SOLUTIONS MANUAL For Macroeconomics 11th Edition By Michael Parkin by welldoneassistant

Part 1: Answers To The Review Quiz C h a p t e r

WHAT IS ECONOMICS?

Answers to the Review Quiz Page 2 1.

List some examples of the scarcity that you face. Examples of scarcity common to students include not enough income to afford both tuition and a nice car, not enough learning capacity to study for both an economics exam and a chemistry exam in one night, and not enough time to allow extensive studying and extensive socializing.

Find examples of scarcity in today’s headlines. A headline in the Chicago Tribune on July 10, 2012 was “Parents Sue to Block Changes in Home care for Children.” This story discusses how the state of Illinois was trying to decrease home care on “technology dependent” ill children in order to “force … [them] out of their homes and into institutional care.” The story points out that the scarcity in-home nursing care had led to high costs, which the state was trying to decrease by moving the children into hospitals where skilled nursing care is more readily available.

Find an example of the distinction between microeconomics and macroeconomics in today’s headlines. Microeconomics: On July 9, 2012 a headline in The Wall Street Journal was “Lenovo Keeps Production In-House.” This story covers a microeconomic topic because it discusses computer manufacturer Lenovo has decided to produce its own computers rather than out-source them to companies that specialize in their production. Macroeconomics: On July 9, 2012, a headline in The New York Times was “Obama Poised for New Fight with G.O.P. Over Tax Cuts.” This story covers a macroeconomic topic because it concerns taxes in the entire economy.

Page 9 1.

Describe the broad facts about what, how, and for whom goods and services are produced. What gets produced is significantly different today than in the past. Today the U.S. economy produces more services, such as medical operations, teaching, and hair styling, than goods, such as pizza, automobiles, and computers. How goods and services are produced is by businesses determining how the factors of production, land, labor, capital and entrepreneurship, are combined to make the goods and services we consume. Land includes all natural resources, both renewable natural resources such as wood, and nonrenewable natural resources such as natural gas. Labor’s quality depends on people’s human capital. In the U.S. economy, human capital obtained through schooling has increased over the years with far more people completing high school and attending college than in past years. Finally, for whom are goods and services to be produced depends on the way income is distributed to U.S. citizens. This distribution is not equal; the 20 percent of people with the lowest income earn about 5 percent of the nation’s total income while the 20 percent of people with the highest incomes earn about 50 percent of total income. On the average, men earn more than women, whites more than non-whites, and college graduates more than high school graduates.

CHAPTER 1

Use headlines from the recent news to illustrate the potential for conflict between selfinterest and the social interest. One example of an issue concerns the size of drinks sold in New York City. Take the June 11, 2012 headline from the Houston Chronicle “NYC Proposes Ban on Large Sodas at Restaurants.” This story discusses Mayor Bloomberg’s intention to pass a law restricting sales in restaurants, movie theaters, and sports arenas from selling sodas in sizes larger than 16 fluid ounces. Mayor Bloomberg believes his action is in the social interest because “The percentage of the population that is obese is skyrocketing.” However soda drinkers, pursuing their self-interest disagree. One analyst said “Folks who want to buy Big Gulps, … a lot of those customers, you’re only going to be able to take it away from them by prying it out of their cold, dead hands.”

Page 11 1.

Explain the idea of a tradeoff and think of three tradeoffs that you have made today. A tradeoff reflects the point that when someone gets one thing, something else must be given up. What is given up is the opportunity cost of whatever is obtained. Three examples of tradeoffs that are common to students include: a) When a student sleeps in rather than going to his or her early morning economics class, the student trades off additional sleep for study time. The opportunity cost of the decision is a lower grade on the exam. b) When a student running late for class parks his or her car illegally, the student trades off saving time for the risk of a ticket. The potential opportunity cost of the decision is the goods and services that cannot be purchased if the student receives an expensive parking ticket. c) A student trades off higher income by spending time during the day working at a part-time job for less time spent at leisure time and study. The opportunity cost for the higher income is less leisure and lower grades in classes.

Explain what economists mean by rational choice and think of three choices that you’ve made today that are rational. A rational choice is one that compares the costs and benefits of the different actions and then chooses the action that has the greatest benefit over cost for the person making the choice. Three rational choices made by students include: a) The choice to skip breakfast to go to class. In this case the benefit is the higher grade in the class and the cost is the breakfast forgone. b) The choice to stop talking with a friend on the phone and start studying for an impending exam. In this case the benefit is the resulting higher grade in the class and the cost is the conversation forgone. c) The choice to do laundry today rather than watch television. In this case the benefit is the fact the student will have clean clothes to wear and the cost is the loss of the entertainment the television show would have provided.

Explain why opportunity cost is the best forgone alternative and provide examples of some opportunity costs that you have faced today. When a decision to undertake one activity is made, often many alternative activities are no longer possible. Often these activities are mutually exclusive so only the highest valued alternative is actually forgone. For instance, the decision to go to a student’s 8:30 AM class eliminates the possibility of sleeping in during the hour and of jogging during the hour. But in this case, it is impossible to both sleep in and to jog during the hour, so the opportunity cost cannot be both activities. What is lost is only the activity that otherwise would have been chosen—either sleeping in or jogging—which is whatever activity would have been chosen, that is, the most highly valued of the forgone alternatives. For students, attending class, doing homework, studying for a test are all activities with opportunity costs.

Explain what it means to choose at the margin and illustrate with three choices at the margin that you have made today.

WHAT IS ECONOMICS?

Choosing at the margin means choosing to do a little more or a little less of some activity. Three common examples students encounter are: a) When a student faces a chemistry and an economics final exam in one day, the student must determine whether spending the last hour studying a little more chemistry or a little more economics will yield a better contribution (marginal benefit) to his or her overall GPA. b) A college student buying a computer must decide whether the marginal benefit of adding 1 GB of additional memory is worth the marginal cost of the additional memory. c) A student football fan with a choice of a cheap seat in the student bleachers located at the far end of the playing field or a more expensive seat located on the 30 yard line must determine whether the marginal benefit of watching the game from a better seat is worth the marginal cost of the higher ticket price.

Explain why choices respond to incentives and think of three incentives to which you have responded today. People making rational decisions compare the marginal benefits of different actions to their marginal costs. Therefore people’s choices change when their incentives, that is the marginal benefit and/or marginal cost, of the choice changes. Just as everyone else, students respond to incentives; a) A student studies because of the incentives offered by grades. b) A student is more likely to attend a class if attendance is factored into the grade. c) A student might attend a meeting of a club if the student’s significant other is eager to attend the meeting.

Page 12 1.

Distinguish between a positive statement and a normative statement and provide examples. A positive statement is a description of how the world is. It is testable. A normative statement is a description of how the world ought to be. It is, by its very nature, not testable because there is no universally approved criterion by which the statement can be judged. “I will receive an A for this course,” is a positive statement made by an economics student—it might not be true, but it is testable. “I will receive a good grade for this course,” is a normative statement. Whether someone agrees with it depends on his or her interpretation of what makes for a “good” grade.

What is a model? Can you think of a model that you might use in your everyday life? A model is a description of some aspect of the economic world. It includes only those features that are necessary to understand the issue under study. An economic model is designed to reflect those aspects of the world that are relevant to the user of the model and ignore the aspects that are irrelevant. A typical model is a GPS map. It reflects only those aspects of the real world that are relevant in assisting the user in reaching his or her destination and avoids using information irrelevant to travel.

How do economists try to disentangle cause and effect? Economists use models to understand some aspect of the economic world. Testing the predictions of models makes it necessary to disentangle cause and effect. To overcome this problem, economists have three methods of testing their models: Using a natural experiment, using a statistical investigation, and using economic experiments. A natural experiment is a situation that arises in the ordinary course of life in which one factor being studied varies and the other factors are the same. This method allows the economist to focus on the effect from the factor that differs between the two situations. A statistical investigation looks for correlations between variables but then determining whether the correlation actually reflects causation can be difficult. An economic experiment puts people into decision making situations and then varies the relevant factors one at a time to determine each factor’s effect.

How is economics used as a policy tool?

CHAPTER 1

Individuals, businesses, and governments use economics as a policy tool. Individuals use the economic ideas of marginal benefit and marginal cost when making decisions for such topics as attending college, paying cash or credit for a purchase, and working. Businesses also use the concepts of marginal benefit and marginal cost when making decisions about what to produce, how to produce, and even how many hours to stay open. Finally governments also use marginal benefit and marginal cost when deciding issues such as the level of property taxes, the amount to fund higher education, or the level of a tariff on Brazilian ethanol.

WHAT IS ECONOMICS?

Answers to the Study Plan Problems and Applications 1.

Apple Inc. decides to make iTunes freely available in unlimited quantities. a. Does Apple’s decision change the incentives that people face? Apple’s decision changes people’s incentives. For example, it increases people’s incentives to buy an iPod to take advantage of the newly “free” music available on iTunes.

b. Is Apple’s decision an example of a microeconomic or a macroeconomic issue? Apple’s decision is a microeconomic decision because it affects a single company and a single market.

Which of the following pairs does not match? a. Labor and wages Labor earns wages, so this pair matches.

b. Land and rent Land earns rent, so this pair matches.

c. Entrepreneurship and profit Entrepreneurship earns profit, so this pair matches.

d. Capital and profit Capital earns interest, so this pair does not match.

Explain how the following news headlines concern self-interest and the social interest. a. Starbucks Expands in China Starbucks’ expansion is a decision made by Starbucks to further Starbucks’ interest. Thus the decision is directly in Srarbucks’ self interest. The social interest is affected because Starbucks’ expansion will have an effect in China. For instance, more Chinese citizens might drink coffee rather than tea and fewer coffee shops run by Chinese firms might open.

b. McDonald’s Moves into Gourmet Coffee McDonald’s decision to serve gourmet coffee is a decision made by McDonald’s to further McDonald’s interest. Thus the decision is directly in McDonald’s self interest. The social interest is affected because more people will drink coffee rather than other drinks such as sodas.

c. Food Must Be Labeled with Nutrition Data The decision to require that food must be labeled with nutrition information is made in the social interest. This decision is not made by any one single firm and so does not (necessarily) reflect anyone’s self interest.

The night before an economics test, you decide to go to the movies instead of staying home and working your MyEconLab Study Plan. You get 50 percent on your test compared with the 70 percent that you normally score. a. Did you face a tradeoff? Yes, you faced a tradeoff. The tradeoff was between a higher test score and an evening with your friends at the movies.

b. What was the opportunity cost of your evening at the movies? The opportunity cost of going to the movies is the fall in your grade. That is the 20 points forgone from choosing to see the movie rather than study.

CHAPTER 1

Costs Soar for London Olympics The regeneration of East London, the site of the 2012 Olympic Games, is set to add extra £1.5 billion to taxpayers’ bill. Source: The Times, London, July 6, 2006 Is the cost of regenerating East London an opportunity cost of hosting the 2012 Olympic Games? Explain why or why not. The regeneration of East London is an opportunity cost of hosting the 2012 Olympics if East London would not have been regenerated otherwise. However, if there were already plans underway to regenerate East London, then the cost is not an opportunity cost of hosting the Olympics because the cost would have been paid even if London did not host the Olympics.

Which of the following statements is positive, which is normative, and which can be tested? a. The United States should cut its imports. The statement is normative and cannot be tested.

b. China is the largest trading partner of the United States. The statement is positive and can be tested.

c. If the price of antiretroviral drugs increases, HIV/AIDS sufferers will decrease their consumption of the drugs. The statement is positive and can be tested.

WHAT IS ECONOMICS?

Answers to Additional Problems and Applications 7.

Hundreds Line up for 5 p.m. Ticket Giveaway By noon, hundreds of Eminem fans had lined up for a chance to score free tickets to the concert. Source: Detroit Free Press, May 18, 2009 When Eminem gave away tickets, what was free and what was scarce? Explain your answer. The seats in the concert are scarce—there are only a limited number (1,500 as it happens) available. Also scarce is the time the enthusiastic fans spent in line to acquire the tickets. In addition, if the fans who scored tickets attended the concert rather than sell their “free” tickets, they incurred the opportunity cost of the foregone ticket price. So the concert was far from “free” for the concert-goers. The publicity that Eminem receives is free to him but the publicity used reporters’ scarce time to report on the lines for the tickets rather than reporting on other news worthy events.

How does the creation of a successful movie influence what, how, and for whom goods and services are produced? The “what” question is affected in two ways. First, one good or service that is produced is the successful movie. Second, spinoffs (Iron Man II) and/or similar films likely will be created in the future. The “how” question is affected to the extent that movies use different production methods. Some movies, for instance, have a lot of special effects while other movies have few or none. The “for whom” question is influenced because those people who, as the result of the blockbuster movie, have higher incomes so that more goods and services are produced for them.

How does a successful movie illustrate self-interested choices that are also in the social interest? The a successful movie increases the income of the people involved with the movie. Hence these people’s choices are driven largely by self interest. However the creation of a successful movie also increases the quantity of widely enjoyed entertainment. The amount of entertainment available in the economy increases which benefits society. So the choices the people made in their self interest also reflected choices made in the social interest.

10.

Before starring in Iron Man, Robert Downey Jr. had appeared in 45 movies that grossed an average of $5 million on the opening weekend. In contrast, Iron Man grossed $102 million. a. How do you expect the success of Iron Man to influence the opportunity cost of hiring Robert Downey Jr.? The salary that must be paid to Robert Downey Jr. to appear in future movies increased because some of the success of Iron Man was attributed to Mr. Downey. As a result the opportunity cost to movie producers of hiring Mr. Downey increased.

b. How have the incentives for a movie producer to hire Robert Downey Jr. changed? There are two effects on the incentives of producers to hire Mr. Downey. First, because the opportunity cost of hiring Mr. Downey increased, the incentive to hire him decreased. However because part of the success of Iron Man was attributed to Mr. Downey’s acting in the title role, producers expect that his acting will lead to increased success for future movies. This belief increases producers’ incentives to hire Mr. Downey.

11.

CHAPTER 1

What might be an incentive for you to take a class in summer school? List some of the benefits and costs involved in your decision. Would your choice be rational? Early graduation, smaller class sizes, and/or retaining eligibility for a scholarship are examples of incentives that encourage taking summer classes. The benefits of taking summer classes might include early graduation, more personal attention from the instructor, retained eligibility for a scholarship, and increased knowledge about some aspect of the world. Costs potentially include forgone summer jobs or internships, less time to spend with friends, and additional tuition and other class-related expenses if the class I not one that would be taken otherwise. The choice is rational as long as the student determines that taking summer classes offers the highest benefit over cost for the use of his or time and efforts.

12.

Look at today’s Wall Street Journal. What is the leading economic news story? With which of the big economic questions does it deal and what tradeoffs does it discuss or imply? On July 10, 2012, the top economic news story discussed President Obama’s proposal to extend tax cuts for families earning less than $250,000 and, by not extending tax cuts for families earning more than $250,000, to raise taxes on families earning more than $250,000. This story involved the “for whom?” question because families paying lower taxes will be able to purchase more goods and services. Of course, families paying higher taxes will be able to purchase fewer goods and services. The story implicitly illustrates a tradeoff: If taxes are raised on families earning more than $250,000, these families will have less income to spend on goods and services but the government will collect more tax revenue to spend on goods and services.

13.

Provide two microeconomic statements and two macroeconomic statements. Classify your statements as positive or normative. Explain why. Microeconomic statements are: Fewer deep water oil wells should be drilled in the Gulf of Mexico. If less oil is produced, the price of oil will rise. The first statement is normative because it relies on what the person thinks “should” be done. The second statement is positive because it is possible to test the effect of less oil being produced. Macroeconomic statements are: The currently unemployment rate is too high. The current unemployment rate is higher for blacks than for whites. The first statement is normative because it depends on what is deemed “too high.” The second statement is positive because it can be checked to determine its validity.

Appendix

GRAPHS IN ECONOMICS

Answers to the Review Quiz Page 28 1.

Explain how we “read” the three graphs in Figs. A1.1 and A1.2. The points in the graphs relate the quantity of the variable measured on the one axis to the quantity of the variable measured on the other axis. The quantity of the variable measured on the horizontal axis (the x-axis) is measured by the horizontal distance from the origin to the point. Similarly, the quantity of the variable measured on the vertical axis (the y-axis) is measured by the vertical distance from the origin to the point. The point relates these two quantities. For instance, in Figure A1.2a, point A shows that at a price of $1.37 cents per song, 3.8 million songs are downloaded.

Explain what scatter diagrams show and why we use them. Scatter diagrams plot the value of one economic variable against the value of another variable for a number of different values of each variable. We use scatter diagrams because they quickly reveal if a relationship exists between the two variables. Moreover, if a relationship exists, scatter diagrams show whether increases in one variable are associated with increases or decreases in the other variable.

Explain how we “read” the three scatter diagrams in Figs. A1.3 and A1.4. The scatter diagram in Figure A1.3 shows the relationship between box office ticket sales and DVDs sold for 9 popular movies. The figure shows that higher box office sales are associated with a higher number of DVDs sold. But the figure shows that the relationship is weak. The scatter diagram in Figure A1.4a shows the relationship between income, in thousands of dollars per year, and expenditure, also in thousands of dollars per year, for the years 2001 to 2011. The scatter diagram shows that higher income leads to higher expenditure. The figure also shows that the relationship is relatively strong. The scatter diagram in Figure A1.4b shows the relationship between the inflation rate and the unemployment rate for the years 2001 to 2011. The figure shows that for most of the years, there was a weak relationship between these variables, with perhaps higher inflation being associated with lower unemployment.

APPENDIX 1

Draw a graph to show the relationship between two variables that move in the same direction. A graph that shows the relationship between two variables that move in the same direction is shown by a line that slopes upward. Figure A1.1 illustrates such a relationship.

Draw a graph to show the relationship between two variables that move in opposite directions. A graph that shows the relationship between two variables that move in the opposite directions is shown by a line that slopes downward. Figure A1.2 illustrates such a relationship.

GRAPHS IN ECONOMICS

Draw a graph to show the relationship between two variables that have a maximum and a minimum. A graph that shows the relationship between two variables that have a maximum is shown by a line that starts out sloping upward, reaches a maximum, and then slopes downward. Figure A1.3 illustrates such a relationship with curve B. A graph that shows the relationship between two variables that have a minimum is shown by a line that starts out sloping downward, reaches a minimum, and then slopes upward. Figure A1.3 illustrates such a relationship with curve A.

Which of the relationships in Questions 4 and 5 is a positive relationship and which is a negative relationship? The relationship in Question 4 between the two variables that move in the same direction is a positive relationship. The relationship in Question 5 between the two variables that move in the opposite directions is a negative relationship.

What are the two ways of calculating the slope of a curved line? To calculate the slope of a curved line we can calculate the slope at a point or across an arc. The slope of a curved line at a point on the line is defined as the slope of the straight line tangent to the curved line at that point. The slope of a curved line across an arc—between two points on the curved line—equals the slope of the straight line between the two points.

How do we graph a relationship among more than two variables? To graph a relationship among more than two variables, hold constant the values of all the variables except two. Then plot the value of one of the variables against the other variable.

10.

Explain what change will bring a movement along a curve. A movement along a curve occurs when the value of a variable on one of the axes changes while all of the other relevant variables not graphed on the axes do not change. The movement along the curve shows the effect of the variable that changes, ceteris paribus (holding all of the other non-graphed variables constant).

11.

Explain what change will bring a shift of a curve. A curve shifts when there is a change in the value of a relevant variable that is not graphed on the axes. In this case the entire curve shifts.

APPENDIX 1

Answers to the Study Plan Problems and Applications Use the spreadsheet to work Problems 1 to 3. The spreadsheet provides data on the U.S. economy: Column A is the year, column B is the inflation rate, column C is the interest rate, column D is the growth rate, and column E is the unemployment rate.

1 2 3 4 5 6 7 8 9 10 11

A 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

B 1.6 2.4 1.9 3.3 3.4 2.5 4.1 0.1 2.7 1.5 3.0

C 3.4 1.6 1.0 1.4 3.2 4.7 4.4 1.5 0.2 0.1 0.1

D 1.1 1.8 2.5 3.5 3.1 2.7 1.9 −0.3 −3.5 3.0 1.7

E 4.7 5.8 6.0 5.5 5.1 4.6 4.6 5.8 9.3 9.6 9.0

Draw a scatter diagram of the inflation rate and the interest rate. Describe the relationship. To make a scatter diagram of the inflation rate and the interest rate, plot the inflation rate on the x-axis and the interest rate on the y-axis. The graph will be a set of dots and is shown in Figure A1.4. The pattern made by the dots tells us that as the inflation rate increases, the interest rate usually increases so there is a (weak) positive relationship.

Draw a scatter diagram of the growth rate and the unemployment rate. Describe the relationship. To make a scatter diagram of the growth rate and the unemployment rate, plot the growth rate on the x-axis and the unemployment rate on the y-axis. The graph will be a set of dots and is shown in Figure A1.5. The pattern made by the dots tells us that when the growth rate increases, the unemployment rate usually decreases so there is a negative relationship.

GRAPHS IN ECONOMICS

Draw a scatter diagram of the interest rate and the unemployment rate. Describe the relationship. To make a scatter diagram of the interest rate and the unemployment rate, plot the interest rate on the x-axis and the unemployment rate on the y-axis. The graph will be a set of dots and is shown in Figure A1.6. The pattern made by the dots tells us that when the interest rate increases, the unemployment rate usually decreases so there is a negative relationship.

Use the following news clip to work Problems 4 to 6. Avengers Shatters More Records: Source: Boxofficemojo.com, Data for weekend of May 11-12, 2012 4.

Draw a graph of the relationship between the revenue per theater on the y-axis and the number of theaters on the x-axis. Describe the relationship. Figure A1.7 shows the relationship. As the figure shows, there is a positive relationship.

Movie Marvel’s The Avengers Dark Shadows Think Like a Man The Hunger Games

Calculate the slope of the relationship between 3,755 and 2,052 theaters. The slope equals the change in revenue per theater divided by the change in the number of theaters. The slope equals ($7,906 − $2,834)/(3,755 − 2,052) which equals $2.98 per theater.

Calculate the slope of the relationship between 2,052 and 2,531 theaters. The slope equals the change in revenue per theater divided by the change in the number of theaters. The slope equals ($2,834 − $1,780)/(2,052 − 2,531) which equals −$2.20 per theater. © 2014 Pearson Education, Inc.

Theater s (numbe r) 4,349

Revenue (dollars per theater)

3,755 2,052 2,531

$7,906 $2,834 $1,780

$23,696

APPENDIX 1

Calculate the slope of the relationship shown in Figure A1.8. The slope is −5/4. The curve is a straight line, so its slope is the same at all points on the curve. Slope equals the change in the variable on the y-axis divided by the change in the variable on the x-axis. To calculate the slope, you must select two points on the line. One point is at 10 on the y-axis and 0 on the x-axis, and another is at 8 on the x-axis and 0 on the y-axis. The change in y from 10 to 0 is associated with the change in x from 0 to 8. Therefore the slope of the curve equals −10/8, which equals −5/4.

Use the relationship shown in Figure A1.9 to work Problems 8 and 9. 8.

Calculate the slope of the relationship at point A and at point B. The slope at point A is −2, and the slope at point B is −0.25. To calculate the slope at a point on a curved line, draw the tangent to the curved line at the point. Then find a second point on the tangent and calculate the slope of the tangent. The tangent at point A cuts the y-axis at 10. The slope of the tangent equals the change in y divided by the change in x. The change in y equals −4 (6 minus 10) and the change in x equals 2 (2 minus 0). The slope at point A is −4/2, which equals −2. Similarly, the slope at point B is −0.25. The tangent at point B goes through the point (4, 2). The change in y equals 0.5, and the change in x equals −2. The slope at point B is −0.25.

Calculate the slope across the arc AB. The slope across the arc AB is −1.125. The slope across an arc AB equals the change in y, which is 4.5 (6.0 minus 1.5) divided by the change in x, which equals −4 (2 minus 6). The slope across the arc AB equals 4.5/−4, which is −1.125.

GRAPHS IN ECONOMICS

Use the table to work Problems 10 and 11. The table gives the price of a balloon ride, the temperature, and the number of rides a day. 10.

Draw a graph to show the relationship between the price and the number of rides, when temperature is 70°F. Describe this relationship.

Price (dollars per ride) 5 10 15

Figure A1.10 shows the relationship between the price and the number of balloon rides when the temperature is 70F. The relationship between the price and the number of rides is inverse; that is, when the price rises, the number of rides decreases.

11.

What happens in the graph in Problem 10 if the temperature rises to 90°F? If the temperature rises to 90F, the curve shifts rightward. This shift is illustrated in Figure A1.11. In that figure, both the initial curve, which applies when the temperature is 70F, and the new curve, which applies when the temperature is 90F, are illustrated. The curve when the temperature is 90F lies to the right of the curve when the temperature is 70F indicating that at every price, more balloon rides are taken when the temperature is 90F rather than 70F.

Balloon rides (number per day) 50F 70F 90F 32 40 50 27 32 40 18 27 32

APPENDIX 1

Answers to Additional Problems and Applications Use the spreadsheet to work Problems 12 to 14. The spreadsheet provides data on oil and gasoline: Column A is the year, column B is the price of oil (dollars per barrel), column C is the price of gasoline (cents per gallon), column D is U.S. oil production, and column E is the U.S. quantity of gasoline refined (both in millions of barrels per day).

12.

1 2 3 4 5 6 7 8 9 10 11

A 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

B 26 26 31 42 57 66 72 100 62 79 95

C 146 139 160 190 231 262 284 330 241 284 358

D 5.8 5.7 5.7 5.4 5.2 5.1 5.1 5.0 5.4 5.5 5.7

E 8.6 8.8 8.9 9.1 9.2 9.3 9.3 9.0 9.0 9.0 8.7

Draw a scatter diagram of the price of oil and the quantity of U.S. oil produced. Describe the relationship. Figure A1.12 shows the scatter diagram between the price of a barrel of oil and the quantity of U.S. oil produced. It shows a very weak negative relationship.

13.

Draw a scatter diagram of the price of gasoline and the quantity of gasoline refined. Describe the relationship. Figure A1.13 shows the scatter diagram between the price of a gallon of gasoline and the quantity of gasoline refined. It shows a weak positive relationship.

GRAPHS IN ECONOMICS

14.

Draw a scatter diagram of the quantity of U.S. oil produced and the quantity of gasoline refined. Describe the relationship. Figure A1.14 shows the scatter diagram between the quantity of U.S. oil produced and the quantity of gasoline refined. It shows a negative relationship.

Use the following data to work Problems 15 to 17. Draw a graph that shows the relationship x between the two variables x and y in the y table to the right.

0 25

1 24

2 22

3 18

4 12

5 0

To make a graph that shows the relationship between x and y, plot the x variable on the xaxis and the y variable on the y-axis. Figure A1.15 shows this graph.

15. a. Is the relationship positive or negative? The relationship is negative because x and y move in opposite directions: As x increases, y decreases.

b. Does the slope of the relationship become steeper or flatter as the value of x increases? The slope becomes steeper as x increases.

c. Think of some economic relationships that might be similar to this one. The less expensive a good, the greater is the number of people who buy it. The higher the interest rate, the smaller is the number of people who take out home mortgages. The less expensive gasoline, the greater the miles car owners drive.

16.

Calculate the slope of the relationship between x and y when x equals 3. The slope equals −5. The slope of the curve at the point where x is 3 is equal to the slope of the tangent to the curve at that point. Plot the relationship and then draw the tangent line at the point where x is 3 and y is 18. Now calculate the slope of this tangent line by finding another © 2014 Pearson Education, Inc.

APPENDIX 1

point on the tangent. When x equals 5, y equals 10 on the tangent, so another point is x equals 5 and y equals 10. The slope equals the change in x, −8, divided by the change in y, 2, so the slope is −4.

17.

Calculate the slope of the relationship across the arc as x increases from 4 to 5. The slope is –12. The slope of the relationship across the arc when x increases from 4 to 5 is equal to the slope of the straight line joining the points on the curve at x equals 4 and x equals 5. When x increases from 4 to 5, y falls from 12 to 0. The slope equals the change in x, −12 (0 minus 12), divided by the change in y, 1 (5 minus 4), so the slope across the arc is −12.

18.

Calculate the slope of the curve in Figure A1.16 at point A. The slope is −2. The curve is a straight line, so its slope is the same at all points on the curve. Slope equals the change in the variable on the y-axis divided by the change in the variable on the x-axis. To calculate the slope, select two points on the line. One point is at 18 on the yaxis and 0 on the x-axis, and another is at 9 on the x-axis and 0 on the y-axis. The change in y from 18 to 0 is associated with the change in x from 0 to 9. Therefore the slope of the curve equals −18/9, which equals −2.

Use Figure A1.17to work Problems 19 and 20. 19. Calculate the slope at point A and at point B. The slope at point A is −4, and the slope at point B is −1. To calculate the slope at a point on a curved line, draw the tangent to the line at the point. Then find a second point on the tangent and calculate the slope of the tangent. The tangent at point A cuts the x-axis at 2.5. The slope of the tangent equals the change in y divided by the change in x. The change in y equals 6 (6 minus 0) and the change in x equals −1.5 (1 minus 2.5). The slope at point A is 6/−1.5, which equals −4. Similarly, the slope at point B is −1. The tangent at point B cuts the yaxis at 5. The change in y equals 3, and the change in x equals −3. The slope at point B is −1.

20.

Calculate the slope across the arc AB. The slope across the arc AB is −2. The slope across the arc AB equals the change in y, which is 4 (6 minus 2) divided by the change in x, which equals −2 (1 minus 3). The slope across the arc AB equals 4/−2, which equals −2. © 2014 Pearson Education, Inc.

GRAPHS IN ECONOMICS

Use the following table to work Problems 21 to 23. The table gives information about umbrellas: price, the number purchased, and rainfall in Price inches. (dollars 21. Draw a graph to show the relationship per between the price and the number of umbrella) umbrellas purchased, holding the 20 amount of rainfall constant at 1 inch. 30 Describe this relationship. 40 Figure A1.18 shows the relationship. To draw a graph of the relationship between the price and the number of umbrellas when the rainfall equals 1 inch, keep the rainfall at 1 inch and plot the data in that column against the price. This curve is the relationship between price and number of umbrellas when the rainfall is 1 inches. The relationship between the price and the number of umbrellas is an inverse relationship; as the price rises, the number of umbrellas decreases.

22.

What happens in the graph in Problem 21 if the price rises and rainfall is constant? If the price rises, the number of umbrellas decreases. In Figure A1.18, there is a movement upward along the (unchanged) curve.

23.

What happens in the graph in Problem 21 if the rainfall increases from 1 inch to 2 inches? As shown in Figure A1.19, the curve shifts rightward. In that figure, both the initial curve, which applies when the rainfall is 1 inch, and the new curve, which applies when the rainfall is 2 inches, are illustrated. The curve when the rainfall is 2 inches lies to the right of the curve when the rainfall is 1 inch indicating that at every price, more umbrellas are purchased when the rainfall is 2 inches than when the rainfall is 1 inch.

Umbrellas (numbers per day) 0 1 2 (inches of rainfall) 4 2 1

7 4 2

8 7 4

C h a p t e r

THE ECONOMIC PROBLEM

Answers to the Review Quizzes Page 34 1.

How does the production possibilities frontier illustrate scarcity? The unattainable combinations of production that lie beyond the PPF illustrate the concept of scarcity. There simply are not enough resources to produce any of these combinations of outputs. Additionally, while moving along the PPF to increase the production of one good requires that the production of another good be reduced, which also illustrates scarcity.

How does the production possibilities frontier illustrate production efficiency? The combinations of outputs that lie on the PPF illustrate the concept of production efficiency. These points are the maximum production points possible and are attained only by producing the goods and services at the lowest possible cost. Any point inside the frontier reflects production where one or both outputs may be increased without decreasing the other output level. Clearly, such points cannot be production efficient.

How does the production possibilities frontier show that every choice involves a tradeoff? Movements along the PPF frontier illustrate that producing more of one good requires producing less of other good. This observation reflects the result that a tradeoff must be made when producing output efficiently.

How does the production possibilities frontier illustrate opportunity cost? The negative slope of the production possibility curve illustrates the concept of opportunity cost. Moving along the production possibility frontier, producing additional units of a good requires that the output of another good must fall. This sacrifice is the opportunity cost of producing more of the first good.

Why is opportunity cost a ratio? The slope of the PPF is a ratio that expresses the quantity of lost production of the good on the yaxis to the increase in the production of the good on the x-axis moving downward along the PPF. The steeper the slope, the greater ratio, and the greater is the opportunity cost of increasing the output of the good measured on the horizontal axis.

Why does the PPF bow outward and what does that imply about the relationship between opportunity cost and the quantity produced? Some resources are better suited to produce one type of good or service, like pizza. Other resources are better suited to produce other goods or services, like DVDs. If society allocates resources wisely, it will use each resource to produce the kind of output for which it is best suited. Consider a PPF with pizza measured on the x-axis and DVDs measured on the y-axis. A small increase in pizza output when pizza production is relatively low requires only a small increases in the use of those resources still good at making pizza and not good at making DVDs. This yields a small decrease in DVD production for a large increase in pizza production, creating a relatively low opportunity cost reflected in the gentle slope of the PPF over this range of output. However, the same small increase in pizza output when pizza production is relatively large will require society to devote to pizza production those resources that are less suited to making pizza © 2014 Pearson Education, Inc.

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and more suited to making DVDs. This reallocation of resources yields a relatively small increase in pizza output for a large decrease in DVD output, creating a relatively high opportunity cost reflected in the steep slope of the PPF over this range of output. The opportunity cost of pizza production increases with the quantity of pizza produced as the slope of the PPF becomes ever steeper. This effect creates the bowed out effect (the concavity of the PPF function) and means that as more of a good is produced, the opportunity cost of producing additional units increases.

Page 37 1.

What is marginal cost? How is it measured? Marginal cost is the opportunity cost of producing one more unit of a good or service. Along a PPF marginal cost is reflected in the absolute value of the slope of the PPF. In particular, the magnitude of the slope of the PPF is the marginal cost of a unit of the good measured along the xaxis. As the magnitude of the slope changes moving along the PPF, the marginal cost changes.

What is marginal benefit? How is it measured? The marginal benefit from a good or service is the benefit received from consuming one more unit of it. It is measured by what an individual is willing to give up (or pay) for an additional that last unit.

How does the marginal benefit from a good change as the quantity produced of that good increases? As the more of a good is consumed, the marginal benefit received from each unit is smaller than the marginal benefit received from the unit consumed immediately before it, and is larger than the marginal benefit from the unit consumed immediately after it. This set of results is known as the principle of decreasing marginal benefit and is often assumed by economists to be a common characteristic of an individual’s preferences over most goods and services in the economy.

What is allocative efficiency and how does it relate to the production possibilities frontier? Production efficiency occurs when production takes place at a point on the PPF. This indicates that all available resources are being used for production and society cannot produce additional units of one good or service without reducing the output of another good or service. Allocative efficiency, however, requires that the goods and services produced are those that provide the greatest possible benefit. This definition means that the allocative efficient level of output is the point on the PPF (and hence is a production efficient point) for which the marginal benefit equals the marginal cost.

What conditions must be satisfied if resources are used efficiently? Resources are used efficiently when more of one good or service cannot be produced without producing less of some of another good or service that is valued more highly. This is known as allocative efficiency and it occurs when: 1) production efficiency is achieved, and 2) the marginal benefit received from the last unit produced is equal to the marginal cost of producing the last unit.

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What generates economic growth? The two key factors that generate economic growth are technological change and capital accumulation. Technological change allows an economy to produce more with the same amount of limited resources, Capital accumulation, the growth of capital resources including human capital, means that an economy has increased its available resources for production.

How does economic growth influence the production possibilities frontier?

THE ECONOMIC PROBLEM

Economic growth shifts the PPF outward. Persistent outward shifts in the production possibility frontier—economic growth—are caused by the accumulation of resources, such as more capital equipment or by the development of new technology.

What is the opportunity cost of economic growth? When a society devotes more of its scarce resources to research and development of new technologies, or devotes additional resources to produce more capital equipment, both decisions lead to increased consumption opportunities in future periods at the cost of less consumption today. The loss of consumption today is the opportunity cost borne by society for creating economic growth.

Why has Hong Kong experienced faster economic growth than the United States? Hong Kong chose to devote a greater proportion of its available resources to the production of capital than the United States. This allowed Hong Kong to grow at a faster rate than the United States. By foregoing consumption and producing a greater proportion of capital goods over the last few decades, Hong Kong was able to achieve output per person equal to 94 percent of that in the United States.

Does economic growth overcome scarcity? Scarcity reflects the inability to satisfy all our wants. Regardless of the amount of economic growth, scarcity will remain present because it will never be possible to satisfy all our wants. For instance it will never be possible to satisfy all the wants of the several thousand people who all would like to ski the best slopes on Vail with only their family and a few best friends present. So economic growth allows more wants to be satisfied but it does not eliminate scarcity.

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What gives a person a comparative advantage? A person has a comparative advantage in an activity if that person can perform the activity at a lower opportunity cost than anyone else, If the person gives up the least amount of other goods and services to produce a particular good or service, the person has the lowest opportunity cost of producing that good or service.

Distinguish between comparative advantage and absolute advantage. A person has a comparative advantage in producing a good when he or she has the lowest opportunity cost of producing it. Comparative advantage is based on the output forgone. A person has an absolute advantage in production when he or she uses the least amount of time or resources to produce one unit of that particular good or service. Absolute advantage is a measure of productivity in using inputs.

Why do people specialize and trade? People can compare consumption possibilities from producing all goods and services through self-sufficiency against specializing in producing only those goods and services that reflect their comparative advantage and trading their output with others who do the same. People can then see that the consumption possibilities from specialization and trade are greater than under selfsufficiency. Therefore it is in people’s own self-interest to specialize. It was Adam Smith who first pointed out in the Wealth of Nations how individuals voluntarily engage in this socially beneficial and cooperative activity through the pursuit of their own self-interest, rather than for society’s best interests.

What are the gains from specialization and trade? From society’s standpoint, the total output of goods and services available for consumption is greater with specialization and trade. From an individual’s perspective, each person who specializes enjoys being able to consume a larger bundle of goods and services after trading with © 2014 Pearson Education, Inc.

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others who have also specialized, than would otherwise be possible under self-sufficiency. These increases are the gains from specialization and trade for society and for individuals.

What is the source of the gains from trade? As long as people have different opportunity costs of producing goods or services, total output is higher with specialization and trade than if each individual produced goods and services under self-sufficiency. This increase in output is the gains from trade.

Page 45 1.

Why are social institutions such as firms, markets, property rights, and money necessary? These social institutions factors necessary for a decentralized economy to coordinate production. Firms are necessary to allow people to specialize. Without firms, specialization would be limited because a person would need to specialize in the entire production of a good or service. With firms people are able to specialize in producing particular bits of a good or service. For a society to enjoy the fruits of specialization and trade, the individuals who comprise that society must voluntarily desire to specialize in the first place. Discovering trade opportunities after a person has specialized in his or her comparative advantage in production is what allows that person to gain from his or her own specialization efforts. Trading opportunities can only take place if a market exists where people observe prices to discover available trade opportunities. Money is necessary to allow low-cost trading in markets. Without money, goods would need to be directly exchanged for other goods, a difficult and unwieldy situation. Finally people must enjoy social recognition of and government protection of property rights to have confidence that their commitments to trade arrangements will be respected by everyone in the market.

What are the main functions of markets? The main function of a market is to enable buyers and sellers to get information and to do business with each other. Markets have evolved because they facilitate trade, that is, they facilitate the ability of buyers and sellers to trade with each other.

What are the flows in the market economy that go from firms to households and the flows from households to firms? On the real side of the economy, goods and services flow from firms to households. On the monetary side of the economy, payments for factors of production, wages, rent, interest, and profits, flow from firms to households. Flowing from households to firms on the monetary side of the economy are the expenditures on goods and services and on the real side are the factors of production, labor, land, capital, and entrepreneurship.

THE ECONOMIC PROBLEM

Answers to the Study Plan Problems and Applications Use the following information to work Problems 1 to 3. Brazil produces ethanol from sugar, and the land used to grow sugar can be used to grow food crops. Suppose that Brazil’s production possibilities for ethanol and food crops are as in the table. 1. a. Draw a graph of Brazil’s PPF and explain how your graph illustrates scarcity. Figure 2.1 shows Brazil’s PPF. The production possibilities frontier indicates scarcity because it shows the limits to what can be produced. In particular, production combinations of ethanol and food crops that lie outside the production possibilities frontier are not attainable.

Ethanol (barrels per day) 70 64 54 40 22 0

and and and and and and

Food crops (tons per day) 0 1 2 3 4 5

b. If Brazil produces 40 barrels of ethanol a day, how much food must it produce to achieve production efficiency? If Brazil produces 40 barrels of ethanol per day, it achieves production efficiency if it also produces 3 tons of food per day.

c. Why does Brazil face a tradeoff on its PPF? Brazil faces a tradeoff on its PPF because Brazil’s resources and technology are limited. For Brazil to produce more of one good, it must shift factors of production away from the other good. Therefore to increase production of one good requires decreasing production of the other, which reflects a tradeoff.

2. a. If Brazil increases its production of ethanol from 40 barrels per day to 54 barrels per day, what is the opportunity cost of the additional ethanol? When Brazil is production efficient and increases its production of ethanol from 40 barrels per day to 54 barrels per day, it must decrease its production of food crops from 3 tons per day to 2 tons per day. The opportunity cost of the additional ethanol is 1 ton of food per day for the entire 14 barrels of ethanol or 1/14 of a ton of food per barrel of ethanol.

b. If Brazil increases its production of food crops from 2 tons per day to 3 tons per day, what is the opportunity cost of the additional food? When Brazil is production efficient and increases its production of food crops from 2 tons per day to 3 tons per day, it must decrease its production of ethanol from 54 barrels per day to 40 barrels per day. The opportunity cost of the additional 1 ton of food crops is 14 barrels of ethanol.

c. What is the relationship between your answers to parts (a) and (b)? The opportunity costs of an additional barrel of ethanol and the opportunity cost of an additional ton of food crop are reciprocals of each other. That is, the opportunity cost of 1 ton of food crops is 14 barrels of ethanol and the opportunity cost of 1 barrel of ethanol is 1/14 of a ton of food crops.

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illustrates increasing opportunity cost? Brazil faces an increasing opportunity cost of ethanol production. For instance, when increasing ethanol production from 0 barrels per day to 22 barrels the opportunity cost of a barrel of ethanol is 1/22 of a ton of food while increasing ethanol production another 18 barrels per day (to a total of 40 barrels per day) has an opportunity cost of 1/18 of a ton of food per barrel of ethanol. The PPF’s bowed outward shape reflects the increasing opportunity cost.

Use the above table (for Problems 1 to 3) to work Problems 4 and 5. 4. Define marginal cost and calculate Brazil’s marginal cost of producing a ton of food when the quantity produced is 2.5 tons per day. The marginal cost of a good is the opportunity cost of producing one more unit of the good. When the quantity of food produced is 2.5 tons, the marginal cost of a ton of food is the opportunity cost of increasing the production of food from 2 tons per day to 3 tons per day. The production of ethanol falls from 54 barrels per day to 40 barrels per day, a decrease of 14 barrels per day. The opportunity cost of increasing food production is the decrease in ethanol product, so the opportunity cost of producing a ton of food when 2.5 tons of food per day are produced is 14 barrels of ethanol per day.

Define marginal benefit, explain how it is measured, and explain why the data in the table in does not enable you to calculate Brazil’s marginal benefit of food. The marginal benefit of a good is the benefit received from consuming one more unit of the good. The marginal benefit of a good or service is measured by the most people are willing to pay for one more unit of it. The data in the table do not provide information on how much people are willing to pay for an additional unit of food. The table has no information on the marginal benefit of food.

Distinguish between production efficiency and allocative efficiency. Explain why many production possibilities achieve production efficiency but only one achieves allocative efficiency. Production efficiency occurs when goods and services are produced at the lowest cost. This definition means that production efficiency occurs at any point on the PPF. Therefore all of the production points on the PPF are production efficient. Allocative efficiency occurs when goods and services are produced at the lowest cost and in the quantities that provide the greatest possible benefit. The allocatively efficient production point is the single point on the PPF that has the greatest possible benefit.

THE ECONOMIC PROBLEM

Use the following graphs to work Problems 7 to 10. Harry enjoys tennis but wants a high grade in his economics course. The graphs show his PPF for these two “goods” and his MB curve from tennis.

What is Harry’s marginal cost of tennis if he plays for (i) 3 hours a week; (ii) 5 hours a week; and (iii) 7 hours a week? (i) Harry’s marginal cost of an hour of tennis is 1.5 percentage points. When Harry increases the time he plays tennis from 2 hours to 4 hours, his grade in economics falls from 78 percent to 75 percent. His opportunity cost of these 2 additional hours of tennis is 3 percentage points, so his marginal cost of playing tennis for the third hour per week is 1.5 percentage points. (ii) Harry’s marginal cost of an hour of tennis is 2.5 percentage points. When Harry increases the time he plays tennis from 4 hours to 6 hours, his grade in economics falls from 75 percent to 70 percent. His opportunity cost of these 2 additional hours of tennis is 5 percentage points. So his marginal cost of playing tennis for the fifth hour per week is 2.5 percentage points. (iii) Harry’s marginal cost of an hour of tennis is 5 percentage points. When Harry increases the time he plays tennis from 6 hours to 8 hours, his grade in economics falls from 70 percent to 60 percent. His opportunity cost of these 2 additional hours of tennis is 10 percentage points. So his marginal cost of playing tennis for the seventh hour per week is 5 percentage points.

8. a. If Harry uses his time to achieve allocative efficiency, what is his economics grade and how many hours of tennis does he play? Harry’s grade in economics is 66 percent and he plays tennis for 7 hours per week. From the answer to part (a), Harry’s marginal cost of playing the third hour a week of tennis is 1.5 percentage points, his marginal cost of playing tennis the fifth hour a week is 2.5 percentage points and his marginal cost of playing tennis the seventh hour a week is 5 percentage points. Plot these three opportunity costs in Figure 2.3 to create Harry’s marginal cost curve. Harry’s opportunity cost of playing tennis increases as he spends more time playing tennis. Harry uses his time efficiently if he plays tennis for 7 hours a week because when he plays 7 hours a week his marginal benefit from the seventh hour of tennis, 5 percentage points, equals his marginal cost, also 5 percentage points. When Harry plays 7 hours of tennis, the PPF in Figure 2.2 shows that his grade in economics 65 percent.

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(a). If Harry studied for enough hours to get a higher grade, he would have fewer hours to play tennis. Harry’s marginal benefit from tennis would be greater than his marginal cost, so he would be more efficient (better off) if he played more hours of tennis and took a lower grade.

If Harry becomes a tennis superstar with big earnings from tennis, what happens to his PPF, MB curve, and his efficient time allocation? If Harry becomes a tennis superstar, his PPF does not change. Harry’s PPF shows the grade he can produce for different hours of playing tennis and these production possibilities are unaffected by Harry’s superstar status. As a result Harry’s MC curve does not change. However Harry’s marginal benefit from playing tennis increases because of his big paydays so his MB curve shifts rightward. As a result, Harry’s efficient allocation of time now allocates more time to tennis (and results in a lower grade).

10.

If Harry suddenly finds high grades in economics easier to attain, what happens to his PPF, his MB curve, and his efficient time allocation? If Harry finds high grades to easier to attain, his PPF shifts outward. In particular for every level of tennis playing his grade in economics is higher. As a result Harry’s marginal cost of earning a high grade in economics is reduced so that Harry’s MC curve shifts downward. Harry’s MB curve does not change because Harry’s marginal benefit from a high grade has not changed. Harry’s efficient time allocation results in Harry increasing the number of hours of tennis he plays.

THE ECONOMIC PROBLEM

11.

A farm grows wheat and produces pork. The marginal cost of producing each of these products increases as more of it is produced. a. Make a graph that illustrates the farm’s PPF. The PPF is illustrated in Figure 2.4 as PPF0. Because the marginal cost of both wheat and pork increase as more of the good is produced, the PPF displays increasing opportunity cost so it has the “conventional” bowed-outward shape.

b. The farm adopts a new technology that allows it to use fewer resources to fatten pigs. Use your graph to illustrate the impact of the new technology on the farm’s PPF. The new technology rotates the PPF outward from PPF0 to PPF1.

c. With the farm using the new technology described in part (b), has the opportunity cost of producing a ton of wheat increased, decreased, or remained the same? Explain and illustrate your answer. The opportunity cost of producing wheat has increased. The opportunity cost of a bushel of wheat is equal to the magnitude of 1/(slope of the PPF). As illustrated in Figure 2.4, for each quantity of wheat the slope of PPF1 has a smaller magnitude than the slope of PPF0 so the opportunity cost of a bushel of wheat is higher along PPF1. For a specific example, the opportunity cost of increasing wheat product from 600 bushels per week to 800 bushels per week along PPF1 is 6,000 pounds of pork but is only 3,000 pounds of pork along PPF0.

d. Is the farm more efficient with the new technology than it was with the old one? Why? The farm is able to produce more with the new technology than with the old, but it is not necessarily more efficient. If the farm was producing on its PPF before the new technology and after, the farm was production efficient both before the new technology and after.

12.

In one hour, Sue can produce 40 caps or 4 jackets and Tessa can produce 80 caps or 4 jackets. a. Calculate Sue’s opportunity cost of producing a cap. Sue forgoes 4 jackets to produce 40 caps, so Sue’s opportunity cost of producing one cap is (4 jackets)/(40 caps) or 0.1 jacket per cap.

b. Calculate Tessa’s opportunity cost of producing a cap. Tessa forgoes 4 jackets to produce 80 caps, so Tessa’s opportunity cost of producing one cap is (4 jackets)/(80 caps) or 0.05 jacket per cap.

c. Who has a comparative advantage in producing caps? Tessa’s opportunity cost of a cap is lower than Sue’s opportunity cost, so Tessa has a comparative advantage in producing caps.

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d. If Sue and Tessa specialize in producing the good in which each of them has a comparative advantage, and they trade 1 jacket for 15 caps, who gains from the specialization and trade? Tessa specializes in caps and Sue specializes in jackets. Both Sue and Tessa gain from trade. Sue gains because she can obtain caps from Tessa at a cost of (1 jacket)/(15 caps), which is 0.067 jacket per cap, a cost that is lower than what it would cost her to produce caps herself. Tessa also gains from trade because she trades caps for jackets for 0.067 jacket per cap, which is higher than her cost of producing a cap.

13.

Suppose that Tessa buys a new machine for making jackets that enables her to make 20 jackets an hour. (She can still make only 80 caps per hour.) a. Who now has a comparative advantage in producing jackets? Sue forgoes 40 caps to produce 4 jackets, so Sue’s opportunity cost of producing one jacket is (40 caps)/(4 jackets) or 10 caps per jacket. Tessa forgoes 80 caps to produce 20 jackets, so Tessa’s opportunity cost of producing one jacket is (80 caps)/(20 jackets) or 4 caps per jacket. Tessa has the comparative advantage in producing jackets because her opportunity cost of a jacket is lower than Sue’s opportunity cost.

b. Can Sue and Tessa still gain from trade? Tessa and Sue can still gain from trade because Tessa (now) has a comparative advantage in producing jackets and Sue (now) has a comparative advantage in producing caps. Tessa will produce jackets and Sue will produce caps.

c. Would Sue and Tessa still be willing to trade 1 jacket for 15 caps? Explain your answer. Sue and Tessa will not be willing to trade 1 jacket for 15 caps. In particular, Sue, whose comparative advantage lies in producing caps, can produce 1 jacket at an opportunity cost of only 10 caps. So Sue will be unwilling to pay any more than 10 caps per jacket.

14.

For 50 years, Cuba has had a centrally planned economy in which the government makes the big decisions on how resources will be allocated. a. Why would you expect Cuba’s production possibilities (per person) to be smaller than those of the United States? Cuba’s economy is almost surely less efficient than the U.S. economy. The Cuban central planners do not know people’s production possibilities or their preferences. The plans that are created wind up wasting resources and/or producing goods and services that no one wants. Because firms in Cuba are owned by the government rather than individuals, no one in Cuba has the selfinterested incentive to operate the firm efficiently and produce goods and services that consumers desire. Additionally Cuba does not actively trade so Cuba produces most of its consumption goods rather than buying them from nations with a comparative advantage. Because Cuba uses its resources to produce consumption goods, it cannot produce many capital goods so its economic growth rate has been low.

b. What are the social institutions that Cuba might lack that help the United States to achieve allocative efficiency? Of the four social institutions, firms, money, markets, and property rights, Cuba’s economy has firms and money. Markets, however, are less free of government intervention in Cuba. But the major difference is the property rights in the Cuban economy. In Cuba the government owns most of the firms; that is, the government has the property right to run the producers. Because the firms are not motivated to make a profit, the managers of these firms have little incentive to operate the firm efficiently or to produce the goods and services that consumers desire. In the United States, firms are owned by individuals; that is, people have the property right that allows them to run firms. These owners have the self-interested incentive to operate the firm efficiently © 2014 Pearson Education, Inc.

THE ECONOMIC PROBLEM

and to produce the goods and services people want, an incentive sorely lacking in the Cuban economy.

Use the following data to work Problems 15 to 17. Brazil produces ethanol from sugar at a cost of 83 cents per gallon. The United States produces ethanol from corn at a cost of $1.14 per gallon. Sugar grown on one acre of land produces twice the quantity of ethanol as the corn grown on an acre. The United States imports 5 percent of the ethanol it uses and produces the rest itself. Since 2003, U.S. ethanol production has more than doubled and U.S. corn production has increased by 45 percent. 15. a. Does Brazil or the United States have a comparative advantage in producing ethanol? Brazil has a comparative advantage in producing ethanol. In Brazil $0.83 worth of other goods and services must be forgone to produce a gallon of ethanol whereas in the United States $1.14 of other goods and services must be forgone to produce a gallon of ethanol.

b. Sketch the PPF for ethanol and other goods and services for the United States.

Figure 2.5 shows the U.S. PPF. For simplicity and in keeping with Figure 2.6 on p. 42 of the textbook, the PPF is linear. (Ignore until Problem 17 the trade line in the figure.)

c. Sketch the PPF for ethanol and other goods and services for Brazil. Figure 2.6 shows Brazil’s PPF. For simplicity and in keeping with the Figure 2.6 on p. 42 of the textbook, the PPF is linear. (Ignore until Problem 17 the trade line in the figure.)

16. a. Do you expect the opportunity cost of producing ethanol in the United States to have increased since 2003? Explain why. If there have been no technological changes in the production of ethanol, so that the PPF between ethanol and other goods and services has not shifted, and if there is increasing opportunity cost when producing more of a good along the PPF, then the opportunity cost of producing ethanol in the United States increased as more ethanol was produced.

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b. Do you think the United States has achieved production efficiency in its manufacture of ethanol? Explain why or why not. The United States has probably attained production efficiency. In the United States firms have the incentive to produce goods and services, such as ethanol, efficiently because the owners of firms have been given the property right to their firm’s profit.

c. Do you think the United States has achieved allocative efficiency in its manufacture of ethanol? Explain why or why not. The United States does not allow free trade in ethanol, which is why the U.S. price exceeds the Brazilian price. It is likely that the allocatively efficient quantity of U.S.-produced ethanol is less than the quantity produced in the United States. Most likely allocative efficiency requires that the United States should produce less ethanol, more other goods and services, and trade with Brazil because Brazil produces ethanol at lower cost than the United States.

17.

Sketch a figure similar to Fig. 2.6 on p. 42 to show how both the United States and Brazil can gain from specialization and trade. In general, the United States gains from trade with Brazil by importing ethanol from Brazil. Brazil produces ethanol at a lower opportunity cost than the United States, so the opportunity cost to the United States of consuming ethanol is lower if the United States consumes ethanol produced in Brazil. In Figure 2.5 initially the United States produced and consumed 400 billion units of other goods and services and 10 million gallons of ethanol. After specializing in the production of other goods and services and trading with Brazil, the United States produces 800 billion units of other goods and services. By trading 200 billion units of goods and services for 20 million gallons of ethanol, the United States consumes 600 billion units of other goods and services and 20 million gallons of ethanol. The consumption of both other goods and services and ethanol increases in the United States. The story in Brazil is similar. In Figure 2.6 prior to trade Brazil produced and consumed 150 billion units of other goods and services and 20 million gallons of ethanol. After specializing in the production of ethanol (50 million gallons of ethanol) and trading with the United States (20 million gallons of ethanol in exchange for 200 billion units of other goods and services) Brazil consumes 200 billion units of other goods and services and 30 million gallons of ethanol. The consumption of both other goods and services and ethanol increases in Brazil.

THE ECONOMIC PROBLEM

Use this news clip to work Problems 18 to 20. Time For Tea Americans are switching to loose-leaf tea for its health benefits. Tea could be grown in the United States, but picking tea leaves would be costly because it can only be done by workers and not by machine. Source: The Economist, July 8, 2005

18. a. Sketch PPFs for the production of tea and other goods and services in India and in the United States. The PPFs might be linear, though more realistic PPFs are bowed out from the origin, as illustrated above. The goods along the two axes are tea and other goods and services. The important point about the two PPFs is that the opportunity cost of producing tea is lower in India. The magnitude of the slope of the PPF is equal to the opportunity cost of producing tea, so the U.S. PPF is steeper than India’s PPF.

b. Sketch marginal cost curves for the production of tea in India and in the United States. The marginal cost curves for producing tea are illustrated in Figure 2.9. The marginal cost curves slope upward. Because tea is less costly to produce in India than in the United States, the U.S. MC curve lies above the Indian MC curve.

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19. a. Sketch the marginal benefit curves for tea in the United States before and after Americans began to appreciate the health benefits of loose tea. As Figure 2.10 shows, after more Americans start to appreciate tea the downward sloping marginal benefit curve for tea shifts rightward from the initial marginal benefit curve, MB0 to the new marginal benefit curve, MB1.

b. Explain how the quantity of loose tea that achieves allocative efficiency has changed. The increase in the marginal benefit from tea increases the quantity of tea that achieves allocative efficiency.

c. Does the change in preferences toward tea affect the opportunity cost of producing tea? If the PPF in India between tea and other goods and services is bowed out from the origin, increasing the production of tea raises the opportunity cost of producing tea.

20.

Explain why the United States does not produce tea and instead imports it from India. The United States imports tea from India because it is cheaper for the U.S. to import tea than to produce it in the United States. Fewer other goods and services must be given up to import tea than would be given up if the United States produced tea.

THE ECONOMIC PROBLEM

Answers to Additional Problems and Applications Use the table to work Problems 21 to 23. Suppose that Yucatan’s production possibilities are given in the table. 21. a. Draw a graph of Yucatan’s PPF and explain how your graph illustrates a tradeoff. Yucatan’s PPF is illustrated in Figure 2.11. The figure illustrates a tradeoff because moving along Yucatan’s PPF producing more of one good requires producing less of the other good. Yucatan trades off more production of one good for less production of the other.

Food (pounds per month) 300 200 100 0

and and and and

Sunscreen (gallons per month) 0 50 100 150

b. If Yucatan produces 150 pounds of food per month, how much sunscreen must it produce if it achieves production efficiency? If Yucatan produces 150 pounds of food per month, then the point labeled A on the PPF in Figure 2.11 shows that Yucatan must produce 75 gallons of sunscreen per month to achieve production efficiency.

c. What is Yucatan’s opportunity cost of producing 1 pound of food? Yucatan’s PPF is linear so the opportunity cost of producing 1 pound of food is the same at all quantities. Calculate the opportunity cost of producing 1 pound of food when increasing the production of food from 0 to 100 pounds per month. Between these two ranges of production, the quantity of sunscreen produced falls from 150 gallons per month to 100 gallons per month, a decrease of 50 gallons. The opportunity cost is 50 gallons of sunscreen to gain 100 pounds of food. The opportunity cost per pound of food equals (50 gallons of sunscreen)/(100 pounds of food), or an opportunity cost of 0.5 gallon of sunscreen per pound of food.

d. What is Yucatan’s opportunity cost of producing 1 gallon of sunscreen? Yucatan’s PPF is linear so the opportunity cost of producing 1 gallon of sunscreen is the same at all quantities. Calculate the opportunity cost of producing 1 gallon of sunscreen when increasing the production of sunscreen from 0 to 50 gallons per month. Between these two ranges of production, the quantity of food produced falls from 300 pounds per month to 200 pounds per month, a decrease of 100 pounds. The opportunity cost is 100 pounds of food to gain 50 gallons of sunscreen, or (100 pounds of food)/(50 gallons of sunscreen) which yields an opportunity cost of 2.0 pounds of food per gallon of sunscreen.

e. What is the relationship between your answers to parts (c) and (d)? Answers (c) and (d) reflect the fact that opportunity cost is a ratio. The opportunity cost of gaining a unit of a good moving along the PPF equals the quantity of the other good or service forgone divided by the quantity of the good or service gained. The opportunity cost of one good, food, is equal to the inverse of the opportunity cost of the other good, sunscreen.

22.

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What feature of a PPF illustrates increasing opportunity cost? Explain why Yucatan’s opportunity cost does or does not increase. If opportunity costs increase, the PPF bows outward. Yucatan’s PPF is linear and along a linear PPF the opportunity cost is constant. Yucatan does not face an increasing opportunity cost of food because the opportunity cost remains constant, equal to 0.5 gallons of sunscreen per pound of food. Yucatan’s resources must be equally productive in both activities.

23.

In problem 21, what is the marginal cost of a pound of food in Yucatan when the quantity produced is 150 pounds per day? What is special about the marginal cost of food in Yucatan? The marginal cost of a pound of food in Yucatan is constant at all points along Yucatan’s PPF and is equal to 0.5 gallons of sunscreen per pound of food. The special point about Yucatan’s marginal cost is the fact that the marginal cost is constant. This result reflects Yucatan’s linear PPF.

24.

The table describes the preferences in Yucatan. a. What is the marginal benefit from sunscreen and how is it measured? The marginal benefit from sunscreen is the benefit enjoyed by the person who consumes one more gallon of sunscreen. It is equal to the willingness to pay for an additional gallon.

b. Draw a graph of Yucatan’s marginal benefit from sunscreen.

Sunscreen (gallons per month) 25 75 125

Willingness to pay (pounds of food per gallon) 3 2 1

The table gives the information necessary to calculate the marginal benefit from sunscreen. The marginal benefit is equal to the willingness to pay for an additional gallon of sunscreen. To draw the marginal benefit curve from sunscreen, plot the quantity of sunscreen on the x-axis and the willingness to pay for sunscreen (that is, the number of pounds of food that a person is willing to give up to get a gallon of sunscreen) on the y-axis. Figure 2.12 shows this figure.

Use the following news clip to work Problems 25 and 26. Malaria Eradication Back on the Table In response to the Gates Malaria Forum in October 2007, countries are debating the pros and cons of eradication. Dr. Arata Kochi of the World Health Organization believes that with enough money malaria cases could be cut by 90 percent, but he believes that it would be very expensive to eliminate the remaining10 percent of cases. He concluded that countries should not strive to © 2014 Pearson Education, Inc.

THE ECONOMIC PROBLEM

eradicate malaria. 25.

Source: The New York Times, March 4, 2008

Is Dr. Kochi talking about production efficiency or allocative efficiency or both? Dr. Kochi is talking about allocative efficiency. His assessment is that the last 10 percent eradication has such a high marginal cost that it almost surely exceeds its marginal benefit.

26.

Make a graph with the percentage of malaria cases eliminated on the x-axis and the marginal cost and marginal benefit of driving down malaria cases on the y-axis. On your graph: (i) Draw a marginal cost curve that is consistent with Dr. Kochi’s opinion. (ii) Draw a marginal benefit curve that is consistent with Dr. Kochi’s opinion. (iii) Identify the quantity of malaria eradicated that achieves allocative efficiency. Figure 2.13 shows a marginal cost curve and a marginal benefit curve that are consistent with Dr. Kochi’s views. Dr. Kochi believes that the last 10 percent of malaria would be very expensive to eradicate. The marginal cost curve in the figure reflects this view because the marginal cost curve rises rapidly after 90 percent of malaria is eradicated. The marginal benefit curve is downward sloping, reflecting diminishing marginal benefit from malaria eradication. The allocatively efficient quantity of malaria eradicated is 90 percent because that is the quantity for which the marginal benefit of eradication equals the marginal cost of eradication. This outcome demonstrates Dr. Kochi’s conclusion that countries should not attempt to completely

27.

Capital accumulation and technological change bring economic growth, which means that the PPF keeps shifting outward: Production that was unattainable yesterday becomes attainable today; production that is unattainable today will become attainable tomorrow. Why doesn’t this process of economic growth mean that scarcity is being defeated and will one day be gone? Scarcity is always being defeated yet will never suffer defeat. Scarcity reflects the existence of unmet wants. People’s wants are infinite—regardless of what a person already possesses, everyone can easily visualize something else he or she wants, if only more time in the day to enjoy their possessions. Because people’s wants are insatiable, scarcity will always exist regardless of economic growth.

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Use the following data to work Problems 28 and 29. Kim can produce 40 pies or 400 cakes an hour. Liam can produce 100 pies or 200 cakes an hour. 28. a. Calculate Kim’s opportunity cost of a pie and Liam’s opportunity cost of a pie. If Kim spends an hour baking pies, she gains 40 pies but forgoes 400 cakes. Kim’s opportunity cost of 1 pie is (400 cakes)/(40 pies), or 10 cakes per pie. If Liam spends an hour baking pies, he gains 100 pies but forgoes 200 cakes. Liam’s opportunity cost of 1 pie is (200 cakes)/(100 pies), or 2 cakes per pie.

b. If each spends 30 minutes of each hour producing pies and 30 minutes producing cakes, how many pies and cakes does each produce? Kim produces 20 pies and 200 cakes. Liam produces 50 pies and 100 cakes. The total number produced is 70 pies and 300 cakes.

c. Who has a comparative advantage in producing pies? Who has a comparative advantage in producing cakes? Liam has the comparative advantage in producing pies because his opportunity cost of a pie is less than Kim’s opportunity cost. Kim has the comparative advantage in producing cakes because her opportunity cost of a cake is less than Liam’s opportunity cost.

29. a

Draw a graph of Kim’s PPF and Liam’s PPF.

Kim’s PPF is illustrated in Figure 2.14; Liam’s PPF is illustrated in Figure 2.15.

b. On your graph, show the point at which each produces when they spend 30 minutes of each hour producing pies and 30 minutes producing cakes. Point A in both figures shows their production points when each spends 30 minutes making cakes and 30 minutes making pies.

c. On your graph, show what Kim produces and what Liam produces when they specialize. Kim will specialize in cakes and Liam will specialize in pies. Point B in both figures shows the production points when each specializes.

d. When they specialize and trade, what are the total gains from trade? Kim will specialize in cakes and Liam will specialize in pies. If they specialize and trade, the total production of both cakes and pies increase. When each spends 30 minutes making cakes and 30 © 2014 Pearson Education, Inc.

THE ECONOMIC PROBLEM

minutes making pies, together they produce 300 cakes and 70 pies. When they specialize, together they produce 400 cakes and 100 pies. The 100 increase in cakes and the 30 increase pies is the gains from trade.

e. If Kim and Liam share the total gains equally, what trade takes place between them? Kim will trade 50 cakes (half of the gain in cake production) to Liam in exchange for 15 pies (half of the increase in pie production).

Use the following information to work Problems 30 and 31. Before the Civil War, the South traded with the North and with England. The South sold cotton and bought manufactured goods and food. During the war, one of President Lincoln’s first actions was to blockade the ports and prevent this trade. The South increased its production of munitions and food. 30.

In what did the South have a comparative advantage? Before the war the South had a comparative advantage in producing cotton.

31. a. Draw a graph to illustrate production, consumption, and trade in the South before the Civil War. Figure 2.16 illustrates the South’s situation. The production point is point a. The South produces a great deal of cotton and very little food and manufactured goods; indeed, in the unlikely case that the South completely specialized, the production point could be at the maximum quantity of cotton and zero food and manufactured goods. From the production point a trade line with a negative slope touches the PPF and extends beyond the PPF. The trade line shows that the South traded cotton for manufacturing goods and food and consumed at point b, well beyond its PPF.

b. Was the South consuming inside, on, or outside its PPF ? Explain your answer. The South was consuming at a point beyond its PPF. The South could do so because it was able to trade cotton, which was relatively less expensive for the South to produce, in exchange for manufactured goods and food, which would have been relatively expensive for the South to produce. In other words, the South enjoyed gains from trade.

c. Draw a graph to show the effects of the Civil War on consumption and production in the South. Assuming that the Civil War did not affect the South’s PPF (which is probably true only for the first part of the war) the North’s blockade meant that the South could no longer trade with others. As a result, the South increased its production of manufactured goods (especially munitions) and food, which caused the South to decrease its production of cotton. The blockade forced the South’s consumption point to lie on its PPF, so the South’s consumption of manufactured goods and food decreased. In Figure 2.16, the South changes so that its production and its consumption point become point c.

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cost of everything increase? Did the opportunity cost of any items decrease? Illustrate your answer with appropriate graphs. The Civil War increased the opportunity cost of food and manufactured goods. However it decreased the opportunity cost of cotton. Figure 2.16 illustrates the changes. The opportunity cost of cotton decreased because the blockade lead the South to produce less cotton, moving from initial production point a to final production point c. Moving along a PPF, as less of a good is produced, its opportunity cost falls. The opportunity cost of food and manufactured goods increased because the South increased the amount of food and manufactured goods it produced. Moving along a PPF, as more of a good is produced, its opportunity cost rises.

Use the following information to work Problems 32 and 33. He Shoots! He Scores! He Makes Movies! NBA All-star Baron Davis and his school friend, Cash Warren, premiered their first movie Made in America at the Sundance Festival in January 2008. The movie, based on gang activity in South Central Los Angeles, received good reviews. Source: The New York Times, February 24, 2008 32. a. Does Barron Davis have an absolute advantage in basketball and movie directing and is this the reason for his success in both activities? Mr. Davis might have an absolute advantage in both endeavors. His success, however, is the result of his comparative advantage in both.

b. Does Barron Davis have a comparative advantage in basketball or movie directing or both and is this the reason for his success in both activities? Mr. Davis has many activities available, so he might have a comparative advantage in both basketball and directing. Mr. Davis, however, will not have a comparative advantage in all the other activities.

33. a. Sketch a PPF between playing basketball and producing other goods and services for Barron Davis and for yourself. Figure 2.17 shows a typical set of PPFs. Unless the student is a future NBA superstar, the PPF for Mr. Davis will definitely intersect the axis that measures playing basketball much farther away from the origin than the student’s PPF. The intersection of the PPF and the axis that measures the production of other goods might be higher for Mr. Davis or might be higher for the student (depending on the student’s ego). But the student’s PPF will be steeper than Mr. Baron’s PPF, indicating that the opportunity cost of producing units of basketball is lower for Mr. Davis than for the student.

b. How do you (and people like you) and Barron Davis (and people like him) gain from specialization and trade? Mr. Davis will specialize in the activity in which he has a comparative advantage, possibly playing basketball. Other people will specialize in the activities in which they have a comparative advantage. As a result, production of all goods and services takes place at the lowest opportunity © 2014 Pearson Education, Inc.

THE ECONOMIC PROBLEM

cost. Then all these low-cost producers can trade with everyone else, so that everybody can enjoy a larger consumption bundle acquired at lower cost than if the goods and services were produced by the person himself or herself.

34.

Indicate on a graph of the circular flows in the market economy, the real and money flows in which the following items belong: a. You buy an iPad from the Apple Store. Figure 2.18 shows the circular flows in a market economy. Your purchase of an iPad from Apple is the purchase of a good from a firm. This flow is in the black arrow indicated by point a in the figure. When you pay for the iPad, the corresponding money flow is in the grey arrow in the opposite direction to the black arrow labeled a.

b. Apple Inc. pays the designers of the iPad. Apple’s payment to the designers of the iPad is the payment of a wage to a factor of production. This flow is in the grey arrow indicated by point b in the figure. The flow of design services from the designer to Apple is in the black arrow in the opposite direction to the grey arrow labeled b.

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c. Apple Inc. decides to expand and rents an adjacent building. Apple’s decision to expand by renting a building means that Apple is increasing the capital it uses. This flow is in the black arrow indicated by point c in the figure. The flow of the payment for the rental services of the building is in the grey arrow in the opposite direction to the black arrow labeled c.

d. You buy a new e-book from Amazon. Your purchase of an e-book from Amazon is the purchase of a good from a firm. This flow is in the black arrow indicated by point d in the figure. When you pay for the e-book, the corresponding money flow is in the grey arrow in the opposite direction to the black arrow labeled a.

e. Apple Inc. hires a student as an intern during the summer. Apple’s decision to hire a student intern is Apple increasing the labor it uses. The flow of labor services is in the black arrow indicated by point e in the figure. The flow of the payment for the labor services is in the grey arrow in the opposite direction to the black arrow labeled c.

Economics in the News 35.

After you have studied Reading Between the Lines on pp. 46–47, answer the following questions. a. How has an Act of the United States Congress increased U.S. production of corn? The Act of Congress increased the amount of ethanol that must be used in gasoline. Because ethanol is made from corn, the mandate increased the demand for corn and farmers responded by growing more corn.

b. Why would you expect an increase in the quantity of corn produced to raise the opportunity cost of corn? Increasing the quantity of corn produced results in a higher opportunity cost of corn because acreage less suited to growing corn is shifted away from other crops and into corn. As increasingly less suitable acreage is used, the opportunity cost in terms of other crops forgone increases.

c. Why did the cost of producing corn increase in the rest of the world? The cost of producing corn in the rest of the world increased for two reasons. First in other parts of the world, droughts shifted the PPF inward, thereby decreasing the corn harvest and increasing the opportunity cost of the land that was being used to grow corn. Second the increased acreage devoted to corn creates a movement along the PPF, which also raised the opportunity cost of producing corn.

d. Is it possible that the increased quantity of corn produced, despite the higher cost of production, moves the United States closer to allocative efficiency? It is possible that the increased quantity of corn has moved the United States closer to allocative efficiency. The marginal benefit from ethanol increased because of the higher price for gasoline, so the allocatively efficient quantity of ethanol increased. To increase the production of ethanol more corn had to be produced, so even with the higher opportunity cost, the United States might have moved closer to the allocatively efficient point of production.

36.

Lots of Little Screens Inexpensive broadband access has created a generation of television producers for whom the Internet is their native medium. As they redirect the focus from TV to computers, cell phones, and iPods, the video market is developing into an open digital network. Source: The New York Times, December 2, 2007 a. How has inexpensive broadband changed the production possibilities of video © 2014 Pearson Education, Inc.

THE ECONOMIC PROBLEM

entertainment and other goods and services? Inexpensive broadband has increased the production possibilities.

b. Sketch a PPF for video entertainment and other goods and services before broadband. The PPF should have video entertainment on one axis and other goods and services on the other as illustrated in Figure 2.19 by PPF0. The PPF is bowed outward as a conventional PPF.

c. Show how the arrival of inexpensive broadband has changed the PPF. The arrival of inexpensive broadband shifts the PPF outward as shown by the change from PPF0 to PPF1 in Figure 2.19. The intersection of the new PPF along the axis measuring video entertainment increases and the intersection of the new PPF along the axis measuring other goods and services does not change.

d. Sketch a marginal benefit curve for video entertainment. The marginal benefit curve should be a conventional downward-sloping marginal benefit curve as shown in Figure 2.20. The marginal benefit from video entertainment is measured along the vertical axis and the quantity of video entertainment is measured along the horizontal axis.

e. Show how the new generation of TV producers for whom the Internet is their native medium might have changed the marginal benefit from video entertainment. The marginal benefit increases because these new producers will be better able to take advantage of the Internet since it is their native medium. Because they will be able to create entertainment designed for the Internet, the marginal benefit from video entertainment increases. In Figure 2.20, the marginal benefit curve shifts rightward from the initial marginal benefit curve, MB0, to the new marginal benefit curve, MB1.

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Explain how the efficient quantity of video entertainment has changed. The arrival of broadband has decreased the marginal cost of providing video entertainment, so the marginal cost curve shifts rightward. This shift is illustrated in the Figure 2.21 by the rightward shift of the marginal cost curve from MC0 to MC1. As Figure 2.21 shows, the allocatively efficient quantity of video entertainment increases. In Figure 2.21, the allocatively efficient quantity increases from 5 million units per year to 8 million units per year.

C h a p t e r

DEMAND AND SUPPLY

Answers to the Review Quizzes Page 56 1.

What is the distinction between a money price and a relative price? The money price of a good is the dollar amount that must be paid for it. The relative price of a good is its money price expressed as a ratio to the money price of another good. Thus the relative price is the amount of the other good that must be foregone to purchase a unit of the first good.

Explain why a relative price is an opportunity cost. The relative price of a good is the opportunity cost of buying that good because it shows how much of the next best alternative good must be forgone to buy a unit of the first good.

Think of examples of goods whose relative price has risen or fallen by a large amount. Some examples of items where both the money price and the relative price have risen over time are gasoline; college tuition; food. Some examples of items where both the money price and the relative price have fallen over time are personal computers; HD televisions; calculators.

Page 61 1.

Define the quantity demanded of a good or service. The quantity demanded of a good or service is the amount that consumers plan to buy during a given time period at a particular price.

What is the law of demand and how do we illustrate it? The law of demand states: “Other things remaining the same, the higher the price of a good, the smaller is the quantity demanded; and the lower the price of a good, the greater is the quantity demanded.” The law of demand is illustrated by a downward-sloping demand curve drawn with the quantity demanded on the horizontal axis and the price on the vertical axis. The slope is negative to show that the higher the price of a good, the smaller is the quantity demanded and the lower the price of a good, the greater is the quantity demanded.

What does the demand curve tell us about the price that consumers are willing to pay? For any fixed quantity of a good available, the vertical distance of the demand curve from the xaxis shows the maximum price that consumers are willing to pay for that quantity of the good. The price on the demand curve at this quantity indicates the marginal benefit to consumers of the last unit consumed at that quantity.

List all the influences on buying plans that change demand, and for each influence, say whether it increases or decreases demand. Influences that change the demand for a good include: • The prices of related goods. A rise (fall) in the price of a substitute increases (decreases) the demand for the first good. A rise (fall) in the price of a complement decreases (increases) the demand for the first good. © 2014 Pearson Education, Inc.

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•

The expected future price of the good. A rise (fall) in the expected future price of a good increases (decreases) the demand in the current period.

•

Income. An increase (decrease) in income increases (decreases) the demand for a normal good. An increase in income decreases (increases) the demand for an inferior good.

•

Expected future income and credit. An increase (decrease) in expected future income or credit increases (decreases) the demand.

•

The population. An increase (decrease) in population increases (decreases) the demand.

•

People’s preferences. If people’s preferences for a good rise (fall), the demand increases (decreases).

Why does demand not change when the price of a good changes with no change in the other influences on buying plans? If the price of a good falls and nothing else changes, then the quantity of the good demanded increases and there is a movement down along the demand curve, but the demand for the good remains unchanged and the demand curve does not shift.

Page 65 1.

Define the quantity supplied of a good or service. The quantity supplied of a good or service is the amount of the good or service that firms plan to sell in a given period of time at a specified price.

What is the law of supply and how do we illustrate it? The law of supply states that “other things remaining the same, the higher the price of a good, the greater is the quantity supplied; and the lower the price of a good, the smaller is the quantity supplied.” The law of supply is illustrated by an upward-sloping supply curve drawn with the quantity supplied on the horizontal axis and the price on the vertical axis. The slope is positive to show that the higher the price of a good, the greater is the quantity supplied and the lower the price of a good, the smaller is the quantity supplied.

What does the supply curve tell us about the producer’s minimum supply price? For any quantity, the vertical distance between the supply curve and the x-axis shows the minimum price that suppliers must receive to produce that quantity of output. As a result, the price is the marginal cost of the last unit produced at this level of output.

List all the influences on selling plans, and for each influence, say whether it changes supply. Changes in the price of the good change the quantity supplied. They do not change the supply of the good. Influences that change the supply of a good include: • Prices of factor of production. A rise (fall) in the price of a factor of production increases firms’ costs of production and decreases (increases) the supply of the good. •

Prices of related goods produced. If the price of a substitute in production rises (falls), firms decrease (increase) their sales of the original good and the supply for the original good decreases (increases). A rise (fall) in the price of a complement in production increases (decreases) production of the original good, causing the supply of the original good to increase (decrease).

•

The expected future price of the good. A rise (fall) in the expected future price of the good decreases (increases) the amount suppliers sell today. This change in expectations decreases (increases) the supply in the current period.

DEMAND AND SUPPLY

•

The number of sellers. An increase (decrease) in the number of sellers in a market increases the quantity of the good available at every price, and increases (decreases) the supply.

•

Technology. An advance in technology increases the supply.

•

The state of nature. A good (bad) state of nature, such as good (bad) weather for agricultural products, increases (decreases) the supply.

What happens to the quantity of cell phones supplied and the supply of cell phones if the price of a cell phone falls? If the price of cell phones falls and nothing else changes, then the quantity of cell phones supplied will decrease and there is a movement down along the supply curve for cell phones. The supply of cell phones, however, remains unchanged and the supply curve does not shift.

Page 67 1.

What is the equilibrium price of a good or service? The equilibrium price is the price at which the quantity demanded by the buyers is equal to the quantity supplied by the sellers.

Over what range of prices does a shortage arise? What happens to the price when there is a shortage? A shortage arises at market prices below the equilibrium price. A shortage causes the price to rise, decreasing quantity demanded and increasing quantity supplied until the equilibrium price is attained.

Over what range of prices does a surplus arise? What happens to the price when there is a surplus? A surplus arises at market prices above the equilibrium price. A surplus causes the price to fall, decreasing quantity supplied and increasing quantity demanded until the equilibrium price is attained.

Why is the price at which the quantity demanded equals the quantity supplied the equilibrium price? At the equilibrium price, the quantity demanded by consumers equals the quantity supplied by producers. At this price, the plans of producers and consumers are coordinated and there is no influence on the price to move away from equilibrium.

Why is the equilibrium price the best deal available for both buyers and sellers? The equilibrium price reflects that the highest price consumers are willing to pay for that amount of the good or service and is just equal to the minimum price that suppliers require for delivering it. Demanders would prefer to pay a lower price, but suppliers are unwilling to supply that quantity at a lower price. Suppliers would prefer a higher price, but demanders are unwilling to pay a higher price for that quantity. Hence neither demanders not suppliers can do business at a better price.

Page 72

What is the effect on the price and quantity of MP3 players (such as the iPod) if 1. The price of a PC falls or the price of an MP3 download rises? (Draw the diagrams!) A fall in the price of a PC decreases the demand for MP3 players because a PC is a substitute for an MP3 player. The demand curve for MP3 players shifts leftward. Supply remains unchanged. The price of an MP3 player falls and the quantity of MP3 players decreases. You can illustrate this outcome by drawing a diagram like Figure 3.10c on page 73.

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A rise in the price of an MP3 download decreases the demand for MP3 players because an MP3 download is a complement of an MP3 player. The demand curve for MP3 players shifts leftward. Supply remains unchanged. The price of an MP3 player falls and the quantity of MP3 players decreases. You can illustrate this outcome by drawing a diagram like Figure 3.10c on page 73.

More firms produce MP3 players or electronics workers’ wages rise? (Draw the diagrams!) An increase in the number of firms that produce MP3 players increases the supply of MP3 players. The supply curve of MP3 players shifts rightward. Demand remains unchanged. The price of an MP3 player falls and the quantity of MP3 players increases. You can illustrate this outcome by drawing a diagram like Figure 3.10d on page 73. A rise in the wages of electronic workers decreases the supply of MP3 players because it increases the cost of producing MP3 players. The supply curve of MP3 players shifts leftward. Demand remains unchanged. The price of an MP3 player rises and the quantity of MP3 players decreases. You can illustrate this outcome by drawing a diagram like Figure 3.10g on page 73.

Any two of these events in questions 1 and 2 occur together? (Draw the diagrams!) There are six combinations: (1) If the price of a PC rises and the price of an MP3 download rises, demand decreases, supply is unchanged, so the price falls and the quantity decreases. (2) If the price of a PC rises and more firms produce MP3 players, demand decreases and supply increases so the price falls and the quantity might increase, decrease, or not change. (3) If the price of PC falls and the wages paid electronic workers rise, demand decreases and supply decreases so the quantity decreases and the price might rise, fall, or not change. (4) If the price of an MP3 download rises and more firms produce MP3 players, demand decreases and supply increases so the price falls and quantity might increase or decrease or remain the same. (5) If the price of an MP3 download falls and the wages paid electronic workers rise, demand decreases and supply decreases so the quantity decreases and the price might rise or fall or remain the same. (6) If more firms produce MP3 players and the wages paid electronics workers rise, supply might increase or decrease or remain unchanged, demand is unchanged, so the outcome cannot be predicted.

DEMAND AND SUPPLY

Answers to the Study Plan Problems and Applications 1.

William Gregg owned a mill in South Carolina. In December 1862, he placed a notice in the Edgehill Advertiser announcing his willingness to exchange cloth for food and other items. Here is an extract: 1 yard of cloth for 1 pound of bacon 2 yards of cloth for 1 pound of butter 4 yards of cloth for 1 pound of wool 8 yards of cloth for 1 bushel of salt a. What is the relative price of butter in terms of wool? 1 pound of butter exchanged for 2 yards of cloth and 4 yards of cloth exchanged for 1 pound of wool. So pound of butter exchanged for 2 yards of cloth and 2 yards of cloth exchanged for 1/2 pound of wool. So the relative price of butter in terms of wool was 1/2 pound of wool per pound of butter.

b. If the money price of bacon was 20¢ a pound, what do you predict was the money price of butter? 1 pound of bacon exchanged for 1 yard of cloth and 2 yards of cloth exchanged for 1 pound of butter. Hence it took 2 pounds of bacon to exchange for 1 pound of butter. As a result, if the money price of a pound of bacon was 20¢, the money price of 1 pound of butter was 40¢.

c. If the money price of bacon was 20¢ a pound and the money price of salt was $2.00 a bushel, do you think anyone would accept Mr. Gregg’s offer of cloth for salt? If the money price of bacon is 20¢ a pound, Mr. Gregg’s offer to exchange 1 pound of bacon for 1 yard of cloth means that anyone could obtain 1 yard of cloth for a money price of 20¢. Mr. Gregg’s further offer to exchange 8 yards of cloth for 1 bushel of salt means that anyone could acquire 1 bushel of salt for $1.60, the price of 8 yards of cloth. If the money price of salt is $2.00 a bushel, many would accept Mr. Gregg’s offer of cloth for salt because it enables them to obtain salt at a money price of only $1.60 a bushel.

The price of food increased during the past year. a. Explain why the law of demand applies to food just as it does to all other goods and services. The law of demand applies to food because there is both a substitution and an income effect that reinforce each other. When the price of food rises, people substitute to different foods. For instance, some might substitute home cooked meals for dining at a restaurant. And when the price rises, there is a negative income effect, so people buy less food overall with the rising price. On both counts, the higher price of food decreases the quantity of food demanded.

b. Explain how the substitution effect influences food purchases and provide some examples of substitutions that people might make when the price of food rises and other things remain the same. When the price of food rises, people substitute away from (some) foods and toward other foods and other activities. People substitute cheaper foods for more expensive foods and they also substitute diets for food.

c. Explain how the income effect influences food purchases and provide some examples of the income effect that might occur when the price of food rises and other things remain the same. Food is a normal good so a rise in the price, which decreases people’s real incomes, decreases the quantity of food demanded. In the United States, restaurants suffer as the negative income effect from a higher price of food leads people to cut back their trips to restaurants. At home, people © 2014 Pearson Education, Inc.

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will buy fewer steaks and instead will buy more noodles. In poor countries (and among the poor in the United States), people literally eat less when the price of food rises and in extremely poor countries starvation increases.

Place the following goods and services into pairs of likely substitutes and pairs of likely complements. (You may use an item in more than one pair.) The goods and services are coal, oil, natural gas, wheat, corn, rye, pasta, pizza, sausage, skateboard, roller blades, video game, laptop, iPod, cell phone, text message, email, phone call, voice mail Substitutes include: coal and oil; coal and natural gas; oil and natural gas; wheat and corn; wheat and rye; corn and rye; pasta and pizza; pasta and sausage; pizza and sausage (they type of sausage that cannot be used as a topping on pizza); skateboard and roller blades; skateboard and video game; roller blades and video game; text message and email; text message and phone call; email and voice mail; and, email and phone call. Complements include: pizza and sausage (the type of sausage that can be used as a topping on pizza); skateboard and iPod; roller blades and iPod; video game (those played on a computer) and laptop; cell phone and text message; cell phone and phone call; cell phone and voice mail; and, phone call and voice mail.

During 2010, the average income in China increased by 10 percent. Compared to 2009, how do you expect the following would change: a. The demand for beef. Explain your answer. Beef is a normal good. The increase in income increases the demand for beef.

b. The demand for rice. Explain your answer. Rice is probably an inferior good. The increase in income decreases the demand for rice.

In January 2010, the price of gasoline was $2.70 a gallon. By spring 2010, the price had increased to $3.00 a gallon. Assume that there were no changes in average income, population, or any other influence on buying plans. Explain how the rise in the price of gasoline would affect a. The demand for gasoline. The rise in the price of gasoline does not change the demand for gasoline. The demand for gasoline changes only when some other relevant factor other than the price of the good changes.

b. The quantity of gasoline demanded. The rise in the price of gasoline decreases the quantity of gasoline demanded. A rise in the price of a good or service decreases the quantity of that good or service demanded.

In 2008, the price of corn increased by 35 percent and some cotton farmers in Texas stopped growing cotton and started to grow corn. a. Does this fact illustrate the law of demand or the law of supply? Explain your answer. This fact illustrates the law of supply: the higher price of corn increases the quantity of corn grown.

b. Why would a cotton farmer grow corn? A cotton farmer would switch to corn because the profit from growing corn exceeds that from growing cotton. Cotton and corn are substitutes in production and corn has become more profitable.

Use the following information to work Problems 7 to 9. Dairies make low-fat milk from full-cream milk. In the process of making low-fat milk, the dairies produce cream, which is made into ice cream. In the market for low-fat milk, the following events occur one at a time: © 2014 Pearson Education, Inc.

DEMAND AND SUPPLY

(i) The wage rate of dairy workers rises. (ii) The price of cream rises. (iii) The price of low-fat milk rises. (iv) With the period of low rainfall extending, dairies raise their expected price of low-fat milk next year. (v) With advice from health-care experts, dairy farmers decide to switch from producing full cream milk to growing vegetables. (vi) A new technology lowers the cost of producing ice cream. 7.

Explain the effect of each event on the supply of low-fat milk. (i) Dairy workers are a factor used to produce low-fat milk. The price of a factor of production rises, which decreases the supply of low-fat milk. (ii) Cream and low fat milk are complements in production. The price of a complement in production rises, which increases the supply of low fat milk. (iii) A rise in the price of low-fat milk does not change the supply of low-fat milk. It does, however, increase the quantity of low-fat milk supplied. (iv) The higher expected price of low-fat milk decreases the (current) supply of low-fat milk. (v) Full-cream milk and low-fat milk are substitutes in production. The decrease in the production of full-cream milk increases the supply of low-fat milk. (vi) Ice cream and low-fat milk are complements in production. The lower cost of producing ice cream increases the quantity of ice cream produced, which increases the supply of low-fat milk.

Use a graph to illustrate the effect of each event.

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Figure 3.1 illustrates events (i) and (iv), both of which decrease the supply of low-fat milk. Figure 3.2 illustrates events (ii), (v), and (vi), all of which increase the supply of low-fat milk. Figure 3.3 illustrates event (iii), which increases the quantity of low-fat milk supplied.

Does any event (or events) illustrate the law of supply? Event (iii), the rise in the price of low-fat milk, illustrates the law of supply because it leads to a change in the quantity supplied.

10.

“As more people buy computers, the demand for Internet service increases and the price of Internet service decreases. The fall in the price of Internet service decreases the supply of Internet service.” Explain what is wrong with this statement. The statement is wrong for several reasons. First, if the demand for Internet services increases and nothing else changes, the price of Internet service will rise not fall. Second, if the price of Internet services falls, the supply of Internet services does not change. Rather, there is a decrease in the quantity supplied, that is, a movement along the supply curve rather than a shift of the supply curve.

11.

The demand and supply schedules for gum are in the table. a. Draw a graph of the market for gum and mark in the equilibrium price and quantity.

Price (cents per pack) 20 40 60 80 100

Figure 3.4 shows the demand and supply curves. The equilibrium price is 50 cents a pack, and the equilibrium quantity is 120 million packs a week. The price of a pack adjusts until the quantity demanded equals the quantity supplied. At 50 cents a pack, the quantity demanded is 120 million packs a week and the quantity supplied is 120 million packs a week.

Quantity Quantity demanded supplied (millions of packs a week) 180 60 140 100 100 140 60 180 20 220

DEMAND AND SUPPLY

b. Suppose that the price of gum is 70¢ a pack. Describe the situation in the gum market and explain how the price adjusts. At 70 cents a pack, there is a surplus of gum and the price falls. At 70 cents a pack, the quantity demanded is 80 million packs a week and the quantity supplied is 160 million packs a week. There is a surplus of 80 million packs a week. The price falls until market equilibrium is restored at a price of 50 cents a pack.

c. Suppose that the price of gum is 30¢ a pack. Describe the situation in the gum market and explain how the price adjusts. At 30 cents a pack, there is a shortage of gum and the price rises. At 30 cents a pack, the quantity demanded is 160 million packs a week and the quantity supplied is 80 million packs a week. There is a shortage of 80 million packs a week. The price rises until market equilibrium is restored at a price of 50 cents a pack.

12.

The following events occur one at a time: (i) The price of crude oil rises. (ii) The price of a car rises. (iii) All speed limits on highways are abolished. (iv) Robots cut car production costs. Which of these events will increase or decrease (state which occurs) a. The demand for gasoline? (ii) and (iii) and (iv) change the demand for gasoline. The demand for gasoline will change if the price of a car rises, all speed limits on highways are abolished, or robot production cuts the cost of producing a car. If the price of a car rises, the quantity of cars bought decrease and the demand for gasoline decreases. If all speed limits on highways are abolished, people will drive faster and use more gasoline. The demand for gasoline increases. If robot production plants lower the cost of producing a car, the supply of cars will increase. With no change in the demand for cars, the price of a car will fall and more cars will be bought. The demand for gasoline increases.

b. The supply of gasoline? (i) changes the supply of gasoline. The supply of gasoline will change if the price of crude oil (a factor of production used in the production of gasoline) changes. If the price of crude oil rises, the cost of producing gasoline rises and the supply of gasoline decreases.

c. The quantity of gasoline demanded? (i) changes the quantity of gasoline demanded. If the price of crude oil rises, the cost of producing gasoline rises and the supply of gasoline decreases. The demand for gasoline does not change. The price of gasoline rises and there is a movement up the demand curve for gasoline. The quantity of gasoline demanded decreases.

d. The quantity of gasoline supplied? (ii) and (iii) and (iv) change the quantity of gasoline supplied. If the price of a car rises, the quantity of cars bought decrease so the demand for gasoline decreases. The supply of gasoline does not change. The price of gasoline falls and there is a movement down the supply curve of gasoline. The quantity of gasoline supplied decreases.

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If all speed limits on highways are abolished, people will drive faster and use more gasoline. The demand for gasoline increases. The supply of gasoline does not change, so the price of gasoline rises and there is a movement up along the supply curve. The quantity of gasoline supplied increases. If robot production plants lower the cost of producing a car, the supply of cars will increase. With no change in the demand for cars, the price of a car will fall and more cars will be bought. The demand for gasoline increases. The supply of gasoline does not change, so the price of gasoline rises and the quantity of gasoline supplied increases.

13.

In Problem 11, a fire destroys some factories that produce gum and the quantity of gum supplied decreases by 40 million packs a week at each price. a. Explain what happens in the market for gum and draw a graph to illustrate the changes. As the number of gum-producing factories decreases, the supply of gum decreases. There is a new supply schedule and, in Figure 3.5, the supply curves shifts leftward by 40 million packs at each price to the new supply curve S1. After the fire, the quantity supplied at 50 cents is now only 80 million packs, and there is a shortage of gum. The price rises to 60 cents a pack, at which the new quantity supplied equals the quantity demanded. The new equilibrium price is 60 cents and the new equilibrium quantity is 100 million packs a week.

b. If at the time the fire occurs there is an increase in the teenage population, which increases the quantity of gum demanded by 40 million packs a week at each price, what are the new equilibrium price and quantity of gum? Illustrate these changes on your graph. The new price is 70 cents a pack, and the quantity is 120 million packs a week. The demand for gum increases and the demand curve shifts rightward by 40 million packs at each price. Supply decreases by 40 millions packs a week and the supply curve shifts leftward by 40 million packs at each price. These changes are shown in Figure 3.6 by the shift of the demand curve from D to D1 and the shift of the supply curve from S to S1. At any price below 70 cents a pack there is a shortage of gum. The price of gum rises until the shortage is eliminated.

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14.

Indian Weddings Boost Gold Price Hopes Indian weddings traditionally take place between late September and December. The predilection for jewelry at this time usually gives a big boost to gold sales, and the record shows the price of gold has generally risen during this period. Source: Financial News, September 9, 2011 a. Describe the changes in demand and supply in the market for gold in India before and during the wedding season. The number of people (couples) demanding gold increases during the wedding season, so the demand for gold increases during the wedding season. This factor, by itself, raises the price of gold during the wedding season. Because this event is predictable, the rise in the price also is predictable, which has further consequences on the demand and supply. The rise in the expected future price during the wedding season increases the demand for gold before wedding season and decreases the supply of gold before the wedding season.

b. Given that the wedding season is a predictable event, how might expectations influence the market for gold in India? The expected rise in price during the wedding season increases the demand before the wedding season and decreases the supply before the wedding season. Before the wedding season, these changes in demand and supply raise the price of gold from what it otherwise would be; the effect on the quantity, however, is ambiguous. Because the demand increased before wedding season, the demand during wedding season will be less than otherwise. Similarly because the supply decreased before the wedding season, the supply during the wedding season will be larger than otherwise. These changes in demand and supply mean that the price during wedding season will be lower than otherwise, though the effect on the quantity is ambiguous.

15.

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Pump Prices on Pace to Top 2009 High by Weekend The cost of filling up the car is rising as the crude oil price soars and pump prices may exceed the peak price of 2009. Source: USA Today, January 7, 2010 a. Does demand for or the supply of gasoline or both change when the price of oil soars? Oil is used to produce gasoline, so when the price of oil rises, the price of a factor used to produce gasoline rises. The higher price of oil decreases the supply of gasoline. The demand for gasoline does not change.

b. Use a demand-supply graph to illustrate what happens to the equilibrium price of gasoline and the equilibrium quantity of gasoline bought when the price of oil soars. Figure 3.7 shows the impact of the higher price of oil. The supply of gasoline decreases so that the supply curve shifts leftward from S0 to S1. The equilibrium price of gasoline rises, in the figure from $3.50 per gallon to $4.25 per gallon, and the equilibrium quantity decreases, in the figure from 100 million gallons per week to 75 million gallons per week.

16.

American to Cut Flights, Charge for Luggage American Airlines announced that it will charge passengers $15 for their first piece of checked luggage and cut domestic flights as it grapples with record-high fuel prices. Source: Boston Herald, May 22, 2008 a. According to the news clip, what is the influence on the supply of American Airlines flights? Fuel prices are a cost of a factor of production. As the cost rises, the supply decreases. American Airlines is decreasing the supply of its flights by cutting domestic flights.

b. Explain how supply changes. An increase in the cost of the factor of production decreases the supply and shifts the supply curve leftward.

DEMAND AND SUPPLY

17.

Frigid Florida Winter is Bad News for Tomato Lovers An unusually cold January in Florida destroyed entire fields of tomatoes. Florida’s growers are shipping only a quarter of their usual 5 million pounds a week. The price has risen from $6.50 for a 25-pound box a year ago to $30 now. Source: USA Today, March 3, 2010 a. Make a graph to illustrate the market for tomatoes in January 2009 and January 2010. Figure 3.8 shows the tomato market in January 2009 and January 2010. In both years the demand curve is labeled D. The supply curve for 2009 is labeled S0 and the supply curve for 2010 is labeled S1. The supply curve for 2010 lies to the left of the supply curve for 2009 because the cold January was a bad state of nature and decreased the supply of tomatoes.

b. On the graph, show how the events in the news clip influence the market for tomatoes. The cold weather shifted the supply curve leftward, from S0 to S1. The equilibrium price of a box of tomatoes rises from $6.25 per box to $30.00 per box and the equilibrium quantity decreases from 5 million pounds of tomatoes per week to 1.25 million pounds of tomatoes per week.

c. Why is the news “bad for tomato lovers”? The news is bad for tomato lovers because the price of tomatoes rises and “tomato lovers” respond to the higher price by decreasing the quantity of tomatoes they consume. Tomato lovers consume fewer of the tomatoes they love.

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Answers to Additional Problems and Applications 18.

What features of the world market for crude oil make it a competitive market? The world oil market is a competitive market because there are a large number of sellers and a large number of buyers. There are so many sellers and so many buyers that no individual seller or individual buyer can influence he price of oil.

19.

The money price of a textbook is $90 and the money price of the Wii game Super Mario Galaxy is $45. a. What is the opportunity cost of a textbook in terms of the Wii game? A textbook costs $90 and a Wii game costs $45. Purchasing 1 textbook forces the buyer to give up 2 Wii games. So the opportunity cost of a textbook in terms of Wii games is 2 Wii games per textbook.

b. What is the relative price of the Wii game in terms of textbooks? The relative price of a Wii game in terms of textbooks equals ($45 per Wii)/($90 per textbook), which is 1/2 of a textbook per Wii game.

20.

The price of gasoline has increased during the past year. a. Explain why the law of demand applies to gasoline just as it does to all other goods and services. When the price of gasoline rises, people decrease the quantity of gasoline they demand. Both the substitution effect and the income effect lead consumers to decrease the quantity of gasoline demanded.

b. Explain how the substitution effect influences gasoline purchases and provide some examples of substitutions that people might make when the price of gasoline rises and other things remain the same. When the price of gasoline rises, people substitute other goods and services for gasoline. For instance, people substitute public transport (such as buses), carpools, motorcycles, walking, and bicycles for driving alone in a car to work.

c. Explain how the income effect influences gasoline purchases and provide some examples of the income effects that might occur when the price of gasoline rises and other things remain the same. When the price of gasoline rises, people’s real incomes fall. People respond by decreasing their demand for normal goods, such as gasoline. In the gasoline market, some people trade in large, fuel guzzling cars because they can no longer afford to fuel the large vehicle. Others will not purchase a car or truck because they are not able to afford the gasoline necessary to use it.

21.

Think about the demand for the three game consoles: Xbox, PS3, and Wii. Explain the effect of the following events on the demand for Xbox games and the quantity of Xbox games demanded, other things remaining the same. a. The price of an Xbox falls. An Xbox and an Xbox game are complements. When the price of an Xbox falls, consumers respond by increasing the quantity of Xboxes demanded so the equilibrium quantity of Xboxes increases. Consumers increase their demand for Xbox games because an Xbox console is useless without Xbox games.

b. The prices of a PS3 and a Wii fall. A PS3 and a Wii are substitutes for an Xbox. When these game consoles fall in price, the demand for Xbox consoles decreases and so the equilibrium quantity of Xboxes decreases. Consumers

DEMAND AND SUPPLY

decrease their demand for Xbox games because an Xbox game is useless without an Xbox console.

c. The number of people writing and producing Xbox games increases. The increase in the number of people writing Xbox games increases the supply of Xbox games. The demand for Xbox games does not change but the increase in the supply lowers the price of an Xbox game. The fall in the price of Xbox games increases the quantity of Xboxes demanded.

d. Consumers’ incomes increase. Xbox games are surely a normal good. So an increase in consumers’ incomes increases the demand for Xbox games.

e. Programmers who write code for Xbox games become more costly to hire. The increase in the cost of programmers decreases the supply of Xbox games. When the supply of a good or service decreases, the price of that good or service rises. Xbox games are not an exception, so the price of an Xbox game rises. The rise in the price of an Xbox game decreases the quantity of Xbox games demanded.

The expected future price of an Xbox game falls. When the price of an Xbox game is expected to fall, the (current) demand for Xbox games decreases.

g. A new game console that is a close substitute for Xbox comes onto the market. The new game console decreases the demand for Xbox consoles. As a result, the equilibrium quantity of Xbox consoles decreases. Consumers decrease their demand for Xbox games because an Xbox game is useless without an Xbox console.

22.

Classify the following pairs of goods and services as substitutes in production, complements in production, or neither. a. Bottled water and health club memberships Bottled water and health club memberships are neither substitutes in production nor complements in production. (For consumers, these are complements because people in health clubs drink a lot of bottled water.)

b. French fries and baked potatoes For a restaurant that produces both French fries and baked potatoes, they are substitutes in production. (For a consumer, they are substitutes.)

c. Leather purses and leather shoes Leather purses and leather shoes are substitutes in production.

d. Hybrids and SUVs For an auto company that produces both on the same assembly line, they are substitutes in production. (For a consumer, hybrids and SUVs are substitutes.)

e. Diet coke and regular coke For a soda company that produces both on the same assembly line, they are substitutes in production. (For a consumer, Diet coke and regular coke are substitutes.)

23.

As the prices of homes fell across the United States in 2008, the number of homes offered for sale decreased. a. Does this fact illustrate the law of demand or the law of supply? Explain your answer. This fact illustrates the law of supply: As the price falls, the quantity supplied decreases.

b. Why would home owners decide not to sell? Home owners delay selling their homes because they believe the price they would receive is too low and the price they will receive in the future will be higher. © 2014 Pearson Education, Inc.

24.

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G.M. Cuts Production for Quarter General Motors cut its fourth-quarter production schedule by 10 percent because Ford Motor, Chrysler, and Toyota sales declined in August. Source: The New York Times, September 5, 2007 Explain whether this news clip illustrates a change in the supply of cars or a change in the quantity supplied of cars. The lower sales of Ford, Chrysler, and Toyota cars probably reflect a decrease in the demand for these cars. G.M. believes that the demand for its cars will decrease, so G.M. is responding to this decrease in demand by decreasing the quantity of its cars supplied.

Use Figure 3.9 to work Problems 25 and 26. 25. a. Label the curves. Which curve shows the willingness to pay for a pizza? The demand curve is the downward sloping curve and the supply curve is the upward sloping curve. The demand curve shows the willingness to pay for a pizza.

b. If the price of a pizza is $16, is there a shortage or a surplus and does the price rise or fall? If the price of a pizza is $16, there is a surplus of pizza; the quantity supplied of pizzas exceeds the quantity demanded. The surplus forces the price lower to the equilibrium price of $14 a pizza.

c. Sellers want to receive the highest possible price, so why would they be willing to accept less than $16 a pizza? Sellers are willing to accept less than $16 because if they charge $16 the surplus means that some sellers have unsold pizzas. From their perspective it is better to have a lower price for the pizza and sell the (decreased) quantity they produce than to keep the price at $16 and be left with unsold pizza.

26. a. If the price of a pizza is $12, is there a shortage or a surplus and does the price rise or fall? If the price of a pizza is $12, there is a shortage of pizza; the quantity demanded of pizzas exceeds the quantity supplied. The shortage forces the price higher to the equilibrium price of $14 a pizza.

b. Buyers want to pay the lowest possible price, so why would they be willing to pay more than $12 for a pizza? If the price of a pizza is $12 the shortage means that not all buyers can buy a pizza. From their perspective they would rather pay more than $12 and be able to purchase a pizza than to keep the price at $12 and leave them without a pizza.

DEMAND AND SUPPLY

The demand and supply schedules for potato chips are in the table. 27. a. Draw a graph of the potato chip market and mark in the equilibrium price and quantity. Figure 3.10 (on the next page) draws the supply and demand curves for this market. The equilibrium price is 65¢ a bag, and the equilibrium quantity is 145 million bags a week.

Price (cents per bag) 50 60 70 80 90 100

Quantity Quantity demanded supplied (millions of bags a week) 160 130 150 140 140 150 130 160 120 170 110 180

b. If the price is 60¢ a bag, is there a shortage or a surplus, and how does the price adjust? At 60¢ a bag, there is a shortage of potato chips and the price rises. At 60¢ a bag, the quantity demanded is 150 million bags a week and the quantity supplied is 140 million bags a week. The difference is a shortage of 10 million bags a week. The price rises until market equilibrium is restored—65¢ a bag and 145 million bags a week.

28.

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In Problem 27, a new dip increases the quantity of potato chips that people want to buy by 30 million bags per week at each price. a. Does the demand for chips change? Does the supply of chips change? Describe the change. As the new dip comes onto the market, the demand for potato chips increases. Supply does not change. The demand curves shifts rightward.

b. How do the equilibrium price and equilibrium quantity of chips change? Demand increases by 30 million bags a week. The demand curve shifts rightward as shown in Figure 3.11 by the shift from D to D1. The quantity demanded at each price increases by 30 million bags. The quantity demanded at 65¢ is now 175 million bags a week of potato chips. The price rises to 80¢ a bag, at which the quantity supplied equals the quantity demanded (160 million bags a week). The new equilibrium price is 80¢ per bag and the new equilibrium quantity is 160 million bags.

29.

In Problem 27, if a virus destroys potato crops and the quantity of potato chips produced decreases by 40 million bags a week at each price, how does the supply of chips change? The supply of potato chips decreases, and the supply curve shifts leftward by 40 million bags. The price rises to 85¢ a bag and the quantity decreases to 125 million bags a week.

30.

If the virus in Problem 29 hits just as the new dip in Problem 28 comes onto the market, how do the equilibrium price and equilibrium quantity of chips change? The result by itself of the new dip entering the market is a price of 80¢ a bag and a quantity of 160 million bags. But now with the virus affecting the market, at this price there is a shortage of potato chips. The price of potato chips rises until the shortage is eliminated. The new equilibrium price is 100¢ a bag, and the new equilibrium quantity is 140 million bags a week.

31.

Strawberry Prices Drop as Late Harvest Hits Market Shoppers bought strawberries in March for $1.25 a pound rather than the $3.49 a pound they paid last year. With the price so low, some growers plowed over their strawberry plants to make way for spring melons; others froze their harvests and sold them to juice and jam makers. Source: USA Today, April 5, 2010 a. Explain how the market for strawberries would have changed if growers had not plowed © 2014 Pearson Education, Inc.

DEMAND AND SUPPLY

in their plants but offered locals “you pick for free.” If the growers had offered “you pick for free” deals, the supply of strawberries increases. The demand for strawberries at local grocery stores would have decreased as people substituted picking their own berries for buying them in the store. The demand curve for store-bought strawberries would have shifted leftward and the equilibrium price of strawberries purchased in the store would have fallen and the equilibrium quantity would have decreased.

b. Describe the changes in demand and supply in the market for strawberry jam. Growers increased the quantity of strawberries they sold to jam makers. The increased supply of strawberries to made into jam decreases the price of these strawberries. In turn, the lower price of strawberries lowers the cost of producing strawberry jam. In the market for jam, the supply of strawberry jam increased. The demand for strawberry jam did not change.

32.

“Popcorn Movie” Experience Gets Pricier Cinemas are raising the price of popcorn. Demand for field corn, which is used for animal feed, corn syrup, and ethanol, has increased and its price has exploded. That’s caused some farmers to shift from growing popcorn to easier-to-grow field corn. Source: USA Today, May 24, 2008 Explain and illustrate graphically the events described in the news clip in the market for a. Popcorn As illustrated in Figure 3.12, the farmers’ actions decrease the supply of popcorn and the supply curve of popcorn shifts leftward. The demand curve does not shift. The equilibrium price of popcorn rises and the quantity decreases.

