Instructor Solution Manual for Exploring Macroeconomics, 6th Edition Robert L. SextonColin C. Kovacs

Instructor’s Solutions Manual to accompany

Prepared by Colin Kovacs Algonquin College

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Answer Key

CONTENTS 1. THE ROLE AND METHOD OF ECONOMICS .................................................................................1 2. SCARCITY, TRADE-OFFS, AND PRODUCTION POSSIBILITIES .....................................................8 3. SUPPLY AND DEMAND ...............................................................................................................13 4. BRINGING SUPPLY AND DEMAND TOGETHER ..........................................................................26 5. INTRODUCTION TO THE MACROECONOMY ..............................................................................35 6. MEASURING ECONOMIC PERFORMANCE .................................................................................38 7. ECONOMIC GROWTH IN THE GLOBAL ECONOMY ...................................................................43 8. AGGREGATE DEMAND ...............................................................................................................46 9. AGGREGATE SUPPLY AND MACROECONOMIC EQUILIBRIUM .................................................49 10. FISCAL POLICY ........................................................................................................................57 11. MONEY AND THE BANKING SYSTEM .......................................................................................62 12. THE BANK OF CANADA ...........................................................................................................67 13. MONETARY POLICY ................................................................................................................70 14. INTERNATIONAL TRADE ..........................................................................................................74 15. INTERNATIONAL FINANCE ......................................................................................................79

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FOR YOUR REVIEW ANSWER KEY CHAPTER 1 THE ROLE AND METHOD OF ECONOMICS Section 1.1 Economics: A Brief Introduction 1. The definition of economics must recognize the central parts of the economist’s point of view: Resources are scarce, scarcity forces us to make choices, and the cost of any choice is the cost of the lost opportunity with the highest value.

2. a. b. c. d. e.

Microeconomics Macroeconomics Microeconomics Macroeconomics Microeconomics

Section 1.2 Economic Theory 3. a. The first is positive and the other is normative. The first statement (a positive statement) expresses a fact or a testable theory that a higher income tax rate would generate increased tax revenues. The second statement (a normative statement) expresses an opinion regarding how any additional tax revenues should be used. b. Both are normative statements that express opinions. The first regards the relative value of studying physics as opposed to studying sociology, and the second regards the value of studying either physics or sociology. c. Both statements are positive. They are expressions of facts or testable theories regarding the relationship between the price of wheat and how much wheat will be purchased and produced. d. The first is positive and the other is normative. The first statement (positive) expresses a fact or testable theory regarding the relationship between the price of butter and how much will be purchased. The second statement (normative) is an expression of opinion about the social value of buying butter. e. Both statements are positive. They are expressions of fact or testable theory regarding demographic change.

4. a. Positive. The statement is a testable hypothesis. b. Normative. Asserting that funding for social assistance should be reduced contains a value judgment about the costs and benefits of doing so. c. Positive. The statement expresses a fact or a testable theory that tariffs will result in higher prices for domestic wine. d. Positive. The statement could be confirmed or refuted by empirical data. e. Normative. A benefit of charging a provincial sales tax on Internet sales is that it will level the playing field with non-Internet retailers. However, a cost of this same tax is that it will reduce

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Answer Key

f.

5. a. b. c. d. e.

total Internet sales and possibly have other negative effects. The statement implies a value judgment that the benefits outweigh the costs.

Positive. The statement is subject to empirical testing.

This involves confusing correlation with causation.

This involves confusing correlation with causation.

This involves the fallacy of composition.

This is a violation of the ceteris paribus conditions.

There is no fallacy in this statement.

6. Observation and prediction are more difficult in economics than in chemistry because, unlike chemists, economists generally cannot observe behaviour in a laboratory setting where all relevant environmental variables can be carefully controlled. Economists study economic behaviour in the real world, where many variables influence behaviour simultaneously. It is difficult in a complex global economy to observe and predict relationships between variables, isolated from other effects.

7. Economics is concerned with reaching generalizations about human behaviour. If you generalize on the basis of observed individual behavior, you risk committing the fallacy of composition.

Generalizations based on observed group behaviour are likely to be both more realistic and useful (reliable).

Section 1.3 Scarcity 8. Being poor means that you have access to few resources, which limits the goods and services you consume. Scarcity means you don’t have enough resources to do everything you want to do, so you have to make choices. Everyone experiences scarcity, because we can always think of more things that we want than we can produce with our resources.

9. The automobile freed Canadians to travel and helped to create the tourism business. New wants included motels, resorts, and theme parks. The increased importance of automobile and truck transportation also created the desire for more and better roads and highways. The automobile also allowed people to live farther from where they worked, so that people wanted more land and newer houses.

10. Scarce goods are those that people pay for in either time or money or, in other words, have an opportunity cost. Garbage and dirty air in the city are not scarce goods since we either pay to get rid of them or pay with the consequences of their presence. Similarly, salt water is not a scarce good.

Although it is in limited supply, the current abundance of salt water makes it seem limitless. Clothes, clean air, and public libraries are scarce goods because their production requires the use of scarce resources that could be used for the production of other goods.

Section 1.4 Opportunity Cost 11. Since Sarah’s time is probably worth more during the school year (it would cost part of her salary), the opportunity cost of the trip is higher in February than in July.

12. The opportunity cost of this decision valued in dollars would be $33.50 ($30 forgone pay for not tutoring for two hours + $3.50 for the cup of coffee).

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13. a. The opportunity cost of going to college or university includes the income you could have earned by working instead; it also includes the money spent on school-specific expenses like tuition and textbooks. Room and board and transportation would not necessarily be included, since you would need those services even if you were not going to school. b. The opportunity cost of missing a lecture includes the potential damage to one’s grade in a course from not being present while important subject material is covered, as well as the knowledge’s forgone value in the ―real world.‖ The magnitude of the opportunity cost depends partly on how much essential information the instructor provides during the missed class session or if any activities were conducted. c. The opportunity cost of spending $100 today is the $105 you could have spent next year. If you are withdrawing the money just to have cash in your pocket, the opportunity cost of holding money is the 5 percent interest you could have been earning. d. The opportunity cost of snowboarding the weekend before final examinations is the expected reduction in grades that will result, in addition to the cost of a lift ticket.

14. Inactions are choices not to do something. Inactions, like actions, have consequences. For example, if you choose not to study, you may fail an exam.

15. One of the most important resources used raising children has historically been the mother's time. As opportunities for women to hold jobs, start businesses, and participate in political life increase, the cost of using women's time for raising children increases. As the cost of the mother's time rises, fewer children are born.

Section 1.5 Marginal Thinking 16. a. $50; $25 b. 3; 5; Mark would go as long as his marginal benefit was greater than the admission price. c. Yes; 6; Mark would buy the pass because his total benefits exceed his total cost. Once he has the pass, the marginal cost of attending one more day becomes zero, so he will go as long as his marginal benefits exceed zero.

17. a. $57; $88 b. 43; 44; he would produce widgets as long as the price (marginal benefit) exceeded the marginal cost.

18. The expected marginal benefits of jaywalking are the time saved and convenience of crossing the street where you want. The expected marginal costs are the additional risk of being hit by a car and the risk of being fined for jaywalking. a. Increases cost by increasing the risk of being hit by a car. b. Lowers cost by lowering the risk of being hit by a car and the risk of being fined. c. Increases the benefit because of the higher value of saved time. d. Increases cost because of a higher risk of receiving a fine. e. The time and convenience benefits are larger. f. The time and convenience benefits are smaller.

19. Marginal thinking involves incremental changes to a plan of action. All of the activities listed involve marginal thinking. When studying, one chooses whether or not to study for one more hour; when eating, one chooses whether or not to consume one more portion; when driving, one chooses whether or not to travel one more kilometre (or one more kilometre per hour); when shopping, one chooses whether or not to buy one more item or visit one more store; when getting ready for a night out, one chooses whether or not to spend another minute styling one's hair.

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20. As long as people follow the rule of rational choice, they will always make decisions from which they expect to gain more in benefits than they have to give up in costs; that is, they will make decisions from which their net marginal benefit (marginal benefit minus marginal cost) is positive. They will always be better off in this case. However, if people’s expectations about benefits or costs are wrong, their decisions may unexpectedly make them worse off.

Section 1.6 Incentives Matter 21. Positive incentives are those that either increase benefits or reduce costs and thus tend to increase the level of an activity. Both of the following are examples of positive incentives: (b) a trip to Hawaii paid for by your parents or significant other for earning an A in your economics course; (d) a subsidy for installing solar panels on your house. Negative incentives either reduce benefits or increase costs, and thus tend to decrease the level of the related activity or behaviour. Both of the following are examples of negative incentives: (a) a fine for not cleaning up after your dog defecates in the park; (c) a higher tax on cigarettes and alcohol.

22. Singapore’s tough drug-trafficking penalty would clearly impact the cost−benefit ratios of would-be smugglers. Lighter sentences would probably result in more drug smuggling because the overall cost of breaking the law would be reduced.

23. The Chinese government was attempting to promote population control. As the world’s most populated country, China has historically struggled with controlling population growth in it attempts to manage economic growth and national standards of living. The sanctions and penalties associated with not following the one-child policy would be considered negative incentives designed to discourage couples from having more than one child. The rewards and honours associated with following the policy would be considered positive incentives designed to promote adherence to the policy.

Section 1.7 Specialization and Trade 24. Denying trade possibilities also eliminates the possibility of specialization. In autarky, a country must produce everything it consumes. Scarce resources will be wasted producing goods with higher opportunity costs. Trading would allow the country to produce more with the same resources.

25. The opportunity cost to Fran of growing soybeans is the lost value because she can’t grow corn. This opportunity cost is equal to $1800 (3000 kg × $0.60/kg). The opportunity cost of growing corn is the lost opportunity to grow and sell soybeans, which is equal to $2250 (1500 kg × $1.50/kg). Fran should specialize in soybeans, which is the crop with the lower opportunity cost. For each hectare of corn that Fran converts to soybeans, she will gain $450.

26. a. b. c. d.

Canada has a comparative advantage in wheat.

Colombia has a comparative advantage in coffee.

British Columbia has a comparative advantage in lumber.

Alberta has a comparative advantage in oil.

27. a. If the country or region with the lower opportunity cost produces the good, the opportunity cost of consuming that good is minimized. b. Trade allows people, regions, and countries to specialize in producing those goods in which they have the lowest opportunity cost, so reducing trade restrictions will encourage specialization,

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Answer Key

thereby increasing efficiency.

Section 1.8 The Three Economic Questions Every Society Faces 28. The three basic economic questions are: (1) What is to be produced? (2) How are these goods and services to be produced? (3) Who will get the goods and services? Scarcity requires that these questions be addressed in some way by every economy. Market economies answer these questions in a decentralized way through the interaction of millions of buyers and sellers. In command economies, decisions are made largely through planning boards. The manner in which an economic system answers these questions helps determine the allocation of limited resources.

29. No, Karl is wrong. Markets provide important signals, and the signal being sent in this situation is that Adam should look for some other way to support his ambitions, something that society values.

Remember the function of consumer sovereignty in the marketplace. Clearly, consumers were not voting for Adam’s art.

30. Differences in economic decision making in pure command and pure market systems stem from differences in control over economic resources. In pure command systems, all economic resources are controlled by a central authority (usually represented by the government); this control gives this same central authority the ability to make all economic decisions for this economy. In a pure market system, economic resources are privately owned and therefore privately controlled. This decentralized control produces decentralized economic decision making.

While economic inequality is possible in any type of economic system, the pure market system’s reliance on individual ability as the deciding factor in determining distribution (answering the ―how to we distribute what we have produced?‖ question) could generate a greater amount of economic inequality. In such a system, different levels of individual ability result in different levels of distribution (i.e., inequality) as opposed to a system where all individuals are treated equally and by association distribution is equal.

CHAPTER 1 APPENDIX WORKING WITH GRAPHS 1. b. c. d. e. f.

a. (−2, 2) (2, 1) (3, 2) (−1, −2) (2, –1) (−2, −1)

2.

a.

8% b. 20% c. Two-door sedans d. All-electric

3.

a.

Semester 1 b. Semesters 3 and 4 c. Semester 2 d. Total number of boys: 372; total number of girls: 366

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4.

Graph 1: Upward sloping

Graph 2: Downward sloping

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Graph 3: Unrelated

5. b. c. d. e.

6.

a.

2 −3 –0.5 Undefined 0

a. b. 5% c. 0.8% d. 5.5

50%

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FOR YOUR REVIEW ANSWER KEY CHAPTER 2 SCARCITY, TRADE-OFFS, AND PRODUCTION POSSIBILITIES Section 2.1 The Production Possibilities Curve 1. a.

b. 1 side of beef; 6 kegs of beer; 9 kegs of beer c. 35 kegs of beer d. No; that combination is inside the production possibilities curve, which means more of one good could be produced without giving up any production of the other good.

e. No; that combination is beyond the production possibilities curve and therefore unattainable.

2. a. b. c.

A production possibilities curve, which applies to a specific period of time, is drawn assuming that resources and the level of technology are held constant.

The opportunity cost of another pizza, when moving from point B to point C, is 4 units of robots. The opportunity cost of another pizza, when moving from point D to point E, is 8 units of robots.

These combinations are exhibiting increasing opportunity cost―the more pizzas you have, the higher the opportunity cost of obtaining additional pizzas.

