fall in New Yorkland’s GDP is likely to hurt Bostonia’s GDP in the short run. Could the economist be correct? Why or why not? Answer: a. i.

Contractionary monetary policy carried out by the New Yorkland Central Bank will increase nominal and real interest rates (holding expected inflation constant) in New Yorkland. An increase in New Yorkland interest rates will lead to capital flowing into New Yorkland and out of Bostonia. Because yank-denominated assets will become more attractive relative to

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sock-denominated assets, investors will demand more yank-denominated assets, and hence demand more yanks to buy those assets. This will cause an appreciation of the yank, and a depreciation of the sock. An appreciation of the yank means that the sock/yank nominal exchange rate will increase— it will take fewer yanks to buy one sock, i.e., one yank is worth more socks. ii. An appreciation of the yank relative to the sock will lead to a fall in net export demand for New Yorkland. Bostonia goods become more attractive to New Yorkland consumers as the purchasing power of the yank abroad increases (increasing imports), while New Yorkland goods become less attractive to Bostonia consumers (the purchasing power of the sock decreases). Hence, New Yorkland’s net exports will decrease. iii. A decrease in New Yorkland’s net exports implies an increase in the net exports of its trading partner, Bostonia. b. Yes, the economist could be correct. Income abroad is a determinant of net exports. When New Yorkland’s GDP decreases, citizens of New Yorkland will have less money to spend on goods, including imports from Bostonia, so there will be less demand for goods and services in Bostonia and less demand for the labor to produce them. GDP is likely to go down in the short run, and unemployment likely to go up, due to the falloff in exports to New Yorkland. 12. Recall the discussion in “Letting the Data Speak” regarding the Chinese yuan. Why did the Chinese authorities keep the yuan undervalued until the end of 2016? At the beginning of 2014, $1 was valued roughly at 6.05 yuan, while by the end of 2016, $1 was valued at 6.95 yuan, since then it has stabilized at $1 = 6.35 yuan by early March 2018. What factor may have caused the strengthening of the Chinese currency since early 2017? Answer: The undervalued Chinese yuan boosts Chinese exports toward the U.S. by keeping the price of Chinese goods low and making them competitive. In return, China buys American debt to allow this transaction to be financed. The problem is that Chinese workers receive lower wages for their work, and hence their purchasing power is lower; they cannot buy as many goods as they would be able to with a “normal” exchange rate. The weak yuan also hurts China’s competitors who export to the U.S. In addition, the weak yuan distorts American business as it crowds out local manufacturing. Eventually, the exchange rate will have to stabilize between the U.S. and China when exports from and production in China probably decline.

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Evidence-Based Economics Solutions by Chapter Chapter 1 1. Student answers will vary. 2. Student answers will vary. 3. Student answers will vary. Chapter 2 1. ii 2. a. (1.10)^6 –1 = 1.77 –1 = 77% b. $50,000×(1.10)^6 = $88,578 Chapter 3 1. a. East, extra benefit of $25 month. b. West, saves $40/month, which outweighs $25/month from the view in East. c. East, since $25/month from the view outweighs $20/month from new driving time saved in West. d. East, since $25/month from the view still outweighs $23/month from driving time saved in West. Chapter 4 1. a. Rise. b. Kuwait > United States > Netherlands. Here we assume that only the price of gasoline has changed and all else is equal, including tastes, preferences, household income, availability and prices of related goods, and beliefs about the future. c. Movement along demand curve. d. Shift in demand curve Chapter 19 1. a. No change b. No change c. Decrease by $2 billion d. Decrease by $1 billion e. No change 2. Real government expenditure grew so quickly that it more than compensated for the fall in the other categories of expenditure. This was due to the expansion of government activity during World War II. The U.S. entered World War II on December 8, 1941.