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b. Movie tickets In the market for movie tickets—essentially the market for viewing movies in the theater— popcorn and viewing movies are complements. The increase in the price of popcorn decreases the demand for attending movies in the theater. As a result, Figure 3.13 shows the demand curve shifting leftward. The equilibrium price of attending a movie in the theater falls and the equilibrium quantity decreases.

33.

Watch Out for Rising Dry-Cleaning Bills In the past year, the price of dry-cleaning solvent doubled. More than 4,000 dry cleaners across the United States disappeared as budget-conscious consumers cut back. This year the price of hangers used by dry cleaners is expected to double. Source: CNN Money, June 4, 2012 a. Explain the effect of rising solvent prices on the market for dry cleaning. Solvents are used to produce dry cleaning, so a rise in the price of solvents increases the cost of dry cleaning. The increase in the cost of dry cleaning decreases the supply of dry cleaning and the supply curve of dry cleaning shifts leftward. The demand for dry cleaning does not change. By itself, the decrease in the supply raises the equilibrium price of dry cleaning and decreases the equilibrium quantity of dry cleaning.

b. Explain the effect of consumers becoming more budget conscious along with the rising price of solvent on the price of dry cleaning. Consumers becoming more budget conscious means that the demand for dry cleaning decreases and the demand curve for dry cleaning shifts leftward. Combined with the decrease in supply from rising solvent prices, the equilibrium quantity of dry cleaning decreases. The effect on the equilibrium price of dry cleaning, however, is ambiguous. If the decrease in supply exceeds the decrease in demand, the price rises; if the decrease in supply is less than the decrease in demand, the price falls; and, if the decrease in supply equals the decrease in demand, the price does not change.

c. If the price of hangers does rise this year, do you expect additional dry cleaners to disappear? Explain why or why not. The increase in the price of hangers raises the costs of dry cleaners but the cost increase is much smaller than the cost increase that resulted from the doubling of the price of dry-cleaning solvent. Therefore the decrease in supply is smaller, which means that the decrease in the equilibrium quantity of dry cleaning also is smaller. If the small decrease in the equilibrium quantity leads some additional dry cleaners to close, the number will be small. © 2014 Pearson Education, Inc.

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Economics in the News 34.

After you have studied Reading Between the Lines on pp. 74–75, answer the following questions: a. What happened to the price of peanut butter in 2011? The price of peanut butter rose.

b. What substitutions do you expect might have been made to decrease the quantity of peanut butter demanded? Peanut butter users could substitute other nut butters, such as cashew, almond, or hazelnut butter. They might also substitute other sandwich items, such as cheese slices.

c. What is the main complement of peanut butter and what do you predict happened in its market in 2011? The classic complement for peanut butter is jelly. The rise in the price of peanut butter decreases the demand for jelly, so the demand curve for jelly shifts leftward. The supply of jelly is unaffected. The decrease in the demand for jelly lowers the equilibrium price of jelly and decreases the equilibrium quantity of jelly.

d. What is one of the main substitutes in production for peanuts and what do you predict happened in its market in 2011? For producers, growing cotton is a substitute for growing peanuts. As farmers switch from growing peanuts to growing cotton, the supply of cotton increases and the supply curve of cotton shifts rightward. The demand for cotton does not change. The increase in the supply of cotton lowers the equilibrium price of cotton and increases the equilibrium quantity of cotton.

e. Do you predict that the higher prices of peanuts and peanut butter will persist or will they return to normal after one year? The higher prices will return to normal after a year. It is likely that the peanut growing season in 2012 will be better than that in 2011. In addition, some farmers who switched away from growing peanuts to growing cotton will switch back because the profit from peanuts appears higher than the profit from cotton. Both effects increase the supply of peanuts and thereby lower its equilibrium price back to normal. With the fall in the price of peanuts, the supply of peanut butter increases. The increase in the supply of peanut butter lowers its equilibrium price back to normal.

Why did the percentage rise in the price of peanuts exceed the percentage rise in the price of peanut butter? Peanuts, while an important component of peanut butter, are not the only cost of producing peanut butter. The cost of capital equipment, the cost of the workers, the cost of transporting the peanut butter to the stores, and so forth are all additional costs, which did not rise. The cost of producing peanut butter did not rise by the same percentage as did the price of peanuts so the supply of peanut butter did not decrease by as much as the supply of peanuts, which moderates the price hike. Additionally, the demand curve for peanut butter might be flatter than the demand curve for peanuts, which also would moderate the rise in the equilibrium price.

C h a p t e r

MEASURING GDP AND ECONOMIC GROWTH**

Answers to the Review Quizzes Page 86 1.

(page 492 in Economics)

Define GDP and distinguish between a final good and an intermediate good. Provide examples. GDP is the market value of all the final goods and services produced within a country in a given time period. A final good or service is an item that is sold to the final user, that is, the final consumer, government, a firm making investment, or a foreign entity. An intermediate good or service is an item that is produced by one firm, bought by another firm, and used as a component of a final good or service. For instance, bread sold to a consumer is a final good, but wheat sold to a baker to make the bread is an intermediate good. Distinguishing between final goods and services and intermediate goods and services is important because only final goods and services are directly included in GDP; intermediate goods must be excluded to avoid double counting them. For example, counting the wheat that went into the bread as well as the bread would double count the wheat—once as wheat and once as part of the bread.

Why does GDP equal aggregate income and also equal aggregate expenditure? GDP equals aggregate income because one way to value production is by the cost of the factors of production employed. The cost of the factors production employed—wages, interest, rent, and profit—equal aggregate income and therefore aggregate income equals GDP. GDP equals aggregate expenditure because another way to value production is by the price that buyers pay for the production in the market. Aggregate expenditure equals the sum of consumption expenditure, investment, government expenditure, and exports minus imports, which is the total amount spent buying the production in the market. Therefore GDP equals aggregate expenditure.

What are the distinctions between domestic and national, and gross and net? “Domestic” means that the production being measured is within a country no matter by whom; “national” means that the production is produced by residents of the nation anywhere within the world. “Gross” means before subtracting depreciation. “Net” means after subtracting depreciation. The terms apply to investment, business profit, and aggregate production.

Page 89 1.

(page 495 in Economics)

What is the expenditure approach to measuring GDP? The expenditure approach measures GDP by focusing on aggregate expenditures. Data are collected on the different components of aggregate expenditure and then summed. Specifically, the Bureau of Economic Analysis collects data on consumption expenditure, C, investment, I, government expenditure on goods and services, G, and net exports, X − M. These expenditures are valued at the prices paid for the goods and services, called the market price. GDP is then calculated as C + I + G + X − M.

What is the income approach to measuring GDP? *

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The income approach measures GDP by focusing on aggregate income. This approach sums all the incomes paid to households by firms for the factors of production they hire. The National Income and Product Accounts divide income into five categories: compensation of employees; net interest; rental income; corporate profits; and proprietors’ income. Adding these income components does not quite equal GDP, because it values the output at factor cost rather than the market price and omits depreciation. So, further adjustments must be made to calculate GDP: Indirect taxes and depreciation must be added and subsidies subtracted.

What adjustments must be made to total income to make it equal GDP? Total income is net domestic product at factor cost. To convert it to gross domestic product at market prices, we must add the depreciation of capital and add indirect taxes minus subsidies.

What is the distinction between nominal GDP and real GDP? Nominal GDP is the value of final goods and services produced in a given year valued at the prices of that year. Real GDP is the value of final goods and services produced in a given year when valued at the prices of a reference base year. By comparing the value of production in the two years at the same prices, we reveal the change in production.

How is real GDP calculated? The traditional method of calculating real GDP is to value each year’s production using the constant prices of a fixed base year and then sum all the values.

Page 95 1.

(page 501 in Economics)

Distinguish between real GDP and potential GDP and describe how each grows over time. Real GDP is the value of final goods and services produced in a given year when valued at the prices of a reference base year. Potential GDP is the maximum amount of real GDP that can be produced while avoiding shortages of labor, capital, land, and entrepreneurial ability that would bring rising inflation. So real GDP is the actual amount produced with the actual level of employment of the nation’s factors of production while potential GDP is the amount that would be produced if there were full employment of all factors of production with no shortages. Real GDP fluctuates from one year to the next, though it grows more often than it shrinks. Potential GDP grows from one year to the next because the quantity of the nation’s resources and technology increase from one year to the next.

How does the growth rate of real GDP contribute to an improved standard of living? A benefit of long-term economic growth is the increased consumption of goods and services that is made possible. Growth of real GDP also allows more resources to be devoted to areas such as health care, research, and environmental protection.

What is a business cycle and what are its phases and turning points? The business cycle is a periodic but irregular up-and-down movement of total production and other measures of economic activity. A business cycle has two phases: recession and expansion. The turning points are the peak and the trough. A business cycle runs from a trough to an expansion to a peak to a recession to a trough and then back to an expansion.

What is PPP and how does it help us to make valid international comparisons of real GDP? PPP is purchasing power parity. To make the most valid international comparisons of real GDP, we need to value each nation’s production using the same prices rather than by using exchange rates and the prices within each country because relative prices within different countries can vary widely. As a result, if the real GDP of each country is valued using the same prices then the comparison of real GDP among the countries is more accurate.

Explain why real GDP might be an unreliable indicator of the standard of living.

MEASURING GDP AND ECONOMIC GROWTH

Real GDP is sometimes used to measure the standard of living but real GDP can be misleading for several reasons. Real GDP does not include household production, productive activities done in and around the house by the homeowner. Because these tasks often are an important component of people’s work, this omission creates a major measurement problem. Real GDP omits the underground economy, economic activity that is legal but unreported or that is illegal. In many countries the underground economy is an important part of economic activity, and its omission creates a serious measurement problem. The value of leisure time is not included in real GDP. People value their leisure hours and an increase in people’s leisure that enhances people’s economic welfare can lower the nation’s real GDP. Environmental damage is excluded from real GDP. So an economy wherein real GDP grows but at the expense of its environment, as was the case with Eastern European countries under communism, falsely appears to offer greater economic welfare than a similar economy that grows slightly more slowly but at less environmental cost.

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Answers to the Study Plan Problems and Applications 1.

Classify each of the following items as a final good or service or an intermediate good or service and identify which is a component of consumption expenditure, investment, or government expenditure on goods and services: • Airline ticket bought by a student. Airline tickets are intermediate goods that are used for the final service, airline flights. They are part of consumption expenditure.

•

New airplanes bought by Southwest Airlines. New airlines purchased by Southwest Airlines are a final good. They are part of investment.

•

Cheese bought by Domino’s.

•

The purchase of a new iPhone for the vice president.

•

New house bought by Bill Gates.

Cheese bought by Domino’s is an intermediate good. This purchase is a final good. It is part of government expenditure on goods and services. A new house purchased by Bill Gates is a final good. It is part of investment.

The firm that printed this textbook bought the paper from XYZ Paper Mills. Was this purchase of paper part of GDP? If not, how does the value of the paper get counted in GDP? The paper is an intermediate good and so it is not (directly) included in GDP. The value of the paper is included in GDP as part of the value of the textbooks that the company produced using the paper.

Use the following figure, which illustrates the circular flow model, to work Problems 3 and 4.

• • • •

MEASURING GDP AND ECONOMIC GROWTH

Name the flows and calculate the value of Flow A is aggregate income; Flow B is consumption expenditure; Flow C is government expenditure; Flow D is investment; Flow E is net exports.

a. Aggregate income. Aggregate income is $13.3 trillion. Aggregate income equals aggregate expenditure, which is the sum of consumption expenditure (Flow B), investment (Flow D), government expenditure (Flow C), and net exports (Flow E). Therefore aggregate expenditure equals $9 billion plus $3 billion plus $2 billion plus −$0.7 trillion, which is $13.3 trillion. Therefore aggregate income also equals $13.3 trillion.

b. GDP. GDP is $13.3 trillion. GDP equals aggregate income, which from part a is $13.3 trillion.

During 2009, flow A was $13.0 trillion, flow B was $9.1 trillion, flow D was $3.3 trillion, and flow E was –$0.8 trillion. Calculate the 2009 values of a. GDP. GDP is $13.0 trillion. GDP equals aggregate income. Flow A is aggregate income, so aggregate income—and hence GDP—is $13.0 trillion,

b. Government expenditure. Government expenditure is $1.4 trillion. Aggregate expenditure equals GDP, which from part (a) is $13.0 trillion. Aggregate expenditure is the sum of consumption expenditure (Flow B), investment (Flow D), government expenditure (Flow C), and net exports (Flow E). Therefore government expenditure equals aggregate expenditure minus consumption expenditure minus investment minus net exports. Government expenditure equals $13.0 trillion minus $9.1 trillion minus $3.3 trillion minus −$0.8 trillion, which is $1.4 trillion.

Use the following data to calculate aggregate expenditure and imports of goods and services. • Government expenditure: $20 billion • Aggregate income: $100 billion • Consumption expenditure: $67 billion • Investment: $21 billion • Exports of goods and services: $30 billion Aggregate expenditure equals aggregate income, so aggregate expenditure equals $100 billion. Aggregate expenditure also equals consumption expenditure plus investment plus government expenditures on goods and services plus exports of goods and services minus imports of goods and services , so imports of goods and services equals consumption expenditure plus investment plus government expenditure on goods and services plus exports minus aggregate expenditure. Using this formula gives imports of goods and services equals $67 billion + $21 billion + $20 billion + $30 billion − $100 billion, which is $38 billion.

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U.S. Economy Shrinks Modestly GDP fell 1 percent as businesses cut investment by 8.9 percent, consumers cut spending by 1.2 percent, purchases of new houses fell 38 percent, and exports fell 29.9 percent. Source: Reuters, July 31, 2009 Use the letters on the figure in Problem 3 to indicate the flows in which the items in the news clip occur. How can GDP have fallen by only 1.0 percent with the big cuts in expenditure reported? GDP, which fell 1 percent, can be measured as aggregate income, which is flow A in the figure or as aggregate expenditure, which is flow B plus flow D plus flow C plus flow E. Investment, which fell by 8.9 percent, is flow D. Consumption, which fell by 1.2 percent, is flow B. Purchases of new houses, which fell 38 percent, is counted as part of investment spending, so it would be included in flow D. Exports, which fell 29.9 percent, is part of flow E. GDP fell by less than the components that were mentioned because government expenditure on goods and services likely rose substantially and imports of goods and services might have fallen significantly.

A U.S. market research firm deconstructed an Apple iPod and studied the manufacturers, costs and profits of each of the parts and components. The final results are: • An Apple iPod sells in the United States for $299. • A Japanese firm, Toshiba, makes the hard disk and display screen, which cost $93. • Other components produced in South Korea cost $25. • Other components produced in the United States cost $21. • The iPod is assembled in China at a cost of $5. • The costs and profits of retailers, advertisers, and transportation firms in the United States are $75. a. What is Apple’s profit? Apple’s profit on the iPod equals the price of an iPod minus the cost of producing it. The total cost to produce an iPod equals $93 + $25 + $21 + $5 + $75, which equals $219. The price of an iPod is $299, so Apple’s profit is $80 per iPod.

b. Where in the national income and product accounts of the United States, Japan, South Korea, and China are these transactions recorded? Presumably all the component parts of the iPod are shipped to China, where they are assembled. The value of these parts is $93 + $25 + $ 21, which is $139. The resulting price of the assembled iPod, as it is imported back to the United States is $93 + $25 + $21 + $5, which is $144. So these transactions show up in the national income and product accounts of: • United States: Exports of $21, imports of $144, consumption expenditure of $299. • Japan: Exports of $93. • South Korea: Exports of $25. • China: Imports of $139, exports of $144.

c. What contribution does one iPod make to world GDP? An iPod is a final good sold to consumers in the United States, so it contributes $299 to world GDP.

MEASURING GDP AND ECONOMIC GROWTH

Use the following data to work Problems 8 and 9. The table lists some macroeconomic data for Item the United States in 2008. 8.

Calculate U.S. GDP in 2008. GDP equals consumption expenditure plus investment plus government expenditure plus net exports, so GDP equals $10,000 billion + $2,000 billion + $2,800 billion − $700 billion, or $14,100 billion.

Explain the approach (expenditure or income) that you used to calculate GDP.

Wages paid to labor Consumption expenditure Net operating surplus Investment Government expenditure Net exports Depreciation

Billions of dollars 8,000 10,000 3,200 2,000 2,800 −700 1,800

The expenditure approach was used.

Use the following data to work Problems 10 and 11. The national accounts of Parchment Paradise are kept on (you guessed it) parchment. A fire destroys the statistics office. The accounts are now incomplete but they contain the following data: • GDP (income approach): $2,900 • Consumption expenditure: $2,000 • Indirect taxes less subsidies: $100 • Net operating surplus: $500 • Investment: $800 • Government expenditure: $400 • Wages: $2,000 • Net exports: –$200 10.

Calculate GDP (expenditure approach) and depreciation. For the expenditure approach, GDP equals the sum of consumption expenditure, investment, government expenditure on goods and services, and net exports. Fortunately, these data were saved from the fire. Hence GDP = C + I + G + X − M = $2,000 + $800 + $400 − $200 = $3,000. From the income approach, GDP equals wages plus net operating surplus plus indirect taxes less subsidies plus depreciation. The value of the income approach GDP survived the fire and is $2,900. The sum of wages, net operating surplus, indirect taxes less subsidies equals $2,000 + $500 + $100 = $2,600. So depreciation equals $2,900 − $2,600 = $300.

11.

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

Use the following data to work Problems 12 and 13.

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Tropical Republic produces only bananas and coconuts. The base year is 2010, and the tables give the quantities produced and the prices. 12.

Calculate nominal GDP in 2010 and 2011.

Quantities Bananas Coconuts

2010 800 bunches 400 bunches

2011 900 bunches 500 bunches

Prices Bananas Coconuts

2010 $2 a bunch $10 a bunch

2011 $4 a bunch $5 a bunch

In 2010, nominal GDP is $5,600. In 2011, nominal GDP is $6,100. Nominal GDP in 2010 is equal to total expenditure on the goods and services produced by Tropical Republic in 2010. Expenditure on Tropical Republic on bananas is 800 bunches of bananas at $2 a bunch, which is $1,600. Expenditure on coconuts is 400 bunches at $10 a bunch, which is $4,000. Total expenditure is $5,600, so nominal GDP in 2010 is $5,600. Nominal GDP in 2011 is equal to total expenditure on the goods and services produced by Tropical Republic in 2011. Expenditure on Tropical Republic on bananas is 900 bunches of bananas at $4 a bunch, which is $3,600. Expenditure on coconuts is 500 bunches at $5 a bunch, which is $2,500. Total expenditure is $6,100, so nominal GDP in 2011 is $6,100.

13.

Calculate real GDP in 2011 expressed in base-year prices. Real GDP in 2011 using base-year prices is $6,800. The base-year prices method calculates the market value of the 2011 quantities at the base-year prices of 2010. To value the 2011 output at 2010 prices, real expenditure on Tropical Republic on bananas is 900 bunches at $2 a bunch, which is $1,800, and real expenditure on coconuts is 500 bunches at $10 a bunch, which is $5,000. Adding these two expenditures shows that real GDP in 2011 using the base-year prices method is $6,800.

Use the following new clip to work Problems 14 and 15. Toyota and Honda Shift Production to North America Toyota plans to stop exporting the Lexus RX to North America from Japan, building all of the vehicles in North America. The company will invest $98.3 million to boost its production capacity. Honda Motor Co. will shift a major chunk of its manufacturing to North America and increase its production capacity by as much as 40 percent. Source: The Wall Street Journal, August 8, 2012 14.

Explain how Toyota’s and Honda’s plans will influence U.S. GDP and its components. Toyota’s change will increase U.S. GDP. In the immediate time frame, Toyota’s expenditure to boost its production capacity will increase investment in the United States. In a longer time frame, presuming the number of Lexus RXs purchased in the United States does not change as a result of Toyota’s action, the production of Lexus RXs in the United States increases the net exports of goods and services because fewer Lexus RXs will be imported. Honda’s change also will increase U.S. GDP. Presuming the number of Honda’s purchased in the United States does not change as a result of Honda’s action, the production of Hondas in the United States increases the net exports of goods and services because fewer Hondas will be imported. Honda’s investment to increase its production capacity also increases U.S. GDP.

15.

Explain how Toyota’s and Honda’s actions will change the factor incomes that make up U.S. GDP. Toyota and Honda likely will need to hire more factors of production to produce the cars. So compensation of employees will rise because more workers are hired. If Toyota and Honda use more land or other rented inputs, then net operating surplus will increase.

MEASURING GDP AND ECONOMIC GROWTH

16.

Use the table to work out in which year the U.S. standard of living (i) increases and (ii) decreases. Explain your answer.

Year 2006 2007 2008 2009

Real GDP $13.0 trillion $13.2 trillion $13.2 trillion $12.8 trillion

Population 300 million 302 million 304 million 307 million

The standard of living is measured by real GDP per person. The standard of living increased in 2007 because real GDP per person increased. The standard of living decreased in 2008 and 2009 because in both years real GDP per person decreased.

17.

Illegal Immigrants Flock to Youth Program Tens of thousands of young illegal immigrants applied to a program that could allow them to remain in the United States and work legally. “So many opportunities are going to open up now,” said one Mexican student, who boasts a 3.95 GPA and hopes to study law. Source: The Wall Street Journal, August 17, 2012 With 2 million illegal immigrants eligible to apply to the youth program, how might U.S. real GDP change in the coming years? Explain why. In theory, the production of U.S. real GDP will not change because real GDP measures all production in the United States. In practice, however, measured real GDP will increase if the work done by the illegal immigrants had been part of the (unmeasured) underground economy. Additionally if these immigrants now become more productive by working at better opportunities, then U.S. real GDP will increase as their production increases.

Use the table to work Problems 18 and 19. Maritime Republic produces only fish and crabs. 18.

Calculate nominal GDP in 2010 and 2011.

Quantities Fish Crabs

2010 1,000 tons 500 tons

2011 1,100 tons 525 tons

Prices

In 2009 nominal GDP is $25,000 and in Fish $20 a ton $30 a ton 2010 nominal GDP is $37,200. Nominal Crabs $10 a ton $8 a ton GDP in 2009 is equal to total expenditure on the goods and services produced by Tropical Republic in 2009. Expenditure on fish is 1,000 tons of fish at $20 a ton, which is $20,000, and expenditure on crabs is 500 tons at $10 a ton, which is $5,000. Total expenditure is $25,000, so nominal GDP in 2009 is $25,000. Nominal GDP in 2010 is equal to total expenditure on the goods and services produced by Tropical Republic in 2010. Expenditure on fish is 1,100 tons at $30 a ton, which is $33,000 and expenditure on crabs is 525 tons at $8 a ton, which is $4,200. Total expenditure is $37,200 so nominal GDP in 2010 is $37,200.

19.

Calculate Maritime Republic’s chained-dollar real GDP in 2011 expressed in 2010 dollars. Real GDP in 2011 is $27,300. The chained-dollar method uses the prices of 2010 and 2011 to calculate the growth rate in 2011. The value of the 2010 quantities at 2010 prices is $25,000. The value of the 2011 quantities at 2010 prices is $1,100 tons of fish × $20 a ton + 525 tons of crab × $10 a ton, which is $27,250. Using 2010 prices, the increase in GDP for these two years is $2,250, so the percentage increase is ($2,250  $25,000)  100, which is 9.0 percent. Next the value of the 2010 quantities at 2011 prices is 1,000 tons of fish × $30 a ton + 500 tons of crab × $8 a ton, which is $34,000. The value of the 2011 quantities at 2010 prices is $37,200. Using 2011 prices, the increase in GDP for these two years is $3, 200 so the percentage increase is ($3,200 ÷ $34,000) × 100, which is 9.4 percent. © 2014 Pearson Education, Inc.

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The chained dollar method calculates the growth rate as the average of these two percentage growth rates, which means that the growth rate in 2011 is 9.2 percent. So real GDP in 2011 is equal to $25,000, which is real GDP in the base year (and is equal to nominal GDP in that year) multiplied by one plus the growth rate. Real GDP in 2011 is $27,300.

MEASURING GDP AND ECONOMIC GROWTH

Answers to Additional Problems and Applications 20.

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

•

Security system bought by the New York Stock Exchange. The security system is a final good. It is part of investment.

•

Coffee beans bought by Starbucks.

•

New coffee grinders bought by Starbucks.

•

Starbuck’s grande mocha frappuccino bought by a student.

Coffee beans bought by Starbucks are an intermediate good. A new coffee grinder bought by Starbucks is a final good. It is part of investment. The Starbuck’s drink is a final good. It is part of consumption expenditure.

•

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

Use Figure 4.2 to work Problems 21 and 22.

21.

In 2009, flow A was $1,000 billion, flow C was $250 billion, flow B was $650 billion, and flow E was $50 billion. Calculate investment. Investment is $50 billion. Aggregate expenditure equals aggregate income, which is flow A, $1,000 billion. Aggregate expenditure is the sum of consumption expenditure (Flow B), investment (Flow D), government expenditure (Flow C), and net exports (Flow E). Therefore investment equals aggregate expenditure minus consumption expenditure minus government expenditure on goods and services minus net exports. Investment equals $1,000 billion minus $650 billion minus $250 billion minus $50 billion, which is $50 billion.

22.

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In 2010, flow D was $2 trillion, flow E was –$1 trillion, flow A was $10 trillion, and flow C was $4 trillion. Calculate consumption expenditure. Consumption expenditure is $5 trillion. Aggregate expenditure equals aggregate income, which is flow A, $10 trillion. Aggregate expenditure is the sum of consumption expenditure (Flow B), investment (Flow D), government expenditure (Flow C), and net exports (Flow E). Therefore consumption expenditure equals aggregate expenditure minus investment minus government expenditure on goods and services minus net exports. Consumption expenditure equals $10 trillion minus $2 trillion minus $4 trillion minus −$1 trillion, which is $5 trillion.

Use the following information to work Problems 23 and 24. Mitsubishi Heavy Industries makes the wings of the new Boeing 787 Dreamliner in Japan. Toyota assembles cars for the U.S. market in Kentucky. 23.

Explain where these activities appear in the U.S. National Income and Product Accounts. When the Dreamliner wings are sent from Japan to the United States, they are counted in the U.S. National Income and Product Accounts as imports, which is a negative entry in the expenditure approach to U.S. GDP. Toyota’s production of cars in Kentucky is included in U.S. GDP because it represents production within the United States. Expenditure on the cars is counted as part of consumption expenditure (if the cars are purchased by U.S. consumers) or investment (if the cars are purchased by U.S. firms) or government expenditure (if the cars are purchased by a government) in the expenditure approach to GDP. If any of the parts of the cars are imported from Japan, the value of these parts is included among U.S. imports. The incomes earned by the factors of production that produce the cars are part of the wages, interest, rent, and profit income that are used in the income approach to GDP.

24.

Explain where these activities appear in Japan’s National Income and Product Accounts. Mitsubishi Heavy Industries’ production of Dreamliner wings in Japan is included in Japanese GDP because it represents production within Japan. When these wings are sent to the United States, they are counted in the National Income and Product Accounts as part of Japanese exports. If any of the parts of wings are imported into Japan, the value of these parts is included among Japanese imports. The incomes earned by the factors of production that produce the wings are part of the wages, interest, rent, and profit income that are used in the income approach to GDP. Toyota’s production of cars in Kentucky is not directly included in Japan’s GDP unless some of the parts for these cars are exported from Japan to the United States. In that case the value of the parts are included in Japan’s GDP as exports.

Use the following news clip to work Problems 25 and 26, and use the circular flow model to illustrate your answers. Boeing Bets the House Boeing is producing some components of its new 787 Dreamliner in Japan and is assembling it in the United States. Much of the first year’s production will be sold to ANA (All Nippon Airways), a Japanese airline. Source: The New York Times, May 7, 2006 25.

Explain how Boeing’s activities and its transactions affect U.S. and Japanese GDP. Goods and services produced within the United States are part of U.S. GDP. Boeing’s decision to produce part of its new 787 airliner in Japan means that this production is not produced within the United States and so it is not part of U.S. GDP. This production is, however, part of Japan’s GDP. The parts of the Dreamliner that are assembled in Japan and sent to the United States for © 2014 Pearson Education, Inc.

MEASURING GDP AND ECONOMIC GROWTH

final assembly add to Japan’s GDP as exports and subtract from U.S. GDP as imports. Then the Dreamliners that Boeing sells to All Nippon Airways in Japan are counted as U.S. exports and Japanese imports so they add to U.S. GDP and subtract from Japan’s GDP.

In terms of the circular flow diagram in Figure 4.3 and U.S. GDP, Boeing’s purchase of parts of the Dreamliner from firms in Japan is flow is Flow A, an import into the United States. This flow travels through the goods market and goes to Boeing as Flow B. In terms of Japanese GDP, the purchase of parts from Japanese firms is a Japanese export. This flow is the reverse of Flow B and of flow A because this flow is an export for the Japanese economy. Flows C and D indicate that the Japanese firms are paying Japanese household for the factors of production they supply.

26.

Explain how ANA’s activities and its transactions affect U.S. and Japanese GDP. ANA’s purchase of Dreamliners is counted in U.S. GDP as exports and is counted in Japan’s GDP as imports. In terms of the circular flow, Boeing sells some Dreamliners to ANA. The airliners travel from Boeing through the goods market and are exported to ANA in Japan. In Figure 4.3 and for the U.S. economy, these are the reverse of flow B and then of flow A because the Dreamliners are a U.S. export. Flows C and D indicate that Boeing is paying households (through the factor market) for the factors of production the households supply to Boeing. For the Japanese economy, the imports are represented by Flow A and then flow B.

Use the following data to work Problems 27 and 28. The table lists some macroeconomic data for the United States in 2009. 27. Calculate U.S. GDP in 2009. GDP equals consumption expenditure plus investment plus government expenditure plus net exports, so GDP equals $10,000 billion + $1,500 billion + $2,900 billion − $340 billion, or $14,060 billion.

Item Wages paid to labor Consumption expenditure Net operating surplus Investment Government expenditure Net exports

Billions of dollars 8,000 10,000 3,400 1,500 2,900 −340

28.

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Explain the approach (expenditure or income) that you used to calculate GDP. The expenditure approach was used.

Use the following data to work Problems 29 to 31. An economy produces only apples and Quantities oranges. The base year is 2012, and the Apples table gives the quantities produced and Oranges the prices. 29.

Calculate nominal GDP in 2012 and 2013.

Prices Apples Oranges

2012 60 80

2013 160 220

2012 $0.50 $0.25

2013 $1.00 $2.00

In 2012 nominal GDP is $50 and in 2013 nominal GDP is $600. Nominal GDP in 2012 is equal to total value of the goods and services produced in 2012. The value of apples is 60 apples at $0.50 each, which is $30, and the value of oranges is 80 oranges at $0.25 each, which is $20. The total value is $50 so nominal GDP in 2012 is $50. Nominal GDP in 2013 is equal to total value of the goods and services produced in 2013. The value of apples is 160 apples at $1.00 each, which is $160 and the value of oranges is 220 oranges at $2.00 each, which is $440. The total value is $600 so nominal GDP in 2013 is $600.

30.

Calculate real GDP in 2012 and 2013 expressed in base-year prices. Real GDP in 2012 is $50 and in 2013 is $135. Real GDP in the base year, 2012, is equal to nominal GDP. Real GDP in 2013 using base-year prices is equal to the quantities produced in 2013 valued at base-year, 2012, prices. Real GDP in 2013 is 160 apples at $0.50 each, which is $80, and the value of oranges is 220 oranges at $0.25 each, which is $55. The total value of 2013 production using 2012 prices is $135, so real GDP in 2013 is $135.

31.

GDP Expands 11.4 Percent, Fastest in 13 Years China’s gross domestic product grew 11.4 percent last year and marked a fifth year of double-digit growth. The increase was especially remarkable given that the United States is experiencing a slowdown due to the sub-prime crisis and housing slump. Citigroup estimates that each 1 percent drop in the U.S. economy will shave 1.3 percent off China’s growth, because Americans are heavy users of Chinese products. In spite of the uncertainties, China is expected to post its sixth year of double-digit growth next year. Source: The China Daily, January 24, 2008 Use the expenditure approach for calculating China’s GDP to explain why “each 1 percent drop in the U.S. economy will shave 1.3 percent off China’s growth.” China’s GDP growth will drop because U.S. demand for China’s exports will decrease. China’s GDP equals its aggregate expenditure and the fall in China’s exports decreases China’s aggregate expenditure.

32.

The United Nations’ Human Development Index (HDI) is based on real GDP per person, life expectancy at birth, and indicators of the quality and quantity of education. a. Explain why the HDI might be better than real GDP as a measure of economic welfare. The HDI might be a better measure of economic welfare because it includes some important factors that affect welfare and which are omitted from GDP. In particular, life expectancy is included in the HDI but not in GDP and on this count the HDI is superior. The HDI also includes direct measures of the quality and quantity of education. These are indirectly included in GDP because they affect GDP per person, but it might be the case that the direct inclusion in the HDI is better. © 2014 Pearson Education, Inc.

MEASURING GDP AND ECONOMIC GROWTH

b. Which items in the HDI are part of real GDP and which items are not in real GDP? The HDI is based on real GDP per person and so directly includes GDP. In addition, the quality and quantity of education affect people’s productivity, which is closely related to GDP per person. So real GDP indirectly includes some of the education effects explicitly included in the HDI.

c. Do you think the HDI should be expanded to include items such as pollution, resource depletion, and political freedom? Explain. Ideally factors such as pollution, political freedom, and so forth should be included in a broad measure of welfare. Two difficulties, however, occur. One difficulty comes when trying to measure these variables. For instance, how can political freedom be measured in a way that is accepted by all? A second difficulty is weighting these factors. For instance, how much should political freedom be weighted relative to GDP per person?

d. What other items should be included in a comprehensive measure on economic welfare? Aside from the factors listed above, potentially some measure of culture might be included. Another set of factors might attempt to take into account sustainability. Religious freedom, discrimination, and civil and international conflict might also matter. But all these factors are hard to measure and to weight.

33.

U.K. Living Standards Outstrip U.S. Oxford analysts report that living standards in Britain are set to rise above those in America for the first time since the nineteenth century. Real GDP per person in Britain will be £23,500 this year, compared with £23,250 in America, reflecting not only the strength of the pound against the dollar but also the UK economy’s record run of growth since 2001. But the Oxford analysts also point out that Americans benefit from lower prices than those in Britain. Source: The Sunday Times, January 6, 2008 If real GDP per person is more in the United Kingdom than in the United States but Americans pay lower prices, does this comparison of real GDP person really tell us which country has the higher standard of living? This comparison does not determine which nation has a higher standard of living. The analysis uses the exchange rate to transform prices in one country into prices of the other country. But a more accurate analysis would use purchasing power parity (PPP) prices to value the goods and services in both countries. By using PPP prices, the analysis can better measure the goods and services available to citizens of each country.

34.

Use the news clip in Problem 31. a. Why might China’s recent GDP growth rates overstate the actual increase in the level of production taking place in China? China’s GDP, similar to all nations’ GDPs, omits the value of home production. As more of China’s economy moves to being traded in markets, China’s GDP and therefore the growth rate of China’s GDP increases even though the actual production is not changing.

b. Explain the complications involved with attempting to compare the economic welfare in China and the United States by using the GDP for each country. China’s GDP is calculated using prices in China while U.S. GDP is calculated using prices in the United States. But relative prices in China and the United States are quite different. When looking at prices of identical or near-identical goods, more of these prices are lower in China than in the United States. So even if China and the United States produced the exact same quantities of these goods and services, China’s GDP, using China’s lower prices, would value China’s production at a © 2014 Pearson Education, Inc.

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smaller value than would U.S. GDP, using U.S. higher prices. To have a valid comparison of Chinese and U.S. GDP, purchasing power parity (PPP) prices must be used to value Chinese and U.S. production because then prices are the same for China and the United States.

35.

Poor India Makes Millionaires at Fastest Pace India, with the world’s largest population of poor people, created millionaires at the fastest pace in the world in 2007. India added another 23,000 more millionaires in 2007 to its 2006 tally of 100,000 millionaires measured in dollars. That is 1 millionaire for about 7,000 people living on less than $2 a day. Source: The Times of India, June 25, 2008 a. Why might real GDP per person misrepresent the standard of living of the average Indian? There are a few reasons why this measurement of real GDP per person misrepresents the standard of living of the average Indian. First GDP includes only goods and services bought and sold in markets. In India many goods and services are produced by the household itself and this home production, while boosting the household’s standard of living, is not included in GDP. Second the prices used to value Indian production and thereby calculate Indian GDP are likely quite different than the prices used to value U.S. production and calculate U.S. GDP. When looking at prices of identical or near-identical goods, it is likely that more of these prices are lower in India than in the United States. So, even if the actual quantities produced are the same, using Indian prices means that India’s production would be valued less than U.S. production and India’s GDP would be less than U.S. GDP. If the same prices, such as purchasing power parity prices, were used to value India’s GDP and U.S. GDP, India’s GDP per person would be closer to U.S. GDP per person.

b. Why might $2 a day underestimate the standard of living of the poorest Indians? One important reason why the $2 a day estimate undervalues the standard of living of the poorest Indians is because much of these people’s transactions do not occur in markets. GDP is calculated using only goods and services bought and sold in markets. So if a poor, self-sufficient farmer grows only enough food for his or her family and does not buy or sell food in the market, the farmer will be estimated to have a very low income. But this low income vastly understates the farmer’s standard of living because it omits all the food the person produced on his or her land. Another reason why the standard of living of the poorest Indians is under estimated is because the estimate is made using prices that prevail in India and then compared to the standard of living in the United States. Prices in India are often much lower than in the United States, so comparing what the income can purchase in the United States understates the standard of living.

Economics in the News 36.

After you have studied Reading Between the Lines on pp. 96–97 (502–503 in Economics), answer the following questions. a. Why does the BEA revise its estimates of GDP? The BEA revises its estimate of GDP because new and better data become available after the passage of time.

b. What is the percentage difference between the highest and lowest estimate of real GDP in the second quarter of 2009 trough? The highest estimate of the trough was the first estimate in 2009, $12,892 billion. The lowest estimate was the estimate in 2011, $12,641 billion. The percentage difference between these two estimates is equal to [($12,892 billion − $12,641 billion)/$12,641 billion] × 100, which equals 2.0 percent. © 2014 Pearson Education, Inc.

MEASURING GDP AND ECONOMIC GROWTH

c. Describe the changes in the estimates of the peak, trough, recession, and recovery over the most recent business cycle. The initial estimate of the peak was slightly higher than the most recent estimates. The estimate of the trough was significantly deepened with the revisions in 2010 and 2011, though the estimate in 2012 slightly offset the deepening. Though the depth of the measured recession differs, the timing of the recession is generally the same for all the estimates though the 2009 estimate suggested the peak was reached in the 4th quarter of 2007 while the other three revisions placed the peak in the 2nd of 2008. The expansion is essentially the same for all the estimates, though it starts from a lower level of real GDP in the more recent revisions.

d. Why does the growth rate of consumption expenditure have a bigger effect on real GDP growth than the growth rates of investment and net exports? The growth rate of consumption has a larger effect on real GDP than investment and net exports because consumption is a much larger part of real GDP than investment and net exports.

37.

Totally Gross GDP has proved useful in tracking both short-term fluctuations and long-run growth. Which isn’t to say GDP doesn’t miss some things. Amartya Sen, at Harvard, helped create the United Nations’ Human Development Index, which combines health and education data with per capita GDP to give a better measure of the wealth of nations. Joseph Stiglitz, at Columbia, advocates a “green net national product” that takes into account the depletion of natural resources. Others want to include happiness in the measure. These alternative benchmarks have merit but can they be measured with anything like the frequency, reliability and impartiality of GDP? Source: Time, April 21, 2008 a. Explain the factors that the new clip identifies as limiting the usefulness of GDP as a measure of economic welfare. GDP focuses on the amount of goods and services produced. While goods and services lead to improving people’s welfare, there are other factors that also come into play. The Human Development Index includes people’s education and health, which are obvious factors that affect people’s wellbeing. Mr. Stiglitz is suggesting that sustainability issues should be included. Others have recommended that people’s overall happiness be a factor in measuring economic welfare.

b. What are the challenges involved in trying to incorporate measurements of those factors in an effort to better measure economic welfare? There are two major difficulties. First, measuring some of these variables, especially “happiness”, would be very difficult. Second, even if the variables could be accurately measured determining the weighting scheme to be used is very difficult. For instance, how much should depletion of copper be weighted relative to GDP per person?

c. What does the ranking of the United States in the Human Development Index imply about the levels of health and education relative to other nations? Because the U.S. ranking in the Human Development Index is well below its ranking of per person real GDP, the levels of health and education in the United States must be lower than those in many other advanced countries.

38.

Use the information in Problem 29 to calculate the chained-dollar real GDP in 2013 expressed in 2012 dollars. Real GDP in 2013 is $135.70. The chained-dollar method uses the prices of 2012 and 2013 to calculate the growth rate in 2013. The value of the 2012 quantities at 2012 prices is $50. The value of the 2013 quantities at 2012 prices is $135 (from Problem 30). Using 2012 prices, the © 2014 Pearson Education, Inc.

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increase in GDP for these two years is $85, so the percentage increase is ($85  $50)  100, which is 170.0 percent. Next the value of the 2012 quantities at 2013 prices is 60 apples × $1.00 per apple + 80 oranges × $2.00 an orange, which is $220. The value of the 2013 quantities at 2013 prices is $600 (from Problem 29). Using 2013 prices, the increase in GDP for these two years is $380 so the percentage increase is ($380 ÷ $220) × 100, which is 100, which is 172.7 percent. The chained dollar method calculates the growth rate as the average of these two percentage growth rates, which means that the growth rate in 2013 is 171.4 percent. So real GDP in 2013 is equal to $50, which is real GDP in the base year (and is equal to nominal GDP in that year) multiplied by one plus the growth rate. Real GDP in 2013 is $135.70.

C h a p t e r

MONITORING JOBS AND INFLATION**

Answers to the Review Quizzes Page 112 1.

(page 518 in Economics)

What determines if a person is in the labor force? Workers who have a job and workers who are unemployed are in the labor force. To be “officially” counted as unemployed, and thus in the labor force, means that the person does not have a job but is available and willing to work and has made some effort to find work within the past four weeks, or waiting to be called back to a job from which he or she has been laid off, or waiting to start a new job within 30 days.

What distinguishes an unemployed person from one who is not in the labor force? A general definition of unemployment is a person who wants to work but does not have a job. A person who is not in the labor force does not have a job and does not want one. More specifically to be considered as unemployed, and thus in the labor force, the person must not have a job but must be available and willing to work. The person must also have made some effort to find work within the past four weeks, or be waiting to be called back to a job from which he or she has been laid off, or be waiting to start a new job within 30 days.

Describe the trends and fluctuations in the U.S. unemployment rate from 1980 to 2012. The unemployment rate has had several significant fluctuations around its average of 6.2 percent. It started by soaring to a high that exceeded 10 percent during the 1982 recession. Then there was a gradual downward trend particularly insofar as the peaks during the recessions in 1990-1991 and 2001 were much lower than in 1982. But that situation reversed itself with the severe and prolonged recession of 2008-2009 when the unemployment once more jumped (slightly) above 10 percent.

Describe the trends and fluctuations in the U.S. employment-to-population ratio and labor force participation rate from 1980 to 2012. The labor force participation rate and the employment-to-population ratio had an upward trend from 1980 until about 2000 after which they turned downward. Both show fluctuations around these trends, especially the employment-to-population ratio which rises during expansions and falls during recessions but its fall between 2008 and 2010 was particularly severe. The labor force participation rate also fell between 2008 and 2010 but the fall was not as dramatic. Recently the labor force participation rate has been near 64 percent and the employment-topopulation ratio has been near 59 percent.

Describe the alternative measures of unemployment. The Bureau of Labor Statistics keeps track of 6 alternative measures of unemployment: • U-1 measures long-term unemployment. It counts as unemployed only workers who have been unemployed for 15 or more weeks. *

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• U-2 measures job losers; that is, only workers who lost their jobs (as opposed to quitting or reentering the labor market) are counted as unemployed. • U-3 is the conventional measure of unemployment. • U-4 adds discouraged workers to the conventional measure of unemployment. • U-5 adds all marginally attached workers to the U-4 measure of unemployment. • U-6 adds part-time workers who would like a full-time job (economic part-time workers) to the U-5 measure of unemployment.

Page 115 1.

(page 521 in Economics)

Why does unemployment arise and what makes some unemployment unavoidable? In a dynamic economy some unemployment is unavoidable. For instance, growth means that some workers will always be entering the labor force without a job and therefore be unemployed. Consumers changing their demand for one good over another means workers in the newly less-favored industry will lose their jobs and also be unemployed. Moreover some workers will always be leaving their current job to search for a better job and these workers, too, will be unemployed. So some unemployment is unavoidable as the economy churns and reacts to changes.

Define frictional unemployment, structural unemployment, and cyclical unemployment. Give examples of each type of unemployment. Frictional unemployment is the unemployment that arises from the normal labor turnover from people entering and leaving the labor force and from the ongoing creation and destruction of jobs. For instance, newly graduated students entering the labor market looking for work are frictionally unemployed. Structural unemployment represents the unemployment created by changes in technology or international competition that change the skills needed to perform jobs or change the locations of jobs in the economy. For instance, workers are structurally unemployed if they lose their jobs because of changes in the amount of foreign competition and if they have different skills from those required by new jobs or if they live in a different region of the country from where new jobs are being created. Finally, cyclical unemployment is the unemployment created by business cycle fluctuations in economic activity. Specifically the higher than normal unemployment at a business cycle trough and the lower than normal unemployment at a business cycle peak is called cyclical unemployment. For instance, a worker laid off in 2009 because of the recession is cyclically employed.

What is the natural unemployment rate? The natural unemployment rate is the unemployment rate when no cyclical unemployment exists. That is, when all unemployment is frictional or structural then the unemployment rate equals the natural unemployment rate. Full employment occurs when there is no cyclical unemployment and the unemployment rate equals the natural unemployment rate.

How does the natural unemployment rate change and what factors might make it change? Changes in the natural unemployment rate arise because of changes in frictional and structural unemployment. Any factor that changes frictional unemployment or structural unemployment changes the natural unemployment rate. For instance, a change in the age distribution of the population, a change in the scale of structural changes that are occurring, a change in the minimum wage rate or efficiency wages, or a change in unemployment benefits all change the natural unemployment rate.

MONITORING JOBS AND INFLATION

Why is the unemployment rate never zero, even at full employment? The unemployment rate is never zero because there is always churning going on the economy. There are always new workers entering the labor market and searching for work, there are always workers leaving one job to search for another, better job, and there are always firms laying off workers. All these cases lead to unemployment as the workers search for a job.

What is the output gap? How does it change when the economy goes into recession? The output gap equals the difference between real GDP and potential GDP. When the economy goes into a recession, the output gap becomes negative.

How does the unemployment rate fluctuate over the business cycle? During a recession the unemployment rate is generally rising. During an expansion the unemployment rate is generally falling.

Page 121 1.

(page 527 in Economics)

What is the price level?

The price level is the average level of prices.

What is the CPI and how is it calculated? The CPI is the Consumer Price Index. The CPI equals (Cost of CPI basket at current prices ÷ Cost of CPI basket at base-period prices) ×100.

How do we calculate the inflation rate and what is its relationship with the CPI? The inflation rate is the percentage change in a price index from one year to the next. The rate of change of the CPI is often used as a measure of inflation as faced by consumers.

What are the four main ways in which the CPI is an upward-biased measure of the price level? The CPI is biased upward because of the new goods bias; the quality change bias; commodity substitution bias; and outlet substitution bias. The new goods bias reflects the point that new goods, such as DVDs are generally more expensive than the old goods they replace, VHS tapes. The quality change bias points out that part of the reason goods and services rise in price is because their quality is improved. Commodity substitution bias occurs because consumers substitute away from goods and services that have risen in the price more than other goods and services. Outlet substitution bias occurs because consumers will use discount stores more frequently when goods and services rise in price.

What problems arise from the CPI bias? The upward bias in the CPI distorts private contracts and government outlays that include formulas based on CPI change as a measure of inflation. If the intent is to maintain the real value of a payment, indexing payments to the CPI will in fact increase the real value of payments over time if the CPI has an upward bias. In one year, the effect of the bias may not be much, but it will accumulate over time. Close to one third of federal government outlays are indexed to the CPI.

What are the alternative measures of the price level and how do they address the problem of bias in the CPI? The first of three alternative price level is the chained CPI. The chained CPI is calculated in a similar manner as chained-dollar real GDP. The chained CPI overcomes the commodity substitution and new goods bias because it uses current as well as previous period quantities. The second alternative price level is the personal consumption expenditure deflator or PCE deflator. The PCE deflator is calculated from real and nominal consumption expenditure. The PCE deflator uses a broader basket of goods and services than the CPI and, similar to the chained CPI, © 2014 Pearson Education, Inc.

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is also calculated using a chained method. The third alternative is the GDP deflator. The GDP deflator is similar to the PCE deflator except the GDP deflator uses the prices from all the goods and services included in GDP.

MONITORING JOBS AND INFLATION

Answers to the Study Plan Problems and Applications 1.

The Bureau of Labor Statistics reported the following data for 2010: Labor force: 153.7 million Employment: 139.1 million Working-age population: 237.9 million

Calculate the a. Unemployment rate. The unemployment rate is 9.5 percent. The unemployment rate is the percentage of the labor force that is unemployed. The labor force is the sum of the people unemployed and the people employed. So the number of people who are unemployed is 153.7 million minus 139.1 million, which is 14.6 million. The unemployment rate equals (the number of people unemployed divided by the labor force) multiplied by 100. That is, (14.6 million/153.7 million)  100, which is 9.5 percent.

b. Labor force participation rate. The labor force participation rate is 64.6 percent. The labor force participation rate is the percentage of the working-age population that is in the labor force. The working-age population is 237.9 million and the labor force is 153.7 million, so the labor force participation rate is (153.7 million/237.9 million)  100, which equals 64.6 percent.

c. Employment-to-population ratio.

The employment-to-population ratio is 58.4 percent. The employment-to-population ratio is the percentage of the people of working age who have jobs. The employment-to-population ratio is equal to the number of people employed divided by the working-age population then multiplied by 100. The employment-to-population ratio is (139.1 million/237.9 million)  100, which is 58.4 percent.

In July 2009, in the economy of Sandy Island, 10,000 people were employed, 1,000 were unemployed, and 5,000 were not in the labor force. During August 2009, 80 people lost their jobs and didn’t look for new ones, 20 people quit their jobs and retired, 150 unemployed people were hired, 50 people quit the labor force, and 40 people entered the labor force to look for work. Calculate for July 2009 a. The unemployment rate. The unemployment rate in July is 9.1 percent. The unemployment rate is the number unemployed as a percentage of the labor force. The number of unemployed workers is 1,000. The labor force is the number employed plus the number unemployed so in July it is 11,000. The unemployment rate equals (1,000/11,000)  100, which is 9.1 percent.

b. The employment-to-population ratio.

The employment-to-population ratio is 62.5 percent. The employment-to-population ratio is the number employed as a percentage of the working-age population. The number of employed people is 10,000. The working-age population is the sum of the labor force and the number of people who are not in the labor force, which is 16,000. The employment-to-population ratio is (10,000/16,000)  100, which is 62.5 percent.

And calculate for the end of August 2009 c. The number of people unemployed. The number of people who are unemployed at the end of August is 840. The number of people who are unemployed at the end of August equals the number unemployed in July plus the number of people who lost their job and who stayed in the labor market plus the number of people entering the labor market minus the number of people who were hired minus the © 2014 Pearson Education, Inc.

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number of people who left the labor market. So the number of people unemployed equals 1,000 + 40 − 150 − 50, which is 840.

d. The number of people employed.

The number of people who are employed at the end of August is 10,050. The number of people who are employed at the end of August equals the number employed in July minus job losers and job leavers plus hires and recalls.

e. The unemployment rate. The unemployment rate at the end of August is 7.7 percent. The unemployment rate equals the number unemployed expressed as a percentage of the labor force. The number of people who are unemployed is 840. The labor force equals the number employed plus the number unemployed and at the end of August it is 10,890. The unemployment rate at the end of August equals (840/10,890)  100, which is 7.7 percent.

Use the following information to work Problems 3 and 4. In October 2009, the U.S. unemployment rate was 10.0 percent. In October 2011, the unemployment rate was 8.9 percent. Predict what happened to: 3.

Unemployment between October 2009 and October 2011, assuming that the labor force was constant. If the labor force is constant, the only way the unemployment rate can decrease is if the number of unemployed workers decreases.

The labor force between October 2009 and October 2011, assuming that unemployment was constant. If unemployment is constant, the only way the unemployment rate can decrease is if the labor force increases.

Shrinking U.S. Labor Force Keeps Unemployment Rate From Rising An exodus of discouraged workers from the job market kept the unemployment rate from climbing above 10 percent. Had the labor force not decreased by 661,000, the unemployment rate would have been 10.4 percent. The number of discouraged workers rose to 929,000 last month. Source: Bloomberg, January 9, 2010 What is a discouraged worker? Explain how an increase in discouraged workers influences the official unemployment rate and U–4. A discouraged worker is a person, who currently is not working, would like a job, has looked for one in the recent past, but has stopped looking for work because of repeated failures in finding a job. If a worker who had been looking for work quits looking, the official unemployment rate, U3, falls. U-4 includes discouraged workers among the ranks of the unemployed so when the worker stops looking for work and becomes a discouraged worker, the U-4 unemployment rate does not change.

Use the following news clip to work Problems 6 to 8. Nation’s Economic Pain Deepens A spike in the unemployment rate—the biggest in more than two decades—raised new concerns that the economy is heading into a recession. The U.S. unemployment rate soared to 5.5% in May from 5% in April—much higher than forecasted. The surge marked the biggest one-month jump in unemployment since February 1986, and the 5.5% rate is the highest seen since October 2004. Source: CNN, June 6, 2008 6.

MONITORING JOBS AND INFLATION

earlier recessions? The unemployment rate in May 2008 was below the typical unemployment rate during the past recessions.

Why might the unemployment rate tend to actually underestimate the unemployment problem, especially during a recession? The unemployment rate probably underestimates the extent of the unemployment problem during a recession because the number of marginally attached workers, including discouraged workers, increases during a recession as does the number of part-time workers looking for fulltime jobs. Both marginally attached workers and part-time workers who want full-time jobs represent an unemployment problem. In a recession neither group is providing the amount of labor they would if times were better.

How does the unemployment rate in May compare to the estimated natural unemployment rate? What does this imply about the relationship between real GDP and potential GDP at this time? In May the unemployment rate was above the estimated natural unemployment rate. This relationship suggests that real GDP was less than potential GDP.

Use the following information to work Problems 9 and 10. Some Firms Struggle to Hire Despite High Unemployment Matching people with available jobs is always difficult after a recession as the economy remakes itself. But Labor Department data suggest the disconnect is particularly acute this time. Since the recovery began in mid-2009, the number of job openings has risen more than twice as fast as actual hires. If the job market were working normally, openings would be getting filled as they appear. Some five million more would be employed and the unemployment rate would be 6.8%, instead of 9.5%. Source: The Wall Street Journal, August 9, 2010 9. If the labor market is working properly, why would there be any unemployment at all? Unemployment will always exist in the labor market because of normal labor market frictions. People newly entering the labor market, workers quitting a job to look for a better job, firms laying-off workers because consumers no longer want to buy the goods produced by the firms will always be part of the labor market. All of these events create unemployment, so even when the labor market is operating at peak efficiency, unemployment will always be present.

10.

Are the 5 million workers who cannot find jobs because of mismatching in the labor market counted as part of the economy’s structural unemployment or part of its cyclical unemployment? Even though these workers are unemployed during a recessionary period, their unemployment is the result of a mismatch between their skills and the skills required for the available jobs. So while they might be counted as part of cyclical unemployment because they lost their jobs because of the recession, the mismatch means that these workers might also be counted as part of the economy’s structural unemployment.

11.

Which of the following people are unemployed because of labor market mismatching? • Michael has unemployment benefits of $450 a week, and he turned down a full-time job paying $7.75 an hour. The reason Michael turned down the job has nothing to do with his skills or the required skills for the job. He turned the job and remained unemployed simply because his unemployment

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insurance benefit exceeded the wage he would earn on the job. Michael’s unemployment is not the result of mismatching.

• Tory used to earn $60,000 a year, and he turned down a low-paid job to search for one that pays at least $50,000 a year. Tory is searching for a job that pays more, presumably because it fully utilizes his skills. Tory’s unemployment is the result of the mismatch between the available job and his skill set.

• David turned down a temporary full-time job paying $15 an hour because it was an hour’s drive away and the gas cost would be high. David turned down the job because of the mismatch between the job’s location and where he lived. David’s unemployment is the result of a mismatch.

Use the following information to work Problems 12 and 13. The people on Coral Island buy only juice and cloth. The CPI basket contains the quantities bought in 2012. The average household spent $60 on juice and $30 on cloth in 2012 when the price of juice was $2 a bottle and the price of cloth was $5 a yard. In the current year, 2013, juice is $4 a bottle and cloth is $6 a yard. 12.

Calculate the CPI basket and the percentage of the household’s budget spent on juice in 2012. The CPI basket is 30 bottles of juice and 6 yards of cloth. The total amount spent on the CPI basket in 2012 was $90 and of that $60 was spent on juice. The percentage of the household’s budget spent on juice was ($60/$90) × 100, which is 66.7 percent.

13.

Calculate the CPI and the inflation rate in 2013. The CPI in 2013 is 173.3. To calculate the CPI, divide the value of the CPI basket in 2013 prices by the base-year value of the CPI basket and then multiply the resulting number by100. The value of the CPI basket in 2013 prices is: ($4  30) + ($6  6) = $156. The value in base-year prices is $60 + $30 (provided in the question), which equals $90. So the CPI is ($156/$90)  100 = 173.3. The inflation rate in the 2013 is 73.3 percent. The inflation rate equals the CPI in 2013 year minus the CPI in the base year expressed as a percentage of the base-year CPI. Because the baseyear CPI is 100, the inflation rate is [(173.3 – 100)/ 100] × 100 = 73.3 percent.

Use the following data to work Problems 14 to 16. The BLS reported the following CPI data: June 2008 217.3 June 2009 214.6 June 2010 216.9 14.

Calculate the inflation rates for the years ended June 2009 and June 2010. How did the inflation rate change in 2010? The inflation rate for the year ended June 2009 is −1.2 percent; the inflation rate for the year ended June 2010 is 1.1 percent. The inflation rate is the percentage change in the price level. It is equal to [(Pthis year – Plast year)/ Plast year]  100. For the year ended in June 2009 the inflation rate is [(214.6 – 217.3)/217.3]  100, which is −1.3 percent. For the year ended in June 2010 the inflation rate is [(216.9 – 214.6)/214.6]  100, which is 1.1 percent. The inflation rate increased in 2010.

MONITORING JOBS AND INFLATION

15.

Why might these CPI numbers be biased? The CPI numbers might be biased because of the new goods bias, the quality change bias, the commodity substitution bias, and the outlet substitution bias. The new goods bias is that new goods are often more expensive than the older goods that they replace. The quality change bias is that increases in the quality of a good are often accompanied by increases in the good’s price. The commodity substitution bias reflects the point that consumers will buy less of a good whose price increased and more of a good whose price has not changed. Finally the outlet substitution bias points out that when prices rise, consumers shop more frequently at stores with cheaper prices.

16.

How do alternative price indexes help to avoid the bias in the CPI numbers? Each of the alternative price indexes attempts to overcome some of the bias in the CPI numbers. The chained CPI uses prices and quantities from the previous period and the current period. The chaining process overcomes the commodity substitution process. And because it contains current period quantities, it also does not suffer from the new goods bias. The personal consumption expenditure deflator contains goods and services omitted from the CPI. It is calculated from the nominal and real consumption expenditure data and so it, too, is computed using a chaining procedure. Because the personal consumption expenditure deflator is calculated using a chaining procedure, it does not suffer from the commodity substitution bias or the new goods bias. The GDP deflator is calculated from nominal and real GDP data. It is broader than the personal consumption expenditure deflator because it contains goods and services in consumption expenditure, investment, government expenditure, and net exports. The GDP deflator is calculated using a chaining procedure and so it also avoids the commodity substitution bias and new goods bias.

17.

Inflation Can Act as a Safety Valve Workers will more readily accept a real wage cut that arises from an increase in the consumer prices than a cut in their nominal wage rate. Source: FT.com, May 28, 2009 Explain why inflation influences a worker’s real wage rate. Why might this observation be true? The real wage rate equals the nominal wage rate divided by the price level. Inflation affects the price level, which, for an unchanged nominal wage rate, affects the real wage rate. For instance, if the nominal wage rate is kept constant, inflation raises the price level, which lowers the real wage rate. The idea that workers will accept a real wage rate cut if it comes in the form of higher prices than if it comes in the form of lower nominal wage rates could be the result of uncertainty. No worker wants to receive a lower real wage rate. Workers will instantly realize that their real wage rate has been lowered if their nominal wage rate is decreased (assuming there is not a corresponding fall in the price level). But workers might not realize that their real wage rate has been lowered if their nominal wage rate is kept steady while the price level rises.

18.

The IMF World Economic Outlook reported the following price level data (2000 = 100): a. In which region was the inflation rate highest in 2010 and in 2011?

Region United States Euro area Japan

2009 217.2 120.0 100.0

2010 220.9 121.9 99.6

2011 227.5 125.3 99.4

In 2010, the inflation rate in the United States was 1.7 percent; in the Euro area the inflation rate was 1.6 percent; and, in Japan the inflation rate was −0.4 percent. The inflation rate was the highest in the United States. In 2011, the inflation rate in the United States was 3.0 percent; in © 2014 Pearson Education, Inc.

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the Euro area the inflation rate was 2.8 percent; and, in Japan the inflation rate was −0.2 percent. The inflation rate was the highest in the United States.

b. Describe the path of the price level in Japan. In Japan, between 2009 and 2010 the price level fell by 0.4 percent, so prices in Japan generally fell that year. Between 2010 and 2011 the price level fell by less, 0.2 percent, so the prices in Japan generally fell slightly that year.

19.

Inflation Getting “Uglier and Uglier” The Labor Department reported that the CPI rose 4.2% through the 12 months ending in May and 0.6% in May. Energy costs rose 4.4% in May, and surged 17.4% over the 12 months ending in May; transportation costs increased 2% in May, and jumped 8.1% over the 12 months ending in May. The price of food increased 0.3% in May, and jumped 5.1% during the 12 months ending in May. The price of milk increased 10.2% over the 12 months. The price of clothing fell 0.2% in May, and decreased 0.4% over the 12 months. The core CPI rose 0.2% in May and 2.3% during the 12 months ending in May. Source: CNN, June 13, 2008 a. Which components of the CPI basket experienced price increases (i) faster than the average and (ii) slower than the average? Energy is the component of the CPI basket that has risen most rapidly in price. Energy costs rose more than 17 percent over the past year. Related to this increase, the cost of transportation also increased significantly, 8.1 percent over the past year. Milk also contributed a large price increase, rising 10.2 percent over the past year while food in general rose 5.1 percent over the year. Clothing was the component with a well below-average price hike. Clothing actually decreased in price over the past year, falling 0.4 percent. Looking at the monthly data, food and clothing rose less than the average while the other goods and services rose more than the average.

b. Distinguish between the CPI and the core CPI. Why might the core CPI be a useful measurement and why might it be misleading? The core CPI eliminates the most volatile prices in the CPI, which are, in practice, food and energy prices. The core CPI might be a useful measurement because the (actual) CPI can jump higher or lower for a month because of changes in these volatile prices. The core CPI might give a better measurement of the underlying inflation in the economy because it filters out short-term jumps. However the core CPI can also be misleading when the relative price of the omitted goods is changing. For instance over the past several years the relative price of food and energy has been rising. Omitting these prices has lead to the core inflation rate being consistently and systematically less than the CPI inflation rate.

20.

Dress for Less Since 1998, the price of the Louis Vuitton “Speedy” handbag has more than doubled, to $685, while the price of Joe Boxer’s “licky face” underwear has dropped by nearly half, to $8.99. As luxury fashion has become more expensive, mainstream apparel has become markedly less so. Clothing is one of the few categories in the CPI in which overall prices have declined—about 10 percent—since 1998. Source: The New York Times, May 29, 2008 a. What percentage of the CPI basket does apparel comprise? Apparel accounts for 4 percent of the CPI basket.

MONITORING JOBS AND INFLATION

b. If luxury clothing prices have increased dramatically since the late 1990s, why has the clothing category of the CPI actually declined by about 10 percent? Luxury clothing is a very small part of the clothing category of the CPI. As a result the large rise in the price of luxury has been swamped by the fall in more modestly priced clothing so that, on net, the cost of the clothing category of the CPI has declined.

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Answers to Additional Problems and Applications 21.

What is the unemployment rate supposed to measure and why is it an imperfect measure? Ideally the unemployment rate would measure the underutilization of labor resources. But it is an imperfect measure for two reasons. First the unemployment rate does not include some underutilized labor. In particular the unemployment rate completely omits marginally attached workers, such as discouraged workers. These workers are not included in the unemployment rate. Second the unemployment rate counts as fully employed workers who are working part time but who want full-time jobs. These workers are underutilized because they would like to work for more hours than is presently the case.

22.

The Bureau of Labor Statistics reported the following data for July 2012: Labor force participation rate: 63.7 percent Working-age population: 243.4 million Employment-to-population ratio: 58.4

Calculate the a. Labor force. The labor force participation rate equals the labor force divided by the working-age population then multiplied by 100. Rearranging this formula shows that the labor force equals the workingage population multiplied by the labor force participation rate then divided by 100. Using this last formula and the data given in the problem shows that the labor force equals 243.4 million × 63.7/100, which is 155.0 million.

b. Employment. The employment-to-population ratio equals employment divided by the working-age population then multiplied by 100. Rearranging this formula shows that employment equals the workingage population multiplied by the employment-to-population ratio then divided by 100. Using this last formula and the data given in the problem shows that employment equals 243.4 million × 58.4/100, or 142.1 million.

c. Unemployment rate. The unemployment rate equals the number of people unemployed divided by the labor force. The labor force, from part (a), is 155.0 million. The labor force equals the number of people employed plus the number of people unemployed. Employment, from part (b), is 142.1 million so the number of people unemployed is 12.9 million. The unemployment rate equals the number of people unemployed divided by the labor force, then multiplied by 100. Using this last formula shows that the unemployment rate equals (12.9 million/155.0 million) × 100, which is 8.3 percent.

23.

Jobs Report: Hiring Up, Unemployment Down The Labor Department reported that hiring accelerated in November, and the unemployment rate fell to 8.6 percent from 9 percent in October. Two reasons for the fall are that more Americans got jobs, but even more people gave up on their job searches altogether. Source: CNNMoney, December 2, 2011 a. If the only change was that all the newly hired people had been unemployed in October, explain how the labor force and unemployment would have changed. The labor force would not have changed. The number of people unemployed would have decreased so the unemployment rate would have fallen.

MONITORING JOBS AND INFLATION

b. If the only change was that people gave up on their job searches, explain how the labor force and unemployment would have changed. The number of people unemployed would have fallen, so the labor force and the unemployment rate would have decreased.

24.

The BLS reported that in July 2012, employment decreased by 195,000 to 142,220,000 and the unemployment rate increased from 8.2 percent to 8.3 percent. About 3.4 million people were marginally attached workers and 0.9 million of them were discouraged. a. Calculate the change in unemployment in July 2012. At the start of July employment was 142,220,000 + 195,000 = 142,415,000. The unemployment rate, which was 8.2 percent, equals (Unemployment/[Unemployment + Employment]) × 100. Using the data for the start of July gives the result that 0.082 = (Unemployment/[Unemployment + 142,415,000]). Solving for the amount of unemployment shows that unemployment at the start of July was 12,721,166 workers. Similar calculations show that at the end of July the amount of unemployment was 12,872,694 workers. Unemployment increased in July by 151,528 workers in July.

b. With 3.4 million marginally attached workers and 0.9 million of them discouraged workers, what are the characteristics of the other 2.5 million marginally attached workers? The other 2.5 million marginally attached workers would like a job but have stopped looking for work. Because they are not discouraged workers, these 2.5 million workers have stopped looking for reasons other than their inability to find a job. For example, a stay-at-home spouse might prefer working in the job market but have quit looking to undertake some home repairs.

25.

A high unemployment rate tells us that a large percentage of the labor force is unemployed but not why the unemployment rate is high. What unemployment measure tells us if (i) people are searching longer than usual to find a job, (ii) more people are economic parttime workers, or (iii) more unemployed people are job losers? U-1 measures long-term unemployment of 15 weeks or more. If U-1 exceeds its normal value, then people are taking longer than usual to find a job. U-6 equals U-5 plus part-time workers who want full-time jobs as unemployed, so the difference between U-6 and U-5 is the result of part-time workers who want a full-time job. If this difference is unusually large, then more workers than normal are working at part-time jobs. U-2 measures unemployment resulting from people losing their jobs. If U-2 is larger than normal, then more unemployment than normal results from people losing their jobs.

26.

Some Firms Struggle to Hire Despite High Unemployment With about 15 million Americans looking for work, some employers are swamped with job applicants, but many employers can’t hire enough workers. The U.S. jobs market has changed. During the recession, millions of middle-skill, middle-wage jobs disappeared. Now with the recovery, these people can’t find the skilled jobs that they seek and have a hard time adjusting to lower-skilled work with less pay. Source: The Wall Street Journal, August 9, 2010 If the government extends the period over which it pays unemployment benefits to 99 weeks, how will the cost of unemployment change? Extending unemployment benefits to 99 weeks decreases the cost of being unemployed and thereby increases the unemployment rate as some people search for a new job for a longer period of time. © 2014 Pearson Education, Inc.

27.

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Why might the unemployment rate underestimate the underutilization of labor resources? The official unemployment rate underestimates the underutilization of labor resources for two reasons. First the official unemployment rate completely omits some underutilized labor. In particular the official unemployment rate omits marginally attached workers, such as discouraged workers. These workers are not included in the unemployment rate because they are not searching for a job, though if the labor market was better and jobs more plentiful they would reenter the labor market. Marginally attached workers are not a major source of mismeasurement because they are a small subset of people. Second the unemployment rate counts as fully employed workers who are working part time but who want full time jobs. These workers are underutilized because they would like to work for more hours than is presently the case. These workers are a significantly more substantial source of error because they account for a much larger part of the labor force.

Use the following data to work Problems 28 to 30. The IMF World Economic Outlook reports the unemployment rates in the table. 28.

What do these numbers tell you about the phase of the business cycle in the three regions in 2011?

Region United States Euro area Japan

2010 9.6 10.1 5.1

2011 9.0 10.9 4.5

The unemployment rates fell in the United States and Japan, so it might well be the case that the United States and Japan were entering an expansionary period. The unemployment rate in the Euro area rose, so it might be the case that the Euro area was in a recession.

29.

What do these numbers tell us about the relative size of their natural unemployment rates? These numbers cover only two years, so making inferences about the relative size of the natural unemployment rates is potentially dangerous. To the extent that these data are representative, the natural unemployment rate is likely the highest in the Euro area and the lowest in Japan.

30.

Do these numbers tell us anything about the relative size of the labor force participation rates and employment-to-population ratios? The numbers tell us nothing about the relative sizes of the labor force participation rates or the employment-to-population ratios in these three regions.

31.

A Half-Year of Job Losses For the first six months of 2008, the U.S. economy lost 438,000 jobs. The job losses in June were concentrated in manufacturing and construction, two sectors that have been badly battered in the recession. Source: CNN, July 3, 2008 a. Based on the news clip, what might be the main source of increased unemployment? The main source of increased unemployment likely is in the form of job losses in manufacturing and construction as opposed to people entering or reentering the labor market or people leaving their jobs. The news clip makes clear that the first six months of the year had been dismal for the economy, so these job losses are likely cyclical unemployment in nature though with a mixture of structural unemployment included because the job losses were concentrated in specific areas..

b. Based on the news clip, what might be the main type of increased unemployment? While the job losses were “concentrated” in manufacturing and construction, the news clip mentioned as the reason for the unemployment the point that the two sectors were “badly battered in the recession.” These job losses represented cyclical unemployment because there were the result of the “battering” that took place during the recession. © 2014 Pearson Education, Inc.

MONITORING JOBS AND INFLATION

32.

Governor Plans to Boost Economy with Ecofriendly Jobs Oregon’s 5.6 percent unemployment rate hovers close to the national average of 5.5 percent. A few years ago, Oregon had one of the highest unemployment rates in the nation. To avoid rising unemployment, Oregon Governor Kulongoski introduced a plan that provides public schools and universities with enough state funds to meet growing demand for skilled workers. Also Kulongoski wants to use state and federal money for bridges, roads, and buildings to stimulate more construction jobs. Source: The Oregonian, July 8, 2008 a. What is the main type of unemployment that Governor Kulongoski is using policies to avoid? Explain. Governor Kulongoski is attempting to decrease both frictional and some structural unemployment. The educational policies of attempting to train students for jobs with growing demand is an attempt to decrease the frictional unemployment of newly graduated students looking for a job. If the students graduate with the skills that firms want to hire, the students quickly will find suitable jobs, thereby decreasing the state’s frictional unemployment. The proposed policy of building more bridges, roads, and buildings to provide more construction jobs is attempting to overcome some structural unemployment in the construction industry. Apparently the number of unemployed workers in the construction sector is large enough and persistent enough that the governor wants to implement policies to decrease it. Because this unemployment is persistent in nature, it is structural unemployment.

b. How might these policies impact Oregon’s natural unemployment rate? Explain. If these policies succeed, they will decrease the natural unemployment rate in Oregon. Natural unemployment is comprised of frictional and structural unemployment. By decreasing these types of unemployment, Governor Kulongoski’s policies are decreasing the natural unemployment rate.

33.

A typical family on Sandy Island consumes only juice and cloth. Last year, which was the base year, the family spent $40 on juice and $25 on cloth. In the base year, juice was $4 a bottle and cloth was $5 a length. This year, juice is $4 a bottle and cloth is $6 a length. Calculate a. The CPI basket. The CPI basket is 10 bottles of juice and 5 lengths of cloth.

b. The CPI in the current year. The CPI in the current year is 107.7. To calculate the CPI, divide the value of the CPI basket in current year prices by the base-year value of the CPI basket and then multiply the resulting number by100. The value of the CPI basket in current year prices is: ($4  10) + ($6  5) = $70. The value in base-year prices is $40 + $25 (provided in the question), which equals $65. So the CPI is ($70/$65)  100 = 107.7.

c. The inflation rate in the current year. The inflation rate in the current year is 7.7 percent. The inflation rate equals the CPI in the current year minus the CPI in the base year expressed as a percentage of the base-year CPI. Because the base-year CPI is 100, the inflation rate is [(107.7 – 100)/ 100] × 100 = 7.7 percent.

34.

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Amazon.com agreed to pay its workers $20 an hour in 1999 and $22 an hour in 2001. The price level for these years was 166 in 1999 and 180 in 2001. Calculate the real wage rate in each year. Did these workers really get a pay raise between 1999 and 2001? The real wage rate equals the nominal wage rate divided by the price level. In 1999 the real wage rate was $20/166 × 100, for a real wage rate of $12.05. In 2001 the real wage rate was $22/180 × 100, for a real wage rate of $12.22. The workers really got a pay raise between 1999 and 2001 but it was less than the raise in their nominal wage rate.

35.

News release In May 2012, real personal consumption expenditure (PCE) was $9,588 billion and the PCE deflator was 115.4. In June 2012, real personal consumption expenditure was $9,576 billion and personal consumption expenditure was $11,062 billion. Source: Bureau of Economic Analysis, July 30, 2012 Calculate personal consumption expenditure in May 2012 and the PCE deflator in June 2012. Was the percentage increase in real personal consumption expenditure greater or smaller than that in personal consumption expenditure? Personal consumption expenditure = (real personal consumption expenditure) × (PCE deflator) ÷ 100, so in May 2012 personal consumption expenditure equaled $9,588 billion × 115.4 ÷ 100 = $11,064 billion. PCE deflator = ([personal consumption expenditure] ÷ [real personal consumption expenditure) × 100, so in June 2012 the PCE deflator = ($11,062 billion ÷ $9,576 billion) × 100 = 115.5. The percentage increase in real personal consumption expenditure was smaller than the percentage increase in personal consumption expenditure. Personal consumption expenditure grows because real personal consumption expenditure grows and/or because the PCE deflator grows. During this period, both real personal consumption expenditure grew and because the PCE deflator grew so the percentage increase in (nominal) personal consumption exceeded the percentage increase in real personal consumption expenditure.

36.

Hardworking Americans Should Not Be Living in Poverty The federal minimum wage has remained frozen for the past three years at $7.25 an hour, while the prices of gas and milk have risen steadily. Over this three-year period, the real value of the minimum wage has fallen to $6.77 per hour. Source: CNN, July 25, 2012 By what percentage did the CPI increase over these three years? The real minimum wage is equal to (minimum wage)/(price level). In real terms, the minimum wage has fallen by a percentage equal to [($7.25 − $6.77)/(7$7.25)] × 100, which is a decrease of 6.6 percent. The nominal minimum wage rate has not changed, so the only factor that has caused the change in the real minimum wage is a change in the price level. Because the real minimum wage has fallen by 6.6 percent, the price level, that is, the CPI, must have risen by 6.6 percent.

37.

After you have studied Reading Between the Lines on pp. 122–123 (528–529 in Economics), answer the following questions. a. What are the two measures of employment? The Current Employment Survey (CES), which is based on a survey of payroll jobs at business establishments, is one measure of employment. The Current Population Survey (CPS) which is based on a survey of households, is another measure of employment.

MONITORING JOBS AND INFLATION

b. What are the sources of difference between the two measures of employment? The surveys differ because the payroll job survey omits three factors that affect the measure of employment. The household survey includes: 1) farm workers; 2) self-employed; and, 3) workers on unpaid leave.

c. What do the two measures of employment tell us about the U.S. economy since 2000? Since 2000, the two surveys convey generally the same picture of the U.S. economy. Both surveys show employment falling in 2001 after which they turn up, though the turn up takes about 2 years longer for the payroll survey. Both surveys then rose until about 2008, after which both fell until 2010, after which both again turned up.

d. Thinking about the information in the news article and its implications for unemployment, would you say that the change in unemployment is a change in cyclical unemployment or a change in natural unemployment? The change in unemployment during the recession of 2008-2009 was cyclical. If Mr. Brown is correct insofar as the growth in employment is fast enough to absorb the increase in population but not fast enough to lower the unemployment rate, the higher unemployment rate is a change in natural unemployment.

e. What do the data on employment, unemployment, and underemployment imply has happened to the number (and percentage) of people who are not in the labor force? Since about 2009 the labor force has fallen increasingly below the population. This fact means that the number (and percentage) of people who are not in the labor force has increased.

38.

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Out of a Job and Out of Luck at 54 Too young to retire, too old to get a new job. That’s how many older workers feel after getting the pink slip and spending time on the unemployment line. Many lack the skills to craft resumes and search online, experts say. Older workers took an average of 21.1 weeks to land a new job in 2007, about 5 weeks longer than younger people. “Older workers will be more adversely affected because of the time it takes to transition into another job,” said Deborah Russell, AARP’s director of workforce issues. Source: CNN, May 21, 2008 a. What type of unemployment might older workers be more prone to experience? Older workers are more likely to experience structural unemployment.

b. Explain how the unemployment rate of older workers is influenced by the business cycle. Older workers might be more likely to be fired when the economy enters a recession because the business would rather train its younger workers to prepare for the future. If this takes place, then the unemployment rate of older workers will rise more than that of other groups when the economy enters a recession.

c. Why might older unemployed workers become marginally attached or discouraged workers during a recession? The news clip explains that older unemployed workers have a significantly more difficult time finding a new job than do younger unemployed workers. Older workers must search an average of 5 weeks longer to find a new job than younger workers. It would be easy for some older workers to become discouraged about their job prospects and either quit looking entirely, thereby becoming marginally attached or discouraged workers.

C h a p t e r

ECONOMIC GROWTH**

Answers to the Review Quizzes Page 134 1.

(page 540 in Economics)

What is economic growth and how do we calculate its rate? Economic growth is the sustained expansion of production possibilities. It is measured by the increase in real GDP over a given time period. The economic growth rate is the annual percentage change in real GDP.

What is the relationship between the growth rate of real GDP and the growth rate of real GDP per person? The growth rate of real GDP tells how rapidly the total economy is expanding while the growth rate of real GDP per person tells how the standard of living is changing. The growth rate of real GDP per person approximately equals the growth rate of real GDP minus the population growth rate.

Use the Rule of 70 to calculate the growth rate that leads to a doubling of real GDP per person in 20 years. The rule of 70 states that the number of years it takes for the level of any variable to double is approximately equal to 70 divided by the growth rate. If the level of real GDP doubles in 20 years, the rule of 70 gives 20 = 70  (growth rate) so that the growth rate equals 70  20, which is 3.5 percent per year.

Page 137 1.

(page 543 in Economics)

What has been the average growth rate of U.S. real GDP per person over the past 100 years? In which periods was growth most rapid and in which periods was it slowest? Over the past 100 years, U.S. real GDP per person grew at an average rate of 2 percent per year. Slow growth occurred during mid-1950s and 1973–1983. Very slow growth (negative growth!) also occurred during the Great Depression. Growth was rapid during the 1920s and 1960s. Growth was also (extremely!) rapid during World War II.

Describe the gaps between real GDP per person in the United States and in other countries. For which countries is the gap narrowing? For which is it widening? For which is it the same? Some rich countries are catching up with the United States, but the gaps between the United States and many poor countries are not closing. Amongst the rich countries, since 1960 Japan has closed the gap with the United States but the gaps between the United States and Canada, and the “Europe Big 4” (France, Germany, Italy, and the United Kingdom) have tended to remain constant. Other Western European nations and the former Communist countries of Central Europe have fallen slightly farther behind the United States. The gap between the United States *

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and most nations in Africa, and Central and South America has widened. But some nations in Asia— including Hong Kong, Singapore, Korea, and China—have grown very rapidly. The gap between these nations and the United States has shrunk; indeed, Singapore has slightly surpassed the United States and Hong Kong has virtually tied the United States.

Compare the growth rates in Hong Kong, Korea, Singapore, Taiwan, China, and the United States. In terms of real GDP per person, how far is China behind these others? Since 1960, income per person in the nations of Hong Kong, Singapore, Korea, Taiwan, and China have grown very rapidly and are rapidly catching up to the United States. Income per person in Hong Kong is virtually the same as that in the United States and income per person in Singapore slightly exceeds that in the United States. Income in Korea also is relatively close. Income in China is the lowest, though recently China has been growing the most rapidly. China’s level of income in 2010 is similar to that of Hong Kong in 1976.

Page 143 1.

(page 549 in Economics)

What is the aggregate production function? The aggregate production function is the relationship that tells us how real GDP changes as the quantity of labor changes when all other influences on production remain the same.

What determines the demand for labor, the supply of labor, and labor market equilibrium? The demand for labor is the relationship between the quantity of labor demanded and the real wage rate. A fall in the real wage rate increases the quantity of labor demanded because of diminishing returns. The demand for labor also depends on productivity. If productivity increases, the demand for labor increases. The supply of labor is the relationship between the quantity of labor supplied and the real wage rate. An increase in the real wage rate increases the quantity of labor supplied because more people enter the labor force and the hours supplied per person increases. The real wage adjusts so that the labor market is in equilibrium. If the real wage rate is above (below) its equilibrium, there is a surplus (shortage) of labor that then causes the real wage rate to fall (rise). For example, if the real wage rate is above the equilibrium level, there is a surplus of labor so the real wage rate falls until it reaches its equilibrium. The equilibrium quantity of employment is the full employment quantity of labor.

What determines potential GDP? Potential GDP is determined from the labor market equilibrium. When the labor market is in equilibrium, there is full employment. The quantity of real GDP produced by the full employment quantity of labor is potential GDP.

What are the two broad sources of potential GDP growth? The two broad sources of growth in potential GDP are growth of the supply of labor and growth of labor productivity.

What are the effects of an increase in the population on potential GDP, the quantity of labor, the real wage rate, and potential GDP per hour of labor? An increase in population increases the supply of labor. Employment increases and the real wage rate falls. The increase in employment creates a movement along the aggregate production function so potential GDP increases. Because of diminishing returns, real GDP per hour of labor decreases.

ECONOMIC GROWTH

What are the effects of an increase in labor productivity on potential GDP, the quantity of labor, the real wage rate, and potential GDP per hour of labor? The increase in labor productivity shifts the aggregate production function curve upward. The demand for labor increases, and the demand for labor curve shifts rightward. The increase in the demand for labor raises the real wage rate and increases employment. The increase in employment as well as the upward shift of the aggregate production function increase potential GDP. Real GDP per hour of labor increases.

Page 145 1.

(page 551 in Economics)

What are the preconditions for labor productivity growth? The fundamental preconditions for labor productivity growth are the existence of: firms, markets, property rights, and money. These fundamental preconditions create an incentive system that can lead to labor productivity growth.

Explain the influences on the pace of labor productivity growth. Once the preconditions for growth are in place, the sources of labor productivity growth are: physical capital growth, human capital growth, and advances in technology. All of these activities enable an economy to grow and they all increase labor productivity. They all also interact: human capital creates new technologies, which are then embodied in both new human capital and new physical capital. Similarly advances in technology also lead to increases in labor productivity.

Page 151 1.

(page 557 in Economics)

What is the key idea of classical growth theory that leads to the dismal outcome? The “dismal outcome” in classical theory is the conclusion that in the long run real GDP per person equals the subsistence level. In classical growth theory, an increase in real GDP per person causes population increases that return real GDP per person to the subsistence level. In the classical growth theory, an increase in income creates a population boom. The increase in population increases the supply of labor. Because of diminishing returns to labor, the increase in the supply of labor lowers the real wage rate and people’s incomes. Eventually the real wage rate falls to equal the subsistence level, at which time the population stops growing.

What, according to neoclassical growth theory, is the fundamental cause of economic growth? In neoclassical growth theory, growth results from technological advances, which are determined by chance.

What is the key proposition of new growth theory that makes economic growth persist? The key proposition that makes growth persist indefinitely in the new growth theory is the assumption that the returns to knowledge and human capital do not diminish. As a result, increases in knowledge do not cause diminishing returns and the incentive to innovate remains high. As people accumulate more knowledge, the incentive to innovate does not fall and so people continue to innovate new and better ways to produce new and better products. This innovation means that economic growth persists indefinitely.

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Answers to the Study Plan Problems and Applications 1.

Brazil’s real GDP was 1,520 trillion reais in 2011 and 1,585 trillion reais in 2012. Brazil’s population was 195 million in 2011 and 196.5 million in 2012. Calculate a. The growth rate of real GDP. The economic growth rate is the growth rate of real GDP. Between 2011 and 2012 this growth rate equals [(1,585 trillion reais − 1,520 trillion reais)/1,520 trillion reais]  100, which is 4.3 percent.

b. The growth rate of real GDP per person. Brazil’s population grew at [(196.5 million − 195 million)/195 million]  100, which is 0.8 percent. Brazil’s economic growth rate is 4.3 percent, so the growth rate of real GDP per person is 4.3 percent − 0.8 percent, or 3.5 percent.

c. The approximate number of years it takes for real GDP per person in Brazil to double if the 2012 growth rate of real GDP and the population growth rate are maintained. Brazil’s real GDP per person is growing at 3.5 percent a year. The rule of 70 tells us that Brazil’s real GDP per person will double in 70/3.5 = 20 years.

Japan’s real GDP was 548 trillion yen in 2011 and 560 trillion yen in 2012. Japan’s population was 127.2 million in 2011 and 127.0 million in 2012. Calculate a. The growth rate of real GDP. The economic growth rate is the growth rate of real GDP. Between 2011 and 2012 this growth rate equals [(560 trillion yen − 548 trillion yen)/548 trillion yen]  100, which is 2.2 percent.

b. The growth rate of real GDP per person. Japan’s population grew at [(127.0 million − 127.2 million)/127.2 million]  100, which is −0.2 percent. Japan’s economic growth rate is 2.2 percent, so the growth rate of real GDP per person is 2.2 percent − (−0.2 percent), or 2.4 percent.

c. The approximate number of years it takes for real GDP per person in Japan to double if its real GDP growth rate returns to 3 percent a year and the population growth rate is maintained. If the real GDP growth rate becomes 3.0 percent, when combined with the −0.2 percent growth rate of the population, means that real GDP per person is growing at 3.2 percent. The rule of 70 tells us that Japan’s real GDP per person will double in 70/3.2 = 21.9 years, which rounds to 22 years.

Use the following data to work Problems 3 and 4. China’s real GDP per person was 11,480 yuan in 2011 and 12,515 yuan in 2012. India’s real GDP per person was 45,045 rupees in 2011 and 47,995 rupees in 2012. 3.

By maintaining their current growth rates, which country will double its 2012 standard of living first? China’s growth rate of real GDP per person is [(12,515 yen − 11,480 yen)/11,480 yen]  100, which is 9.0 percent. India’s growth rate of real GDP per person is [(47,995 rupees − 45,045 rupees)/45,045 rupees]  100, which is 6.5 percent. China’s real GDP per person will double in approximately 70/9.0 = 7.8 years and India’s real GDP per person will double in approximately 70/6.5 = 10.8 years, so China’s standard of living will double first.

The population of China is growing at 1 percent a year and the population of India is growing at 1.4 percent a year. Calculate the growth rate of real GDP in each country. The growth rate of real GDP per person equals the growth rate of real GDP minus the population growth rate. Rearranging this formula shows that the growth rate of real GDP equals the growth © 2014 Pearson Education, Inc.

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rate of real GDP per person plus the population growth rate. Using this formula, China’s real GDP growth rate is equal to 9.0 percent + 1.0 percent, which is 10.0 percent and India’s real GDP growth rate is equal to 6.5 percent + 1.4 percent, which is 7.9 percent.

China’s Economy Picks Up Speed China’s trend growth rate of real GDP per person was 2.2 percent a year before 1980 and 8.7 percent a year after 1980. In the year to August 2009, China’s output increased by 11.3 percent. Source: World Economic Outlook and FT.com, September 14, 2009 Distinguish between a rise in China’s economic growth rate and a temporary cyclical expansion. How long, at the current growth rate, will it take for China to double its real GDP per person? GDP growth will vary from one year to the next. Economic growth is the long-run growth, the economy’s average growth. It’s best measured by the economy’s trend rate of growth. A cyclical expansion is temporary. China’s long-run economic growth has average 8.7 percent since 1980. In 2009 China’s annual growth rate was 11.3 percent. The excess of the one-year growth rate over the long-term economic growth is probably a temporary cyclical expansion. At the long-run growth rate of 8.7 percent of, China’s real GDP will double in 70/8.7 = 8.0 years; at the one-year growth rate of 11.3 percent, China’s real GDP will double in 70/11.3 = 6.2 years.

China was the largest economy for centuries because everyone had the same type of economy—subsistence—and so the country with the most people would be economically biggest. Then the Industrial Revolution sent the West on a more prosperous path. Now the world is returning to a common economy, this time technology- and information-based, so once again population triumphs. a. Why was China the world’s largest economy until 1890? GDP equals GDP per person multiplied by the number of people. Until 1890 most people in the world had approximately the same subsistence level of income so that every nation’s GDP per person was about the same. Because China had, by far, the world’s largest population, China also had the world’s largest GDP.

b. Why did the United States surpass China in 1890 to become the world’s largest economy? The United States benefited from the industrial revolution that was sweeping Western nations at the time while China did not. U.S. economic growth accelerated well beyond Chinese economic growth so that the U.S. GDP became larger than China’s GDP.

Use the following information to work Problems 7 and 8. Suppose that the United States cracks down on illegal immigrants and returns millions of workers to their home countries. 7.

Explain what will happen to U.S. potential GDP, employment, and the real wage rate. The supply of labor in the United States decreases, which decreases equilibrium U.S. employment and raises the U.S. real wage rate. U.S. potential GDP decreases. The U.S. production function is unchanged, but equilibrium employment decreases in the United States so that U.S. potential GDP decreases.

Explain what will happen in the countries to which the immigrants return to potential GDP, employment, and the real wage rate. The supply of labor increases, which increases equilibrium employment but lowers the real wage rate. Potential GDP increases. The production function is unaffected, but equilibrium employment increases in those countries so that potential GDP increases. © 2014 Pearson Education, Inc. Wesley

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Use the following news clip to work Problems 9 to 11. U.S. Workers World’s Most Productive Americans work longer hours than those in other rich nations. Americans also produce more per person but only part of the U.S. productivity growth can be explained by the longer hours they work. Americans also create more wealth per hour of work. U.S. employees worked an average of 1,804 hours in 2006, compared to 1,564.4 for the French, but far less than the 2,200 hours that Asians worked. But in Asian countries the average labor productivity is lower. Source: CBS News, September 3, 2007 9.

What is the difference between productivity in this news clip and real GDP per person? Productivity equals GDP divided by the number of people employed; real GDP per person equals real GDP divided by the population. The article probably means to use real GDP rather than nominal GDP when calculating productivity. The major difference is the difference in the denominator: Productivity divides by the number of workers and real GDP per person divides by the population.

10.

Identify and correct a confusion between levels and growth rates of productivity in the news clip. If the aggregate production function in the United States and the European Union is the same, then the increased hours at work in the United States means that the level of U.S. real GDP per worker exceeds that in the European Union. But it does not mean that the growth rate of U.S. productivity will exceed that in the European Union.

11.

If workers in developing Asian economies work more hours than Americans, why are they not the world’s most productive? It is likely the case that the aggregate production functions in the Asian economies lie below the U.S. aggregate production function so that for any level of employment U.S. real GDP exceeds the Asian economies’ real GDPs. In this case, even though Asian workers put in more hours on the job than American workers, U.S. real GDP exceeds Asian real GDP so that U.S. real GDP per worker exceeds Asian real GDP per worker.

Use the following tables to work Problems 12 to 14. The first table describes an economy’s labor market in 2010 and the second table describes its production function in 2010. Real wage rate (dollars per hour) 80 70 60 50 40 30 20 12.

Labor hours supplied 45 40 35 30 25 20 15

Labor hours demanded

Labor (hours)

Real GDP (2005 dollars)

5 10 15 20 25 30 35

5 10 15 20 25 30 35 40

425 800 1,125 1,400 1,625 1,800 1,925 2,000

What are the equilibrium real wage rate, the quantity of labor employed in 2010, labor productivity, and potential GDP in 2010? The equilibrium real wage rate is $40 per hour and the equilibrium quantity of labor employed is © 2014 Pearson Education, Inc.

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25 hours. With employment of 25 hours, the production function shows that potential GDP is $1,625. Labor productivity equals $1,625  25 hours, or $65.00 per hour.

13.

In 2011, the population increases and labor hours supplied increase by 10 at each real wage rate. What are the equilibrium real wage rate, labor productivity, and potential GDP in 2011? The equilibrium real wage rate is $30 per hour and the equilibrium quantity of employment is 30 hours. With employment of 30 hours, the production function shows that real GDP is $1,800. Labor productivity equals $1,800  30 hours, or $60.00 per hour.

14.

In 2011, the population increases and labor hours supplied increase by 10 at each real wage rate. Does the standard of living in this economy increase in 2011? Explain why or why not. The standard of living does not increase. In fact, it decreases because real GDP per person falls. The economy moves along its production function so that potential GDP increases but real GDP per person decreases.

15.

Labor Productivity on the Rise The Bureau of Labor Statistics reported the following data for the year ended June 2009: In the nonfarm sector, output fell 5.5 percent as labor productivity increased 1.9 percent—the largest increase since 2003—but in the manufacturing sector, output fell 9.8 percent as labor productivity increased by 4.9 percent—the largest increase since the first quarter of 2005. Source: bls.gov/news.release, August 11, 2009 In both sectors, output fell while labor productivity increased. Did the quantity of labor (aggregate hours) increase or decrease? In which sector was the change in the quantity of labor larger? Labor productivity equals output divided by labor hours, so labor hours equals output divided by labor productivity. In terms of growth rates, this last formula means that the growth in labor hours approximately equals the growth in output minus the growth in labor productivity. (This is the same calculation as on page 540 of the text for the approximation formula for growth in real GDP per person.) Using this equation, in the nonfarm sector labor hours fell by −5.5 percent – 1.9 percent = −7.4 percent and in the manufacturing sector labor hours fell by −9.8 percent – 4.9 percent = −14.7 percent. The change in labor was the largest in the manufacturing sector.

16.

For three years, there was no technological change in Longland but capital per hour of labor increased from $10 to $20 to $30 and real GDP per hour of labor increased from $3.80 to $5.70 to $7.13. Then, in the fourth year, capital per hour of labor remained constant but real GDP per hour of labor increased to $10. Does Longland experience diminishing returns? Explain why or why not. Longland experienced diminishing returns. From year 1 to year 2, capital per hour of labor increased by $10 and real GDP per hour of labor increased by $1.90. From year 2 to year 3, capital per hour of labor increased again by $10 but GDP per hour of labor increased by only $1.43. The second $10 increase in capital per hour of labor increased real GDP per hour of labor less than did the first $10 increase in capital per hour of labor, so Longland had diminishing returns.

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Explain the processes that will bring the growth of real GDP per person to a stop according to a. Classical growth theory. According to the classical theory, population growth continues at a rapid pace as long as real GDP per person exceeds the subsistence level. With population growth, the supply of labor increases and diminishing returns lowers real GDP per person. Eventually real GDP per person equals the subsistence amount, at which time economic growth ends.

b. Neoclassical growth theory. In the neoclassical model, technological growth leads to increased saving so that capital accumulates and real GDP per person grows. When technological growth stops, capital continues to accumulate but diminishing marginal returns drives the return on capital lower and so decreases investment and saving. Eventually the capital stock stops growing and economic growth stops.

c. New growth theory. According to the new growth theory, economic growth will not stop.

18.

In the economy of Cape Despair, the subsistence real wage rate is $15 an hour. Whenever real GDP per hour rises above $15, the population grows, and whenever real GDP per hour of labor falls below this level, the population falls. The table shows Cape Despair’s production function. Initially, the population of Cape Despair is constant and real GDP per hour of labor is at the subsistence level of $15. Then a technological advance shifts the production function upward by 50 percent at each level of labor. a. What are the initial levels of real GDP and labor productivity?

Labor (billions of hours per year) 0.5 1.0 1.5 2.0 2.5 3.0 3.5

Real GDP (billions of 2000 dollars) 8 15 21 26 30 33 35

Before the technological advance, labor productivity, which is defined as real GDP divided by employment, was $15.00 an hour. Real GDP was $15 billion and 1.0 billion hours of labor were employed.

b. What happens to labor productivity immediately following the technological advance? Immediately following the technological advance, real GDP rises to $22.5 billion and employment remains at 1.0 billion hours. Labor productivity increases to $22.50 an hour.

c. What happens to the population growth rate following the technological advance? Real GDP per hour exceeds the subsistence level of $15.00, so population growth increases.

d. What are the eventual levels of real GDP and real GDP per hour of labor? Eventually population growth will increase labor supply so that productivity will return to its subsistence level of $15.00 an hour. Real GDP will increase to $52.5 billion. Labor employment will equal 3.5 billion hours so that labor productivity equals $15.00.

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Answers to Additional Problems and Applications 19.

If in 2012 China’s real GDP is growing at 9 percent a year, its population is growing at 1 percent a year, and these growth rates continue, in what year will China’s real GDP per person be twice what it is in 2012? The growth rate of real GDP per person equals the growth rate of real GDP minus the population growth rate. China’s real GDP per person is growing at a rate of 9 percent – 1 percent = 8 percent. Then using the rule of 70, it will take 70/8 = 8.75 years for China’s real GDP per person to double, which means it will double in approximately 2021.

20.

Mexico’s real GDP was 9,100 trillion pesos in 2011 and 9,550 trillion pesos in 2012. Mexico’s population was 109.7 million in 2011 and 110.8 million in 2012. Calculate a. The growth rate of real GDP. The economic growth rate is the growth rate of real GDP. Between 2011 and 2012 this growth rate equals [(9,550 trillion pesos − 9,100 trillion pesos)/9,100 trillion pesos]  100, which is 4.95 percent.

b. The growth rate of real GDP per person. Mexico’s population grew at [(110.8 million − 109.7 million)/109.7 million]  100, which is 1.00 percent. Mexico’s economic growth rate is 4.95 percent, so the growth rate of real GDP per person is 4.95 percent − 1.00 percent, or 3.95 percent.

c. The approximate number of years it takes for real GDP per person in Mexico to double if the 2012 growth rate of real GDP and the population growth rate are maintained. Mexico’s real GDP per person is growing at 3.95 percent a year. The rule of 70 tells us that Mexico’s real GDP per person will double in 70/3.95 = 17.7 years.

21.

South Africa’s real GDP was 1,900 billion rand in 2011 and 1,970 billion rand in 2012. South Africa’s population was 50.5 million in 2011 and 51.0 million in 2012. Calculate a. The growth rate of real GDP. The economic growth rate is the growth rate of real GDP. Between 2011 and 2012 this growth rate equals [(1,970 billion rand − 1,900 billion rand)/1,900 billion rand]  100 = 3.7 percent.

b. The growth rate of real GDP per person. South Africa’s population growth rate is equal to [(51.0 million − 50.5 million)/50.5.6 million]  100, which is 1.0 percent. South Africa’s economic growth rate is 3.7 percent, so the growth rate of real GDP per person is 3.7 percent − 1.0 percent, or 2.7 percent.

c. The approximate number of years it will take for real GDP per person in South Africa to double if the current growth rate of real GDP is maintained. South Africa’s real GDP per person is growing at 2.7 percent a year. The rule of 70 tells us that South Africa’s real GDP per person will double in 70/2.7 = 25.9 years.

22.

The New World Order While gross domestic product growth is cooling a bit in emerging market economies, the results are still tremendous compared with the United States and much of Western Europe. The emerging market economies posted a 6.7% jump in real GDP in 2008, down from 7.5% in 2007. The advanced economies grew an estimated 1.6% in 2008. The difference in growth rates represents the largest spread between emerging market economies and advanced economies in the 37-year history of the survey. Source: Fortune, July 14, 2008 Do growth rates over the past few decades indicate that gaps in real GDP per person © 2014 Pearson Education, Inc. Wesley

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around the world are shrinking, growing, or staying the same? Explain. Gaps with a few countries are shrinking but for the most part gaps are remaining more or less the same. The gaps between U.S. real GDP per person and real GDP per person in a few Asian countries, such as Hong King, Singapore, Taiwan, Korea, and China have narrowed sharply over the last 40 years. But the gaps between U.S. real GDP per person and real GDP per person in Canada, Europe, Japan (since 1970), and Central and South America have remained roughly constant over the past decades. And the gap between U.S. real GDP per person and real GDP per person in Africa has widened slightly since 1960.

23.

If a large increase in investment increases labor productivity, explain what happens to a. Potential GDP. The production function curve shifts upward and equilibrium employment increases, both of which increase potential GDP.

b. Employment. Employment increases. The demand for labor increases, which increases equilibrium employment.

c. The real wage rate. The real wage rate rises. The demand for labor increases, which raises the equilibrium real wage rate.

24.

If a severe drought decreases labor productivity, explain what happens to a. Potential GDP. The production function curve shifts downward and equilibrium employment decreases, both of which decrease potential GDP.

b. Employment. Employment decreases. The demand for labor decreases, which decreases equilibrium employment.

c. The real wage rate. The real wage rate falls. The demand for labor decreases, which lowers the equilibrium real wage rate.

Use the following tables to work Problems 25 to 27. The first table describes an economy’s labor market in 2010 and the second table describes its production function in 2010. Real wage rate (dollars per hour) 80 70 60 50 40 30 20

Labor hours supplied 55 50 45 40 35 30 25

Labor hours demanded

Labor (hours)

Real GDP (2005 dollars)

15 20 25 30 35 40 45

15 20 25 30 35 40 45 50

1,425 1,800 2,125 2,400 2,625 2,800 2,925 3,000

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25.

105

What are the equilibrium real wage rate and the quantity of labor employed in 2010? The equilibrium real wage rate is $40 per hour and the equilibrium quantity of labor employed is 35 hours.

26.

What are labor productivity and potential GDP in 2010? Potential GDP is $2,625, the quantity of real GDP produced with the equilibrium quantity of employment. Labor productivity equals $2,625  35 hours, or $75.00 per hour.

27.

Suppose that labor productivity increases in 2010.What effect does the increased labor productivity have on the demand for labor, the supply of labor, potential GDP, and real GDP per person? The increase in labor productivity increases the demand for labor. The supply of labor does not change. The equilibrium wage rate rises and equilibrium employment increases. Potential GDP increases for two reasons: First, the increase in labor productivity increases potential GDP; second, the increase in equilibrium employment increases potential GDP. Real GDP per person increases.

28.

India’s Economy Hits the Wall Just six months ago, India was looking good. Annual growth was 9%, consumer demand was huge, and foreign investment was growing. But now most economic forecasts expect growth to slow to 7%—a big drop for a country that needs to accelerate growth. India needs urgently to upgrade its infrastructure and education and health-care facilities. Agriculture is unproductive and needs better technology. The legal system needs to be strengthened with more judges and courtrooms. Source: BusinessWeek, July 1, 2008 Explain five potential sources for faster economic growth in India suggested in this news clip. One suggested source of increased economic growth is increased infrastructure investment. Infrastructure includes factors such as roads, ports, railways, and electricity transmission. The second suggestion mentioned is to raise education achievement. This recommendation, while not a short-term fix, would be quite powerful at raising India’s long-term growth. The third factor is to increase health-care facilities. Better health care for its citizens translates into increased labor productivity because India’s workers would be better able to work in the marketplace. The fourth source of increased economic growth is to increase productivity in agriculture. This suggestion, however, is not well detailed; in particular, it is much easier to suggest raising productivity than to actually do so. The last suggestion is to increase the number of judges and strengthen the legal system, and improve governance. However, while a seemingly simple suggestion, this process is likely to wind up politically quite difficult.

29.

The Productivity Watch According to former Federal Reserve chairman Alan Greenspan, IT investments in the 1990s boosted productivity, which boosted corporate profits, which led to more IT investments, and so on, leading to a nirvana of high growth. Source: Fortune, September 4, 2006 Which of the growth theories that you’ve studied in this chapter best corresponds to the explanation given by Mr. Greenspan? Mr. Greenspan is describing the new growth theory. According to this theory, economic growth will persist indefinitely because of the perpetual pursuit of profit.

30.

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case for slower growth. Then reach a conclusion on whether growth should be increased or slowed. More rapid economic growth brings increased consumption possibilities in the future, which is the benefit from economic growth. Economic growth has costs: Decreased current consumption and the possibility of increased resource depletion and environmental damage. (Of course, the technological change that results from economic growth might allow for less resource depletion and less environmental damage.) Whether economic growth should be increased or decreased depends on the benefits of more rapid growth relative to the costs of more rapid growth.

31.

Makani Power: A Mighty Wind Saul Griffith, a 34-year-old Australian, has developed a new wind-power technology for generating electricity that is vastly more efficient than conventional wind power. A Makani Airborne Wind Turbine is a tethered wing, somewhat like a giant kite, that generates power by flying in large circles where it captures a stronger and more consistent wind. One of Makani’s investors is Google. The Makani technology uses 90 percent less material than a conventional wind turbine and accesses wind that is out of reach for land or sea-based turbines. Source: Fortune, April 28, 2008 Explain which growth theory best describes the news clip. The new growth theory stresses the role of innovation and the birth of new firms and the death of old ones. The new growth theory best describes the article because Mr. Griffith is innovating a new way to generate energy. And if his novel method is successful, then new firms that exploit this method will be born and old firms that use outdated technology will die.

Economics in the News 32.

After you have studied Reading Between the Lines on pp. 152–153 (558–559 in Economics), answer the following questions. a. How do South Africa and Botswana compare on economic growth rates? Botswana’s economic growth rate has been much higher than South Africa’s economic growth rate.

b. For South Africa to grow faster, how would the percentage of GDP invested in new capital need to change? The percent of GDP invested in new capital needs to increase.

c. If South Africa is able to achieve a growth rate of 8 percent per year, in how many years will real GDP have doubled? The rule of 70 shows that South Africa’s GDP will double in approximately 70/8.0 , which is 8.75 years.

d. Describe the policies proposed by the author of the news article and explain how they might change labor productivity. There are a variety of proposals designed to increase labor productivity. These proposals include (1) reforming labor laws by removing the automatic extension of collective bargaining agreements across sectors; (2) establishing “jobs zones” that feature special exemptions from restrictive regulations; (3) lifting administrative requirements for small businesses; (4) creating a youth wage subsidy and market-driven skills development programs; (5) distributing shares in state-owned companies; (6) introducing tax deductions to incentivize employee sharedownership schemes; and, (7) promoting joint ownership in the agricultural sector. The first three © 2014 Pearson Education, Inc.

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proposals aim to increase labor productivity by decreasing rigidities in the labor market that prevent workers from being allocated to their highest-valued jobs. The fourth proposal aims to increase labor productivity by boosting workers’ human capital. The last three proposals attempt to increase labor productivity by changing the incentives of managers to a more profitdriven goal, which increases their incentives to boost their workers’ productivity.

e. What is the source of Botswana’s growth success story and what must South Africa do to replicate that success? Botswana has secure property rights and invests a a very large proportion of its GDP. South Africa must increase the growth of its capital, both physical capital and human capital. South Africa must increase the growth rate of its labor productivity. It also needs to make property rights secure.

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Draw a PPF graph to show what has happened in Botswana and South Africa since 1980. Figure 6.1 shows the PPFs of Botswana and South Africa in 1980 and 2012. In 1980, South Africa’s PPF lay beyond Botswana’s PPF. But in the intervening years, Botswana has grown more rapidly so that its GDP has overtaken that in South Africa and so that now, as illustrated in the figure, Botswana’s PPF lies beyond South Africa’s PPF.

33.

Make Way for India—The Next China China grows at around 9 percent a year, but its one-child policy will start to reduce the size of China’s working-age population within the next 10 years. India, by contrast, will have an increasing working-age population for another generation at least. Source: The Independent, March 1, 2006 a. Given the expected population changes, do you think China or India will have the greater economic growth rate? Why? Economic growth occurs because labor productivity grows and because the population grows. If labor productivity grows at the same rate in China as in India, then the more rapid population growth in India will lead to more rapid economic growth in India.

b. Would China’s growth rate remain at 9 percent a year without the restriction on its population growth rate? According to the classical theory of economic growth, restricting population growth is necessary for persisting economic growth. According to the new growth theory, restricting population growth leads to slower economic growth. So whether China’s growth would remain at 9 percent a year without restricting population growth is not clear.

c. India’s population growth rate is 1.6 percent a year, and in 2005 its economic growth rate was 8 percent a year. China’s population growth rate is 0.6 percent a year, and in 2005 its economic growth rate was 9 percent a year. In what year will real GDP per person double in each country? India’s growth in real GDP per person equals 8 percent a year minus 1.6 percent a year, which is 6.4 percent a year. According to the Rule of 70, at this rate India’s real GDP per person will double in 70/6.4, which is 10.9 years. So India’s real GDP per person will double by 2016. China’s growth in real GDP per person equals 9 percent a year minus 0.6 percent a year, which is 8.4 percent a year According to the Rule of 70, at this rate China’s real GDP per person will double in 70/8.4, which is 8.3 years. So China’s real GDP per person will double in 2014.

C h a p t e r

FINANCE, SAVING, AND INVESTMENT**

Answers to the Review Quizzes Page 164 1.

