Economics Updated Edition, 8th Edition Glenn Hubbard Solution Manual.pdf (22)

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CHAPTER 18 | GDP: Measuring Total Production and Income Net exports Exports minus imports. Nominal

Government purchases Spending by federal, state, and local governments on goods and services.

GDP The value of final goods and services evaluated at current-year prices.

Price level A measure of the average prices of goods and services in the economy.

Real GDP The value of final goods and

Gross domestic product (GDP) The market value of all final goods and services produced in a country during a period of time, typically one year.

Inflation rate The percentage increase in the price level from one year to the next.

Intermediate good or service A good or service that is an input into another good or service, such as a tire on a truck.

services evaluated at base-year prices.

Recession The period of a business cycle during which total production and total employment are

Investment. Spending by firms on new factories, office buildings, machinery, and additions to inventories, plus spending by households and firms on new houses.

Macroeconomics The study of the economy as a whole, including topics such as inflation, unemployment, and economic growth.

decreasing.

Transfer payments Payments by the government to households for which the government does not receive a new good or service in return.

Underground economy Buying and selling of goods and services that is concealed from the product. government to avoid taxes or regulations or because the goods and services are illegal.

Value added The market value a firm adds to a

Microeconomics The study of how households and firms make choices, how they interact in markets, and how the government attempts to influence their choices.

Chapter Outline

Politics, Macroeconomics, and General Motors If you want to be reelected president, your chances improve if the election occurs during a year when the economy is growing. Since the end of World War II in 1945, each president running for reelection when the economy was growing has won and each president running when the economy was contracting has lost. These presidents were experiencing the political effects of the business cycle, which refers to alternating periods of economic expansion and economic recession. Production and employment increase during expansions and decrease during recessions. In 2019, the U.S. economy was in a record 10-year long expansion from the 2007-2009 recession, which had been the worst recession since the Great Depression of the 1930s. The experience of General Motors (GM) and the automobile industry mirrored that of the economy. In the mid-2000s, GM had been selling sold about 4 million cars and trucks per year in the United States. In 2009, the company sold only 2.1 million cars and in June of that year it filed for bankruptcy. But the economic expansion that began in 2009 was good news for GM, as it emerged from bankruptcy, and for the other automobile producers. Sales of cars and trucks in the United States rose from 10.6 million in 2009 to 17.1 million in 2019. Although recessions in the United States are usually caused by declines in total spending in the economy, in early 2020, the Covid-19 pandemic plunged the economy into a deep recession largely because state and local governments ordered businesses to close to help contain the spread of the virus. GM and the other U.S. automobile manufacturers temporarily shut down all their factories. Later in the spring of 2020, GM and most other manufacturers reopened factories after adopting enhanced cleaning protocols, improving ventilation, and establishing social distancing

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measures. Manufacturers were then met with a surprise: Unlike in previous recessions, demand for their products quickly rebounded.

Teaching Tips The end of the chapter in the main text includes a special category of exercises titled Real-Time Data Exercises. These exercises are well worth assigning and discussing in class because they help students become familiar with a key data source, learn how to locate data, and develop skills in interpreting data.

Many RTDA exercises require more elaborate calculations than other problems and the use of Excel spreadsheets.

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

Microeconomics is the study of how households and firms make choices, how they interact in markets, and how the government attempts to influence their choices. Macroeconomics is the study of the economy as a whole, including topics such as inflation, unemployment, and economic growth.

The business cycle refers to alternating periods of economic expansion and economic recession. An expansion is the period of a business cycle during which total production and total employment are increasing. A recession is the period of a business cycle during which total production and total employment are decreasing. Economic growth refers to the ability of an economy to produce increasing quantities of goods and services. The inflation rate is the percentage increase in the price level from one year to the next.

A. Measuring Total Production: Gross Domestic Product Economists use gross domestic product to measure total production. Gross domestic product (GDP) is the market value of all final goods and services produced in a country during a period of time, typically one year. In the United States, the Bureau of Economic Analysis (BEA) compiles data used to compute GDP. Economists measure total production in an economy by taking the value, in dollar terms, of all goods and services produced. GDP includes only final goods and services. A final good or service is a good or service purchased by a final user. An intermediate good or service is a good or service that is an input into and another good or service, such as a tire on a truck. If we included the value of intermediate goods

B. Production, Income, and the Circular-Flow Diagram

services in GDP, we the would be double counting.

GDP in includes only production that takes placewe during When we add up value of total production the economy by calculating GDP, are simultaneously measuring the value of total income.

The circular-flow diagram illustrates the the interaction of firms and households in markets.

Firms sell goods and services to domestic households, indicated time period. GDP does not include the value of used goods. foreign firms and households, and the government. Firms use factors of production to produce goods and services. Households supply the factors of production to firms in exchange for income. Transfer payments are payments by the government to households for which the government does not receive a new good or service in return. The circular-flow diagram allows us to trace the ways households use their income. The circular-flow diagram shows that we can measure GDP either by calculating the total value of expenditures on final goods or services or by calculating the value of total income. We get the same dollar amount of GDP with either approach.

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C. Components of GDP The BEA divides its statistics on GDP into four major categories of expenditures. Economists use these categories to understand why GDP fluctuates and to forecast future GDP. 1. Personal consumption expenditures, or consumption, is spending by households on goods and services, not including spending on new houses. Consumption expenditures are divided into expenditures on services, nondurable goods, and durable goods.

2. Gross private domestic investment, or investment, is spending by firms on new factories, office buildings, machinery, and additions to inventories, plus spending by households and firms on new houses.

3. Government consumption and gross investment, or government purchases, are spending by federal, state, and local governments on goods and services.

4. Net exports of goods and services or net exports are equal to exports minus imports.

D. An Equation for GDP and Some Actual Values A simple equation sums up the components of GDP: Y = C + I + G = NX. The equation tells us that GDP )(Y equals consumption (C) plus investment (I) plus government purchases (G) plus net exports (NX).

E. Measuring GDP Using the Value-Added Method An alternative way of calculating GDP is the value-added method. Value added is the market value a firm adds to a product. It is equal to the difference between the price for which the firm sells a good and the price it paid other firms for intermediate goods.

Extra Apply the Adding More Lady Gaga to GDP Concept The Bureau of Economic Analysis (BEA) is constantly doing research to improve its measurement of GDP. Prior to 2013, the BEA considered R&D by firms or the government to be an intermediate good, just as tires or batteries are considered intermediate goods in automobile manufacturing. But spending on R&D is similar to investment spending. For example, when Ford buys new machine tools—which are included in investment spending—it does so to help manufacture automobiles now and in the future. Similarly, when Ford spends on R&D to improve the battery in its Ford Focus electric car, it does so to help improve the car now and in the future.

The BEA now counts spending on R&D as investment. In other words, the BEA shifted from not counting spending on R&D as part of GDP to counting it.

Just as firms and the government devote resources to R&D, movie and television studios, book authors, and musicians devote time and resources to producing new movies, television programs, books, and recordings. In past years, the BEA counted spending by firms and individuals on developing entertainment counted the products as part of the cost of producing those products, in the same way that it cost of labor and materials. The cost of developing entertainment products was therefore not included in GDP. began But in 2013, the BEA changed its procedures to include those costs as part of investment and including these investment costs in GDP. For example, prior to 2013, sales of Lady Gaga’s and Taylor Swift’s sales for their concerts, were included in GDP . ⸻ songs on iTunes and on CDs, as well as ticket but the costs of writing and recording the songs were not included. Now both types of spending are

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By broadening the definition of investment spending, the BEA increased measured GDP in 2013 by about 3 percent. The BEA adjusted its historical data on GDP back to 1929, so while the levels of GDP increased, the changes in GDP from one year to the next were not greatly affected. The BEA makes changes to its calculations of GDP after consulting with government statistical agencies in other countries. The objective is to allow economists, firms, and policymakers to more accurately compare GDP in different countries. The broadening of the definition of investment was meant to increase the importance of intellectual property (IP)⸻ such as software, movies, and books⸻ in GDP. IP-intensive industries include pharmaceuticals, computers and software, telecommunications, book publishing, and radio and television broadcasting. A study by the U.S. Patent and Trademark Office estimated that in the United States IP-intensive industries account for about 40 million jobs and more than one-third of GDP. As the economy changes over time, the BEA will continue to evaluate whether to adjust the way it measures GDP.

Sources: David Kestenbaum, “Lady Gaga Writing a New Song Is Like a Factory Investing in a New Machine,” www.npr.org, April 25, 2013; Osagie Imasogie and Thaddeus J. Kobylarz, “Yes, Lady Gaga’s Songs Contribute to GDP,” Wall Street Journal, May 27, 2013; U.S. Bureau of Economic Analysis, “Preview of the 2013 Comprehensive Revision of the National Income and Product Accounts,” Survey of Current Business, Vol. 93, No. 3, March 2013; and U.S. Department of Commerce, Intellectual Property and the U.S. Economy: Industries in Focus, March 2012.

Extra Apply the How Did the Recession of 2007–2009 Affect Household Saving Concept and Spending?

In 2014, consumption was 68.5 percent of GDP in the United States. Consumption is a larger fraction of GDP in the United States than in most other high-income countries or in rapidly growing lower-income countries such as China and India. As shown in the following figure, over time, consumption in the United States has increased as a fraction of GDP. Through the mid-1980s, consumption was less than 65 percent of GDP. By the early 2000s, consumption had increased to about 70 percent of GDP.

U.S. households financed this increased consumption partly by reducing saving and partly by increasing borrowing. While households were saving about 10 percent of their income in the mid-1980s, saving dropped to about 1 percent by 2005. Low saving rates were partly due to an increase in household wealth resulting from rising housing prices and rising stock prices. In many parts of the country, housing prices increased rapidly between 2001 and 2006. Stock prices, as measured by the Dow Jones Industrial Average and the S&P 500, reached record highs in October 2007. Some households felt less need to save out of their current incomes because their homes and their investments in the stock market were increasing in value.

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During the early 2000s, many households borrowed against the increased value of their homes by taking out home equity loans, which many banks were increasingly willing to grant. Banks and other financial firms also loosened the requirements for issuing credit cards, so some households with flawed credit histories were able to borrow against their credit cards to finance their spending. The ratio of loans and other household debt to household income, which had been about 65 percent in the mid-1980s, rose to a record 133 percent in 2007 before declining to 102 percent in mid-2011.

Housing prices began to decline in 2006, and that decline accelerated with the start of the recession in December 2007. Stock prices also declined sharply. The combination of falling housing and stock prices wiped out trillions of dollars in household wealth. Banks and other financial institutions also tightened lending standards, making it more difficult for many households to borrow money. In the face of declining wealth and with reduced access to loans, household saving rates began to increase, rising above 6 percent by 2009. As the economy recovered from the recession, the saving rate declined to about 5 percent in 2016.

Increased household saving can be good news for the economy in the long run because it provides more funds that firms can borrow to finance investment, which can lead to more rapid rates of economic growth. But in the short run, many firms—particularly firms such as General Motors that sell consumer durables—worried that the slow recovery from the 2007–2009 recession was due in part to the Question An article on USAToday.com in 2011 observed: “Consumer spending, once the driving determination of U.S. households to cut back on spending and increase saving. force of the U.S. economy, is likely to remain stagnant for years as households struggle to cut debt Sources: U.S.up Bureau of Economic Analysis; Organization for Economic Cooperation and Development; and United and build savings, economists say.”

Why does cutting debt and building up savings affect Nations. consumer spending? If consumer spending remains stagnant, what will be the likely effect on the economy?

Source: Karina Frayter, “Economists: Consumers Won’t Save the Economy,” USAToday.com, October 2, 2011.

Answer Cutting debt and building up savings require, for a given amount of income, a decrease in consumer spending. If consumer spending remains stagnant, the economy will most likely grow slowly in the short run.

18.2 Does GDP Measure What We Want It to Measure?

Learning Objective: Discuss whether GDP is a good measure of well-being.

Economists use GDP to measure total production in the economy. Most economists believe that GDP does a good—but not flawless—job of measuring production. GDP provides only a rough measure of well-being.

A. Shortcomings in GDP as a Measure of Total Production When the BEA calculates GDP, it does not include two types of production: production in the home and production in the underground economy. Household production refers to goods and services people produce for themselves. The underground economy refers to buying and selling of goods and services that is concealed from the government to avoid taxes or regulations or because the goods and services are illegal.