3. This is the law of increasing opportunity cost in action. As you planted more and more of your land in wheat, you would move into some of the less fertile land and, consequently, wheat yields on this additional land would fall. If you were to go so far as to plant the entire island with wheat, you would find that some of the less fertile land would yield virtually no extra wheat. It would, however, have been great for cattle grazing—a large loss.

So, the opportunity cost of using that marginal land for wheat rather than cattle grazing would be very high.

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Section 2.1 The Production Possibilities Curve ―And― Section 2.2 Economic Growth and the Production Possibilities Curve 4. a.

Double-digit unemployment would not affect the production possibilities curve itself. An economy experiencing double-digit unemployment would be operating at a point inside the production possibilities curve. b. The production possibilities curve shifts outward whenever the economy experiences economic growth. c. Assuming resources are being used efficiently, the economy moves from one point along the production possibilities curve to another in the direction of more food production (requiring a sacrifice of shelter). d. Assuming resources are being used efficiently, the economy moves from one point along the production possibilities curve to another in the direction of more shelter (requiring a sacrifice of food).

5. a.

b.

As indicated in the table above, if the province of Quebec is to continually increase tractor production by 10 tractors it must give up increasing amounts of cheese―thus illustrating the law of increasing opportunity cost.

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Answer Key c.

d.

The alteration in production from production alternative B to alternative E represents an increase in capital goods and a decrease in consumption goods. As a result, the prediction would be that the province of Quebec would experience greater economic growth in the future.

6. a.

Yes, the bowed-outward shape of the production possibilities curve indicates increasing opportunity costs. b. Zero; because point I is inside the production possibilities curve, moving from point I to point D means that the output of food can increase with no decrease in the output of shelter. c. 10 units of food d. All of the points on the production possibilities curve are efficient because at any of those points, more of one good could be produced only by sacrificing some output of the other good. However, the curve does not tell us which of those points is best from the perspective of society. e. Point N; additional resources or new technology (shifting the PPC outward). f. Point I; the economy must ensure that all resources are being utilized to their fullest extent―no wasted resources.

Section 2.2 Economic Growth and the Production Possibilities Curve 7. Investment in capital goods increases the future productive potential of an economy. Economy A will grow more rapidly, shifting the production possibilities curve outward to a greater extent over time, if it invests in a higher proportion of capital goods than does Economy B.

8. The politician would be able to keep her promise if the economy was operating inside the production possibilities curve. It would then be possible to have more of both schools and prisons by better utilizing

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Answer Key available resources. Alternatively, an advance in technology or an increase in available resources (perhaps due to immigration) would also make it possible to have more of both goods by shifting the production possibilities curve in an outward direction.

9. a. A country will fail to grow if its sacrificed consumption is spent in other countries. b. A country will fail to grow if it chooses not to sacrifice because it cares so much about current consumption. c. Growth will be limited if a country does not invest in human capital. d. A country will fail to grow if its sacrificed consumption is spent on goods other than capital goods.

10. People acquire human capital though education, which adds to the nation's ability to produce, just as is the case with additions to the physical capital stock.

Section 2.3 Market Prices Coordinate Economic Activity 11. The definition of a market focuses on the process of exchange not on the physical location where the exchange takes place. Therefore, even though online buyers and sellers are never actually in the same place, their behaviour still constitutes a market transaction due to the fact that goods and services are being exchanged.

12. Buyers determine the demand side of the market. Consumers demand goods and services in product markets and producers demand resources in factor markets. Alternatively, resource owners supply factors of production in factor markets and producers supply goods and services in product markets.

13. Options (a), (b), and (c) would cause increases in the relative value and price of potatoes. In option (d), the reduction in the prices of potato substitutes would make alternatives more attractive and reduce the relative value and price of potatoes.

14. a. b. c. d. e.

Price of Jack Russell terriers rises Price of housing in Tampa rises Price of coffee rises Price of wheat rises Wages of Canadian doctors fall

15. The market is global. Manufacturers sell to dealers throughout the world. Transportation costs are low relative to the costs of a laptop computer. Middlepersons make information about prices and quality easily available.

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Section 2.4 The Circular Flow Model 16.

17. a. b. c. d.

Product market Factor market Product market Factor market.

Furniture is a good purchased in the product market from firms. Labour is a resource that households sell to firms in the factor market. Restaurant food is a good purchased by consumers in the product market.

Finally, Billy’s entrepreneurial resource is paid a profit, which is the amount left over after all his other costs have been paid. This takes place in the factor market.

18. a. The events of Claire getting paid $800 as a rental agent and Markus getting paid $70 to teach a b.

fitness class both occur in the factor market.

The events of Claire spending $40 a week on her gym membership and Markus spending $200 on a rental car both occur in the product market.

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FOR YOUR REVIEW ANSWER KEY CHAPTER 3 SUPPLY AND DEMAND Section 3.1 Demand 1. a.

P $5 4 3 2 1

QD 4 8 12 16 20

P $5 4 3 2 1

QD 6 12 18 24 30

b.

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Answer Key c.

P $5 4 3 2 1

QD 5 10 15 20 25

2. The market demand curve shows the total amounts of a good or service that all of the buyers as a group are willing to buy at various possible prices in a particular time interval, while the individual demand curve shows how much a single buyer is willing to purchase at various prices over a particular time period. The market quantity demanded at a given price is just the sum of the quantities demanded by each individual buyer at that price.

3.

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Answer Key 4.

Quantity Demanded (mL per week) Price ($ per mL) $15 12 9 6 3

Hillary 5 10 15 20 25

Marita 0 5 10 15 20

Jacquie 15 20 25 30 35

Market 20 35 50 65 80

Section 3.2 Shifts in the Demand Curve 5. a. b. c. d.

Demand decreases (Determinant: Price of substitute falls) Demand decreases (Determinant: Price of complement rises) Demand increases (Determinant variable: Taste and preference increase) Demand increases (Determinant: Number of consumers increases)

6. a. b. c. d.

Demand decreases (Determinant: Price of substitute decreases) Demand increases today (Determinant: Expected future price increases) Demand increases (Determinant: Income increases for a normal good) Demand increases (Determinant: Price of a complement decreases)

7. a. b. c. d.

Point B represents an increase in quantity demanded.

Point E represents an increase in demand.

Point F represents a decrease in demand.

Point C represents a decrease in quantity demanded.

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Answer Key

8. a.

Assuming that beef is a normal good, demand for beef increases with consumer income, causing the demand curve to shift to the right.

b. An increase in the price of beef, ceteris paribus, decreases the quantity of beef demanded.

c. Ceteris paribus, an outbreak of mad cow disease is likely to decrease the demand for beef, shifting the demand curve to the left.

d. An increase in the price of a substitute increases the demand for beef, shifting the demand curve to the right.

e. If the price of a complement, barbecue grills, increases, the demand for beef will likely decrease, shifting

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Answer Key the demand curve to the left.

9. a.

Hamburgers and ketchup are complements. An increase in the price of hamburger will decrease the demand for ketchup.

b. Coca-Cola and Pepsi are substitutes. An increase in the price of Coca-Cola will increase the demand for Pepsi.

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c. iPhones and iPhone cases are complements. An increase in the price of iPhones will decrease the demand for iPhone cases.

d. Golf clubs and golf balls are complements. An increase in the price of golf clubs will decrease the demand for golf balls, ceteris paribus.

e. Assuming that skateboards and razor scooters are substitutes, an increase in the price of skateboards will increase the demand for razor scooters.

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Answer Key

10. The demand for plane travel and all other normal goods will increase if incomes increase, while the demand for bus travel and all other inferior goods will decrease if incomes increase.

11. a. b. c. d.

The shift from D0 to D1 is called an increase in demand.

The movement from B to A is called a decrease in the quantity demanded.

The movement from A to B is called an increase in the quantity demanded.

The shift from D1 to D0 is called a decrease in demand.

12. a.

The demand curve would shift rightward, indicating an increase in demand. b.

The demand curve would shift leftward, indicating a decrease in demand. c.

The demand curve would shift rightward, indicating an increase in demand.

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Answer Key d.

The demand curve would shift leftward, indicating a decrease in demand. e.

The demand curve would shift leftward, indicating a decrease in demand.

Section 3.3 Supply 13. The market price of wheat would have to rise for Felix to have the incentive to produce from the second field.

Because costs are higher in the second field, Felix must receive a higher price to compensate him for his higher costs.

14.

15.

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Answer Key

Price ($ per barrel) $5 10 15

Quantity Supplied (barrels per month) Rolling Rock Armadillo Oil Pecos Petroleum

Market

10 000 15 000 20 000

8 000 10 000 12 000

2 000 5 000 8 000

20 000 30 000 40 000

20 25

25 000 30 000

14 000 16 000

11 000 14 000

50 000 60 000

P $5 4 3 2 1

QS 25 20 15 10 5

16. a.

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Answer Key b.

P $5 4 3 2 1

QS 30 24 18 12 6

P $5 4 3 2 1

QS 20 16 12 8 4

c.

Section 3.4 Shifts in The Supply Curve 17. a. b. c. d.

The shift from S0 to S1 is called an increase in supply.

The movement from A to B is called an increase in the quantity supplied.

The movement from B to A is called a decrease in the quantity supplied.

The shift from S1 to S0 is called a decrease in supply.

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Answer Key

18. a.

The supply curve would shift rightward, indicating an increase in supply. b.

The supply curve would shift leftward, indicating a decrease in supply. c.

The supply curve would shift leftward, indicating a decrease in supply.

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Answer Key d.

The supply curve would shift rightward, indicating an increase in supply.

19. a.

An increase in the price of corn would increase the quantity of corn supplied, but not the supply of corn. This is because a change in the price of corn causes the market for corn to experience a movement in supply (as opposed to a shift in supply). b. An increase in the price of corn would decrease the supply of wheat, which is a substitute in production to corn. This is because a change in the price of corn―a substitute in production with wheat―causes the market for wheat to experience a shift in supply (as opposed to a movement).

20. a. Supply decreases (Determinant: Input prices increase) b. Supply decreases (Determinant: Taxes increase) c. Supply increases (Determinant: Technology advances) 21. a. b. c. d. e.

Supply decreases (Determinant: Bad weather) Supply decreases (Determinant: Input prices rise) Supply increases (Determinant: Subsidies) Supply increases (Determinant: Technology advance) Supply decreases today (Determinant: Expected future price increases)

22. a. b. c. d.

Supply increases (Determinant: Input prices) Supply increases (Determinant: Number of suppliers) Supply decreases (Determinant: Taxes) Supply increases (Determinant: Technology)

23. a. b. c. d.

Point B represents an increase in quantity supplied Point C represents an increase in supply Point D represents a decrease in quantity supplied Point E represents a decrease in supply

24. a.

An increase in the price of sugar would increase the quantity of sugar supplied, but not the supply of sugar. This is because a change in the price of sugar causes the market for sugar to experience a movement in supply (as opposed to a shift in supply). b. An increase in the price of sugar would increase the supply of molasses, which is a complement in production to sugar. This is because a change in the price of sugar―a complement in production with molasses―causes the market for molasses to experience a shift in supply (as opposed to a movement).

25. An increase in wages, or any other input price, would decrease the supply of guitars (the supply curve would shift to the left), making fewer guitars available for sale at any given price, by raising the opportunity cost of producing guitars.

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Answer Key

Section 3.4 Shifts in The Supply Curve 26. a. b. c. d. e.

The supply of oil decreases, (supply curve for oil shifts left).

The supply of oil increases, (supply curve for oil shifts right).

The demand for heating oil increases, (demand curve for oil shifts right).

The supply of oil increases (supply curve shifts right) Fewer people will drive gasoline-powered automobiles, decreasing the demand for oil (demand curve for oil shifts left).

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FOR YOUR REVIEW ANSWER KEY CHAPTER 4 BRINGING SUPPLY AND DEMAND TOGETHER Section 4.1 Market Equilibrium Price and Quantity 1.

When a price is above the equilibrium price, the quantity of a good or service willingly supplied by sellers exceeds the quantity willingly demanded by buyers. If sellers want to sell a greater quantity of goods or services, it is necessary to reduce the price (or otherwise improve the terms of sale, such as with free delivery or lower interest rate financing) in order to induce buyers to make additional purchases. Market forces thus exert a downward pressure on price in the direction of equilibrium price. A surplus is eliminated once price falls to the equilibrium price.

If a price is below the equilibrium price, then the quantity of a good or service willingly demanded by buyers exceeds the quantity willingly supplied by sellers. In order to induce sellers to provide a greater quantity to the marketplace, it is necessary for buyers to offer a higher price for the good or service. Market forces exert upward pressure on price in the direction of the equilibrium. A shortage is eliminated once price increases to the equilibrium price.

2.

a.

$9

b. There is a shortage of 400 bottles. c. There is a surplus of 200 bottles.

3.

a.

Equilibrium price = $400; Equilibrium quantity = 6.3 million units

b. A shortage exists at any price below $400; market forces would raise the price of a tablet computer up to $400 to self-regulate a solution to this shortage situation.

c. A surplus exists at any price above $400; market forces would lower the price of a tablet computer down to $400 to self-regulate a solution to this surplus situation.

Section 4.1 Market Equilibrium Price and Quantity and Section 4.2 Changes in Equilibrium Price and Quantity 4.

a.

Pe = $4; Qe = 5000 kg

b. Surplus of 6000 kg c. Shortage of 3000 kg

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Answer Key

d. Surplus of 3000 kg e. Coffee market is in equilibrium at $2; therefore, no surplus or shortage.