(page 570 in Economics)

Distinguish between physical capital and financial capital and give two examples of each. Physical capital is the actual tools, instruments, machines, buildings and other items that have been produced in the past and are presently used to produce goods and services. Financial capital is the funds that businesses use to acquire their physical capital. Examples of physical capital are the pizza ovens owned by Pizza Hut and the buildings in which the Pizza Huts are located. Examples of financial capital are the bonds issued by Pizza Hut to buy pizza ovens and the loans Pizza Hut has made to fund their purchases of new buildings.

What is the distinction between gross investment and net investment? Gross investment is the total amount spent on new capital; net investment is the change in the capital stock. Net investment equals gross investment minus depreciation.

What are the three main types of markets for financial capital? The main types of markets for financial capital are the loan markets, the bond markets, and the stock markets.

Explain the connection between the price of a financial asset and its interest rate. There is an inverse relationship between the price of a financial asset and its interest rate. When the price of a financial asset rises, its interest rate falls. Similarly, when the interest rate on an asset falls, the price of the asset rises.

Page 169 1.

(page 575 in Economics)

What is the loanable funds market?

The loanable funds market is the market in which households, firms, governments, banks, and other financial institutions borrow and lend. It is the aggregate of all the individual financial markets and includes loan markets, bond markets, and stock markets. The real interest rate is determined in this market.

Why is the real interest rate the opportunity cost of loanable funds? The real interest rate is the opportunity cost of loanable funds because the real interest rate measures what is forgone by using the funds. If the funds are loaned, then the real interest rate is received. If the funds are borrowed, then the real interest is paid for the funds. The real interest rate forgone when funds are used either to buy consumption goods and services or to invest in new capital goods is the opportunity cost of not saving or not lending those funds.

How do firms make investment decisions? To determine the quantity of investment, firms compare the expected profit rate from an investment to the real interest rate. The expected profit from an investment is the benefit from the investment. The real interest rate is the opportunity cost of investment. If the expected profit *

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from an investment exceeds the cost of the real interest rate, then firms make the investment. If the expected profit from an investment is less than the cost of the real interest rate, then firms do not make the investment.

What determines the demand for loanable funds and what makes it change? The demand for loanable funds depends on the real interest rate and expected profit. If the real interest rate falls and nothing else changes, the quantity of loanable funds demanded increases. Conversely, if the real interest rate rises and everything else remains the same, the quantity of loanable funds demanded decreases. Movements along the loanable funds demand curve illustrate these events. If the expected profit increases and nothing else changes, the demand for loanable funds increases and the demand for loanable funds curve shifts rightward. If the expected profit decreases and everything else remains the same, the demand for loanable funds decreases and the demand for loanable funds curve shifts leftward.

How do households make saving decisions? A household’s saving depends on five factors: the real interest rate, the household’s disposable income, the household’s expected future income, wealth, and default risk. A household increases its saving if the real interest rate increases, its disposable income increases, its expected future income decreases, its wealth decreases, or if default risk decreases.

What determines the supply of loanable funds and what makes it change? The supply of loanable funds depends on the real interest rate, disposable income, expected future income, wealth, and default risk. An increase in the real interest rate increases the quantity of loanable funds supplied; a decrease in the real interest rate decreases the quantity of loanable funds supplied. An increase in disposable income increases the supply of loanable funds; a decrease in disposable income decreases the supply of loanable funds. An increase in wealth decreases the supply of loanable funds; a decrease in wealth increases the supply of loanable funds. An increase in expected future income decreases the supply of loanable funds; a decrease in expected future income increases the supply of loanable funds. Finally, an increase in default risk decreases the supply of loanable funds; a decrease in default risk increases the supply of loanable funds.

How do changes in the demand for and supply of loanable funds change the real interest rate and quantity of loanable funds? The real interest rate is determined by the supply of loanable funds and the demand for loanable funds. The equilibrium real interest rate is the real interest rate at which the quantity of loanable funds supplied equals the quantity of loanable funds demanded. Changes in the demand for or supply of loanable funds change the equilibrium real interest rate and equilibrium quantity of loanable funds. If the demand for loanable funds increases and the supply does not change, the real interest rate rises and the quantity of loanable funds increases. If the demand for loanable funds decreases and the supply does not change, the real interest rate falls and the quantity of loanable funds decreases. If the supply of loanable funds increases and the demand does not change, the real interest rate falls and the quantity of loanable funds increases. If the supply of loanable funds decreases and the demand does not change, the real interest rate rises and the quantity of loanable funds decreases.

Page 172 1.

(page 578 in Economics)

How does a government budget surplus or deficit influence the loanable funds market? A government budget surplus adds to the supply of loanable funds. A government budget deficit adds to the demand for loanable funds.

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The crowding out effect refers to the decrease in investment that occurs when the government budget deficit increases. An increase in the government budget deficit increases the demand for loanable funds. As a result the real interest rate rises. The rise in the real interest rate decreases—“crowds out”—investment.

What is the Ricardo-Barro effect and how does it modify the crowding-out effect? The Ricardo-Barro effect points out that the crowding out effect is less than predicted by looking only at the effect of a budget deficit on the demand for loanable funds. The Ricardo-Barro effect asserts that as a result of a government budget deficit households increase their saving to pay the higher taxes that will be needed in the future to repay the debt issued to fund the deficit. The increase in saving increases the supply of loanable funds. This increase in the supply of loanable funds offsets the rise in the real interest rate from the increase in the demand for loanable funds caused by the budget deficit. Because the real interest rate does not rise as much, the decrease in investment, that is the amount of crowding out, is less in the presence of the Ricardo-Barro effect.

Page 175 1.

(page 581 in Economics)

Why do loanable funds flow among countries? Loanable funds flow among countries because savers are searching for the highest (riskadjusted) real interest rate and borrowers are searching for the lowest (risk-adjusted) real interest rate.

What determines the demand for and supply of loanable funds in an individual economy? The demand for and supply of loanable funds in an economy with international lending and borrowing depend on the same factors as in an economy without international lending and borrowing with one exception: Demand is determined by the country’s demand but supply is determined by the world supply. In particular, if at the world real interest rate, the country has a surplus of funds, it can lend the surplus to the rest of the world while if at the world real interest rate, the country has a shortage of funds, it can borrow from the rest of the world.

What happens if a country has a shortage of loanable funds at the world real interest rate? If a country has a shortage of loanable funds at the world real interest rate, it borrows from other nations and becomes an international borrower.

What happens if a country has a surplus of loanable funds at the world interest rate? If a country has a surplus of loanable funds at the world real interest rate, it loans to other nations and becomes an international lender.

How is a government budget deficit financed in an open economy? A government budget deficit increases the demand for loanable funds. In an open economy, the increase in the demand for loanable funds means the country lends less to the rest of the world (if it initially was an international lender) or borrows more from the rest of the world (if it initially was an international borrower). These changes in lending or borrowing finance the budget deficit.

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Answers to the Study Plan Problems and Applications Use the following information to work Problems 1 and 2. Michael is an Internet service provider. On December 31, 2011, he bought an existing business with servers and a building worth $400,000. During his first year of operation, his business grew and he bought new servers for $500,000. The market value of some of his older servers fell by $100,000. 1.

What was Michael’s gross investment, depreciation, and net investment during 2012? Michael’s gross investment was $500,000, his depreciation was $100,000, and his net investment was $400,000.

What is the value of Michael’s capital at the end of 2012? Michael’s capital at the end of 2012 is equal to his capital at the beginning of 2012, $400,000, plus his net investment during the year, also $400,000, for a total of $800,000.

Lori is a student who teaches golf on the weekend and in a year earns $20,000 after paying her taxes. At the beginning of 2012, Lori owned $1,000 worth of books, DVDs, and golf clubs and she had $5,000 in a savings account at the bank. During 2012, the interest on her savings account was $300 and she spent a total of $15,300 on consumption goods and services. There was no change in the market values of her books, DVDs, and golf clubs. a. How much did Lori save in 2012? Lori’s saving equals her disposable income minus her consumption expenditure. Lori’s disposable income is $20,000 plus the interest on her savings account, $300, for a total of $20,300.Her consumption expenditure is $15,300, so her saving is $5,000.

b. What was her wealth at the end of 2012? Lori’s wealth at the end of 2012 is equal to the value of her wealth at the beginning of 2012 plus her saving during the year. At the beginning of 2012 Lori’s wealth is $6,000—the value of her books, DVDs, golf clubs, and savings account. Lori saved $5,000 during 2012 so her wealth at the end of 2012 is $11,000.

In a speech at the CFA Society of Nebraska in February 2007, William Poole (former Chairman of the St. Louis Federal Reserve Bank) said: Over most of the post-World War II period, the personal saving rate averaged about 6 percent, with some higher rates from the mid-1970s to mid-1980s. The negative trend in the saving rate started in the mid-1990s, about the same time the stock market boom started. Thus it is hard to dismiss the hypothesis that the decline in the measured saving rate in the late 1990s reflected the response of consumption to large capital gains from corporate equity [stock]. Evidence from panel data of households also supports the conclusion that the decline in the personal saving rate since 1984 is largely a consequence of capital gains on corporate equities. a. Is the purchase of corporate equities part of household consumption or saving? Explain your answer. The purchase of corporate equities, that is, shares of corporate stock, is part of household saving. Consumption refers to the purchase of goods and services that are then consumed, but corporate equities are not consumable goods or services.

b. Equities reap a capital gain in the same way that houses reap a capital gain. Does this mean that the purchase of equities is investment? If not, explain why it is not. The purchase of equities is not an investment because investment refers to the purchase of physical capital. Equities are not physical capital and so they are not investment.

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Treasury Yields Fall to Two-Week Low Treasury bond prices rose on Monday, pushing yields down for the sixth session in seven, as the lack of major data and low trading volumes gave traders little fodder. Yields on 10year bonds, which move inversely to prices, fell 4 basis points to 1.65%. They haven’t closed below that level since August 13. A basis point is one one-hundredth of a percentage point. Source: The Wall Street Journal, August 27, 2012 a. The news clip calls the percentage return or interest rate on a security the “yield.” What is the relationship between the price of a treasury bond and its interest rate? Why does the interest rate move inversely to price? When the price of a treasury bond rises, its interest rate falls. This inverse relationship exists because of the definition of an interest rate. The interest rate equals the amount paid as interest divided by the price of the security, then multiplied by 100. When the price rises, mathematically the interest rate must fall.

b. What can you say about the relationship between the price of a treasury bond at the date of the news clip and on August 13? On August 13, the interest rate was below 1.65 percent, the rate on August 27. Therefore on August 13, the price of a treasury bond must have been higher than it was on August 27.

Use the information in Problem 4. a. U.S. household income has grown considerably since 1984. Has U.S. saving been on a downward trend because Americans feel wealthier? Even though U.S. household income has grown, the fall in U.S. saving might be because people’s wealth has increased because the higher a household’s wealth, the smaller is its saving.

b. Explain why households preferred to buy corporate equities rather than bonds. When the market value of corporate equities increases, households that own the equities receive a capital gain, which increases their wealth. Bonds only deliver a capital gain when the interest rate falls because the interest rate on a bond falls when the price of the bond rises. Interest rates do not consistently fall. Interest rates fluctuate, so capital gains are interspersed with capital losses for bonds. For many years, stocks experienced ongoing capital gains, so households apparently believed that the risk-adjusted return on corporate equities, which includes capital gains, exceeded the risk-adjusted return on bonds.

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Use the following information to work Problems 7 and 8. First Call, Inc., is a cellular phone company. It plans to build an assembly plant that costs $10 million if the real interest rate is 6 percent a year. If the real interest rate is 5 percent a year, First Call will build a larger plant that costs $12 million. And if the real interest rate is 7 percent a year, First Call will build a smaller plant that costs $8 million. 7. Draw a graph of First Call’s demand for loanable funds curve. Figure 7.1 shows First Call’s demand for loanable funds curve.

First Call expects its profit from the sale of cellular phones to double next year. If other things remain the same, explain how this increase in expected profit influences First Call’s demand for loanable funds. When First Call expects its profit to increase, First Call increases its investment. The increase in its investment leads First Call to increase its demand for loanable funds.

Draw a graph to illustrate how an increase in the supply of loanable funds and a decrease in the demand for loanable funds can lower the real interest rate and leave the equilibrium quantity of loanable funds unchanged. Figure 7.2 shows the effect of an increase in the supply of loanable funds and a decrease in the demand for loanable funds. The supply of loanable funds curve shifts rightward from SLF0 to SLF1, and the demand for loanable funds curve shifts leftward from DLF0 to DLF1. The magnitude of the increase in supply is equal to the magnitude of the decrease in demand, so the real interest rate falls (from 7 percent to 4 percent in the figure) and the quantity of loanable funds does not change (staying at $2.5 trillion in the figure).

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Use the table to work Problems 10 to 12. The data is for an economy when the government’s budget is balanced. 10. If the government’s budget becomes a surplus of $1 trillion, what are the real interest rate, investment, and private saving? Is there any crowding out in this situation? The real interest rate is 6 percent, the quantity of investment is $7.5 trillion, and the quantity of private saving is $6.5 trillion. There is no crowding out.

11.

Real interest rate (percent per year) 4 5 6 7 8 9 10

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Loanable Loanable funds funds demanded supplied (trillions of 2005 dollars) 8.5 8.0 7.5 7.0 6.5 6.0 5.5

5.5 6.0 6.5 7.0 7.5 8.0 8.5

If the government’s budget becomes a deficit of $1 trillion, what are the real interest rate, investment, and private saving? Is there any crowding out in this situation? The equilibrium real interest rate becomes 8 percent, the quantity of investment is $6.5 trillion, and the quantity of private saving is $7.5 trillion. There is crowding out of $500 billion of investment.

12.

If the government’s budget becomes a deficit of $1 trillion and the Ricardo-Barro effect occurs, what are the real interest rate and the investment? The equilibrium real interest rate remains 7 percent and the quantity of investment remains $7.0 trillion. There is no crowding out because the $1 trillion increase in the budget deficit leads to an offsetting $1 trillion increase in private saving.

Use the data in Problem 10 and the following information to work Problems 13 to 15. Suppose that the quantity of loanable funds demanded increases by $1 trillion at each real interest rate and the quantity of loanable funds supplied increases by $2 trillion at each interest rate. 13.

If the government budget is balanced, what are the real interest rate, the quantity of loanable funds, investment, and private saving? Does any crowding out occur? The table to the right, which shows Real interest Loanable Loanable the new demand for loanable funds rate funds funds and new supply of loanable funs demanded supplied schedules, is helpful to answer the (percent per (trillions of 2005 dollars) problem. The new real interest rate year) is 6 percent, and the quantity of 4 9.5 7.5 loanable funds, private saving, and 5 9.0 8.0 investment are all $8.5 trillion. 6 8.5 8.5 There is no crowding out. 7 8.0 9.0 8 7.5 9.5 9 7.0 10.0 10 6.5 10.5

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If the government’s budget becomes a deficit of $1 trillion, what are the real interest rate, the quantity of loanable funds, investment, and private saving? Does any crowding out occur? The equilibrium real interest rate becomes 7 percent. The equilibrium quantity of loanable funds is $9.0 trillion, the equilibrium quantity of investment is $8.0 trillion, and the equilibrium quantity of private saving is $9.0 trillion. There is crowding out of $500 billion of investment.

15.

If the government wants to stimulate investment and increase it to $9 trillion, what must it do? Assuming no Ricardo-Barro effect, the government needs to have a budget surplus of $1 trillion. In this case, the new equilibrium is at a real interest rate of 5 percent. The quantity of investment is $9 trillion and the quantity of private saving is $8 trillion.

Use the following information to work Problems 16 and 17. Global Saving Glut and U.S. Current Account, remarks by Ben Bernanke (when a governor of the Federal Reserve) on March 10, 2005: The U.S. economy appears to be performing well, but one aspect of U.S. economic performance still evokes concern: the nation’s large and growing current account deficit (negative net exports). Most forecasters expect the current account imbalance to decline slowly, implying a continued need for foreign credit and a concomitant decline in the U.S. net foreign asset position. 16.

Why is the United States, with the world’s largest economy, borrowing heavily on international capital markets—rather than lending, as would seem more natural? At the world real interest rate the quantity of loanable funds demanded in the United States exceeds the quantity of loanable funds supplied. The surprising aspect of this point is that the quantity of loanable funds is low in the United States because U.S. disposable income is so high. Investment is funded by household saving, the government budget surplus, and borrowing from the rest of the world, so that I = S + (T – G) + (M – X). Foreigners might be eager to make investments in the United States, perhaps because the investment is more productive or perhaps safer than elsewhere in the world. In this situation, then the supply of loanable funds by foreigners to the United States is greater than would otherwise be the case, which leads to a lower U.S. real interest and a greater quantity of funds borrowed from abroad.

17. a. What implications do the U.S. current account deficit (negative net exports) and reliance on foreign credit have for economic performance in the United States? The United States is borrowing from abroad to meet the demand for loanable funds. With the borrowing, the quantity of loanable funds in the United States is larger than otherwise, which means that the quantity of investment projects funded is larger than otherwise. As a result, the U.S. capital stock is larger than otherwise, which helps enhance U.S. economic performance. However, the United States will need to repay its loans from the rest of the world and this repayment will detract from U.S. citizens’ well-being.

b. What policies, if any, should be used to address this situation? If the goal is to decrease U.S. borrowing from abroad, then either the U.S. demand for loanable funds needs to decrease or the U.S. supply of loanable funds needs to increase. Increasing the quantity of U.S. loanable funds seems to be the more reasonable policy, so policy proposals need to focus on increasing savings. Government policies to boost private saving might include tax policies that exempt the return from saving from taxation. Additionally government policies that decrease the size of the budget deficit and perhaps move the government budget to a surplus also would decrease U.S. borrowing from abroad.

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India Budget Will Aim to Cut Deficit In India, the government’s budget deficit will shrink to 5.1 percent of GDP from its current 5.6 percent as the government cuts its spending and stronger economic growth increases tax revenues. To finance its current debt, the government will borrow $108.2 billion. Source: The Wall Street Journal, March 14, 2012 a. Explain how the government’s budget deficit and the stronger economic growth influence the loanable funds market in India. The government budget deficit adds to the private demand for loanable funds, thereby increasing the total demand for loanable funds. Stronger economic growth increases current disposable income, which increases the supply of loanable funds.

b. When the Indian government borrows to finance its current debt, what changes will occur in the global financial market? When the Indian government borrows, the world demand for loanable funds increases, India will increase its net foreign borrowing. If India’s increased borrowing is a small part of the global loanable funds market, the real interest rate will not change.

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Answers to Additional Problems and Applications 19.

On January 1, 2011, Terry’s Towing Service owned 4 tow trucks valued at $300,000. During 2011, Terry’s bought 2 new trucks for a total of $180,000. At the end of 2011, the market value of all of the firm’s trucks was $400,000. What was Terry’s gross investment? Calculate Terry’s depreciation and net investment. His gross investment was $180,000. His depreciation was $80,000. His net investment, equal to gross investment minus depreciation, was $100,000.

Use the following information to work Problems 20 and 21. The Bureau of Economic Analysis reported that the U.S. capital stock was $40.4 trillion at the end of 2007, $41.1 trillion at the end of 2008, and $41.4 trillion at the end of 2009. Depreciation in 2008 was $1.3 trillion, and gross investment during 2009 was $1.5 trillion (all in 2005 dollars). 20. Calculate U.S. net investment and gross investment during 2008. Net investment equals the change in the capital stock. In 2008, U.S. net investment was $41.1 trillion − $40.4 trillion, which is $0.7 trillion. Gross investment equals net investment plus depreciation. In 2008, U.S. gross investment was $0.7 trillion + $1.3 trillion, which is $2.0 trillion.

21.

Calculate U.S. depreciation and net investment during 2009. Net investment equals the change in the capital stock. In 2009, U.S. net investment was $41.4 trillion − $41.1 trillion, which is $0.3 trillion. Depreciation equals gross investment minus net investment. In 2009, U.S. depreciation was $1.5 trillion − $0.3 trillion, which is $1.2 trillion.

22.

Annie runs a fitness center. On December 31, 2011, she bought an existing business with exercise equipment and a building worth $300,000. During 2012, business improved and she bought some new equipment for $50,000. At the end of 2012, her equipment and buildings were worth $325,000. Calculate Annie’s gross investment, depreciation, and net investment during 2012. Annie’s net investment during 2012 is $25,000 because that is the change in her capital stock. Annie’s gross investment is $50,000 because that is her total purchase of capital equipment in 2012. Annie’s depreciation during 2012 is $25,000 because Annie’s net investment, $25,000, equals her gross investment, $50,000, minus her depreciation.

23.

Karrie is a golf pro, and after she paid taxes, her income from golf and interest from financial assets was $1,500,000 in 2012. At the beginning of 2012, she owned $900,000 worth of financial assets. At the end of 2012, Karrie’s financial assets were worth $1,900,000. a. How much did Karrie save during 2012? Karrie’s wealth increased by $1,000,000 in 2012. So her saving in 2012 is $1,000,000. (This answer assumes no capital gains or losses on her stocks and bonds.)

b. How much did she spend on consumption goods and services? Her income after taxes was $1,500,000. Her consumption equals her income minus her saving, which is $1,500,000 − $1,000,000 = $500,000.

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Use the following information to work Problems 24 and 25. In 2012, the Lee family had disposable income of $80,000, wealth of $140,000, and an expected future income of $80,000 a year. At a real interest rate of 4 percent a year, the Lee family saves $15,000 a year; at a real interest rate of 6 percent a year, they save $20,000 a year; and at a real interest rate of 8 percent, they save $25,000 a year. 24.

Draw a graph of the Lee family’s supply of loanable funds curve. Figure 7.3 (on the next page) shows the Lee family’s supply of loanable funds curve.

25.

In 2013, suppose that the stock market crashes and the default risk increases. Explain how this increase in default risk influences the Lee family’s supply of loanable funds curve. If default risk increases the Lee family will decrease its saving. As a result, the Lee family’s supply of loanable funds decreases and its supply of loanable funds curve shifts leftward.

26.

Draw a graph to illustrate the effect of an increase in the demand for loanable funds and an even larger increase in the supply of loanable funds on the real interest rate and the equilibrium quantity of loanable funds. Figure 7.4 shows the effect of an increase in the demand for loanable funds and an even larger increase in the supply of loanable funds. The demand curve for loanable funds shifts rightward from DLF0 to DLF1, and the supply curve of loanable funds shifts rightward from SLF0 to SLF1. The increase in supply is larger than the increase in demand, so the real interest rate falls (from 6 percent to 5 percent in the figure) and the quantity of loanable funds increases (from $2.3 trillion to $2.7 trillion in the figure).

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Greenspan’s Conundrum Spells Confusion for Us All In January 2005, the interest rate on bonds was 4 percent a year and it was expected it to rise to 5 percent a year by the end of 2005. As the rate rose to 4.3 percent during February, most commentators focused not on why the interest rate rose, but on why it was so low before. Explanations of this “conundrum” included that unusual buying and expectations for an economic slowdown were keeping the interest rate low. Source: Financial Times, February 26, 2005 a. Explain how “unusual buying” might lead to a low real interest rate. “Unusual buying” means that the demand in the financial bond market is “unusually” large. In this case, the unusually large demand leads to bond prices being unusually high. Higher bond prices mean a lower interest rate on the asset. So unusually high bond prices creates unusually low interest rates on bonds.

b. Explain how investors’ “expectations for an economic slowdown” might lead to a lower real interest rate. Investors’ expectations of an economic slowdown mean that the expected profit from investing in capital falls. The lower expected profit decreases the demand for investment, which decreases the demand for loanable funds. The fall in the demand for loanable funds then lowers the equilibrium real interest rate.

28.

Keystone Pipeline Clears a Hurdle A judge in Lamar County, Texas, ruled that TransCanada has permission to build its Keystone XL pipeline from Cushing, Okla. to Port Arthur, Texas. TransCanada has said it will start building as soon as possible. Source: CNN, August 23, 2012 Show on a graph the effect of TransCanada going to the loanable funds market to finance the building of its pipeline. Explain the effect on the real interest rate, private saving, and investment. Keystone’s demand for financial capital to fund its pipeline increases the demand for loanable funds. As Figure 7.5 illustrates, the demand curve for loanable funds shifts rightward from DLF0 to DLF1. The real interest rate rises, in the figure from 2 percent per year to 3 percent per year. Private saving and investment both increase.

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Use the following information to work Problems 29 and 30. India’s Economy Hits the Wall At the start of 2008, India had an annual growth of 9%, huge consumer demand, and increasing foreign investment. But by July 2008, India had 11.4% inflation, large government deficits, and rising interest rates. Economic growth is expected to fall to 7% by the end of 2008. A Goldman Sachs report suggests that India needs to lower the government's deficit, raise educational achievement, control inflation, and liberalize its financial markets. Source: Business Week, July 1, 2008 29.

If the Indian government reduces its deficit and returns to a balanced budget, how will the demand for or supply of loanable funds in India change? If the Indian government reduces its deficit, the demand for loanable funds decreases.

30.

With economic growth forecasted to slow, future incomes are expected to fall. If other things remain the same, how will the demand or supply of loanable funds in India change? If expected future incomes slow, the major effect is an increase in the supply of loanable funds as households’ increase their saving.

31.

Federal Deficit Surges to $1.38 trillion through August House Republican Leader John Boehner of Ohio asks: When will the White House tackle these jaw-dropping deficits that pile more and more debt on future generations while it massively increases federal spending? Source: USA Today, September 11, 2009 Explain the effect of federal deficit and the mounting debt on U.S. economic growth. The large deficits increase the demand for loanable funds and, in the absence of a Ricardo-Barro effect, raise the real interest rate and crowd out investment. The decrease in investment means that the U.S. capital stock is lower than would otherwise be the case, which will decrease U.S. economic growth.

32.

The Global Savings Glut and Its Consequences Several developing countries are running large current account surpluses (representing an excess of savings over investment) and rapid growth has led to high saving rates as people save a large fraction of additional income. In India, the saving rate has risen from 23% a decade ago to 33% today. China’s saving rate is 55%. The glut of saving in Asia is being put into U.S. bonds. When a poor country buys U.S. bonds, it is in effect lending to the United States. Source: The Cato Institute, June 8, 2007 a. Graphically illustrate and explain the impact of the “glut of savings” on the real interest rate and the quantity of loanable funds. Figure 7.6 shows the global loanable funds market. In the world loanable funds market the supply of loanable funds—the so-called “glut of savings”—has significantly increased the supply of loanable funds. The supply curve shifts rightward from SLF0 without the “glut” to SLF1 with it. The increase in the supply of loanable funds lowers the real interest rate, in the figure from 4 percent to 2 percent, and © 2014 Pearson Education, Inc.

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increases the quantity of loanable funds, in the figure from $13 trillion to $15 trillion.

b. How do the high saving rates in Asia impact investment in the United States? The high savings rates in Asia increase the world supply of loanable funds and lower the world real interest rate. The lower global real interest rate lowers the real interest rate in the United States. U.S. investment increases because of the lower real interest rate in the United States.

Use the following information to work Problems 33 to 36. Most economists agree that the problems we are witnessing today developed over a long period of time. For more than a decade, a massive amount of money flowed into the United States from investors abroad, because our country is an attractive and secure place to do business. This large influx of money to U.S. financial institutions—along with low interest rates—made it easier for Americans to get credit. It also allowed more families to borrow funds for cars and homes and college tuition and allowed more entrepreneurs to get loans to start new businesses and create jobs. President George W. Bush, Address to the Nation, September 24, 2008 33.

Explain why, for more than a decade, a massive amount of money flowed into the United States. Compare and contrast your explanation with that of the President. Financial funds flow throughout the world seeking the highest risk-adjusted return. The riskadjusted real interest rate in the United States was higher than that in many other countries so funds flowed vigorously into the United States. Mr. Bush’s explanation was similar but did not point out the desirability of investing in the United States because of the higher risk-adjusted interest rate.

34.

Provide a graphical analysis of the reasons why the interest rate was low. Figure 7.7 shows the U.S. loanable funds market and the world real interest rate, assumed to be 4 percent. In the figure, if there was no international lending and borrowing the real interest rate in the United States would be 6 percent, the interest rate that sets the quantity of loanable funds demanded in the United States equal to the quantity supplied. However the United States can borrow from abroad. When the United States borrows from abroad, the real interest rate equals the world real interest. In the figure the real interest rate in the United States is 4 percent and the United States borrows $0.5 trillion from the rest of the world.

35.

Funds have been flowing into the United States since the early 1980s. Why might they have created problems in 2008 but not earlier? The financial landscape was different in 2008 than in earlier years. By 2008 the quantity of mortgage loans in the United States had exploded over the past few years. Additionally in 2008 the real interest rate had risen and many homeowners were unable to make the scheduled repayments on their mortgages. They defaulted on their mortgages and by so doing drove many financial firms into insolvency. Compared to previous years, 2008 was unique and hence a financial crisis occurred in 2008 rather than in earlier years. © 2014 Pearson Education, Inc.

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Could the United States stop funds from flowing in from other countries? How? The United States could stop funds from flowing in from other countries. The United States could try to do so directly by forbidding borrowing from abroad. However the United States would probably be more successful if it could either decrease the demand for loanable funds (perhaps by decreasing the government budget deficit) and/or increase the supply of loanable funds (perhaps by giving saving a more favorable tax treatment). In this case the United States could become a net foreign lender of funds.

Economics in the News 36.

After you have studied Reading Between the Lines on pp. 176–177 (582–583 in Economics), answer the following questions. a. What is the “fiscal cliff”? The “fiscal cliff” is the end of temporary tax cuts and the start of automatic spending cuts, which are due to happen on January 1, 2013 unless Congress intervenes.

b. How does a government budget deficit influence the loanable funds market? In the absence of a Ricardo-Barro effect, with everything else the same a government budget deficit increases the demand for loanable funds, thereby raising the real interest rate and decreasing investment.

c. How does a decrease in the government budget deficit influence the loanable funds market in a recession? In the absence of a Ricardo-Barro effect, a decrease in the government budget deficit decreases the demand for loanable funds. However it also worsens the recession by decreasing aggregate expenditure and, by worsening the recession, decreases the supply of loanable funds. The real interest rate does not change and hence investment does not change.

d. How does a decrease in the government budget deficit influence the loanable funds market at full employment? In the absence of a Ricardo-Barro effect, a decrease in the government budget deficit decreases the demand for loanable funds. The supply of loanable funds does not change, The real interest rate falls, which increases investment.

e. If when the United States hit its “fiscal cliff,” the governments in Europe, China, and Japan also were to cut their budget deficits, what would happen to the world interest rate, saving, and investment? In the United States, the “fiscal cliff’ likely decreases the U.S. budget deficit and decreases the demand for loanable funds. If the governments in Europe, China, and Japan also cut their budget deficits, the world demand for loanable funds decreases. The world real interest rate falls. The equilibrium quantity of saving and investment decrease.

If when the United States hit its “fiscal cliff,” the governments in Europe, China, and Japan were to increase their budget deficits, what would happen to the world interest rate, saving, and investment? In the United States, the “fiscal cliff’ likely decreases the U.S. budget deficit, which decreases the demand for loanable funds. If the governments in Europe, China, and Japan increased their budget deficits, the demand for loanable funds increases. If the decrease in demand for loanable funds from the U.S. fiscal cliff is larger than the increase in demand for loanable funds from the increase in budget deficits in Europe, China, and Japan, the world real interest rate falls and the equilibrium quantity of saving and investment decrease. If the decrease in demand for loanable funds from the U.S. fiscal cliff is smaller than the increase in demand for loanable funds from the increase in budget deficits in Europe, China, and Japan, the world real interest rate rises and the equilibrium quantity of saving and investment increase. And if the decrease in demand for © 2014 Pearson Education, Inc.

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loanable funds from the U.S. fiscal cliff is equal to the increase in demand for loanable funds from the increase in budget deficits in Europe, China, and Japan, the world real interest rate does not change and neither do the equilibrium quantity of saving and investment.

C h a p t e r

MONEY, THE PRICE LEVEL, AND INFLATION**

Answers to the Review Quizzes Page 186 1.

(page 592 in Economics)

What makes something money? What functions does money perform? Why do you think packs of chewing gum don’t serve as money? Money is anything that is generally acceptable as a means of payment. Money has three functions: medium of exchange (money is accepted in exchange for goods and services), unit of account (prices are quoted in terms of money), and store of value (money can be held and exchanged for goods and services later). Packs of chewing gum do not function as money because they are not particularly good as a store of value—gum deteriorates. Additionally, packs of gum are not generally accepted in exchange for goods and services, so packs of gum are not a medium of exchange.

What are the problems that arise when a commodity is used as money? Commodities are not used as money because of several problems. Many commodities are bulky. And many commodities change in value over time. Using as money a commodity that changes in value would be awkward. Prices would change simply because the commodity’s value changed. Additionally, using a commodity as money has a higher opportunity cost than do currency and bank deposits because the commodity has alternative uses that must be foregone.

What are the main components of money in the United States today? The main components of money in the United States today are currency and deposits at banks and other depository institutions. What are the official measures of money? Are all the measures really money?

The official measures of money are M1 (the sum of currency, traveler’s checks, and checking deposits owned by individuals and businesses) and M2 (the sum of M1, savings deposits, time deposits, and money market mutual funds and other deposits). All of the components of M1 are truly money because all the components serve as a means of payment. Some of the components of M2 are not truly money because they are not a means of payment. (For instance, funds at money market mutual funds cannot be used as a means of payment for small purchases.) But all of these “non-money” assets are highly liquid so they are operationally similar to money.

Why are checks and credit cards not money? Checks and credit cards are not money because they are not a means of payment. A check is an order to transfer a deposit from one person to another. The deposits are money but the checks are not. A credit card is an ID card that lets a person take out a loan at the instant he or she buys something. The loan still needs to be repaid with money so the credit card is not a means of payment, that is, it is not money.

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Page 190 1.

(page 596 in Economics)

What are depository institutions?

Depository institutions are financial firms that take deposits from households and firms. They then make loans available to other households and firms.

What are the functions of depository institutions? Depository institutions have four major economic functions: They create liquidity, pool risk, lower the cost of borrowing, and lower the cost of monitoring borrowers.

How do depository institutions balance risk and return? Banks earn a higher return by using the funds they acquire from their deposits to buy higheryielding, riskier assets such as loans. But these assets are risky. If the loans fail, then the bank might not have sufficient funds to repay their depositors. If the bank undertakes too much risk, then its depositors might rush to withdraw their deposits, which would cause the bank to fail. But if the bank forgoes all risky assets its profit will be much lower. So the bank must balance its search for higher return against the risk earning the return entails.

How do depository institutions create liquidity, pool risks, and lower the cost of borrowing? Liquidity is the property of being easily convertible into a means of payment without loss in value. Depository institutions create liquidity when they offer deposits that can be withdrawn as money at short (or no) notice and then use these deposits to make long-term loans. Depository institutions pool risk because they use funds obtained from many depositors to make loans to many borrowers. As a result, if a borrower defaults, no one depositor bears the entire loss because the loss is spread over all depositors. By spreading the risk, depository institutions are pooling risk. Depository institutions lower the cost of borrowing because they specialize in borrowing. For instance, a firm that wants to borrow a large sum of money need only visit one depository institution to arrange such a loan. In the absence of depository institutions, the firm would need to undertake many transactions with many lenders, which would be a costly process.

How have depository institutions made innovations that have influenced the composition of money? Checking deposits at thrift institutions such as S&L’s savings banks, and credit unions are examples of deposits that were created by innovations in the 1980s and 1990s. These deposits have become an increasingly large percentage of M1. Savings deposits have decreased as a percentage of M2, while time deposits and money market mutual funds have increased, and checking deposits at commercial banks have become a decreasing percentage of M1.

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What is the central bank of the United States and what functions does it perform? The Federal Reserve System is the central bank of the United States. The Federal Reserve conducts the nation’s monetary policy and regulates the nation’s depository institutions. The Fed provides banking services to commercial banks.

What is the monetary base and how does it relate to the Fed’s balance sheet? The monetary base is the sum of Federal Reserve notes, coins, and depository institutions’ deposits at the Fed. Aside from coins, the rest of the monetary base consists of Federal Reserve liabilities. Federal Reserve notes and depository institutions’ deposits are liabilities of the Federal Reserve.

What are the Fed’s three policy tools?

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The Federal Reserve has three policy tools: required reserve ratio, last resort loans, and open market operations.

What is the Federal Open Market Committee and what are its main functions? The Federal Open market Committee (FOMC) is the main policy-making group within the Federal Reserve System. It decides upon the nation’s monetary policy as conducted through open market operations. The FOMC meets approximately once every six weeks.

How does an open market operation change the monetary base? The monetary base is the sum of coins, Federal Reserve notes, and depository institution deposits at the Federal Reserve, that is, banks’ reserves. When the Federal Reserve conducts an open market operation, it either buys securities and pays for them with newly created reserves or it sells securities and is paid with reserves held by banks. In both cases the monetary base changes. In the first case, when the Fed buys securities, the monetary base increases. In the second case, when the Fed sells securities, the monetary base decreases.

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How do banks create money?

Banks within the banking system create money by creating deposits, which are part of the nation’s money. Banks create deposits by making loans because part or all of the loans they make will be deposited in another bank. For instance, a student given a loan may purchase books at the local bookstore. The bookstore will then deposit the proceeds into its bank as part of the bookstore’s checking account. Thus the loan has created new deposits at the bookstore’s bank.

What limits the quantity of money that the banking system can create? The quantity of money that the banking system can create is limited by: the monetary base, desired reserves, and desired currency holdings.

A bank manager tells you that she doesn’t create money. She just lends the money that people deposit. Explain why she’s wrong. Though the manager does not see the entire process, nonetheless the loans the manager makes create more deposits and more money. Point out to the manager that when she makes a loan, the deposits at her bank initially increase. And, when the loan is spent, the recipient selling the goods or services that have been purchased will deposit part or all of the proceeds in his or her bank. When the recipient makes this deposit, the total amount of the nation’s deposits increase and, because deposits are part of the nation’s money, the quantity of money also increases. However, actions of other economic agents also affect the creation of money. For example, if people decide to hold less currency and more deposits, the immediate effect on the quantity of money is nil. But over time the quantity of money increases because banks gain more (excess) reserves, which are then loaned and then deposited, thereby creating additional deposits and increasing the quantity of money.

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What are the main influences on the quantity of real money that people and businesses plan to hold? The quantity of real money demanded depends on four factors: the price level, the nominal interest rate, real GDP, and financial innovation. An increase in the price level increases the nominal demand for money but the quantity of real money demanded is independent of the price level. An increase in the nominal interest rate decreases the quantity of real money demanded, because the nominal interest rate is the opportunity cost of holding money. An increase in real GDP increases the demand for real money, because more real GDP implies more transactions and

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an increase in the demand for money to finance the transactions. And, financial innovations that make it less costly to get by with less money on hand decrease the demand for money.

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Show the effects of a change in the nominal interest rate and a change in real GDP using the demand for money curve. An increase in the nominal interest rate decreases the quantity of real money demanded. The slope of the demand for money curve shows how the quantity of real money demanded depends on the nominal interest rate. As illustrated in Figure 8.1, a decrease in the nominal interest rate results in a movement downward along the demand for money curve. A change in real GDP changes the demand for money. An increase in real GDP increases the demand for money and shifts the demand for curve for real money rightward from MD0 to MD1, as shown in Figure 8.2.

How is money market equilibrium determined in the short run? In the short run, the nominal interest rate adjusts to restore equilibrium to the money market. When the quantity of money demanded equals the quantity supplied, the nominal interest rate is at its equilibrium level.

How does a change the supply of money change the interest rate in the short run? In the short run an increase in the supply of money lowers the interest rate and a decrease in the supply of money raises the interest rate. Suppose the Federal Reserve increases the supply of money. At the initial interest rate people hold more money than the quantity they demand. To © 2014 Pearson Education, Inc.

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restore the amount of money they hold to equality with the quantity demanded, people use the surplus in the loanable funds market to buy bonds. The price of a bond rises which means that the interest rate on the bond falls. When the Federal Reserve decreases the supply of money, the reverse occurs: At the initial interest rate people have less money than the quantity they demand so they sell bonds in the loanable funds market to acquire more money. Selling bonds lowers their price which raises the interest rate.

How does a change the supply of money change the interest rate in the long run? In the long run a change in the supply of money does not change the interest rate. For example, suppose the Federal Reserve increases the supply of money (the effects from a decrease in the supply of money are the reverse of an increase). In the short run the nominal interest rate and the real interest rate fall. Both households and firms increase their demand for goods. The resulting shortages force prices higher and therefore the price level rises. As the price level rises, the quantity of real money decreases, which raises the nominal interest rate and real interest rate. The rise in the interest rate decreases the demand for goods. Eventually the price level rises so that the quantity of real money equals the initial amount. At this point, the nominal interest rate and real interest rate have risen to equal their initial values so there is no long-run effect on the interest rate from a change in the supply of money.

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What is the quantity theory of money? The quantity theory of money is the proposition that in the long run an increase in the quantity of money creates an equal percentage increase in the price level.

How is the velocity of circulation calculated? The velocity of circulation is the average number of times a dollar of money is used annually to buy the goods and services that make up GDP. The velocity of circulation equals (nominal) GDP divided by the quantity of money.

What is the equation of exchange? The equation of exchange is the formula that MV = PY, where M is the quantity of money, V is the velocity of circulation, P is the price level, and Y is real GDP. The equation of exchange is always true by definition because the velocity of circulation is defined as PY/M.

Does the quantity theory correctly predict the effects of money growth on inflation? The long-run historical and international evidence on the relationship between money growth and the inflation rate support the quantity theory. The data suggest a marked tendency for nations with high money growth rates to have high inflation rates.

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Answers to the Study Plan Problems and Applications 1.

In the United States today, money includes which of the following items? a. Federal Reserve bank notes in Citibank’s cash machines

Money includes currency outside the banks. Currency inside cash machines is not money.

b. Your Visa card The Visa card is not money.

c. Coins inside a vending machine The coins inside a vending machine are money.

d. U.S. dollar bills in your wallet The dollar bills inside your wallet are money.

e. The check you’ve just written to pay for your rent The check is not money.

The loan you took out last August to pay for your school fees The loan is not money.

In June 2011, currency held by individuals and businesses was $963 billion; traveler’s checks were $5 billion; checkable deposits owned by individuals and businesses were $977 billion; savings deposits were $5,647 billion; time deposits were $843 billion; and money market funds and other deposits were $659 billion. Calculate M1 and M2 in June 2011. M1 consists of currency and traveler’s checks plus checking deposits owned by individuals and businesses. In June, 2011 M1 equaled $963 billion + $5 billion + $977, or $1,945 billion. M2 consists of M1 plus time deposits, savings deposits, and money market mutual funds and other deposits. In June, 2011 M2 equaled $1,945 + $843 billion + $5,647 billion + $659 billion, or $9,094 billion.

In June 2010, M1 was $1,722 billion; M2 was $8,584 billion; checkable deposits owned by individuals and businesses were $835 billion; time deposits were $1,053 billion; and money market funds and other deposits were $718 billion. Calculate currency and traveler’s checks held by individuals and businesses and calculate savings deposits. M1 consists of currency and traveler’s checks plus checkable deposits owned by individuals and businesses so currency and traveler’s checks equals M1 minus checkable deposits owned by individuals and businesses. In June, 2010 currency and travelers’ checks equaled $1,722 billion − $835 billion, or $887 billion. M2 consists of M1 plus time deposits, savings deposits, and money market mutual funds and other deposits, so savings deposits equals M2 minus M1 minus time deposits minus money market mutual funds and other deposits. In June, 2010 savings deposits equaled $8,584 billion − $1,722 billion − $1,053 billion − $718 billion, or $5,091 billion.

Are You Ready to Pay by Cell Phone? Starbucks customers can now pay for their coffee using their smartphone. Does this mean the move to electronic payments is finally coming? Source: The Wall Street Journal, January 20, 2011 If people can use their cell phones to make payments, will currency disappear? How will the components of M1 change? People will probably carry less currency because their cell phone will substitute for currency, but currency won’t disappear because currency is used in the underground economy. As a component of M1, currency and traveler’s checks will be smaller and most of M1 will be checkable deposits. © 2014 Pearson Education, Inc.

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Europe’s Banks Must Be Forced to Recapitalize In addition to specifying higher prudential capital ratios, European governments must now bully banks to act immediately. Where private funding is not forthcoming, recapitalization must be imposed, in return for fundamental changes in the way financial institutions operate and burdens are shared. Source: Financial Times, November 24, 2011 a. Why do European banks need to hold more capital? European banks need to hold more capital so that they remain solvent in case more loans or other assets go bad. If banks do not have enough capital, the likelihood increases of the bank failing if many assets go bad.

b. What exactly is the “capital” referred to in the news clip? The “capital” means owners’ capital; that is, funds the owners have invested in the bank.

c. How might the requirement to hold more capital make banks safer? When loans or other assets go bad, the bank incurs a loss and the bank’s capital decreases. If the enough losses are incurred, the bank’s capital might be totally dissipated, in which case the bank fails because the bank has no further cushion to absorb more losses. The requirement to hold more capital makes the possibility of failure less likely.

During a time of uncertainty, why might it be necessary for a bank to hold large cash reserves and to have a large percentage of its assets purchased by its own capital? During times of uncertainty banks must be concerned that a large fraction of its depositors might decide to withdraw their deposits from the bank. Because banks loan most of the deposits they receive, the bank might become illiquid if it fails to hold a large cash reserve. Equally, the bank might face insolvency if its assets fall in price. In this situation, if a large percentage of the assets are purchased with the bank’s capital, the bank is less likely to become insolvent.

At the end of December 2011, the monetary base in the United States was $2,615 billion, Federal Reserve notes were $999 billion, and banks’ reserves at the Fed were $1,597 billion. Calculate the quantity of coins. The monetary base equals Federal Reserve notes + coins + depository institution deposits (banks’ reserves) at the Federal Reserve. Therefore coins equals the monetary base − Federal Reserve notes − banks’ reserves. In December, 2011 coins equaled $2,615 billion − $999 billion − $1,597 billion, or $19 billion.

In September 2007 before the financial crisis and recession, the Fed had assets of $800 billion, mainly short-term government securities. In June 2012 after two rounds of quantitative easing, the Fed’s assets totaled $2,600 billion. Many of those assets were longterm securities and not all of them were government securities. a. How did the Fed increase its assets to $2,600 billion in 2012? Describe the transactions the Fed must undertake to increase its assets. The Fed purchased the assets—largely long-term securities, both government and private—and paid for the purchases either by issuing new Federal Reserve notes or by increasing depository institutions’ deposits at the Federal Reserve.

b. How did the monetary base change between 2007 and 2012? The monetary base sharply increased, from about $700 billion in 2007 to $2,600 billion 2012.

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The FOMC sells $20 million securities to Wells Fargo. Enter the transactions that take place to show the changes in the following balance sheets. The first balance sheet to the right shows Federal Reserve Bank of New York the balance sheet of the Federal Reserve Assets Liabilities Bank of New York. The Fed’s assets (millions) (millions) decrease by $20 million because the Fed Securities Wells Fargo reserve deposit now has $20 million less securities. The −$20 −$20 Fed’s liabilities also decrease by $20 million because Wells Fargo pays for its purchases using the reserves that it has on deposit at the Fed. The second balance sheet to the right shows the balance sheet of Wells Fargo Bank. Wells Fargo gains assets in the form of securities of $20 million. Simultaneously it also losses reserve deposit assets of $20 million because it pays for the government securities using its reserve deposits at the Fed.

10.

Wells Fargo Assets (millions) Securities Reserve deposit −$20

Liabilities (millions) +$20

The commercial banks in Zap have: Reserves $250 million Loans $1,000 million Deposits $2,000 million Total assets $2,500 million If the banks hold no excess reserves, calculate their desired reserve ratio. The banks’ desired reserves equal their reserves, $250 million, divided by their deposits, $2,000 million, which is 12.5 percent.

Use the following information to work Problems 11 and 12. In the economy of Nocoin, banks have deposits of $300 billion. Their reserves are $15 billion, two thirds of which is in deposits with the central bank. Households and firms hold $30 billion in bank notes. There are no coins! 11.

Calculate the monetary base and the quantity of money. The monetary base is $45 billion. The monetary base is the sum of the central bank’s notes, banks’ deposits at the central bank, and coins held by households, firms, and banks. There are $30 billion in notes held by households and firms, banks’ deposits at the central bank are $10 billion (2/3 of $15 billion), the banks hold other reserves of $5 billion (which are notes), and there are no coins. The monetary base is $45 billion. The quantity of money is $330 billion. In Nocoin, deposits are $300 billion and currency is $30 billion, so the quantity of money is $330 billion.

12.

Calculate the banks’ desired reserve ratio and the currency drain ratio (as percentages). The banks’ reserve ratio is 5 percent. The banks’ reserve ratio is the percent of deposits that is held as reserves. In Nocoin, deposits are $300 billion and reserves are $15 billion, so the reserve ratio equals ($15 billion/$300 billion)  100, which is 5 percent. The currency drain is 10 percent. The currency drain is the ratio of currency to deposits. In Nocoin, currency is $30 billion and deposits are $300 billion, so the currency drain equals ($30 billion/$300 billion)  100, which is 10 percent.

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Use the following news clip to work Problems 13 and 14. China Cuts Banks’ Reserve Ratios The People’s Bank of China made a long-awaited move to boost lending in the country’s slowing economy with the announcement that it would lower the required reserve ratio by 50 basis points from February 24. The cut will bring the ratio down to 20.5 percent for the largest banks. Source: Financial Times, February 19, 2012 13.

Explain how lowering the required reserve ratio impacts banks’ money creation process. Lowering the required reserve ratio decreases banks’ desired reserves. When banks’ desired reserves decrease they will make more loans so the quantity of money in China increases. (The Mathematical Note shows that an decrease in the desired reserve ratio increases the money multiplier.)

14.

How would a lower required reserve ratio influence bank profits? Funds kept as reserves earn low or zero returns. If banks are required to keep less of their funds as reserves, the total returns they earn increases so their profit increases.

15.

The spreadsheet provides information about the demand for money in Minland. Column A is the nominal interest rate, r. Columns B and C show the quantity of money demanded at two values of real GDP: Y0 is $10 billion and Y1 is $20 billion. The quantity of money supplied is $3 billion. Initially, real GDP is $20 billion. What happens in Minland if the interest rate (i) exceeds 4 percent a year and (ii) is less than 4 percent a year?

A r

2 3 4 5 6 7 8

7 6 5 4 3 2 1

B Y0 1.0 1.5 2.0 2.5 3.0 3.5 4.0

C Y1 1.5 2.0 2.5 3.0 3.5 4.0 4.5

(i) The equilibrium nominal interest rate is 4 percent. If the interest rate exceeds 4 percent a year, people want to hold less money than is available. So they try to decrease the amount of money held by buying bonds. The prices of bonds rise, and the interest rate falls. (ii) The equilibrium nominal interest rate is 4 percent. If the interest rate is less than 4 percent a year, people want to hold more money than is available. So they try to increase the amount of money held by selling bonds. The prices of bonds fall, and the interest rate rises.

16.

Figure 8.3 shows the demand for money curve. If the Fed decreases the quantity of real money supplied from $4 trillion to $3.9 trillion, explain how the price of a bond will change. If the Fed decreases the quantity of money to $3.9 trillion, the price of a bond falls. The decrease in the quantity of money means that at the initial interest rate, 4 percent, people are holding less money than the quantity they demand. In response people sell bonds to try to increase the quantity of money they hold. As people sell bonds, the price of a bond falls and the interest rate rises, in the figure from 4 percent to 6 percent.

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Quantecon is a country in which the quantity theory of money operates. In year 1, the economy is at full employment and real GDP is $400 million, the GDP deflator is 200 (a price level is 2), and the velocity of circulation is 20. In year 2, the quantity of money increases by 20 percent. Calculate the quantity of money, the GDP deflator, real GDP, and the velocity of circulation in year 2. The quantity of money in year 1 is $40 million. Because the equation of exchange tells us that MV = PY, we know that M = PY/V. Then, with P = 2.0, Y = $400 million, and V = 20, M = $40 million. Then in year 2 the quantity of money is $48 million because money grows by 20 percent, which is $8 million. The GDP deflator is 240. Because the quantity theory of money holds and because the factors that influence real GDP have not changed, the GDP deflator rises by the same percentage as the increase in the quantity of money, which is 20 percent. Real GDP is $400 million because it remains equal to potential GDP (the quantity of GDP produced at full employment). The velocity of circulation is 20. Because the factors that influence velocity have not changed, velocity is unchanged.

18.

In Problem 11, the banks have no excess reserves. Suppose that the Bank of Nocoin, the central bank, increases bank reserves by $0.5 billion. a. What happens to the quantity of money? The quantity of money increases by $3.67 billion. The quantity of money increases by the change in the monetary base multiplied by the money multiplier. The money multiplier is 7.33 (see part c), so when the monetary base increases by $0.5 billion, the quantity of money increases by $3.67 billion.

b. Explain why the change in the quantity of money is not equal to the change in the monetary base. The change in the quantity of money is not equal to the change in the monetary base because of the multiplier effect. The open market operation increases bank reserves and creates excess reserves, which banks use to make new loans. New loans are used to make payments and some of these loans are placed on deposit in banks. The increase in bank deposits increases banks’ reserves and increases desired reserves. But the banks now have excess reserves which they loan out and the process repeats until excess reserves have been eliminated.

c. Calculate the money multiplier. The money multiplier is 7.33. The money multiplier is equal to (1 + C/D)/(R/D + C/D), where C/D is the currency drain ratio and R/D is the banks’ reserve ratio. From the problem, C/D = 0.1 and R/D = 0.05, so the money multiplier equals (1 + 0.1)/(0.1 + 0.05), which equals 7.33.

19.

In Problem 11, the banks have no excess reserves. Suppose that the Bank of Nocoin, the central bank, decreases bank reserves by $0.5 billion. a. Calculate the money multiplier. The money multiplier is 7.33. The money multiplier is equal to (1 + C/D)/(R/D + C/D), where C/D is the currency drain ratio and R/D is the banks’ reserve ratio. From the problem, C/D = 0.1 and R/D = 0.05, so the money multiplier equals (1 + 0.1)/(0.1 + 0.05), which equals 7.33.

b. What happens to the quantity of money, deposits, and currency? The quantity of money decreases by $3.67 billion. The quantity of money decreases by the change in the monetary base multiplied by the money multiplier. The money multiplier is 7.33, so when the monetary base decreases by $0.5 billion, the quantity of money decreases by $3.67 billion. The quantity of deposits decreases by $3.34 billion. The quantity of money decreases by $3.67 billion. Part of the decrease in the quantity of money is a decrease in currency held by the public. © 2014 Pearson Education, Inc.

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The currency drain is 0.1. So deposits decrease by $3.34 billion and currency decreases by $0.33 billion for a total decrease in the quantity of money of $3.67 billion.

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Answers to Additional Problems and Applications 20.

Sara withdraws $1,000 from her savings account at the Lucky S&L, keeps $50 in cash, and deposits the balance in her checking account at the Bank of Illinois. What is the immediate change in M1 and M2? M1 increases by $1,000; M2 does not change. M1 is the sum of currency, traveler’s checks, and checking deposits held by individuals and businesses. M2 is the sum of M1, savings deposits, time deposits, and money market mutual funds and other deposits. The withdrawal of $1,000 from a savings account leaves M2 unchanged because the $1,000 goes into M1 types of money, which is part of M2. The $50 held as cash and the $950 held in a checking account increase M1 by $1,000.

21.

Rapid inflation in Brazil in the early 1990s caused the cruzeiro to lose its ability to function as money. Which of the following commodities would most likely have taken the place of the cruzeiro in the Brazilian economy? Explain why. a. Tractor parts It is unlikely that tractor parts would be used as money because tractor parts are heavy and unwieldy to carry around for use as a medium of exchange.

b. Packs of cigarettes Packs of cigarettes would likely be used as a substitute for money because they are light to carry around, are durable, and can be easily divided into fractions of packs for making change.

c. Loaves of bread Loaves of bread would be unlikely to be used as a substitute for money because they would spoil too rapidly.

d. Impressionist paintings Impressionist paintings would be unlikely to be used as a substitute for money because they would be unwieldy to carry around and because their quality and value differs dramatically from one artist to another.

e. Baseball trading cards Baseball cards would be unlikely to be used as a substitute for money because most Brazilians are unfamiliar with baseball (and unlikely to value the cards per se) and because the cards are not very durable.

22.

From Paper-Clip to House, in 14 Trades A 26-year-old Montreal man appears to have succeeded in his quest to barter a single, red paperclip all the way up to a house. It took almost a year and 14 trades. Source: CBC News, July 7, 2006 Is barter a means of payment? Is it just as efficient as money when trading on eBay? Explain. Barter is a means of payment, but an inefficient one because the person who is paying must have a good or service that the person who is being paid desires. Barter would be an inefficient means of payment on e-Bay. First, barter requires that the person paying must have a good or service that the person being paid desires. Second, on e-Bay the person being paid is unable to examine the quality of the good or service being offered in exchange.

Use the following news clip to work Problems 23 and 24. U.S. Bank Earnings Up 21% As Loan Losses Decline, FDIC Says For the 12th straight quarter, U.S. bank profits increased. At $34.5 billion, they were 21 percent higher than a year earlier, and, according to the Federal Deposit Insurance Corporation (FDIC), balance sheets were less risky. FDIC Acting Chairman Martin Gruenberg said “Levels of troubled © 2014 Pearson Education, Inc.

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assets and troubled institutions remain high, but they are continuing to improve.” The number of institutions on FDIC’s list of banks deemed to be at greater risk of collapse fell for a fifth straight quarter. By August, 40 banks had failed in 2012. The FDIC’s deposit insurance fund, which protects customer accounts up to $250,000 against bank failure, increased. www.bloomberg.com, August 29, 2012 23.

Explain how the pursuit of profits can sometimes lead to bank failures. The bank knows that its safe reserves pay low (or no) returns so retaining safe reserves lowers the bank’s profit. If the bank minimizes these reserves to maximize its profit, the bank’s depositors might become concerned that the bank will be unable to repay the funds they have deposited in the bank. In this situation, if a large number of depositors request the return of their funds, the bank might fail if it does not have adequate reserves on hand to meet these withdrawals.

24.

How does FDIC insurance help minimize the cost of bank failure? Does it bring more stability to the banking system? Prior to FDIC insurance, a bank failure might impose significant costs on its depositors because the depositors might lose their entire deposit. FDIC insurance removes this cost of bank failure. It also increases the stability to the banking system. One way that banks fail is when the bank’s depositors become concerned that the bank will be unable to repay the funds that have been deposited with it. If there is no FDIC insurance, and this belief becomes widespread all the depositors rush to the bank to withdraw their funds. This rush causes the bank to fail because it will be unable to meet the massive demand for funds. FDIC insurance, however, eliminates depositors’ incentive to rush to withdraw their funds because depositors know that the funds they have deposited with the bank will be repaid. FDIC insurance thereby increases the stability of the banking system.

25.

Explain the distinction between a central bank and a commercial bank. A central bank is basically a “bank for banks.” It will conduct business with commercial banks, such as making loans to them and holding their reserves. A central bank does not accept deposits from private citizens. A central bank also regulates the nation’s depository institutions and conducts the nation’s monetary policy. A commercial bank conducts business with firms and households. It accepts deposits from individuals and then makes loans to other people or firms. Commercial banks are privately owned and have as their objective the maximization of their profit.

26.

If the Fed makes an open market sale of $1 million of securities to a bank, what initial changes occur in the economy? If the Fed sells $1 million of securities to a bank, both the Fed’s balance sheet and the bank’s balance sheet change. The Fed’s holding of securities falls by $1 million and the bank’s holding of securities rises by $1 million. The bank pays for the purchase with its reserves, so the reserves held by the Fed fall by $1 million and the bank’s reserves fall by $1 million. The amount of the bank’s assets does not change, though the composition changes (more securities, fewer reserves). The Fed’s assets and liabilities both fall by an equal amount ($1 million in this case).

27.

Set out the transactions that the Fed undertakes to increase the quantity of money. The Fed has three procedures by which it can increase the quantity of money: • The Fed could use an open market purchase of securities from banks. When the Fed buys securities, it pays for the purchase by increasing banks’ reserves. The increase in banks’ reserves increases the monetary base and allows banks to make more loans, which then increase the quantity of money.

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• •

28.

The Fed could make a last resort loan to a bank. When the Fed makes a loan to a bank, the bank’s reserves increase. The increase in reserves increases the monetary base and allows the bank to make more loans, which then increase the quantity of money. The Fed could lower the required reserve ratio. By lowering the required reserve ratio, the Fed lowers the reserves banks must hold and thereby lowers their desired reserve ratio. Banks respond by increasing their loans, which then increase the quantity of money.

Describe the Fed’s assets and liabilities. What is the monetary base and does it relate to the Fed’s balance sheet? The Fed has two main assets: U.S. government securities and loans to depository institutions. The Fed also has two main liabilities, Federal Reserve notes and depository institution deposits (the reserves that depository institutions hold at the Fed). The monetary base is the sum of coins, Federal Reserve notes, and depository institution deposits at the Fed. Coins are only a small part of the monetary base. The two largest components of the monetary base, Federal Reserve notes and depository institutions deposits at the Fed, are the Fed’s two liabilities.

29.

Fed Minutes Show Active Discussion of QE3 The FOMC discussed “a new large-scale asset purchase program” commonly called “QE3.” Some FOMC members said such a program could help the economy by lowering long-term interest rates and making financial conditions more broadly easier. They discussed whether a new program should snap up more Treasury bonds or buying mortgage-backed securities issued by the likes of Fannie Mae and Freddie Mac. Source: The Wall Street Journal, August 22, 2012 What would the Fed do to implement QE3, how would the monetary base change, and how would bank reserves change? To implement QE3 the Fed would undertake massive (“quantitative”) purchases of assets. These assets likely would be long-term securities and could include Treasury bonds and/or mortgage backed securities, such as those issued by Fannie Mae or Freddie Mac. These purchases would increase both the monetary base and banks’ reserves.

30.

Banks in New Transylvania have a desired reserve ratio of 10 percent of deposits and no excess reserves. The currency drain ratio is 50 percent of deposits. Now suppose that the central bank increases the monetary base by $1,200 billion. a. How much do the banks lend in the first round of the money creation process? Banks loan $1,200 billion because the entire increase in reserves is excess reserves.

b. How much of the initial amount lent flows back to the banking system as new deposits? $800 billion flows back to the banks as new deposits. The currency drain, which is the percentage ratio of currency to deposits, is 50 percent. Of the $1,200 billion that has been loaned, $800 billion is deposited back in banks and 50 percent of the deposits, $400 billion, is kept as currency.

c. How much of the initial amount lent does not return to the banks but is held as currency? Currency increases by $400 billion. The currency drain, which is the percentage of currency to deposits, is 50 percent. Of the $1,200 billion that has been loaned, $800 billion is deposited and 50 percent of the deposits, $400 billion, is kept as currency.

d. Why does a second round of lending occur? A second round of lending takes place because the $800 billion flowing back to the banks as new deposits means that banks have excess reserves. Of the $800 billion flowing back to the banks, 10 percent, or $80 billion, is kept as reserves leaving $720 billion that will be loaned in a second round of lending. © 2014 Pearson Education, Inc.

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31.

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Explain the change in the nominal interest rate in the short run if a. Real GDP increases. The nominal interest rate rises. When real GDP increases, the quantity of money demanded increases. At the initial interest rate people are holding less money than the quantity they demand. People sell bonds to increase the money they hold. The price of a bond falls and the nominal interest rate rises.

b. The money supply increases. The nominal interest rate falls. When the supply of money increases, the quantity of real money increases. At the initial interest rate people are holding more money than the quantity they demand. People buy bonds to decrease the money they hold. The price of a bond rises and the nominal interest rate falls.

c. The price level rises. The nominal interest rate rises. When the price level rises, the quantity of real money decreases. The supply of money decreases. The demand for money does not change. At the initial interest rate people are holding less money than the quantity they demand. People sell bonds to increase the money they hold. The price of a bond falls and the nominal interest rate rises.

32.

In Minland in Problem 15, the interest rate is 4 percent a year. Suppose that real GDP decreases to $10 billion and the quantity of money supplied remains unchanged. Do people buy bonds or sell bonds? Explain how the interest rate changes. When real GDP decreases, the demand for money decreases. At the initial interest rate of 4 percent, the quantity of money people are holding exceeds the quantity of money they want to hold. People buy bonds to decrease the quantity of money they are holding. When people demand bonds, the price of a bond rises, and the interest rate falls. When the interest rate equals 3 percent a year, people are holding exactly the quantity of money that they want to hold so 3 percent is the new equilibrium interest rate.

33.

The table provides some data for the United States in the first decade following the Civil War. Source of data: Milton Friedman and Anna J. Schwartz, A Monetary History of the United States 1867–1960 a. Calculate the value of X in 1869.

Quantity of money Real GDP (1929 dollars) Price level (1929 = 100) Velocity of circulation

1869 $1.3 billion $7.4 billion X

1879 $1.7 billion Z 54

4.50

4.61

Using the formula MV = PY gives ($1.3 billion  4.5) = (P  $7.4 billion) so that P equals 0.79, or, transformed to an index number, P = 79.

b. Calculate the value of Z in 1879. Using the formula MV = PY gives ($1.7 billion  4.61) = (0.54  Y) so that Y equals $14.5 billion.

c. Are the data consistent with the quantity theory of money? Explain your answer. The quantity theory holds. The quantity theory predicts that the inflation rate equals the growth rate of the quantity of money plus the growth rate of velocity minus the growth rate of real GDP. The growth rate of velocity is approximately zero, so the inflation rate equals the growth rate of the quantity of money minus the growth rate of real GDP. The quantity of money grew by approximately 27 percent, real GDP grew by approximately 65 percent and the price level fell by approximately 38 percent. (These percentages are calculated using the average of the quantity of money, the price level, and real GDP as the base for the percentage.) The inflation rate, −38

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percent (deflation) equals the growth rate of the quantity of money, 27 percent, minus the growth rate of real GDP, 65 percent.

34.

In the United Kingdom, the currency drain ratio is 38 percent of deposits and the reserve ratio is 2 percent. In Australia, the quantity of money is $150 billion, the currency drain ratio is 33 percent of deposits, and the reserve ratio is 8 percent of deposits. a. Calculate the U.K. money multiplier. The money multiplier equals 3.45. The money multiplier is equal to (1 + C/D)/(R/D + C/D), where C/D is the currency drain ratio and R/D is the banks’ reserve ratio. From the problem, C/D = 38 percent and R/D = 2 percent, so the money multiplier equals (1 + 0.38)/(0.38 + 0.02), which equals 3.45.

b. Calculate the monetary base in Australia. The monetary base equals $46.2 billion. The monetary base equals the sum of currency and depository institution deposits at the central bank. The currency drain is 33 percent, so with the quantity of money equal to $150 billion, currency is $37.2 billion and deposits are $112.8 billion. The banks’ reserve ratio is 8 percent, so reserves are ($112.8  0.08), which is $9 billion. The monetary base equals $37.2 billion + $9.0 billion, or $46.2 billion.

Economics in the News 35.

After you have studied Reading Between the Lines on pp. 204–205 (610–611 in Economics,) answer the following questions. a. What changes in the monetary base have occurred since October 2008 and how much of the increase occurred during the Fed’s QE2 period? Since October, 2008 the monetary base has increased by about $1,800 billion to $2,600 billion in 2012. During QE2 the monetary base increased by $600 billion, which is about 1/3 of the total increase,

b. How does the Fed bring about an increase in the monetary base? The Fed increases the monetary base by buying securities.

c. How did the increase in the monetary base change the quantity of M2? Why was the increase so small? The quantity of M2 barely changed, increasing by only $140 billion. Banks increased their desired reserves so the huge increase in the monetary base was held as reserves rather than being loaned and thereby increasing M2.

d. How did the change in M2 influence short-term nominal interest rates? Why? Short-term nominal interest rates fell. The Fed used its control over the federal funds rate to lower short-term interest rates by increasing its purchases of short-term assets.

e. How did the change in monetary base influence long-term nominal interest rates? Why? During the QE2 period, long-term nominal interest rates hardly changed. To lower the long-term interest rate requires that banks increase their lending. But when the monetary base increased, banks increased their desired reserves and so they held the increased monetary base as reserves rather than making loans. Since the end of QE2, long-term nominal interest rates have fallen slightly.

How did the change in monetary base influence long-term real interest rates? Why? The long-term real interest rate fell during QE2. QE2 increased the supply of loanable funds, which lowered the long-term real interest rate. After the end of QE2, the long-term interest continued to fall and then started to rise, though it remains below its level before QE2.

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Fed at Odds with ECB over Value of Policy Tool Financial innovation and the spread of U.S. currency throughout the world has broken down relationships between money, inflation, and output growth, making monetary gauges a less useful tool for policy makers, the U.S. Federal Reserve chairman, Ben Bernanke, said. Many other central banks use monetary aggregates as a guide to policy decision, but Bernanke believes reliance on monetary aggregates would be unwise because the empirical relationship between U.S. money growth, inflation and output growth is unstable. Bernanke said that the Fed had “philosophical” and economic differences with the European Central Bank. “There are differences between the United States and Europe in terms of the stability of money demand,” Bernanke said. Ultimately, the risk of bad policy arising from a devoted following of money growth led the Fed to downgrade the importance of money measures. Source: International Herald Tribune, November 10, 2006 a. Explain how the debate surrounding the quantity theory of money could make “monetary gauges a less useful tool for policy makers.” The ECB policymakers believe that the quantity theory and its relationship between the monetary growth rate and the inflation rate are a useful guide for policy. As a result they pay greater attention to the quantity of money than does the Federal Reserve. Mr. Bernanke’s statements indicate that he believes that velocity is less stable in the United States because of instability of the demand for money and financial innovation. Because velocity is less stable, Mr. Bernanke believes that the quantity theory, and emphasis on monetary aggregates, is less useful in the United States than in Europe. Indeed, Mr. Bernanke perhaps believes that ECB policymakers pay too much attention to monetary aggregates.

b. What do Ben Bernanke’s statements reveal about his view on the accuracy of the quantity theory of money? At the least Mr. Bernanke believes that velocity changes make the short-run tie between growth in the quantity of money and the inflation rate unreliable. He mentions that the empirical relationship between money growth and inflation and nominal output growth has “continued to be unstable” and he states that the risk of “bad policy” has led the Fed to “downgrade the importance of monetary measures.” The article, however, sheds no light on Mr. Bernanke’s views about the validity of the quantity theory in the long run.

C h a p t e r

THE EXCHANGE RATE AND THE BALANCE OF PAYMENTS**

Answers to the Review Quizzes Page 218 1.

(page 624 in Economics)

What are the influences on the demand for U.S. dollars in the foreign exchange market? The demand for U.S. dollars depends on four main factors: the exchange rate, the world demand for U.S. exports, the interest rate in the United State and other countries, and the expected future exchange rate.

Provide an example of the exports effect on the demand for U.S. dollars. The exports effect is the result that the larger the value of U.S. exports, the larger the quantity of U.S. dollars demanded for purchasing those exports from U.S. firms. Suppose the U.S. exchange rate falls. When the U.S. exchange rate falls, U.S. exports become cheaper relative to other countries’ goods and services. The volume of U.S. exports increases, which increases the quantity demanded of U.S. dollars needed to finance their purchase. So if the exchange rate falls (and other influences remain the same), the quantity of U.S. dollars demanded in the foreign exchange market increases.

What are the influences on the supply of U.S. dollars in the foreign exchange market? The supply of U.S. dollars depends on four main factors: the exchange rate, the U.S. demand for imports, the interest rate in the United State and other countries, and the expected future exchange rate.

Provide an example of the imports effect on the supply of U.S. dollars. The imports effect is the result that the larger the value of U.S. imports, the larger the quantity of U.S. dollars supplied for purchasing those imports from foreign firms. Suppose the U.S. exchange rate rises. When the U.S. exchange rate rises foreign imports become cheaper relative to U.S.produced goods and services so the volume of U.S. imports increases, which increases the quantity supplied of U.S. dollars to exchange for foreign currency to finance the purchase of the imports. So if the exchange rate rises (and other influences remain the same), the quantity of U.S. dollars supplied in the foreign exchange market increases.

How is the equilibrium exchange rate determined? The equilibrium exchange rate is the exchange rate that sets the quantity of U.S. dollars demanded equal to the quantity of U.S. dollars supplied. At the equilibrium exchange rate there is neither a shortage nor a surplus of U.S. dollars.

What happens if there is a shortage or a surplus of U.S. dollars in the foreign exchange market?

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If there is a shortage of U.S. dollars, the quantity of U.S. dollars demanded exceeds the quantity supplied. As long as there is a shortage, this upward pressure on the price automatically forces the price higher to its equilibrium. If there is a surplus of U.S. dollars, the quantity of U.S. dollars demanded is less than the quantity supplied. As long as there is a surplus, this downward pressure on the price automatically forces the price lower to its equilibrium.

Page 223 1.

(page 629 in Economics)

Why does the demand for U.S. dollars change? Three factors change the demand for U.S. dollars: the world demand for U.S. exports, the interest rate in the United States and other countries, and the expected future exchange rate. If world demand for U.S. exports increases, the demand for U.S. dollars increases. If the interest rate in the United States rises relative to interest rates in other countries, the demand for U.S. dollars increases. And if the expected future exchange rate rises, the demand for U.S. dollars increases.

Why does the supply of U.S. dollars change? Three factors change the supply of U.S. dollars: U.S. demand for imports, the interest rate in the United States and other countries, and the expected future exchange rate. If U.S. demand for imports increases, the supply of U.S. dollars increases. If the interest rate in the United States falls relative to interest rates in other countries, the supply of U.S. dollars increases. And if the expected future exchange rate falls, the supply of U.S. dollars increases.

What makes the U.S. dollar exchange rate fluctuate? Changes in the demand for U.S. dollars and the supply of U.S. dollars lead to fluctuations in the U.S. dollar exchange rate. Because the demand for dollars and the supply of dollars generally change at the same time and in opposite directions, exchange rate fluctuations are frequently large.

What is interest rate parity and what happens when this condition doesn’t hold? Interest rate parity occurs when, adjusted for risk, the rate of return earned by a unit of currency is the same in different nations. If the rate of return for the U.S. dollar is higher than that for, say, the Japanese yen, interest rate parity does not occur. In this case people will generally expect the value of the dollar to fall against the yen (that is, the U.S. dollar is expected to depreciate over time) so that interest rate parity is restored because the rate of return earned by a unit of currency is the same in both nations.

What is purchasing power parity and what happens when this condition doesn’t hold? Purchasing power parity occurs when a unit of money buys the same amount of goods and services in different nations. If prices of goods and services are higher in the United States than the (exchange rate adjusted) prices of goods and services in, say, Japan, purchasing power parity does not occur because a unit of currency buys less in the United States than in Japan. The demand for U.S. dollars decreases and the supply of U.S. dollars increases so that the value of the dollar falls against the yen to restore purchasing power parity.

What determines the real exchange rate and the nominal exchange rate in the short run? The real exchange between the United States and Japan, RER, equals E  P/P* where P is the U.S. price level, P* is the Japanese price level, and E is the nominal exchange rate in yen per dollar. In the short run, changes in the nominal exchange rate bring an equal change in the real exchange rate because the price levels in Japan and the United States do not adjust instantly to a change in the nominal exchange rate. In the short run, the nominal U.S. exchange rate is determined in the foreign exchange market as the exchange rate that sets the quantity of U.S. dollars demanded equal to the quantity of U.S. dollars supplied. © 2014 Pearson Education, Inc.

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What determines the real exchange rate and the nominal exchange rate in the long run? In the long run, the real exchange rate is determined by demand and supply in the goods market. Identical goods in the United States and Japan sell for the same price once adjusted for the (nominal) exchange rate. The relative prices of goods that are not identical are determined by the supply and demand for them and so the relative price levels in different countries are determined by supply and demand. These relative price levels determine the real exchange rate. In the long run, changes in the real exchange rate and changes in the price levels change the nominal exchange rate. In the long run, the price level is determined by the quantity of money. So changes in the U.S. or the Japanese quantity of money change the price level and also bring an offsetting change in the nominal exchange rate.

Page 226 1.

(page 632 in Economics)

What is a flexible exchange rate and how does it work? A flexible exchange rate policy is an exchange rate that is determined by demand and supply with no direct intervention in the foreign exchange market by the central bank. In this arrangement, the forces of supply and demand with no direct central bank intervention are the only factors that influence the exchange rate.

What is a fixed exchange rate and how is its value fixed? A fixed exchange rate policy is an exchange rate that is pegged at a value decided by the government or central bank. The central bank directly intervenes in the foreign exchange market to block the unregulated forces of supply and demand from changing the exchange rate away from its pegged value. For instance, if a central bank wanted to hold the exchange rate steady in the presence of diminished demand for its currency, the central bank props up demand by buying its currency in the foreign exchange market to keep the exchange rate from falling. If the demand for its currency increases, the central bank increases the supply by selling its currency and keeps the exchange rate from rising.

What is a crawling peg and how does it work? A crawling peg exchange rate policy selects a target path for the exchange rate and then uses direct central bank intervention in the foreign exchange market to achieve that path. A crawling peg works like a fixed exchange rate except that the central bank changes the target value of the exchange rate in accord with its target path.

How has China operated in the foreign exchange market, why, and with what effect? From 1997 until 2005, the People’s Bank of China fixed the Chinese yuan exchange rate. Over this time, the demand for the yuan increased, so the People’s Bank of China supplied additional yuan to keep the exchange rate constant. By supplying yuan, the People’s Bank acquired large amounts of foreign currency. In addition, by fixing its exchange rate China essentially pegged its inflation rate to equal the U.S. inflation rate. Since 2005 the yuan has been allowed to appreciate slightly as the People’s Bank moved to a crawling peg exchange rate policy. The exchange rate has not been allowed to change much, so over the long run the Chinese inflation rate remains closely tied to U.S. inflation.

Page 231 1.

(page 637 in Economics)

What are the transactions that the balance of payments accounts record? The current account records payments for imports of goods and services from abroad, receipts from exports of goods and services sold abroad, net interest income paid abroad, and net transfers abroad (such as foreign aid payments). The capital and financial account records foreign investment in the U.S. minus U.S. investment abroad. Any statistical discrepancy is also

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recorded in the capital account. The official settlements account records the change in U.S. official reserves.

Is the United States a net borrower or a net lender? Is it a debtor or a creditor nation? The United States is a net borrower and is a debtor nation.

How are net exports and the government sector balance linked? Net exports is the value of exports of goods and services minus the value of imports of goods and services. Net exports is equal to the sum of government sector surplus or deficit plus the private sector surplus or deficit. The government sector balance is equal to net taxes minus government expenditure on goods and services. If the government sector balance is negative, then the government sector has a deficit, that is, a budget deficit. Because net exports equals the sum of the government sector balance plus private sector balance, if the government budget deficit increases and the private sector balance does not change, the value of net exports becomes more negative.

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Answers to the Study Plan Problems and Applications

Use the following data to work Problems 1 to 3. The U.S. dollar exchange rate increased from $0.96 Canadian in June 2011 to $1.03 Canadian in June 2012, and it decreased from 81 Japanese yen in June 2011 to 78 yen in June 2012. 1. Did the U.S. dollar appreciate or depreciate against the Canadian dollar? Did the U.S. dollar appreciate or depreciate against the yen? The U.S. dollar appreciated against the Canadian dollar and it depreciated against the yen.

What was the value of the Canadian dollar in terms of U.S. dollars in June 2011 and June 2012? Did the Canadian dollar appreciate or depreciate against the U.S. dollar over the year June 2011 to June 2012? One Canadian dollar was worth 104 U.S. cents in June 2011 and 97 U.S. cents in June 2012. The Canadian dollar depreciated against the U.S. dollar.

What was the value of 100 yen in terms of U.S. dollars in June 2011 and June 2012? Did the yen appreciate or depreciate against the U.S. dollar over the year June 2011 to June 2012? One hundred yen was worth 123 U.S. cents in June 2011 and 128 U.S. cents in June 2012. The yen appreciated against the U.S. dollar.

Use the following data to work Problems 4 to 6. In June 2011, the exchange rate was 0.69 euros per U.S. dollar. In June 2012, the exchange rate was 0.79 euros per U.S. dollar. 4.

Explain the exports effect of this change in the exchange rate. The rise in the U.S. exchange rate raises the price in Europe of U.S.-produced goods. The higher the price in Europe for these goods, the smaller the quantity demanded. The volume of U.S. exports to Europe decreases and to finance this trade the quantity of U.S. dollars demanded in the foreign exchange market decreases.

Explain the imports effect of this change in the exchange rate. The rise in the U.S. exchange rate lowers the price in the United States of European -produced goods. The lower the price in the United States for these goods, the larger the quantity demanded. The volume of U.S. imports from Europe increases and consequently the quantity of U.S. dollars supplied in the foreign exchange market increases.

Explain the expected profit effect of this change in the exchange rate. For a given future expected exchange rate, the rise in the U.S. exchange rate decreases the expected profit from buying U.S. dollars today. The decrease in the expected profit decreases the quantity of U.S. dollars demanded in the foreign exchange market.

On March 30, 2012, the U.S. dollar was trading at 82 yen per U.S. dollar on the foreign exchange market. On August 30, 2012, the U.S. dollar was trading at 79 yen per U.S. dollar. a. What events in the foreign exchange market could have brought this fall in the value of the U.S. dollar? The fall in the U.S. exchange rate is the result of a decrease in the demand for U.S. dollars and/or an increase in the supply of U.S. dollars. Factors that decrease the demand for U.S. dollars include a decrease in the Japanese demand for U.S. exports; a fall in the U.S. interest rate relative to the Japanese interest rate; and, a fall in the expected future exchange rate. Factors that increase the supply of U.S. dollars include an increase in the U.S. demand for Japanese imports; a fall in the U.S. interest rate relative to the Japanese interest rate; and, a fall in the expected future exchange rate.

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dollars, or both demand and supply in the foreign exchange market? A decrease in the Japanese demand for U.S. exports leads to only a decrease in the demand for U.S. dollars. An increase in the U.S. demand for Japanese imports leads only to an increase in the supply of U.S. dollars. The other factors, a fall in the U.S. interest rate relative to the Japanese interest rate and a fall in the expected future exchange rate, change both the demand for U.S. dollars and the supply of U.S. dollars.

Colombia is the world’s biggest producer of roses. The global demand for roses increases and at the same time, the central bank in Colombia increases the interest rate. In the foreign exchange market for Colombian pesos, what happens to a. The demand for pesos? The demand for the peso increases because the Colombian interest rate differential increases and because the demand for Colombia’s export, roses, increases.

b. The supply of pesos? The supply of the pesos decreases because the Colombian interest rate differential increases.

c. The quantity of pesos demanded? The Colombian exchange rate rises. The rise in the exchange rate creates a movement upward along the new demand curve, so along the new demand curve for pesos, the quantity of pesos demanded decreases.

d. The quantity of pesos supplied? The Colombian exchange rate rises. The rise in the exchange rate creates a movement upward along the new supply curve, so along the new supply curve of pesos, the quantity of pesos supplied increases.

e. The exchange rate of the pesos against the U.S. dollar? The Colombian exchange rate appreciates against the dollar because the demand for Colombian pesos increases and the supply decreases.

If a euro deposit in a bank in Paris, France, earns interest of 4 percent a year and a yen deposit in Tokyo, Japan, earns 0.5 percent a year, everything else remaining the same and adjusted for risk, what is the exchange rate expectation of the Japanese yen? For interest rate parity to hold, the Japanese yen must be expected to appreciate by the difference in the interest rates. So the Japanese yen must be expected to appreciate by 4.0 percent minus 0.5 percent, or 3.5 percent.

10.

The U.K. pound is trading at 1.50 U.S. dollars per U.K. pound. There is purchasing power parity at this exchange rate. The interest rate in the United States is 1 percent a year and the interest rate in the United Kingdom is 3 percent a year. a. Calculate the U.S. interest rate differential. The U.S. interest rate differential equals 1 percent minus 3 percent, or −2 percent per year.

b. What is the U.K. pound expected to be worth in terms of U.S. dollars one year from now? For interest rate parity to hold, the U.K. pound must be expected to depreciate 2 percent per year. Therefore next year the U.K. pound is expected to be equal to 0.98  1.50 U.S. dollars per U.K. pound, which is 1.47 U.S. dollars per U.K. pound.

c. Which country more likely has the lower inflation rate? How can you tell? Because the U.K. pound is expected to depreciate, the United Kingdom likely has the higher inflation rate, which means that the United States is expected to have the lower inflation rate.

11.

You can purchase a laptop in Mexico City for 12,960 Mexican pesos. If the exchange rate is 10 Mexican pesos per U.S. dollar and if purchasing power parity prevails, at what price can © 2014 Pearson Education, Inc.

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you buy an identical computer in Dallas, Texas? The price of the laptop converted to U.S. dollars equals 12,960 Mexican pesos ÷ 10 Mexican pesos per dollar, which is $1,296.

12.

When the Chips Are Down The Economist magazine uses the price of a Big Mac to determine whether a currency is undervalued or overvalued. In July 2012, the price of a Big Mac was $4.33 in New York, 15.65 yuan in Beijing, and 6.50 Swiss francs in Geneva. The exchanges rates were 6.37 yuan per U.S. dollar and 0.98 Swiss francs per U.S. dollar. Source: The Economist, July 25, 2012 a. Was the yuan undervalued or overvalued relative to purchasing power parity? Changing the price of a Big Mac in China into U.S. prices shows that the Chinese Big Mac has a dollar price of 15.65 yuan ÷ 6.37 yuan per dollar which is $2.46. The yuan was undervalued relative to purchasing power parity.

b. Was the Swiss franc undervalued or overvalued relative to purchasing power parity? Changing the price of a Big Mac in Switzerland into U.S. prices shows that the Swiss Big Mac has a dollar price of 6.50 francs ÷ 0.98 francs per dollar which is $6.63. The Swiss franc was overvalued relative to purchasing power parity.

c. Do you think the price of a Big Mac in different countries provides a valid test of purchasing power parity? The price of a Big Mac is the price of only one good. Purchasing power parity applies to national price levels not to the price of an individual good. Using an individual good means that local supply and demand conditions might lead the price to diverge from purchasing power parity.

13.

The price level in the Eurozone is 124, the price level in the United States is 115, and the nominal exchange rate is 0.80 euros per U.S. dollar. What is the real exchange rate expressed as Eurozone real GDP per unit of U.S. real GDP? The real exchange rate equals (E × P)/P* in which E is the nominal exchange rate, P is the U.S. price level, and P* is the Eurozone price level. The real exchange rate is (.80 × 115)/124 = .742 Eurozone real GDP per unit of U.S. real GDP.

14.

The U.S. price level is 115, the Japanese price level is 92, and the real exchange rate is 98.75 Japanese real GDP per unit of U.S. real GDP. What is the nominal exchange rate? The real exchange rate equals (E × P)/P* in which E is the nominal exchange rate, P is the U.S. price level, and P* is the Japanese price level. Rearranging this formula gives E = (real exchange rate × P*)/P. Using the rearranged formula, the nominal exchange rate equals (98.75 × 92)/115 = 79.0 yen per dollar.

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Dollar Hits All-Time Low vs. Yen The dollar fell as low as 76.54 against the yen in late trading Wednesday, as global uncertainty and the prospect of more cash flowing into Japan pushed its currency higher. The previous all-time low for the dollar in terms of the yen was 79.75 set in April 1995. The strong yen is making Japanese exports more expensive. Source: CNN Money, March 16, 2012 On a graph of the foreign exchange market show the effects of a. Japanese exports becoming more expensive. When the exchange rate falls, imported goods and services from Japan (which are Japanese exports from the perspective of Japan) become more expensive to U.S. residents. U.S. residents decrease the quantity of Japanese imports they buy so the quantity of dollars supplied (to buy Japanese yen) decreases. There is a movement downward along the supply curve for U.S. dollars, as illustrated by the grey arrow in Figure 9.1 moving downward along the supply of dollars curve S1.

b. The prospect of more cash flowing into Japan. If investors step-up buying yen, they must sell dollars so the supply of dollars increases. In Figure 9.1, the increase in the supply of dollars shifts the supply curve rightward from S0 to S1. As illustrated in the figure, the increase in the supply of dollars lowers the U.S. exchange rate.

16.

With the strengthening of the yen against the U.S. dollar in 2012, Japan’s central bank did not take any action. A Japanese politician called on the central bank to take actions to weaken the yen, saying it will help exporters in the short run and have no long-run effects. a. What is Japan’s current exchange rate policy? Japan’s current exchange rate policy is a flexible exchange.

b. What does the politician want the exchange rate policy to be in the short run? Why would such a policy have no effect on the exchange rate in the long run? The politician wants the exchange rate to be a crawling peg by lowering it over a period of time. This policy has no effect on the exchange rate in the long run because in the long run the real exchange rate is determined by supply and demand for the nation’s goods. In addition, the nominal exchange rate adjusts to make the ratio of the nations’ price levels equal to the real exchange rate.

17.

The Federal Reserve in the International Sphere Under flexible exchange rates, the main aim of Federal Reserve foreign currency operations has been to counter disorderly conditions in exchange markets through the purchase or sale of foreign currencies (called foreign exchange intervention operations), primarily in the New York market. During some episodes of downward pressure on the foreign exchange value of the dollar, the Federal Reserve has purchased dollars (sold foreign © 2014 Pearson Education, Inc.

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currency) and has thereby absorbed some of the selling pressure on the dollar. Similarly, the Federal Reserve may sell dollars (purchase foreign currency) to counter upward pressure on the dollar’s foreign exchange value. The Federal Reserve Bank of New York also executes transactions in the U.S. foreign exchange market for foreign monetary authorities, using their funds. Source: Board of Governors of the Federal Reserve System a. How does U.S. exchange rate policy described above differ from that of the 1950s and 1960s? In the 1950s and 1060s the world, including the United States, was on a fixed exchange rate system. In a fixed exchange system regime, the Fed had to intervene in the foreign exchange market to block any changes in demand or supply. Fed intervention in the foreign exchange market was more frequent in the 1950s and 1960s.

b. Explain how the Fed “counters disorderly conditions in exchange markets.” The Fed “counters disorderly conditions in exchanges markets” by offsetting “disorderly” changes in the demand for U.S. dollars or the supply of U.S. dollars. For example, if the demand for U.S. dollars drastically increases so that the U.S. exchange rate would drastically rise, then the Fed can offset the change in the exchange rate by purchasing foreign reserves and thereby increasing the supply of U.S. dollars, which serves to lower the exchange rate. Effectively the Fed meets “disorderly” changes in the demand for U.S. dollars by similar changes in supply and “disorderly” changes in the supply of U.S. dollars by opposite changes in supply.

c. Explain why a currency can experience short-run fluctuations and how the Fed counters them. Illustrate with a graph. The exchange rate is volatile because factors that change the demand for U.S. dollars also change the supply of dollars. The supply and demand change in opposite directions (for instance, when the supply increases, the demand decreases) which creates large changes in the exchange rate. The Fed can counter these changes by sufficiently offsetting the change in supply. Figure 9.2 shows how the Fed can counter short-run fluctuations. In the figure, the demand for dollars increases and the demand curve for dollars shifts rightward from D0 to D1. In the absence of Fed action, the factor that increased the demand for dollars also decreases the supply and the supply curve of dollars shifts leftward from S0 to S1. With these changes the dollar appreciates, rising in the figure from 90 yen per dollar to 100 yen per dollar. The Fed, however, can counter this increase in the exchange rate by selling U.S. dollars to purchase foreign reserves. By selling U.S. dollars the Fed increases the supply of U.S. dollars. If the Fed increased the supply so that in Figure 9.2 the supply curve shifted to S0, there would be no effect on the exchange rate, it would remain at 90 yen per dollar.

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The table gives some information about the U.S. international transactions in 2010. a. Calculate the current account balance. The current account balance equals exports of goods and services ($1,754 billion) minus imports of goods and services ($2,215 billion) plus net interest income ($167 billion) plus net transfers (−$142 billion). So the current account balance is −$436 billion.

Item Imports of goods and services Foreign investment in the United States Exports of goods and services U.S. investment abroad Net interest income Net transfers Statistical discrepancy

Billions of U.S. dollars 2,215 1,408 1,754 1,200 167 −142 231

b. Calculate the capital and financial account balance. The capital and financial account balance equals foreign investment in the United States ($1,408 billion) minus U.S. investment abroad ($1,200 billion) plus the statistical discrepancy ($231 billion). So the capital and financial account balance is $439 billion.

c. Did U.S. official reserves increase or decrease? The official settlements account balance equals − current account balance ($436 billion) − capital and financial account balance ($439 billion). So the official settlements account balance is −$3 billion. Because the official settlements account is negative, U.S. official reserves are increasing.

d. Was the United States a net borrower or a net lender in 2010? Explain your answer. The United States was a net borrower because foreign investment in the United States exceeded U.S. investment abroad.

19.

The United States is a debtor nation, and since 1980 it has piled up trade deficits that total $9 trillion. At its peak in 2006, the current account deficit was almost 6 percent of GDP. To pay for the $9 trillion of goods and services we’ve imported in excess of our exports, we have borrowed from the rest of the world. Foreigners have purchased large amounts of U.S. assets. a. Explain why a current account deficit means we must borrow from the rest of the world. A current account deficit means that the United States is spending more on imports than it is receiving for exports. As a result the United States must finance the deficit. It does so by borrowing from the rest of the world. This borrowing is a capital inflow.

b. Under what circumstances does the debtor nation status of the United States be a concern? Whether we should be concerned with U.S. debtor nation status depends on what the debt has been used to finance. If the international debt has been used to finance investment, then the debt is not a major concern because the investment will generate a return sufficient to repay the loan. But if the international debt has been used to finance consumption, then the debt is a problem because the funds to repay the loan will need to be taken from what otherwise would have been used for consumption expenditure or investment in the United States.

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Answers to Additional Problems and Applications 20.

Suppose that yesterday, the U.S. dollar was trading on the foreign exchange market at 0.75 euros per U.S. dollar and today the U.S. dollar is trading at 0.80 euros per U.S. dollar. Which of the two currencies (the U.S. dollar or the euro) has appreciated and which has depreciated today? The U.S. dollar appreciated because its exchange rate rose. The euro depreciated because its exchange rate fell (from 1.33 U.S. dollars per euro to 1.25 U.S. dollars per euro).

21.

Suppose that the exchange rate fell from 80 yen per U.S. dollar to 70 yen per U.S. dollar. What is the effect of this change on the quantity of U.S. dollars that people plan to buy in the foreign exchange market? The fall in the exchange rate increases the quantity of U.S. dollars that people plan to buy in the foreign exchange market.

22.

Suppose that the exchange rate rose from 80 yen per U.S. dollar to 90 yen per U.S. dollar. What is the effect of this change on the quantity of U.S. dollars that people plan to sell in the foreign exchange market? The rise in the exchange rate increases the quantity of U.S. dollars that people plan to sell in the foreign exchange market.

23.

Today’s exchange rate between the yuan and the U.S. dollar is 6.40 yuan per dollar and the central bank of China is buying U.S. dollars in the foreign exchange market. If the central bank of China did not purchase U.S. dollars would there be excess demand or excess supply of U.S. dollars in the foreign exchange market? Would the exchange rate remain at 6.40 yuan per U.S. dollar? If not, which currency would appreciate? In the absence of the purchases by the central bank of China there would be an excess supply of U.S. dollars in the foreign exchange market. Without these purchases, the exchange rate would fall from 6.40 yuan per dollar to something lower. The Chinese yuan would appreciate (and the U.S. dollar would depreciate).

24.

Yesterday, the current exchange rate was $1.05 Canadian per U.S. dollar and traders expected the exchange rate to remain unchanged for the next month. Today, with new information, traders now expect the exchange rate next month to fall to $1 Canadian per U.S. dollar. Explain how the revised expected future exchange rate influences the demand for U.S. dollars, or the supply of U.S. dollars, or both in the foreign exchange market. The revision in the expected future exchange rate lowers the expected profit from holding U.S. dollars and thereby affects both the demand for U.S. dollars and the supply of U.S. dollars. The fall in the expected profit from holding dollars decreases the demand for U.S. dollars because people would rather more profitable currencies. It also increases the supply of U.S. dollars as people supply dollars in order to buy other, more profitable currencies.

25.

In 2011, the exchange rate changed from 94 yen per U.S. dollar in January to 84 yen per U.S. dollar in June, and back to 94 yen per dollar in December. What information would you need to determine the factors that caused these changes in the exchange rate? Which factors would change both demand and supply? The factors that influence the U.S. exchange rate include the Japanese demand for U.S. exports; the U.S. demand for Japanese imports; the U.S. interest rate relative to the Japanese interest rate; and, the expected future exchange rate. Changes in any of these factors will change the U.S. exchange rate. Changes in the U.S. interest rate differential and the excepted future exchange rate change both demand and supply.

26.

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for which has increased rapidly as China and other emerging economies expand. a. Explain how growth in the demand for Australia’s natural resources would affect the demand for Australian dollars in the foreign exchange market. The growth in demand for Australia’s natural resources increases the demand for Australian dollars.

b. Explain how the supply of Australian dollars would change. Absent any change in the expected future exchange rate, the supply of Australian dollars does not change (there is a change in the quantity supplied).

c. Explain how the value of the Australian dollar would change. The increase in demand for Australian dollars raises the value of the Australian dollar.

d. Illustrate your answer with a graphical analysis. Figure 9.3 Illustrates the effect of the increase in demand for Australian dollars. The demand curve for Australian dollars shifts rightward, from D0 to D1. The supply curve does not shift. The exchange rate rises from 90 yen per Australian dollar to 95 yen per Australian dollar.

Use the following news clip to work Problems 27 and 28. Indian Entrepreneur Seeks Opportunities Rahul Reddy, an Indian real estate entrepreneur, believes that “The United States is good for speculative higher-risk investments.” He profited from earlier investment in Australia and a strong Australian dollar provided him with the funds to enter the U.S. real estate market at prices that he believed “we will probably not see for a long time.” He said, “The United States is an economic powerhouse that I think will recover, and if the exchange rate goes back to what it was a few years ago, we will benefit.” Based on an article in Forbes, July 10, 2008 27.

Explain why Mr. Reddy is investing in the U.S. real estate market. At the time of the news article, the U.S. dollar had depreciated. The short-run effect of this depreciation was to make U.S. goods and services and U.S. properties less expensive for foreigners. Mr. Reddy, among others, was trying to take advantage of the lower price by purchasing investment properties and development opportunities in the United States.

28.

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Would expectations become self-fulfilling? Mr. Reddy’s actions increase the demand for U.S. dollars. If others take similar actions, the demand for U.S. dollars increases. If U.S. residents also begin to believe that buying U.S. investment properties offers a profitable opportunity, the supply of U.S. dollars decreases as U.S. residents purchase U.S. properties rather than foreign properties. In addition, Mr. Reddy is expecting that the dollar will appreciate back to its previous level. If others have the same expectation, once again the demand for dollars increases and the supply of dollars decreases. On both counts, the dollar appreciates. This change in the exchange rate resembles a self-fulfilling prophecy because market participants expect the dollar to appreciate and, as a result, it does so. Of course, the fundamental reason for the change is the shift in people’s beliefs.

Use the following information to work Problems 29 and 30. Brazil’s Overvalued Real The Brazilian real has appreciated 33 percent against the U.S. dollar and has pushed up the price of a Big Mac in Sao Paulo to $4.60, higher than the New York price of $3.99. Despite Brazil’s interest rate being at 8.75 percent a year compared to the U.S. interest rate at near zero, foreign funds flowing into Brazil surged in October. Source: Bloomberg News, October 27, 2009 29.

Does purchasing power parity hold? If not, does PPP predict that the Brazilian real will appreciate or depreciate against the U.S. dollar? Explain. Purchasing power parity (PPP) does not hold because a Big Mac is significantly more expensive in Brazil than in New York. PPP predicts that the Brazilian real will depreciate against the U.S. dollar. Depreciation will reduce the number of U.S. dollars it takes to buy a Brazilian and thereby decrease the number of U.S, dollars it takes to purchase a Big Mac in Brazil back to equality with the number of dollars it takes to purchase a Big Mac in New York.

30.

Does interest rate parity hold? If not, why not? Will the Brazilian real appreciate further or depreciate against the U.S. dollar if the Fed raises the interest rate while the Brazilian interest rate remains at 8.75 percent a year? Interest rate parity holds. The difference in the interest rates is offset by the expected depreciation of the Brazilian real, so the real is expected to depreciate by 8.75 percent a year. If the Fed raises the U.S. interest rate, interest rate parity will continue to hold. Because the U.S. interest rate is now higher, the real depreciates. The higher U.S. interest rate means that the U.S. interest rate differential increases. The demand for dollars increases and the supply decreases, so the dollar immediately appreciates which means the real immediately depreciates. The real is still expected to depreciate in the future, but the expected future depreciation is less than 8.75 percent a year because the interest rate differential is smaller.

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Use the following news clip to work Problems 31 to 34. U.S. Declines to Cite China as Currency Manipulator The Bush administration has declined to cite China for manipulating its currency to gain unfair trade advantages against the United States. America’s growing trade deficit with China, which last year hit an all-time high of $256.3 billion, is the largest deficit ever recorded with a single country. Chinese currency, the yuan, has risen in value by 18.4 percent against the U.S. dollar since the Chinese government loosened its currency system in July 2005. However, American manufacturers contend the yuan is still undervalued by as much as 40 percent, making Chinese products more competitive in this country and U.S. goods more expensive in China. China buys U.S. dollar-denominated securities to maintain the value of the yuan in terms of the U.S. dollar. Source: MSN, May 15, 2008 31.

What was the exchange rate policy adopted by China until July 2005? Explain how it worked. Draw a graph to illustrate your answer. The actions in the foreign exchange market of the People’s Bank allowed China to maintain a fixed exchange rate with the United States. If, at the fixed exchange, there was surplus of dollars (which implies there is a shortage of yuan), the People’s Bank bought the dollars using yuan. Without this action by the People’s Bank, the surplus of dollars would have depreciated the dollar and appreciated the yuan; with this action by the People’s Bank, the exchange rate stayed fixed. Figure 9.4 shows the foreign exchange market. At the fixed exchange of 7.00 yuan per dollar, there is a surplus of $0.2 trillion U.S. dollars. If the market is allowed to reach its equilibrium exchange rate, the dollar would depreciate to 5.00 yuan per dollar, which means that the yuan would appreciate. But the People’s Bank purchased the $0.2 trillion U.S. dollar surplus and thereby kept the exchange rate pegged at 7.00 yuan per dollar. By fixing its exchange rate in order to keep the yuan from appreciating, the People’s Bank accumulated U.S. dollars.

32.

What was the exchange rate policy adopted by China after July 2005? Explain how it works. After July 2005 China has not allowed a truly flexible exchange rate. Instead China uses a crawling peg policy, in which the exchange rate is allowed to make small changes.

33.

Explain how fixed and crawling peg exchange rates can be used to manipulate trade balances in the short run, but not the long run. Changes in fixed and crawling peg exchange rates can affect the trade balance in the short run because these changes affect the relative price of the domestically-produced good and the foreign good. But changes in fixed and crawling peg exchange rates cannot affect the trade balance in the long run because the trade balance is (ultimately) determined by the real exchange rate. In the long run, the price levels will adjust to create a real exchange rate that balances trade.

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34.

153

Explain the long-run effect of China’s current exchange rate policy. A crawling peg exchange rate ties (but does not “perfectly” link) the inflation rate in the crawling nation to the inflation rate of its trading partner. The inflation rate in the crawling nation cannot rise significantly above that of its trading partner. If inflation in the crawling nation rises above inflation in the trading partner, the crawling nation eventually starts to run a current account deficit and there is a surplus of its currency on the foreign exchange market. If the nation’s central bank attempts to maintain the crawl by selling foreign currency and buying its currency, eventually the central bank runs out of foreign currency and is forced to abandon its crawl. So the crawling peg exchange rate policy limits inflation in the country.

35.

Aussie Dollar Hit by Interest Rate Talk The Australian dollar fell against the U.S. dollar to its lowest value in the past two weeks. The CPI inflation was reported to be generally as expected, but not high enough to justify expectations for an aggressive interest rate rise by Australia’s central bank next week. Source: Reuters, October 28, 2009 a. What is Australia’s exchange rate policy? Explain why expectations about the Australian interest rate lowered the value of the Australian dollar against the U.S. dollar. Because the Australian dollar was allowed to fall, the central bank must be following a flexible exchange rate policy. When Australia’s central bank raises the interest rate, the demand for Australian dollars increases and the supply decreases, so the Australian exchange rate rises. Before the report, traders expected the Australian central bank would raise the interest rate at some point in the future, which meant that the (expected) future exchange rate would rise. But the report indicated that the interest rate would not rise, which thereby decreased the expected future exchange rate. The fall in the expected future exchange rate decreases the demand for Australian dollars and increases the supply of Australian dollars, thereby lowering the Australian exchange rate.

b. To avoid the fall in the value of the Australian dollar against the U.S. dollar, what action could the central bank of Australia have taken? Would such an action signal a change in Australia’s exchange rate policy? To avoid a fall in the Australian exchange rate, the central bank of Australia could have entered the foreign exchange market to purchase Australian dollars or it could have immediately raised the exchange rate. If the central bank prevented 100 percent of the change in the exchange rate, then the central bank would be pegging the exchange rate. If it prevented some of the change in the exchange rate, then the central bank might be allowing the exchange rate to crawl. In either case, however, the exchange rate regime would no longer be flexible.

Use the table to work Problems 36 to 38. The table gives some data about the U.K. economy: 36.

Calculate the private sector balance. The private sector balance equals saving (£162 billion) minus investment (£181 billion), which is −£19 billion.

37.

Calculate the government sector balance.

Item Consumption expenditure Exports of goods and services Government expenditure Net taxes Investment Saving

Billions of U.K. pounds 721 277 230 217 181

The government sector balance is equal to net taxes (£217 billion) minus government expenditures on goods and services (£230 billion), which is −£13 billion.

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Calculate net exports and show the relationship between the government sector balance and net exports. Net exports equals the private sector balance (−£19 billion) plus the government sector balance (−£13 billion), which is −£32 billion. The U.K. had a net export deficit of £32 billion. The government sector balance plus the private sector balance equals net exports. If the government sector balance changes and the private sector balance does not change, then net exports change by the same amount as the change in the government sector balance.

Economics in the News 39.

After you have studied Reading Between the Lines on pp. 232–233 (638–639 in Economics), answer the following questions. a. What happened to the U.S. dollar in August 2012? The dollar fell against both the euro and the yen.

b. What could the Fed have done to stop the fall in the dollar? The Fed could have purchased U.S. dollars in the foreign exchange market by selling foreign reserves. The Fed’s actions would have increased the demand for dollars and thereby lessened the dollar’s fall.

c. What could the European Central Bank have done that might have stopped the euro from rising? The European Central Bank could have sold euros by purchasing foreign reserves. The European Central Bank’s actions would have increased the supply of euros and thereby lessened the euro’s rise.

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d. How does the Bank of Japan (BoJ) enter the story of the U.S. dollar-euro exchange rate? Although the BoJ didn’t and wasn’t expected to make any policy changes, why does that matter for the U.S dollar and the euro? By its purchase or sale of foreign reserves, mainly U.S. dollars, the Bank of Japan can increase or decrease the demand for U.S. dollars. For example, if the Bank of Japan had intervened to limit the rise in the yen by purchasing U.S. dollars (and thereby supplying yen) the increase in the demand for U.S. dollars would have moderated the rise in the euro/dollar exchange rate. The point that the Bank of Japan was not expected to make any policy changes means that traders do not expect actions by the Bank of Japan to change the demand for U.S. dollars in the future. Therefore traders will not change their expected future exchange rate, which eliminates the effect from this influence from the current foreign exchange market.

If the dollar continues a downward slide against the euro, what do you predict will be the consequences for U.S. and European inflation rates? Purchasing power parity implies that if the U.S. dollar continues to fall, it is likely that the U.S. inflation rate will rise. Similarly, if the euro continues to rise, it is likely that the European inflation rate will fall.

C h a p t e r

AGGREGATE SUPPLY AND AGGREGATE DEMAND**

Answers to the Review Quizzes Page 245 1.

(page 651 in Economics)

If the price level and the money wage rate rise by the same percentage, what happens to the quantity of real GDP supplied? Along which aggregate supply curve does the economy move? If the price level and the money wage rate rise by the same percentage, there is no change in the quantity of real GDP supplied and a movement occurs up along the LAS curve.

If the price level rises and the money wage rate remains constant, what happens to the quantity of real GDP supplied? Along which aggregate supply curve does the economy move? If the price level rises and the money wage rate remains constant the quantity of real GDP supplied increases and the economy moves along the SAS curve.

If potential GDP increases, what happens to aggregate supply? Does the LAS curve shift or is there a movement along the LAS curve? Does the SAS curve shift or is there a movement along the SAS curve? If potential GDP increases both long-run aggregate supply and short-run aggregate supply increase and the LAS curve and SAS curve shift rightward.

If the money wage rate rises and potential GDP remains the same, does the LAS curve or the SAS curve shift or is there a movement along the LAS curve or the SAS curve? If the money wage rate rises and potential GDP remains the same there is a decrease in short-run aggregate supply and no change in long-run aggregate supply. The SAS curve shifts leftward and the LAS curve is unchanged.

Page 249 1.

(page 655 in Economics)

What does the aggregate demand curve show? What factors change and what factors remain the same when there is a movement along the aggregate demand curve? The aggregate demand curve shows the relationship between the quantity of real GDP demanded and the price level when other influences on expenditure plans remain the same. When there is a movement along the aggregate demand curve, the price level changes and other factors such as expectations, fiscal and monetary policy, and the world economy remain the same.

Why does the aggregate demand curve slope downward? The aggregate demand curve slopes downward because of the wealth effect and two substitution effects. First, a rise in the price level decreases real wealth, which brings an increase in saving and a decrease in spending—the wealth effect. Second, a rise in the price level raises the interest *

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rate, which decreases borrowing and spending—an intertemporal substitution effect as people decrease current spending in favor of future spending—and increases the price of domestic goods and services relative to foreign goods and services, which decreases exports and increases imports—an international substitution effect.

How do changes in expectations, fiscal policy and monetary policy, and the world economy change aggregate demand and the aggregate demand curve? Aggregate demand increases and the AD curve shifts rightward if: expected future income, expected future inflation, or expected future profits increase; government expenditure increases or taxes are cut; the quantity of money increases and the interest rate is cut; the exchange rate falls; or foreigners’ income increases. The reverse changes decrease aggregate demand and shift the AD curve leftward.

Page 255 1.

(page 661 in Economics)

Does economic growth result from increases in aggregate demand, short-run aggregate supply, or long-run aggregate supply? Economic growth results from increases in long-run aggregate supply. Economic growth occurs because the quantity of labor increases, capital is accumulated and there are technological advances over time. All three of these factors increase potential GDP and shift the LAS curve rightward.

Does inflation result from increases in aggregate demand, short-run aggregate supply, or long-run aggregate supply? Inflation results from increases in aggregate demand that exceed the increase in long-run aggregate supply. As the aggregate demand curve shifts rightward the price level rises. Increases in AD that exceed increases in LAS produce inflation.

Describe three types of short-run macroeconomic equilibrium. Short-run macroeconomic equilibrium occurs when the quantity of real GDP demanded equals the quantity of real GDP supplied. There are three types of short-run equilibrium: below fullemployment equilibrium where a recessionary gap exists with real GDP less than potential GDP; above full-employment equilibrium where an inflationary gap exists with real GDP greater than potential GDP; full-employment equilibrium where no gap exists and real GDP equals potential GDP.

