SOLUTIONS MANUAL FOR Macroeconomics Fourth Canadian Edition. Glenn Hubbard Anthony Patrick O’Brien A by welldoneassistant

Solutions Manual For

Macroeconomics Fourth Canadian Edition Glenn Hubbard Anthony Patrick O’Brien Apostolos Serletis Jason Childs

Contents Chapter 1: Economics: Foundations and Models.................................................

Chapter 2: Trade-offs, Comparative Advantage, and the Market System .......

Chapter 3: Where Prices Come From: The Interaction of Supply and Demand

Chapter 4: GDP: Measuring Total Production and Income .................................

Chapter 5: Unemployment and Inflation ...............................................................

Chapter 6: Economic Growth, the Financial System, and Business Cycles .......

Chapter 7: Long-Run Economic Growth: Sources and Policies ..........................

Chapter 8: Aggregate Expenditure and Output in the Short Run ......................

Chapter 9: Aggregate Demand and Aggregate Supply Analysis .....................

Chapter 10: Money, Banks, and the Bank of Canada ......................................... 100 Chapter 11: Monetary Policy .................................................................................. 112 Chapter 12: Fiscal Policy .......................................................................................... 127 Chapter 13: Inflation, Unemployment, and Bank of Canada Policy .................. 137 Chapter 14: Macroeconomics in an Open Economy.......................................... 147

CHAPTER 1 | Economics: Foundations and Models SOLUTIONS TO END-OF-CHAPTER EXERCISES 1.1

Three Key Economic Ideas Learning Objective: Explain these three key economic ideas: People are rational; people respond to incentives; and optimal decisions are made at the margin.

Review Questions 1.1 “People are rational” is the assumption that decision makers explicitly or implicitly weigh the benefits

and costs of each action and then choose an action only if the benefits are expected to outweigh the costs. “People respond to incentives” means that consumers and firms consistently respond to economic incentives. “Optimal decisions are made at the margin” means that most decisions are not “all or nothing” but involve doing a little more or a little less of an activity. Therefore, the optimal decision is to continue any activity up to the point where the marginal benefit equals the marginal cost.

1.2 Scarcity is the situation in which unlimited wants exceed the limited resources available to fulfill those wants. Economics is the study of the choices consumers, business managers, and government officials make to attain their goals. Scarcity is central to the study of economics because scarcity requires people to make choices about how to use their resources to best fulfill their wants.

Problems and Applications 1.3 As noted in the chapter, the economic incentive to banks is clear—it is less costly to put up with bank

robberies than to take these additional security measures. The marginal cost of adding the additional security is greater than the expected marginal benefit.

1.4 a. Students face scarcity of time, like everyone else, and respond to the incentives of the teacher’s grading system. Students have more incentive to direct their efforts into the parts of the course that have the most weight in the grading system. b. Too little weight on outside readings or the like gives students little incentive to read and master the material. Students will put less effort into the parts of the course that have little effect on their grades. c. Quizzes over assigned readings would give students an incentive to come to class having read the upcoming material. Some teachers give preparation assignments where students have to read and answer questions about the upcoming material, and over the course of the semester students have to successfully complete a certain percentage of the preparation assignments to qualify for an A, or B, or other grade in the course. 1.5 The carbon price and the subsequent increase in the price of gasoline (and other carbon-intensive products) will encourage people to use less gasoline. If people respond to the negative incentive of higher gas prices by using less gas, maybe by taking the bus or buying a more fuel-efficient car, we will emit fewer greenhouse gases and do less damage to the environment. Copyright © 2024 Pearson Canada Inc.

CHAPTER 1 | Economics: Foundations and Models

1.6 a. In deciding whether or not to go to the gym on a specific day, most people aren’t comparing the benefits of an active lifestyle and the cost of the gym membership. They’re comparing what they stand to miss out on and the relatively small benefit any single workout will have on their overall health. By implementing a simple payment system, the researchers increase the benefit of a small number of trips to the gym. Further thought: The benefits of going to the gym tend to materialize over a long time after the decision to go to the gym is made. Some of those benefits will be received years into the future. By offering cash payments in the relatively near term, the researchers offer a benefit that can be received in the same time frame as the costs of going to the gym are paid. b. Those who do not respond to the monetary incentive to go to the gym clearly value their other options more than the health benefits and monetary reward received by going to the gym. Consider a student who is working to pay for their education. The payment received by going to the gym is likely less than the payment received by going to work. In short, the incentive isn’t big enough.

1.7 Jill is correct. The difference between the grade before and after watching an extra episode is exactly the same as knowing the change in the grade.

1.8 Your friend is failing to think at the margin. It doesn’t matter how much time your friend has already

spent studying psychology. What matters is the marginal benefit to be received from studying psychology relative to the marginal cost, where cost is measured as the opportunity cost of lower grades in other subjects. If the course is required to graduate, that may raise the marginal benefit associated with completing the course.

The Economic Problems All Societies Must Solve 1.2 Learning Objective: Discuss how a society answers these three key economic questions: What goods and services will be produced? How will the goods and services be produced? Who will receive the goods and services produced?

Review Questions 2.1 Scarcity implies that every society and every individual faces trade-offs because wants are unlimited, but the ability to satisfy those wants is limited. Societies and individuals cannot have everything they want, so they have to make choices about what to have and what not to have.

2.2 The three economic questions that every society must answer are: (1) What goods and services will

be produced? (2) How will the goods and services be produced? (3) Who will receive the goods and services produced? In a centrally planned economy, the government makes most of these decisions. In a pure market economy, almost all these decisions are made by the decentralized interaction of households and firms in markets. In a mixed economy, most economic decisions result from the interaction of buyers and sellers in markets, but the government plays a significant role in the allocation of resources.

2.3 Productive efficiency occurs when a good or service is produced at the lowest possible cost. Allocative efficiency means that what is produced reflects consumer preferences—every good or service is produced up to the point at which the last unit provides a marginal benefit to consumers equal to the marginal cost of producing it.

CHAPTER 1 | Economics: Foundations and Models

2.4 Efficiency is concerned with producing the goods and services that people want at the lowest cost. Equity is “fairness,” a concept that can differ from person to person. Government policymakers often want to make economic outcomes “fairer,” but doing so usually involves redistributing income from one group to another. Redistributing income usually (but not always) hampers efficiency because it reduces incentives to produce and drives up production costs.

Problems and Applications 2.5 Yes, even Bill Gates faces scarcity because his wants exceed his resources. First, Gates has established a foundation with billions of dollars to spend on worthy causes like eradicating malaria and reducing homelessness. However, there are an unlimited number of worthy causes that Gates can fund, so even he faces scarcity. Second, even Gates has only 24 hours in a day, so he must make choices about how to spend his scarce time. Everyone faces scarcity, because human desires are virtually unlimited. Because the world’s resources are limited, the only way not to face scarcity would be to reduce your wants to be fewer than what your resources can accomplish.

2.6 a. It is doubtful that centrally planned economies have been less efficient purely by chance. The

underlying reason seems to be that centrally planned economies don’t provide as strong incentives for hard work and innovation as market economies do. In addition, the people running centrally planned economies cannot make the most efficient decisions because they don’t have the information that is in the minds of all the decentralized decision makers in a market economy.

b. You might still prefer having a centrally planned economy if you considered it to be more equitable. (Also, you might prefer a centrally planned economy if you were in charge.)

2.7 A complete explanation for the connection between majoring in economics and succeeding in business

or government leadership would involve many factors. But we can say that economics teaches us how to look at the trade-offs involved in every decision we make. Those who cannot understand the costs of an action and weigh them against its benefits are unlikely to make good decisions. Climbing the corporate or governmental ladder requires making a wider and wider array of such decisions.

2.8 a. The groups of students most likely to try to get the tickets will be those for whom the expected marginal benefit of going to the athletic department’s office on Monday morning is greater than the expected marginal cost. These would include students who have a relatively low opportunity cost of their time, such as those who have no Monday-morning classes. Other students who are likely to stand in line are those who would have a large benefit from getting the tickets: those who love hockey and those who hope to sell their tickets (“scalpers”). b. The major opportunity cost of distributing the tickets this way is the cost to those students who attempt to get the tickets: the costs of missing out on the activities that cannot be done while standing in line, and the costs to those people who try to get tickets but don’t arrive soon enough to do so. There’s also the cost of the lost revenue to the college from giving away the tickets instead of selling them. c. This isn’t an efficient way to distribute the tickets because it wastes a lot of time. It would be more efficient to sell the tickets to those willing to pay the highest prices. d. Equity is hard to define. Some people will see this way of distributing tickets as equitable because students with low incomes can still get tickets, provided they are willing to pay the opportunity cost of waiting in line. Some people will see this way of distributing the tickets as equitable because only those with the greatest desire to watch the game in person will put up with the hassle of getting the tickets. Some people might argue that this system is equitable because students are more deserving than non-student recipients of the tickets. Others may disagree, saying that people with a strong desire to obtain the tickets, but who are unable to be at the athletic Copyright © 2024 Pearson Canada Inc.

CHAPTER 1 | Economics: Foundations and Models department’s office at the designated time, would have no chance to get the tickets. Still others could argue that the system is not equitable because no revenue is received for the tickets— revenue that could be used to cover some of the costs of administering the university’s athletic programs.

1.3

Economic Models Learning Objective: Understand what economic models are and aren’t, and why they are a good idea.

Review Questions 3.1 Economists use models for the same reason that any other scientist (and indeed everyone else) does— to make a complicated world simple enough that it can be understood and analyzed, so that questions about it can be usefully answered. Useful models will generate testable predictions. If these predictions are consistent with economic data, then the model isn’t rejected and can be used to understand the economy. Testing models with data can be very difficult, however, because the economy is always changing, and it is difficult to conduct controlled economic experiments. 3.2 In arriving at a useful economic model, these five steps are followed: (1) decide the assumptions to be used; (2) formulate a testable hypothesis; (3) use economic data to test the hypothesis; (4) revise the model if it fails to explain the economic data; and (5) retain the revised model to help answer similar economic questions in the future. 3.3 Positive economic analysis concerns what is; that is, it deals with how the economy actually behaves. Normative economic analysis concerns what ought to be. Economics is mainly concerned with positive analysis—conceptualizing and measuring the costs and benefits of different courses of action. Decision makers (including voters and government officials) can use the trade-offs and costs and benefits identified by positive economic analysis in normatively deciding what course of action should be taken.

Problems and Applications 3.4 The economist should revise the model in light of its failure to explain or predict real-world events. 3.5 The problem with Dr. Strangelove’s theory is that it cannot be tested unless we can devise a way to measure the emission of these subatomic particles, which seems to be impossible because they don’t exist in our universe. Because we cannot test the model’s predictions, it is not very useful to us; even though it might be true, we have no way of knowing. 3.6 The positive elements of debate would be the costs of the policy (people who were harmed and how much they were harmed) and the benefits of the policy (people who were made better off and how much better off they were). The economic data that would be most useful would be to identify those who are unemployed due (largely) to the increase in the minimum wage and to identify those who are able to enjoy the improved income resulting from increased wages. Understanding the number and nature of those who lose and those who gain can help us understand the positive side of the issue. Unfortunately, this data will not resolve the normative side of the data debate, as the normative side of the debate requires people to make an assessment of which group is more important.

CHAPTER 1 | Economics: Foundations and Models

3.7 a. Tim Hortons and other coffee shops will likely respond to the reduction in the amount of coffee available by increasing the price they charge their customers. b. Centrally planned economies tend to deal with shortages in two different ways. First, when goods are scarce in centrally planned economies, the central planning committee rations the scarce resource by either issuing a small share to each person or restricting the amount any one person is allowed to buy at a time. Second, consumers are often required to wait in long lines to get the scarce goods. By requiring that someone wait in line for hours in order to receive their ration of coffee, central planners are effectively raising the cost of coffee to consumers—some consumers will choose to give up their coffee rather than wait in line. 3.8. a. and c. are positive statements; b. and d. are normative statements.

1.4

Microeconomics and Macroeconomics Learning Objective: Distinguish between microeconomics and macroeconomics.

Review Questions 4.1 Microeconomics is the study of how households and firms make choices, how they interact in specific markets, and how the government influences their choices. Micro means small, and microeconomics deals with individual decision makers. Macroeconomics is the study of the economy as a whole. Macro means large, and macroeconomics deals with economy-wide outcomes, such as the inflation rate, the unemployment rate, and the economic growth rate. 4.2 No, because many economic situations have both a microeconomic and a macroeconomic aspect. For example, the level of total consumption spending by households helps to determine how fast the economy grows—which is a macroeconomic issue. But to understand the amount of consumption spending by households, we have to analyze the incentives and constraints individual households face—which is a microeconomic issue.

Problems and Applications 4.3 a. and d. are microeconomic issues; b. and c. are macroeconomic issues. 4.4 You should disagree with the assertion. Microeconomics deals with individual decision makers, while macroeconomics deals with economy-wide outcomes. Because the unemployment rate in any one city would be an issue for the economy of the entire city and not an individual, it is a macroeconomic issue rather than a microeconomic issue. The effect of an increase in the taxes on alcohol on underage drinking concerns underage individuals who drink alcohol, so it is a microeconomic issue rather than a macroeconomic issue.

Suggestions for Critical Thinking Exercises CT1.1 Clearly, answers to this question will vary substantially and will depend on the background of the student. The main point is not correctness but to help students connect the chapter to their prior knowledge. This is difficult for an instructor to evaluate. By connecting to their prior knowledge, students should be able to learn this topic more deeply. Copyright © 2024 Pearson Canada Inc.

CHAPTER 1 | Economics: Foundations and Models

CT1.2 The key here is what incentive(s) you need to put in place to encourage yourself and your team to train harder or more often. Also, keep in mind that this article suggests that the training is already in progress, so it is also about additional training, or marginal analysis. Simply put, what can you do to make sure you train for an extra hour or session, or to make sure you work a little bit harder in your next previously scheduled training session?

SOLUTIONS TO CHAPTER 1 APPENDIX A-1

Using Graphs and Formulas Learning Objective: Review the use of graphs and formulas

Problems and Applications 1A.1 a. The relationship is negative because as price decreases, the quantity of pies purchased increases. b.

The slope = ∆y/∆x = rise/run = −1/1 = –1.

CHAPTER 1 | Economics: Foundations and Models

1A.2

1A.3

Answers will vary somewhat depending on the values determined from the time-series graph. The calculations below use Ford sales rounded to the nearest million as shown in the table below. Year 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Year 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Ford’s Auto Sales (in millions of dollars) 6.8 6.6 6.6 5.4 4.9 5.5 5.7 5.7 6.3 6.3 6.6 6.7 Percentage Change [(6.6 – 6.8)/6.8] × 100 = −2.9% [(6.6 – 6.6)/6.6] × 100 = 0.0% [(5.4 – 6.6)/6.6] × 100 = −18.2% [(4.9 – 5.4)/5.4] × 100 = −9.3% [(5.5 – 4.9)/4.9] × 100 = 12.2% [(5.7 – 5.5)/5.5] × 100 = 3.6% [(5.7 – 5.7)/5.7] × 100 = 0.0% [(6.3 – 5.7)/5.7] × 100 = 10.5% [(6.3 – 6.3)/6.3] × 100 = 0.0% [(6.6 – 6.3)/6.3] × 100 = 4.8% [(6.7 – 6.6)/6.6] × 100 = 1.5%

We can conclude that sales fell at the highest rate in 2008.

CHAPTER 1 | Economics: Foundations and Models

1A.4

Percentage change in real GDP: [($16 397 billion − $15 982 billion)/$15 982 billion] × 100 = 2.6% The percentage change in real GDP from one year to the next is the economy’s growth rate.

1A.5 a.

b. At $2.50 per bottle, the total revenue equals rectangles A + B = $250 000 (because $2.50 × 100 000 = $250 000). At $1.25 per bottle, the total revenue equals rectangles B + C = $250 000 (because $1.25 × 200 000 = $250 000). 1A.6

The triangle’s area = 0.5 × 60 000 × $0.75 = $22 500.

1A.7

The slope is calculated using the formula: Slope =

Change in value on the vertical axis ∆ y Rise = = . Change in value on the horizontal axis ∆ x Run

At point A: rise = 300 − 175 = 125, run = 7 − 5 = 2. Therefore, the slope = 125/2 = 62.5. At point B: rise = 900 − 700 = 200, run = 14 – 12 = 2. Therefore, the slope = 200/2 = 100.

CHAPTER 2 | Trade-offs, Comparative Advantage, and the Market System SOLUTIONS TO END-OF-CHAPTER EXERCISES Production Possibilities Frontiers and Opportunity Costs 2.1 Learning Objective: Use a production possibilities frontier to analyze opportunity costs and trade-offs.

Review Questions 1.1 Scarcity is the situation in which wants exceed the limited resources available to fulfill those wants. There are some things that are available in such abundance that they exceed our wants. For example, for most people there is enough oxygen in the atmosphere that the amount they want to inhale would not exceed the available amount—so oxygen isn’t scarce for them. Another example might be something undesirable, such as weeds in your garden—unlike tomato plants, the number of weeds available exceeds the number you desire. 1.2 The production possibilities frontier (PPF) is a curve showing all the attainable combinations of two products that may be produced with available resources and existing technology. Combinations of goods that are on the frontier are efficient because all available resources are being fully utilized, and the fewest possible resources are being used to produce a given amount of output. Points inside the production possibilities frontier are inefficient, because the maximum output is not being obtained from the available resources. A production possibilities frontier will shift outward (to the right) if more resources become available for making the products or if technology improves so that firms can produce more output with the same amount of inputs. 1.3 Increasing marginal opportunity costs means that as more and more of a product is made, the opportunity cost of making each additional unit rises. It occurs because the first units of a good are made with the resources that are best suited for making that good, but as more and more of the product is made, resources must be used that are better suited for producing something else. Increasing marginal opportunity costs implies that the production possibilities frontier is bowed out—the slope gets steeper and steeper as you move down the production possibilities frontier.

Problems and Applications 1.4 a. The production possibilities frontiers in the figure are bowed to the right from the origin because of increasing marginal opportunity costs. The drought causes the production possibilities frontier to shift to the left (see the graph part (b)). b. The genetic modifications would shift the maximum soybean production to the right (doubling it), but not the maximum cotton production.

CHAPTER 2 | Trade-offs, Comparative Advantage, and the Market System

1.5 Increasing the number of cells will decrease range, as shown in the figure below. Trade-offs can be between physical goods, such as cotton and soybeans in Problem 1.4, or between less tangible features, such as range or cells, or time to charge battery and cells.

1.6 You would still have an opportunity cost represented by the next best use of your time.

CHAPTER 2 | Trade-offs, Comparative Advantage, and the Market System 11 1.7 a.

If you spend all five hours studying for your economics exam, you will score a 95 on the exam; therefore, your production possibilities frontier will intersect the vertical axis at 95. If you devote all five hours to studying for your chemistry exam, you will score a 91 on the exam; therefore, your production possibilities frontier will intersect the horizontal axis at 91. b. The points for choices C and D can be plotted using information from the table. Moving from choice C to choice D increases your chemistry score by four points but lowers your economics score by four points. Therefore, the opportunity cost of increasing your chemistry score by four points is the four-point decline in your economics score. c. Choice A might be sensible if the marginal benefits of doing well on the chemistry exam are low relative to the marginal benefits of doing well on the economics exam—for example, if the chemistry exam is only a small portion of your grade but the economics exam is a large portion of your grade; or if you are majoring in economics and don’t care much about chemistry; or if you have already achieved an A in chemistry but want the economics professor to replace your low exam grade in economics with this exam grade. 1.8 Your report should focus on the opportunity costs of spending more money on research to find a cure for heart disease. While heart disease kills thousands of Canadians every year, you need to consider what else could be done with the government resources your minister is considering spending. These same resources could be spent on preventative programs, promotion of the arts, road maintenance, or other things. You also need to consider the impact the additional spending is likely to have on heart disease treatments. These factors make many government decisions very difficult to make. 1.9 The government should consider whether the costs involved in either of the two programs exceed the benefits received from the programs. If the government decides that the costs of Sport A exceed its benefits, it may decide that the funds would be better spent on Sport B. Sport A will allow four more students to participate than Sport B, but at an extra cost of $812.5 per participant. Although this would be a difficult trade-off to consider, spending less—even though four fewer students can participate— would save resources that could be used for other purposes.

CHAPTER 2 | Trade-offs, Comparative Advantage, and the Market System

Comparative Advantage and Trade 2.2 Learning Objective: Understand comparative advantage and explain how it is the basis for trade.

Review Questions 2.1 Absolute advantage is the ability to produce more of a good or service than competitors using the same amount of resources. Comparative advantage is the ability to produce a good or service at a lower opportunity cost than competitors. It is possible to have a comparative advantage in producing a good even if someone else has an absolute advantage in producing that good (and every other good). Unless the two producers have exactly the same opportunity costs of producing two goods—that is, the same trade-off between the two goods—one producer will have a comparative advantage in making one of the goods and the other producer will have a comparative advantage in making the other good. 2.2 The basis for trade is comparative advantage. If each party specializes in making the product for which it has the comparative advantage, they can arrange a trade that makes both of them better off. Each party will be able to obtain the product made by its trading partner at a lower opportunity cost than without trade.

Problems and Applications 2.3 In Figure 2.4 the opportunity cost of 1 kilogram of apples is 1 kilogram of cherries to you and 2 kilograms of cherries to your neighbour. Any price of apples between 1 and 2 kilograms of cherries will be a fair trading price, and because 10 kilograms of apples for 15 kilograms of cherries is the same as 1 kilogram of apples for 1.5 kilograms of cherries, it falls within this range. We could take any other value in this range to complete the table. Let’s take, for example, 1.25 kilograms of cherries per kilogram of apples. We will keep the kilograms of apples traded as before at 10. The completed table will now be as follows: Summary of the Gains from Trade

Production and consumption without trade Production with trade Consumption with trade Gains from trade (increased consumption)

Apples (kilograms) 8 20 10 2

You

Neighbours

Cherries (kilograms)

Apples (kilograms)

Cherries (kilograms)

12 0 10 × 1.25 = 12.5 12.5 − 12 = 0.5

9 0 10

42 60 60 − 12.5 = 47.5

47.5 − 42 = 5.5

Note: Both you and your neighbour are better off after trade than before trade. Also, this rate of trading cherries for apples is better for your neighbour than the original rate of trading and worse for you.

CHAPTER 2 | Trade-offs, Comparative Advantage, and the Market System 13 2.4 a. Canada has a comparative advantage in making lumberjack boots. Canada’s opportunity cost of making one boot is giving up one shirt. In the United States, the opportunity cost of making one boot is giving up three shirts. The United States has a comparative advantage in making shirts. In the United States, the opportunity cost of making one shirt is giving up one-third boot, but Canada’s opportunity cost of making one shirt is one boot. b. Neither country has an absolute advantage in making both goods. The United States has an absolute advantage in making shirts, but Canada has an absolute advantage in making boots. Remember, both countries have the same amount of resources. If each country puts all of its resources into making shirts, then the United States makes 12 shirts, but Canada makes only 6 shirts. If each country puts all of its resources into making boots, then Canada makes 6 boots, but the United States makes only 4 boots. c. If each country specializes in the production of the good in which it has a comparative advantage and then trades with the other country, both will be better off. Let’s use the case in which each country trades half of what it makes for half of what the other makes. The United States will specialize by making 12 shirts and Canada will specialize by making 6 boots. Because each gets half of the other’s production, they both end up with 6 shirts and 3 boots. They are better off than before trading because they end up with the same number of boots but twice as many shirts. Other trades will also make them better off. 2.5 Yes, Canada can still benefit from trade with developing countries like Vietnam, despite Canada having an absolute advantage in all goods. Vietnam will still have a comparative advantage in some goods, typically goods that are labour-intensive to produce (such as clothes), so Canada can specialize in goods in which it has a comparative advantage and Vietnam can do the same. After trade, both Canada and Vietnam will both be better off. 2.6 a. When France produces one more bottle of wine, it produces two fewer kilograms of schnitzel. When Germany produces one more bottle of wine, it produces three fewer kilograms of schnitzel. Therefore, France’s opportunity cost of producing wine—two kilograms of schnitzel—is lower than Germany’s—three kilograms of schnitzel. When Germany produces one more kilogram of schnitzel, it produces 0.33 fewer bottles of wine. When France produces one more kilogram of schnitzel, it produces 0.50 fewer bottles of wine. Therefore, Germany’s opportunity cost of producing schnitzel —0.33 bottles of wine—is lower than that of France—0.50 bottles of wine. We can conclude that France has the comparative advantage in making wine and that Germany has the comparative advantage in making schnitzel. b. We know that France should specialize where it has a comparative advantage and Germany should specialize where it has a comparative advantage. If both countries specialize, France will make four bottles of wine and zero kilograms of schnitzel, and Germany will make zero bottles of wine and fifteen kilograms of schnitzel. After both countries specialize, France could then trade three bottles of wine to Germany in exchange for seven kilograms of schnitzel. This will give France the same amount of wine as they initially had but an extra one kilogram of schnitzel. Germany will have three bottles of wine and eight kilograms of schnitzel—that is, the same amount of wine but more schnitzel. Other mutually beneficial trades are possible as well. 2.7 An individual or a country cannot produce beyond its production possibilities frontier. The production possibilities frontier shows the most that an individual or country can produce for a given amount of resources and technology. Without trade, an individual or country cannot consume beyond its production possibilities frontier, but with specialization and trade, an individual or country can consume beyond its production possibilities frontier. In Figure 2.5, both you and your neighbour were

CHAPTER 2 | Trade-offs, Comparative Advantage, and the Market System able to consume beyond your production possibilities frontiers, and in Solved Problem 2.2, both Canada and the United States were able to consume beyond their production possibilities frontiers.

2.8 Colombia could have a comparative advantage in producing coffee if Nicaragua has an even larger absolute advantage relative to Colombia at producing another product. Say Nicaragua can produce four times more cashews than Colombia can using the same resources. Then Colombia will have a comparative advantage in producing coffee. 2.9 Specialization and trade are about standard of living, not jobs. In both cases, individuals and countries have jobs. You have a job if you produce everything yourself and do not trade with others, and you have a job if you specialize and trade with others. But your standard of living will be higher if you specialize and trade. 2.10 Importing only products that cannot be produced here would result in Canada producing—rather than importing—many goods for which it does not have a comparative advantage. These products would be produced at a higher opportunity cost than if they had been imported.

2.3

The Market System Learning Objective: Explain the basic idea of how a market system works.

Review Questions 3.1 A circular-flow diagram illustrates how participants in markets are linked. It shows that in factor markets, households supply labour and other factors of production in exchange for wages and other payments from firms. In product markets, households use the payments they earn in factor markets to purchase the goods and services produced by firms. 3.2 The two main categories of market participants are households and firms. Households as consumers are of greatest importance in determining what goods and services are produced. Firms make a profit only when they produce goods and services valued by consumers. Therefore, only the goods and services that consumers are willing and able to purchase are produced. 3.3 A free market is one with few government restrictions on how goods or services can be produced or sold, or on how factors of production can be employed. Economic decisions are made by buyers and sellers in the market. In a centrally planned economy, the government—rather than households and firms—makes almost all the economic decisions. Free market economies have a much better track record of providing people with rising standards of living. 3.4 Private property rights are the rights that individuals or firms have to the exclusive use of their property, including the right to buy or sell it. If individuals and firms believe that property rights are not well enforced, they will be reluctant to risk their wealth by opening new businesses. Therefore, the enforcement of property rights and contracts is vital for the functioning of the economy. Independent courts are crucial because property rights and contracts will be enforced only if judges make impartial decisions based on the law rather than decisions that favour powerful or politically connected individuals.

CHAPTER 2 | Trade-offs, Comparative Advantage, and the Market System 15

Problems and Applications 3.5 a. An auto purchase takes place in the product market. The household (George) demands the good and the firm (Toyota) supplies the good. b. The labour market is a factor market. Households supply labour and the firm demands labour. c. The labour market is a factor market. The household (George) supplies the factor of production (labour), while the firm (McDonald’s) demands it. d. The land market is a factor market. The household (George) supplies the factor of production (land) and the firm (McDonald’s) demands it. 3.6 Adam Smith was making the “invisible hand” argument that, in pursuing their self-interest, business people end up producing the goods and services most desired by consumers. 3.7 Adam Smith realized—as economists today realize—that people’s motives can be complex. But in analyzing people in the act of buying and selling, economists have concluded that in most instances, the motivation of financial reward provides the best explanation for the actions people take. Moreover, being self-interested—looking out for your own well-being and happiness—and being selfish—caring only about yourself—are not exactly the same thing. Many successful business people are, in fact, generous: donating to charity, volunteering for activities, and otherwise acting in a generous way. This is not inconsistent with making business decisions that maximize profits for their companies. 3.8 a. “Psychic rewards” refers to the psychological benefits of, in this case, buying lottery tickets, which provide the excitement of playing the lottery and the chance of winning big. b. An entrepreneur might receive the psychic rewards of creating and running their own business along with the chance of making large profits. c. Answers will vary here. Elements of being an entrepreneur do appear to be similar to buying a lottery ticket, with the psychic rewards of playing the game along with the possibility of large returns. Other elements may differ, such as the probability of success. 3.9 Weak property rights force resource owners to spend additional resources defending their property and/or reduce the incentive to invest in ways to make their property more productive and valuable. Finally, weak property rights make it very difficult for someone to use the property as collateral for a loan to start or expand a business.

Suggestions for Critical Thinking Exercises CT2.1

There are very few (if any) companies that make things without purchasing inputs from others. We couldn’t think of any. This is a great illustration of comparative advantage. Companies are able to specialize in what they do well (have a comparative advantage) and make gains from trade.

CT2.2. Most economists would consider this method of production highly inefficient. This person is not exploiting any specialization that would increase their productivity. Even adding just one more person would create opportunities for specialization and the large gains that accompany it. Such gains are one of the advantages a group has over individuals.

CHAPTER 3 | Where Prices Come From: The Interaction of Supply and Demand SOLUTIONS TO END-OF-CHAPTER EXERCISES 3.1

The Demand Side of the Market Learning Objective: Discuss the variables that influence demand.

Review Questions 1.1 A demand schedule is a table showing the relationship between the price of a product and the quantity of the product demanded. A demand curve is a curve that shows the relationship between the price of a product and the quantity of the product demanded. 1.2 Ceteris paribus means “all else equal”—that is, holding everything else constant when examining the relationship between two variables. 1.3 A “change in demand” refers to a shift of the demand curve, while a “change in quantity demanded” refers to a movement along the demand curve as a result of a change in the product’s price. 1.4 The law of demand states that, holding all else constant, when the price of a product falls, the quantity demanded of the product will increase (and when the price of a product rises, the quantity demanded of the product will decrease). An increase in the price of a product raises the price of the product relative to other products, causing consumers to substitute away from the higher-priced product. The increase in the price of the product also causes a decrease in the real incomes of consumers and, assuming that the product is a normal good, leads consumers to buy less of the product. 1.5 The main variables that will cause a demand curve to shift include (1) changes in the prices of related goods—substitutes or complements, (2) changes in income, (3) changes in tastes, (4) changes in population or demographics, and (5) changes in expected future prices. Examples of substitute goods are Coca-Cola and Pepsi, and examples of complementary goods are hot dogs and hot dog buns. The impact of a change in income depends on the nature of the good: normal or inferior. An example of a normal good may be a name brand product, like Coca-Cola. An example of an inferior good may be a store brand product, like PC Cola. An example of a change in tastes would be the increasing popularity of organic produce. An example of a change in population or demographics would be an increase in the number of people over the age of 65 leading to an increase in the demand for health care services. An example of a change in expected future prices would be the prices of hybrid vehicles expected to come down in the future, causing today’s demand to decrease.

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply 17

Problems and Applications 1.6 a. Substitutes b. Complements c. Probably unrelated d. Substitutes 1.7 Assuming that premium bottled water and carbonated soft drinks are substitutes, then a tax on soft drinks will increase the price of soft drinks and increase the demand for premium bottled water. 1.8 a. Because the price of a substitute good has declined, the demand curve for Quarter Pounders will shift to the left from D1 to D2 in the following graph.

b. The coupon results in a cut in the price of Quarter Pounders, so there will be a movement down the demand curve for Quarter Pounders in the following graph.

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply c. Because for many people Quarter Pounders and french fries are complements, an increase in the price of french fries will shift the demand curve for Quarter Pounders to the left from D1 to D2 in the following graph.

d. If McDonald’s made this switch, it would expect there to be an increase in the demand for Quarter Pounders (demand would shift from D1 to D3 in the following graph), but until the switch is made the effect on the demand for Quarter Pounders is uncertain.

e. The demand curve for Quarter Pounders will shift. If Quarter Pounders are an inferior good, the demand curve will shift to the left from D1 to D2 in the following graph. If Quarter Pounders are a normal good, the demand curve will shift to the right from D1 to D3.

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply 19

1.9 The demand for Allbirds shoes decreased from 2019 to 2020, which could be caused by the following: a decrease in the price of leather shoes, which are a complementary good (Allbirds shoes are made from wool and other plant materials); a decrease in national income assuming Allbirds shoes are normal goods; a decrease in the taste (preference) for Allbirds shoes as a result of a campaign against using wool; or any other factors decreasing demand. 1.10 The student’s reasoning is flawed. Whether a good is normal or inferior depends on how your demand changes when your income changes. If this person were to buy less lobster when their income increased, then they’d be correct. Just because you don’t like something doesn’t make it an inferior good. 1.11 a. Music downloads, SAT test prep services, text messaging services b. Diapers, developmental toys, child-care services c. English language courses, prepaid phone cards, foreign-language newspapers 1.12 The data does not indicate that the demand curve for Priuses is upward sloping. It is likely that factors such as income, fuel prices, and the prices of other hybrid vehicles have changed during these three years. Therefore, the data is likely to represent points from three different demand curves. 1.13 As given by the reporter, Posner’s statement confuses a change in demand and a change in quantity demanded. The reduction in the cost of books—the price of books—will increase the quantity demanded of books. It will not cause the demand curve to shift outward. 1.14 a. Factors that have caused a decline in sales of carbonated beverages include the following: increases in demand for substitutes, such as bottled water; health concerns among consumers regarding sugar and other ingredients found in carbonated beverages; and increases in taxes on sugary drinks. It is likely that these factors will continue to affect demand for carbonated beverages in the future. b. Sales of bottled water might decline during a recession because consumers can use tap water as a substitute for bottled water. Because the price of premium bottled water is higher than the price of regular bottled water, sales of premium bottled water are likely to decline more than regular bottled water during a recession.

3.2

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply

The Supply Side of the Market Learning Objective: Discuss the variables that influence supply.

Review Questions 2.1 A supply schedule is a table that shows the relationship between the price of a product and the quantity of the product supplied. A supply curve is a curve that shows the relationship between the price of a product and the quantity of the product supplied. 2.2. A “change in supply” refers to a shift of the supply curve, while a “change in quantity supplied” refers to a movement along the supply curve as a result of a change in the product’s price. 2.3 The law of supply states that, holding everything else constant, an increase in price causes an increase in the quantity supplied (and a decrease in price causes a decrease in the quantity supplied). The main variables that will cause a supply curve to shift include (1) changes in the prices of inputs used to make the product, (2) technological change, (3) changes in the prices of substitutes in production (other things that the producers could be making), (4) changes in expected future prices, and (5) changes in the number of firms. An example of a change in price of input used would be if the price of hybrid engines increases, the supply of hybrid cars will decrease. An example of technological change would be an improvement in the technology of producing iPhones leading to an increase in the supply of iPhones. An example of changes in the prices of substitutes in production would be if Sony is producing both plasma and LED flat-screen televisions, and the price of LED televisions increases, the supply of plasma televisions will decrease. An example of changes in expected future prices would be if Toyota believes that the price of the Prius hybrid will increase in the future, it will decrease supply today and increase it in the future. An example of changes in the number of firms would be as more firms enter the flat-screen television market, the supply of flat-screen televisions will increase.

Problems and Applications 2.4

a. Change in quantity supplied: A movement up the supply curve. b. Change in supply: The supply curve shifts to the right. c. Change in demand: The demand curve shifts to the left.

2.5 The supply of Allbirds shoes decreased from 2021 to 2022. The supply decrease could be caused by an increase in the price of wool (or any other material used in the production of these shoes) or an increase in the price of the machines used to assemble the shoes, an increase in the price of other types of shoes that the makers of Allbirds could produce, or any of the other factors identified in the text. 2.6 Not necessarily. Firms may have different costs of producing tablet computers and, therefore, supply different quantities at the same price. 2.7 The increase in the quantity supplied is likely to be larger the longer the time period being considered. Over time, new firms can enter the market and existing firms can better adjust their mix of products by increasing the quantity they supply of the good whose price has increased.

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply 21

3.3

Market Equilibrium: Putting Buyers and Sellers Together Learning Objective: Use a graph to illustrate market equilibrium.