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B. Shortcomings of GDP as a Measure of Well-Being The main purpose of GDP is to measure a country’s total production. Although increases in GDP often lead to increases in the well-being of the population, GDP is not a perfect measure of wellbeing for the following reasons: • • • •

GDP does not include the value of leisure.

GDP is not adjusted for pollution or other negative effects of production.

GDP is not adjusted for changes in crime and other social problems.

GDP may not provide good information about the goods and services consumed by the typical person. In other words, GDP measures the size of the pie but now how the pie is divided.

Extra Solved Problem 18.2 Measuring Economic Welfare Although GDP is widely used as a measure of the value of a country’s production and income, most economists agree that it is an inadequate measure of the progress countries make in raising the standard of living of their citizens. In 2010, then British Prime Minister David Cameron announced the United Kingdom’s plans to construct a measure of well-being that would account for such factors as citizens’ satisfaction with their lives. France also announced an effort to construct an alternative to GDP as a measure of well-being. But measuring “well-being” is more difficult than measuring the market value of output. “There is more to life than GDP, but it will be hard to come up with a single measure to replace it…” commented Paul Allin, the director of the United Kingdom’s Measuring National Well-Being Project. Economists have long struggled to find an alternative to GDP as a welfare index. Among the earliest attempts was the “Measure of Economic Welfare (MEW),” by William Nordhaus and James Tobin in 1972. The MEW differs from GDP primarily in three ways: 1. MEW subtracts estimates of the effect of “bads,” such as pollution, from GDP. 2. MEW excludes certain services, such as police protection, because increases in these services may reflect more crime and civil disorder, which would mean lower welfare.

3. MEW adds an estimate of some activities, such as housework and leisure, that result in greater welfare but are not included in GDP. One critic of GDP wrote that the recession of 2007–2009 “. . . offers an excellent opportunity to get rid of [an joineconomic concept] that has long outlived its usefulness: gross domestic product. . . . It ought to buggy whips and VCRs on the dust-heap of history.”

Sources: Market Whitehouse, “Nations Seek Success Beyond GDP,” Wall Street Journal, January 10, 2011. William a. Doand economists overstate the value of GDP as a measure of economic welfare?

Nordhaus James Tobin, “Is Growth Obsolete?”

Economic Growth, Fiftieth Anniversary Colloquium, Vol. 5. New York: National Bureau of Economic Research, 1972; and Eric Zencey, New York Times, August b. Should GDP be replaced as a measure of growth in the overall economy? 10, 2009.

Solving the Problem Step 1:

Review the chapter material.

This problem is about whether gross domestic product is a good measure of well-being, so you may want to review the section “Does GDP Measure What We Want It to Measure?”

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Step 2:

Step 3:

Answer part (a) by discussing whether economists overstate the value of GDP as a measure of economic welfare.

GDP was designed as a measure of production and income, not welfare. Although GDP is an imperfect measure of production—for example, it does not measure household production—it is very valuable as an indicator of the short-run and long-run performance of the overall economy. Economists typically do not overstate the value of GDP as a measure of economic welfare because they do not use GDP as a measure of welfare.

Answer part (b) by discussing whether GDP should be replaced as a measure of growth in the overall economy.

Despite its shortcomings as a measure of welfare, most economists agree that GDP is the best measure of growth of the overall economy. Over time, economists at the BEA have made changes to improve the way GDP is calculated in order to make it a more accurate measure of the value of total production and income.

Extra Apply the Did World War II Bring Prosperity?

Concept The Great Depression of the 1930s was the worst economic downturn in U.S. history. GDP declined by more than 25 percent between 1929 and 1933 and did not reach its 1929 level again until 1938. The unemployment rate remained at 10 percent or more through 1940. Then, in 1941, the United States entered World War II. The following graph shows that GDP rose dramatically during the war years of 1941 to 1945. (The graph shows values for real GDP, which corrects measures of GDP for changes in the price level.) The unemployment rate also fell to very low levels—below 2 percent.

Traditionally, historians have argued that World War II brought prosperity back to the U.S. economy. But did it? Economist Robert Higgs argued that if we look at the well-being of a typical person, the World

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War II years were anything but prosperous. Higgs pointed out that increased production of tanks, ships, planes, and munitions accounted for most of the increase in GDP during those years. Between 1943 and 1945, more than 40 percent of the labor force was either in the military or producing war goods. As a result, between 1939 and 1944, production of clothing, radios, books, and other consumption goods per person increased only about 2 percent, leaving the quantity of consumption goods available to the typical person in 1944 still below what it had been in 1929. With the end of the war, true prosperity did return to the U.S. economy, and by 1946, production of consumption goods per person had risen by more than 25 percent from what it had been in 1929.

World War II was a period of extraordinary sacrifice and achievement by the “greatest generation.” But statistics on GDP may give a misleading indication of whether it was also a period of prosperity.

Sources: Robert Higgs, “Wartime Prosperity? A Reassessment of the U.S. Economy in the 1940s,” Journal of Economic History, Vol. 52, No. 1, March 1992; Robert Higgs, “From Central Planning to the Market: The American Transition, 1945–1947,” Journal of Economic History, Vol. 59, No. 3, September 1999; and data from the U.S. Bureau of Economic Analysis.

18.3 Real GDP versus Nominal GDP

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

A. Calculating Real GDP The BEA separates price changes from quantity changes by calculating a measure of production called real GDP. Nominal GDP is the value of final goods and services evaluated at current-year prices. Real GDP is the value of final goods and services evaluated at base-year prices. Real GDP is calculated by designating a particular year as the base year and then using the prices of goods and services in the base year to calculate the value of goods and services in all other years.

B. Comparing Real GDP and Nominal GDP Real GDP holds prices constant, which makes it a better measure than nominal GDP of changes in the production of goods and services from one year to the next. Because, on average, prices rise from one year to the next, real GDP is greater than nominal GDP in years before the base year and less than nominal GDP for years after the base year. In the base year, real and nominal GDP are the same.

C. The GDP Deflator Economists and policymakers are interested not just in the level of production but also in the price level. The price level is a measure of the average prices of goods and services in the economy. The GDP deflator is a measure of the price level, calculated by dividing nominal GDP by real GDP and multiplying by 100.

Extra Apply the Did the Standard of Living in Nigeria Almost Double Overnight?

Concept Government agencies in developing countries like Nigeria have difficulty measuring GDP for two primary reasons: First, the size of the underground economy may be large, making it difficult for the government to gather data on many businesses. Second, government agencies may lack the budgets or the trained staff to accurately process the data they do collect or to use the same approaches to calculating GDP that are used in the United States and other high-income countries. For example, we’ve seen that in calculating real GDP, governments use base-year prices that, over time, may change relative to each .

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other, potentially distorting the measurement. To deal with this problem, the BEA changes the base year fairly frequently and uses chain-weighted prices. This approach, though, can be difficult for developing countries to implement because it can be expensive to have government employees collect large amounts of price data.

By 2010, the government of Nigeria knew that the data it was publishing on real GDP were inaccurate because it was still using 1990 as its base year, even though the economy had changed dramatically over the years. The Nigerian National Bureau of Statistics was given a larger budget and the task of both changing the real GDP base year to 2010 and gathering data on previously unrecorded output in the underground economy. As an article in the Wall Street Journal put it: “Nigerian number crunchers traversed the West African nation by motorcycle and speedboat, visiting Internet cafe owners, movie producers and other businesspeople to record previously uncaptured commercial activity.” The number of businesses being surveyed for data increased from 85,000 to 850,000.

When the new data on GDP were released in 2014, the results were dramatic. The estimate for real GDP for large2013 was changed from $270 billion to $510 billion, an 89 percent increase. The increase was enough for Nigeria to pass South Africa as the largest economy in Africa. As the following figure shows, the new data also gave a more accurate picture of the structure of the Nigerian economy. For instance, where previously the service sector was believed to make up less than one-third of the economy, it was shown to actually be more than half the economy. In addition, although not shown in the figure, the telecommunications sector actually makes up 9 percent of the economy, rather than the 1 percent in previous estimates, and the oil industry is only 14 percent of the economy rather than 33 percent.

Sources: “Rewriting GDP History,” Economist, May 2, 2016; Drew Hinshaw and Patrick McGroarty, “Nigeria’s Economy The government of Kenya alsoStreet updated and expanded the data used toWallis, calculate base-year prices Journal Surpasses South Africa’s in Size,”Wall , April 6, 2014; Javier Blas and William “Nigeria Almost Doubles GDP in Recalculation,”Financial Times, April 7, 2014; and “How Nigeria’s Economy Grew by 89% Overnight,” Economist, April 7, 2014.

and found similarthat its economy was 25 percent larger than it had previously estimated. After following a

Measures Totalannounced Production and Income process, Other the government of of Ghana that itsTotal economy was 60 percent larger than 18.4

previously Learning Objective: Describe other measures of total production and total income. estimated. increased? But had the standard of living of the typical person in these countries actually Certainly, the new estimatesrefers madetoit the appear so. For instance, real production GDP per person in National income accounting methods the BEA uses estimated to track total and total income in the economy.

In addition to computing GDP, the BEA computes the following four Nigeria measures production income: increased of from $1,500 toand $2,688.

Of course, all that had really changed was how accurately the governments were measuring real GDP. The countries were producing no more goods and services on 1. Gross national product the income day 2. theNational new GDP data were announced than they had been the day before.

These experiences with measuring GDP demonstrate the problems governments have in accurately constructing these statistics and how misleading they can be as measures of a country’s standard of living. .

CHAPTER 18 | GDP: Measuring Total Production and Income 3 .

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Personal income Disposable personal income

A. Gross National Product Gross National Product (GNP) is the value of final goods and services produced by residents of the United States, even if the production takes place outside the United States. GNP includes foreign production by U.S. firms but excludes U.S. production by foreign firms. For the United States, GNP is almost the same as GDP.

B. National Income In producing goods and services, some machinery, buildings, and equipment wear out (or become depreciated) and have to be replaced. The Bureau of Economic Analysis formally labels depreciation consumption of fixed capital. If we subtract this value from GDP, we are left with national income.

C. Personal Income Personal income is income received by households. To calculate personal income, we subtract the earnings that corporations retain rather than pay to shareholders in the form of dividends and we add in the payments received by households from the government in the form of transfer payments or interest on government bonds.

D. Disposable Personal Income Disposable personal income is equal to personal income minus personal tax payments, such as the federal personal income tax. Disposable personal income is the best measure of the income households have available to spend.

E. The Division of Income We can measure GDP in terms of total expenditure or as the total income received by households.

GDP calculated as the sum of income payments to households is sometimes called gross domestic income. The largest component of gross domestic income is wages, which are about three times as large as profits.

Extra Solved Problem 18.4 GDP and National Income: Accounting for Changes in the Stock of Capital Suppose you are hired to measure the population in your hometown. You could go door-to-door and determine how many people live in each household. But let’s assume that your mayor had the following data: (a) the town’s population the last time the census was taken; (b) the number of people who were born since the last census was taken; and (c) the number of people who moved into town since the last census was taken. Would adding these three numbers give you the current population? Clearly, the answer is no because these numbers do not account for decreases in population since the last census was taken due to deaths and out-migration (people who moved away from your town).

Included in GDP is the value of gross private domestic investment (or simply “investment”). This value is an overestimate of the change in the nation’s stock of capital because some investment spending represents replacement of capital such as buildings and machines that have worn out. Using gross private domestic as a measure of the increase in the nation’s stock of capital is similar to computinginvestment a . population census without accounting for people who died and moved elsewhere. Net private

domestic investment subtracts from gross investment estimates of the “deaths”—or depreciation—of the nation’s

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capital stock. The following example illustrates the difference between gross private domestic investment and net private domestic investment for 2020 Data are measured in billions of dollars.

Gross private domestic investment Minus: consumption of fixed capital Net private domestic investment Source: https://fred.stlouisfed.org/

2020 $3,637.8 billion $2,969.6 billion $668.3 billion

National income, which equals GDP minus the consumption of fixed capital, is a better measure of the market value of final goods and services produced in a given time period than GDP because GDP does not account for the consumption of fixed capital.

Why don’t economists use national income rather than GDP as the primary measure of total production and income in the economy?

Solving the Problem Step 1:

Step 2:

Review the chapter material.

This problem is about measuring total production and income, so you may want to review the section “Other Measures of Total Production and Total Income” the textbook.