How do fluctuations in aggregate demand and short-run aggregate supply bring fluctuations in real GDP around potential GDP? Fluctuations in aggregate demand with no change in short-run aggregate supply bring fluctuations in real GDP around potential GDP. For instance, starting from full employment, a decrease in aggregate demand decreases the price level and real GDP and creates a recessionary gap. In the long run the money wage rate (and the money prices of other resources) falls so that short-run aggregate supply increases and the economy returns to its full employment equilibrium. Starting from full employment, a decrease in short-run aggregate supply decreases real GDP and raises the price level. The fall in real GDP combined with a rise in the price level is a phenomenon called stagflation.

Page 257 1.

(page 663 in Economics)

What are the defining features of classical macroeconomics and what policies do classical macroeconomists recommend? Classical macroeconomists believe that the economy is self-regulating and always at full employment. Classical macroeconomists assert that the proper government policy is to minimize the disincentive effects of taxes on employment, investment, and technological change. © 2014 Pearson Education, Inc.

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What are the defining features of Keynesian macroeconomics and what policies do Keynesian macroeconomists recommend? Keynesian macroeconomists believe that if the economy was left alone, it would rarely operate at full employment. To achieve and maintain full employment the economy needs active help from fiscal and monetary policy. Aggregate demand fluctuations combined with a very sticky money wage rate are the major sources of the business cycle. Keynesian macroeconomists assert that active fiscal and monetary policy, designed to offset fluctuations in aggregate demand, are the proper government policies.

What are the defining features of monetarist macroeconomics and what policies do monetarist macroeconomists recommend? Monetarists believe that the economy is self-regulating and will typically operate at full employment if monetary policy is not erratic and the money growth rate is kept steady. The major source of business cycle fluctuations are similar to the Keynesian view, that is, changes in aggregate demand combined with a sticky money wage rate. However, according to monetarists, the changes in aggregate demand are the result of fluctuations in the growth rate of money caused by the Federal Reserve. Monetarists assert that the proper government policies are low taxes, to avoid the disincentive effects stressed by classical macroeconomists, and steady monetary growth.

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Answers to the Study Plan Problems and Applications 1.

Explain the influence of each of the following events on the quantity of real GDP supplied and aggregate supply in India and use a graph to illustrate. • U.S. firms move their call handling, IT, and data functions to India. Moving call-handling, IT, and data functions to India increases short-run and long-run aggregate supply because it increases the amount of employment at full employment and (probably) also increases the capital stock. As Figure 10.1 shows, both the short run aggregate supply curve and long-run aggregate supply curve shift rightward, from SAS0 to SAS1 and from LAS0 to LAS1.

•

Fuel prices rise. The rise in fuel prices raises firms’ costs. Short-run aggregate supply decreases and the short-run aggregate supply curve shifts leftward. Long-run aggregate supply does not change. Figure 10.2 shows the leftward shift of the short-run aggregate supply curve from SAS0 to SAS1.

•

Wal-Mart and Starbucks open in India. When Starbucks and Wal-mart open in India, short-run and long-run aggregate supply increase. When these stores open, employment at full employment increases and India’s capital stock increases. Both the short-run and long-run aggregate supply curves shift rightward, as illustrated in Figure 10.1.

•

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run and long-run aggregate supply increases, as shown in Figure 10.1 by the rightward shifts in the short-run and long-run aggregate supply curves.

•

The money wage rate rises. An increase in the money wage rate increases firms’ costs. Short-run aggregate supply decreases but long-run aggregate supply does not change. Long-run aggregate supply does not change because in the long run the price level rises by the same percentage the money age rate increased, so in the long run employment does not change. This situation is illustrated in Figure 10.2, in which the short-run aggregate supply curve shifts leftward and the long-run aggregate supply curve does not change.

•

The price level in India increases. In the short run, an increase in the price level increases the quantity of real GDP demanded. In the long run, the money wage rate rises by the same percentage so in the long run there is no change in the quantity of real GDP supplied. These results are illustrated in Figure 10.3 by the grey arrows showing the movement along the short-run aggregate supply curve, SAS, and the movement along the long-run aggregate supply curve, LAS.

Wages Rising Faster than Prices Paychecks in Kansas are growing, according to the U.S. Department of Labor. Jacqueline Midkiff, with the department's office in Kansas City, says the average overall increase across the board through the Midwest, is 1.9 percent over this time last year, while inflation grew at 1.4 percent for the same time period. Source: Kansas Public Radio, August 1, 2012 Explain how “the average overall increase across the board” wage increase will influence aggregate supply. The “average overall increase across the board” in the money wage rate decreases the short-run aggregate supply and shifts the short-run aggregate supply curve leftward. It has no effect on the long-run aggregate supply because it does not change potential GDP.

Labor productivity is rising at a rapid rate in China and wages are rising at a similar rate. Explain how a rise in labor productivity and wages in China will influence the quantity of real GDP supplied and aggregate supply in China. The rise in labor productivity increases potential GDP and increases aggregate supply. The shortrun and long-run aggregate supply curves shift rightward. The rise in the money wage rate in China decreases short-run aggregate supply and shifts the short-run aggregate supply curve leftward. It has no effect on potential GDP or on the long-run aggregate supply curve. © 2014 Pearson Education, Inc.

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Canada trades with the United States. Explain the effect of each of the following events on Canada’s aggregate demand. • The government of Canada cuts income taxes. Cutting income taxes increases aggregate demand because it increases people’s disposable incomes.

•

The United States experiences strong economic growth. Strong growth in the United States increases U.S. demand for Canadian exports. Canadian exports are a component of Canada’s aggregate demand so the increase in demand for Canada’s exports means that Canada’s aggregate demand increases.

•

Canada sets new environmental standards that require power utilities to upgrade their production facilities. To upgrade their facilities, power utilities must increase their investment. Investment is a component of aggregate demand so an increase in investment means that Canada’s aggregate demand increases.

The Fed cuts the quantity of money and all other things remain the same. Explain the effect of the cut in the quantity of money on aggregate demand in the short run. A decrease in the quantity of money decreases aggregate demand and shifts the AD curve leftward. By cutting the quantity of money, the interest rate rises, so firms decrease their investment and households cut back their expenditure on new homes, new cars, and other bigticket items. The decrease in consumption expenditure and investment both decrease aggregate demand.

Mexico trades with the United States. Explain the effect of each of the following events on the quantity of real GDP demanded and aggregate demand in Mexico. • The United States goes into a recession. If the United States goes into a recession, the demand for Mexican exports decreases. Exports are a component of aggregate demand, so the decrease in exports decreases Mexico’s aggregate demand.

•

The price level in Mexico rises. The rise in the Mexican price level decreases the quantity of real GDP demanded in Mexico. There is no change in Mexico’s aggregate demand.

•

Mexico increases the quantity of money. An increase in the quantity of money lowers the interest rate and increases consumption expenditure and investment. Mexico’s aggregate demand increases.

Gross Domestic Product for the Second Quarter of 2012 The increase in real GDP in the second quarter primarily reflected increases in personal consumption expenditures, exports, and investment. Government spending decreased. Source: Bureau of Economic Analysis, August 29, 2012 Explain how the items in the news clip influence U.S. aggregate demand. The increase in consumption expenditures, exports, and investment all increase U.S. aggregate demand. The decrease in government spending decreases U.S. aggregate demand.

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Use Figure 10.4 to work Problems 8 to 10. Initially, the short-run aggregate supply curve is SAS0 and the aggregate demand curve is AD0. 8.

Some events change aggregate demand from AD0 to AD1. Describe two events that could have created this change in aggregate demand. What is the equilibrium after aggregate demand changed? If potential GDP is $1 trillion, the economy is at what the type of macroeconomic equilibrium? Aggregate demand increases when the aggregate demand curve shifts from AD0 to AD1. Aggregate demand increases if expected future income, expected future inflation, or expected future profit increases; if the government cuts taxes, increases its expenditure on goods and services, or increases its transfer payments; if the Fed lowers the interest rate; or if the U.S. exchange rate falls or foreign income increases. After the change in aggregate demand, equilibrium is at point C: real GDP is $1.1 trillion and the price level is 105. The economy is at an above full-employment equilibrium with an inflationary gap.

Some events change aggregate supply from SAS0 to SAS1. Describe two events that could have created this change in aggregate supply. What is the equilibrium after aggregate supply changed? If potential GDP is $1 trillion, does the economy have an inflationary gap, a recessionary gap, or no output gap? Aggregate supply decreases when the aggregate supply curve shifts from AS0 to AS1. Aggregate supply decreases if potential GDP decreases; if the money wage rate rises; or if the money prices of other resources rise. After the change, equilibrium is at point A: real GDP is $0.9 trillion and the price level is 105. The economy is at a below full-employment equilibrium with a recessionary gap.

10.

Some events change aggregate demand from AD0 to AD1 and aggregate supply from SAS0 to SAS1. What is the new macroeconomic equilibrium? After the changes, equilibrium is at point D: real GDP is $1.0 trillion and the price level is 110. The economy is at a full-employment equilibrium.

Use the following data to work Problems 11 to 13. The following events have occurred in the history of the United States: • A deep recession hits the world economy. • The world oil price rises sharply. • U.S. businesses expect future profits to fall. 11.

Explain for each event whether it changes short-run aggregate supply, long-run aggregate supply, aggregate demand, or some combination of them. A deep recession in the world economy decreases aggregate demand. A sharp rise in oil prices decreases short-run aggregate supply. The expectation of lower future profits decreases investment and decreases aggregate demand. © 2014 Pearson Education, Inc.

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Explain the separate effects of each event on U.S. real GDP and the price level, starting from a position of long-run equilibrium. A deep recession in the world economy decreases aggregate demand, which decreases real GDP and lowers the price level. A sharp rise in oil prices decreases short-run aggregate supply, which decreases real GDP and raises the price level. The expectation of lower future profits decreases investment and decreases aggregate demand, which decreases real GDP and lowers the price level.

13.

Explain the combined effects of these events on U.S. real GDP and the price level, starting from a position of long-run equilibrium. The combined effect of a deep recession in the world economy, a sharp rise in oil prices, and the expectation of lower future profits decreases both aggregate demand and short-run aggregate supply, which decreases real GDP and the price level rises, falls, or remains the same.

Use the following data to work Problems 14 and 15. The table shows the aggregate demand and short-run aggregate supply schedules of a country in which potential Price level GDP is $1,050 billion. 100 14. What is the short-run equilibrium 110 real GDP and price level? 120 The short-run equilibrium real 130 GDP and price level are 140 determined by the price level that 150 sets the quantity of real GDP 160

Real GDP Real GDP supplied in demanded the short run (billions of 2005 dollars) 1,150 1,050 1,100 1,100 1,050 1,150 1,000 1,200 950 1,250 900 1,300 850 1,350

demanded equal to the quantity of real GDP supplied in the short run. From the table, the short-run equilibrium real GDP is $1,100 billion and the price level is 110.

15.

Does the country have an inflationary gap or a recessionary gap and what is its magnitude? Equilibrium real GDP exceeds potential GDP, so the country has an inflationary gap. The inflationary gap equals the difference between real GDP and potential GDP, which is $50 billion.

16.

Geithner Urges Action on Economy

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Treasury Secretary Timothy Geithner is reported as having said that the United States can no longer rely on consumer spending to be the growth engine of recovery from recession. Washington needs to plant the seeds for business investment and exports. “We can’t go back to a situation where we’re depending on a near short-term boost in consumption to carry us forward,” he said. Source: The Wall Street Journal, September 12, 2010 a. Explain the effects of an increase in consumer spending on the short-run macroeconomic equilibrium. Consumption expenditure is part of aggregate demand, so an increase in consumer expenditure increases aggregate demand and shifts the aggregate demand curve rightward. As illustrated in Figure 10.5, the rightward shift of the aggregate demand curve from AD0 to AD1 increases real GDP and raises the price level.

b. Explain the effects of an increase in business investment on the short-run macroeconomic equilibrium. Investment is part of aggregate demand, so an increase in investment increases aggregate demand and shifts the aggregate demand curve rightward. As illustrated in Figure 10.5, the rightward shift of the aggregate demand curve from AD0 to AD1 increases real GDP and raises the price level.

c. Explain the effects of an increase in exports on the short-run macroeconomic equilibrium. Exports are part of aggregate demand, so an increase in exports increases aggregate demand and shifts the aggregate demand curve rightward. As illustrated in Figure 10.5, the rightward shift of the aggregate demand curve from AD0 to AD1 increases real GDP and raises the price level.

17.

Describe what a classical macroeconomist, a Keynesian, and a monetarist would want to do in response to each of the events listed in Problem 11. Classical and monetarist economists probably would recommend no policy action for all three of the events. If they suggested any policy at all, the policy would involve cutting taxes. A Keynesian economist likely would suggest several policies for all three events, such as the U.S. government should increase aggregate demand by increasing its expenditure on goods and services or by cutting taxes. The Keynesian economist also would suggest that the Fed should increase the quantity of money and lower interest rates.

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Krugman on Monetary and Fiscal Policy New York Times columnist and Nobel Laureate economist Paul Krugman has launched an all-out attack on the monetary policy actions and inactions of Fed Chairman Ben Bernanke. Bernanke has increased the quantity of money by historically large amounts and in mid2012 was cautiously trying to determine whether more stimulation was needed. Krugman says Bernanke is too cautious and should print money faster and move the inflation rate upward. Krugman also wants Congress to cut taxes and increase spending. And his advice to boost government spending isn’t limited to the United States. He says European governments should boost their spending too. Sources: The New York Times, Washington Post, and other papers and blogs, April, 2012 a. Explain which macroeconomic school of thought Paul Krugman most likely represents in the views described above. Mr. Krugman most likely follows the Keynesian (or new Keynesian) approach because he is making proposals that increase aggregate demand to offset the recessionary economy.

b. Explain which macroeconomic school of thought supports Ben Bernanke’s actions described above. Mr. Bernanke has been conducting monetary policy to fight the recession, so he most likely follows the Keynesian (or new Keynesian) approach, albeit not as forceful as Mr. Krugman.

19.

Based upon the news clip in Problem 16, explain which macroeconomic school of thought Treasury Secretary Timothy Geithner most likely follows. The clip does not make totally clear Mr. Geithner’s views. He stated that “Washington needed to plant the seeds for business investment and exports.” If “planting the seeds” means cutting taxes to minimize their disincentive effects, then Mr. Geithner might follow the classical school. Much more likely, however, Mr. Geithner is recommending an active fiscal policy of tax cutting in order to combat the recession. In this case Mr. Geithner is following the Keynesian school.

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Answers to Additional Problems and Applications 20.

Explain for each event whether it changes the quantity of real GDP supplied, short-run aggregate supply, long-run aggregate supply, or a combination of them. • Automotive firms in the United States switch to a new technology that raises productivity. When firms switch to a new technology, both the short-run aggregate supply and the long-run aggregate supply increase.

•

Toyota and Honda build additional plants in the United States. Building new plants in the United States increases the U.S. capital stock and thereby increases both the short-run aggregate supply and the long-run aggregate supply.

•

The prices of auto parts imported from China rise. The increase in the price of auto parts imported from China decreases the short-run aggregate supply because the cost of producing automobiles increases. There is no effect on the long-run aggregate supply.

•

Autoworkers agree to a lower money wage rate. The lower money wage rate increases short-run aggregate supply because the cost of producing automobiles falls. There is no effect on the long-run aggregate supply.

•

The U.S. price level rises. The increase in the price level increases the short-run quantity of real GDP supplied. It has no effect on the long-run quantity of real GDP supplied.

21.

Explain for each event whether it changes the quantity of real GDP demanded or aggregate demand. • Automotive firms in the United States switch to a new technology that raises productivity. The new technology increases aggregate supply, which creates a change in the quantity of real GDP demanded.

•

Toyota and Honda build new plants in the United States. Building new plants in the United States increases U.S. aggregate supply, which brings a change in the aggregate quantity demanded. Building the new plants also increases investment, which increases aggregate demand.

•

Autoworkers agree to a lower money wage rate. A fall in the nominal wage rate increases (short-run) aggregate supply, which leads to a change in the quantity of real GDP demanded.

•

The U.S. price level rises. The rise in the U.S. price level leads to a change in the quantity of real GDP demanded.

22.

Inventory Investment Decreases When real GDP increased in the second quarter of 2012, consumption expenditure, exports, and fixed investment increased but business inventory investment fell. Source: Bureau of Economic Analysis, August 29, 2012 Explain how a fall in inventories influences aggregate demand. Inventories are a component of investment and investment is a component of aggregate demand. When inventories decrease, investment decreases so that aggregate demand decreases.

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Exports and Imports Increase Real exports of goods and services increased 6.0 percent in the second quarter, compared with an increase of 4.4 percent in the first. Real imports of goods and services increased 2.9 percent, compared with an increase of 3.1 percent. Source: Bureau of Economic Analysis, August 29, 2012 Explain how the changes in exports and imports reported here influence the quantity of real GDP demanded and aggregate demand. In which of the two quarters reported did exports and imports make the greater contribution to aggregate demand growth? Net exports is part of aggregate demand, which means that an increase in net exports increases aggregate demand. Net exports equals exports minus imports, so an increase in exports increases aggregate demand while an increase in imports decreases aggregate demand. In both quarters, exports increased so in both quarters exports increased aggregate demand. In both quarters, imports increased, so in both quarters imports decreased aggregate demand. The biggest contribution to economic growth was in the second quarter, because export growth rose significantly from 4.4 percent to 6.0 percent while import growth fell, from 3.1 percent to 2.9 percent.

Use the following information to work Problems 24 to 26. The following events have occurred at times in the history of the United States: • The world economy goes into an expansion. • U.S. businesses expect future profits to rise. • The government increases its expenditure on goods and services in a time of war or increased international tension. 24.

Explain for each event whether it changes short-run aggregate supply, long-run aggregate supply, aggregate demand, or some combination of them. The expansion in the world economy increases U.S. exports and increases aggregate demand. The expectation of higher profits in the future increases investment and increases aggregate demand. An increase in government expenditure on goods and services increases aggregate demand.

25.

Explain the separate effects of each event on U.S. real GDP and the price level, starting from a position of long-run equilibrium. The expansion in the world economy increases U.S. exports and increases aggregate demand, which increases real GDP and raises the price level. The expectation of higher profits in the future increases investment and boosts aggregate demand, which increases real GDP and raises the price level. The increase in government expenditure on goods and services increases aggregate demand, which increases real GDP and raises the price level.

26.

Explain the combined effects of these events on U.S. real GDP and the price level, starting from a position of long-run equilibrium. The combined effect of an expansion in the world economy, the expectation of higher profits in the future, and an increase in government expenditures increase aggregate demand, which increases real GDP and lowers the price level.

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Use the following information to work Problems 27 and 28. In Japan, potential GDP is 600 trillion Real GDP Real GDP supplied in yen. The table shows the aggregate demanded the short run demand and short-run aggregate supply Price level (trillions of 2005 yen) schedules. 75 600 400 27. a. Draw a graph of the aggregate 85 550 450 demand curve and the short-run 95 500 500 aggregate supply curve. 105 450 550 Figure 10.6 shows the aggregate 115 400 600 demand curve and the short-run 125 350 650 aggregate supply curve. 135 300 700 b. What is the short-run equilibrium real GDP and price level? Equilibrium real GDP is ¥500 trillion and the price level is 95. Short-run macroeconomic equilibrium occurs at the intersection of the aggregate demand curve and the short-run aggregate supply curve.

28.

Does Japan have an inflationary gap or a recessionary gap and what is its magnitude? Equilibrium real GDP is less than potential GDP, so Japan has a recessionary gap. The recessionary gap equals the difference between potential GDP and real GDP, which is ¥100 trillion.

Use the following information to work Problems 29 and 30. Spending by Women Jumps The magazine Women of China reported that Chinese women in big cities spent 63% of their income on consumer goods last year, up from a meager 26% in 2007. Clothing accounted for the biggest chunk of that spending, at nearly 30%, followed by digital products such as cell phones and cameras (11%) and travel (10%). Chinese consumption as a whole grew faster than the overall economy in the first half of the year and is expected to reach 42% of GDP by 2020, up from the current 36%. Source: The Wall Street Journal, August 27, 2010 29. Explain the effect of a rise in consumption expenditure on real GDP and the price level in the short run. Figure 10.7 (on the next page) shows the effect from the increase in consumption expenditure. Consumption is one of the components of aggregate demand, so an increase in consumption © 2014 Pearson Education, Inc.

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expenditure increases aggregate demand and shifts the aggregate demand curve rightward. In the figure the aggregate demand curve shifts from AD0 to AD1. Because aggregate demand increased, equilibrium real GDP increases (in Figure 10.7 from 33.0 trillion yuan to 33.2 trillion yuan) and the price level rises (in the figure from 117 to 119).

30.

If the economy had been operating at a fullemployment equilibrium, a. Describe the macroeconomic equilibrium after the rise in consumer spending. If the economy had been operating at a fullemployment equilibrium before the increase in consumer expenditure, after the increase equilibrium real GDP exceeds potential GDP. The economy is at an above full-employment equilibrium with an inflationary gap.

b. Explain and draw a graph to illustrate how the economy can adjust in the long run to restore a full-employment equilibrium. Figure 10.8 shows how the economy can adjust to its long-run equilibrium. In the short run, real GDP exceeds potential GDP. Employment exceeds full employment. The tight labor market means that the money wage rate starts to rise. As the money wage rate rises short-run aggregate supply decreases and the short-run aggregate supply curve shifts leftward. Real GDP and employment decrease. Even though employment is decreasing, as long as employment exceeds full employment, the money wage rate continues to rise and the short-run aggregate supply continues to decrease. The process ultimately ends when real GDP has decreased back to equal potential GDP and employment equals full employment. Short-run aggregate supply has decreased and the short-run aggregate supply curve has shifted from SAS0 to SAS1. At this point the price level has risen (to 121 in Figure 10.8) and real GDP has returned to potential GDP (33.0 trillion yuan).

31.

Why do changes in consumer spending play a large role in the business cycle? Changes in consumer spending play a large role in business cycles because consumption expenditure is by far the largest part of GDP. A small percentage change in consumption expenditure is a large change in GDP.

32.

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countries have been growing significantly faster than the rest of the world. Because there is no reason to believe that world production will rise miraculously at least in the immediate future, many people expect that prices will keep on rising. These expectations in turn exacerbate the inflationary process. Households buy more of nonperishable goods than they need for their immediate consumption because they expect prices to go up even further. What is worse is that traders withhold stocks from the market in the hope of being able to sell these at higher prices later on. In other words, expectations of higher prices become self-fulfilling. Source: The Times of India, June 24, 2008 Explain and draw a graph to illustrate how inflation and inflation expectations “become self fulfilling.” The news clip asserts that households increase their consumption expenditure to beat higher future prices. The increase in consumption expenditure increases aggregate demand, which then results in a rise in the price level, a self-fulfilling prophecy. Figure 10.9 shows this outcome. In the figure the aggregate demand curve shifts rightward from AD0 to AD1 because of the increase in consumption expenditure. As a result of the increase in aggregate demand, the price level rises, from 120 to 140.

33.

Cut Taxes and Boost Spending? Raise Taxes and Cut Spending? Cut Taxes and Cut Spending This headline expresses three views about what to do to get the American economy growing more rapidly and contribute to closing a large recessionary gap. Economists from which macroeconomic school of thought would recommend pursuing policies described by each of these views? The first policy, cut taxes and boost spending, would be endorsed by the Keynesian and new Keynesian schools. The second policy, raise taxes and cut spending, is endorsed by no school of thought. The third policy, cut taxes and cut spending, would be endorsed by the classical and new classical schools.

Economics in the News 34.

After you have studied Reading Between the Lines on pp. 258–259 (664–665 in Economics), answer the following questions. a. What are the main features of the U.S. economy in the second quarter of 2012? The main feature of the U.S. economy in the second quarter of 2012 was slow growth. The economy grew at a slow rate of 1.7 percent in that quarter. Boosting the tepid growth rate were increases in consumer expenditure and exports. © 2014 Pearson Education, Inc.

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b. Did the United States have a recessionary gap or an inflationary gap in 2012? How do you know? The U.S. economy had a recessionary gap. Unemployment was high and actual GDP was distinctly below potential GDP.

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c. Use the AS-AD model to show the changes in aggregate demand and aggregate supply that occurred in 2011 and 2012 that brought the economy to its situation in mid-2012. Figure 10.10 shows the changes between 2011 and 2012. There was a recessionary gap so in the figure the aggregate demand curve, AD11, and the short-run aggregate supply curve, SAS11, intersect to the left of the long-run aggregate supply curve, LAS11. Potential GDP was $14.2 trillion in 2011 and actual real GDP was only $13.3 trillion. The economy had a large recessionary gap though it would shrink slightly in 2011 and 2012. In 2011 and 2012 fiscal and monetary policy as well as an expanding world economy increased aggregate demand. Short-run aggregate supply did not change because an increase in potential GDP (which increases short-run aggregate supply) was offset by a higher money wage rate (which decreases short-run aggregate supply). The aggregate demand curve shifted rightward, to AD12 in Figure 10.10. The economy remained below full employment because the long-run aggregate supply curve had shifted rightward to LAS12. Real GDP was $13.6 trillion but potential GDP was $14.4 trillion.

d. Use the AS-AD model to show the changes in aggregate demand and aggregate supply that would occur if monetary policy cut the interest rate and increased the quantity of money by enough to restore full employment. Cutting the interest rate increases aggregate demand and shifts the aggregate demand curve rightward. Figure 10.11 shows this policy. In it the aggregate demand curve has shifted rightward from AD12 to ADpolicy. Equilibrium real GDP is $14.4 trillion, the same as potential GDP. The price level has risen, from 115 to 120.

e. Use the AS-AD model to show the changes in aggregate demand and aggregate supply that would occur if the federal government increased its expenditure on goods and services or cut taxes further by enough to restore full employment. Fiscal policy of increasing government expenditure on goods and services or cutting taxes increases aggregate demand and shifts the aggregate demand curve rightward. Figure

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10.11 shows this policy. In it the aggregate demand curve has shifted rightward from AD10 to ADpolicy. Equilibrium real GDP is $14.4 trillion, the same as potential GDP. The price level has risen, from 115 to 120.

Use the AS-AD model to show the changes in aggregate demand and aggregate supply that would occur if monetary and fiscal policy stimulus turned out to be too much and took the economy into an inflationary gap. Show the short-run and the long-run effects. If government policy leads to an inflationary gap, the aggregate demand curve will have shifted rightward so that it intersects the short-run aggregate supply curve at a point to the right of potential GDP. In Figure 10.12, the government policy would shift the aggregate demand curve to AD. The price level is 121.5 and equilibrium real GDP is $14.6 trillion while potential GDP is only $14.4 trillion. The economy has an inflationary gap. In the long run, the inflationary gap will be eliminated. For simplicity, presuming that neither potential GDP nor aggregate demand increase, the tight labor market will lead to increases in the money wage rate. As the money wage rate rises, firms’ costs increase. The short-run aggregate supply decreases and the short-run aggregate supply curve shifts leftward. Eventually aggregate supply decreases so that the short-run aggregate supply curve has shifted to SAS in Figure 10.12 At that moment, the economy is back to full employment: Equilibrium real GDP, $14.4 trillion, equals potential GDP, also $14.4 trillion. The price level, of course, has risen, in the figure from 121.5 to 122.5.

C h a p t e r

EXPENDITURE MULTIPLIERS**

Answers to the Review Quizzes Page 269 1.

(page 675 in Economics)

Which components of aggregate expenditure are influenced by real GDP? Consumption expenditure and imports are influenced by real GDP. Both increase when real GDP increases.

Define and explain how we calculate the marginal propensity to consume and the marginal propensity to save. The marginal propensity to consume is the proportion of an increase in disposable income that is consumed. In terms of a formula, the marginal propensity to consume, or MPC, can be calculated as C/YD, where  means “change in.” The marginal propensity to save is the proportion of an increase in disposable income that is saved. In terms of a formula, the marginal propensity to save, or MPS, can be calculated as S/YD.

How do we calculate the effects of real GDP on consumption expenditure and imports by using the marginal propensity to consume and the marginal propensity to import? The effects of real GDP on consumption expenditure and imports are determined respectively by the marginal propensity to consume and the marginal propensity to import. In particular, the effect of a change in real GDP on consumption expenditure equals the marginal propensity to consume multiplied by the change in disposable income. Similarly, the effect of a change in real GDP on imports equals the marginal propensity to import multiplied by the change in real GDP.

Page 273 1.

(page 679 in Economics)

What is the relationship between aggregate planned expenditure and real GDP at equilibrium expenditure? Equilibrium expenditure occurs when aggregate planned expenditure equals real GDP.

How does equilibrium expenditure come about? What adjusts to achieve equilibrium? Equilibrium expenditure results from adjustments in real GDP. For instance, if aggregate planned expenditure exceeds real GDP, firms find that their inventories are below their targets. In response, firms increase production to meet their inventory targets,. And, as production increases, real GDP increases. The increase in real GDP increases aggregate planned expenditure. Eventually real GDP increases sufficiently so that it equals aggregate planned expenditure and, at that point, equilibrium expenditure occurs.

If real GDP and aggregate expenditure are less than equilibrium expenditure, what happens to firms’ inventories? How do firms change their production? And what happens to real GDP? If real GDP and aggregate expenditure are less than their equilibrium levels, an unplanned decrease in inventories occurs. The unplanned decrease in inventories leads firms to increase production to restore inventories to their planned levels. The increase in production increases *

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real GDP.

If real GDP and aggregate expenditure are greater than equilibrium expenditure, what happens to firms’ inventories? How do firms change their production? And what happens to real GDP? If real GDP and aggregate expenditure are greater than their equilibrium levels, an unplanned increase in inventories occurs. The unplanned increase in inventories leads firms to decrease production to restore inventories to their planned levels. The decrease in production decreases real GDP.

Page 278 1.

(page 684 in Economics)

What is the multiplier? What does it determine? Why does it matter? The multiplier is the amount by which a change in autonomous expenditure is multiplied to determine the change in equilibrium expenditure and real GDP. A change in autonomous expenditure changes real GDP by an amount determined by the multiplier. The multiplier matters because it tells us how much a change in autonomous expenditure changes equilibrium expenditure and real GDP.

How do the marginal propensity to consume, the marginal propensity to import, and the income tax rate influence the multiplier? The marginal propensity to consume, the marginal propensity to import, and the income tax rate all influence the magnitude of the multiplier. The multiplier is smaller when the marginal propensity to consume is smaller, when the marginal propensity to import is larger, and when the income tax rate is larger.

How do fluctuations in autonomous expenditure influence real GDP? Fluctuations in autonomous expenditure bring business cycle turning points. When autonomous expenditure changes, the economy moves from one phase of the business cycle to the next. For example, if autonomous expenditure decreases, equilibrium expenditure and real GDP decrease and, as a result, the economy enters the recession phase of the business cycle.

Page 283 1.

(page 689 in Economics)

How does a change in the price level influence the AE curve and the AD curve? A change in the price level shifts the AE curve and creates a movement along the AD curve.

If autonomous expenditure increases with no change in the price level, what happens to the AE curve and the AD curve? Which curve shifts by an amount that is determined by the multiplier and why? A change in autonomous expenditure with no change in the price level shifts both the AE curve and the AD curve. The AE curve shifts by an amount equal to the change in autonomous expenditure. The multiplier determines the magnitude of the shift in the AD curve. The AD curve shifts by an amount equal to the change in autonomous expenditure multiplied by the multiplier.

How does an increase in autonomous expenditure change real GDP in the short run? Does real GDP change by the same amount as the change in aggregate demand? Why or why not? In the short run, an increase in aggregate expenditure increases real GDP. However, the increase in real GDP is less than the increase in aggregate demand because the price level rises. The more the price level rises (the steeper the SAS curve) the smaller the increase in real GDP.

How does real GDP change in the long run when autonomous expenditure increases? Does real GDP change by the same amount as the change in aggregate demand? Why or why not? In the long run, an increase in aggregate expenditure has no effect on real GDP, that is, real GDP does not change. The change in real GDP—zero—is less than the change in aggregate demand. The change in real GDP is nil because, in the long run, the economy returns to its full© 2014 Pearson Education, Inc.

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employment equilibrium. In the long run, an increase in aggregate expenditure raises the price level but has no effect on real GDP.

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Answers to the Study Plan Problems and Applications Use the following data to work Problems 1 and 2. You are given the information in the table about the economy of the United Kingdom. 1. Calculate the marginal propensity to consume. The marginal propensity to consume is the fraction of a change in disposable income that is consumed. In the United Kingdom, when disposable income increases by £100 billion per year, consumption expenditure increases by £80 billion per year. The marginal propensity to consume equals £80 billion ÷ £100 billion, or 0.8.

Calculate saving at each level of disposable income and calculate the marginal propensity to save. Disposable The table to the right shows the United Kingdom’s saving schedule. Saving equals disposable income minus consumption expenditure. The marginal propensity to save is the fraction of a change in disposable income that is saved. In the United Kingdom, for each increase in disposable income of £100 billion, saving increases by £20 billion, so the marginal propensity to save is £20 billion ÷ £100 billion, which is 0.2.

Disposable Consumption income expenditure (billions of pounds per year) 300 340 400 420 500 500 600 580 700 660

income Saving (billions of pounds per year) 300 −40 400 −20 500 0 600 20 700 40

Collapsing Savings Rate Before 1984, the U.S. savings rate held steady for decades, though it dipped during the Great Depression and rose sharply during WWII, when there was little to buy besides war bonds. The rate dipped briefly again after WWII, and then rose steadily until 1984, when saving was 10.2 percent of income. Since 1984, saving has fallen to between 2 percent and 3 percent of income. Source: Deseret, August 18, 2012 Compare the MPC and MPS in the United States at different dates. Why might they differ? The MPC is (much) higher and the MPS is (much) lower in recent years than in 1984. The MPC might be higher in recent years because the return to saving (and the cost of borrowing) is lower than in 1984. Additionally wealth and perhaps expected future income might be higher in recent years than in 1984, in which case consumption is higher and saving lower in recent years.

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Use Figure 11.1 to work Problems 4 and 5. Figure 11.1 illustrates the components of aggregate planned expenditure on Turtle Island. Turtle Island has no imports or exports, no incomes taxes, and the price level is fixed. 4. Calculate autonomous expenditure and the marginal propensity to consume. Autonomous expenditure is $2 billion. Autonomous expenditure is expenditure that does not depend on real GDP. Autonomous expenditure equals the value of aggregate planned expenditure when real GDP is zero. The marginal propensity to consume is 0.6. When the country has no imports or exports and no income taxes, the slope of the AE curve equals the marginal propensity to consume. When income increases from zero to $6 billion, aggregate planned expenditure increases from $2 billion to $5.6 billion. That is, when real GDP increases by $6 billion, aggregate planned expenditure increases by $3.6 billion. The marginal propensity to consume is $3.6 billion ÷ $6 billion, which is 0.6.

5. a. What is aggregate planned expenditure when real GDP is $6 billion? Figure 11.1 shows that aggregate planned expenditure is $5.6 billion when real GDP is $6 billion.

b. If real GDP is $4 billion, what is happening to inventories? Firms’ inventories are decreasing. When real GDP is $4 billion, aggregate planned expenditure exceeds real GDP, so firms sell all that they produce and more. As a result, inventories decrease.

c. If real GDP is $6 billion, what is happening to inventories? Firms are accumulating inventories. That is, unplanned inventory investment is positive. When real GDP is $6 billion, aggregate planned expenditure is less than real GDP. Firms cannot sell all that they produce and inventories pile up.

Explain the difference between induced consumption expenditure and autonomous consumption expenditure. Why isn’t all consumption expenditure induced expenditure? Induced consumption expenditure is consumption expenditure that changes when disposable income changes. Autonomous consumption expenditure is consumption expenditure that would occur in the short run even if disposable income was zero. Not all consumption expenditure is induced consumption expenditure because, in the short run, even if someone has no income they still will have some (autonomous) consumption expenditure, if for nothing else, for food.

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Recovery? In the second quarter, businesses increased spending on equipment and software by 21.9%, while a category that includes home building grew amid a rush by consumers to take advantage of tax credits for homes. Source: The Wall Street Journal, July 31, 2010 Explain how an increase in business investment at a constant price level changes equilibrium expenditure. Investment is a component of autonomous aggregate expenditure. An increase in investment increases aggregate expenditure so the AE curve shifts upward. Equilibrium expenditure increases.

Use the following data to work Problems 8 and 9. An economy has a fixed price level, no imports, and no income taxes. MPC is 0.80, and real GDP is $150 billion. Businesses increase investment by $5 billion. 8.

Calculate the multiplier and the change in real GDP. With no imports and no income taxes, the multiplier equals 1/(1 − MPC). So the multiplier is 1/(1 − 0.8), which is 5.0 Then the $5 billion increase in investment increases real GDP by 5.0 × $5 billion, which is $25 billion.

Calculate the new real GDP and explain why real GDP increases by more than $5 billion. Real GDP was initially $150 billion. The increase in investment increased real GDP by $25 billion, so real GDP increases to $175 billion. Real GDP increases by more than the initial increase in investment because the increase in investment increases disposable income which induces additional increases in consumption expenditure. So real GDP increases both because investment increases and also because of induced increases in consumption expenditure.

Use the following data to work Problems 10 and 11. An economy has a fixed price level, no imports, and no income taxes. An increase in autonomous expenditure of $2 trillion increases equilibrium expenditure by $8 trillion. 10.

Calculate the multiplier and the marginal propensity to consume. The multiplier is defined as the change in equilibrium expenditure divided by the change in autonomous expenditure. In this problem the multiplier equals $8 trillion ÷ $2 trillion which is 4.0. If there are no imports and no taxes, the multiplier can be calculated from the formula that the multiplier equals 1/(1 − MPC). The multiplier equals 4.0, so 4.0 = 1/(1 − MPC). Solving this formula for the MPC shows that the MPC equals 0.75.

11.

What happens to the multiplier if an income tax is introduced? If an income tax is introduced, the multiplier decreases in value.

Use the following data to work Problems 12 to 16. Suppose that the economy is at full employment, the price level is 100, and the multiplier is 2. Investment increases by $100 billion. 12. What is the change in equilibrium expenditure if the price level remains at 100? The initial change in equilibrium expenditure is $200. The initial effect of the increase in investment increases equilibrium expenditure by the change in investment times the multiplier. The multiplier is 2 and the change in investment is $100 billion, so the initial change in equilibrium expenditure is $200 billion.

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13. a. What is the immediate change in the quantity of real GDP demanded? The quantity of real GDP demanded increases by $200 billion. The increase in investment shifts the aggregate demand curve rightward by the change in investment times the multiplier. The multiplier is 2 and the change in investment is $100 billion, so the aggregate demand curve shifts rightward by $200 billion.

b. In the short run, does real GDP increase by more than, less than, or the same amount as the immediate change in the quantity of real GDP demanded? In the short-run, real GDP increases by less than $200 billion. Real GDP is determined at the intersection of the AD curve and the SAS curve. In the short run, the price level will rise and real GDP will increase but by an amount less than the shift of the AD curve.

14.

In the short run, does the price level remain at 100? Explain why or why not. In the short run, the price level rises. Real GDP is determined at the intersection of the AD curve and the SAS curve. In the short run, the increase in aggregate demand means that the price level will rise as the economy moves along its upward-sloping SAS curve.

15. a. In the long run, does real GDP increase by more than, less than, or the same amount as the immediate increase in the quantity of real GDP demanded? In the long run, real GDP equals potential GDP, so real GDP does not increase. Real GDP is determined at the intersection of the AD curve and the SAS curve. After the initial increase in investment, money wages increase, the SAS curve shifts leftward, and in the long run, real GDP moves back to potential GDP.

b. Explain how the price level changes in the long run. Real GDP is determined at the intersection of the AD curve and the SAS curve. In the long run, money wages increase so the SAS curve shifts leftward, raising the price level by more than it rose in the short run.

16.

Are the values of the multipliers in the short run and the long run larger or smaller than 2? The multiplier in the short run is less than the multiplier of 2 because the short-run increase in real GDP is less than $200 billion. The long-run multiplier is even smaller. It equals zero.

Use the following news clip to work Problems 17 and 18. The New New Deal Remember what was actually in the stimulus bill of 2009: slightly more than $600 billion went toward poor and middle-class tax cuts, safety net spending (more unemployment assistance and food stamps), and aid to state governments with budget shortfalls. These are the most directly simulative parts of the bill, bolstering demand and preventing lay-offs—and stimulate they did. Economists of differing ideological stripes generally agree that the economy would have as many as 3 million fewer jobs now were it not for the stimulus. The remaining sixth of the bill focused on longer-term investments, which included putting $90 billion into green energy. Source: Financial Times, September 2, 2012 17.

Did the $600 billion of spending described above increase aggregate expenditure by more than, less than, or exactly $600 billion? Explain. The $600 billion of spending increases aggregate expenditure by more than $600 billion because the spending from the $600 billion stimulus increased disposable income and thereby has a multiplied effect on the aggregate expenditure. Part of the $600 billion increase is spent, leading the recipients’ incomes to increase. In turn, part of this increase in income is spent, thereby further increasing aggregate expenditure.

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Explain and draw a graph to illustrate how this fiscal stimulus will influence aggregate expenditure and aggregate demand in both the short run and the long run.

Figure 11.2 shows the short-run and long-run effects on aggregate expenditure (Figure 11.2a) and on aggregate demand (Figure 11.2b). In the short run the stimulus increases aggregate expenditure and aggregate demand. The aggregate expenditure curve shifts upward from AE0 to AE1 and the aggregate demand curve shifts rightward from AD0 to AD1. (The initial upward shift in the aggregate expenditure curve is larger but the increase in the price level moderated the initial increase in aggregate expenditure.) In the long run, however, short-run aggregate supply decreases and the short-run aggregate supply curve shifts from SAS0 to SAS1. While the higher price level does not shift the aggregate demand curve, it does shift the aggregate expenditure downward from AE1 back to AE0.

Use the following news clip to work Problems 19 to 21. Consumer Growth Could Buoy China’s Economy Annual double-digit wage growth since 2000 has created a Chinese middle class ready to spend. And spend they have. Spending by China’s consumers has grown at double-digit rates for a decade. Digital Luxury Group, a Geneva-based market researcher, reports that Chinese travelers made 70 million overseas trips in 2011 to places that include Bali, Dubai, Paris, London, Singapore, and Hong Kong. To cope with all this extra travel, China plans to build 56 new airports before the end of 2016. China’s wealthy consumers in aggregate are poised to spend more on luxury goods than consumers in Japan and the United States. Source: The New York Times, August 13, 2012 19.

Explain and draw a graph to illustrate the changes in autonomous expenditure and induced expenditure and the multiplier process at work in the above story. There are two different effects on autonomous expenditure. The first effect results from the increase in overseas trips. This effect increases imports and thereby decreases autonomous expenditure. The second

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effect results from the construction of additional airports and expenditure on luxury goods. Presuming that the luxury goods are produced in China, both of these changes increase autonomous expenditure. If the second effect is larger than the first, on net autonomous expenditure increases and therefore induced expenditures increase. As illustrated in Figure 11.3, the aggregate expenditure curve shifts upward from AE0 to AE1.

20.

Explain how China’s real GDP is influenced by an increase in overseas travel and vacations. Overseas travel and vacations increase China’s imports and thereby decrease autonomous spending in China. The increase in imports decreases aggregate expenditure and aggregate demand. These decreases reduce China’s real GDP.

21.

Explain how China’s consumption expenditure influences real GDP in the countries to which Chinese tourists travel in the short run and the long run. The increase in China’s expenditure on trips abroad increases aggregate expenditure and aggregate demand in these countries. In the short run, real GDP and the price level both increase. In the long run the price level in these countries rises, which decreases aggregate expenditure and aggregate demand. In the long run, real GDP does not change but the price level rises.

22.

In the Canadian economy, autonomous consumption expenditure is $50 billion, investment is $200 billion, and government expenditure is $250 billion. The marginal propensity to consume is 0.7 and net taxes are $250 billion. Exports are $500 billion and imports are $450 billion. Assume that net taxes and imports are autonomous and the price level is fixed. a. What is the consumption function? The consumption function is the relationship between consumption expenditure and disposable income, other things remaining the same. In this case the consumption function is C = 50 + 0.7(Y – 250) where the “50” is $50 billion and the “250” is $250 billion.

b. What is the equation of the AE curve? The equation of the AE curve is AE = 375 + 0.7Y, where Y is real GDP and the 375 is $375 billion. Aggregate planned expenditure is the sum of consumption expenditure, investment, government purchases, and net exports. Using the symbol AE for aggregate planned expenditure, aggregate planned expenditure is AE = 50 + 0.7(Y – 250) + 200 +250+ 50 AE = 50 + 0.7Y – 175 + 200 + 250 + 50 AE = 375 + 0.7Y © 2014 Pearson Education, Inc.

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c. Calculate equilibrium expenditure. Equilibrium expenditure is $1,250 billion. Equilibrium expenditure is the level of aggregate expenditure that occurs when aggregate planned expenditure equals real GDP. That is, AE = 375 + 0.7Y and AE = Y. Solving these two equations for Y gives equilibrium expenditure of $1,250 billion.

d. Calculate the multiplier. The multiplier equals 1/(1 − the slope of the AE curve). The equation of the AE curve tells us that the slope of the AE curve is 0.7. So the multiplier is 1/(1 − 0.7), which is 3.333.

e. If investment decreases to $150 billion, what is the change in equilibrium expenditure? Equilibrium real expenditure decreases by $166.67 billion. From part d the multiplier is 3.333. The change in equilibrium expenditure equals the change in investment, $50 billion, multiplied by 3.333.

Describe the process in part (e) that moves the economy to its new equilibrium expenditure. When investment decreases by $50 billion, aggregate planned expenditure is less than real GDP. Firms find that their inventories are accumulating above target levels. As a result, they decrease production to reduce inventories. Real GDP decreases. The decrease in real GDP decreases disposable income so that consumption expenditure falls. In turn, the decrease in consumption expenditure leads to a further decrease in aggregate planned expenditure. Real GDP still exceeds aggregate planned expenditure though by less than was initially the case. Nonetheless unwanted inventories are still accumulating and firms continue to cut production, further reducing real GDP. This process continues until eventually real GDP will decrease enough to equal aggregate planned expenditure.

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Answers to Additional Problems and Applications Use the following data to work Problems 23 and 24. You are given the information in the table about the economy of Australia. 23.

Calculate the marginal propensity to save. The marginal propensity to save is the fraction of a change in disposable income that is saved. In Australia, when disposable income increases by $100 billion per year, saving increases by $25 billion per year. The marginal propensity to save is $25 billion ÷ $100 billion, which is 0.25.

24.

Disposable income Saving (billions of dollars per year) 0 −5 100 20 200 45 300 70 400 95

Calculate consumption at each level of disposable income. Calculate the marginal propensity to consume. The table to the right shows Australia’s consumption expenditure schedule. Consumption expenditure equals disposable income minus saving. For each increase in disposable income of $100 billion, consumption expenditure increases by $75 billion. The marginal propensity to consume is 0.75. The marginal propensity to consume plus the marginal propensity to save equals 1. Because the marginal propensity to save equals 0.25, the marginal propensity to consume equals 0.75.

Disposable Consumption income expenditure (billions of dollars per year) 0 5 100 80 200 155 300 230 400 305

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Use the following news clip to work Problems 25 to 27. Americans $2.4 trillion Poorer The Federal Reserve reported that household wealth decreased by $2.4 trillion or $21,000 per household in the third quarter of 2011. This drop is the steepest since 2008 and the second consecutive quarterly drop. Foreclosures lowered household debt slightly but credit card debt increased. Many households are struggling to buy the essentials and spending on food has decreased. Separately, the Bureau of Economic Analysis reported that consumption expenditure increased by $39 billion in the third quarter of 2011. Sources: The New American, December 11, 2011 and the Bureau of Economic Analysis 25. Explain and draw a graph to illustrate how a fall in household wealth would be expected to influence the consumption function and saving function.

Figure 11.4a shows the effect of a decrease in wealth on the consumption function and Figure 11.4b shows the effect on the saving function. Consumption expenditure decreases so the consumption function shifts downward from CF0 to CF1 while saving increases so the saving function shifts upward from SF0 to SF1.

26.

What factors might explain the actual changes in consumption expenditure and wealth that occurred in the third quarter of 2011? According to the article, consumption increased. At least two other factors could explain the discrepancy between the “predicted” decrease in consumption in part a and the increase that actually occurred. First, disposable income might have increased. This change would lead to a movement upward along the (downward-shifted) consumption function so that consumption expenditure increased. Alternatively people’s expected future incomes might have risen. The upward revision in expected future income would lead to an upward shift of the consumption function which would offset the fall from the decrease in wealth.

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27.

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Draw a graph of a consumption function and show at what points consumers were actually operating in the second and third quarters. Make any necessary assumptions and explain your answer. Regardless of any increase in future expected income, it is likely the case that the decrease in wealth led to a net downward shift of the consumption function because the decrease in wealth was so large. In Figure 11.4a the consumption function shifts downward from CF0 to CF1. Equally likely, however, disposable income increased. So the economy moves from disposable income of $10.5 trillion and consuming at point A on consumption function CF0 to disposable income of $11.0 trillion and consuming at point B on consumption function CF1.

A 1 2 3 4 5 6 7

A B C D E F

B Y 100 200 300 400 500 600

C C 110 170 230 290 350 410

D I 50 50 50 50 50 50

E G 60 60 60 60 60 60

F X 60 60 60 60 60 60

G M 15 30 45 60 75 90

Use the spreadsheet above, which lists real GDP (Y ) and the components of aggregate planned expenditure in billions of dollars, to work Problems 28 and 29. 28.

Calculate autonomous expenditure. Calculate the marginal propensity to consume. Autonomous expenditure equals the value of aggregate planned expenditure when real GDP is zero. Because the spreadsheet does not list GDP of zero, we must extrapolate to calculate the value of consumption expenditure and imports when GDP equals zero. From the spreadsheet, consumption expenditure falls by $60 billion for every $100 billion decrease in GDP. So when GDP equals zero, autonomous consumption expenditure is $50 billion. Similarly, from the spreadsheet, imports decrease by $15 billion for every $100 billion decrease in GDP. So when GDP equals zero, imports equal zero. Autonomous expenditure is $50 billion (consumption expenditure) plus $50 billion (investment) plus $60 billion (government expenditure) plus $60 billion (exports), which equals $220 billion. The marginal propensity to consume is 0.6. When income increases from $100 billion to $200 billion, consumption expenditure increases from $110 billion to $170 billion. A $100 billion increase in GDP increases consumption expenditure by $60 billion. So the marginal propensity to consume is $60 billion ÷ $100 billion, which is 0.6.

29. a. What is aggregate planned expenditure when real GDP is $200 billion? Aggregate planned expenditure is $310 billion. Aggregate planned expenditure is the sum of consumption expenditure ($170 billion) plus planned investment ($50 billion) plus government expenditure ($60 billion) plus exports ($60 billion) minus imports ($30 billion), which is $310 billion.

b. If real GDP is $200 billion, explain the process that moves the economy toward equilibrium expenditure. Inventories are decreasing so that the unplanned inventory change is negative. When real GDP is $200 billion, aggregate planned expenditure is $310 billion. Because aggregate planned expenditure exceeds real GDP, firms sell all that they produce and even more so that inventories are decreasing. Firms then increase their production, to restore their inventories, and real GDP increases. © 2014 Pearson Education, Inc.

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c. If real GDP is $500 billion, explain the process that moves the economy toward equilibrium expenditure. Firms are accumulating inventories so that the unplanned inventory change is positive. When real GDP is $500 billion, aggregate planned expenditure is $445 billion. Firms cannot sell all that they produce so that unplanned inventories increase. Firms respond by decreasing their production, to lower their inventories, and real GDP decreases.

30.

Wholesale Inventories Decline, Sales Rise The Commerce Department reported that wholesale inventories fell 1.3 percent in August for a record 12th consecutive month, evidence that companies are trimming orders to factories, which helped depress economic output during the recession. Economists hope that the rising sales will encourage businesses to begin restocking their inventories, which would boost factory production and help bolster broad economic growth in coming months. Source: The New York Times, October 8, 2009 Explain why a fall in inventories is associated with recession and a restocking of inventories might bolster economic growth. Inventories are part of investment. If the fall in inventories reflects a fall in planned inventories, then planned investment decreases which decreases aggregate expenditure and real GDP. If the restocking of inventories is a planned restocking, then planned investment increases, which boosts aggregate expenditure and real GDP.

31.

Obama’s New Stimulus The Obama recovery plan announced on Monday includes proposed spending of $50 billion to rebuild 150,000 miles of roads, construct and maintain 4,000 miles of rail, and fix or rebuild 150 miles of runways. Source: USA Today, September 10, 2010 If the slope of the AE curve is 0.7, calculate the immediate change in aggregate planned expenditure and the change in real GDP in the short run if the price level remains unchanged. The increase in government expenditure will have a multiplier effect on aggregate expenditure and real GDP. The multiplier equals 1/(1 − the slope of the AE curve). The slope of the AE curve is 0.7 so the multiplier is 1/(1 − 0.7), which is 3.3. With this multiplier, the $50 billion increase in government expenditure increases aggregate expenditure by 3.3 × $50 billion, or $165 billion. In the short run, when the price level is constant, real GDP increases by the same amount, $165 billion.

32.

Obama’s Economic Recovery Plan President Obama's proposal to jolt a listless recovery with $180 billion worth of tax breaks and transportation projects left economists largely unimpressed Tuesday. Source: USA Today, September 10, 2010 If taxes fall by $90 billion and the spending on transport projects increases by $90 billion, which component of Obama’s recovery plan would have the larger effect on equilibrium expenditure, other things remaining the same? The spending on transportation projects will have the larger effect because the expenditure multiplier is larger than the tax multiplier. The expenditure multiplier is larger because in the first round all of the increased government expenditure increases aggregate expenditure whereas part of a tax cut is saved and hence does not increase aggregate expenditure.

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33.

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Price Jump Worst Since ’91 The biggest annual jump in the CPI since 1991 has fanned fears about growing pressures on consumers. The Labor Department report confirms what every consumer in America has known for months: Inflation is soaring and it’s having an adverse impact on the economy. Source: CNN, July 16, 2008 Explain and draw a graph to illustrate the effect of a rise in the price level on equilibrium expenditure. The jump in inflation means that the price level has soared higher. The increase in the price level decreases aggregate expenditure because it decreases real wealth. As shown in Figure 11.5, the aggregate expenditure curve shifts downward from AE0 to AE1. Because aggregate expenditure has decreased, real GDP decreases, In Figure 11.5 the decrease in aggregate expenditure decreases real GDP from $13.0 trillion to $12.4 trillion.

Use the following news clip to work Problems 34 to 36. Consumer Sentiment in U.S. Rose to Three Month High Consumer sentiment was up in August helped by merchant discounts, especially from auto dealerships who received incentives from automakers Honda, General Motors, and Toyota to lower prices. But consumers are worried about the future. They are worried about tax changes and government budget cuts that are on the horizon. Capital spending fell somewhat. Source: Bloomberg, September 1, 2012 34.

Which of the expenditures listed in the news clip are part of induced expenditure and which is part of autonomous expenditure? Induced consumption expenditure changes with changes in disposable income. Autonomous consumption expenditure does not change when disposable income changes. For many consumers, purchasing new cars increase when their incomes rise. For these consumers, these items are induced expenditure. Other Americans plan to buy automobiles regardless of the change in their income perhaps because their consumer sentiment is “up,” or perhaps because

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prices of cars have fallen. For these consumers, these expenditures are autonomous. Capital spending is part of autonomous expenditure.

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35.

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Which of the events reported in the news clip would change aggregate demand and which would change the quantity of real GDP demanded? Provide a graphical illustration of the distinction. The increase in consumption expenditure induced by increased income, the autonomous increase in consumption, and the increase in capital spending all increase aggregate demand and shift the aggregate demand curve rightward. The increase in consumption expenditure that results from lower prices reflects a change in consumption from a lower price level and creates a change in the quantity of real GDP demanded. Figure 11.6 illustrates these differences. The change from point A to point B reflects a change in aggregate demand. The movement from point A to point B reflects a change in the quantity of real GDP demanded.

36.

Explain and draw a graph to illustrate how increasing consumer confidence influences aggregate expenditure and aggregate demand.

Increasing consumer confidence increases autonomous consumption. It increases aggregate expenditure and aggregate demand. As illustrated in Figure 11.7a, the aggregate expenditure

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curve shifts upward, from AE0 to AE1 and in Figure 11.7b the aggregate demand curve shifts rightward, from AD0 to AD1.

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37.

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Japan Slides Into Recession In Japan, consumer prices slid at a faster pace in July and industrial production unexpectedly slumped. Source: Bloomberg, September 1, 2012 Contrast what the news clip says is happening in Japan with what is happening in the United States in Problem 34 and provide a graphical analysis of the differences.

The news clip suggests that in Japan aggregate demand is decreasing so that both the price level and real GDP are decreasing. Figure 11.8a shows this situation. The information in Problem 34 suggests that consumption expenditure is increasing and, while investment (capital spending) is decreasing. However it seems that the change in consumption expenditure exceeds the change in investment so U.S. aggregate demand is increasing. Figure 11.8b shows this situation.

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Economics in the News 38.

After you have studied Reading Between the Lines on pp. 284–285 (690–691 in Economics), answer the following questions. a. If the 2012 changes in inventories were mainly planned changes, what role did they play in shifting the AE curve and changing equilibrium expenditure? Use a two-part figure (similar to that on p. 272 (p. 678 in Economics)) to answer this question.

Figure 11.9a shows aggregate planned expenditure; Figure 11.9b shows unplanned inventory change. When aggregate planned expenditure is given by AE0, unplanned inventory change is equal to zero when real GDP is $13.5 trillion, so unplanned inventory change is given by the top line in Figure 11.9b. If the change in inventories was planned, then planned investment increased and with it aggregate planned expenditure also increased. The increase in aggregate planned expenditure shifts the aggregate expenditure curve upward, as illustrated by the shift from AE0 to AE1 in Figure 11.9a. It shifts the unplanned inventory change line downward to the lower curve, Unplanned inventory change1, in Figure 11.9b. The increase in aggregate expenditure increases equilibrium real GDP. In figure 11.9a, real GDP increases from $13.5 trillion to $13.6 trillion. In Figure 11.9b, at real GDP of $13.6 trillion, along the new unplanned inventory change curve line, unplanned inventory change is zero.

b. The news article reports changes in expenditure on existing homes and new homes. Explain where each of these expenditures appear in aggregate planned expenditure. Changes in expenditure on new homes is counted as part of investment expenditure. Changes in expenditure on used homes does not appear in aggregate planned expenditure.

c. Using the assumptions made in Figure 2 on p. 285 (p. 691 in Economics), what is the value of the autonomous expenditure multiplier? The autonomous expenditure multiplier equals 1/(1 – slope of AE line). In the figure, the slope along the top red line is equal to ($13.57 trillion − $13.54 trillion)/($13.57 trillion − $13.51 trillion) = ($0.03 trillion)/(($0.06 trillion) = 0.5. So the autonomous expenditure multiplier equals 1/(1 – 0.5) = 2.0. © 2014 Pearson Education, Inc.

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In an economy autonomous spending is $20 trillion and the slope of the AE curve is 0.6. a. What is the equation of the AE curve? The equation of the AE curve is AE = 20 + 0.6Y, where Y is real GDP and the 20 is $20 trillion.

b. Calculate equilibrium expenditure. Equilibrium expenditure is $50 trillion. Equilibrium expenditure is the level of aggregate expenditure that occurs when aggregate planned expenditure equals real GDP. That is, AE = 20 + 0.6Y and AE = Y. Solving these two equations for Y gives equilibrium expenditure of $50 trillion.

c. Calculate the multiplier if the price level is unchanged. The multiplier equals 1/(1 − the slope of the AE curve). The equation of the AE curve tells us that the slope of the AE curve is 0.6. So the multiplier is 1/(1 − 0.6), which is 2.5.

C h a p t e r

INFLATION, JOBS, AND THE BUSINESS CYCLE**

Answers to the Review Quizzes Page 301 1.

(page 707 in Economics)

How does demand-pull inflation begin? Demand-pull inflation begins with an increase in aggregate demand. The increase in aggregate demand increases real GDP and the price level.

What must happen to create a demand-pull inflation spiral? When the economy is at an above full-employment equilibrium, the money wage rate rises which decreases the short-run aggregate supply. The decrease in the short-run aggregate supply decreases real GDP and raises the price level. If nothing else changes, the price level eventually stops rising. To create a demand-pull inflation spiral, aggregate demand must persistently increase, and the only way in which aggregate demand can persistently increase is if the quantity of money persistently increases.

How does cost-push inflation begin? Cost-push inflation begins with an increase in the money wage rate or an increase in the money prices of raw materials, which decreases short-run aggregate supply. The decrease in short-run aggregate supply raises the price level and decreases real GDP.

What must happen to create a cost-push inflation spiral? If the Fed responds to each decrease in short-run aggregate supply by increasing the quantity of money, aggregate demand increases and freewheeling cost-push inflation ensues.

What is stagflation and why does cost-push inflation cause stagflation? Stagflation occurs when real GDP decreases and the price level rises. Cost-push inflation causes stagflation when short-run aggregate supply decreases because a decrease in short-run aggregate supply raises the price level and decreases real GDP.

How does expected inflation occur? Expected increases in aggregate demand or expected decreases in short-run aggregate supply create expected inflation because they change the expected price level. For example, in anticipation of an increase in aggregate demand, the money wage rate rises by the same percentage as the price level is expected to rise. With the correct expectation, real GDP remains equal to potential GDP and unemployment remains at its natural rate.

How do real GDP and the price level change if the forecast of inflation is incorrect? If the actual inflation rate exceeds the forecasted inflation rate, the price level rises by more than expected and real GDP exceeds potential GDP. If the actual inflation rate falls short of the expected inflation rate, the price level rises by less than expected and real GDP is less than potential GDP. *

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Page 304 1.

(page 710 in Economics)

How would you use the Phillips curve to illustrate an unexpected change in inflation? An unexpected change in inflation results in a movement along the short-run Phillips curve. In particular, an unexpected increase in the inflation rate lowers the unemployment rate and an unexpected decrease in the inflation rate raises the unemployment rate.

If the expected inflation rate increases by 10 percentage points, how do the short-run Phillips curve and the long-run Phillips curve change? A 10 percentage point increase in the expected inflation rate shifts the short-run Phillips curve vertically upward by 10 percentage points. (Each point on the new short-run Phillips curve lies 10 percentage points above the point on the old Phillips curve directly below it). A 10 percentage point increase in the expected inflation rate does not change the long-run Phillips curve.

If the natural unemployment rate increases, what happens to the short-run Phillips curve and the long-run Phillips curve? An increase in the natural unemployment rate shifts both the short-run and long-run Phillips curves rightward by an amount equal to the increase in the natural unemployment rate.

Does the United States have a stable short-run Phillips curve? Explain why or why not. The United States does not have a stable short-run Phillips curve. The U.S. short-run Phillips curve shifts with changes in the expected inflation rate and the natural unemployment rate, so it is not stable.

Page 309 1.

(page 715 in Economics)

Explain the mainstream theory of the business cycle. Mainstream business cycle theory attributes business cycles to fluctuations in aggregate demand growth. According to the mainstream view, potential GDP grows steadily and aggregate demand, while generally growing slightly faster that potential GDP, at times grows more slowly than potential GDP and at other times grows significantly more rapidly than potential GDP. When aggregate demand grows more slowly than potential GDP, the price level falls below its expected level and the economy slides into a recession so that real GDP is less than potential GDP. When aggregate demand grows more rapidly than potential GDP, the price level rises above its expected level and the economy moves into a strong expansion accompanied by inflation.

What are the four special forms of the mainstream theory of the business cycle and how do they differ? The four special forms of the mainstream theory are the Keynesian cycle theory, the monetarist cycle theory, the new classical cycle theory, and the new Keynesian cycle theory. These theories differ according to the factors they believe are the most responsible for causing fluctuations in the growth of aggregate demand. Keynesian cycle theory asserts that fluctuations in aggregate demand growth are the result of fluctuations in investment driven by fluctuations in business confidence. The monetarist cycle theory says that fluctuations in both investment and consumption expenditure lead to fluctuations in aggregate demand growth and that the basic source of the fluctuations in investment and consumption expenditure is fluctuations in the growth rate of the quantity of money. New classical cycle theory claims that the money wage rate and the position of the short-run aggregate supply curve are determined by the rational expectation of the price level, which in turn is determined by potential GDP and the expected aggregate demand. As a result, only unexpected changes in aggregate demand growth lead to business cycles. Finally, new Keynesian cycle theory says that money wage rates and the position of the short-run aggregate supply are determined by rational expectations of the price level from the past. As a result, both expected and unexpected fluctuations in aggregate demand growth lead to business cycles. © 2014 Pearson Education, Inc.

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According to RBC theory, what is the source of the business cycle? What is the role of fluctuations in the rate of technological change? Real business cycle (RBC) theory says that economic fluctuations are caused by technological change that makes productivity growth fluctuate. Fluctuations in the rate of technological change are the impulse that creates the business cycle.

According to RBC theory, how does a fall in productivity growth influence investment demand, the market for loanable funds, the real interest rate, the demand for labor, the supply of labor, employment, and the real wage rate? According to real business cycle theory, a fall in productivity growth decreases investment demand and the demand for labor. The decrease in investment demand decreases the demand for loanable funds and lowers the real interest rate. Via the intertemporal substitution effect, the lower real interest rate decreases the supply of labor. Because both the demand for labor and the supply of labor decrease, employment decreases. The real wage rate also falls because the decrease in the demand for labor exceeds the decrease in the supply of labor.

What are the main criticisms of RBC theory and how do its supporters defend it? Critics of the real business cycle theory level three criticisms at it: 1) the money wage rate is sticky; 2) the intertemporal substitution effect is small so that the small changes in the real wage rate cannot account for large changes in employment; and, 3) measured productivity shocks are likely to be caused by changes in aggregate demand so that business cycle fluctuations cause the measured productivity shocks. Real business cycle supporters respond that 1) the real business cycle theory is consistent with the facts about economic growth and it explains the facts about business cycles; and 2) real business cycle theory is consistent with a wide range of microeconomic evidence about labor supply, labor demand, investment demand, and the distribution of income between labor and capital.

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Answers to the Study Plan Problems and Applications 1.

Best to Get Used to High Food and Energy Prices—They’re Here to Stay Rising energy and food costs are slowing the economy at a time when it is already facing severe headwinds. Just as Western Europe and North America are showing a bit of sparkle, along comes another oil price shock or food price shock to put out the light. On top of rising energy prices, a severe U.S. drought, a poor monsoon season in Asia, and a bad harvest in Russia and Ukraine have sent grain prices soaring. Globally, this is the third major food price shock in five years. Source: The Telegraph, August 29, 2012 Explain what type of inflation the news clip is describing and provide a graphical analysis of it. The news clip is describing a cost-push inflation. The costs of important inputs, such as oil, as well as the cost of other raw materials, such as grain, have all risen. Figure 12.1 illustrates a cost-push inflation. In it the shortrun aggregate supply curve has shifted leftward, from SAS0 to SAS1 and the price level has risen from 122 to 124.

Use Figure 12.2 to answer Problems 2, 3, 4, and 5. In each question, the economy starts out on the curves AD0 and SAS0. 2. Some events occur and the economy experiences a demand-pull inflation. a. List the events that might cause a demandpull inflation. Anything that increases aggregate demand can be the factor that starts a demand-pull inflation. For instance, an increase in the quantity of money, an increase in government expenditure, a tax cut, or an increase in exports could all be the start of a demand-pull inflation. To sustain the inflation, the quantity of money must keep increasing.

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b. Describe the initial effects of a demand-pull inflation.

Starting at the intersection of AD0 and SAS0, the price level is 120 and real GDP is at potential GDP of $10 trillion. Aggregate demand increases and the AD curve shifts rightward to AD1. The new equilibrium is at the intersection of AD1 and SAS0, so the price level rises and real GDP increases. There is an inflationary gap.

c. Describe what happens as a demand-pull inflation spiral proceeds.

Starting at the intersection of AD1 and SAS0, there is an inflationary gap so the money wage rate rises and short-run aggregate supply decreases. The SAS curve starts to shift leftward toward SAS1. The price level keeps rising, but real GDP now decreases. If the central bank responds with persistent increases in the quantity of money, the process repeats: AD shifts to AD2, an inflationary gap opens again, the money wage rate rises again, and the SAS curve shifts toward SAS2.

Some events occur and the economy experiences a cost-push inflation. a. List the events that might cause a cost-push inflation. Anything that decreases short-run aggregate supply can set off a cost-push inflation. For instance, an increase in the money wage rate or an increase in the money price of raw materials could be the start of a cost-push inflation. But to sustain such an inflation, the quantity of money must keep increasing.

b. Describe the initial effects of a cost-push inflation.

Starting at the intersection of AD0 and SAS0, the price level is 120 and real GDP is at potential GDP of $10 trillion. Short-run aggregate supply decreases and the SAS curve shifts leftward to SAS1. The price level rises and real GDP decreases. There is now a recessionary gap.

c. Describe what happens as a cost-push inflation spiral proceeds.

Starting out at the intersection of AD0 and SAS1, there is a recessionary gap so real GDP is below potential GDP and unemployment is above the natural rate. In an attempt to restore full employment, the central bank increases the quantity of money. The aggregate demand curve shifts rightward to AD1. Real GDP returns to $10 trillion and the price level rises to 160. A further cost increase occurs, which shifts the short-run aggregate supply curve to SAS2 and a recessionary gap opens up again. The economy is again below potential GDP. In an attempt to restore full employment, the central bank increases the quantity of money. The aggregate demand curve shifts rightward to AD2. Real GDP returns to $10 trillion and the price level rises to 200.

Some events occur and the economy is expected to experience inflation. a. List the events that might cause an expected inflation. Anything that increases aggregate demand can set off an expected inflation as long as the event is expected. For instance, an expected increase in the quantity of money, an increase in government expenditure, a tax cut, or an increase in exports could all be the start of an expected inflation. But to sustain such an expected inflation, the quantity of money must keep increasing along its expected path.

b. Describe the initial effects of an expected inflation.

Starting at the intersection of AD0 and SAS0, the price level is 120 and real GDP is at potential GDP of $10 trillion. Aggregate demand increases, and the AD curve shifts rightward to AD1. The increase in aggregate demand is expected so the money wage rate rises and the SAS curve shifts to SAS1. The price level rises, and real GDP remains equal to potential GDP.

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c. Describe what happens as an expected inflation proceeds.

Starting at the intersection of AD1 and SAS1, a further expected increase in aggregate demand occurs. The AD curve shifts to AD2, and because the increase in aggregate demand is expected, the money wage rate rises again and the SAS curve shifts to SAS2. Again, the price level rises and real GDP remains equal to potential GDP.

Suppose that people expect deflation (a falling price level), but aggregate demand remains at AD0. a. What happens to the short-run and long-run aggregate supply curves? (Draw some new curves if you need to.) People expect that the price level will fall. The money wage rate falls in expectation of the lower price level. The short-run aggregate supply curve shifts rightward. There is no change in potential GDP. The long-run aggregate supply curve does not shift.

b. Describe the initial effects of an expected deflation.

Starting at the intersection of AD0 and SAS0, the price level is 120 and real GDP is equal to potential GDP of $10 trillion. Short-run aggregate supply increases, and the SAS curve shifts rightward. The aggregate demand curve does not shift. The price level falls, but by less than people expected. The real wage rate falls because the money wage rate has fallen by more than the price level. Real GDP increases. Real GDP is greater than potential GDP and an inflationary gap opens.

c. Describe what happens as it becomes obvious to everyone that the expected deflation is not going to occur. The money wage rate rises to reflect the higher expected price level. The rise in the money wage rate decreases short-run aggregate supply and the SAS curve shift leftward to SAS0. The price level rises to 120 and the economy returns to its potential GDP.

Use the following news clip to work Problems 6 to 8. Official: China May Face Heavy Inflation Pressure China is expected to face great inflationary pressure in the future due to higher costs and an abundant global money supply, a senior Chinese official said in an article published Tuesday. He said inflation in China is also the result of excessive global liquidity from loose monetary policies adopted by developed nations, China’s lending expansion, and a pile-up of outstanding foreign exchange funds. China’s consumer price index (CPI), a main gauge of inflation, rose 4.9 percent year on year in February, the same level as in January. The CPI data for March is scheduled to be released this week and is estimated to show a rise above 5 percent. Source: China Daily, April 12, 2011 6. Is China experiencing demand-pull or costpush inflation? Explain. Even though the official mentioned “higher costs,” all the reasons advanced for the inflation create demand-pull inflation, so China is experiencing a demand-pull inflation.

Draw a graph to illustrate the initial rise in the price level and the money wage rate response to a one-time rise in the price level. Figure 12.3 shows the effect of a one-time increase in the price level that results from a © 2014 Pearson Education, Inc.

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one-time increase in aggregate demand. The aggregate demand curve shifts rightward from AD0 to AD1 and initially the price level rises from 130 to 132. Real GDP also increases, from 25.0 trillion yuan to 25.4 trillion yuan. In response to the tight labor market, the money wage rate rises. Aggregate supply decreases so that the SAS curve shifts leftward from SAS0 to SAS1. The price level rises still more from 132 to 134. Once at 134, the price level stops rising so there is not an on-going inflation.

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Draw a graph to illustrate and explain how China might experience an inflation spiral. Figure 12.4 shows how the situation in part b can change into a demand-pull inflation. After the short-run aggregate supply decreases to SAS1 and the economy is back at full employment, an increase in the quantity of money by the central bank increases aggregate demand and the aggregate demand curve, shifts rightward to AD2. The price level rises to 136 and, just as in part b, the money wage rate rises again so that the short-run aggregate supply once more decreases. After the decrease in short-run aggregate supply to SAS2 the price level rises still higher to 138. As long as the quantity of money continues to increase, the inflation spiral will continue with aggregate demand increasing and short-run aggregate supply decreasing.

Use the following news clip to work Problems 9 to 11. Getting a Raise: Why It’s Not Happening Didn’t get a raise this year? Blame inflation. American wages didn’t budge last month, according to Labor Department data released Wednesday. And with inflation remaining at near zero, experts say it could be quite a while before many workers see their next raise. While stagnant prices are a boon for consumers on supermarket checkout lines, they can be hard on workers’ bottom lines. Wages typically track inflation, soaring higher when prices take off. In fact, some say wages tend to feed inflation. That was the case in the 1970s, when wage growth picked up after prices soared. But pricing pressures are weaker today, with the consumer price index, a measure of inflation, unchanged in July from the previous month. Source: Huffington Post, August 16, 2012 9. a. Explain why the inflation rate and the rate at which wages rise are connected. The inflation rate and the rate at which money wages rise are connected because in the long run the economy returns to its long-run aggregate supply curve. Along the long-run aggregate supply curve the economy is at its natural unemployment rate. If the inflation rate exceeds the rate at which the money wage rate is rising, the economy moves along its short-run aggregate supply curve and temporarily the unemployment rate is less than natural unemployment rate. But in the long run, the money wage rate will grow more rapidly to catch up to the inflation rate and the economy returns to its long-run aggregate supply curve. The reverse occurs if the money wage rate grows more rapidly than the inflation rate: The unemployment rate is greater than the natural unemployment rate, so in the long-run the growth rate of the money wage rate slows to equal the inflation rate and the economy returns to its natural unemployment rate.

b. Explain in what type of inflation wages are “soaring higher when prices take off.” Wages are “soaring higher” when the inflation starts in a cost-push inflation started by a higher money wage rate. © 2014 Pearson Education, Inc.

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Explain in what type of inflation “wages tend to feed inflation.” “Wages tend to feed inflation” in a demand-pull inflation.

11.

If “pricing pressures are weaker today,” compared to the 1970s, what does that suggest about the expected inflation rate in the 1970s and today? Draw a graph to illustrate an expected inflation during the 1970s. If “pricing pressures are weaker today” compared to the 1970s, the expected inflation rate is lower today compared to the 1970s. The lower inflation rate means that the shortrun aggregate supply curve today does not shift leftward as rapidly as it did in the 1970s. Figure 12.5 illustrates the large leftward shift of the short-run aggregate supply curve in the 1970s with the shift from SAS0 to SAS1.

12.

Iran Postpones Cutting Gasoline Subsidies Inflation is about 10 percent and the unemployment rate is about 14 percent. Earlier this month Iran’s main audit body slammed the government's plan to scrap gasoline subsidies, warning that implementing such a reform might result in unrest. The government also intends to scrap subsidies on natural gas, which most Iranians use for cooking and heating, as well as electricity, but the new prices are still not known. However, in recent weeks some households have received electricity bills with nearly sevenfold price increases. Source: AFP, September 15, 2010 a. If Iran removes the subsidies on necessities and consumers don’t know what the higher prices will be, draw a graph to show the most likely path of inflation and unemployment. If consumers do not know that the prices will rise, the inflation is unexpected. In this case the Iranian economy is likely to move upward along an unchanging short-run Phillips curve. Figure 12.6 illustrates this situation. The Iranian natural unemployment rate is assumed to be 10 percent. Initially the economy is at point A, with an inflation rate of 10 percent and an unemployment rate of 14 percent. Then the burst of unexpected inflation occurs. The economy moves along its short-run Phillips curve, SRPC0, from point A © 2014 Pearson Education, Inc.

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to point B. The inflation rate rises, to 13 percent in the figure, and the unemployment rate falls, to 8 percent in the figure.

b. If Iran removes the subsidies and announces the new prices so that consumers know what they are, draw a graph to show the most likely path of inflation and unemployment. If consumers know that prices will rise, the inflation is expected. In this case people revise upward their inflation expectations and the short-run Phillips curve shifts upward. Figure 12.7 illustrates this outcome. Once again the Iranian natural unemployment rate is assumed to be 10 percent. Initially the economy is at point A, with an inflation rate of 10 percent and an unemployment rate of 14 percent. Then the burst of expected inflation occurs. The short-run Phillips curve shifts upward, from SRPC0 to SRPC1. The economy moves from point A on its initial short-run Phillips curve to point B on the new short-run Phillips curve. The inflation rate rises, to 13 percent in the figure, but because the inflation was expected the unemployment rate does not change.

13.

Eurozone Unemployment Hits Record High As Inflation Rises Unexpectedly Spain is suffering mass unemployment with a 25 percent unemployment rate and half of those out of work under 25. Eurozone unemployment as a whole rose to 10.7 percent. At the same time, eurozone inflation unexpectedly rose to 2.7 percent a year, up from the previous month’s 2.6 percent a year. Source: Huffington Post, March 1, 2012 a. How does the Phillips curve model account for a very high unemployment rate? The Phillips curve can account for very high unemployment either by a very low inflation rate, which creates a movement along a stationary short-run Phillips curve, or by a very high natural unemployment rate, which shifts both the short-run and long-run Phillips curves rightward.

b. Explain the change in unemployment and inflation in the eurozone in terms of what is happening to the short-run and long-run Phillips curves. The small burst of unexpected inflation mentioned in the news clip brought a movement up along the short-run Phillips curve. But a large increase in the natural unemployment rate shifts both the short-run and long-run Phillips curves rightward. So in the Eurozone, the trade-off between inflation and unemployment worsened as the short-run Phillips curve shifted rightward.

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From the Fed’s Minutes Members expected real GDP growth to be moderate over coming quarters and then to pick up very gradually, with the unemployment rate declining only slowly. With longer-term inflation expectations stable, members anticipated that inflation over the medium run would be at or below 2 percent a year. Source: FOMC Minutes, June 2012 Are FOMC members predicting that the U.S. economy will move rightward or leftward along a short-run Phillips curve or that the short-run Phillips curve will shift up or down through 2012 and 2013? The Fed is predicting that the U.S. economy will move leftward along a generally flat short-run Phillips curve. The Fed expects that the unemployment rate will fall. Because the Fed thinks longer-term inflation expectations are stable, it does not expect the short-run Phillips curve to shift.

15.

Debate on Causes of Joblessness Grows What is the cause of the high unemployment rate? One side says more government spending can reduce it. The other says it’s a structural problem—people who can’t move to take new jobs because they are tied down to burdensome mortgages or firms that can’t find workers with the requisite skills to fill job openings. Source: The Wall Street Journal, September 4, 2010 Which business cycle theory would say that the rise in unemployment is cyclical? Which would say it is an increase in the natural rate? Why? It is likely that most of the mainstream business cycle theories say that the rise in the unemployment rate is cyclical in nature. Definitely the Keynesian cycle theory and new Keynesian cycle theory agree that the rise is cyclical. It is also likely that the monetarist cycle theory and new classical cycle theory agree. The real business cycle theory, however, disagrees. It regards all unemployment as natural and so it would assert that the rise in the unemployment rate reflects a rise in the natural rate.

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Answers to Additional Problems and Applications

Use the following news clip to work Problems 16 and 17. Inflation Should Be Feared The Fed is trying as hard as it can to spur growth, and to create some inflation. But the Fed must be careful. Inflation remains a danger because U.S. debt is skyrocketing, with no visible plan to pay it back. For the moment, foreigners are buying that debt. But they are buying out of fear that their governments are worse. They are short-term investors, waiting out the storm, not long-term investors confident that the United States will pay back its debts. If their fear passes, or they decide some other haven is safer, watch out. Inflation will come with a vengeance. It’s not happening yet: Interest rates are low now. But so were mortgage-backed security rates and Greek government debt rates just a few years ago. But if it happens, it will happen with little warning, the Fed will be powerless to stop it, and it will bring stagnation rather than prosperity. Source: John H. Cochrane, The New York Times, August 22, 2012 16. What type of inflation process does John Cochrane warn could happen? Explain the role that inflation expectations would play if the outbreak of inflation were to “happen with little warning.” Mr. Cochrane is concerned that a cost-push inflation could occur. Mr. Cochrane worries that if foreigners decide to sell their U.S. government securities, the U.S. exchange rate will fall as foreigners try to sell dollars to purchase their currency. With the fall in the U.S. exchange rate, the costs of goods imported into the United States will rise, thereby starting a cost-push inflation. If the inflation starts with little warning, people’s inflation expectations will not change so that inflation expectations will play a small role in the inflation.

17.

Explain why the inflation that John Cochrane fears would “bring stagnation rather than prosperity.” Mr. Cochrane is fearful of a cost-push inflation. In a cost-push inflation, real GDP decreases and the unemployment rate rises, being “stagnation rather than prosperity.”

Use the following information to work Problems 18 and 19. The Reserve Bank of New Zealand signed an agreement with the New Zealand government in which the Bank agreed to maintain inflation inside a low target range. Failure to achieve the target would result in the governor of the Bank (the equivalent of the chairman of the Fed) losing his job. 18. Explain how this arrangement might have influenced New Zealand’s short-run Phillips curve. The Reserve Bank of New Zealand’s arrangement with New Zealand’s government affected the short-run Phillips curve because it affected people’s expectations of the inflation rate. In particular, since the agreement was credible and had significant sanctions for the governor of the Reserve Bank of New Zealand, the public likely kept their expected inflation rates lower than might otherwise have been the case. As a result, the short-run Phillips curve was lower than it otherwise would have been and, in addition, was probably less likely to shift higher if the inflation rate temporarily rose.

19.

Explain how this arrangement might have influenced New Zealand’s long-run Phillips curve. The long-run Phillips curve is independent of the inflation rate and of people’s inflationary expectations, so the arrangement probably had little direct effect on the long-run Phillips curve. The only way in which the long-run Phillips curve could have been affected was if the © 2014 Pearson Education, Inc.

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arrangement affected the natural unemployment rate. If the agreement lowered the natural unemployment rate, the long-run Phillips curve shifted leftward.

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Use the following information to work Problems 20 and 21. An economy has an unemployment rate of 4 percent and an inflation rate of 5 percent a year at point A in Figure 12.8. Some events occur that move the economy in a clockwise loop from A to B to D to C and back to A. 20.

Describe the events that could create this sequence. Has the economy experienced demand-pull inflation, cost-push inflation, expected inflation, or none of these? First the inflation rate increases from 5 percent a year to 15 percent a year and the unemployment rate does not change. Then the unemployment rate increases from 4 percent to 8 percent and the inflation rate does not change. Next the inflation rate falls from 15 percent a year to 5 percent a year and the unemployment rate does not change. Finally the unemployment rate falls from 8 percent to 4 percent and the inflation rate does not change. This set of changes could be the result of an expected increase in the inflation rate from 5 percent to 15 percent, followed by an increase in the natural unemployment rate from 4 percent to 8 percent, followed by an expected fall in the inflation rate from 15 percent to 5 percent, finally followed by a decrease in the natural unemployment rate from 8 percent to 4 percent.

21.

Draw in the figure the sequence of the economy’s short-run and long-run Phillips curves. Figure 12.9 shows these short-run and longrun Phillips curves. The initial increase in the expected inflation rate moves the economy up its (stationary) long-run Phillips curve LRPC0 from point A to point B. The short-run Phillips curve shifts upward from SRPC0 to SRPC1 and intersects the long-run Phillips curve at point B. Then the increase in the natural unemployment rate shifts both the long-run and short-run Phillips curves rightward to LRPC1 and SRPC2 so that they intersect at point D. Next the fall in the expected inflation rate moves the economy along its (stationary) new long-run Phillips curve LRPC1 from point D to point C. The short-run Phillips curve shifts downward from SRPC2 to SRPC3 and intersects the long-run Phillips curve at point C. Finally, the fall in the natural unemployment rate shifts both the long-run and short-run Phillips curves leftward back to LRPC0 and SRPC0 so that they intersect at point A.

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Use the following news clip to work Problems 22 and 23. Fed Pause Promises Financial Disaster The indication is that inflationary expectations have become entrenched and strongly footed in world markets. As a result, the risk of global stagflation has become significant. A drawn-out inflationary process always precedes stagflation, anathema to the so-called Phillips Curve. Following the attritional effect of inflation, the economy starts to grow below its potential. It experiences a persistent output gap, rising unemployment, and increasingly entrenched inflationary expectations. Source: Asia Times Online, May 20, 2008 22. Evaluate the claim that stagflation is anathema to the Phillips Curve. Moving along a short-run Phillips curve, a higher inflation rate leads to a decrease in the unemployment rate. Stagflation occurs when a higher inflation rate occurs along with higher unemployment. On its face, stagflation is an “anathema” to the Phillips curve because it appears that stagflation contradicts the Phillips curve. But stagflation can occur when the short-run Phillips curve shifts rightward or upward, possibly because of an increase in the natural unemployment rate or higher expected inflation. In this situation, higher inflation and higher unemployment can occur simultaneously.

23.

Evaluate the claim made in the news clip that if “inflationary expectations” become strongly “entrenched” an economy will experience “a persistent output gap.” The comment that inflationary expectations become strongly entrenched likely means that the expected inflation rate becomes high. The Phillips curve model, however, shows that even with high expected inflation the economy will eventually return to the long-run Phillips curve and the natural rate of unemployment. Hence the assertion that high expected inflation means that the economy will experience a “persistent output gap” is incorrect.

Use the following information to work Problems 24 and 25. Because the Fed doubled the monetary base in 2008 and the government spent billions of dollars bailing out troubled banks, insurance companies, and auto producers, some people are concerned that a serious upturn in the inflation rate will occur, not immediately but in a few years time. At the same time, massive changes in the global economy might bring the need for structural change in the United States. 24.

Explain how the Fed’s doubling of the monetary base and government bailouts might influence the short-run and long-run unemployment–inflation tradeoffs. Will the influence come from changes in the expected inflation rate, the natural unemployment rate, or both? The doubling of the monetary base might lead to significant inflation at some point in the future. If the inflation is unexpected, it will not change either the short-run Phillips curve or the longrun Phillips curve. But if at some point the inflation becomes expected, the short-run Phillips curve will shift upward. In either case, however, the long-run Phillips curve is not affected. The government bailouts probably decreased the amount of cyclical unemployment that otherwise would have occurred. In this case they forestalled a movement downward along the short-run Phillips curve. As long as the bailed out companies operate efficiently, the bailouts by themselves did not affect the natural unemployment rate and thereby did not change the longrun Phillips curve.

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Explain how large scale structural change might influence the short-run and long-run unemployment–inflation tradeoffs. Will the influence come from changes in the expected inflation rate, the natural unemployment rate, or both? Large-scale structural changes increase structural unemployment, thereby increasing the natural unemployment rate. The long-run and short-run Phillips curves shift rightward, worsening the tradeoff between unemployment and inflation.

Use the following information to work Problems 26 to 28. Suppose that the business cycle in the United States is best described by RBC theory and that a new technology increases productivity. 26.

Draw a graph to show the effect of the new technology in the market for loanable funds. The advance in technology makes investment in industries that can utilize the new technology more profitable. Investment demand increases, which increases the demand for loanable funds. As Figure 12.10 shows, the increase in the demand for loanable funds shifts the demand for loanable funds curve rightward from DLF0 to DLF1. The increase in the demand for loanable funds raises the equilibrium real interest rate and increases the equilibrium quantity of loanable funds. In Figure 12.10 the real interest rate rises from 4 percent a year to 5 percent a year and the quantity of loanable funds increases from $2.5 trillion to $2.7 trillion.

27.

Draw a graph to show the effect of the new technology in the labor market. The advance in technology directly increases the demand for labor as firms look to hire more workers to exploit the technology. In addition, the supply of labor increases as workers respond to the higher real interest rate. The increase in the supply of labor, however, is less than the increase in the demand for labor. As Figure 12.11 shows, the demand for labor curve shifts rightward from LD0 to LD1 and the supply of labor curve shifts rightward from LS0 to LS1. Both changes increase the equilibrium quantity of employment. In Figure 12.11 employment increases from 300 billion hours to 330 billion hours. The effect on the real wage rate is ambiguous, but if, as illustrated in the figure, the increase in demand exceeds the increase in © 2014 Pearson Education, Inc.

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supply, then the net effect raises the real wage rate. In Figure 12.11 the real wage rate rises from $20 per hour to $30 per hour.

28.

Explain the when-to-work decision when technology advances. The when-to-work decision is an important part of the real business cycle theory. As the answer to Problem 26 showed, the increase in technology raises the real interest. Changes in the real interest rate create an “intertemporal substitution effect,” which is the “when-to-work” decision. If the real interest rate rises, the return to current work increases because any funds saved reap a higher real interest rate. (The effect is called “intertemporal” because in the future the increased saving influences people to work less.) As a result, a higher real interest rate increases the current supply of labor, which shifts the supply of labor curve rightward and increases equilibrium employment.

29.

Real Wages Fail to Match a Rise in Productivity For most of the last century, wages and productivity—the key measure of the economy’s efficiency—have risen together, increasing rapidly through the 1950s and ’60s and far more slowly in the 1970s and ’80s. But in recent years, the productivity gains have continued while the pay increases have not kept up. Source: The New York Times, August 28, 2006 Explain the relationship between wages and productivity in this news clip in terms of real business cycle theory. Increases in productivity increase the demand for labor. By itself, this effect raises the real wage rate. But the article suggests that “the pay increases have not kept up,” that is, the real wage rate has not increased. One reason that pay increases have not kept up might be errors in measuring the wage. In particular, if pay hikes have taken the form of higher fringe benefits, then focusing on only the wage rate itself might fail to capture the actual pay rise. Alternatively, it might be that the supply of labor has increased by more than the demand for labor. The real business cycle theory says that the supply of labor increases when productivity increases. So if the supply of labor increased by more when the demand for labor increased—as the real business cycle theory predicts will occur as a result of technological advances—then the effect on the real wage rate would be small and possibly even negative.

Economics in the News 30.

After you have studied Reading Between the Lines on pp. 310–311 (716–717 in Economics), answer the following questions. a. What are the main features of U.S. inflation and unemployment since 1948 that brought fluctuations in the misery index? From 1948 to about 1981 the inflation rate trended higher. The unemployment fluctuated but after 1972 generally rose until 1981. Over this period the slowly trending higher inflation rate created a gradual increase in the misery index. In 1973/1974 and 1980/1981 oil prices soared. Because of the higher oil prices both the inflation rate and unemployment rate spiked higher in 1973/1974 and 1980/1981, which spiked the misery index higher. After 1981 the inflation rate fell and generally remained low. Since its peak in 1980 the unemployment rate gradually fell until 2008, except during recessions when it rose. Until 2008 the lower inflation and the lower unemployment during non-recession years meant that the misery index was been low during those years. During recessions, such as 1990, the misery index rose. Since 2008 the persistently high unemployment rate has pushed the misery index to approximate its high point in 1981.

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b. When the misery index was at its peak in 1980, did inflation or unemployment contribute most to the high index? In 1980 inflation contributed the most to the high index. The inflation rate was 14.4 percent and the unemployment rate was (only) 7.6 percent.

c. Do you think the U.S. economy had a recessionary gap, an inflationary gap, or no gap in 1980? How might you be able to tell? In 1980 the U.S. economy had a recessionary gap because the unemployment rate was well above the natural unemployment rate.

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d. Use the AS-AD model to show the changes in aggregate demand and aggregate supply that are consistent with the rise of the misery index to its peak in June 1980. Figure 12.12 shows the situation in 1980. Before the misery index soared, the economy was at point A, on aggregate demand curve AD0 and short-run aggregate supply curve SAS0. Then over the next two years short-run aggregate supply decreased and the short-run aggregate supply curve shifted leftward to SAS1. The decrease in the short-run aggregate supply was large because people’s inflation expectations were high and because the economy was hit with significantly higher oil prices. Aggregate demand increased and the aggregate demand curve shifted rightward to AD1. But the increase in aggregate demand was significantly less than the decrease in short-run aggregate supply. The economy was at point B. From point A to point B the price level skyrocketed, creating an extremely high inflation rate. The economy had a severe recessionary gap (for simplicity the LAS curve is assumed to have not changed over this time period) so the unemployment rate rose. With these results, the misery index hit its 60 year peak from 1950 to 2012.

e. Use the AS-AD model to show the changes in aggregate demand and aggregate supply that are consistent with the rise of the misery index since President Obama assumed office. Figure 12.13 shows the situation since President Obama took office. When President Obama took office, the economy was at point A, on aggregate demand curve AD0 and short-run aggregate supply curve SAS0. The economy had a recessionary gap, so the unemployment rate, 8.3 percent, exceeded the natural rate. The inflation rate was zero. From then until August, 2012, aggregate supply decreased but there was a larger increase in aggregate demand. The aggregate demand curve shifted rightward to AD1 and the short-run aggregate supply curve shifted leftward to SAS1. The economy was at point B. From point A to point B the price level rose and the inflation rate was approximately 4 percent. The recessionary gap decreased slightly from when President Obama took office (again for simplicity the LAS curve is assumed to have not changed over this time period) so the unemployment rate fell from 8.3 percent to 8.2 percent. The misery index hit 12.5.

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Germany Leads Slowdown in Eurozone The pace of German economic growth has weakened “markedly,” but the reason is the weaker global prospects. Although German policymakers worry about the country’s exposure to a fall in demand for its export goods, evidence is growing that the recovery is broadening with real wage rates rising and unemployment falling, which will lead into stronger consumer spending. Source: The Financial Times, September 23, 2010 a. How does “exposure to a fall in demand for its export goods” influence Germany’s aggregate demand, aggregate supply, unemployment and inflation? If there is a severe decrease in demand for Germany’s exports, Germany’s aggregate demand decreases. There is no impact on aggregate supply. The decrease in aggregate demand lowers the price level and decreases real GDP. The fall in the price level means that the inflation rate falls; the decrease in real GDP means that unemployment rises.

b. Use the AS-AD model to illustrate your answer to part (a). Figure 12.14 illustrates this situation. Aggregate demand decreases and the aggregate demand curve shifts leftward, from AD0 to AD1. The economy moves from point A to point B. Real GDP decreases and the price level falls.

c. Use the Phillips curve model to illustrate your answer to part (a). In part (a) the inflation rate fell and the unemployment rate increased. People’s inflation expectations likely did not change so the German economy moved along its shortrun Phillips curve. In 2010, the German inflation rate was 1 percent and the unemployment rate was 7 percent. Figure 12.15 shows the effect of the decrease in demand for exports as the movement from point A on the short-run Phillips curve SRPC to point B on the same short-run Phillips curve. The inflation rate falls and the unemployment rate rises.

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d. What do you think the news clip means by “the recovery is broadening with real wage rates rising and unemployment falling, which will lead into stronger consumer spending”? The clip is implicitly talking about the multiplier effect. It is predicting that aggregate demand will increase as a result of the increase in consumption expenditure. Aggregate supply might also change but the emphasis in the news clip is on aggregate demand. The increase in aggregate demand increases real GDP and raises the price level. The increase in real GDP lowers the unemployment rate and the increase in the price level raises the inflation rate.

e. Use the AS-AD model to illustrate your answer to part (d). Figure 12.16 illustrates this situation. Aggregate demand increases because of the higher consumption expenditure and the aggregate demand curve shifts rightward, from AD0 to AD1. The economy moves from point A to point B. Real GDP increases and the price level rises.

Use the Phillips curve model to illustrate your answer to part (d). In part e the inflation rate rose and the unemployment rate decreased. People’s inflation expectations likely did not change so the German economy moved along its shortrun Phillips curve. In 2010, the German inflation rate was 1 percent and the unemployment rate was 7 percent. Figure 12.17 shows the effect of the increase in consumption expenditure as the movement from point A on the short-run Phillips curve SRPC to point B on the same short-run Phillips curve. The inflation rate rises and the unemployment rate decreases.

C h a p t e r

FISCAL POLICY**

Answers to the Review Quizzes Page 326 1.

(page 732 in Economics)

What is fiscal policy, who makes it, and what is it designed to influence? Fiscal policy is the use of the federal budget to achieve macroeconomic objectives. Fiscal policy is made by the president and Congress. It is designed to influence employment, economic growth, and price level stability.

What special role does the president play in creating fiscal policy? Each year the president proposes the budget that Congress amends and enacts.

What special roles do the Budget Committees of the House of Representatives and the Senate play in creating fiscal policy? Each year the Budget Committees of the House of Representatives and the Senate consider the budget proposed by the president, and develop their own ideas of how it should be modified. Eventually, formal conferences between the two houses resolve the differences between them and a series of spending acts and an overall budget act passed.

What is the timeline for the U.S. federal budget each year? When does a fiscal year begin and end? Consider the budget for 2013 as an example in answering this question. In February 2012 the president proposes a budget to Congress. Then, from February until October 1, 2012, the Congress debates the budget, amends it, and eventually passes the necessary budget bills. The president then signs or vetoes the budget bills that were presented to him. When the president vetoes bills, the Congress may over-ride the veto or pass other bills acceptable to the president. Fiscal year 2013 begins on October 1, 2012 and runs until September 30, 2013. During this year the Congress may pass—and the president may sign—supplementary bills. Then, after the fiscal year ends, accounts are prepared and the “official” amounts of outlays, receipts, and budget deficit or surplus are reported.

Is the federal government budget today in surplus or deficit? Currently, the U.S. federal government is running a (large) budget deficit.

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How does a tax on labor income influence the equilibrium quantity of employment? A tax on labor income drives a wedge between the after-tax wage rate of workers and the beforetax wage rate paid by firms. The tax on labor income decreases the supply of labor. That is, for each before-tax wage rate, workers provide a lower quantity of labor when faced with a tax that lowers their after-tax wage. The decrease in labor supply raises the before-tax wage rate, even though the after-tax wage rate received by workers falls. The decrease in labor supply also

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means that the quantity of employment at full employment (i.e., equilibrium employment in the labor market) falls.

How does the tax wedge influence potential GDP? By decreasing employment, the tax wedge lowers potential GDP.

Why are consumption taxes relevant for measuring the tax wedge? A tax on consumption raises the price paid for consumption goods and services and so is equivalent to a cut in the real wage rate from the perspective of workers.

Why are income taxes on capital income more powerful than those on labor income? Given positive inflation, what appears to be a moderate tax on interest income dramatically decreases the real after-tax interest rate, which is the interest rate that influences investment and saving plans. In particular, by driving a wedge between the real interest rate savers receive and firms pay, the tax on interest income decreases the supply of loanable funds, which lowers investment and saving in the economy.

What is the Laffer curve and why is it unlikely that the United States is on the “wrong” side of it? The Laffer curve is the relationship between the tax rate and the amount of tax revenue collected. The amount of tax revenue collected increases with the tax rate only up to a certain tax rate, after which, further increases in the tax rate cause tax revenue to fall. When tax rates are higher than the tax rate that maximizes tax revenue, a country is said to be on the wrong side of the Laffer curve. It is unlikely that the United States is on the wrong side of the Laffer curve because U.S. tax rates are among the lowest in the industrial world and past changes in U.S. tax rates have produced changes in tax revenues in the same direction.

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What is a present value?

A present value is the amount of money that, if invested today, will grow to equal a given future amount when the interest that it earns is taken into account.

Distinguish between fiscal imbalance and generational imbalance. Fiscal imbalance is the present value of the government’s commitments to pay benefits minus the present value of its tax revenues. Generational imbalance is the division of the fiscal imbalance between the current and future generations, assuming that the current generation continues to enjoy the current levels of taxes and benefits.

How large was the estimated U.S. fiscal imbalance in 2010 and how did it divide between current and future generations? In 2010, the fiscal imbalance was estimated to be $79 trillion. The generational imbalance estimates suggest that the current generation will pay 43 percent and future generations will pay 57 percent of the fiscal imbalance.

What is the source of the U.S. fiscal imbalance and what are the painful choices that we face? The source of the fiscal imbalance is largely the social security and Medicare obligations made under current law. The painful choices are to raise income taxes, raise social security taxes, cut social security benefits, or cut federal government discretionary spending.

How much of U.S. government debt is held by the rest of the world? U.S. government debt held by the rest of the world is about $4.8 trillion.

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Automatic fiscal policy is triggered by the state of the economy with no need for any government action. Discretionary fiscal policy, however, requires an act of Congress to either change government spending and/or change taxes.

How do taxes and needs-tested spending programs work as automatic fiscal policy to dampen the business cycle? Taxes, such as income taxes, and needs-tested spending programs both work as automatic fiscal policy because they decrease the effect a change in income has on aggregate expenditure. For instance, when income decreases, consumption expenditure and aggregate expenditure decrease. But with the fall in income, income taxes decrease and needs-tested spending increase so that disposable income does not fall as much as does income. The smaller fall in disposable income means that the fall in consumption expenditure is smaller, so that the fall in aggregate expenditure is likewise smaller.

How do we tell whether a budget deficit needs discretionary action to remove it? A budget deficit needs discretionary government action to remove it when the deficit is a structural deficit. If the deficit is a structural deficit, then even when the economy is at full employment, the deficit will remain. However, if the deficit is a cyclical deficit, then when the economy returns to full employment, the deficit will disappear.

How can the federal government use discretionary fiscal policy to stimulate the economy? If the economy has a recessionary gap, the government can increase its expenditure or lower taxes to increase aggregate demand and move the economy back toward potential GDP.

Why might fiscal stimulus crowd out investment? Fiscal stimulus, such as an increase in government expenditure or a decrease in taxes, increases the budget deficit. The increase in the budget deficit increases the (government’s) demand for loanable funds, thereby raising the real interest. The higher real interest rate decreases—crowds out—investment.

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Answers to the Study Plan Problems and Applications

Use the following news clip to work Problems 1 and 2. Economy Needs Treatment It’s the debt, stupid! Only when the government sets out a credible business plan will confidence and hiring rebound. Source: The Wall Street Journal, October 7, 2010 1. How has the U.S. government debt changed since 2006? What are the sources of the change in U.S. government debt? Since 2006 the U.S. government debt has skyrocketed, particularly after 2008. The debt dramatically rose because federal government taxes fell (as a percent of GDP) while federal government expenditures and transfer payments, shot upwards. Federal government expenditures on goods and services rose but not nearly as much as transfer payments.

What would be a “credible business plan” for the government to adopt? A “credible business plan” would be a plan for the government that shrinks the deficit and thereby stops the rapid increase in the government debt. This plan likely would involve cutting government outlays and increasing government receipts.

At the end of 2011, the government of China’s debt was ¥12.2 trillion. (¥ is yuan, the currency of China.) In 2012, the government spent ¥12.7 trillion and ended the year with a debt of ¥11.6 trillion. How much did the government receive in tax revenue in 2012? How can you tell? The government received ¥13.3 trillion in tax revenue. The government’s debt fell by ¥0.6 trillion, which means that the government’s budget surplus was ¥0.6 trillion. With total outlays of ¥12.7 trillion, a surplus of ¥0.6 trillion means that tax revenues were ¥12.7 trillion + ¥0.6 trillion, or ¥13.3 trillion.

The government is considering raising the tax rate on labor income and asks you to report on the supply-side effects of such an action. Answer the following questions using appropriate graphs. You are being asked about directions of change, not exact magnitudes. What will happen to: a. The supply of labor and why? The supply of labor will decrease. As shown in Figure 13.1, the supply of labor curve shifts leftward from LS0 to LS1. The supply of labor decreases because at each real wage rate, the hike in the tax rate on labor income lowers the after-tax wage rate received by workers.

b. The demand for labor and why? The demand for labor will remain the same so in Figure 13.1 the demand for labor curve remains LD. The demand for labor depends on the productivity of labor, which does not change after the increase in the tax rate on labor income.

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employment decreases from 310 billion hours per year to 300 billion hours per year.

d. The equilibrium before-tax wage rate and why? As Figure 13.1 shows, the equilibrium before-tax wage rate increases from $29 per hour to $30 per hour. The before-tax wage rate rises because the leftward shift of the supply of labor curve leads to a movement up along the demand for labor curve.

e. The equilibrium after-tax wage rate and why? The equilibrium after-tax wage rate decreases. The tax wedge in the figure is $2 per hour, so the after-tax wage rate falls from $29 per hour to $28 per hour. The increase in the tax rate on labor income increases the wedge between the before-tax wage rate and the after-tax wage rate. The before-tax wage rate increases but not by as much as the increase in tax. So the after-tax wage rate decreases.

Potential GDP? Potential GDP decreases. The equilibrium level of employment is full employment. So as full employment decreases, potential GDP decreases along the aggregate production function. Figure 13.2 shows this change as the movement along the aggregate production function, PF, from point A, with 310 billion hours of employment and potential GDP of $12.2 trillion, to point B, with 300 billion hours of employment and potential GDP $12.1 trillion.

What fiscal policy action might increase investment and speed economic growth? Explain how the policy action would work. A decrease in the tax on capital income will increase investment and thereby increase economic growth. A decrease in the tax on capital income increases the supply of loanable funds. The real interest rate falls and investment increases. The increase in investment increases economic growth.

Suppose that instead of taxing nominal capital income, the government taxed real capital income. Use appropriate graphs to explain and illustrate the effect that this change would have on: a. The tax rate on capital income. The nominal interest rate is the (nominal) income from capital. If the government changes the tax code to subtract the inflation rate from the (nominal) interest rate before taxes are imposed, the true tax rate on capital income falls because the part of the capital income—the inflation rate—that is received in compensation for inflation is no longer taxed.

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b. The supply of and demand for loanable funds. With a lower tax rate on capital income, the supply of loanable funds increases as the after-tax real interest rate rises. This change is illustrated in Figure 13.3 (on the next page) by the rightward shift of the supply of loanable funds curve from the initial supply of loanable funds curve, SLF0, to SLF1. The demand for loanable funds generally remains the same because it depends in large part on investment demand. Firms’ investment demand depends on how productive capital is and the productivity of capital does not necessarily change when the tax code changes. In Figure 13.3, the demand for loanable funds curve does not shift.

c. Investment and the real interest rate. As shown in Figure 13.3, the increase in the supply of loanable funds shifts the supply of loanable funds curve rightward. This change leads to a lower real interest rate and a higher amount of loanable funds and investment.

7. Fiscal Policy Priorities In 2008, the Obama administration proposed the following fiscal policy actions: (1) Increased spending on universal health insurance ($65 billion), alternative energy ($15 billion), help for homeowners ($20 billion), infrastructure ($60 billion), a scheme to pay college tuition in exchange for public service ($10 billion), and many other projects. (2) End Bush-era tax cuts on families with incomes greater than $250,000, increase payroll taxes on high-income earners, increase the tax rate on capital gains to 25 percent, increase the tax on dividends, and end arrangements that enable corporations to lower their taxes. Source: Fortune, June 23, 2008 Explain the potential supply-side effects of the various components of Obama’s fiscal plan. How would you expect these policy actions to change potential GDP and its growth rate? The supply-side effects of Mr. Obama’s economic plan are mixed. The plan for universal health care might slightly increase aggregate supply and potential GDP by increasing the health of the labor force. But this effect is likely small. The plan to increase alternative energy sources also might increase potential GDP and aggregate supply. The plan to help homeowners’ avoid default on their mortgages has no direct supply-side effects. However by reducing the default risk and increasing the supply of loanable funds, the program might lower the real interest rate and increase investment, but these effects likely would be small. The spending on infrastructure and college tuition would both increase potential GDP and aggregate supply. Ending the Bush tax cuts and raising payroll taxes on the wealthy would decrease their supply of labor, which decreases potential GDP and aggregate supply. Cutting taxes on middle-income earners would increase their labor supply and increase potential GDP and aggregate supply. Increasing taxes on investment and closing “corporate tax loopholes” would decrease potential GDP and aggregate supply. They also would decrease the growth rate of potential GDP. © 2014 Pearson Education, Inc.

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Under current policies, a plausible projection is that U.S. public debt will reach 250 percent of GDP in 30 years and 500 percent in 50 years. a. What is a fiscal imbalance? How might the U.S. government reduce the fiscal imbalance? The fiscal imbalance is the present value of the government’s commitments to pay benefits minus the present value of its tax revenues. To reduce the fiscal imbalance, the government needs to decrease its benefit payments—both its present payments and those promised in the future—and increase its tax revenue—both its current tax revenue and tax revenue in the future. While the annual government budget deficit is not the fiscal imbalance, it is related because, in general, the larger the budget deficit the larger the fiscal imbalance. Additionally, the larger the budget deficit, the larger the accumulated public debt becomes.

b. How would your answer to part (a) influence the generational imbalance? The generational imbalance is the division of the fiscal imbalance between the current and future generations, assuming that the current generation will enjoy the existing levels of taxes and benefits. The changes in part (a) of cutting benefits and raising taxes will affect the generational imbalance if the reduction in benefits and/or the hike in taxes affects the current generation. In that case the generational imbalance would change so that more of the fiscal imbalance is paid by the current generation and less by future generations.

Increase in Payroll Taxes Needed for Social Security Social Security faces a $5.3 trillion shortfall over the next 75 years, but a congressional report says the massive gap could be erased by increasing payroll taxes paid by both employees and employers from 6.2 percent to 7.3 percent and by raising the retirement age to 70. Source: USA Today, May 21, 2010 a. Why is Social Security facing a $5.3 trillion shortfall over the next 75 years? Social Security is facing the massive $5.3 trillion shortfall because the promised payments exceed the predicted tax revenue.

b. Explain how the suggestions in the news clip would reduce the shortfall. By raising the retirement age, the suggestion in the news clip decreases the expected payments made to retired workers. By increasing the payroll tax rates paid by employees and employers, the suggestion in the news clip increases the expected tax revenue. Both these changes decrease the predicted shortfall.

c. Would the suggestions in the news clip change the generational imbalance? If the changes affect the current generation (as well as future generations) the generational imbalance is changed. The current generation would pay more of the imbalance and therefore future generations would pay less.

10.

The economy is in a recession, and the recessionary gap is large. a. Describe the discretionary and automatic fiscal policy actions that might occur. Fiscal policy that increases government expenditure or decreases taxes would boost aggregate demand. In terms of automatic fiscal policy, needs-tested spending increases in recessions and tax revenue falls. Congress might also use discretionary policy by passing a new spending bill or a cut in tax rates.

b. Describe a discretionary fiscal stimulation package that could be used that would not bring an increase in the budget deficit. An increase in government expenditure with an offsetting increase in tax rates to boost tax revenue would not bring a budget deficit and would increase aggregate demand because the

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increase in government expenditure increases aggregate demand by more than the increase in taxes decreases aggregate demand.

c. Explain the risks of discretionary fiscal policy in this situation. The risk of discretionary policy is that, because of time lags, it takes effect too late and ends up moving the economy away from potential GDP.