Review Questions 3.1 Market equilibrium is the situation in which the quantity demanded equals the quantity supplied. 3.2 A shortage is a situation in which the quantity demanded is greater than the quantity supplied, and a surplus is a situation in which the quantity demanded is less than the quantity supplied. 3.3 If the current price is above equilibrium, the quantity supplied will be greater than the quantity demanded, and there will be a surplus. A surplus causes the market price to fall toward equilibrium. If the current price is below equilibrium, the quantity demanded will be greater than the quantity supplied, and there will be a shortage. A shortage causes the market price to rise toward equilibrium.

Problems and Applications 3.4 You should disagree. If there is a shortage, firms will raise the prices they charge. The quantity supplied will increase, the quantity demanded will decrease, and equilibrium will be reached at a higher price. 3.5 Begin by drawing two demand curves. Label one “Demand for diamonds” and the other “Demand for water.” Make sure that the water demand curve is much farther to the right than the diamond demand curve. Based on the demand curves you have just drawn, think about how it might be possible for the market price of water to be lower than the market price of diamonds. The only way this can be true is if the supply of water is much greater than the supply of diamonds. Draw on your graph a supply curve for water and a supply curve for diamonds that will result in an equilibrium price of diamonds that is much higher than the equilibrium price of water.

3.6 No. It only means that those willing to pay the equilibrium price received the goods. They would have been happier paying less. And there are likely to be consumers who want the good but are not willing (or able) to pay the market price. Similarly, on the supply side, sellers would be happier to receive a higher price than the equilibrium price, and there may be sellers who are only willing to sell at a higher price and, therefore, do not participate in the market.

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply

3.7 a. A supply chain is a series of processes or steps in a production process involved in the production and distribution of good, often involving several different firms. A breakdown in the supply chain suggests reduction in supply at every given price so that at the prior equilibrium price quantity demanded will exceed quantity supplied. b. The reduced supply will put upward pressure on prices, causing the equilibrium price to rise. c. The rising prices will make empty shelves less likely. As prices rise, all else equal, quantity demanded will fall until the price has risen sufficiently to cause quantity demanded to be equal to quantity supplied.

The Effect of Demand and Supply Shifts on Equilibrium 3.4 Learning Objective: Use demand and supply graphs to predict changes in prices and quantities.

Review Questions 4.1 When the demand curve shifts to the right, the equilibrium price and equilibrium quantity both rise. The first graph that follows illustrates this case. When the supply curve shifts to the left, the equilibrium price rises, but the equilibrium quantity falls. The second graph that follows illustrates this case.

4.2 If the demand curve shifts to the right more than the supply curve does, the equilibrium price will rise. Figure 3.11(a) illustrates this case. If the supply curve shifts to the right more than the demand curve, the equilibrium price will fall. Figure 3.11(b) illustrates this case.

Problems and Applications 4.3 You should agree. The increase in demand for athletic shoes would cause the demand curve to shift to the right along an unchanged supply curve. By itself, this shift in the demand curve would result in an increase in the price of athletic shoes. But an increase in the number of firms producing athletic shoes would result in an increase in supply—the supply curve will shift to the right—and a lower price—if demand remained unchanged. The relative size of the shift of the demand curve and the supply curve will determine whether the equilibrium price rises or falls. The following graph illustrates this

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply 23 uncertainty. For a given increase in demand—from D1 to D2—an increase in supply from S1 to S2 results in an increase in the equilibrium price from P1 to P2, but an increase in supply from S1 to S3 results in a decrease in the equilibrium price from P1 to P3.

4.4

c. The falling demand for renewable diesel means the price of a substitute in the production for cooking oil falls. As a result of a decrease of the price of a substitute in production, the supply curve for the product in question shifts to the right. Thus, if the price of renewable diesel falls, the supply of cooking oil will shift to the right. 4.5 Because demand is falling, and the exit of some smaller firms will cause supply to fall, the equilibrium quantity will definitely decrease. You cannot tell for certain if the new equilibrium price will be higher or lower than the old equilibrium price. If the decrease in demand is greater than the decrease in supply, the new equilibrium price will be lower. If the decrease in demand is less than the decrease in supply (as is shown on the graph), the new equilibrium price will be higher.

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply

4.6 a. The following graph illustrates an increase in the demand for coffee from D1 to D2 due to the millennials’ “unquenchable thirst” for coffee. The supply curve shifts to the left from S1 to S2 as the result of dry weather in Brazil and Asia. The shifts in demand and supply would each increase the equilibrium price of coffee, but an increase in demand by itself would increase the equilibrium quantity while a decrease in supply by itself would cause the equilibrium quantity to decrease. The graph shows that the equilibrium quantity of coffee will increase from Q1 to Q2 if the increase in demand is greater than the decrease in supply.

b. The quantity of coffee sold over time is a result of changes in both demand and supply. The quantity of coffee sold can increase due to an increase in supply even if demand hasn’t increased. 4.7 Draw a demand and supply graph showing the market equilibrium in the winter, label both the demand and supply curves “winter,” and label the equilibrium price created by these curves as “winter.” Add to your graph the demand curve for summer, making sure it is to the right of the winter demand curve. Look at the graph to see how the equilibrium price in the summer could be lower than the equilibrium price you have established for the winter. The only way for this to happen is for the summer supply

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply 25 curve to shift to the right by enough to cause the equilibrium price to be lower in the summer than it is in the winter. The demand for watermelons does increase in the summer compared with in the winter, but the increase in the supply of watermelons in the summer is even greater, so the equilibrium price falls.

4.8 The demand will be greater if the season is moved, and therefore price will be higher.

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply

4.9 The student’s analysis is correct. The decrease in demand will decrease the equilibrium price and the equilibrium quantity. The increase in supply will decrease the equilibrium price and increase the equilibrium quantity. The equilibrium price, therefore, will definitely decrease, but the equilibrium quantity could increase or decrease, depending on which change is larger—the decrease in demand or the increase in supply. The graph shows changes in demand and supply of equal magnitude, so the equilibrium quantity does not change.

4.10 The student’s reasoning is incorrect. He should have said, “Increased production leads to a lower price, which increases the quantity demanded. There is a movement along the demand curve, but the demand curve does not shift.” 4.11 The student’s analysis is incorrect—the shift from D1 to D2 will not happen. There will be a movement along the demand curve, D1, due to the price change, but the demand curve will not shift. 4.12 a. Scenario a. is shown in Graph 1. The demand for premium bottled water rises because a decrease in the supply of sports drinks will increase the price of sports drinks, which are substitutes for premium bottled water. The shift in the demand curve for premium bottled water results in a movement along the supply curve for premium bottled water. b. Scenario b. is shown in Graph 4. The demand for premium bottled water falls when incomes fall, assuming premium bottled water is a normal good. The shift in the demand curve for premium bottled water results in a movement along the supply curve for premium bottled water. c. Scenario c. is shown in Graph 3. An improvement in technology reduces the cost of producing premium bottled water and shifts the supply curve for premium bottled water to the right. d. Scenario d. is shown in Graph 2. A rise in an input’s price shifts the supply curve for premium bottled water to the left.

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply 27

4.13 The rising costs will cause the supply curve to shift to the left, from S1 to S2, while the improvement in quality will cause the demand curve to shift to the right from D1 to D2. Because we don’t know if the demand curve shifts to the right more than the supply curve shifts to the left, we don’t know if the equilibrium quantity purchased will increase or decrease. If the shift in the supply curve is greater, as shown in the figure, the equilibrium quantity will fall. We do know that the equilibrium price of childcare services will rise as a result of the regulation.

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply

4.14 The graph with the vertical demand curve is more likely to represent the market for the cancer-fighting drug. If the price of this good rises, patients are unlikely to reduce the quantity they demand, but if the price of the BMW rises, households will reduce the quantity they demand as they switch to buying other luxury cars.

Suggestions for Critical Thinking Exercises CT3.1 Students often have more difficulty with supply as they’re generally on the demand side of most markets. By working together, they will see this and better understand the topic as they talk to each other and describe what they find to be most difficult. CT3.2 It should be a market. Students are likely to have difficulty picking the appropriate theoretical representation of data. Students may also have a problem with this question as they are presented with data and asked what they represent, the type of question they are not used to addressing. CT3.3 The order would be (i) an external (or exogenous) event, (ii) a curve shifting, and (iii) a new equilibrium. Students sometimes have difficulty integrating these separate pieces in the correct order.

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply 29

SOLUTIONS TO CHAPTER 3 APPENDIX A-1

Quantitative Demand and Supply Analysis Learning Objective: Use quantitative demand and supply analysis.

Review Question 3A.1 The intercept of a demand curve identifies the price at which quantity demanded of the good is zero. This is the price at or above which no one will be willing to purchase the good. The intercept of a supply curve identifies the price at which producers will begin to supply the good. This is the price at or below which no firms will be willing to sell the good.

Problems and Applications 3A.2

a. W = 10; L = 60 b. W = 12; L = 72

3A.3

a. P = 50; Q = 100 b. P = 62.5; Q = 75 c. P = 50; Q = 50

CHAPTER 4 | GDP: Measuring Total Production and Income SOLUTIONS TO END-OF-CHAPTER EXERCISES 4.1

Gross Domestic Product Measures Total Production Learning Objective: Explain how total production is measured.

Review Questions 1.1 In microeconomics, we focus on a particular market and can measure production by the quantity of the units produced. In macroeconomics, we look at the production of all goods and services, and measuring production by the quantity of goods and services produced isn’t feasible because it would involve adding together goods and services measured in different units. Therefore, in macroeconomics, economists measure quantity by market value. 1.2 The total of every good and service sold during the year would be larger than GDP, because some of the goods and services sold are intermediate goods and services, and some were produced in a prior year. 1.3 All the money a business receives from the sale of its output is paid out as income to the owners of the factors of production. 1.4 GDP = C + I + G + NX. Consumption (C) is spending by households on goods and services, and investment (I) is spending by firms on new plant, equipment, buildings, and changes in inventories, and by households and firms on new single-family and multi-unit houses. Government purchases (G) are made by the federal, provincial, local, and municipal governments for goods and services, and net exports (NX) equal exports minus imports. Exports are goods and services produced in Canada that are purchased by foreign firms, households, and governments, and imports are goods and services produced in foreign countries, but purchased by Canadian firms, households, and governments. 1.5 A firm’s “value added” refers to the additional market value a firm gives to a product. It is equal to the difference between the price for which the firm sells a good and the price it paid other firms for intermediate goods.

Problems and Applications 1.6 The value of intermediate goods and services, though not counted directly, is included in the value of the final goods and services and therefore is included in GDP. The value of the computer chip is not counted separately but is included in the value of the new PC. 1.7 a. The purchase of flour by a bakery is the purchase of an intermediate good, not a final good, because the flour is included in the bread, or other final goods, the bakery produces. b, c, and d are all purchases of final goods because they are not purchased to become part of other goods or services.

CHAPTER 4 | GDP: Measuring Total Production and Income 31 1.8 a. Consumption b. Not included because the car is not new production. c. Not included because seats are intermediate goods, not final goods. d. Investment 1.9 The value of the house built in 2010 would not be included in the GDP of 2022 because the sale does not represent new production. The value of the services of the real estate agent who helped sell or buy the house in 2022 would be included in the GDP of 2022 because those services were newly provided in 2022. 1.10 Nominal GDP = (100 × $60) + (100 × $2) + (50 × $25) = $7450. Cotton is an intermediate good (in this case, it is used in the production of shirts), so it is not included directly in calculating GDP. 1.11 The statement is incorrect, because it confuses investment in the economic sense of purchases of machinery, factories, and houses with financial investment in stocks and bonds. 1.12 Cutting debt and increasing personal savings requires, for a given amount of income, a decrease in consumer spending. If consumers decided to reduce their spending at the same time, the economy will most likely grow slowly or even shrink in the short run. 1.13 Profits are one part of the income paid to the owners of the factors of production. A business uses the money it receives from the sale of its product to pay wages to labour, interest to capital, rent to natural resources, and profits to the owners of the firm. 1.14 Value added by the artist = ($800 × 10) − $5000 = $8000 – $5000 = $3000 Value added by the local art store = ($1000 × 10) – ($800 × 10) = $10 000 – $8000 = $2000

4.2

Does GDP Measure What We Want It to Measure? Learning Objective: Discuss whether GDP is a good measure of well-being.

Review Questions 2.1 GDP measures the value of final goods and services produced in a country during a given period and the level of income in the country during that same period. Although production of goods and services is not the only factor in determining the quality of life of people in a country, we would normally expect that when a country produces few goods and services, the quality of life in the country will be less than when it produces more goods and services. 2.2 GDP does not include household production and the informal economy. Even if GDP included all production, it would still not be a perfect measure of economic well-being because it does not consider many things that affect well-being. For example, GDP does not include the value of leisure and is not adjusted for the negative effects of pollution or crime and other social problems.

CHAPTER 4 | GDP: Measuring Total Production and Income

Problems and Applications 2.3 a. It is likely to increase measured GDP because work outside the home is measured while work inside the home is not measured. b. This is likely to increase measured GDP if it results in increased government expenditures on law enforcement and increased private expenditures on security. (However, an increase in the crime rate might indicate that the level of production in the informal economy is increasing, which should reduce measured GDP, not increase it.) c. It is likely to reduce measured GDP as more production moves to the informal economy. 2.4 Real GDP per capita is the level of real output or income per person. Real GDP per capita for Canada has risen since 1890. A higher income level today may be due to Canadians working more hours or simply being more productive. The fact that the typical Canadian today works fewer hours while earning a higher income suggests that the economic well-being of the average Canadian has increased more than is indicated by comparing 1890 real GDP per capita with current real GDP per capita. The average person has more leisure time today than in 1890, and the value of this time is not included in GDP. 2.5 Sorted by GNI Country Singapore UAE Norway US Canada Australia South Korea Greece China Iran Venezuela Zimbabwe

Real GNI per Person (2020 PPP) 88 155 67 462 66 494 63 826 48 527 48 085 43 044 30 155 16 057 12 447 7 045 2 666

HDI 0.938 0.89 0.957 0.926 0.929 0.944 0.916 0.888 0.761 0.783 0.711 0.571

CHAPTER 4 | GDP: Measuring Total Production and Income 33 Sorted by HDI Country Norway Australia Singapore Canada US South Korea UAE Greece Iran China Venezuela Zimbabwe

Real GNI per Person (2020 PPP) 66 494 48 085 88 155 48 527 63 826 43 044 67 462 30 155 12 477 16 057 7 045 2 666

HDI 0.957 0.944 0.938 0.929 0.926 0.916 0.89 0.888 0.783 0.761 0.711 0.571

The two rankings parallel each other in the sense that countries with higher real GNI per person tend to be countries with a higher HDI, while countries with lower real GNI per person tend to be those with a lower HDI. However, the orders do not match perfectly. For example, the United Arab Emirates’ real GNI per person was the second highest at $67 462, but the country’s HDI was only seventh out of 12. The possible reasons for the observed differences include differences in factors that affect the HDI but not GNI, such as life expectancy at birth, adult literacy, and school enrolment. 2.6 a. Household consumption would likely change the most. b. Compensation of employees (wages and salaries) and gross mixed income (net mixed income) would likely change the most. c. Government capital consumption and compensation of employees (both wages and salaries and benefits) would likely change the most. 2.7 a. A summary statistic is a single number that characterizes an underlying set of data. GDP is a summary statistic of how well an economy is doing because it measures how much an economy produces during a period of time, which equals a country’s total income. b. GDP provides a summary measure of the performance of an overall economy but not a perfect measure. It excludes production in the informal economy and household production and does not include the value of leisure or adjust for the negative effects of pollution, crime, and other social problems.

CHAPTER 4 | GDP: Measuring Total Production and Income

4.3

Real GDP versus Nominal GDP Learning Objective: Discuss the difference between real GDP and nominal GDP.

Review Questions 3.1 Nominal GDP can change because of either quantity changes or price changes. When there is inflation, nominal GDP overstates the increase in total production. Statistics Canada separates price changes from quantity changes by calculating real GDP. 3.2 The GDP deflator is a measure of the average prices of the final goods and services included in GDP and equals nominal GDP divided by real GDP, multiplied by 100. 3.3 a. Nominal GDP is greater than real GDP. b. Nominal GDP equals real GDP. c. Nominal GDP is less than real GDP.

Problems and Applications 3.4 a. Real GDP, 2018

= (100 × $50) + (100 × $2) + (50 × $30) = $6700

Real GDP, 2019

= (100 × $50) + (120 × $2) + (65 × $30) = $7190

b. Growth rate of real GDP, 2019 $7190 − $6700 × 100 = 7.3% $6700 3.5 a. Disagree. Nominal GDP is less than real GDP if the current price level, which is used in calculating nominal GDP, is less than the base-year price level, which is used in calculating real GDP. A fall in the price level during the year is neither necessary nor sufficient to cause nominal GDP to be less than real GDP. b. Disagree. If prices increase more than the quantity of production decreases, nominal GDP can increase when real GDP declines. c. Agree. If a recession is so severe that both the quantity of production and the price level decline, both real and nominal GDP will decline. d. Disagree. Nominal GDP could decline because either the GDP deflator declined or total production (real GDP) declined. In fact, between 2008 and 2009, nominal and real GDP both declined, while the GDP deflator increased.

CHAPTER 4 | GDP: Measuring Total Production and Income 35 3.6 The only way for nominal GDP to rise while real GDP is constant (or nearly so) is if the value of the GDP deflator is higher. To see this point, look at the formula for the GDP deflator:

= GDP deflator

Nominal GDP × 100. Real GDP

With nominal GDP higher and real GDP the same, the GDP deflator must be higher. A higher GDP deflator means a higher inflation rate. Therefore, the author must be expecting higher oil prices to increase the inflation rate in Canada. 3.7 a. (1)

(2)

(3)

(4)

(5)

GDP Percentage Deflator Real GDP Change Nominal (base year (base year in Real Year = 2016) = 2016) GDP GDP

(6)

(7)

(8)

GDP Deflator Real GDP Percentage (base year (base year Change in = 2018) = 2018) Real GDP

2014 2015 2016

$ 980.00 1020.00 1050.00

90 92 100

$1088.89 1108.70 1050.00

-----1.8% −5.3%

81.8 83.6 90.9

$1198.04 1220.10 1155.12

----1.8% −5.3%

2017

1200.00

105

1142.86

8.8%

95.5

1256.55

8.8%

2018

1400.00

110

1272.73

11.4%

100.0

1400.00

11.4%

The calculations for the annual percentage change in real GDP are not affected by the change in the base year.

A change in the base year used to calculate the GDP deflator would result in the same values for the annual percentage changes in real GDP.

3.8 It is likely that the article is referring to the percentage change in real GDP, which measures the value of output, holding constant the change in the price level. Because changes in nominal GDP measure the change in the value of output in current year prices, it would not be possible to determine how much the euro zone’s economy grew—how much more output of final goods and services were produced and sold, holding prices constant—if the 2 percent change referred to nominal GDP. 3.9 The GDP deflator is calculated as [nominal GDP/real GDP] × 100. The percentage change is calculated as [(value in the second period – value in the first period)/ value in the first period] × 100.

CHAPTER 4 | GDP: Measuring Total Production and Income

2012 2013 2014 2015 2016

Nominal GDP Real GDP GDP Deflator $16 155 $15 355 105.2 16 692 15 612 106.9 17 393 15 982 108.8 18 037 16 397 110.0 18 569 16 662 111.4

Percentage Increase — 1.62% 1.79 1.08 1.31

As shown in the table, 2014 saw the largest percentage increase in the price level.

4.4

Other Measures of Total Production and Total Income Learning Objective: Become familiar with other measures of total production and total income.

Review Questions 4.1 GDP is the market value of all final goods and services produced within Canada. GNI is the market value of all final goods and services produced by residents of Canada, even if the production takes place outside Canada. For Canada, GDP is almost the same as GNI. In many countries, GDP is much larger than GNI. 4.2 National income is the total income received by a country’s residents. National income is equal to GDP minus the value of depreciation, or the consumption of fixed capital. Household income, which is income actually received by households, is national income minus corporations’ retained earnings plus payments received by households from the government in the form of transfer payments or interest on government bonds. Household disposable income, which represents the income available for households to spend, is equal to household income minus personal tax payments, such as the federal personal income tax. 4.3 Gross domestic income is GDP calculated as the sum of income payments to households. Wages, which include all compensation received by employees including fringe benefits, comprise a majority of gross domestic income and are more than three times as large as profits, the second-largest income category.

Problems and Applications 4.4 GNI would be larger than GDP. The country has relatively more of its firms and residents working in other countries. 4.5 With GDP significantly above GNI, the value of income produced within Ireland is significantly above the value of income produced by the residents of Ireland, making the Irish people appear to be richer than they are. 4.6 The federal personal income tax partially accounts for the difference between household income and household disposable income. Therefore, the levels of national income and household income will not change, while the level of household disposable income will decrease.

CHAPTER 4 | GDP: Measuring Total Production and Income 37 4.7 To forecast the level of consumption spending by households, we should focus on the income measure that is most closely related to the households’ ability to spend, which is household disposable income.

Real-Time Data Exercises D4.1

a. In the first quarter of 2021, total personal consumption expenditures were $15 070.1 billion, personal consumption expenditures on durable goods were $1 940.7 billion, personal consumption expenditures on non-durable goods were $3 278.3 billion, and personal consumption expenditures on services were $9 851.2 billion. All figures are expressed as annual rates. b. [($1 940.7 billion + $3 278.3 billion)/$15 070.1 billion] × 100 = 34.6%

D4.2

a. In the first quarter of 2021, gross private domestic investment was $3 920.0 billion, private non-residential fixed investment was $2 960.7 billion, and private residential fixed investment was $1 051.3 billion. All figures are expressed as annual rates. b. $3 920.0 billion − [$2 960.7 billion + $1 051.3 billion] = −$92.0 billion, which equals the change in inventories.

D4.3

a. Real exports of goods and services in 2020 were $2 216.9 billion, and in 2019 they were $2 546.6 billion. Real imports of goods and services in 2020 were $3 142.9 billion and in 2019 they were $3 464.2 billion. b. Net exports in 2020 equaled − $926.0 billion (= $2 216.9 billion − $3 142.9 billion) and in 2019 they equaled − $917.6 billion (= $2 546.6 billion − $3 464.2 billion).

D4.4

a. In the first quarter of 2021, nominal GDP equaled $22 061.5 billion and nominal GNP equaled $22 255.7 billion. Both figures are expressed as annual rates. b. With GNP greater than GDP, foreign production by U.S. firms exceeded U.S. production by foreign firms by $194.2 billion in the first quarter of 2021.

D4.5

a. In the first quarter of 2021, personal income equaled $22 101.6 billion, disposable personal income equaled $22 079.6 billion, and personal consumption expenditures equaled $15 070.1 billion. All figures are expressed as annual rates. b. The difference between personal income and disposable personal income is personal tax payments which in the first quarter of 2021 equaled $22.0 billion (= $22 101.6 billion − $22 079.6 billion).

D4.6

a. Nominal GDP equaled $22 061.5 billion in the first quarter of 2021 and equaled $21 561.1 billion in the first quarter of 2020. Real GDP equaled $19 086.4 billion in the first quarter of 2021 and equaled $19 010.8 billion in the first quarter of 2020. All figures are expressed as annual rates. b. The GDP price deflator in the first quarter of 2021 equaled 115.6 = [($22 061.5 billion/ $19 086.4 billion) × 100], and in the first quarter of 2020 it equaled 113.4 = [($21 561.1 billion/$19 010.8) × 100]. c. The inflation rate from the first quarter of 2020 to the first quarter of 2021 as measured by the GDP price deflator was 1.94 percent [= (115.6 − 113.4)/113.4) × 100].

CHAPTER 4 | GDP: Measuring Total Production and Income d. The nominal and real GDP lines intersect at the base year because the current-year prices used for nominal GDP and the base-year prices used for real GDP are the same when the base year is the current year. The value of the GDP deflator in the year when the nominal and real GDP lines intersect is 100.

D4.7

a. Nominal GDP in the first quarter of 2021 equaled $22 061.5 billion, and in the first quarter of 2020 it equaled $21 561.1 billion. Both figures are expressed as annual rates The GDP Implicit Price Deflator in the first quarter of 2021 equaled 115.588, and in the first quarter of 2020 it equaled 113.415. b. Real GDP in the first quarter of 2021 is approximately $19 086.3 billion [($22 061.5 billion/115.588) × 100], and in the first quarter of 2020 it equaled $19 010.8 billion [($21 561.1 billion/113.415) × 100]. c. The growth rate of the real GDP from the first quarter of 2020 to the first quarter of 2021 was approximately 0.4 percent = [($19 086.3 billion – $19 010.8 billion)/$19 010.8 billion) × 100].

Suggestions for Critical Thinking Exercises CT4.1 Students will likely misunderstand the meaning of the word investment. By thinking more about it and comparing notes with their peers, students will remember this important concept better than they otherwise would. Research in other disciplines has shown that in some instances, simply talking about ideas that conflict with students’ prior knowledge does not lead to much change in students’ views. CT4.2 Answers will vary by student, but by asking students what they expected and what they learned, they should be able to learn the material in a deeper way. CT4.3 The best interpretation is that inflation occurred. Nominal GDP grows, but production is constant; therefore, the GDP deflator increased. This question will encourage students to consider several key points from this chapter.

CHAPTER 5 | Unemployment and Inflation SOLUTIONS TO END-OF-CHAPTER EXERCISES 5.1

Measuring the Unemployment Rate and the Labour Force Participation Rate Learning Objective: Define the unemployment rate and the labour force participation rate, and understand how they are computed.

Review Questions 1.1 The unemployment rate is calculated monthly from data gathered by Statistics Canada in its Labour Force Survey (LFS). The unemployment rate equals the percentage of the labour force that is unemployed: (Unemployed/Labour force) × 100. The three conditions to be counted as unemployed are that the person (1) did not work in the previous week, (2) was available for work, and (3) actively looked for work in the past four weeks. 1.2 The challenge of measuring unemployment is in collecting the data and properly identifying what is happening to people and why. For example, Statistics Canada must determine whether someone actually wants to work or not. The official Statistics Canada measure of the unemployment rate understates the true degree of unemployment to the extent that it does not count discouraged workers as unemployed because they have stopped looking for a job, and it counts involuntary part-time workers as employed even though these workers would prefer to work more hours. The official Statistics Canada measure overstates the true degree of unemployment because (1) some people are not actively looking for work but they claim to do so to remain eligible for government payments to the unemployed and (2) some people have jobs in the informal economy that they do not disclose. 1.3 The labour force participation rate measures the percentage of the working age population that is in the labour force: (Labour force/Working age population) × 100. Since 1970, the labour force participation rate for men has gradually declined, while the rate for women has significantly increased. The overall labour force participation was higher in 2021 than in 1970. In recent years, the decline in the labour force participation rate of prime-age men has been a policy concern. The labour force participation rate for women has declined somewhat since the 2007–2009 recession. Participation of both men and women fell significantly during the COVID-19 pandemic. 1.4 The employment–population ratio measures the percentage of the working-age population that is employed: (Employment/Working-age population) × 100. An unemployed person dropping out of the labour force would decrease the unemployment rate, but it would not change the employment– population ratio. 1.5 The Survey of Household Spending is a sample of about 18 000 households chosen to represent the Canadian population and provides information on household spending habits. The Labour Force Survey is a different survey of households that focuses on labour market activity (employment) of those in the household, not how much and on what they spend.

CHAPTER 5 | Unemployment and Inflation

Problems and Applications 1.6

Working-Age Population (Feb. 2019) Employment Unemployment Unemployment Rate Labour Force Labour Force Participation Rate Employment–Population Ratio

30 575 898 18 662 000 1 212 334 6.1% 19 874 300 65% 61.0%

The number of people unemployed can be found using the definition that the unemployment rate equals the number of unemployed divided by the sum of the number of unemployed and the number of employed. The labour force equals the employed plus the unemployed. The labour force participation rate equals the labour force divided by the working-age population. The employment– population ratio equals the number of employed divided by the working-age population. 1.7 The key is to realize that the labour force is not a fixed number of people. If enough people enter the labour force, with most becoming employed and only some becoming unemployed, then the unemployment rate could decrease while the number of unemployed increases. 1.8 For the unemployment rate to remain unchanged while the number of people employed decreased, the number of people in the labour force must have fallen by even more than the fall in employment. For employment overall to fall while Saskatchewan and Alberta saw increases, other provinces must have seen employment fall. 1.9 For this to occur, more of those remaining in the labour force would have been employed than previously. Those leaving the labour force would have been unemployed. 1.10 a. No, they are not counted as unemployed by Statistics Canada. These people have left the job market and no longer “want” to have a paid job. They have chosen to do other things instead. Therefore, they don’t meet the definition of “unemployed” used by Statistics Canada. b. Yes, new entrants to the labour market are counted as unemployed if they don’t find a job immediately. They meet the definition of unemployment used by Statistics Canada: They are able to work, they want to work, and they have looked for work, but they don’t have a job. 1.11 The unemployment rate can increase while employment increases if the number of discouraged workers and other people not previously counted as unemployed entering the labour force more than offsets the effect of the employment increase. In this case, the number of people counted as unemployed in Georgia was increasing faster than the increase in employment, causing the unemployment rate to increase. 1.12 It’s unlikely that only 3 million jobs were created during this period. What was most likely being referred to was the increase in the total number of jobs compared to March 2020. In order for the total number of jobs to increase by 3 million, many more than 14 million jobs would have to have been created, as some jobs would have been “destroyed” during the same period. If we saw 1 million new jobs created but 1 million jobs destroyed (perhaps because of firms closing), we wouldn’t see any increase in the total number of jobs.

CHAPTER 5 | Unemployment and Inflation 41

5.2

Types of Unemployment Learning Objective: Identify the four types of unemployment.

Review Questions 2.1 The four types of unemployment are frictional unemployment, structural unemployment, cyclical unemployment, and seasonal unemployment. Frictional unemployment is short-term unemployment that arises from the process of matching workers with jobs. Structural unemployment is unemployment that arises from a persistent mismatch between the skills and attributes of workers and the requirements of jobs. Cyclical unemployment is unemployment caused by a business cycle recession. Seasonal unemployment is unemployment caused by changes in economic activity due to changes in the seasons. 2.2 The natural rate of unemployment is the normal rate of unemployment, consisting of frictional unemployment plus structural unemployment. The natural rate of unemployment is also called the full-employment rate of unemployment. Economists do not define full employment as being an unemployment rate equal to zero because the creating and destroying of jobs that leads to frictional unemployment and the structural changes in the economy from factors such as innovation that lead to structural unemployment are ongoing features of a growing, dynamic economy. No economy attains an unemployment rate of zero, even during wartime.

Problems and Applications 2.3 Decisions are made by comparing the marginal cost and benefit associated with the activities. The decision of applying for graduate school depends on the opportunity cost of attending versus the payoff received from a graduate degree. During a recession, jobs are less plentiful and the chances of getting a high-wage job offer are lower. This means that the opportunity cost of attending graduate school is lower, so new university and college graduates are more likely to attend graduate school instead. Conversely, demand in the job market is higher during an economic expansion, so the opportunity cost of attending graduate school is also higher. 2.4 Disagree. The economy would operate less efficiently if frictional unemployment were eliminated. By devoting time to job search, workers end up with jobs they find satisfying and in which they can be more productive. Government policies to enhance the job search process of matching workers with jobs could make the economy operate more efficiently, but entirely eliminating frictional unemployment would not be efficient. 2.5 For someone frictionally unemployed, the advice would be to keep searching. The person has the required skills, but matching worker skills to job openings takes time. For someone structurally unemployed, the advice would centre on the need to retrain or to find another occupation. For someone cyclically unemployed, the advice would be to realize that the search will take longer because of the recession and to consider temporarily taking a lower-paying job or going back to school until the economy picks up. 2.6 Efficiency wages can increase the productivity of workers as well as workers’ incomes. They can also increase the profitability of firms. The main disadvantage of efficiency wages is they tend to increase unemployment.

CHAPTER 5 | Unemployment and Inflation

2.7 The workers referred to in the article are likely to be structurally unemployed because they lack the skills required for the available jobs or because they have addiction problems or other personal troubles that make it difficult for them to remain employed. 2.8 a. Discouraged workers are people who would like to have a job but have become discouraged about their prospects of finding one and have given up looking for a job as a result. Because these people are not looking for work, they are not included in the official unemployment rate. Increases in the number of discouraged workers is an indication that the economy is not performing well, even if the official unemployment rate is falling. b. Full employment is the level of employment at which we only observe frictional and structural unemployment. Involuntary part-time or discouraged workers may be suffering from either frictional or structural unemployment. Those who are involuntarily working part-time jobs may be between full-time jobs, so they are frictionally unemployed. Discouraged workers may not have the skills employers demand or may be in the wrong location to find a job that uses their skills and are thus structurally unemployed.

5.3

Explaining Unemployment Learning Objective: Explain what factors determine the unemployment rate.

Review Questions 3.1 The payment of employment insurance likely raises the unemployment rate. The employment insurance payments lower the opportunity cost (the income lost by not working) of continuing to search for a job, which leads the unemployed to spend more time searching for a job. The payment of employment insurance lessens the severity of recessions by helping the unemployed maintain their income and spending. 3.2 a. Minimum wage laws likely increase the rate of unemployment if they are set above the marketclearing wage rate. (Author’s note: This is still subject to some debate.) b. Labour unions, by negotiating higher wages for their members, tend to increase the unemployment rate. c. Efficiency wages, like labour unions, tend to increase the unemployment rate. 3.3 A significant reason that the unemployment rate in the United States has been lower than the unemployment rates in Canada and countries in Western Europe is the more generous unemployment compensation payments and social insurance programs in Canada and Western Europe, which lower the opportunity cost of continuing to search for a job.

Problems and Applications 3.4 If Parliament eliminated the employment insurance system, the opportunity cost of job search would increase, decreasing the level of frictional unemployment. There would be conflicting effects on the level of real GDP. Lower frictional unemployment would increase real GDP, but the possibility of less effective matching of worker skills to jobs due to less time for job search would decrease real

CHAPTER 5 | Unemployment and Inflation 43 GDP. Well-being would probably decrease if the employment insurance system were eliminated because unemployed workers would suffer large drops in income. 3.5 Prices were much lower in 1965 than they are today. It is difficult to state whether $0.50 was below the equilibrium wage in 1965 without information about the level of wages in 1965. 3.6 If this analyst is correct, we cannot conclude that Costco is paying efficiency wages and Walmart is not. The higher Costco wages would be due to the higher-skilled workers required to sell Costco’s higher-cost products. 3.7 a. and c. are likely to increase the unemployment rate. Lengthening the time workers are eligible to receive employment insurance lowers the opportunity cost of a job search. An increase in union membership pushes more wages above market wages, thereby increasing unemployment, at least temporarily until these workers can find jobs in the non-union sector of the economy. b. and d. are likely to reduce the unemployment rate. Abolishing the minimum wage lowers the wage from above the market wage for some workers, thereby increasing the number of workers firms will employ. Making information on job openings more available shortens the search involved in frictional unemployment. 3.8 Henry Ford was paying an efficiency wage, which can cut a firm’s cost by increasing the productivity of workers. Paying an efficiency wage results in an increase in the quality of workers willing to work for the firm and a decrease in the turnover of workers. 3.9 By paying an efficiency wage (a wage above the minimum required) Amazon may attract higherquality workers and increase worker productivity. These higher wages will improve Amazon’s profits if the increase in productivity is greater than the increase in wages. Extra credit: By paying higher than required wages, Amazon also can reduce the likelihood of consumer boycotts and regulatory action. By paying a higher wage, Amazon may be protecting the profits it is currently earning.

Measuring Inflation 5.4

Learning Objective: Define price level and inflation rate, and understand how they are computed.

Review Questions 4.1 The GDP deflator is the broadest measure of the price level because it includes the prices of all final goods and services included in GDP. The consumer price index measures the prices of goods and services purchased by consumers. The producer price index measures the prices of goods and services at all stages of the production process. 4.2 The potential biases include the substitution bias, the increase in quality bias, the new product bias, and the outlet bias.

Problems and Applications 4.3 The statement misinterprets the CPI. The inflation rate in 2021 is the percentage change in the CPI since 2020, not since the base year.

CHAPTER 5 | Unemployment and Inflation

4.4 The CPI, at any point in time, uses a fixed market basket, comparing the cost of buying the fixed market basket in the current period to the cost of buying the fixed market basket in the base period. As a fixed market basket, Statistics Canada uses the quantities in the market basket, not the quantities actually purchased in the current period. 4.5 a.