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Chapter 20 1. a. Since both countries have the same human capital per worker and physical capital per worker, the difference must be in TFP. In other words, Ruritania must have 10% higher TFP than Francia. b. Ruritania’s physical capital increases by 20%. This will lead to an increase in GDP per capita and the exact magnitude of this increase will depend on the marginal product of capital. The actual increase is 36%. This large increase may be driven by more than just an increase in the capital stock. For example, the investment in new factories and infrastructure may have improved technology (broadly construed), so the overall increase may be due to a combination of TFP and physical capital per worker. c. Since the country’s physical capital and human capital per worker do not change, the 20% growth in GDP per capita must be due to 20% increase in TFP. d. Even though Francia’s does not experience technological progress (worsening of techniques and knowledge), the banning of left-hand people from management, science and medical professions would reduce observed TFP. This is because it leads to a misallocation of talent, and hence the existing resources of the country cannot be well utilized. In this example, this causes a decline of 10% in GDP, corresponding to a 10% worsening in TFP. In the same way that TFP differences driven by misallocation of talent could be important for over-time changes, they could also be responsible for the initial differences in 2015. Chapter 21

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1. a. 4% growth for Mississippi for 10 years would increase its GDP per capita by (1.04)^ (10) -1 = 48%. Since the initial gap is to folds, this does not close the full gap. If instead it was 4% growth for Mississippi for 10 years, it would lead to an increase of (1.7)^ (10) 1 = 100%, thus successfully closing the gap between the 2 states. b. In this case to achieve a 7% growth difference Mississippi would need to grow at 9% a year for 10 years. c. Although investment in primary education may have high social value, it won’t be very effective for increasing GDP per capita in the next 10 years, since individuals who fully benefit from this education (those who are in kindergarten now) will not join the labor force for another 12 years. d. We know from the previous answers that we need 7% a year growth difference between Mississippi and Connecticut for the gap to be closed. A 7% increase in the physical capital stock will not be sufficient, because with human capital and technology fixed, this will run into diminishing returns. Chapter 22 1. a. Since the researcher’s theory emphasizes agriculture and both countries’ economies had much higher shares of agriculture in 1850, the GDP per capita ratio should have been greater. In reality, it was lower. b. Similarly, if climate is the determining factor, then the area that was the United States should have been richer in 1500 than the area that later became Mexico. In practice, the Mexican side was richer. This suggests that climate is unlikely to be determining factor for the US-Mexico prosperity difference. c. If the researcher is right, the two Nogaleses, which have the same climate, should have the same average income per capita. In practice, Nogales Arizona is about twice as rich as Nogales Sonora. This also sheds doubt on the researcher’s theory. d. If the two towns used to be united and the inhabitants have similar cultural backgrounds, then cultural factors cannot explain the differences. In practice, there may be some cultural differences between the two sides, and one would need to study how large they are and whether they could impact the different economic outcomes in the two Nogaleses. Chapter 23 1. a. Nominal wages didn’t fall during either recession. b. Downward nominal wage rigidity is the term that economists use to describe the tendency of nominal wages to remain fixed (instead of falling) during a period of economic contraction. Firms tend to hold nominal wages fixed to sustain the morale of their employees. Consequently, firms usually prefer to fire some workers rather than cutting the nominal wages of workers they employ. In addition, average wages among surveyed workers rose during the 2020 recession because job losses were disproportionately prone to hit workers with low wages.

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c. Downward nominal wage rigidity increases the level of unemployment compared to the level of unemployment that would emerge with flexible wages. Exhibit 23.11 illustrates this mechanism. If wages were allowed to fall, the quantity of labor demanded would be higher than it is when wages are held rigid above the market clearing level. Moreover, if wages were allowed to fall, the quantity of labor supplied would equal the quantity of labor demanded, eliminating unemployment altogether in theory. 2. a. This is a leftward shift of the labor demand curve because there are 2000 fewer firms hiring workers. Since the labor demand curve of the remaining 98,000 firms does not change and the wage remains constant, the shutdown of the 2000 firms will reduce employment by 2000× 8 = 16,000. This means total employment will be 800,000-16,000 = 784,000. b. If the 16,000 workers remain in the labor force, then unemployment will increase by 16,000 (since employment has declined by 16,000). Some of these workers may leave the labor force, in which case unemployment will increase by less than 16,000. Since wages are being kept constant, workers are not necessarily on their supply curve, hence much of the 16,000 increase in unemployment would be involuntary. c. If wages adjusted downwards to $65,000, then this would encourage the remaining 98,000 employers to hire more workers, and thus employment would be higher than 784,000. It can never increase above 800,000, since the reason why the wage is decreasing is because the labor demand curve has shifted left, and hence, employment can never increase. Exactly where between 784,000 and 800,000 the level of employment will be depends on the elasticities of labor supply and labor demand, and whether $65,000 is along the labor supply curve of workers or is constrained by downwardrigidity in wages. d. If employment of Black workers fell by the same percentage decline as overall employment, then a quarter of the 16,000 decline in total employment, 4000, would be among Black workers. But if declines in labor demand disproportionately affect Black workers, then the decline in employment among Black workers would be more than 4000. Since the question specifies that Black workers were more likely to be among those employed in textile and apparel, we would expect that the burden of employment declines would fall more on their shoulders, and thus more than 4000 of the workers losing their jobs in Raleigh-Durham would be Black. Chapter 24 1. Without deposit insurance, if all $50 billion of deposits are demanded back, there is no way the bank can pay all these depositors and will fail. If depositors come to believe that the bank will fail, they will all wish to line up outside the bank to get their money back, because they expect others to do so and if they didn’t do it, some of the other depositors will get their money back and they might not get anything themselves. When there is deposit insurance, then each depositor knows that their deposits are insured, and thus they