Use the following news clip to work Problems 11 to 13. Fiscal Stimulus for Growth When China was hit by the global financial meltdown of 2008, its government increased spending on infrastructure investment, building miles and miles of expressway and subway systems. Source: The Nation, October 6, 2012 11.

What would be the effect on China’s budget deficit and real GDP of increased government spending on infrastructure? Increased government spending on infrastructure would, by itself, increase China’s budget deficit. Increased government spending on infrastructure increases aggregate demand. However increasing the budget deficit would raise the real interest rate and decrease investment, which would decrease aggregate demand. If the increase in aggregate demand from the increase in government spending exceeds the decrease from the decrease in investment, China’s real GDP would increase. But if the increase in aggregate demand from the increase in government spending is less than the decrease in aggregate demand from the decrease in investment, then China’s real GDP would decrease.

12.

What would be the effect on jobs of increased government spending on infrastructure? If, as explained in the previous answer, real GDP increases, then employment and jobs increase. However, if real GDP decreases, then jobs and employment decrease.

13.

If the government of China froze its current spending and instead cut taxes, what would be the effect on investment and jobs? If the government cut its taxes, the supply of loanable funds would increase so investment would increase. Additionally the supply of labor would increase so employment—jobs—would increase.

14.

An economy is in a recession, the recessionary gap is large, and the economy has a budget deficit. a. Do we know whether the budget deficit is a structural deficit or a cyclical deficit? Explain your answer. We know that at least some of the budget deficit in a recession is a cyclical deficit as needs-tested spending is higher and tax revenue is lower than at potential GDP. However, some of the budget deficit might be a structural deficit. The structural deficit is the deficit that would exist if real GDP equaled potential GDP and the economy was at full employment.

b. Do we know whether automatic fiscal policy is increasing or decreasing the output gap? Explain your answer. We know that automatic fiscal policy is decreasing the output gap relative to what it would be otherwise in a recession because they increase aggregate demand relative to what it would be otherwise in a recession. That is, aggregate demand decreases in a recession, but it would decrease by more without the increase in needs-tested spending and the decrease in tax revenue that produce the cyclical deficit.

c. If a discretionary increase in government expenditure occurs, what happens to the structural deficit? Explain. A discretionary increase in government expenditure, if not reversed following the end of the © 2014 Pearson Education, Inc.

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recession, moves the budget balance toward a structural deficit.

15.

Do Tax Cuts Ever Increase Government Revenues? Republican politicians insist that tax cuts “pay for themselves,” increasing receipts by goosing economic growth. Democrats and virtually all economists say they're wrong. Source: Slate, June 24, 2011 a. Explain what is meant by tax cuts paying for themselves. What does this statement imply about the tax multiplier? The idea of “tax cuts paying for themselves” refers to the Laffer curve. If the tax rate is on the “wrong side” of the Laffer curve, a reduction in the tax rate raises the total tax revenue collected so that, instead of lowering total tax revenue, the tax cut “pays for itself” by raising total tax revenue. When a tax cut pays for itself, each dollar of the tax cut generates more than a dollar increase in aggregate demand, so the multiplier is greater than 1.

b. Why would tax cuts not pay for themselves? The evidence strongly suggests that the United States is not on the “wrong side” of the Laffer curve, that is, to the right of the maximum point. In the United States a cut in the tax rate decreases the government’s total tax revenue. This outcome occurs if the tax cut leads to only a moderate rather than a huge increase in potential GDP.

Use the following news clip to work Problems 16 and 17. Summers Calls for Infrastructure Spending Larry Summers, the outgoing director of the White House National Economic Council, said the United States must ramp up spending on domestic infrastructure to drive the economic recovery. He said that a combination of low borrowing costs, cheap building costs and high unemployment in the construction industry make this the ideal time to rebuild roads, bridges, and airports. Source: Ft.com, October 7, 2010 16.

Is this infrastructure spending a fiscal stimulus? Would such spending be a discretionary or an automatic fiscal policy? This spending is a fiscal stimulus because it, like any other government expenditure on goods and services, increases aggregate demand and thereby increases real GDP. The spending is discretionary because new spending laws would be required to implement it.

17.

Explain how the rebuilding of roads, bridges, and airports would drive the economic recovery. The rebuilding of roads, bridges, and airports would initially add to aggregate demand. This increase in aggregate demand would raise real GDP. After these infrastructure projects are completed, they will increase potential GDP and aggregate supply. This effect, too, would increase real GDP.

Use the following news clip and fact to work Problems 18 to 20. Senate Approves Obama Tax Cut Plan The U.S. Senate has passed legislation extending Bush-era tax cuts for middle-class Americans earning up to $250,000 per year. Source: Financial Times, July 26, 2012 Fact: Middle and low-income earners spend almost all their disposable incomes. High-income earners save a significant part of their disposable incomes. © 2014 Pearson Education, Inc.

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18. a. Explain the intended effect of extending tax cuts for middle-class Americans but not for high-income families. Draw a graph to illustrate the intended effect. The goal of extending the tax cuts for middle-class Americans has an intended effect of increasing consumption expenditure, which increases aggregate demand. Figure 13.4 shows the intended effect of this policy where, including the multiplier effect, the aggregate demand curve shifts rightward from AD0 to AD1. As a result real GDP increases, in the figure from $12.7 trillion to $12.9 trillion. In the figure real GDP remains below potential GDP but the recessionary gap becomes smaller.

b. Explain why the effect of tax cuts depends on who receives them. The effect of this fiscal policy depends on the size of the impact on aggregate demand. The more of the tax cut that is spent (which means the less that is saved) the larger the magnitude of the effect on aggregate demand. If the tax rebates go to people who spend more of the rebate, that is, middle and low-income earners, the effect of this fiscal policy is larger.

19.

What would have a larger effect on aggregate demand: extending the Bush-era tax cuts to everyone; extending them for middle-class only; or extending them for high-income earners only? How would each alternative compare with no tax cuts but an equivalent increase in government expenditure? Extending the income tax cuts to everyone will have the largest effect on aggregate demand. Middle-income tax payers will spend most of the tax cut and high-income tax payers, while spending only a small fraction of their income, still spend some. In general, tax cuts have a larger effect on real GDP than do increases in government expenditure because the tax cuts have stronger supply-side effects. So whichever tax cut policy—extending the tax cuts to everyone, to only middle-class taxpayers, or to only high-income tax payers—has the largest supply-side effect also has the largest effect on real GDP.

20.

Explain whether a stimulus package centered around a one-time consumer tax rebate is likely to have a small or a large supply-side effect. The supply-side effects of a one-time consumer tax rebate are likely to be small. The tax rebate has no effect on the tax wedge and so does not affect the supply of labor or employment. It also has no effect on the incentive to save and so does not affect the supply of loanable funds or investment.

21.

Compare the impact on equilibrium real GDP of a same-sized decrease in taxes and increase in government expenditure on goods and services. According to the aggregate demand/aggregate supply model, the government expenditure multiplier exceeds the tax multiplier, so government expenditure has a larger impact on real GDP. Some economists, such as Robert Barro and Harald Uhlig disagree and assert that the tax multiplier exceeds the government expenditure multiplier because taxes affect aggregate demand and aggregate supply. In this case the decrease in taxes has a larger impact on real GDP.

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Answers to Additional Problems and Applications 22.

2012 Deficit: Smaller, But Still Big The Congressional Budget Office said the budget deficit was about $1.1 trillion in fiscal year 2012. That is about $200 billion smaller than in 2011, but still ranks as the fourth-largest deficit since World War II. Source: The Congressional Budget Office, October 5, 2012 Of the components of government outlays and receipts, which have changed most to contribute to the huge budget deficits in 2011 and 2012? In general, since 2008 outlays have increased substantially while receipts have risen slightly. The major factor leading to the massive rise in the budget deficit is an increase in transfer payments. An increase in government expenditure on goods and services also has lead to increasing the budget deficit but the effect from this factor is dwarfed by the rise in transfer payments.

Use the following information to work Problems 23 and 24. Suppose that in the United States, investment is $1,600 billion, saving is $1,400 billion, government expenditure on goods and services is $1,500 billion, exports are $2,000 billion, and imports are $2,500 billion. 23.

What is the amount of tax revenue? What is the government budget balance? Tax revenue equals $1,200 billion. From the circular flow of expenditure and income, we know that I = S + T – G + M – X. Rearranging the equation gives T = I– S + G + X – M, which equals $1,200 billion.

24. a. Is the government’s budget exerting a positive or negative impact on investment? The government has a budget deficit. It is exerting a negative influence on investment by increasing the demand for loanable funds, which increases the real interest rate and crowds out investment.

b. What fiscal policy action might increase investment and speed economic growth? Explain how the policy action would work. A decrease in the budget deficit by increasing taxes or decreasing government expenditure decreases the demand for loanable funds, which lowers the real interest rate and increases investment. The increase in investment increases economic growth.

25.

Suppose that capital income taxes are based (as they are in the United States and most countries) on nominal interest rates. And suppose that the inflation rate increases by 5 percent a year. Use appropriate diagrams to explain and illustrate the effect that this change would have on: a. The tax rate on capital income. The increase in the inflation rate increases the true tax rate on capital income because the interest income that is received in compensation for inflation is larger so that the tax paid on capital income increases.

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b. The supply of loanable funds. With a higher tax rate on capital income, the supply of loanable funds decreases and the after-tax real interest rate falls. This change is illustrated in Figure 13.5 by the leftward shift of the supply of loanable funds curve from the initial supply of loanable funds curve SLF0 to the new supply, SLF1, when the inflation rate is higher.

c. The demand for loanable funds. The demand for loanable funds generally remains the same because it depends in large part on investment demand. Firms’ investment demand depends on how productive capital is and the productivity of capital does not change when the tax code changes.

d. Equilibrium investment. As illustrated in Figure 13.5, when the supply of loanable funds decreases, the supply of loanable funds curve shifts leftward from SLF0 to SLF1. The real interest rate rises from 4 percent a year to 5 percent a year, and the equilibrium quantity of loanable funds deceases from $2.5 trillion to $2.4 trillion. Investment decreases.

e. The equilibrium real interest rate. The decrease in the supply of loanable funds leads to a higher equilibrium real interest rate. In the figure the real interest rate rises from 4 percent to 5 percent.

Use the following information to work Problems 26 and 27. Policy Changes Scheduled to Take Effect in 2013 A host of significant provisions of the Job Creation Act of 2010 are set to expire on January 1, 2013, including the emergency unemployment benefits and a temporary reduction of 2 percentage points in the Social Security payroll tax. Source: The Congressional Budget Office, October 5, 2012 26.

Explain the supply-side effects of allowing unemployment benefits and the Social Security payroll tax cut to expire. Allowing emergency unemployment benefits to expire decreases job search by making unemployed workers more likely to accept employment offers, thereby boosting employment. Allowing the Social Security payroll tax cuts to expire increases the income tax on labor, which decreases the supply of labor, thereby decreasing employment.

27. a. Explain the potential demand-side effects of extending unemployment benefits and not increasing the Social Security payroll tax. Compared to the situation of allowing these policies to expire, extending unemployment benefits will increase the income of unemployed workers who cannot find jobs. Extending the Social Security payroll tax cut increases the income of employed workers. The increase in income for both classes of workers boosts their consumption expenditure higher than what it would be if the policies expired, so aggregate demand increases from what it would be otherwise.

b. Explain the potential supply-side effects of these fiscal policy actions. Compared to the situation of allowing these policies to expire, extending emergency unemployment benefits increases job search by making unemployed workers less likely to © 2014 Pearson Education, Inc.

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accept employment offers, thereby reducing employment. Allowing the Social Security payroll tax cuts to continue continues the decreases the income tax on labor, which means that the supply of labor will not decrease and hence employment will not decrease.

c. Draw a graph to illustrate the combined demand-side and supply-side effect of these fiscal policy actions. Figure 13.6 shows the combined effects of these policies compared to what the situation would be if the policies were allowed to expire. Aggregate demand unambiguously increases, so the aggregate demand curve shifts rightward from AD0 to AD1. The effect on aggregate supply is ambiguous. Continuing the unemployment benefits decreases aggregate supply; continuing the Social Security payroll tax cuts increases aggregate supply. Presuming that the effects from extending the unemployment benefits and Social Security payroll tax cuts just offset each other, aggregate supply does not change so the aggregate supply curve does not shift. In Figure 13.6 the shift of the aggregate demand curve increases real GDP, in the figure from $13.4 trillion to $13.8 trillion, and the price level rises, in the figure from 122 to 126.

Use the following news clip to work Problems 28 and 29. Paul Ryan’s Roadmap Business Tax Paul Ryan has proposed replacing the corporate income tax, which is among the highest in the industrialized world, with what he calls a business consumption tax but what is in effect a tax of a firm’s value added. He proposes that this tax be set at 8.5 percent, which is half that of the valueadded taxes in the rest of the industrialized world. Source: A Roadmap for America’s Future, http://roadmap.republicans.budget.house.gov/ 28.

Explain the potential supply-side effects of Paul Ryan’s tax plan. Mr. Ryan’s plan effectively lowers the tax on business income. By decreasing the tax on profits, business’s demand for investment increases, which increases the nation’s capital stock. Aggregate supply and potential GDP both increase.

29.

Where on the Laffer curve do you think Paul Ryan believes the U.S. economy lies? Explain your answer. Mr. Ryan probably believes that the tax rate U.S. economy lies beyond the rate that maximizes U.S. tax revenue.

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30. Mandatory Spending Is Hard to Contain In Fiscal 2013, spending on the big three entitlement programs—Social Security, Medicare, and Medicaid—was $2.1 trillion. The CBO baseline projection sees this expenditure rising by 70 percent to $3.55 trillion by 2022. Over that same period, discretionary expenditure, mainly national defense, is projected to grow by only 17 percent from $1.2 trillion to $1.4 trillion. The deficit is projected to fall from $1 trillion to $200 billion. Source: Congressional Budget Office, 2013 If politicians continue to avoid debating the projected increases in the three big entitlement programs, how do you think the fiscal imbalance will change? If Congress introduced changes that slowed the growth of expenditure on the three entitlement programs, who would benefit and who would pay? If politicians avoid tackling spending from the three big entitlement programs, the fiscal imbalance will increase because their scheduled spending will skyrocket. If Congress introduces changes that slow the growth of expenditures on the three entitlement programs, the current generation would pay because they do not receive the benefit from any growth in the programs. The future generation would benefit because they do not have to pay higher taxes.

31.

The economy is in a boom and the inflationary gap is large. a. Describe the discretionary and automatic fiscal policy actions that might occur. Fiscal policy that decreases expenditure or increases taxes would decrease aggregate demand. In terms of automatic fiscal policy, need-tested spending decreases in expansions and tax revenue increases. Congress might also use discretionary policy by cutting spending programs or increasing tax rates.

b. Describe a discretionary fiscal restraint package that could be used that would not produce serious negative supply-side effects. A decrease in government expenditure with an offsetting decrease in autonomous taxes would not bring a change in government saving and so would not change investment and the growth of real GDP.

32.

The economy is growing slowly, the inflationary gap is large, and there is a budget deficit. a. Do we know whether the budget deficit is structural or cyclical? Explain your answer. The economy is at an above full-employment equilibrium because there is an inflationary gap. Real GDP exceeds potential GDP. There is a budget deficit, but with potential GDP greater than real GDP there is a cyclical surplus. The structural deficit is larger than the total budget deficit because the cyclical surplus offsets some of structural deficit. So the budget deficit is composed of a structural deficit and a cyclical surplus.

b. Do we know whether automatic stabilizers are increasing or decreasing aggregate demand? Explain your answer. We know that automatic stabilizers are decreasing aggregate demand relative to what it would be otherwise in an inflationary gap.

c. If a discretionary decrease in government expenditure occurs, what happens to the structural budget balance? Explain your answer. A discretionary decrease in government expenditure decreases the structural deficit. Following the change in fiscal policy, government outlays would be smaller even when the economy returned to full employment. © 2014 Pearson Education, Inc.

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Use the following news clip to work Problems 33 to 35. Is Fiscal Stimulus Necessary? China’s economy is slowing from its normal 9 percent or higher rate to just below 9 percent. The source of the slowdown is the global economic slowdown that is restricting exports growth and the government’s deliberate decision to discourage unproductive investment. The situation now is not like that in 2008 when real GDP growth dropped from 9 percent to 6.8 percent and fiscal stimulus does not appear to be urgently needed. Source: China Daily, June 8, 2012 33.

Explain why fiscal stimulus was needed in 2008 but not in 2012. Fiscal stimulus was needed in 2008 because the growth rate of the Chinese economy significantly slowed. The slowdown in the growth rate in 2012 is much milder and hence fiscal stimulus is not needed.

34.

Would you expect automatic stabilizers to be operating in 2012 and if so, what effects might they have? China’s automatic stabilizers will operate in 2012. China has fewer automatic stabilizers than the United States because China has fewer unemployment benefit programs and fewer welfare programs. China’s income tax, however, will operate as an automatic stabilizer as fewer people rise into higher tax brackets and some fall into lower tax brackets.

35.

Why might stimulus come too late? What are the potential consequences of stimulus coming too late? Stimulus might come too late because forecasters’ predictions that the slowdown in China’s growth will be slight might prove incorrect. So stimulus might be delayed until the economy was actually in a recession. If this outcome occurred, the unemployment rate would already have risen and real GDP already have decreased because of the delay in implementing the program. Additionally, if the program is implemented too late, then GDP might already be rising and unemployment falling when the program’s impacts occur, which could result in a significantly higher price level.

Economics in the News 36.

After you have studied Reading Between the Lines on pp. 340–341 (746–747 in Economics), answer the following questions. a. What is the fiscal cliff? The fiscal cliff is the simultaneous expiration of Bush-era tax cuts, a temporary payroll tax cut, and the beginning of automatic spending cuts to both defense and domestic budgets. All of these policies are contractionary; that is, all would decrease real GDP and raise unemployment.

b. Explain the effects of the fiscal cliff on the labor market tax wedge and the level of employment and potential GDP. Part of the fiscal cliff is the expiration of the Bush-era tax cuts and the temporary payroll tax cut. If these tax cuts expire, the labor market tax wedge increases. The increase in the labor market tax wedge decreases the level of employment and thereby decreases potential GDP.

c. Explain the effects of the fiscal cliff on aggregate demand and aggregate supply. The expiration of the Bush-era tax cuts and the temporary payroll tax cut increase the labor market tax wedge. This increase decreases potential GDP and short-run aggregate supply. The expiration of Bush-era tax cuts, a temporary payroll tax cut, and the automatic spending cuts to both defense and domestic spending all decrease aggregate demand.

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d. Draw a graph to show how the fiscal cliff changes real GDP and the output gap if the effect on aggregate demand is greater than that on aggregate supply. The labor market tax wedge decreases potential GDP and short-run aggregate supply. If these effects are larger than other effects that increases potential GDP, then both potential GDP and short-run aggregate supply decrease. Figure 13.7 shows the effect of the decrease in potential GDP and short-run aggregate supply. In Figure 13.7, the long-run aggregate supply curve shifts from LAS0 to LAS1 and the short-run aggregate supply curve shifts from SAS0 to SAS1. In the figure aggregate demand does not change. Potential GDP decreases from $13.0 trillion to $12.8 trillion and equilibrium real GDP decreases from $12.6 trillion to $12.5 trillion. The recessionary gap—the difference between potential GDP and real GDP—decreases from $0.4 trillion to $0.3 trillion.

37. More Fiscal Stimulus Needed? In New York Times articles and in blogs, economists Paul Krugman and Joseph Stiglitz say there is a need for more fiscal stimulus in both the United States and Europe despite the large federal budget deficit and large deficits in some European countries. a. Do you agree with Krugman and Stiglitz? Why? Students who agree with Mr. Krugman and Mr. Stiglitz likely believe that the U.S. economy will not return to full employment rapidly without further government stimulus. Students who disagree with Mr. Krugman and Mr. Stiglitz likely believe that the U.S. economy is on track to return to full employment.

b. What are the dangers of not engaging in further fiscal stimulus? If the economy is not returning to full employment, fiscal stimulus might be necessary. In this situation, if there is no fiscal stimulus, the economy will remain mired in a recessionary gap and unemployment will exceed natural unemployment.

c. What are the dangers of embarking on further fiscal stimulus when the budget is in deficit? The fiscal stimulus will further increase the budget deficit. The rise in the deficit increases the government’s demand for loanable funds and thereby raises the real interest rate. The higher real interest rate decreases—crowds out—investment. The net effect on aggregate demand is uncertain: The fiscal stimulus increases aggregate demand; however, the decrease in investment expenditure decreases aggregate demand. If aggregate demand does not change, there is no immediate effect on real GDP. But the decrease in investment lowers the future capital stock, which means that aggregate supply does not increase as much as otherwise so that U.S. economic growth will be slower.

38. Payroll Tax Cut Is Unlikely to Survive Into Next Year The payroll tax holiday in 2012 reduced workers’ tax by $700 for an income of $35,000 a year and by $2,202 for incomes of $110,100 and over. If the tax holiday ends, the Economic Policy © 2014 Pearson Education, Inc.

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Institute recommends replacing the payroll tax cut with infrastructure spending. Source: The New York Times, September 30, 2012 a. Explain how a payroll tax affects the before-tax and after-tax wage rate and employment and unemployment. The payroll tax places a wedge between the before-tax wage rate and the after-tax wage rate. The payroll tax raises the before-tax wage rate (though by less than the amount of the tax) and lowers the after-tax wage rate. Employment decreases and unemployment increases.

b. Explain the effects of an increase in infrastructure spending on employment and unemployment. In the short-run, an increase in infrastructure increases aggregate demand, which increases real GDP and thereby increases employment and decreases unemployment. In the longer-run, an increase in infrastructure spending increases the nation’s productive resources, which increases potential GDP and short-run aggregate supply. The increase in short-run aggregate supply increases employment and decreases unemployment.

c. Which fiscal policy action would have the bigger effect on employment: continuing the payroll tax cut or new infrastructure spending? Explain your answer. The payroll tax cut has only an aggregate supply effect; the infrastructure spending increases both aggregate supply and aggregate demand. Because the increase in infrastructure spending affects both aggregate demand and aggregate supply, it might have a larger effect on employment.

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MONETARY POLICY**

Answers to the Review Quizzes Page 350 1.

(page 756 in Economics)

What are the objectives of monetary policy? As set out in law, the objectives of monetary policy are to achieve “maximum employment, stable prices, and moderate long-term interest rates.”

Are the goals of monetary policy in harmony or in conflict (a) in the long run and (b) in the short run? The monetary policy goals are essentially in harmony for the long run. In the long run, stable prices will bring about maximum employment because firms and households can make the best possible decisions against a backdrop of stable prices. With stable prices, the inflation rate is low—perhaps even zero if prices are precisely stable. The nominal interest rate equals the real interest rate plus the (expected) inflation rate. If the inflation rate is low, then the nominal interest rate will be as low as possible. In the short run, however, the monetary policy goals might conflict with each other. In the short run, in a recession the Federal Reserve might lower the federal funds rate and increase the growth rate of the quantity of money to combat the recession. The Fed’s policy will increase employment and real GDP but also increase the price level and eventually the nominal interest rate.

What is the core inflation rate and how does it differ from the overall CPI inflation rate? The core inflation rate is the rate of increase in the core PCE deflator. The core PCE deflator is the personal consumption expenditure deflator excluding food and fuel The Federal Reserve believes that food and fuel prices are more volatile than other prices and largely respond to factors other than the state of inflation in the general economy. Accordingly, the core inflation rate is smoother, that is, less volatile than the actual inflation rate.

Who is responsible for U.S. monetary policy? The Governors of the Federal Reserve System and the Federal Open Market Committee (FOMC) are responsible for the conduct of U.S. monetary policy.

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What is the Fed’s monetary policy instrument? While the Fed could use the quantity of money, the exchange rate, or a short-term interest rate, the Fed chooses to use a short-term interest rate, in particular, the federal funds rate. The federal funds rate is the interest rate on overnight loans of reserves that commercial banks make to each other.

How is the federal funds rate determined in the market for reserves? The federal funds rate is determined by equilibrium in the reserve markets. The federal funds rate is the rate that sets the quantity of reserves demanded equal to the quantity of reserves supplied. *

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What are the main influences on the FOMC federal funds rate decision? Though the Federal Reserve does not use an explicit formula to determine changes in its targeted federal funds rate, the Fed seems to respond to the inflation rate, the unemployment rate, and the output gap when determining its federal funds target rate.

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Describe the channels by which monetary policy ripples through the economy and explain how each channel operates. When the Federal Reserve lowers the federal funds rate, other short-term interest rates also fall. As a result, the exchange rate falls because investors decrease their demand for U.S. dollars since the interest yield on dollars is lower. When the Federal Reserve lowers the federal funds rate it does so by buying securities in the open market. Bank reserves increase so that banks have excess reserves. Because banks have excess reserves, they loan the excess. Loans increase and a multiple expansion of the quantity of money results. The supply of loanable funds increases so that the long-term real interest rate falls and consumption and investment increase. Net exports increase because of the lower exchange rate. All three of these changes increase aggregate demand, so that real GDP growth and the inflation rate both increase.

Do interest rates fluctuate in response to the Fed’s actions? Yes, interest rates fluctuate in response to the Fed’s actions. Indeed, the first effect of a change in monetary policy is a change in the federal funds interest rate.

How do the Fed’s actions change the exchange rate? A change in the U.S. interest rate changes the U.S. interest rate differential. For example, a rise in the U.S. interest rate, other things remaining the same, means that the U.S. interest rate differential increases. When the U.S. interest rate differential increases people want to move funds from other countries into the United States to obtain the relatively higher returns on U.S. assets. To move funds into the United States, people buy dollars and sell other currencies, driving the price of the dollar up. A higher dollar means that foreigners must pay more for U.S.-made goods and services and Americans pay less for foreign goods and services. So the rise in the interest rate means that exports decrease and imports increase, corresponding to a fall in net exports.

How do the Fed’s actions influence real GDP and how long does it take for real GDP to respond to the Fed’s policy changes? The Fed’s actions affect real GDP by changing expenditure plans. For instance, an expansionary policy by the Fed that lowers the interest rate increases consumption expenditure, investment, and net exports. All three of these changes boost aggregate demand so that real GDP growth increases. The effect on real GDP is far from immediate because there are time lags in the process. Real GDP initially responds about two years after the policy is initiated.

How do the Fed’s actions influence the inflation rate and how long does it take for inflation to respond to the Fed’s policy changes? The Fed’s actions affect the inflation rate and the price level by changing expenditure plans. For instance, an expansionary policy by the Fed that lowers the interest rate increases consumption expenditure, investment, and net exports. All three of these changes boost aggregate demand so that the price level rises and the inflation rate increases. The effect on the price level and inflation rate is far from immediate because there are time lags in the process. The change in inflation is slower than the change in real GDP.

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What are the three ingredients of a financial and banking crisis? A financial and banking crisis occurs when there is a widespread fall in assets prices, a significant currency drain, and a run on banks. When these events occur, banks and other financial institutions face incipient failure and so they drastically decrease their lending activities.

What are the policy actions taken by the Fed and the U.S. Treasury in response to the financial crisis? The Fed and the U.S. Treasury have undertaken eight policies designed to combat the financial crisis. The Fed conducted massive open market operations to provide liquidity to banks. To provide liquidity to money market funds, the Fed also created an asset-backed commercial paper money market mutual fund liquidity facility. To provide liquidity to other financial institutions, the Fed allowed created programs that allowed term auction credit and also primary dealer and other broker credit. The U.S. Treasury engaged in two Troubled Asset relief Programs, TARP 1 and TARP 2. TARP 1 was designed to give banks more liquidity. Under it banks were to sell troubled assets to the U.S. Treasury in exchange for U.S. government assets. This program did not work well and was replaced by TARP 2. Under TARP 2 the U.S. Treasury directly purchased stock in financial institutions, thereby increasing their solvency and making their failure less likely. Finally, accounting rules were changed to allow financial institutions to use fair value accounting rather than mark-to-market accounting to value assets. This change also increased their solvency and made failure less likely.

Why was the recovery from the 2008–2009 recession so slow? The recovery from the recession has been slow because investment has not rebounded. Investment has remained low because of uncertainty about the future.

How might inflation targeting improve the Fed’s monetary policy? Inflation targeting, under which the Fed would make public its inflation target and face penalties if the target was missed, would improve the Fed’s monetary policy because it would remove uncertainty. The public would know what the Fed’s policy was and would not need to guess at what the inflation rate would be the future. This certainty would improve people’s decision making about saving and investment and thereby improve economic performance.

How might using the Taylor rule improve the Fed’s monetary policy? The Taylor rules is a formula that sets the federal funds rate according to the inflation rate and the output gap. This rule has worked well in computer simulations when it comes to avoiding excessive inflation or recessions. Given this track record, it might improve the Fed’s monetary policy and make the Fed better able to avoid high inflation and recessions. It also has the advantage of inflation targeting insofar as it removes uncertainty about what will be the Fed’s policy.

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Answers to the Study Plan Problems and Applications 1.

“Unemployment is a more serious economic problem than inflation and it should be the focus of the Fed’s monetary policy.” Evaluate this statement and explain why the Fed’s primary policy goal is price stability. The Fed’s primary goal is price stability because price stability helps the Fed reach all three of its goals of maximum employment, stable prices, and moderate long-term interest rates. Price stability directly meets the second goal of price stability. And because price stability means that the inflation rate is low, it helps keep nominal long-term interest rates close to the long-term real interest rate. Finally price stability helps consumers and businesses make better decisions about saving and investment and thereby keep unemployment close to the natural rate.

“Because the core inflation rate excludes the prices of food and fuel, the Fed should pay no attention to it and should instead be concerned about the CPI inflation rate.” Explain why the Fed regards the core inflation rate a good measure on which to focus. Core inflation is the inflation rate calculated using the core personal consumption expenditure (PCE). The core deflator is the PCE deflator excluding food and fuel prices. The prices of food and fuel are generally quite volatile. Because of the added volatility the actual CPI inflation rate is extremely volatile, often shooting upward for a month or two and then plunging downward for the next few months. The Fed believes that if it focuses on the CPI inflation rate, it frequently would make policy on the basis of factors that might be quickly reversed. By focusing instead on the core inflation rate, the Fed believes it has a better measure of the nation’s underlying inflation rate, that is, a measure that does not respond as strongly to strictly temporary occurrences.

“Monetary policy is too important to be left to the Fed. The President should be responsible for it.” How is responsibility for monetary policy allocated among the Fed, the Congress, and the President? The Fed has primary responsibility for the nation’s monetary policy. It is the FOMC that decides upon monetary policy. The Congress plays, at best, a minor role. Each year the Fed must make two reports to Congress about its monetary policy and the Fed chairman testifies before Congress at these times. The President’s role is limiting to appointing the members and the chairman of the Board of Governors, though Presidents have tried to influence the Fed’s decisions.

Bernanke Warns of High Budget Deficits The government must rein in budget deficits in the years ahead, Federal Reserve Chairman Ben S. Bernanke told Congress. centralbanking.com, June 15, 2011 a. Does the Fed Chairman have either authority or responsibility for federal budget deficits? The Fed Chairman has neither the authority nor the responsibility for the federal budget deficit. The Fed Chairman can try to use moral suasion to convince policymakers to adopt a particular deficit policy but there is nothing else the chairman can do.

b. How might a federal budget deficit complicate the Fed’s monetary policy? (Hint: Think about the effects of a deficit on interest rates.) If the economy is in a recession and if the government adopts an expansionary fiscal policy, the budget deficit increases. The increase in the budget deficit increases the government’s demand for loanable funds, which raises the real interest rate. If the Fed tries to use an expansionary policy to combat the recession, the Fed’s policy requires lowering the interest rate. It will be more difficult for the Fed to lower the interest rate if the government’s fiscal policy is raising the interest rate. © 2014 Pearson Education, Inc.

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c. How might the Fed’s monetary policy complicate Congress’s deficit cutting? (Hint: Think about the effects of monetary policy on interest rates.) If the Fed raises the interest rate to combat an inflationary gap, the interest payments the government must make on its debt rise. The higher interest payment on its debt makes Congress’s attempt to cut the budget deficit more difficult.

Fed’s Easing Has Little Impact So Far The Federal Reserve’s latest easing program may be nicknamed “QE Infinity” on Wall Street, but it’s having a limited effect on the economy so far. Source: cnbc.com, October 3, 2012 a. What does the Federal Reserve Act of 2000 say about the Fed’s control of the quantity of money? The Federal Reserve Act of 2000 says that the Fed “shall maintain long-run growth of the monetary and credit aggregates commensurate with the economy’s long-run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”

b. How can the massive increase in the monetary base resulting from “quantitative easing” or QE be reconciled with the Federal Reserve Act of 2000? The Fed is charged with setting monetary growth to “promote effectively the goal(s) of maximum employment.” The massive increase in the monetary base attempts to decrease the unemployment rate from its level at the time, near 9.5 percent, to something closer to the natural unemployment rate, thereby helping to achieve its goal of maximum employment.

What are the two possible monetary policy instruments, which one does the Fed use, and how has its value behaved since 2000? The Fed could use either the monetary base or the federal funds rate as its monetary policy instrument. The Fed has chosen to use the federal funds rate. Since 2000 the federal funds rate has been on a roller coaster. Starting from about 6.5 percent in early 2000, the federal funds rate fell for the next four years until it reached 1 percent in the second quarter of 2004. From that time the federal funds rate rose to slightly more that 5 percent in 2006 and 2007. After 2007 the federal funds rate fell until it hit its historic low, 0.2 percent in 2008. From 2008 until 2010, the federal funds rate has stayed at this historic low.

How does the Fed hit its federal funds rate target? Illustrate your answer with an appropriate graph. To hit its federal funds rate target, the Fed uses open market operations to change the quantity of reserves. Figure 14.1 illustrates this process. Initially the federal funds rate target is 5.25 percent. The quantity of reserves is $100 billion, as indicated by RS0. If the Fed wants to lower the federal funds rate to 2 percent, the Fed will use open market purchases of government securities to increase reserves to $200 billion. These open market operations will shift the supply of reserves curve to RS1 and thereby lower the equilibrium federal funds rate to the targeted value, 2.00 percent.

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What does the Fed do to determine whether the federal funds rate should be raised, lowered, or left unchanged? The Fed changes in the federal funds rate based on its forecasts of the three economic variables: the inflation rate, the unemployment rate, and the output gap. If the inflation rate is forecasted to rise, the unemployment rate is forecasted to fall, or the output gap is forecasted to fall and perhaps become an inflationary gap, the Fed might be concerned about inflation and push the federal funds rate up. If the inflation rate is forecasted to fall, the unemployment rate is forecasted to rise, or the output gap is forecasted to rise, the Fed might be concerned about unemployment and push the federal funds rate down.

Use the following news clip to work Problems 9 and 10. Fed Sees Unemployment and Inflation Rising It is May 2008 and the Fed is confronted with a rising unemployment rate and rising inflation. Source: CNN, May 21, 2008 9. Explain the dilemma faced by the Fed in May 2008. Rising unemployment calls for expansionary monetary policy, that is, a cut in the interest rate to lower the unemployment rate. This policy, however, raises the inflation rate. Rising inflation calls for a contractionary monetary policy, that is, a hike in the interest rate to lower the inflation rate. This policy, however, raises the unemployment rate. So if the Fed combats unemployment, it worsens the inflation problem. But if the Fed combats inflation, it worsens the unemployment problem.

10. a. Why might the Fed decide to cut the interest rate in the months after May 2008? The Fed might have decided to cut the interest rate after May 2008 if unemployment worsened and became a more severe problem than inflation.

b. Why might the Fed have decided to raise the interest rate in the months after May 2008? The Fed might have decided to raise the interest rate after May 2008 if inflation worsened and became a more severe problem than unemployment.

Use the following news clip to work Problems 11 and 12. Sorry Ben, You Don’t Control Long-Term Rates Perhaps Ben Bernanke didn’t learn in school that long-term interest rates are set by the market but he is about to learn this lesson. Long-term interest rates cannot be manipulated lower by the central bank for a great length of time. Source: safehaven.com, May 5, 2009 11. What is the role of the long-term interest rate in the monetary policy transmission process? The long-term real interest rate is a key component of the monetary policy transmission process. When monetary policy changes the long-term real interest rate, then firms’ investment decisions and consumers’ expenditure plans for big-ticket goods, such as houses, respond. Changes in investment and consumption expenditure affect aggregate demand and thereby change real GDP and the price level.

12. a. Is it the long-term nominal interest rate or the long-term real interest rate that influences spending decisions? Explain why. It is the real long-term interest rate that influences spending decisions. The real interest rate strips out the effects of inflation and measures borrowers’ real cost—the cost in terms of goods and services—of borrowing. The real interest rate also measures savers’ real return—the return © 2014 Pearson Education, Inc.

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in terms of goods and services—of saving. Firms are interested in the real cost and savers are interested in the real return when they make their investment and saving decisions.

b. How does the market determine the long-term nominal interest rate and why doesn’t it move as much as the short-term interest rates? The long-term nominal interest rate fluctuates less than the short-term interest rate because the long-term interest rate is an expected average of short-term interest rates. People can either borrow or save by making a long-term commitment or by making successive short-term commitments. Adjusted for risk, the average of the interest rates on the short-term commitments must equal the long-term interest rate. If they were not equal one method of borrowing would be more or less expensive than the other. People would stream to borrow using the less expensive method, pushing that interest rate higher, back toward equality. Simultaneously other people would stream to save using the method with the higher return, pushing that interest rate lower, back toward equality. The expected average future short-term interest rates fluctuate less than the current short term interest rate, so the long-term interest rate—which is, in part, comprised of the expected future short-term interest rates—fluctuates less than the current short-term interest rate.

Use the following news clip to work Problems 13 and 14. Euro Reaches Seven-Week High vs. Dollar The euro extended its rally against the dollar for a fourth session, rising to a seven-week high as mounting expectations for Federal Reserve easing weighed on the dollar. Source: The Wall Street Journal, August 23, 2012 13. How does Fed easing strengthen the euro and weaken the dollar and how does a fall in the dollar exchange rate influence monetary policy transmission? Fed easing means that the Fed will lower the interest rate. The fall in the U.S. interest rate makes saving using U.S. assets less attractive because the interest rate on these assets will fall. Fewer foreign savers will demand U.S. dollars because now they will save in other countries. In addition, more U.S. savers will demand foreign currency so that they can save in foreign countries. The decrease in demand for U.S. dollars combined with the increase in supply of U.S. dollars drives the U.S. exchange rate lower. The fall in the U.S. exchange rate makes U.S. exports less expensive to foreigners and makes U.S. imports more expensive to U.S. residents. U.S. net exports increase, which increases U.S. aggregate demand, thereby raising U.S. real GDP and the U.S. price level.

14.

Would a fall in the exchange rate mainly influence unemployment or inflation? The fall in the exchange rate increases aggregate demand, raising the price level and increasing real GDP. The extent to which the price level rises (so that the inflation rate rises) or real GDP increases (so that the unemployment rate falls) depends on short-run aggregate supply. If higher prices have only a small short-run effect on the quantity of real GDP supplied, the short-run aggregate supply curve is steep and the fall in the exchange rate will affect mainly inflation and not unemployment. However, if higher prices have a large short-run effect on the quantity of real GDP supplied, the short-run aggregate supply curve is flat and the fall in the exchange rate will affect mainly unemployment and not inflation.

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Use the following news clip to work Problems 15 to 17. Business Investment Flat Business investment in the second quarter of 2012 was $1,483 billion, $97 billion less than in 2008. Source of data: Bureau of Economic Analysis 15. Explain the effects of the Fed’s low interest rates on business investment. Draw a graph to illustrate your explanation. The low interest rates are achieved by increasing banks’ reserves, which leads to an increase in the supply of loanable funds. Then, as illustrated in Figure 14.2, the increase in the supply of loanable funds lowers the real interest rate, in the figure from 5 percent per year to 3 percent per year. The fall in the real interest rate increases firms’ purchase of investment items, such as factories, plants, machine tools, and so forth, because it makes their purchase less expensive.

16.

Explain the effects of business investment on aggregate demand. Would you expect it to have a multiplier effect? Why or why not? The increase in investment increases aggregate demand as illustrated in Figure 14.3. It is likely that the increase in investment has a multiplier effect. The initial increase in investment increases real GDP and consumers’ disposable income. In turn the increase in disposable income induces additional consumption expenditure, which serves to further increase aggregate demand and real GDP.

17.

What actions might the Fed take to stimulate business investment further? The Fed might commit to keeping the inflation rate low by stating that it will raise the interest rate at some specified point in the future if inflation starts to pick up. This commitment would help dispel fears of inflation. It would also make clear that buying investment goods will be cheaper at the present time, when the interest rate is low, then in the future, when the © 2014 Pearson Education, Inc.

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interest rate rises. This belief would lead firms to increase their investment at the present time.

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Use the following news clip to work Problems 18 to 20. IMF Warns Global Economic Slowdown Deepens, Prods U.S., Europe The IMF said the global economic slowdown is worsening and warned U.S. and European policymakers that failure to fix their economic ills would prolong the slump. Source: Reuters, October 9, 2012 18. If the IMF forecasts turn out to be correct, what would most likely happen to the output gap and unemployment in 2013? The “global economic slowdown” means that the output gap will probably increase and the unemployment rate will either rise or not change.

19. a. What actions that the Fed had taken in 2011 and 2012 would you expect to influence U.S. real GDP growth in 2013? Explain how those policy actions would transmit to real GDP. The Fed has undertaken monetary stimulus of almost historic proportions. The Fed has driven the federal funds rate to its lowest level ever, virtually 0 percent. The Fed has engaged in bouts of quantitative easing. These expansionary policies are designed to increase consumption expenditure, net exports, and particularly investment and thereby increase aggregate demand. The Fed’s goal is to increase aggregate demand and by so doing increase real GDP and employment, which would lower the stubbornly high unemployment rate.

b. Draw a graph of aggregate demand and aggregate supply to illustrate your answer to part (a). Figurer 14.4 shows the outcome described in part (b). In the absence of the Fed’s policy, the aggregate demand curve would be AD0 and the aggregate supply curve would be SAS. The Fed’s expansionary policies increased aggregate demand so the aggregate demand curve shifts to AD1. In the absence of the Fed’s policies, real GDP would be $12.7 trillion and the price level would be 119. The Fed’s expansionary policies have raised the price level to 121 and increased real GDP to $12.9 trillion.

20.

What further actions might the Fed take in 2013 to influence the real GDP growth rate in 2013? (Remember the time lags in the operation of monetary policy.) The time lags in the operation of monetary policy suggest that any further expansionary policy the Fed takes in 2013 likely will have a small effect in 2013. If, early in 2013 the Fed conducts a further quantitative easing, by buying a significant quantity of assets, there might be a positive impact on real GDP and employment in late 2013.

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Use the following news clip to work Problems 21 to 23. Dollar Under Pressure Amid QE2 Speculation Persistent speculation that the Federal Reserve would soon embark on a fresh program of longterm asset purchases—a second round of quantitative easing or QE2—kept the dollar under pressure in the foreign exchange market ahead of crucial U.S. employment data. Source: ft.com, October 7, 2010 21. What is the connection between actions that the Fed might take and U.S. employment data? The Fed uses forecasts of U.S. economic variables—the inflation rate, the unemployment rate, and the output gap—to help determine its monetary policy. These forecasts are based on data about the U.S. economy. If the employment data show pronounced weakness, then the Fed will increase its predicted unemployment rate and output gap. These predictions will lead the Fed to take more expansionary monetary policy.

22.

What does the new clip mean by “the dollar under pressure”? The dollar was “under pressure” because foreign exchange market participants expected the interest rate in the United States to fall. When that occurred, the U.S. exchange rate would depreciate. So the employment data which indicated that the Fed was more likely to undertake expansionary monetary policy also increased the expected future depreciation of the U.S. exchange rate. The increased future depreciation decreases the current demand for U.S. dollars and increases the current supply, so the current U.S. exchange was “under pressure” to fall.

23.

Why was the Fed contemplating QE2? What were the arguments for and against further quantitative easing in the fall of 2010? The Fed was contemplating QE2 because it was worried that the economy might head into a second recession without coming close to fully recovering from the 2007-2008 recession. In that case the U.S. unemployment rate was likely to jump higher and the output gap to widen more. The argument for QE2 is that in its absence, the economy would weaken and potentially enter a new recession. The argument against QE2 is that the Fed already has put into play substantial expansionary monetary policy and when it finally had its impact on the real economy, further expansionary policy, such as QE2, could create significantly higher inflation.

24.

Prospects Rise for Fed Easing Policy William Dudley, president of the New York Fed, raised the prospect of the Fed becoming more explicit about its inflation goal to “help anchor inflation expectations at the desired rate.” Source: ft.com, October 1, 2010 a. What monetary policy strategy is Mr. Dudley raising? Mr. Dudley is suggesting that the Fed move toward inflation rate targeting.

b. How does inflation targeting work and why might it “help anchor inflation expectations at the desired rate”? If the Fed followed a policy of inflation rate targeting, it would make a public commitment about its inflation rate target and would explain how its policy actions will achieve its goal. Inflation rate targeting gives the public guidance about what the central bank expects the inflation rate will be. This will help “anchor inflation expectations” and, as long as the announced inflation rate target is the desired rate, it will help anchor the expectations “at the desired rate.”

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Suppose that the Fed had followed the Taylor rule before the financial crisis of 2008. In the first quarter of 2007, the inflation rate was 2.5 percent a year and the output gap was zero. At what level would the Fed have set the federal funds rate target? The actual federal funds rate target was 5.25 percent a year. Was the Fed restraining aggregate demand by too much or too little? The Taylor rule sets the federal funds rate according to FFR = 2 + INF + 0.5(INF − 2) + 0.5GAP. So the federal funds rate would have been set at 2 + 2.5 + 0.5(2.5 − 2) + 0.5(0), which is 4.75 percent. The actual federal funds rate exceeded the Taylor rule rate, so according to the Taylor rule the Fed was restraining aggregate demand by too much.

26.

Suppose that the FOMC had followed the Taylor rule starting in 2000. a. How would the federal funds rate have differed from its actual path? If the Fed had followed the Taylor rule, the federal funds rate would have been 1.5 percentage points higher through 2005 and then 0.5 percentage points lower in 2006 and 2007. However, in 2009 the Taylor rule called for a negative interest rate, so the Fed would not have been able to follow it precisely.

b. How would real GDP and the inflation rate have been different? According to Taylor rule proponents, real GDP and the inflation rate would have been lower from 2000 to 2005. This outcome would have avoided the boom of those years. Then real GDP and the inflation rate would have been higher in 2006-2007. This outcome would have avoided the bust during those years.

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Answers to Additional Problems and Applications

Use the following information to work Problems 27 to 29. The Fed’s mandated policy goals are “maximum employment, stable prices, and moderate longterm interest rates.” 27. Explain the harmony among these goals in the long run. In the long run, stable prices bring about maximum employment because firms and households can make the best possible decisions against a backdrop of stable prices. With stable prices, the inflation rate is low—perhaps even zero if prices are precisely stable. The nominal interest rate equals the real interest rate plus the (expected) inflation rate. If the inflation rate is low, then the nominal interest rate will be as low as possible.

28.

Explain the conflict among these goals in the short run. In the short run, the monetary policy goals might conflict with each other. In the short run, during a recession the Federal Reserve lowers the federal funds rate and increases the growth rate of the quantity of money to combat the recession. The Fed’s policy increases employment and real GDP but at the cost of also increasing the price level and, eventually, the inflation rate and the nominal interest rate. Conversely in an expansion the Fed raises the federal funds rate to decrease inflation but at the cost of decreasing employment and real GDP.

29.

Based on the performance of U.S. inflation and unemployment, which of the Fed’s goals appears to have taken priority since 2000? It appears that the Fed put more emphasis on keeping prices stable because over this period the core inflation rate was either within or very close to the Fed’s comfort zone for inflation.

30.

What is the core inflation rate and why does the Fed regard it as a better measure on which to focus than the CPI? The core inflation rate is the rate of increase in the core personal consumption expenditure (PCE) deflator. The core PCE deflator is the personal consumption expenditure deflator excluding food and fuel. The Federal Reserve believes that food and fuel prices are more volatile than other prices and largely respond to factors other than the state of inflation in the general economy. Accordingly, the core inflation rate is the inflation rate over which the Fed believes it has the greatest control.

31.

Suppose Congress decided to strip the Fed of its monetary policy independence and legislate interest rate changes. How would you expect the policy choices to change? Which arrangement would most likely provide price stability? If interest rates are determined by Congress, there would be a bias toward persistently increasing monetary growth to keep the interest rate low and help the re-election prospects of legislators. While this policy is successful in the short run, in the long run the higher monetary growth leads to higher inflation. In turn, the higher inflation rate leads to a higher nominal interest rate. Keeping the Fed independent of Congress is most likely to provide price stability.

Use the following CBO report to work Problems 32 to 34. Fiscal 2012 Deficit: Smaller, But Still Big The budget deficit was about $1.1 trillion in fiscal year 2012, CBO estimates. That is about $200 billion smaller than in 2011, but still ranks as the fourth-largest deficit since World War II. Source: Congressional Budget Office 32. How does the federal government get funds to cover its budget deficit? How does financing the budget deficit affect the Fed’s monetary policy? The federal government borrows the funds. Borrowing, by selling government securities, is how © 2014 Pearson Education, Inc.

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the federal government funds its budget deficit. When the government borrows to fund its deficit, the increased demand for loanable funds raises the real interest rate. The budget deficit has no direct impact on the Federal Reserve’s monetary policy. But the budget deficit might exert an indirect effect. For its monetary policy, the Federal Reserve targets the federal funds rate and uses open market operations to meet the target. When government borrowing raises the real interest rate, the federal funds rate rises. The rise in the federal funds rate might affect the Fed’s assessment of the level at which to target the federal funds rate.

33.

How was the budget deficit of 2012 influenced by the Fed’s low interest rate policy? The Fed’s low interest rate policy lowered the interest payments the federal government had to make on its debt. Therefore the low interest rate policy decreased the amount of government spending and hence decreased the size of the government budget deficit.

34. a. How would the budget deficit change in 2013 and 2014 if the Fed moved interest rates up? If the Fed boosts interest rates, the government payments on its debt will increase. The higher payments increase the amount of government spending and therefore increase the size of the budget deficit.

b. How would the budget deficit change in 2013 and 2014 if the Fed’s monetary policy lead to a rapid depreciation of the dollar? A rapid depreciation of the dollar can have two effects on the budget deficit. First it can increase the U.S. inflation rate. With the increase in the inflation rate, inflation expectations would increase, thereby increasing interest rates. The increase in the interest rate increases the budget deficit because the government must increase the interest payments it makes on its debt. Second, a rapid depreciation of the dollar can also increase U.S. net exports which decreases the U.S. unemployment rate. A decrease in unemployment decreases the needs-based expenditure the government must make and thereby lowers the budget deficit.

35.

The Federal Reserve Act of 2000 instructs the Fed to pursue its goals by “maintain[ing] long-run growth of money and credit aggregates commensurate with the economy’s longrun potential to increase production.” a. Has the Fed followed this instruction? The Fed would argue that it has tried to follow this instruction. The Fed would point to the relatively low inflation rate as evidence that it did not let the growth rate of the quantity of money get out of hand. And the Fed would argue that the financial crisis and ensuing recession is not the fault of its monetary policy.

b. Why might the Fed increase money by more than the potential to increase production? During a recession the Fed increases the quantity of money by more than the “long-run potential” in an effort to conduct a monetary policy that moves real GDP back to its “long-run potential.”

36.

Looking at the federal funds rate since 2000, identify periods during which, with the benefit of hindsight, the rate might have been kept too low. Identify periods during which it might have been too high. Some analysts assert that the federal funds rate was too low during the period from 2001 to 2005. During this period house prices skyrocketed. It was the following rapid fall in house prices, starting in 2006, that helped lead to the financial crisis. These analysts say that if the Fed had raised interest rates earlier, then demand for housing would have not been as strong, thereby limiting the rise in house prices. Some observers believe that the Fed kept interest rates too high at the start of in 2000 and in 2006-2007. In both periods the economy was poised to enter a recession. These observers say © 2014 Pearson Education, Inc.

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that if the Fed had lowered the interest rate before the economy entered the recession, the following recession would have been milder and might have been avoided all together.

37.

Now that the Fed has created $3 trillion of bank reserves, how would you expect a further open market purchase of securities to influence the federal funds rate? Why? Illustrate your answer with an appropriate graph. The Fed’s immense creation of $3 trillion of bank reserves might mean that further open market operations would have no effect on the federal funds rate. The $3 trillion of reserves has sent the federal funds to virtually 0 percent, so there is little room for it to fall further. At this exceedingly low federal funds rate, banks might be willing to hold any quantity of additional reserves. In this situation, as Figure 14.5 illustrates, the demand curve for reserves is horizontal. If the demand curve for reserves is flat, then increasing the quantity of reserves has no effect on the federal funds rate because banks merely hold the additional reserves. Banks hold the reserves because the opportunity cost of holding them rather than loaning them in the federal funds market is so low.

38.

What is the Beige Book and what role does it play in the Fed’s monetary policy decisionmaking process? The Beige Book is a key element in the Fed’s monetary policy decision-making process. The Beige Book summarizes economic conditions within each of the Federal Reserve districts. It provides the FOMC important information about the current state of the economy that, together with forecasts of the future evolution of the economy, determines the nation’s monetary policy.

To work Problems 39 to 41, use the information that during 2012 the inflation rate increased but remained in the “comfort zone” and the unemployment rate remained high. 39.

Explain the dilemma that rising inflation and high unemployment poses for the Fed. Raising inflation and high unemployment pose a dilemma for the Fed because the policy necessary to decrease one of these factors increases the other. On one hand, to control inflation, the Fed must raise the interest rate and decrease growth in the quantity of money. But this policy raises the unemployment rate. However, on the other hand to control high unemployment the Fed needs to lower the interest rate and increase the growth rate of the quantity of money. But this expansionary policy raises the inflation rate.

40.

Why might the Fed decide to try to lower interest rates (or stimulate in other ways) in this situation? The Fed might lower the interest rate because it perceives high unemployment as a larger problem than inflation because inflation, while increasing, was in the “comfort zone.”

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Why might the Fed decide to raise interest rates in this situation? The Fed might raise the interest rate if it perceives that inflation will rise outside of its comfort zone and if it perceives the rising inflation as a larger problem than the high unemployment.

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Use the following information to work Problems 42 to 44. From 2009 through 2012, the long-term real interest rate paid by the safest U.S. corporations fell from 4 percent to 2 percent. During that same period, the federal funds rate was roughly constant at 0.25 percent a year. 42. What role does the long-term real interest rate play in the monetary policy transmission process? The long-term real interest rate plays an important part in the monetary transmission process. Both consumption expenditure and investment respond to the long-term real interest rate. When the long-term real interest rate falls, consumption expenditure and investment both increase. The increase in consumption expenditure and investment increase aggregate demand and thereby increase real GDP and the price level.

43.

How does the federal funds rate influence the long-term real interest rate? The long-term interest rate is an expected average of short-term interest rates. People can either borrow or save by making a long-term commitment or by making successive short-term commitments. Adjusted for risk, the average of the interest rates on the short-term commitments must equal the long-term interest rate. If they were not equal one method of borrowing would be more or less expensive than the other. People would stream to borrow using the less expensive method, pushing that interest rate higher, back toward equality. Simultaneously other people would stream to save using the method with the higher return, pushing that interest rate lower, back toward equality. When the Fed lowers the federal funds rate, other short-term interest rates also fall. This fall makes borrowing by using a series of short-term loans less expensive and saving using a series of short-term commitments less profitable. The demand for long-term loans falls, which lowers the long-term interest rate and the supply of long-term saving commitments rises, which also lowers the long-term interest rate. So a fall in the federal funds rate lowers the long-term real interest rate.

44.

What do you think happened to inflation expectations between 2009 and 2012 and why? Inflation expectations probably increased. The expected inflation rate equals the nominal interest rate minus the real interest rate. Over this time period, the federal funds rate did not change, so the nominal interest rate did not change. But the real interest rate fell. Therefore inflation expectations increased.

45.

Dollar Reaches New Low vs. Yen Traders continued to make bets in favor of the yen, sending the dollar to a record low against the Japanese currency. Source: The Wall Street Journal, August 20, 2011 a. How do “bets in favor of the yen” influence the exchange rate? “Bets in favor of the yen” are “bets” that the yen will rise in the future. To place this “bet,” traders need to buy yen. The demand for yen increases, which raises the value of the yen and lowers the dollar exchange rate.

b. How does the Fed’s monetary policy influence the exchange rate? The Fed’s monetary policy affects U.S. interest rates, which affect the exchange rate. For example, if people expect the Fed to either lower U.S. interest rates or else keep U.S. interest rates lower for a longer period of time, the fall in expected interest rates lowers the exchange rate. U.S. savers become more likely to sell dollars to acquire foreign exchange to save abroad, so the supply of dollars increases. Foreign savers become less likely to buy dollars to save in the United States, so the demand for dollars decreases. On both counts the U.S. exchange rate falls.

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Use the following news clip to work Problems 46 and 47. Top Economist says America Could Plunge into Recession Robert Shiller, Professor of Economics at Yale University, predicted that there was a very real possibility that the United States would be plunged into a Japan-style slump, with house prices declining for years. Source: timesonline.co.uk, December 31, 2007 46. If the Fed had agreed with Robert Shiller in December 2007, what actions might it have taken differently from those it did take? How could monetary policy prevent house prices from falling? By December 2007 the Fed was already starting to respond to what would become the financial crisis and later the severe recession. It was starting to lower the federal funds rate and increase reserves. However these actions were tentative and not extreme. If the Fed had agreed with Mr. Shiller, it could have undertaken these actions more aggressively and rapidly. Monetary policy might not be able to fully prevent home prices from falling. However at least partially it can help prevent a fall in house prices by lowering the mortgage interest rate. When the mortgage interest rate is lower, the demand for houses is higher which leads to higher prices. The demand for homes also responds to consumers’ incomes. If monetary policy can keep real GDP near potential GDP, then people’s disposable income will be higher, which leads to an increase in the demand for homes and thereby higher home prices.

47.

Describe the time lags in the response of output and inflation to the policy actions you have prescribed. The lags between the Fed’s actions and their effect on the real economy are substantial. Before the policy affects output, it must first lower the exchange rate—which occurs rapidly—but then it must increase net exports—which occurs slowly. The policy must also lower the long-term real exchange rate—which does not immediately occur—and then it must increase consumption expenditure and investment—which both occur slowly.

Use the following news clip to work Problems 48 and 49. Greenspan Says Economy Strong The central bank chairman said inflation was low, consumer spending had held up well through the downturn, housing-market strength was likely to continue, and businesses appeared to have unloaded their glut of inventories, setting the stage for a rebound in production. Source: cnn.com, July 16, 2002 48.

What monetary policy actions had the Fed taken in the year before Alan Greenspan’s optimistic assessment? In the year before to Mr. Greenspan’s statement, the Fed had lowered the federal funds quite substantially in an effort to spur the economy into a stronger expansion.

49.

What monetary policy actions would you expect the Fed to take in the situation described by Alan Greenspan? Mr. Greenspan’s assessment of the economy was that it was primed for sustained economic growth. Even though inflation was low, once the economy started to rapidly grow, higher inflation becomes a potential problem. With the lags for monetary policy to take effect, it would be reasonable to expect little change in monetary policy unless economic growth and/or inflation started to pick up, at which time the Fed would undertake policy designed to lower inflation and economic growth.

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Philly Fed’s Plosser Opposes QE3 Federal Reserve Bank of Philadelphia president Charles Plosser does not think that monetary policy can “do much to speed up the slow progress” in the labor market and opposes the Fed’s latest round of stimulus, known as QE3, saying he does not think it prudent to risk the Fed’s hard-won credibility. Source: Philadelphia Inquirer, September 25, 2012 a. Describe the QE3 asset purchases that are causing Charles Plosser concern. Mr. Plosser is concerned about the Fed’s large purchases of mortgage-backed securities.

b. How might asset purchases damage the Fed’s credibility? The asset purchases might cause people to doubt the Fed’s commitment to price level stability. The asset purchases increase banks’ reserves and if banks loan these reserves, the money supply could expand significantly and with it the price level and inflation rate might jump higher.

51.

Suppose that the Reserve Bank of New Zealand is following the Taylor rule. In 2012, it sets the official cash rate (its equivalent of the federal funds rate) at 4 percent a year. If the inflation rate in New Zealand is 2 percent a year, what is its output gap? The Taylor rule sets the official cash rate according to CASH = 2 + INF + 0.5(INF − 2) + 0.5GAP. So the with a cash rate of 4 percent and an inflation rate of 2 percent, the Taylor rule is that 4 = 2+ 2 + 0.5(2 – 2) + 0.5GAP, or 4 = 4 + 0.5GAP. The last equation shows that the output gap is 0 percent.

Economics in the News 52.

After you have studied Reading Between the Lines on pp. 366–367 (772–773 in Economics) answer the following questions. a. What was the state of the U.S. economy in the fall of 2011 when the Fed made the decision to undertake operation twist? The economy was mired in a very slow recovery from a very deep recession. The unemployment rate was high by historical standards and a large recessionary gap existed. The Fed was concerned that the slow recovery was faltering.

b. What was the Fed’s expectation about future employment, real GDP growth, and inflation at the time of the news article? The expectation of the majority of the Fed policymakers was that growth in future employment and real GDP, were going to be low or perhaps even turn negative. Inflation was low and the majority of Fed policymakers did not worry that it would rapidly increase in the future.

c. How would operation twist influence the markets for short-term and long-term loanable funds, and aggregate demand? Operation twist was designed to decrease the supply of short-term loanable funds and increase the supply for long-term loanable funds. The goal of operation twist was to lower the long-term interest rate and thereby increase investment and thereby increase aggregate demand.

d. Would you expect the effects on real GDP and the price level to be immediate or spread over a number of months and even years? Why? The effect on real GDP and the price level will be spread out over a number of months and years. There are significant lags in the effect of monetary policy. In particular, operation twist was designed to boost investment. Operation twist’s effect on the long-term interest rate is likely to be relatively quick, though not immediate. But the effect on investment will be much slower because firms need to plan before they respond to the lower long-term interest rate by boosting their investment. Once investment increases, there are further lags because it takes time for the multiplier effect to work. Hence the increase in aggregate demand will be spread out over time. © 2014 Pearson Education, Inc.

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Fed’s Evans: Offers Full Support for New Stimulus Federal Reserve Bank of Chicago President Charles Evans expressed strong support for the new stimulus provided by the central bank saying, “This was the time to act” and adding, “I am optimistic that we can achieve better outcomes through more monetary policy accommodation.” Source: The Wall Street Journal, September 18, 2012 a. Why, in the economic conditions of September 2012, was Charles Evans happy to see the Fed stimulating the economy? Mr. Evans was concerned that the economy still had a large recessionary gap and that the economy might even move into another recession.

b. What would be the effects of the Fed’s QE3 and other stimulative actions? Explain the immediate effects and the ripple effects. If the Fed buys securities, banks’ reserves increase. The federal funds rate falls and along with it other short-term interest rates fall. The exchange rate also falls. The supply of money and the supply of loanable funds increase. The increase in the supply of loanable funds lowers the real interest rate. Consumption expenditure, investment, and net exports increase, which increases aggregate demand. Real GDP increases and the price level rises.

c. What are the risks arising from greater monetary stimulus? The risk from greater monetary stimulus is significantly higher inflation. If the monetary stimulus is too great, it could propel the United States into a situation in which inflation and inflation expectations soar.

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Answers to the Review Quizzes Page 377 1.

Explain the effects of imports on the domestic price and quantity, and the gains and losses of consumers and producers. The goods and services the United States will import are those in which the United States has a higher opportunity cost of production relative to other countries. In those markets the U.S. notrade price is higher than the world price. With trade the price in the United States falls, the quantity produced in the United States decreases, and the quantity consumed increases. Domestic consumers gain from imports and domestic producers lose from imports.

Explain the effects of exports on domestic price and quantity, and the gains and losses of consumers and producers. The goods and services the United States will export are those in which the United States has a lower opportunity cost of production relative to other countries. In those markets the U.S. notrade price is lower than the world price. With trade the price in the United States rises, the quantity produced in the United States increases, and the quantity consumed decreases. Domestic consumers lose from exports and domestic producers gain from exports

Page 383 1.

What are the tools that a country can use to restrict international trade? A country can use tariffs, import quotas, other import barriers such as health, safety, and regulation barriers, and voluntary export restraints to restrict international trade. Export subsidies also decrease other countries’ exports and restrict their international trade.

Explain the effects of a tariff on domestic production, the quantity bought, and the price. A tariff raises the domestic price of the product. The higher price increases domestic production and decreases the domestic quantity purchased.

Explain who gains and who loses from a tariff and why the losses exceed the gains. Domestic consumers lose from the tariff. Domestic producers gain from the tariff. The government also gains revenue from the tariff. But the gain to producers plus the gain in government revenue is less than the loss to consumers, so on net a tariff creates a social loss. There is a social loss for two reasons: First, high-cost domestic production expands, so society uses more resources producing some high-cost units of the good than it would use if low-cost foreign units were purchased. Second the high price leads domestic consumers to decrease their consumption of the good, thereby robbing society of the benefits these units would have produced.

Explain the effects of an import quota on domestic production, consumption, and price. An import quota raises the domestic price of the product. The higher price increases domestic production and decreases domestic purchases.

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Domestic consumers lose from the import quota. Domestic producers gain from the import quota. The importers also gain additional profit from the import quota. But the gain to producers plus the importers’ profits is less than the loss to consumers, so on net an import quota creates a social loss. There is a social loss for two reasons: First, high-cost domestic production expands, so society uses more resources producing some high-cost units of the good than it would use if low-cost foreign units were purchased. Second the high price leads domestic consumers to decrease their consumption of the good, thereby robbing society of the benefits these units would have produced.

Page 387 1.

What are the infant industry and dumping arguments for protection? Are they correct? The attempt to stimulate the growth of new industries is the infant-industry argument for protection, which states that it is necessary to protect a new industry from import competition to facilitate the growth of that industry, making it competitive in the world markets. This argument is based on the concept of dynamic competitive advantage. Learning-by-doing is a powerful engine of productivity growth. However the learning-by-doing argument for protection only works if the benefits also spill over into other industries and other parts of the economy. This is rarely the case, as the entrepreneurs of infant industries and their financial supporters take this risk into account and all returns usually accrue only to them, not to other industries. And it is more efficient to subsidize the infant industry needing protection than it is to protect it by restricting trade. The dumping argument for protection states that a foreign firm is selling its exports at a lower price than its cost of production. Foreign firms trying to monopolize the international market may use this practice. Once the competition is gone, the foreign firm will raise prices and reap profits. This argument fails for several reasons. First, it is virtually impossible to detect the occurrence of dumping since it is impossible to verify a firm’s production costs. The test most commonly used is if the export price is lower than the import price. This test only examines the supply side of the two markets and ignores the demand side. If the domestic market is inelastic and the export market is elastic (which is almost always the case) then it is natural for a firm to price the domestic goods higher than the exports. Second, it is difficult to see how a global firm could have a monopoly for the goods or services it exports. There are too many foreign suppliers (and potential suppliers), making global competition too extensive for a monopoly to exist in the global market. And, even if there is global monopoly it is more efficient to regulate it than to impose trade restrictions on its products.

Can protection save jobs and the environment and prevent workers in developing countries from being exploited? There are many myths about trade restrictions. The problem mentions three of them, all false reasons often offered as reasons to restrict international trade. These arguments are: •

•

Trade restrictions save domestic jobs: This argument ignores the fact that, under free trade, consumers in the importing country will have greater disposable income and citizens in the exporting countries will have greater incomes. This means total demand for the goods and services that are exported by our domestic industry increases, increasing the number of jobs created in the domestic industries under free trade. Trade restrictions penalize lax environmental standards: Not all developing countries have lax environmental standards. Also, a clean environment is a normal good. Countries that are relatively poor and have lax pollution standards do not care as much about the environment because imposing clean air, water, and land standards have a high opportunity cost because they will slow economic development. The best way to encourage environmental quality is not to restrict economic development but to encourage rapid economic growth, which will © 2014 Pearson Education, Inc.

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more quickly increase citizen demand for a cleaner environment in those developing countries. Trade restrictions prevent rich countries from exploiting poorer countries: Importing goods made in countries with low wage levels increases the demand for labor in those countries, increasing the number of jobs available and raising wages over time. The more free trade that occurs with these countries, the more quickly the wages will rise and the working conditions will increase in quality and safety.

What is offshore outsourcing? Who benefits from it and who loses? Offshore outsourcing occurs when a firm in the United States buys finished goods, components, or services from firms in other countries. Workers who have skills for jobs that have been sent abroad lose from offshore outsourcing. Consumers who consume the goods and services produced abroad and imported into the United States benefit.

What are the main reasons for imposing a tariff? There are two main reasons for imposing tariffs on imports. First the government receives tariff revenues from imports, which can be useful when revenues from income taxes and sales taxes are less effective ways of gaining government revenue. Second rent seeking by individuals in industries that would be hurt by foreign competition can influence the government to impose tariffs.

Why don’t the winners from free trade win the political argument? Trade restrictions are enacted despite the inherent inefficiency because of the political actions of rent seeking groups, which fear that foreign competition might have a negative impact on their industry, firm, or jobs. The anti-trade groups are easily organized and have much to gain from trade restrictions, whereas the vast millions of consumers, who would win from free trade, are difficult to organize because each individual has only a small amount of loss when trade restrictions are imposed. Hence the winners from trade restrictions frequently out-lobby the winners from free trade.

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Answers to the Study Plan Problems and Applications Use the following information to work Problems 1 to 3. Wholesalers of roses (the firms that supply Price Quantity Quantity your local flower shop with roses for (dollars per demanded supplied Valentine’s Day) buy and sell roses in container) (millions of containers per containers that hold 120 stems. The table year) provides information about the wholesale 100 15 0 market for roses in the United States. The 125 12 2 demand schedule is the wholesalers’ 150 9 4 demand and the supply schedule is the U.S. 175 6 6 rose growers’ supply. Wholesalers can buy 200 3 8 roses at auction in Aalsmeer, Holland, for 225 0 10 $125 per container. 1. a. Without international trade, what would be the price of a container of roses and how many containers of roses a year would be bought and sold in the United States? Without international trade, in the United States the price of a container of roses is $175 and 6 million containers of roses are bought and sold.

b. At the price in your answer to part (a), does the United States or the rest of the world have a comparative advantage in producing roses? The price of roses in the United States exceeds the price in the rest of the world, so the rest of the world has a comparative advantage in producing roses.

If U.S. wholesalers buy roses at the lowest possible price, how many do they buy from U.S. growers and how many do they import? The price of roses in the United States is $125 per container. At this price, U.S. rose growers supply 2 million containers per year and U.S. wholesalers demand 12 million containers of roses. U.S. wholesalers buy the 2 million containers from U.S. growers and purchase 10 million containers from foreign sources, which are imported into the United States.

Draw a graph to illustrate the U.S. wholesale market for roses. Show the equilibrium in that market with no international trade and the equilibrium with free trade. Mark the quantity of roses produced in the United States, the quantity imported, and the total quantity bought. In Figure 15.1, the equilibrium without international trade is determined at the intersection of the demand curve and the supply curve. Without international trade the equilibrium price is $175 per container and 6 million containers per year are bought and produced. With international trade the world price is $125 per container, as shown in Figure 15.1. The quantity produced in the United States is 2 million containers and the quantity bought in the United States is 12 million containers. Imports into the United States © 2014 Pearson Education, Inc.

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account for the difference between the quantity bought and the quantity produced, 10 million containers.

Use the following news clip to work Problems 4 and 5. Underwater Oil Discovery to Transform Brazil into a Major Exporter A huge underwater oil field discovered late last year has the potential to transform Brazil into a sizable exporter. Fifty years ago, Petrobras was formed as a trading company to import oil to support Brazil’s growing economy. Two years ago, Brazil reached its long-sought goal of energy self-sufficiency. Source: International Herald Tribune, January 11, 2008 4. Describe Brazil’s comparative advantage in producing oil and explain why its comparative advantage has changed. Until recently Brazil did not have a comparative advantage in producing oil. Its cost of producing oil was higher than the world market price and Brazil imported oil. But with the discovery of the new oil field, the cost of producing oil in Brazil fell so that Brazil now has a comparative advantage in the production of oil. With this new comparative advantage, Brazil now exports oil.

5. a. Draw a graph to illustrate the Brazilian market for oil and explain why Brazil was an importer of oil until a few years ago. Figure 15.2 illustrates the market for oil in Brazil. The supply curve labeled Sold shows the supply curve before the discovery of the new oil field. When the supply curve is Sold, the price in Brazil is higher than the world price, and Brazil imports oil. In the figure, that Brazil imports 2 million barrels a week.

b. Draw a graph to illustrate the Brazilian market for oil and explain why Brazil may become an exporter of oil in the near future. Figure 15.2 illustrates the market for oil in Brazil. The supply curve labeled Snew shows the supply curve after the discovery of the new oil field. When the supply curve is Snew, the price in Brazil is lower than the world price, and Brazil exports oil. In the figure, Brazil exports 2 million barrels a week.

The End of Cheap Chinese Goods Beginning in the 1990s, as China emerged as a major exporter, the prices of many goods fell. For example, clothing prices fell through 2007 when they bottomed out. But as China’s labor costs started to rise, clothing production moved from China to other countries. Source: The New York Times, October 21, 2011 a. Explain why China emerged as a major exporter of clothing through 2007. Production of clothing requires a lot of labor. Through 2007, wages in China were low and, with the low wages, China had a comparative advantage in producing clothes, which made China a major exporter of clothing.

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cheap clothing. China’s wage rate has risen as the nation has developed. The higher wages mean that China’s opportunity cost of producing cheap clothing is higher than that in other countries. China no longer has a comparative advantage in producing cheap clothing, so China no longer exports cheap clothing.

In the news clip in Problem 6, who will gain and who will lose from the trade in goods that the news clip predicts? The firms and workers that gain are those that will now produce and export cheap clothing. The consumers of cheap clothing will also gain because the clothing will remain cheap. The losers from this international trade are workers and producers in China who used to produce and export cheap clothing.

Use the information on the U.S. wholesale market for roses in Problem 1 to a. Explain who gains and who loses from free international trade in roses compared to a situation in which Americans buy only roses grown in the United States. U.S. rose wholesalers, who are the consumers in the problem, gain from free international trade. U.S. rose growers lose from free international trade.

b. Draw a graph to illustrate the gains and losses from free trade. Figure 15.3 illustrates the market with free trade. U.S. consumers gain because they pay a lower price with trade—$125 per container with trade versus $175 per container with no trade—and thereby respond by increasing their purchases—from 6 million containers per year to 12 million containers per year. U.S. producers lose because they receive a lower price container with trade than without and thereby respond by decreasing their production from 6 million containers per year to only 2 million containers per year.

c. Calculate the gain from international trade. The gains from trade are enjoyed by U.S. rose consumers. They gain a lower price, $125 per container rather than $175 per container and, in response, they increase the quantity of roses they consume from 6 million containers per year to 12 million containers per year. These gains are partially offset by losses to U.S. growers, because they decrease their production, but on net the gains to consumers exceed the losses to producers.

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Use the following news clip to work Problems 9 and 10. Steel Tariffs Appear to Have Backfired on Bush President Bush set aside his free-trade principles last year and imposed heavy tariffs on imported steel to help out struggling mills in Pennsylvania and West Virginia. Some economists say the tariffs may have cost more jobs than they saved, by driving up costs for automakers and other steel users. Source: The Washington Post, September 19, 2003 9. a. Explain how a high tariff on steel imports can help domestic steel producers. The high tariff raises the price of steel in the United States. This higher price results in domestic steel producers increasing the quantity of steel they produce and increases their profits.

b. Explain how a high tariff on steel imports can harm steel users. The tariff raises the U.S. price of steel and boosts steel users’ costs. The rise in costs leads steel users to decrease the supply of the product they produce and also leads to lower profits for steel users.

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Draw a graph of the U.S. market for steel to show how a high tariff on steel imports Helps U.S. steel producers. Figure 15.4 shows the steel market. The amount of the tariff is equal to the height of the light gray arrow. Before the tariff U.S. producers produced 200 million tons of steel at a price of $125 per ton. With the tariff U.S. producers are helped because the price they receive rises to $150 per ton and they respond by increasing the quantity they produce to 400 million tons.

ii. Harms U.S. steel users. Figure 15.4 shows the steel market. The amount of the tariff is equal to the height of the light gray arrow. Before the tariff U.S. users purchased 1,200 million tons of steel at a price of $125 per ton. With the tariff U.S. users are harmed because the price they pay rises to $150 per ton and they respond by decreasing the quantity they consume to only 867 million tons.

Use the information on the U.S. wholesale market for roses in Problem 1 to work Problems 11 to 16. 11. If the United States puts a tariff of $25 per container on imports of roses, explain how the U.S. price of roses, the quantity of roses bought, the quantity produced in the United States, and the quantity imported change. The price of roses rises from $125 per container (the price with free trade) to $150 per container. The quantity of roses produced in the United States increases from 2 million containers to 4 million containers. The quantity of roses consumed in the United States decreases from 12 million containers (the quantity consumed with free trade) to 9 million containers. The quantity imported decreases from 10 million containers to 5 million containers.

12.

Who gains and who loses from this tariff? U.S. rose consumers lose from the tariff. U.S. rose producers gain from the tariff. The U.S. government gains revenue from the tariff.

13.

Draw a graph of the U.S. market for roses to illustrate the gains and losses from the tariff and on the graph identify the gains and losses, and the tariff revenue. Figure 15.5 shows the effect of the tariff. The amount of the tariff is equal to the height of the light gray arrow. In the United States, the price of a container of roses rises from $125 per container to $150 per container. Before © 2014 Pearson Education, Inc.

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the tariff U.S. rose producers grew 2 million containers per year; after the tariff they increase their production to 4 million containers per year. This change is shown in the figure by the movement from point a to point b. Before the tariff U.S. rose wholesalers, the consumers in this problem, purchased 12 million containers per year; after the tariff they decrease their consumption to 9 million containers per year. This change is shown in the figure by the movement from point c to point d. The quantity of roses imported decreases from 10 million containers per year before the tariff to 5 million per year after the tariff and a tariff of $25 per container is imposed. The tariff revenue is equal to 10 million containers × $25 per container, which is $250 million and is illustrated in Figure 15.5 as the area of the grey rectangle.

14.

If the United States puts an import quota on roses of 5 million containers, what happens to the U.S. price of roses, the quantity of roses bought, the quantity produced in the United States, and the quantity imported? The U.S. price of roses rises to $150 per container. 9 million containers of roses are purchased in the United States and 4 million containers of roses are produced in the United States. The difference, 5 million containers, is imported into the United States.

15.

Who gains and who loses from this quota? U.S. rose growers and importers of roses gain from the quota. U.S. rose wholesalers lose from the quota.

16.

Draw a graph to illustrate the gains and losses from the import quota and on the graph identify the gains and losses, and the importers’ profit. Figure 15.6 shows the effect of the import quota. The amount of the quota is equal to the length of the grey arrow. The price in the United States rises from $125 per container to $150 per container. Before the import quota U.S. rose producers grew 2 million containers per year; after the import quota they increase their production to 4 million containers per year. This change is shown in the figure by the movement from point a to point b. Before the import quota U.S. rose wholesalers, the consumers in this problem, purchased 12 million containers per year; after the import quota they decrease their consumption to 9 million containers per year. This change is shown in the figure by the movement from point c to point d. The quantity of roses imported decreases from 10 million containers per year before the import quota to 5 million per year after the tariff. U.S. producers receive $150 per container while foreign producers receive the world price, $125 per container. The difference, $25 per container, goes to the importers as added profit. The total added profit is equal to 10 million containers × $25 per container, which is $250 million and is illustrated in Figure 15.5 as the area of the grey rectangle.

Use the following news clip to work Problems 17 and 18. Car Sales Go Up as Prices Tumble Car affordability in Australia is now at its best in 20 years, fueling a surge in sales as prices tumble. In 2000, Australia cut the tariff to 15 percent and on January 1, 2005, it cut the tariff to 10 © 2014 Pearson Education, Inc.

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percent. 17.

Source: Courier Mail, February 26, 2005 Explain who gains and who loses from the lower tariff on imported cars. The lower tariff lowers the price of cars in Australia. As a result, Australian consumers increase the quantity of cars they purchase and so they gain from the tariff reduction. However, also as a result of the lower price, Australian producers decrease the quantity of cars they produce and so they lose from the tariff reduction.

18.

Draw a graph to show how the price of a car, the quantity of cars bought, the quantity of cars produced in Australia, and the quantity of cars imported into Australia changed. Figure 15.7 shows the effect of the tariff reduction. The tariff is reduced by the amount of the gray arrow. The price of an automobile in Australia falls from $30,000 to $27,000. In the figure the quantity of cars demanded in Australia increases from 5 million to 6 million (shown by the movement from a to b) and the quantity of automobiles produced in Australia decreases from 3 million to 2 million (shown by the movement from c to d) . With the higher tariff, 2 million cars per year were imported; with the lower tariff 4 million cars per year are imported.

Use the following news clip to work Problems 19 and 20. A New Food Crisis Is on Our Plates Over the past year the price of corn has risen 52 percent, wheat 49 percent, and soybeans 28 percent. Alarmed at spiking food prices, a score of countries, including Russia and Ukraine, have banned food exports to make sure they can feed their own people first. Source: Sydney Morning Herald, February 22, 2011 19. a. What are the benefits to a country from importing food? The benefits to a country that imports food are the same as the benefits to a country that imports any good or service: The country gets the food at a lower opportunity cost than what it would face if it produced the food itself.

b. What costs might arise from relying on imported food? The demand for food is highly inelastic because there are not many substitutes for food. If food exports are restricted or decrease, the price of the imported food will rise sharply. If food exports are bountiful, the price of food will fall sharply. So relying on food imports makes the country vulnerable to large swings in the price of food.

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If a country restricts food exports, what effect does this restriction have in that country on the price of food, the quantity of food it produces, the quantity of food it consumes, and the quantity of food it exports? If a country restricts its food exports, the price of food within that country falls. The lower price decreases the quantity of food produced and increases the quantity of food consumed. The quantity of food exported decreases.

21. Chinese Tire Maker Rejects U.S. Charge of Defects U.S. regulators ordered the recall of more than 450,000 faulty tires. The Chinese producer of the tires disputed the allegations and hinted that the recall might be an effort by foreign competitors to hamper Chinese exports to the United States. Mounting scrutiny of Chinese-made goods has become a source of new trade frictions between the United States and China and fueled worries among regulators, corporations, and consumers about the risks associated with many products imported from China. Source: International Herald Tribune, June 26, 2007 a. What does the information in the news clip imply about the comparative advantage of producing tires in the United States and China? Because the tires were produced in China, the news clip suggests that China has the comparative advantage in producing tires.

b. Could product quality be a valid argument against free trade? Product quality is not a valid argument against free trade. Quality is a valid concern for consumers. If consumers cannot judge quality themselves, then government inspection might be necessary. But in that case government inspection of both imported and domestically produced goods is required. To single out imported goods or services makes little sense.

c. How would the product-quality argument against free trade be open to abuse by domestic producers of the imported good? Domestic producers could easily assert that the imported good lacks some essential quality characteristic and hence should be prohibited in the U.S. market. Product quality concerns raised by domestic producers can also be used to raise worry amongst U.S. consumers about imported goods. Domestic producers would have a never-ending incentive to complain about quality defects of imported goods.

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Answers to Additional Problems and Applications 22.

Suppose that the world price of sugar is 10 cents a pound, the United States does not trade internationally, and the equilibrium price of sugar in the United States is 20 cents a pound. The United States then begins to trade internationally. a. How does the price of sugar in the United States change? The price of sugar in the United States falls.

b. Do U.S. consumers buy more or less sugar? As a result of the lower price, U.S. consumers buy more sugar.

c. Do U.S. sugar growers produce more or less sugar? As a result of the lower price, U.S. growers produce less sugar.

d. Does the United States export or import sugar and why? The United States imports sugar. The quantity of sugar demanded increases while quantity supplied decreases. The difference is made up by imports.

23.

Suppose that the world price of steel is $100 a ton, India does not trade internationally, and the equilibrium price of steel in India is $60 a ton. India then begins to trade internationally. a. How does the price of steel in India change? The price of steel in India rises to equal the world price.

b. How does the quantity of steel produced in India change? Producers respond to the higher price by increasing the quantity of steel produced.

c. How does the quantity of steel bought by India change? Steel users respond to the higher price by decreasing the quantity of steel bought.

d. Does India export or import steel and why? Because the price of steel in India is lower than the world, India has a comparative advantage in the production of steel. India will export steel.

24.

A semiconductor is a key component in your laptop, cell phone, and iPod. The table provides information about the market for semiconductors in the United States. Producers of semiconductors can get $18 a unit on the world market. a. With no international trade, what would be the price of a semiconductor and how many semiconductors a year would be bought and sold in the United States?

Price (dollars per unit) 10 12 14 16 18 20

Quantity Quantity demanded supplied (billions of units per year) 25 0 20 20 15 40 10 60 5 80 0 100

With no international trade the price of a semiconductor in the United States is $12 per unit. 20 billion units are bought and sold in the United States.

b. Does the United States have a comparative advantage in producing semiconductors? The United States has a comparative advantage in producing semiconductor units because the U.S. price is lower than the price in the world market.

Act Now, Eat Later The hunger crisis in poor countries has its roots in U.S. and European policies of subsidizing the diversion of food crops to produce biofuels like corn-based ethanol. That is, doling out subsidies to put the world’s dinner into the gas tank. Source: Time, May 5, 2008 © 2014 Pearson Education, Inc.

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25. a. What is the effect on the world price of corn of the increased use of corn to produce ethanol in the United States and Europe? The use of corn to produce ethanol increased the demand for corn, thereby raising the price of corn. This diversion of corn from food to fuel was increased by the U.S. and European policies of subsidizing the use of corn as fuel.

b. How does the change in the world price of corn affect the quantity of corn produced in a poor developing country that has a comparative advantage in producing corn, the quantity it consumes, and the quantity that it either exports or imports? The higher world price of corn decreases the consumption of corn and increases the production of corn in poor developing countries. Because the country has a comparative advantage it will export corn. The higher price leads the country to increase its exports.

26.

Explain why the U.S. and European policies of subsidizing the production of corn creates a social loss for a poor developing country that has a comparative advantage in producing corn. The U.S. and European subsidies increase the production of corn and lower its price. The lower price decreases production and increases consumption in poor developing nations. It also decreases the exports from corn from poor developing nations. Although consumers in those nations gain, producers lose more and so overall the nation loses from these subsidization policies.

Use the following news clip to work Problems 27 and 28. South Korea to Resume U.S. Beef Imports South Korea will reopen its market to most U.S. beef. South Korea banned imports of U.S. beef in 2003 amid concerns over a case of mad cow disease in the United States. The ban closed what was then the third-largest market for U.S. beef exporters. Source: CNN, May 29, 2008 27. a. Explain how South Korea’s import ban on U.S. beef affected beef producers and consumers in South Korea. The South Korean ban raised the price of beef in South Korea. The higher price led to increased production in South Korea, which made South Korean producers better off. The higher price also led to decreased consumption in South Korea, which made South Korean consumers worse off.

b. Draw a graph of the market for beef in South Korea to illustrate your answer to part (a). Identify the Korean winners and losers from this policy. Is this policy in Korea’s interest? Figure 15.8 shows the effect of South Korea’s import ban. Prior to the ban the price of beef in South Korea was $4 per pound. At this price the quantity consumed in South Korea was 12 million tons of beef per year and the quantity produced in South Korea was 2 million tons of beef per year. The difference, 10 million tons of beef per year, was imported from the United States. With the import ban, the price of beef in South Korea rises to $6 per pound. At this price 6 million tons of beef per year are consumed in South Korea and 6 million tons of beef per year are produced in South Korea. There are no imports. The winners from the © 2014 Pearson Education, Inc.

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policy are South Korean beef producers; they receive a higher price for beef and so increase the quantity they produce. The losers from the policy are South Korean beef consumers; they pay a higher price for beef and so decrease the quantity they consume.

28. a. Assuming that South Korea is the only importer of U.S. beef, explain how South Korea’s import ban on U.S. beef affected beef producers and consumers in the United States. South Korea’s ban meant that the United States no longer exported beef. (Recall the assumption that South Korea is the only importer of U.S. beef.) In the United States the price of beef falls to the no-trade price. U.S. consumption increases and U.S. production decreases.

b. Draw a graph of the market for beef in the United States to illustrate your answer to part (a). Does anyone in the United States gain from Korea’s policy? Figure 15.9 shows the situation in the U.S. market for beef. With trade the price of beef is $4 per pound. The United States produces 30 million pounds of beef, consumes 20 million pounds of beef, and exports the difference. When South Korea eliminates U.S. exports, the price falls to $3.50 per pound, the notrade price. U.S. consumption increases to 25 million pounds of beef and U.S. production decreases to 25 million pounds of beef. There is no international trade. U.S. beef consumers gain from this policy because they pay a lower for beef and so they increase the quantity of beef they demand.

Use the following information to work Problems 29 to 31. Before 1995, trade between the United States and Mexico was subject to tariffs. In 1995, Mexico joined NAFTA and all U.S. and Mexican tariffs have gradually been removed. 29. Explain how the price that U.S. consumers pay for goods from Mexico and the quantity of U.S. imports from Mexico have changed. Who are the winners and who are the losers from this free trade? With NAFTA, the prices that U.S. consumers pay for goods from Mexico have fallen so the quantity of imports from Mexico have increased. Winners from this free trade are Mexican producers of goods exported to the United States and U.S. consumers of these goods. Losers are Mexican consumers of the goods and U.S. producers of the goods.

30.

Explain how the quantity of U.S. exports to Mexico and the U.S. government’s tariff revenue from trade with Mexico have changed. The prices of U.S. goods in Mexico have fallen and, as a result, the quantity of U.S. goods exported to Mexico has increased. The U.S. government’s tariff revenue from trade with Mexico decreased.

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Suppose that in 2013, tomato growers in Florida lobby the U.S. government to impose an import quota on Mexican tomatoes. Explain who in the United States would gain and who would lose from such a quota. U.S. tomato growers gain from such a quota. The importers who hold the quota rights also gain. U.S. consumers of tomatoes lose from such a quota.

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Use the following information to work Problems 32 and 33. Suppose that in response to huge job losses in the U.S. textile industry, Congress imposes a 100 percent tariff on imports of textiles from China. 32. Explain how the tariff on textiles will change the price that U.S. buyers pay for textiles, the quantity of textiles imported, and the quantity of textiles produced in the United States. The tariff raises the U.S. price of textiles. With the higher price, the quantity of textiles consumed in the United States decreases and the quantity produced increases. Imports of textiles into the United States decrease.

33.

Explain how the U.S. and Chinese gains from trade will change. Who in the United States will lose and who will gain? The U.S. and Chinese gains from trade decrease. In the United States, U.S. producers gain from the tariff. The U.S. government also gains revenue from the tariff. U.S. textile consumers lose.

Use the following information to work Problems 34 and 35. With free trade between Australia and the United States, Australia would export beef to the United States. But the United States imposes an import quota on Australian beef. 34. Explain how this quota influences the price that U.S. consumers pay for beef, the quantity of beef produced in the United States, and the U.S. and the Australian gains from trade. The quota raises the price of beef in the United States. By raising the U.S. price, the quota increases the quantity of beef produced in the United States and decreases the quantity of beef consumed in the United States. The U.S. and Australian gains from trade decrease.

35.

Explain who in the United States gains from the quota on beef imports and who loses. U.S. beef producers gain from the quota. The people who hold the import quota rights also gain. U.S. beef consumers lose from the quota.

36. Trading Up The cost of protecting jobs in uncompetitive sectors through tariffs is high: Saving a job in the sugar industry costs American consumers $826,000 in higher prices a year; saving a dairy industry job costs $685,000 per year; and saving a job in the manufacturing of women’s handbags costs $263,000. Source: The New York Times, June 26, 2006 a. What are the arguments for saving the jobs mentioned in this news clip? The arguments for saving these jobs are (explicitly) the argument that protection saves jobs and (implicitly) that protection allows us to compete with cheap foreign labor.

b. Explain why these arguments are faulty. The fact these arguments are wrong can be demonstrated by comparing the cost of saving a job to the wage paid on the job. The cost to U.S. consumers of saving a job massively outweighs the benefit a job to the worker, that is, the wage rate paid on the job. This empirical result demonstrates the conclusion that the cost of protection to the losers, U.S. consumers, exceeds the gain to the winners, U.S. producers.

c. Is there any merit to saving these jobs? There is merit to the workers whose jobs are saved and who might not receive any government assistance if their jobs are not protected. There also is merit to the politicians who can obtain a reward from lobbyists for the protection. There is no merit, however, to society as a whole.

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Economics in the News 37.

After you have studied Reading Between the Lines on pp. 388–389, answer the following questions. a. What events put U.S. solar panel producers under pressure? The price of solar panels fell, which pressured U.S. producers of solar panels.

b. Explain how a tariff on solar panel imports changes domestic production, consumption, and imports of solar panels. The tariff raises the U.S. price of solar panels. The higher price increases domestic U.S. production, decreases domestic U.S. consumption, and decreases U.S. imports.

c. Illustrate your answer to part (b) with an appropriate graphical analysis assuming that imports are not completely eliminated. Figure 15.10 shows the effect of the tariff in the market for solar panels. In the figure the tariff, which equals the length of the grey arrow, raises the price in the United States from $150 per panel to $175 per panel. U.S. production of solar panels increases from 1,000 panels per week to 2,000 panels per week. U.S. consumption of solar panels decreases from 6,000 panels per week to 4,500 panels per week. U.S. imports decrease from 5,000 panels per week to 2,500 panels per week.

d. Explain how a U.S. tariff on solar panel imports produces winners and losers and why the losses exceed the gains. The tariff on solar panel imports harms U.S. solar panel consumers because they must pay a higher price and therefore decrease the quantity of solar panels they demand. The tariff helps U.S. solar panel producers because they receive a higher price and therefore increase the quantity they produce. The losses exceed the gains because the U.S. economy must buy solar panels at a higher price than would otherwise be paid and so more resources must be devoted to acquiring solar panels than would otherwise be the case.

38. Aid May Grow for Laid-Off Workers Expansion of the Trade Adjustment Assistance (TAA) program would improve the social safety net for the 21st century, as advances permit more industries to take advantage of cheap foreign labor—even for skilled, white-collar work. By providing special compensation to more of globalization’s losers and retraining them for stable jobs at home, an expanded program could begin to ease the resentment and insecurity arising from the new economy. Source: The Washington Post, July 23, 2007 a. Why does the United States engage in international trade if it causes U.S. workers to lose their jobs? While some U.S workers lose from international trade, other U.S. workers and U.S. consumers gain from the trade. On an economy-wide level, the gains from international trade exceed the losses.

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move toward freer international trade. The Trade Adjustment Assistance program encourages workers to retrain for jobs in industries in which the United States has a comparative advantage. Workers who stand to lose from free international trade lobby to keep or establish protection for their industry. If Trade Adjustment Assistance was expanded, then these workers’ losses would be decreased, which makes them less likely to lobby for protection.

Part 2: Lecture Notes C h a p t e r

WHAT IS ECONOMICS?

The Big Picture Where we are going: After completing Chapter 1, the student will have a good sense for the range of questions that economics addresses and will be on the path towards an economic way of thinking. The students will begin to think of cost as a forgone alternative—an opportunity cost—and also about making choices by balancing marginal costs and marginal benefits. Chapter 2 reinforces the central themes of Chapter 1 by laying out a core economic model, the production possibilities frontier (PPF), and using it to illustrate the concepts of tradeoff and opportunity cost. Chapter 2 also provides a deeper explanation, again with a model, of the concepts of marginal cost and marginal benefit, beginning with the concept of efficiency, and concluding with a review of the source of the gains from specialization and exchange.

New in the Eleventh Edition This important chapter is not one to gloss over as it lays down an important foundation that can be drawn from as you move through more specific applications later. A nicely expanded section on self and social interest calls out issues of both efficiency and fairness. Real world examples previously labeled Economics in Action are now more concise and directly in the body of the text. Two new text boxes bring updated current events to light in Economics in the News and At Issue. The latter confronts the recent events of Occupy Wall Street as it relates to age old battles of free market versus more centrally planned economies.

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Lecture Notes

What Is Economics? I.

Definition of Economics • •

Economic questions arise because we always want more than we can get, so we face scarcity, the inability to satisfy all our wants. Everyone faces scarcity because no one can satisfy all of his or her wants. Scarcity forces us to make choices over the available alternative. The choices we make depend on incentives, a reward that encourages a choice or a penalty that discourages a choice.

Forbes lists Bill Gates and Warren Buffet among some of the wealthiest Americans. Do these two men face scarcity? According to The Wall Street Journal, both men are ardent bridge players, yet they have never won one of the many national bridge tournaments they have entered as a team. These two men can easily afford the best bridge coaches in the world and but other duties keep them from practicing as much as they would need to in order to win. So even the wealthiest two Americans face scarcity (of time) and must choose how to spend their time.

Economics • • •

Economics is the social science that studies the choices that individuals, businesses, governments and entire societies make when they cope with scarcity and the incentives that influence and reconcile those choices. Economists work to understand when the pursuit of self-interest advances the social interest Economics is divided into microeconomics and macroeconomics: • Microeconomics is the study of the choices that individuals and businesses make, the way these choices interact in markets, and the influence of governments. • Macroeconomics is the study of the performance of the national economy and the global economy.

On the first day do a “pop quiz.” Have your students write on paper the answer to “What is Economics?” Reassure them that this is their opinion since it is the first day. You will find most of the answers focused around money and/or business. Stress that Economics is a social science, a study of human behavior given the scarcity problem. All too often first-time students (especially business students) think that Economics is just about making money. Certainly, the discipline can and does outline reasons why workers work longer hours to increase their wage earnings, or why firms seek profit as their incentive. But Economics also explains why a terminally ill cancer patient might opt for pain medication as opposed to continued chemotherapy/radiation, or why someone no longer in the workforce wants to go to college and attain a Bachelor’s degree, in their sheer pleasure of learning and understanding. Stressing the social part of our science now will help later when relating details to the overall bigger picture (especially when time later in the semester seems scarce, no pun intended!). The definition in the text: “Economics is the social science that studies the choices that individuals, businesses, governments, and societies make as they cope with scarcity and the incentives that influence and reconcile these choices,” is a modern language version of Lionel Robbins famous definition, “Economics is the science which studies human behavior as a relationship between ends and scarce means that have alternative uses.” Other definitions include those of Keynes and Marshall: John Maynard Keynes: “The theory of economics does not furnish a body of settled conclusions immediately applicable to policy. It is a method rather than a doctrine, an apparatus of the mind, a technique of thinking, which helps it possessors to draw correct conclusions.” © 2014 Pearson Education, Inc.

WHAT IS ECONOMICS?

Alfred Marshall: “Economics is a study of mankind in the ordinary business of life; it examines that part of individual and social action which is most closely connected with the attainment and with the use of the material requisites of wellbeing.” A “shorthand” definition that resonates with students is: “Economics is the study of trying to satisfy unlimited wants with limited resources.” Students can—and do—easily abbreviate this definition to “unlimited wants and limited resources,” which captures an essential economic insight.

II. Two Big Economic Questions How do choices wind up determining what, how, and for whom goods and services are produced? What, How and For Whom? • •

• •

Goods and services are the objects that people value and produce to satisfy human wants. What we produce changes over time—today we produce more MP3s and CDs than 5 years ago. Goods and services are produced using the productive resources called factors of production. These are land (the “gifts of nature”, natural resources), labor (the work time and work effort people devote to production), capital (the tools, instruments, machines, buildings, and other constructions now used to produce goods and services), and entrepreneurship (the human resource that organizes labor, land, and capital). The quality of labor depends on human capital, which is the knowledge and skill that people obtain from education, work experience, and on-the-job training. Owners of the factors Land earns rent, labor earns wages, capital earns interest, and entrepreneurship earns profit.

Does the Pursuit of Self-Interest Unintentionally Promote the Social Interest? • You make a choice in your self-interest if you think that choice is the best one available for you. • •

An outcome is in the social interest if it is best for society as a whole. A major question economists explore is “Could it be possible that when each of us makes choices in our self-interest, these choices are in the social interest?’

The Two Big Economic Questions Don’t skip the questions in a rush to get to the economic way of thinking. Open your students’ eyes to economic in the world around them. Ask them to bring a newspaper to class and to identify headlines that deal with stories about What, How, and For Whom. Use Economics in the News Today on your Parkin Web site for a current news item and for an archive of past items (with questions). Pose questions but hold off on the answers letting them know that “we can have a much more fruitful discussion when our toolbox is full.” Remind them that this course is about learning simple economic models that provide tools to seek answers to complex issues. Students (and others!) often take the answers to the what, how, and for whom questions for granted. For instance, most of the time we do not bother to wonder “How does our economy determine how many light bulbs, automobiles, and pizzas to produce?” (what), or “Why does harvesting wheat from a plot of land in India occur with hundreds of laborers toiling with oxen pulling threshing machines, while in the United States, a single farmer listening to a Garth Brooks CD and sitting in an air-conditioned cab of a $500,000 machine harvests the same quantity of wheat from the same sized plot of land?” (how), or “Why is the annual income of an inspiring and effective grade school teacher much less than that of an average majorleague baseball player?” (for whom). Explaining the answers to these types of questions and determining whether the answers are in the social interest is a major part of microeconomics. Figure 1.1 in the textbook “What Three Countries Produce” ties in nicely with Chapter 2’s later discussion on the PPF. Figure 1.1 also links the three questions of what, how and for whom nicely to the component © 2014 Pearson Education, Inc.

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parts of those questions: goods and services, factors of production (land, labor, capital, entrepreneurship), and incomes economic agents earn (rent, wages, interest and profit). •

We can examine whether the self-interested choices serve the social interest for a variety topics: • Globalization: Buying an iPod allows workers overseas to earn a wage and provide for family • Information-Age Monopolies: A firm producing popular software leads to format standards • Climate Change: Carbon dioxide emissions led to higher global temperatures and climate change • Economic instability: Volatility and risk in financial markets leads to less student lending available

III. Economic Way of Thinking

Scarcity requires choices and choices create tradeoffs.

What is the difference between scarcity and poverty? Ask the students why they haven’t yet attained all of their personal goals. One reason will be that they lack sufficient money. Ask them if they could attain all of their goals if they were as rich as Bill Gates. They quickly realize that time is a big constraint—and the great leveler: we all have only 24 hours in a day. They have stumbled on the fact that scarcity, which even Bill Gates faces, is not poverty.

A Choice is a Tradeoff • •

A tradeoff is an exchange—giving up one thing to get another. Whatever choice you make, you could have chosen something else.

Virtually every choice that can be thought of involves a tradeoff. Presenting a few of the following as examples can help your class better appreciate this key point: • Consumption and savings: If someone decides to save more of his or her income, savings can be funneled through the financial system to finance businesses new capital purchases. As a society, we trade off current consumption for economic growth and higher future consumption. • Education and training: A student remaining in school for another two years to complete a degree will need to forgo a significant amount of leisure time. But by doing so, he or she will be better educated and will be more productive. As a society, we trade off current production for greater future production. • Research and development: Factory automation brings greater productivity in the future, but means smaller current production. As a society, we trade off current production for greater future production.

Making a Rational Choice • •

A rational choice is one that compares costs and benefits and achieves the greatest benefit over cost for the person making the choice. But how do people choose rationally? Why do more people choose an iPod rather than a Zune? Why has the U.S. government chosen to build an interstate highway system and not an interstate high-speed railroad system? The answers turn on comparing benefits and costs.

Benefit: What you Gain • •

The benefit of something is the gain or pleasure that it brings and is determined by preferences— by what a person likes and dislikes and the intensity of those feelings. Some benefits are large and easy to identify, such as the benefit that you get from being in school. Much of that benefit is the additional goods and services that you will be able to enjoy with the boost to your earning power when you graduate. © 2014 Pearson Education, Inc.

WHAT IS ECONOMICS?

•

Some benefits are small, such as the benefit you get from a slice of pizza. That benefit is just the pleasure and nutrition that you get from your pizza.

Cost: What You Must Give Up

Seeing choices as tradeoffs shows there is an opportunity cost of a choice. The opportunity cost of something is the highest-valued alternative that must be given up to get it. So, for instance, the opportunity cost of being in school is all the good things that you can’t afford and don’t have the spare time to enjoy.

What is the Opportunity Cost of Getting a College Degree? When the students calculate their opportunity cost of being in school, be sure they place a value on their leisure time lost to studying on weekends and evenings. Most students are shaken when they realize that when lost leisure time and income is included in their calculations, the opportunity cost of a college degree approaches $200,000 or more. Don’t leave them hanging here though. Mention that a college education does yield a high rate of financial return over. To ensure that people do not die of any serious side effects, the Food and Drug Administration (FDA) requires all drug companies to thoroughly test newly developed medicines before allowing them to be sold in the United States. However, it takes many years to perform these tests and many people suffering from the terminal diseases these new medicines are designed to cure will die before good new medicines are eventually approved for use. Yet, if the FDA were to abandon this testing process, many others would die from the serious side effects of those bad medicines that made it to market. People’s lives will be at risk under either policy alternative. This stark example of a tradeoff reveals the idea that choices have opportunity costs.

How Much? Choosing at the Margin •

• •

Making choices at the margin means looking at the trade-offs that arise from making small changes in an activity. People make choices at the margin by comparing the benefit from a small change in an activity (which is the marginal benefit) to the cost of making a small change in an activity (which is the marginal cost). Changes in marginal benefits and marginal costs alter the incentives that we face when making choices. When incentives change, people’s decisions change. For example, if homework assignments are weighed more heavily in a class’s final grade, the marginal benefit of completing homework assignments has increased and more students will do the homework.

Choices Respond to Incentives • •

Economists take human nature as given and view people acting in their self-interest. Self-interest actions are not necessarily selfish actions.

Self interest can be said to be in the eye of the beholder. Thus, covering the next portion on positive versus. normative analysis can be crucial to the student’s understanding how economic agents act in their own self-interests, but perhaps not (and often not) in other’s self-interest.

IV. Economics as Social Science and Policy Tool Economist as Social Scientist •

Economists distinguish between positive statements and normative statements. A positive statement is about “what is” and is testable. A normative statement is about “what ought to be” and is an opinion and so is inherently not testable. A positive statement is “Raising the tax on a gallon of © 2014 Pearson Education, Inc.

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• •

•

gasoline will raise the price of gasoline and lead more people to buy smaller cars” while a normative statement is “The tax on a gallon of gasoline should be raised.” Economists tend to agree on positive statements, though they might disagree on normative statements. An economic model describes some aspect of the economic world that includes only those features needed for the purpose at hand. Economic models describe the economic world in the same way that a road map explains the road system: Both focus on only what is important and both are abstract depictions of the real world. Testing an economic model can be difficult, given we observe the outcomes of the simultaneous operation of many factors. So, economists use the following to copy with the problem: • Natural experiment: A situation that arises in the ordinary course of economic life in which the one factor of interest is different and other things are equal or similar. • Statistical Investigation: A statistical investigation might look for the correlation of two variables, to see if there is some tendency for the two variables to move in a predictable and related way (e.g. cigarette smoking and lung cancer). • Economic Experiment: Putting people in a decision-making situation and varying the influence of one factor at a time to see how they respond.

Economist as Policy Adviser • •

Economics is useful. It is a toolkit for advising governments and businesses and for making personal decisions. For a given goal, economics provides a method of evaluating alternative solutions— comparing marginal benefits and marginal costs and finding the solution that makes the best use of the available resources.

The success of a model is judged by its ability to predict. Help your student’s appreciate that no matter how appealing or “realistic looking” a model appears to be, it is useless if it fails to predict. And the converse, no matter how abstract or far removed from reality a model appears to be, if it predicts well, it is valuable. Milton Friedman’s Pool Hall example illustrates the point nicely. Imagine a physicist’s model that predicts where a carefully placed shot of a pool shark would go as he tries to sink the eight ball into the corner pocket. The model would be a complex, trigonometric equation involving a plethora of Greek symbols that no ordinary person would even recognize as representing a pool shot. It certainly wouldn’t depict what we actually see—a pool stick striking a pool cue on a rectangular patch of green felt. It wouldn’t even reflect the thought processes of the pool shark that relies on years of experience and the right “touch.” Yet, constructed correctly, this mathematical model would predict exactly where the cue ball would strike the eight ball, hit opposite the bank, and fall into the corner pocket. (You can easily invent analogous examples from any sport.)

WHAT IS ECONOMICS?

Additional Problems 1.

You plan a major adventure trip for the summer. You won’t be able to take your usual summer job that pays $6,000, and you won’t be able to live at home for free. The cost of your travel on the trip will be $3,000, film and videotape will cost you $200, and your food will cost $1,400. What is the opportunity cost of taking this trip?

The university has built a new parking garage. There is always an available parking spot, but it costs $1 per day. Before the new garage was built, it usually took 15 minutes of cruising to find a parking space. Compare the opportunity cost of parking in the new garage with that in the old parking lot. Which is less costly and by how much?

Solutions to Additional Problems 1.

The opportunity cost of taking this trip is $10,600. The opportunity cost of taking the trip is the highest-valued activity that you will give up so that you can go on the trip. In taking the trip, you will forgo all the goods and services that you could have bought with the income from your summer job ($6,000) plus the expenditure on travel ($3,000), film and videotape ($200), and food ($1,400).

The opportunity cost of parking before the building of the new parking garage is the highest-valued activity that you forgo by spending 15 minutes parking your car. The opportunity cost of parking in the new parking garage is $1 that you could have spent elsewhere. If the opportunity cost of 15 minutes spent parking your car is greater than the opportunity cost of $1, then the new parking garage is less costly.

Additional Discussion Questions 1.

Why are economists so concerned about the material aspects of life? Explain that this is a myth! Economists are often criticized for focusing on material well-being because of the general public’s view that economics is about money. Explain that there are economists that research social and emotional (or spiritual) aspects of life. You may also add that these parts of life often depend heavily on attaining material well-being. You may want to reference the Economic Freedom Index and its explanatory power on issues of world hunger and poverty. Ask them to consider the need for life-enhancing goods and services such as health care or education to support spiritual or emotional well-being. Ask how protestors would be able to voice their opinions without low-cost air travel and the power of the Internet to coordinate the activities of hundreds of protesters. (Be careful not to seem to be either condoning or condemning these activities.) Most students will begin to see that the more efficient we are at producing material prosperity, the more time and opportunity everyone has to promote emotional (or spiritual) goals.

Mini Case Study Illustrating How Economists Use Modeling: Women are unfairly underpaid when compared to men. Ask your students whether this statement is positive or normative. Mention that the media frequently reports that the average woman gets paid only 3/4 the wages of the average man. Is this “fact” a sufficient test of the positive statement? If women were paid more than men in one or two professions (like professional modeling or elementary teaching) is that sufficient evidence to conclude that women in © 2014 Pearson Education, Inc.