City

Percentage Change in House Price

Halifax

Montreal

18.3%

Toronto

7.4%

Winnipeg

22.5%

Regina

7.6%

Edmonton

6.3%

Vancouver

12.4%

The percentage change is calculated as [(January 2022 index value – January 2021 index value)/January 2021 index value] × 100. Winnipeg saw the largest increase and Edmonton the smallest. b. The home price index measures how much housing prices in the city have changed since the base month. It does not give information on which city had the most expensive homes in January 2021. 4.6 a. During the period from point B to C when the CPI did not change, the country experienced zero inflation. b. During the period from point C to D when the CPI decreased, the country experienced deflation. c. During the period from point A to B when the CPI increased at a decreasing rate, the country experienced a slowdown in inflation (disinflation). d. During the period from point 0 to A when the CPI increased at an increasing rate, the country experienced an increasing inflation rate. 4.7 Until Statistics Canada updates the market basket of goods used to compute the CPI to include the new television models, the introduction of the new models will have no effect on the CPI. Once the new models are included in the CPI market basket, they will most likely contribute to the increase in quality bias that causes changes in the CPI to overstate the true inflation rate. Increases in the prices of these new models partly reflect their improved quality and partly are pure inflation. Statistics Canada attempts to make adjustments so that only the pure inflation part of price increases is included in the CPI, but these adjustments are difficult to make, so the recorded price increases overstate the pure inflation in some products.

CHAPTER 5 | Unemployment and Inflation 45

5.5

Using Price Indexes to Adjust for the Effects of Inflation Learning Objective: Use price indexes to adjust data for the effects of inflation.

Review Questions 5.1 A nominal variable is a variable measured in current dollars, which means that it is measured using the actual prices from that year. A real variable is a variable measured in constant dollars, which means that it is measured using prices from the base year. That is, a real variable is adjusted for the effects of inflation. 5.2 The real wage for a given year between 2004 and 2022 can be calculated by using this formula: Real wage = (Nominal Wage/CPI) × 100. For example, the real wage for 2004 would be calculated as Real wage2004 = (Nominal Wage2004 / CPI2004) × 100. 5.3 As prices of goods and services decrease during a period of deflation, nominal earnings are likely to rise slowly and may even fall. Real earnings will not fall as much as nominal earnings and will rise if the decline in prices is greater than the decline in nominal earnings. Therefore, real average hourly earnings are likely to increase faster than nominal average hourly earnings during a period of deflation.

Problems and Applications 5.4 In the United States, the real minimum wage in 1957 was $3.70 [($1.00/27) × 100], and in 2016 it was $3.02 [($7.25/240) × 100]. In France, the real minimum wage in 1957 was €2.38 [(€0.19/8) × 100], and in 2016 it was €9.21 [(€9.76/106) × 100]. Between 1957 and 2016, there was an 18.4 percent decrease in the real minimum wage in the United States [($3.02 – $3.70)/$3.70] × 100. And there was a 287.7 percent increase in the real minimum wage in France [(€9.21 – €2.38)/€2.38] × 100. It does not matter whether we have information about the base year as long as we have the CPI data. Whatever the base year is, we would get the same percentage increase in prices. The percentage increase in the price level was less in the United States—[(240 – 27)/27 × 100] = 788.9 percent—than in France—[(106 – 8)/8 × 100] = 1225.0 percent. 5.5 Real GDP in 2019 = (Nominal GDP in 2019/CPI in 2019) × 100 = (2311/136) × 100 = $1699 billion. Real GDP in 2020 = (Nominal GDP in 2020/CPI in 2020) × 100 = (2207/137) × 100 = $1611 billion, making the percentage change in real GDP = (1699 - 1611)/1699 × 100% = -5.2%, or a 5.2% decrease in real GDP. 5.6 If three cups of coffee and a doughnut can be purchased in 2022 for $10 and in 2062 for $2000, the CPI would have to be 200 times greater in 2062 than in 2022 because 200 × $10 = $2000. Therefore, the CPI in 2062 would be 240 × 200 = 48 000. 5.7 The real receipts in 2020 dollars for each film are listed in the last column below. The first column shows the rankings of the top 10 films based on their earnings in 2020 dollars. Real receipts in 2020 dollars equal the nominal receipts reported in the third column multiplied by the CPI in 2020 divided by the CPI in the year that the movie was released.

CHAPTER 5 | Unemployment and Inflation

Rank 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17

Film Gone with the Wind Snow White and the Seven Dwarfs Star Wars: A New Hope 101 Dalmatians Jaws ET: The ExtraTerrestrial Titanic Star Wars: The Force Awakens Avatar Avengers: Endgame Star Wars: The Phantom Menace Black Panther Jurassic World The Avengers Avengers: Infinity War Star Wars: The Last Jedi Incredibles 2

Total Box Office Receipts 200 852 579

Year Released 1939

CPI 14

184 925 486

1937

460 998 007

1977

144 880 014 260 758 300

1961 1975

30 54

435 110 554

1982

659 363 944

1997

161

936 662 225

2015

237

760 507 625 858 373 000

2009 2019

215 256

474 544 677

1999

167

700 426 566 652 270 625 623 357 910 678 815 482

2018 2015 2012 2018

251 237 230 251

620 181 382

2017

245

608 581 744

2018

251

Real Receipts (2020 dollars) $3 715 772 712 3 421 121 491 1 957 352 194 1 250 797 454 1 250 674 069 1 161 790 036 1 060 715 910 1 023 609 773 916 146 395 868 432 059 735 970 487 722 750 919 712 818 953 701 955 212 700 451 035 655 620 318 627 978 772

5.8 The economy of Venezuela was suffering from hyperinflation and on the verge of collapse. The hyperinflation would have wiped out the 60 percent increase in the minimum wage, leaving the real minimum wage lower. With the economy near collapse, jobs were hard to find and there was little food available to purchase.

CHAPTER 5 | Unemployment and Inflation 47

Real versus Nominal Interest Rates 5.6 Learning Objective: Distinguish between the nominal interest rate and the real interest rate. Review Questions 6.1 The nominal interest rate is the stated interest rate on a loan, while the real interest rate is the nominal interest rate minus the inflation rate. 6.2 Because the nominal interest rate is the real interest rate plus the inflation rate, an increase in expected inflation raises the nominal interest rate by the increase in the expected rate of inflation, assuming that the real interest rate remains constant. 6.3 It is impossible to know whether a particular nominal interest rate is “high” or “low” without knowing the inflation rate. It is the real interest rate that matters to borrowers and lenders, not the nominal interest rate. A nominal interest rate of 5 percent with an inflation rate of 0 percent has a higher real interest rate than a nominal interest rate of 20 percent with an inflation rate of 19 percent. 6.4 If the economy is experiencing deflation, the nominal interest rate will be lower than the real interest rate. The real interest rate equals the nominal interest rate minus the inflation rate, but with deflation the inflation rate is negative.

Problems and Applications 6.5 The reporter does not understand the definition of deflation. Deflation occurs when the price level declines. Inflation, even if only half the national rate, increases the price level. It is not possible for the CPI to drop below zero. The reporter should have written that the change in the CPI drops below zero when there is deflation. 6.6 The real interest rate on a loan with a nominal interest rate of 20 percent and 19 percent inflation is 1 percent. The real interest rate on a loan with a nominal interest rate of 5 percent and 2 percent inflation is 3 percent. Therefore, you should prefer the loan with the 20 percent nominal rate. 6.7 If the monthly inflation rate is 4 percent, the annual inflation rate is about 60 percent. To see this, notice that at a 4 percent inflation rate, the price level is rising 4 percent per month. If the price level starts at 100, after two months it would have increased to 100 × 1.04 × 1.04 = 108.2; after three months it would have increased to 100 × 1.04 × 1.04 × 1.04 = 112.5; and after twelve months to 100 × (1.04)12 = 160.1, or by 60.1 percent. So, the real interest rate would be 4% − 60% = –56%. 6.8 Real interest rate = Nominal interest rate – Inflation rate. With $1000, you can purchase 500 hamburgers at the beginning of the year. If you lend $1000 for one year at an interest rate of 5 percent, you will receive $1050 at the end of the year. With the higher price of hamburgers, at the end of the year you can buy $1050/$2.08 = 504.8 hamburgers. So, you can purchase [(504.8 − 500)/500] × 100 = 0.96% more hamburgers. Therefore, the real interest rate you receive on the loan is 0.96 percent. Notice that this is very close to the real interest rate on the loan, calculated by subtracting the 4 percent inflation in hamburger prices from the 5 percent nominal interest rate on the loan. 6.9 Lenders would agree to a nominal interest rate of almost 0 percent, because with deflation, the real interest rate would be higher than the nominal interest rate by the rate of deflation.

CHAPTER 5 | Unemployment and Inflation

5.7

Does Inflation Impose Costs on the Economy? Learning Objective: Discuss the problems inflation can cause.

Review Questions 7.1 We know from the circular flow of expenditures and income that when inflation increases the nominal value of expenditures, it must also increase nominal incomes. Consequently, inflation does not reduce the purchasing power of the average consumer. 7.2 Inflation affects the purchasing power of money. People with incomes rising faster than the rate of inflation enjoy an increasing purchasing power, while people with incomes rising more slowly than the rate of inflation are hurt by a decreasing purchasing power. In general, inflation particularly hurts people on fixed incomes, such as retired persons who may be receiving a pension of a fixed number of dollars each year. (As we noted, however, the Canada Pension Plan, Old Age Security, and other social security payments tend to move at the same rate as the CPI, but not always.) 7.3 Unanticipated inflation is the greater problem. Anticipated inflation can be incorporated into nominal interest rates and nominal wage contracts. Unanticipated inflation causes the actual real interest rate and actual real wage rate received to differ from the expected real interest rate and the expected real wage rate. 7.4 Deflation can cause consumers to reduce their current spending in anticipation of future lower prices, and unanticipated deflation increases the burden on borrowers by raising the real interest rate above the expected real interest rate. 7.5 Menu costs are the costs of changing prices. The term comes from the notion that restaurants would have to reprint menus to change (increase) the prices they charged. The internet has likely reduced menu costs for many firms. Online retailers can change the price they charge for each item with a few keystrokes, while previously they would have to pay an employee to replace every price tag on each individual item. 7.6 If inflation turns out to be lower than anticipated, borrowers tend to benefit at the expense of lenders. A higher than expected inflation rate reduces the value of money paid by borrowers to lenders, reducing the real interest rate. So when inflation rises unexpectedly, borrowers pay back less in terms of purchasing power (they give up fewer other purchases) than they were expecting. 7.7 a. Frank is likely to have a higher real income 10 years from now. Real income is income adjusted for inflation. James’s fixed pension income will have been constantly eroded by inflation, while Frank will constantly have to purchase new GICs. The GICs that Frank purchases will be subject to interest rates that change with the rate of inflation. The nominal rate of interest tends to adjust in response to inflation so that the real interest rate is moderately stable. Thus, Frank will be better protected from inflation than will James. b. In this situation James is likely to have a higher income than Frank. Frank’s GICs cannot account for unanticipated inflation, while James’s pension is now adjusted for inflation every year. If inflation is higher than expected in any given year, Frank’s interest payments will be lower in real terms than he was expecting. He will have to wait until his GICs are up for renewal in order to get an interest rate that reflects the higher inflation rate.

CHAPTER 5 | Unemployment and Inflation 49 7.8 If the actual inflation rate is 6 percent rather than 2 percent, Apple will benefit at the expense of those that lent it money (purchased bonds). In this scenario the real interest rate turns out to be zero rather than the expected real interest rate of 4 percent. This means that Apple’s lenders receive no financial benefit from their loan.

Real-Time Data Exercises D5.1

a. The CPI for August 2019 was 256.3 and for August 2018 was 251.9. b. The inflation rate as measured by the CPI from August 2018 to August 2019 equalled [(256.3 – 251.9)/251.9] × 100 = 1.7 percent.

D5.2

a. and b. Data used in the graph in (c) below covers the period from August 2013 to August 2019. c.

Federal Reserve Economic Data (FRED) website (fred.stlouisfed.org).

d. The inflation rate of 2.95 percent in July 2018 was the highest during these years with the inflation rate of 2.85 percent in June 2018 and 2.74 percent in May 2018 being the second and third highest. D5.3

a. and b. Data used in the graph in (c) below covers the period from July 2009 to August 2019. c.

Federal Reserve Economic Data (FRED) website (fred.stlouisfed.org).

CHAPTER 5 | Unemployment and Inflation d. The inflation rate as measured by the CPI was more volatile than the inflation rate as measured by the CPI less prices of food and energy. In July 2010 the inflation rate measured by the CPI was 1.34 percent but measured by the CPI less food and energy prices was 0.96 percent. In February 2017, the inflation measured by the CPI was 2.73 percent, but measured by the CPI less food and energy prices it was 2.19 percent. In August 2019, the two inflation rates were 1.76 percent as measured by the CPI and 2.39 percent as measured by the CPI less food and energy prices.

D5.4

a. The CPI for food and beverages in August 2019 was 258.2, and in August 2012 it was 234.1. The CPI for apparel in August 2019 was 125.1, and in August 2012 it was 125.3. The CPI for transportation in August 2019 was 210.3, and in August 2012 it was 217.6. The CPI for medical care in August 2019 was 501.3, and in June 2012 it was 417.6. b. The inflation rate over the entire period from August 2012 to August 2019 for food and beverages was [(258.2 – 234.1)/234.1] × 100 = 10.329 percent; for apparel it was [(125.1 – 126.3)/126.3] × 100 = −10.095 percent; for transportation it was [(210.3 – 217.6)/217.6] × 100 = −3.435 percent; for medical care it was [(501.4 – 417.6)/417.6] × 100 = 20.1 percent. These inflation rates are the percentage changes over the entire five-year period, not annual inflation rates. c. Transportation experienced the lowest inflation rate (−3.35 percent), and medical care experienced the highest inflation rate (20.1 percent).

D5.5

a. In August 2019, the number of unemployed equalled 6044 thousand, the civilian labour force equalled 163 922 thousand, and workers with part-time employment for economic reasons, slack work, or business conditions equalled 2678 thousand. These data are reported monthly and measured in thousands of persons. b. The civilian unemployment rate equalled [(6044 thousand/163 922 thousand) × 100] = 3.7 percent. The civilian unemployment rate including persons who are underemployed equalled [(6044 thousand + 2678 thousand)/163 922 thousand] × 100 = 5.3 percent.

D5.6

a. In August 2019, the number of unemployed men equalled 3233 thousand, the number of unemployed women equalled 2812 thousand, the civilian labour force for men equalled 86 832 thousand, and the civilian labour force for women equalled 77 090 thousand. These data are reported monthly and are measured in thousands of persons. b. The unemployment rate for men equalled [(3233 thousand/86 832 thousand) × 100] = 3.7 percent, and the unemployment rate for women equalled [(2812 thousand/77 090 thousand) × 100] = 3.6 percent.

D5.7

a. In August 2019, the number of unemployed equalled 6044 thousand, civilian employment equalled 157 878 thousand, and those not in the labour force equalled 95 510 thousand. b. The working-age population equals the labour force plus those not in the labour force. In August 2019, the labour force equalled 6044 thousand + 157 878 thousand = 163 922 thousand, and the working-age population equalled 163 922 thousand + 95 510 thousand = 259 432 thousand. The employment–population ratio equals civilian employment divided by the working-age population, which for August 2019 equalled [(163 922 thousand/259 432 thousand) × 100] = 63.18 percent. c. If the economy entered a recession, one would expect the employment–population ratio to decline as fewer people would have jobs.

CHAPTER 5 | Unemployment and Inflation 51 D5.8

a. The civilian unemployment rate equalled 3.6 percent in the second quarter of 2019, and it equalled 4.4 percent in the second quarter of 2017. The natural rate of unemployment equalled 4.381 percent in the second quarter 2019 and 4.611 percent in the second quarter of 2017. Note that the natural rate of unemployment is calculated on a quarterly, not monthly, basis. b. The cyclical unemployment rate equals the unemployment rate minus the natural rate of unemployment. The cyclical unemployment rate equalled (3.6 percent − 4.4 percent) = −0.8 percent in the second quarter of 2019 and equalled (4.4 percent − 4.6 percent) = −0.2 percent in the second quarter of 2017. c. The economy improved over the two-year period, and the unemployment rate in the second quarter of 2019 was further below the natural rate of unemployment than in the second quarter of 2017.

D5.9

a. In August 2019, the number of unemployed equalled 6 044 000, civilian employment equalled 157 878 000, employment level—part-time for economic reasons equalled 4 381 000, and not in the labour force, searched for work and available equalled 1 561 000. b. The official unemployment rate equals the number of unemployed divided by the labour force, which equals the unemployed plus the employed. For August 2019, the official unemployment rate equalled [(6 044 000/(6 044 000 + 157 878 000) × 100] = 3.7 percent. c. This broader measure of the unemployment rate would include as unemployed the three categories of unemployed: unemployed; employed but part-time for economic reasons; and not in the labour force, searched for work and available. In August 2019, this broader measure of the unemployment rate equalled [(6 044 000 + 4 381 000 + 1 561 000)/(6 044 000 + 4 381 000 + 1 561 000 + 157 878 000)] × 100 = [11 986 000/169 864 000] × 100 = 7.1 percent. d. One would expect the gap between the official rate of unemployment and the broader rate of unemployment to widen during recessions and narrow during expansions. One would expect the number of part-time workers for economic reasons and discouraged workers to rise during a recession and fall during an expansion.

D5.10 a. In September 2019, the three-month Treasury bill interest rate equalled 1.89 percent and the University of Michigan inflation expectation equalled 2.70 percent. b. The expected real interest rate equals the nominal interest rate minus the expected inflation rate. In September 2019, the expected real interest rate for the three-month Treasury bill equalled 1.89 percent − 2.70 percent = −0.81 percent. c. If the actual inflation rate is greater than the expected inflation rate, borrowers gain and lenders lose from the actual real interest (nominal interest rate minus the actual inflation rate) being below the expected real interest rate. D5.11 a. In August 2019, the CPI equalled 256.6 and average hourly earnings of private production and non-supervisory employees equalled $23.59, and in August 2019, the CPI equalled 252.1 and average hourly earnings equalled $22.80. b. The average hourly real wage in August 2019 equalled [($23.59/256.6) × 100] = $9.19, and in August 2018 equalled [($22.80/252.1) × 100] = $9.04. With the CPI having a base period of 1982–1984, the real wage is measured in 1982–1984 dollars. c. The percentage change in the average hourly nominal wage equalled [(23.59 – 22.80)/22.80] × 100 = 3.46 percent, and the percentage change in the average hourly real wage equalled [(9.19 – 9.04)/9.04] × 100 = 1.7 percent.

CHAPTER 5 | Unemployment and Inflation d. Given that the average hourly real wage increased 1.7 percent from August 2018 to August 2019, the average worker was better off.

Suggestions for Critical Thinking Exercises CT5.1

The unemployment rate would likely increase as unemployment increased by a large number. If you check the expansions after the recessions of 1991, 2001, and 2007–2009, you’ll see the unemployment rate rising for a time.

CT5.2

A key part in the construction of the CPI is seeing how much a consistent market basket of goods and services costs at different times. The GDP deflator compares real GDP (constructed with constant prices) to nominal GDP to compute the GDP deflator.

CHAPTER 6 | Economic Growth, the Financial System, and Business Cycles SOLUTIONS TO END-OF-CHAPTER EXERCISES 6.1

Long-Run Economic Growth Learning Objective: Discuss the importance of long-run economic growth.

Review Questions 1.1 Real GDP per capita increased by almost three times. The actual increase in living standards is likely to be larger as this measure does not account for many of today’s goods and services, increases in life expectancy, and the like. 1.2 The rule of 70 is a quick way to calculate the approximate number of years it will take for a quantity such as real GDP per capita to double. Dividing 70 by the growth rate per year yields the approximate number of years to double. If real GDP per capita grows at the rate of 7 percent per year, it will take 10 years (70/7) for real GDP per capita to double. 1.3 The most important factor that explains increases in real GDP per capita in the long run is labour productivity, which is the quantity of goods and services that can be produced by one worker or by one hour of work. 1.4 Potential real GDP is the level of real GDP attained when all firms are producing at capacity. Historically, potential real GDP has substantially increased over time.

Problems and Applications 1.5 There is no one correct answer to this question, but there are some relevant considerations: An income of $1 000 000 in 1900 represents 23 times more basic purchasing power than $50 000 in 2021, so with that income you could have many more goods and services in 1900 than in 2021. Even though there were no automatic dishwashers, microwaves, or airplanes in 1900, with $1 000 000 you could afford to have servants wash the dishes, cook, do the laundry, and provide other desired personal services. You could travel in private train cars and in luxurious suites on ocean liners. With an income of $1 000 000 in 1900, you could live what in many ways would be a more luxurious life than with an income of $50 000 today. However, you would not have television, personal computers, the Internet, movies, iPads, streaming services, smartphones, or many other goods available today that we often think of as necessities. So, a person living with an income of $50 000 in 2021 might in fact enjoy a higher living standard than a person living with an income of $1 000 000 in 1900. 1.6 A positive relationship between economic prosperity and life expectancy may be due to increased spending on health care in an economy with a higher income level. Therefore, greater economic prosperity would imply a health care sector that is larger relative to the economy. In addition, because the use of the health care system increases with age, as life expectancy increases and the average age of the population increases, we should expect that more people will use the health care system for more years. This should cause the health care sector in Canada to expand relative to the size of the economy. Copyright © 2024 Pearson Canada Inc.

CHAPTER 6 | Economic Growth, the Financial System, and Business Cycles

1.7 Increases in real GDP per capita not only increase the amount of goods and services available to a country’s citizens but also increase life expectancy at birth and allow people to have a higher portion of leisure time over the course of their lives. So, a rising GDP per capita should ordinarily result in a rising quality of life. 1.8 a. Growth rate for 1991 =

8015 − 8034 × 100 = –0.24% 8034

Growth rate for 1992 =

8287 − 8015 × 100 = 3.39% 8015

Growth rate for 1993 =

8523 − 8287 × 100 = 2.85% 8287

Growth rate for 1994 =

8871 − 8523 × 100 = 4.08% 8523

b. Average annual growth =

−0.24% + 3.39% + 2.85% + 4.08% = 2.52% 4

1.9 Using the rule of 70, it will take approximately 38.8 years for real GDP per capita to double if it grows at 1.8 percent a year. If the annual growth rate falls to 1.5 percent, real GDP per capita will take approximately 46.7 (70/1.5) years to double. 1.10 Many developing countries have faced difficulties implementing policies that boost economic growth, such as protecting private property and avoiding political instability and corruption. India faces particular challenges around property rights and corruption. (Thankfully, the political system seems fairly robust.) 1.11 a. The government measure would understate the rate of growth of labour productivity, because the government calculates labour productivity using the official measure of work hours, not the adjusted measure that Smith believes to be more accurate. If Smith is correct, workers are producing the measured level of output in fewer hours than the official work hours used in the calculation in the government statistics. b. Increases in real GDP per capita as calculated by the economists and Statistics Canada would understate increases in well-being. For any given level of output, workers are working fewer hours and consuming more leisure, increasing their well-being beyond that indicated by increases in real GDP per capita alone. 1.12 Real wages increase when workers produce more output per hour. Business firms generally pay workers the marginal revenue product of their labour, which increases as labour productivity increases. Looked at another way, the real wages of workers as a group cannot increase unless the output the workers produce is also increasing.

CHAPTER 6 | Economic Growth, the Financial System, and Business Cycles 55

Saving, Investment, and the Financial System 6.2

Learning Objective: Discuss the role of the financial system in facilitating long-run economic growth.

Review Questions 2.1 The financial system allows businesses to borrow funds to finance purchases of capital equipment, to train workers, and to adopt new technologies. Long-run economic growth depends on increases in the quantity of capital equipment, increases in the amount of human capital, and technological advances. 2.2 The equality between saving and investment follows from national income accounting and the definitions of saving and investment. By rearranging the components of GDP for a closed economy (Y = C + I + G), investment equals income minus consumption minus government purchases. Adding together private saving by households (SPrivate = Y + TR – C – T) and public saving by government (SPublic = T – G – TR) yields total saving, and also equals income minus consumption minus government purchases, or investment. 2.3 Loanable funds are the money that households save and lend to businesses. Businesses demand loanable funds to borrow money to fund new investment projects. Households supply loanable funds to save money and earn interest for future years.

Problems and Applications 2.4 You would have to take the time and expense to gather information on the borrower and their likelihood of repaying. Your funds would not be liquid. If you wanted the money back before the loan was due, the borrower would not have to pay before the due date. If the borrower stopped paying, you might have to go to court to try to get your money back. Lastly, your money would not be spread out across different investments to reduce risk. 2.5 a. Private saving: Sprivate = Y + TR – C – T = $11 trillion + $1 trillion – $8 trillion – $3 trillion = $1 trillion b. Public saving: Spublic = T – G – TR, but G not given. Use I = Sprivate + Spublic; $2 trillion = $1 trillion + Spublic; Spublic = $1 trillion c. Government purchases: Spublic = T – G – TR, or I = Y – C – G G = $1 trillion d. Government budget surplus = T – G – TR = $1 trillion

CHAPTER 6 | Economic Growth, the Financial System, and Business Cycles

2.6 a. Private saving: Sprivate = Y + TR – C – T, but TR not given. Use I = Sprivate + Spublic I = Y – C – G = $12 trillion – $8 trillion – $2 trillion = $2 trillion. Spublic = −$0.5 trillion, so Sprivate = $2.5 trillion b. Investment spending: I = $2 trillion c. Transfer payments: Spublic = T – G – TR; −$0.5 trillion = $2 trillion − $2 trillion – TR, TR = $0.5 trillion d. Government budget deficit: T – G – TR = –$0.5 trillion 2.7 S and I must drop by $0.5 trillion. I = S = Y – C – G. With no change in Y and C, an increase in G must drop I and S by the same amount. 2.8 a. The shift represents a decrease in the supply of loanable funds. b. The equilibrium quantity of loanable funds decreases. c. The quantity of saving decreases as does the quantity of investment. 2.9 a. Both the equilibrium interest rate and the quantity of loanable funds increase. b. The demand for loanable funds increases. For a given demand for loanable funds, an increase in the interest rate does decrease the quantity of loanable funds demanded, but it also increases the quantity of loanable funds supplied.

CHAPTER 6 | Economic Growth, the Financial System, and Business Cycles 57 2.10 As illustrated in the graph below, an economic expansion will increase the expected profitability of new investment, which will increase the demand for loanable funds. The equilibrium real interest and the quantity of loanable funds will both rise, as will the quantity of saving and investment.

2.11 As illustrated in the graph below, an increase in business taxes will decrease the after-tax rate of return on investment projects, which will decrease the demand for loanable funds. The equilibrium real interest rate and quantity of loanable funds will both decrease, which will decrease the quantity of investment and the economy’s future capital stock.

CHAPTER 6 | Economic Growth, the Financial System, and Business Cycles

2.12 a.

A reduction in deficits shifts the supply of loanable funds to the right. As the supply curve for loanable funds shifts right, the equilibrium real interest rate falls, and the equilibrium quantity of loanable funds rises. Since the equilibrium quantity of loanable funds rises, the equilibrium quantity of saving and investment also rises. b. A decrease in saving by households in anticipation of lower taxes in the near future would partly or fully offset the increase in public saving caused by the reduction in federal budget deficit. If the decrease in private saving matches the increase in public saving, the supply of loanable funds will not shift, and there will be no change in the real interest rate or the equilibrium quantity of loanable funds. 2.13 Households are interested in the return they receive from saving after they have paid their taxes. If the government switched from taxing nominal interest payments to taxing only real interest payments, the tax households would pay would decrease, leaving them a higher after-tax return. This increase in the after-tax return would increase the supply of loanable funds. The supply curve for loanable funds would shift to the right (from S1 to S2 in the graph below) as the after-tax return to saving increases. The equilibrium real interest rate will fall (from i1 to i2), but the quantity of loanable funds would increase (from L1 to L2), as would the quantity of saving and investment. Because investment increases, the capital stock and the quantity of capital per hour worked will grow, and the rate of economic growth should increase.

CHAPTER 6 | Economic Growth, the Financial System, and Business Cycles 59

2.14 Agree. A sound financial system helps to channel saving (the supply of loanable funds) to firms that borrow for capital investment and the adoption of new technologies, both of which are key factors for economic growth. 2.15 a. Graph 4 shows a situation where there would be a small increase in the quantity of loanable funds supplied from an increase in the real interest rate. b. Graph 1 shows a situation where there would be a substantial increase in the quantity of loanable funds demanded following a decrease in the real interest rate. c. Graph 2. The elimination of non-deductible retirement accounts would reduce the after-tax return on saving, which would shift the supply curve for loanable funds to the left. d. Graph 3. A reduction in the tax on corporate profits would increase the after-tax return on investment projects, which would shift the demand curve for loanable funds to the right. 2.16 a. “Index-tracking funds” or “funds” refer to mutual funds, which sell shares to savers and then use the money to buy a portfolio of stocks, bonds, mortgages, and other financial securities. b. The use of artificial intelligence (AI) represents a technological advance and would increase labour productivity in the financial system by allowing financial firms to offer the same number of mutual funds with fewer (human) managers or more mutual funds with the same number of managers. c. By increasing labour productivity and decreasing costs in the financial system, the use of AI would increase the flow of loanable funds, which would increase saving and investment and thereby the rate of long-run economic growth.

CHAPTER 6 | Economic Growth, the Financial System, and Business Cycles

6.3

The Business Cycle Learning Objective: Explain what happens during the business cycle.

Review Questions 3.1 a. Peak b. Trough c. Recession d. Expansion 3.2 During an economic expansion, particularly near the end of the expansion, the inflation rate typically increases. During recessions, the inflation rate typically decreases. The unemployment rate rises during recessions and, after a delay, falls during expansions. The unemployment rate may continue to rise during the early stages of a recovery because employment may grow more slowly than the labor force (from population growth and discouraged workers re-entering the labor force), and because some firms are operating well below capacity, these firms may be slow to hire laid-off workers or may continue to lay off more workers for a period of time.

Problems and Applications 3.3 Ford F-150 trucks (a), refrigerators (c), and Bombardier passenger aircraft (e) are durable goods and would be expected to fluctuate more than real GDP during the business cycle. McDonald’s Big Macs (b) and Huggies diapers (d) are non-durable goods and would be expected to fluctuate less than real GDP. 3.4 As part of the federal government, Statistics Canada could be pulled into politics with the dating of recessions. It could come under pressure to set the start or the end of a recession to help the administration in power. 3.5 When firms expand during a recession, they risk spending too much money too quickly. If it is difficult to predict when a recession will end, firms that expand too quickly will find themselves with increasing debt loads and not enough business to cover their increased expenses. This situation can lead to substantial losses for these businesses. In certain industries, a more cautious approach may be advisable. If a recession has significantly changed consumer spending habits, firms need to be aware of the changes and realize that consumer spending habits from before the recession may not re-emerge after the recession has ended. For example, casual dining restaurants experienced a significant drop in business during the recession of 2007–2009. This particular market may not be quick to rebound once the recession ends, as consumers seem to be taking a much more cautious approach in spending their incomes on items many consider luxuries and instead appear to be more interested in increasing their savings to better insulate themselves from future economic downturns. The recovery from the 2020–2021 COVID-19 recession seems to have taken a different path, likely as the cause was different. In this case, restaurants seemed to boom once the pandemic ended as people who were unable to dine out during lockdowns returned to restaurants.

CHAPTER 6 | Economic Growth, the Financial System, and Business Cycles 61 3.6 You should disagree with this statement. While $1.6 trillion is a lot of money for one person, the GDP in a single year doesn’t tell you about the rate of economic growth. You would need to know the level of GDP in the preceding year to determine the rate of economic growth. 3.7 Samuelson explained that households were willing to assume debt and lenders were willing to make loans during the Great Moderation because they were confident that continued economic growth would allow the loans to be paid off. But consumers were more reluctant to borrow and lenders were more reluctant to make loans after experiencing the effects of the financial crisis: “Consumers are not only . . . paying down debt but also trying to build up savings against possible future setbacks. Businesses are reluctant to invest in major expansions because they’re unsure of future demand.” Greater lending and debt prior to the recession of 2007–2009 increased the number of defaulted loans during the recession, making it worse than it might otherwise have been.

Real-Time Data Exercises Note: FRED continues to update data. The solutions below contain the data available on FRED the first quarter of 2021. D6.1

a. In the first quarter of 2021, nominal GDP equalled $22 061.5 billion, real GDP equalled $19 086.4 billion in chained 2012 dollars, and real potential GDP equalled $19 602.5 billion in chained 2012 dollars. These GDP values are at annual rates. b. The GDP price deflator in the first quarter of 2021 equalled [($21,061.5 billion/$19,086.4 billion) × 100] = 110.35. c. The percentage difference between real GDP and real potential GDP in the first quarter of 2021 equalled [($19,086.4 billion – $19,602.5 billion)/$19,602.5 billion] × 100 = –2.63%. Real GDP in the first quarter of 2021 was 2.63 percent below real potential GDP. d. Real GDP was below real potential GDP in 2011 as the economy continued to recover from a severe recession. Since the trough of the recession in the second quarter of 2009, real GDP has slowly climbed back up to and was above real potential GDP in 2019. However, real GDP fell below potential GPD in 2020 due to the COVID-19 pandemic and remained below potential GDP in the first quarter of 2021.

D6.2

a. Gross private saving equalled $7951.9 billion in the first quarter of 2021 and equalled $4447.7 billion in the first quarter of 2018. Gross government saving equalled − $3654.0 billion in the first quarter of 2021, and it equalled − $537.5 billion in first quarter of 2018. Saving values are at annual rates. b. Total saving equals gross private saving plus gross public saving (gross government saving). Total saving equalled $4297.9 billion (= $7951.9 billion − $3654.0 billion) in the first quarter of 2021 and equalled $3910.2 billion (= $4447.7 billion − $537.5 billion) in the first quarter of 2018. c. The graph below shows the loanable funds market in equilibrium. The supply of loanable funds represents total saving.

CHAPTER 6 | Economic Growth, the Financial System, and Business Cycles

d. The decrease in total saving from the first quarter of 2018 to the first quarter of 2021 shifts the supply curve for loanable funds to the left from S1 to S2, which would decrease the equilibrium quantity of loanable funds and increase the real interest rate. This result assumes that the decrease in total saving was due to factors other than changes in the real interest rate. D6.3

a. Gross government saving equalled −$3654.0 billion in the first quarter of 2021 and equalled −$383.4 billion in the first quarter of 2017. Saving values are annual rates. b. Government saving represents the government budget surplus if positive or budget deficit if negative. c. In both the first quarter of 2021 and the first quarter of 2017, there was a government budget deficit. From the first quarter of 2017 to the first quarter of 2021, government saving decreased, going from −$383.4 billion to −$3654.0 billion.

CHAPTER 6 | Economic Growth, the Financial System, and Business Cycles 63 d. The decrease in government saving resulting from the larger government budget deficit shifts the supply curve for loanable funds to the left, which raises the equilibrium real interest rate and lowers the equilibrium quantity of loanable funds (and the level of investment).

Suggestions for Critical Thinking Exercises CT6.1

The economy is unlikely to be in a strong expansion and still have unemployment above the natural rate and real GDP less than potential GDP. This question encourages students to bring several related concepts together.

CHAPTER 7 | Long-Run Economic Growth: Sources and Policies SOLUTIONS TO END-OF-CHAPTER EXERCISES 7.1

Economic Growth over Time and around the World Learning Objective: Define economic growth, calculate economic growth rates, and describe global trends in economic growth.

Review Questions 1.1

Creative destruction refers to the process of new technologies advancing living standards while destroying many existing firms. Joseph Schumpeter developed the concept of creative destruction. He believed that the key to rising living standards is not small changes to existing products but, rather, new products that meet consumer wants in qualitatively better ways. Many of the new products and new technologies brought about by creative destruction improve worker productivity. The increase in worker productivity ultimately increases the growth rate of the economy in the long run.

1.2

The total percentage increase is the percentage increase in real GDP from 2007 to 2019. It is not an annual growth rate. The average annual growth rate is the growth rate at which the value for real GDP in 2007 would have to grow on average each year to end up with the value for real GDP in 2019.

Problems and Applications 1.3

Shiue and Keller’s finding of the importance of market efficiency in explaining long-run economic growth supports North’s argument that a government can promote economic growth by protecting private property rights, as the British government did beginning with the Glorious Revolution of 1688.

1.4

The annual rate of economic growth is calculated as the percentage change in real GDP from the previous year. For example, the rate of economic growth for Mexico in 2018 equals [(4632 – 4553)/4553] × 100 = 1.74 percent. The average annual growth rate between 2018 and 2020 is calculated as the simple average of the growth rates for each year. Country Mexico France United States

2018 1.74% 1.82% 4.08%

2019 –0.04% 1.48% 5.22%

2020 –8.68% –8.33% –3.50%

Average Annual Growth Rate –2.33% –1.68% 1.93%

CHAPTER 7 | Long-Run Economic Growth: Sources and Policies

a. During 2018, the United States experienced the highest economic growth rate of 4.08 percent. b. Between 2018 and 2020, the United States experienced the highest average annual growth rate of 1.93 percent. c. During 2020, Mexico experienced the largest decline in real GDP of –2.33 percent. d. It does not matter that each country’s real GDP is measured in a different currency and uses a different base year. Growth rates are measured as percentage changes, which are not dependent on the specific units (in this case, currencies) or base year used. 1.5

You will have earned more on your Andover Bank CDs due to the compounding in 2023 and 2024 on the extra $30 you earned on the Andover Bank CD in 2022.