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4. 5. 6.

will be able to get their money back, even if the bank fails. Hence, they will have no incentive to line up outside the bank. Recall from the answer to part 1 that even without this adverse shock, when there is no deposit insurance, a bank run is possible if depositors suddenly become pessimistic about the survival of a bank. Hence, the same possibility is present when there is a negative shock (and arguably more likely, since such a negative shock could be the trigger that makes people more pessimistic about the survival chances of a bank). Once again, in the presence of deposit insurance, a bank run is not possible, even with the $5 billion loss of assets of the bank. When the bank does not fail, the bank’s stockholders are the ones bearing the $5 billion loss, and since there is $10 billion of stockholders’ equity, there is enough of a buffer to withstand this loss. In the previous two parts, bank failures were caused because of bank runs even though the bank itself was solvent — it had enough equity to cover losses, but depositors became pessimistic about the survival of a bank and demanded their money back. When they did not do so, the bank still had enough equity to cover the loss of its real estate assets. However, in the current case that’s no longer true — there is $10 billion of stockholders’ equity and a loss of $11 billion. Therefore, without any other intervention, the bank is now insolvent and will fail. This is regardless of whether there is deposit insurance. Such a handout would save the bank, because it would no longer be insolvent. In this case, asset losses exceed the bank’s stockholders’ equity ($15 billion vs. $10 billion of stockholders’ equity). So the bank is insolvent and will fail. We do not know for sure, but deposit insurance appears to have played a central role. Deposit insurance was introduced in 1933, after most of the Great Depression’s bank failures had already occurred. In addition, the magnitude of the economic downturn was smaller during the 2007-2009 compared to the downturn during the Great Depression. Thus as suggested in part (5), fewer banks may have been pushed into insolvency in the 2007-2009 period. Some also believe that the Fed gave handouts to banks during the 2007-2009 financial crisis, especially large banks, that saved them from failing. This is an active area of debate, and regardless of whether there was such handouts, it seems unlikely that this can explain why so few banks failed, since the banks that failed both during the Great Depression and the recent crisis tended to be smaller, and these are generally not the ones that are thought to have received more favorable treatment from the government during 2007-2009.

Chapter 25 1. The equation only says that the growth rate of nominal GDP will rise. Nominal GDP can be decomposed into inflation plus the growth rate of real GDP. Using only the quantity theory of money we don’t know how an increase in the growth rate of money supply will separately affect inflation and the growth rate of real GDP. 2. The quantity theory of money predicts that Growth rate of money supply = Inflation rate + Growth rate of real GDP.

By rearranging this equation we can show that

202 Inflation rate = Growth rate of money supply -Growth rate of real GDP.

Accordingly, the quantity theory of money implies that the long-run (annualized) inflation rate will be 100% = 102% - 2% Accordingly, the price level is doubling on average each year. To be a hyperinflation the price level needs to double within three years, so this would be a hyperinflation. 3. The price level will increase by a factor of 8, which is equivalent to an increase of 700 percent.