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general are not underpaid when compared to men? Ask the students to think about how to properly test the model. Are these counter examples enough to discard the idea that women are underpaid? What would you take into account when you collected data to compare women’s salaries versus men’s salaries? Remind the students that any model directly comparing men’s and women’s wages should control for any differences in wage-relevant characteristics between working men and women. You can discuss many different reasons why a gender wage gap can occur, including: • Women are underrepresented in higher paid occupations and are overrepresented in lower paid occupations (the problem may not be unequal pay but instead it may be unequal access to high paying jobs (glass ceiling?); • Women are underrepresented among those earning advanced degrees, though mostly among older age cohorts (U.S. Bureau of Labor Statistics, Employment and Earnings, Vol. 45, January, 1998). Here the problem here might not be unequal pay but unequal access to higher education; • Women have relatively less occupational-specific work experience and have relatively less unbroken work experience, as many women struggle between pursuing a career and raising a family. For example, one study found that women who were not mothers earned 90 percent of men’s salaries, whereas those who were mothers earned only 77 percent (Waldfogel, “Understanding the ‘Family Gap’ in Pay for Women with Children,” Journal of Economic Perspectives, Vol. 12, No. 1, 1998). Does it further the public interest (and the interests of women workers specifically) to propagate normative statements about wage inequality based on statistics without taking account of all relevant factors? Summarize the discussion by noting that economic studies have indeed found evidence that a gender gap in wages exists in the United States, even after controlling for all known relevant factors. However, the gender wage gap is much less than the 1/3 number often quoted by the media, and has been decreasing significantly over the last few decades (Blau, “Trends in the Well Being of American Women, 19701995,” Journal of Economic Literature, Vol. 36, No.1, March 1998). Get the students to see how properly applying the science of economics to social issues helps us strip away inflammatory rhetoric and examine the problem carefully and objectively.

WHAT IS ECONOMICS?

Chapter 1 Appendix, Graphs in Economics Lecture Notes Goggle Theory Explain to students that you are going to ask them to use three sets of goggles to view math in the course. I have found this to be a great tool for students to understand why we present data in different ways. 1. Equation Goggles: Write an equation in slope-intercept form and explain that this is one way to show relationships between two variables. I like to use X and Y for this one and then quickly explain that economics is much more fun than math because we may be talking about X-rays and Yo-Yo’s. This helps some students break the barrier early on what “variable” means. 2. Graphing Goggles: Work through a graph of the equation you wrote highlighting slope and intercept. Indicate that this may be a Demand or Supply curve for instance. 3. Schedule Goggles: Draw a simple “T” schedule with X and Y choosing your own numbers to “plug and chug” with the equation you first used. Now you can explain that they will see all three of these forms of math at different times during the course and it is important for them to understand that you can move between all three anytime. We usually have it shown just one way for convenience. It is also fun during lecture to say, “I need you to pull out your graphing goggles.”

Graphing Data • • •

Graphs are valuable tools that clarify what otherwise might be obscure relationships. Graphs represent “quantity” as a distance. Two-variable graphs use two perpendicular scale lines. The vertical line is the y-axis. The horizontal line is the x-axis. The zero point in common to both axes is the origin. Scatter diagram—a graph that plots the value of one variable on the x-axis and the value of the associated variable on the y-axis. A scatter diagram can make clear the relationship between two variables.

II. Graphs Used in Economic Models •

Graphs are used to show the relationship between variables. Graphs can immediately convey the relationship between the variables: • A positive relationship (or direct relationship)—when the variable on the x-axis increases the variable on the y-axis increases. A straight line is a linear relationship. • A negative relationship (or inverse relationship)—when the variable on the x-axis increases, the variable on the y-axis decreases. • A maximum or a minimum—when the variable has a highest or lowest value.

III. The Slope of a Relationship •

• • •

The slope of a curve equals the change in the value of the variable on the vertical axis at the point where the slope is being calculated divided by the change in the value of the variable on the horizontal axis at the relevant point. • In terms of symbols, the slope equals y/x, with  standing for “change in.” The slope of a straight line is constant. The slope is positive if the variables are positively related and negative if the variables are negatively related. The slope of a curved line at a point equals the slope of the straight line that is tangent to the curved line at the point. The slope of a curved line across an arc equals the slope of the straight line between the two points on the curved line. © 2014 Pearson Education, Inc.

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IV. Graphing Relationships Among More Than Two Variables •

A. When a relationship involves more than two variables, we can plot the relationship between two of the variables by holding other variables constant.

C h a p t e r

THE ECONOMIC PROBLEM

The Big Picture Where we have been: Chapter 1 introduced the economic reality that wants exceed the resources available to satisfy them—we face scarcity. Chapter 2 reinforces these central themes by laying out the core economic model, the Production Possibilities Frontier, or PPF, and uses it to illustrate the concepts of tradeoff and opportunity cost. Chapter 2 further details the concepts of marginal cost and marginal benefit, presenting a first look at the concept of efficiency. It then concludes with an explanation of the source of the gains from specialization and exchange and the roles of firms and markets in achieving those gains. Where we are going: The key concept of opportunity cost and the widespread tendency for the opportunity cost of a good to increase as the quantity produced of that good increases returns in Chapter 3 when we explain the supply curve. For Micro classes, we see it again in Chapters 10 and 11 when we study a firm’s costs and cost curves. Preferences return and are treated more rigorously when we explain marginal utility theory in Chapter 8 and indifference curves in Chapter 9. Efficiency returns in Chapter 5 when we study the efficiency of markets and first preview the impediments to efficiency. The gains from trade are explored more completely in the context of international trade in Chapter 7 in Microeconomics and Chapter 15 of Macroeconomics. The PPF principles make great ties to explain the reasons we use RGDP as a primary measure of economic growth in Chapter 6 of Macro. Finally, the role of markets and prices in allocating resources and coordinating activity is an ongoing theme throughout most of the rest of the text. The next task, in Chapter 3, is to develop the central demand and supply model.

New in the Eleventh Edition Chapter 2 has been slightly rewritten. The Economics in Action boxes have been replaced with two Economics in the News boxes. One discusses global food costs and the other energy independence.

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Lecture Notes

The Economic Problem • • •

Scarcity creates the need to make choices. Economic choices can be evaluated in terms of their efficiency. We can expand possible choices through capital accumulation and specialization and trade.

Production Possibilities and Opportunity Cost • •

The production possibilities frontier (PPF) is the boundary between those combinations of goods and services that can be produced and those that cannot given available resources and technology. Consider the production choices for two goods: books and movies. The table with the data for the PPF is below and a figure showing the PPF is to the right. A B C D

• • •

Books 0 200 400 600

Movies 600 500 300 0

Production points beyond the PPF are not attainable without increases in resources or technology (these factors shift the PPF); Production points on and within the PPF are attainable, but production points within the PPF, such as point Z, are inefficient. It is possible to get more of one good without giving up any of the other. The PPF illustrates how scarcity creates the need to make choices. Producing more books (moving from point A to point B) means producing fewer movies, and producing more movies (moving from point C to point B) means producing fewer books.

Using the PPF above, make a point outside the PPF and ask the students about it. Once they state it is not possible, ask them how we could get there. After they highlight a few shifters, summarize for them that the resources and technology we held constant when we drew the PPF now relocate it when they change. Now give them an example of a new movie camera invention and ask them if this will help us get more books? You will likely get an immediate round of “NO.” Reply, “Are you sure?” and you should be able to find a student who sees that the new resource frees up other resources that can now be used for more books. Show them graphically a shift that is pinned at the book axis and it will open their eyes to how technology and resource growth in any sector can make more of all goods!

Production Efficiency

Production is efficient only on the frontier. • We achieve production efficiency if we cannot produce more of one good without producing less of some other good. • Inside the frontier (point Z), production is inefficient. Resources could be better employed to increase production of both books and movies.

Tradeoff Along the PPF •

Moving along the PPF, there is always a tradeoff involved in diverting resources from the production of one thing to another. We gain one thing but at the opportunity cost of losing something else. © 2014 Pearson Education, Inc.

THE ECONOMIC PROBLEM

The key here is to make sure the student understands that given scarcity, because we produce one thing, we cannot produce something else. Some students will see the tradeoff immediately as a cost (giving up something), but they will incorrectly interpret that cost as only that valued in money units. To eliminate this ambiguity (better now than later), ask them to think about a meal they purchased recently. Now ask them what the money cost was as well as what else they might have picked for a meal? Most students pick up on this concept quickly with one or two more examples. And since this is a consumption example, tell them to put themselves in the place of an office manager, who must produce a service but can do so only given tradeoffs. While money costs are measurable and useful, propose to the students that opportunity costs are indeed even more useful in identifying the tradeoffs made in production.

Opportunity Cost • •

The opportunity cost of an action is the highest valued alternative forgone. Efficiency means that the opportunity cost of producing more books or movies is the tradeoff along the frontier.

Increasing Opportunity Costs • •

•

The “bowed-out” shape of the PPF reflects the principle of increasing opportunity cost. Not all resources are the same, which is why the PPF bows out. Publishers are better at producing books and Hollywood studios are better at producing movies. Moving along the frontier and producing more movies inevitably means that more and more publishers must produce movies. As this happens, the increase in movies becomes smaller and the decrease in books becomes larger. Emphasize the intercepts where the PPF crosses the axes. Take the vertical intercept in the figure. At this point all resources are used to produce movies. Basically to get to that point the economy has crammed and slammed every resource into movie production. Now when the economy moves down the PPF to produce the first book, that book is really inexpensive—has very low opportunity cost—because the economy uses resources better suited for book production first rather than movies. As more and more resources are diverted from production of one good to another, the smaller the additional increase in the production of the one good will be and the larger the decrease in the production of the other good.

You can bring in the relationship of slope and opportunity cost here if you want. OPTION 1: A soft way to bring in slope is to offer it as a double check on calculating marginal cost: “The opportunity cost of whatever is being measured on the horizontal axis is equal to the magnitude of the slope of the PPF.” OPTION 2: You can also introduce the slope of a curve is the slope of a tangent line to the curve. The bowed-out shape is a key feature of typical PPFs, often overlooked by the student (and too often not accentuated by the instructor). The key here is to link the ever increasing opportunity cost exhibited by the shape of a bowed out PPF with that of the marginal cost curve, which is upward sloping. To make the PPF model useful, it was necessary to simplify. By considering the case where production of all goods other than two remain fixed, we can use a relatively simple picture to see how concepts apply to the real world. With three goods, we would have a 3-D frontier surface. With more than 3 goods, it would be impossible to represent the frontier using a graph. The cool thing is that all relevant results of the 2-D model are true in the N-good model.

II. Using Resources Efficiently

CHAPTER 2

The PPF and Marginal Cost • •

Marginal cost is the opportunity cost of producing one more unit of a good. As more books are produced, the marginal cost of a book increases. The table shows the marginal cost of producing books from the PPF data presented before and the figure shows the upward sloping marginal cost curve.

Books 0

200

400

600

Marginal cost of a book (movies per book) 0.5 1.0 1.5

Preferences and Marginal Benefit • • •

Preferences are a description of a person’s likes and dislikes. The marginal benefit of a good or services is the benefit received from consuming one more unit of it. The principle of decreasing marginal benefits is why the marginal benefit curve in the figure above slopes downward.

You might have some students that have had a microeconomics course in their past, and have already been introduced to the concept of marginal cost and marginal benefit. And, they might inquire if the marginal benefit curve is linked to the Law of Diminishing Marginal Utility. While this might be adequate discussion for an advanced undergraduate course, and certainly a graduate micro seminar, pass it up in your principles course. Let the student know that the goal is to employ demand side concepts, in a marginal sense. As such, key in on the fact that the marginal benefit curve can be characterized as a willingness to pay curve. Keep the discussion of marginal cost and marginal benefit separate and distinct, making sure that the student realizes these are in essence the foundation of market forces (supply and demand, respectively). While the PPF can tell us the opportunity costs in production, and the tradeoffs therein, it is the market that allows us to determine the allocatively efficient point. Allocative efficiency only occurs with a balance between benefits and costs, at the margin.

Allocative Efficiency

Allocative efficiency occurs only when marginal benefit equals marginal cost. • In the figure, when 100 books per month are produced, the marginal benefit from another book exceeds its marginal cost, which means that people prefer another book more than the movies they must give up. • When the allocatively efficient number of books, 200 per month, is produced, the PPF in the previous figure shows that the allocatively efficient number of movies is 500 movies per month. • When marginal cost equals marginal benefit it is impossible to make people better off by reallocating resources.

III. Economic Growth

THE ECONOMIC PROBLEM

•

Technological change (the development of new goods and of better ways of producing goods and services) and capital accumulation (the growth of capital resources, which includes human capital) lead to economic growth.

You can have some fun and generate some discussion by getting the students to think about what life might be like after another 200 years of economic growth. Provide some numbers: In 2008, income per person in the United States was about $100 a day. In 1808 it was about 70¢ a day, and if the past growth rate prevails for another 200 years, in 2208 it will be $14,000 a day. Emphasize the magic of compound growth. If they think that $14,000 a day is a big income, get them to do a ballpark estimate of the daily income of Bill Gates (about $10 million!). Encourage a discussion of why scarcity is still present even at these large incomes.

The Cost of Economic Growth •

Economic growth requires that resources must be devoted to developing technology or accumulating capital, which means that current consumption decreases. The decrease in current consumption is the opportunity cost of economic growth.

A Nation’s Economic Growth • •

Countries that devote a higher share of resources to developing technology or accumulating capital are more likely to grow faster. Some nations, such as Hong Kong, have chosen faster capital accumulation at the expense of current consumption and so have experienced faster economic growth.

Running through the above example can really help students catch on to how economic growth is linked to choices (less consumption now for more later). You may wish to demonstrate more consumption or more capital biased shifts of the PPF, to demonstrate changes in opportunity costs.

IV. Gains from Trade

Specialization and trade expand consumption possibilities

Comparative Advantage and Absolute Advantage • •

•

A person has a comparative advantage in an activity if that person can perform the activity at a lower opportunity cost than anyone else. The PPF shows opportunity cost. In the figure the opportunity cost of a bushel of wheat in Canada is 1/4 of a computer and in Japan it is 1 computer. In Canada the opportunity cost of a computer is 4 bushels of wheat and in Japan it is 1 bushel of wheat. Canada has a comparative advantage in producing wheat and Japan has a comparative advantage in producing computers. A person has an absolute advantage if that person is more productive than others in that activity or activities. A person (or country) can have an absolute advantage in all activities but that person (or country) will not have a comparative advantage in all activities.

An easy way for students to remember the difference between comparative and absolute advantages is that with comparative advantage, the opportunity costs comparison matters. If one has a comparative advantage in producing something, they should specialize in production of that good or service. An © 2014 Pearson Education, Inc.

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absolute advantage can be characterized by being able to “absolutely out-produce” the other economic agent. Even though a country might have absolute advantages, it should not produce everything, and should focus on identifying its comparative advantages.

Achieving the Gains from Trade •

When countries specialize by producing the good in which each country has a comparative advantage more goods in total can be produced. If without trade Canada and Japan each produce at point A, a total of 8 computers and 16 bushels of wheat are produced. If they specialize according to comparative advantage, Japan produces at point B* and Canada produces at point B for a combined total of 12 computers and 24 bushels of wheat.

•

Trade allows consumption to be different than production for each nation, so Canada can trade wheat for computers and Japan can trade computers for wheat. Because more computers and more wheat are produced, both nations can consume more than they can produce on their own. For example, suppose that the market price of wheat is ½ computer per 1 bushel of wheat. As illustrated, each country can now be consuming at point C along the trade line. Note that each country’s consumption point lies beyond its own PPF.

•

The gains from trade can now be easily seen in terms of Japan and Canada each gaining 2 computers and 4 bushels of wheat compared to their initial, no-trade consumption points. Note that it is more likely that point C for each country will be on a different point on the trade line according to preferences. In the end, the sum of consumption among the two countries must equal the sum of production (imports=exports). For simplicity, this example has points A and C equal for both countries.

V. Economic Coordination Firms and Markets • •

A firm is an economic unit that hires factors of production and organizes those factors to produce and sell goods and services. A market is any arrangement that enables buyers and sellers to get information and to do business with each other.

Property Rights and Money • •

The social arrangements that govern the ownership, use, and disposal of resources, goods, and services are called property rights. Types of property include real (buildings and land), financial (stocks and bonds) and intellectual (ideas and technology). Money is anything generally accepted as a means of payment. Money’s main purpose is to facilitate trade.

Students are usually fixated on money, but ask them to dig deeper. It is what we can do or buy with money that brings us happiness not the actual bills themselves.

Circular Flows Through Markets •

THE ECONOMIC PROBLEM

Coordinating Decisions •

Prices within markets coordinate firms’ and households’ decisions.

Everyone knows what prices are. But not everyone knows why prices rise or fall. The point is that no one needs to know why a price has changed when making the choice to buy or sell. All that someone needs to know is what the price is relative to what he or she believes the item to be worth. •

Enforced property rights ensure that exchange is voluntary (not theft). Property rights and prices help insure that production takes place efficiently without waste because the owner of a firm has the property right to any profit the firm can earn.

Willingness to pay affects production and production affects willingness to pay. It would appear that we have the classic “which came first, the chicken or the egg” conundrum. However, in the next chapter, we will discuss the most powerful model in economics, Demand and Supply, which allows us to think clearly about the behavior of markets.

CHAPTER 2

Additional Problems 1.

Jane’s Island’s production possibilities are given in the table to the right. a. Draw a graph of the production possibility possibilities frontier on Jane’s Island. b. What are Jane’s opportunity costs of producing corn and cloth at each output in the table?

In problem 1, Jane is willing to give up 0.75 pounds of corn per yard of cloth if she has 2 yards of cloth; 0.50 pounds of corn per yard of cloth if she has 4 yards of cloth; and 0.25 pound of corn per yard of cloth if she has 6 yards of cloth. a. Draw a graph of Jane’s marginal benefit from corn. b. What is Jane’s efficient quantity of corn?

Corn (pounds per month) 3.0 2.0 1.0 0

Joe’s production possibilities are given in the table to the right. What are Joe’s opportunity costs of producing corn and cloth at each output in the table?

Corn (pounds per month) 6 4 2 0

and and and and

Cloth (yards per month) 0 2 4 6

Cloth (yards per month) 0 1.0 2.0 3.0

In problems 1 and 2, Jane’s Island produces and and consumes 2 pounds of corn and 2 yards of cloth. Joe’s and Island produces and consumes 2 pounds of corn and and 2 yard of cloth. Now the islands begin to trade. and a. What good does Jane sell to Joe and what good does Jane buy from Joe? b. If Jane and Joe divide the total output of corn and cloth equally, what are the gains from trade?

Solutions to Additional Problems 1.

Jane’s Island’s PPF is a straight line. To make a graph of Jane’s Island’s PPF measure the quantity of one good on the x-axis and the quantity of the other good on the y-axis. Plot the quantities in each row of the table. Figure 2.1 illustrates Jane’s Island’s PPF. The opportunity cost of 1 pound of corn is 2 yards of cloth. The opportunity cost of the first pound of corn is 2 yards of cloth. To find the opportunity cost of the first pound of corn, increase the quantity of corn from 0 pounds to 1 pound. In doing so, Jane’s Island’s production of cloth decreases from 6 yards to 4 yards. The opportunity cost of the first pound of corn is 2 yards of cloth. Similarly, the opportunity costs of producing the second pound and the third pound of corn are 2 yards of cloth. The opportunity cost of 1 yard of cloth is 0.5 pound of corn. The opportunity cost of producing the first 2 yards of cloth is 1 pound of corn. To calculate this opportunity cost, increase the quantity of cloth from 0 yards to 2 yards. Jane’s Island’s production of corn decreases from 3 pounds to 2 pounds. © 2014 Pearson Education, Inc.

THE ECONOMIC PROBLEM

Similarly, the opportunity cost of producing the second 2 yards and the third 2 yards of cloth are 1 pound of corn. 2.

The marginal benefit curve slopes downward. To draw the marginal benefit curve from cloth, plot the quantity of cloth on the x-axis and the willingness to pay for cloth (that is, the number of pounds of corn that Jane is willing to give up to get a yard of cloth) on the y-axis, as illustrated in Figure 2.2. The efficient quantity is 4 yards a month. The efficient quantity to produce is such that the marginal benefit from the last yard equals the opportunity cost of producing it. The opportunity cost of a yard of cloth is 0.5 pound of corn. The marginal benefit of the fourth yard of cloth is 0.5 pound of corn. And the marginal cost of the fourth yard of cloth is 0.5 pound of corn.

Joe’s Island’s opportunity cost of a pound of corn is 1/2 yard of cloth, and its opportunity cost of a yard of cloth is 2 pounds of corn. When Joe’s Island increases the corn it produces by 2 pounds a month, it produces 1 yard of cloth less. The opportunity cost of 1 pound of corn is 1/2 yard of cloth. Similarly, when Joe’s Island increases the cloth it produces by 1 yard a month, it produces 2 pounds of corn less. The opportunity cost of 1 yard of cloth is 2 pound of corn. a.

Jane’s Island sells cloth and buys corn. Jane’s Island sells the good in which it has a comparative advantage and buys the other good from Joe’s Island. Jane’s Island’s opportunity cost of 1 yard of cloth is 1/2 pound of corn, while Joe’s Island’s opportunity cost of 1 yard of cloth is 2 pounds of corn. Jane’s Island’s opportunity cost of cloth is less than Joe’s Island’s, so Jane’s Island has a comparative advantage in producing cloth. Jane’s Island’s opportunity cost of 1 pound of corn is 2 yards of cloth, while Joe’s Island’s opportunity cost of 1 pound of corn is 1/2 yard of cloth. Joe’s Island’s opportunity cost of corn is less than Jane’s Island’s, so Joe’s Island has a comparative advantage in producing corn. With specialization and trade, together they can produce 6 pounds of corn and 6 yards of cloth and each will get 3 pounds of corn and 3 yards of cloth—an additional 1 pound of corn each and an additional 1 yard of cloth each. Hence the total gains from trade are 2 yards of cloth and 2 pounds of corn.

Additional Discussion Questions 1.

Use the PPF model to analyze an “Arms Race” between nations. You might like to get the students to realize how useful even a simple economic model (such as the PPF model) is for helping us understand and interpret important political events in history. Draw a PPF for military goods and civilian goods production (or, simply, the traditional example of “guns versus butter”). Then draw another PPF for a country that is about twice the size of the first, but with the same degree of concavity as the PPF for the first country. Now assume that each country considers the other as a mortal “enemy,” and that they engage in a costly © 2014 Pearson Education, Inc.

CHAPTER 2

“arms race.” Each country picks a point on the PPF that produces an equal level of military output (in absolute terms). What would happen if the larger country decided to increase military production? Emphasize that while the distance on the military output axis at the point of production is equal for both countries, the resulting distance on the civilian output axis is (by definition) a smaller quantity for the smaller country. The large country can create significant economic and political pressures on the government of the small country by forcing the small country to match the increase in military production. The PPF reveals how much more additional civilian output is forgone by the citizens of the small economy relative to the citizens of the larger economy. Emphasize also that the opportunity cost of civilian goods is higher for the smaller country. What were the economic repercussions of the Cold War? History and political science majors quickly perceive that these two PPF models reflect the Cold War relationship between the United States and the U.S.S.R. during the early 1980s. The Reagan administration increased U.S. military expenditures during the early 1980s to a post–Viet Nam War peak of 6.6 percent of GDP (as compared to about 3.5 percent of GDP in the late 1990s). Many experts agree that this strategy contributed to the many political and economic pressures that ultimately lead to the dissolution of the U.S.S.R. What are the implications for the next 50 years? China is currently the world’s second largest economy. It could become the biggest by mid-century. How does this development influence the strategic balance and the position of the United States? 12. Using the PPF model to analyze global environmental agreements between nations. This application of the PPF is a more “green” perspective that uses the same logic as the “Arms Race” on a timely international policy issue. Compare a rich economy PPF to a poor economy PPF, each with the same degree of concavity. (Production levels are now measured as output per person.) The goods are now “cleaner air” and “other goods and services.” What if the citizens of each country were required to make equal reductions in perperson greenhouse gas emissions? Show an equal quantity increase in per person output on the clean air axis for both countries’ PPF curves. Show how the opportunity cost of requiring additional pollution reduction (cleaner air) of equal amounts per person is much greater for the citizens of a poorer country than for the citizens of the richer country. This fact has been used to persuade developed countries (like the United States) to accept larger pollution reduction targets than developing countries (like China, India, and African nations). 3.

Why do some of the brightest students not get Recreation Marginal cost a 4.0 GPA? The answer—because it doesn’t (hours per day) (GPA points per hour) achieve allocative efficiency—can now be 0.5 0.1 approached. The first conceptual step is to 1.5 0.2 derive the marginal cost curve from the PPF. 2.5 0.3 The table provides eight points on the MC curve. 3.5 0.4 Tell the students that this table is from a PPF 4.5 0.5 between hours spent at recreation and GPA. Use 5.5 0.6 this opportunity to explain why we plot 6.5 0.7 marginal values at the midpoints of changes 7.5 0.8 because the marginal cost at the midpoint approximately equals the average of the opportunity costs across the interval.

THE ECONOMIC PROBLEM

The students must now think about preferences for recreation and study. You’ll be surprised how many students want to derive preferences from the PPF! Explain that the PPF provides the constraint—what is feasible—and preferences provide the objective—what is desirable in the opinion of the chooser. Each additional hour of recreation likely yields a smaller marginal benefit to the student. Translate this to the proposition that the student’s willingness to give up GPA points for additional hours of recreation decreases and provide a table similar to that in Figure 2.3 that captures this observation. The table has a preference schedule. Stress once again that this table did not come from the PPF.

Recreation

Willingness to pay

(hours per day)

(GPA points per hour)

0.5 1.5 2.5 3.5 4.5 5.5 6.5 7.5

0.7 0.6 0.5 0.4 0.3 0.2 0.1 0

To determine the efficient amount of recreation and hence study time, the student must ask “Do I study a little bit longer?” That is the question. Walk the student through the thought experiment: 1. If I study for 8 hours a day I get a 4.0, but I am willing to pay much more than I will pay if a take a bit of time off studying and have some fun. So I will be better off if study less and take more recreation time. 2.

If I don’t study at all I get a 0.4, and I am paying much more in lost GPA than I am willing to pay for the last bit of fun. So I will be better off if I study more and take less recreation time.

The only allocation at which I can’t become better off by studying a little bit more or a little bit less is where I am just willing to pay what the last bit of recreation costs— where marginal cost equals marginal benefit.

In this example, the student studies for 4.5 hours and takes 3.5 hours a week of recreation time. Explain that there is nothing strange or wrong with the fact that the student gets no net benefit from the last seconds-worth of recreation time. He or she is just willing to pay what it costs him or her. 4.

Gains from Trade The gain from trade is a real eye-opener for students. Their first reaction is one of skepticism. Convincing students of the power of trade to raise living standards and the costs of trade restriction is one of the most productive things we will ever do. Here are some questions to drive home the idea of comparative advantage: Why didn’t Billy Sunday do his own typing? Billy Sunday, an evangelist in the 1930s, was reputed to be the world’s fastest typist. Nonetheless, he employed a secretary who was a slower typist than he. Why? Because in one hour of preaching, Billy could raise several times the revenue that he could raise by typing for an hour. So Billy plays to his comparative advantage. Why doesn’t Martha Stewart bake her own bread? Martha Stewart is probably a better cook than most people, but she is an even better writer and TV performer on the subject of food. So Martha plays to her comparative advantage and writes about baking bread but buys her bread. Why doesn’t Vinnie Jones play soccer? Vinnie Jones was one of the world’s best soccer players. But he stopped playing soccer and started making movies some years ago. Why?

CHAPTER 2

Because, as he once said, “You go to the bank more often when you’re in movies.” Vinnie’s comparative advantage turned out to be in acting.

C h a p t e r

DEMAND AND SUPPLY

The Big Picture Where we have been: In Chapter 3, the students have their first encounter with demand and supply and the powerful forces that determine price and quantity in a competitive market. Chapter 3 builds on Chapter 2, which provides the simplest rigorous description of the economic problem and the implications of the pursuit of an efficient use of resources. If you have time, it is worth forging links between Chapters 2 and 3. Chapter 2 explains why we trade in markets. Chapter 3 shows how trade in markets determines where on the PPF the economy operates. Where we are going: Demand and supply lie at the heart of the principles course. Eventually in the microeconomics class we derive the demand curve and the supply curve from deeper views of the choices that people and firms make. And in the macroeconomic class, the lessons learned here apply, albeit with subtle differences, to the aggregate supply-aggregate demand model.

New in the Eleventh Edition The content of this chapter is virtually the same except for the Economics in Action which are now replaced with new current topics of gasoline and college education under the heading Economics in the News. The Reading Between the Lines is new and provides an extended straightforward example of using demand and supply to understand the market for peanut butter.

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Lecture Notes

Demand and Supply • • • •

In our market-based economy, the interaction of demand and supply in markets determines the prices of goods and services and the quantity produced and consumed. Changes in demand and/or supply lead to changes in the price of the good or service and in the quantity produced and consumed. Markets vary in the intensity of competition. This chapter studies a competitive market, which is a market that has many buyers and sellers, so no single buyer or seller can influence price. The money price of a good or service is the number of dollars that must be given up for it. The ratio of one (money) price to another is called a relative price. A relative price is an opportunity cost. The theory of demand and supply determines relative prices and so when we use the word “price” we mean “relative price.”

To point out the importance of relative prices, ask your students if turkey at 40¢ a pound is a good buy. Tell them that is all they know—turkey is 40¢ a pound. Generally most students respond that turkey at this price is cheap and a good buy. Then tell them that steak is 8¢ a pound. Now is turkey such a good buy? Students realize that the relative price of turkey is 5 pounds of steak per pound of turkey and so turkey is actually expensive. Point out to them that these money prices are actual prices from circa 1800. At that time, turkey was relatively quite expensive because turkeys could fly and needed to be hunted rather than harvested! Also point out to them the unimportance of the money price and the crucial importance of the relative price.

Demand • •

The price of a good or service affects the quantity people plan to buy. The quantity demanded of a good or service is the amount that consumers plan to buy during a given time period at a particular price. The law of demand states that other things remaining the same, the higher the price of a good, the smaller is the quantity demanded; and the lower the price of a good, the greater the quantity demanded. The law of demand occurs for two reasons: • Substitution Effect: When the relative price of good changes, the opportunity cost of the good changes. An increase in the price increases the opportunity cost of buying the good and people respond by buying less of the good and buying more of its substitutes. • Income Effect: A change the price of a good changes the amount that a person can afford to buy. When the price of a good rises, people cannot afford to buy the same quantities that they purchased before, so the quantities bought of some goods and services must decrease. Normally the good whose price rises is one of the goods for which less is purchased.

DEMAND AND SUPPLY

Demand Curve and Demand Schedule •

•

The demand for a good Price Quantity refers to the entire (dollars) demanded relationship between the 1 50 price of the good and the 2 40 quantity demanded of 3 30 the good. The table gives 4 20 a demand schedule. 5 10 A demand curve shows the relationship between the quantity demanded of a good and its price when all other influences on consumers’ planned purchases remain the same. The figure illustrates the demand curve resulting from the demand schedule. The demand curve is a willingness-to-pay curve— for each quantity, the price along the demand curve is the highest price a consumer is willing to pay for that unit of output which means that a demand curve is a marginal benefit curve.

Of the hundreds of classroom experiments that are available today, very few are worth the time they take to conduct. The classic demand-revealing experiment is one of the most productive and worthwhile ones. Bring to class two bottles of ice-cold, ready-to-drink Mt. Dew, bottled water, or sports drink. (If your class is very large, bring six bottles). Tell the students that you have these drinks and ask them to indicate if they would like one. Most hands will go up. Tell the class that you are going to sell them to the high bidder. Tell them that this auction is real. The winner will get the drink and will pay. Ask for a show of hands of those who have some cash and can afford to buy a drink. Explain that these indicate an ability to buy but not a definite plan to buy. Now begin the auction. Appoint a student to count hands (more than one for a big class). Begin at a low price: say 10¢ a bottle and count the number willing to buy. Raise the price in 10¢ increments and keep the tally of the number who are willing to buy at each price. When the number willing to buy equals the number of bottles you have for sale, do the transactions. (If you make a profit, and you might do so, tell the students that the profit, small though it is, will go the department fund for undergraduate activities—and deliver on that promise.) Now use the data to make a demand curve for Mt. Dew (or other drink) in your classroom today. You can easily emphasize the law of demand. And, now that you have a demand curve, you can do some thought experiments that will shift it. Ask: How would this demand curve have been different if the temperature in the classroom was 10 degrees higher/lower? How would this demand curve have been different if half the class was sick and absent today? How would this demand curve have been different if there was a Coke machine right in the classroom?

A Change in Demand (Demand Shifters) •

When any factor that influences buying plans other than the price of the good changes, there is a change in demand and the demand curve shifts. An increase in demand shifts the demand curve rightward and a decrease in demand shifts the demand curve leftward. Six factors change demand: • Prices of Related Goods: A substitute is a good that can be used in place of another good (tea and coffee) and a complement is a good that is used in conjunction with another good. (sugar and coffee). A rise in the price of a substitute or a fall in the price of a complement increases the demand for the good. • Expected Future Prices: If the price of a good is expected to rise in the future, the demand for the good today increases. • Income: A normal good is one for which demand increases as income increases; an inferior good is one for which demand decreases as income increases. © 2014 Pearson Education, Inc.

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• • •

Expected Future Income and Credit: When expected future income increases, demand today increases. When credit becomes easier to obtain, demand increases. Population: The larger the (relevant) population, the greater the demand. Preferences: Preferences are an individual’s attitudes toward goods and services. If people “like” a good more, the demand for it increases.

A Change in the Quantity Demanded Versus a Change in Demand •

•

II.

A change in price results in a movement along the demand curve, which is change in the quantity demanded. A change in other factors shifts the demand curve, which is a change in demand. In the figure, the movement along demand curve D0 from point a to point b as a result of the price rising from $2 to $4 is a change in the quantity demanded. The shift of the demand curve from D0 to the new demand curve D1 is a change in demand.

Supply •

•

The price of a good or service affects the quantity firms plan to sell. The quantity supplied of a good or service is the amount that firms plan to sell during a given time period at a particular price. The law of supply states that other things remaining the same, the higher the price of a good, the greater is the quantity supplied; and the lower the price of a good, the smaller the quantity supplied. The law of supply occurs because an increase in the quantity of a good produced results in an increase in its marginal cost. So the price must rise in order to induce firms to increase the quantity they produce.

Supply Curve and Supply Schedule •

•

The supply of a good Price Quantity refers to the entire (dollars) supplied relationship between 1 10 the price of the good 2 20 and the quantity 3 30 supplied of the good. 4 40 The table gives a 5 50 supply schedule. A supply curve shows the relationship between the quantity supplied of a good and its price when all other influences on producers’ planned sales remain the same. The figure illustrates the supply curve resulting from the supply schedule. The supply curve is a minimum-supply-price curve—for each quantity, the price along the supply curve is the lowest price a producer must receive in order to produce that unit of output which means that a supply curve is a marginal cost curve.

A Change in Supply (Supply Shifters) •

When any factor that influences selling plans other than the price of the good changes, there is a change in supply and the supply curve shifts. An increase in supply shifts the supply curve rightward and a decrease in supply shifts the supply curve leftward. Six factors change supply: © 2014 Pearson Education, Inc.

DEMAND AND SUPPLY

• •

• • • •

Prices of Productive Resources: If the price of a resource used to produce the good rises, the supply of the good decreases. Prices of Related Goods Produced: A substitute in production is a good that can be produced using the same resources and a complement in production is a good that must be produced with the initial good. A fall in the price of a substitute in production or a rise in the price of a complement in production increases the supply of the good. Expected Future Prices: If the price of a good is expected to rise in the future, the supply of the good today decreases. Number of Suppliers: If the number of suppliers increases, the supply increases. Technology: Technology refers to the ways in which factors of production are used to produce a good. A technological advance increases the supply of a good. The State of Nature: The state of nature includes all natural forces that influence supply. Bad weather or an earthquake decreases the supply of a good.

A Change in the Quantity Supplied Versus a Change in Supply •

•

A change in price results in a movement along the supply curve, which is change in the quantity supplied. A change in other factors shifts the supply curve, which is a change in supply. In the top figure, the movement along supply curve S0 from point a to point b as a result of the price rising from $2 to $4 is a change in the quantity supplied. The shift of the supply curve from S0 to the new supply curve S1 is a change in supply.

III. Market Equilibrium • •

An equilibrium is a situation in which opposing forces balance. The equilibrium price is the price at which the quantity demanded equals the quantity supplied. The equilibrium quantity is the quantity bought and sold at the equilibrium price. In the figure, the equilibrium price is $3 and the equilibrium quantity is 30 per week.

Price as a Regulator and Price Adjustments • •

• •

The price of a good regulates the quantities demanded and supplied. Shortage: If the price is below the equilibrium price, consumers plan to buy more than firms plan to sell. A shortage results, which forces the price higher, toward the equilibrium price. In the figure, there is a shortage at any price below $3 and so the price is forced higher, toward the equilibrium price. Surplus: If price is above the equilibrium, firms plan to sell more than consumers plan to buy. A surplus results, which forces the price lower, toward the equilibrium price. In the figure, there is a surplus at any price above $3 and so the price is forced lower, toward the equilibrium price. The price continues to adjust until the quantity supplied equals quantity demanded. © 2014 Pearson Education, Inc.

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To help students have a base of knowledge from which build tell them to memorize “Home Base”—the basic Supply and Demand curves showing an initial starting position with proper labels on the axis’ and an initial equilibrium, P0 and Q0 on the axis at the intersection of the two curves. “Home Base” provides them a starting place for every story problem they face. Then as you work through examples, be sure to ask them what “shifter” is changing. This procedure will keep them using the economic tool rather than just going with a gut feeling. The magic of market equilibrium and the forces that bring it about and keep the market there need to be demonstrated with the basic diagram, with intuition, and, if you’ve already used the demand experiment outlined above, with hard evidence in the form of the class activity. Using the experiment is straightforward. Start by explaining that in that market, the supply was fixed (vertical supply curve) at the quantity of bottles that you brought to class. The equilibrium occurred where the market demand curve (demand by the students) intersected your supply curve. Point out that the trades you made in your little economy made both buyers and sellers better off. Back in the dim mists of time, circa 1870 or so, economists struggled to understand if it was the supply or the demand that determined the price and quantity of a good. Nowadays we know that these efforts were misguided. To borrow from the great economist Alfred Marshall, demand and supply curves are like the blades on a pair of scissors. It does not make sense to ask which blade does the cutting because the cutting takes both blades and occurs at the intersection of the two blades. Likewise, it takes both the demand and supply to determine the price and quantity and the price and quantity are determined at the intersection of the demand and supply curves.

IV. Predicting Changes in Price and Quantity

The demand and supply model can be used to determine how changes in factors affect a good’s price and quantity.

A Change In Demand •

•

• •

If the demand for a good or service increases, the demand curve shifts rightward. As a result, the equilibrium price rises and the equilibrium quantity increases. If the demand for a good or service decreases, the demand curve shifts leftward. As a result, the equilibrium price falls and the equilibrium quantity decreases. Supply does not change and the supply curve does not shift. Instead there is a change in the quantity supplied and a movement along the supply curve. The figure illustrates an increase in demand. In the figure the demand curve shifts from D0 to D1. As a result, the equilibrium price rises from $3 to $4 and the equilibrium quantity increases from 30 to 40. The supply curve does not shift; there is, however, a movement along the supply curve.

DEMAND AND SUPPLY

A Change In Supply •

•

If the supply of a good or service increases, the supply curve shifts rightward. As a result, the equilibrium price falls and the equilibrium quantity increases. If the supply of a good or service decreases, the supply curve shifts leftward. As a result, the equilibrium price rises and the equilibrium quantity decreases. Demand does not change and the demand curve does not shift. Instead there is a change in the quantity demanded and a movement along the demand curve. The figure illustrates an increase in supply. In the figure the supply curve shifts from S0 to S1. As a result, the equilibrium price falls from $3 to $2 and the equilibrium quantity increases from 30 to 40. The demand curve does not shift; there is, however, a movement along the demand curve.

The whole chapter builds up to this section, which now brings all the elements of demand, supply, and equilibrium together to make predictions. Students are remarkably ready to guess the consequences of some event that changes either demand or supply or both. They must be encouraged to work out the answer and draw the diagram. Explain that the way to answer any question that seeks a prediction about the effects of some event(s) on a market has five steps. Once you have already worked an example or two, walk them through the steps and have one or two students work some examples in front of the class. The five steps are: 1. Draw a demand-supply diagram and label the axes with the price and quantity of the good or service in question. 2. Think about the event(s) that you are told occur and decide whether they change demand, supply, or both demand and supply. 3. Determine if the events that change demand or supply bring an increase or a decrease. 4. Draw the new demand curve and supply curve on the diagram. Be sure to shift the curve(s) in the correct direction—leftward for decrease and rightward for increase. (Lots of students want to move the curves upward for increase and downward for decrease—this view works ok for demand but is exactly wrong for supply. So emphasize the left-right shift.) 5. Find the new equilibrium and compare it with the original one. It is critical at this stage to return to the distinction between a change in demand (supply) and a change in the quantity demanded (supplied). You can now use these distinctions to describe the effects of events that change market outcomes. At this point, the students know enough for it to be worthwhile emphasizing the magic of the market’s ability to coordinate plans and reallocate resources.

Demand and Supply Change in the Same Direction •

If both the demand and the supply of a good or service increase, both the demand and supply curves shift rightward. The quantity unambiguously increases but the effect on the price is ambiguous. • If the increase in demand is greater than the increase in supply, the price rises. • If the increase in demand is the same size as the increase in supply, the price does not change. • If the increase in demand is less than the increase in supply, the price falls.

CHAPTER 3

•

If both the demand and the supply of a good or service decrease, both the demand and supply curves shift leftward. The quantity unambiguously decreases but the effect on the price is ambiguous. • If the decrease in demand is greater than the decrease in supply, the price falls. • If the decrease in demand is the same size as the decrease in supply, the price does not change. • If the decrease in demand is less than the decrease in supply, the price rises. The figure illustrates an increase in both demand and supply. In the figure the demand curve shifts from D0 to D1 and the supply curve shifts from S0 to S1. The shifts are the same size, so the equilibrium price does not change and the equilibrium quantity increases from 30 to 50.

Demand and Supply Change in the Opposite Directions •

•

If the demand increases and the supply decreases, the demand curve shifts rightward and the supply curve shifts leftward. The price unambiguously rises but the effect on the quantity is ambiguous. • If the increase in demand is greater than the decrease in supply, the quantity increases. • If the increase in demand is the same size as the decrease in supply, the quantity does not change. • If the increase in demand is less than the decrease in supply, the quantity decreases. If the demand decreases and the supply increases, the demand curve shifts leftward and the supply curves shifts rightward. The price unambiguously falls but the effect on the quantity is ambiguous. • If the decrease in demand is greater than the increase in supply, the quantity decreases. • If the decrease in demand is the same size as the increase in supply, the quantity does not change. • If the decrease in demand is less than the increase in supply, the quantity increases. The figure illustrates an increase in demand and a decrease in supply. In the figure the demand curve shifts from D0 to D1 and the supply curve shifts from S0 to S1. The shifts are the same size, so the equilibrium quantity does not change and the equilibrium price rises from $3 to $5.

DEMAND AND SUPPLY

Additional Problems 1.

What is the effect on the price of hotdogs and the quantity of hotdogs sold if a. The price of a hamburger rises? b. The price of a hotdog bun rises? c. The supply of hotdog sausages increases? d. Consumers’ incomes increase if hot dogs are a normal good? e. The wage rate of a hotdog seller increases? f. If the wage rate of the hotdog seller rises and at the same time prices of ketchup, mustard, and relish fall?

Suppose that one of the following events occurs: (i) The price of wool rises. (ii) The price of sweaters falls. (iii) A close substitute for wool is invented. (iv) A new high-speed loom is invented. a. b. c. d.

Which of the above events increases or decreases (state which) The demand for wool? The supply of wool? The quantity of wool demanded? The quantity of wool supplied?

Figure 3.1 illustrates the market for bread. a. Label the curves in the figure. b. What are the equilibrium price of bread and the equilibrium quantity of bread?

CHAPTER 3

The demand and supply schedules for potato chips are in the table. a. What are the equilibrium price and equilibrium quantity of potato chips? b. If chips were 60 cents a bag, describe the situation in the market for potato chips and explain what would happen to the price of a bag of chips.

Price (cents per bag) 40 50 60 70 80 In problem 4, suppose a new snack food 90 comes onto the market and as a result 100 the demand for potato chips decreases 110 by 40 million bags per week.

Quantity Quantity demanded supplied (millions of bags a week) 170 90 160 100 150 110 140 120 130 130 120 140 110 150 100 160

a. Has there been a shift in or a movement along the supply curve of chips? b. Has there been a shift in or a movement along the demand curve for chips? c. What is the new equilibrium price and quantity of chips? 6.

In problem 5, suppose that a flood destroys several potato farms and as a result supply decreases by 20 million bags a week at the same time as the new snack food comes onto the market. What is the new equilibrium price and quantity of chips?

Solutions to Additional Problems 1.

The price of a hot dog rises, and the quantity of hot dogs sold increases. Hot dogs and hamburgers are substitutes. If the price of a hamburger rises, people buy more hot dogs and fewer hamburgers. The demand for hot dogs increases. The price of a hot dog rises, and more hot dogs are sold. The price of a hot dog falls, and fewer hot dogs are sold. Hot dog buns and hot dogs are complements. If the price of a hot dog bun rises, fewer hot dog buns are bought. The demand for hot dogs decreases. The price of a hot dog falls, and people buy fewer hot dogs. The price of a hot dog falls and more hot dogs are sold. The increase in the supply of hot dog sausages lowers the price of hot dog sausages. Hot dog sausages are a factor used in the production of hot dogs. With the lower priced factor, the supply of hot dogs increases. The price of a hot dog falls and people buy more hot dogs. The price of a hot dog rises, and the quantity sold increases. An increase in consumers' income increases the demand for hot dogs. As a result, the price of a hot dog rises and the quantity bought increases. The price of a hot dog rises, and the quantity sold decreases. If the wage of the hot dog seller increases, the cost of producing a hot dog increases and the supply of hot dogs decreases. The price rises, and people buy fewer hotdogs. The price of a hot dog rises, but the quantity might increase, decrease, or remain the same. Ketchup, mustard, and relish are complements of hot dogs. If the price of ketchup, mustard, and relish fall, more ketchup, mustard, and relish are bought and the demand for hot dogs increases. The price of a hot dog rises, and people buy more hot dogs. If the wage of the hot dog seller increases, the cost of producing a hot dog increases and the supply of hot dogs decreases. The price rises, and people buy fewer hotdogs. Taking the two events together, the price of a hot dog rises, but the quantity might increase, decrease, or remain the same. (ii) and (iii) Wool is used in the production of sweaters. If the price of a sweater falls because the supply of sweaters has increased, then the equilibrium quantity of sweaters increases and the © 2014 Pearson Education, Inc.

DEMAND AND SUPPLY

b. c.

a. b.

a. b. c.

demand for wool increases. If the price of a sweater falls because the demand for sweaters has decreased, then the equilibrium quantity of sweaters decreases and the demand for wool decreases. If a close substitute for wool is invented, some sweater producers will switch from wool to the substitute. When they do, the demand for wool decreases. (iv) If a new high-speed loom is invented, the cost of making wool will fall and the supply of wool will increase. (i) and (iv) If the price of wool rises there is a movement up along the demand curve. The quantity demanded of wool decreases. If a new high-speed loom is invented, the cost of producing wool will fall. So the supply of wool increases. With no change in the demand for wool, the price of wool will fall and there is a movement down along the demand curve for wool. The quantity demanded of wool increases. (i), (ii), and (iii) If the price of wool rises there is a movement up along the supply curve. The quantity supplied of wool increases. If the price of a sweater falls because the supply of sweaters has increased, then the equilibrium quantity of sweaters increases and the demand for wool increases. With no change in the supply of wool, the price of wool rises and the quantity of wool supplied increases. If the price of a sweater falls because the demand for sweaters has decreased, then the equilibrium quantity of sweaters decreases and the demand for wool decreases. With no change in the supply of wool, the price of wool falls and the quantity of wool supplied decreases. If some sweater producers switch to using the new close substitute for wool, the demand for wool will decrease. With no change in the supply of wool, the price of wool falls and the quantity of wool supplied decreases. The demand curve is the curve that slopes down toward to the right. The supply curve is the curve that slopes up toward to the right. The equilibrium price is $3 a loaf, and the equilibrium quantity is 100 loaves a day. Market equilibrium is determined at the intersection of the demand curve and supply curve. The equilibrium price is 80 cents a bag, and the equilibrium quantity is 130 million bags a week. The price of a bag adjusts until the quantity demanded equals the quantity supplied. At 80 cents a bag, the quantity demanded is 130 million bags a week and the quantity supplied is 130 million bags a week. At 60 cents a bag, there will be a shortage of potato chips and the price will rise. At 60 cents a bag, the quantity demanded is 150 million bags a week and the quantity supplied is 110 million bags a week. There is a shortage of 40 million bags a week. The price will rise until market equilibrium is restored—80 cents a bag. There has been a movement along the supply curve. The demand for potato chips decreases, and the demand curve shifts leftward. Supply does not change, so the price falls along the supply curve. The demand curve has shifted leftward. As the new snack food comes onto the market, the demand for potato chips decreases. There is a new demand schedule, and the demand curve shifts leftward. The equilibrium price is 60 cents, and the equilibrium quantity is 110 million bags a week. Demand decreases by 40 million bags a week. That is, the quantity demanded at each price decreases by 40 million bags. The quantity demanded at 80 cents is now 90 million bags, and there is a surplus of potato chips. The price falls to 60 cents a bag, at which the quantity supplied equals the quantity demanded (110 million bags a week). The new price is 70 cents a bag, and the quantity is 100 million bags a week. The supply of potato chips decreases, and the supply curve shifts leftward. The quantity supplied at each price decreases by 20 million bags. The result of the new snack food entering the market is a price of 60 cents a bag.

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At this price, there is now a shortage of potato chips. The price of potato chips will rise until the shortage is eliminated.

Additional Discussion Questions 1.

John Q: Could a legal market for human organ donations have saved his dying son? An opinion piece written by Richard Epstein in The Wall Street Journal (2/21/02) discusses the donation of human organs for transplant operations. He raises the issue that if a market for human donor organs were legal, the dilemma of a lack of organs, as raised by Denzel Washington’s character in the movie “John Q,” might be closer to fiction rather than fact. You can use this movie and the motive of the main character as an intriguing basis for getting students to construct and interpret the demand and supply model. Can we illustrate a market for something as vital as organ doations? Begin by asking the students to graph a demand and supply model for the market for human organ donations, making sure that their model reflects the real-life characteristics of this unique market: i) the federal government does not allow individuals or businesses to engage in the buying and selling of human organs, unless the organs are donated and received for free, ii) a small number of organs are donated by living volunteers (like kidney donations) or by the families of the recently deceased (especially after an otherwise healthy individual suffers an accidental death), meaning that the positively sloped supply curve for human organ donations intercepts the quantity axis at some positive value, iii) the demand curve for organs must intercept the supply curve at a positive price. Are there unintended consequences when market forces are ignored? The government wants to assure that poor people have the same access to available organ transplants as rich people, so it imposes a zero-price restriction on the market. However, this creates a shortage of organs available for transplant, where the quantity of organs demanded at a zero price far exceeds the quantity supplied. If the market for organ donations were unregulated, then the equilibrium price for an organ would surely increase, but so would the total number of people receiving an organ transplant, and presumably, the total number of people who would survive to live another day. Should society institute a policy that maximizes the numbers of lives saved or manipulates the characteristics of those fewer lives that do get saved? Conclude this discussion with a great set-up for the efficiency versus equity issues developed later in chapter five. Our command of the demand and supply model for human organ donations allows us to discover an important insight into one aspect of health care policy: the government places a lower priority for maximizing the total number of people saved regardless of income, and a higher priority on achieving a “proper” income mix among the smaller number of people that are saved by being one of the few receiving organ transplants.

What are some goods that college students might buy today but will give up when they enter the workforce after graduation? College students usually recognize that they will change their consumption patterns when they are employed after college graduation. Use this to get the students to appreciate inferior goods. When you were an undergraduate, you probably complained about having to eat mostly canned soup or beans as a cheap staple to fill your hungry stomach on a small budget. You swore that when you finally entered the workforce you wouldn’t eat soup or beans again, unless under extreme duress. Today the single food item most frequently cited by students as an inferior good is the Raman style noodles—those dry, thin, near flavorless oriental style noodles that are reconstituted with © 2014 Pearson Education, Inc.

DEMAND AND SUPPLY

boiling water. Get the students to create a list other such inferior goods they will avoid when their incomes increase. This gets them to carefully consider how income changes can cause demand curves to shift in an unintuitive manner for an inferior good. 3.

Because computers are cheaper and more abundantly available now than a decade ago, doesn’t this mean the supply curve for computers is downward sloping? This is a real world example for illustrating the confusion between changes in supply and changes in the quantity supplied. (It is easier to analyze this example if the students assume that consumer demand for computer software applications has not changed over the last decade.) Has anything in the world of computer manufacturing changed over the last decade? Point out that the observation about falling computer prices with rising quantities sold assumes that nothing significant has changed in the computer industry. Emphasize how such statements reflect how the ceteris paribus condition of careful economic analysis has been violated. Over the years, advances in technology have allowed computer makers to: i) offer greater computer power and versatility for contemporary software applications at the same opportunity cost of resources (market price) as before, or ii) to provide the same level of computer power and versatility for contemporary software applications at lower opportunity costs (market prices) as before. Either way, this represents a rightward shift in the supply curve for computers. The students should recognize that the two prices and two quantities that give the appearance of more computers offered for less are actually from two separate supply curves.

Since the average price of a car has increased substantially over the last 30 years, and the number of cars owned has risen faster than the population, doesn’t this mean that the demand curve for cars is upward sloping? This is a real world example for illustrating the confusion between changes in demand and changes in the quantity demanded. (It is easier to analyze this example if the students assume that automobile production technology has not changed over these last three decades.) Has anything in the world of consumers changed over the last decade? Point out that this real world observation of car prices and rising quantities sold over time assumes that nothing significant has changed in the consumers’ environment. Emphasize how statements such as these reflect how the ceteris paribus condition of careful economic analysis has been violated. Consumer incomes have increased significantly over the last three decades, allowing them to: i) consume greater personal transportation opportunities for more family members while giving up the same amount of other goods as before, or ii) consume the same level of personal transportation opportunities while giving up less of all other goods as before. Either way, this represents a rightward shift in the demand curve for automobiles. The students should recognize that the two prices and quantities that give the appearance of more automobiles demanded at higher prices are actually from two separate demand curves. If the status of the family automobile has increased in recent decades, what affect would this have on consumer demand? There is evidence that the proportion of income that typical families spend on automobiles (versus all other goods) has increased substantially over the last 30 years. This means that the percent increase in automobile purchases has been higher than the percent increase in family incomes. This makes for a great lead into the measures of the income elasticity of demand discussed in Chapter 4.

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C h a p t e r

MEASURING GDP AND ECONOMIC GROWTH**

The Big Picture Where we have been: Chapter 4 does not directly use the material developed in the previous chapters. Where we are going: Chapter 4 is the first of the macroeconomic chapters. It provides some basic definitions (GDP, real GDP, aggregate expenditure, potential GDP, and business cycles) that are used in virtually all the remaining chapters. The circular flow model and the national income accounting explained in this chapter serve as a general framework for macroeconomic analysis. The fact that aggregate expenditure equals aggregate income equals the value of production is the key to understanding why changes in aggregate expenditure change aggregate income, which then changes aggregate expenditure. The components of aggregate expenditure provide an underpinning for the theory of aggregate demand in Chapter 10 and the aggregate expenditure model and multiplier in Chapter 11.

New in the Eleventh Edition This chapter is substantially the same as the 10th edition. All of the data have been updated to 2012. The section “Limitations of Real GDP” has been shortened by more concisely describing household production, underground economic activity, leisure time and environmental quality as well as eliminating discussion on health and life expectancy, political freedom, and social justice. The Reading Between the Lines article discusses issues related to the timing and revisions of GDP making it a good article for discussion in lecture.

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Lecture Notes

Measuring GDP and Economic Growth • • •

GDP is a measure of total production and total income. Real GDP measures production of goods and services. GDP can be used to make comparisons over time and across countries.

Gross Domestic Product •

GDP or gross domestic product is the market value of all the final goods and services produced within a country in a given time period.

How do you add apples and oranges? You can pick any goods you like but I think it is helpful to show GDP as an equation early on. You can start with real goods and then generalize to “n goods”: GDP = PAQA + POQO + … GDP = P1Q1 + P2Q2 + P3Q3 + … + PNQN GDP = ∑ PiQi You may find it useful to add slang while you discuss GDP, “GDP is the dollar value of all ‘stuff’ made over one year.” Be sure to repeat the definition as you move through all the chapters rather than assuming the your students always remember what is in GDP and how it is measured. A solid understanding of GDP is crucial for other material to make sense. •

• • • •

The items in GDP are valued at their market values, that is, at their prices. So if 100,000,000 slices of pizza are sold for $3 each, slices of pizza contribute $300,000,000 to GDP. Using market values means that the total value of output, that is, GDP will be in the dollars (or whatever the country’s currency unit might be). A final good is an item that is bought by its final user. It contrasts with an intermediate good, which is an item that is produced by one firm, bought by another firm, and used as a component of a final good or service. To avoid double counting, GDP includes only final goods and services (no intermediate goods and services are directly counted). Only the goods and services produced within a country are counted. A Honda produced in North Carolina is counted in U.S. GDP. GDP is measured over a period of time, typically a quarter of a year or a year.

Gross Domestic Product. The main challenge in teaching this topic is generating interest in it. Many teachers are bored by it and not surprisingly, they bore their students. If you are one of the many who lean toward boredom, start by recalling just how vital it is that we measure the value of production with reasonable accuracy. Working through issues with GDP is vital since it serves as the basis of measurement of the standard of living, economic welfare, and making international comparisons. Final goods versus intermediate goods. The distinction between final and intermediate goods is one of the key points in this first section. Use some standard examples to make the key point—tires and autos, chips and computers, and so on. Also, if you want to spend a bit of time on this topic, tell your students about the Bureau of Economic Analysis (BEA) revision in the treatment of business spending on software. The BEA began a major revision in 1998 and published the first revisions to reclassify software from intermediate to final good status in 1999. When the 1996 GDP was recalculated to include software as a final good, GDP increased by $115 billion, or 1.5 percent.

GDP and the Circular Flow of Expenditure and Income •

The circular flow illustrates the equality of income, expenditure, and the value of production. The circular flow diagram shows the transactions among four economic agents—households, firms, © 2014 Pearson Education, Inc.

MEASURING GDP AND ECONOMIC GROWTH

•

governments, and the rest of the world—in two aggregate markets—goods markets and factor markets. In the goods market, households, firms, governments, and foreigners buy goods and services. For analytical purposes, we can categorize spending by these four agents in the calculation of GDP: • The total payment for goods and services by households in the goods markets is consumption expenditure, C. • The purchases of new plants, equipment, and buildings and the additions to inventories are investment, I. • Governments buy goods and services, called government expenditure or G, from firms. • Firms sell goods and services to the rest of the world, exports or X, and buy goods and services from the rest of the world, imports or M. Exports minus imports are called net exports, X − M.

Government transfer payments, such as Social Security payments, are not part of government expenditures because government expenditures include only funds used by the government to buy goods and services. Transfer payments are not buying a good or service for the government and so are not included in government expenditures. •

In factor markets households receive income from selling the services of resources to firms. The total income received is aggregate income. It includes wages paid to workers, interest for the use of capital, rent for the use of land and natural resources, and profits paid to entrepreneurs; retained profits can be viewed as part of household income, lent back to firms.

The Circular Flow Model. Start with a simpler picture than Figure 4.1—just households and firms, and just income and consumption. Explain that you are starting from the basics, in which all goods and services produced are sold to consumers. Explain that even beyond the assumption that all goods and services are consumption goods and services, we’re simplifying things in the picture but are not omitting anything that leads us into a misleading conclusion. For instance the picture envisages all the income being paid to households. Nothing is lost and clarity is gained by this device. Emphasize that the blue flows are incomes and the red flows are expenditures on final goods and services. Clearly in this simplest case aggregate income equals aggregate expenditure. Then add investment. It is still the case that aggregate expenditure (which is now C + I) equals aggregate income. Next add the government and the flow of government expenditure. Finally add the rest of the world and the flow of net exports. In both cases you can continue to make the crucial point at aggregate expenditure equals aggregate income.

GDP Equals Expenditure Equals Income •

•

Aggregate expenditure equals C + I + G + (X − M). Aggregate expenditure equals GDP because all the goods and services that are produced are sold to households, firms, governments, or foreigners. (Goods and services not sold are included in investment as inventories and hence are “sold” to the producing firm.) Because firms pay out as income everything they receive as revenue from selling goods and services, aggregate income equals aggregate expenditure equals GDP.

Why “Domestic” and Why “Gross”? •

•

Depreciation is the decrease in the stock of capital that results from wear and tear and obsolescence. The total amount spent on purchases of new capital and on replacing depreciated capital is called gross investment. The amount by which the stock of capital increases is net investment. Net investment = Gross investment − Depreciation. The “Gross” in gross domestic product reflects the fact that the investment in GDP is gross investment and so part of it goes to replace depreciating capital. Net domestic product subtracts depreciation from GDP. © 2014 Pearson Education, Inc.

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II.

Measuring U.S. GDP

Most of the income data used by the BEA to measure GDP come from the IRS. Expenditure data come from a variety of sources.

The Expenditure Approach •

The expenditure approach measures GDP as the sum of consumption expenditure, C, investment, I, government expenditure on goods and services, G, and net exports of goods and services, (X − M). So GDP = C + I + G + (X − M) or, in 2010 and in billions of dollars, $10,285 + $1,842 + $2,991 + −$539 = $14,579.

The Income Approach •

The income approach measures GDP as the sum of compensation of employees, net interest, rental income, corporate profits, and proprietors’ income. This sum equals net domestic income at factor costs. To obtain GDP, indirect taxes (which are taxes paid by consumers when they buy goods and services) minus subsidies plus depreciation are included. Finally any discrepancy between the expenditure approach and income approach is included in the income approach as “statistical discrepancy.”

Measuring U.S. GDP, the low cost of economic data. You might like to tell your students that measuring real GDP is actually very cheap. The BEA (in the Department of Commerce) employs fewer than 500 economists, accountants, statisticians, and IT specialists at an annual cost of less that $70 million. It costs each American less than 0.25¢ (a quarter of a cent) to measure the value of the nation’s production. For some further perspective, the National Oceanic and Atmospheric Administration (also in the Department of Commerce), whose mission is to “describe and predict changes in the Earth’s environment, and conserve and manage wisely the nation’s coastal and marine resources so as to ensure sustainable economic opportunities,” employs more than 11,000 scientists and support personnel at an annual cost of $3.2 billion! Creative accounting and GDP measurement. In recent years, the first estimates of GDP, which are based on companies’ reported profits, have been revised downward when data on company profits as reported to the IRS became available. Enron-style accounting has contaminated the initial estimates of GDP but not the final estimates. You can make a nice point with one example of creative accounting. For some years, in its reports to stock holders AOL recorded its advertising expenditure as investment and amortized it over a number of years. First, you can explain that the correct treatment of this item is as an expenditure on intermediate goods and services by AOL and as a charge against AOL profit. The expenditure on AOL services is the value of AOL’s production. And AOL’s expenditure on advertising is part of the value of the production of the advertising agencies used by AOL. You can go on to explain that AOL accounting practice would misleadingly swell GDP by causing some double counting. On the expenditure approach, AOL’s advertising expenditure shows up as investment in the national accounts. On the income approach, because the expenditure is not a cost, it swells profit, so AOL’s corporate profit increases by the same amount as its “investment.” If AOL filed its income tax return in this same way, the national income accounts wouldn’t get corrected. But if, when AOL files its tax returns, it calls its advertising a cost and lowers its profits by that amount, the BEA picks up these numbers from the IRS and the national accounts are adjusted appropriately.

Nominal GDP and Real GDP • •

The market value of production and hence GDP can increase either because the production of goods and services are higher or because the prices of goods and services are higher. Real GDP allows the quantities of production to be compared across time. Real GDP is the value of final goods and services produced in a given year when valued at the prices of a reference base year. © 2014 Pearson Education, Inc.

MEASURING GDP AND ECONOMIC GROWTH

•

Nominal GDP is the value of the final goods and services produced in a given year valued at the prices that prevailed in that same year.

Data for 2012 Item

Quantity

Price

Market Value

Books

$25

$1,000

Coffee

1,000

$2,000

Calculating Real GDP •

•

• •

Nominal GDP $3,000 Traditionally, real GDP is calculated using prices of the Data for 2013 reference base year (the year Item Quantity Price Market Value in which real GDP=nominal Books 50 $30 $1,500 GDP). Coffee 1,500 $3 $4,500 The tables to the right show this method of calculating real Nominal GDP $6,000 GDP for an economy that produces only books and 2013 Quantities and 2012 Prices coffee. If 2012 is the reference Item Quantity Price Market Value base year, nominal GDP in Books 50 $25 $1,250 2012 in the top table equals real GDP in 2012 Real GDP in Coffee 1500 $2 $3,000 2012 is $3,000. Real GDP $4,250 The second table shows the (2010 calculation for nominal GDP dollars) in 2013. Real GDP in 2013 is in the bottom table. It values 2013 production using the prices from the reference base year, 2012. Real GDP in 2013 is $4,250.

You may want to mention the GDP deflator at this point even though coverage of it is in next chapter. Stress the separation of the “quantity effect,” measured by real GDP, and the “price effect,” measured by the price level. Real GDP will be used to compute the economic growth rate while the price level will be used to compute the inflation rate.

REQUIRES MATHEMATICAL NOTE: Chained-Dollar Real GDP •

• •

The top table to the right has data GDP Data for 2012 for 2012 for an economy that Item Quantity Price Market Value produces only books and coffee. In 2012, nominal GDP is $3,000. The Books 40 $25 $1,000 second table to the right has the Coffee 1,000 $2 $2,000 same data for 2013. (These tables Nominal GDP $3,000 are the same as used above to calculate real GDP using the GDP Data for 2013 standard method.) In 2013, nominal GDP is $6,000. Item Quantity Price Market Value Nominal GDP has doubled but how Books 50 $30 $1,500 much has real GDP changed Coffee 1,500 $3 $4,500 between these years? Nominal GDP $6,000 To determine how real GDP changes, suppose that 2012 is the base year. Then we need to determine the growth rate between 2012 and 2013 by calculating the value of production in both years using 2012 prices and also calculating it in both years using 2013 prices. © 2014 Pearson Education, Inc.

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•

Using 2012 prices, the value of production increases from $3,000 (the first table) to $4,250 (the third table). Using 2012 prices, the value of production has grown by 100  ($4,250 − $3,000)/$3,000 = 41.7 percent.

2013 Quantities and 2012 Prices

•

Quantity

Price

Market Value

Books

$25

$1,250

Coffee

1500

$3,000

Value of production (2010 dollars)

•

Using 2013 prices, real GDP increases from $4,200 (the fourth table) to $6,000 (the second table). Using 2013 prices, the value of production has grown by 100  ($6,000 − $4,200)/$4,200 = 42.9 percent.

Item

$4,250

2012 Quantities and 2013 Prices Item

Quantity

Price

Market Value

Books

$30

$1,200

Coffee 1,000 $3 $3,000 The average growth rate is equal Value of $4,200 to (41.7 percent + 42.9 percent)/2 production = 42.3 percent. So real GDP (2011 dollars) between these years has grown by 42.3 percent. If 2012 is the base year, real GDP in 2011 is $3,000  1.423 = $4,269. Similar calculations are made for each pair of adjacent years from the reference base year onwards. This procedure chains real GDP back to the reference base year.

III. The Uses and Limitations of Real GDP The Standard of Living Over Time • • •

One measure of the standard of living over time is real GDP per person, or real GDP divided by the population. Real GDP per person tells us the value of goods and services that the average person can enjoy. The value of real GDP when all the economy’s labor, capital, land, and entrepreneurial ability are fully employed is called potential GDP. Potential GDP grows at a steady pace because the quantities of the factors of production and their productivity grow at a steady pace. The growth rate of real GDP slowed in the productivity growth slowdown after 1970. This slowdown created a Lucas wedge. A Lucas wedge is the dollar value of the accumulated gap between what real GDP per person would have been if the growth rate had persisted and what real GDP per person actually turned out to be.

The Importance of the Lucas Wedge. It is usually straightforward to interest students in the business cycle. But it is perhaps a bit more difficult to motivate interest in economic growth and the Lucas wedge. Yet economic growth and the Lucas wedge should be of immense importance to young students because they help determine the long-run living standard of their lives. One way to make this point clear is to ask the students whether the difference between, say, 3 percent annual growth in income versus 4 percent annual growth is important. This difference probably does not sound important. But, suppose that the initial income was $35,000. After 10 years with 3 percent growth, the income would be $47,037 and with 4 percent growth the income would be $51,809. This difference of about $4,500 might not seem like much. But point out to the students that this difference is for only ten years and that the annual difference will continue to enlarge: After 30 years with 3 percent growth, the income would be $84,954 and with 4 percent growth the income would be $113,519, a one year difference of about $40,000. And, over a 30year working career, the total differences in income, which is the analog to the Lucas wedge, is approximately $420,000. Over a 40-year working career, the Lucas wedge difference is over $1,000,000!

MEASURING GDP AND ECONOMIC GROWTH

Viewed from this perspective, the seemingly slight 1 percentage point difference in growth rates makes for an incredibly major difference in incomes, which should easily capture your students’ attention. • Fluctuations in the pace of expansion of real GDP is denoted the business cycle, periodic but irregular increases and decreases in the total production and other measures of economic activity. Each cycle is categorized by: trough, expansion, peak, recession. The Business Cycle. Students generally are interested in the topic of business cycles, particularly if the economy happens to be in a recession when this chapter is covered. Often it is very difficult to tell the future path of the economy. Stress to the students that it is not stupidity on the part of economists that prevents us from knowing where the economy is heading. Rather it is the fact that forecasting is difficult for at least two reasons. First, different sectors of the economy frequently send different signals. For instance, retail sales may be down, signaling a start to a recession, but housing starts may be up, indicating that an expansion will continue for a while. Second, the data that must be used always are at least a bit outof-date. For example, the preliminary estimate of GDP is not made until approximately six weeks after the end of the quarter, and the final revision of GDP doesn’t appear until years later. Although economists’ forecasts are much better than those of others, forecasting GDP with complete accuracy is unlikely. Conclude by mentioning that this fact is important in later chapters when we discuss implementation of counter-cyclical policies. The Business Cycle, Part 2: The business cycle and its dating are interesting to students, especially when the economy is in or near a recession. If you have the capacity to show or assign Web pages, look at the NBER Business Cycle Dating Committee’s page at http://www.nber.org/cycles/recessions.html. You might like to look at the dating of the cycle in other countries. This dating is done by the Economic Cycle Research Institute (ECRI). You can find their Web site at http://www.businesscycle.com/. Another page on the ECRI Web site shows the cycle peak and trough dates for 18 countries from 1948 nicely aligned in a table. You can compare the timing of cycles internationally. You can also compare the severity of U.S. cycles over time. Note that the recession that the NBER dates as beginning in March 2001 and ending in November 2001 was incredibly mild on all criteria except the labor market. The “Great Recession” that started in 2007, however, is one of the worst since the great depression.

The Standard of Living Across Countries •

•

Real GDP can be used to compare living standards across countries. But two problems arise in using real GDP to compare living standards: • First, the real GDP of one country must be converted into the same currency unit as the real GDP of the other country. Second, the goods and services in both countries must be valued at the same prices. Relative prices in countries will differ, so goods and services should be weighted accordingly. For example, if more prices are lower in China than in the United States, China’s prices put a lower value on China’s production than would U.S. prices. If all the goods and services produced in China are valued using U.S. prices, than a more valid comparison can be made of real GDP in the two countries. This comparison using the same prices is called purchasing power parity (PPP) prices.

International comparisons and PPP prices. Students sometimes see estimates of GDP per person in developing nations. Most such estimates are extremely low, and students often ask how people can live on such low incomes. Point out that the estimate is biased downward in two ways. First, in poor nations, more transactions do not go through a market than in rich nations. For example, transportation services in developing nations include a lot of walking, which is not counted as part of GDP. In richer nations, people ride a bus or subway and pay a fare, which is counted as part of GDP. Second, many locally produced and consumed goods and services have extremely low prices in poor nations. For example, a haircut that costs $20 in New York might cost $1 in Calcutta. (You might get a better haircut in New York, but probably not © 2014 Pearson Education, Inc.

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one that is 20 times better!) Converting Indian GDP into U.S. dollars at the market exchange rate leaves this bias in the data. Using purchasing power parity prices to convert India’s GDP into U.S. dollars avoids this bias.

Limitations of Real GDP •

Some of the factors that influence the standard of living are not part of real GDP. Omitted from GDP are: • Household Production: As more services, such as childcare, are provided in the marketplace, the measured growth rate overstates development of all economic activity. • Underground Economic Activity: If the underground economy is a reasonably stable proportion of all economic activity, though the level of GDP will be too low, the growth rate will be accurate. • Health and Life Expectancy: Better health and long life are not directly included in real GDP. • Leisure Time: Increases in leisure time lower the economic growth rate, but we value our leisure time and we are better off with it. • Environmental Quality: Pollution does not directly lower the economic growth rate. • Political Freedom and Social Justice: Political freedom and social justice are not measured by real GDP.

YouTube Video: This is a wonderful video that should get anyone excited about data and its ability to help tell a story. Hans Rosling's 200 Countries, 200 Years, 4 Minutes - The Joy of Stats - BBC Four http://youtu.be/jbkSRLYSojo

Measuring Real GDP and Economic Growth. A discussion of omissions from GDP can arouse students’ interest. For example, you might point out that if you mow your own lawn, the value of your production doesn’t show up in GDP. But if you hire a student to mow your lawn (and if your student reports the income earned correctly to the IRS), the value of the student’s production does show up in GDP. Why don’t we measure all lawn mowing as part of GDP? Some reasons are the cost of collecting data and the degree of intrusiveness we’d be willing to tolerate. But note how little we spend on collecting the GDP data and how relatively inexpensive it would be to add some questions about domestic production to either the Labor Force Survey or the Family Expenditure Survey. You might like to explain how the omission of illegal goods and services also leads to some misleading comparisons. For instance, the day before prohibition ended, the production of (illegal) beer was not counted as part of GDP. But the day after prohibition ended, the production of (now legal) beer counted. Ask your students to suggest two good reasons why illegal goods and services are omitted. First, the data are hard (but not impossible) to obtain. Second, there may be the moral position that illegal activities should not be included in GDP. This latter observation can lead to an interesting discussion. Ask the students if they think that the production of, say, marijuana should be included in GDP. Some, maybe even many, of them will see no problem with this. Then ask about the production of murder-for-hire. The response, we hope, will be significantly different. Does such a good have any value?

MEASURING GDP AND ECONOMIC GROWTH

Additional Problems

Figure 4.1 shows the flows of expenditure and income for a small nation. During 2009, flow A was –$15 million, flow B was $40 million, flow C was $90 million, and flow D was $45 million. Calculate a. Aggregate expenditure. b. Aggregate income. c. GDP.

The transactions in Jupiter last year are in the table to the right. a. Calculate Jupiter’s aggregate expenditure. b. Calculate Jupiter’s net exports. c. Calculate Jupiter’s government expenditure.

Item GDP Consumption expenditure Taxes Transfer payments Profits Investment Exports Saving Imports

Dollars 1.400,000 700,000 350,000 150,000 300,000 350,000 400,000 400,000 350,000

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The table shows data from the United Kingdom in 2005. a. Calculate GDP in the United Kingdom. b. Explain the approach (expenditure or income) that you used to calculate GDP.

Desert Kingdom produces Quantities 2010 only dates and camel rides. Dates 1,000 pounds The base year is 2010, and the Camel rides 50 rides tables give the quantities produced and the prices in Prices 2010 and 2011. Calculate Dates $1 per pound Desert Kingdom’s Camel rides $100 per ride a. Nominal GDP and real GDP in 2010 and 2011. b. Real GDP in 2011 in terms of the base-year prices.

Item Wages paid to labor Consumption expenditure Taxes Transfer payments Profits Investment Government expenditure Exports Saving Imports

Billions of pounds 685 791 394 267 273 209 267 322 38 366 2011 1,100 pounds 60 rides $2 per pound $120 per ride

Desert Kingdom (described in problem 3) decides to use the chain-weighted output index method of calculating real GDP. Using this method, calculate a. The growth rate of real GDP in 2011. b. Compare and comment on the differences in real GDP in terms of the base-year prices and real GDP calculated using the chain-weighted output index method.

Solutions to Additional Problems 1.

b. c. 2.

a. b. c.

Aggregate expenditure is $160 million. Aggregate expenditure is the sum of consumption expenditure, investment, government expenditure, and net exports. In the figure, flow C is consumption expenditure, flow D is investment, flow B is government expenditure, and flow A is net exports. So aggregate expenditure equals $90 million plus $45 million plus $40 million minus $15 million, which is $160 million. Aggregate income is $160 million. Aggregate income equals aggregate expenditure, which from part a is $160 million. GDP is $160 million. GDP equals aggregate expenditure, which from part a is $160 million. Jupiter’s aggregate expenditure is $1,400,000. Aggregate expenditure equals GDP and Jupiter’s GDP is $1,400,000. Jupiter’s net exports equal $50,000. Net exports equal exports, $400,000, minus imports, $350,000. Jupiter’s government expenditure was $300,000. Aggregate expenditure equals the sum of consumption expenditure, investment, government expenditure, and exports minus imports. That is, $1,400,000 equals $700,000 plus $350,000 plus government expenditure plus $400,000 minus $350,000. Solving this equation for government expenditure gives $300,000. © 2014 Pearson Education, Inc.

MEASURING GDP AND ECONOMIC GROWTH

a. b.

GDP in the United Kingdom was £1,223 billion. The expenditure approach was used; that is, GDP was calculated by adding consumption expenditure, investment, government expenditure, and exports, and subtracting imports.

In 2010, nominal GDP is $6,000. In 2009, nominal GDP is $9,400. Nominal GDP in 2010 is equal to total expenditure on the goods and services produced by Desert Kingdom in 2010. Expenditure on dates is 1,000 pounds at $1 a pound, which is $1,000. Expenditure on camel rides is 50 rides at $100 a ride, which is $5,000. Total expenditure is $6,000, so nominal GDP in 2010 is $6,000. Nominal GDP in 2011 is equal to total expenditure on the goods and services produced by Desert Kingdom in 2011. Expenditure on dates is 1,100 pounds at $2 a pound, which is $2,200. Expenditure on camel rides is 60 rides at $120 a ride, which is $7,200. Total expenditure is $9,400, so nominal GDP in 2011 is $9,400. Real GDP in 2011 in terms of base-year prices is $7,100. To calculate real GDP in 2011 in terms of base-year prices, we calculate market value of the 2011 quantities at the base-year prices of 2010. To value the 2011 output at 2010 prices, expenditure on dates is 1,100 pounds at $1 a pound (which is $1,100), and expenditure on camel rides is 60 rides at $100 a ride (which is $6,000). So real GDP in 2011 in terms of base-year prices is $7,100. The growth rate of real GDP in 2011 is 17.9 percent. The chain-weighted output index method uses the prices of 2010 and 2011 to calculate the growth rate in 2011. The value of the 2010 quantities at 2010 prices is $6,000. The value of the 2011 quantities at 2010 prices is $7,100. We now compare these values. The increase in the value is $1,100. The percentage increase is ($1,100  $6,000)  100, which is 18.33 percent. The value of the 2010 quantities at 2011 prices is $8,000. The value of the 2011 quantities at 2011 prices is $9,400. We now compare these values. The increase in the value is $1,400. The percentage increase is ($1,400  8,000)  100, which is 17.5 percent. The chain-weighted output index calculates the growth rate as the average of these two percentage growth rates. That is, the growth rate in 2009 is 17.9 percent Real GDP in 2011 in terms of base-year prices is $7,100. Real GDP in 2011 using the chainweighted output index method is $7,074. Real GDP growth is fastest when real GDP is measured in terms of base-year prices.

Additional Discussion Questions 11. To estimate GDP you add the value of all the goods and services produced, both final and intermediate goods. Is this procedure correct? Why? Adding all the goods and services produced is incorrect because it will lead to significant double counting. Intermediate goods and services will be double counted. For instance, if a CPU produced by Intel and then used in a Dell computer is counted both as a CPU from Intel and as part of the computer from Dell, the CPU has been double counted. 12. What is the relationship between aggregate income and aggregate production? Why does this relationship exist? Aggregate income equals aggregate production. The circular flow shows this result: The flow of production out of business firms equals the flow of expenditure into business firms. The flow of expenditure into business firms equals the flow of costs out of business firms. And the flow of costs out of business firms is the same as the flow of aggregate income to households.

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13. Does my purchase of a domestically produced Ford automobile that was manufactured in 2000 add to the current U.S. GDP? Why? How about my purchase of a domestically produced, newly produced Ford? Why? The purchase of the used Ford does not add to the current U.S. GDP though it did add to U.S. GDP in 2000 when the car was newly produced. GDP measures production within a given time period and the used Ford was not produced within the current year. A new Ford automobile, however, is counted in current U.S. GDP because it was produced in the current year. 4.

Does my purchase of 100 shares of stock in Google add to the nation’s GDP? Why? Purchasing shares of stock does not add to the nation’s GDP. GDP measures production. Shares of stock are not the production of a good or service and therefore are not included in GDP.

If a homeowner cuts his or her lawn, is the value of this work included in real GDP? Suppose that the homeowner hires a neighborhood kid to cut the lawn. Is this activity included in real GDP? Comment on your answers. The homeowner’s work around his or her home is not included in GDP because home production is excluded. Hiring a neighborhood kid to cut the lawn is, in theory, included in GDP because it is a service that has been sold in a market. This difference in the treatment of these two activities shows a flaw in how GDP is computed. In both cases the precise same lawn is mowed. But in one case GDP is unaffected and in the other GDP increases. It is paradoxical that the effect on GDP of producing the same service depends on who produces the service.

In 1900, the average work week was 65 hours; today it is approximately 35 hours. How did this change affect real GDP within the United States? How did it affect the standard of living within the United States? Comment on your answers. The decrease in the average work week decreases real GDP from what it would have been if the work week had remained at 65 hours because less time is spent at production of goods and services. Taken by itself, the decrease in real GDP means that the standard of living within the United States is lower. However the fall in the average work week also means a significant increase in people’s leisure time, which raises the standard of living. For many people it is likely the case that their standard of living is higher with the shorter work week—and hence lower level of real GDP—that it would be with the longer work week because they value their leisure more than the goods and services that would have been produced. But at the least, looking only at the change in real GDP as the sole measure of the standard of living is incorrect because that view ignores the gain in the standard of living from the increased leisure.

In the United States, many children receive day-care from commercial providers. In Africa, this is unknown; children are almost all cared for by relatives. How would this difference affect comparisons of GDP per person? This difference means that U.S. GDP per person is biased higher than GDP per person in African countries. In both the United States and in Africa children are cared for so the same service is produced in both regions. But in the United States this service is included in GDP because it is purchased in a market; however, in Africa the service is not included in GDP because it is performed as household production.

MEASURING GDP AND ECONOMIC GROWTH

C h a p t e r

MONITORING JOBS AND INFLATION**

The Big Picture Where we have been: Chapter 5 finishes introducing macroeconomic issues and describing how key macroeconomic variables are measured. The link developed in this chapter between employment and real GDP is an important concept that helps serve as a foundation for the presentation of the aggregate production function in the next chapter. Perhaps more significantly, the explanation of the natural rate of unemployment and its relationship to potential GDP are important building blocks for the AS-AD model developed in Chapter 10 and the Phillips curve framework developed in Chapter 12. These topics also recur in Chapters 13 and 14 when fiscal and monetary policy is covered. Where we have been: This chapter increases students’ understanding of the types and sources of unemployment. It also provides students with detail on the use of the CPI to measure inflation. Alternative price measures also are introduced.

New in the Eleventh Edition Chapter 11 content is substantially the same as in the 10th edition. The multiple graphs and data in this chapter have all been updated through 2012. The Reading Between the Lines is new and discusses job stabilization during the slow recovery in 2012.

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Lecture Notes

Monitoring Jobs and Inflation • • • •

The unemployment rate, the employment-to-population ratio, and the labor force participation rate are key labor market indicators. The natural unemployment rate is the unemployment rate at full employment; it is comprised of frictional and structural unemployment. The unemployment rate fluctuates over the business cycle. The price level and the inflation rate are measured using the CPI as well as other price indexes.

Employment and Unemployment

Current Population Survey •

•

The U.S. Census Bureau measures the population, labor force, and amount of employment. The working-age population is the total number of people aged 16 years and over who are not in jail, a hospital, or some other form of institutional care. The labor force is the sum of the employed and the unemployed. Unemployment occurs when someone who wants a job cannot find one. To be counted as unemployed, a person must be available for work and must be in one of three categories: • Without work but has made specific efforts to find a job within the previous four weeks • Waiting to be called back to a job from which he or she has been laid off • Waiting to start a new job within 30 days

Ask the students, “If I was to assign a homework assignment of estimating the unemployment rate in your city, how would you do it?” You will probably get an answer of “Google it,” but tell them that this is not an Internet mining project! Try to have some of your students suggest an in-person survey or a phone survey. Now you can walk through some of the issues economists face with data collection (questions to ask, sample size, bias, etc.). Discuss how a grocery store may be a decent place to get a random sample of people from all demographics and how a phone survey might miss some poor, unemployed person without a phone or students who do not have a land-based phone.

Three Labor Market Indicators •

•

The unemployment rate is the percentage of the people in the labor force who are unemployed. Number of peopleunemployed It equals 100 and Labor force = Number of people employed + Labor force Number of people unemployed. Between 1980 and 2010 the unemployment rate averaged 6.2 percent. The employment-to-population ratio is the percentage of people of working age who have jobs. Number of people employed 100. In recent years the employment-to-population ratio has It equals Working - age population been about 62 percent. It fell during the recession and in June 2010 was 58.5 percent. The labor force participation rate is the percentage of working-age population who are members Labor force 100. The labor force participation rate has of the labor force. It equals Working - age population been declining since it reached about 67 percent in 2000 and in June 2010 was 64.7 percent.

Jobs and home production. It is interesting to ask students to think about appropriate measures of labor force participation over long periods of time or in very different economic arrangements. The technical definition involves spending time working for gain, or seeking work for gain. In the United States, this usually equates to work outside the home. Ask students whether women who are unpaid family workers © 2014 Pearson Education, Inc.

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on farms are in or out of the labor force; and then ask whether they are if they don’t work outside the home, but cook, make and wash clothing, and otherwise maintain the household for a family. •

• •

Marginally attached workers are people who are available and willing to work but currently are neither working nor looking for work. These workers often temporarily leave the labor force during a recession and decrease the labor force participation rate. Because they are no longer counted as unemployed, marginally attached workers lower the unemployment rate. A discouraged worker is a marginally attached worker who has stopped looking for work because of repeated failures to find a job. Economic part-time workers are people who are working part-time but would like to find full time work. These workers are not unemployed by the U-3 standard but are considered “partunemployed.” Marginally attached workers (and discouraged workers) as well as economic part-time workers who want a full-time job are not counted as unemployed in the official unemployment rate.

Alternative Measures of Unemployment

The BLS creates several alternative measures of unemployment to take account of the long-term unemployed (who lose the most from unemployment) and marginally attached workers: • U–1: includes only those unemployed for 15 weeks as unemployed. • U–2: includes only job losers as unemployed. • U–3: the official unemployment rate. • U–4: adds discouraged workers to the official unemployment rate. • U–5: adds all marginally attached workers to the official unemployment rate. • U–6: adds part-time workers who want full-time jobs to the U-5 unemployment rate. • Long-term unemployment (U–1) and unemployed job losers (U–2) are about 40 percent of the unemployed on average but 60 percent in a deep recession. • Adding discouraged workers (U–4) makes very little difference to the unemployment rate, but adding all marginally attached workers (U–5) adds about one percentage point. • A really big difference is made by adding the economic part-time workers (U–6). In June 2010, adding these workers to the U-5 unemployed increased the unemployment rate from 11 percent to 16 percent.

II. Unemployment and Full Employment Types of Unemployment •

•

Frictional unemployment is the unemployment that arises from normal labor turnover. These workers are searching for jobs. The unemployment related to this search process is a permanent phenomenon in a dynamic, growing economy. Frictional unemployment increases when more people enter the labor market or when unemployment compensation payments increase. Structural unemployment is the unemployment that arises when changes in technology or international competition change the skills needed to perform jobs or change the locations of jobs. Sometimes there is a mismatch between skills demanded by firms and skills provided by workers, especially when there are great technological changes in an industry. Structural unemployment generally lasts longer than frictional unemployment. Minimum wages and efficiency wages create structural unemployment. Cyclical unemployment is the fluctuating unemployment over the business cycle. Cyclical unemployment increases during a recession and decreases during an expansion.

Identifying frictional, structural, and cyclical unemployment. Ask your class if anyone they know has been laid off. Then discuss whether losing a job creates frictional, structural, or cyclical unemployment. Look at your local examples. If you live in a steel-producing or car manufacturing area, for example, you can talk about local structural unemployment arising from the closing of factories due to international © 2014 Pearson Education, Inc.

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competition. For cyclical unemployment, ask students how they think the business cycle and cyclical unemployment is related to full-time enrollments at higher education institutions. Students often don’t think there is any relationship. But nationally during a recession, the growth rate of full-time enrollments increases. Ask students if they can explain this relationship. The answer is that during a recession and due to the increase in cyclical unemployment, the opportunity cost of school decreases. This is a great way to keep students thinking about marginal benefits and costs. Work through each type of employment asking whether it is good or bad for society (call to their attention that it is usually bad for the individual, but may be good long term for society) • Frictional? Good because a healthy, dynamic, economy needs new entrants to the labor force , such ascollege graduates, and freedom for people to quit a job they don’t like. • Structural? Good because a healthy, growing economy has technological change that makes some jobs obsolete. • Cyclical? Bad because it is unfortunate to have unemployment strictly because of the cyclical nature of the economy. If it were possible to maintain the same level of economic growth with less fluctuation, we would have less cyclical unemployment with a higher level of welfare. Can and should the cycle be managed? This is a big question in Macroeconomics that we will continue to tackle!

“Natural” Unemployment •

•

Natural unemployment is the unemployment that arises from frictions and structural change when there is no cyclical unemployment—when all the unemployment is frictional and structural. Natural unemployment as a percentage of the labor force is called the natural unemployment rate. Full employment is defined as a situation in which the unemployment rate equals the natural unemployment rate.

What Determines the Natural Unemployment Rate? • • •

•

The Age Distribution of the Population An economy with a young population has a large number of new job seekers every year and has a high level of frictional unemployment. The Scale of Structural Change The scale of structural change is sometimes small but sometimes there is a technological upheaval. When the pace and volume of technological change and when the change driven by international competition increase, natural unemployment rises. The Real Wage Rate The natural unemployment rate increases if minimum wage is raised to exceed the equilibrium wage rate or if more firms use an efficiency wage (a wage set above the equilibrium real wage to enable the firm to attract the most productive workers and motivate them to work hard and discourage them from quitting). Unemployment Benefits Unemployment benefits increase the natural unemployment rate by lowering the opportunity cost of job search.

There are two controversies that surround the natural unemployment rate. The first is the use of the term “natural,” which offends many who believe any unemployment is always a bad thing. From the perspective of an unemployed individual who has yet to find the job he or she wants, unemployment is bad. However, there is some level of unemployment that is good for society because it will help create more productive matches between firms and workers and allow for technological changes that lead to economic growth. The second controversy is what level of unemployment corresponds to the natural rate. Because this number is unobserved, it must be estimated. Some estimates imply the natural rate is stable and changes only slowly over time. Others imply that most of the fluctuations in unemployment are “natural”. These

MONITORING JOBS AND INFLATION

differences are important for macroeconomic policy because one of the typical goals of policy is to keep the unemployment rate from making wide swings around the natural rate.

Real GDP and Unemployment Over the Cycle •

When the economy is at full employment, the unemployment rate equals the natural unemployment rate and real GDP equals potential GDP. When the unemployment rate is greater than the natural unemployment rate, real GDP is less than potential GDP. And when the unemployment rate is less than the natural unemployment rate, real GDP is greater than potential GDP. The gap between real GDP and potential GDP is called the output gap.

Students often have an innate sense of an asymmetry in business cycle fluctuations around potential GDP. In particular, students often think that the economy is almost always below potential GDP. It is important for students to understand that it is possible for the economy to temporarily rise above potential GDP so that the unemployment rate is less than natural unemployment rate. One (small) example of this state of affairs occurred in Silicon Valley in the late 1990s when workers who became dissatisfied with a job could quit and be assured of a new job (often at higher pay!) within a few days. Indeed, firms paid for expensive radio advertisements “begging” for workers to apply for jobs.

III. The Price Level, Inflation, and Deflation The price level is the average level of prices. The average level of prices can be rising, falling, or stable. Inflation occurs when the price level persistently rises; deflation occurs when the price level persistently falls. The inflation rate is the percentage change in the price level.

Why Inflation and Deflation are Problems •

• •

Unexpected inflation or deflation is a problem for society because they redistribute income and wealth. Unexpected inflation benefits workers and borrowers; unexpected deflation benefits employers and lenders. They motivate people to divert resources from producing goods and services to forecasting and protecting themselves from the inflation or deflation. Unexpected deflation hurts businesses and households that are in debt (borrowers) who in turn cut their spending. A fall in total spending brings a recession and rising unemployment. Hyperinflation is an inflation rate of 50 percent a month or higher

The Consumer Price Index • • •

The Consumer Price Index (CPI) is a measure of the average of the prices paid by urban consumer for a fixed “basket” of consumer goods and services. The CPI is calculated monthly by the Bureau of Labor Statistics. The CPI is defined to equal 100 for a period called the reference base period. The current reference base period is 1982-1984, so the average CPI during that period was 100. In June 2010, the CPI was 218.0. In June 2009, the CPI was 215.7. Thus, since 1982-84, prices increased by 115.7 percent to 2009 and by 118.0 percent to 2010.

In June 2008, the CPI was 218.8 so the economy experienced deflation between June 2008 and June 2009. Deflation is very uncommon but it does occur.

Constructing the CPI •

The BLS conducts an infrequent survey of consumers to determine the average “basket” of goods and services purchased by urban household. Then each month the BLS records the prices of goods and services in the basket, keeping the representative items as similar as possible in consecutive months. The BLS uses the fixed basket quantities and the recorded prices to determine the cost of the basket each month. The CPI for the month equals 100 multiplied by the ratio of the cost in the current month to the cost in the base period.

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•

For example, suppose the initial survey Cost shows that the CPI basket is 2 books and Item Quantity Price (dollars) 20 coffees. The initial base period prices Books 2 $30 $60 and quantities are in the table to the Coffee 20 $2 $40 right. In this base period, say 2005, the Basket $100 cost of the CPI basket is $100. Next suppose that the BLS survey taken one month in 2011 reveals that the price of Cost a book is $35 and the price of a coffee is $3. Item Quantity Price (dollars) These 2013 prices and the initial base Books 2 $35 $70 period quantities are in the table to the Coffee 20 $3 $60 right. In this period the cost of the CPI Basket $130 basket is $130. Using these data, the CPI equals ($130  $100)  100, or 130. So between the base period and the current period, the CPI has risen by 30 percent.

Measuring the Inflation Rate •

•

The inflation rate is the percentage change in the price level from one year to the next. In a formula,  CPI this year- CPI last year  100. Inflation rate =  CPI last year   In June 2010, the CPI was 218.0. In June 2009, the CPI was 215.7. Between 2009 and 2010, the  218.0 - 215.7  inflation rate was   100 or 1.1%. 215.7  

The Biased CPI •

The CPI has four biases that lead it to overstate the inflation rate. The biases are: • New Goods Bias: New goods are often more expensive than the goods they replace. • Quality Change Bias: Sometimes price increases reflect quality improvements (safer cars, improved health care) and should not be counted as part of inflation. • Commodity Substitution Bias: Consumers substitute away from goods and services with large relative price increases. • Outlet Substitution Bias: When prices rise, people use discount stores more frequently and convenience stores less frequently.

The Magnitude and Consequences of the Bias • •

The Boskin Commission in 1996 estimated the bias overstates the inflation rate by about 1.1 percentage points a year. Any bias in the CPI matters because many contracts and payments are indexed to the CPI, including Social Security. Close to 1/3 of government outlays are linked to the CPI.

In terms of government outlays linked to the CPI, such as Social Security, a bias of 1 percent amounts to close to a trillion dollars in additional expenditures over a decade. Politically, it is hard to adjust social security payments for the bias, so the current plan is reduce the measurement bias in the CPI, for instance by revising the basket more frequently to reflect new goods and substitution changes. In 2010, President Obama proposed a two year wage freeze on all federal employees. Their pay is traditionally linked to the CPI and this freeze was estimated to save the federal government $2 billion dollars!

MONITORING JOBS AND INFLATION

Alternative Price Indexes •

Three alternative to the CPI are: • Chained CPI: The chained CPI is calculated similarly to chained GDP (discussed in the Mathematical Note to the previous chapter.) The chained CPI incorporates both new goods and the substitution of one good for another and so overcomes these sources of bias. But the difference between the chained CPI and regular CPI is small: on average, since 2000 the chained CPI is 0.3 percentage points lower per year. • Personal Consumption Expenditure Deflator (PCE deflator): The deflator from nominal and real Nominal consumption expenditure 100. The consumption expenditure. The PCE deflator equals Real consumption expenditure basket of goods in the PCE deflator is broader than the basket in the CPI because it includes all consumption expenditure. • GDP Deflator: Similar to the PCE deflator, the GDP deflator is from nominal and real GDP. The Nominal GDP  100. The difference between the GDP deflator and regular GDP deflator equals Real GDP CPI is small: on average, since 2000 the GDP deflator is 0.2 percentage points lower per year.

Core CPI Inflation •

The inflation rate is often volatile. To strip out the volatile elements and focus on the underlying trend inflation, the core inflation rate is used. The core inflation rate is the CPI inflation rate excluding volatile elements. The core CPI inflation rate equals the percentage change in the CPI excluding food and fuel prices.

Real Variables in Macroeconomics •

Real variables are measured in constant prices and can be considered to be measured in units of “goods and services.” In general nominal variables, such as the nominal wage rate and nominal Nominal variable  100. GDP, are deflated to become real variables using the formula real variable = Price level The exception to this rule is the nominal interest rate. (In two chapters the students see that the real interest rate = nominal interest rate − inflation rate.)

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Additional Problems 1.

Michigan: Unemployment Record Holder Michigan now holds a dubious record: It leads the U.S. in joblessness. The state’s unemployment rate was 8.5% in May while the U.S. unemployment rate was only 5.5%. The reason is clear: Detroit’s emphasis on big trucks and sport-utility vehicles has turned sour. But even though the official unemployment numbers look awful, the reality is worse. The official number does not reflect those who have given up looking for a job. Business Week, June 24, 2008 In 2010, at 13.6 percent of the state’s labor force, Michigan had the nation’s highest official unemployment rate. But in 2012, Michigan’s unemployment rate fell to 9 percent, a larger fall than that in the United States as a whole. Around 11,000 businesses in Michigan produce high-tech scientific instruments and components for defense equipment, energy plants, and medical equipment. a. Why was the reality of the unemployment problem in Michigan actually worse than the 8.5 percent unemployment rate statistic in 2008? b. Was this higher unemployment rate in Michigan frictional, structural, or cyclical? Explain. c. What factor led to the favorable 2012 employment results in Michigan compared to the U.S. average? Was this a frictional, structural or cyclical factor? Explain.

The Great Inflation Bias In 1996 the Boskin Commission was established to determine the accuracy of the CPI. The commission concluded that the CPI overstated inflation by 1.1%. The commission described four biases in the way the CPI was determined. Fortune, April 3, 2008 a. What are the main sources of bias that are generally believed to make the CPI overstate the inflation rate? By how much did Boskin estimate the CPI overstates the inflation rate? b. Do the substitutions among different kinds of meat make the CPI biased up or down? c. Why does it matter if the CPI overstates or understates the rate of inflation?

Solutions to Additional Problems 1.

The unemployment problem is worse than the 8.5 percent unemployment rate indicates for three reasons. First, the unemployment rate does not include marginally attached workers, such as discouraged workers. Second, the unemployment rate does not include part-time workers would want full-time jobs. Finally the unemployment rate counts only workers who are currently unemployed. If a company has announced that it will be laying off workers in the future, its workers are measured as employed even though they will shortly join the ranks of the unemployed. The higher unemployment rate in Michigan is structural. Consumers are decreasing the number of U.S.-made large cars in favor of foreign-made smaller cars. And to the extent that consumers are buying U.S.-made cars, they are generally smaller cars, many of which are not manufactured in Michigan. So the skills possessed by Michigan workers are not the skills needed for jobs and the location of workers in Michigan is not the location of available jobs. The improved labor statistics for Michigan reflected a structural factor in that industries with goods in high demand were able to move to Michigan and use retrained skilled workers for their production. © 2014 Pearson Education, Inc.

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The Boskin Commission presented four reasons why the CPI overstates the inflation rate. The four sources of bias are the new goods bias (new goods often cost more than the good they replace); quality change bias (price hikes might reflect quality changes); commodity change bias (changes in relative price lead consumers to switch away from goods and services whose price has risen more rapidly than other goods and services); and, outlet substitution bias (people buy from lower-priced sources when prices rise). The Boskin Commission estimated that the CPI overstates the inflation rate by 1.1 percentage points. Substitutions among different types of meat biases the CPI upward because the CPI ignores these substitutions. For instance, if the price of beef rises and the price of chicken does not change, then consumers respond by switching from beef to chicken. Consumers will eat (approximately) the same amount of protein as before but the substitution of chicken for beef means that their expenditure on protein will not change by the full amount of the price rise for beef. The CPI ignores this substitution and assumes that people buy the same amount of beef as before. Therefore the CPI erroneously reports that expenditure on protein has risen by the full amount of the price hike of beef. The article says that when consumers respond to a change in relative price by switching from one type of meat to another, the price of the new type can’t be compared to the price of the old type because consumers prefer the old type of meat to the new one. However the article’s statement can’t be literally true because consumers generally cannot think the second type of meat ranks at zero compared to the first type of meat. Hence allowing for no substitution biases the CPI upward because consumers will substitute from one meat to another when relative prices change. Many decisions depend on the CPI and any errors in the CPI will lead to errors in these decisions. For instance, some wage contracts are linked to the CPI. If the CPI overstates inflation, then the firms pay too much and some workers might lose their jobs if the firm decides to fire them. Conversely if the CPI understates inflation, then workers are paid too little. Additionally the government links about a third of its expenditures, including Social Security payments, to the CPI, If the CPI overstates inflation, then government outlays rise more rapidly than justified whereas if the CPI understates inflation, then outlays do not rise enough to offset the true inflation rate.

Additional Discussion Questions 1.

Should discouraged workers be counted as part of the unemployment rate? By definition, discouraged workers should not be counted as “officially” unemployed because they are not searching for employment. However, the real issue is whether the definition is appropriate. On the one hand, these people have given up looking for a job because they cannot find one. On the other hand, because these people have given up looking for a job they are quite unlikely to find one. Discouraged workers are different from other unemployed workers because discouraged workers are unlikely to find work since they have stopped search. All in all, it is probably better that discouraged workers not be counted directly with other unemployed workers because their low likelihood of finding work makes them fundamentally different than other unemployed workers.

What harm is there in calling a part-time worker that wants full-time work unemployed? Unlike discouraged workers or marginally attached workers, these people are employed. Interpretation of these statistics needs to be mindful that people may have a distorted view of what they want versus what they will do. The U-3 standard is based on their current situation and gives us actual knowledge of the current state of employment. The U-6 measure, which includes these part-time workers, might have more uncertainty in its level. Nonetheless, it is helpful to see how all of the various alternative measures compare and useful data can be obtained from all of them. © 2014 Pearson Education, Inc.

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“Unemployment is bad for the unemployed individual and bad for the nation. Hence the government should force the unemployment rate to 0 percent.” Comment on this assertion, discussing both its feasibility and its desirability. The assertion is highly unfeasible. The laws necessary to drive the unemployment rate to 0 percent would be draconian. For instance, no college student would be allowed to graduate until he or she had a job lined up. Once employed, workers would be forbidden to change jobs unless they had another job already arranged. Furthermore consumers would be forbidden to change their consumption baskets because if enough people changed, a firm might go bankrupt…allowing its workers to become unemployed. The assertion is similarly undesirable. Some unemployment is productive for the individual because it allows the worker to leave one job from which he or she is dissatisfied, to look for another job that will be a better match for the worker’s talents and skills.

How can the unemployment rate be less than the natural rate? The unemployment rate can be less than the natural unemployment rate when the cyclical unemployment rate is negative. This outcome can occur when the economy is in a strong expansion. When the economy is growing rapidly, unemployed workers find jobs quickly. In many instances the match between worker and job will be poor: The firm is eager to find a worker and the worker accepts the offered job to end his or her spell of unemployment. But then as time passes the match is discovered to be poor—the worker does not perform well and/or dislikes the job. This situation is bad for the business and bad for the worker.

How do you think the business cycle affects the duration of unemployment? On the average, unemployment has a longer duration in recessions and a shorter duration in expansions.

Why is a change in the age structure of the population, increasing the proportions of young or old workers in the labor force, likely to change the natural unemployment rate? When the proportion of young workers increases, the natural unemployment rate rises because young workers change jobs more frequently than experienced workers. As these young workers change their jobs, frictional unemployment and, therefore, natural unemployment rise. Older workers are less prone to change jobs because they have had more time to find a good job match. The frictional unemployment rate is lower and so, too, is the natural unemployment rate when the proportion of old workers in the labor force is higher.

What is the natural unemployment rate? What is the controversy concerning its measurement? The natural unemployment rate is the unemployment rate when the economy is at full employment. The natural rate is comprised of frictional and structural unemployment. One controversy arises because it is difficult to measure frictional and structural unemployment. Another controversy arises because the issue of whether discouraged workers and marginally attached workers should be included in the natural rate is unclear. While the number of these workers can be measured with reasonable accuracy, whether they should be included in the natural rate is controversial.

MONITORING JOBS AND INFLATION

C h a p t e r

ECONOMIC GROWTH**

The Big Picture Where we have been: Chapter 6 focuses on economic growth. It uses the definitions and concepts of aggregate income and real GDP presented in Chapter 4 as well as tying economic growth in the macroeconomy to the PPF of Chapter 2. Where we are going: Chapter 6 is the first of four chapters that examine the economy in the long run when the economy is at full employment. The following chapters focus on finance and investment, money and the price level, and the exchange rate and balance of payments. After these chapters the next section examines macroeconomic fluctuations by developing the AS-AD model. The material presented in Chapter 6 provides the long run fundamental variables and results that need to be remembered as various other models are developed in future chapters. Chapter 6 (and Chapter 7) is particularly useful in Chapter 13 when the supplyside effects of fiscal policy are covered.

New in the Eleventh Edition All the data are updated through 2012. A new section near the beginning of the chapter titled “Economic Growth versus Business Cycle Expansion” brings the PPF of Chapter 2 to illustrate long-term versus business cycle growth. “Robots as Skilled Workers” is the new title in the Economics in the News section. The Reading Between the Lines is new and features a discussion of South Africa’s economic growth issues and how it plans to implement more economic freedom to spur growth.

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Lecture Notes

Economic Growth You can start your discussion of this chapter by listing on the board or on an overhead various countries ranked from highest per capita real GDP to lowest. It is a real eye opener for students to consider income per person because it really shows how fortunate we are in the United States. Tell your students that in the 1960s countries like Hong Kong, Singapore and Japan used to rank around where China ranks today. Explain that this extraordinary growth is part of what motivated economists over the last 20-30 years to try to deduce how this type of growth can occur. Is it possible the United States could do something differently to grow at those growth rates? Is the neoclassical model correct in its prediction that there will be a global equilibrium in which all nations have the same real GDP per person? Then leave your students with the fact that China is 200 times the population of Hong Kong and 4 times the population of the United States. This brings the obvious question: Should we be concerned? • • •

Economic growth leads to large changes in standards of living from one generation to the next. Economic growth rates vary across countries and across time. There are different economic theories to explain these variations in growth rates.

The Basics of Economic Growth •

The economic growth rate is the annual percentage change of real GDP. This growth rate is equal to: RealGDP in current year− Re al GDP in past year  100 Real GDP growth rate = Re al GDP in past year

•

The standard of living depends on real GDP per person, which is real GDP divided by the population. The growth rate of real GDP per person can be calculated using the formula above, though substituting real GDP per person. • The growth rate of real GDP per person also approximately equals the growth rate of real GDP minus the population growth rate. Real GDP can increase for two distinct reasons: The economy might be returning to full employment in an expansion phase of the business cycle or potential GDP might be increasing. •

The movement from point A to point B reflects an expansion phase of the business cycle. It occurs with no change in production possibilities. Such an expansion is not economic growth.

•

The increase in aggregate production reflected by the movement from point B on PPF0 to point C on PPF1 is economic growth—it reflects an expansion of production possibilities shown by an outward shift of the PPF.

The Rule of 70 is useful for determining how long it will take for a variable to double. The Rule of 70 states that the number of years it takes for the level of any variable to double is approximately 70 divided by the annual percentage growth rate of the variable.

ECONOMIC GROWTH

Run through an example of the rule of 70 that does not relate to economic growth. Examples: If tuition rates rise at 6 percent per year, how long will it take it to double? 70/6 = 11.67 years. If you invest $10,000 at 12 percent interest, how long will it take to double your money? 70/12 = 5.83 years. Compound Interest: You can reinforce the importance of economic growth by relating the fact that if real GDP per person had grown just 0.25 percentage points faster between 1960 and the present, every household today, on average, would have almost $12,000 more income (every person would have $4,500 more). If real GDP per person had grown 1 percentage point faster between 1960 and the present, every household today, on average, would have $50,000 more income (every person would have $21,200 more).To make concrete just how much better off we would have been, get the students to list what they would buy with an extra $21,200 a year.

II. Long-Term Growth Trends Long-Term Growth in the U.S. Economy The growth of real GDP per person in the United States has fluctuated but has averaged 2 percent per year over the last century. The growth rate was 1.4 percent prior to the Great Depression and 2.1 percent after World War II.

Real GDP Growth in the World Economy Economic growth varies across countries. Among richest countries, there seems to be some convergence of real GDP per person but most other countries show less evidence of convergence. The “Asian Miracle” is the fast rate of convergence for Hong Kong, Singapore, Taiwan, Korea, and China. Is there convergence or divergence in standards of living? What is the role of economic growth for economic inequality? These are highly controversial questions. Most anti-globalization activists treat it as incontrovertible that economic growth creates higher inequality. But this view is likely incorrect. First, there has been a general convergence of standards of living over the past 50 years. This fact is in part the result of economic growth in China with a population that accounts for close to one-fifth of humanity. Second, while some nations have fallen behind, those less developed countries that have grown fastest are those that have been most involved in “globalization” by becoming more integrated into global markets for goods and capital. The policy suggestions of the anti-globalization movement, such as reducing foreign trade and international capital mobility or even abandoning capitalism, property rights, and markets are the policies that are currently most practiced in countries that have grown the slowest. This result might not be a coincidence.

III. How Potential GDP Grows Potential GDP is the amount of real GDP that is produced when the quantity of labor employed is the fullemployment amount. To determine potential GDP we use the aggregate production function and the aggregate labor market.