Andover Bank Lowell Bank 1.6 Year 2016 2017 2018 2019 2020

Value of CD at End of Year 2022 2023 2024 $1050.00 $1102.50 $1157.63 $1020.00 $1081.20 $1156.88 Real GDP per Capita (2009 prices) $54 861 55 790 57 158 58 113 55 802

Annual Growth Rate — 1.69% 2.45 1.67 –3.98

a. The percentage change in real GDP per capita between 2016 and 2020 was [($55,802 – $54,861)/$54,861] × 100 = 1.72 percent. b. The average annual growth rate in GDP per capita between 2016 and 2020 can be measured as the average of the annual growth rates in the above table, which is 0.46 percent [(1.69% + 2.45% + 1.67% – 3.98%)/4]. 1.7

a. Real GDP per capita most likely did not increase significantly from the near elimination of measles and the large decrease in childhood deaths, but because the health of many people improved, the standard of living did increase significantly. b. For a developing country, the elimination of measles and childhood deaths from diarrhea is more achievable than sustained increases in real GDP per capita. Fewer additional resources and less time are required to achieve the elimination of disease than the additional investment and the institutional changes needed for sustained increases in real GDP per capita.

1.8

Ideas and inventions include vaccines for diphtheria, pertussis, and tetanus (DPT) and recognizing the importance of education. Process technologies include laws and inventory management systems. If inventions “flow like water” while process technologies “flow like bricks,” then lowincome countries will be able to increase their standard of living as measured by better health and more education faster than they will be able to increase real GDP per capita.

7.2

CHAPTER 7 | Long-Run Economic Growth: Sources and Policies

What Determines How Fast Economies Grow? Learning Objective: Use the economic growth model to explain why growth rates differ across countries.

Review Questions 2.1

A movement from point A to point B shows the effect on real GDP per hour worked of an increase in capital per hour worked, holding technology constant. A movement from point A to point C shows the effect of an increase in technology, holding the quantity of capital per hour worked constant. 2.2

Diminishing returns to capital imply that, holding technology constant, increases in capital per hour worked result in smaller and smaller increases in real GDP per hour worked. Therefore, sustained increases in real GDP per hour worked require more than continuing increases in capital per hour worked. To maintain high growth rates despite diminishing returns to capital, economies must experience technological change.

2.3

New growth theory is a model of long-run economic growth that emphasizes the effect of economic incentives on technological change, which is determined by the working of the market system. The Solow growth theory does not seek to explain what determines technological change but instead assumes that technological change occurs because of chance scientific discoveries. The new growth theory, besides seeking to explain factors that influence technological change, incorporates knowledge capital. Investments in knowledge capital result in increasing returns, unlike increases in physical capital, which are subject to diminishing returns.

2.4

Firms are likely to underinvest in research and development because competing firms will gain much of the returns from their research and development. To increase the accumulation of knowledge capital, governments can protect intellectual property with patents and copyrights, subsidize research and development, and subsidize education.

CHAPTER 7 | Long-Run Economic Growth: Sources and Policies

Problems and Applications 2.5

Productivity growth increases a nation’s per capita GDP, which is a measure of a nation’s standard of living. China will not be able to increase the standard of living of its citizens as fast as it would if productivity growth had not declined. A growing economy produces both increasing quantities of goods and services and better goods and services. It is only through economic growth that living standards can increase.

2.6

a. An increase in capital per hour worked results in a movement along the per-worker production function. b. and c. Both result in shifts of the per-worker production function because they are likely to lead to technological change by increasing real GDP per hour worked, holding capital per hour worked constant.

2.7

Even though they are not spending their own money, salaried managers in the United States are judged by the profitability of their companies, which often depends on adopting new technologies.

2.8

a. The rapid increases in capital per hour worked in the Soviet Union after 1950 had resulted in rapid increases in real GDP per hour worked. At such rapid rates of growth of real GDP per hour worked, the Soviet economy could eventually become larger than the US economy. b. The Soviet economy ran into diminishing returns to capital and experienced a much slower rate of technological progress than did the US economy.

2.9

a. False, because technology is assumed constant along a given per-worker production function. The movement from point A to point B represents an increase in capital per hour worked. b. False, because the movement from point B to point C represents technological change, which occurs despite the existence of diminishing returns to capital. c. True, because point C represents both a higher level of capital per hour worked and a higher level of technology than point A.

2.10

If the per-worker production function turned upward, with the slope of the curve increasing as capital per hour worked increases, a country could experience increasing rates of economic growth with increases in the quantity of capital per hour worked. Instead of capital per hour worked experiencing diminishing returns, it would experience increasing returns.

2.11

The Soviet Union’s growth strategy of pursuing very high rates of investment ran into the problem of diminishing returns to capital. There was little emphasis on technological change, which meant that the capital stock was increasing much more rapidly than technology. Continuing rapid increases in capital per hour worked led only to diminishing increases in output per hour worked. With these diminishing returns, the growth rate of real GDP per capita in the Soviet Union stagnated.

2.12

a. The success that Greenspan and Wooldridge are referring to is the sustained growth in labour productivity and real GDP per capita over many decades. Creative destruction played a major role in US economic growth because a majority of growth can be attributed to the introduction and the adoption of new technology. Inventions such as the steam engine, electrification, telephones, and airplanes increased both productivity and the standard of living, while investment in universities and research institutions accelerated the rate of technological change that further contributed to more rapid growth rates.

CHAPTER 7 | Long-Run Economic Growth: Sources and Policies b. While creative destruction leads to a country’s success, not everyone benefits from it. The introduction of new technologies and new products disrupts existing industries. For example, many people who built horse-drawn wagons and carriages lost their jobs when the automobile became widely available. Today, the introduction of robots and other new technologies has changed the way many products are made. For example, employment in the automobile industry has declined as companies have replaced workers with robots on their assembly lines.

2.13

a. In Romer’s new growth theory, he argues that the accumulation of knowledge capital is a key determinant of economic growth. He notes that the accumulated knowledge, or stock of knowledge, of a country is more important than are the country’s natural resources. Therefore, the more people there are, the more likely it is that additional knowledge will be accumulated, increasing the rate of economic growth. b. The existence of the Portuguese, or of people in general, is more important in Romer’s new growth theory than in Solow’s original growth model. Although economic growth is dependent on technological change in both models, Solow’s model does not explain what causes technological change. The greater knowledge that is accumulated as a result of having more people helps to explain growth in Romer’s model but is not explicitly considered in Solow’s model.

7.3

Economic Growth in Canada Learning Objective: Discuss fluctuations in productivity growth in Canada.

Review Questions 3.1

The growth rate of productivity increased from 1800 through the mid-1970s, slowed for more than 20 years, increased again beginning in the mid-1990s, and then slowed again beginning in 2006. Economists are unsure whether the slowdown in productivity growth during the past 10 years indicates that Canada is heading for a long period of slow economic growth.

3.2

Some economists are optimistic that the increase in productivity that began in the mid-1990s from advances in information and communication technology will continue. These economists believe high rates of growth will come from higher productivity in the information technology (IT) sector itself and in other sectors of the economy as the result of progress that IT advances made possible. Other economists argue that the IT revolution is now having a greater effect on consumer products, such as smartphones and tablets, than on labour productivity. These economists also identify other factors⸻such as an aging population, declining educational achievement, and the consequences of increased regulations and higher taxes⸻that will lead to lower productivity growth rates continuing into the future.

Problems and Applications 3.3

The growth rates would be lower if they were calculated for real GDP per capita instead of per hour worked because the number of hours worked per person in Canada has decreased in the years since 1800. The denominator in the expression for real GDP per capita has increased more than has the denominator in the expression for real GDP per hour worked.

3.4

Productivity growth enables workers to produce more output, which translates to a higher GDP, holding everything else constant. The columnist noted the connection between overall economic output (GDP) and changes in productivity. Specific factors (such as advances in technology) can

CHAPTER 7 | Long-Run Economic Growth: Sources and Policies

increase worker productivity and drive economic growth. The second statement is an observation that the columnist does not see any changes coming in the next few years that will push productivity growth higher and therefore increase overall economic growth. So, there is a connection between the two observations. However, it is worth noting that many technological breakthroughs that lead to greater productivity and drive economic growth are difficult to predict. 3.5

Future labour productivity growth rates in Canada will be low if Gordon’s observations are correct. The higher labour productivity growth rates that lasted from 1996 to 2005 were due partly to advances in information and communication technology. To the extent that these advances continue to result more in increased consumer enjoyment than in increased business productivity, labour productivity growth rates will remain relatively low.

3.6

a. There are benefits derived from Internet searches that affect GDP, but those benefits are probably not measured directly. Finding information more quickly and efficiently than was possible prior to the existence of the Internet results in more time and other resources available to produce new final goods and services. In other words, as the opportunity cost of finding information has declined, more resources have become available to produce additional output that is included in GDP. b. There are measurement problems that could explain why productivity growth has declined in recent years, but some economists have pointed out that similar problems resulted in an underestimate of productivity growth in periods when measured productivity growth was higher. Improvements in technology lead to long-run increases in GDP per capita. If these increases occur, the implication will be that the recent decline in productivity was partly the result of measurement problems.

3.7

Secular stagnation is an extended period of slow economic growth. Economists who believe in secular stagnation believe that the demand for loanable funds may be low in the coming years due to (1) slower population growth reducing the demand for housing, (2) high-technology firms needing less capital, and (3) prices for economic capital falling so firms need less money for expenditures. All these factors will shift the demand for loanable funds to the left and result in a lower quantity of loanable funds demanded and a lower equilibrium interest rate. These changes are shown in the following graph.

7.4

CHAPTER 7 | Long-Run Economic Growth: Sources and Policies

Why Isn’t the Whole World Rich? Learning Objective: Explain economic catch-up and discuss why many poor countries have not experienced rapid economic growth.

Review Questions 4.1

Increases in the quantity of capital per hour worked and the adoption of new technology should occur at a high rate in poor countries because the profitability of using additional capital or better technology is generally greater in a poor country than in a rich country. Some poor countries have been catching up to rich countries, but many have not.

4.2

Foreign direct investment (FDI) occurs when a firm builds or purchases a facility in a foreign country. Foreign portfolio investment occurs when an individual or a firm buys stocks or bonds issued in another country. Foreign direct investment can give low-income countries access to better technologies, as when a Japanese firm builds a clothing factory in Vietnam. Foreign portfolio investment can give a low-income country access to funds that otherwise would not be available, as when investors in the United States buy stock in a firm in Kenya.

4.3

Globalization is the process of countries becoming more open to foreign trade and investment. Globalization can help a developing country break out of a vicious cycle of low saving and investment and low growth by providing access to funds and technology from foreign direct investment and foreign portfolio investment.

Problems and Applications 4.4

The catch-up effect predicts that countries with a lower level of GDP per capita will grow faster than countries with a higher level of GDP per capita. In the table, the data for Botswana, Ireland, and the United States are consistent with the catch-up prediction because Botswana’s GDP per capita in 1960 was the lowest and its growth between 1960 and 2019 was the highest, while Ireland’s GDP per capita and growth rate in 1960 were between that of Botswana and the United States. The data for other countries, however, is not consistent with the catch-up prediction. For example, Uganda and Madagascar should have grown faster than Ireland and the United States, but they grew more slowly.

4.5

a. No, these data do not support the catch-up prediction. The countries with the highest initial levels of real GDP per capita have growth rates of real GDP per capita similar to the countries with average initial levels of real GDP per capita. b. Yes, these data support the catch-up prediction. The countries with the lowest initial levels of real GDP per capita have the highest growth rates of real GDP per capita, and the countries with the highest initial levels of real GDP per capita have the lowest growth rates of real GDP per capita. c. No, these data do not support the catch-up prediction. The countries have roughly the same growth rates of real GDP per capita regardless of their initial levels of real GDP per capita.

4.6

a. The horizontal line in Graph 1 matches the experience of all countries, indicating that most of the world hasn’t been catching up. b. The slight upward-sloping line in Graph 3 matches the experience of Western Europe, Canada, and Japan, indicating that these high-income countries have stopped catching up to the United States.

CHAPTER 7 | Long-Run Economic Growth: Sources and Policies

c. The downward-sloping line in Graph 2 matches the experience of current high-income countries, indicating that there has been catch-up among high-income countries. 4.7

a. Adopting “thoroughgoing innovation” means the country adopts the latest technology throughout its economy. Getting within “hailing distance of the West” means reaching a standard of living close to that of the countries of Western Europe, the United States, and Canada. b. No. Real GDP per capita in Haiti in 2069 would equal $1245 × (1.065)50 = $29 017, which is below Italy’s real GDP per capita in 2019 of $35 680. Haiti did gain substantial ground but remains behind Italy even after two generations. c. Failure to enforce the rule of law, wars and revolutions, poor systems of public education and health, and low rates of saving and investment can prevent low-income countries from adopting widespread innovation. Even if a low-income country adopts widespread innovation, these same factors can prevent the country from achieving high rates of economic growth.

4.8

a. The article is referring to real GDP, not nominal GDP, because economists, policymakers, and journalists are typically referring to changes in real GDP when they discuss growth. Because changes in nominal GDP are partly the result of changes in the price level, they are not as good an indicator of changes in a country’s production of goods and services as are changes in real GDP. b. More slowly. Real GDP per capita will grow more slowly than the real GDP, as long as a country is experiencing population growth. c. Based on parts (a) and (b) and assuming that the Mexican central bank’s forecast is accurate, Mexican real GDP per capita definitely fell if population grew more rapidly than 1.8 percent in 2019 and definitely rose if population grew more slowly than 0.8 percent. The central bank’s forecast gives a range of possible increases in real GDP, so it isn’t possible to be more specific. In fact, the population of Mexico was forecast to grow about 1 percent during 2019. So, whether real GDP per capita rose or fell depends on where actual growth in real GDP ended up within the forecast range.

4.9

a. Goldman Sachs is an investment banking firm that specializes in raising funds for businesses through stock and bond offerings and also investing money for its clients. Therefore, the analyst knows that government policies that encourage investment, both domestic and foreign, will result in higher economic growth rates. Specifically, foreign direct investment (FDI) is one of the easiest ways for a nation to gain access to technologies that increase productivity and drive economic growth. If Mexico adopted policies that encouraged FDI, it could increase its rate of economic growth. b. Foreign direct investment gives poor nations access to funds and technology that might not otherwise be available. Wealthy nations, such as the United States, already have access to financial capital and technology. However, US investors gain some diversification benefits when US firms engage in FDI in other countries.

4.10

a. Free trade and foreign investment that result from globalization make it possible for poor countries to attract foreign investment and gain access to the best technology. Without the free flow of trade and investment that globalization represents, poor countries would have to rely primarily on their own resources. Supporters of free trade argue that it improves economic efficiency and average incomes. Nevertheless, some countries isolate themselves from the world economy because they believe that globalization (1) destroys domestic industries, (2) is

CHAPTER 7 | Long-Run Economic Growth: Sources and Policies disruptive of domestic culture by replacing native goods with foreign goods, or (3) leads to dominance by foreign firms and governments. b. Someone can argue that globalization can result in unemployment and lower incomes for workers in industries that compete with foreign imports and can lead to greater income inequality. As mentioned in the answer to part (a), critics believe that globalization, by promoting free trade and foreign investment, threatens to destroy the distinctive cultures of developing countries by replacing domestically produced goods with goods imported from foreign markets.

4.11

a. The decline in trade would harm countries that rely heavily on exports. Workers in these nations and industries would lose income from the decline in global trade, and many of these nations lack the social safety nets that exist in Canada. Any labour-intensive industry that exported goods from developing nations to developed nations would feel a significant impact from lower global trade. b. Firms and individuals working in domestic industries that compete with imports will benefit from the reduced competition of declining trade.

4.12

7.5

For the most part, the Roman Empire lacked the secure private property rights required for a market system to work. If modern economic growth had begun 1700 years earlier than it did, the standard of living today would be many times higher than it is.

Growth Policies Learning Objective: Discuss government policies that foster economic growth.

Review Questions 5.1

Governments can aid economic growth through policies that enhance property rights and the rule of law, improve health and education, subsidize research and development, and provide incentives for saving and investment.

5.2

Economic growth is associated with higher living standards, improved health, improved working conditions, and longer life expectancy. However, some critics argue that economic growth has contributed to income inequality, global warming, deforestation, and other environmental problems. Because it is a normative matter, economic analysis cannot settle the question of whether continued economic growth will always improve economic well-being.

Problems and Applications 5.3

a. Restrictions on firing employees make it difficult for a firm to get rid of a worker who it no longer needs or who is no longer productive. This restriction forces the firm to employ the workers that may have low productivity instead of firing them. These workers are likely to be better off if they reenter the job market where they can find a job at which they are more productive. Moreover, restrictions on firing may make firms hire fewer workers if they know that it will be difficult to fire workers who turn out to have low productivity or a poor fit for their jobs. b. Taxing business payrolls is likely to reduce the number of workers hired for two reasons: Hiring workers involves a firm not just paying the workers’ wages and benefits but also paying a tax to the government. A payroll tax also imposes a wedge, or gap, between the amount that a firm

CHAPTER 7 | Long-Run Economic Growth: Sources and Policies

pays to hire a worker and the amount that the worker receives. As with any tax, that wedge reduces the equilibrium of the good or service, in this case labour services. Taxing incomes does reduce the return to working (and saving and investing), but the effect on employment is smaller. c. A tax perk is a decrease in a firm’s tax obligation. Firms that receive tax perks are more likely to grow and expand than are firms that don’t receive tax perks because the return on investing in firms receiving tax perks is greater. Levy is assuming that the productivity of small firms is lower than the productivity of large firms, so favouring small firms with tax perks is likely to reduce the growth of the Mexican economy. d. Contract enforcement implies that agreements made by individuals and firms should be binding, and individuals and firms that do not fulfill their end of the bargain will face repercussions. Contract enforcement improves economic growth because the market becomes more efficient as individuals and firms take advantage of gains from trading with other people that they do not know. Without contract enforcement, individuals and firms would be reluctant to enter into an agreement, particularly a long-term agreement, with another individual or firm because they could not rely on the agreement being carried out. 5.4

China’s investment in residential housing will increase economic growth in the short run because construction of the housing employs labour and consumes building materials that may be manufactured in China. However, after the housing is built, it is not used to produce other goods and services (other than providing shelter for its occupants). In contrast, investment in infrastructure, factories, equipment, and research and development does boost productivity in the long term if it is utilized.

5.5

a. The rule of law refers to the ability of a government to enforce the laws of the country, particularly with respect to protecting property rights and enforcing contracts. b. Without the rule of law, particularly rules that protect property rights, the market cannot operate efficiently. If laws are not well enforced, buyers and sellers are hesitant to participate in market transactions for fear that they may be cheated in the transaction. Owners of firms are less likely to invest in their firms’ growth and expansion if they fear their firms may be confiscated by the government or they are forced to pay bribes to government officials. Firms may also be reluctant to enter into the long-term agreements that are essential to the operation of market economies if they do not have confidence in the agreements being enforceable in court. c. Neither China today nor the Soviet Union during the period before its collapse followed the rule of law. In both cases, the government made arbitrary decisions that affected businesses, and businesses could not expect to necessarily receive impartial justice from the court system. (In fact, the Soviet government allowed few private businesses to operate.) Both China and the Soviet Union achieved high rates of economic growth during the period in which large fractions of their populations moved out of lower-productivity agricultural occupations and into higher-productivity non-agricultural occupations. Both countries also benefited from increasing rapidly what had been very low levels of capital per hour worked. The failure to follow the rule of law and allow for property rights contributed to the eventual stagnation of Soviet economic growth and contributed to the collapse of the government. Whether China can successfully maintain high rates of economic growth without more fully establishing the rule of law remains to be seen.

5.6

a. The passage of an investment tax credit is likely to increase the rate of economic growth in Canada because the credit will give firms incentives to purchase more capital, thereby increasing the capital to labour ratio (K/L). In addition, if some of the new capital embodies

CHAPTER 7 | Long-Run Economic Growth: Sources and Policies new technologies, the tax credit may contribute to shifting the Canadian production function upward. b. Shortening the period of patent protection will decrease the incentive to invest in research and development because the length of time that a firm can have to recoup its investment declines as well. The shorter period of patent protection will therefore decrease the amount of new technology that the country generates and will result in a decline in labour productivity and the rate of economic growth. c. Increasing education funds will result in a more educated workforce. More education increases productivity per worker and will increase economic growth.

5.7

A free press could serve as a watchdog against government violations of property rights and the rule of law. When the government controls the press, it limits the means for citizens of a country to become informed about government misbehavior. Similarly, by publicizing cases of corruption that undermine the rule of law and property rights, the press can help reduce the frequency of its occurrence. Over time, crusading newspapers and news websites can help reduce corruption and improve the rule of law.

5.8

a. Adesina is probably referring to aid in the form of cash transfers from foreign countries. These are funds that are donated by foreign countries that do not need to be repaid. He may also be referring to aid that helps develop infrastructure projects, such as roads, bridges, and dams. b. African countries need investment in new firms and in the expansion of existing firms. Foreign portfolio investment can provide funds that African firms need to expand. Foreign direct investment can provide African countries with access to current technology as foreign firms build new factories and other facilities in African countries. As we’ve seen, economic growth depends on increasing the amount of capital per hour worked and on technological change. Traditional foreign aid programs have not had much success in raising African growth rates, which is why Adesina believes that investment is a better approach.

5.9

a. The tariffs on Chinese goods will result in an increase in the demand for and production of USmade goods because the tariffs will make US-made goods and services relatively cheap in comparison with imported goods and services. Higher production by domestic firms will result in an increase in the growth rate in GDP between 2019 and 2020. This effect will be offset to the extent that foreign retaliation against US exports reduces production by exporters, to the extent that some domestic firms lose sales because US consumers are paying higher prices for imported goods, and to the extent that US firms have to raise their prices to offset the higher costs of imported inputs. b. For reasons discussed in Chapter 9, in the long run, tariffs will make the US economy less efficient. As a result, tariffs will reduce the long-run growth rate of the US economy.

Real-Time Data Exercises Note: FRED continues to update data. The solutions below contain the data available on FRED for the first quarter of 2021. D7.1

a. Output per hour for all persons in the manufacturing sector in the United States was 44.437 in the first quarter of 1987 and 97.53 in the first quarter of 2021. Output per hour for all persons in the non-farm business sector was 58.132 in the first quarter of 1987 and 112.729 in the first quarter of 2021.

CHAPTER 7 | Long-Run Economic Growth: Sources and Policies

b. Labour productivity in manufacturing increased by 119.48 percent from 1987 to the first quarter of 2021. Labour productivity increased by 93.92 percent in the non-farm business sector from 1987 to the first quarter of 2021. c. If the trend in other advanced countries is similar to that of the United States, labour productivity in these countries will decline in the future as the manufacturing sector shrinks relative to other industry sectors. D7.2

a. Using estimates for 2019, the country with the highest real GDP (purchasing power parity) was China at $22.53 trillion, and the country with the lowest real GDP (purchasing power parity) was Tuvalu at $49 million (Niue, Tokelau, and Saint Helena, Ascension and Tristan da Cunha were excluded because their GDPs were for earlier years). b. Using estimates for 2019, the country with the highest per capita real GDP (purchasing power parity) was Macau with $123 965 (Note: Liechtenstein was higher with $139 100, but the estimate was for 2009), and the countries with the lowest per capita real GDP (purchasing power parity) was Burundi with $752. c. The country with the most equal income distribution was Belarus with a Gini index of 25.2 (the latest value is for 2018), and the country with the least equal income distribution was Brazil with a Gini index of 53.9 (the latest value is for 2018). If you use 2014 estimates, then South Africa has the least income equality with a Gini index of 63.0, and Jersey has a Gini index of 0.3, indicating almost perfect income equality. If income were distributed with perfect equality, the Gini index would equal zero, and if income were distributed with perfect inequality, the Gini index would equal 100. d. Using estimates for 2017, the country with the highest real GDP growth rate was Libya at 64 percent, and the country with the lowest real GDP growth rate was Venezuela at −19.67 percent (2018 estimates). (Note: Syria has a lower real GDP growth rate at 36.5 percent, but the estimate was for 2014.) e. Canada had the 15th highest real GDP (purchasing power parity) among countries, the 34th highest per capita real GDP (purchasing power parity) at $45 900, the 128th least equal income distribution (33.3 for 2017), and the 148th highest real GDP growth rate at 1.66 percent (2019 estimate).

Suggestions for Critical Thinking Exercises CT7.1 Answers may vary. Some answers that students may come up with are cellular phones replacing landline phones, MP3 players replacing cassette and CD players, Google searches replacing dictionaries and library visits, and streaming videos replacing video rental. CT7.2 a. You should disagree. Moldova’s economy today is not heavily industrialized like the economy of the Soviet Union was in the 1980s. Given the low levels of capital in Moldova today, additional investments in more machinery and factories will increase Moldova’s economy’s growth. b. Please refer to the following figure. Point A illustrates Moldova’s position before investments in machinery and factories. With its lower level of capital per worker, Moldova’s investment in capital moves up in the production function to point B, where the country experiences a large increase in the real GDP per hour worked. Point C illustrates the Soviet Union’s position before investments in machinery and factories. With its higher level of capital per worker, the Soviet Union’s investment in capital moves up in the production function to point D, where the country experiences a small increase in the real GDP per hour worked.

CHAPTER 7 | Long-Run Economic Growth: Sources and Policies

Source: Central Intelligence Agency, CIA World Factbook, cia.gov.

CT7.3 a. Please refer to the following figure. GDP per capita growth rate, 2020

6.0 YK 3.0 0.0 -3.0 -6.0

NT 0

20,000

40,000 NS PEI NB QB

60,000

1,00,000

NFL SK MB ON AB

-9.0 -12.0

80,000

NWT GDP per capita, 2020 (chained 2012 dollars) Source: Statista.com

b. Yes, the data above exhibit convergence or catch-up in income levels. c. To more accurately test if provinces are catching up, we need to know about the economies of each province and group together those provinces with similar economic profiles. For example, provinces whose economies rely predominantly on agriculture should be grouped separately from provinces that have GDPs that rely mostly on manufacturing.

CHAPTER 8 | Aggregate Expenditure and Output in the Short Run SOLUTIONS TO END-OF-CHAPTER EXERCISES 8.1

The Aggregate Expenditure Model Learning Objective: Understand how macroeconomic equilibrium is determined in the aggregate expenditure model.

Review Questions 1.1 The key idea of the aggregate expenditure model is that in any particular year, the level of real GDP is determined mainly by the level of aggregate expenditure. 1.2 Inventories are goods that have been produced but not yet sold. Inventories usually rise at the beginning of a recession and usually fall at the beginning of an expansion. 1.3 The aggregate expenditure model seeks to explain the business cycle and by doing so also explains cyclical unemployment. The model does not seek to explain long-run economic growth (the model does not address the factors that cause potential GDP to increase) and inflation (the model assumes the price level is fixed).

Problems and Applications 1.4 a. Consumption b. Government purchases c. Planned investment 1.5 a. Apple’s planned investment equals 100 000 iPhones, which is the expected addition to the inventories in its stores. Apple’s actual investment equals 300 000 iPhones, which equals the sum of planned investment plus the difference between its expected sales of 2.1 million iPhones and its actual sales of 1.9 million iPhones. b. Apple’s planned investment still equals 100 000 iPhones, which is the expected addition to the inventories in its stores. Apple’s actual investment is −100 000 iPhones, which equals the sum of planned investment plus the difference between its expected sales of 2.1 million iPhones and its actual sales of 2.3 million iPhones. 1.6 We can’t tell. We have to know what the planned change in inventories was. 1.7 The article indicates that Japanese firms faced an unplanned increase in inventories. If Japanese firms did not expect the drop in demand and did not sell the amount of a product they were planning to, inventories would increase.

CHAPTER 8 | Aggregate Expenditure and Output in the Short Run

Determining the Level of Aggregate Expenditure in the Economy 8.2

Learning Objective: Discuss the determinants of the four components of aggregate expenditure and define marginal propensity to consume and marginal propensity to save.

Review Questions 2.1 In the aggregate expenditure model, real GDP changes only when aggregate expenditure changes, so it is crucial to understand the factors that change each of the four categories of aggregate expenditure. 2.2 An example of consumption spending would be a household buying food; an example of planned investment spending would be a firm buying a computer; an example of government purchases would be the government buying a military airplane; and an example of net exports would be a Canadian automobile purchased by an American minus the value of a Canadian buying a Californian wine. 2.3 The four main determinants of investment spending are expectations of future profitability, the interest rate, business taxes, and cash flow. An increase in the interest rate would decrease investment spending, and a decrease in the interest rate would increase investment spending. 2.4 The three main determinants of net exports are the price level in Canada relative to the price level in other countries, the growth rate of GDP in Canada relative to the growth rate of GDP in other countries, and the exchange rate between the Canadian dollar and other currencies. An increase in the growth rate of GDP in the developing countries, for any given growth rate of GDP in Canada, would increase Canadian net exports.

Problems and Applications 2.5 (a) would cause the demand forecast to rise because it involves an increase in aggregate expenditure, and (b), (c), and (d) would cause the demand forecast to fall because each involves a decline in aggregate expenditure. 2.6 In the graph of the consumption function below, an increase in income increases consumption spending along the consumption function C1 (A to B). The increase in income causes a movement along the consumption function, but an increase in expected future income or household wealth would shift the consumption function upward, from C1 to C2.

CHAPTER 8 | Aggregate Expenditure and Output in the Short Run

2.7 Consumption will fluctuate less. The five main determinants of consumption spending are current disposable income, household wealth, expected future income, the price level, and the interest rate. The most important determinant is current disposable income. Therefore, as employment insurance benefits reduce fluctuations in income, fluctuations in consumption are also reduced. 2.8 If the Consumer Confidence Index is a strong predictor of household spending, it tells businesses and governments when spending is likely to increase. For business owners, this information will signal when to begin to expand hiring or cut back on workers’ hours before a change in demand for their products actually occurs. In short, it will allow them to get ready. 2.9 Y = C + S + T. With taxes equal to zero, this equation becomes Y = C + S, and this can be used to fill in the Saving column. To fill in the MPC and MPS columns, use the expressions MPC = ΔC / ΔY MPS = ΔS / ΔY. For example, to calculate the value of the MPC in the second row, MPC = ΔC / ΔY = ($875 − $800) / ($1000 − $900) = $75/$100 = 0.75. To calculate the value of the MPS in the second row, MPS = ΔS/ΔY = ($125 − $100)/($1000 − $900) = $25/$100 = 0.25. National Income and Real GDP Consumption (Y) (C) $ 900 $ 800 1000 875 1100 950 1200 1025 1300 1100 2.10

Saving (S) $100 125 150 175 200

Marginal Propensity Marginal Propensity to Consume to Save (MPC) (MPS) — — 0.75 0.25 0.75 0.25 0.75 0.25 0.75 0.25

This question is intended to highlight the importance of regional differences in GDP. Housing is not a geographically traded good; as such, a local builder would be better served by paying attention to local unemployment rates or the growth in incomes in their immediate surroundings.

CHAPTER 8 | Aggregate Expenditure and Output in the Short Run

2.11

You should disagree. This student is confusing saving and investment. By putting additional funds into a savings account, the student is “saving” money rather than making an investment in the economic sense. Investment in the economic sense is typically done with either borrowed funds or with money that could have been saved (as in a savings account). Economic investment is the purchase of new capital equipment or buying inventory or starting a new business.

2.12

a. Conventional trade statistics treat imported goods as produced entirely within the country of origin. This approach dates to a time when most products were produced entirely within one country. b. With global supply chains being used by large firms, the country of origin often will not produce the product entirely and may produce a relatively small portion of the product, as in the case of the iPhone exported to Canada from China. c. Trade statistics might mislead policymakers (and the public) in terms of the magnitude of a country’s overall trade deficit or trade surplus, and also as to whether a country is running a trade surplus or deficit with another country.

8.3

Graphing Macroeconomic Equilibrium Learning Objective: Use a 45°-line diagram to illustrate macroeconomic equilibrium.

Review Questions 3.1 The 45o line represents all the points that are at equal distances from both axes. In the 45o-degree diagram, the 45o line shows all the points where planned real aggregate expenditure equals real GDP. 3.2

CHAPTER 8 | Aggregate Expenditure and Output in the Short Run

3.3 The slope of the aggregate expenditure line is the change in aggregate expenditure for a change in real GDP (ΔAE/ΔReal GDP). The simple aggregate expenditure model assumes that taxes, planned investment spending, government purchases, and net exports are independent of income. So, the slope of the aggregate expenditure line equals the slope of the consumption function, which is the marginal propensity to consume. 3.4 Aggregate expenditure represents the total spending in the economy. Consumption spending is just one component of aggregate expenditure. The other components of aggregate expenditure are planned investment, government purchases, and net exports. 3.5 Firms will decrease production until they sell the unintended inventories.

Problems and Applications 3.6

Planned aggregate expenditure is greater than GDP at point A, equal to GDP at point B, and less than GDP at point C. The unplanned change in inventories is denoted by the vertical distance from the point to the 45o line.

CHAPTER 8 | Aggregate Expenditure and Output in the Short Run

3.7 Net exports equal the value of exports minus the value of imports. Net exports are graphed as a downward-sloping line because although increases in Canadian real GDP will not directly affect Canadian exports, these increases will cause imports to increase, thereby causing net exports to decline.

3.8 In most of 2007 and 2008, firms expected the economy to grow and so invested in inventories. When the global recession took hold in Canada, firms reduced their costs by reducing their investment in inventories. This explains the negative entries in the table. During 2009, firms reduced their inventory levels by selling what they had already produced. This is an indication that the economy is shrinking rather than growing. Inventory investment returns to positive territory in 2010, but the occasional negative numbers show that the return to economic health has been slow and uneven. 3.9 Calculate the missing values in the last two columns of the table by using two equations: Planned aggregate expenditure (AE) = Consumption (C) + Planned investment (I) + Government purchases (G) + Net exports (NX) and Unplanned change in inventories = Real GDP (Y) − Planned aggregate expenditure (AE). Real GDP (Y) $ 900 1000 1100 1200 1300

Planned Government Planned Aggregate Unplanned Consumption Investment Purchases Net Exports Expenditures Change in (C) (I) (G) (NX) (AE) Inventories $ 760 $120 $120 –$40 $ 960 −$60 840 120 120 –40 1040 −40 920 120 120 –40 1120 −20 1000 120 120 –40 1200 0 1080 120 120 –40 1280 20

a. The MPC equals the change in consumption divided by the change in income. In this case, consumption changes by $80 billion for every $100 billion change in income. So, the MPC = $80 / $100 = 0.8. b. Equilibrium real GDP occurs where real GDP equals planned aggregate expenditure. The table above shows that equilibrium real GDP equals $1200 billion.

CHAPTER 8 | Aggregate Expenditure and Output in the Short Run 3.10

The argument is incorrect. Aggregate expenditure includes not only consumption but also planned investment, government purchases, and net exports. A decline in GDP can be caused by a decline in any of the four components of aggregate expenditure.

8.4

The Multiplier Effect Learning Objective: Describe the multiplier effect and use the multiplier formula to calculate changes in equilibrium GDP.

Review Questions 4.1 The multiplier effect is the process by which a change in autonomous expenditure leads to a change in real GDP. In the graph that follows, the decrease in government purchases causes the line representing planned aggregate expenditure to shift down. Equilibrium real GDP declines by more than the drop in government purchases: Real GDP declines by the drop in government purchases multiplied by the value of the multiplier.

4.2 Multiplier =

1 . 1 − MPC

The multiplier formula ignores the effect that changes in GDP can have on imports, the price level, income taxes, and interest rates. Ignoring these factors causes the multiplier formula to overstate the size of the real-world multiplier. 4.3

The movement from point A to point B shows a change in autonomous expenditure. At each level of income (real GDP), aggregate expenditure has increased. The movement from point B to point C shows a change in induced expenditure. An increase in income (real GDP) has induced (or caused) an increase in aggregate expenditure.

CHAPTER 8 | Aggregate Expenditure and Output in the Short Run

Problems and Applications 4.4 No, because as real GDP increases to $7 trillion, it will induce additional aggregate expenditures. In the simplest case, aggregate expenditure will increase by the marginal propensity to consume multiplied by the increase in real GDP. This effect is the multiplier at work. The increase in investment spending of $1 trillion increases aggregate expenditure to $7 trillion when real GDP is $6 trillion. As real GDP increases, aggregate expenditure will increase further. Real GDP will ultimately increase by the change in investment spending of $1 trillion times the multiplier. 4.5 We can answer this question by adding a column in the table for aggregate expenditure. Real GDP (Y) $800 900 1000 1100 1200

Planned Consumption Investment (C) (I) $730 $100 790 100 850 100 910 100 970 100

Government Aggregate Purchases Net Exports Expenditure (G) (NX) (AE) $100 –$50 $880 100 –50 940 100 –50 1000 100 –50 1060 100 –50 1120

a. Equilibrium real GDP is $1000 billion, because at this level real GDP equals aggregate expenditure. b.