Answer the question by explaining why economists don’t use national income rather than GDP as the primary measure of total production and income in the economy.

There are two reasons economists use GDP rather than national income to measure total production and income in the economy. First, measures of the consumption of fixed capital are estimates of depreciation rather than the actual amounts. It is impossible to accurately determine how much a building or machine is used up in a year. Second, in any year there will be a difference between the size of the national income and the size of the GDP, but the percentage change in national income will be nearly equal to the percentage change in GDP. Because the change in total production is of greater importance to economists than the level of total production, switching from GDP to national income would not result in much benefit.

Extra Apply the “I see more lights—increase GDP” Concept The United States and other industrialized nations recognize the importance of accurately calculating GDP and other measures of total production and income. In the United States, the Bureau of Economic Analysis publishes “benchmark” estimates of GDP every four or five years. These estimates are based on an economic survey of more than seven million businesses with paid employees and over 95 percent of the expenditures that are included in GDP. In the years between the benchmark estimates, annual GDP estimates are based on annual surveys that cover about 150,000 reporting units; quarterly estimates are based on monthly surveys of about 35,000 reporting units.

The national income data published for some areas of the world, such as sub-Saharan Africa and other developing nations, are not measured so carefully. The quality of data from some countries, such as Somalia, Libya, and North Korea, are so poor that national income and price data do not appear in the Penn World Tables, a standard source for international macroeconomic data. Three economists from Brown University, J. Vernon Anderson, Adam Storeygard, and David N. Weil use an unusual .

framework for supplementing data for countries that have unreliable measures of their national income and output:

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using satellite images of an area’s nighttime lights. Henderson, Storeygard, and Weil suggest combining official data with changes in a country’s lights as viewed from outer space using U.S. Air Force weather satellite picture composites. The authors’ observations of ten years of changes in light density were combined with income data to produce estimates of economic growth. The authors explain that “Consumption of nearly all goods in the evening requires lights. . . . As income rises, so does light usage per person, in both consumption and many investment activities.” Henderson stated that “Our hope is that people start using this when they don’t have actual data on economic growth . . . or when the numbers are pretty bad.”

Sources: J. Vernon Henderson, Adam Storegard and David N. Weil, “Measuring Economic Growth from Outer Space,” American Economic Review, Vol. 102, No. 2, 2012, pp. 994-1028; Steven Landefeld, Eugene P. Seskin, and Barbara Fraumeni, “Taking the Pulse of the Economy: Measuring GDP,” Journal of Economic Perspectives, Vol. 22, No. 2, spring 2008, pages 196– 197; and “Economists Measure GDP Growth From Outer Space,” ScienceDaily, September 6, 2009. http://www.sciencedaily.com/releases/2009/09/090904165302.htm.

Extra Economics in Your Life & Career: What is the Most Desirable Country to Live In? Since 1990, the United Nations Development Programme (UNDP) has ranked the world’s “most desirable places to live.” The rankings are based on a Human Development Index (HDI), which includes national measures of life expectancy at birth, mean years of schooling, expected years of schooling, and per capita GDP. In 2020, the five nations that scored the highest HDI values were as follows: (1) Norway, (2) and (3) Ireland and Switzerland (tied), and (4) and (5) Hong Kong and Iceland (tied). The United States was ranked 17th and Canada was 16th.

Question: If you were asked to make your own list of the best places to live, how important would a country’s per capita real GDP be as a criterion? What other factors would you consider in making your list?

Answer: A list of “best places to live” is subjective. Someone who enjoys skiing and ice skating might rank GDP a country that had a cold, snowy climate higher than someone who hated cold weather. Since per capita is a measure of the real income people have to obtain goods and services, it is a good criterion to use toofrank countries, but GDP provides only one measure of well-being. Examining other measures the quality of life in each country—for example, political freedom, environmental quality, racial and gender equality—would help you make your choice. The UNDP rankings are less useful for differentiating Norway from Australia (ranked 8th), for example, than for distinguishing countries that had wider (189), differences in their HDI values. Chad (187), the Central African Republic (188), and Niger which were ranked lowest on the UNDP list for 2020. These counties had low per capita incomes, relatively low life expectancies, and poor education.

Source: “Human Development Reports. Human Development Data.” http://hdr.undp.org/en/data

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Solutions to End-of-Chapter Exercises Domestic Product Measures Total Production 18.1 Gross Learning Objective: Explain how total production is measured.

Review Questions 1.1

Because sales of cars and trucks increased as incomes increased, we can conclude that unless other factors affecting the demand for cars and trucks changed during this period, cars and trucks are normal goods.

1.2

You should disagree with the definition. GDP measures all the final goods and services produced in an economy during a particular period. GDP does not measure all the goods and services

1.3 1.4

produced because, to avoid double counting, it excludes the production of intermediate goods and services.

All of the revenue a firm receives from the sale of its output is paid out as income to the ▪ Consumption (C) is spending by households on goods and services. Investment (I) is spending by firms on new plant, equipment, buildings, and changes in owners ▪ inventories, and residential investment by households and firms on new single-family of the factors of production. and GDPmulti-unit = C + I + houses.

G + NX.Government purchases (G) are made by the federal, state, and local governments for goods ▪ and services.

Net exports (NX) equal exports minus imports.

▪ Exports are goods and services produced in the United States that are purchased by foreign firms, households, and governments. Imports are goods and services produced in foreign countries, but purchased by U.S. firms, households, and governments.

1.5

A firm’s value added refers to the additional market value a firm gives to a product. Value added is equal to the difference between the price for which the firm sells a good and the price it paid other firms for intermediate goods.

Problems and Applications 1.6

a. No. The denim fabric is an intermediate good that will be included in a final good (the b. jeans). No. The value of the denim fabric won’t be included separately in U.S. GDP. The value of c. the fabric is included in the price of the denim jeans when the jeans are sold.

Whether the denim is bought by a U.S. or a Canadian citizen does not matter in determining whether place in that good is included in U.S. GDP. What matters is that the production took the United States. .

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a. The purchase of flour by a bakery is the purchase of an intermediate good, not a final good, because the flour is included in the bread, cakes, and other final goods the bakery produces. b., c., and d. are all purchases of final goods because they are not purchased to become part of other goods or services.

1.8

Part of the investment component of GDP is changes in inventories—final goods that have been produced but not purchased in the time period in which they were produced. When the value of inventories at the end of a time period is greater than the value of inventories at the beginning of the same time period, changes in inventories is a positive number. When the value of inventories at the end of a time period is less than the value of inventories at the beginning of the same time period, changes in inventories is a negative number. If a change in inventories “gave GDP a small boost,” there must have been an increase in the value of inventories.

1.9

a. Consumption. The purchase was made by an individual for private use. b. None of the components of GDP will be affected because the truck is a used good. Only current production of goods and services is included in GDP. c. None of the components of GDP will be affected because the door handles are intermediate goods, not final goods. d. Net exports. Because U.S. goods were shipped to another country, this transaction will be reflected in net exports. e. Investment. Any business purchase of tools or equipment to use in the manufacturing process will be recorded as investment. f. Government purchases. Because the state of Michigan is spending this money, it is included in GDP as a government purchase. g. Investment. Any business purchase of tools or equipment to use in the manufacturing process will be recorded as investment.

1.10

1.11

The value of the house built in 2010 would not be included in GDP for 2022 because the sale does not represent new production. The value of the services of the real estate agent who helped sell or buy the house in 2022 would be included in GDP for 2022 because those services would be newly provided in 2022. a. Because GDP measures current production, the destruction of existing goods, such as homes and buildings, does not directly change GDP. If the efforts to fight the fire resulted in increased government purchases of firefighting equipment or overtime pay for firefighters, GDP would have increased by the amount of those expenditures. b. As homeowners and business owners start rebuilding after the fire, GDP increases as investment expenditures on the new buildings and new homes begin. Even though this spending is for structures replacing those that have been destroyed, that spending is still included in GDP.

1.12

$25) = $7,450.

Nominal GDP Cotton = (100 is$60) an intermediate + (100 $2) + (50 good (in this case, it is used in the production of shirts), so it is not included directly in calculating GDP.

1.13

The statement is incorrect because it confuses investment in the economic sense of purchases of new machinery, factories, and houses with financial investment in stocks and bonds.

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CHAPTER 18 | GDP: Measuring Total Production and Income

1.14

a. Yes. Government purchases include spending by federal, state, and local governments on government employee salaries and benefits. b. No. Social Security payments to retired and disabled people are considered transfer

1.15

payments and are not production of included in government purchases because they do not result in the

a.

new goods and services.

b.

10) − $5,000 = $8,000 – $5,000 = $3,000 10) – ($800

10) = $10,000 – $8,000 =

Value added by the artist = ($800 Value added by the local art store = ($1,000 $2,000

18.2 Does GDP Measure What We Want It to Measure?

Learning Objective: Discuss whether GDP is a good measure of well-being.

Review Questions 2.1

2.2

No. The quality of life may not be high in a country with a large GDP if that country also has a large population. It is more likely that people in a country with a high GDP per capita or person will have a high quality of life. However, this conclusion is not always true. There are many factors that contribute to the quality of life that people experience. If a country is suffering from high rates of crime or severe environmental problems, people who live there may not be experiencing a high quality of life⸻even if their incomes as measured by GDP per capita are high.

The shadow economy is the buying and selling of goods and services that individuals and firms conceal from the government to avoid taxes or regulations or because the goods and services are illegal. Some countries have larger underground economies than other countries due to high taxes and that aextensive government regulations. Having a large shadow economy typically indicates

2.3

government is pursuing policies that make it difficult for many businesses to operate openly.

Owners of businesses in the shadow economy are likely to be reluctant to invest in expansion and growth for fear that eventually the government may take action to penalize them or even

seize their businesses.

Problems and Applications GDP is an imperfect measure of economic well-being because it does not include a. This is likely to increase measured GDP because household production is not counted in 2.4 GDP. household b. This is likely to increasemade measured if it results in increased expenditures on production or transactions in theGDP underground economy.

Evengovernment if GDP included all production, it wouldand stillincreased not be aprivate perfectexpenditures measure of on economic it does law enforcement security.well-being However, because an increase in the crime rate might indicate that the level of production in the underground economy is not increasing, which should reduce measured GDP, not increase it. consider factors that affect well-being. For example, GDP does not include the value of This ismany likely to reduce measured GDP as more production moves to the underground c. leisure and is not adjusted for the negative effects of pollution or social problems such as economy. crime.

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CHAPTER 18 | GDP: Measuring Total Production and Income 2.5

2.6

2.7

495

Because the decline in the number of hours of paid work was almost the same as the increase in the number of hours of work devoted to household production, total production in the economy probably did not change much when these workers became unemployed, even though measured GDP might have decreased as a result of the decline in paid work. However, if the household production performed by unemployed workers replaced work that others had previously been paid to perform, then the value of total production (the sum of production measured by GDP and production not measured by GDP) will have declined because the household production the unemployed are now doing was already being carried out.

Real GDP per capita for the United States has risen since 1890. A higher income level today might be due to Americans working more hours or to workers being more productive. The fact that the typical American today works fewer hours while earning a higher income suggests that the economic well-being of the average American has increased more than is indicated by comparing 1890 real GDP per capita with current real GDP per capita. The average person has more leisure time today than in 1890, and the value of leisure time is not included in GDP. a. A summary statistic is a single number that characterizes an underlying set of data. GDP is a summary statistic of how well an economy is doing because it measures how much an economy produces during a period of time, which equals a country’s total income. b. GDP provides a summary measure of the performance of an overall economy, but not a perfect measure. GDP excludes the production in the underground economy, household production, the value of leisure, and it does not adjust for the negative effects of pollution and the effect of social problems such as crime.

2.8

a. When people hide the buying and selling of goods and services, they are participating in the informal or underground economy. Individuals hide what they buy and sell for three main reasons: (1) They are dealing in illegal goods and services; (2) they want to avoid paying taxes on the income they earn; or (3) they want to avoid government regulations. In this case, these individuals likely needed to generate income when they were forced out of the workforce during the pandemic, so they were trying to avoid government scrutiny. Earning income in the underground economy would also not affect any government benefits, such as unemployment benefits, they were receiving. Being paid in cash makes these transactions impossible to trace and prevents the government from knowing about the income earned from this source. b. If more people moved transactions to the underground economy due to the pandemic, then U.S. GDP would be understated by even more than normal because these transactions are not reported to the government and therefore not included in GDP. However, no estimates have been made about changes in the size of the underground economy during the pandemic. Most estimates prior to the pandemic place the size of the underground economy in the United States at no more than 10 percent of GDP—and probably less.