The Aggregate Production Function •

•

The aggregate production function is the relationship between real GDP and the quantity of labor employed when all other influences on production remain the same. The figure shows an aggregate production function. The additional real GDP produced by an additional hour of labor when all other influences on production remain the same is subject to the law

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of diminishing returns, which states that as the quantity of labor increases, other things remaining the same, the additional output produced by the labor decreases. The production function in the figure shows the law of diminishing returns because its shape demonstrates that as additional labor is employed, the additional GDP produced diminishes.

The Labor Market The Demand for Labor • The demand for labor is the relationship between the quantity of labor demanded and the real wage rate. • The real wage rate equals the money wage rate divided by the price level. The real wage rate is the quantity of goods and services that an hour of labor earns and the money wage rate is the number of dollars that an hour of labor earns. • Because of diminishing returns, firms hire more labor only if the real wage falls to reflect the fall in the additional output the labor produces. There is a negative relationship between the real wage rate and the quantity of labor demanded so, as illustrated in the figure, the demand for labor curve is downward sloping. The Supply of Labor • The supply of labor is the relationship between the quantity of labor supplied and the real wage rate. • An increase in the real wage rate influences people to work more hours and also increases labor force participation. These factors mean there is a positive relationship between the real wage rate and the quantity of labor supplied so, as illustrated in the figure, the supply of labor curve is upward sloping. Labor Market Equilibrium and Potential GDP • In the labor market, the real wage rate adjusts to equate the quantity of labor supplied to the quantity of labor demanded. In equilibrium, the labor market is at full employment. In the figure, the equilibrium quantity of employment is 200 billions of hours per year. • Potential GDP is the level of production produced by the full employment quantity of labor. In combination with the production function shown in the previous figure, the labor market equilibrium in the figure of 200 billion hours per year means that potential GDP is $12 trillion.

What Makes Potential GDP Grow? Potential GDP grows when the supply of labor grows and when labor productivity grows. Growth of the Supply of Labor • The supply of labor increases if average hours per worker increases, if the employment-topopulation ratio increases, or if the working-age population increases. Of these factors, in the United States over the past years the first two have offset each other. • Only increases in the working-age population can cause persisting economic growth. Persisting increases in the working-age population result from population growth. • An increase in population increases the supply of labor, which shifts the labor supply curve rightward. The real wage rate falls and the quantity of employment increases. The increase in employment leads to a movement along the production function to a higher level of potential GDP.

ECONOMIC GROWTH

An Increase in Labor Productivity • An increase in labor productivity increases the demand for labor and shifts the production function upward. • As the top figure illustrates, the increase in the demand for labor from LD0 to LD1 raises the real wage rate, from $20 to $30 per hour in the figure, and increases the level of employment, from 200 billion hours per year to 300 billion hours per year. • The bottom figure shows that the production function has shifted upward, from PF0 to PF1. Combined with the increase in employment to 300 billion hours per year, the increase in labor productivity increases potential GDP from $10 trillion to $15 trillion. • An increase in labor productivity leads to an increase in real GDP per person and increases the standard of living.

IV. Why Labor Productivity Grows Preconditions for Labor Productivity Growth •

•

The institutions of markets, property rights, and monetary exchange create incentives for people to engage in activities that create economic growth and are preconditions for growth in labor productivity. Market prices send signals to buyers and sellers that create incentives to increase or decrease the quantities demanded and supplied. Property rights create incentives save and invest in new capital and develop new technologies. Monetary exchange creates incentives for people to specialize and trade. Persistent growth requires that people face incentives to create: • Physical Capital Growth: Saving and investing in new capital expands production possibilities. • Human Capital Growth: Investing in human capital speeds growth because human capital is a fundamental source of increased productivity and technological advance. • Technological Advances: Technological change, the discovery and the application of new technologies and new goods, has made the largest contribution to economic growth.

The Causes of Economic Growth: A First Look; The limits of economics. The major obstacles to growth are political, and economists don’t know much about how to remove those political obstacles. You can give your students a glimpse of these obstacles in their worst form by reminding them of news video clips they’ve almost certainly seen of Kabul, Mogadishu, and other troubled cities in which the rule of law has completely broken down. Economists know a lot about how to make an economy grow if the preconditions are in place, but virtually nothing about how to bring those preconditions about. The preconditions. The three preconditions for growth—markets, property rights, and monetary exchange—are all essential to create acceptable levels of risk and low enough transaction costs to justify investment, specialization, and exchange. If you want to spend time on it, you can generate an interesting discussion on whether what matters is the particular system of property rights, or just that they be clear, © 2014 Pearson Education, Inc.

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certain, and enforceable with reasonable cost—the concept of the rule of law. Most students have never realized that property rights are highly varied, and many fast growing economies have nothing like U.S. absolute property rights in land, for example. Interactions of sources of growth. Most students can see immediately how investment in physical and human capital in the form of education and training contribute to growth. Some have more difficulty getting a clear view of the role of learning by doing and technical change, particularly the small continuous refinement and improvement to existing technology rather than the spectacular breakthroughs. Much growth probably comes from the interaction of the last two, and this source of growth can be illustrated with a discussion of why firms offer incentives to workers to suggest improvements to working methods and procedures.

V. Growth Theories, Evidence, and Policies Historical development of theories and an aside. The three growth theories studied in this chapter— classical, neoclassical, and new—are presented in historical order. Point out this fact to the students to emphasize and illustrate how economic theory builds on itself. (An aside for you, not your students: Note that the chapter skips the Keynesian era Harrod-Domar model. The main reason for this omission is that these models were quickly shown to be in error and never formed the basis of a seriously proposed growth theory. Based on fixed coefficients and fixed saving rates, the Harrod-Domar model produces either secular stagnation or secular inflation. Neither phenomenon occurs in real economies. Solow’s neoclassical model was developed, historically, to show the error of the Harrod-Domar model, but the neoclassical model also builds naturally on its classical predecessor, and that is the sequence in the textbook.) Classical theory. Start with the classical theory. The classical theory of growth takes technological change as exogenous, essentially ignores the role of capital (as a result of the era in which it was developed), and assumes that population growth increases when income increases (also as a result of the era in which it was developed). As a result, the conclusions from the classical theory are “dismal” indeed! Some students find it interesting to know that Thomas Malthus, most closely associated with the population part of this theory, was a clergyman, but was also the first person in the Anglophone world to hold the title of Professor of Political Economy (at the East India College). Economists came to realize that capital accumulation and technological change were important parts of the growth process. They also came to understand that population growth does not necessarily increase with income. Hence the stage was set for the neoclassical theory. Neoclassical theory. Neoclassical theory follows the classical theory by taking technological growth as exogenous. It differs insofar as it assumes that population growth also is exogenous. The major difference is that neoclassical theory stresses the role played by technological change and how it influences saving and capital accumulation. So of the two differences between neoclassical and classical growth theory, the first—the different assumptions about how population growth is determined—reflects an advance in empirical knowledge of the relationship between population growth and income. The second difference— the importance given to technological change, saving, and capital—shows how the neoclassical theory built on the simpler classical model. New growth theory. Neoclassical theory also is incomplete because the primary engine of economic growth, technology, is exogenous. New growth theory attempts to overcome this weakness. It still uses many of the insights of the neoclassical theory by emphasizing the role of capital accumulation and assuming that population growth is exogenous. But the new growth theory builds on neoclassical theory by examining more closely the role of technology and the factors that influence technological advances. Giving the students this type of broad overview before presenting the details of the different models is important because it, along with the text’s outstanding overview, allows the students to see the forest as well as the trees. This knowledge not only helps them understand the particular models, but it also helps them gain an appreciation of how economics progresses. (Of course, progress is hardly as steady as the © 2014 Pearson Education, Inc.

ECONOMIC GROWTH

students might believe; for instance, Pigou and Ramsey presented important papers about growth in the early part of the twentieth century, but, nonetheless, progress has been made.)

Classical Growth Theory Classical growth theory is the view that real GDP growth is temporary and that when real GDP per person rises above the subsistence level, a population explosion eventually brings real GDP per person back to the subsistence level. •

A problem with the classical theory is that population growth is independent of economic growth rate.

Classical growth theory is based on the work of Thomas Malthus, an economist from the early nineteenth century. Very few modern-day economists would refer to themselves as Malthusians. But, as the textbook says, there are many other people today who are Malthusians. The persistence of this viewpoint represents what one can only refer to as the triumph of despair over experience. At some point in history, Malthusian theory might have been applicable. But certainly since the industrial revolution, parents have chosen to concentrate on the quality of children not the quantity. And this shift in emphasis only gets stronger as economic growth advances. Thus, the assumption that the population growth rate is primarily determined by economic growth with a positive relationship has no basis in reality. Indeed, some of the richest countries in the world, such as Sweden and Japan, have some of the lowest birth rates.

Neoclassical Growth Theory Neoclassical growth theory is the proposition that the real GDP per person grows because technological change induces a level of saving and investment that makes capital per hour of labor grow. • • • • •

A technological advance increases productivity. Real GDP per person increases. The technological advances increase expected profit. Investment and saving increase so that capital increases. The increase in capital raises real GDP per person. As more capital is accumulated, eventually projects with lower rates of return must be undertaken so that the incentive to invest and saving decrease. Eventually capital stops increasing so that economic growth stops. The improvement in technology permanently increases real GDP per person. A problem with the neoclassical theory is that it predicts that real GDP per person in different nations will converge to the same level. But in reality, convergence does not seem to be taking place for all nations.

New Growth Theory New growth theory holds that real GDP per person grows because of the choices people make in the pursuit of profit and that growth can persist indefinitely. • • • •

The theory emphasizes that discoveries result from choices, discoveries bring profit, and competition then destroys the profit. It also stresses that knowledge can be used by everyone at no cost and knowledge is not subject to diminishing returns. The ability to innovate means new technologies are developed and capital accumulated as in the neoclassical model. The production function shifts upward. Real GDP per person increases. The pursuit of profit means that more technological advances occur and the production function continues to shift upward. Nothing stops the upward shifts of the production function because the lure of profit is always present. The ability to innovate determines how capital accumulation feeds into technological change and the resulting growth path for the economy. Productivity and real GDP constantly grow.

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The Empirical Evidence on the Causes of Economic Growth •

Economists have studied the growth rate data for more than 100 countries for the period since 1960 and explored the correlations between the growth rate and more than 60 possible influences on it. The conclusion of this data crunching is that most of these possible influences have variable and unpredictable effects, but a few of them have strong and clear effects. Amongst the strongest are: • International Trade: Nations that are open to trade grow more rapidly • Investment: Nations that have more investment in human capital and physical capital grow more rapidly. • Market Distortions: Nations that have more exchange rate controls, price controls, and black markets grow more slowly. • Economic System: Capitalist nations grow more rapidly. • Politics: Nations that support the rule of law and protect civil liberties grow more rapidly. Nations that have revolutions, military coups, or fight wars grow more slowly. • Region: Nations located far from the equator grow more rapidly; nations in Sub-Sahara Africa grow more slowly.

Policies for Achieving Faster Growth •

Growth theory and the empirical evidence suggest some policies that might stimulate growth: • Stimulate saving, to increase capital accumulation • Stimulate research and development, to increase technology • Improve the quality of education, to increase human capital. • Provide international aid to developing nations. However studies show that aid tends to get diverted to consumption. If the objective is to increase growth, then the aid must be carefully directed. • Encourage international trade, to increase international specialization

The Classical Model. Explain that more capital and more productive capital that uses new technologies increases productivity, shifts the production function upward, and shifts the demand for labor curve rightward. Real GDP increases and on the average, the real wage rate rises. You might then spend a few minutes agreeing that capital accumulation and technological change decrease the demand for the labor that the new capital replaces. But it increases the demand for other types of labor—complementary labor. People must acquire more skill—some people learn to work with the new capital, some learn how to maintain it in good condition, some learn how to build it, some learn how to market and sell it, some learn to design new ways of using it, some work on thinking up new goods and services to produce with it, and so on. All of these people are more productive that they were before. New technologies that create new products have even more obvious effects on productivity. The development of the CD in the early 1980s is a good example. Suddenly thousands of people became very productive converting the heritage of recorded music into digital format, cleaning up the sound, and making and selling millions of CDs. The same type of thing is now happening with the conversion of media to digital formats for all of our digital devices.

ECONOMIC GROWTH

Additional Problems 1.

If in 2008 China’s real GDP is growing at 9 percent a year, its population is growing at 1 percent a year, and these growth rates continue, in what year will China’s real GDP per person be twice what it is in 2008?

Underinvesting in the Future For the past half century, South Korea, Hong Kong, Taiwan and Singapore have averaged the highest consistent economic growth rates in the world. But in one vital respect these countries may have the worst record of investment in the future since homo sapiens evolved: They have the lowest fertility rates in the world. For economic growth, raising children is at least as raising new buildings. International Herald Tribune, July 7, 2008 a. Explain why the rapid growth rates of these Asian economies might be masking a misallocation of resources that will result in lower income per person in the future. b. Explain the difficulties in balancing goals for immediate economic growth and future economic growth.

Solutions to Additional Problems 1.

China’s real GDP is growing at 9 percent a year and its population is growing at 1 percent a year, so China’s real GDP per person is growing at 8 percent a year. The rule of 70 tells us that China’s real GDP per person will double in 70/8 = 8¾ years. So at this rate China’s real GDP per person will be twice what it is in 2008 in 2017. a.

The new growth theory concludes that population growth increases economic growth because population growth means more people to develop new knowledge and new technologies. The Asian economies are currently growing rapidly but their population growth is extremely slow. The new growth theory predicts that the slow population growth means that in the future their economic growth rates will slow. People have a limited amount of time, which they can spend at work, perhaps developing new knowledge or new technology, or at home, raising children. If they spend their time at work, immediate economic growth will be higher than if they spend the time at home. But if they spend their time at home raising children, the future economic growth will be higher as the population growth is higher.

Additional Discussion Questions 11. What has been the average annual growth in real GDP per person in the United States over the last 100 years? Over the past 50 years, during which periods has annual growth been more rapid than the average? When has it been slower? The average annual growth rate in real GDP per person in the United States has been 2 percent over the past 100 years. Growth was most rapid in the 1960s. It was also rapid in the 1990s. Growth slowed in the 1970s. This slowdown is the “productivity growth slowdown.” 12. What is an aggregate production function? A change in what factor or factors cause a movement along the aggregate production function? A change in what factor or factors shifts the aggregate production function? The aggregate production function shows the relationship between real GDP and the quantity of labor employed when all other influences © 2014 Pearson Education, Inc.

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on production remain the same. Changes in employment create movements along the aggregate production function. Changes in other factors of production, such as capital, as well as changes in technology, shift the aggregate production function. 13. Define labor productivity. Why is labor productivity important? Labor productivity is equal to real GDP divided by aggregate labor hours, so it tells the quantity of real GDP produced by an hour of labor. Labor productivity is important because it is directly related to the standard of living. The standard of living is real GDP per person so labor productivity is essentially the “standard of living per worker.” Therefore an increase in labor productivity means there is an increase in the standard of living. 14. Explain why reducing uncertainty with respect to property rights is regarded as likely to stimulate economic growth. Necessary preconditions for economic growth are physical capital growth, human capital growth, and technological advances. However people are willing to invest in physical capital and human capital only if they believe they will be able to reap the rewards from their investment. If property rights are unsecure, so that investors are unsure if they will gain from the investment, then people are much less likely to invest in either physical capital or human capital. Uncertainty about property rights therefore will dramatically slow economic growth because it will slow growth in physical and human capital. The story about technology is similar: People are willing to invest in new technology only if they believe they personally will reap the rewards. Once again, reducing uncertainty about property rights will increase people’s incentives to develop new technology, which will lead to more rapid economic growth. 15. What role do technological advances play in the classical theory of growth? The neoclassical theory? The new theory? In all the growth models a technological advance raises economic growth and real GDP per person. But whether the increase is temporary or permanent differ among the models. In the classical growth model a technological advance temporarily raises economic growth and real GDP per person. After the advance economic growth ceases. And the ensuing increase in population drives real GDP per person back to the subsistence level. In the neoclassical growth model a technological advance temporarily raises economic growth and permanently raises real GDP per person. After the advance economic growth ceases. But the increase in the capital stock brought about by the advance allows real GDP per person to remain permanently higher. In the new growth theory a technological advance permanently increases economic growth and real GDP per person. In the new growth theory a technological advance creates new profit opportunities so that pursuit of profit leads to still more technological advances and investment in capital. As a result economic growth persists. And with the persistence of economic growth, the increase in real GDP per person is permanent and increasing over time.

ECONOMIC GROWTH

165

C h a p t e r

FINANCE, SAVING, AND INVESTMENT**

The Big Picture Where we have been: This chapter builds on the definition of real GDP from Chapter 4 to explain how investment is financed. It also uses the demand and supply model explained in Chapter 3. The chapter explains how equilibrium in the loanable funds market determines the real interest rate and quantity of investment. It also discusses how government actions affect this market. Where we are going: Chapter 7 is the second of four chapters that examine the economy in the long run when the economy is at full employment. The following chapters focus on money and the price level, and the exchange rate and balance of payments. After these chapters the next section examines macroeconomic fluctuations by developing the AS-AD model. The material presented in Chapter 7 is used in many of the following chapters. For instance the result that the real interest rate is determined in the loanable funds market is important in the next chapter to help determine the long-run effects from changes in the quantity of money. The loanable funds model also is used in Chapter 13 when examining the supply-side effects of fiscal policy.

New in the Eleventh Edition Chapter 7 is virtually the same as the 10th edition. The Reading Between the Lines is a new article that outlines the issues surrounding deficit reduction and the “fiscal cliff”.

CHAPTER 7

Lecture Notes

Finance, Saving, and Investment • •

The supply and demand for loanable funds determine the real interest rate and the quantity of loanable fund and investment. Government budget deficits might also affect the real interest rate and quantity of investment.

Financial Institutions and Financial Markets

Finance and Money; Physical Capital and Financial Capital • •

Finance and money differ: • Finance refers to providing the funds used for investment. • Money refers to what is used to pay for goods and services. Physical capital and financial capital differ: • Physical capital is the tools, instruments, machines, buildings, and other items that have been produced in the past and that are used to today to produce goods and services. • Financial capital is the funds that firms use to buy physical capital.

Definitions and the meaning of investment in economics. The student has met the key definitions of investment in this chapter, but to be absolutely sure that they are remembered it is worth emphasizing that in economics, “capital” and “investment” without any qualification mean physical capital and purchase of newly produced physical capital goods. Everyday usage of investment as the purchase of stocks or bonds can lead to confusion. So it is worth getting these matters clear right from the start.

Capital and Investment; Wealth and Saving •

The quantity of capital changes because of investment and depreciation. Gross investment is the total amount spent on new capital; net investment is the change in the capital stock. Net investment equals gross investment minus depreciation.

A concrete understanding of stock and flow variables is an important building block to understanding economic principles. You can use “buckets” to convey the relationship between stock and flow variables. Buckets are easy to draw along with a simple faucet and hole in the bucket. You can use this illustration to show how the stock changes over time due to the inflow and outflow of material into the bucket. You can extend the use of buckets to any stock/flow concept, such as wealth and saving. For use with the capital stock, draw a bucket with a “K” on it. At a point in time there is fixed amount of capital in the bucket. Over some time period, investment flows in the top and depreciation flows out. The net effect of these two flows leaves the bucket higher or lower at the end of that time period. •

Wealth is the value of all the things people own; saving is the amount of income not paid in taxes or spent on consumption. Saving adds to wealth. Wealth also changes when the market value of wealth changes.

Financial Capital Markets Financial markets transform saving and wealth into investment and capital. • Loan markets: Both businesses and households obtain loans from banks. Financing for inventories, purchasing houses, and so forth can be obtained in this market. • Bond markets: Businesses and governments can raise funds by issuing bonds. A bond is a promise to make specified payments on specified dates. One type of bond is a mortgage-backed security, which entitles its owner to the income from a package of mortgages. The failure of many mortgagebacked securities to make their specified payments was a factor leading to the financial crisis in 2007 and 2008. • Stock markets: Businesses can raise funds by issuing stock. A stock is a certificate of ownership and a claim to the firm’s profit. © 2014 Pearson Education, Inc.

FINANCE, SAVING, AND INVESTMENT

Financial Institutions •

A financial institution is a firm that operates on both sides of the markets for financial capital by being a borrower in one market and a lender in another market. Financial institutions include, commercial banks, government-sponsored mortgage lenders (Fannie Mae and Freddie Mac), pension funds, and insurance companies.

Financial Crisis: The fall of 2008 saw the biggest financial crisis since the Great Depression. Essentially securities, such as mortgage-backed securities, lost value and many financial institutions became insolvent. These institutions, such as Fannie Mae, Freddie Mac, Bear Sterns, AIG, and others were considered “too large” to fail. While you cannot fully explain the reasons why failure of a large financial institution might have external costs, your students can readily appreciate the point that if these institutions failed many borrowers would find it significantly more costly to arrange loans. The government acted in most all of these cases by arranging a bailout in form or another. Some companies were given government loans (AIG received an $85 billion loan from the Fed); others were taken into government oversight (Fannie Mae and Freddie Mac); others were merged into healthier companies, albeit with government assistance (Bear Sterns); a few were allowed to fail (Lehman Brothers).Even beyond these events, most financial institutions were given government assistance in the form of government loans and/or government purchase of stock.

Insolvency and Illiquidity • •

A financial institution’s net worth is the total market value of what it has lent minus the market value of what it has borrowed. If the net worth is positive, the institution is solvent and can remain in business. If the net worth is negative, the institution is insolvent and might go out of business. A firm is illiquid if it can not meet a sudden demand to repay what it has borrowed because it does not have enough available cash. A firm can be illiquid but solvent.

Interest Rates and Asset Prices • •

Stocks, bonds, short-term securities, and loans are financial assets. The interest rate on a financial asset is equal to the interest paid on the asset expressed as a percentage of the asset’s price. $2.50 100 = 5.0 • If an asset’s price is $50 and it pays $2.50 in interest, the interest rate is $50.00 percent. • If the price of the asset rises, the interest rate falls. Conversely if the interest rate falls, the price of the asset rises.

It is helpful to show explicitly how the market price of a bond is determined by the current interest rate. Using an example of government bond will be useful for future chapters on monetary and fiscal policy. Explain that a bond is an “IOU” from the issuer and its basic components of are its term, face value and coupon payment. For example, a bond might have a $10,000 face value with a coupon payment of $500 for the next 5 years. Point out to your students that this coupon payment means that the bond is essentially paying an interest rate of 5 percent for the next five years…at least as long as its price is $10,000. Explain how the bond can be traded in the secondary market and ask them what they think the bond’s price would be if the market interest rate rose to 6 percent. Make clear that when the interest rate rises to 6 percent, which means that “new” government bonds with a $10,000 face value will sell for $10,000 and will pay a $600 coupon payment. Your students should be able to see that the “old” bond must be worth less than the new bond because the old bond has a smaller coupon payment. Tell your students that while it is possible to determine the precise price for which the old bond will trade, your key point is that the price has fallen

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from $10,000 to something less. In other words, an increase in the interest rate has lowered the price of (old) bonds!

II. The Loanable Funds Market The loanable funds market is the aggregate of all the individual financial markets. In this market households, firms, governments, banks, and other financial institutions lend and borrow.

Funds that Finance Investment • •

The funds that finance investment are from household saving, the government budget surplus, and international borrowing. Households’ income is consumed, saved, or paid in net taxes (taxes paid to the government minus transfer payments received from the government): Y = C + S + T. GDP equals income and also equals aggregate expenditure, so Y = C + I + G + (X − M). Combining shows that C + S + T = C + I + G + (X − M), which can be rearranged to show how investment is financed:

I = S + (T − G) + (X − M).

This formula shows that investment is financed using private saving, a government budget surplus, (T − G) and borrowing from the rest of the world, (X − M). • The sum of private saving, S, plus government saving, (T − G), is national saving. • If we export less than we import, (X − M) is negative and we borrow (M − X) from the rest of the world. • If we export more than we import, (X − M) is positive and we loan (X − M) to the rest of the world.

The Real Interest Rate •

The nominal interest rate is the number of dollars that a borrower pays and a lender receives expressed as a percentage of the number of dollars borrowed or lent. The real interest rate is the nominal interest rate adjusted to remove the effects of inflation on the buying power of money. The real interest rate is approximately equal to the nominal interest rate minus the inflation rate. The real interest rate is the opportunity cost of loanable funds.

Giving a numeric example of why the real interest rate and nominal interest rate differ can be enlightening for your students. Suppose you have $100 this year and you can invest it at a (nominal) interest rate of 10 percent. One year later you will have $110, that is, 10 percent more dollars. If the price of a cheeseburger is $1 this year you can buy 100 cheeseburgers. But if one year later the price level rose from 100 to 108 and the price of cheeseburgers rose at this average rate, then the cheeseburgers will cost you $1.08. Next year your $110 will only buy about 102 cheeseburgers ($110/$1.08). The purchasing power of your 10 nominal interest rate is only about 2 more cheeseburgers, a 2 percent real interest rate! Real versus nominal interest rate. To drive home the distinction between the nominal interest rate and real interest rate, ask your class if an interest rate of 10 percent is high. Almost assuredly they will respond with a resounding “Yes.” Point out to them that around 1980 a 10 percent interest rate was exceedingly low. At the time a typical interest rate was between 12 percent and 17 percent, depending on the riskiness of the asset and the length of the loan. What accounts for the difference between then and now? The answer is simple: inflation. In 1980 the inflation rate was running at more than 10 percent per year. Given the high inflation rate, the nominal interest rate adjusted so that it, too, was high. Most of the dollars lenders received as (nominal) interest went to keeping their purchasing power intact. But the real interest rate at that time was not much different than the real interest rate nowadays. In other words, the increase in purchasing power received by lenders (the real interest rate) in the 1980s was about the same as the increase in purchasing power received by lenders today.

FINANCE, SAVING, AND INVESTMENT

The Demand for Loanable Funds •

• •

•

The quantity of loanable funds demanded is the total quantity of funds demanded to finance investment, the government budget deficit, and international investment or lending during a given time period. Business investment makes up the majority of the demand for loanable funds and so the initial focus is on investment. Investment depends on the real interest rate and expected profit. Firms will make the investment only if they expect to earn a profit. The demand for loanable funds is the relationship between the quantity of loanable funds demanded and the real interest rate when all other influences on borrowing plans remain the same. • The real interest rate is the opportunity cost of loanable funds, so there is a negative relationship between the quantity of loanable funds demanded and the real interest rate. • Investment is influenced by expected profit. The higher the expected profit, the more investment firms make. Expected profit rises during a business cycle expansion and falls during a business cycle recession; rises when technology advances; rises as the population grows; and fluctuates with swings in business optimism and pessimism. The demand curve for loanable funds is downward sloping as shown in the figure. The demand for loanable funds increases when investment increases, so when expected profit increases, the demand for loanable funds increases and the demand for loanable funds curve shifts rightward.

The Supply of Loanable Funds • • • •

The quantity of loanable funds supplied is the total quantity of funds available from private saving, the government budget surplus, and international borrowing during a given time period. Saving makes up the majority of the loanable funds available, so the initial focus is on saving. The supply of loanable funds is the relationship between the quantity of loanable funds supplied and the real interest rate when all other influences on lending plans remain the same. When the real interest rate rises, saving increases so the supply of loanable funds increases. As illustrated in the figure, the supply of loanable funds curve is upward sloping. Saving and hence the supply of loanable funds increases when disposable income increases, when wealth decreases, when expected future income decreases, and when default risk decreases. When the supply of loanable funds increases the supply curve of loanable funds curve shifts rightward.

Equilibrium in the Loanable Funds Market •

As the figure shows, the equilibrium real interest rate sets the quantity of loanable funds demanded equal to the quantity of loanable funds supplied. In the figure, the equilibrium real interest rate is 5 percent and the equilibrium quantity of loanable funds is $1.6 trillion.

Changes in Demand and Supply •

Changes in either demand or supply change the real interest rate and the price of financial assets. • If expected profit increases the demand for loanable funds increases. The equilibrium real interest rate rises and the equilibrium quantity of loanable funds and investment increase. • If the supply of loanable funds increases, the equilibrium real interest rate falls and the equilibrium quantity of loanable funds and investment increase.

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•

Short-run changes in the demand and supply can be sharp so that changes in the real interest rate also can be sharp. But in the long run the demand and supply grow at the same pace so there is no upward or downward trend in the real interest rate.

FINANCE, SAVING, AND INVESTMENT

III. Government in the Loanable Funds Market A Government Budget Surplus •

Changes in the government surplus can shift the supply of loanable funds curve. In the figure, PSLF is the private supply of loanable funds curve. The government has a budget surplus equal to the length of the arrow ($0.4 trillion). The surplus adds to private saving and so the supply of loanable funds curve becomes SLF. Without the budget surplus, the real interest rate is 6 percent and the quantity of loanable funds and investment is $1.4 trillion; with a budget surplus, the real interest rate is 5 percent and the quantity of loanable funds and investment is $1.6 trillion.

A Government Budget Deficit •

• •

Changes in the government deficit can shift the demand for loanable funds curve. In the figure, PDLF is the private demand for loanable funds curve. The government has a budget deficit equal to the length of the arrow ($0.4 trillion). The deficit adds to private demand and so the demand for loanable funds curve becomes DLF. Without the budget deficit, the real interest rate is 5 percent and the quantity of loanable funds and investment is $1.6 trillion; with the budget deficit, the real interest rate is 6 percent, the quantity of loanable funds is $1.8 trillion, and investment is $1.4 trillion. The tendency for a government budget deficit to decrease investment is called a crowding-out effect. The possibility that a budget deficit increases private saving supply in order to offset the increase in the demand for loanable funds is called the Ricardo-Barro effect. The reasoning behind this effect is that taxpayers will save to pay higher future taxes that result from the deficit. To the extent that the Ricardo-Barro effect occurs, it reduces the crowding-out effect because the SLF curve shifts rightward to offset the deficit.

Take advantage of this model to highlight the effect of the deficit. Whether you draw it on the board or use a laser pointer, track the increase in the real interest rate and the decrease moving along the PDLF curve. Mention that crowding out decreases the capital stock because of the decrease in investment.

IV. The Global Loanable Funds Market International Capital Mobility • •

The loanable funds market is a global market. Lenders look worldwide to find the highest real interest rate; borrowers likewise look worldwide to find the lowest real interest. These actions bring the risk-adjusted real interest rate to equality throughout the world. If a country’s net exports are negative, X < M, then the country finances the shortfall in exports by borrowing from the rest of the world. If a country’s net exports are positive, X > M, then the country uses the excess to loan to the rest of the world. © 2014 Pearson Education, Inc.

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Demand and Supply in Global and National Markets • •

•

Demand and supply in the world global loanable funds market determines the world equilibrium real interest rate. A country is a net foreign borrower if the world equilibrium real interest rate is less than what would be the no-trade interest rate in the country. The figure shows this situation. • In the figure, when the country is isolated from international trade the equilibrium real interest rate would be 6 percent and the equilibrium quantity of loanable funds would be $1.6 trillion. • With international trade, the real interest rate in the country becomes the world real interest rate, 5 percent. At this lower real interest rate, the quantity of loanable funds supplied decreases to $1.4 trillion and the quantity of loanable funds demanded increases to $1.8 trillion. The difference, $0.4 trillion, is borrowed from abroad. The country has negative net exports, with X < M. A country is a net foreign lender if the world equilibrium real interest rate exceeds what would be the no-trade interest rate in the country. The figure shows this situation. • In the figure, when the country is isolated from international trade the equilibrium real interest rate would be 4 percent and the equilibrium quantity of loanable funds would be $1.6 trillion. • With international trade, the real interest rate in the country becomes the world real interest rate, 5 percent. At this higher real interest rate, the quantity of loanable funds supplied increases to $1.8 trillion and the quantity of loanable funds demanded decreases to $1.4 trillion. The difference, $0.4 trillion, is loaned abroad. The country has positive net exports, with X > M. In a small country, changes in the national demand and supply of loanable funds change the country’s international loaning or borrowing and will change the country’s net exports.

FINANCE, SAVING, AND INVESTMENT

Additional Problems 1.

Government expenditure decreases by $100 billion. a. If there is no Ricardo-Barro effect, explain how loanable funds, saving, investment, and the real interest rate respond to this fiscal policy. b. How does your answer in part a depend on the strength of the Ricardo-Barro effect?

Figure 7.1 shows the market for loanable funds. The government is running a budget surplus of $900 billion. a. Show the effect of a $400 billion decrease in the government budget surplus if there is no Ricardo-Barro effect. How much investment is crowded out by the fall in the surplus? b. How does the Ricardo-Barro effect change the results?

IMF Warning Over Slowing Growth Turmoil in the world’s financial markets may well slow global economic growth. BBC News, October 10, 2007 Explain how turmoil in global financial markets might affect the demand for loanable funds, investment, and global economic growth in the future.

Solutions to Additional Problems 1.

The decrease in government expenditure by $100 billion increases the supply of loanable funds, which increases the equilibrium quantity of loanable funds. Compared to what otherwise would have been the case, the decrease in government expenditure lowers the real interest rate and increases investment. The stronger the Ricardo-Barro effect, the less the increase in the supply of loanable funds as taxpayers expect future taxes to be lower due to the decrease in government expenditures. The smaller the increase in the supply of loanable funds, the smaller the changes in loanable funds, the real interest rate, and investment.

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Figure 7.2 shows the effect of the $400 billion decrease in the government surplus. The government deficit decreases saving by $400 billion and so shifts the supply of loanable funds curve leftward by $400 billion. As the figure shows, the equilibrium real interest rate rises from 5 percent to 6 percent and the equilibrium quantity of loanable funds decreases from $2.0 trillion to $1.8 trillion. So the $400 billion decrease in surplus crowds out (decreases) $200 billion of investment. The Ricardo-Barro effect says that people change their saving to offset the effect of changes in the government budget balance. In the extreme, people increase their saving by the full amount of the decrease in surplus, in which case the supply of loanable funds curve does not shift and so investment and the real interest rate do not change. In a less extreme case, the saving increase offsets only some of the decrease in surplus, so the supply of loanable funds curve still shifts leftward, but by a smaller amount. As a result, the real interest rises less and investment decreases less that they would in the absence of the Ricardo-Barro effect. The turmoil in financial markets leads some people to decrease their saving because of fear that they might lose these funds due to the turmoil; in other words, default risk increases. As a result, the supply of loanable funds decreases, which pushes up the real interest rate. The primary source demanding loanable funds is business firms who want these funds to make investment. If the real interest rate rises, the quantity of loanable funds demanded decreases as businesses cancel nolonger profitable investments. With less investment there will be less capital and so the growth in potential GDP slows.

Additional Discussion Questions 11. What is the difference between “insolvency” and “illiquidity”? Insolvency occurs when a firm has negative net worth; that is, the firm’s liabilities—what it owes—exceed the firm’s assets—what it owns. Illiquidity occurs when a firm does not have enough cash to meet a sudden demand for repayment of what it has borrowed. The situations are different: A firm can be insolvent and liquid. A firm can also be solvent and illiquid. 12. Explain why and how investment depends on the real interest rate. The real interest rate is the opportunity cost of investment. A firm that borrows funds to make an investment faces the real interest as the opportunity cost of its investment because the real interest rate determines the purchasing power—the amount of goods and services—that a firm must repay on its loan. A firm that uses its own funds to make an investment also faces the real interest rate as the opportunity cost of its investment because the firm could loan the funds to others and collect as its return the real interest rate. Because the real interest rate is the opportunity cost of investment, an increase in the real interest rate decreases the quantity of investment firms demand. 13. If the actual real interest rate differs from the equilibrium real interest rate, what forces drive the real interest rate to the equilibrium real interest rate? If the real © 2014 Pearson Education, Inc.

FINANCE, SAVING, AND INVESTMENT

interest rate is higher than the equilibrium real interest rate, there is a surplus of loanable funds. In this case lenders cannot loan all the funds they want. In order to loan their funds, loaners reduce the real interest rate they charge and the real interest falls to the equilibrium real interest rate. If the real interest rate is lower than the equilibrium real interest rate, there is a shortage of loanable funds. In this case borrowers cannot borrow all the funds they want. In order to borrow their funds, borrowers raise the real interest rate they will pay and the real interest rises to the equilibrium real interest rate. 14. Assuming a country cannot engage in international borrowing and lending, suppose that people increase their saving. What effect does this change have on the equilibrium real interest rate and quantity of investment? Now suppose the country can participate in the global loanable funds market. If the country cannot affect the world real interest rate, when people increase their saving what happens to the equilibrium real interest rate and quantity of investment within the country? If people increase their saving the supply of loanable funds increases and the supply curve of loanable funds shifts rightward. If there is no global lending or borrowing, the increase in the supply of loanable funds lowers the equilibrium real interest rate and increases the quantity of investment. If the country can participate in the global loanable funds market but is too small to affect the world real interest rate, the increase in its citizens’ saving does not affect the real interest rate. The supply of savings increases and the increase is loaned abroad so that either net foreign borrowing decreases or net foreign lending increases. Investment within the country does not change.

C h a p t e r

MONEY, THE PRICE LEVEL, AND INFLATION**

The Big Picture Where we have been: Because Chapter 8 is the first chapter on money, it introduces a lot of new material. The discussion of the market for money relates back to the supply and demand model in Chapter 3. Where we are going: Chapter 8 is the first of two chapters that examine money and the economy. This chapter defines money, introduces the Federal Reserve, explains the money creation process, and then concentrates on the long run effects (the quantity theory) of changes in the quantity of money. Chapter 14 returns to these topics to study monetary policy. Chapter 8 also is the 3rd of 4 chapters that cover the economy in the long run. The next chapter looks at the exchange rate and balance of payments.

New in the Eleventh Edition An At Issue page is added to discuss issues of “too big to fail” by reviewing the Volker Rule. The data and figures in the chapter are updated to 2012. The Economics in the News highlights quantitative easing and the Reading Between the Lines is a new article that takes a more indepth look at the effects of quantitative easing using the money market and loanable funds market models. There are three updated and four new problems in the Study Plan Problems and Applications replacing some older headlines with more current material. The same was done in Additional Problems and Applications with two new problems.

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Lecture Notes

Money, the Price Level, and Inflation • • • •

Money is anything that is used as a means of payment. Banks play a major role in creating money but this process is ultimately controlled by the Federal Reserve. In the short run, equilibrium in the money market determines the nominal interest rate. In the long run, an increase in the growth rate of the quantity of money leads to a higher inflation rate.

What Is Money?

The contrast between money in economics and money in everyday language. It can be helpful to emphasize that “money” is a technical term in economics that has a precise meaning and that differs from its looser usages in everyday language. For example, an economist would not say “Bill Gates makes a lot of money.” Rather, the economist would say “Bill Gates earns a large income.” An interesting exercise is to have students think of statements containing the word “money” that make complete sense in normal language but that misuse the word in its precise economic sense, and to get them to explain why. •

Money is any commodity or token that is generally acceptable as a means of payment. A means of payment is a method of settling a debt. Money has three functions: • Medium of exchange • Unit of account • Store of value

Medium of Exchange A medium of exchange is any object that is generally accepted in exchange for goods and services. Money acts as a medium of exchange. As a result, money eliminates the need for barter, which is the exchange of goods and services directly for other goods and services. The defining characteristic of money. Adam Smith wrote, “Money is a commodity or token that everyone will accept in exchange for the things they have to sell.” Most people have interpreted this statement as defining money as the medium of exchange. That interpretation is wrong. Smith is defining money as the means of payment. Money is a commodity or token that everyone will accept as payment for the things they have to sell. When Michael Parkin was a young economist, he had the enormous good fortune to meet Anna Schwartz, Milton Friedman, and a group of other leading monetary economists. It was during the late 1960s when the monetarist debate was alive and well and people were still arguing about whether the demand for money was interest inelastic (as the monetarists claimed) or almost perfectly elastic (as the Keynesians claimed). Anna made a remark that for Michael was one of those defining moments. She said money is the means of payment. Nothing else performs this function. It is unique to money. Many things serve as a medium of exchange, unit of account, or store of value, but money alone serves as the means of payment— the means of settling a debt so that there is no remaining obligation between the parties to a transaction. Get the class involved in figuring out what money is. To involve the students in the process of determining what money is, after noting its definition and three functions, ask them what they think should be counted as money. List the suggestions on the board before commenting on them. Coins and currency will certainly be mentioned. Usually each class has a few members who have read the text and will suggest checkable deposits. Almost always you will obtain some not-so-excellent answers, ranging from gold to shares of stock to credit cards.

MONEY, THE PRICE LEVEL, AND INFLATION

The point of this exercise is to obtain these incorrect answers because they give you a chance to discuss why these items are not money. Without ridiculing the wrong answers, you might point out that students rarely pay for books by giving the bookstore shares of IBM stock and asking for change in AT&T stock. By being involved and having to think, the students emerge with a stronger grasp of why money is measured as it is.

Unit of Account Money serves as a unit of account, which is an agreed measure for stating the prices of goods and services.

Store of Value Money serves as a store of value because it can be held and exchange later for goods and services. During the Great Depression there was deflation so the real return on money was positive. Thus, many people held money as an asset and did not immediately use it to spend on goods and services. This is the idea behind Keynes’ concern that people were stuffing money in their mattresses instead of spending it. Concerns about deflation have been revived in recent years. Japan has had deflation on and off for the past decade and many other countries have very low rates of inflation. One of the more interesting suggestions by Fed economists in thinking how to avoid the problem of money serving so well as a store of value is to have money which expires like a coupon. It is not clear whether such a form of money is feasible from a political or psychological point of view, but the suggestion is interesting.

Money in the United States Today • • •

•

Money consists of currency (the notes and coins held by individuals and businesses) and deposits at banks and other depository institutions. Deposits are also money because they can be converted into currency and because they are used to settle debts. M1 consists of currency and traveler’s checks plus checking deposits owned by individuals and businesses. M2 consists of M1 plus time deposits, saving deposits, and money market mutual funds and other deposits. M2 is much larger than M1, $8,6117,687 billion versus $1,723 billion in June, 2010. M2 includes liquid assets that are not means of payment. Liquidity is the property of being instantly convertible into a means of payment with little loss in value. The assets in M2 are generally quite liquid. Checks are not money—they are instructions to transfer money from one person’s deposits to another person’s deposits. Credit cards are not money—they are IDs that allow an instant loan.

Fiat money. Pull out a dollar bill, wave it at the class and ask, “What backs our currency?” You should get someone to state gold. Tell them, “Yes, I have heard about all the gold stored in Fort Knox, but none of it is there for a trade-in value. We went off the gold standard with Nixon. If you look closely at the bill you’ll find your backing, “In God we trust,” That’s it! The dollar has value because of your faith that someone else will accept it for something else you want. Alternatively (or additionally) take a green piece of paper and cut it to the same size as a dollar bill. Then take the paper into class along with a dollar bill. Ask the students why one piece of paper has value and the other does not. Is there anything intrinsically more valuable about the dollar bill? If not, why won’t someone in class exchange his or her old wrinkled piece of green paper with writing on it for the nice new piece you offer?

II. Depository Institutions •

A firm that takes deposits from households and firms and makes loans to other households and firms is called a depository institution. There are three types of depository institutions whose deposits are money: commercial banks, thrift institutions, and money market mutual funds.

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Commercial Banks • •

A commercial bank is a firm that is licensed to receive deposits and make loans. In 2010 there are about 7,000 commercial banks but that number has been trending downward. The deposits of commercial banks account for 40 percent of M1 and 65 percent of M2. Banks accept deposits and then divide these funds into reserves (cash in the vault plus its deposits at the Federal Reserve), liquid assets (such as Treasury bills and commercial bills), securities (such as U.S. government bonds and mortgage-backed securities), and loans (made primarily to corporations for purchases of capital equipment and to households to finance homes, consumer durable goods, and credit cards). Loans are the riskiest of a bank’s assets. As a percentage of deposits, on June 30, 2012 reserves were 17.5 percent, liquid assets were 3.1 percent, securities and other assets were 46.5 percent, and loans were 81.3 percent. (The percentages sum to more than 100 percent because deposits are just one source of funds; borrowing and the banks’ own capital are other sources of funds and are equal to about 50 percent of deposits.)

Because of concerns about the financial crisis and bank runs, banks increased their reserves from the more typical 0.6 percent of deposits in June 2008 to 14.3 percent in June, 2010 and to 17.5 percent in June, 2012.

Thrift Institutions The thrift institutions are savings and loan associations, savings banks, and credit unions.

Money Market Mutual Funds A money market mutual fund is a fund operated by a financial institution that sells shares in the fund and holds liquid assets such as U.S. Treasury bills and short-term commercial bills.

The Economic Functions of Depository Institutions •

Depository institutions make a profit from the spread on the interest rate at which they lend over the interest rate they pay on deposits. The spread reflects four services provided by depository institutions: • Create Liquidity: Most assets are less liquid than liabilities, so depository institutions turn lessliquid funds into more liquid funds.

A bank run is a liquidity crisis in the sense that banks can have the deposits backed by assets such as mortgage loans, but the assets are less liquid than the deposits. This scenario should be familiar to anyone who has seen It’s a Wonderful Life with Jimmy Stewart. As suggested by the movie, bank runs were a big problem in the 1930s and many economists believe they made the Great Depression much worse than other recessions. Indeed, banks runs were feared by the Federal Reserve during the financial crisis of 2008 and this fear likely accounted one reason why the Fed responded so strongly to the crisis. • • •

Lower the Cost of Borrowing Obtaining Funds: Depository institutions lower transaction costs of matching borrowers and lenders. Lower the Cost of Monitoring Borrowers: Depository institutions lower transaction costs by specializing in monitoring risky loans. Pool Risk: The costs of defaults on loans are spread across all depositors, instead of being borne by individual lenders.

What do banks do? Students usually have bank accounts, but often they have never fully thought through what banks do, how they do it, or what the differences are between banks and other deposit-taking institutions, so what tends to strike instructors as rather dry descriptive material can be interesting to students. It is worth being explicit about the fact, which students tend to be very aware of, that in practice commercial banks earn income not only by the spread between their deposit and lending rates, but also by charging fees for their services. The text focuses on the role of depository institutions as a source of credit © 2014 Pearson Education, Inc.

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creation; for most students, like most customers, their most important function is actually facilitating the payment process, and a little discussion on that (and how relatively cheap it is) can also engage students.

Financial Innovation •

The development of new financial products is called financial innovation. Some innovation has been a response to economic circumstances such as high inflation and high interest rates in the 1970s. Others, such communications networks which have spread the use of credit cards, are the result of advances in technology. Still others, such as sub-prime mortgages, were developed during the 2000s.

III. The Federal Reserve System The central bank of the United States is the Federal Reserve System. A central bank is a bank’s bank and a public authority that regulates a nation’s depository institutions and controls the quantity of money. The Fed conducts the nation’s monetary policy, which means that it adjusts the quantity of money in circulation. By adjusting the quantity of money, the Fed can change interest rates. Conspiracy theory of the Fed. Some students will have heard about a “conspiracy theory of the Fed.” This theory, advanced by the ignorant, the misinformed, or the deceitful, is that the commercial banks own the Fed, which is run solely to benefit the banks to ensure that they earn large profits. Point out that commercial banks do indeed own the Fed—they own all the stock issued by the Fed. But Fed stock is not like shares in General Electric or Microsoft. The dividend on the Fed’s stock is fixed at 6 percent of the purchase price, and the stock cannot be sold in a marketplace. So this stock is a lousy investment. What privileges come with the stock? Commercial banks elect six of the nine directors of their Federal Reserve Regional bank; each commercial bank has the same number of votes regardless of the amount of stock it owns. But the directors of the regional banks are hardly key players in the Federal Reserve System. Essentially, the most important task they perform is nominating a president for the regional bank. The regional banks’ presidents are important. The directors, however, do not get much freedom in this choice because their nominee must be approved by the Board of Governors, which does not hesitate to veto anyone considered unacceptable. Regional bank presidents gain their power from sitting on the FOMC. But there they are a minority because the voting members of the FOMC consist of five regional bank presidents and seven members of the Board of Governors. Because the board members are appointed by the president and approved by the Senate, the government thus wields the ultimate power in the Federal Reserve. The regional bank presidents must be approved by the publicly appointed board members and the board members constitute a majority on the FOMC.

The Structure of the Fed • • •

The Board of Governors has seven members, including the chairman (currently Ben Bernanke). There are 12 regional Federal Reserve banks. The Federal Open Market Committee (FOMC) is the main policy-making group of the Fed. It is comprised of the members of the Board of Governors and the Presidents of the regional Federal Reserve Banks. The Board of Governors, the President of the Federal Reserve Bank of New York, and, on a rotating basis, the presidents of four other regional Federal Reserve Banks, vote on monetary policy. In practice, the chairman has the largest influence on policy.

The Fed’s Balance Sheet • •

The Fed’s two main assets are U.S. government securities and loans to depository institutions. The Fed’s two main liabilities are Federal Reserve notes (currency) and banks’ deposits.

The Fed’s balance sheet changed dramatically as a result of the financial crisis in 2008: • On the asset side of its balance sheet, in 2007 the Fed had virtually no loans to depository institutions. However in October, 2008 the Fed had more loans to depository institutions than U.S. government © 2014 Pearson Education, Inc.

• •

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securities! Holdings of government securities fell from $800 billion to $500 billion while loans to depository institutions rose from near $0 to $1,000 billion. (Included in the $1,000 billion was $150 billion of “Term Auction Credit,” which enabled banks to swap risky private securities for high-quality government securities.) Loans to depository institutions fell to $70 billion in 2010 and $5 billion in 2012. On the liability side of its balance sheet, reserves of depository institutions skyrocketed. In 2007 these reserves were $44 billion but by October 2008 reserves rose to $650 billion. •

The monetary base is the sum of coins, Federal Reserve notes, and depository institution deposits at the Fed. The major parts of the monetary base, Federal Reserve notes and depository institution deposits, are liabilities of the Federal Reserve. Changes in the monetary base lead to changes in the quantity of money.

The Fed’s Policy Tools •

•

Required Reserve Ratios: The minimum percentage of deposits that depository institutions must hold as reserves are the required reserve ratios. The Fed sets the required reserve ratio. A decrease leads to an increase in the quantity of money and an increase leads to an increase in the quantity of money. Last Resort Loans: The Fed is the lender of last resort, which means that if depository institutions are short of reserves, they can borrow from the Fed. The interest rate charged on these loans is the discount rate. In 2008 the Fed changed its policy and encouraged depository institutions to borrow from it. A decrease in the discount rate leads to an increase in the quantity of money and an increase in the discount rate leads to a decrease in the quantity of money. Open Market Operation: An open market operation is the purchase or sale of government securities by the Federal Reserve System in the open market. The Fed does not directly purchase bonds from the federal government because it would appear that the government was printing money to finance its expenditures. An open market purchase leads to an increase in the money supply.

IV. How Banks Create Money Creating Deposits by Making Loans When a bank makes a loan, it makes a deposit to finance the loan. Because deposits are money, the bank has created money. For example, if you use a credit card to buy $50 at Walgreens, loans to you increase and Walgreens deposits increase. The increase in deposits increases the quantity of money. Three factors limit the amount of deposits that the banking system can create: •

•

The monetary base: Banks have a desired amount of reserves they want to hold and people have a desired amount of currency. The monetary base sets a limit on the sum of these two. Both of these desired holdings depend on the quantity of money, and so the monetary base limits the amount of money that can be created. Alternatively, the monetary base limits the amount of the banking systems’ reserves. Desired reserves: A bank’s actual reserves are the coin and currency in its vault and its deposits at the Federal Reserve. The fraction of a bank’s total deposits that are held in reserves is called the reserve ratio. The desired reserve ratio is the ratio of reserves to deposits that banks want to hold. Actual reserves minus desired reserves are excess reserves. Excess reserves can be loaned and can thereby create money. Desired currency holding: The other use of the monetary base involves the public’s holding it as currency. When banks create new money by creating new deposits, the public wants to hold some of this money as currency. As a result, currency leaves the banking system when banks increase their loans, which limits the overall increase in loans. The currency drain is the ratio of currency to deposits. Banks use excess reserves to make loans. In the process, banks create money. © 2014 Pearson Education, Inc.

MONEY, THE PRICE LEVEL, AND INFLATION

•

For each dollar deposited, a bank keeps a fraction as reserves and lends out the rest. When a bank makes a loan, it creates a new deposit (new money) equal to the value of the loan. After the loan is spent by the borrower, the new money eventually ends up back as a new deposit in a bank. As new deposits are made, the process of money creation begins again, albeit with a smaller amounts each time because banks keep a fraction of each deposit in the form of reserves. The total of amount of new money created by the entire banking system depends on the fraction of the deposits that banks loan at each step in the process.

The Money Creation Process • • •

• •

The monetary base increases and banks have excess reserves. Banks lend the excess reserves and thereby create new deposits, that is, create new money. The new money is used to make payments. Some of the new money remains in the banking system as deposits and some of it is drained out of the banking system via the currency drain. The funds that stay within the banking system are reserves for the banks. Because deposits have increased, banks’ desired reserves have increased. But the actual reserves have increased by more than desired reserves, so banks still have excess reserves to loan. Banks lend these excess reserves and the process continues. Eventually the money creation process comes to a stop when the sum of additional currency holdings plus additional desired reserves equals the initial increase in the monetary base and banks’ reserves. The money multiplier is the ratio of the change in the quantity of money to the change in the monetary base. It determines the change in the quantity of money that results from a given change in the monetary base. A change in the monetary base has a multiplied effect on the quantity of money because banks’ loans are deposited in other banks where they are loaned once again. The formula for the money multiplier is derived in the Mathematical Note to the chapter (see the end of these lecture notes).

A money creation experiment. The process through which banks “create money” can be a dark and mysterious secret to the students. Indeed, even though the text contains a superb description of the process, students still manage to end up confused. The first prerequisite to students understanding the process is that they be comfortable with balance sheets shown in the form of T-accounts, and it is well worth spending time on them to make sure students understand what they are and what they show. This will be the first time some students have ever had to interpret a balance sheet, and it is key that they understand that assets are what are owned, liabilities are what are owed, by the institution for which the balance sheet is constructed; and that the two sides must balance. Mark Rush (our study guide author and supplements czar) tackles the problem of getting students to understand bank money creation head-on by (again) involving the class in a demonstration. Prepare by decorating a piece of green paper with currency-like symbols. (For instance, Mark draws a seal and around it writes “In Rush We Trust.” You may write the same slogan, but substituting your name for his probably will be more effective; an alternative is to use “play money.”) Label this piece of paper a “$100 bill.” In class use one of the students by handing him the bill. Tell him that he has decided to deposit it in his bank and ask him his bank’s name. On the chalkboard draw a balance sheet for the bank with deposits of $100, reserves of $10, and loans of $90. Tell the students that the required reserve ratio is 10 percent, so this bank currently has no excess reserves. Now, instruct the student to deposit the money in his bank, which coincidentally happens to be run by the student next to him. Show the class what happens to the balance sheet and how the bank now has excess reserves of $90. Clearly the “banker” will loan these reserves to the next student in the class, who wants a $90 dollar loan so she can take a bus ride to some nearby dismal location. (Being located in Gainesville, Florida, Mark picks on the city of Stark, home to Florida’s electric chair and a town with an apt name.) When the loan © 2014 Pearson Education, Inc.

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takes place, rip the $100 bill so that only about nine tenths of it is given as the loan. This student pays the money to Greyhound—coincidentally the next student. Ask the name of Greyhound’s bank and draw an initial balance sheet for this bank identical to the initial balance sheet of the first bank. Greyhound deposits the money in the bank—the next student in the row. Work with the balance sheets to show what happens to the first bank and what happens to the second bank. Clearly the first one no longer has excess reserves but the second bank now has $81 of excess reserves ($90 of additional deposits minus $9 of required reserves). The second bank will make a loan, which you can act out with more students in the class, again ripping off nine tenths of the remaining bill. Work through the point where the second loan winds up deposited in a third bank and then stop to take stock. At this point the quantity of money has increased by $90 in the second bank and $81 in the third, for a total increase—so far—of $171. The students will see that this loaning and reloaning process is not yet over and that the quantity of money will increase by still more. Moreover (and more important) the students will grasp how banks “create money.”

MONEY, THE PRICE LEVEL, AND INFLATION

V. The Money Market A picky point. The textbook is careful to not use the term “money supply” in this chapter. Instead, it talks about the “quantity of money.” The term “money supply” is reserved for the relationship between the quantity of money and the interest rate, other things remaining the same. It parallels the demand for money. Although this point might seem picky, you can help your students by using this same language convention.

The Influences on Money Holding The demand for money refers to the choice to hold an inventory of money, not to the desire to receive money. The quantity of money that people plan to hold depends on: •

• • •

The Price Level: The quantity of nominal money demanded is proportional to the price level so that, for example, when the price level doubles, the quantity of nominal money demanded doubles. • Real money is the quantity of money measured in constant dollars and equals nominal money divided by the price level. The quantity of real money demanded is independent of the price level. The Nominal Interest Rate: The nominal interest rate is the opportunity cost of holding money, so an increase in the nominal interest rate decreases the quantity of real money demanded. Real GDP: An increase in real GDP increases the quantity of money people plan to hold. Financial Innovation: Some financial innovation decreases the quantity of money people plan to hold (ATM machines) and other financial innovation increases it (interest paid on checking accounts).

The Demand for Money Curve The demand for money curve is the relationship between the quantity of real money demanded and the interest rate, holding all else equal. As the figure shows, the negative relationship between the interest rate and the quantity of money demanded means the demand for money curve is downward sloping.

Shifts in the Demand for Money Curve •

A change in real GDP or financial innovation changes the demand for money and shifts the demand for money curve. An increase in real GDP increases the demand for money and shifts the demand for money curve rightward.

The Demand for Money Students are often confused by the phrase “demand for money” and it is worth tackling it head-on by emphasizing this does not equate to “wanting to be rich,” but refers to how much of total wealth (assets) the public want to hold in the particular form of “money.” Students often find it straightforward to think about their behavior and the quantity of cash they hold in their wallet when dealing with the factors that change the demand for money and shift the demand for money curve. But they frequently get confused about the effect the interest rate has on the quantity of money demanded, probably because their holdings of money are not large. So tell your students to imagine themselves in the job of treasurer of a corporation with large liquid resources and to think how their behavior with respect © 2014 Pearson Education, Inc.

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to those funds might differ according to the short-term interest rates available on non-money alternatives, such as bonds. It is easier for them to see that a treasurer will surely shift $5 million dollars into nonmoney assets in order to reap the higher interest-rate reward when the interest rate rises.

Money Market Equilibrium Money market equilibrium occurs when the quantity of money demanded equals the quantity of money supplied. The quantity of money supplied is determined by the Federal Reserve. •

•

Short Run: On any given day, the quantity of real money is fixed, so the supply of money curve is vertical. The nominal interest rate adjusts to establish equilibrium in the money market. The equilibrium nominal interest rate equates the quantity of real money demanded with the fixed quantity of real money. In the figure, the equilibrium interest rate is 5 percent. The Short-Run Effect of a Change in the Supply of Money: Starting from a short-run equilibrium, if the Fed increases the quantity of money, people hold more money than the quantity demanded. With a surplus of money holding, people enter the loanable funds market and buy bonds. The increase in demand for bonds raises the price of a bond and lowers the interest rate. Long Run: In the long run, supply and demand in the loanable funds market determines the equilibrium real interest rate. That, plus the expected inflation rate determines the nominal interest rate, so the nominal interest rate cannot adjust to restore equilibrium in the money market. The factor that adjusts in the long run is the price level: The price level adjusts to make the real quantity of money equal to the real quantity of money demanded. In the long run, an increase in the quantity of money raises the price level by the same proportion.

VI. The Quantity Theory of Money • • •

•

The quantity theory of money is the proposition that in the long run, an increase in the quantity of money brings an equal percentage increase in the price level. The velocity of circulation is the average number of times a dollar of money is used annually to buy the goods and services that make up GDP. Nominal GDP equals real GDP, Y, multiplied by the price level, P, or GDP=PY. So the velocity of circulation, V, is given by V = PY/M. The equation of exchange states that the quantity of money, M, multiplied by the velocity of circulation, V, equals GDP: MV = PY. The equation of exchange is a definition and so is always true. It becomes the quantity theory of money by adding two assumptions: • The velocity of circulation is not influenced by the quantity of money. • Potential GDP is not influenced by the quantity of money. The equation of exchange can be rearranged as P = M(V/Y). This equation, together with the assumptions about velocity and potential GDP, implies that in the long run, the price level is determined by the quantity of money. • In growth rates, the equation of exchange is: (Money growth rate) + (Growth rate of velocity) = (Inflation rate) + (Real GDP growth rate). Rearranging this equation gives (Inflation rate) = (Money growth rate) + (Growth rate of velocity) − (Real GDP growth rate). If velocity does not grow, then in the long run the inflation rate equals the growth rate of the quantity of money minus the growth rate of potential GDP.

MONEY, THE PRICE LEVEL, AND INFLATION

Historical Insight. When Milton Friedman’s quantity theory of money was brought to the attention of policymakers during the 1960s, he was labeled an ivory tower academic with his head in the clouds. When his predictions of inflation came true in the 1970s, he was crowned king of monetary theory.

Evidence on the Quantity Theory of Money The predictions of the quantity theory can be tested using evidence on money growth and inflation across time. On the average, the money growth rate and the inflation rate are correlated, supporting the quantity theory. The predictions of the quantity theory also can be tested using the evidence on money growth and inflation across countries. As predicted, rapid money growth is correlated with high inflation. The idea that growth in the quantity of money causes inflation sounds obvious enough to students that they might miss just how controversial the idea is, at least outside of the economics profession. In an economy suffering from inflation, many observers blame “special circumstances,” such as hikes in the price of oil, bad crop harvests, import prices, or whatever. Economists from the central bank often lend their support to these assertions. The fact that central bank employees wish to divert attention away from their role in creating inflation is understandable if not commendable. But why do other observers go astray? Most often it is because they look at only their economy and do not consider what data from other economies indicates or data from their own economy over a long period of time shows. When looking at only one economy and one time period, it is always possible to find some price-increasing factor other than growth in the quantity of money and blame inflation on it. But when looking across economies or across time, the paramount role growth in the quantity of money plays in creating inflation is immediately apparent. So, contrary to the assertions emanating from the central banks and other analysts in nations with high inflation, almost surely their inflation is the result of high monetary growth and not some other “special, unique to them, unique to this time period circumstance!”

MATHEMATICAL NOTE The mathematical note derives the formula for the money multiplier. •

Money is M, deposits is D, and currency is C. M=D+C

•

The monetary base is MB and banks’ reserves is R. MB = C + R

•

The money multiplier, mm, is equal to mm = M/MB = (D + C)/(R + C)

•

Divide all the variables on the right side of the money multiplier equation by D: mm = (1 + C/D)/(R/D + C/D)

• •

C/D is the currency drain ratio and R/D is the banks’ reserve ratio. The formula shows that the size of the money multiplier depends on the reserve ratio and the currency drain. In 2008, when times were more “normal,” for M1 the currency drain ratio, C/D, was equal to 1.24 1 + 1.24 and the reserve ratio, R/D, was equal to 0.28, so the money multiplier for M1 was = 0.28 + 1.24 1.47. In 2008, for M2 the currency drain ratio was equal to 0.12 and the reserve ratio was equal to 1 + 0.12 0.03, so the money multiplier for M2 was = 7.5. 0.03 + 0.12 In 2012, when banks are holding substantially more reserves than in past decades, for M1 the currency drain ratio, C/D, is equal to 0.87 and the reserve ratio, R/D, is equal to 1.26, so the money

•

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multiplier for M1 was

1 + 0.87 1.26 + 0.87

= 0.88. In 2012, for M2 the currency drain ratio is equal to 0.12

and the reserve ratio is equal to 0.17, so the money multiplier for M2 was

1 + 0.12 0.17 + 0.12

= 3.86.

MONEY, THE PRICE LEVEL, AND INFLATION

Additional Problems 1.

Higher Reserve Requirement China’s central bank raised its reserve ratio requirement by one percentage point to 17.5 percent by June 25. China’s action was an attempt to decrease lending growth. People’s Daily Online, June 11, 2008 a. Compare the required reserve ratio in China and in the United States. d. Explain how raising the required reserve ratio changes the interest rate in the short run and draw a graph to illustrate the change.

In Zimbabwe the growth rate of the quantity of money increased from 52 percent a year to 66,700 percent a year in 2007. Accordingly the inflation rate in Zimbabwe skyrocketed, from 56 percent a year in 2000 to 24,000 percent a year in 2007. The growth rate of real GDP between these years is harder to measure but was probably −30 percent per year. a. How do we know that Zimbabwe’s reported inflation between 2003 and 2007 is almost certainly below the true inflation rate? b. What must be done to stop Zimbabwe’s inflation? c. Zimbabwe’s government frequently responded to its inflation by changing its currency to “knock off” zeros on the currency. At one point it was proposed to knock off ten zeros from the currency (so that an old 10,000,000,000 denomination bill would become a new 1 domination bill). Why will knocking ten zeroes off all prices not stop Zimbabwe’s inflation?

Solutions to Additional Problems 1.

The required reserve ratios in China are much higher than those set by the Federal Reserve. The required reserve ratio is 17.5 percent in China. In the United States, the required reserve ratio is 3 percent of checking deposits between $10.3 million and $44.4 million and 10 percent of these deposits in excess of $44.4 million. The required reserve ratio on other types of deposits is zero. Figure 8.1 shows the effect of the boost in the required reserve ratio. The increase in the required reserve ratio decreases the quantity of money supplied and the money supply curve shifts leftward from MS0 to MS1. As a result, the interest rate rises, in the figure from 4 percent to 6 percent.

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b. c.

We know that the reported inflation rate is too low because the velocity of circulation calculated with it fell. The (true) velocity of circulation rises during hyperinflations as people strive to spend money as rapidly as possible. If the true velocity of circulation rose, then the true inflation rate is higher (probably much higher) than the reported inflation rate. To stop Zimbabwe’s inflation, the central bank must stop or drastically lower the growth rate of the quantity of money. Knocking ten zeros off of all prices will not stop Zimbabwe's inflation because it just changes the units in which prices are measured. Prices will continue to grow as long as the quantity of money grows.

Additional Discussion Questions 11. Why is the use of money in the exchange of goods and services less costly than using barter? Barter requires a “double coincidence of wants.” For instance, suppose the first person has good A and wants good B. The person must find a second person with good B and who wants good A. Barter requires that the first person must undertake costly search for his or her trade partner. Use of money, on the other hand, breaks the necessity for the double coincidence of wants. The first person who has good A and wants good B can trade with anyone who wants good A and has money. After exchanging good A for money, the first person can now search for anyone who has good B and wants something else. That person will be willing to accept money in exchange for his or her good B because that person knows that the money can then be exchanged for whatever he or she wants. Therefore money has eliminated the need for the time-consuming and costly search needed with barter. 12. “Everyone knows that true money is issued by the government; that is, the only real form of money is the nation’s currency.” Comment on this assertion. This assertion is false. Money is anything that can be used as a medium of exchange. Funds in checking accounts clearly qualify because they can be used as a medium of exchange. Therefore funds in checking accounts are definitely money. Other sources of funds, such as funds in savings accounts, also come close to be money because they can be used with only slight difficulty as a medium of exchange. Therefore money includes many assets beyond governmentissued currency. 13. Define the monetary base. The monetary base is equal to the sum of coins, Federal Reserve notes, and depository institutions’ deposits at the Federal Reserve. Except for coins, which are a small part of the monetary base, the monetary base is made up of liabilities of the Federal Reserve. 14. “Ask anyone if he or she has enough money. No one ever has enough money, that is, everyone demands more money. Thus theorizing about the demand for money makes no sense because this demand obviously is infinite.” Correct and comment on the error in this assertion. This assertion makes a fundamental error by confusing money with income. Money is M1. The demand for money is the amount of M1 people want to hold. People have a finite amount of M1 that they want to hold; that is, no one wants to hold an infinite amount of M1. Income, however, is a different story: people would like to receive infinite income because that means that they could have infinite consumption. But infinite income is not the same as holding an infinite quantity of M1! 15. If the price level was already doubling every month and inflation accelerating, what would you expect to happen to the velocity of circulation and why? How close would you expect the relation between the quantity of money and the price level to be? The velocity © 2014 Pearson Education, Inc.

MONEY, THE PRICE LEVEL, AND INFLATION

of circulation would increase. People would try to spend the money they receive as rapidly as possible in order to avoid suffering the loss that comes from higher prices. In this case, which occurs in hyperinflations, the inflation rate exceeds the growth rate of the quantity of money. In a hyperinflation with accelerating inflation, the inflation rate equals the growth rate of the quantity of money plus the growth rate of velocity. 16. How does a currency drain affect the money multiplier? [Requires Mathematical Note] A currency drain decreases the magnitude of the money multiplier. The money multiplier exists because some of the proceeds of the loans that one bank makes are deposited in other banks where it can be loaned once again. The more of the proceeds that are deposited in banks, the larger will be the next round of loans and hence the larger will be the money multiplier. A currency drain decreases the amount of the loans that is deposited back in banks. Because the faction of the loans that is deposited is less, the ultimate increase in the quantity of money—and hence the money multiplier—is smaller.

C h a p t e r

THE EXCHANGE RATE AND THE BALANCE OF PAYMENTS**

The Big Picture Where we have been: Chapter 9 is the last of four that examine the long-run trends of the economy. It uses the quantity theory result from Chapter 8 that in the long run, the price level is determined by the quantity of money. This result is used to show that in the long run, the nominal exchange rate is determined by the quantities of money in the two countries. Chapter 9 also uses the national income accounting identities introduced in Chapter 4 when explaining the balance of payments and, quite importantly, the demand and supply model of Chapter 3 when explaining short-run fluctuations in the exchange rate. Where we are going: Chapter 9 is the last of the “long-run chapters.” The next section looks at short-run fluctuations. Chapter 10, with its introduction of the aggregate supply/aggregate demand model, is key to understanding short run business cycle fluctuations. The material in this chapter is not prominently featured in future chapters, though it makes a slight recurrence in Chapter 14 when monetary policy is covered. Chapter 15, on International Trade, does not use the material in this chapter.

New in the Eleventh Edition This chapter is substantially the same as the tenth edition. The interview with Xavier Sala-iMartin has been reduced to one page with the full interview in MyEconLab. I recommend that you read the full interview as it has lots of great commentary that you can discuss in lecture. The chapter has been updated by bringing the data and figures up to date. The Reading Between the Lines article is new covering the dollar’s recent depreciation against the Euro and issues surrounding the debt crisis in Europe. There are seven updated and two new problems in the Study Plan Problems and Applications replacing some older headlines with more current material. The same was done in Additional Problems and Applications with four updated and three new problems.

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Lecture Notes

The Exchange Rate and the Balance of Payments • • •

International trade, borrowing, and lending, make it necessary to exchange currencies and the foreign exchange value of the dollar is determined in the foreign exchange market. The exchange rates for currencies are determined by supply and demand in the foreign exchange market. When a nation trades with other nations, the country’s balance of payments records the transactions.

The Foreign Exchange Market

Trading Currencies •

International trade, borrowing, and lending, make it necessary to exchange currencies. Foreign currency is the money of other countries regardless of whether that money is in the form of notes, coins, or bank deposits. The foreign exchange market is the market in which the currency of one country is exchanged for the currency of another. The price at which one currency exchanges for another is called the exchange rate.

Exchange rates: Exchange rates are always somewhat confusing. The problem is that there are two ways to express an exchange rate: It can be expressed as the units of foreign currency per U.S. dollars (84 yen per U.S. dollar) or as U.S. dollars per unit of foreign currency (1.28 U.S. dollars per Euro). Tell this fact to the students. But, because the textbook is consistent in using the exchange rate as the units of foreign currency per U.S. dollars, stick to the “84 yen per dollar” format in your lectures. This also makes it easier for graphing and for the discussion about appreciation or depreciation. A change from 84 to 94 yen per dollar is dollar appreciation and shown by an increase along the vertical axis. •

Over time, the U.S. dollar appreciates and depreciates against other currencies such as the Japanese yen or European euro. Currency depreciation is the fall in the value of one currency in terms of another currency. Currency appreciation is the rise in the value of one currency in terms of another currency. • A rise in the U.S. exchange rate is called an appreciation of the dollar; a fall in the U.S. exchange rate is called a depreciation of the dollar.

The Demand for One Money is the Supply of Another Money The exchange rate is determined by demand and supply in the (competitive) foreign exchange market. When people holding the money of some other country want to exchange it for U.S. dollars, they supply the other currency and demand dollars. When people holding U.S. dollars want to buy the currency of some other country, they supply U.S. dollars and demand the other currency.

Demand in the Foreign Exchange Market The main factors that influence the dollars that people plan to buy in the foreign exchange market are the exchange rate, world demand for U.S. exports, interest rates in the United States and other countries, and the expected future exchange rate. •

The law of demand in the foreign exchange market is: Other things remaining the same, the higher the exchange rate, the smaller is the quantity of dollars demanded in the foreign exchange market. There are two reasons for the law of demand: • Exports Effect: Dollars are used to buy U.S. exports. The lower the exchange rate, with everything else the same, the cheaper are U.S. exports so the greater the quantity of dollars demanded on the foreign exchange market to pay for the exports. © 2014 Pearson Education, Inc.

THE EXCHANGE RATE AND THE BALANCE OF PAYMENTS

• •

Expected Profit Effect: The lower the exchange rate, with everything else the same (including the expected future exchange rate), the larger the expected profit from buying dollars so the greater the quantity of dollars demanded on the foreign exchange market. The law of demand means that the demand curve for U.S. dollars is downward sloping, as illustrated in the figure below.

Supply in the Foreign Exchange Market The main factors that influence the dollars that people plan to sell in the foreign exchange market are the exchange rate, U.S. demand for imports, interest rates in the United States and other countries, and the expected future exchange rate. •

•

The law of supply in the foreign exchange market is: Other things remaining the same, the higher the exchange rate, the greater is the quantity of dollars supplied in the foreign exchange market. There are two reasons for the law of supply: • Imports Effect: Dollars are used to buy U.S. imports. The higher the exchange rate, with everything else the same, the cheaper are foreign produced imports so the greater the quantity of dollars supplied on the foreign exchange market to buy these imports. • Expected Profit Effect: The higher the exchange rate, with everything else the same (including the expected future exchange rate), the smaller the expected profit from holding dollars so the larger the quantity of dollars supplied on the foreign exchange market. The law of supply means that the supply curve for U.S. dollars is upward sloping, as shown in the figure.

Market Equilibrium •

Demand and supply in the foreign exchange market determine the exchange rate. In the figure, the equilibrium exchange rate is 100 yen per dollar, where the demand and supply curves intersect. • If the exchange rate is higher than the equilibrium exchange rate, a surplus of dollars drives the exchange rate down. • If the exchange rate is lower than the equilibrium exchange rate, a shortage of dollars drives the exchange rate up. • The market is pulled to the equilibrium exchange rate at which there is neither a shortage nor a surplus.

II. Exchange Rate Fluctuations Changes in the Demand for U.S. Dollars •

A change in any relevant factor other than the exchange rate changes the demand for dollars and shifts the demand curve for dollars. • World Demand for U.S. Exports: An increase in the world demand for U.S. exports increases the demand for U.S. dollars because U.S. producers must be paid in U.S. dollars. The demand curve for U.S. dollars shifts rightward. • U.S. Interest Rate Differential: The U.S. interest rate differential is the U.S. interest rate minus the foreign interest rate. The larger the U.S. interest rate differential, the greater is the demand for U.S. assets and the greater is the demand for U.S. dollars on the foreign exchange market. An increase in the U.S. interest rate differential shifts the demand curve for U.S. dollars rightward. © 2014 Pearson Education, Inc.

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•

Expected Future Exchange Rate: The higher the expected future exchange rate, the greater is the expected profit from holding U.S. dollars. As a result, the demand for U.S. dollars increases and the demand curve shifts rightward.

Changes in the Supply of U.S. Dollars •

A change in any relevant factor other than the exchange rate changes the supply of dollars and shifts the supply curve of dollars. • U.S. Demand for Imports: An increase in the U.S. demand for imports increases the supply of U.S. dollars because U.S. importers offer U.S. dollars in order to buy the foreign currency necessary to pay foreign producers. The supply curve of U.S. dollars shifts rightward. • U.S. Interest Rate Differential: The larger the U.S. interest rate differential, the greater is the demand for U.S. assets and the smaller is the supply of U.S. dollars on the foreign exchange market. An increase in the U.S. interest rate differential shifts the supply curve for U.S. dollars leftward. • Expected Future Exchange Rate: The higher the expected future exchange rate, the greater is the expected profit from holding U.S. dollars. As a result, the supply of U.S. dollars decreases and the supply curve shifts leftward.

Emphasize that the quantity of dollars measured on the horizontal axis are only dollars that are being offered for foreign exchange, not the entire quantity of money as we learned in Chapter 8.

Changes in the Exchange Rate The exchange rate changes when the demand for and/or the supply of foreign exchange change. •

When the expected future U.S. exchange rate increases, the demand for U.S. dollars increases and the supply decreases. As the figure shows, the demand curve shifts rightward, from D0 to D1, and the supply curve shifts leftward, from S0 to S1. The exchange rate rises, in the figure from 108 yen per dollar to 127 yen per dollar, and quantity traded does not change by much, indeed in the figure it does not change at all. Such changes took place between 2005 and 2007 when the Federal Reserve raised the interest rate in the United States while the Japanese interest rate did not change.

Exchange Rate Expectations •

Exchange rate expectations depend on deeper economic forces that influence the value of money: • Interest Rate Parity: Interest rate parity, which means equal rates of return, is the idea that the real interest on equally risky assets is the same in different countries. Adjusted for risk, interest rate parity always prevails. Market forces achieve interest rate parity very quickly.

Interest Rate Parity. Be sure that your students appreciate interest rate parity. There are many horror stories of people losing their shirts by misunderstanding interest rate parity. One story concerns the once wealthy Catholic Church of Australia that decided to borrow in Japan at a low interest rate and lend the proceeds of its borrowing in Australia at higher interest rates. When the Australian dollar nosedived against the Japanese yen, the church struggled to repay its loans. Interest rate parity always holds. Interest

THE EXCHANGE RATE AND THE BALANCE OF PAYMENTS

rates might look unequal, but the market expectation of the change in the exchange rate equals the gap between interest rates. It is a foolish person (or organization) that acts as if it can beat the market. •

Purchasing Power Parity: Purchasing power parity, which means equal value of money, is the idea that, at a given exchange rate, goods and services should cost the same amount in different countries. Purchasing power parity is an important force affecting prices and exchange rates in the long run and influences exchange rate expectations.

If one U.S. dollar exchanges for 1.33 Canadian dollars, then purchasing power parity is attained when one U.S. dollar buys the same quantity goods and services in the United States as 1.33 Canadian dollars buys in Canada. • If one U.S. dollar buys more goods and services in the United States than 1.33 Canadian dollars buy in Canada, people will expect that the U.S. dollar will eventually appreciate. • Similarly, if one U.S. dollar buys less goods and services in the United States than 1.33 Canadian dollars buy in Canada, people will expect that the U.S. dollar will eventually depreciate. The Economist reports a Big Mac Index that uses the prices of McDonald’s Big Macs and purchasing power parity to make predictions about exchange rate movements. The index is somewhat tongue-in-cheek as it would be hard to arbitrage differences in Big Mac prices by taking a Big Mac on a plane from, say, Japan to the United States. However, it is easier to arbitrage the inputs into Big Macs such as beef. Thus, one might still expect some convergence of Big Mac prices over time. The Economist claims some success in its exchange rate predictions. Purchasing Power Parity. You can easily get your students to test purchasing power parity. Have them check the prices of some well-known DVDs at amazon.com and at amazon.co.uk, get the latest exchange rate for the U.S. dollar and the U.K. pound, and see whether it is cheaper to buy a given DVD in the United States or the United Kingdom. •

The exchange rate market responds instantly to news about changes in the factors that influence the demand and supply in the foreign exchange market.

The Real Exchange Rate •

The nominal exchange rate is the value of the U.S. dollar expressed in units of foreign currency per U.S. dollar. It tells how many units of a foreign currency one U.S. dollar buys. The real exchange rate is the relative price of U.S-produced goods and services to foreign-produced goods and services. It tells how many units of foreign GDP one unit of U.S. GDP buys. The real exchange rate, RER, is equal to

RER = (E  P)/P* where E is the nominal exchange rate, P is the U.S. price level, and P* is the foreign price level.

The Nominal and Real Exchange Rates in the Short Run and in the Long Run Nominal and real exchange rates are linked by the equation RER = E  (P/P*). •

•

Short Run: In the short run, this equation determines the real exchange rate. The nominal exchange rate is determined in the foreign exchange market by the supply and demand for dollars. Price levels do not change rapidly and so any change in the nominal exchange rate translates into a change in the real exchange rate. Long Run: In the long run, rewrite the equation as E = RER  (P*/P). In the long run, the real exchange rate is determined by the supply and demand for imports and exports and the price level in each nation is determined by the quantity of money in that nation. So in the long run, a change in the quantity of money changes the price level and thereby changes the nominal exchange rate. This result means that in the long run, the nominal exchange rate is a monetary phenomenon. Chapter 8 © 2014 Pearson Education, Inc.

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showed that in the long run, the quantity of money determines a nation’s price level, so the nominal exchange rate is determined by the quantities of money in the two countries.

III. Exchange Rate Policy Because the exchange rate is the price of a country’s money, governments and central banks must have a policy toward the exchange rate. Three possible exchange rates policies are.

Flexible Exchange Rate •

A flexible exchange rate policy permits the exchange rate to be determined by demand and supply with no direct intervention by the central bank. Even so, the exchange rate is influenced by the central bank’s actions. For instance, if the Fed raises the U.S. interest rate, the U.S. interest rate differential increases, which appreciates the U.S. exchange rate. Most countries, including the United States, have flexible exchange rates.

Fixed Exchange Rate •

A fixed exchange rate policy pegs the exchange rate at a value determined by the government or the central bank and blocks the unregulated forces of supply and demand by direct intervention in the foreign exchange market. A fixed exchange rate requires direct and frequent intervention by the central bank. • If the demand for dollars decreases or the supply of dollars increases, to fix the exchange rate the Fed buys U.S. dollars. By so doing the Fed increases the demand for dollars and raises the exchange rate. But the Fed cannot pursue this policy forever because it eventually will run out of the foreign reserves it is using to purchase the dollars. • In the figure the demand for dollars has decreased from D0 to D1. To keep the exchange rate fixed at 100 yen per dollar, the Fed needs to buy 2 billion dollars per day, the difference between the quantity of dollars supplied at the fixed exchange rate (7 billion dollars per day) and the [new] quantity of dollars demanded (5 billion dollars per day). To purchase these dollars the Fed must use its foreign reserves. Ultimately the Fed will run out of foreign reserves and when that takes place the Fed can no longer peg the exchange rate at 100 yen per dollar. • If the demand for dollars increases or the supply of dollars decreases, with no intervention the exchange rate will rise. To fix the exchange rate the Fed sells U.S. dollars so that it increases the supply of dollars and lowers the exchange rate. But the Fed will accumulate large stocks of the foreign reserves it is accepting in payment for the dollars. The People’s Bank of China pursued such a policy to hold down the value of the yuan and while so doing accumulated billions of dollars of U.S. dollars.

Crawling Peg •

A crawling peg policy selects a target path for the exchange rate with intervention in the foreign exchange market to achieve that path. A crawling peg works like a fixed exchange rate only the target value changes. The target changes whenever the central bank changes. China is now currently using a crawling peg exchange rate policy for the yuan.

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The People’s Bank of China in the Foreign Exchange Market •

• •

From 1997 until 2005, the People’s Bank of China fixed the Chinese exchange rate by selling yuan and buying dollars to offset the effects of increases in the demand for yuan. China accumulated foreign currency reserves of almost $1 trillion by mid-2006, and by the end of 2007 was fast approaching $2 trillion. Since 2005, the People’s Bank has allowed the yuan to crawl upward. Even so the yuan has not risen to its equilibrium level, hence the People’s Bank must buy U.S. dollars to hold the yuan/dollar exchange rate down. China most likely fixed its exchange rate to anchor its inflation rate so that it does not deviate much from the U.S. inflation rate. The Chinese inflation rate departs from the U.S. inflation rate by an amount determined by the speed of the crawl.

IV. Financing International Trade Balance of Payments Accounts •

•

A country’s balance of payments accounts records its international trading, borrowing, and lending. There are three balance of payments accounts: • The current account records payments for imports of goods and services from abroad, receipts for exports of goods and services sold abroad, net interest income paid abroad, and net transfers (such as foreign aid payment). The current account balance equals exports plus net interest income plus net transfers minus imports. • The capital account records foreign investment in the United States minus U.S. investment abroad. Any statistical discrepancy is included in this account. • The official settlements account records the change in U.S. official reserves, which are the government’s holdings of foreign currency. An increase in foreign reserves corresponds to a negative official settlements account balance. This occurs because holding foreign currency is like (but not the same as) investing abroad, which is a negative entry in the capital account. The sum of the balances always equals zero:

current account + capital account + official settlements account = 0.

•

In 2010, the U.S. current account balance was negative and entirely offset by a positive capital account balance. Over time, the current account balance tends to mirror the capital account balance because the official settlements account balance is small.

Borrowers and Lenders, Debtors and Creditors Because of current account deficits and surpluses, countries, like individuals, can be borrowers or lenders. •

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A country that is borrowing more from the rest of the world than it is lending to it is a net borrower. A net lender is a country that is lending more to the rest of the world than it is borrowing from the rest of the world. The United States currently is net borrower. Being a net borrower is not a problem provided the borrowed funds are used to finance capital accumulation that increases income. Being a net borrower is a problem if the borrowed funds are used to finance consumption. A debtor nation is a country that during its entire history has borrowed more from the rest of the world than it has lent to it. A creditor nation is a country that during its entire history has invested more in the rest of the world than other countries have invested in it. The United States currently is debtor nation. • The net borrower/net lender difference refers to the current flow of borrowing or lending over a period of time. The debtor nation/creditor nation refers to the stock of debt or foreign assets that exists at a moment in time.

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The analogy of a country being like an individual in terms of being a borrower or lender is revealing. However, you may want to point out a big difference in lifespan. Long periods of deficit seem bad for an individual, but are short when you are expected to live forever. Much economic activity and development would be impossible without borrowing and lending. This is true at the individual level and for countries. The key is what the debt is being spent on. The United States financed its industrialization and railroads in the nineteenth century by being a debtor nation.

Current Account Balance and Net Exports •

The current account balance (CAB) is:

CAB = X − M + Net interest income + Net transfers • •

•

The main item in the current account balance is net exports (X − M). The other two items are much smaller and don’t fluctuate much. The national accounts show that Y = C + I + G + X − M and also that Y = C + S + T. These two relationships can be equated and rearranged to give (X − M) = (S − I) + (T − G). In this formula, • (X − M) is net exports, exports of goods and services minus imports of goods and services. • (S − I) is the private sector balance, saving minus investment. • (T − G ) is the government sector balance, net taxes minus government expenditures on goods and services. The formula shows that net exports equal the sum of the private sector balance and the government sector balance. There is a strong tendency for the private sector balance and the government sector balance to move in opposite directions, which means that the relationship between net exports and the other two sectors taken individually is not a strong one.

Where Is the Exchange Rate? •

In the short run, a change in the nominal exchange rate changes the real exchange rate and affects the U.S. current account balance. In the long run, a change in the nominal exchange rate leaves the real exchange rate unaffected and so in the long the nominal exchange rate plays no role in determining the current account balance.

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Additional Problems 1.

The Dollar’s Short-Lived Comeback The dollar fell to record lows against the euro in April. Over the next month the exchange rate rose because traders began to expect that the Federal Reserve was not going to cut U.S. interest rates any further. CNN, May 16, 2008 Explain how expectations that the Federal Reserve will not cut the interest rate can make the dollar appreciate.

Suppose that traders in the foreign exchange market come to believe that the U.S. exchange rate will rise over the next few months. How does this belief affect the demand for U.S. dollars and the supply of U.S. dollars? What is the impact of this belief on the current exchange rate? Draw a graph of the foreign exchange market to illustrate your answer.

A country has a lower inflation rate than all other countries. It has more rapid economic growth. The central bank does not intervene in the foreign exchange market. What can you say (and why) about: a. The exchange rate? b. The current account balance? c. The expected exchange rate? d. The interest rate differential? e. Interest rate parity? f. Purchasing power parity?

Solutions to Additional Problems 1.

If traders come to believe that the Federal Reserve will not cut interest rates, the interest rate in the future will be higher than previously expected. With the higher future U.S. interest rate, the future U.S. interest rate differential will also be higher. In turn, the higher future U.S. interest rate differential will raise the future U.S. exchange rate. Finally, the expected higher future U.S. exchange rate increases the current demand for U.S. dollars and decreases the current supply, thereby raising the current exchange rate and appreciating the dollar.

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The rise in the expected future exchange rate increases the expected profit from holding dollars. The increase in expected profit increases the current demand for U.S. dollars and decreases the current supply of U.S. dollars. The current exchange rate rises. Figure 9.1 shows the effect on the foreign exchange market of the change in traders’ beliefs. The demand increases so the demand curve for dollars shifts rightward from D0 to D1. The supply curve of dollars shifts leftward from S0 to S1. The dollar immediately appreciates, rising in the figure from 110 yen per dollar to 120 yen per dollar.

a. b.

c. d. e. f.

The exchange rate most likely rises—the currency appreciates. The reason is that to preserve purchasing power parity, the lower inflation rate means that the currency must appreciate. The current account balance depends on domestic investment relative to national saving. The balance could be positive or negative. Possibly with more rapid growth, investment in the country is high and so the current account might be in deficit. The exchange rate will be expected to appreciate so the expected future exchange rate is higher than the current exchange rate. The interest rate differential is negative. The interest rates in other countries exceed the domestic interest rate by an amount equal to the expected exchange rate appreciation. Interest rate parity holds every day. If it did not, large above-average profits would be available. Such profit opportunities do not go unexploited. Purchasing power parity probably doesn’t hold every day, but does hold on the average in the long run.

Additional Discussion Questions 1.

In 2007−2008, the nominal exchange rate of U.S. dollars declined relative to both the Japanese yen and the European euro. What would you need to know about the U.S. economy to determine whether this would be a benefit or a problem for the U.S. economy? Point out that the United States was just starting to enter a recession in 2008, as potentially was Japan and most of Europe. The Federal Reserve was ahead of other central banks in responding to the recession by lowering the interest rate before the other central banks took action. By lowering the U.S. interest rate, the U.S. interest rate differential decreased, which decreased the demand for U.S. dollars, increased the supply of U.S. dollars, and forced the exchange rate lower. By lowering the U.S. exchange rate, U.S. exports increased, which helped keep the U.S. economy stronger than otherwise would have been the case.

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interest rates in the U.S. financial markets and lowering the cost of employing productive capital. What impact did this policy have on the exchange rates in the foreign exchange markets, all else equal? The fall in U.S. interest rates means that the U.S. interest rate differential falls. The fall in the interest rate differential increases the supply of dollars to the foreign currency exchange market, shifting the supply curve of dollars rightward. It also decreases the demand for dollars, shifting the demand curve for dollars leftward. With no other changes, the equilibrium exchange rate for dollars falls. As it happened, however, other factors were not equal. In late 2008 other central banks also lowered their interest rates. And apparently investors believed that the United States had less default risk than other countries. So on net the demand for dollars actually increased and the supply decreased so that the U.S. exchange rate rose. But the increase would have been significantly greater had it not been for the actions of the Federal Reserve. 3.

In part due to the recession of 2008, the U.S. government budget changed from a smaller deficits to larger deficits. What impact would this have on the net exports and private sector balances, all else equal? The three balances are related: Net exports equal the sum of government and private sector balances. If the private sector balance does not change, the net export deficit will increase. However if the public sector surplus were to increase substantially, the net export deficit might decrease.

C h a p t e r

AGGREGATE SUPPLY AND AGGREGATE DEMAND**

The Big Picture Where we have been: This chapter provides the work horse model, the aggregate supply-aggregate demand model, used to explore answers to the questions about short-run macroeconomic issues. The chapter uses the fact established in Chapter 4, that expenditure equals C + I + G + (X – M), to explain the forces that determine aggregate demand. It also draws on Chapter 3, demand and supply, for the crucial concepts of equilibrium and the distinction between shifts and movements along demand and supply curves. Where we are going: This chapter provides a description of the AS-AD model. The treatment parallels that of the demand and supply model in Chapter 3. That is, the curves are defined and the reasons for their slopes and the factors that shift them are explained. But the curves are not formally derived. The next chapter more formally derives the aggregate demand curve from the aggregate expenditure curve. It lays out the aggregate expenditure model, explains the multiplier effect of changes in investment, describes the adjustment process that moves the economy toward the AD curve, and derives the AD curve from the AE equilibrium. Then Chapters 12, 13, and 14 make use of the aggregate supply-aggregate supply framework to explore business cycles and inflation, fiscal policy, and monetary policy.

New in the Eleventh Edition All the data are updated through 2012 and a discussion of the United States “fiscal cliff” is in Economics in Action. The Reading Between the Lines is new and uses the AS-AD framework to analyze the U.S. economy in the second quarter of 2012. There are three new problems in the Study Plan Problems and Applications replacing some older headlines with more current material. The Additional Problems and Applications have three new problems.

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Lecture Notes

Aggregate Supply and Aggregate Demand • •

The aggregate supply-aggregate demand (AS-AD) model explains how real GDP and the price level are determined. The model also helps explains the factors that determine inflation and the business cycle.

Tell students that there is heated debate among economists on the most important influences in the macro economy and how to model those influences. Economists as a group are ambivalent about the aggregate supply-aggregate demand (AS-AD) model. Real business cycle theorists, who like to build their models from the base of production functions and preferences, don’t use the model because the AS and AD curves are not independent. Technological change shifts both the AS and AD curves simultaneously and in complicated ways. New Keynesian economists have dropped the model in favor of a dynamic variant that places the inflation rate on the y-axis and the output gap (real GDP minus potential GDP as a percentage of potential GDP) on the x-axis. Despite the controversy, the AS-AD model is the key macroeconomic model for most economists. The model plays a similar role in the organization of the macroeconomics to that played by the demand and supply model in microeconomics. The author does a good job of using the ASAD model to explain various schools of thought. The AS-AD model is the best model currently available for introducing students to macroeconomics. It enables them to gain insights into the way the economy works, to organize their study of the subject, and to understand the debates surrounding the effects of policies designed to improve macroeconomic performance. Devoting at least a week of lecture time to the AS-AD model is worthwhile. Your goal at this point in the course is to help them understand the components of the model intuitively and to put the model to work using some of its more simple and obvious features.

Aggregate Supply

The quantity of real GDP supplied is the total quantity of goods and services, valued in constant dollar prices, that firms plan to produce in a given time period. This amount depends on the quantity of labor employed, the capital stock, and the state of technology. In the short run, only the quantity of labor can vary, so fluctuations in employment lead to changes in real GDP.

Long-Run Aggregate Supply •

•

The long-run aggregate supply curve is the relationship between the quantity of real GDP supplied and the price level in the long run when real GDP equals potential GDP. As illustrated in the figure, the LAS curve is vertical at the level of potential GDP ($13 trillion in the figure), showing that potential GDP does not depend on the specific price level. In the long run, the wage rate and other resource prices change in proportion to the price level. So moving along the LAS curve both the price level and the money wage rate change by the same percentage.

Short-Run Aggregate Supply •

The short-run aggregate supply curve is the relationship between the quantity of real GDP supplied and the price level in the short run when the money wage rate, the prices of other resources, and potential GDP remain constant. © 2014 Pearson Education, Inc.

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As illustrated in the figure, the SAS curve is upward sloping. This slope reflects that a higher price level combined with a fixed money wage rate, lowers the real wage rate, thereby increasing the quantity of labor firms employ and hence increasing the real GDP firms produce.

Difference between LAS and SAS: The distinction between the LAS and the SAS comes about by assuming that resource and output prices adjust at different rates. Ask the class, “When there is an increase in demand, what do you think adjusts first, prices of goods on the shelves at Wal-Mart or wages of employees at Wal-Mart?” By discussing out the potential lag times in resource price adjustment, you have opened up a hotly contested item among economists. How long is that lag time? Tell the students that there are different schools of thought about this issue and during the term we will see how different assumptions yield different answers.

Movements Along the LAS and SAS Curves and Changes in Aggregate Supply Movements Along the Curves • When the price level, the money wage rate, and other resource prices change by the same percentage, real GDP remains at potential GDP and there is a movement along the LAS curve. • When the price level changes and the money wage rate and other resource prices remain constant, real GDP departs from potential GDP and there is a movement along the SAS curve. Shifts in the Curves • When potential GDP increases, both long-run and short-run aggregate supply increase and the LAS and SAS curves shift rightward. Potential GDP increases when the full employment quantity of labor increases, the quantity of capital increases, or technology advances. • Short-run aggregate supply changes and the SAS curve shifts when there is a change in the money wage rate or other resource prices. A rise in the money wage rate or other resource prices decreases short-run aggregate supply and shifts the SAS curve leftward. The flavor of the Classical-Keynesian controversy. If you want to convey the flavor of one of the biggest controversies in macroeconomics, you can do so at this early stage of the course by using only the aggregate supply curves. The difference between the upward-sloping SAS and the vertical LAS lies at the core of the disagreement between Classical economists who believe that wages and prices are highly flexible and adjust rapidly and Keynesian economists who believe that the money wage rate in particular adjusts very slowly. Along the SAS curve: You cannot repeat yourself too many times about this topic: Moving along the SAS curve, resource prices are fixed. Point out that this is the same assumption for the “micro” supply curve. In particular, if there is an increase in the money wage rate at the Pepsi plant, the supply curve for Pepsi shifts leftward. That same principle gets applied to all goods and services in the AS-AD model so an increase in the money wage rate shifts the SAS curve leftward. Along the LAS curve: Students seem comfortable with the idea that the SAS curve has a positive slope but they seem less at ease with the vertical LAS curve. Emphasize (as the textbook does) the crucial idea that along the LAS curve two sets of prices are changing — the prices of output and the prices of resources, especially the money wage rate. Once they get this point, students quickly catch on to the result that firms won’t be motivated to change their production levels along the LAS curve. The vertical LAS curve is both vital and difficult and class time spent on this concept is well justified. Though you do not “need” to emphasize this point, what the LAS curve illustrates is that the real economy is independent of money prices!

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II. Aggregate Demand • •

The quantity of real GDP demanded is the sum of consumption expenditure (C), investment (I ), government expenditure (G), and net exports (X − M), or Y = C + I + G + (X − M). Buying plans depend on many factors including: • The price level • Expectations • Fiscal policy and monetary policy • The world economy

The Aggregate Demand Curve •

Other things remaining the same, the higher the price level, the smaller is the quantity of real GDP demanded. The relationship between the quantity of real GDP demanded and the price level is called aggregate demand. As the figure shows, the AD curve is downward sloping. • The negative relationship between the price level and the quantity of real GDP demanded reflects the wealth effect (when the price level rises, real wealth decreases and so people decrease consumption) and substitution effects (first, the intertemporal substitution effect: when the price level rises, real money decreases and the interest rates rises so that consumption expenditure and investment decrease; and, second, the international price substitution effect: when the price level rises, domestic goods become more expensive relative to foreign goods so people decrease the quantity of domestic goods demanded).

Keep it simple. You know that the AD curve is a subtle object—an equilibrium relationship derived from simultaneous equilibrium in the goods market and the money market. This description of the AD curve is not helpful to students in the principles course and is a topic for the intermediate macro course. At the same time that we want to simplify the aggregate demand story, we also want to avoid being misleading. The textbook walks that fine line, and we suggest that you stick closely to the textbook treatment and don’t try to convey the more subtle aspects of aggregate demand. A major problem with the AD curve is that a change in the price level that brings a movement along the curve is not a strict ceteris paribus event. A change in the price level changes the quantity of real money, which changes the interest rate. Indeed, this chain of events is one of the reasons for the negative slope of the AD curve. In telling this story, we must be sensitive to the fact that the student don’t totally appreciate the ceteris paribus condition. We must provide intuition with stories such as the Maria stories in the textbook. Income equals expenditure on the AD curve. Some instructors want to emphasize a second and more subtle violation of ceteris paribus, that along the AD curve, aggregate planned expenditure equals real GDP. That is, the AD curve is not drawn for a given level of income but for the varying level of income that equals the level of planned expenditure. If you want to make this point when you first introduce the AD curve, you must cover the AE model in the next chapter before you cover this chapter. (The material is written in a way that permits this change of order.) If you do not want to derive the AD curve from the equilibrium of the AE model, don’t even mention what’s going on with income along the AD curve. Silence is vastly better © 2014 Pearson Education, Inc.

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than confusion. You can pull this rabbit out of the hat when you get to the next chapter if you’re covering the material in the order presented in the textbook.

Changes in Aggregate Demand •

Any factor that influences buying plans other than the price level brings a change in aggregate demand and a shift in the aggregate demand curve. Factors that change aggregate demand are: • Expectations: Expectations of higher future income, expectations of higher future inflation, and expectations of higher future profits increase aggregate demand and shift the AD curve rightward. • Fiscal policy and monetary policy: The government’s attempt to influence the economy by setting and changing taxes, making transfer payments, and purchasing goods and services is called fiscal policy. Tax cuts or increased transfer payments increase disposable income (aggregate income minus tax payments plus transfers) and thereby increase consumption expenditure and aggregate demand. Increased government expenditures increase aggregate demand. Monetary policy consists of changes in interest rates and in the quantity of money in the economy. An increase in the quantity of money and lower interest rates increase aggregate demand. • The world economy: Exchange rates and foreign income affect net exports (X − M) and, therefore, aggregate demand. A decrease in the exchange rate or an increase in foreign income increases aggregate demand.

III. Explaining Macroeconomic Trends and Fluctuations Short-Run and Long-Run Macroeconomic Equilibrium •

Short-run macroeconomic equilibrium occurs when the quantity of real GDP demanded equals the quantity of real GDP supplied. This equilibrium is determined where the AD and SAS curves intersect. • If the quantity of real GDP supplied exceeds the quantity demanded, inventories pile up so that firms will cut production and prices. • If the quantity of real demanded exceeds the quantity supplied, inventories are depleted so that firms will increase production and prices.

Short-run macroeconomic equilibrium. Emphasize that in short-run macroeconomic equilibrium, firms are producing the quantities that maximize profit and everyone is spending the amount that they want to spend. Describe the convergence process using the mechanism laid out in the textbook. In that process, firms always produce the profit-maximizing quantities—the economy is on the SAS curve. If they can’t sell everything they produce, firms lower prices and cut production. Similarly, they can’t keep up with sales and inventories are falling, firms raise prices and increase production. These adjustment processes continues until firms are selling their profit-maximizing output. •

Long-run macroeconomic equilibrium occurs when real GDP equals potential GDP— equivalently, as the figure shows, when the economy is on its long-run aggregate supply curve. The figure shows the long-run macroeconomic equilibrium at a real GDP of $13 trillion and a price level of 110.

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From the short run to the long run. Explain that market forces move the money wage rate to the long-run equilibrium level. At money wage rates below the long-run equilibrium level, there is a shortage of labor, so the money wage rate rises and employment decreases. At money wage rates above the long-run equilibrium level, there is a surplus of labor, so the money wage rate falls and employment increases. At the long-run equilibrium money wage rate, there is neither a shortage nor a surplus of labor and the money wage rate remains constant and employment is constant at its full employment level.

Economic Growth and Inflation • •

Economic growth occurs when potential GDP increases so that the LAS curve shifts rightward. Inflation occurs when the AD curve continually shifts rightward at a faster rate than the LAS curve. In the long run, only growth in the quantity of money makes the AD curve continually shift rightward.

The Business Cycle

The business cycle occurs because aggregate demand and aggregate supply fluctuate and the money wage rate does not adjust quickly enough to keep the economy at potential GDP. • A below full-employment equilibrium is a macroeconomic equilibrium in which potential GDP exceeds real GDP. The gap between real GDP and potential GDP is the output gap. With a belowfull employment equilibrium, the gap is called a recessionary gap. A recessionary gap occurs when the SAS curve and the AD curve intersect to the left of the LAS curve. • An above full-employment equilibrium is a macroeconomic equilibrium in which real GDP exceeds potential GDP. The amount by which real GDP exceeds potential GDP, the output gap, is called an inflationary gap. An inflationary gap occurs when the SAS curve and the AD curve intersect to the right of the LAS curve. • A full-employment equilibrium is a macroeconomic equilibrium in which real GDP equals potential GDP. • The figure below to the left shows a below-full employment equilibrium with a recessionary gap of $1 trillion. The figure on the right shows an above full-employment equilibrium with an inflationary gap of $1 trillion.

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Point out to the students that to simplify analysis of the business cycle, economists typically abstract from the long-term persisting increases in the LAS curve and AD curve that generate economic growth and inflation, respectively. So, by fixing the LAS curve when considering business cycle fluctuations, economists are looking at short-term movements around a slower moving long-run equilibrium level of output. Explain to the students that one reason to abstract from these long-term movements is simply that the figures get very complicated if all the curves shift rather than just the immediately relevant ones. A second reason is the standard view that short-term movements around the LAS are driven by different economic forces than the persisting long-run shifts in the LAS curve. So abstracting from long-term growth in order to focus on business cycle fluctuations simplifies matters without any loss of relevant details.

Fluctuations in Aggregate Demand An increase in aggregate demand shifts the AD curve rightward, as in the figure where the aggregate demand curve shifts from AD0 to AD1. In the short run, a rightward shift of the AD curve leads to movement along the SAS curve so that both the price level and real GDP increase. In the figure the economy moves from an initial equilibrium at point a with real GDP equal to potential GDP of $13 trillion and a price level of 100 to point b with real GDP of $14 trillion and a price level of 105. But in the long run, the higher price level and tight labor market lead to an increase in the money wage rate. Short-run aggregate supply decreases and the SAS curve shifts leftward, in the figure from SAS0 to SAS1. The long-run equilibrium is reached when the short-run aggregate supply has decreased enough so that the economy is back producing at potential GDP, which in the figure occurs when the economy moves from b to point c. In the long run, the increase in aggregate demand has no effect on real GDP—it has returned to potential GDP, $13 trillion in the figure--and only results in a higher price level—which has risen from 100 to 110 in the figure. Shifting the SAS curve. Reinforce the movement toward long-run equilibrium with a curve-shifting exercise. Take the case where the AD curve shifts rightward. The fact that the initial equilibrium occurs where the new AD curve intersects the SAS curve is not difficult. But the notion that the SAS curve shifts leftward as time passes is difficult for many students. The trick to making this idea clear is to spend enough time when initially discussing the SAS so that the students realize that wages and other input prices remain constant along an SAS curve. Once the students see this point, they can understand that, as input prices increase in response to the higher level of (output) prices, the SAS curve shifts leftward. Avoid confusing students by using “up” to correspond to a decrease in SAS. But do point out that that when the SAS curve shifts leftward it is moving vertically upward, as input prices rise to become consistent with potential GDP and the new long-run equilibrium price level. Most students find it easier to see why the SAS curve shifts leftward once they see that rising input prices shift the curve vertically upward. In the figure above, instead of using identifying the short-run aggregate supply curve with SAS0you might use SASW=$10 with the explanation that along this SAS curve the money wage rate, W, is fixed at $10/hour. Then, rather than label the new short-run aggregate supply curve SAS1, can identify it as SASW=$11. You can now show your students the qualitative point that the money wage rate has increased and you can show them the quantitative point that the 10 percent increase in the price level (from 100 to 110) lead to a 10 percent increase in the money wage rate. © 2014 Pearson Education, Inc.

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Fluctuations in Aggregate Supply Some business cycle fluctuations are driven by shifts in short-run aggregate supply. An increase in energy prices decreases the short-run aggregate supply and shifts the SAS curve leftward. The price level increases and real GDP decreases. The combination of recession and higher inflation is called stagflation and occurred in the United States in the 1970s as a result of the oil price shocks.

IV. Macroeconomic Schools of Thought There is a fair degree of consensus among mainstream economists about economic growth and inflation, although there is still immense debate about the business cycle. The importance of macroeconomic issues and the complexities of economic systems mean that there are strong incentives to speak knowledgeably about macroeconomics, but it is difficult for most people to evaluate whether the speaker is truly knowledgeable or a charlatan. Mainstream economic theories are completely thought out and fully articulated. Thus, one should be wary of anyone who confidently rejects that one of these mainstream theories as “just plain wrong.”

The Classical View •

• •

A classical macroeconomist believes that the economy is self-regulating and that it is always at full employment. A new classical view is that business cycle fluctuations are the efficient responses of a well-functioning market economy that is bombarded by shocks that arise from the uneven pace of technological change. The uneven pace of technological advancement are the main source of business cycle fluctuations. There is no distinct short-run aggregate supply curve because the economy is always producing at potential GDP. Classical economists emphasize that taxes blunt people’s incentives to work, so the most the government should do to affect the business cycle is to keep taxes low.

The Keynesian View • •

• •

A Keynesian macroeconomist believes that left alone, the economy would rarely operate at full employment and that to achieve and maintain full employment, active help from fiscal policy and monetary policy is required. Aggregate demand fluctuations driven by changes in expectations (“animal spirits”) about business conditions and profits are the main source of business cycle fluctuations. Because money wages are sticky (slow to adjust), especially in the downward direction, the economy can remain mired in a recession. A modern version of the Keynesian view known as the new Keynesian view holds that not only is the money wage rate sticky but that the prices of some goods and services are also sticky. Keynesians believe that fiscal policy and monetary policy should be used actively to stimulate demand to end recessions and restore full employment.

Although Keynes agreed that the economy would return to its potential in the long run, he stated, “In the long run, we are all dead”. Keynes believed that because of the interaction between financial markets, the price level, and the labor market, there was no inherent tendency of the market system to return quick enough to potential GDP following an aggregate demand shock. The role of the government, in Keynes’ view, was not to replace markets with central planning, but to use stabilization policies to help the macroeconomy find equilibrium at potential GDP. Keynes’ analogy was that market capitalism in the Great Depression was like a car with a broken alternator. Fiscal policy would give the economy a jump-start when aggregate demand was inadequate. Keynes worried that without active aggregate demand

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management, high unemployment would lead to a breakdown of capitalism, with revolution leading to totalitarianism in the form of communism or fascism.

The Monetarist View •

A monetarist macroeconomist believes that the economy is self-regulating and that it will normally operate at full employment provided that monetary policy is not erratic and that the pace of money growth is kept steady.

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• • •

Aggregate demand fluctuations driven by monetary policy mistakes are the main source of business cycle fluctuations. There is a short-run aggregate supply curve because money wages are sticky. The monetarist view of policy is that tax rates should be kept low and the quantity of money should be kept growing on a steady path. Beyond these policies, however, the government should not undertake active stabilization policy.

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Additional Problems 1.

Explain and draw a graph to illustrate how a depreciation of the dollar changes the shortrun equilibrium real GDP and price level.

Suppose the government creates a fiscal stimulus by sending people checks representing temporary tax cuts. a. Explain and draw a graph to illustrate the effect of this fiscal stimulus payments on real GDP and the price level in the short run. b. At which type of short-run equilibrium would the government want to use this policy? c. Which macroeconomic school of thought would justify this policy? d. If the government used this policy when the economy was at full employment, explain what would happen in the long run. e. Draw a graph to illustrate your answer to d.

What is stagflation? Explain how the increase in the price of oil can cause stagflation and draw a graph to illustrate this outcome.

Solutions to Additional Problems 1.

The depreciation of the dollar increases U.S. net exports, which increases U.S. aggregate demand. The increase in aggregate demand increases real GDP and raises the price level. These changes are illustrated in Figure 10.1. In this figure the aggregate demand curve shifts rightward from AD0 to AD1. As a result real GDP increases, from $13.0 trillion to $13.2 trillion, and the price level rises, from 119 to 121.