MPC =

$790 − $730 = 0.6 $900 − $800

c. Multiplier =

1 1 = 2.5 . = 1 − 0.6 1 − MPC

So, Change in equilibrium real GDP = Change in autonomous expenditure × 2.5 = $40 billion × 2.5 = $100 billion. The new level of equilibrium real GDP = $1000 billion + $100 billion = $1100 billion. 4.6 The aggregate expenditure line will shift up by the $40 billion increase in planned investment spending. Equilibrium real GDP will increase by $40 billion times the expenditure multiplier. With a marginal propensity to consume of 0.75, the expenditure multiplier equals 4. Equilibrium real GDP increases by $160 billion ($40 billion × 4). 4.7 (a), (b), and (e), would cause the value of the multiplier to be smaller. (c) and (d) would cause the value of the multiplier to be larger. 4.8 Multiplier =

1 =5 1 − 0.8

Change in equilibrium GDP = $75 billion × 5 = $375 billion. 4.9 A larger multiplier would be likely to lead to longer and more severe recessions because it would magnify the effect on the economy of changes in autonomous expenditures.

CHAPTER 8 | Aggregate Expenditure and Output in the Short Run

4.10 a. $12 trillion b. MPC =

$13.6 − $12 = 0.8 $14 − $12

c. Multiplier =

1 =5 1 − 0.8

4.11 Quebec has a much larger and more diversified economy than Nunavut. Larger and more diversified economies will see less spending on new construction projects go to imports, meaning more new spending at each round of the multiplier process. 4.12 a. The analysts and politicians are referring to the expenditure multiplier, whereby an increase in autonomous expenditure has a multiplied effect on real GDP. Each additional dollar of autonomous expenditure will increase real GDP by more than one dollar. b. The investment spending on plant and equipment by Tesla increases autonomous expenditure, causing an even larger increase through the multiplier effect on real GDP and employment. As Tesla’s suppliers increase their sales to Tesla, they will expand production and employment. Higher incomes earned by newly employed workers will result in increased consumption spending. The increased consumption spending will lead to further increases in production and employment, as the multiplier process continues. c. The real-world multiplier is not simple to calculate. It will be a smaller value than the simple multiplier formula of 1/(1 − MPC), which assumes no change in the price level, interest rates, taxes, or imports. 4.13 Robust business and consumer confidence would increase investment spending and consumption spending, and improving world trade would increase net exports. The increases in these three spending components would increase autonomous expenditure, resulting in an increase in real GDP. In the graph below, the increase in autonomous expenditure shifts the aggregate expenditure line upward from AE0 to AE1, causing equilibrium real GDP to increase from Y0 to Y1.

CHAPTER 8 | Aggregate Expenditure and Output in the Short Run

4.14

The implied value of the multiplier if $150 billion was spent on infrastructure (= I) is

∆Y $270 billion = = 1.8. ∆I $150 billion The implied value of the multiplier if $180 billion was spent on infrastructure is

∆Y $320 billion = = 1.8. ∆I $180 billion

8.5

The Aggregate Demand Curve Learning Objective: Understand the relationship between the aggregate demand curve and aggregate expenditure.

Review Questions 5.1 Aggregate expenditure is the total amount of spending in the economy, and aggregate demand is the relationship between the price level and the level of planned aggregate expenditure. 5.2 A change in the price level affects (a) consumption by affecting the real value of household wealth, (b) net exports by affecting the domestic price level relative to foreign price levels, and (c) investment spending by affecting the interest rate. 5.3

A change in the price level causes a shift of the aggregate expenditure line but causes a movement along the aggregate demand curve.

Problems and Applications 5.4 An upward-sloping aggregate expenditure line reflects the positive relationship between real GDP and aggregate expenditure, while a downward-sloping aggregate demand curve reflects the inverse relationship between the price level and the level of planned aggregate expenditure. 5.5 You should not agree with the statement that the aggregate demand curve slopes downward because people cannot afford to buy as many goods and services when the price level is higher. A higher overall price level means an equivalent increase in nominal income so that consumers as a group should be able to afford the same number of goods and services as with a lower overall price level. 5.6 If exports become more sensitive to changes in the price level in Canada, then a given change in the price level in Canada will cause a greater change in aggregate expenditure. In this case, the aggregate demand curve becomes less steep.

Real-Time Data Exercises Note: FRED continues to update data. The solutions below contain the data available on FRED the first quarter of 2021.

CHAPTER 8 | Aggregate Expenditure and Output in the Short Run

D8.1 a. Download data from FRED on real exports from 1990 to the present. b. Real exports of goods and services decreased from $1790.0 billion in the second quarter of 2008 to $1535.3 billion in the first quarter of 2009, for a decline of $254.7 billion. With a multiplier of 2 and holding everything else constant, the decline in exports would have decreased real GDP by $254.7 billion × 2 = $509.4 billion. c. Real exports of goods and services were $2523.97 billion in the second quarter of 2018 and $2554.36 billion in the first quarter of 2019. Between the two quarters, the real exports of goods and services increased by $30.39 billion. If the multiplier is 2, then the increase in the real exports of goods and services by $30.39 billion will increase GDP by $60.78 billion. D8.2 a.

Download data from FRED on annual real consumption expenditures from 2000 to 2018.

b. Download data from FRED on annual real GDP from 2000 to 2018. c. The year with the highest MPC was 2001 with an MPC of 1.66. The year with the lowest value was 2012 with an MPC of 0.46.

Suggestions for Critical Thinking Exercises CT8.1 Answers will vary depending on what the students find confusing. CT8.2 Here, equilibrium is achieved by changes in inventories. In a market, equilibrium is achieved by changes in the price of a product. CT8.3 It would be smaller as an increase in P would reduce the increase in real GDP; see the discussion on the aggregate demand curve at the end of this chapter.

CHAPTER 8 | Aggregate Expenditure and Output in the Short Run

SOLUTIONS TO APPENDIX C Review Questions 8A.1 AE = ( C + I + G + NX ) + MPC (Y) The intercept would be ( C + I + G + NX ) and the slope would be equal to the value of the MPC. 8A.2 Y = 150 + 0.75Y + 125 + 125 + 250; Y = 650 + 0.75Y; Y − 0.75Y = 650 Y (1 − 0.75) = 650 Y (0.25) = 650 Y = 650 × 4 = 2600 8A.3 AE = 650 + 0.75Y For GDP of 1600, aggregate expenditure = 1850. The unintended change in inventories = 1600 − 1850 = −250. For GDP of 1200, aggregate expenditure = 1550. The unintended change in inventories = 1200 − 1550 = −350. 8A.4 Equilibrium GDP = Autonomous expenditure × multiplier Equilibrium GDP =

50 +100 +125 − 25 =1250 0.2

CHAPTER 9 | Aggregate Demand and Aggregate Supply Analysis SOLUTIONS TO END-OF-CHAPTER EXERCISES Aggregate Demand 9.1

Learning Objective: Identify the determinants of aggregate demand and distinguish between a movement along the aggregate demand curve and a shift of the curve.

Review Questions 1.1 The three reasons the aggregate demand curve slopes downward are the wealth effect, the interest rate effect, and the international trade effect. The wealth effect refers to the effect that a change in the price level has on wealth. For example, an increase in the price level decreases the real value of household wealth, which decreases consumption. The interest rate effect refers to the effect that a change in the price level has on aggregate expenditures. For example, an increase in the price level raises interest rates, which decreases investment spending and consumption spending, particularly on durable goods. The international trade effect refers to the effect that a change in the price level has on spending on exports and imports. For example, an increase in the domestic price level makes Canadian exports more expensive and foreign imports less expensive, which decreases net exports. 1.2 The variables that will cause the aggregate demand curve to shift are interest rates, government purchases, personal income taxes or business taxes, household expectations of future incomes, firms’ expectations of the future profitability of investment spending, the growth rate of domestic GDP relative to the growth rate of foreign GDP, and the exchange rate value of the Canadian dollar. Increases in government purchases, household expectations of future incomes, and firms’ expectations of the future profitability of investment spending will cause the aggregate demand curve to shift to the right. Increases in interest rates, personal income taxes or business taxes, the growth rate of domestic GDP relative to the growth rate of foreign GDP, and the exchange rate value of the Canadian dollar will cause the aggregate demand curve to shift to the left. 1.3 The aggregate demand curve shows the relationship between the price level and the quantity of real GDP demanded by households, firms, and the government. The short-run aggregate supply curve shows the relationship in the short run between the price level and the quantity of real GDP supplied by firms. The long-run aggregate supply curve shows the relationship in the long run between the price level and the quantity of real GDP supplied by firms.

Problems and Applications 1.4 a. An increase in the price level would cause a movement up along the aggregate demand curve. b. Higher provincial income taxes would decrease disposable income, thereby decreasing consumption spending and causing the aggregate demand curve to shift to the left. c. Higher interest rates would decrease investment spending and consumer spending, particularly on durable goods, causing the aggregate demand curve to shift to the left. Copyright © 2024 Pearson Canada Inc.

CHAPTER 9 | Aggregate Demand and Aggregate Supply Analysis d. An increase in government spending would cause the aggregate demand curve to shift to the right. e. Faster income growth in other countries would increase Canada’s exports, causing the aggregate demand curve to shift to the right. f.

A higher exchange rate between the Canadian dollar and foreign currencies would decrease Canada’s net exports, causing the aggregate demand curve to shift to the left.

1.5 Disagree. The increase in aggregate supply with the resulting drop in the price level will not cause a shift in aggregate demand but simply a movement along the aggregate demand curve. 1.6 The relative size of the changes in investment and government spending will determine the impact on the aggregate demand curve. An increase in interest rates can cause investment to fall as firms pass on projects with expected rates of return lower than the opportunity cost of funds, while higher interest rates tend to push up government spending on debt service and can also increase demand for government services 1.7 a. An increase in spending on machinery and equipment will shift the aggregate demand curve to the right. b. Inflation is an increase in the price level. An increase in the price level causes a movement up along the aggregate demand curve. 1.8 (a) Longer skirts and skinnier neckties are both indicators of recession (or at least slowdowns). (b) Instructors will have to be somewhat flexible here. Sample answer: Smartphone sales and contracts. When people are uncertain about the economic future, they are less likely to upgrade their phones. People uncertain about their income are also less likely to take on a long-term phone contract. 1.9 Some sectors of the economy are more dependent on other parts of the world than others. Sectors of the economy that produce goods for export to China are going to be strongly affected by falls in aggregate demand in China (iron ore, oil, etc.). Sectors that produce non-traded goods (barbers, lawyers, etc.) are going to be much less sensitive to changes in the state of the Chinese economy. 1.10 A movement from point A to point B along the aggregate demand curve would be caused by a decrease in the price level. A movement from point A on aggregate demand curve AD1 to point C on aggregate demand curve AD2 would be caused by any of the factors that shift the aggregate demand curve to the right, such as a decrease in interest rates, an increase in government purchases, or a decrease in personal or business taxes.

CHAPTER 9 | Aggregate Demand and Aggregate Supply Analysis

Aggregate Supply 9.2

Learning Objective: Identify the determinants of aggregate supply and distinguish between a movement along the short-run aggregate supply curve and a shift of the curve.

Review Questions 2.1 The long-run aggregate supply curve is vertical because in the long run, changes in the price level do not affect the number of workers, the capital stock, or technology, which are the factors that determine potential GDP. 2.2 The variables that will cause the long-run aggregate supply curve to shift are the size of the labour force, the size of the capital stock, and technology. An increase in each variable will increase potential real GDP and cause the long-run aggregate supply curve to shift to the right. 2.3 As the prices of final goods and services rise, the prices of inputs usually rise more slowly. The higher price level increases profits and the willingness of firms to supply more goods and services. A secondary reason the SRAS curve slopes upward is that, as the price level rises, some firms are slow to adjust their prices. A firm that raises its prices slowly when the price level increases may find that its sales increase; therefore, the firm will increase production. 2.4 The variables that will cause the short-run aggregate supply to shift are the size of the labour force, the size of the capital stock, productivity, the expected future price level, workers and firms adjusting to having previously underestimated the price level, and the expected price of an important natural resource. Increases in the labour force, the capital stock, or productivity will cause the short-run aggregate supply curve to shift to the right. Increases in the expected future price level, increases in the price of an important natural resource, and workers and firms adjusting to having previously underestimated the price level will cause the short-run aggregate supply curve to shift to the left.

Problems and Applications 2.5 a. A higher price level would cause a movement up along the long-run aggregate supply curve. b. An increase in the quantity of capital goods would cause the long-run aggregate supply curve to shift to the right. c. Technological change would cause the long-run aggregate supply curve to shift to the right. 2.6 Disagree. The labour force and the capital stock, along with technology, determine potential GDP, but inflation expectations do not. Inflation expectations, however, do affect the short-run aggregate supply of goods and services. 2.7 a. A higher price level would cause a movement up along the short-run aggregate supply curve. b. An increase in what the price level is expected to be in the future would cause the short-run aggregate supply curve to shift to the left. c. An unexpected increase in the price of an important raw material would cause the short-run aggregate supply curve to shift to the left.

CHAPTER 9 | Aggregate Demand and Aggregate Supply Analysis d. An increase in the labour force participation rate would cause the short-run aggregate supply curve to shift to the right.

2.8 Both workers and firms benefit from the ability to plan for the future. Signing long-term contracts increases this ability. 2.9 Menu costs are costs to firms of changing prices. If menu costs were eliminated, the short-run aggregate supply curve would still not be vertical because other factors, such as contracts and the inability of workers and firms to always accurately predict next year’s price level, can still make wages and prices sticky. 2.10 A movement from point A to point B along the short-run aggregate supply curve would be caused by an increase in the price level. A movement from point A on SRAS1 to point C on SRAS2 could be caused by any of the factors that shift the short-run aggregate supply curve to the right, such as an increase in the labour force, the capital stock, or productivity, or a decrease in the expected future price level or the expected price of an important natural resource.

9.3

Macroeconomic Equilibrium in the Long Run and the Short Run Learning Objective: Use the aggregate demand and aggregate supply model to illustrate the difference between short-run and long-run macroeconomic equilibrium.

Review Questions 3.1 When the economy is in long-run equilibrium, the short-run aggregate supply curve and the aggregate demand curve intersect at a point on the long-run aggregate supply curve. 3.2 The long-run effects of an increase in aggregate demand differ from the short-run effects because the long-run and the short-run aggregate supply curves differ. With a vertical LRAS, changes in AD affect only the price level, not real GDP. With an upward-sloping SRAS, changes in AD affect both the price level and real GDP. 3.3 The correct answer is (b). The unemployment rate will rise in the short run as real GDP and income decline during the recession. Rising unemployment and lower output will result in lower wages. Eventually the short-run aggregate supply curve will shift to the right, returning GDP to its potential level and unemployment to the natural rate of unemployment but at a lower price level. Even if government policymakers do not respond to a recession, the economy will return to potential GDP in the long run, although the process may take several years.

CHAPTER 9 | Aggregate Demand and Aggregate Supply Analysis

Problems and Applications 3.4 a.

The large increase in the demand for Canadian exports shifts the aggregate demand curve to the right, moving short-run equilibrium from point A to point B with a higher price level and real GDP. The unemployment rate is lower because real GDP has increased with no change in potential real GDP. Workers and firms will eventually adjust to the price level being higher than they expected. Workers will push for higher wages, causing the short-run aggregate supply curve to shift to the left. In the long run, the economy will be in equilibrium at point C with a higher price level, the same level of real GDP (GDP1), and the same unemployment rate. b.

An unexpected increase in the price of an important raw material causes the short-run aggregate supply curve to shift to the left. Equilibrium moves from point A to point B, with a higher price level and lower real GDP. The unemployment rate has increased with real GDP below potential real GDP. The drop in real GDP and the increase in unemployment lead workers to accept lower wages and firms to accept lower prices. The short-run aggregate supply curve shifts from SRAS2 back to SRAS1, and equilibrium moves from point B back to point A. When the economy has

CHAPTER 9 | Aggregate Demand and Aggregate Supply Analysis adjusted back to equilibrium at point A, real GDP, the price level, and the unemployment rate are back to their original values.

3.5 Any of the factors that decrease aggregate demand (an increase in interest rates, an increase in personal income taxes or business taxes, an increase in the exchange rate, an increase in the growth rate of domestic GDP relative to the growth rate of foreign GDP, a decrease in government purchases, a decrease in households’ expected future incomes, or a decrease in firms’ expectations of the future profitability of investment spending) would cause a decrease in real GDP. Any of the factors that decrease short-term aggregate supply (an increase in the expected future price level, an increase in the price of an important natural resource, workers and firms adjusting to having previously underestimated the price level, a decrease in the labour force or the capital stock, and a decrease in productivity) would cause a decrease in real GDP. Any of the factors that increase aggregate demand or any of the factors that decrease short-run aggregate supply would cause an increase in the price level—inflation. 3.6 Because of the tight trade relationship between Canada and the United States, growth in the US economy tends to increase demand for Canadian exports, which increases the overall demand for Canadian products. When the US economy grows, the Canadian economy tends to grow too. 3.7 a. Points A and C represent long-run equilibrium points because they are on the LRAS curve where the SRAS curve and the AD curve intersect. b. Point D represents the short-run equilibrium and point C the long-run equilibrium. Workers and firms will eventually adjust to the price level being higher than they expected. Workers will push for higher wages and firms will charge higher prices, causing the short-run aggregate supply curve to shift to the left until it reaches SRAS1, and long-run equilibrium is restored at point C. 3.8 These goods have the potential to be good indicators of the state of the economy because they are common and cheap enough that people purchase them somewhat regularly. These goods often reflect people’s moods at the time the purchase was made. Expect a wide variety of answers for what other goods could play a similar role in forecasting the state of the economy. Smartphone sales, luxury vacations, or take-out coffee sales all have potential. Any good that is widely purchased and is relatively easy to cut back on is a good candidate. 3.9 a. If firms operate beyond their normal capacity, and structural and frictional unemployment drop below their normal levels, then actual real GDP can be above potential GDP. b. The unemployment rate increased from 2000 to 2001 because the increase in actual real GDP was not as large as the increase in potential GDP. c. If the slowdown was caused by a shift in aggregate demand (which, in fact, it was), the inflation rate is likely to have been lower in 2001 than in 2000. If the slowdown was caused by a shift in aggregate supply, the inflation rate was likely to have been higher. 3.10 a. The following graph assumes that the Greek economy was in long-run equilibrium at point A (P1 and real GDP1) prior to the decrease in government spending and net exports in 2016. As a result of the reduction in government spending and net exports, the aggregate demand curve shifts to the left (AD1 to AD2). The price level falls to P2 and real GDP falls to real GDP2 (point B).

CHAPTER 9 | Aggregate Demand and Aggregate Supply Analysis

b. As workers and firms adjust their wages and prices to the decline in aggregate demand, the shortrun aggregate supply curve shifts to the right (SRAS1 to SRAS2). The economy will reach long-run equilibrium at P3 and real GDP1 (point C).

9.4

A Dynamic Aggregate Demand and Aggregate Supply Model Learning Objective: Use the dynamic aggregate demand and aggregate supply model to analyze macroeconomic conditions.

Review Questions 4.1 In the dynamic model, potential real GDP increases continually, shifting LRAS to the right, aggregate demand shifts to the right during most years, and except during periods when workers and firms expect high rates of inflation or there is a large adverse supply shock, the short-run aggregate supply curve will shift to the right. 4.2 Aggregate demand increasing faster than potential GDP results in inflation. Aggregate demand increasing slower than potential GDP results in the equilibrium level of real GDP being below potential GDP.

Problems and Applications 4.3 To go from potential real GDP in 2022 to potential real GDP in 2023 without inflation, aggregate demand, long-run aggregate supply, and short-run aggregate supply must all increase—or, shift to the right—by the same amount.

CHAPTER 9 | Aggregate Demand and Aggregate Supply Analysis

4.4 From the Bank of Canada website: “This can throw the economy in a deflationary spiral, as incomes fall and the real debt burden of borrowers increases. In such a case, ongoing price declines lead to lower production and wages, which further reduce demand by consumers and businesses, leading to still lower prices, and so on.” 97.8 − 95.4 × 100% = 2.5%, which is 95.4 slightly above the Bank of Canada target for inflation. The values of the price level 95.4 in 2000 and 97.8 in 2001 are the values of the CPI relative to 2002, the year in which the CPI is set equal to 100. Values below 100 only indicate that we’re talking about years in which prices were lower than in the base year, which almost always means years before the base year.

4.5 No, the inflation rate between 2001 and 2000 was equal to

4.6 a. Growth rate of potential real GDP =

1.80 − 1.75 2.9%. × 100% = 1.75

b. The unemployment rate will be higher in year 2 than in year 1. In year 1, actual GDP is equal to potential GDP, so cyclical unemployment must be zero, and the only unemployment we will observe is frictional and structural. In year 2, potential GDP is higher than actual GDP, so we will observe cyclical unemployment in addition to frictional and structural unemployment. c. The inflation rate =

127 − 125 × 100% = 1.6%. 125

d. Growth rate of real GDP =

1.77 − 1.75 × 100% = 1.1%. 1.75

4.7 This shows that the economy is in recovery because lowering unemployment and decreasing wages are part of the shift in aggregate supply that returns equilibrium to long-run aggregate supply, removing the recessionary gap.

CHAPTER 9 | Aggregate Demand and Aggregate Supply Analysis

4.8 a. An economic bellwether is an indicator of how well the economy is currently doing. b. i.

Tim Hortons isn’t obvious. Students may make an argument for either case. While CN ships necessities as well as luxuries, Tim’s coffee and doughnuts are likely seen as small luxuries. These tend not to be cut back on as quickly as other products. This would suggest that Tim’s is likely to see less fluctuation than CN. Students may also argue that CN ships a lot of raw materials for export, which may not be subject to the same influences as Canadian consumers, making CN’s sales more stable.

ii.

Kent Homes are likely to be subject to greater fluctuations than CN. Again, this is a major consumer purchase and people tend not to buy new homes when they’re concerned about the future.

iii. Novels and romances may in some cases be countercyclical. Like lipstick, purchasing a novel may be a low-cost substitute for other forms of entertainment. When people are feeling poor, they might buy a book ($10 or so) instead of going to the movies ($15+).

Real-Time Data Exercises D9.1

a. The following graph shows the economy at equilibrium at potential GDP in 1960 and in 2019. With real GDP rising from $3 262.0 billion in 1960 to $19 032.7 billion in 2019, the long-run and the short-run aggregate supply curves shifted to the right. With the GDP price deflator (2015 = 100) rising from 15.9 in 1960 to 107.3 in 2019, aggregate demand grew more than long-run aggregate supply.

CHAPTER 9 | Aggregate Demand and Aggregate Supply Analysis b. Given that real GDP declined from $5687.2 billion in 1973 to $5644.8 billion in 1975 and that the GDP price deflator rose from 24.0 in 1973 to 28.5 in 1975, the short-run aggregate supply curve shifted to the left from 1973 to 1975. For simplicity, the following graph shows for 1975 only the shift to the left of the short-run aggregate supply curve.

D9.2

a. As indicated in the exercise, download monthly data on the personal consumption expenditure price index and calculate the percentage change from the same month in the previous year. Calculate this percentage change over the entire 1982 through 2007 period. b. The average inflation rate from 1982 through 1994 was 3.49 percent and from 1995 through 2007 was 2.03 percent. c. The decline in the inflation rate from 1995 through 2007 compared to 1982 through 1994 is consistent with a continuing positive supply shock after 1994. Positive supply shocks increase aggregate supply, decreasing the inflation rate.

D9.3

a. Data gathered for use in part (b). b. The United Kingdom has had a similar experience to the United States since 2007. The United Kingdom experienced a larger drop in real GDP in late 2008 and early 2009 and has had slower growth in real GDP since 2009. From 2007 to 2011, the United Kingdom experienced higher inflation and lower unemployment than the United States. The data in the following graph show data for the United Kingdom over this period of time.

Source: Federal Reserve Economic Data (FRED) website (fred.stlouisfed.org).

CHAPTER 9 | Aggregate Demand and Aggregate Supply Analysis

Suggestions for Critical Thinking Exercises CT9.1 There are no common factors for the demand curves and one for the supply curve: productivity (and the expected future price of a good and the price level are clearly analogous). One can conclude from this that much of what was learned in microeconomics does not carry over to macroeconomics. This question targets what seems to be persistent student confusion on the differences between microeconomics and macroeconomics. CT9.2 No. They deal with different sectors of the economy. Students often have difficulty with AD and SRAS; this question helps them explore the factors that shift these curves by comparing them. CT9.3 The economy moved to the upper right as both variables grew.

CHAPTER 10 | Money, Banks, and the Bank of

Canada

SOLUTIONS TO END-OF-CHAPTER EXERCISES 10.1

What Is Money, and Why Do We Need It? Learning Objective: Define money and discuss the four functions of money.

Review Questions 1.1

The problem is called a double coincidence of wants, where each person in a trade must want what the other person has.

1.2

Commodity money, such as gold coins, has value independent of its use as money, while fiat money, typically paper currency, does not have value independent of its use as money.

1.3

The four functions are medium of exchange, unit of account, store of value, and standard of deferred payment. In the long run, something will not serve as money if it does not fulfill all four functions.

1.4

Businesses accept paper currency because they believe paper currency is acceptable to their customers and to other businesses. Paper currency serves as money because people believe that others will accept it from them.

Problems and Applications 1.5

In French Polynesia in the 1880s, the food the French singer received as payment served as a medium of exchange, but the food did not serve well as a store of value, a unit of account, or a standard of deferred payment.

1.6

a. Fiat currency is money, such as paper currency, that is authorized by a central bank or governmental body and that does not have to be exchanged by the central bank for gold or some other commodity money. b. The currency made from the bark of mulberry trees was fiat money because that currency had no other use other than as money, and it required a decree from Kublai Khan’s government in order to achieve acceptance. c. Executing those who did not accept the fiat currency was not necessary. Modern governments get the public to accept their fiat money by requiring that it be accepted in payment of debts and by requiring that cash or cheques denominated in dollars be used in payment of taxes. Governments, however, do have to convince individuals and firms that the fiat money will not lose significant value during the time they hold it. Typically, governments ensure that fiat money does not lose significant value by avoiding issuing too much of it.

CHAPTER 10 | Money, Banks, and the Federal Reserve System 1.7

101

a. Eggs in Venezuela were serving as money in that people were accepting them in exchange for goods and services. Judging eggs by criteria for money set out in the text: 1. Eggs were accepted by most people, though it was out of necessity because people did not want to accept bolivars, the Venezuelan currency. 2. Eggs do not possess standardized quality. Some eggs are larger than others, and eggs that are laid by one breed of chicken may not look and taste the same as those laid by other breeds. 3. Eggs are not durable. Not only can the shells crack easily, but eggs can also lose freshness after a period of time and eventually will spoil and give off a bad odour. 4. Eggs are not valuable relative to their weight. Someone would need a large number of eggs to buy a motorcycle. 5. Eggs are not divisible. You can’t easily split an egg unless you hard boil it and slice it up, which people at the professor’s university weren’t doing. b. Eggs are more durable than some fruits and vegetables. At the correct temperature, eggs can last a few weeks. Eggs, however, require extra care in handling. Aside from breaking easily, they need to be stored in refrigerated trucks in order to extend their shelf life. c. Using eggs was still more efficient than trading directly with other people because trading directly requires a double coincidence of wants. Trades done using eggs as a medium of exchange bypass the need for a double coincidence of wants and allow individuals to complete trades faster and with lower search costs.

1.8

a. A medium of exchange refers to anything that is generally accepted in exchange for goods and services. b. Because many members of the German tribes used Roman coins as they bought and sold goods and services, the coins became the German tribes’ medium of exchange. c. A member of a German tribe was willing to accept the Roman coins as long as they believed that the coins were acceptable to other people in the tribe.

1.9

Legally requiring all firms to accept paper currency in exchange for whatever they are selling would help people who do not use credit cards or debit cards, and it would help people who want to leave little or no record of their purchases. The requirement could hurt issuers of credit cards and debit cards, and it would hurt businesses like Apple that want to prevent customers from buying large numbers of their products to resell on eBay, craigslist, or elsewhere. Some firms—for instance, a car dealership—might also find it awkward to have to accept large amounts of currency in exchange for the goods they are selling. In addition, some firms would worry about robberies if they were known to have large amounts of cash in their stores.

1.10

a. To “ditch cash” means that the business would not accept cash for payment for goods and services. b. Mobile wallet smartphone apps and the development of technology that makes it easy for stores to accept credit card payments on smartphones or tablets make it possible for businesses to ditch cash. c. The pros to a business of ditching cash include faster speed of service and a deterrent to robberies. The cons include losing some customers who strongly prefer using cash.

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10.2

How Is Money Measured in Canada Today? Learning Objective: Discuss the definitions of the money supply used in Canada today.

Review Questions 2.1

M1+ includes currency and all chequable deposits at chartered banks, TMLs, and CUCPs. M1++ includes everything that is in M1+, plus all non-chequable deposits at chartered banks, TMLs, and CUCPs.

2.2

Wealth equals the value of assets minus the value of liabilities, or debts; income equals earnings during a period of time, such as a year; and money (using the M1+ definition) equals currency plus chequing account and savings account deposits. The central bank controls the quantity of money. The actions of the central bank have only an indirect effect on income and wealth.

Problems and Applications 2.3

a., b., and c. are all counted in M1+. d. is not counted in M1+ because credit cards are not part of the money supply.

2.4

a. Venmo still performs the function of medium of exchange as long as some sellers are willing to accept it as a payment for goods and services, even if other sellers would not. However, the efficiency of Venmo as a medium of exchange is based on how many sellers use Venmo as a payment for goods and services. b. Venmo is an app that functions as a peer-to-peer payment system. People who want to make payments digitally can transfer funds from their banks or their credit cards into Venmo or a similar payment app. Whether the funds people have in these accounts should be counted in M1 is a complicated question. Funds that are transferred from chequing accounts into Venmo or a similar app reduce M1 by reducing chequing account balances, but because the funds are likely to be quickly spent, they should probably be included in M1. But funds transferred from a credit card to a payment app should probably not be counted for the same reasons that credit cards are not currently counted—the funds are effectively a loan from the credit card company. The Fed currently has no mechanism for measuring funds being held on payment apps or for distinguishing the sources of those funds, which would make including in M1 the balances on payment apps difficult even if the Fed wanted to do so. At this time, the size of the balances on these apps is likely too small to make a significant difference in the size of M1. If the apps grow in popularity, the Fed may have to revisit the issue of whether to include these balances in M1.

2.5

You should disagree. The wealth of Canada consists of the buildings, lands, and other assets owned by the government and by the households and businesses in Canada minus the liabilities of the government and the households and businesses in Canada. The money supply of Canada does not represent the country’s wealth.

2.6

You should disagree. Income is not a way to measure wealth. Wealth equals net worth, or the total value of assets minus the total value of liabilities (or debts). Income, the amount earned over a given period of time, is not a measure of wealth.

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2.7

Chequing account deposits and currency are both included in M1+. Therefore, there is no effect on M1+. The $100 was part of M1+ when it was in your chequing account and is still part of M1+ when you hold it as currency.

2.8

Funds in money market mutual funds are included in M2+ but not in M1+. Therefore, this transaction will increase M1+ by $1000. M2+ is not affected because money market mutual funds and funds in chequing accounts are both included in M2+.

2.9

a. The US dollar is formally accepted as a medium of exchange in a number of other countries and territories—including East Timor, Ecuador, El Salvador, and Zimbabwe—and is widely used in the underground economy in other countries. Many economists believe that the majority of US currency is in circulation outside of the United States. b. The Federal Reserve’s measures of the currency component of the money supply (M1 and M2) overstate the amount of currency held domestically.

2.10

a. The reason most people do not use cryptocurrencies to buy goods and services is that their values fluctuate too widely. Currently, most people hold cryptocurrencies such as bitcoin as investments, hoping that their values will increase. b. One advantage of using cryptocurrencies to buy and sell goods and services is that there is no permanent record of the transaction. The lack of a record of the transaction is most useful to people who do not want their transactions monitored by government officials who might limit or tax the transactions. In the United States, if tax rates become sufficiently high or government regulations restrict more currently legal transactions, it’s conceivable that buyers and sellers will be more willing to use cryptocurrencies. If developing countries’ informal economies become significantly larger, it is possible that more people will start using bitcoins rather than government-issued currency to conceal the buying and selling from the government. However, cryptocurrencies are unlikely to be widely used unless their values in terms of governmentissued money become more stable.

2.11

10.3

The monetary value of 1.4 billion pennies is $14 million. If all the pennies were worth $0.05 each, then M1+ would increase by $56 million. Such a change would represent a small fraction in the total value for M1+ and, therefore, would have a negligible effect on the economy.

How Do Banks Create Money? Learning Objective: Explain how banks create money.

Review Questions 3.1 3.2

3.3

The largest asset of a typical bank is loans, and its largest liability is deposits. Assets

Liabilities

Reserves –$100

Deposits –$100

To say that banks “create money” means that banks create chequing account deposits, which are part of M1+, when they make loans from their excess reserves.

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3.4

The simple deposit multiplier is 1/rd where rd is the desired reserve ratio (the level of reserves banks want to hold relative to their deposits). The maximum increase in chequing account deposits would be $20 000 × (1/0.20), or $20 000 × 5 = $100 000. The maximum increase is unlikely to occur because some of the chequing account deposits will be converted into currency, and banks are likely to hold some excess reserves rather than use all of their reserves to create new loans, which create new chequing account deposits.

Problems and Applications 3.5

Using your savings to make loans rather than keeping the funds in bank accounts that earn very low rates of interest involves more default risk and less liquidity and requires more information and monitoring. The loans have a higher chance of default and are not liquid because you won’t receive your money back until the loan is paid off. Also, you would want to research the loan recipient; research what the funds will be used for, monitor the loan payments, and take steps—perhaps even going to court—if the borrower misses payments.

3.6

a. Refinancing a loan means that someone is taking out a new loan in order to pay off an old loan. Borrowers usually refinance a loan in order to get a lower interest rate than they were paying on the previous loan. b. Unlike a conventional bank, SoFi does not have customers who make deposits into the bank. The “base of deposits” refers to the customer deposits that banks use to make loans. Lacking deposits, SoFi has to borrow from banks the money that it lends out. c. Conventional banks need to maintain multiple branches in order to attract depositors. SoFi does not have branches like conventional banks do, and therefore SoFi avoids having to pay tellers and incur the other costs of running a conventional bank. Because its costs are lower than the costs of conventional banks, SoFi can pay interest on loans to banks and still make a profit on the loans SoFi makes to recent graduates.

3.7

With a desired reserve ratio of 10 percent, Royal Bank would have to hold $10 000 of reserves against Deja’s $100 000 deposit, leaving Royal Bank with $90 000 of excess reserves. The maximum loan that Royal Bank can make would equal the $90 000 of excess reserves.

3.8

a. Excess reserves = $10 000 – ($70 000 × 0.10) = $3000. b. The maximum amount by which this single bank can expand its loans is the amount of its excess reserves, or $3000. c. The following balance sheet shows the immediate effect of the loan. The entry for loans and the entry for deposits have both increased by $3000. Assets Liabilities Reserves

+$10 000

Deposits

+$2000

Loans

+$69 000

Stockholders’ equity

+$6000

3.9

The larger the fraction of deposits that banks lend out, the larger the money supply. Most of the money supply is created by banks lending out their excess reserves. Funds that banks lend out result in increases in chequing account balances and, therefore, increases in M1+. Funds that the bank keeps as reserves rather than lending out do not increase the money supply.

3.10

You should disagree with the statement because the balance in a chequing account represents something the bank owes to the owner of the account and is a liability for the bank. The car loan represents something that the borrower owes to the bank and is an asset for the bank. Copyright © 2024 Pearson Canada Inc.