Chapter 26 1. i. A collapsing housing bubble. ii. A reduction in consumption. iii. Mortgage defaults leading to a financial/banking crisis. 2. a. Consumption should fall by $300 billion. b. Consumption would be predicted to decline by about 3 percent. 3. Between 2000 and 2006, housing prices in the United States increased by about 90 percent. As detailed in the chapter, this increase abruptly reversed. a. What caused the housing bubble in the first place? b. When the bubble burst, what was its impact on banks and the financial system? Answer: a. The symptom of the bubble was an increase in house prices by almost 90 percent between 2000 and 2006. Many people took mortgages (which is natural); however, their annual income only allowed a very long-term maturity loan. Further, the properties themselves were listed as collateral. Since the price of the collateral was also increasing, many people had obtained homes they would not have been able to own under normal circumstances. In addition, banks were granting mortgages based on the current value of the property and not the pre-boom value. This meant that if people lost their jobs, they would have to default on their mortgages. b. When the bubble burst, banks tried to cash in on the collateral, which they were only able to sell at a discount. This meant that banks very quickly became insolvent and had to shut down. When a bank fails, money is drawn out of the financial system. Over time, this creates a lack of access to credit and loans and/or significantly increases the interest rate, slowing down business and plunging the economy into a recession.

4. Okun’s Law predicts that the change in the rate of unemployment will be –(1/2)(g – 2%), where g is the real rate of economic growth. In 2020, the real rate of economic growth was -3.5%, implying that Okun’s Law predicts that the change in the rate of unemployment would be –(1/2)(-3.5% - 2%) = +2.75 percentage points. The actual change in the rate of unemployment was +4.4 percentage points. The actual increase in unemployment exceeded the amount predicted by Okun’s Law because the labor market responded more quickly than usual during a pandemic in which many firms shut down altogether and did not engage in labor hoarding.

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Chapter 27 1. 0.75*$250 billion = $187.5 billion. 2. 0.75*$300 billion = $225 billion. 3. 0.5*$300 billion = $150 billion 4. 0.25*$1,350 billion = $337.5 billion 5. ($187.5+$225+$150+$337.5)= $900. $900 billion/$19.1 trillion = 4.7 percent. 6. People who are unemployed tend to be short on funds to pay for essentials, like food and shelter (e.g., paying the rent). Payments made to these households by the government, are more likely to be spent than payments made to households with jobs (who tend to be less cash-squeezed). Chapter 28 1. Agricultural workers tend to be paid half as much as factory workers. Factory jobs provide comparatively reliable income that does not depend on the timing of seasonal rains or whether the harvest happens to be good or bad. Famines generally don’t occur in factory towns. Finally, foreign direct investment, which is used to create factories for multinational firms, facilitates the transfer of new technology to developing countries. On the other hand, factory work can often be dangerous/unhealthy and tends to require workers to relocate from their agricultural villages (where multi-generational families live). 2. Economic development almost always coincides with a movement from agricultural work to factory work, substantially increasing the fraction of the population that lives in towns and cities. 3. The fraction of children (ages 7-14) working falls by about 20 percentage points. 4. Globalization will likely increase factory jobs for girls, allowing them to gain marketable skills, establish more independence, and improved self-sufficiency with higher incomes. Chapter 29 1. a. This is a sustainable strategy because every country can issue as much of its own currency as it wants to issue. b. No. Future movements in the exchange rate are not necessarily predictable. 2. a. In 10 months, the country will run out of foreign currency reserves and will no longer be able to keep its currency overvalued. Foreign exchange traders may anticipate this oncoming crisis and begin putting pressure on the exchange rate to devalue (by selling the currency) long before the monetary authority actually runs out of foreign reserves. b. An investor could profit by selling the domestic currency at an over-valued exchange rate (before the anticipated future devaluation) and then buying domestic currency back at the new exchange rate after the devaluation. The difference in the exchange rate is profit to the investor. 3. Most managed exchange rates are undervalued because that is a sustainable policy that does not rely on spending down foreign exchange reserves. See The Economist’s Big

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Mac index (https://www.economist.com/big-mac-index) for suggestive evidence that undervaluation is, in fact, far more common than over-valuation for managed exchange rates in developing economies. 4. a. The Thai government must sell U.S. dollars to keep the baht overvalued. If they run out of dollars, they cannot defend the overvaluation. b. During this period, the Thai economy was struggling and the government was forced to use dollar reserves to help stabilize corporations that could not pay back their foreign debts.

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