2.9

a. The informal sector, or underground economy, is the buying and selling of goods and services that is concealed from the government to avoid taxes or regulations or because the goods and services bought and sold are illegal. b. Being smaller makes the firms in the informal sector harder for the government to detect.

Also, the owners of firms in the informal sector are less likely to invest to make their firms larger because the owners are concerned that the government may someday close the firms down and confiscate their assets.

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CHAPTER 18 | GDP: Measuring Total Production and Income

2.10

This is a normative question so responses will vary. German workers receive a mandatory 20 paid vacation days and 10 paid holidays. Some workers value additional leisure time more than the income they would earn from additional hours worked, while other workers would rather trade days off for additional income. The different trade-offs between money income and leisure in the two countries shown in the table may represent the choices made by the countries’ workers. In that case, German workers appear to value leisure more than do U.S. workers, although we can’t be sure whether the well-being of German workers is higher as a result. If German workers work fewer hours because of legal restrictions on how much they can work, they might prefer to work more than they are allowed to. Measures of income are objective, but normative judgments are required to determine a country’s “well-being.” Other variables that we could include in a measure of well-being are measures of health (for example, average life expectancy at birth and infant mortality), environmental quality, and crime rates.

We would also have to decide on the relative importance of the factors included in a measure of well-being.

18.3 RealGDP versus Nominal GDP

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

Review Questions 3.1

Nominal GDP can change because of either quantity changes or price changes. When there is inflation, nominal GDP overstates the increase in total production. The Bureau of Economic Analysis separates price changes from quantity changes by calculating real GDP.

3.2

The GDP deflator is a measure of the average prices of the final goods and services included

3.3

in i. Between 2021 and 2022, the overall price level measured by the GDP deflator increased by GDP and equals nominal GDP divided by real GDP, multiplied by 100.

100 × = 4.35%. ii. The GDP deflators for 2021 and 2022 do not provide information regarding the growth rate of real GDP between the two years. If we were also given the values for nominal GDP, we could use the values for the GDP deflator to calculate real GDP for the two years.

Problems and Applications 3.4

a. Note that because cotton is an intermediate input, it should not be included in the calculation for real GDP. Real GDP for 2022 Real GDP for 2023 b. Growth in real GDP in 2023:

3.5

a. Disagree. Nominal GDP is less than real GDP if the current price level, which is used in calculating nominal GDP, is less than the base period price level, which is used in calculating

.

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497

real GDP. A fall in the price level during the year is neither necessary nor sufficient to cause nominal GDP to be less than real GDP. b. Disagree. If prices increase more than the quantity of production decreases, nominal GDP can increase when real GDP declines. c. Agree. If a recession is so severe that both the quantity of production and the price level decline, both real and nominal GDP will decline. d. Disagree. Nominal GDP could decline because either the GDP deflator declined or total production (real GDP) declined. In fact, between 2019 and 2020, nominal and real GDP both declined, while the GDP deflator increased.

3.6

The only way for nominal GDP to be lower than previously expected at the same time as the value of real GDP remains the same is if the value of the GDP deflator is lower than expected. To see this point, look at the formula for the GDP deflator:

With nominal GDP lower and real GDP the same, the GDP deflator must be lower. A lower GDP deflator means a lower inflation rate. Therefore, Finance Minister Oliver must be expecting lower oil prices to reduce the inflation rate in Canada.

3.7

a.and b.

(2) Nominal GDP

(3) GDP Deflator (base year = 2020)

(4) Real GDP (base year = 2020)

(5) Percentage Change in Real GDP

$980

90.0

$1,089

—

2019

1,020

92.0

1,109

1.8%

2020

1,050

100.0

1,050

−5.3

2021

1,200

105.0

1,143

8.8

2022

1,400

110.0

1,273

11.4

(2) Nominal GDP

(3) GDP Deflator (base year = 2022)

(4) Real GDP (base year = 2022)

(5) Percentage Change in Real GDP

$980

81.8

$1,198

—

2019

1,020

83.6

1,220

1.8%

2020

1,050

90.9

1,155

−5.3%

2021

1,200

95.5

1,257

8.8%

2022

1,400

100.0

$1,400

11.4

(1) Year 2018

c. and d.

(1) Year 2018

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CHAPTER 18 | GDP: Measuring Total Production and Income c. A change in the base year will not affect the percentage change in the GDP deflator. When we change the base year, we simply rescale the GDP deflator by dividing all observations by the value of the GDP deflator for the newly designated base year.

3.8

3.9

The article is probably referring to the percentage change in real GDP, which measures the value of output, holding constant the change in the price level. Because changes in nominal GDP measure the change in the value of output in current year prices, it would not be possible to determine how much the euro zone’s economy grew—how much more output of final goods and services were produced and sold, holding prices constant—if the 1.5 percent change referred to nominal GDP. The GDP deflator is calculated as [nominal GDP/real GDP] 100.

The percentage change is calculated as [(value in the second period – value in the first period)/ value in the first period] 100.

2016 2017 2018 2019 2020

Nominal GDP $18,745 19,543 20,612 21,433 20,933

Real GDP $17,731 18,144 18,688 19,092 18,423

GDP Deflator 105.7 107.7 110.3 112.3 113.6

Percentage Increase — 1.89% 2.41 1.81 1.16

As shown in table, 2018 saw the largest percentage increase in the price level.

18.4 Other Measures of Total Production and Total Income

Learning Objective: Describe other measures of total production and total income.

Review Questions 4.1

4.2

GDP is the market value of all final goods and services produced within the United States.

GNP is the market value of all final goods and services produced by residents of the United States, even if the production takes place outside the United States. For the United States, GDP is almost the same as GNP. National income is the total income received by a country’s residents. National income is equal to GDP minus the value of depreciation, or the consumption of fixed capital. Personal income, which is income actually received by households, is national income minus corporations’ retained earnings transfer plus payments received by households from the government in the form of

4.3

payments or interest on government bonds. Disposable personal income, which represents the income available for households to spend, is equal to personal income minus personal tax payments, such as the federal personal income tax.

There are several approaches to calculating GDP in addition to adding up the market value of all final to goods and services in the economy. GDP calculated as the sum of income payments households is sometimes called gross domestic income (GDI). GDI includes the values of .

wages, interest, rent, profit, with wages being the largest component of gross domestic income.

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Problems and Applications 4.4

4.5

GNP would be larger than GDP because GNP is the value of final goods and services produced by a country’s residents, whether or not the production takes place inside the country. Switzerland has relatively more of its firms and residents producing in other countries than other countries’ firms and residents are producing in Switzerland.

In Ireland, GDP is significantly larger than GNP, which makes the value of income produced within Ireland.Ireland significantly greater than the value of income produced by the residents of If by “the size and growth rate of the Irish economy” we mean the income available to Irish residents and the growth rate in that income, then GDP is overstating both values in comparison with the more accurate measures given by GNP and the growth rate in GNP.

4.6

The federal personal income tax partially accounts for the difference between personal

4.7

income and disposable personal income. Therefore, the levels of national income and personal income will not change, while the level of disposable personal income will decrease.

To forecast the level of consumption spending by households, we should focus on the

4.8 The GDP of This Country The GNP of This Country Scenarioincome measure that is most closely related to the households’ ability to spend, which is disposable income.

Robertopersonal is a Mexican citizen who USA Mexico The country where Roberto The country where Roberto is a is working as an economics citizen is where the GNP professor at a community college works is where the GDP transaction is counted. transaction is counted. in California. His income is recorded in: German car manufacturer BMW USA The country where BMW produces sedans in its North Carolina plant. The value of the produces the cars is where the GDP transaction is counted. cars produced count in: China Chinese multinational company The country where the phones Huawei produces phones in are made is where the GDP China and sells them to transaction is counted. customers in Thailand. The value of the phones produced count as part of: 4.9

Germany BMW is a German company, so this is where the GNP transaction is counted.

China Huawei is a Chinese company, so this

is

where

the

GNP

transaction is counted.

a. In theory, GDP and GDI should have the same value because the total value of what’s spent on goods and services ultimately becomes income to households. This point can best we illustrated by looking at the circular-flow diagram in this chapter (Figure 8.1 in the Macroeconomics volume; Figure 18.1 in the Economics volume). As firms receive revenue when households buy goods and services in the product market, the firms will use the revenue to pay households for the inputs that the firms procured when they produced goods

.

500

CHAPTER 18 | GDP: Measuring Total Production and Income and services. Extra revenue that is not used by the firms to pay input costs are profits that the firms send to the owners of the firms. b.

The two related reasons that GDP and GDI differ are: (1) the Bureau of Economics Analysis (BEA) data uses different data sets to measure GDP and GDI, and (2) the errors in the income used to measure GDI can differ from the errors in the data on production and spending

Real-Timeused Data Exercises

measure GDP. of 2021, total personal consumption expenditures were $15,070.1 billion, first quarter D18.1 a. Intothe personal consumption expenditures on durable goods were $1,940.7 billion, personal consumption expenditures on nondurable goods were $3,278.3 billion, and personal consumption expenditures on services were $9,851.2 billion. All figures are expressed as annual rates. b.[($1,940.7 billion + $3,278.3 billion)/$15,070.1 billion] × 100 = 34.6% D18.2 a. In the first quarter of 2021, gross private domestic investment was $3,920.0 billion, private nonresidential fixed investment was $2,960.7 billion, and private residential fixed investment was $1,051.3 billion. All figures are expressed as annual rates. b.$3,920.0 billion − [$2,960.7 billion + $1,051.3 billion] = −$92.0 billion, which equals the change in inventories.

D18.3 a.

Real exports of goods and services in 2020 were $2,216.9 billion and in 2019 they were $2,546.6 billion. Real imports of goods and services in 2020 were $3,142.9 billion and in 2019 they were $3,464.2 billion.

Net exports in 2020 equaled − $926.0 billion (= $2,216.9 billion − $3,142.9 billion) and in 2019 they equaled − $917.6 billion (= $2,546.6 billion − $3,464.2 billion).

b.

In the first quarter of 2021, nominal GDP equaled $22,061.5 billion and nominal GNP D18.4 a. equaled $22,255.7 billion. Both figures are expressed as annual rates.

With GNP greater than GDP, foreign production by U.S. firms exceeded U.S. production by b.foreign firms by $194.2 billion in the first quarter of 2021.

In the first quarter of 2021, personal income equaled $22,101.6 billion, disposable personal D18.5 a. income equaled $22,079.6 billion, and personal consumption expenditures equaled $15,070.1 billion. All figures are expressed as annual rates.

The difference between personal income and disposable personal income is personal tax b.payments which in the first quarter of 2021 equaled $22.0 billion (= $22,101.6 billion − $22,079.6 billion).

Nominal GDP equaled $22,061.5 billion in the first quarter of 2021 and equaled $21,561.1 D18.6 a. billion in the first quarter of 2020. Real GDP equaled $19,086.4 billion in the first quarter of 2021 and equaled $19,010.8 billion in the first quarter of 2020. All figures are expressed as annual rates.

The GDP price deflator in the first quarter of 2021 equaled 115.6 = [($22,061.5 billion/ b.$19,086.4 billion) × 100], and in the first quarter of 2020 it equaled 113.4 = [($21,561.1 billion/$19,010.8) × 100].

.

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c. The inflation rate from the first quarter of 2020 to the first quarter of 2021 as measured by the

GDP price deflator was 1.94 percent [= (115.6 − 113.4)/113.4) × 100]. d. The nominal and real GDP lines intersect at the base year because the current year prices used base for nominal GDP and the base-year prices used for real GDP are the same when the D18.7 a.

year is the current year. The value of the GDP deflator in the year when the nominal and real GDP lines intersect is 100.

Nominal GDP in the first quarter of 2021 equaled $22,061.5 billion, and in the first

b.

quarter of 2020 it equaled $21,561.1 billion. Both figures are expressed as annual rates The GDP c. Implicit Price Deflator in the first quarter of 2021 equaled 115.588, and in the first quarter of 2020 it equaled 113.415.

Real GDP in the first quarter of 2021 is approximately $19,086.3 billion [($22,061.5 Suggestions for Critical Thinking Exercises billion/115.588) × 100], and in the first quarter of 2020 it equaled $19,010.8 billion [($21,561.1 billion/113.415) × 100].