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a. T-accounts show only the changes in a balance sheet that result from relevant transactions, with assets listed on the left side and liabilities on the right side. Because the bank now has your $2000 in currency in its vault, its reserves (and, therefore, its assets) have risen by $2000. This transaction also increases your chequing account balance by $2000. Because the bank owes you this money, the bank’s liabilities have also increased by $2000. Bank of Montreal Assets

Liabilities

Reserves + $2000

Deposits + $2000

b. The problem tells you to assume that Bank of Montreal has no excess reserves and that the bank wants to keep 20 percent of the value of its deposits as reserves. So, if the bank’s chequing account deposits go up by $2000, the bank will keep $400 as reserves and will loan out the remaining $1600. The first line of the following T-account shows the transaction from part (a). The second line shows that Bank of Montreal has loaned out $1600 by increasing the chequing account of the borrower by $1600. (Remember, new loans usually take the form of an increase in the borrower’s chequing account balance.) The loan is an asset for Bank of Montreal because it represents a promise by the borrower to make certain payments stated in the loan agreement. Bank of Montreal Assets

Liabilities

Reserves + $2000

Deposits + $2000

Loans

Deposits + $1600

+ $1600

c. The following T-accounts show the effect of the borrower having spent the $1600 they received as a loan from Bank of Montreal. The person who received the $1600 cheque deposits it in their account at CIBC. In the first T-account, once CIBC sends the cheque written by the borrower to Bank of Montreal, Bank of Montreal loses $1600 in reserves (which it transfers to CIBC). Bank of Montreal also deducts the $1600 from the account of the borrower. In the second T-account, CIBC has an increase in deposits of $1600 and an increase in reserves of $1600, which it receives from Bank of Montreal. Bank of Montreal Assets

Liabilities

Reserves +$400

Deposits +$2000

Loans +$1600 CIBC Assets

Liabilities

Loans +$1600

Deposits +$1600

d. The formula for the simple deposit multiplier is: Change in chequing account deposits = (1/rd) × change in bank reserves. Because bank reserves rose by $2000 as a result of your initial deposit and the bank is keeping 20 percent of deposits as reserves (essentially the same result as if there were a desired reserve ratio of 20 percent), the change in chequing account deposits is:

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CHAPTER 10 | Money, Banks, and the Federal Reserve System $2 000 ×

= $2 000 × 5 = $10 000.

Because chequing account deposits are part of the money supply, it is tempting to say that the money supply has also increased by $10 000. But remember that your $2000 in currency was counted as part of the money supply while you had it, but that currency is not included when it is sitting in a bank vault. Therefore: Change in the money supply = Increase in chequing account deposits – Decline in currency in circulation = $10 000 – $2 000 = $8 000.

10.4

The Bank of Canada Learning Objective: Describe how the Bank of Canada manages the money supply.

Review Questions 4.1 The government established the Bank of Canada to be responsible for monetary policy and a lender of last resort to banks to prevent banking panics. 4.2 The two policy tools are open market buyback operations and lending to banks, with open market buyback operations being the most important. 4.3 When the Bank of Canada buys government securities from the public, the sellers of the securities deposit the funds in their banks, increasing bank reserves. When the Bank of Canada sells government securities to the public, the buyers of the securities pay with cheques, decreasing bank reserves. 4.4 Shadow banking system is a term used when referring to investment banks, money market mutual funds, hedge funds, and other firms engaged in similar activities to these firms. These firms raise funds from individual investors and from other financial firms and lend or invest the funds, either directly or indirectly. In doing so, these firms are carrying out a function that at one time was almost exclusively the domain of commercial banks. The financial firms of the shadow banking system are more vulnerable to runs than commercial banks are because they are more highly leveraged, they do not have deposit insurance, and the government agencies, including OSFI and the Bank of Canada, that regulate the commercial banking system have not regulated these firms as closely.

Problems and Applications 4.5 A government can create money by printing currency, but banks create the majority of the money supply by making loans, which increases chequing account balances. The central bank can increase the number of loans banks make by increasing the banks’ reserves. In this case, the Federal Reserve or the European Central Bank can buy government bonds, which increase the reserves of banks. As bank reserves rise, the banks make more loans, which increase chequing account balances. Because chequing account balances are part of the money supply, the central bank’s actions create money.

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a. Scotiabank Assets Reserves +$10 000 000

Liabilities Bank of Canada Loans +$10 000 000

b. Scotiabank can loan out the entire $10 million. c. If banks are keeping 10 percent of their deposits as reserves, the simple deposit multiplier is (1/0.10) = 10. The money supply can increase by a maximum of (the discount loan × the multiplier) or ($10 million × 10) = $100 million. 4.7

When the Bank of Canada acts as a lender of last resort during a bank panic, it does not “bail out” banks in the way that the US government is said to have “bailed out” private companies during the recession of 2007–2009 and its aftermath. The Bank of Canada does not use taxpayer funds to pay bank debts. Instead, the Bank of Canada offers to lend reserves to banks so that they can meet their depositors’ desires to withdraw funds from their accounts. A bank panic is made possible by the nature of the fractional reserve system. Even banks that are well managed and profitable do not have enough reserves on hand to meet a large volume of deposit withdrawals.

4.8

In the T-account for the Bank of Canada, assets decrease by $25 million in Canada bonds and liabilities decrease by $25 million in bank reserves. In the T-account for the banking system, assets increase by $25 million in Canada bonds and decrease by $25 million in reserves as the Bank of Canada deducts the payment for the Canada bonds from bank reserves. Federal Reserve to Bank of Canada Assets Treasury bill

−$25 million

Liabilities Reserves

−$25 million

Treasury bills to Canada bonds Assets

4.9

Treasury bill

+$25 million

Reserves

−$25 million

Liabilities

Money market mutual funds are not protected by deposit insurance, as commercial banks’ deposits are through the Canada Deposit Insurance Corporation (CDIC). Customers of a bank with CDIC insurance are guaranteed that if the bank fails their individual deposits will be insured for amounts up to $100 000. There would be no need for depositors in such banks to “rush to the exits.”

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10.5

The Quantity Theory of Money Learning Objective: Explain the quantity theory of money and use it to explain how high rates of inflation occur.

Review Questions 5.1

The quantity theory of money starts from the quantity equation: M × V = P × Y, where M is the money supply, V is the velocity of money, P is the price level, and Y is the real output. Because velocity is equal to (P × Y)/M, the quantity equation must always hold true. Irving Fisher turned the quantity equation into the quantity theory of money by asserting that velocity was constant. With velocity constant, inflation occurs whenever the growth rate of the money supply is greater than the growth rate of real output.

5.2

The quantity theory of money is better able to explain the inflation rate in the long run because in the short run there can be significant fluctuations in the value of velocity.

5.3

Hyperinflation refers to very high rates of inflation—in excess of 50 percent per month. The rapid growth of the money supply that leads to a hyperinflation typically results from large budget deficits that are financed by money creation—the central bank of the country purchasing government bonds. Governments allow this rapid money creation because the alternative of financing government spending by raising taxes is politically unpopular, and private investors are usually unwilling to buy bonds issued by the governments of low-income countries with large budget deficits.

Problems and Applications 5.4

The inflation rate = Growth rate of the money supply + Growth rate of velocity – Growth rate of real output. So, if velocity is constant, the inflation rate would be 6 percent + 0 percent – 3 percent = 3 percent. If velocity grows at 1 percent, then the inflation rate would be 6 percent + 1 percent – 3 percent = 4 percent.

5.5

The quantity theory of money states that the money supply (M) multiplied by the velocity of money (V) equals the price level (P) multiplied by real GDP (Y), or M × V = P × Y. Note that P × Y equals nominal GDP. If velocity does not change, an increase in the money supply must increase nominal GDP. But real GDP may or may not increase. The increase in M × V could lead to an increase in the price level (P) with no change in real GDP.

5.6

a. The quantity equation indicates that the growth rate in a nation’s money supply plus the growth rate of velocity will equal the inflation rate plus the growth rate of real GDP. Because we are given values only for the average annual growth rate of the money supply and for the average inflation rate, we can’t determine whether the values are consistent with the quantity equation. To make this determination, we also need data for the average annual growth rate of velocity and the average annual growth rate of real GDP. Because the quantity equation is an identity, though, the values for the growth rate of velocity and the growth rate of real GDP would be consistent with the quantity equation. b. The quantity theory of money assumes that the growth rate of velocity is constant. In that case, we have:

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Inflation rate = Growth rate of the money supply − growth rate of real GDP. Here we have: 1.7 percent = 7.5 percent − growth rate of real GDP, or, Growth rate of real GDP = 7.5 percent − 1.7 percent = 5.8 percent. Although such a high average annual growth rate of real GDP is possible, it has not been experienced in the United States since World War II and is higher than the actual average annual growth rate experienced by the US economy during the years 2011 to 2020. We can conclude that the data given are not consistent over this period of time with the quantity theory of money. 5.7

a. Price deflation occurs when the price level declines from one year to the next. b. Price deflation increases the burden of a debt because it means that the debt must be repaid in money that is increasing in value. If borrowers have to divert more funds to repaying debts, they will have less available to buy goods and services. The resulting decrease in spending can make an economic recession worse. c. Gesell’s proposal would increase the incentive that households and firms have to spend money because, effectively, holdings of currency are being taxed at a rate of 5 percent per year. The result would be an increase in velocity, or the average number of times that a unit of currency is spent. The quantity equation shows us that if velocity (V) increases, for a given level of the money supply (M) and level of real output (Y), the price level (P) must increase. As a consequence, the deflation would end, or at least the size of price decreases (and increases in the real burden of debts) would be reduced.

5.8

a. A country experiences hyperinflation when its central bank increases the country’s money supply much faster than the growth rate of real GDP. b. Yes, because when a country experiences hyperinflation, its money loses much of its value and households and firms become reluctant to accept it in exchange for goods and services. The only alternatives are to use a foreign currency, such as the US dollar, or to engage in barter trades. Both those choices are less efficient than using a stable domestic currency. As a result, economic activity is likely to slow and real GDP will decline.

5.9

Hyperinflation reduced the purchasing power of money. Individuals and firms that borrowed during that period would likely have benefited from the hyperinflation as the same amount of debt would have been worth much less—or nothing at all—in real terms when it was eventually paid back.

Real-Time Data Exercises Note: FRED continues to update data. The solutions below contain the data available on FRED for the first quarter of 2021. D10.1 a. M1 money stock (billion $) M3 money stock (billion $) M1/M3

2020 $1269.8 $2849.2 0.44

2015 $787.4 $1934.4 0.40

2010 $532.1 $1362.2 0.39

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CHAPTER 10 | Money, Banks, and the Federal Reserve System b. M1 as a proportion of M3 increased over the 10-year period. The exceptionally low interest rates of the recent period probably account for M1 rising as a proportion of M3.

D10.2 a.

b. The scatterplot shows that the money growth rate and the CPI growth rate do not behave as predicted by the quantity equation. This is because the growth rate of GDP and the velocity of money for the UK were not constant during this period. D10.3 For the second quarter of 2019, real gross domestic product equalled $19 021.86 billion in chained 2012 dollars and for the second quarter of 2027 real potential gross domestic product equals $22 014.9 billion in chained 2012 dollars. a. The average annual rate of change for real GDP over this eight-year period, assuming that real GDP equals potential GDP at the end of the eight-year period equals {[($22 104.9 billion/$19 021.86 billion)1/8] – 1} × 100 = 1.84 percent. b. For the annual inflation rate to average 2 percent, the growth rate of M1, if the velocity of money is constant, would have to be 3.84 percent. The equation of exchange indicates that the growth rate of the money supply equals the inflation rate plus the growth rate of real GDP, when velocity is constant: 2 percent + 1.84 percent = 3.84 percent. c. If M1 grows at 3.84 percent and real GDP grows at 1.84 percent, then if actual inflation averages more than 2 percent, the velocity of money will have increased.

Suggestions for Critical Thinking Exercises CT10.1 In general, students seem to count far too much as money and often conflate it with income and wealth. The cognitive scientist Dan Willingham is fond of the phrase “memory is the residue of thought,” and hopefully thinking here will lead to a correct memory on this topic. CT10.2 a. Students’ answers may vary. Some students will say that they use only cash, others may say that they use only credit or debit cards, while some students may use only Wealthsimple Cash or Apple Pay. b. Answers will vary, depending on students’ preferences and on whether stores accept alternative forms of payment. Some students may also state that they prefer paying by using their smartphones with an app like Apple Pay.

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c. Answers will vary. d. Again, answers will vary, depending on students’ familiarity with the different alternative payment methods and on their preferences among those methods that they are familiar with. CT10.3 Answers will vary depending on the state of hyperinflation in Venezuela at the time this exercise is assigned. Based on the discussion in this chapter, the Venezuelan government should reduce the rate at which it is printing Venezuelan bolivars. To credibly make such a commitment, the government will likely have to announce a means of eliminating or sharply reducing its government budget deficit so that the government will no longer have to rely on selling bonds to the central bank to pay its bills. Without reducing the rate of growth of the money supply, the government will be unable to end hyperinflation.

CHAPTER 11 | Monetary Policy SOLUTIONS TO END-OF-CHAPTER EXERCISES 11.1

What Is Monetary Policy? Learning Objective: Define monetary policy and describe the Bank of Canada’s monetary policy goals.

Review Questions 1.1 When the government established the Bank of Canada in 1934, the main responsibility of the Bank of Canada was to prevent bank panics by making loans to banks. The government broadened the Bank of Canada’s responsibilities in the aftermath of the Great Depression. 1.2 The Bank of Canada’s four monetary policy goals are price stability, high employment, economic growth, and stability of financial markets and institutions. However, price stability is the Bank’s main policy objective. 1.3 The government can influence the conduct of monetary policy since the objectives of monetary policy in Canada are determined jointly by the Department of Finance and the Bank of Canada. In fact, according to the “joint responsibility system” that dates back to the 1967 revision of the Bank of Canada Act, the Bank of Canada has instrument independence but not goal independence. 1.4 Investment banks can be subject to liquidity problems because they often borrow short term— sometimes as short as overnight—and invest the funds in longer-term investments.

Problems and Applications 1.5

A bank panic occurs when large numbers of depositors simultaneously make withdrawals from many banks. When the Bank of Canada was founded, its primary responsibility was to deal with bank panics by making loans to banks. The failure of a single large bank can lead to a bank panic as depositors (or lenders in the case of shadow banks) become concerned about their deposits (loans). Bank failures disrupt the flow of credit to small and medium-size businesses and to households. Failures of restaurants or clothing stores do not spread to other stores in the way that bank failures spread to other banks (when the government does not provide deposit insurance), and restaurants and clothing stores do not play as important a role in the economy as banks and financial intermediaries do by providing credit to households and firms.

1.6

Many economists consider price stability to be the Bank of Canada’s most important policy goal. As we saw in earlier chapters, the problems that inflation causes the economy include the loss of purchasing power of money, menu costs, an unintended redistribution of income, and the use of scarce resources to avoid losses from inflation.

1.7

Commercial banks are financial institutions that provide commercial services to the public. The Bank of Canada is the central bank, responsible for monetary policy in the country. The Bank of Canada does not provide commercial services.

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a. “Stock and bond volatility” means substantial swings in the prices of stocks and bonds. Avoiding volatility in financial asset prices, and promoting stability in financial markets generally, is usually considered to be a policy goal of the central bank. However, avoiding volatility in bond and stock prices is not explicitly a part of the central bank’s dual mandate of high employment and price stability. b. Some economists argue that the central bank should consider key asset prices, such as stock prices, bond prices, and housing prices, in its policy decisions. Rapidly rising stock prices could be a concern for the central bank to the extent that the higher stock prices increase household wealth, spurring consumption spending and, possibly, inflation. A greater concern would be stock prices rising to an unsustainably high level (a bubble), risking a collapse in stock prices that would decrease household wealth, increase uncertainty in the economy, and possibly disrupt the flow of credit. Bond market volatility makes it more difficult for firms to issue bonds to finance new investments. Some firms may wait to issue bonds in order to get a more favourable interest rate. Increased volatility also creates volatility in investors’ holdings of bonds.

The Money Market and the Bank of Canada’s Choice of Monetary Policy 11.2 Targets Learning Objective: Describe the Bank of Canada’s monetary policy targets and explain how expansionary and contractionary monetary policies affect the interest rate.

Review Questions 2.1

A monetary policy target is a variable that the Bank of Canada can affect directly and that, in turn, affects variables that are closely related to the Bank’s policy goals, such as low unemployment and low inflation. The Bank uses policy targets because it cannot achieve its policy goals directly but must reach its goals indirectly through its policy targets.

2.2

The demand for money refers to the amount of money, as measured by M1+ or M2+, that households and firms decide to hold at different nominal interest rates. The advantage of holding money (the medium of exchange) is that it can be used to buy goods, services, and financial assets. The disadvantage of holding money is that money earns little or no interest. An increase in the interest rate increases the return that households and firms can earn on Canada bonds or other shortterm interest-bearing financial assets. An increase in the interest rate, therefore, increases the opportunity cost of holding money and decreases the quantity of money demanded.

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2.3

To lower the equilibrium interest rate, the Bank of Canada would increase the money supply. The following graph shows the money supply curve shifting to the right from MS1 to MS2, which causes the equilibrium interest rate to fall from i1 to i2.

2.4

The overnight interest rate is the interest rate banks charge each other for overnight loans. It is the interest rate that the Bank of Canada targets to conduct monetary policy.

Problems and Applications 2.5

A decrease in the money supply from MS1 to MS2 could be caused by the Bank of Canada selling Canadian government securities, raising the overnight interest rate. An increase in money demand from MD1 to MD2 could be caused by an increase in the price level or an increase in real GDP.

2.6

a. The headline is referring to the overnight interest rate. b. Commercial banks are able to borrow and lend reserves at the overnight funds rate. c. Changes in the overnight interest rate affect other interest rates, including other short-term interest rates, such as the interest rate on Canadian Treasury bills, and long-term interest rates, such as the interest rates on mortgage loans and on corporate bonds.

2.7

The Fed was targeting the federal funds rate. The Fed gave up targeting the money supply because the relationship between M1 and M2 and other key economic variables, such as the inflation rate and the growth of GDP, weakened after 1980.

2.8

a. Scenario 3. Widespread use of mobile wallets shifts the money demand curve to the left because people require less currency and smaller balances in their chequing accounts. b. Scenario 4. The decrease in the desired reserve ratio shifts the money supply curve to the right. c. Scenario 2. The Bank of Canada selling Canada securities shifts the money supply curve to the left because it pulls reserves from the banking system. d. Scenario 1. An increase in real GDP shifts the money demand curve to the right because households and firms require more currency and chequing account deposits to finance their higher level of spending.

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11.3

115

Monetary Policy and Economic Activity Learning Objective: Use aggregate demand and aggregate supply graphs to show the effects of monetary policy on real GDP and the price level.

Review Questions 3.1

An increase in interest rates decreases three of the four components of aggregate demand. Higher interest rates decrease investment spending, including spending on new homes, and consumption spending, particularly spending on durable goods. Net exports also decline as higher interest rates increase the exchange rate between the dollar and foreign currencies. Government purchases are not affected by increases in interest rates.

3.2

If the Bank of Canada believes the economy is headed for a recession, it should conduct expansionary monetary policy, increasing the money supply (or increasing the rate of growth of the money supply) and decreasing interest rates. If the Bank believes that the inflation rate is about to increase, it should conduct contractionary monetary policy, decreasing the money supply (or decreasing the growth of the money supply) and increasing interest rates.

3.3

Quantitative easing refers to the buying of securities (such as 10-year Canada bonds and mortgagebacked securities) with longer maturities than short-term Canada bonds (Treasury bills) that the Bank of Canada usually buys in open market operations. The Bank of Canada cannot reduce the overnight interest rate below zero, so it has used quantitative easing to reduce long-term interest rates. Other central banks are in the same situation of being unable to reduce their short-term interest rate targets below zero, so they have also used quantitative easing to reduce long-term interest rates.

Problems and Applications 3.4

The Bank of Canada typically uses contractionary monetary policy in situations where it believes that real GDP has increased beyond potential GDP, resulting in an increase in the inflation rate. Real GDP cannot remain above potential GDP indefinitely. Rather than wait for the automatic mechanism to return real GDP to the level of potential GDP—which would result in the price level being driven even higher—the Bank of Canada uses contractionary monetary policy by raising its target for the overnight interest rate. By promptly enacting a contractionary policy, the Bank can bring real GDP back to potential GDP more quickly and with a smaller increase in the price level.

3.5

Apparently, banks in Japan were not lending out the new reserves being created by the Bank of Japan’s expansionary monetary policy. For an expansionary monetary policy to be successful, banks have to lend out the reserves created by the central bank. Banks in Japan were either reluctant to make loans to their existing customers—perhaps because they believed that the risk of borrowers defaulting on loans had increased—or the banks were having difficulty finding firms optimistic enough to be willing to borrow to purchase new machinery, equipment, and buildings.

3.6

a. The central bank uses expansionary monetary policy to stimulate consumption and investment. This practice will shift the aggregate demand curve to the right and increase both real output and the price level. An increase in the price level is inflation. b. Since the recession of 2007–2009, the US Fed has been very aggressive is using expansionary monetary policy. During the years following the crisis, the Fed instituted successive rounds of quantitative easing to increase the money supply by trillions of dollars. The Fed had been slowly easing its expansionary policy prior to the pandemic but rapidly responded to the Copyright © 2024 Pearson Canada Inc.

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CHAPTER 11 | Monetary Policy COVID-19 pandemic by cutting its target for the federal funds rate to near zero in 2020. By early 2021, the US economy appeared to be recovering, but the Fed maintained its expansionary policies. The stock market responded so favourably that many experts forecast a stock market bubble and high inflation. However, the Fed appeared to be more concerned that the economic recovery might derail and push the economy back into recession. The fear of more aggressive strains of Covid-19 emerging appears to have been more important to the Fed’s decisions than were concerns about inflation.

3.7

a. A central bank will typically react to inflation falling and concerns over economic growth by implementing an expansionary monetary policy. The cut in India’s policy rate should result in decreases in other interest rates, which would increase consumption, investment, and net exports, thereby increasing aggregate demand and real GDP, which would amount to “supporting the economy.” b. If inflation rates are slowing, then the central bank has some flexibility to engage in expansionary monetary policy without increasing inflation to levels that might damage the economy. Cutting interest rates when inflation is increasing would continue to push inflation even higher and harm the economy. c. The central bank of India was hoping to see economic growth resulting from increased consumption and investment spending. Lower interest rates encourage both consumers and businesses to borrow and spend, which stimulates the economy by increasing aggregate demand.

3.8

William McChesney Martin meant that if real GDP exceeds potential GDP (“the party is getting going”) and the inflation rate begins to increase, the Fed needs to take steps to restrain aggregate demand (“remove the punchbowl”). He also may have been referring to the need to keep a new higher rate of inflation from being established in the expectations of households, workers, and firms in a way that might make it difficult to reduce.

3.9

a. Rounds of quantitative easing (QE) by the Fed, the European Central Bank (ECB), and other central banks around the world had driven long-term interest rates to very low levels. Eventually, investors bid up the prices of some long-term bonds issued by European governments to such high levels that the yields on the bonds were actually negative—investors would receive less when the bonds matured than they were paying to buy them. In these conditions, the ECB believed that to spur banks to make loans, it needed to make the interest rates on bank reserves negative. b. With interest rates on many corporate bonds and on bank deposits being at very low levels, investors did not believe that the interest rates were sufficiently high to compensate for the default risk on those bonds and deposits. So, investors were willing to receive a negative nominal interest rate on German government bonds because they believed there was no chance that the German government would default on the bonds. c. Negative interest rates in Germany should push depositors to pull most of their money out of banks. Individuals would probably begin using more cash for transactions. d. People can get by without a bank for most transactions, and some demographic groups remain largely unbanked and rely on other mechanisms, such as Venmo or similar smartphone apps, to transfer funds.

3.10

a. The Federal Reserve’s balance sheet is a financial statement that lists all the assets and liabilities of the Fed.

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b. The Fed increases its balance sheet when it buys financial assets such as Treasury securities or mortgage-backed securities. These purchases increase the reserves banks hold because the funds the Fed uses to pay for the securities are typically deposited in banks. c. By “bank credit,” William Dudley means banks making loans to consumers and businesses. Higher bank reserves mean that banks have funds they can use to make more loans. However, following the financial crisis, government regulators were requiring banks to hold safer assets, like bank reserves, and low interest rates on loans and bonds meant that the opportunity cost to banks of holding more reserves was low. For this reason, most banks increased their bank reserves. If the Fed wants to reduce bank lending, it can simply raise the interest rate it pays on the bank reserves held on deposit at the Fed. Conversely, the Fed can encourage bank lending by lowering or eliminating the interest rate it pays banks on their reserve deposits. 3.11

Forecasting anything as complex as the effects of a new virus or correctly forecasting that a recession will occur are both very difficult. Because COVID-19 was a previously unknown virus, biologists lacked the data necessary to fully understand its effects. As the economy evolves over time, economic institutions may change, which complicates the difficulty of forecasting the likelihood of a recession that results from a shock to aggregate demand or to aggregate supply. For instance, because prior to the 1970s, the Canadian economy had not experienced the effects of a sharp increase in oil prices, few economists predicted the severity of the recession of 1974–1975. Similarly, because the United States had not experienced a significant decline in housing prices since the 1930s and because economists did not fully understand the importance of the growth of the banking system, many economists, including Fed policymakers, were surprised by the severity of the 2007–2009 recession.

3.12

You should disagree because the statement is incorrect. An increase in the money supply does not affect real GDP directly, and certainly not dollar-for-dollar. An increase in the money supply increases real GDP by lowering interest rates, which in turn increases spending. When interest rates are lower, households are more likely to buy new homes and automobiles, and firms are more likely to buy new factories and computers. Lower interest rates also lead to a lower foreign exchange rate for the dollar, which lowers the prices of exports in foreign currencies and raises the prices of imports in dollars, thereby increasing net exports. Because the exact size of these effects is uncertain, the Bank of Canada’s job is much more difficult than the statement suggests.

Monetary Policy in the Dynamic Aggregate Demand and Aggregate 11.4 Supply Model Learning Objective: Use the dynamic aggregate demand and aggregate supply model to analyze monetary policy.

Review Questions 4.1

In the basic aggregate demand and aggregate supply model, an expansionary monetary policy is illustrated by the aggregate demand curve shifting to the right, while neither the short-run aggregate supply curve nor the long-run aggregate supply curve shifts. In the dynamic model, the aggregate demand curve still shifts to the right, but by more than it would have in the absence of the expansionary policy. The short-run aggregate supply curve and the long-run aggregate supply curve also shift to the right to illustrate that the economy experiences inflation and long-run growth in potential GDP.

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4.2

In the basic aggregate demand and aggregate supply model, a contractionary monetary policy is illustrated by the aggregate demand curve shifting to the left, while neither the short-run aggregate supply curve nor the long-run aggregate supply curve shifts. In the dynamic model, the aggregate demand curve shifts to the right, but by less than it would have in the absence of the contractionary policy. The short-run aggregate supply curve and the long-run aggregate supply curve both shift to the right to illustrate that the economy experiences inflation and long-run growth in potential GDP. So, in the basic aggregate demand and aggregate supply model, a contractionary monetary policy will cause a decline in both real GDP and the price level. In the dynamic aggregate demand and aggregate supply model, a contractionary monetary policy will cause real GDP and the price level to increase by less than they would have in the absence of the policy.

Problems and Applications 4.3

You should disagree with this argument. In the basic aggregate demand and aggregate supply model, a contractionary monetary policy causes the price level to fall. In the more accurate dynamic AD-AS model, however, a contractionary monetary policy causes the price level to rise by less than it would have in the absence of the policy. In the dynamic AD-AS model, the short-run aggregate supply curve, the long-run aggregate supply curve, and the aggregate demand curve all typically shift to the right each year. In the dynamic AD-AS model, a contractionary monetary policy causes the aggregate demand curve to shift to the right by less than it would in the absence of policy. As a result, the price level will still increase, but by less than it would have in the absence of the policy.

4.4

a. Without policy action, aggregate demand will shift from AD2024 to AD2025 (without policy). Real GDP increases from $2 trillion to $2.3 trillion, and the price level increases from 124 to 130. b. Because real GDP will be greater than potential GDP in 2025, the Bank of Canada should use a contractionary policy to keep real GDP at its potential level. To implement a contractionary policy, the Bank needs to sell Canada bonds. Selling Canada bonds will decrease reserves in the banking system. Banks will decrease their loans, which will decrease the money supply and increase the interest rate. c. If the Bank of Canada takes no policy action, the price level will increase from 124 in 2024 to 130 in 2025. The rate of inflation would equal [(130 – 124)/124] × 100 = 4.8 percent. If the Bank uses monetary policy to keep real GDP at its full employment level, the price level will increase from 124 in 2024 to 128 in 2025. The rate of inflation would equal [(128 – 124)/124] × 100 = 3.2 percent.

4.5

a. The information in the table tells us that without monetary policy, real GDP will be greater than potential GDP in 2025. The Bank of Canada should use contractionary monetary policy because real GDP is greater than potential GDP. The Bank will increase its target for the overnight interest rate in an attempt to cause real GDP to equal potential GDP. b. i.

If the policy is successful, real GDP in 2025 will decrease from the level given in the table of $2.2 trillion to its potential level of $2.1 trillion.

ii. Monetary policy does not affect potential GDP, so its value will not change. iii. The contractionary monetary policy will shift the AD curve to the left . Therefore, the price level will decrease more than it would have had the Bank of Canada not acted. iv. Because the level of real GDP will be lower, the unemployment rate will be higher than it would have been without policy. c. Equilibrium in 2024 is at point A, with the AD and SRAS curves intersecting along the LRAS2024 curve. Real GDP is at its potential level of $2 trillion, and the price level is 124. Without

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monetary policy, the AD curve shifts to AD2025 (without policy), and short-run equilibrium occurs at point B. Because potential real GDP has increased from $2 trillion to $2.1 trillion, short-run equilibrium real GDP of $2.2 trillion is above the potential level. The price level has increased from 124 to 130. With policy, the AD curve shifts to the left to AD2025 (with policy), and equilibrium is at point C. At point C, real GDP is equal to its potential level of $2.1 trillion. The equilibrium price level will be at P2025 (with policy), which will be lower than 130. Without policy, the inflation rate in 2025 would have been 4.84 percent [(130 − 124)/124 × 100). With policy, it will be less than 4.84 percent.

4.6

a. By shifting its stance on monetary policy to neutral from accommodative, the Reserve Bank of India (RBI) expected the AD curve in 2017 to shift to AD2017 (RBI), moving equilibrium to point C with real GDP equal to potential.

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CHAPTER 11 | Monetary Policy b. The private forecasters were more pessimistic about growth, implying that they expected the AD curve to shift only to AD2017(private), leaving short-run equilibrium at point B with real GDP below potential GDP.

A Closer Look at the Bank of Canada’s Setting of Monetary Policy 11.5 Targets Learning Objective: Describe the Bank of Canada’s setting of monetary policy targets.

Review Questions 5.1

With a monetary rule, monetary policy follows a set rule rather than being determined at the discretion of Bank of Canada policymakers. For example, a monetary growth rule is a plan to increase the money supply at a constant rate that does not change in response to economic conditions. Milton Friedman proposed a monetary growth rule where the money supply would grow each year at a rate equal to the long-run growth rate of real GDP. Support for the monetary growth rule has declined because the strong relationship that once existed between changes in the money supply and changes in real GDP and the price level has become much weaker.

5.2

The Bank of Canada can’t hit both targets because it can achieve only combinations of the interest rate and the money supply that represent equilibrium in the money market. Because the Bank does not control money demand, it cannot target both the overnight interest rate and the money supply at the same time.

5.3

The Taylor rule is a rule developed by John Taylor, an economist at Stanford University, which links the central bank’s target for the overnight interest rate to economic variables. The purpose of the Taylor rule is to have a convenient way to determine approximately the target for the overnight interest rate and to use that approximation to help evaluate whether the actual overnight interest rate target set by the Bank of Canada is too high or too low.

Problems and Applications 5.4

Overnight interest target rate = 4% + 2% +

 1 1  $20.2 trillion  $20.0 trillion  (4%  2%) +    100 2 2  $20.0 trillion  

= 4% + 2% +

1 1 (4%  2%) + 1% 2 2

 6%  1%  0.5%  7.5% 5.5

The Taylor Rule can be written as: Federal funds target rate  Current inflation rate  Equilibrium real federal funds rate.  [(1/2) × Inflation gap]  [(1/2) × Output gap]

Overnight funds rate target  1%  2%  [(1/2) × (−1%)]  [(1/2) × 0%]  3%  [−(1/2)%]  [0] 2.5%

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a. The central bank is inflation rate targeting if it announces the inflation rate, say 2 percent, that it believes is consistent with its goal of price stability and implements policies that will keep the inflation rate around that target. b. When the central bank announces a target, households and firms need to understand the inflation target so that they will expect the targeted inflation rate will prevail when they make decisions about prices, wages, and interest rates. c. Once a central bank establishes a credible inflation target, it reduces the uncertainty that firms and households would otherwise have about future inflation rates. The result will be that firms and households will be more likely to enter into long-term contracts, thereby reducing uncertainty over future spending. In addition, households and firms will be less likely to experience losses or gains when the actual inflation rate is significantly different from the expected inflation rate. Households and firms generally consider gains resulting from unexpectedly high or low inflation to be unfair.

5.7

a. Recall that the growth rate of nominal GDP is approximately equal to the growth rate of the price level (or the inflation rate) plus the growth rate of real GDP. If the Fed expected 3 percent annual growth in real GDP and wanted an inflation rate of 2 percent, it would set a target of nominal GDP growth of 5 percent per year. If real GDP growth slowed, as during a recession, the Fed would automatically pursue an expansionary monetary policy in an attempt to hit its nominal GDP target. If the inflation rate increased above 2 percent, the Fed would automatically pursue a contractionary policy to keep nominal GDP from rising above its target. b. Because real GDP and the inflation rate declined during the 2007–2009 recession, nominal GDP targeting would have resulted in a more expansionary monetary policy because the Fed would have needed to implement an expansionary policy to increase the growth rate of real GDP and the inflation rate. c. It would be easier to follow a nominal GDP target if a central bank was concerned with both unemployment and inflation than if it were concerned with just inflation because the central bank could conduct an expansionary monetary policy to hit its nominal GDP target even if it had already achieved its inflation target.

5.8

a. Both the headline CPI and the core CPI measure prices paid by consumers, but the headline CPI is broader. b. To set monetary policy, the Bank of Canada wants to use the best measure it can of the underlying inflation rate. For this reason, the Bank uses the core CPI as its preferred measure of inflation.

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11.6

Central Bank Policies during the 2007–2009 and 2020 Recessions Learning Objective: Describe the policies the central banks used during the 2007–2009 and 2020 recessions.

Review Questions 6.1

A mortgage is a loan a borrower takes out to buy a house. Prior to 1970, mortgages were not considered securities—financial assets that were sold in secondary markets. After 1970, secondary markets in mortgages were created to help the housing market. By the 2000s, investment banks had become significant participants in the secondary market for mortgages. Investment banks began buying mortgages, bundling them together as mortgage-backed securities, and reselling them to investors. Also, by the mid-2000s, lenders had greatly loosened the standards for obtaining a mortgage loan.

6.2

Among the actions the Fed and the US Treasury took were the following: In March 2008:  The Fed announced it would temporarily make discount loans to primary dealers—firms that participate in open market transactions with the Fed.  The Fed announced that it would loan up to $200 billion of US Treasury securities in exchange for mortgage-backed securities to primary dealers.  The Fed and the US Treasury took direct action to keep large financial institutions from bankruptcy by helping JPMorgan Chase acquire the investment bank Bear Stearns. In September 2008:  The US Treasury moved to have the federal government take control of Fannie Mae and Freddie Mac. Fannie Mae and Freddie Mac were each provided with up to $100 billion in exchange for 80 percent ownership of the firms.  The Fed agreed to provide an $85 billion loan to the American International Group (AIG) insurance company in exchange for an 80 percent ownership stake, effectively giving the federal government control of the company.  The US Treasury announced a plan to provide insurance for deposits in money market mutual funds, similar to the existing insurance on bank deposits.  The Fed announced that it would lend directly to corporations by purchasing three-month commercial paper issued by non-financial corporations. In October 2008:  Congress passed the Troubled Asset Relief Program (TARP), under which the US Treasury attempted to stabilize the commercial banking system by providing funds to banks in exchange for stock.

6.3

The Bank of Canada responded to the 2020 recession caused by the COVID-19 pandemic by cutting its target for the overnight interest rate to 25 basis points and by introducing temporary lending facilities that would allow it to lend to businesses that are not commercial banks and so are not typically eligible to borrow from the Bank of Canada. By using these facilities, the Bank of Canada was able to ensure that funds flowed to firms and to provincial and local governments that might otherwise have had difficulty borrowing.

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Problems and Applications 6.4

a. By the fall of 2007, the housing bubble had collapsed and sales of new homes had declined substantially. Credit availability refers to the ability to get a loan. b. Problems of credit availability affect a homebuilder’s ability to borrow to build and develop real estate properties and affect the ability of households to obtain mortgage loans to purchase new houses.

6.5

a. The establishment of Fannie Mae and Freddie Mac by Congress spurred the development of a secondary market in mortgage-backed securities. The existence of a secondary market, in turn, greatly expanded the sources of funding for mortgages. These developments meant that borrowers have been able to choose from a greater variety of lenders, and small local banks face greater competition. Quoting further from the article by McDonald and Thornton: “For the borrower, robust mortgage trading allows for more intense ‘competition.’ . . . The Internet has provided an outlet to quickly compare mortgage rates.” Small local banks that had little competition for mortgage loans in the 1960s and 1970s now face much greater competition because potential customers can shop for mortgages from their home computers. b. This greater competition has reduced the interest rates borrowers have to pay on mortgages. In addition, the supply of funds available to finance mortgages has also increased as investors purchase mortgage-backed securities. The increased supply of funds has also contributed to lower mortgage interest rates. Source: Daniel J. McDonald and Daniel L. Thornton, “A Primer on the Mortgage Market and Mortgage Finance,” Federal Reserve Bank of St. Louis Review, January/February 2008.