5. a.

b. $7; 40 units traded. c. Surplus. At $9, above the equilibrium price, there will be a surplus of 30 units of Z [the quantity supplied at $9 (50) minus the quantity demanded at $9 (20)].

d. Shortage. At $3, below the equilibrium price, there will be a shortage of 60 units of Z [the quantity demanded at $3 (80) minus the quantity supplied at $3 (20)].

e. $8, with 45 units traded (at the new supply and demand intersection). f. $6, with 50 units traded (at the new supply and demand intersection).

6. a.

The equilibrium price equals $4, where the quantity of baseball tickets demanded equals the quantity of tickets supplied. b. The supply curve is unusual in that it is vertical at a level of 2000 tickets. c. A shortage would exist if the market price was less than the $4 equilibrium price. For example, at a price of $2, there would be a shortage of 2000 tickets. d. A surplus would exist if the market price of baseball tickets exceeded $4. For example, at a price of $6, a 1000 ticket surplus would occur. At a price of $8, a 1500 ticket surplus would occur. e. Next year's demand curve will shift to the right. The new equilibrium price of baseball tickets increases to $6, where the new quantity demanded (1000 + 1000) equals the 2000-seat stadium capacity.

7. An increase in supply increases the quantity supplied at the original equilibrium price, but it does not change the quantity demanded at that price, meaning that it would create a surplus at the original equilibrium price.

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Answer Key

8. a.

The price of wheat increases, and the equilibrium quantity of wheat traded decreases.

b.

If the price of corn decreases, corn farmers are likely to plant less corn and more wheat. As a result, the supply of wheat to the marketplace will increase, decreasing the equilibrium price of wheat and increasing the equilibrium quantity of wheat exchanged.

c.

If the Prairie provinces have exceptionally favourable weather, crop yields are likely to increase. The supply curve for wheat will shift to the right, decreasing the equilibrium price and increasing the equilibrium quantity of wheat traded.

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Answer Key d.

Fertilizer is an input to the production of wheat. As a result of a decrease in the price of fertilizer, wheat is less expensive to produce, and the supply of wheat will increase. The equilibrium price of wheat will decrease, and the equilibrium quantity will increase.

e.

If more individuals begin growing wheat, the market supply for wheat will increase. The equilibrium price of wheat will decrease, and the equilibrium quantity will increase.

9. a.

Effect on the hamburger market of an increase in the price of hot dogs:

b.

Effect on cab trips of a decrease in the number of taxi companies:

c.

Effect of El Niño rainstorm destruction of strawberry crops.

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Answer Key

10. Even though the tuition ―price‖ is the same in both cases, student demand for 10 a.m. classes is typically greater than for 8 a.m. classes. Students often prefer to sleep in later than punctual attendance at an 8 a.m. class would allow. A shortage of 10 a.m. class spaces relative to demand is the likely result. There may be a surplus of class spaces in 8 a.m. courses if the demand for early- morning classes is sufficiently low.

11.

Fresh fruit is less expensive in the summer because the supply curve for fresh fruit shifts rightward in the summer, thus lowering equilibrium price and increasing equilibrium quantity.

  

This event is supply-side, since it deals with how growers are making product available for sale.

The event is a shift since the price of fresh fruit is not independently changing in the question.

The event is expansionary, since Canadian producers are seen as being able to make more fresh fruit available in the summer, when it is in season, as opposed to in the winter.

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Answer Key 12.

a.

An increase in consumer income, when laptop computers are assumed to be a normal good, will

cause the demand curve to shift rightward (the supply curve remains unchanged). This rightward shift in demand will cause equilibrium price to increase and equilibrium quantity to increase. b.

c.

d.

e.

Now that laptop computers are easier to use, there would be a greater preference (on behalf of consumers) to use them. This greater preference would shift the demand curve rightward (the supply curve remains unchanged). This rightward shift in demand will cause equilibrium price to increase and equilibrium quantity to increase.

More expensive components would increase the cost of producing laptop computers. This increase in production cost will cause the supply curve to shift leftward (the demand curve remains unchanged). This leftward shift in supply will cause equilibrium price to increase and equilibrium quantity to decrease.

The lower price of desk-top computers will increase the quantity demanded of desk-top computers. If desktop computers and considered a substitute to laptop computers, this increase in the quantity demanded of desk-top computers will result in a decrease in the demand for laptop computers (a leftward shift in demand). This decline in demand will cause equilibrium price to decrease and equilibrium quantity to decrease.

Subsidizing the production of laptop computers will result in an increase in their production. This rightward shift in the supply curve will cause equilibrium price to decrease and equilibrium quantity to increase.

Section 4.3 Simultaneous Changes in Demand and Supply 13. a.

Price falls, quantity rises.

b.

Price rises, quantity rises.

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Answer Key c.

Price rises, quantity falls.

d.

Price falls, quantity falls.

14.

b.

c.

d.

a.

An increase in income for a normal good will increase demand, shifting the demand curve to the right. A decrease in the price of an input will increase supply, shifting the supply curve to the right.

Equilibrium quantity will increase, but equilibrium price is indeterminate.

A technological advance increases supply, shifting the supply curve to the right. A decrease in the number of buyers reduces demand, shifting the demand curve to the left. Equilibrium price will fall but the effect on quantity is indeterminate.

An increase in the price of a substitute good will increase demand, shifting the demand curve to the right.

An increase in the number of suppliers will increase supply, shifting the supply curve to the right.

Equilibrium quantity will increase, but equilibrium price is indeterminate.

If producers expect that prices will soon fall, supply will be increased, shifting the supply curve to the right.

A reduction in consumers’ taste for the good will reduce demand, shifting the demand curve to the left.

Equilibrium price will fall but the effect on quantity is indeterminate.

15. If grape buyers expect grape prices to rise in the near future, it will increase their current demand to buy grapes, which would tend to increase current prices and increase the current quantity of grapes sold. If grape sellers expect grape prices to rise in the near future, they will decrease their current supply of grapes for sale, which would tend to increase current prices and decrease the current quantity of grapes sold. Because both of these effects tend to increase the current price of grapes, grape prices will rise. However, the supply and demand curve shifts tend to change current sales in opposing directions, so without knowing which of these shifts was of a greater magnitude, we do not know what will happen to current grape sales. They could go up, go down, or even stay the same.

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Answer Key 16. a.

The first group of economists believes that an increase in demand is the cause of the increasing price of bathroom tissue. Panic buying results in a rightward shift in the demand curve which will cause equilibrium price to increase and equilibrium quantity to increase. The second group of economists believes that the increase in price is being caused by a decrease in supply. Supply-chain problems and resource shortages would both cause the supply curse for bathroom tissue to shift leftward, causing equilibrium price to increase and equilibrium quantity to decrease.

b.

The simultaneous impact of both of these changes on equilibrium quantity can be used to determine which effect is greater. If the demand effect is greater than the supply effect, equilibrium quantity will increase.

However, if the supply effect is greater than the demand effect, equilibrium quantity will decrease.

Section 4.4 Price Controls 17.

b.

c.

d. e.

a.

To get to point A would require a decrease in supply; to get to point B would require a decrease in supply and an increase in demand; to get to point C would require an increase in demand; to get to point D would require a decrease in supply and a decrease in demand; point E is the current equilibrium; to get to point F would require an increase in supply and an increase in demand; to get to point G would require a decrease in demand; to get to point H would require an increase in supply and a decrease in demand; and to get to point I would require an increase in supply.

The new equilibrium would be point F, because it is an increase in supply and an increase in demand.

Equilibrium quantity would increase and if the magnitude of the demand and supply changes were equal, equilibrium price would remain constant.

Indeterminate; because one of the changes decreases supply and the other increases supply, we don’t know what the net effect is on supply. If the effects were of the exact same magnitude, the result would be E; if the increase in supply was greater than the decrease in supply, the answer would be I; if the decrease in supply was greater than the increase in supply, the answer would be A. C; A; A. G; I; G.

18.

a.

b. c.

If the price floor is raised, the quantity supplied increases, the quantity demanded decreases, and the surplus increases; if the price floor is lowered, the quantity supplied decreases, the quantity demanded increases, and the surplus decreases.

The quantity supplied does not change, the quantity demanded increases, and the surplus decreases.

The quantity supplied increases, the quantity demanded does not change, and the surplus increases.

19.

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Answer Key

a. If the price ceiling is raised, the quantity supplied increases, the quantity demanded decreases, and the shortage is reduced; if the price ceiling is lowered, the quantity supplied decreases, the quantity demanded increases, and the shortage is increased. b. The quantity supplied does not change, the quantity demanded increases, and the shortage is increased. c. The quantity supplied increases, the quantity demanded does not change, and the shortage is decreased.

20. When a price floor is imposed above the equilibrium price, the quantity demanded by buyers falls. Sellers cannot sell what buyers are unwilling to purchase at this price. The quantity traded is therefore reduced relative to the market equilibrium. When a price ceiling is imposed below the equilibrium price, the quantity supplied falls. Buyers cannot purchase more units than sellers are willing to exchange. Therefore, the quantity traded decreases relative to the market equilibrium.

21. A price floor set above the equilibrium price for dairy products would result in a surplus. A price floor set below the equilibrium price would have no impact on the price or quantity of dairy products traded. (A price floor is a minimum allowed price, not a mandated market price.)

22. The $2 price ceiling will likely result in a shortage of movie tickets. At the new, lower price, quantity demanded will rise. People will want more tickets at $2 than they did at $10. Assuming that the equilibrium price is somewhere around $10, the ceiling will cause the quantity of tickets sold to decline. Some theatres may reduce their hours of operation, and some may even go out of business. Some theatres may stop showing first-run movies. Theatre owners will certainly suffer. While some movie-goers may benefit from lower prices, they may also have to stand in long lines to buy tickets. They may also see a reduction in the quality of movies offered by theatres.

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FOR YOUR REVIEW ANSWER KEY CHAPTER 5 INTRODUCTION TO THE MACROECONOMY Section 5.1 Macroeconomic Goals 1. Answers will vary based on information obtained at the time.

2. The three macroeconomic goals discussed in the chapter are those that are relevant for the majority of economics most of the time. However, one must remember that this does not mean that all economies will pursue these goals all of the time. In some circumstances, it is possible for other goals―such as food selfsufficiency―to become economically relevant and therefore be seen as being more important than maintaining employment, maintaining stable prices, and achieving a high rate of economic growth.

Section 5.2 Employment and Unemployment 3. a. b. c. d.

80 percent (160 million/200 million) 70 percent (140 million/200 million) The labour force participation rate would become 65 percent (130 million/200 million).

Nothing; neither the adult population nor the size of the labour force would change.

The country’s labour force participation rate is 80 percent (160 million ÷ 200 million) and its unemployment rate is 12.5 percent (20 million ÷ 160 million). b. Its labour force participation rate would be 90 percent (180 million ÷ 200 million) and its unemployment rate would be 16.7 percent (30 million ÷ 180 million). c. Its labour force participation rate would be 75 percent (150 million ÷ 200 million) and its unemployment rate would be 6.7 percent (10 million ÷ 150 million). d. Its labour force participation rate would be 75 percent (150 million ÷ 200 million) and its unemployment rate would be 6.7 percent (10 million ÷ 150 million).

4. a.

5. a.

Sam is a discouraged worker who is not actively seeking work and is therefore not considered to be unemployed. b. The 12-year-old is under 15 years of age and therefore is not considered to be part of the labour force. c. The factory worker is unemployed as long as she is looking for work. d. The receptionist is considered to be employed, even though she would like to work more hours each week. e. The high-school graduate is not actively seeking work and therefore is not considered to be unemployed.

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Answer Key

6. The official unemployment rate understates the ―true‖ degree of unemployment by not including discouraged workers as unemployed, by counting part-time workers who cannot find full-time jobs as ―fully‖ employed, and by counting those employed in jobs that underutilize worker skills as ―fully‖ employed. It overstates the ―true‖ degree of unemployment by not counting those working overtime or multiple jobs as ―overemployed,‖ by counting those employed in the underground economy as unemployed, and by including those just ―going through the motions‖ of job search to maintain unemployment benefits or other government benefits as unemployed.

7. Full-time students are not considered part of the labour force, so the labour force, the number officially unemployed, and the unemployment rate would all fall if a substantial group of unemployed people became full-time students.

Section 5.3 Different Types of Unemployment 8. Structural unemployment: b Frictional unemployment: c, d Cyclical unemployment: a

9. a. b. c. d. e. f.

Frictional; increase Seasonal; increase Frictional; decrease Structural; increase Structural; decrease Cyclical; increase

10. a.

The natural rate of unemployment equals the sum of frictional and structural unemployment; cyclical unemployment is zero. b. i.

Unemployment increases; the natural rate of unemployment is unchanged. ii. Both unemployment and the natural rate of unemployment would increase. iii. Unemployment is unchanged, and the natural rate of unemployment decreases. iv. Unemployment decreases, and the natural rate of unemployment increases. v. Both unemployment and the natural rate of unemployment are unchanged.

11. a. b.

A natural rate of 6 percent would account for the sum of structural and frictional unemployment.

The additional 2 percent of unemployment above the natural rate would be attributed to cyclical unemployment.

Since cyclical unemployment cannot be negative, the only way actual unemployment can fall below the natural rate is if either structural or frictional levels of unemployment fall below their maximums (that is, below-average levels of either structural or frictional unemployment).

12. There is less incentive to find new employment once unemployed in these European countries than in Canada due to the more generous unemployment benefits. As a result, the unemployment rate in these European countries is likely to be higher than the rate in Canada.