CT18.1 Students will likely misunderstand the meaning of the word “investment.” By thinking more The rate of the realwith GDPtheir frompeers, the first quarter ofremember 2020 to thethis first quarter ofconcept 2021 about it growth and comparing notes students will important was approximately 0.4 percent = [($19,086.3 billion – $19,010.8 billion)/$19,010.8 billion) better than they otherwise would. Research in other disciplines has shown that in some × instances, simply talking about ideas that conflict with students’ prior knowledge does not lead 100]. change in students’ views. to much Answers will vary by student, but by asking students what they expected and what they learned, CT18.2 they should learn the material in a deeper way. Some students are surprised that Social Security payments are not part of government purchases. Other students are surprised that the purchase of a new home is not part of consumption expenditures because they believe that consumption expenditures include all expenditures made by households.

The best interpretation of the data in the table is that inflation occurred. Nominal GDP grows, CT18.3 but production is constant; therefore, the GDP deflator increased. This question will encourage students to consider how to use the relationship between changes in nominal GDP and changes in real GDP to draw conclusions about what is happening in the economy.

.

CHAPTER 19 |

Unemployment and Inflation

Brief Chapter Summary and Learning Objectives 19.1 Measuring the Unemployment Rate, the Labor Force Participation Rate, and the Employment-Population Ratio Define the unemployment rate, the labor force participation rate, and the employmentpopulation ratio and understand how they are computed.

▪ The U.S. Bureau of Labor Statistics uses a monthly household survey to calculate the

unemployment rate, the labor force participation rate, and the employment-population ratio.

19.2 Types of Unemployment Identify the three types of unemployment.

▪ The three types of unemployment are as follows: frictional, structural, and cyclical.

19.3 Explaining Unemployment Explain what factors determine the unemployment rate.

▪ Government policies can reduce the level of frictional and structural unemployment by

aiding job search and worker retraining. Government policies can add to the level of

▪ frictional and structural unemployment by increasing the time workers devote to searching

for jobs, providing disincentives for firms to hire workers, or by keeping wages above their market level.

19.4 Measuring Inflation Define the price level and the inflation rate and understand how they are computed.

▪ The price level measures the average prices of goods and services in the economy. The

inflation rate is the percentage increase in the price level from one year to the next.

19.5 Using Price Indexes to Adjust for the Effects of Inflation Use price indexes to adjust for the effects of inflation. a variable by a price index and ▪ To correct for the effects of inflation, we divide nominal multiply by 100 to obtain a real variable.

19.6 Nominal Interest Rates versus Real Interest Rates Distinguish between the nominal interest rate and the real interest rate.

▪ The real interest rate is the nominal interest rate minus the inflation rate.

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CHAPTER 19 | Unemployment and Inflation

19.7 Does Inflation Impose Costs on the Economy?

Discuss the problems that inflation causes.

▪ When the inflation rate is different from the expected inflation rate some people gain and

some people lose.

Key Terms Labor force participation rate The percentage of the working-age population in the labor force.

Consumer price index (CPI) A measure of the average of the prices a typical urban family of four pays for the goods and services they purchase.

Menu costs The costs to firms of changing prices.

Natural rate of unemployment The normal rate of unemployment, consisting of frictional unemployment and structural unemployment.

Cyclical unemployment Unemployment caused by a business cycle recession.

Deflation A decline in the price level.

Nominal interest rate The stated interest rate on a loan.

Price level A measure of the average prices of goods and services in the economy.

Producer price index (PPI) An average of the prices received by producers of goods and services at all stages of the production process.

Discouraged workers People who are available for work but have not looked for a job during the previous four weeks because they believe no jobs are available for them.

Efficiency wage An above-market wage that a firm pays to increase workers’ productivity.

Employed In government statistics, someone who currently has a job or who is temporarily away from his or her job.

Real interest rate The nominal interest rate minus the inflation rate.

Structural unemployment Unemployment that arises from a persistent mismatch between the skills or attributes of workers and the requirements of jobs.

Unemployed In government statistics, someone who is not currently at work but who is available for work and who has actively looked for work during the previous month.

Unemployment rate The percentage of the labor force that is unemployed.

Employment-population ratio The percentage of the working-age population that is employed.

Frictional unemployment Short-term unemployment that arises from the process of matching workers with jobs.

Inflation rate The percentage increase in the price level from one year to the next.

Labor force The sum of employed and unemployed workers in the economy.

Chapter Outline A Tale of Two Labor Markets in the Covid-19 Economy In early 2021, the U.S. economy and labor market were still suffering from the effects of the Covid-19 pandemic. But the suffering wasn’t evenly distributed. If before the pandemic you worked for a tech firm like Apple or Facebook, you likely kept your job, and your firm may have hired more workers.

The same was true of many manufacturing firms, some of which were having trouble attracting enough workers. .

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But the overall labor market wasn’t doing nearly as well. The percentage of the labor force without a job—the unemployment rate—was 6.1 percent in April 2021⸻far above the 3.5 percent unemployment rate in February 2020, before the arrival of the pandemic in the United States. In particular, employment in service industries, such as restaurants, gyms, and movie theaters, remained far below early 2020 levels either because of government restrictions or because people didn’t want to be indoors close to other people. In mid-2021, as more people in the United States became vaccinated, governments were lifting social distancing regulations, and the economy was experiencing a rapid recovery. But President Joe Biden, Congress, and policymakers at the Federal Reserve still faced challenges in helping to bring the economy and the labor market back to the conditions that prevailed in early 2020, particularly following the appearance of the Delta variant of Covid-19 in 2021, which was more transmissible than earlier strains of the virus.

Measuring the Unemployment Rate, the Labor Force Participation Rate, 19.1 and the Employment-Population Ratio

Learning Objective: Define the unemployment rate, the labor force participation rate, and the employment-population ratio and understand how they are computed.

A. The Household Survey Each month, the U.S. Bureau of the Census conducts the Current Population Survey to collect data needed to compute the monthly unemployment rate. The Department of Labor’s Bureau of Labor Statistics (BLS) uses these data to calculate the unemployment rate. In government statistics, an employed person is someone who currently has a job or is temporarily away from his or her job. An unemployed person is someone who is not currently at work but who is available for work and who has actively looked for work during the previous month.

The labor force is the sum of employed and unemployed workers in the economy. The unemployment rate are is the percentage of the labor force that is unemployed. Discouraged workers are people who available for work but have not looked for a job during the previous four weeks because they believe no jobs age are available for them. The labor force participation rate is the percentage of the workingThe unemployment rateforce. is notThe a employment-population perfect measure of the current statepercentage of joblessness. population in the labor ratio is the of the During working-a recession, an increase in the number of discouraged workers occurs, but these workers are not counted age as unemployed. The BLS counts people as employed if they hold part-time jobs even though they population that employed. would prefer to is hold full-time jobs. There are other problems that cause the measured unemployment B. with the Unemployment rateProblems to overstate the Measuring extent of joblessness.

The survey usedRate to measure the unemployment rate does not verify the responses of people included in the survey. A person might claim to be actively looking for a job to remain eligible for government programs. Other people might be employed but engaged in illegal activity or might want to conceal a legitimate job to avoid paying taxes.

C. Unemployment Rates for Different Groups Different groups in the population can have very different unemployment rates. In January 2021, whites had a lower unemployment rate, and African Americans had a higher unemployment rate, than the overall rate.

D. How Long Are People Typically Unemployed?

In the modern U.S. economy, the typical unemployed person stays unemployed for a relatively brief period of time, although that time lengthens significantly during a recession.

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E. Trends in Labor Force Participation The labor force participation rate determines the amount of labor that will be available to the economy from a given population. The higher the labor force participation rate, the more labor will be available and the higher a country’s level of GDP. The labor force participation rate of adult men has declined gradually since 1948, but the labor force participation rate of adult women has increased sharply. The overall labor force participation rate rose from 59 percent in 1948 to 68 percent in 2020.

F. The Establishment Survey: Another Measure of Employment The BLS uses the establishment survey, sometimes called the payroll survey, to measure total employment in the economy. This monthly survey samples about 300,000 business establishments to provide information on the total number of persons who are employed and on a company payroll.

Despite some drawbacks, the establishment survey has the advantage of being determined by actual payrolls. In recent years, some economists have come to rely more on establishment survey data than on household survey data in analyzing current labor market conditions.

G. Revisions in the Establishment Survey Employment Data: How Bad Was the 2007–2009 Recession?

To avoid long waits in supplying data, such as the employment data from the establishment survey, to policymakers and the general public, government agencies typically issue preliminary estimates that they revise as additional information becomes available.

H. Job Creation and Job Destruction over Time The U.S. economy creates and destroys millions of jobs every year. The creation and destruction of jobs result from changes in consumer tastes, technological progress, and the successes and failures of entrepreneurs in responding to the opportunities and challenges of shifting consumer tastes and technological change. When the BLS announces the increases or decreases in the number of people employed and unemployed each month, these are net figures.

Teaching Tips The end of the chapter in the main text includes a special category of exercises titled Real-Time Data Exercises (RTDA). These exercises are well worth assigning and discussing in class because they help students become familiar with a key data source, learn how to locate data, and develop skills in interpreting data. Many RTDA exercises require more elaborate calculations than other problems as well as the use of Excel spreadsheets.

Extra Apply the How Unusual Was the Unemployment Situation Following the Concept 2007–2009 Recession?

The Great Depression of the 1930s left its mark on nearly everyone who lived through it. The Depression began in August 1929, became worse after the stock market crash in October 1929, and reached its lowest point in 1933, following the collapse of the banking system. Real GDP fell by more than 25 percent between 1929 and 1933—the largest decline ever recorded. The unemployment rate in 1933 was above 20 percent—the highest rate ever recorded. The unemployment rate did not return to its 1929 level until 1942, the year after the United States entered World War II. With the unemployment rate so high for so long, many people were out of work for years. As one historian put it: “What was distinctive about the

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Great Depression, in fact, was . . . the extraordinary lengths of time that most jobless men and women remained out of work.”

By the 2000s, many people in the United States, including most economists and policymakers, believed that 1930sprolonged periods of unemployment such as the U.S. economy had suffered from during the were very unlikely to happen again. Although the 1981–1982 recession had been severe and the unemployment rate had risen above 10 percent for the first time since the 1930s, the recovery was strong, and many unemployed workers found new jobs relatively quickly. So, following the 2007–2009 recession, most economists and policymakers were unprepared for how slowly the unemployment rate declined and for how much the average period of unemployment rose. During the 1981–1982 recession, the unemployment rate peaked at 10.8 percent in December 1982, but 18 months later, in June 1984, it had already declined to 7.2 percent. In contrast, after the recession of 2007–2009, the unemployment rate peaked point at 10.0 percent in October 2009, while 18 months later it had declined by only 1 percentage to 9.0 percent. The following figure shows that the average period of unemployment was twice as high following the 2007–2009 recession as following any other recession since the end of World War II.

Source: Federal Reserve Bank of St. Louis.

Unemployment was so persistent and widespread that a survey taken by the Pew Research Center in the spring of 2011 found that more than half of all households had experienced at least one member losing his or her job during the previous year. Another Pew survey taken in June 2011 found that more than half of people with jobs expected to receive a pay cut or to lose their job during the next year. As we have seen, one drawback to the unemployment data is that workers who drop out of the labor market are no longer counted by the BLS as unemployed. As a result, some economists focus on the employment–population ratio because it measures the fraction of the population that has jobs. The following figure shows the employment–population ratio for the period from 1948 through mid-2013. The overall upward trend of the ratio reflects the increased labor force participation rate of women. In each recession, the employment–population ratio falls as some workers lose their jobs. The fall of the employment– population ratio was particularly dramatic during the recession of 2007–2009, and the ratio was actually even lower four years after the end of the recession. The fall of the employment–population ratio may be the best indication of how weak the U.S. labor market was during and after the 2007–2009 recession.

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As we will see in later chapters, explaining the weakness of the U.S. labor market during these years had become a top priority of economists and policymakers.

Sources: Alexander Keyssar, Out of Work: The First Century of Unemployment in Massachusetts, New York: Cambridge University Press, 1986, p. 290; Federal Reserve Bank of St. Louis; U.S. Bureau of Labor Statistics; Pew Research Center, “The Recession, Economic Stress, and Optimism,” May 4, 2011; and Pew Research Center, “Views of Personal Finances,” June 23, 2011.