6.6

a. A “subprime mortgage” is a mortgage granted to a borrower with a poor credit history who makes a small down payment or otherwise represents a higher-than-average risk of default. b. A deeper pool of capital refers to greater potential financing for borrowers, which was the result of the increased securitization of the mortgage market after 1970. c. Because of the greater risk of default, a subprime borrower typically would pay a higher interest rate than a borrower with a better credit history. d. A lender would prefer to lend to a borrower with a poor credit history if the lender believed the higher interest rate would more than compensate for the greater risk of default.

6.7

a. The key events that many economists believe led to the financial crisis were the following:     

The increased securitization of mortgage loans The increased availability of mortgage loans to subprime and Alt-A borrowers The investment in mortgage-backed securities by shadow banks Shadow banks financing their investment in long-term mortgage-backed securities with short-term loans The lack of supervision of shadow banks by government regulators

Answers will vary as to whether the events leading to the financial crisis should have been anticipated. In fact, few economists or policymakers did anticipate them. In particular, few economists or policymakers anticipated the dramatic decline in housing prices—by far the largest decline since the 1930s—that led to widespread defaults on mortgage loans. b. “Cheap loans” were encouraged by two government-sponsored enterprises—Fannie Mae and Freddie Mac—that sold bonds to investors and used the funds to buy mortgages from banks in

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secondary markets. By 2005, lenders were issuing many mortgages to subprime borrowers with flawed credit histories and Alt-A borrowers who were required to make only small down payments and who were not required to document their incomes in order to qualify for mortgage loans. The “American dream” that Fuld refers to is owning a home. 6.8

Case I (20 percent down payment) 0.20 × $150 000 = $30 000 down payment $165 000 – $150 000 = $15 000 profit on sale Your return on investment (ROI) = [$15 000/$30 000] × 100 = 50% Case II (5 percent down payment) 0.05 × $150 000 = $7 500 down payment ROI = [$15 000/$7 500] × 100 = 200%

6.9

a. During typical recessions, the Bank of Canada engages in expansionary monetary policy, cutting its target for the overnight interest rate to encourage consumption and investment. The most common Bank of Canada tool was using open market buyback operations. b. In both recessions, the Bank of Canada rapidly cut its target for the overnight interest rate nearly to zero and directly intervened in financial markets by buying securities, such as corporate bonds, that it typically doesn’t buy in conducting monetary policy. c. The Bank of Canada’s response to the Great Recession was to reduce the overnight interest rate. The Bank of Canada took more actions during the recession caused by the COVID-19 pandemic. The Bank’s response to the recession caused by the pandemic included creating new lending and credit facilities. By using these facilities, the Bank was able to ensure that funds flowed to firms and to provincial and local governments that might otherwise have had difficulty borrowing. The result was that the Canadian financial system largely avoided the credit crunch that had increased the length and severity of the 2007–2009 recession.

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Real-Time Data Exercises D11.1 a. See the following table:

CPI Inflation CPI-trim Inflation CPI-common Inflation

2020Q3

2021Q3

0.2% 1.7% 1.4%

4.1% 3.2% 1.8%

Inflation Rate Increase (year over year) 3.9% 1.5% 0.4%

b. The inflation rate using the headline CPI was highest at 4.1 percent, and the inflation rate using the CPI-common was the lowest at 1.8 percent. The measures of inflation differ because the price indexes include somewhat different goods and services and are not calculated in the same manner. D11.2 a. In the first quarter of 2012, the output gap was 0.1 percent, or the GDP was slightly above the potential GDP. Because the output gap was positive, we expect that the Bank of Canada increased the overnight interest rate during this period. b. In the third quarter of 2021, the output gap was -2.1 percent, or the GDP was 2.1 percent below the potential GDP. Because the output gap was negative, we expect that the Bank of Canada followed easy monetary policy. D11.3 Other than December 31, 2015, through January 3, 2016—when the effective federal funds rate was below the lower limit—and on September 17, 2019—when the effective federal funds rate was above the upper limit—the Fed has been able to keep the effective federal funds rate within the target range.

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Suggestions for Critical Thinking Exercises CT11.1 The Bank of Canada is the central bank of Canada and is able to control both the money supply and the level of interest rates. The interest rate the Bank controls is the overnight interest rate, which influences other interest rates in the economy, such as those on car loans and home mortgages. The Bank has influence over these rates, and when they rise or fall, private spending changes and, in turn, employment also changes. So, the Bank of Canada can have a substantial effect on the level of employment in the economy even though it directly hires very few people. CT11.2 a. Answers may vary depending on the bank and the date when the student checks the rates in their financial institution. However, their answers will most likely show that the interest rates for home loans and auto loans are lower than credit card rates and personal loan rates. Home loans and auto rates have lower interest rates because these loans are secured by collateral (for example, the house or car that you plan to buy), while credit card loans and personal loans are not secured by collateral, so they are considered to be more risky. Moreover, the interest rate on loans with a shorter term may be lower than on loans with a longer term (for example, threeyear auto loans in comparison with five-year auto loans), particularly if interest rates are expected to rise in the future. b. The students will observe that interest rates that banks pay when they borrow from each other or from the Bank of Canada are lower than the interest rates that the banks charge consumers who borrow from them. Banks accept more risk when they lend to consumers than when they lend to each other, and banks have higher costs to administer loans to consumers. Banks also need to charge a higher interest rate than the overnight interest rate because banks also need to make a profit from the loans.

CHAPTER 12 | Fiscal Policy SOLUTIONS TO END-OF-CHAPTER EXERCISES 12.1

What Is Fiscal Policy? Learning Objective: Define fiscal policy.

Review Questions 1.1 Fiscal policy is any change in government spending or taxation with the explicit goal of affecting the economy in either the short or the long run. Parliament and provincial legislative assemblies are responsible for fiscal policy. 1.2 Fiscal policy involves changes in government purchases and taxes. Monetary policy involves changes in the money supply and interest rates. Both are intended to achieve macroeconomic policy objectives. 1.3 Federal purchases refer to federal spending where the federal government receives a good, such as a new jet fighter or building, or a service, such as the services of an RCMP officer, in return. Federal expenditures include federal purchases plus interest on the national debt, grants to provincial and local governments, and transfer payments. Federal government expenditure rose as a share of GDP in response to the global recession linked to the global financial crisis that began in 2007.

Problems and Applications 1.4 Fiscal policy refers to changes in government purchases and taxes that are intended to achieve macroeconomic policy objectives, such as high employment, price stability, and high rates of economic growth. Because the BC government is paying for cars with low gas mileage, government spending has definitely increased. Whether or not this program is an example of fiscal policy depends on the goals the BC government had in mind when launching the program. If the goals included increasing employment and stimulating economic growth, then this program is an example of fiscal policy. If the goal was to reduce pollution by replacing poor-mileage cars with more fuel-efficient ones, then this is an example of environmental policy and not fiscal policy. In reality, most policies have many objectives. 1.5 This should not be considered a part of fiscal policy. The purchase was made to help provincial governments deal with the expected increase in severe cases of COVID-19, not in pursuit of a macroeconomic objective. 1.6 No, these payments are not made as part of an effort to meet a macroeconomic target. The specific programs the borrowed funds were used for (Canada Emergency Response Benefit, Canada Emergency Wage Subsidy, etc.) may have been fiscal policy, but the interest payments are not.

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The Effects of Fiscal Policy on Real GDP and the Price Level 12.2 Learning Objective: Explain how fiscal policy affects aggregate demand and how the government can use fiscal policy to stabilize the economy.

Review Questions 2.1 An expansionary fiscal policy is a decrease in taxes or an increase in government purchases intended to increase aggregate demand. A contractionary fiscal policy is an increase in taxes or a decrease in government purchases intended to decrease aggregate demand. 2.2 If policymakers decide to implement an expansionary fiscal policy, then they should raise government spending or lower taxes. If they decide to implement a contractionary fiscal policy, then they should lower government spending or raise taxes. 2.3

a. The expansionary fiscal policy shifts the aggregate demand curve to the right. Real GDP will increase. b. The increase in real GDP will decrease the unemployment rate. c. The shift of the aggregate demand curve to the right will increase the price level.

Problems and Applications 2.4 You should disagree. A decrease in taxes raises real GDP, and an increase in taxes lowers real GDP. The statements are incorrect because an expansionary fiscal policy involves a decrease instead of an increase in taxes, and a contractionary fiscal policy involves an increase instead of a decrease in taxes. 2.5 i.

Contractionary fiscal policy

ii. Not part of fiscal policy, but part of monetary policy instead iii. Expansionary fiscal policy iv. Expansionary fiscal policy for that province 2.6 The economy begins at the intersection of LRAS, SRAS, and AD1 (point A). The sharp decline in the demand for housing shifts AD to the left, from AD1 to AD2 (point B). Parliament and the prime minister can engage in an expansionary fiscal policy by increasing government spending and/or reducing taxes, to shift AD back to the right, from AD2 back to AD1.

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2.7 You should agree. Cutting taxes and increasing government purchases to stimulate a sluggish economy would be more popular than raising taxes and decreasing government purchases to slow down an economy that is growing too fast. 2.8

a. Without the stimulus package, the Japanese government expects short-run equilibrium to be at point A in the following graph, with real GDP below potential GDP.

b. The stimulus package will shift the aggregate demand curve to the right from Aggregate demand(without stimulus) to Aggregate demand(with stimulus), increasing real GDP in the new equilibrium represented by point B in the above graph. 2.9

The purpose of expansionary fiscal policy is to increase aggregate demand either by having the government directly increase its own purchases or by cutting taxes to increase household disposable income and, therefore, consumption spending. Increasing or decreasing government spending or taxes does not have a direct effect on the money supply. So, Parliament and the prime minister can carry out an expansionary fiscal policy without the money supply increasing.

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Fiscal Policy in the Dynamic Aggregate Demand and Aggregate 12.3 Supply Model

Learning Objective: Use the dynamic aggregate demand and aggregate supply model to analyze fiscal policy.

Review Questions 3.1 In the basic aggregate demand and aggregate supply model, an expansionary fiscal policy is illustrated by the aggregate demand curve shifting to the right, while neither the short-run aggregate supply curve nor the long-run aggregate supply curve shifts. In the dynamic model, the aggregate demand curve shifts to the right but by more than it would have in the absence of the expansionary policy. The shortrun aggregate supply curve and the long-run aggregate supply curve also shift to the right because the economy experiences increasing inflation and long-run growth. 3.2 In the basic aggregate demand and aggregate supply model, a contractionary fiscal policy is illustrated by the aggregate demand curve shifting to the left, while neither the short-run aggregate supply curve nor the long-run aggregate supply curve shifts. In the dynamic model, the aggregate demand curve shifts to the right, but by less than it would have in the absence of the contractionary policy. The shortrun aggregate supply curve and the long-run aggregate supply curve both shift to the right because the economy experiences increasing inflation and long-run growth. So, in the basic aggregate demand and aggregate supply model, a contractionary fiscal policy will cause a decline in both real GDP and the price level. In the dynamic aggregate demand and aggregate supply model, a contractionary fiscal policy will cause real GDP and the price level to increase by less than they would have in the absence of the policy.

Problems and Applications 3.3 a. The value of real GDP in year 2 will be $1.51 trillion and the price level will be 110.5. b. The government could conduct expansionary fiscal policy by increasing spending or reducing taxes. c. Without expansionary fiscal policy, the inflation rate between year 1 and year 2 will be 110.5 − 110 × 100% = 0.45% . With the expansionary fiscal policy, the inflation rate will be 110 112 − 110 × 100% = 1.8% . 110 3.4 a. Since real GDP is below potential GDP in 2022, the federal government should use expansionary fiscal policy to keep real GDP at its potential level. Expansionary policy includes increasing government spending and/or decreasing taxes. b. If Parliament is successful in keeping real GDP at its potential level, real GDP will increase, potential GDP will not change, the inflation rate will increase, and the unemployment rate will decrease. c. Without policy, aggregate demand shifts from AD2021 to AD2022 (without policy). Real GDP is $1.50 trillion and the price level is 111.5 (point B). With policy, aggregate demand shifts from AD2021 to AD2015(with policy). Real GDP is $1.54 trillion and the price level will be higher than 111.5. (On the graph, it is shown at 112, represented by point C.)

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3.5

The economy does not have to be in a recession during 2022 for deflation to take place. As is shown on the following graph, aggregate demand increases from 2021 to 2022, but the shift to the right in short-run aggregate supply is greater than the shift to the right in aggregate demand, resulting in an increase in real GDP but also a decrease in the price level (point A to point B).

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12.4

Government Purchases and Tax Multipliers Learning Objective: Explain how government purchases and tax multipliers work.

Review Questions 4.1 A $1 increase in government purchases initially increases real GDP and national income by $1. The $1 increase in national income increases consumption spending by, say, $0.50. The $0.50 increase in consumption spending increases income, which increases consumption spending again. The process continues as increases in income lead to increases in consumption spending, which lead to increases in income, which lead to increases in consumption spending, and on and on. This process is referred to as the multiplier effect. 4.2 The government purchases multiplier is the ratio of the change in equilibrium real GDP to the change in government purchases. The tax multiplier is the ratio of the change in equilibrium real GDP to the change in taxes. 4.3 At each round of the multiplier process, a higher income tax rate reduces the amount of income after taxes, or disposable income, that households receive. The lower disposable income reduces additional consumption at each round of the multiplier process, decreasing the multiplier effect.

Problems and Applications 4.4 Government construction projects represent an increase in government purchases, which increases aggregate demand, stimulating the economy in the short run. The “ripple effect” means the multiplier effect. 4.5 a. To bring the economy to equilibrium at potential GDP, government purchases need to be increased by ($1.35 − $1.31)/2 = $0.02 trillion. b. To bring the economy to equilibrium at potential GDP, taxes need to be decreased by ($1.35 − $1.31)/1.6 = −$0.025 trillion. c. One example is to increase government purchases by $100 billion and decrease taxes by $125 billion. 4.6 a. MPC = 0.6, which is reasonable, likely even a low estimate for a typical Canadian city. b. MPC = 1, which is unreasonable, as no city completely generates absolutely zero savings. 4.7 Many economists believe that consumers base their spending on their permanent income rather than just on their current income. A consumer’s permanent income reflects their expected future income. By basing spending on permanent income, a consumer can smooth out consumption over a period of years. The longer the time period for which a change in taxes is in effect, the more consumers are likely to accept this change as having a permanent effect on their income and therefore adapt their consumption to reflect the change in taxes. For example, one-time tax rebates, such as the one in 2008, increase consumers’ current income but not their permanent income. Only a permanent decrease in taxes increases consumers’ permanent income. Therefore, a tax rebate is likely to increase consumption spending less than would a permanent tax cut. The tax multiplier effect will therefore be greater after two years than after just one year, when a tax decrease is viewed as being permanent.

CHAPTER 12 | Fiscal Policy 133 4.8 There are a number of different reasons for this. One key reason is that infrastructure projects add to a country’s productive capacity as soon as they’re finished and for years into the future. In this way, governments can not only move the aggregate demand curve but the long-run aggregate supply curve as well. Another important reason why infrastructure projects are a popular option for stimulus packages is that the spending is temporary. Once a new road is built, government spending can return to its pre-stimulus level (or at least close to it). 4.9 You should disagree with the statement. The $30 billion change in government spending or taxation is too large. A decrease in government spending of $30 billion would cause GDP to fall from $1.65 trillion to less than $1.62 trillion. 4.10

Keynes was describing the multiplier effect. By repercussions, he meant the rounds of spending and new production set off by an initial increase in autonomous expenditure. Keynes believed that the government purchases multiplier was about 10. Therefore, even wasteful government spending would result in a substantial increase in the production of goods and services and in employment.

4.11

a. The size of the government purchases multiplier is different from the size of the tax multiplier. So, the size of the multiplier depends on the type of fiscal policy—changes in government purchases or changes in taxes—that is used. b. When real GDP is close to potential GDP, an increase in government purchases or a cut in taxes may have a greater effect on the price level than on real GDP. When real GDP is far away from potential GDP, an increase in government purchases or a cut in taxes may have a greater effect on real GDP than on the price level.

12.5

The Limits of Fiscal Policy as a Stimulus Learning Objective: Discuss the difficulties that can arise in implementing fiscal policy.

Review Questions 5.1 Monetary policy can be changed more quickly than fiscal policy. The Bank of Canada can change monetary policy at any of its meetings, which are scheduled to occur eight times per year—or more frequently, if need be. Fiscal policy has to go through the legislative process of the prime minister, cabinet, and legislature approving a fiscal policy action. Even once approved, it takes time to implement the fiscal policy change. 5.2 Crowding out refers to a decline in private expenditures—consumption, investment, and net exports—as a result of an increase in government purchases. In the short run, an increase in government purchases results in partial crowding out of private expenditures, but in the long run, a permanent increase in government purchases results in the complete crowding out of private expenditures.

Problems and Applications 5.3 Managing the economy and trying to completely offset recessions is virtually impossible. In many cases, the federal government can’t tell the economy is in recession until well after the fact. This makes offsetting each and every reduction in aggregate demand impossible. This is often described as trying to drive down the highway by only looking in the rear view mirror.

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5.4 “Heavy public debt” means a large government debt relative to the size of the economy. Heavy public debt might lead to insolvency in that the country’s government might default on the debt. A large and rising debt pushes up the interest rates on the debt, making it more difficult for the government to make the interest payments on the debt. At some point, a country may choose to default on the debt rather than raise taxes or cut government spending sufficiently to substantially reduce the debt. 5.5 An expansionary fiscal policy will, by itself, tend to cause the equilibrium rate of interest to increase. An expansionary monetary policy will cause the equilibrium rate of interest to decrease. An expansionary monetary policy will therefore lessen the effect of crowding out in the short run. 5.6 Ruhm’s findings that average health improves during a recession suggest less need for medical care (and thus medical spending) during a recession. 5.7

a. This outcome will most likely occur if investment spending is crowded out because accumulating more machinery, equipment, and buildings increases economic growth. b. Increased spending on infrastructure such as highways and bridges may aid economic growth, whereas increased spending on national parks is unlikely to do so.

Deficits, Surpluses, and Federal Government Debt

12.6 Learning Objective: Define federal budget deficit and federal government debt and explain how the federal budget can serve as an automatic stabilizer.

Review Questions 6.1 When actual GDP falls below potential GDP, households and firms pay less in taxes to the federal government and the federal government makes more transfer payments to the unemployed. These changes in taxes and transfer payments make the decline in income smaller than it would otherwise be, which results in a smaller decline in consumption spending. With aggregate demand not declining by as much as it otherwise would, the decline in GDP is reduced. When actual GDP increases above potential GDP, households and firms pay more in taxes and the federal government makes fewer transfer payments. These changes reduce the increase in income that would otherwise take place, which results in a smaller decline in consumption spending. With aggregate demand not increasing by as much as it otherwise would, the increase in GDP is reduced. 6.2 The cyclically adjusted budget deficit or surplus measures what the budget deficit or surplus would be if the economy were at potential GDP. A recession would decrease government tax revenues and increase government spending on transfer payments, which would lead to a federal budget deficit. 6.3 Balancing the government’s budget during a recession would require raising taxes or reducing government purchases. These actions would reduce aggregate demand and make the recession worse. 6.4 The federal budget deficit is the annual amount by which federal government expenditures exceed federal tax revenues. To finance the budget deficit, the government must borrow funds by selling bonds. The national debt is the accumulation of past budget deficits minus past budget surpluses and equals the total value of government securities outstanding.

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Problems and Applications 6.5 a. Faster. An economy growing faster than expected would result in more tax revenues and less government spending on transfer payments. b. Yes, because it shows that it is difficult to forecast the performance of the economy well enough to accurately forecast the state of the federal budget. 6.6 Requiring that the budget be balanced in each and every year rules out countercyclical fiscal policy. There are times when it may not make sense to pursue a balanced budget at the expense of all other policy objectives. The year 2009 in BC was quite likely one of those times. 6.7 In the long run, large federal deficits and the resulting increase in the federal debt can pose a problem. Crowding out of investment spending may occur if an increasing debt drives up interest rates. Lower investment spending means a lower capital stock in the long run and a reduced capacity of the economy to produce goods and services. Government debts typically mean higher taxes, lower spending, or higher inflation at some point in the future. As a result, large and sustained government deficits can discourage investment without increasing the interest rate. Provincial governments can “rein in” the provincial budget deficit by decreasing government purchases or increasing taxes. 6.8 A reduction in US government spending would likely cause the US economy to shrink (at least in the short run). This would reduce Americans’ demand for imports, many of which come from Canada. This will reduce demand for Canadian products and could potentially lead to a Canadian recession. 6.9 It doesn’t necessarily tell us anything. Government revenues from income taxes rise when the economy grows, and expenditures shrink when the economy grows. As a result, the increase in surplus could have been due to economic growth alone. 6.10

An excessive budget deficit would be a budget deficit that would be unsustainable in the long run and raise the risk that the government could default on its debt. Judging whether a budget deficit is excessive depends on whether the country is in a recession. If the recession is the primary reason for the budget deficit, then the budget deficit will decline as the economy returns to full employment. Budgetary policies that could be used to reduce a budget deficit are a decrease in government spending and an increase in taxes.

6.11

When a country enters a recession, tax revenues decrease as household incomes and business profits fall. Government payments for unemployment benefits and other transfer programs increase government spending. The typical result is a budget deficit, or an increase in the government’s existing deficit. Governments don’t usually respond to recessions with budget cuts. Increasing taxes and cutting government purchases to cut the budget reduces aggregate demand and makes the recession worse. The Greek budget cuts were part of the bailout deal by the European Union and the International Monetary Fund to aid Greece with its sovereign debt crisis. Otherwise, the Greek government is unlikely to have taken these actions.

6.12

a. “Budget balances” mean the relationship between a government’s expenditures and its tax revenues—in other words, its budget surplus or budget deficit. b. Yes. Budget deficits increase the government debt. Large budget deficits raise the debt-to-GDP ratios when budget deficits increase the government debt at a faster rate than nominal GDP rises.

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12.7

The Effects of Fiscal Policy in the Long Run Learning Objective: Discuss the effects of fiscal policy in the long run.

Review Questions 7.1 Supply-side economics refers to fiscal policy actions intended to have long-run effects by expanding the productive capacity of the economy and increasing the rate of economic growth. 7.2 The “tax wedge” is the difference between the pretax and posttax return to an economic activity.

Problems and Applications 7.3 The tax laws are used for many purposes, including encouraging certain activities and discouraging others. This is a main reason for the complexity of the tax laws. 7.4 The increase in marginal tax rates would cause both aggregate demand and long-run aggregate supply to decline relative to what they would have been in the absence of the tax increase. As a result, equilibrium real GDP will be lower relative to what it would have been in the absence of the tax increase and the equilibrium price level will be higher. The effect on real GDP will be larger and the effect on equilibrium price level will be smaller than if the tax increase had affected only aggregate demand, leaving long-run aggregate supply unchanged. 7.5 Brett is arguing that corporate taxes may have significant supply-side effects, but not other forms of taxation. Supply-side effects can have an impact on economic activity only if the economy is supplyconstrained and people are free to increase their supply. In many cases, workers have to work 40 hours a week or less. If there are no opportunities to work more hours, reducing the rate of income tax will have no effect. 7.6 People and businesses in countries like Canada and the United States already have made large investments in setting up the infrastructure to deal with the progressive income tax system and its deductions. Former Soviet Union countries would have to set up that infrastructure from scratch. As a result, opting for a simpler (and thus lower compliance cost) system is more appealing. 7.7

A cut in marginal tax rates increases the incentives to work, save, invest, and start a business. If the cut in marginal tax rates increases economic activity and income enough, total taxes collected can increase even with the lower tax rates. The “behavioural response” refers to the idea that marginal tax rates influence people’s behaviour by changing their incentives to work, save, invest, and start a business.

Suggestions for Critical Thinking Exercises CT12.1 You should ask students to refer again to Chapter 11, Table 11.1, “Expansionary and Contractionary Monetary Policies.” The first two boxes in the table would be replaced with either a change in taxes or a change in federal expenditures, which would then affect aggregate expenditures, specifically consumption and investment for fiscal policy and AE directly for government expenditures. CT12.2 The value of the government purchases multiplier if there were complete crowding out would be zero as, ultimately, an increase in G leads to no change in real GDP.

CHAPTER 13 | Inflation, Unemployment, and

Bank of Canada Policy

SOLUTIONS TO END-OF-CHAPTER EXERCISES The Discovery of the Short-Run Trade-off between Unemployment and 13.1 Inflation Learning Objective: Describe the Phillips curve and the nature of the short-run trade-off between unemployment and inflation.

Review Questions 1.1 The Phillips curve is a curve showing the short-run relationship between the unemployment rate and the inflation rate.

1.2 The Bank of Canada would undertake an expansionary monetary policy, which would increase aggregate demand, causing both real GDP and the price level to increase. An increase in real GDP will increase employment, lowering the unemployment rate. 1.3 The Phillips curve had been stable during the 1960s, so it appeared that policymakers could permanently reduce unemployment if they were willing to accept permanently higher inflation. Economists were wrong to think of the Phillips curve as a policy menu because the long-run Phillips curve is a vertical line at the natural rate of unemployment. In other words, the Phillips curve does not represent a policy menu because in the long run there is no trade-off between unemployment and inflation.

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1.4 The late Milton Friedman argued that in the long run the unemployment rate would equal the natural rate of unemployment, which is the unemployment rate that exists when the economy is at potential GDP. Just as the price level does not affect real GDP in the long run because real GDP will be at potential GDP, the inflation rate does not affect the unemployment rate in the long run because the unemployment rate will be at the natural rate of unemployment.

Problems and Applications 1.5 a. A “tight labor market” is a labour market with a very low unemployment rate, usually lower than the natural rate of unemployment. b. With a downward-sloping short-run Phillips curve, a fall in the unemployment rate will increase the inflation rate. If for a given decrease in the unemployment rate, there is a smaller increase in the inflation rate, the short-run Phillips curve must be flatter than if the decrease in the unemployment rate resulted in a larger increase in the inflation rate. c.

If the Phillips curve is steep, a small decrease in the unemployment rate will cause a much larger increase in the inflation rate than would be the case with a flat Phillips curve.

1.6 a. Point E on the Phillips curve graph best represents the same economic situation as point B on the aggregate demand and aggregate supply graph because the smaller increase in aggregate demand results in an inflation rate of 2 percent (= [123.4 – 121.0]/121.0 × 100]), a lower level of real GDP (compared with point C), and a higher level of unemployment. b. Point D on the Phillips curve graph best represents the same economic situation as point C on the aggregate demand and aggregate supply graph because the larger increase in aggregate demand results in an inflation rate of 4 percent (= [125.8 – 121.0]/121.0 × 100]), a higher level of real GDP (compared with point B), and a lower level of unemployment. 1.7 The aggregate demand and aggregate supply model and the Phillips curve provide two different ways of illustrating the same macroeconomic events, but the Phillips curve has an advantage when we want to explicitly analyze changes in the inflation rate and the unemployment rate, which are not directly shown on an aggregate demand and aggregate supply graph. 1.8 In the 1960s, the Phillips curve was widely viewed as a stable relationship representing a menu of policy choices between low inflation and high unemployment and between high inflation and low unemployment. A party that cares primarily about price stability would want low inflation at the cost of high unemployment, and the other party that cares more about keeping unemployment low would be willing to accept higher inflation. Today, the Phillips curve is not viewed as a policy menu, and most economists believe that in the long run there is no trade-off between inflation and unemployment. 1.9 Negotiations between a union such as the CAW and General Motors, or any other company, usually take considerable amounts of time. Annual negotiations would impose a much greater time commitment on both parties than is required for three-year contracts. Multi-year contracts also provide a greater amount of certainty for workers and firms, particularly when inflation rates have been low and stable in the recent past. Some multi-year contracts include a cost-of-living adjustment (COLA) that increases wages by an agreed amount (for example, 2 or 3 percent annually) plus an amount equal to the percentage increase in prices (this is often based on changes in the consumer price index) in the previous year. The COLA helps insulate companies and union members from the effects of unanticipated changes in the rate of inflation.

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1.10 If inflation is higher than households and firms had expected, then real wages will be lower than expected. The lower real wage will cause employment to be higher in the short run than it would be with a higher real wage because firms will increase the quantity of labour that they will demand. In the long run, households and firms will adjust to the higher inflation and employment will return to its full-employment level. 1.11 As discussed in Apply the Concept: Do Workers Understand Inflation?, there is some evidence that the general public does not think that nominal wages keep up with inflation, which means real wages fall. If this conclusion was correct, inflation would be a more important problem than most economists believe it is. 1.12 Inflation is caused by movements in aggregate demand and aggregate supply, not by greed. If greed causes inflation, then fluctuations in the inflation rate would be caused by fluctuations in the extent of greed in the economy. It’s implausible that the extent of greed in the economy fluctuates as much as the inflation rate does.

13.2 The Short-Run and Long-Run Phillips Curves

Learning Objective: Explain the relationship between the short-run and long-run Phillips curves.

Review Questions 2.1 Along the short-run Phillips curve, the expected inflation rate is constant. When the expected inflation rate changes, the short-run Phillips curve shifts. The long-run Phillips curve is a vertical line at the natural rate of unemployment. The short-run Phillips curve intersects the long-run Phillips curve at the expected inflation rate. If the expected inflation rate increases from 2 percent to 3 percent, the short-run Phillips curve would shift up so that it intersects the long-run Phillips curve at a 3 percent inflation rate. 2.2 A vertical long-run aggregate supply curve implies that changes in the price level—inflation—do not change potential GDP and the natural rate of unemployment. In order for the long-run Phillips curve to be downward sloping, changes in the price level (inflation) would have to affect the unemployment rate in the long run.

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Problems and Applications 2.3

2.4 A movement from point A to point B would be caused by a decline in aggregate demand—this decline could result from contractionary monetary policy—that decreased the inflation rate and increased the unemployment rate, without changing the expected inflation rate. A movement from point A to point C would be caused by a decrease in the expected inflation rate. 2.5 Because there is no trade-off in the long run between unemployment and inflation, Herbert Stein’s statement is correct. Most economists in 1968 believed that there was a long-run trade-off between unemployment and inflation, so they would not have agreed with Stein’s statement. 2.6 a. Graph 3 matches because a decrease in the proportion of younger and less-skilled workers in the labour force decreases the natural rate of unemployment, shifting the long-run and short-run Phillips curves to the left. b. Graph 4 matches because expansionary monetary policy increases the inflation rate and decreases the unemployment rate. c.

Graph 1 matches because significant new legal barriers to firing workers increases the natural rate of unemployment, shifting the long-run and short-run Phillips curves to the right.

d. Graph 2 matches because a decrease in the expected inflation rate shifts the short-run Phillips curve downward. 2.7 a. When an economy experiences a severe recession, we would expect workers in occupations that require greater skills or training would have less difficulty in finding a job after the recession ends because the greater the skills a worker has, the fewer other workers who are able to compete with the worker for job openings. However, if these skilled occupations have experienced a permanent reduction in the number of workers employed—for instance, if skilled bricklayers were being replaced by bricklaying machines or a declining number of newspapers was reducing the number of journalism jobs available—then workers with these skills will have difficulty being employed unless they acquire new skills or accept employment in an unskilled job. The research by Victor Copyright © 2024 Pearson Canada Inc.

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Ortego-Marti also indicates that if technical workers are unemployed for a significant period during a severe recession, their skills may decline. In that case, the normal advantages that skilled workers have in finding new jobs may shrink or even disappear for workers in these occupations. Additional information on the effect of the recession on different occupations would make it easier to answer the question. b. If jobs in Canada require increasing amounts of skill, unskilled workers may have greater difficulty finding jobs. As a result, the level of structural unemployment may increase, thereby increasing the NAIRU. In these circumstances, the Bank of Canada may achieve its goals. 2.8 a. Flexibility of the labour market refers to the ability of firms to freely hire and fire workers and to set their wages; for workers to easily move among jobs; and for firms to be free to change the requirements of jobs without being hindered by government regulations or union contracts. A country with a more flexible labour market is likely to have a lower natural rate of unemployment and, therefore, a lower NAIRU than would a country with a less flexible labour market. Other factors, including the age structure of the population and the availability of employment insurance and other transfer payments also determine the NAIRU. b. When the unemployment rate drops below the natural rate of unemployment, firms have more difficulty in filling their job openings and are forced to pay a higher wage to attract more workers. The competition among firms to hire the remaining workers in the market will drive the wages up, increasing firms’ costs and causing firms to increase the prices of goods and services at a faster rate.

13.3 Monetary Policy and Expectations of the Inflation Rate

Learning Objective: Discuss how expectations of the inflation rate affect monetary policy.

Review Questions 3.1 Workers, firms, banks, and investors care about real, inflation-adjusted values. The future inflation rate affects real wages, real profits, and real interest rates. During periods of moderate and stable inflation, workers, firms, banks, and investors are most likely to form their expectations adaptively, basing them on the pattern of inflation rates in the recent past. During periods of high and unstable inflation, they are more likely to incorporate all available information, including current central bank policy. 3.2 Rational expectations mean that workers and firms form current expectations using not only information from the past but all available information. In forming expectations of inflation, rational expectations mean that workers and firms don’t use just information on recent inflation rates but also other information, such as knowledge of the central bank’s current monetary policy. 3.3 With rational expectations, workers and firms may correctly anticipate any change in the inflation rate caused by monetary policy. If the actual inflation rate equals the expected inflation rate, then the unemployment rate equals the natural rate of unemployment and the short-run Phillips curve is vertical. If the Phillips curve is vertical in the short run, then expansionary monetary policy cannot reduce the unemployment rate even in the short run.

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Problems and Applications 3.4 Rational expectations are likely to give the more accurate forecasts. When inflation is increasing over time, adaptive expectations that rely on only past information will always result in a forecast of a lower inflation rate than the actual inflation rate will turn out to be. 3.5 a. The economic framework that Lucas’s arguments changed was that workers and firms formed their expectations adaptively, without taking into account the likely effects of monetary policy. Lucas argued that if expansionary monetary policy was anticipated and credible, and if workers and firms had rational expectations, they would adjust their expectations of inflation so that there would be no decrease in unemployment. b. Many economists do not agree with Lucas’s main conclusion that anticipated monetary policy will not affect the unemployment rate because they believe that workers and firms may not have rational expectations, and wages and prices may not be able to adjust rapidly to an unexpected change in inflation. 3.6 This characterization of Lucas’s position is accurate because Lucas argued that people have rational expectations and will make use of all available information about whatever economic variable they are interested in. So, for instance, the Bank of Canada would be unable to permanently expand output and reduce unemployment by keeping the inflation rate higher than workers and firms expect. Workers and firms would incorporate information on Bank of Canada policy into their expectations of future inflation, making ineffective the Bank’s attempt to run an expansionary monetary policy by “tricking” people. 3.7 a. Lucas, Sargent, and Prescott all belong to the new classical macroeconomics school of thought because they share the assumptions that people have rational expectations and that wages and prices adjust rapidly. b. Stabilizing the economy means the Bank of Canada implements policies that result in real GDP being equal to potential GDP, reducing the severity of—or even eliminating—the business cycle. The new classical economists doubt the central bank’s ability to stabilize the economy because they believe that change in “real” factors, such as technology shocks, and not monetary policy, explain movements in real GDP. 3.8 a. The reasoning is that an unanticipated increase in inflation will lower the real wage below its expected level. As a result, firms will hire more workers and increase output. Therefore, an unanticipated increase in inflation will have led to economic growth. b. If the increase in inflation is unanticipated, then the actual real wage will be below its expected level and employment and output are likely to increase. If the increase in inflation was anticipated, then firms and workers would have taken it into account when bargaining over real wages. As a result, the increase in inflation would not result in a decrease in the expected real wage or an increase in employment. Some economists would argue, though, that even an anticipated increase in inflation can cause a decline in the real wage if workers and firms have entered multi-year wage contracts.

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13.4

143

Bank of Canada Policy from the 1970s to the Present Learning Objective: Use a Phillips curve graph to show how the Bank of Canada can permanently lower the inflation rate.

Review Questions 4.1 The reduction in the inflation rate from above 5 percent in 1979 to 2 percent in 1993 brought about by contractionary monetary policy is known as the “Canadian disinflation.” The disinflation was accompanied by recession, as the unemployment rate increased from about 7.5 percent to 11.4 percent. 4.2 The credibility of policy announcements is important for the effectiveness of monetary policy because a more credible policy allows the Bank of Canada to have a greater effect on the expected inflation rate. In particular, a credible policy of disinflation will cause the short-run Phillips curve to shift down more rapidly than if the policy is less credible, thereby making the increase in the unemployment rate smaller and more short-lived. 4.3 The main reason to keep a country’s central bank independent of the rest of the government is to avoid inflation. Whenever a government is spending more than it is collecting in taxes, it must borrow the difference by selling bonds. The governments of many developing countries have difficulty finding anyone other than their central bank to buy their bonds. The more bonds the central bank buys, the faster the money supply grows, and the higher the inflation rate will be. Another fear is that if the government controls the central bank, it may use that control to further its political interests. It is difficult in any democratic country for a government to be re-elected at a time of high unemployment. If the government controls the central bank, it may be tempted just before an election to increase the money supply and drive down interest rates to increase production and employment, thereby increasing the risk of inflation.