13. In a period of plentiful jobs, frictional unemployment can be higher because job opportunities are more plentiful. The fact that there is the potential of getting a better job stimulates mobility between jobs, which, in turn, increases frictional unemployment.

14. While some workers are displaced, new technological advances create new industries and also new demands for workers.

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Answer Key

Section 5.4 Inflation 15. a.

Retirees on fixed incomes: Hurt Workers: Hurt (unless wages kept up with inflation) Debtors: Help Creditors: Hurt Shoe-leather costs: Increase Menu costs: Increase b. Workers, debtors, and creditors would be unaffected. If retirees stayed on their fixed incomes, they would be hurt. Shoe-leather costs and menu costs would still increase.

16. a.

4 percent, 7 percent b. Nothing; in both cases, it would remain unchanged (5 percent in the first case and 3 percent in the second case).

17. Price index 2020 = $16/$16 × 100 = 100 Price index 2021 = $17.28/$16 × 100 = 108 Price index 2022 = $20/$16 × 100 = 125 Inflation rate 2020–2021 = ([108 – 100]/100) × 100 = 8 percent Inflation rate 2020–2022= ([125 – 100]/100) × 100 = 25 percent Inflation rate 2021–2022= ([125 – 108]/108) × 100 = 15.7 percent

18. If the slowing of the rate of inflation is unexpected, then there is a redistribution of income from borrowers to lenders (assuming the borrowers do not default on their loans as a result). If the slowing of the rate of inflation is fully anticipated at the time the loan is taken out, then there is no redistribution of income associated with the student loan. The interest rate of a loan will be based on the anticipated inflation rate. If the parties had been aware that inflation would slow, there would have been a lower interest rate.

19. Unanticipated inflation would have a larger impact because it creates additional uncertainty and complicates business planning, and the risk discourages investment, which reduces economic growth.

20. a. 110 b. 180 c. 200

Section 5.5 Economic Fluctuations 21. Expansion phase.

22. True, in the expansionary phase, increased demand tends to lower unemployment and put upward pressure on prices (causing inflation). In the recessionary phase, lower economic demand tends to increase unemployment and put less pressure on the overall price level (price level stability).

Therefore, unemployment and inflation are typically inversely related over the business cycle.

23. a. b. c. d.

Year 5 Years 6 and 7 Year 8 Years 1, 2, 3, 4, 9, and 10

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FOR YOUR REVIEW ANSWER KEY CHAPTER 6 MEASURING ECONOMIC PERFORMANCE Section 6.1 National Income Accounting: Measuring Economic Performance 1. The following are included in Canadian GDP calculations: a. d. g. h.

Cleaning services performed by a cleaning company Prescription drugs manufactured in Canada and sold at a local pharmacy Toxic waste cleanup performed by a local company Car parts manufactured in Canada for assembly of a car in Mexico

2. a.

GDP is the value of all final goods and services produced within a country during a given period of time (almost always one year). b. To count intermediate goods as well as final goods and services would result in double counting the value of some goods and services. c. GDP is an attempt to measure domestic output; therefore, it must exclude goods and services produced in other countries (even if those goods and services are produced by Canadians in other countries). d. The value of used goods was included in GDP when those goods were newly produced, so sales of used goods are not counted as part of GDP (although any sales commissions on such sales would be counted as newly produced services). e. Because such sales simply rearrange existing ownership claims, sales of corporate shares from one shareholder to another are not counted because they are not payments for newly produced goods or services (although any sales commissions on such sales would be counted as newly produced services).

3. Existing homes and used cars were both produced in the past and therefore aren’t counted as part of current GDP. However, the services provided this year by real estate agents and used-car dealers are currently produced, so the market value of those services, measured by real estate agent commissions and the profits earned by used-car dealers, are included in GDP.

4. When Ford Motor Company buys tires to put on a vehicle that it manufactures, the tires are considered to be intermediate goods. Only final goods, goods that are ready for their designated ultimate use, are included in GDP statistics. Tires purchased by consumers to replace worn ones represent final goods and are therefore included in GDP.

5. a. b.

40

The value added of the farmer is $0.10 (the full value of their production). The value added of the miller is $0.40 ($0.50 – $0.10). The value added of the baker is $0.70 ($1.20 – $0.50). The value added of the grocer is $0.80 ($2.00 – $1.20).

The total value added for the single loaf of bread is $2.00 ($0.10 + $0.40 + $0.70 + $0.80).

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Answer Key c.

If the value of intermediate stages of production were included along with the final value of the loaf of bread, the estimated value of the loaf of bread would be double counted, once as a final value and a second time as the cumulative value of the intermediate stages of production.

Section 6.2 The Expenditure Approach to Measuring GDP 6. a. b. c. d. e. f. g. h.

Ministry of Transportation snow-clearing services: Government spending Automobiles exported to Europe: Exports Refrigerator: Consumption (consumer durables) Newly constructed four-bedroom house: Investment Restaurant meal: Consumption Additions to inventory at a furniture store: Investment Purchases of new computers by Statistics Canada: Government spending New steel mill: Investment

7. Included in GDP calculated via the expenditure approach: Consumption: Consumer durables +$420 billion Consumer semi-durables +$185 billion Consumer nondurables +$275 billion Consumer services +$600 billion Investment: Fixed investment +$120 billion Inventory investment +$50 billion Government Spending: Government wages and salaries +$300 billion Government purchase of goods and services +$110 billion Net Exports: Exports +$ 40 billion Imports –$ 80 billion GDP: $2020 billion

8.

Consumption Consumption of durable goods Consumption of semi-durable goods Consumption of nondurable goods Consumption of services Investment Fixed investment Inventory investment Government expenditures on goods and services Government transfer payments Exports Imports Net exports GDP

$6500 $1200 $1100 $1800 $2400 $1400 $800 $600 $1600 $500 $500 $650 –$150 $9350

9. a. Sales of consumer durable goods tend to change more than consumer nondurable goods over the course of a business cycle.

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Answer Key

b. Consumer durables are like investments in two primary ways: Both provide a stream of services into the future in exchange for current expenditures, and both are often financed by borrowing.

c. Fixed investments cannot be negative because additions to the capital stock cannot be negative. However, inventory investments can be negative, because inventories can end a period of time lower than they began that period. d. Government transfer payments are not included in GDP because GDP measures the value of newly produced goods and services, but transfer payments are not made in exchange for newly produced goods or services.

10. Economic forecasters focus so much on consumption purchases and their determinants because consumption purchases are by far the largest component of GDP (in Canada, nearly 55 percent); what happens to consumption purchases is therefore crucial to what happens to GDP. 11. a. b. c.

Consumption ($86) + Investment ($22) + Government ($32) + Exports ($27) – Imports ($36) = $131 Net investment is $14 million; therefore, the capital stock is expanding.

Calculate Net Exports = Exports ($27) – Imports ($36) = –$9 million. Overall, the foreign sector is having a negative, or contractionary, impact on domestic production for Ecoland.

Section 6.3 The Income Approach to Measuring GDP 12. Output creates income of equal value.

13.

Personal consumption expenditures

$210

Gross investment

100

Government current purchases of goods and services

60

Exports

10

Imports

(20)

GDP–Expenditure Approach Compensation of employees

$360 $210

Corporation profits before taxes

62

Net mixed income

21

Indirect taxes (less subsidies)

35

Capital consumption allowances (depreciation)

32

GDP–Income Approach

$360

Compensation of employees

$110

Corporation profits before taxes

73

Net mixed income

27

Indirect taxes (less subsidies)

45

Capital consumption allowances (depreciation)

18

GDP–Income Approach

$273

14.

Section 6.4 Issues with Calculating an Accurate GDP 15. You cannot say that production has increased in Nowhereland from 2020 to 2021 by just looking at nominal GDP. Production may have increased. However, nominal GDP could have increased due to

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Answer Key

inflation while production remains unchanged (as would be the case with a 10 percent inflation rate) or even decreased (with a greater than 10 percent inflation rate).

16. Year 2017 2018 2019 2020 2021

Nominal GDP

Real GDP

($720 billion/100) × 100 = $720 billion ($750 billion/102) × 100 = approximately $735 billion ($800 billion/110) × 100 = approximately $727 billion ($900 billion/114) × 100 = approximately $789 billion ($960 billion/120) × 100 = $800 billion

The real economic growth rate for 2021 was 1.4 percent [($800 – $789)/$789] ×100.

17.

Year 2017 2018 2019 2020 2021

GDP Deflator 90.9 100 125 140 150

Nominal GDP (in billions) $700 $800 $1000 $1400 $1800

Real GDP (in billions) $770 $800 $800 $1000 $1200

18. a.

Year 2016 2017 2018 2019 2020 2021

Nominal GDP (in millions of $) 3237.0 3156.4 2995.3 3376.2 3517.6 3797.3

GDP Deflator 93.3 97.2 100 103.2 101.4 102.6

Real GDP (in millions of $) 3469.5 3247.3 2995.3 3271.5 3469.0 3701.1

b. The base year is 2018 (identified by the GDP deflator value of 100). The significance of the year 2018 is

c.

that the conversion of nominal GDP values into real GDP involves the conversion of current dollar output (nominal GDP) to constant dollar output (real GDP). The constant dollars that real GDP is measured in is 2018 dollars.

Looking at the behaviour of real GDP between 2016–2021, the following trends are apparent: real GDP (production) is falling in 2017 and 2018; real GDP (production) is rising in 2019, 2020, and 2021.

19. Year

Real GDP per capita

2001 $4000 million/1.25 million = $3200 2011 $6750 million/1.6 million = approximately $4219 2021 $9000 million/1.8 million = $5000 Real GDP per capita increases over time.

Section 6.5 Problems with GDP as a Measure of Economic Welfare 20. a. Next year’s real GDP growth rate can exceed next year’s nominal GDP growth rate, but only if the price level falls. If the price level rises, next year’s nominal GDP growth rate will exceed next year’s real GDP growth rate. b. Yes. It will happen when the population growth rate exceeds the growth rate of real GDP. c. Since only what is produced can be consumed, if we measured all sources of output accurately, real per

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Answer Key capita consumption possibilities can expand only when real per capita GDP grows. However, if, say, the underground (therefore, unmeasured) economy grew fast enough, real per capita consumption possibilities could increase despite measured decreases in real per capita GDP. d. Leisure is valuable but its value is not counted in GDP. So changing amounts of leisure over time will not be accurately incorporated into GDP measures. Further, while a decrease in leisure (an increase in labour market work) would increase measured GDP, people would be better off only if their real after-tax wages were higher than the value of the leisure they gave up, which is not always the case (especially when workers don’t take into account the fact that, as their wages increase, so do the prices of goods and services).

21. It is not enough to simply look at real GDP in the United States versus real GDP in Canada. The United States has a much larger population than Canada, so it would be expected to have a higher real GDP. To compare real GDP across countries, one should look at real GDP per capita. Real GDP per capita is an imperfect measure of well-being but can give some idea of the standard of living in these two countries.

22. Since nonmarket activities are not included in GDP, GDP statistics understate the true value of total output more for developing economies than for developed economies. This statistical bias tends to make developed economies (with their smaller shares of nonmarket activities) look more productive relative to developing economies (with larger shares of nonmarket activities).

23. Decreasing hours worked will reduce real GDP, other things being equal. However, choosing to do so voluntarily would mean that we place a higher value on leisure time (which is not counted in GDP) than on the market output (which is counted in GDP) forgone by reducing hours worked. As a result, the measured change in real GDP would be inaccurate as it would not accurately reflect the change in our well-being.

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FOR YOUR REVIEW ANSWER KEY CHAPTER 7 ECONOMIC GROWTH IN THE GLOBAL ECONOMY Section 7.1 Economic Growth 1. a.

b.

0.5 percent 1.0 percent 1.4 percent 2.0 percent 2.8 percent 3.5 percent 7.0 percent 1.4 percent 2.8 percent 7.0 percent

140 years 70 years 50 years 35 years 25 years 20 years 10 years $200 billion $400 billion $3200 billion

2. When capital goods are manufactured in the current period, the ability to produce and consume in future periods is enhanced. So, when a choice is made in the current period between producing consumer goods and capital goods, it represents a trade-off between present and future consumption.

3. a.

b.

Using the Rule of 70, Country A’s real per capita GDP would double every 50 years (70/1.4) and Country B’s real per capita GDP would double every 25 years (70/2.8). In the course of 100 years, Country B’s real per capita GDP would double 4 times, while Country A’s would double only 2 times. If they started at the same size, Country B’s real per capita GDP would be 4 times that of Country A after that period of time, but since Country B started out one-fourth as large as Country A, their real per capita GDP would end up the same size in 100 years.

At 2.8 percent annual growth, Country A’s real per capita GDP would double every 25 years, or 4 times in a century. At 3.5 percent annual growth, Country B’s real per capita GDP would double every 20 years, or 5 times in a century. As a result, Country B’s real per capita GDP would be twice that of Country A after a century.

4. Real GDP per capita provides one measure of the standard of living in a country. Since Country A is growing at a more rapid pace than Country B, Country A’s standard of living will improve more rapidly over time than will Country B’s. According to the Rule of 70, it will take approximately 10 years to double the standard of living in Country A, and over 23 years in Country B.

5. Building dikes in Holland increased the quantity of usable land the Dutch had to work with; an increase in the amount of usable natural resources shifts a country’s production possibilities curve outward.