Question An article published in the New York Times in July 2011 argued: “For the second straight year, the recovery in the job market has essentially stalled. This chart, showing the share of adults with jobs, offers the best summary you’ll find.” The “share of adults with jobs” is known more formally as the employment–population ratio. Why might the employment–population ratio provide the “best summary” of the state of the job market rather than the unemployment rate?

New York Times , July 8, 2011.

Source: David Leonhardt, “Overly Optimistic, Once Again,”

Answer A weakness of the unemployment rate is that it does not count as unemployed those workers who drop out of the labor force. As a result, some economists focus on the employment-population ratio because it measures the fraction of the working-age population that has jobs.

19.2 Types of Unemployment

Learning Objective: Identify the three types of unemployment.

A. Frictional Unemployment and Job Search Most workers spend time engaging in a job search, and most firms spend time searching for people to fill job openings. Frictional unemployment is short-term unemployment that arises from the process of matching workers with jobs. There will always be some workers who are frictionally unemployed because they are between jobs and in the process of searching for new ones. Some unemployment is due to seasonal factors, such as weather or fluctuations in demand during different times of the year.

Seasonal unemployment refers to unemployment due to factors such as weather, variations in tourism, and other calendar-related events.

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B. Structural Unemployment Structural unemployment is unemployment that arises from a persistent mismatch between the skills or attributes of workers and the requirements of jobs. This type of unemployment can last for longer periods than frictional unemployment because workers need time to learn new skills.

C. Cyclical Unemployment When the economy moves into recession, many firms find their sales falling and cut back on production. As production falls, firms lay off workers. Cyclical unemployment is unemployment caused by a business cycle recession.

D. Full Employment The natural rate of unemployment is the normal rate of unemployment, consisting of frictional unemployment and structural unemployment. The natural rate of unemployment is also called the fullemployment rate of unemployment.

Teaching Tips Though categorizing unemployment as frictional, structural, or cyclical is useful in understanding the sources of unemployment, the Bureau of Labor Statistics (BLS) provides estimates of total unemployment but doesn’t classify unemployment as frictional, structural, or cyclical.

Extra Analyze How Should We Categorize the Unemployment Resulting from the Concept Boeing’s Layoffs in 2017

Boeing announced in 2017 that it was laying off 1,800 workers in addition to the 7,000 workers it had cut the year before. Did these layoffs result in an increase in frictional unemployment, structural unemployment, or cyclical unemployment? In answering this question, we should acknowledge that dividing unemployment into these three categories is useful in understanding the sources of unemployment, but it can be difficult to apply these categories in a particular case. The BLS, for instance, provides estimates of total unemployment but does not classify it as frictional, structural, or cyclical.

Despite these difficulties, we can roughly categorize the unemployment resulting from the layoffs at Boeing. At the time of the layoffs in 2016 and 2017, the U.S. economy was expanding, and the U.S. unemployment rate had declined to less than 4.5 percent. The economies of the European and Asian countries to which Boeing sells jetliners were also expanding. The layoffs at Boeing were therefore not increasing cyclical unemployment, and the firm was unlikely to rehire the workers it was laying off, even if the economic recovery continued in future years.

In discussing Boeing’s decision to lay off workers, an article in the Wall Street Journal noted that “Boeing in recent years has invested heavily in automated manufacturing equipment.” Because other aerospace firms have been adopting similar technology, some of the laid-off Boeing workers were likely to need to retrain for other jobs before becoming employed again. So, these workers were structurally unemployed. Boeing was also laying off some workers because of declines in military spending by the federal government.

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Unless military spending increased, the workers Boeing laid off would be structurally unemployed because other defense contractors were facing similar cutbacks. But Boeing was also laying off some workers because it was losing sales to Airbus and to Bombardier. Although Airbus is a European firm and Bombardier is a Canadian firm, both assemble some planes in the United States. If laid off Boeing workers eventually find jobs at these firms, then these workers would have been frictionally unemployed during the time they were out of work.

It therefore seems likely that some of the unemployment resulting from Boeing’s layoffs was structural and some was frictional. Given the state of the economy, none of it was likely cyclical.

Sources: Julie Johnsson, “Boeing to Dismiss Hundreds of Engineers Amid Sales Slowdown,” bloomberg.com, April 17, 2017; Doug Cameron, “More Than 1,800 Boeing Employees Accept Voluntary Buyouts,” Wall Street Journal, March 3, 2017; Jon Ostrower, “Jet Prices Take Center Stage in Boeing Job Cuts,” Wall Street Journal, March 31, 2016; and Doug Cameron, “Boeing to Cut Defense Jobs,” Wall Street Journal, November 15, 2016.

Extra Solved Problem 19.2 Reasons for Unemployment, 2008 - 2014 Some of the data the Bureau of Labor Statistics collects regarding the reasons people are unemployed appear in the following table (numbers are in thousands, seasonally adjusted).

Reason for Unemployment

Unemployment

Job Losers Year 2008 2009 2010 2011 2012 2013 2014

Rate (%) 5.8 9.3 9.6 8.9 8.1 7.4 6.2

Number 8,924 14,265 14,825 13,747 12,506 11,460 9,617

Total 4,789 9,160 9,250 8,106 6,877 6,073 4,878

On Layoff 1,176 1,630 1,431 1,230 1,183 1,136 1,007

Other 3,614 7,530 7,819 6,876 5,694 4,937 3,831

Job Leavers 896 882 889 956 967 932 824

Reentrants 2,472 3,187 3,466 3,401 3,345 3,207 2,829

New Entrants 766 1,035 1,220 1,284 1,316 1,247 1,086

Source: U.S. Department of Labor, Bureau of Labor Statistics. www.bls.gov

a. Calculate the percentage of the unemployed who lost their jobs (Job Losers) and the percentage that left their jobs (Job Leavers) from 2008 to 2014. b. Calculate the percentage of the unemployed who were unemployed as the result of entering the labor force, either for the first time or as reentrants, from 2008 to 2014.

Solving the Problem Step 1:

Review the chapter material.

This problem is about the sources of unemployment, so you may want to review the section “Types of Unemployment” in the textbook.

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CHAPTER 19 | Unemployment and Inflation Step 2:

Answer part (a) by calculating the percentage of the unemployed who lost their jobs and the percentage that left their jobs from 2008 to 2014.

The percentage of “job losers,” for example in 2008, can be calculated as (4,789/8,924) 100 = 53.7 percent. The percentages for each year are in the second column (Job Losers) of the following table. The percentage of “job leavers” can be calculated for 2008 as (896/8,924) 100 = 10.0 percent. The percentages for each year are in the third column (Job Leavers) of the following table.

Year 2008 2009 2010 2011 2012 2013 2014 Step 3:

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Percentage of The Unemployed Reentrants and New Entrants Job Losers Job Leavers 36.3 53.7 10.0 29.6 64.2 6.2 31.6 62.4 6.0 34.8 60.2 7.1 37.3 55.0 7.7 38.9 53.0 8.1 40.7 50.7 8.6

Answer part (b) by calculating the percentage of the unemployed who were unemployed as the result of entering the labor force from 2008 to 2014.

The percentage of reentrants and new entrants for 2008 is [(2,472 + 766)/8,924] 100 = 36.3 percent. The percentages for each year are included final column in the above table. The main source of unemployment is job losers, followed by reentrants and new entrants.

There were more reentrants—people who lost or quit jobs in the past, dropped out of the labor force and are now looking for new jobs—than new entrants to the labor force.

19.3 Explaining Unemployment

Learning Objective: Explain what factors determine the unemployment rate.

A. Government Policies and the Unemployment Rate Governments can reduce the level of frictional unemployment with policies that speed up the process of matching unemployed workers with unfilled jobs. Governments can help reduce structural unemployment with policies that aid worker retraining. Some government policies, however, can add to the level of frictional and structural unemployment. In the United States and most industrial countries, the unemployed are eligible for unemployment insurance payments. The unemployed spend more time searching for jobs because they receive these payments.

Unemployment insurance helps the unemployed maintain their income and spending, which lessens the personal hardship of being unemployed. In the United States, unemployed workers are typically eligible to receive unemployment insurance payments equal to about half of their previous wage for six months, although this period is often extended during recessions. In many other countries workers are eligible to receive unemployment payments for a year or more, and payments may equal 70 percent of their previous wage.

In 1938, the federal government enacted a minimum-wage law. If the minimum wage is set above the market wage, the quantity supplied of labor will be greater than the quantity of labor demanded. As a result, the unemployment rate will be higher than it would be without the minimum wage. Studies estimate that a 10 percent increase in the minimum wage reduces teenage unemployment by about 2 percent. Because teenagers and others receiving the minimum wage are less than 4 percent of the labor force, most economists believe that to this point the minimum wage has had a fairly small effect on the unemployment rate in the United States. .

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B. Labor Unions Labor unions are organizations of workers that bargain with employers for higher wages and better working conditions for their members. In unionized industries, the wage is usually above what otherwise would be the market wage, but most economists believe that this does not result in an increase in the overall unemployment rate because only about 6 percent of workers outside the government sector are unionized.

C. Efficiency Wages An efficiency wage isan above-market wage that a firm pays to increase workers’ productivity.

Efficiency wages are another reason economies experience some unemployment even when cyclical unemployment is zero.

19.4

Measuring Inflation Learning Objective: Define the price level and the inflation rate and understand how they are computed.

The price level is a measure of the average prices of goods and services in the economy. The inflation rate is the percentage increase in the price level from one year to the next. The GDP deflator is the broadest measure of the price level, but to know the impact of inflation on the typical household, the deflator can be misleading. Changes in the consumer price index come closest to measuring changes in the cost of living as experienced by the typical household.

A. The Consumer Price Index To obtain prices of a representative group of goods and services, the BLS surveys 14,000 households on their spending habits. The survey is used to construct a market basket of 211 types of goods and services used by the typical urban family of four. The consumer price index (CPI) is a measure of the average of the prices a typical urban family of four pays for the goods and services they purchase.

One year is chosen as the base year, and the value of the CPI is set equal to 100 for that year. In any other year, the CPI equals the ratio of the dollar amount necessary to buy the market basket in that year divided by the dollar amount necessary to buy the market basket in the base year, multiplied by 100. The CPI is sometimes called the cost-of-living index.

B. Is the CPI Accurate?

The CPI is the most widely used measure of inflation. It is important that the CPI be as accurate as possible, but there are four biases that cause the CPI to overstate the true inflation rate: substitution bias, increase in quality bias, new product bias, and outlet bias. The BLS takes steps to reduce the size of the bias.

C. The Producer Price Index In addition to the GDP deflator and the CPI, the government also computes the producer price index (PPI), which is an average of the prices received by producers of goods and services at all stages of the production process. Changes in the PPI can give an early warning of future movements in the CPI.

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Extra Solved Problem 19.4 Calculating the CPI The consumer price index (CPI) compares the cost of a market basket of goods in a given year with the cost of the same market basket in the base year. Suppose that a market basket includes: (1) admission for two to a local theater for a weekend movie; (2) a large box of popcorn at the theater; (3) a large pepperoni pizza (carry-out from a local pizzeria); and (4) a two-liter bottle of diet Coke.

Year 1 2 3

Theatre Admission for One Person $5.00 6.00 6.50

Popcorn $2.00 2.50 3.00

Pizza $12.00 12.50 13.00

Diet Coke $1.25 1.40 1.50

Assume that Year 1 is the base year. Calculate the value of the CPI for each year and the rate of inflation for Years 2 and 3.

Solving the Problem Step 1:

Review the chapter material.

This problem is about using the CPI to calculate the inflation rate, so you may want to review the section “Measuring Inflation” in the textbook.

Determine the value of the market basket.

Step 2: The value of the market basket is the sum of the quantity of each good included in the basket multiplied by its price. The market basket in this example has a quantity of two for theater admissions, and a quantity of one for each of the other goods. The value of the market basket in Year 1, the base year, is (2 $5.00) + $2.00 + $12.00 + $1.25 = $25.25.

The table in Step 3 lists the value of the market basket for all three years.

Calculate the value of the CPI and the inflation rates for Years 2 and 3.