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c. d.

The fiscal stimulus check increased households’ consumer expenditure. The increase in consumption expenditure boosted aggregate demand so the aggregate demand curve shifted rightward. Figure 10.2 shows the effect of this change. The aggregate demand curve shifts rightward from AD0 to AD1. As a result real GDP increases, in the figure from $13 trillion to $13.1 trillion, and the price level rises, in the figure from 119 to 121. The government wants to use this type of policy when the economy is in a below full-employment equilibrium with a recessionary gap. Keynesian economists would support this policy. If this stimulus policy was used when the economy was at full employment, in the short run the price rises and real GDP increases. But in the long run the money wage rate rises to reflect the higher price level. The rise in the money wage rate decreases short-run aggregate supply. Ultimately in the long run real GDP returns to potential GDP so there is no long-run change in real GDP. The price level, however, rises as short-run aggregate supply decreases. So the price level in the long-run is higher than in the short run. Figure 10.3 shows the long-run changes described in the previous answer. After the initial shift in the aggregate demand curve from AD0 to AD1, the price level has risen. As a result the money wage rate rises so that the short-run aggregate supply curve shifts leftward, in the figure from SAS0 to SAS1. In turn the price level rises still more, in the figure ultimately to 122. Real GDP, however, decreases and eventually returns to its initial level, which is potential GDP and in the figure is $13.0 trillion.

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Stagflation is the combination of recession and inflation. Increases in the price of oil can decrease aggregate supply. The decrease in aggregate supply raises the price level—so there is inflation—and decreases real GDP—so there is a recession. Figure 10.4 illustrates these results. In this figure the aggregate supply curve shifts leftward from AS0 to AS1. As a result real GDP decreases from $13.0 trillion to $12.8 trillion and the price level rises, from 118 to 120.

Additional Discussion Questions 11. “The demand curves for all products have negative slopes. For instance, the demand curves for milk, automobiles, personal computers, and shirts all have negative slopes. Therefore, because the aggregate demand curve shows the demand for all products, it too must have a negative slope.” Comment on this assertion. The assertion is incorrect. Demand curves for goods and services such as milk and so forth have negative slopes because the price measured along the vertical axis is a relative price; that is, it is the price of the good or service relative to the price of another good or service. As a result, the demand curve for these goods or services captures the possibility of substitution: A higher price for a gallon of milk causes consumers to substitute away from milk and toward other beverages, such as water or soda, whose price has not risen. The price level, which is the variable along the vertical axis for the aggregate demand curve, is not a relative price. It is the average of all prices. When the price level rises, all domestic prices have risen so the only substitution possibility is toward imported goods and over time (the intertemporal substitution effect). These substitutions offer reasons why the aggregate demand curve has a negative slope. Another, possibly more important reason for the negative slope is the wealth effect: When the price level rises and nothing else changes, people’s real wealth decreases. When real wealth decreases, people’s consumption expenditure decreases so that the aggregate quantity of goods and services demanded decreases. 12. Explain why the SAS curve slopes upward and the LAS curve is vertical. The SAS curve applies in the short run; the LAS curve applies in the long run. When the price level rises, firms find that the prices of the goods and services they produce have risen. In the short run the money wage rate (and other costs) do not change. With higher prices and unchanged costs, firms find it profitable to increase their production. Hence in the short run the quantity of real GDP produced increases, which means that along the SAS curve a higher price level leads to an increase in the quantity of real GDP supplied. However in the long run money wage rates adjust to reflect the higher price level. In the long run the money wage rate and price level rise in the same proportion. In the long run, with both higher prices and © 2014 Pearson Education, Inc.

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higher costs, firms return to their initial level of production. Hence in the long run the quantity of real GDP produced does not change, which means that along the LAS curve a higher price level leads to no change in (potential) GDP. 13. When the equilibrium real GDP is below potential GDP, how does the unemployment rate compare with the natural rate? What is the result of this state of affairs that restores the long-run equilibrium? When real GDP is less than potential GDP, the unemployment rate exceeds the natural rate. In the labor market, the high unemployment rate forces the money wage rate lower. As the money wage rate falls, firms hire more workers and short-run aggregate supply increases. The increase in short-run aggregate supply increases real GDP. Eventually the money wage rate falls sufficiently so that real GDP equals potential GDP. At this point, long-run equilibrium is reached and the money wage rate no longer falls so that all adjustments cease. 14. Explain how an increase in money wages affects the SAS curve. Why does a change in money wages affect only the SAS curve and not the LAS curve? An increase in the money wage rate means that firms’ costs have risen. At a given price level, the increase in their costs causes firms to decrease the quantity of goods and services they produce. The quantity of real GDP produced decreases and the SAS curve shifts leftward. The change in the money wage rate does not affect the quantity of production along the LAS curve because along that curve both the money wage rate and price level change in the same proportion. In other words, it is not possible to assume a given price level to investigate the effect of an increase in the money wage rate along the LAS curve because along that curve both variables change. And when both the price level and money wage rate change by the same proportion, firms will not change the quantity of real GDP they produce. 15. If the government spends more money by buying more goods and services, is this change an example of fiscal policy or monetary policy? When the government increases its expenditure by purchasing more goods and services, the government is engaging in fiscal policy. 16. What is a recessionary gap? How does the economy adjust to eliminate a recessionary gap? A recessionary gap occurs when actual real GDP is less than potential GDP. With a recessionary gap the unemployment rate exceeds the natural rate. In the labor market, the high unemployment rate forces the money wage rate lower. As the money wage rate falls, firms hire more workers and short-run aggregate supply increases. The increase in shortrun aggregate supply increases real GDP. Eventually the money wage rate falls sufficiently so that real GDP equals potential GDP. At this point, long-run equilibrium is reached and the money wage rate stops falling so that short-run aggregate supply stops increasing.

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EXPENDITURE MULTIPLIERS**

The Big Picture Where we have been: Chapter 11 uses the background provided in Chapters 4 and 10 to focus on aggregate expenditure and aggregate demand. It builds on the division of GDP into C + I + G + (X – M) explained in Chapter 4 and then derives the aggregate demand curve previously used in Chapter 10. Where we are going: Chapter 11 examines the details of the AS-AD model by focusing on the factors that determine the AD curve. The AD curve is important in all the core short-run macroeconomic chapters. The material in this chapter is used in Chapters 12-14 on the business cycle, fiscal policy, and monetary policy.

New in the Eleventh Edition The data have been updated to 2012. The Reading Between the Lines examines an August 2012 article on expenditure changes during the 2012 expansion. There are three new problems in the Study Plan Problems and Applications replacing some older headlines with more current material. The Additional Problems and Applications also have two updated and one new problem.

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Lecture Notes

Expenditure Multipliers • • •

The Keynesian model focuses on the short run. In the Keynesian model, business cycle fluctuations are driven by changes in the components of aggregate expenditure, especially investment. The multiplier effect describes the amplified effect on real GDP from changes in expenditure.

Historical background. If you want to talk about Keynes and his contribution to economics, this is probably the best place to do it. The model, now generally called the aggregate expenditure model, presented in this section is the essence of Keynes General Theory. According to Don Patinkin, a leading historian of economic thought and Keynes scholar, the innovation of the General Theory was to replace price with income (GDP) as the equilibrating variable. This version of the model cannot be found in the General Theory, mainly because Keynes was writing before the national income accounting system had been developed. So he made up his own aggregates, based on employment and a money wage measure of the price level. But the words and equations of the General Theory can be translated readily into the textbook version of the model. This version of the model first appeared in The Elements of Economics, a textbook authored by Lorie Tarshis published in 1947. It was popularized by Paul Samuelson in the first edition of his celebrated text published in 1948. The main difference between the Keynesian cross model of the 1940s and the aggregate expenditure model of today is that from the 1940s through the mid-1960s, economists believed that the fixed price level assumption was an acceptable (if not exactly accurate) description of reality, so the model was seen as actually determining real GDP, and the multiplier was seen as an empirically relevant phenomenon. In contrast, today, we see the model as part of the aggregate demand story. The value of the model today— and it is valuable today and not, as some people claim, eclipsed by the AS-AD model and irrelevant—is that it explains the multiplier that translates a change in autonomous expenditure into a shift of the AD curve and it explains the multiplier convergence process that pulls the economy toward the AD curve. (When an unintended change in inventories occurs, the economy is off the AD curve but moving toward it.)

Fixed Prices and Expenditure Plans

The Keynesian model applies to the very short run in which firms have fixed the prices of their goods and services. As a result, the price level is fixed and so aggregate demand determines real GDP.

Expenditure Plans • •

Aggregate planned expenditure is equal to planned consumption expenditure plus planned investment plus planned government expenditure on goods and services plus planned exports minus planned imports. In the very short term, planned investment, planned government expenditure, and planned exports are fixed. Planned consumption expenditure and planned imports are not fixed, but depend on aggregate income. An increase in real GDP increases aggregate expenditure and an increase in aggregate expenditure increases real GDP.

Consumption Function and Saving Function •

Consumption expenditure and saving depend on the real interest rate, disposable income, wealth, and expected future income. Disposable income is aggregate income minus taxes plus transfer payments. The relationship between consumption expenditure and disposable income, other things remaining the same, is called the consumption function. The relationship between saving and disposable income, other things remaining the same, is called the saving function.

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The figure shows a consumption function. Along the 45 degree line, consumption equals disposable income. When the consumption function is above the 45 degree line, there is dissaving. When the consumption function is below the 45 degree line, there is saving. The consumption expenditure when disposable income is zero, $4 trillion in the figure, is autonomous consumption. Consumption expenditure in excess of this amount is induced consumption.

The 45° line. Don’t assume that the student immediately understands the 45° line! Spend a bit of time explaining how to “read” it. Fundamentally, it shows all points where x = y. This line happens to be a 45° line when the scales along the x-axis and the y- axis are the same. Then point out that the horizontal distance to a point along the x-axis equals the vertical distance from that point to the 45° line. So at all points along the 45° line, x = y. If you wish, you can go on to show the students how the x = y line changes its appearance if we stretch or squeeze the scale on the y-axis holding the scale on the x-axis constant. Emphasize that x and y can be anything. In the figure above, x is disposable income and y is consumption expenditure; in the figure below, x is real GDP and y is aggregate planned expenditure.

Marginal Propensities to Consume and Save • • •

The marginal propensity to consume (MPC) is the fraction of a change in disposable income that is consumed, C/YD. The MPC is the slope of the consumption function, which is 0.67 in the figure. The marginal propensity to save (MPS) is the fraction of a change in disposable income that is saved, S/YD. The MPS is the slope of the saving function. The sum of the MPC plus the MPS equals 1.0.

Marginal propensities. The text defines the MPC and MPS, and shows that they sum to one because disposable income can only be consumed or saved. Students generally relate to percentages better, so you can explain it as percent but stress that we use the decimal number for analytical purposes.

Other Influences on Consumption Expenditure and Saving A change in any other factor influencing consumption and saving besides disposable income (such as the real interest rate, wealth, and expected future income) shifts the consumption function and the saving function. An increase in wealth or expected future income and a decrease in the real interest rate increases consumption—and shifts the consumption function upward—and decreases saving—and shifts the saving function downward. •

The U.S. MPC is about 0.9. Since the 1960s, increases in expected future income and wealth have shifted the consumption function upward.

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Consumption as a Function of Real GDP and the Import Function • •

For a given level of taxes and transfers, disposable income changes when real GDP changes, so consumption also is a function of real GDP. We use this observation when we derive the aggregate expenditure function. Just as consumption of domestically produced goods and services depends on real GDP, so do imports. The marginal propensity to import is the fraction of an increase in real GDP that is spent on imports.

II. Real GDP with a Fixed Price Level Real GDP (Y)

Consumption expenditure (C)

Investment (I)

Government expenditure (G)

Exports (X)

Imports (M)

Aggregate planned expenditure (AE=C+I+G+X−M)

(trillions of 2000 dollars) 11.0

7.2

2.0

1.0

0.8

11.4

12.0

8.1

2.0

1.0

0.9

12.2

13.0

9.0

2.0

1.0

13.0

14.0

9.9

2.0

1.0

1.1

14.8

Aggregate Planned Expenditure and Real GDP •

•

Aggregate planned expenditure, AE, is the sum of planned consumption expenditure plus planned investment plus planned government expenditure on goods and services plus planned exports minus planned imports. The above table shows the calculation of an aggregate planned expenditure schedule. The figure shows the resulting AE curve. Consumption expenditure minus imports vary with real GDP and are induced expenditure. The sum of investment, government expenditures, and exports do not vary with real GDP and are autonomous expenditure. Consumption expenditure and imports also have an autonomous component. Actual expenditure can differ from planned expenditure because firms do not always sell what they plan to, in which case they have unplanned inventory investment. For instance, a car that is manufactured but not immediately sold is part of that firm’s actual inventory investment regardless of whether the firm planned to add it to inventory or not.

Equilibrium Expenditure and Convergence to the Equilibrium • •

Equilibrium expenditure is the level of aggregate expenditure that occurs when aggregate planned expenditure equals real GDP. In the figure, equilibrium expenditure is $12 trillion. If aggregate expenditure does not equal its equilibrium, forces lead to convergence. For example, if real GDP exceeds aggregate planned expenditure, firms find their inventories are increasing more than planned. The unplanned inventory accumulation leads firms to cut production so that real GDP decreases, which decreases aggregate planned expenditures. Real GDP still exceeds aggregate planned expenditure, but by less than before. The process continues until real GDP equals aggregate planned expenditure so that there is no unplanned inventory accumulation.

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III. The Multiplier • •

•

The multiplier is the amount by which a change in autonomous expenditure is magnified or multiplied to determine the change in equilibrium expenditure and real GDP. When there is an autonomous change in a component of expenditure such as investment, additional changes in aggregate expenditure are set in motion. Because of the feedback between real GDP and consumption expenditure, the total change in real GDP is larger than the initial change in autonomous expenditure. The multiplier effect operates for a decrease as well as an increase in autonomous expenditure.

Work through an example of a change in government spending. Suppose there are no taxes, no imports, no exports and the MPC is 0.9. If the government purchases $5 billion of weapons from Nuc’s-R-US, what happens to that spending? Nuc’s has to pay all of its employees, subcontractors and material suppliers among other costs. These costs to Nuc’s turn into income (Y) for others (remind your students of the circular flow). These other people are going to consume 90 percent of that income, $45 billion, at stores such as JCPenney. Now JCPenney must pay its costs, which again turns into other people’s income, of which 90 percent again gets spent again ($40.5 billion) and so on and so on and so on… Explain to the students that we have a short-cut to explain this iterative process and capture the total change in income (Y) from the change in government spending (G). That short-cut is the multiplier, which shows that the change in GDP is given by GDP = 1/(1 − MPC) × G

Why is the Multiplier Greater Than 1? An increase in autonomous expenditure increases real GDP and the increase in real GDP induces an additional increase in aggregate expenditure (primarily an increase in consumption expenditure). Each additional increase in aggregate expenditure increases real GDP further, leading to yet further increases in aggregate expenditure. The process converges because the increase in aggregate expenditure is smaller at each step of the process.

The Multiplier and the Marginal Propensities to Consume and Save •

•

The change in real GDP can be divided into the change in induced expenditure plus the change in autonomous expenditure, Y = N + A, where Y is real GDP, N is induced expenditures, and A is autonomous expenditure. The slope of the AE curve = N÷Y, so N = (slope of AE curve) Y. Using this equality in the previous formula shows Y = (slope of AE curve) Y + A. Solving for 1 the change in GDP, Y, gives Y =  A. This last result shows that the 1 − slopeof the AE curve 1 multiplier equals . In the previous figure, the slope of the AE curve is 0.8, so 1 − slopeof the AE curve the multiplier is 5.0. If there are no imports or income taxes, the slope of AE curve equals the MPC so the multiplier 1 1 equals or, equivalently, . 1 − MPC MPS The size of the multiplier depends on the MPC and the MPS. The smaller the MPC or, equivalently, the larger the MPS, the smaller the increase in expenditure at each step of the multiplier process and so the smaller the multiplier.

The basic idea and practice. Students need quite a lot of practice using multipliers. One good problem involves working out the effects on consumption as well as on GDP of a change in investment (when the price level is fixed). The best way to present this problem to the students seems to be sequentially. Begin by giving them the data necessary to deduce how real GDP changes from an increase in investment. Tell them there is no foreign trade, so that there are no exports or imports, and no income taxes. Tell them that the marginal propensity to consume is b (pick any valid number you like), and that investment has © 2014 Pearson Education, Inc.

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changed by I (pick any valid number you like). Then, after the students have computed the change in GDP, ask them what the change in consumption expenditure is. Review their attempts to answer this question as follows: The change in GDP, Y, is given by the equation: Y = C + I. Given I from the initial statement of the problem and Y from the first set of calculations, the students can readily calculate C. Focusing the students’ attention on the change in consumption is important because it reinforces the point that a change in autonomous expenditure (investment in this example) leads to an induced change in consumption expenditure and that this increase in consumption expenditure is the source of the multiplier.

The Effect of Imports and Income Taxes on the Multiplier; Business Cycle Turning Points • • •

Imports and income taxes both mean that the increase in expenditure on domestic production will be smaller at each step of the multiplier process and so the multiplier is smaller. An unexpected decrease in autonomous expenditure is signaled by a buildup of unplanned inventories. The buildup in inventories sets the multiplier process in motion that decreases aggregate expenditure and real GDP so that a recession follows. An unexpected increase in autonomous expenditure is signaled by an unwanted depletion of inventories. The depletion in inventories sets the multiplier process in motion and an expansion follows.

The idea that prices are fixed, even in the very short run, is controversial in economics. However, the fact that changes in inventories have long been a good leading indicator of business cycles is less controversial.

IV. The Multiplier and the Price Level In the short run, when firms find their inventories changing in an unexpected fashion, they change their production not their prices. But eventually they also change prices. To study the determination of the price level and real GDP the AS-AD model must be used. The AD curve is related to the AE curve.

The Aggregate Expenditure Curve and the Aggregate Demand Curve •

•

The AE curve is the relationship between aggregate planned expenditures and real GDP, all other influences (such as the price level) remaining the same. The AD curve is the relationship between the aggregate quantity of goods and services demanded and the price level. When the price level changes, the AE curve shifts and there is a movement along the AD curve. A change in the price level has two effects on consumption expenditure: • Wealth Effect: A rise in the price level decreases the purchasing power of consumers’ real wealth, which decreases their consumption expenditures. • Substitution Effects: A rise in the price level makes purchasing today more expensive relative to the future (an intertemporal substitution effect). It also makes U.S. goods and services more expensive relative to imports (an international substitution effect).

The multiplier and the price level: Emphasize the key point of this section: That the AE model and the multiplier tell us how far the AD curve shifts when autonomous expenditure changes. It is through the multiplier process that expenditure and GDP respond to unplanned changes in inventories. The mechanics of the relationship between the AE and AD curves. Students need a lot of help and clear explanation of the mechanics of the link between these two curves. Here’s what to stress: 1. The AE curve shows how aggregate planned expenditure depends on real GDP (through the effects of disposable income), other things remaining the same. 2. The AD curve shows how equilibrium aggregate expenditure depends on the price level, other things remaining the same. The next two points are really hard for students: © 2014 Pearson Education, Inc.

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A change in the price level changes autonomous expenditure, which shifts the AE curve, generates a new level of equilibrium expenditure, and creates a new point on the AD curve. A change in autonomous expenditure at a given price level shifts the AE curve, generates a new level of equilibrium expenditure, and shifts the AD curve by an amount equal to the change in autonomous expenditure multiplied by the multiplier.

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•

The wealth effect and the substitution effects show that a rise in the price level decreases consumption expenditure. So, as shown in the figure below to the left, a rise in the price level from 120 to 140 decreases aggregate planned expenditure and shifts the AE curve downward from AE0 to AE1. In the figure, equilibrium expenditure decreases to $11 trillion. The diagram to the right, below, shows that when the price level rises from 120 to 140, there is a movement along the AD curve from point a to point b. The aggregate quantity of real GDP demanded decreases from $13 trillion (which is the initial equilibrium expenditure in the AE diagram to the left) to $11 trillion (which is the new equilibrium expenditure along AE1 in the AE diagram to the left).

If the AE curve shifts for any reason other than a change in the price level, then the AD curve also shifts. For instance, an increase in autonomous expenditures shifts the AE curve upward and increases equilibrium expenditure by a multiplied amount. In this case, the AD curve shifts rightward and the amount of the rightward shift is equal to the increase in equilibrium expenditure. In the figure to the right, autonomous expenditure increases so that the AD curve shifts rightward. The multiplied increase in autonomous expenditure has created a $2 trillion increase in equilibrium expenditure, so the AD curve shifts rightward by $2 trillion (which equals the length of the double headed arrow) from AD0 to AD1.

Equilibrium Real GDP and the Price Level • •

Aggregate demand and short-run aggregate supply determine the equilibrium price level and real GDP. In the short run: • An increase in aggregate demand raises the price level and increases real GDP. In the

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figure to the right, the increase in aggregate demand and rightward shift of the aggregate demand curve from AD0 to AD1 creates a movement from point a to point b so that the price level rises from 120 to 130 and real GDP increases from $13 trillion to $14 trillion. • The increase in real GDP ($1 trillion) is less than the initial increase in equilibrium expenditure ($2 trillion) because the rise in the price level decreases aggregate planned expenditure. In terms of the AE curve, the increase in the price level shifts the AE curve downward. • Because the actual increase in real GDP is less than the initial increase in equilibrium expenditure, the multiplier is smaller once price level effects are taken into account. The more that the price level changes (that is, the steeper the SAS curve), the smaller the multiplier in the short run. In the long run: • Real GDP exceeds potential GDP and employment exceeds full employment. So the money wage rate rises, which decreases the short-run aggregate supply and shifts the SAS curve leftward. The economy moves along the AD curve so that the price level rises and real GDP decreases. • In the figure above, the economy moves along AD1 from point b to point c. (The shift in the SAS curve is not illustrated in order to simplify the figure.) The price level rises from 130 to 140 and real GDP decreases from $14 trillion back to potential GDP of $13 trillion. • The further increase in the price level further decreases aggregate planned expenditure. In terms of the AE curve, the AE curve shifts downward and eventually returns to its initial level. As a result, the long-run multiplier is equal to zero.

It is important to emphasize that the aggregate expenditure model is not without connection to the AS-AD model. Point out to the students that the AE model provides the underpinnings for the AD curve in the ASAD model used throughout macroeconomics. That is, the students can now understand why the AD curve shifts, why it is downward sloping, and why changes in the price level lead to movements along the AD curve. It may be a good time to remind students that, just as the Keynesian AE model provides underpinnings for the AD curve, the labor market/aggregate production function model discussed in Chapter 6 provides underpinnings for the long-run aggregate supply curve. Thus, the mechanics of the model have not changed, but the students now have a deeper understanding of the forces behind those mechanics.

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Additional Problems 1. a. How is it possible for households to have a negative savings rate? What has caused this negative household savings rate? b. Is this negative household savings rate sustainable in the long-run? 2.

Why is the multiplier only a short-run influence on GDP?

When the economy is in a recession and the government enacts a stimulus package, why might a low MPS be good in the short-run in this situation, but not in the long-run?

Solutions to Additional Problems 1.

Households can have a negative saving rate by borrowing. Households increase their borrowing if their wealth rises, if the real interest rate falls, or if their expected future income rises. Any or all of these factors could lead to a negative saving rate. A negative saving rate is not sustainable in the long run. In the long run the saving rate must be positive, if for no other reason than to repay the borrowing.

The multiplier has only a short-run influence on real GDP because in the long run the money wage rate changes. The change in the money wage rate affects short-run aggregate supply and lowers the price level. The fall in the price level restores aggregate planned expenditure back to its initial level and moves the economy back to its long-run equilibrium. The long-run change in aggregate expenditure offsets the initial multiplier effect on real GDP.

In the short run, the fear is that a stimulus package while not have enough force to move the economy back to potential GDP. In this situation a small MPS is desirable because it means more spending from any increase in disposable income. However in the long run the economy needs saving to help it grow. Saving in the United States is quite low so in the long run a small value for the MPS is not helpful.

Additional Discussion Questions 11. Why is there a “two-way” link between consumption and GDP? Consumption is part of aggregate expenditure so an increase in consumption increases aggregate expenditure and hence increases GDP. Simultaneously GDP is equal to aggregate income so an increase in GDP increases disposable income and hence increases consumption. 12. How does an increase in disposable income affect the consumption function? An increase in expected future income? An increase in disposable income leads to a movement upward along the consumption function. An increase in expected future income shifts the consumption function upward. 13. If the consumption function shifts upward, what happens to the saving function? Why? If the consumption function shifts upward, the saving function shifts downward. The upward shift in the consumption function means that for each level of disposable income consumption increases. If consumption increases at each level of disposable income, saving necessarily must decrease. The decrease in saving at each level of disposable income means that the saving function shifts downward. 14. When is actual aggregate expenditure different from planned aggregate expenditure? What happens to bring the two back to equality? Actual aggregate expenditure differs from planned aggregate expenditure whenever the economy is not at its equilibrium. These © 2014 Pearson Education, Inc.

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amounts differ as a result of unplanned inventory changes. Take, for instance, the situation when actual aggregate expenditure exceeds equilibrium expenditure. In this case the 45° line, which shows actual aggregate expenditure, lies above the aggregate planned expenditure curve, which shows planned aggregate expenditure. Hence actual aggregate expenditure exceeds planned aggregate expenditure. In this situation actual inventory change—which is the measure of inventory change that is included in actual aggregate expenditure—exceeds planned inventory change—which is the measure of inventory change that is included in planned aggregate expenditure. Because actual inventory change exceeds the planned inventory change, firms are finding that their inventories are accumulating in an undesired fashion. They respond to this state of affairs by decreasing their production. As production decreases, real GDP and hence aggregate expenditure decrease until aggregate expenditure eventually equals equilibrium expenditure. 15. Explain why income taxes reduce the size of the expenditure multiplier. The expenditure multiplier results because an increase in autonomous expenditure increases disposable income and induces additional consumption expenditure. In turn the additional consumption expenditure increases disposable income once again, which then induces still additional consumption expenditure. The result that expenditure increases because of the initial increase in autonomous expenditure and then also because of the induced increase in consumption expenditure is why the expenditure multiplier exists. Income taxes decrease the size of the increase in disposable income that results from an increase in expenditure. Therefore the resulting (induced) increase in consumption expenditure is smaller so that the overall expenditure multiplier is smaller. 16. Explain the difference between the aggregate expenditure curve and the aggregate demand curve. The aggregate expenditure curve shows how aggregate expenditure changes when GDP changes. The aggregate demand curve shows how (equilibrium) expenditure and GDP change when the price level changes. 17. Suppose that exports (autonomously) increase. What happens to the aggregate expenditure curve? The equilibrium level of aggregate expenditure? The aggregate demand curve? The aggregate expenditure curve shifts upward. Through the multiplier process the equilibrium level of aggregate expenditure increases. The aggregate demand curve shifts rightward by an amount equal to the increase in equilibrium expenditure.

C h a p t e r

INFLATION, JOBS, AND THE BUSINESS CYCLE**

The Big Picture Where we have been: Chapter 12 uses the AS-AD model developed in Chapter 10 to explore inflation and business cycles. The distinction between the short-run and long-run aggregate supply curves is useful for appreciating the difference between the short-run and long-run Phillips curves. Chapter 12 also draws on the definition of inflation in Chapter 5. Where we are going: Chapter 12 is the last of three chapters dealing with macroeconomic fluctuations. The explanation of the business cycle through the lens of the aggregate supply-aggregate demand model lays the foundation for the next two chapters, on fiscal policy and monetary policy respectively.

New in the Eleventh Edition This chapter’s content is primarily the same as the tenth edition except that real business cycle theory was modified and partly incorporated into an Economics in Action box. The Reading Between the Lines includes an October 2011 article on the Misery Index. There are five new problems in the Study Plan Problems and Applications replacing some older headlines with more current material. The Additional Problems and Applications have one new problem added. The interview with Ricardo Caballero has been shortened to one page with the full interview available in MyEconLab.

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Lecture Notes

Inflation, Jobs, and the Business Cycle • • •

What are the economic consequences of inflation? Does the Fed face a tradeoff between inflation and unemployment? How does the mainstream business cycle theory account for fluctuations in real GDP and unemployment? How does the real business cycle theory account for these fluctuations?

Inflation Cycles

Inflation is a process in which the price level is rising and money is losing value. Inflation is not a rise in one price—it is a broad increase in the price level. Inflation also is not a one-time jump in the price level. It is an ongoing process. There are many examples of one-time jumps in the price level that are not the same as inflation. In Canada, when the federal sales tax was changed in the early 1990s, there was a one-time increase in the CPI. Likewise, when the euro was introduced in 2001, there were one-time increases in many prices in some countries. Neither of these events led to a persistent rise in the rate at which the price level increased and measured inflation using the CPI fell to previous levels soon after the one-time events.

Demand-Pull Inflation An inflation that results from an initial increase in aggregate demand is called demand-pull inflation. Any factor that increases aggregate demand, such as an increase in the quantity of money, an increase in government expenditure, or an increase in exports, can start a demand-pull inflation. •

•

In the short run, an increase in aggregate demand raises the price level and increases real GDP. In the figure the aggregate demand curve shifts from AD0 to AD1 so that the economy moves from point a to point b and the price level rises from 100 to 110. Real GDP exceeds potential GDP and so in the tight labor market the money wage rate rises. The rise in the money wage rate decreases short-run aggregate supply. In the figure, the SAS curve shifts from SAS0 to SAS1. As a result, the economy moves from point b to point c and the price level rises even more, in the figure to 120. Real GDP returns to potential GDP. Inflation occurs only if aggregate demand continues to increase. And aggregate demand continues to increase only if the quantity of money persistently increases.

Demand-Pull Inflation. The potential difficulty with both demand-pull and cost-push inflation stories is how the one-time increase translates into an inflationary process. It is relatively easy to come up with stories as to why aggregate demand might shift to the right, for example because of persistent government budget deficits. (However immediately tell the students that if the budget deficit does not constantly increase in size relative to GDP, it will not lead to a constant increase in aggregate demand.) What is a little harder is to provide a plausible story as to why the monetary authorities would continue to accommodate the budget deficit with continuous increases in the quantity of money. Point out that this has been rare in the United States, and has tended to happen when the political situation was such that the Fed was not willing to be blamed for an increase in unemployment. In other countries, particularly where the central © 2014 Pearson Education, Inc.

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bank is less independent than in the United States, it has been more common for the central bank to consistently monetize budget deficits.

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Cost-Push Inflation An inflation that results from an initial increase in costs is called cost-push inflation. The two main sources of increases in costs are an increase in money wage rates or an increase in the money prices of raw materials. •

•

The cost hike decreases short-run aggregate supply, which raises the price level and decreases real GDP. In the figure the shortrun aggregate supply curve shifts from SAS0 to SAS1 so that the economy moves from point a to point b and the price level rises from 100 to 110. The combination of a rise in the price level and a fall in real GDP is called stagflation. One possible response to the decrease in real GDP is for the Fed to use monetary policy to increase aggregate demand. If the Fed increases aggregate demand, real GDP increases and the price level rises still higher. In the figure, this Fed policy shifts the aggregate demand curve from AD0 to AD1 and the price level rises to 120. Inflation occurs only if, in response to the higher price level, the force that initially decreased aggregate supply recurs so that aggregate supply continues to decrease and, at the same time, the Fed continues to increase aggregate demand.

Cost-Push Inflation. The text gives a good description of the first oil price increase in the 1970s as a costpush inflation, and contrasts it well with the Fed’s refusal to accommodate the second oil price increase in 1979. An explanation of how cost-push can be a more widespread cause of inflation in other countries can be given in terms of countries where labor is highly unionized, and in effect there are attempts by different interest groups to obtain shares of GDP that add up to more than 100 percent, with accommodation by a weak monetary authority. Such a process of repeated wage increases, inflation, and monetary accommodation can give rise to continuing inflation. Analysts often “explain” the cause of inflation by focusing attention on the good or service whose price increased the most during the most recent time period. This is incorrect; inflation is the result of monetary growth. To explain inflation, economists are looking for an explanation that fits all cases not an explanation that focuses on specific prices of specific goods that differ from one inflation to another.

Expected Inflation •

•

When inflation is anticipated, the money wage rate changes to keep up with the anticipated inflation. So when the AD curve shifts rightward, increasing the price level, the money wage rate increases and the SAS curve shifts leftward. If the increase in the price level is fully anticipated, then the money wage rate rises by the same percentage so that the real wage rate remains constant. There are no deviations from full employment. The magnitude of the shift in A D equals that in SAS so that GDP remains equal to potential GDP and the economy moves up along the LAS curve, from point a to point c in the figures above. If inflation is not perfectly anticipated, the money wage rate changes but by a different percentage than the price level. Some of the inflation is unanticipated, so as a result the real wage rate changes and there are deviations from full employment. If aggregate demand grows faster than anticipated, real GDP exceeds potential GDP and the economy behaves as if it were in a demand-pull inflation. If © 2014 Pearson Education, Inc.

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aggregate demand grows slower than anticipated, real GDP is less than potential GDP and the economy behaves as if it were in a cost-push inflation. Because of the costs to of unanticipated inflation, there are benefits to forming accurate forecasts of inflation. The best available forecast is the one that is based on all relevant information and is called a rational expectation.

II. Inflation and Unemployment: The Phillips Curve A Phillips curve shows the relationship between inflation and unemployment. There are two time frames for a Phillips curve: the short run and the long run. HISTORY NOTE: The Phillips Curve. As a description of how economics advances, I like to give the students a stylized history of the Phillips curve. The story I tell starts in 1958 when A. W. Phillips published his empirical work. At that time the mainstream economic model was quite different from the AS-AD model derived in the text. Essentially, it was similar to the simple aggregate expenditure model presented in Chapter 11. He had British data that covered a long period of time and so his results appeared to be a long run phenomenon. The model was based on the assumption that the price level was constant, making the inflation rate zero. This assumption was not too unrealistic immediately after World War II. By 1955, however, the inflation rate began to creep higher and averaged 2.7 percent per year between 1956 and 1959. Inflation was beginning to be perceived as a problem, one that a model with a “fixed price level assumption” was poorly suited to solve. In this environment, economists gladly welcomed the simple, short-run Phillips curve, for it gave them a handle on inflation. They believed that they could predict the unemployment rate from their standard model and then combine this unemployment rate with the Phillips curve to determine the resulting inflation rate. The vital assumption in this procedure is that the Phillips curve captures a fixed tradeoff between the actual inflation rate and the unemployment rate that is part of the economy’s structure. This type of analysis reached its peak of popularity during the early and middle 1960s. By 1967, however, it was under attack. On a theoretical level, economist Milton Friedman—among others—pointed out the flimsy justification behind the simple, fixed Phillips curve assumption. On an empirical level, the simple, fixed Phillips curve failed as the inflation rate rose toward the end of the 1960s and into the 1970s: the unemployment rate did not fall as predicted by the fixed Phillips curve. At this point the idea of a long-run Phillips curve (as distinct from the short-run one) was developed. The concept that aggregate supply is an important component of macroeconomics was taking hold, as was the idea that short-run Phillips curves shift because of changes in people’s expectations. Thus the profession advanced significantly between the initial discussion of the Phillips curve and what students learn today. This advance was the result of the interaction between theory, suggesting that the idea of a fixed short-run Phillips curve was inadequate, and empirical work that reinforced the point that the simple, early approach was deficient.

The Short-Run Phillips Curve •

•

The short-run Phillips curve (SRPC) shows the relationship between the inflation rate and the unemployment rate holding constant the expected inflation rate and the natural unemployment rate. The figure shows a short-run Phillips curve. Inflation and unemployment have a negative relationship in the short run, so moving along a short-run Phillips curve, a higher inflation rate (holding constant the expected inflation rate) leads to lower a unemployment rate. The downward sloping short-run Phillips curve is equivalent to the upward sloping short-run aggregate supply curve. When aggregate demand © 2014 Pearson Education, Inc.

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unexpectedly increases so that real GDP and the price level both unexpectedly rise, the increase in real GDP lowers the unemployment rate and the unexpectedly higher price level means there is unexpectedly high inflation. The short-run Phillips curve captures the relationship between the lower unemployment rate and higher inflation rate. Use the board to create a scatter plot of observations that allow you to later “statistically fit” a line through the points as the Phillips curve. As you make the points on the graph, you can call them out as different years from 1950-1969. Now discuss how policy-makers embraced this model as getting to choose where they want to be on the Phillips curve. You can motivate this by picking two points and asking the students which one they thought would be preferred, high inflation and low unemployment or vice versa. As government started to think it could “fine-tune the economy,” we began to observe data points that had high inflation and high unemployment. Was Phillips wrong? Ask the students what might have happened and you may get someone to say it shifted! This answer is, of course, correct. Economists started to explore the effect of expected inflation as a factor that shifts the Phillips curve. You can now discuss the distinction between the long-run and the sort-run Phillips curve.

The Long-Run Phillips Curve •

•

The long-run Phillips curve (LRPC) shows the relationship between the inflation rate and the unemployment rate when the actual inflation rate equals the expected inflation rate. As illustrated in the figure, the long-run Phillips curve is vertical at the natural unemployment rate. The short-run Phillips curve intersects the longrun Phillips at the expected inflation rate. In the figure the expected inflation rate is equal to 4 percent. In the long run, higher or lower inflation has no effect on the unemployment rate. This result is analogous to the conclusion from the AS-AD model that in long run, a higher or lower price level has no effect on real GDP, which equals potential GDP so that the economy is at full employment.

The Phillips curve and the AS-AD model: Students can become confused about the tie between the Phillips curve and the aggregate supply/aggregate demand (AS-AD) model. Although this relationship is nicely developed in the text, some students will remain baffled. I do not think that a principles course is the appropriate place to derive the link between the two in much detail. But I do think that my lectures are an appropriate place to convey the idea of the relationship. Thus I point out that the vertical long-run aggregate supply curve is analogous to the vertical long-run Phillips curve. If you graph the two side by side, identify potential real GDP and the natural rate of unemployment on the two graphs at the intersection of the long run curves and the horizontal axis. The point that the long-run aggregate supply curve is vertical means that a higher price level has no effect on real GDP and hence no effect on the unemployment rate. Similarly, the fact that the long-run Phillips curve is vertical implies that a higher inflation rate has no effect on the unemployment rate and hence no effect on real GDP. The analogy also carries over to the short-run curves: the positively sloped short-run aggregate supply curve shows that in the short-run an unexpected higher price level raises real GDP and thus lowers unemployment. In the same way, the negatively sloped short-run Phillips curve demonstrates that in the short-run an © 2014 Pearson Education, Inc.

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unexpected higher inflation rate lowers unemployment, thereby raising real GDP. Students find that the two diagrams actually complement each other. I think that this approach is preferable to having the two diagrams compete with each other!

Shifts of the Phillips Curves • •

A change in the expected inflation rate shifts the SRPC vertically upward or downward by the amount of the change but has no effect on the LRPC. A change in the natural unemployment rate shifts both the SRPC and the LRPC. An increase in the natural rate shifts the SRPC and LRPC rightward by the amount of the increase; a decrease shifts the curves leftward by the amount of the decrease.

The U.S. Phillips Curves Because of changes in the expected inflation and the natural rate of unemployment, the short-run Phillips curve has shifted around a lot over time so that there is no single obvious negative relationship between inflation and unemployment.

III. The Business Cycle Business Cycles. Most principles of economics textbooks have a chapter that is similar to this one. However, many of them contain an extended discussion to the effect that, “This school of thought thinks this, but this other school of thought disagrees, and, by the way, here’s a third school of thought that thinks the first school is partially correct but partially wrong ...” This material is (appropriately enough!) found to be exceptionally tedious by the students. Fortunately, Parkin’s chapter is not at all like these other weak attempts. Parkin shows the students how the schools relate to each other and presents an incredibly exciting chapter. You can take advantage of this fact in your lecture by discussing with your students which school of thought best describes your views and what evidence convinced you. Just as students are always fascinated by why their instructor chose his or her field, so, too, are students fascinated about where their instructor fits into the scheme of controversies that they are learning about. By discussing your place in the line-up of different schools, be it “hard-line” monetarist, or new Keynesian, or an eclectic mixture, you can be guaranteed of your students’ strong interest when you discuss this topic. You might also point out to the students that theories are not necessarily mutually exclusive. For instance, even though you may be, perhaps, a monetarist, this does not necessarily mean that you totally deny that the factors emphasized by real business cycle proponents are occasionally important. By identifying your point of view and also giving the students some instruction about your view as to the usefulness of the other approaches, you can not only interest them but also help give them an enhanced general understanding of macroeconomics.

Mainstream Business Cycle Theory The mainstream business cycle theory regardless fluctuations in aggregate demand around a growing potential GDP (and hence constantly rightward shifting LAS and SAS curves) as the cause of the business cycle. Real GDP differs from potential GDP when money wage rates do not offset changes in the price level. • •

Keynesian Cycle Theory: The Keynesian cycle theory asserts that fluctuations in investment driven by fluctuations in business confidence—summarized by the phrase “animal spirits”—are the main source of fluctuations in aggregate demand. Money wage rates are assumed rigid. Monetarist Cycle Theory: The monetarist cycle theory asserts that fluctuations in both investment and consumption expenditure, driven by fluctuations in the growth rate of the quantity of money, are the main sources of fluctuations in aggregate demand. Money wage rates are assumed rigid.

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•

New Classical Cycle Theory: The new classical cycle theory asserts that the money wage rate and hence the position of the SAS curve are determined by the rational expectation of the price level, which depends on potential GDP and expected aggregate demand. Because the money wage rate changes with expected changes in aggregate demand, only unexpected fluctuations in aggregate demand lead to business cycle fluctuations. New Keynesian Cycle Theory: The new Keynesian cycle theory asserts that today’s money wage rates were negotiated at many past dates, which mean that past rational expectations of the current price level influence the money wage rate and the position of the SAS curve. Because the money wage rate does not change with newly expected changes in aggregate demand, both expected and unexpected fluctuations in aggregate demand lead to business cycle fluctuations.

Real Business Cycle Theory The real business cycle theory (or RBC theory) regards random fluctuations in productivity as the main source of economic fluctuations. • •

•

RBC Impulse: changes in the growth rate of productivity that results from technological change. A decrease in productivity growth brings a recession and an increase brings an expansion. Productivity shocks are measured using growth accounting The RBC Mechanism: A change in productivity changes investment demand and the demand for labor. • If productivity falls, investment demand and hence the demand for loanabe fund decreases. In addition, the demand for labor decreases. The decrease in the demand for loanable funds means the real interest rate falls. According to RBC theory, the fall in the real interest rate decreases the supply of labor because of intertemporal substitution. Because both the supply of labor and the demand for labor decrease, employment decreases and the change in the real wage rate is small. Real GDP decreases. Money plays no role in generating business cycles in the RBC theory; it affects only the price level.

I like to motivate RBC theory by suggesting that economists, such as Lucas and Prescott, challenged our previous portrayal of the LAS curve as being a stable curve that the short run fluctuations revolve around. You can use your arm to suggest that the LAS curve itself might shift leftward and rightward because of technology continuously impacting productivity in unstable ways.

Criticisms and Defenses of Real Business Cycle Theory •

•

Critics assert that money wages are sticky and that intertemporal substitution is too weak to account for large fluctuations in the supply of labor, which are necessary for RBC theory to explain the empirical fact that there are large fluctuations in employment with only small fluctuations in the real wage rate. A second criticism of RBC theory has to do with the direction of causality between productivity and business cycle fluctuations. RBC theory assumes changes in productivity cause business cycle fluctuations. Traditional aggregate demand theories suggest that measures of productivity change as a result of business cycle fluctuations. For instance, they assert that in expansions, capital and labor are used more intensely so that measured productivity increases, even with no change in technology.

What does it mean to use capital and labor more intensely? It is easy to see with labor hours. A firm could record the same number of labor hours in an expansion as in a recession. But, if the firm is trying to increase production to meet high demand in the expansion, workers will work harder and, therefore, be more productive in the expansion. This change in productivity is not related to technology but growth accounting likely will (erroneously) attribute the increase in productivity to a technological advance.

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RBC theory defenders point out that the theory is consistent with microeconomic evidence about labor supply decisions and labor demand and investment demand decisions.

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Additional Problems 1. 2.

Has the U.S. economy experienced inflation or deflation during recent recessions? Explain. The spreadsheet provides information about the economy in Argentina. Column A is the year, Column B is real GDP in billions of 2000 pesos, and Column C is the price level. a. In which years did Argentina experience inflation? In which years did it experience deflation (a falling price level)? b. In which years did recessions occur? In which years did expansions occur? c. In which years do you expect the unemployment rate was highest? Why? d. Do these data show a relationship between unemployment and inflation in Argentina?

1 2 3 4 5 6 7 8 9 10 11 12

A 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

B 277 288 278 276 264 235 256 279 305 331 359 384

C 105.6 103.8 101.9 102.9 101.8 132.9 146.8 160.4 174.5 198.0 226.1 267.7

Solutions to Additional Problems 1,

The United States has experienced inflation during recent recessions, though there have been instances when the inflation rate fell during recessions. For instance in late 2008 the inflation rate fell as the economy moved into a recession. Inflation, however, generally continued because aggregate demand continued to increase during the recessions, though at a slower rate. a. Argentina experienced inflation in 2000 and from 2002 through 2008. Argentina experienced deflation in 1998, 1999, and 2001. b. Argentina had recessions in 1999, 2000, 2001, and 2002. Argentina had expansions in 1998 and 2003 through 2008. c. The unemployment rate was probably high in all of the recessionary years. It was probably the highest in 2000 and 2002 when the recessions were at their worst. d. There is not a strong relationship between unemployment and inflation in the data. The unemployment rate would likely have been higher in the recession years of 1999, 2000, 2001, and 2002. In 2000 Argentina experienced low inflation and 2002 Argentina experienced high inflation. In 1999 and 2001 Argentina experienced deflation. But Argentina also experienced deflation 1998. So there is no consistent relationship between either inflation and high unemployment or deflation and high unemployment. There also is a similar lack of relationship between inflation and low unemployment or deflation and low unemployment.

Additional Discussion Questions 11. Some economists claim that inflation is always a “monetary phenomenon.” What do they mean by this claim and are they correct? This claim points to the result that an ongoing inflation requires the central bank to constantly increase the quantity of money. In the absence of continual monetary growth, the price level might rise but it would eventually stabilize. The price level will continue to rise, which means that on-going inflation will occur, only if the Federal Reserve constantly increases the quantity of money. Because © 2014 Pearson Education, Inc.

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inflation requires constant growth in the quantity of money, inflation can be thought of as a “monetary phenomenon.” 12. How can a higher price of oil create inflation? By itself a higher price of oil cannot create inflation. Taken by itself a higher price of oil can lead to a higher price level but after the adjustment is made to the higher price of oil, the price level stops rising—that is, inflation stops. A higher price of oil can lead to inflation only if the central bank “ratifies” it by increasing the quantity of money. If the central bank, the Federal Reserve in the United States, responds to the decrease in real GDP created by the higher price of oil by increasing the quantity of money, then inflation can result. The increase in the quantity of money will drive the price level still higher. In this situation oil producers might respond by again boosting the price of oil. If the Fed responds once again in turn, the process can continue indefinitely and a cost-push inflation results. 13. What is the relationship between the short-run aggregate supply curve and the shortrun Phillips curve? Between the long-run aggregate supply curve and the long-run Phillips curve? The short-run aggregate supply curve and the short-run Phillips curve are closely related. If aggregate demand increases, the economy moves upward along its shortrun aggregate supply curve so that the price level and real GDP both increase. The rise in the price level means that inflation rises and the increase in real GDP means that unemployment falls. The rise in the inflation rate combined with the fall in the unemployment rate correspond to a movement upward along the economy’s short-run Phillips curve. Similarly the long-run Phillips curve and long-run aggregate supply curve also are closely related. In the long run an increase in aggregate demand moves the economy upward along its long-run aggregate supply curve so that the price level rises and real GDP does not change—it remains equal to potential GDP. The rise in the price level means that the inflation rate rises and the result that real GDP remains equal to potential GDP means that the unemployment rate remains equal to its natural rate. The rise in the inflation rate combined with the unemployment rate remaining equal to its natural rate correspond to a movement upward along the economy’s long-run Phillips curve. 14. Suppose the expected and actual inflation rates are 7 percent and the natural rate of unemployment is 6 percent. If the inflation rate falls to 5 percent while the expected inflation rate remains at 7 percent, what happens to the unemployment rate? If the actual inflation rate falls and the expected inflation rate does not change, the economy moves downward along a short-run Phillips curve so that the unemployment rate increases. 15. Suppose the expected and actual inflation rates are 7 percent and the natural rate of unemployment is 6 percent. If the inflation rate falls to 5 percent and the expected inflation rate also falls to 5 percent, what happens to the unemployment rate? If the actual inflation rate and the expected inflation rate fall by the same amount, the economy moves downward along its long-run Phillips curve so that the unemployment rate does not change—it remains equal to the natural unemployment rate. 16. Suppose that the actual inflation rate is 7 percent and that the economy is at the natural unemployment rate. If the Fed announces that it is going to lower the inflation rate and people believe this announcement (so that the decline in the inflation rate is not a surprise), what happens to the unemployment rate? Suppose that people believe the Fed’s announcement and that the expected inflation rate falls, but then the Fed keeps the inflation rate at 7 percent. Now what happens to the unemployment rate? If the Fed follows through on its announcement, both the actual and expected inflation rate fall by the same amount so that the unemployment rate remains equal to its natural rate. © 2014 Pearson Education, Inc.

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However if the Fed actually does not lower the inflation rate, then the actual inflation rate exceeds the expected inflation rate. In this case the short-run Phillips curve shifts downward. The economy moves to a point on its new short-run Philips curve at the unchanged inflation rate and the unemployment rate falls. 17. How do you think recessions influence elections? Recessions have large impacts on elections. If an election occurs during (or near) a recession, the incumbent party suffers. This empirical result holds true for President Ford who lost his reelection bid in 1976; President Carter who lost his reelection bid in 1980; President Bush who lost his reelection bid in 1992; and Senator McCain who lost his election bid in 2008. All of these candidates were members of the incumbent party and all faced election either near or during a recession. President Obama’s re-election in 2012 was an unusual case in that the economy was in recovery but unemployment was still high near 8 percent.

C h a p t e r

FISCAL POLICY

The Big Picture Where we have been: This chapter extensively uses the aggregate supply-aggregate demand model introduced in Chapter 10. It also makes use of Chapter 11’s discussion of multipliers. The material on the labor market and potential GDP from Chapter 6 is important when discussing the supplyside effects of fiscal policy. Where we are going: Chapter 14 on monetary policy completes the material on macroeconomic stabilization policies.

New in the Eleventh Edition All data throughout the chapter have been updated to 2012. The Reading Between the Lines section is new. It has an article from August 2012 that discusses what might result if the economy goes over the “fiscal cliff.” There are three new problems in the Study Plan Problems and Applications replacing some older headlines with more current material. The Additional Problems and Applications have eight new problems.

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Lecture Notes

Fiscal Policy • •

Fiscal policy refers to changes in government expenditure and taxes. Fiscal policy impacts both aggregate supply and aggregate demand.

The Federal Budget

The annual statement of the outlays and receipts of the government of the United States together with the laws and regulations that approve and support those outlays and receipts make up the federal budget. The use of the federal budget to achieve macroeconomic objectives such as full employment, sustained economic growth, and price level stability is called fiscal policy.

The Institutions and Laws •

•

The President submits a budget proposal to Congress. Congress debates, amends, and enacts the budget. The budget operates within the framework of the Employment Act of 1946, which states: “… it is the continuing policy and responsibility of the Federal Government to use all practicable means … to coordinate and utilize all its plans, functions, and resources … to promote maximum employment, production, and purchasing power.” The Council of Economic Advisers monitors the economy and keeps the President and the public well informed about the current state of the economy and the best available forecasts of where it is heading.

Highlights of the 2013 Budget • • •

Receipts come from four sources: personal income taxes ($1,348 billion), social security taxes ($1,058 billion), corporate income taxes ($441 billion), and indirect taxes and other receipts ($289 billion). Outlays are classified in three categories: transfer payments ($2,644 billion), expenditure on goods and services ($1,132 billion), and debt interest ($35760 billion). Budget balance = Receipts – Outlays • If receipts exceed outlays, the government has a budget surplus. • If outlays exceed receipts, the government has a budget deficit. • If receipts equal outlays, the government has a balanced budget.

The U.S. Budget in Historical Perspective and in Global Perspective • • •

Since 1980, except between 1998 to 2001, since 1980 the U.S. government has had a budget deficit. Government debt is the total amount that the government has borrowed. A budget deficit adds to the government debt. In 2010, all of the world’s major economies had a budget deficit. The newly industrialized economies of Asia had the smallest deficits while the United Kingdom, the United States, and Japan (in that order) had the largest deficits as a fraction of GDP. The U.S. deficit was about 11.8 percent of GDP.

Deficit and debt. Many students need help with the distinction between the deficit and the debt (and with what happens to the debt when there is a surplus). Use the student loan or credit card analogy. Explain that the budget balance (the deficit or surplus) is just like a personal budget balance (the amount that a student borrows or pays back during a given year). The debt—the total amount owed by the government—is like the balance on a student loan or credit card account. Students (usually) have a budget deficit and increasing debt. And graduates with a job (usually) have a budget surplus and decreasing debt.

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An interesting historical episode. During the mid-1830s—a long time ago—the U.S. government had virtually repaid all its debt. At that time the government faced a problem that doesn’t occur today: it had a surplus and didn’t know what to do with it. The decision was made to transfer money to the state governments. Each state was to receive $400,000 in four payments of $100,000 each. The first three payments were made, but the last one was postponed because of a recession in 1837 that lowered the federal government’s revenue and then was never made. In the 1970s, faced with a severe budget crunch, the State of New York sued to receive that last payment plus interest. The state lost the suit and so the last payment probably will never be made! (You might remark that $100,000 invested in 1837 at the average interest rate would have accumulated to about $30 billion by 2010!)

II. Supply-Side Effects of Fiscal Policy The effects of fiscal policy on employment, potential GDP, and aggregate supply are known as supply-side effects.

The Effects of Taxes on Full Employment and Potential GDP • •

•

The labor market determines the full employment quantity of labor, which, together with the production function, determine potential GDP. The equilibrium quantity of employment is determined in the labor market. The first figure shows the labor market. In the figure equilibrium employment is 250 billion hours per year. This amount of employment is full-employment. The second figure shows the production function. With employment of 250 billion hours, the production function shows that real GDP is $13 trillion. An income tax decreases the supply of labor and shifts the supply of labor curve leftward. In the top figure, the LS curve shifts leftward. Because of the tax wedge, the level of employment decreases. In the bottom figure the decrease in employment decreases potential GDP. An income tax drives a tax wedge between the before-tax wage rate that firms pay and the aftertax wage rate that workers receive. Other taxes, such as sales taxes, add to the tax wedge by effectively lowering the real wage rate.

Some Real World Tax Wedges … Does the Tax Wedge Matter? Tax wedges vary across countries, being much higher in France than in the United States. According to supply-side economists such as Ed Prescott, the tax wedge has a large impact on potential GDP. Potential GDP per person in France is 14 percent below that in the United States and Prescott asserts that the entire difference can be attributed to the difference in the countries’ tax wedges.

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Taxes and the Incentive to Save and Invest •

•

A tax on interest income decreases the supply of saving and shifts the supply of loanable funds curve leftward. The tax drives a wedge between the after-tax interest rate received by savers and the interest rate paid by firms. The tax does not change the demand for loanable funds. The figure shows the result: the real interest rate paid by borrowers rises (from 5 percent to 6 percent in the figure) and the equilibrium quantity of loanable funds and investment decrease. The decrease in investment lowers the growth rate of potential GDP.

Tax Revenues and the Laffer Curve •

•

The relationship between the tax rate and the amount of tax collected is called the Laffer curve. The Laffer curve shows that at a high enough tax rate, an increase in tax rates decreases tax revenues. Tax revenues decrease because individuals find ways to avoid the high taxes, including by working less. Most economists believe that taxes have an effect on the supply of labor, but that in the U.S. economy, the tax rate is low enough so that an increase in the tax rate increases tax revenues.

Laffer Curve and Napkins: Students get a kick out of the napkin roots of the Laffer Curve. The story that Laffer himself cannot deny nor confirm is that he first drew the Laffer curve on a napkin during one of his first attempts to persuade someone of his supply side theory. Draw the Laffer curve and ask what side of the curve are we on? Ask them what they think the highest tax rate was in the United States, they are usually shocked to learn that we had marginal rates in the 70% range as recently as the 1970. This a great discussion point on how high tax rates can deter work!

III. Generational Effects of Fiscal Policy Generational accounting is an accounting system that measures the lifetime tax burden and benefits of government programs to each generation.

Generational Accounting and Present Value To compare the costs and benefits that occur at different points in the future, which is necessary in generational accounting, the concept of present value is used. A present value is an amount of money that, if invested today, will grow to equal a given future amount when the interest that it earns is taken into account. Because there is uncertainty about the proper interest rate to use when calculating present values, plausible alternative numbers are used to estimate a range of present values.

The Social Security Time Bomb •

•

Fiscal imbalance is the present value of the government’s commitments to pay benefits minus the present value of its tax revenues. In 2010, the fiscal imbalance was estimated to be $79 trillion and growing by about $2 trillion every year. The fiscal imbalance is high because of obligations under Social Security laws and Medicare. There are four alternatives for redressing the fiscal imbalance: raise income taxes, raise Social Security taxes, cut Social Security benefits, or cut federal government discretionary spending. But the changes needed would be severe. It is estimated that income taxes would need to be raised by 69 percent; or Social Security taxes raised by 95 percent; or Social Security benefits cut by 56 percent. © 2014 Pearson Education, Inc.

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Generational Imbalance Generational imbalance is the division of the fiscal imbalance between the current and future generations assuming that the current generation will enjoy the current levels of taxes and benefits. It is estimated that the current generation will pay 43 percent of the fiscal imbalance and the future generations will pay 57 percent.

IV. Fiscal Stimulus • •

A fiscal action that is initiated by an act of Congress is called discretionary fiscal policy. A fiscal action that is triggered by the state of the economy is called automatic fiscal policy.

Automatic Fiscal Policy and Cyclical and Structural Budget Balances •

• •

Tax revenues and needs-tested spending change with the business cycle. • The government sets tax rates. As incomes vary with the business cycle, the tax revenue collected changes. Tax revenue automatically falls in recessions and automatically rises in expansions. • Government expenditure on programs that pay benefits to people and businesses depending on their economic status is called needs-tested spending. Needs-tested spending automatically increases in a recession and automatically decreases in an expansion, helping to stabilize the economy. Induced taxes and needs-tested spending mean that the federal budget deficit is counter-cyclical, with the deficit increasing in a recession and decreasing in an expansion. The structural surplus or deficit is the budget balance that would occur if the economy were at full employment and real GDP were equal to potential GDP. The cyclical surplus or deficit is the actual surplus or deficit minus the structural surplus or deficit. • In 2012 the total U.S. budget deficit was $1.1 trillion. According to the Congressional Budget Office (CBO) the cyclical deficit was $0.4 trillion so the structural deficit was $0.7 trillion. • The structural deficit skyrocketed after 2008, from about $400 billion in that year to $1.0 trillion in 2009.

By their nature, automatic fiscal policy implies federal budget deficits in recessions as tax revenues fall and spending increases. By contrast, balanced budget rules for state and local governments mean that these governments do not conduct stabilizing fiscal policy. In the 2008 recession, the sharp decline in state and local tax revenues meant that state spending programs had to be cut and, in some states, taxes raised. Such policies are the opposite of the policies that can be used to help stabilize the business cycle. •

Automatic fiscal policy helps stabilize the business cycle because it provides an automatic stimulus during a recession and an automatic contraction during an expansion.

Discretionary Fiscal Stimulus • •

The government expenditure multiplier is the quantitative effect of a change in government expenditure on real GDP. An increase in government expenditure increases aggregate expenditures setting in motion the multiplier process. The tax multiplier is the quantitative effect of a change in taxes on real GDP. A decrease in taxes increases disposable income and hence consumption expenditure, setting in motion the multiplier process. • The effect on aggregate demand from a tax cut is less than that from a similar sized increase in government expenditure. A $1 tax cut generates less than a $1 increase in consumption expenditure since only a fraction (equal to the MPC) of the $1 increase in disposable income is spent on consumption expenditure.

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Fiscal Stimulus •

•

Expansionary fiscal policy (an increase in government expenditure or a decrease in taxes) seeks to eliminate a recessionary gap. If timed correctly and of the correct magnitude, fiscal policy can be used to push the economy to potential GDP. The figure shows the effect of expansionary fiscal policy on aggregate demand. At the initial equilibrium, $12 trillion real GDP and price level of 110, there is a recessionary gap. The expansionary policy increases aggregate demand and the multiplied effect shifts the AD curve rightward from AD0 to AD1. The recessionary gap is eliminated and the economy moves to its new equilibrium, $13 trillion real GDP (which equals potential GDP) and price level of 115.

Fiscal Stimulus and Aggregate Supply The focus so far has been on only aggregate demand. But fiscal policy also impacts aggregate supply. • Government Expenditure: An increase in government expenditure increases the budget deficit. The demand for loanable funds increases, so the real interest rate rises and investment is crowded out. The decrease in investment offsets the expansionary effect from the increase in government expenditure. The crowding-out effect is strong enough so that the government expenditure is less than 1. • Tax Cut: A tax cut also has effects on aggregate supply. A tax cut increases the supply of labor and the supply of loanable funds, both of which increase aggregate supply. The supply-side effects make the tax multiplier larger than the government expenditure multiplier. There is quite a bit of controversy about the size of the multipliers. Christina Romer, while working for the Obama administration, asserted that the government expenditure multiplier was 1.5. Robert Barro, of Harvard University, says his research shows the multiplier is 0.5. These differences are dramatic and students can appreciate their importance and real-world relevance. Highlight the Ricardo-Barro effect as a possible argument for smaller multipliers.

Limitations of Discretionary Fiscal Policy In practice, discretionary fiscal policy is hampered by three time lags: • • •

Recognition Lag: The recognition lag is the time it takes to figure out that fiscal policy actions are needed. Law-Making Lag: The law-making lag is the amount of time it takes Congress to pass the laws needed to change taxes or spending. Impact Lag: The impact lag is the time it takes from passing a tax or spending change to implementing the new arrangements and feeling their effects on real GDP.

Fiscal policy in practice. Most economists acknowledge that, in principle, discretionary fiscal policy can be used for stabilization purposes, but in practice such stabilization is extremely difficult because of long legislative lags. It is worth reminding the students that the equilibrium in the AS-AD model takes time to work out. The multiplier is a long drawn out process. An increase in government expenditure shifts the AD curve rightward but the new equilibrium price level and real GDP take time to occur. It is also useful to discuss the length of time it took the Congress to pass the 2002 “stimulus package” and the time it took in

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the Fall of 2008 to decide on a fiscal policy to be used after the initial “bailout package.” The law-making lag can be substantial and the outcomes questionable!

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Additional Problems 1.

The government is proposing to lower the tax rate on labor income and asks you to report on the supply-side effects of such an action. Answer the following questions and describe what happens on the relevant graph. You are being asked about directions of change, not exact magnitudes. a. What will happen to the supply of labor and why? b. What will happen to the demand for labor and why? c. What will happen to the equilibrium level of employment and why? d. What will happen to the equilibrium before-tax wage rate? e. What will happen to the equilibrium after-tax wage rate? f. What will happen to potential GDP?

How Reagan Would Fix the Economy Many Republicans look at Reagan’s policies in the early 1980s and assert that tax cuts pay for themselves. That’s wrong—Reagan’s rate cuts for the rich paid for themselves, but the tax cuts for the poor, the middle class and corporations did not. The deficit increased. But there is a limit to the deficit. At some time the government debt grows so large that it starts to harm the economy through higher interest rates, bigger debt payments, a weaker currency, etc. Time, May 26, 2008 a. Explain why Reagan’s tax rate cuts for high income taxpayers may have paid for themselves, but cuts for lower-income and middle-income taxpayers did not. b. Explain the negative consequences of running persistently large budget deficits.

Explain why extending unemployment insurance benefits has both a supply-side and demand-side effect on real GDP and the price level.

Solutions to Additional Problems 1.

b. c.

d. e.

f. 2.

The supply of labor increases. The supply of labor curve shifts rightward. The supply of labor increases because at each real wage rate, the after-tax wage rate received by workers will be higher given a decrease in the tax rate on labor income. The demand for labor remains the same. The demand for labor depends on the productivity of labor, which remains the same following the decrease in the tax rate on labor income. The equilibrium level of employment increases. With the rightward shift in the supply of labor curve, the real wage rate decreases and the quantity of labor demanded increases along the demand for labor curve. Equilibrium employment increases. The equilibrium pre-tax wage rate decreases. The rightward shift of the supply of labor curve leads to movement down along the demand for labor curve. The equilibrium after-tax wage rate increases. The decrease in the tax rate on labor income decreases the wedge between the before-tax wage rate and the after-tax wage rate. The before-tax wage rate decreases but not by as much as the decrease in tax. So the after-tax wage rate increases. Potential GDP increases. The equilibrium level of employment is the full employment quantity of labor. So as full employment increases, potential GDP increases along the production function. High-income taxpayers faced very high tax rates. For these taxpayers, the cut in tax rates probably lead to large increases in the quantity of labor they supplied so that the tax revenue from high© 2014 Pearson Education, Inc.

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income taxpayers increased. But middle-income and lower-income taxpayers did not face such high rates. For these groups the tax cut increased the quantity of labor they supplied but by only a small amount so that the tax revenue from middle-income and low-income taxpayers decreased. Persistently running large budget deficits increases the government debt, which increases the interest the government must pay and contributes to larger budget deficits in the future. Budget deficits also crowd out investment, so persistently running budget deficits decreases investment and the capital stock is less than otherwise. Because the capital stock is smaller, U.S. potential GDP is lower. Extending unemployment insurance benefits increases the amount of time unemployed workers search for new jobs, which decreases employment. The decrease in employment decreases aggregate supply. Simultaneously extending unemployment insurance benefits increases the income received by unemployed workers. The increase in income increases consumption expenditure, which increases aggregate demand.

Additional Discussion Questions 11. What is the distinction between the government’s budget deficit and the government’s debt? The budget deficit is the amount the government is borrowing in any given year. The government debt is the total amount the government has borrowed over all the years. The budget deficit adds to the (total) government debt. 12. Suppose that the government increases its expenditures payments by $100 billion and pays for the increase by raising taxes by $100 billion. What is the effect on aggregate demand and real GDP of each change individually and of the two combined? The increase in government expenditure adds directly to aggregate demand so that aggregate demand and real GDP both increase. The increase in taxes indirectly decreases aggregate demand by decreasing consumption expenditure. The decrease in aggregate demand leads to a decrease in real GDP. The magnitude of the increase in aggregate demand from the increase in government expenditure exceeds the magnitude of the decrease from the increase in taxes. So when both effects are combined, on net aggregate demand increases so that real GDP increases. 13. Why does a change in income taxes have a different effect on aggregate supply than a change in government expenditures? A change in income taxes changes the tax wedge and affects people’s incentives to supply labor. The supply of labor changes, which affects employment and hence potential GDP. For example, if income taxes are boosted, the supply of labor decreases. With the decrease in the supply of labor, employment decreases so that potential GDP decreases. The decrease in potential GDP decreases aggregate supply. A change in government expenditures does not have this same incentive effect. Because it does not have this effect, it has no impact on aggregate supply. 14. Suppose because of a recession, most state governments experience reductions in tax revenues, and respond by reducing their expenditures and increasing their taxes to keep their state budgets in balance (a constitutional requirement in many U.S. states). Will this have any effect on the recession, and if so, what? This policy on the part of states deepens the recession. In a recession fiscal policy generally aims to increase aggregate demand because the increase in aggregate demand increases real GDP. Cutting state government spending and raising taxes decreases aggregate demand. A decrease in aggregate demand decreases real GDP and worsens the recession.

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5. In 2012, the looming “Fiscal Cliff” meant that there would be an increase in taxes coupled with a decrease in government spending. Meanwhile the Federal Reserve was continuing “Quantitative Easing.” Discuss the combined effects of these events on the economy. The fiscal cliff is a combination of two contractionary fiscal policies which would decrease aggregate demand. Quantitative Easing is an expansionary monetary policy meant to increase aggregate demand. Chairman Bernanke stated during the fourth quarter of 2012 that the Fed was pursuing that policy in part to hedge against the negative effects of the fiscal cliff should it happen.

C h a p t e r

MONETARY POLICY**

The Big Picture Where we have been: Chapter 14 heavily uses material from Chapter 8, which was the first chapter dealing with money, and Chapter 10, which introduced the aggregate supply-aggregate demand model. The expenditure multiplier, covered in Chapter 11, plays a small role in this chapter. Playing a larger role is the loanable funds market, developed in Chapter 7. Where we are going: Chapter 14 is the last dealing with macroeconomics. The next chapter, on international trade, will not use the material from this chapter.

New in the Eleventh Edition This chapter’s theory content is largely the same as the tenth edition but there are two nice applied pieces added. One is found in the Economics in the News and it discusses how monetary stimulus has been less than stimulating post 2008. The other is found in the At Issue where differing opinions on quantitative easing are presented. The data throughout the chapter are updated to 2012. The Reading Between the Lines section is a September 2011 article that deals with the Fed’s policy of “Operation Twist”. There are four new problems in the Study Plan Problems and Applications replacing some older headlines with more current material. The in Additional Problems and Applications has three updated and four new problems.

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Lecture Notes

Monetary Policy • • •

The Fed can influence the federal funds interest rate and thereby affect economic activity. What are the transmission channels of monetary policy? What are alternative monetary policy strategies? The Fed (and other government agencies) has responded to the financial crisis of 2007-2008 with a variety of innovative policies designed to fight the crisis.

Monetary Policy Objectives and Framework

Monetary Policy Objectives The Fed’s mandate is that “The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long-run growth of the monetary and credit aggregates commensurate with the economy’s long-run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” •

Goals: The goals in the mandate are “maximum employment, stable prices, and moderate longterm interest rates.” Achieving stable prices, keeping the inflation rate low, is the key. It is the source of maximum employment and moderate long-term interest rates. Low inflation rates mean that people make decisions without the confusion created by inflation. And, because the nominal interest rate equals the real interest plus the inflation rate, a low inflation rate means low longterm interest rates. • Operational “Stable Prices” Goal: The Fed pays close attention to the core PCE deflator, the PCE deflator excluding food and fuel. The core inflation rate is the rate of increase of the core PCE deflator. Price stability can mean either a core inflation rate “low and stable enough so that it does not enter materially into the decisions of households and firms” (Alan Greenspan) or a core inflation rate of “1 or 2 percent” (Ben Bernanke). •

Operational “Maximum Employment” Goal: The Fed tracks the output gap, the percentage deviation of real GDP from potential GDP. The Fed tries to minimize the output gap.

Responsibility for Monetary Policy •

• •

The Role of the Fed The Federal Reserve Act makes the Board of Governors of the Federal Reserve System and the Federal Open Market Committee (FOMC) responsible for the conduct of monetary policy. The Fed has ultimate responsibility for monetary policy. The FOMC makes monetary policy decisions at eight scheduled meetings a year. The Role of Congress Congress plays no role in making monetary policy decisions but the Federal Reserve Act requires the Board of Governors to report on monetary policy to Congress. The Role of the President The formal role of the president of the United States is limited to appointing the members and the chairman of the Board of Governors.

II. The Conduct of Monetary Policy The Monetary Policy Instrument A monetary policy instrument is a variable that the Fed can directly control or closely target. • •

The Fed could fix the exchange rate as its policy instrument. But then it could not pursue an independent monetary policy, so for that reason the Fed does not fix the exchange rate. The Fed, similar to most central banks, chooses to use a short-term interest rate as its monetary policy instrument. The interest rate the Fed targets is the federal funds rate, the interest rate on overnight loans (of reserves) that banks make to each other. Although the Fed can change the federal funds rate by any reasonable amount, it normally changes the federal funds rate one quarter of a percentage point at a time. © 2014 Pearson Education, Inc.

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The federal funds rate is determined in the market for reserves. The higher the federal funds rate, the greater the opportunity cost of holding reserves rather than loaning them. So the higher the federal funds rate, the smaller the quantity of reserves demanded. As shown in the figure, the demand curve for reserves is downward sloping. The Fed’s open market operations determine the supply of reserves. Because the Fed determines the quantity of reserves, the figure shows that the supply curve of reserves is vertical at this quantity. • An Open Market Purchase: The Fed buys government securities from a bank and pays for the purchase by increasing the bank’s reserves. The supply of reserves increases. • An Open Market Sale: The Fed sells government securities to a bank and receives payment for the sale by decreasing the bank’s reserves. The supply of reserves decreases. The figure shows the market for reserves. In the figure the equilibrium federal funds rate is 5 percent. • If the Fed wants to lower the federal funds rate, the Fed undertakes an open market purchase of government securities. The quantity of reserves increases and the federal funds rate falls. •

If the Fed wants to raise the federal funds rate, the Fed undertakes an open market sale of government securities. The quantity of reserves decreases and the federal funds rate rises.

Interest Rate Determination: The reason that an increase in the reserves lowers the interest rate can be easily developed by focusing on banks. Using an open market operation, the Fed increases excess reserves. Banks want to loan these new excess reserves, and thus the supply of loans and loanable funds increases. As a result, the interest rate on loans falls as they struggle to make more loans. This type of intuitive explanation often can be quite helpful in supplementing the formal analysis.

FOMC Decision Making and the Market for Reserves After assessing the current state of the economy using the Beige book (which is now online), the Fed turns to forecasting three key variables: the inflation rate, the unemployment rate, and the output gap. Based on those forecasts, The FOMC formulates its monetary policy and decides upon its target federal funds rate. The FOMC instructs the New York Fed to use open market operations—the purchase or sale of government securities in the open market—to hit its federal funds target rate.

III. Monetary Policy Transmission Ripple Effects of Changing the Interest Rate Suppose the Fed lowers the federal funds rate using an open market sale. As a result: • • •

Other interest rates: Other short-term interest rate falls. Long-term bond interest rates also fall, but by a lesser amount. Exchange rate: The fall in the U.S. interest rate lowers the U.S. interest rate differential. The demand for U.S. dollars decreases and the supply of U.S. dollars increases. The exchange rate falls (the dollar depreciates). Money and bank loans: Banks’ reserves have increased so they have excess reserves. Banks loan the excess reserves, so loans and the quantity of money increases. © 2014 Pearson Education, Inc.

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• • •

Long-term real interest rate: The real interest rate is determined in the loanable funds market. In the short run, the increase in loans increases the supply of loanable funds and lowers the real interest rate. Expenditure plans: Consumption expenditure and investment increase as a result of the lower real interest rate. Net exports increase as a result of the fall in the exchange rate. Aggregate demand: Aggregate demand increases with a multiplier effect so that the price level rises and real GDP increases.

Effects of Money on Real GDP and the Price Level: We bring in here the expenditure multiplier; it is important to ensure that students do not get confused between the multiplier impact of open market operations on the quantity of money, and the multiplier process that magnifies autonomous expenditure changes. Additionally, when using the AS-AD model to explain the impact of deflationary monetary policy, it is important to stress the text’s point that the model is a stationary simplification, whereas in reality output and the price level both tend to grow, so that rather than reducing real GDP and the price level, the Fed’s anti-inflation policy would slow their growth.

The Fed Fights Recession If the Fed believes that real GDP is less than potential GDP (a negative output gap), the Fed will undertake expansionary monetary policy: it lowers the federal funds rate using an open market sale. The monetary policy is transmitted as outlined above and real GDP increases.

The Fed Fights Inflation If the Fed believes that real GDP is greater than potential GDP so that inflation is a problem (a positive output gap), the Fed will undertake contractionary monetary policy: it raises the federal funds rate using an open market sale. The effect of the monetary policy is transmitted as described, only the directions of the changes are reversed. Real GDP decreases. Tying it All Together: Students often think that macroeconomics is difficult because there are so many different concepts introduced. Among others, students must learn about aggregate demand curve and the short-run and long-run aggregate supply curves; the aggregate production function; ; the demand for labor, the supply of labor, and the labor market; the demand for reserves, the supply of reserves, how Fed policy affects the supply of reserves, and the market for reserves; the demand for money, the supply of money, the money multiplier, and the market for money; and, the demand for loanable funds, the supply of loanable funds, the market for loanable funds, and government impacts on this market. This chapter offers a great chance for you to use the book’s very clear presentation and very straightforward presentation of monetary policy transmission to help the student see how all the parts interact. Use the book’s “four quadrant diagrams” (Figures 14.6a, 14.6b, 14.6c, and 14.6d as well as 14.7a, 14.7b, 14.7c, and 14.7d) to show the students how everything they learned ties together to give a complete and coherent view of the otherwise exceedingly complex macroeconomy. Don’t hesitate to refer back to earlier chapters to remind the students what they learned in those chapters and how that is now being used to explain how our economy functions.

Loose Links and Long and Variable Lags •

In reality, the ripple effects of monetary policy are not as precise as outlined above. • The long-term real interest rate that influences expenditure plans is linked only loosely to the federal funds rate. And the response of expenditure plans to the real interest rate also is not tight. •

•

The transmission channels described above take time to operate and the time can vary from one episode to the next.

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Effects of Money on Real GDP and the Price Level Revisited: You might want to remind the students that the effects of monetary policy on real GDP and the price level so clearly discussed in this chapter are short run effect. In the long run, the quantity theory covered in Chapter 8 rules the roost. You can point out to your students that in the long run, the impact on real GDP dissipates and the only long run effect is on the price level (or the inflation rate). In the late 1970s and early 1980s, several central banks targeted the quantity of money to successfully lower their inflation rates. However, central banks eventually abandoned this procedure as financial innovations made the demand for money (and velocity) mush less stable than in the past.

IV. Extraordinary Monetary Stimulus The Key Elements of the Crisis The financial crisis of 2007-2008 started in the United States in August 2007. Banks were at the center of the crisis which eventually led to the largest recession since the great depression. •

• •

Banks were put under stress from three sources: • A Widespread Fall in Asset Prices: The so-called “housing bubble” burst and house prices rapidly switched from rising to falling. Sub-prime mortgage defaults occurred and these assets as well as derivatives based on these assets lost value. Banks suffered losses which reduced their equity. • A Significant Currency Drain: Depositors started to withdrawal their deposits at money market mutual funds. This process created concern among banks that similar withdrawals would occur and that bank runs might start. • A Run on the Bank: One bank in the United Kingdom, Northern Rock, experienced a bank run. In the United States, massive withdrawals of deposits from money market mutual funds occurred. Banks’ desired reserves increased so banks increased their reserves by calling in loans. • The widespread fall in asset prices threatened banks’ solvency; the currency drain threatened their liquidity; and, the potential run on the bank threatened both solvency and liquidity. Banks’ efforts to shore up their balance sheet severely decreased the supply of loans and commercial paper, so these markets essentially closed. Because the loanable funds market is worldwide, these problems immediately spread throughout the world. The drastic decrease in the supply of loanable funds started to affect the real economy.

The Policy Actions •

Policy actions responding to the crisis were slowly implemented until by November 2008 eight groups of policies were in place: • Open Market Operations: The Fed undertook massive open market operations to give banks more liquidity. The federal funds rate was lowered, in December to between 0.00 and 0.25 percent. • Extension of Deposit Insurance: Deposit insurance was extended to other institutions, such as money market funds. This policy was aimed at preventing runs. • Term Auction Credit; Primary Dealer and Other Broker Credit; and Asset-backed Commercial Paper Money Market Mutual Fund Liquidity Facility: These are three separate policies but all have similar effects: The Fed accepted significantly riskier assets from a wider range of depository institutions than before in exchange for assets or reserves. These policies allowed depository institutions to swap risky assets for safer assets or reserves. • Troubled Asset Relief Program (TARP 1): The TARP is conducted by the U.S. Treasury not the Fed. The TARP was funded with $700 billion of government debt. As first envisioned, the plan was for the U.S. government to buy troubled assets from depository institutions and replace them with U.S. government securities. But this process was more difficult than thought and its overall value was questioned. © 2014 Pearson Education, Inc.

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•

Troubled Asset Relief Program (TARP 2): Because of the difficulties of the TARP 1 and concern about its effectiveness, the TARP was modified to the TARP 2, in which the U.S. government took direct equity stakes in major depository institutions. This action directly increased these firms’ equity and reserves. In December of 2008 some of the TARP funds were used to assist major automakers. Fair Value Accounting: The accounting standard that required depository institutions to value their assets at their current market value was relaxed and they were permitted, in rare occasions, to use a model to value the assets. The effect of this policy was to try to keep depository institutions’ (accounting measure of their) equity higher.

Persistently Slow Recovery • •

Despite extraordinary efforts by monetary and fiscal policy, the U.S. economy at the end of 2010 still had slow growth and high unemployment, with the unemployment rate near 10 percent. Critics argue that the Fed did more harm than good by creating uncertainty with its policies. They argued that the Fed should create greater clarity about its monetary policy strategy.

Policy Strategies and Clarity Two alternative decision-making strategies have been proposed. Both strive to create greater openness and certainty about the Fed’s monetary policy.

Inflation Rate Targeting •

Inflation rate targeting is a monetary policy strategy in which the central bank makes a public commitment to achieve an explicit inflation target and to explain how its policy actions will achieve that target. Other countries (England, New Zealand, Canada, Sweden, and the EU) have successfully used inflation targeting rules to keep their inflation rate low.

Taylor Rule •

The Taylor rule uses a formula to set the target federal funds rate. The Taylor rule sets the federal funds rate (FFR) at the equilibrium real interest rate, assumed to be 2 percent, plus amounts based on the inflation rate (INF) and the output gap (GAP) according to: FFR = 2 + INF + 0.5(INF − 2) + 0.5GAP John Taylor says that the Fed has come close to following this rule but if it had followed it precisely the economy would have performed better.

Why Rules? •

Rules are important because rules enable households and firms to form more accurate inflation expectations. Markets work best when inflation expectations are most accurate and rules allow accuracy in inflationary expectations.

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153

Additional Problems 1.

In Freezone, shown in Figure 14.1, the aggregate demand curve is AD, potential GDP is $300 billion, and the short-run aggregate supply curve is SASB. a. What are the price level and real GDP? b. Does Freezone have an unemployment problem or an inflation problem? Why? c. What will happen in Freezone if the central bank takes no monetary policy actions? d. What monetary policy action would you advise the central bank to take and what do you predict will be the effect of that action?

Suppose that in Freezone, shown in problem 1, the short-run aggregate supply curve is SASA and a drought decreases potential GDP to $250 billion. a. What happens in Freezone if the central bank lowers the federal funds rate and buys securities on the open market? b. What happens in Freezone if the central bank raises the federal funds rate and sells securities on the open market? c. Do you recommend that the central bank lower or raise the federal funds rate? Why?

Figure 14.2 shows the economy of Freezone. The aggregate demand curve is AD, and the short-run aggregate supply curve is SASA. Potential GDP is $300 billion. a. What are the price level and real GDP? b. Does Freezone have an unemployment problem or an inflation problem? Why? c. What do you predict will happen in Freezone if the central bank takes no monetary policy actions? d. What monetary policy action would you advise the central bank to take and what do you predict will be the effect of that action?

Suppose that in Freezone, shown in problem 3, the short-run aggregate supply curve is SASB and potential GDP increases to $350 billion. a. What happens in Freezone if the central bank lowers the federal funds rate and buys securities on the open market? b. What happens in Freezone if the central bank raises the federal funds rate and sells securities on the open market? c. Do you recommend that the central bank lower or raise the federal funds rate? Why? © 2014 Pearson Education, Inc.

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China Raises Reserve Requirements The People’s Bank of China, the country’s central bank, raised the reserve requirements of its top commercial banks to put a squeeze on the credit market following a spell of robust economic growth. Source: International Business Times, October 11, 2010 a. If the United States had the economic performance of China, what monetary policy actions would the Fed’s most likely take. b. How would you expect China’s monetary policy of squeezing the credit market to influence aggregate demand in China. Would you expect it to have a multiplier effect? Why or why not? c. What actions might the People’s Bank of China take to slow the economy?

Solutions to Additional Problems 1.

a. b. c.

c. 3.

a. b. c.

The price level and real GDP are determined at the intersection of the aggregate demand curve and short-run aggregate supply curve. The price level is 110 and real GDP is $400 billion. Freezone has an inflation problem because its real GDP, $400 billion, is greater than its potential GDP, $300 billion. In this case if no action is taken Freezone will suffer from inflation. If the central bank takes no monetary policy action, the nominal wage rate and other resource costs will eventually rise so that short-run aggregate supply decreases. Ultimately in the long run the economy will reach equilibrium with real GDP equal to potential GDP, $300 billion, and the price level will rise to 120. The central bank can take a contractionary monetary policy by raising the interest rate. This policy decreases aggregate demand, which decreases real GDP, lowers the price level, and decreases inflation. Decreasing real GDP, however, will increase the unemployment rate. Freezone’s price level is 130 and its real GDP is $200 billion. Freezone has an unemployment problem because its real GDP is less than its potential GDP. If the central bank lowers the federal funds rate and buys securities, aggregate demand will increase. The increase in aggregate demand will raise the price level and increase real GDP, helping solve Freezone’s unemployment problem. If the central bank raises the federal funds rate and sells securities, aggregate demand decreases. As a result, the price level falls and real GDP decreases, which worsens Freezone’s unemployment problem. Freezone should lower the interest rate and buy securities because this policy will help solve Freezone’s unemployment problem. The price level and real GDP are determined at the intersection of the aggregate demand curve and short-run aggregate supply curve. The price level is 130 and real GDP is $200 billion. Freezone has an unemployment problem because its real GDP, $200 billion, is less than its potential GDP, $300 billion. If the central bank takes no action, the nominal wage rate and other resource costs eventually fall so that the short-run aggregate supply increases. Ultimately in the long run the economy will reach an equilibrium with real GDP equal to potential GDP, $300 billion, and the price level will fall to 120. The central bank can take an expansionary monetary policy by lowering the interest rate. This policy increases aggregate demand, which raises the price level and increases real GDP. Unemployment decreases. Raising the price level, however, increases the inflation rate.

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c. 5.

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Freezone’s price level is 110 and its real GDP is $400 billion. Freezone has an inflation problem because its real GDP is greater than its potential GDP. If the central bank lowers the federal funds rate and buys securities, aggregate demand increases. The increase in aggregate demand increases real GDP and further raises the price level, worsening Freezone’s inflation problem. If the central bank raises the federal funds rate and sells securities, aggregate demand decreases. As a result, real GDP decreases and the price level falls, which will decrease inflation and help solve Freezone’s inflation problem. Freezone should raise the federal funds rate and sell securities because this policy will help solve Freezone’s inflation problem. The Fed most likely would undertake contractionary monetary policy, as did the People’s Bank of China. The Fed, however, would probably raise the federal funds rate rather than raise reserve requirements. China’s policy is designed to decrease the supply of loanable funds in China, thereby raising the real interest rate in China and decreasing investment and consumption expenditure. Aggregate demand decreases because both consumption expenditure and investment decrease. The overall impact of this policy might be smaller than expected because foreign loanable funds will flow into China to take advantage of the higher Chinese real interest rate. This increase in the supply of loanable funds will moderate the rise the interest rate. Even so, it is likely there will be a small multiplier effect if aggregate demand decreases because there will be some induced decrease in consumption expenditure. The People’s Bank of China could raise the Chinese interest rate or, as it has done, increase reserve requirements.

Additional Discussion Questions 1.

Suppose events in the rest of the world cause the exchange rate to fall when the U.S. economy is at full employment. How should the Fed react in order to maintain macroeconomic stability? Why? The fall in the foreign exchange rate increases U.S. aggregate demand and will, if left alone, create an inflationary gap. The Fed should conduct a contractionary monetary policy by raising the federal funds rate. The contractionary monetary policy decreases U.S. aggregate demand and offsets the incipient inflationary gap.

What limits the Fed’s ability to steer the economy to avoid both recession and inflation? The Fed can offset fluctuations in aggregate demand because its monetary policy affects aggregate demand. So, for instance, if aggregate demand decreases the Fed can undertake expansionary monetary policy to increase aggregate demand, thereby offsetting the original decrease. However the Fed cannot offset fluctuations in aggregate supply without either creating more inflation or more unemployment. For instance, if aggregate supply decreases, the price level rises and real GDP decreases. If the Fed combats the higher price level (and rise in inflation) by using contractionary monetary policy, real GDP decreases even more. And if the Fed combats the decrease in real GDP (and rise in unemployment) by using expansionary monetary policy, the price level rises still higher.

Why is there a difference between the short-run and long-run effects from an increase in the quantity of money? In the short run the price level rises and the money wage rate does not change, so the economy moves along its short-run aggregate supply curve and real GDP increases. Real GDP can be different from potential GDP. But in the long run the money wage rate rises to adjust to the rise in price level. Once this adjustment takes place, real GDP

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returns to potential GDP. When that occurs in the long run, the effect of the increase in the quantity of money has worn off. 4.

What are the benefits of using rules to conduct monetary policy? Rules have one major benefit: People can understand them. The point is that members of the economy need to make decisions about what to supply and what to demand. On average these decisions will be better the less uncertainty faced. One source of uncertainty is monetary policy. If monetary policy is erratic and takes people by surprise they will often find that they have made sub-optimal decisions that they regret. If monetary policy follows rules—especially easily followed and easily understood rules—then this source of uncertainty is removed from people’s calculations. As a result, following rules will help members of the public make better economic decisions which means the economy will function better.

C h a p t e r

INTERNATIONAL TRADE POLICY

The Big Picture Where we have been: Chapter 2 introduced the gains from trade in a simple model with a linear PPF’s. This chapter continues the explanation of the gains from trade by looking at individual markets using the demand and supply model, first developed in Chapter 3. The chapter also reviews the effects of, case against, and reasons for trade restrictions and protection with a focus on the loss resulting from trade restrictions. You might want to do this chapter after Chapter 2 and 3 before getting into traditional Macro topics. It could be especially helpful background information to have prior to discussing exchange rates in Chapter 9. It can also be helpful to assist the students in Chapter 4’s discussion of net exports.

New in the Eleventh Edition This chapter’s section on “The Case Against Protection” has been substantially revised providing economic justification to the often made arguments for protection of domestic industry. The details and discussion of offshore outsourcing are highlighted in a new At Issue piece. The data on international trade are updated to 2011. A new article review and discussion about international trade in coat hangers is found in the Economics in the News box. There is a new Reading Between the Lines that discusses U.S. tariffs imposed on Chinese exports of solar panels.

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Lecture Notes

International Trade Policy • • •

Comparative advantage means that all countries can gain from trade. Society gains from international trade. There are many arguments in favor of restricting international trade, but restricting free trade results in loss to society.

How Global Markets Work

The Big Assumption: Counties cannot be identical! Of all the assumptions economist make this one is easy to swallow. The basis for international trade is simply recognizing that countries are different and then exploiting those differences to benefit all countries involved. Ask your class how countries differ (quality and quantity of resources, climate, etc.) Now point out to them that one reason to trade is to acquire goods that you cannot make yourself. A tougher question is why we want to trade for goods that we can make ourselves. •

The goods and services that we buy from people in other countries are called imports. The goods and services that we sell to people in other countries are called exports.

International Trade Today

The United States is the world’s largest international trader and accounts for 10 percent of world exports and 13 percent of world imports. • In 2011, total U.S. exports were $2.1 trillion, which is about 14 percent of the value of U.S. production. • Total U.S. imports were $2.7 trillion, which is about 18 percent of total expenditure in the United States. • The value of exports minus the value of imports is called net exports. In 2011, U.S. net exports were negative $0.6 trillion. (Exports were $2.1 trillion and imports were $2.7 trillion.)

What Drives International Trade? •

The fundamental force that generates international trade is comparative advantage. A country has a comparative advantage in producing a good if it can produce that good at a lower opportunity cost than any other country. By specializing in producing the good for which each country has comparative advantage, both countries gain from international trade.

For more data on international trade: Data on U.S. international trade can be accessed at the Bureau of Economic Analysis web site www.bea.gov/international/index.htm. Key facts worth emphasizing are the enormous growth in volume of trade over time and huge two-way trade in manufactures. Explain that the balance of trade results from spending and saving decisions in the United States and the rest of the world and is independent of the forces that generate the volume of trade, which this chapter covers.

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U.S. Exports •

•

The United States will export goods for which it has comparative advantage. In the figure the world price of coal is $60 per ton and the price in the United States before trade is $40 per ton. The United States has a comparative advantage in producing coal because the price before trade is lower than the world price. In this case the United States will export coal. In the figure, before international trade the price of coal in the United States was $40 per ton and at that price the United States produced 3 million tons of coal per year and consumed 3 million tons per year. With international trade the price in the United States rises to the world price, $60 per ton. At that price the United States produces 5 million tons of coal per year, consumes 1 million tons per year, and exports the difference, 4 million tons per year.

U.S. Imports •

•

The United States will import goods in which it does NOT have a comparative advantage. In the figure, the world price of automobiles is $20,000 per car and the price in the United States before trade is $40,000 per car, so the United States does not have a comparative advantage in producing automobiles. In this case the United States will import cars. In the figure, before international trade the price of a car in the United States was $40,000 per car and at that price the United States produced 3 million cars per year and consumed 3 million cars per year. With international trade the price in the United States falls to the world price, $20,000 per car. At that price the United States produces 1 million cars per year, consumes 5 million cars per year, and imports the difference, 4 million cars per year.

Winners and Losers From International Trade •

•

When a country starts to export goods, its domestic price rises to the higher world price. Therefore, exports raise the U.S. price of the good or service domestically. With the higher price domestic consumers lose and domestic producers gain. On net, society gains because the winners’ “wins” are larger than the losers’ “losses.” When a country begins importing, its current domestic price falls to the lower world price. Therefore, imports lower the U.S. price of the good or service. With the lower price domestic consumers win and domestic producers lose. On net, society gains because the winners’ “wins” are larger than the losers’ “losses.”

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The Fable of Adam Blackbox: There is an enormously rich heritage of stories, parables, fables, and satires that you can use to enliven your classes on this topic. The following fable, inspired by James Ingram (from International Economic Problems, John Wiley, 1970) is a powerful way to begin. Make up your own version with local flavor and embellishment. Adam Blackbox announces that he has discovered an amazing way to produce low-price, high-quality automobiles. He sets up a plant on a large tract of land along the coast of Massachusetts, hires 10,000 employees, swears them to secrecy, and begins delivering his low-price, high-quality autos to the nation’s showrooms. Adam Blackbox is hailed as an American industrial hero. Blackbox Enterprises floats stock and Wall Street booms. Consumers love him. His automobiles are better and cheaper than those they could buy before he came along. Automakers hate him, but their attempts to pass laws to restrict his operations fail. The president and Congressional leaders explain that economic adjustment is an inevitable consequence of technological advance. And Adam Blackbox’s new technology for delivering low-price, high-quality automobiles is clearly part of the process of achieving greater prosperity for all. The press becomes increasingly curious about what is going on in the giant New England auto plant. Investigative journalists create endless hours of speculative television programming on the amazing new technology. Then a tabloid journalist with a big checkbook finds a worker who is willing to talk. Adam Blackbox's secret is revealed. Nothing is produced at the plant. Adam Blackbox is a trader, not a producer. He buys grain from American farmers, exports it to Japan, and imports automobiles from Japan. His secret revealed, Adam Blackbox is hauled before Congressional committees on fair trade and denounced as an evil destroyer of American jobs. The president makes a special State of the Union speech in which he denounces Adam Blackbox, praises a vigilant press for saving Americans from the threat of cheap foreign labor, and announces a new budget initiative that will spend $50 billion on research in technologies to produce low cost, high-quality automobiles. Ask your students why the president and Congress accepted Adam Blackbox initially but then changed their tune. Was Adam Blackbox hurting America or helping America?

II. International Trade Restrictions •

Governments restrict international trade to protect domestic industries from foreign competition using tariffs, import quotas, other import barriers, and subsidies

Tariffs • •

•

A tariff is a tax that is imposed by the importing country when an imported good crosses its international boundary. A tariff increases the price of the good in the nation. As a result, the following occur: • Consumers buy less of the good and producers increase the quantity supplied; • Government collects tariff revenue equal to the tariff times the quantity imported of the good; • Less of the good is imported; • A social loss results. These results are shown in the figure. The government imposes a $10,000 per car tariff on imported automobiles so the U.S. price rises to $30,000. U.S. consumption of cars decreases from 5 million per year to 4 million and U.S. production increases from 1 million per year to 2 million so that imports decrease from 4 million per year to 2 million. The government gains tariff revenue. © 2014 Pearson Education, Inc.

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Import Quotas • •

•

An import quota is a restriction that limits the maximum quantity of a good that may be imported in a given period. A quota increases the price of the good in the nation. As a result, the following occur: • Consumers buy less of the good and producers increase the quantity supplied; • The importers collect additional profit; • Less of the good is imported; • A social loss results. These results are shown in the figure. The government imposes a 2 million per year import quota on automobiles as shown. With this quota the supply curve becomes the U.S. supply curve below the world price of $20,000 per car and then the U.S. curve plus the 2 million import quota at prices above the $20,000 world price. The U.S. price rises to $30,000 per car. As a result U.S. consumption of cars decreases from 5 million per year to 4 million and U.S. production increases from 1 million per year to 2 million. Imports decrease from 4 million per year to 2 million.

Other Import Barriers • •

Although they are not designed to limit international trade, health, safety, and regulation barriers have that effect. Voluntary export restraints, while not common, act like a quota and exist if a country voluntarily limits its exports.

Export Subsidies •

An export subsidy is a payment by the government to the producer of an exported good. Although export subsidies are illegal under many international agreements, the United States and the European Union pay subsidies to their farmers that result in increased domestic production, some of which is imported.

IV. The Case Against Protection

Arguments for protection include the following: • Helps an infant industry grow: The so-called infant-industry argument for protection is that it is necessary to protect a new industry to enable it to grow into a mature industry that can compete in world markets. The idea relates to dynamic comparative advantage in comparative advantages change over time due to learning-by-doing (from Chapter 2). However, the infant industries argument only applies if the benefits of learning-by-doing spill over to other industries. • Counteracts dumping: Dumping occurs when a foreign firm sells its exports at a lower price than its cost of production. Dumping might be used by a firm that wants to gain a global monopoly. However, it is difficult to measure the cost of production so whether dumping is taking place is difficult to determine. And charging a different export price than domestic price is not necessarily evidence of dumping because firms often sell goods and services for different prices in different markets.

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•

Saves Domestic Jobs: The argument that trade protection saves jobs is flawed. International trade changes the type of jobs in an economy, but it does not decrease employment in the aggregate because jobs lost in one sector are offset by jobs created in other sectors. Allows us to compete with cheap foreign labor: The argument that trade protection allows us to compete with cheap foreign labor is flawed. Differences in real wage rates generally reflect differences in productivity, and competitiveness is determined by both differences in wages and differences in productivity. Penalizes lax environmental standards: The argument that trade liberalization leads to a “race-to-the-bottom” in environmental standards is weak. Many poorer countries have comparable environmental standards and should not be targeted. And environmental standards are positively related to income (they are a normal good). The best way to encourage improved environmental standards is to allow trade and the economic benefits it brings to poorer countries. Prevents rich countries from exploiting developing countries: The argument for protection to prevent people of the rich industrial world from exploiting the poorer people of the developing countries is wrong. While wage rates in many developing countries are very low, they would be even lower without foreign demand for the goods that these countries produce. Reduces offshore outsourcing that sends good U.S. Jobs to other countries

Offshore Outsourcing • •

When U.S. firms send jobs that could be done in America to another country, they are offshoring. If U.S. firms buy finished goods from other U.S. or foreign firms, they are outsourcing. Offshoring brings gains from specialization, but those who have invested in human capital to do a specific job that has now gone offshore will be hurt.

Does free trade exploit workers in developing countries? Students might be somewhat familiar with the terminology of “exploitation.” Have the students think about what “exploitation” means in the context of voluntary trade. If I benefit from someone I trade with, did I exploit them? Did they exploit me? If trade is voluntary, how did I manage to exploit the person whom I traded with? Is it because I am smarter than the other person? This seems to be the condescending assumption of those who talk about exploitation of workers in developing countries. Indeed, representatives from many developing countries do not see trade as exploitation, but rather see it as a way to improve standards of living. When these representatives are upset at WTO meetings, it is usually about the trade restrictions rich countries place on imports from developing countries keeping developing countries poor.

Why is International Trade Restricted?

Despite arguments against protection, trade is still restricted because key economic interests benefit from protection. • Tariff revenues provide a relatively inexpensive way for the government to collect revenues. • Rent seeking is lobbying and other political activity that seek to capture the gains from trade. While the benefits from liberalized trade are large in the aggregate, they are widespread across all consumers. Meanwhile, the costs are concentrated on a smaller number of producers. It is in the interests of those who pay the costs of liberalized trade to undertake a large quantity of political lobbying to promote protection. • If the gains from free trade exceed the losses, it is possible to compensate the losers so that everyone is in favor of free trade. To some extent, unemployment compensation and job-retraining programs are designed to serve this purpose. However, providing compensation is difficult because it is hard to identify exactly who has lost a job as a result of free international trade and not because of other reasons.

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Another fable: There is also a rich heritage of stories, parables, fables, and satires on protectionism. But it is hard to beat Bastiat’s. Claude Frederic Bastiat (1801–1850) is a very interesting French economist. An ardent advocate of free trade, he wrote articles with Richard Cobden (the famous English free trader and opponent of the Corn Laws). His most wonderful piece is his satirical “Pétition des marchands de chandelles …” “Petition from the Manufacturers of Candles, Tapers, Lanterns, Sticks, Street Lamps, Snuffers, and Extinguishers, and from Producers of Tallow, Oil, Resin, Alcohol, and Generally of Everything Connected with Lighting,” to give it its full title. The basic idea is that the sun creates unfair competition for candle merchants and a law must be passed to ban all windows and other openings that enable it to shine its light inside buildings. You can have a lot of fun with it not only in the context of trade, but also to talk about opportunity cost and production possibilities. For further reading: If you haven’t already done so, read this nice little book and use its basic ideas to illustrate and illuminate the analysis of the false arguments of protectionists: Russell D. Roberts, The Choice: A Fable of Free Trade and Protectionism, Updated and Revised Edition, 2000, Prentice Hall (ISBN: 0130870528). The book tells the story of David Ricardo being granted God’s permission to return to Earth and meet with Ed Johnson, a 1950s U.S. television manufacturer. Ricardo has some powers that enable him to create counterfactuals and to travel through time. The dialog between Ricardo and Johnson provides a powerful commentary on the benefits of free trade and the costs of protectionism. Unrestricted international trade benefits all the countries involved with trade. Emphasize the key benefits from unrestricted international trade: --The gains from international trade arise from the diversity of opportunity costs of production across countries. The source of prosperity in free trade arises from each country generating gains from specialization in their comparative advantage, minimizing its own opportunity cost of production, and sharing in each of the other country’s gains. --Both exporting and importing domestic industries benefit from free trade. Free trade liberates each country’s consumption possibilities from the bonds of their own production possibilities frontier, enabling the consumers in both the importing and exporting country to enjoy consumption bundles of goods and services that would be unobtainable without trade. --Restrictions on international trade hurt the importing firms, the consumers of imports, the domestic exporting firms, and even the non-exporting firms. Protecting domestic industry from international competition backfires: i) it increases the relative price that other countries pay for domestically produced goods and services that are exported; ii) it raises the price of the imported goods consumed by domestic consumers; and iii) it lowers the income of producers of the goods for which the country has a comparative advantage in production by more than the increase in the incomes of those industries that gain from trade restrictions. Together, these influences decrease the total demand for domestic goods and services in the country imposing trade restrictions by more than the increase in demand for those domestic goods and services in industries for which the country does not have a comparative advantage. International trade is a “win-win” situation for all countries involved in trade. This is the most important message that can be delivered from this chapter. All legitimate counterpoints are rooted in the concern over unequal distributions of the gains from trade that are created. Emphasize that economic efficiency and economic prosperity can be achieved only through free trade among nations, and that the gains generated are more than sufficient to reimburse those individuals whose lives are made worse off from free trade. Point out that it is the difficulties of implementing such a reimbursement program are what prevent such programs from being established on a large scale. There is no good economic argument in support of trade restrictions. Dispel the many myths surrounding various justifications for imposing trade restrictions. The section of the chapter entitled “Cases Against Protection” contains concise and complete counter-arguments to the often heard justifications for restraining international trade. Emphasize that economists are overwhelmingly agreed that there is no good argument against free trade. © 2014 Pearson Education, Inc.

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Additional Problems 1.

Suppose that the world price of bananas is 18 U.S. cents a pound and that when Australia does not trade bananas internationally, their equilibrium price in Australia is 12 U.S. cents a pound. If Australia opens up to international trade, does it export or import bananas? Explain how the price of bananas in Australia changes. How does the quantity of bananas consumed in Australia change? How does the quantity of bananas grown in Australia change?

Suppose that in response to huge job losses in the U.S. textile industry, Congress imposes a 100 percent tariff on imports of textiles from China. a. Explain how the tariff on textiles will change the price of textiles, the quantity of textiles imported, and the quantity of textiles produced in the United States. b. Explain how the U.S. and Chinese gains from trade will change. Who in the United States will lose and who will gain?

In the 1950s, Ford and General Motors established a small car-producing industry in Australia and argued for a high tariff on car imports. The tariff has remained through the years. Until 2000, the tariff was 22.5 percent. What might have been Ford’s and General Motor’s argument for the high tariff? Is the tariff the best way to achieve the goals of the argument?

Use the information below to answer the following question U.S. Expands China Paper Anti-Dumping Tariff Responding to a case brought by the NewPage Corporation of Dayton, Ohio, the U.S. Commerce Department announced it was imposing a tariff of 99.65 percent on imported glossy paper from China. Glossy paper is the type of paper used to manufacture art books, high-end magazines, textbooks, and annual reports. In 2006 imports of glossy paper from China was estimated to be $224 million. Reuters, May 30, 2007 a. What is dumping? Who in the United States loses from China’s dumping of glossy paper? b. What argument might NewPage Corp. have used to persuade the U.S. Commerce Department to impose a 99.65 percent tariff? c. Explain who, in the United States, will gain and who will lose from the tariff on glossy paper. How do you expect the prices of magazines and textbooks that you buy to change?

Solutions to Additional Problems 1.

With no international trade, the price in Australia is less than that in the world, so Australia has a comparative advantage in producing bananas. As a result, if Australia opens up to international trade, it will export bananas. With international trade, the price of bananas in Australia rises. The higher price leads to a decrease in the quantity of bananas consumed in Australia. The higher price also leads to an increase in the quantity of bananas grown in Australia. a.

Higher tariffs increase the price U.S. consumers pay for textiles imported from China. Because the price of Chinese imported textiles rises, the quantity imported decreases. The quantity of textiles produced in the United States increases.

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This trade restriction means that the U.S. and Chinese gains from trade definitely decrease. Textile workers and owners of textile firms will gain from the higher price. Textile consumers will lose from the higher price. Most likely the argument in favor of the tariff was the infant-industry argument. According to proponents of this argument, protection is necessary to a new industry to enable it to grow into a mature industry that can compete in world markets. Alternatively, Ford and General Motors might also have argued that a high tariff was necessary to protect Australian jobs. Protection is not the best way to achieve these goals. A more efficient way to protect infant industries is to subsidize the firms in the industry. And the jobs lost in the auto sector will be regained in other sectors devoted to exporting Australian goods.

a. b.

Dumping is when a foreign firm sells its exports at a lower price than the cost of production. U.S. producers of glossy paper lose from China’s dumping of glossy paper. Dumping is illegal under the rules of international trade, so dumping is regarded as a justifiable reason for a temporary tariff. NewPage might have argued that Chinese exporters of glossy paper were charging a price of (approximately) one half the cost of production. In this case a tariff of 99.65 percent will (approximately) double the U.S. price of the imported glossy paper, thereby raising the price to the (alleged) cost of production. The U.S. producers of glossy paper (such as NewPage!) will gain. The U.S. government also will gain because it will receive additional tariff revenue. U.S. consumers of glossy paper will lose. The higher price of glossy paper increases the costs of magazine and textbook publishers. The supply of magazines and textbooks decreases so their price rises.

Additional Discussion Questions 1.

How can we know that the benefits to the economy from free trade are greater than the benefits accruing to the domestic industry that is protected from foreign competition? Stress to the students that if unrestrained international trade creates the efficient outcome for both countries involved, it also must mean that prosperity for each country is maximized. • Emphasize that free trade between nations encourages each country to pursue specialization in production in those industries for which the country has a comparative advantage relative to other countries. • If the total quantity of goods and services consumed in each country after international trade is greater than without international trade, then total incomes accruing to individuals must be greater, which means the prosperity of each nation’s economy as a whole is greater under free trade.

How will countries know which domestic industries have a comparative advantage in order to allocate resources towards specialization in producing those goods and services? Specialization and gains from international trade will arise naturally through relative price changes on the world market. • When domestic firms within an industry have a lower opportunity cost of production than firms in other countries, these firms discover that the price they can receive from foreign buyers (importers from other countries) is higher than the price they can receive from domestic consumers. These domestic firms increase output, demand more labor, capital, and raw materials, and resources flow toward these industries. • When domestic firms within an industry have a higher opportunity cost of production than firms in other countries, domestic consumers discover that the price they must © 2014 Pearson Education, Inc.

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pay to foreign sellers for a good than the price they must pay domestic producers. Domestic consumers switch their purchases to foreign imports. The domestic firms producing this good decrease output, decrease their use of labor, capital, and raw materials, and resources flow away from these firms. Each country’s economy naturally becomes specialized in producing output in those industries for which the country enjoys a comparative advantage. However, for each country to gain, each country must allow consumers and producers to have free access to foreign markets.

Shouldn’t we protect the workers of those industries that are hurt by foreign competition? Point out that protecting the workers in industries for which our country does not have a comparative advantage is akin to making everyone in the economy suffer a lower level of prosperity than under unrestricted trade—all to ensure that a small minority of people does not suffer the economic losses associated with relocating to another community and finding employment in another industry. Use some specific examples in recent history: • If Congress imposes import quotas on Japanese vehicles being imported into the United States, tens of thousands of American autoworkers would be forced to find employment in another industry. Compare this to the tens of millions of car buyers each year that must pay hundreds or even thousands of extra dollars for their cars. • In 2002, President George W. Bush signed into law a tariff on foreign steel by some 30 percent. He effectively cost the hundreds of millions of American consumers tens of billions of dollars in higher prices for the myriad of goods containing steel, as well as those goods and services requiring transportation in trucks, trains, airplanes, and ships that are made from steel. He did this seeking political support from those states with a large presence of steel workers who work for firms that could not make a profit at the unregulated world market price of steel. The president’s defense was that other nation’s steel industries were receiving subsidies and had an “unfair “ advantage in production costs, effectively “dumping” steel in the U.S. markets at prices below production costs. Ask the students: What is “unfair” about having foreign governments effectively subsidizing the purchase of automobiles, trucks, and rail and air transportation by hundreds of millions of American citizens? Point out it is only “unfair” to the tens of thousands of steel workers who stand to face job relocation costs of finding work in another industry. • Emphasize that in each of these cases of trade restrictions, the economy as a whole would have gained from free international trade, but the autoworkers and the steel workers are groups of people that are much more easily organized and stand to benefit much more individually from trade restrictions than the wide-spread American consumers. The result is successful lobbying efforts to restrict trade to the detriment to all consumers in the American economy.