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Answer Key

6. The following will shift the Canadian production possibilities curve outward: a. b. d.

Discovery of new oil reserves.

Increased immigration of scientists and engineers to Canada.

Production of fewer pizzas in order to produce more tractors (it will increase the capital stock, shifting out the production possibilities curve over time).

Section 7.2 Determinants of Economic Growth 7. It depends. Both capital investment and human capital investment increase productivity, so the answer depends on which is more productive in a given case. If education (human capital investment) is more productive, shifting from capital investment to human capital investment would increase the growth rate of real per capita GDP. If education (human capital investment) is less productive, shifting from capital investment to human capital investment would decrease the growth rate of real per capita GDP.

8. Labour is the physical and/or mental effort used to produce goods and services. Human capital is the investment in education or on-the-job training or experience.

9. Each of the following will likely improve the productivity of labour: a. b. d.

On-the-job experience College education Improvements in management of resources

10. Hong Kong has virtually no natural resources, yet has long been among the fastest-growing economies in the world, proving that abundant natural resources are not necessary for rapid economic growth.

Section 7.2 Determinants of Economic Growth―And― Section 7.3 Public Policy and Economic Growth 11.

An increase in population An increase in labour force participation An increase in population and labour force participation An increase in current consumption An increase in technology An increase in illiteracy An increase in tax rates An increase in productivity An increase in tariffs on imported goods An earlier retirement age in the country An increase in technology and a decrease in labour force participation An earlier retirement age and an increase in the capital stock

Real GDP Growth Real GDP Growth per Capita Increase Indeterminate Increase Increase Increase Increase Decrease Increase Decrease Decrease Increase Decrease Decrease Indeterminant

Decrease Increase Decrease Decrease Increase Decrease Decrease Indeterminant

Indeterminant

Indeterminant

Section 7.3 Public Policy and Economic Growth 12. When patent and copyright laws are only weakly enforced, it reduces the incentive of individuals and firms to innovate by reducing the reward for innovation. Economic growth, which is enhanced by technological change

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Answer Key and innovation, is likely to suffer as a result.

13. Permanently lower marginal tax rates would increase the after-tax rate of return to each of these productive activities, which, over time, would increase the levels of the capital stock, education, and technology, and the amount of developed natural resources.

14. Without protected property rights and the rule of law, both production and exchange become far more difficult, costly, and uncertain, undermining the ability of market incentives to induce the effective use of the factors of production. Similarly, the rewards to investors and those who seek new and better ways of doing things are also more uncertain, reducing the incentives to make such investments and innovations.

Section 7.4 Population and Economic Growth 15. a. b.

Real GDP will grow while real GDP per capita falls whenever the population growth rate exceeds the growth rate of real GDP. Country A has a higher real per capita GDP growth rate of 2 percent (4 percent real GDP growth minus 2 percent population growth). Country B’s real per capita GDP growth rate is 1 percent (6 percent real GDP growth minus 5 percent population growth).

16. If population fell, but technology improved, so that real GDP per worker increased, then real GDP could rise.

One possible source of that result would be an increase in labour force participation (an increase in the fraction of the population working).

17. In countries with a fixed supply of land and little if any technological advance, Malthus’s assumptions are not far from reality. Population control is one way to hold down the rate of population increase, to prevent the Malthusian subsistence wage result.

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FOR YOUR REVIEW ANSWER KEY CHAPTER 8 AGGREGATE DEMAND Section 8.1 The Determinants of Aggregate Demand 1. a. 0.90 b. c. d. e.

0.80 0.60 $300 000; 0.75 $120 000; 1.2

2. A higher price level in Canada makes it more expensive for domestic consumers to purchase goods produced at home. As a result, domestic consumers turn toward foreign-produced substitutes, increasing imports.

Section 8.2 The Investment and Saving Market 3.

a.

4.

Vertical axis: Real Interest Rate Horizontal axis: Quantity of Saving and Investment a. The investment demand (ID) curve would shift to the right, increasing both interest rates and the dollar amount of investment demanded. b. The saving supply (SS) curve would shift to the right, decreasing interest rates and increasing the dollar amount of investment demanded. c. The investment demand (ID) curve would shift to the left, decreasing both interest rates and the dollar amount of investment demanded. d. The saving supply (SS) curve would shift to the right, decreasing interest rates and increasing the dollar amount of investment demanded.

5.

An increase in current disposable income would cause an increase in private saving, shifting the saving supply curve to the right. A decrease in new technologies creating investment opportunities would shift the investment demand curve to the left, moving the equilibrium down along the saving supply curve but not shifting it.

6.

A budget deficit would decrease public savings and shift the saving supply curve to the left. This would increase the equilibrium real interest rate and decrease the equilibrium level of saving and investment exchanged, and the higher real interest rate would tend to decrease economic growth.

48

The quantity of investment demanded increases, but the investment demand curve does not shift. b. The investment demand curve shifts to the left. c. The investment demand curve shifts to the right. d. The quantity of saving supplied increases but the saving supply curve does not shift. e. The saving supply curve shifts to the right.

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Answer Key 7.

In a simple closed economy, exports (X) and imports (M) are both zero. Therefore, GDP – C – G is what is left over from income (GDP) after spending on consumption (C) and government purchases (G), which is what is available for investment (I). But in equilibrium, investment (I) must equal saving (S).

8.

Increased net personal taxes reduce disposable income, which in turn reduces private saving. However, increased net personal taxes move the government budget toward surplus, increasing public saving.

Section 8.3 The Aggregate Demand Curve 9.

The aggregate demand curve shows what happens to the total quantity of all real goods and services demanded in the economy as a whole (i.e., the quantity of real GDP demanded) at different price levels. The downward slope of the aggregate demand curve is explained by the real wealth effect, the interest rate effect, and the open economy effect. All three effects tell us that as the price level in the economy increases, the various components of aggregate demand [C, I, and (X – M)] will decline.

10. The statement is correct. A higher price level reduces the quantity of goods and services that can be purchased with a Canadian dollar. Exports will decrease since a higher Canadian price level makes it relatively more expensive for foreign consumers to purchase Canadian goods. At the same time, imports will increase since, faced with higher prices at home, more Canadian residents will buy imported goods. Net exports, and therefore real GDP demanded, decrease.

11. A reduced price level increases the real value of people’s currency holdings; as their wealth increases, so does the quantity of real goods and services demanded, particularly consumption goods. As a result, the aggregate demand curve, which represents the relationship between the price level and the quantity of real goods and services demanded, slopes downward.

12. A reduced price level reduces the demand for money, which lowers interest rates, thereby increasing the quantity of investment goods and services and consumer goods and services people are willing to purchase. As a result, the aggregate demand curve, which represents the relationship between the price level and the quantity of real goods and services demanded, slopes downward.

13. The open economy effect occurs when a higher domestic price level raises the prices of domestically produced goods relative to the prices of imported goods. This reduces the quantity of domestically produced goods demanded (by both citizens and foreigners) as relatively cheaper foreign-made goods are substituted for them.

As a result, the aggregate demand curve, which represents the relationship between the price level and the quantity of real goods and services demanded, slopes downward.

Section 8.4 Shifts in the Aggregate Demand Curve 14. a. Increase b. Indeterminate c. Decrease d. Increase e. Indeterminate f. No change (change in quantity of RGDP demanded) g. No change (change in quantity of RGDP demanded)

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Answer Key

15. A rapid depletion of inventories is consistent with a rightward shift of the aggregate demand curve.

As a result of an increase in aggregate demand, both output and investment are likely to increase.

16. Of the choices available, only option (b), an increase in personal income taxes, both decreases consumption and shifts the aggregate demand curve to the left.

17. a. b. c. d.

Investment expenditures will increase.

Investment expenditures will decrease.

Investment expenditures will decrease.

Investment expenditures will decrease.

18. a. b. c. d. e.

Investment and consumption; the aggregate demand curve will shift to the right.

Consumption and investment; the aggregate demand curve will shift to the right.

Investment: the aggregate demand curve will shift to the right.

Consumption: the aggregate demand curve will shift to the left.

Exports: the aggregate demand curve will shift to the right.

19. Any recession in the United States reduces the incomes of Americans. As a result, Americans probably buy fewer Canadian goods and services, decreasing Canadian exports and aggregate demand.

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FOR YOUR REVIEW ANSWER KEY CHAPTER 9 AGGREGATE SUPPLY AND MACROECONOMIC EQUILIBRIUM Section 9.1 The Aggregate Supply Curve 1. This is an example of the misperception effect. The misperception effect implies an upward sloping short-run aggregate supply curve.

2. The short-run aggregate supply curve is upward sloping because in the short run, before input prices have completely adjusted to the price level, an increase in the price level increases profit margins by increasing output prices relative to input prices. This leads producers to increase real output. The long-run aggregate supply curve is vertical because in the long run, when input prices have completely adjusted to changes in the price level, input prices as well as output prices have adjusted to the price level; hence, profit margins in real terms do not change as the price level changes, and therefore there is no relationship between the price level and real output in the long run. The long-run aggregate supply curve is vertical at the natural rate of real output because that is the maximum output level allowed by capital, labour, land, entrepreneurship, and technological inputs at full employment (i.e., given the determinants of the economy’s production possibilities curve), which is therefore sustainable over time.

3. Profit incentives are the key to understanding what happens to real output as the price level changes in the short run (before input prices completely adjust to the price level). When the prices of outputs rise relative to the prices of inputs (costs), as when aggregate demand increases in the short run, profit margins increase, which increases the incentives to produce, which leads to increased real output. When the prices of outputs fall relative to the prices of inputs (costs), as when aggregate demand decreases in the short run, profit margins decrease, which decreases the incentives to produce, which leads to decreased real output.

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Answer Key

Section 9.2 Shifts in the Aggregate Supply Curve 4.

Change An increase in aggregate demand

Short-Run Aggregate Supply No change

Long-Run Aggregate Supply No change

A decrease in aggregate demand

No change

No change

An increase in the stock of capital

Increase (right shift)

Increase (right shift)

A reduction in the size of the labour force

Decrease (left shift)

Decrease (left shift)

An increase in input prices (that does not reflect permanent changes in their supplies)

Decrease (left shift)

No change

A decrease in input prices (that does reflect permanent changes in their supplies)

Increase (right shift)

Increase (right shift)

An increase in usable natural resources

Increase (right shift)

Increase (right shift)

A temporary adverse supply shock

Decrease (left shift)

No change

Increases in the cost of government regulations

Decrease (left shift)

Decrease (left shift)

5. a. b. c. d. e.

Shift SRAS to the right Shift SRAS to the left Shift SRAS to the right No shift of the SRAS occurs (aggregate demand increases and there is a movement up along the SRAS).

Shift SRAS to the left

6. a. b. c. d.

Shift LRAS to the right No effect on LRAS unless it reflects permanent changes in the supply of labour Shift LRAS to the left

7. a. b. c. d.

Shift LRAS to the right

A decrease in SRAS A decrease in both SRAS and LRAS A decrease in SRAS An increase in both SRAS and LRAS

8. A temporary change in input prices can change the short-run aggregate supply curve by changing profit margins in the short run. However, when input prices return to their previous levels (reflecting a return to their previous relative scarcity) in the long run, the sustainable level of real output will be no different from before. If, on the other hand, input price changes reflect a permanently changed supply of inputs (lower input prices reflecting an increased supply), a change in input prices would increase both the long-run and short-run aggregate supply curves by increasing the real output producible both currently and on an ongoing basis (permanently shifting the economy’s production possibilities curve outward).

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Answer Key

Section 9.3 Macroeconomic Equilibrium 9. a.

With greater confidence in the economy, consumers would undertake more consumption. This increase in consumption would cause aggregate demand to increase. The price level increases, real output increases, employment increases, and unemployment decreases. b.

The price level ends up higher, real output ends up back where it began at potential output, employment ends up back where it began at full employment, and unemployment ends up back where it began at the natural rate of unemployment.

10. a.

Government purchases are a component of aggregate demand [AD = C + I + G + (X − M)], so a decrease in government purchases would cause a decline in aggregate demand. The price level falls, real output falls, employment falls, and unemployment rises b.

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Answer Key

The price level ends up lower, real output ends up back where it began at potential output, employment ends up back where it began at full employment, and unemployment ends up back where it began at the natural rate of unemployment.

11. a.

b.

In the long run, the price level will end up lower than before, but real output and unemployment will return to their long-run equilibrium levels.

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Answer Key

12. a.

b.

In the long run, the price level will end up higher than before, but real output and unemployment will return to their long-run equilibrium levels.

13. Cost-push inflation occurs when the short-run aggregate supply curve shifts to the left, pushing up prices. Demand-pull inflation occurs when the aggregate demand curve shifts to the right, pulling up prices. Examples will vary. Cost-push inflation may be caused by an increase in input prices, such as the price of crude oil or wages. Demand-pull inflation may be caused by an increase in consumer confidence or a decrease in taxes.

14. Yes, an economy could operate above full employment in the short run by using its resources more intensively. Firms encourage workers to work overtime, extend the hours of part-time workers, hire recently retired employees, or reduce frictional unemployment through more extensive searches for employees. However, this level of output and employment cannot be sustained in the long run.

15. Sticky prices and wages is a term for input prices and wages that may be very slow to adjust in the downward direction. This delay in adjustment may cause the economy's self-adjustment mechanism to a recessionary gap to take a substantial amount of time.

16. b. Striking workers demand and receive large nominal wage increases e.