Step 3: The CPI is the ratio of the value of the market basket in a given year to the value of the market basket in the base year, multiplied by 100. We can use the CPI to calculate the inflation rate, which is the percentage change in the CPI from Year 1 to Year 2 and from Year 2 to Year 3. These values are in the following table:

Year 1 2 3

Value of the Market Basket $25.25 28.40 30.50

CPI 100.0 112.5 120.8

Rate of Inflation — 12.5% 7.4%

Extra Apply the Explaining How the CPI Measures the Price Level and Rate of Concept Inflation

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There are many misconceptions about how the consumer price index (CPI) is constructed and exactly what it measures. Economists John Greenlees and Robert McCelland addressed these misconceptions in an article published in the Monthly Labor Review. They explain that “…when prices change, the goal of the CPI is to measure the percentage by which consumers would have to increase their spending to be as well off with the new prices as they were with the old prices…”

The following information regarding the CPI and its construction are taken from the Greenlees and McCelland article.

Since 1978, the Bureau of Labor Statistics (BLS) has published the CPI for all urban consumers (CPI-U) and the CPI for urban wage earners and clerical workers (CPI-W). Though the items and prices included in both indexes are the same, the weights given to some of the index components differ. The U.S. Census Bureau administers a Telephone Point-of-Purchase Survey in which consumers are asked where they recently purchased goods and services. The BLS uses these data to select a sample of grocery stores, service regularlystations, doctors’ offices, and other locations at which to collect prices. BLS employees collect the prices of representative samples of items from these locations. The BLS then constructs individual Consumer item-area indexes and averages the indexes together using weights based on the Expenditure Survey, which the Census Bureau conducts for the BLS. The all-items CPI-U is the CPI that is reported most widely, but the CPI-U and the CPI-W are both used to andmake cost-of-living adjustments. The CPI-W is the index used to make annual Social Security federal retirement cost-of-living adjustments and is often used for periodic wage adjustments in collective bargaining amounts agreements. The CPI-U is used for indexation of tax brackets and personal exemption in the federal tax system. CPI data are also used in the construction of the National Income and Products Accounts (NIPA). For example, CPI component indexes are inputs into the NIPA Personal Consumption Expenditures (PCE) price index and are used in the calculation of real GDP. Monthly

In 2002, the BLS began publishing the chained Consumer Price Index for urban consumers (C-CPIU). This Using Price Indexes to Adjustindex for the Inflationsubstitution among item more closely approximates a cost-of-living

by Effects reflectingofconsumer categories.

19.5

Over time, some goods and services consumers commonly bought are replaced by new goods and Learning Objective: Use price indexes to adjust for the effects of inflation. services.

Adjustments the be made a shrinking basket that is Price indexes to give us aCPI waymust of adjusting fortotheavoid effectshaving of inflation so that market we can compare dollar unrepresentative of what values fromare different To correct for thethe effects of inflation, we divide a nominal variable by a consumers buying.years.

For many food items, substitution is facilitated because the BLS measures price index and multiply by 100 to obtain a real variable. Economic variables that are calculated in prices on a prices are called nominal variables. current-year per-ounce example ofor a per-pound basis, rather than a per-item, basis. Greenlees and McCelland use a simple maker of a candy bar that replaces a 1-ounce bar with a 1.5-ounce bar that sells for the same 75 cent price. The .

BLS would record a 50 percent increase in price rather than recording that the price of the bar had not changed.

More complicated adjustments are required when an item, such as a standard-definition television set,

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Extra Solved Problem 19.5 Calculating Real Wages at Caterpillar In 2013, Caterpillar and the United Steelworkers Union signed a labor contract that froze the wages of caterpillar workers for six years. In 2013, the average wage at Caterpillar was about $27 per hour and the CPI was 233. Suppose the CPI rises to 260 in 2018, the last year of the contract.

Calculate the percentage change between 2013 and 2018 in the real wage earned by an average Caterpillar worker. Be sure to explain what the values you calculate for the real wage represent.

Solving the Problem Step 1:

Step 2:

Review the chapter material.

This problem is about using price indexes to correct for the effects of inflation, so you may want to review the section “Using Price Indexes to Adjust for the Effects of Inflation” in the textbook.

Begin by defining the real wage in 2013 and 2018 and explaining what the values of the real wage represent.

The number of dollars a worker receives is the worker’s nominal wage. To calculate the worker’s real wage, we have to divide the nominal wage by the CPI for that year and multiply by 100. We can make the following calculations for the two years: For 2013:

For 2018:

The base year for the CPI is the average of prices during the period 1982–1984. So, the values values for the real wage we calculated are in 1982–1984 dollars. In other words, these Step 3:

for the real wage tell us that in 2013, $27 would buy what $11.59 would have bought in 1982–1984, and change that in equals: 2018, $27 would buy what $10.38 would have bought in 1982– This percentage 1984.

Complete the answer by calculating the percentage change in the real wage Caterpillar workers will receive.

We can conclude that if the estimate of the CPI in 2018 is correct, an average Caterpillar worker will experience about a 10 percent decline in his or her real wage between 2013 and 2018.

Extra Credit: The values we computed for the real wages Caterpillar workers earn are measured in 1982–1984 dollars. Because this period is more than 30 years ago, the values are somewhat difficult to interpret. We can convert the earnings to 2013 or 2018 dollars by using the method we used in Section

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19.5 of the textbook to calculate your mother’s salary. But notice that, for purposes of calculating the change in the value of real average hourly earnings over time, the base year of the price index doesn’t matter. The change from 2013 to 2018 would still be −10.4 percent, no matter what the base year of the price index was. If you don’t see that this is true, test it by using the mother’s salary method to calculate the real wage for 2013 and 2018 in 2013 dollars. Then calculate the percentage change. Unless you make an arithmetic error, you should find that the answer is still −10.4 percent.

Question In 1924, the famous novelist F. Scott Fitzgerald wrote an article for the Saturday Evening Post titled “How to Live on $36,000 a Year,” in which he wondered how he and his wife had managed to spend all of that very high income without saving any of it. The CPI in 1924 was 17, and the CPI in 2020 was 259.

Saturday Evening Post , April 5, 1924.

Source: F. Scott Fitzgerald, “How to Live on $36,000 a Year,”

What income would you have needed in 2020 to have had the same purchasing power that Answer We can convert Fitzgerald’s 1924 nominal income of $36,000 to an equivalent income in 2020 Fitzgerald’s by $36,000 had in 1924? Be sure to show your calculation. multiplying the 1924 nominal income by the ratio of the CPI for 2020 to the CPI for 1924: $36,000 × (259/17) = $548,471. So, you would have needed an income of $548,471 in 2020 to have the same purchasing power that Fitzgerald’s $36,000 had in 1924.

19.6 Nominal Interest Rates versus Real Interest Rates Learning Objective: Distinguish between the nominal interest rate and the real interest rate.

The difference between nominal and real values is important when money is being borrowed and lent.

Because it is corrected for the effects of inflation, the real interest rate provides a better measure of the true cost of borrowing and the true return to lending than does the nominal interest rate. The nominal interest rate is the stated interest rate on a loan. The real interest rate is the nominal interest rate minus the inflation rate. For the economy as a whole, we can measure the nominal interest rate as the interest rate on three-month U.S. Treasury bills. The nominal interest rate will be less than the real interest rate when the inflation rate is negative. Deflation is a decline in the price level.

Extra Solved Problem 19.6 Computing the Real Rate of Interest The real interest rate is defined as the nominal interest rate minus the inflation rate. The textbook uses the three-month interest rate on U.S. Treasury bills (short-term loans investors make to the federal government) as a measure of the nominal interest rate. The following table contains: • •

The average annual interest rate on three-month Treasury bills (T-bills The percentage change in the consumer price index (CPI-U) for 1981, 1984, and 1985 (years of relatively high nominal interest rates) and 2014, 2015 and 2016 (years of relatively low nominal interest rates).

1981 Interest rate on three-month T-bills 14.03 10.38 Percentage change in the CPI-U

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1984 9.52 4.37

1985 7.48 3.53

2014 0.03 1.61

2015 0.05 0.12

2016 0.32 1.28

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Source: https://fred.stlouisfed.org/

a. What was the real interest rate in the years 1981, 1984, 1985, 2014, 2015, and 2016? b. In which of these years was the real interest highest? In which years was the real interest rate negative?

Solving the Problem Step 1:

Step 2:

Review the chapter material.

This problem refers to real and nominal interest rates, so you may want to review the section “Nominal Interest Rates versus Real Interest Rates” in the textbook. .

Answer part (a) by calculating the real interest rate for the years 1981, 1984, 1985, 2014, 2015, and 2016.

Real interest rates for the given years are: 1981 1984 1985 3.65 5.15 3.95

Step 3:

2014 −1.58

2015 −0.07

2016 −0.96

Answer part (b) by explaining in which of these years the real interest rate was highest and in which years the real interest rate was negative.

The real interest rate was highest in 1984 at 5.15 percent and was negative in 2014, 2015, and 2016. A negative real interest rate means that lenders are receiving a negative real return on funds they have loaned. Eventually, nominal interest rates must rise to make the real interest rate positive. At some point, investors will demand a positive interest rate in order to convince them to keep buying Treasury bills.

Inflation Impose Costs on the Economy? Learning Objective: Discuss the 19.7 Does problems that inflation causes.

A. Inflation Affects the Distribution of Income Although inflation does not reduce the affordability of goods and services to the average consumer, it still imposes costs on the economy. Inflation affects the distribution of income. Some people will find their incomes rising faster than the rate of inflation, and so their purchasing power will rise. Other people will find their incomes rising slower than the rate of inflation, so their purchasing power will fall. The extent to which inflation redistributes income depends, in part, on whether the inflation is anticipated or unanticipated.

B. The Problem with Anticipated Inflation When inflation is anticipated, its main cost is that paper money loses value. Anyone holding paper money will find its purchasing power decreasing each year by the rate of inflation. To avoid this cost, workers and firms try to hold as little money as possible. Firms that print catalogs listing prices of products will have to reprint them more frequently. Stores will devote more time and labor to changing prices. Menu costs are the costs to firms of changing prices. Anticipated inflation raises taxes paid by investors because they are taxed on the nominal payments they receive rather than on the real payments.

C. The Problem with Unanticipated Inflation When people borrow money or banks lend money, they must forecast the rate of inflation so they can calculate the real rate of interest on a loan. When the actual inflation rate turns out to be different from the

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expected rate, some people gain while other people lose. This apparently unfair redistribution is a key reason people dislike unanticipated inflation.

Extra Economics in Your Life & Career: How will the real interest rate affect the cost of your car loan?

Imagine that you drive an old car that needs $500 in repairs in order to pass an annual car inspection. You are considering buying a new car, and you contact car dealers and banks to determine the best deal you can get on a car loan. Assume two different scenarios: (a) The lowest interest rate you find on a five-year car loan is 10 percent, and the annual rate of inflation for the next five years will be 9 percent. (b) The lowest interest rate you can find on a five-year car loan is 6 percent, and the annual rate of inflation for the next five years will be 1 percent.

Question: Under which scenario—(a) or (b)—will you pay less, in real income, for your car loan?

Answer: Although the nominal interest rate is much lower under scenario (a), you should base your decision on the real interest rate. Of course, you will not know what the actual rate of inflation will be in the future, but if the rate of inflation is 9 percent annually, the real rate of interest on your car loan will be only 1 percent. Under scenario (b), if the annual rate of inflation is 1 percent over the duration of your loan the real rate of interest will be 5 percent. You will pay less in real income under scenario (a) even though the nominal interest rate is much higher than it is under scenario (b).

Extra AN INSIDE LOOK News Article to Use in Class Visit www.mylabeconomics.com for current AnInside Look news articles.

Solutions to End-of-Chapter Exercises Measuring the Unemployment Rate, the Labor Force Participation Rate, 119.1 and the Employment-Population Ratio

Learning Objective: Define the unemployment rate, the labor force participation rate, and the employment-population ratio and understand how they are computed.

Review Questions 1.1

1.2

The unemployment rate is calculated monthly from data gathered by the U.S. Bureau of the Census in its household survey. The unemployment rate equals the percentage of the labor force that is unemployed: (Unemployed/Labor Force) × 100. To be counted as unemployed, a person would need to meet these three conditions: (1) did not work in the previous week, (2) was available for work, and (3) actively looked for work at some time during the previous four weeks.

The official Bureau of Labor Statistics (BLS) measure of the unemployment rate understates the true degree of unemployment to the extent that it (1) does not count discouraged workers as

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unemployed because they have stopped looking for a job, and it (2) counts involuntary parttime workers as employed even though these workers would prefer to work more hours.