Problems and Applications 4.4 a. A supply chain is a network of firms that are involved in the production and sale of a good or service. b. i. A demand shock that decreases aggregate demand will result in a higher unemployment rate. A supply shock that decreases aggregate supply will also result in a higher unemployment rate. ii. A demand shock that decreases aggregate demand will result in a lower inflation rate. A supply shock that decreases aggregate supply will result in a higher inflation rate. iii. A demand shock that decreases aggregate demand will result in a decline in real GDP (relative to what real GDP would have been in the absence of the shock). A supply shock that decreases aggregate supply will also result in a decline in real GDP (relative to what real GDP would have been in the absence of the shock). c.

You should agree. A negative supply shock forces the Bank of Canada to choose between (1) stimulating aggregate demand to reduce the unemployment rate, but thereby making the inflation rate worse, and (2) decreasing aggregate demand to reduce the inflation rate, but thereby making the unemployment rate worse. With a negative aggregate demand shock, the Bank of Canada can focus on stimulating aggregate demand to restore both the unemployment rate and the inflation rate to their previous levels.

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4.5 Not according to the usual definition of disinflation. There was deflation in 1933 because the price level in 1933 was lower than the price level in 1932. Disinflation refers to a situation in which the inflation rate declines. 4.6 To reduce the inflation rate from 4 percent to 3 percent, the Bank of Canada will have to raise its target for the overnight interest rate. Higher interest rates will reduce aggregate demand, raise unemployment, and cause a movement down the initial short-run Phillips curve, where the expected inflation rate is 3 percent (see arrow 1 on the following graph). As unemployment stays above the full-employment level at U1 and the actual inflation rate is 3 percent, workers and firms will lower their expectations of future inflation, and the short-run Phillips curve will shift to the left (see arrow 2 on the graph). With the new short-run Phillips curve, the unemployment rate will be back at the natural rate of unemployment of 4 percent, and workers and firms will expect the inflation rate to be 3 percent.

4.7 a. Many economists wondered whether the short-run Phillips curve trade-off between unemployment and inflation still holds because the unemployment rate has fallen without resulting in much increase in the inflation rate. b. Some economists note that the short-run Phillips curve trade-off still exists for wage inflation, although not for price inflation, raising the possibility that firms are no longer passing higher wage costs through to higher price increases to the extent that they did in previous decades. Some economists and policymakers argue that there may be more slack in the labour market for a given unemployment rate than was true in earlier years. If this slack in the labour market eventually disappears, the short-run relationship between inflation and unemployment may begin to show a more typical Phillips curve pattern. 4.8 a. The output gap is the percentage difference between real GDP and potential GDP, and it is difficult to estimate potential GDP. b. A preannounced rule, such as the Taylor rule, sets the target for the federal funds rate by a chosen weight between 0 and 1 multiplied by the output gap, such as, 0.5 × output gap. Differences in the estimate of the output gap lead to different targets for the federal funds rate. In conducting Copyright © 2024 Pearson Canada Inc.

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monetary policy, recent Fed chairs have preferred to rely on measures of tightness in labour markets and trends in the underlying rate of inflation rather than on a mechanical rule.

Real-Time Data Exercises Note: FRED and the Bank of Canada continue to update data. The solutions below contain the data available on the first quarter of 2021. D13.1 a. During this period the output gap was negative. b. Although the output gap was negative, it has been decreasing. The expectation is that it will keep on decreasing as the economy recovers from the COVID-19 recession. It is also to be noted that the output gap is the percentage difference between real GDP and potential GDP, and it is difficult to estimate potential GDP. D13.2 See the plot in the following graph of the annual unemployment rate and the annual inflation rate since 1962.

Source: fred.stlouisfed.org a. For the 1966–1969 period, the unemployment rate declined and the inflation rate rose, which implies an upward movement along the short-run Phillips curve. b. For the 1973–1975 period, both the unemployment rate and the inflation rate rose, which implies that the short-run Phillips curve shifted upward. c. For the 1992–1994 period, both the unemployment rate and the inflation rate declined, which implies that the short-run Phillips curve shifted downward. d. For the 2000–2002 period, the unemployment rate rose and the inflation rate declined, which implies a movement down along the short-run Phillips curve.

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D13.3 See the plot in the following graph of consumers’ expectations of the inflation rate and the actual inflation rate as measured by the consumer price index. Consumers did a good job forecasting the inflation rate in the mid-1990s and mid-2000s. Consumers did a poor job forecasting the inflation rate in the late 1970s and early 1980s when the expected inflation rate was lower than the actual inflation rate and between 2009 and 2020 when the expected inflation rate was typically higher than the actual inflation rate. Consumer expectations of the inflation rate tend to be less volatile than the actual inflation rate.

Source: fred.stlouisfed.org

Suggestions for Critical Thinking Exercises CT13.1 Answers may vary, but many students will cite unemployment and inflation rate data for OECD countries from the FRED website. Countries like the United States, Germany, and Japan have low inflation rates and unemployment rates that are between 3 percent and 6 percent. Other countries, like France and Italy, have low inflation rates but unemployment rates close to 10 percent. For these countries, students may suggest that their central banks conduct expansionary monetary policy to lower their unemployment rates. (In the case of France and Italy, their governments would have to convince the European Central Bank to follow such policies because countries that use the euro cannot conduct independent monetary policies.) CT13.2 a. Every five years, the Bank of Canada and the government of Canada review the country’s monetary policy framework. In December 2021, the Bank and the government agreed to continue the flexible inflation-targeting framework. They agreed that the Bank of Canada would target the inflation rate (based on headline CPI) between 1 percent and 3 percent for another five years, until December 2026. b. In general, economists and policymakers have supported the agreement, because the flexible inflation-targeting framework is well understood by the public and delivered low and stable inflation rates for over 30 years, allowing Canadians to better plan for their future. c. There was not really opposition to the agreement, but recommendations for alternative monetary policy frameworks could include, for example, average inflation targeting or nominal GDP growth targeting.

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SOLUTIONS TO END-OF-CHAPTER EXERCISES 14.1 The Balance of Payments: Linking Canada to the International Economy Learning Objective: Explain how the balance of payments is calculated.

Review Questions 1.1

Leaving aside the statistical discrepancy and the capital account, both of which are small for Canada, the current account plus the financial account equals the balance of payments, which always equals zero.

1.2

The current account balance includes net exports plus net income on investments and net transfers.

1.3

a. The current account records (1) the value of a country’s net exports (exports of goods and services minus imports of goods and services); (2) net income on investments (income received on foreign investments minus income payments on investments); and (3) net transfers. b. The following answers explain why in each case a country is likely to have a deficit in its current account. Note that because net exports are part of a country’s current account, anything that causes net exports to become negative makes it more likely, holding other factors constant, that the country will have a deficit in its current account. i.

A higher price level would make a country’s exports more expensive and its imports less expensive.

ii. Higher interest rates would increase a country’s exchange rate, which would make the prices of its exports higher in foreign currencies and the prices of its imports lower in domestic currency. iii. Lower import barriers would encourage firms and households in the country to increase their imports. iv. More attractive investment opportunities would increase foreign demand for the country’s currency, thereby increasing the country’s exchange rate. A higher exchange rate will decrease net exports.

Problems and Applications 1.4

With a current account deficit of €44.3 billion in 2020, France would have experienced a net capital inflow because having a current account deficit means that France must have run a financial account surplus. A country running a financial account surplus experiences a net capital inflow.

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1.5

The best way to answer this question is by placing the values given into a table in a format similar to that of Table 14.1: Current Account Exports of goods Imports of goods Balance of trade Exports of services Imports of services Balance of services Income received on investments Income payments on investments Net income on investments Net transfers Balance on current account Financial Account Increase in foreign holdings of assets in the United States Increase in US holdings of assets in foreign countries Balance on financial account Balance on Capital Account

$856 −1108 325 –256 392 –315

–252 69 77 –60 –166

1181 –1040

Statistical discrepancy Balance of payments

141 0 25 0

1.6

The reason Germany’s current account surplus was larger than its trade surplus is that the sum of the other components in the current account, other than trade, was positive. These components are the balance of services, net investment income, and net transfers. A trade surplus of €193 billion and a current account surplus of €233 billion implies that the sum of the balance of services, net investment income, and net transfers was a surplus of €40 billion. Leaving aside the balance on the capital account and the statistical discrepancy, a current account surplus of €233 billion would mean a financial account deficit of €233 billion.

1.7

a. By “foreign-trade gap” the article meant the trade balance. In this case, a widening of the trade gap meant that US imports of goods had increased relative to US exports of goods. b. The United States usually sells more services to other nations than it buys from them, and so the United States runs a positive balance on services This positive balance on services helps offset the usual negative balance on trade in goods, so a smaller positive balance on services would not offset as much of the negative balance on goods and, therefore, widen the overall US foreign trade gap.

1.8

When a country runs a current account surplus, it must also run a financial account deficit. When a country runs a financial account deficit, capital inflows—foreign direct investment and foreign portfolio investment—are less than capital outflows. These countries use often use some of their current account surplus to buy foreign government bonds. So, the article is correct in making these two statements.

1.9

Disagree. The observation confuses the capital account with the financial account. With a current account deficit, the United States must have a financial account surplus.

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When the country experiences current account deficits, it is also experiencing financial account surpluses. A financial account surplus represents a net capital inflow—the country is selling more physical assets (direct foreign investment) and financial assets (foreign portfolio investment) than it is buying from other countries. To the extent that the capital inflow takes the form of foreign portfolio investment, the article is correct that foreign investors “can end up owning a big share of assets.”

The Foreign Exchange Market and Exchange Rates Learning Objective: Explain how exchange rates are determined and how changes in exchange rates affect the prices of imports and exports.

Review Questions 2.1

The reciprocal: $1/¥115, or $0.0087 = ¥1. If the exchange rate changes from €0.85 = $1 to €0.90 = $1, then the quantity of euros required to buy a dollar has increased and the euro has depreciated against the dollar.

2.2

The three main sets of factors are (1) changes in the demand for US-produced goods and services and changes in the demand for foreign-produced goods and services; (2) changes in the desire to invest in the United States and changes in the desire to invest in foreign countries; and (3) changes in the expectations of currency traders about the likely future value of the dollar and the likely future value of foreign currencies.

2.3

The theory of purchasing power parity holds that in the long run, exchange rates move to equalize the purchasing power of different currencies. Three real-world complications keep purchasing power parity from being a complete explanation of exchange rates in the long run: (1) not all products are traded internationally; (2) products and consumer preferences are different across countries; and (3) countries impose barriers to trade.

Problems and Applications 2.4

1.9558 marks = 1 euro and 2.0938 marks = 1 dollar. First, convert the euro and the dollar exchange rates in terms of 1 German mark: (1/1.9558) euros = 1 mark, or 0.5113 euros = 1 mark, and (1/2.0938) dollars = 1 mark, or 0.4776 dollars = 1 mark. So, 0.5113 euros = 0.4776 dollars, or 1.07 euros = $1. Similar results would follow if we use one of the other currencies, for example French francs. Put both the euro and the dollar in terms of 1 French franc: 6.5596 French francs = 1 euro, or 0.1524 euros = 1 French franc, and 7.0223 French francs = 1 dollar, or 0.1424 dollars = 1 French franc. So, 0.1524 euros = 0.1424 dollars, or 1.07 euros = $1.

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2.5

a. The Canadian dollar appreciated against the yen because now it takes more yen to purchase a Canadian dollar. b. Events (ii) and (iii) could have caused the shift in demand shown in the graph: (i) would cause the demand curve for Canadian dollars to shift to the left, as foreign investors decrease their demand for Canadian financial assets; (ii) would cause the demand curve for Canadian dollars to shift to the right as Japanese consumers increase their demand for Canadian exports; and (iii) would also cause the demand curve for Canadian dollars to shift to the right as investors anticipate a future increase in the value of the Canadian dollar.

2.6

a. “Additional monetary stimulus” means that the European Central Bank will conduct an expansionary monetary policy to lower interest rates to increase aggregate demand and real GDP. An expansionary monetary policy will lower interest rates, making financial assets priced in euros less desirable than financial assets priced in US dollars. As a result, the demand for the euro will decrease, causing it to depreciate against the US dollar.

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b. In the following graph, because Draghi’s remarks caused investors to expect that they will receive lower interest rates in the future on financial assets priced in euros, the demand for euros shifts to the left from D1 to D2. The result is a lower equilibrium exchange rate between the euro and the US dollar. The graph shows the exchange rate falling from $1.20 per euro to $1.15 per euro.

2.7

a. A “weak dollar” means that the US dollar will not buy as many units of foreign currency given the current exchange rate. b. Investors constantly look for investments that pay higher returns for a given level of risk. If investors decide to invest abroad, they will sell dollars to buy other currencies needed to invest in foreign assets. An increase in the supply of US dollars lowers the price of the dollar in other currencies or weakens the dollar.

2.8

a. The exchange rate between the yen and the pound is (¥115/$1) × ($1/£0.75) = ¥153.33/£1. b. The new exchange rate between the yen and the pound is (¥120/$1) × ($1/£0.70) = ¥171.43/£1. The Canadian dollar appreciated against the Japanese yen because it now takes more yen to buy a dollar. The Canadian dollar depreciated against the British pound because it now takes fewer pounds to buy a dollar. The yen depreciated against the pound because it now takes more yen to buy a pound.

2.9

a. A strong euro means the euro will exchange for more dollars or other currencies. b. When the euro is strong, European exporters of goods and services to other countries are harmed because their exports have higher prices in foreign currencies. Higher prices will reduce foreign consumers’ demand for these products. In addition, the profits European firms earn on these products will be exchanged for fewer euros when the firms transfer the profits back to Europe.

2.10

When the Reserve Bank of Australia cut interest rates, the return on investing in Australian dollar– denominated assets, such as bonds issued by the Australian government, decreases. As a result, the demand for the Australian dollar decreases, which causes the Australian dollar to depreciate versus the US dollar.

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2.11

a. Amazon is exposed to foreign exchange risk primarily because of its many operations in foreign markets. The dollar value of the profits earned in foreign currencies varies with changes in the exchange rate between the foreign currencies and the US dollar. b. Amazon’s profit would be affected to the extent that households and firms in other countries buy its products. For example, if the dollar appreciates, buyers in other countries would pay higher prices for Amazon’s products. An appreciating dollar would also make imports into the United States cheaper, which could decrease Amazon’s sales in the United States. Finally, because some of the goods that Amazon sells on its US website are imported from other countries, an appreciation or depreciation of the dollar will still expose Amazon to exchange rate risk.

2.12

a. The phrase “75 or 80 cent Canadian dollar” refers to the exchange rate between the US dollar and the Canadian dollar: 1 Canadian dollar exchanges for $0.75 to $0.80 in US dollars. b. An NHL team that is based in Canada receives most of its revenue in Canadian dollars from sales of tickets to its games and in payment from Canadian television and streaming services. c. An NHL team that operates in Canada would be better off if the Canadian dollar appreciates against the US dollar. With an appreciation against the US dollar, the NHL team’s costs that are denominated in US dollars, such as the salaries of its players, can be paid for by the expenditure of fewer Canadian dollars.

2.13

By this standard, the US dollar is overvalued against the Mexican peso, Japanese yen, British pound, Indonesian rupiah, Canadian dollar, and Chinese yuan because the implied exchange rate indicates that it should take fewer units of these currencies to purchase a US dollar than is indicated by the actual exchange rate. The US dollar is undervalued against the Swiss franc because the implied exchange rate indicates that it should take more units of this currency to purchase a US dollar than is indicated by the actual exchange rate.

2.14

To calculate the purchasing power exchange rate, divide the foreign currency price of a Big Mac by the US price ($5.66). Country Chile Israel Russia New Zealand

Big Mac Price 2940 pesos 17 shekels 135 rubles 6.8 NZ dollars

Implied Exchange Rate 519.43 3.00 23.85 1.20

Actual Exchange Rate 719.43 pesos per dollar 3.18 shekels per dollar 74.63 rubles per dollar 1.40 NZ dollars per US dollar

The US dollar is overvalued if the actual exchange rate is greater than the implied exchange rate and undervalued if the actual exchange rate is less than the implied exchange rate. In this case, the US dollar is overvalued against the Chilean peso, the Israeli shekel, the Russian ruble, and the New Zealand dollar. Overvaluation of the US dollar would lead us to predict that the value of the dollar will fall in the future relative to the value of all four currencies. The implied exchange rate between the Russian ruble and the New Zealand dollar is 135 rubles/6.8 NZ dollars, or 19.85 rubles per New Zealand dollar. The actual exchange rate between the two currencies is 53.31 rubles per NZ dollar (74.63/1.40 = 53.31). Therefore, in terms of Big Mac purchasing power parity, the New Zealand dollar is overvalued.

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2.15

If Australia’s inflation rate is higher than New Zealand’s inflation rate, then the Australian dollar will depreciate relative to the New Zealand dollar.

2.16

These data are consistent with the theory of purchasing power parity, but the data also show that the theory does not offer a full explanation of movements in exchange rates. The theory of purchasing power parity argues that in the long run, the most important determinant of exchange rates between two currencies is the relative price levels in the two countries. With the Mexican consumer price index increasing by 98 percent and the US consumer price index increasing by 35 percent, purchasing power parity predicts that the exchange rate value of the dollar should rise approximately 63 percent against the peso. The dollar actually rose 67 percent against the peso, so purchasing power parity offers a good explanation of the rise of the dollar against the peso.

14.3 Exchange Rate Systems

Learning Objective: Discuss the three key features of the current exchange rate system.

Review Questions 3.1

An exchange rate system is an arrangement among countries about how exchange rates should be determined. The current exchange rate system is a managed float exchange rate system under which the value of most currencies—including the US dollar—is determined by demand and supply, with occasional government intervention.

3.2

Countries such as France, Germany, Spain, and Italy decided to adopt a common currency in order to increase trade with other countries using the same currency. A common currency makes it easier for consumers and firms to buy and sell across borders and, therefore, should reduce production and transactions costs and increase competition.

3.3

One currency is pegged against another currency when a country decides to keep the exchange rate between its currency and another currency fixed. Countries peg their currencies for the following reasons: (1) to make planning easier for firms with extensive trade with another country; (2) to aid firms that have borrowed foreign investment funds denominated in other currencies; and (3) to reduce inflation. Countries that peg can find that their currencies become either overvalued or undervalued relative to the equilibrium exchange rate. A pegged currency that is overvalued can lead to capital flight and a destabilizing speculative attack.

Problems and Applications 3.4

a. To alleviate recession in Germany, interest rates should be lowered. b. To curb inflation in Ireland, interest rates should be raised. c. Because they use the same currency, Germany and Ireland cannot have different monetary policies, which means they cannot have different interest rate policies.

3.5

Between March 2020 and November 2021, the euro depreciated against the Canadian dollar. This depreciation was bad news for Canadian firms exporting goods and services to Europe as the euro prices of Canadian goods and services increased. The euro’s depreciation was also bad news for European consumers buying goods and services imported from Canada as the euro prices of those imports increased.

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3.6

a. South Korea would not want its currency to appreciate too much relative to the Chinese yuan because it would worsen their trade balance with China. If the won appreciated against the yuan, Korean exporters to China would be hurt because their products would have a higher price in yuan. As a result, businesses and firms in China would be likely to buy fewer Korean imports. b. If the won appreciated against the yuan, the Korean central bank would want to sell won in exchange for yuan. Doing so would increase the supply of won, lowering the exchange rate between the won and the yuan.

3.7

a. There is a shortage of baht in exchange for Canadian dollars because at the pegged exchange rate the quantity of baht demanded is greater than the quantity of baht supplied. b. To maintain the pegged exchange rate, the Thai central bank will have to sell baht in exchange for Canadian dollars. The Thai central bank will have to sell 50 (= 120 – 70) million baht per day.

3.8

Argentina’s peg collapsed when it stopped fixing the value of the peso against the US dollar, and the value of the peso declined dramatically. Argentine firms that borrowed dollars had to make interest payments in dollars, but their revenues were in Argentine pesos. After the end of the peg, the firms needed to spend more pesos in order to buy the dollars they needed to make their interest payments.

3.9

The following graph assumes that the Chinese central bank pegs the exchange rate for the yuan below the market equilibrium exchange rate. As a result, the yuan is undervalued. Compared to the equilibrium exchange rate, an undervalued yuan will increase exports and decrease imports. As shown in this graph, the Chinese central bank would have to supply Y2 – Y1 yuan each trading period to maintain the exchange rate peg.

3.10

It would be good news for US-based firms such as Apple and Yum Brands if the yuan increases in value relative to the US dollar. These firms earn significant sales revenue in China. The firms will earn more dollars when they convert an appreciated yuan into US dollars.

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14.4 The International Sector and National Saving and Investment Learning Objective: Define and apply the saving and investment equation.

Review Questions 4.1

Net exports equal net foreign investment, assuming that net exports are roughly equal to the current account balance. When a country’s net exports are negative, households, firms, and the government must have sold assets and borrowed (negative foreign investment) from foreign households, firms, and governments to pay for the excess of imports over exports. When a country’s net exports are positive, households and firms must have bought foreign assets and lent (positive foreign investment) to foreign households, firms, and governments.

4.2

National saving = Domestic investment + Net foreign investment, or S = I + NFI. If national saving declines, the sum of domestic investment and net foreign investment will decline.

4.3

Because S = I + NFI, if S > I, then net foreign investment must be positive.

Problems and Applications 4.4

Recall that National saving = Domestic investment + Net foreign investment, or S = I + NFI. Because NFI = Net Exports, then S = I + NX. If we assume that the current account is roughly equal to net exports, we arrive at the equation S = I + CA or CA = S − I. Based on this equation, a country that saves more than it invests domestically will have a current account surplus, while a country that invests domestically more than it saves will have a current account deficit.

4.5

a. “Excess saving” means that national saving exceeds domestic investment, or S > I. b. Recall that National saving = Domestic investment + Net foreign investment, or S = I + NFI. Because NFI = Net Exports, then S = I + NX. If the current account is roughly equal to net exports, we arrive at the equation S = I + CA or CA = S − I. Based on this equation, a country with “excess saving” (that is S > I) will have a current account surplus, while a country that invests more than it saves will have a current account deficit.

4.6

We know that S = I + NFI, or S − I = NFI. So, for Germany: 27.2 percent − 21.5 percent = 5.7 percent. Therefore, German net foreign investment in 2020 was 5.7 percent of GDP.

4.7

You should disagree. The statement is incorrect because national saving as a percentage of GDP is not equal to domestic investment as a percentage of GDP due to the presence of net foreign investment. So, it could be the case that in 2020 the United States had larger net foreign investment than did the United Kingdom. If that was true, then domestic investment in the United States might have been smaller than domestic investment in the United Kingdom, even though national saving was larger in the United States.

4.8

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Substituting the expression for Y into the above equation, we have:

14.5

The Effect of a Government Budget Deficit on Investment Learning Objective: Explain the effect of a government budget deficit on investment in an open economy.

Review Questions 5.1

National saving increases when the government runs a budget surplus unless private saving decreases by the amount of the budget surplus, which is unlikely. The twin deficits idea is that a government budget deficit will lead to a current account deficit. The twin deficits did not hold in Canada in the years before the COVID-19 recession, when government budget deficits fell and eventually became budget surpluses, while the current account deficit remained stable.

5.2

The exchange rate of the dollar for other currencies was high, which increased the foreign currency price of Canadian exports. As a result, Canadian exports declined.

Problems and Applications 5.3

a. Net foreign investment in Korea = national saving – domestic investment = 34.8 percent of GDP – 30.0 per cent of GDP = 4.8 percent of GDP. b. No, there is not enough information to make this conclusion. National saving, which was 34.8 percent of GDP, equals private saving plus public saving. To determine if the government was in a surplus or a deficit, we would need information on private saving.

5.4

High interest rates raise the foreign exchange value of a country’s currency, decreasing net exports and increasing current account deficits.

5.5

The United States is sometimes called the “world’s largest debtor” nation because, since the 1980s, the large net capital flows into the United States resulting from the large US current account deficits have resulted in foreign investors owning, as of the end of 2020, over $14 trillion more of US assets—such as stocks, bonds, and factories—than US investors own of foreign assets.

5.6

The willingness of foreign investors and companies to purchase financial and physical assets in the Canada leads to a Canadian financial account surplus. If Canada runs a financial account surplus, it must run a current account deficit.

5.7

a. In this context (stating that the financial account surplus “goes to finance an investment shortfall in the United States, especially government borrowing”), the editorial means a shortfall in US financial investment—that is, a shortfall in national saving, which is caused by government saving being negative as a result of a federal budget deficit. b. The editorial means that the financial capital from foreign investments could be used to finance US private investment instead of being used to finance the federal budget deficit. c. Possibly. The federal budget deficit could raise interest rates, which increases the foreign exchange value of the dollar, decreasing net exports and increasing the current account deficit. This is the Copyright © 2024 Pearson Canada Inc.

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twin deficits idea. Leaving aside the statistical discrepancy and the capital account, the current account plus the financial account equals zero, so an increase in the current account deficit increases the financial account surplus. From the perspective of the financial account, the higher US interest rates resulting from the federal budget deficit attract foreign investment into the United States, which increases the financial account surplus. 5.8

14.6

Every country poses a unique set of risks. Factors to consider include (1) foreign exchange rates and historic volatility of those exchange rates; (2) trade barriers; (3) political risks; (4) shipping costs or proximity to the customer base; (5) labour issues; and (6) environmental concerns.

Monetary Policy and Fiscal Policy in an Open Economy Learning Objective: Compare the effectiveness of monetary policy and fiscal policy in an open economy and in a closed economy.

Review Questions 6.1

A policy channel is a way in which monetary or fiscal policy affects the domestic economy. In an open economy, monetary or fiscal policy affects domestic spending and also the exchange rate and, therefore, net exports.

6.2

In an open economy, changes in interest rates that result from monetary policy will not only affect investment spending and consumer spending on durable goods but also net exports through changes in the exchange rate. For instance, lower interest rates from expansionary monetary policy will increase investment spending and consumer spending on durables and will decrease the exchange rate, which increases net exports.

6.3

Fiscal policy has a smaller effect in an open economy than in a closed economy because of a larger crowding out effect. In an open economy, through its effect on interest rates, fiscal policy affects the exchange rate and net exports. For example, higher interest rates as a result of an expansionary fiscal policy lead to an increase in the exchange rate and a decrease in net exports, thereby offsetting some of the effect of the expansionary fiscal policy.

Problems and Applications 6.4

An open economy is an economy that has interactions in trade and finance with other countries. Fiscal policy in Switzerland is likely to be less effective than it would be in a less open economy. The crowding out effect of an expansionary fiscal policy is typically higher in a more open economy where net exports represent a larger percentage of GDP.

6.5

a. For a closed economy, higher interest rates reduce domestic investment spending and purchases of consumer durables in the short run, which would cause real GDP to decline. b. For an open economy, higher interest rates reduce domestic investment spending and purchases of consumer durables, as they do in a closed economy. However, in an open economy, higher interest rates also raise the exchange rate between the dollar and foreign currencies. As a result, net exports will decrease; therefore, the decline in real GDP as a result of this contractionary monetary policy is larger in an open economy than in a closed economy. c. If the interest rates of the trading partners of Canada also rise, then the effect of the Bank of Canada’s policy on the foreign exchange rate will be reduced, and the effects of policy on real GDP will be closer to those of a closed economy.

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6.6

As the Canadian economy has become more open, monetary policy has become more effective and fiscal policy has become less effective.

6.7

In a closed economy, an expansionary fiscal policy directly increases aggregate demand, leading to increases in real GDP and the price level. An expansionary fiscal policy also results in crowding out as higher interest rates reduce domestic investment and purchases of consumer durables. In an open economy, an expansionary fiscal policy also directly results in an increase in aggregate demand and, therefore, increases in real GDP and the price level. However, in addition to lower domestic investment, higher interest rates in an open economy also lead to an increase in the country’s exchange rate with foreign currencies, which decreases net exports. The crowding out effect in an open economy is, therefore, larger than in a closed economy.

Real-Time Data Exercises Note: FRED and the Bank of Canada continue to update data. The solutions below contain the data available on the first quarter of 2021. D14.1 a. The value of the euro decreased from 1.5586 Canadian dollars per euro in December 2020 to 1.4462 Canadian dollars per euro in December 2021. The euro depreciated by 7.2116 percent against the Canadian dollar. b. The Canadian dollar appreciated in value against the euro because it took less dollars to purchase the same number of euros in December 2021 than it did in December 2020. D14.2 See the following graphs of the US dollar–euro exchange rate, the yen–US dollar exchange rate, and the Canadian dollar–US dollar exchange rate. Note that the US dollar–euro exchange rate has been converted to euros per dollar. The yen–US dollar exchange rate is yen per US dollar, and the Canadian dollar–US dollar exchange rate is Canadian dollars per US dollar.

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a. The euro reached its highest value in July 2008 at 1.58 US dollars per euro (or 0.63 euros per dollar). b. During the financial crisis of 2007–2009, by and large, the yen appreciated against the dollar as the exchange rate was above 110 yen per dollar at the beginning of the financial crisis and was about 96 yen per dollar at the end of the crisis. The yen did, however, depreciate against the dollar during the worst of the crisis in the fall of 2008. c. From January 2001 to May 2021, the dollar depreciated the most against the euro. The dollar went from 1.08 euros per US dollar in January 2001 to 0.82 euros per US dollar in May 2021, for a depreciation of 24 percent. Note that these exchange rates are expressed as euros per US dollar.

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Suggestions for Critical Thinking Exercises CT14.1 You would hope that between now and the time you convert your Canadian dollars into euros that the dollar appreciates so that you will have more for living expenses. If you have any euros left over after the semester, you would hope that the euro appreciated so you would be able to convert them into more dollars on your return to Canada. CT14.2 a. If you invest in Canada, you will have $100 000 × 1.05 = $105 000. If you invest in Japan, your $100 000 will be worth ¥120/$ × $100 000 = ¥12 000 000. After one year, your Japanese bond is worth ¥12 000 000 × 1.03 = ¥ 12 360 000. Converting it back to Canadian dollars will yield ¥12 360 000 × $1/¥120 = $ 103 000. b. If the exchange rate is expected to change to $1 = ¥110, your investment in Japan will now be worth ¥12 360 000 × $1/¥110 = $ 126 300. Because your return on your investment in Canada bonds will still be $105 000, it would be more profitable to invest in Japanese bonds. c. No. Investments are not based solely on interest rates but are also based on the expected appreciation or expected depreciation of the home or foreign currency. The example in this problem shows that investing in a country with a lower interest rate on government bonds is still more profitable than investing at home if the home currency is expected to depreciate by more than the interest rate difference between the bonds of the two countries.

Appendix Solutions | The Gold Standard and the Bretton Woods System Review Questions 14A.1 Under the gold standard, the exchange rate between two currencies was determined by the quantity of gold in each currency. The gold standard collapsed during the Great Depression because central banks wanted to fight the Depression with expansionary monetary policy, but under the gold standard central banks had only limited control of their countries’ money supplies. 14A.2 Under the Bretton Woods System of fixed exchange rates, the United States pledged to buy or sell gold at a fixed price of $35 per ounce, and the central banks of the member countries pledged to buy and sell their currencies at a fixed rate against the dollar. If a shortage or surplus of a country’s currency occurred at the fixed exchange rate (also known as the par exchange rate), the central bank of the member country would buy or sell dollars with their currency to maintain the fixed exchange rate. 14A.3 A devaluation is a reduction in a fixed exchange rate. A revaluation is an increase in a fixed exchange rate. 14A.4 Capital controls are limits on the flow of foreign exchange and financial investment across countries. 14A.5 The International Monetary Fund provided loans to central banks that were short of dollar reserves, oversaw the operation of the Bretton Woods system, and approved adjustments to fixed exchange rates.

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14A.6 Destabilizing speculation refers to actions by investors that make it more difficult to maintain a fixed exchange rate. Destabilizing speculation in 1971 involving the German mark led to the collapse of the Bretton Woods system. Investors became convinced in early 1971 that Germany would have to allow a revaluation of the mark against the dollar. Investors increased their demand for marks, which increased the shortage of marks. The West German government finally opted out of the fixed exchange-rate system and allowed the mark to float against the dollar.

Problems and Applications 14A.7 With the $4 = £1 exchange rate, you would buy gold in London for £1 per ounce and sell the gold in the New York for $5. You could then exchange $4 for £1 and have a $1 profit per ounce of gold. You could make an unlimited profit by buying gold in London and shipping it to New York. With the $6 = £1 exchange rate, you would buy gold in the United States for $5 per ounce and sell the gold in London for £1. You could then exchange £1 for $6 and have a $1 profit per ounce of gold. You could make an unlimited profit by buying gold in New York and shipping it to London. 14A.8 A discovery of new gold deposits would cause the money supply to increase. Unless the increase in the money supply was matched by an increase in output, the new gold discovery would lead to inflation, which would not be a desirable result. 14A.9 Countries on the gold standard during the Great Depression of the 1930s could not pursue monetary policies that were expansionary enough to counteract the severity of the downturn. 14A.10 Both the gold standard and the euro are fixed exchange rate systems. Under fixed exchange rate systems, countries are not free to pursue independent monetary policies and to allow their currencies to depreciate to stimulate their economies during economic downturns. 14A.11 The author was incorrect about what the United States abandoned in the 1970s. It was the Bretton Woods fixed exchange rate system that the United States abandoned rather than the gold standard, which the United States abandoned in 1933. Two problems led to the collapse of the Bretton Woods system. First, the total number of dollars held by foreign central banks had become much larger than the gold reserves of the United States. The basis of the Bretton Woods system was a credible promise by the United States to redeem dollars for gold if called on to do so by foreign central banks. Second, some countries with undervalued currencies, particularly West Germany, were unwilling to revalue their currencies, which would have raised the foreign currency prices of their countries’ exports. 14A.12 a. The gold standard did not allow countries to stimulate their economies by pursuing expansionary monetary policies that would have allowed for lower interest rates and the depreciation of their exchange rates. b. Fixed exchange rates can provide important advantages to businesses involved in international trade. When the exchange rate is fixed, business planning becomes much easier. For instance, businesses that export products abroad do not need to be concerned about an appreciation of their country’s currency raising the prices of their products abroad. 14A.13 a. By using the phrase “zealous money printing,” the writer of this column means that the Federal Reserve increased the money supply more at a rate that exceeded the rate of increase in US real GDP in the 1960s. Inflation results when a country’s money supply increases more rapidly than its rate of output.

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CHAPTER 14 | Macroeconomics in an Open Economy b. With the United States pursuing zealous money printing, the theory of purchasing power parity implies that the underlying equilibrium exchange rates would get out of alignment if the other countries did not follow suit with similar inflationary monetary policies. Not wanting to incur higher inflation, some of the other countries, particularly West Germany, were reluctant to follow suit. Pressure mounted for a revaluation of their currencies at a higher exchange rate. Not wanting an increase in the foreign currency prices of their exports, countries resisted revaluation. c. Domestically, under the Bretton Woods system, the dollar was already fiat money because US residents could not redeem paper dollars for gold. Internationally, though, under the Bretton Woods system, foreign central banks could redeem dollars for gold. With the collapse of the Bretton Woods system, there was no longer any link between dollars and gold, either domestically or internationally. So, the dollar (and the other currencies involved in the Bretton Woods system) became complete fiat money.

14A.14 The Bretton Woods system broke down because countries were not able to maintain exchange rates that were either above or below equilibrium exchange rates; fixed exchange rates are difficult to maintain in the long run. By pegging their currencies to the dollar, East Asian countries were following a fixed exchange rate policy. 14A.15 For a country to leave its currency to the “whims of the markets” means that the currency floats with the exchange rate determined by demand and supply. A floating exchange rate makes doing business across countries more difficult, and large fluctuations in the exchange rate significantly affect the prices of a country’s exports and imports. Most European Union member countries eventually replaced their floating exchange rates by adopting the euro, a single currency. The adoption of the euro is equivalent to adopting a fixed exchange rate system within the euro zone.

Real-Time Data Exercises

Note: FRED continues to update data. The solutions below contain the data available on FRED for the first quarter of 2021. D14A. 1 a. Until mid-1971, the United States fixed the price of gold at $35 ounce, so it did not fluctuate much until the United States abandoned that policy. To keep the price of gold at $35, the US government bought and sold gold. b. It would be difficult to return to the gold standard since fixing the dollar price of gold would require constant market intervention to maintain the price. Notice how volatile gold prices are over that period of time. The same would be true for any other currency. In October 2021, the price of gold was about $1800 per ounce.