A temporary decrease in OPEC oil production

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Answer Key

17. a.

b. The equilibrium price level is 110 and the equilibrium level of real GDP is $500 billion. c. As the initial equilibrium (a short-run equilibrium) occurs at potential output, the economy is initially experiencing neither a recessionary nor an inflationary gap. d.

e.

New equilibrium price level is 100; equilibrium level of real GDP is $450 billion.

At this short-run equilibrium, the economy of Adanac is experiencing a $50 billion recessionary gap.

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Answer Key

THE KEYNESIAN AGGREGATE EXPENDITURE MODEL 1. a. An increase in interest rates c. A decrease in disposable income d. An increase in income taxes 2. Investment is the most volatile component of aggregate expenditure. Consumption is its largest component.

3. a. c. e.

An increase in consumer optimism An increase in the sale of exports An increase in government spending due to the outbreak of war

4. If household debt fell, disposable income would rise, and autonomous consumption would rise as a result. If interest rates rose, savings would also rise, reducing autonomous consumption. The net effect on autonomous consumption would depend on the relative magnitudes of the effects.

5. Both an increase in real wealth and more optimistic expectations would increase autonomous consumption, so together they must also increase autonomous consumption.

6. The MPC equals the $6000 increase in consumption, divided by the $10 000 increase in disposable income, or 0.60. The MPS equals 0.40 (1 – MPC). The spending multiplier is 1 divided by 1 − 0.60, or 2.5.

7. If the value of a consumer’s stock market investments rose, it would increase autonomous consumption, but if household debt rose, it would reduce autonomous consumption. Since these effects are in opposite directions, the net effect would be indeterminate without more information.

8. No. Doubling your income would double your income-induced consumption spending but not change autonomous consumption, so it would less than double your total consumption.

9. If MPC was greater than one, the aggregate expenditure line would never intersect the 45-degree expenditure equals output line, so there would not be any stable equilibrium.

10. If unplanned inventory changes are negative, people are purchasing more than produced this period, so production will rise. If unplanned inventory changes are positive, people are purchasing less than produced this period, so production will fall.

11. An increase in planned investment shifts up the aggregate expenditure line, increasing the equilibrium level of real GDP. An unplanned increase in investment, however, indicates that real GDP is greater than its equilibrium level, which will lead to a decrease in real GDP toward that equilibrium level.

12. Autonomous expenditures equal the sum of autonomous consumption plus investment plus government purchases plus net exports. If net exports are negative, autonomous expenditures are lower and the aggregate expenditure line shifts down, resulting in lower equilibrium income.

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Answer Key

13. An increase in unplanned investment would indicate real GDP was greater than its equilibrium level, leading to a decrease in real GDP produced. In contrast, an increase in planned investment would increase planned expenditures, tending to increase real GDP produced.

14. If government purchases increased by $500 million and investment fell by $500 million at the same time, there would be no change in autonomous expenditures and therefore no change in equilibrium income. If government purchases increased by $500 million and investment fell by $400 million at the same time, autonomous expenditures would increase by $100 million. It would increase equilibrium income by:

(

)

15. Net exports would decrease by $100 million, which would decrease autonomous expenditures by $100 million.

Income would fall by:

(

)

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FOR YOUR REVIEW ANSWER KEY CHAPTER 10 FISCAL POLICY Section 10.1 Fiscal Policy 1. a. An increase in government spending would decrease a budget surplus. b. An increase in government spending would increase aggregate demand. c. When the threat of a recession is developing 2. An increase in government purchases would be expansionary, while an increase in taxes would be contractionary. Without knowing the relative magnitudes of the different effects, we cannot know what the net effect is. Similarly, an increase in government purchases would increase the federal government deficit, while an increase in taxes would reduce it, so that the net effect again depends on the relative magnitudes of the changes.

3. a. An increase in taxes would decrease a budget deficit. b. An increase in taxes would decrease aggregate demand. c. When the threat of an unsustainable, inflationary boom is likely 4. Government deficits are increased whenever government purchases rise or taxes fall, other things equal.

However, either higher government purchases or lower taxes increase aggregate demand, tending to expand the economy. Government deficits are decreased whenever government purchases fall or taxes rise, other things equal. However, either lower government purchases or higher taxes decrease aggregate demand, tending to contract the economy.

Section 10.2 Government: Spending and Taxation 5. Suppose the government places an additional $1 per package tax on cigarettes. For individuals who have an income of $50, this amounts to 2 percent of their income; however, for individuals who have an income of $100, the tax amounts to only 1 percent. Uniform taxes, such as excise taxes on cigarettes, have a greater impact on lower-income individuals.

6. This question is asking about the sources of revenue for the federal government. While the federal government has numerous ways in which it can generate revenue (see Exhibit 1[b]), income taxes represent the single largest source of revenue.

Section 10.3 The Multiplier Effect 7. MPC = 0.25, multiplier value is 1.33, the tax multiplier value is 0.33 MPC = 0.5, multiplier value is 2, the tax multiplier value is 1 MPC = 0.75, multiplier value is 4, the tax multiplier value is 3

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Answer Key

8.

Change in Aggregate Demand

Change in Consumption

a. 0.20

$2.5 billion

$0.5 billion

b. 0.5

$4 billion

$2 billion

c. 2/3

$6 billion

$4 billion

d. 0.75

$8 billion

$6 billion

e. 0.8

$10 billion

$8 billion

9. The larger the marginal propensity to consume, the larger the fraction of increased income in each ―round‖ of the multiplier process that will go to additional consumption purchases. Since each round of the multiplier process will therefore be larger the greater the marginal propensity to consume, the multiplier will also be larger.

10. It is the initial effect in the goods and services market that triggers the multiplier process. When government increases its purchases, the dollar amount of the purchases is the magnitude of the initial effect. However, with a change in taxes, the initial effect is the change in consumption caused by the change in taxes, and that change in consumption is smaller than the change in taxes.

Section 10.4 Fiscal Policy and the AD/AS Model 11. a. b. c. d.

GDP will increase.

GDP will decrease.

GDP will increase.

GDP will decrease.

12. An increase in spending by $7.5 billion; an increase in spending by $10 billion.

13. A reduction in taxes of $10 billion; a reduction in taxes of $15 billion.

14. A tax increase would be needed to address the inflationary gap. If the MPC = 0.9, a tax increase of $25 million would be appropriate.

15. An economy can operate above the full employment level of output temporarily by using resources intensively. For example, factories can run three shifts per day, instead of two. Employees can be asked to work more hours each week. Firms can attempt to lure workers away from other firms by offering higher wages. As firms compete for scarce resources to maintain high levels of production, there will be upward pressure on input prices. When that occurs, the short-run aggregate supply curve will shift to the left, moving the economy back toward full employment and the economy will experience inflation. The government may be able to prevent inflation from occurring by decreasing government spending. To determine the correct magnitude, the government would need to know the size of the multiplier and then use this value to determine the appropriate reduction in government spending to eliminate the $25 billion inflationary gap.

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Answer Key

16.

When the economy is operating above full employment, as depicted above, a tax cut increases disposable income, shifting aggregate demand to the right, from AD1 to AD2. As a result, the existing inflationary gap and the price level both increase. Such a policy may be imprudent because it creates inflation.

17. a. b. c. d. e. f.

At point E3.

The economy would end up at a long-run equilibrium at point E2.

The economy would end up at a long-run equilibrium at point E0.

At point E1.

The economy would end up in long-run equilibrium at point E0.

The economy would end up in long-run equilibrium at point E2.

Section 10.5 Automatic Stabilizers 18. Automatic stabilizers automatically increase budget deficits when the economy is weak and decrease budget deficits when the economy is strong. An annually balanced budget rule would not allow the automatic stabilizers to work, since those deficits and surpluses would not be allowed.

19. Discretionary fiscal policy requires new policies to be made, so it is subject to time lags in deciding what the problem is and what to do about it, and in implementing a solution. Since automatic stabilizers do not require new policy to be adopted, those lags do not handicap it in the same way.

20. a. b. c. d.

Employment Insurance benefits decrease.

Welfare payments decrease.

Income tax receipts increase.

The government budget deficit (surplus) decreases (increases).

21. Some taxes, such as progressive income taxes and corporate profits taxes, automatically increase as the economy grows, and this increase in taxes restrains disposable income and the growth of aggregate demand below what it would have been otherwise. Similarly, these taxes automatically decrease in recessions, and this decrease in taxes increases disposable income and acts as a partial offset to the fall in aggregate demand. The result is reduced business cycle instability. Some transfer payment programs, such as Employment Insurance (EI), act as automatic stabilizers because when business cycle conditions worsen, people can start receiving increased transfer payments as soon as they become eligible (e.g., lose their jobs, in the case of EI). The same is true of some other welfaretype programs, such as the Canada Child Benefit (CCB).

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Answer Key

Section 10.6 Possible Obstacles to Effective Fiscal Policy 22. Government spending may crowd out private investment by increasing interest rates. Firms faced with higher interest payments on their borrowings may scale back plans to build new factories, introduce new products, etc. To the extent that the increase in government spending adds less to the value of the nation’s capital stock than the private investment that is crowded out would have, longterm economic growth may be negatively impacted.

23. a. An increase in government purchases increases the government budget deficit. The increased budget deficit reduces national savings, which increases real interest rates (see Section 8.2).

Higher real interest rates crowd out some of the investment that would otherwise have taken place. b. The crowding-out of investment increases the more that interest rates are bid up by the government borrowing and the more that investment falls as a result of increased interest rates. c. The greater the crowding-out effect, the smaller the net effect of a given increase in government purchases on aggregate demand.

24. The time lag between when a policy change is desirable and when it is adopted and implemented (for data gathering, decision making, etc.), as well as the time lag between when a policy is implemented and when it has its effects, makes it difficult for fiscal policy to have the desired effect at the desired time, particularly given the difficulty in forecasting the future course of the economy.

Section 10.7 The Federal Government Debt 25. In the short run, deficit reduction is contractionary fiscal policy; either tax increases and/or a reduction in government purchases will shift the aggregate demand curve to the left, and a lower price level and lower RGDP will result.

26. In the long run, however, the story is different. Lowering the budget deficit, or running a larger budget surplus, leads to a lower real interest rate, which increases private investment and stimulates higher growth in capital formation and economic growth, shifting the SRAS and LRAS curves rightward. The final effect is a higher RGDP and a lower price level than would have otherwise prevailed.

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Answer Key

27. Arguments can be made that the generation of taxpayers living at the time that the debt is issued shoulders the true cost of the debt, because the debt permits the government to take command of resources that would be available for other, private uses. However, the issuance of debt does involve some intergenerational transfer of incomes. Long after federal debt is issued, new generations of taxpayers are making interest payments to people of the generation that bought the bonds issued to finance that debt. If public debt is created intelligently, however, the ―burden‖ of the debt should be less than the benefits derived from the resources acquired as a result; this is particularly true when the debt allows for an expansion in real economic activity or for the development of vital infrastructure for the future.

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FOR YOUR REVIEW ANSWER KEY CHAPTER 11 MONEY AND THE BANKING SYSTEM Section 11.1 What is Money?

1. An economics professor might find it difficult to locate a trading partner willing to listen to economics lectures or receive economic advice in exchange for a new car. There may be significant search costs involved in locating such a trading partner. The professor might have to provide lectures in exchange for goods that are not desired, hoping that ultimately, after perhaps a series of trades, to be able to obtain a new car.

2. Domestic currencies lose their purchasing power quickly in countries experiencing rapid inflation. In such situations, people prefer to hold a more stable currency, such as the U.S. dollar, that better maintains its purchasing power and has the confidence of buyers and sellers.

3. Having some good function as money lowers transaction costs, allowing increasing specialization and exchange to create increasing wealth for a society. That increase in wealth made possible by using money is why virtually all societies create something to function as money.

Section 11.2 Measuring Money 4. a. b. c. d.

Savings deposit Six-month Treasury bill Demand deposit Savings account

5. ATMs and online banking have made it far easier to convert savings accounts into chequing accounts, so savings accounts have become more liquid as a result.

6.

64

Change

M2

M2+

An increase in currency in circulation An increase in demand deposits An increase in savings deposits An increase in credit card balances A transfer of demand deposit balances from credit unions to chartered banks

Increase Increase Increase No change Increase

Increase Increase Increase No change No change

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Answer Key

7. Credit cards are not money. They are actually guaranteed loans available on demand to users, which can be activated by consumers. Credit cards are convenient substitutes for making transactions directly with money; that is, they are substitutes for the use of money in exchange.

Section 11.3 How Banks Create Money 8. a. b. c. d. e. f. g.

Asset side of a bank’s balance sheet Asset side of a bank’s balance sheet Liability side of a bank’s balance sheet Asset side of a bank’s balance sheet Liability side of a bank’s balance sheet Asset side of a bank’s balance sheet Liability side of a bank’s balance sheet

9. Banks make money (profits) by loaning out their deposits at a higher interest rate than they pay their depositors.

However, it is the extension of new loans in search of profits that creates new demand deposits, thereby increasing the stock of money.

10. If loaning out excess reserves was more profitable than the interest rate that could be received from the Bank of Canada on excess reserves, we would still normally expect banks to lend out excess reserves rather than maintain them as excess reserves.

11. A new $10 000 deposit adds that amount to both your demand deposit account and to the reserves of your bank.

But only a fraction of the added reserves is desired by the addition to your demand deposit account. The rest are excess reserves, which the bank will look to convert to interest-earning loans or other assets.

Section 11.4 The Money Multiplier 12. a.

10 Percent Desired Reserve Ratio Assets Desired reserves Excess reserves

Bank Balance Sheet Liabilities $10 000 Demand deposits $90 000

$100 000

20 Percent Desired Reserve Ratio Assets Desired reserves Excess reserves

Bank Balance Sheet Liabilities $20 000 Demand deposits $80 000

$100 000

25 Percent Desired Reserve Ratio Assets Desired reserves Excess reserves

Bank Balance Sheet Liabilities $25 000 Demand deposits $75 000

$100 000

50 Percent Desired Reserve Ratio Assets Desired reserves Excess reserves

Bank Balance Sheet Liabilities $50 000 Demand deposits $50 000

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$100 000

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Answer Key

b.

10 Percent Desired Reserve Ratio Assets Desired reserves Loans

Bank Balance Sheet Liabilities $10 000 Demand deposits $90 000

$100 000

20 Percent Desired Reserve Ratio Assets Desired reserves Loans

Bank Balance Sheet Liabilities $20 000 Demand deposits $80 000

$100 000

25 Percent Desired Reserve Ratio Assets Desired reserves Loans

Bank Balance Sheet Liabilities $25 000 Demand deposits $75 000

$100 000

50 Percent Desired Reserve Ratio Assets Desired reserves Loans

Bank Balance Sheet Liabilities $50 000 Demand deposits $50 000

c.

10 percent 20 percent 25 percent 50 percent

$900 000 $400 000 $300 000 $100 000

13. a.

10 percent 15 percent 20 percent

$10 000 Zero (it has zero excess reserves) Zero (it has insufficient reserves)

b.

10 percent 15 percent 20 percent

$46 000 $34 000 $22 000

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$100 000

Answer Key

14. a. b. c. d.

15. a. b.

c.

10 50 5 12.5 $45 000 ($4500 × 1/0.10) If the bank had no excess reserves, the withdrawal would result in the bank having insufficient reserves to support its demand deposits. In this situation, the bank would have to either sell other assets or reduce the amount of existing loans to make up the reserve shortfall. The resulting loss in potential deposit creation would be $500 ($50 × 1/0.10).

While the balance sheets of the individual banks are affected, there is no change in the level of demand deposits in the overall banking system.

16. The value of the money multiplier would equal 1. Banks would not be able to create money in such a case because they would be unable to issue loans using customer deposits. As a result, the banks could not generate new demand deposit accounts.

17. Excess reserves equal $300 000. The potential expansion in demand deposits from loaning out these excess reserves equals $3 000 000 ($300 000 × 1/0.10).

10 Percent Desired Reserve Ratio Bank Balance Sheet (revised)

Assets Reserves Loans Loans (new) Buildings

$ 500 000 1 600 000 3 000 000 1 200 000

Total Assets

$6 300 000

Liabilities Demand deposits Demand deposits (new) Total Liabilities Capital Total Liabilities and Capital

$2 000 000 3 000 000 $5 000 000 1 300 000 $6 300 000

18. Excess reserves equal $75 000. The potential expansion in demand deposits from loaning out these excess reserves equals $500 000 ($75 000 × 1/0.15).

15 Percent Desired Reserve Ratio Bank Balance Sheet (revised)

Assets Reserves Loans Loans (new) Buildings

$ 300 000 1 200 000 500 000 500 000

Total Assets

$2 500 000

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Liabilities Demand deposits Demand deposits (new) Total Liabilities Capital Total Liabilities and Capital

$1 500 000 500 000 $2 000 000 500 000 $2 500 000

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Answer Key

19. Excess reserves equal $50 000. The potential expansion in demand deposits from loaning out these excess reserves equals $250 000 ($50 000 × 1/0.20).

20 Percent Desired Reserve Ratio Bank Balance Sheet (revised)

Assets

Liabilities

Reserves Loans Loans (new) Buildings

$ 750 000 2 500 000 250 000 1 250 000

Total Assets

$4 750 000

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Demand deposits Demand deposits (new) Total Liabilities Capital Total Liabilities and Capital

$3 500 000 250 000 $3 750 000 1 000 000 $4 750 000

FOR YOUR REVIEW ANSWER KEY CHAPTER 12 THE BANK OF CANADA Section 12.1 The Bank of Canada 1. The following are functions of the Bank of Canada: b. d. e. f. g.

Lender of last resort Issue currency Regulate the money supply Loan reserves to banks Act as the bank for the Canadian government

2. The Bank of Canada is effectively insulated from federal government pressures by having seven-year terms for the governor of the Bank of Canada. This prevents a prime minister from dominating the Bank of Canada by his or her selections for governor of the Bank of Canada.

Section 12.2 Tools of The Bank of Canada 3.

Nonbank Public Liabilities –$10 million +$10 million

Assets Securities Demand deposits

Banking System

Asset Reserves +$10 million

Liabilities Demand +$10 deposits million

Bank of Canada

Asset Securities +$10 million

Liabilities Reserves of +$10 banking million system

5 Percent Desired Reserve Ratio Assets Reserves Excess Reserves

Banking System Liabilities $500 000 Demand Deposits $9 500 000

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$10 million

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Answer Key Potential deposit creation (Bank system lending) Initial demand deposit Potential increase in money supply

=

=

$190 million ($9.5 million × 1/0.05)

= $10 million $200 million

25 Percent Desired Reserve Ratio Assets Reserves Excess Reserves

Banking System Liabilities $2 500 000 Demand Deposits $7 500 000

Potential deposit creation (Bank system lending) Initial demand deposit Potential increase in money supply

=

=

$10 million

$30 million ($7.5 million × 1/0.25)

= $10 million $40 million

4.

Banking System

Assets Reserves +$10 million Securities

Liabilities

Bank of Canada

Assets Securities +$10 million

Liabilities Reserves +$10 of banking million system

-$10 million

Note: In this case, the entire $10 million is excess reserves and therefore is included in the money multiplier effect.

Potential increase in money supply: (5% desired reserve ratio) $200 million ($10 million × 1/0.05) Potential increase in money supply: (25% desired reserve ratio) $40 million ($10 million × 1/0.25)

5. The potential change in the money supply is $250 000 ($50 000 × 1/0.20).

6. According to the balance sheet, reserves are currently 10 percent of deposits. If the desired reserve ratio fell to 5 percent, the bank would have excess reserves of $50 000. With a 5 percent reserve ratio, the $100 000 in reserves could support deposits of $2 000 000, increasing the money supply by $1 000 000.

7. If the bank increases the desired reserve ratio to 12.5 percent, there would be insufficient reserves for the $1 000 000 in deposits by an amount of $25 000. The $100 000 in reserves would support only $800 000 in deposits, so this would decrease the money supply by $200 000. To acquire the additional desired reserves, the bank could sell securities or lower the amount of loans it has previously issued.

8. a. Decrease, b. Decrease, c. Increase, d. Decrease, e. Indeterminate 9. When the Bank of Canada pays for an open market purchase and its cheque (electronic payment) clears, it will add that amount of new reserves to the bank where the payment is deposited by the seller. The excess reserves created by that process lead to an expansion of bank loans of those reserves, creating additional demand deposits and therefore additional money.

10. An increase in the target for the overnight interest rate would tend to reduce the money supply. This would be at cross-purposes with an open market purchase of government securities, which would be intended to increase the money supply.

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Answer Key

Section 12.3 Money and Inflation 11. a. b. c. d. e.

M×V=P×Q Nominal GDP would double.

The price level would double.

Nominal GDP would double.

Nominal GDP would remain unchanged.

12. According to the quantity equation of money, a 5 percent increase in real GDP will result in a 5 percent decrease in prices if the money supply and the velocity of money remain constant. A 2 percent decrease in real GDP will result in a 2 percent increase in the price level.

13. If the money supply is $50 billion and velocity is 2 (so that M × V = $100 billion), the product of the price level and real output (P × Q, or nominal output), must also be $100 billion. If the price level is 10, real GDP would equal the $10 billion (nominal output divided by the price level of 10, or $10 billion).

14. Since M × V = P × Q, V = P × Q/M. V = $200 billion/$50 billion, or 4, in this case.

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FOR YOUR REVIEW ANSWER KEY CHAPTER 13 MONETARY POLICY Section 13.1 Money, Interest Rates, and Aggregate Demand 1. The higher the price level, the more money will be needed to conduct a given real value of transactions or for ―just in case‖ precautionary purposes, so the demand for money for such purposes will be roughly proportionate to the price level. People will want to hold less money for either purpose when the opportunity cost of holding money—the interest rate—is higher.

2. A higher price level increases the demand for money (shift rightward), which, for a given supply of money, increases interest rates. That in turn raises the cost of borrowing, which reduces investment and consumer durable purchases, which reduces the real quantity of real goods and services demanded. In terms of the AD curve, you experience a movement up the curve, from right to left―the higher price level does not change or shift the aggregate demand curve.

3. Since holding wealth in the form of other financial assets is the alternative to holding it in the form of money, nonmoney financial assets are substitutes for holding money. When the earnings (interest) available on alternative financial assets rise, the opportunity cost of holding money instead also rises; so, you would want to hold less money, other things being equal.

4. a. b. c. d.

Asset motive Precautionary motive Transaction motive Precautionary motive

5. a.

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Answer Key b.

Section 13.2 Expansionary and Contractionary Monetary Policy 6. The 1929 economy was at PL1929 and RGDP1929. The lack of consumer confidence coupled with the reduction in the money supply and falling investment sent the aggregate demand curve reeling. As a result, the aggregate demand curve fell from AD1929 to AD1933, real GDP fell to RGDP1933―resulting in the significant rise in unemployment―and the price level fell to PL1933―deflation. Expansionary monetary policy would have been the appropriate monetary policy response in 1933.

7. a.

The short-run result is indicated by the movement from point A to point B in the diagram above.

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Answer Key b.

The long-run result is indicated by the movement from point B to point C in the diagram above.

8. Effects of a decrease in the money supply: Variable a. The inflation rate b. The unemployment rate c. Real output

Short Run Reduced Increases Falls

Long Run* Unaffected Unaffected Unaffected

* This assumes that the LRAS curve is vertical 9. An expansionary monetary policy shifts aggregate demand to the right. Starting from less than full employment, the result will be an increase in the price level, an increase in real output, and a decrease in unemployment as the economy moves up along the short-run aggregate supply curve. This increased output will be sustainable if it does not exceed the natural level of real output.

10. A contractionary monetary policy, starting from a point beyond full employment, will reduce aggregate demand and will move the economy from the short-run equilibrium position beyond full employment toward the new long-run equilibrium position at full employment, preventing an inflationary boom. There is, then, a reduction in both RGDP and the price level.

Section 13.3 Problems in Implementing Monetary and Fiscal Policy 11. The more excess capacity there is in the economy, the flatter the short-run aggregate supply curve over that range of output. Therefore, the more excess capacity there is in the economy, a given shift in aggregate demand will result in a larger effect on real output and a smaller effect on the price level.

12. The short-run aggregate supply curve gets flatter the larger the degree of excess capacity in the economy (the further output is below its long-run equilibrium level). Beyond full employment, however, it becomes very steep.

13. Expansionary fiscal policy would increase aggregate demand. To counteract that fiscal policy effect on aggregate demand, the Bank of Canada would want to adopt contractionary monetary policy (through an open market sale of government securities and/or an increase in the target for the overnight interest rate), which would tend to reduce aggregate demand, other things being equal.

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Answer Key

14. The lag time for adopting monetary policy changes is shorter than for fiscal policy changes because decisions regarding monetary policy are not slowed by the budgetary process that fiscal tax and expenditure policy changes must go through.

15. A desire on the part of the banking system to keep some excess reserves would reduce the money supply, other things being equal. The retention of some excess reserves essentially equates to a higher desired reserve ratio, which would have a negative effect on the size of the money multiplier. Such a change would thus at least partly offset the effects of the Bank of Canada’s expansionary policy changes, which would hinder the Bank of Canada’s ability to successfully use expansionary monetary policy to increase the money supply.

Section 13.4 The Phillips Curve 16. Although the data does exhibit an inverse relationship between the inflation rate and the unemployment rate, the relationship is not quite as expected. At higher rates of inflation, smaller and smaller reductions in the rate of unemployment should result, instead of the larger reductions shown in the data. Presumably, at higher rates of inflation (lower unemployment rates), part of the economy is already operating at or near full capacity. Further fiscal or monetary stimulus triggers inflationary pressures in sectors already at capacity, while eliminating decreasing amounts of unemployment in those sectors where some excess capacity and unemployment still exist.

17. A movement up and to the left along a Phillips curve indicates an increase in inflation and a reduction in unemployment. A movement up and to the right along a short-run aggregate supply curve (achieved by a rightward shift in aggregate demand) indicates a price level increase (higher inflation) and an increase in RGDP (lower unemployment).

18. For a given upward-sloping, short-run aggregate supply curve, an increase in aggregate demand moves the economy up along the short-run aggregate supply curve to an increased price level and increased RGDP. The increase in the price level is an increase in inflation and the increase in RGDP is accompanied by a decrease in unemployment, so the same effect is shown by a move up (higher inflation) and to the left (lower unemployment) along a Phillips curve.

19. The argument is that once capacity utilization is high and unemployment is low, an increased part of the economy is already operating at or near full capacity; further fiscal or monetary policy stimulus primarily triggers inflationary pressures in sectors already at capacity, while eliminating decreasing amounts of unemployment in those fewer sectors where excess capacity and high unemployment still exist.

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FOR YOUR REVIEW ANSWER KEY CHAPTER 14 INTERNATIONAL TRADE Section 14.1 Canada’s Merchandise Trade 1. Exports of natural-based products make up 60 percent of our exports of goods. Out imports are concentrated in finished goods, like electronic and electrical equipment, motor vehicles, and consumer goods.

2. Canada and the United States are the two largest trading partners in the world. This means that the effects of trade restrictions imposed by the United States would have a far greater effect on Canada than similar restrictions imposed by Sweden. (For certain items, however, the magnitude of our trade with Sweden is greater than it is with the United States, so for these items Swedish restrictions would be of more concern.)

Section 14.2 International Trade Agreements 3. All countries are significantly affected by international trade, although the magnitude of the international trade sector varies substantially by country. International connections mean that any of a large number of disturbances that originate elsewhere may have important consequences for the domestic economy.

4. For Canada. the general consensus is that the CUSMA represents an improvement over the previous NAFTA. Not only does Canada maintain its preferential access to the North American market, but key improvements have been made in the CUSMA that were lacking in NAFTA—universal labour standards, environmental protections, and intellectual property (IP) rights to name just a few. The CUSMA will continue to encourage greater specialization and trade in North America, leading to a decline in industries where a country had a ―comparative disadvantage‖ and an expansion in industries where there was a comparative advantage.

Section 14.3 Comparative Advantage and Gains from Trade 5. a.

Fish per Day Bud Larry Total

76

16 8 24

Buckets of Berries per Day 8 8 16

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Answer Key

b. Bud is better off because he can produce and consume more fish while producing the same quantity of berries. c.

Bud Larry

Opportunity Cost of a Bucket of Berries 2 fish 1 fish

Opportunity Cost of a Fish 1/2 bucket of berries 1 bucket of berries

d. Bud has a comparative advantage in fishing and Larry has a comparative advantage in picking berries. e. A total of 16 fish and 8 buckets of berries will be produced.

6. Canada and Mexico can increase their total production if each specializes where it has a comparative advantage and then engages in trade. Canada can expand its consumption possibilities if it specializes in the production of cars, which it can produce at a lower opportunity cost than Mexico can, and then trades cars to Mexico in exchange for computers. Likewise, Mexico can be better off if it specializes in the production of computers, and trades computers to Canada for cars.

7. Country B has a comparative advantage over the production of Good X because its opportunity cost of producing 1 unit of Good X is only 1.5 units of Good Y versus 2 units of Good Y in country A. Country A has a comparative advantage in the production of Good Y. 8. The statement is false. A country may be able to produce wheat more efficiently in an absolute sense than other countries and yet not have a comparative (or relative) advantage in the production of wheat.

9. a. The opportunity cost of producing X in Freeland is 2Y. The opportunity cost of producing X in Braveburg is 1.5Y. b. Since Braveburg has a comparative advantage in producing X, it will ship X to Freeland in exchange for Y produced in Freeland. c. The terms of trade will have to be between 1.5Y per X and 2Y per X (the opportunity costs of producing X in the two countries). d. Transaction costs, transportation costs, or tariffs greater than the net gains from trade (0.5 units of Y per X traded) would eliminate trade between Freeland and Braveburg.

10. If country A becomes three times more productive at producing both X and Y, it is more likely to have an absolute advantage in both goods. However, that change does not change its opportunity costs of producing one good relative to another, so it does not change comparative advantages at all.

Section 14.4 Supply and Demand in International Trade 11. Voluntary trade generates consumer surplus because a rational consumer would not purchase if he did not value the benefits of the purchase at greater than its price, and consumer surplus is the difference between that value and the price he is forced to pay. Voluntary trade generates producer surplus because a rational producer would not sell additional units unless the price he received was greater than his marginal cost, and producer surplus is the difference between the price and the marginal costs of production.

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Answer Key

12. a. The price will fall from PBT to the world price, PAT, eliminating the price differential with the rest of the world. b. The new QDT will be where the SDOMESTIC curve intersects the world price curve. Imports will equal the difference between the QAT consumption level and the QDT domestic production level. c. The lost producer surplus area is the area below PBT and above PAT, out to the domestic supply curve SDOMESTIC. d. The net gains from trade are measured by the area between SDOMESTIC and DDOMESTIC from the old PBT and the world price PAT. e. Since consumers gain more than producers lose (as shown in answer [d] above), they could compensate the producers and leave both consumers and producers better off than before.

13.

Domestic Gains and Losses from Free Trade (exports) Area Consumer surplus (CS) Producer surplus (PS) Total welfare from trade (CS + PS)

Before Trade a+b c a+b+c

After Trade a b+c+d a+b+c+d

Change –b +(b + d) +d

14. When a country has a comparative advantage in producing a good, the marginal benefit from exporting is the world price, which is greater than the forgone value domestically (along the domestic demand curve) for those units of domestic consumption crowded out and greater than the marginal cost of the expanded output. Therefore, there are net domestic gains to international trade (the gains to domestic producers exceed the losses to domestic consumers).

15. When a country has a comparative disadvantage in producing a good, the marginal cost of importing is the world price, which is less than the additional value (along the domestic demand curve) for those units of expanded domestic consumption and less than the marginal cost of the domestic production crowded out. Therefore, there are net domestic gains to international trade (the gains to domestic consumers exceed the losses to domestic producers).

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Answer Key

Section 14.5 Tariffs, Import Quotas, and Subsidies 16.

Gains and Losses from Tariffs Area Consumer surplus (CS) Producer surplus (PS) Government revenues (tariff) Total welfare from tariff (CS + PS + Tariff revenues)

Before Tariff a + b +c + d + e f 0

After Tariff a b+f d

Change –(b + c + d + e) +b +d

a+b+c+d+e+f

a+b+d+f

–(c + e)

17. Tariffs raise the price of imported goods to domestic consumers, resulting in higher prices received by domestic producers as well. As a result, the higher price reduces domestic consumer surplus but increases domestic producer surplus.

18. Import tariffs increase employment in ―protected‖ industries because the barriers to lower-price imports increase the demand faced by domestic producers, increasing their demand for workers.

However, imports are the means by which foreigners get the dollars to buy our exports, so restricted imports will mean restricted exports (even more so if other countries retaliate with import restrictions of their own). This restriction in exports will result in lower demand and lower employment (higher unemployment) in other industries. In summary, the gains from employment in ―protected‖ industries will be offset by losses of employment elsewhere.

19. The cost of resources used in lobbying government in favour of tariffs or quotas must be added to the traditional welfare cost measures. That is, the deadweight loss normally associated with tariffs and import quotas will likely underestimate the actual deadweight loss to society of these policies due to these additional resource costs.

20. a. In favour of freer trade, which will increase demand for your exports b. Against freer trade, which will decrease the price you can get for your output c. In favour of freer trade, which will decrease the price you must pay for imported parts

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Answer Key

21. Tariff revenues end up in a country’s treasury, where they can be used to produce benefits for the country’s citizens or to reduce the domestic tax burden. Import quotas, however, transfer most of those benefits to foreign producers as the higher prices they receive.

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FOR YOUR REVIEW ANSWER KEY CHAPTER 15 INTERNATIONAL FINANCE Section 15.1 The Balance of Payments 1. a. b. c. d.

2. a. b. c. d.

Payment Receipt Payment Receipt Receipt Payment Payment Receipt

3. a. Canadian exports will increase, imports decrease, and the trade deficit (surplus) will decrease (increase). b. Canadian exports will decrease, imports increase, and the trade deficit (surplus) will increase (decrease). c. Canadian exports will increase and the trade deficit (surplus) will decrease (increase). d. Canadian imports will decrease and the trade deficit (surplus) will decrease (increase). e. Canadian exports will decrease and the trade deficit (surplus) will increase (decrease).

4.

Receipt

Payment

a.

Canadians buy autos from Japan.

X

b.

Canadian tourists travel to Japan.

X

c.

Japanese consumers buy rice grown in Canada.

d.

Canada gives foreign aid to Rwanda.

e.

Lululemon, a Canadian company, earns profits in France.

f.

Royal Dutch Shell earns profits from its Canadian operations.

X

g.

Bombardier builds a new plant in Vietnam.

X

h.

Japanese investors purchase Canadian government bonds.

X X X

X

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Answer Key

5.

Current Account and Capital Account Exports of goods

$50

Imports of goods

40

Merchandise trade balance

10

Exports of services Import of services

10 20

Services trade balance

−10

Net primary income Net secondary income

5 −15

Current account and capital account balance

−10

Financial Account Net acquisition of

financial assets

−$45

Net incurrence of liabilities

60

Financial account balance

Statistical discrepancy

15 −5

Net balance

$0

6.

Current Account and Capital Account Exports of goods

$530

Imports of goods

470

Merchandise trade balance

60

Exports of services Import of services

320 410

Services trade balance

−90

Net primary income Net secondary income

60 30

Current account and capital account balance

60

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Financial Account Net acquisition of

financial assets

−$230

Net incurrence of liabilities

160

Financial account balance

Statistical discrepancy

-70 10

Net balance

$0

Answer Key

Section 15.2 Exchange Rates 7. a.

50 pounds b. 800 pesos c. The Canadian dollar would depreciate, making the Canadian product cheaper in the other country. d. The Canadian dollar would depreciate, making the Canadian product cheaper in the other country. e. The Canadian dollar would depreciate, making the Canadian product cheaper in the other country.

8. A strong Canadian dollar will lower the price of imports and make trips to foreign countries less expensive.

Lower prices on foreign goods also help keep inflation in check. A strong dollar will also make investments in foreign financial markets (foreign stocks and bonds) relatively cheaper. However, it makes Canadian exports more expensive. Consequently, foreigners will buy fewer Canadian goods and services. The net effect is a fall in exports and a rise in imports—net exports fall. Note that some Canadians are helped (vacationers going to foreign countries and those preferring foreign goods), whereas others are harmed (producers of Canadian exports, operators of hotels dependent on foreign visitors in Canada). A stronger dollar also makes it more expensive for foreign investors to invest in Canada.

9. When a Canadian dollar buys relatively more British pounds, the cost of imports from England falls in Canada because it takes fewer Canadian dollars to buy a given number of British pounds to pay English producers. In other words, the price in Canadian dollars of English goods and services has fallen.

10. An increase in domestic demand for foreign goods and services increases the demand for those foreign currencies because the demand for foreign currencies is derived from the demand for foreign goods and services and foreign capital. The more foreign goods and services are demanded, the more of that foreign currency that will be needed to pay for those goods and services.

11. As euros become cheaper relative to the Canadian dollar, European products become relatively more inexpensive to Canadians, who therefore buy more European goods and services. To do so, the quantity of euros demanded by Canadian consumers will rise to buy them, as the price (exchange rate) for euros falls. The demand (as opposed to quantity demanded) of euros doesn’t increase because this represents a movement along the demand curve for euros caused by a change in exchange rates, rather than a change in demand for euros caused by some other factor.

Section 15.3 Equilibrium Changes in the Foreign Exchange Market 12. a. b. c. d.

13. a. b.

Likely to weaken the value of the Canadian dollar relative to the euro Likely to strengthen the value of the Canadian dollar relative to the euro Likely to strengthen the value of the Canadian dollar relative to the euro Likely to weaken the value of the Canadian dollar relative to the euro The supply curve for Canadian dollars shifts to the right.

The supply curve for Canadian dollars shifts to the left

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Answer Key

14.

Change

Supply of Euros

Reduced Canadian tastes for European goods Increased incomes in Canada Increased Canadian interest rates Decreased inflation in Europe Reduced Canadian tariffs on imports Increased European tastes for Canadian goods

No change No change Increases Decrease No change Increases

15. a.

Demand for Euros Decreases Increases Decreases Increases Increases No change

Dollar Price of Euros Decreases Increases Decreases Increases Increases Decreases

Demand for euros increases (demand shifts right in the euro market), the Canadian dollar will depreciate, and the euro will appreciate, ceteris paribus.

Demand for dollars increases (demand shifts right in the dollar market), the dollar will appreciate, and the yen will depreciate, ceteris paribus. Alternatively, you could think of this as an increase in supply in the yen market.

International investors will increase their demand for dollars in the dollar market to take advantage of the higher interest rate. The dollar will appreciate relative to other foreign currencies, ceteris paribus.

More foreign investors will want to buy Canadian assets, causing an increase in demand for dollars. The dollar will appreciate relative to other foreign currencies.

b.

c. d.

Section 15.4 Flexible Exchange Rates 16.

Event a. b. c. d. e.

Canadians buy more European goods Europeans invest in Canadian stock markets European tourists flock to Canada Europeans buy Government of Canada bonds Canadian tourists flock to Europe

Supply of Dollars Increases

Demand for Dollars Unchanged

Equilibrium Exchange Rate Decreases

Unchanged

Increases

Increases

Unchanged

Increases

Increases

Unchanged

Increases

Increases

Increases

Unchanged

Decreases

17. The central bank must purchase the currency using foreign reserve assets to prevent its currency from falling in value relative to foreign currencies.

18. The uncertainty argument against flexible exchange rates is that flexible exchange rates add another source of uncertainty to world trade, which would increase the cost of international transactions, reducing the magnitude of international trade. Proponents of flexible exchange rates point to the faster growth of international trade since the introduction of flexible exchange rates, the fact that markets exist on which to hedge exchange rate risks (through forward or futures markets), and the contention that the alleged exchange rate certainty was fictitious, since with fixed exchange rates large changes could take place at a nation’s whim.

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