The official BLS measure overstates the true degree of unemployment because (1) some people are not actively looking for work but claim to be in order to remain eligible for government payments to the unemployed, and (2) some people have jobs in the underground economy although they claim to be unemployed.

The BLS can have difficulty accurately measuring the unemployment rate precisely even during normal economic times and 2020 was far from normal economic times. During the Covid-19 pandemic, some people were not working because many state and local governments ordered businesses counted to close. Some businesses continued to pay these workers. The BLS initially these workers as “employed but absent from work”⸻not as unemployed. Typically, 1.3

workers in the “employed but absent from work” category are on vacation or have a short-term illness.

Workers who are on temporary layoff from a business are classified as unemployed.

Several months into the pandemic, the BLS decided that workers who were not on the job because of the

1.4

pandemic⸻even if the workers were still being paid⸻should have been counted as unemployed rather monthsthan as employed. We can conclude that the official unemployment data for these are likely to be underestimates of the true unemployment rate, although we can’t be sure of

1.5

1.6

the extent of the underestimation.

The following groups tend to have above-average unemployment rates: African Americans, Hispanics, high school dropouts, and high school graduates.

The following groups tend to have below-average unemployment rates: Whites, Asians, and college graduates.

The labor force participation rate measures the percentage of the working-age population that is in the labor force: (Labor Force/Working-Age Population) × 100. Since 1950, the labor force participation rate for men has gradually declined, while the rate for women has significantly increased.

The overall labor force participation was higher in 2020 than in 1950. In recent years, policymakers have been concerned about the decline in the labor force participation rate of primeage males. The labor force participation rate for women has declined somewhat since the 2007– 2009 recession.

The employment-population ratio measures the percentage of the working-age population .

that is employed: (Employment/Working-Age Population) × 100. An unemployed person dropping out

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Problems and Applications 1.7 Working-Age Population

261,082,927

Employed

149,830,000

Unemployed

10,736,000

Unemployment rate Labor force

6.7% 160,566,000

Labor force participation rate

61.5%

Employment–population ratio

57.4%

We can calculate the number of people unemployed using the definition that the unemployment rate equals the number of unemployed divided by the sum of the number of unemployed and the number of employed, multiplied by 100: [Unemployed/(Unemployed + Employed)] × 100 = 6.7%.

The labor force equals the employed plus the number of people unemployed: 149,830,000 + 10,736,000 = 160,566,000.

We can calculate the working-age population using the definition that the labor force participation rate equals the labor force divided by the working-age population: (160,566,000/Working-age Population) = 0.615.

Therefore, the working-age population = 160,566,000/0.615 = 261,082,927.

The employment-population ratio equals the number of employed divided by the working-age population, multiplied by 100: (149,830,000/261,082,927) × 100 = 57.4%.

1.8

1.9

Including homemakers as employed would decrease the unemployment rate because it increases the size of the labor force but leaves unchanged the number of unemployed.

Including homemakers as employed would increase the labor force participation rate because it increases the labor force but leaves unchanged the working-age population. Including homemakers would increase the employment-population ratio because it increases the number of employed but does not change the working-age population.

The formula for the unemployment rate is (Number of unemployed/Labor force) × 100. The labor force is of equal to the sum of the employed and the unemployed. Holding constant the number people employed from October to November 2020, a decrease in the labor force participation rate would numbermean the size of the labor force decreased, which could only have happened if the

1.10

of people unemployed had decreased by the same amount. Both the numerator and the denominator in the equation for the unemployment rate would decrease. Subtracting the same number to both the numerator and the denominator of a fraction that is less than 1 decreases the value percentofinthe fraction. Therefore, the unemployment rate would have been less than 6.7 November 2020. The Covid-19 pandemic . and subsequent mandatory shutdown of many businesses caused significant changes in the labor market. The BLS interviewers initially underestimated

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not reporting to work as “employed but absent from work.” Several months into the pandemic, the BLS decided that workers who were not on the job because of the pandemic ⸻even if the workers were still being paid⸻should have been counted as unemployed rather than as employed. This practice resulted in underestimating true unemployment rates.

The BLS changed its instructions to its interviewers in March 2020 so that the interviewers could correctly therefore distinguish between workers who were idle because of the pandemic (and should be counted as unemployed) and workers who were on vacation or suffering from a 1.11

shortterm the illness (and therefore should be counted as employed). Even for the early months of pandemic when the undercount of unemployment was likely quite large, the BLS decided not to adjust its original estimates.

If the size of the labor force and working-age population did not change, then the labor

1.12 for a job. force participation rate will remain unchanged.

Thelabor 30,000 newthe jobs would simply the b. i.

If an additional million people enter the force, unemployment rateincrease will increase number of employed by jobs 30,000 reduceif the of If unemployed by 30,000 if theyworkers fail to find andand decrease theynumber find jobs. some of theworkers million people find jobs and some don’t, then the effect on the unemployment rate will depend on how many with people found jobs and how many didn’t. no change the size of the labor force. This addition in the number of jobs is not large enough to inthe ii. When number of people who are in the labor force increases by 1 million, the change the unemployment rate and the employment-population ratio since these ratios are working-age population will remain the same, while the labor force increases. The labor onlyforce participation rate increases because the labor force population rate is calculated as the number people place in theinlabor force divided the working age Question population measured to oneofdecimal precision.

Refer toby answer to Review 1.7multiplied for a by 100. refresher on how these three ratios are computed. iii. Thewho working age population is unaffected by people who were disabled a. People are retired are not counted as unemployed because theypreviously are not actively looking entering the labor force. Therefore, if these 1 million people enter the labor force and any of them find a job, the employment-population ratio will rise.

1.13

The unemployment rate can decrease while the number of employed people falls if the number of discouraged workers or retirees increases. These discouraged workers and retired workers are not counted in the labor force because they are no longer actively looking for work. Because of this decline in the labor force, a state could see the total number of people employed increase and the unemployment rate fall if the decline in labor force numbers is enough to offset the job loss.

1.14

President Trump was referring to the net increase in jobs. The U.S. economy would have created far more than 7.0 million jobs over the two-year period, but it would have also destroyed many jobs. There was a net increase of 7.0 million jobs.

19.2 Types of Unemployment

Learning Objective: Identify the three types of unemployment.

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Review Questions 2.1

The three types of unemployment are frictional unemployment, structural unemployment, and cyclical unemployment: ▪ ▪ ▪

2.2

2.3

Frictional unemployment is short-term unemployment that arises from the process of matching workers with jobs.

Structural unemployment is unemployment that arises from a persistent mismatch between the skills and attributes of workers and the requirements of jobs.

Cyclical unemployment is unemployment caused by a business cycle recession.

Cyclical unemployment and structural unemployment result in greater hardship than frictional unemployment. Frictional unemployment typically does not last as long as cyclical unemployment or structural unemployment, and the frictionally unemployed do not need to retrain or relocate to find a job as the structurally unemployed typically do.

Frictional unemployment arises from the process of matching workers with jobs. Because job search takes time, there are always some workers who are frictionally unemployed because they have begun a job search and have not yet found a job. The more difficult or lengthy the job search process, the greater the amount of frictional unemployment.

The natural rate of unemployment is the normal rate of unemployment, consisting of frictional unemployment plus structural unemployment. The natural rate of unemployment is considered the full-employment rate of unemployment.

Problems and Applications 2.4

2.5

2.6

The Lenox Corporation’s workers are structurally unemployed because they will not be able to find new employment in this industry. They will probably have to learn new skills in order to get other jobs. Structural unemployment is long-term in nature and is due to a persistent mismatch between the job skills of these workers and the requirements of other jobs. It is worth noting that the timing of the layoffs might also be due to lower demand for some goods and services during the recession caused by the Covid-19 pandemic. However, because these jobs in this industry have been permanently lost the unemployment should be classified as structural.

Someone who lost his or her job because of machine learning is structurally unemployed. That worker’s skill is no longer needed because a machine now performs the task that the worker used to perform. As a result, the worker should not expect to be hired in the future by a firm to do a similar job. For someone structurally unemployed due to machine learning, you should advise the unemployed person to retrain, find another occupation, or possibly move to another part of the country where jobs that require the person’s skills are more readily available. a. A job quit is considered frictional unemployment. Workers typically quit jobs when they feel that they are not a good fit for their current job or expect to be able to easily find a better job or are moving to a different area. b. Workers usually don’t quit their jobs if the economy is in a recession or only growing slowly because few firms may be hiring and a new job may be difficult to find. When the economy is growing rapidly and many firms are hiring, finding a new job becomes easier and workers are more likely to quit their current jobs. So, a decrease in the number of job quits suggests that it is becoming more difficult for workers to find jobs.

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2.8

523

The president of this manufacturing firm was referring to workers who are likely to be structurally unemployed because they apparently lack the skills required for the available jobs or because they have addiction problems or other personal troubles that make it difficult for them to remain employed. a. The newspaper employees who were laid off in the small towns were more likely to end up structurally employed because a small town is unlikely to have other newspapers and may also have few other firms that would be likely to hire journalists. In a big city, it’s more likely that a journalist can find a job at another newspaper or at some other firm—such as an online news service—that hires journalists. Even in a big city, though, the total number of job openings for journalists has declined. b. No. The decline in the number of newspaper jobs does not mean that no journalism graduates were hired during these years. Since 1990, the number of people hired in journalism was much smaller than the number of people who lost their jobs in journalism, but some journalism graduates did find jobs.

19.3 Explaining Unemployment

Learning Objective: Explain what factors determine the unemployment rate.

Review Questions 3.1

3.2

The payment of government unemployment insurance likely raises the unemployment rate.

Unemployment insurance payments lower the opportunity cost (the income lost by not working) of continuing to search for a job, which leads the unemployed to spend more time searching for a job. The payment of government unemployment insurance lessens the severity of recessions by helping the unemployed maintain their income and spending. a. The federal minimum-wage law pushes the actual wage paid in the market for low-skilled workers above the market wage, causing some unemployment. b. In unionized industries, the wage is usually above what otherwise would be the market wage, resulting in employers hiring fewer workers. Most economists do not believe that the existence of unions increases the overall unemployment rate, though, because in the United States only about 6.4 percent of workers outside the government sector are unionized. c. Efficiency wages increase the wages for some workers above the market wage, which likely causes some unemployment unless workers who are not hired at firms paying efficiency wages are able to find jobs at other firms (likely forcing down the wages that those firms pay).

3.3

A significant reason that the unemployment rate in the United States has been lower than the unemployment rates in Canada and countries in Western Europe is the more generous unemployment compensation payments and social insurance programs in Canada and Western Europe, which lower the opportunity cost of continuing to search for a job.

Problems and Applications 3.4

a. The workers are being laid off because they lack the skills that employers now need, so they are structurally unemployed. If some of these workers are able to find new jobs that don’t

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CHAPTER 19 | Unemployment and Inflation require the skills their current employers need, the workers would be frictionally unemployed during the period that they are between jobs. b. When workers are retrained or “reskilled,” they find jobs more easily and are less likely to require government aid in the form of unemployment insurance. The government would also be saving these workers from the negative consequences of unemployment, including lower incomes and deterioration in the skills they currently possess. Moreover, a “reskilled” worker finds a job and earns income on which the government can collect taxes. Whether these benefits offset the funds the federal government would need to spend on the program would depend partly on quantifying the benefits and costs and is partly a normative judgment on how best the government should allocate its spending.

3.5

a. The benefit of shorter benefit periods for unemployment insurance is that it increases the incentive for workers to find a job more quickly. The main cost or disadvantage of a short benefit period is that workers may be forced to take jobs for which their skills are not well suited, increasing the risk of a mismatch between workers and jobs and causing a decrease in productivity in the economy. b. Unemployment rises during a recession, so unemployment claims and unemployment insurance payments should go up. If unemployment insurance payments are available for only a short time during a recession, unemployed workers are likely to suffer large drops in income and the economy would suffer the results of the drop in consumption spending by those unemployed workers.

3.6

a. and c. are likely to increase the unemployment rate. Lengthening the time workers are eligible to receive unemployment insurance lowers the opportunity cost of a job search. An increase in union membership pushes more wages above market wages, thereby increasing unemployment, at least temporarily until these workers can find jobs in the non-union sector of the economy. b. and d. are likely to reduce the unemployment rate. Abolishing the minimum wage lowers the wage from above the market wage for some workers, thereby increasing the number of workers firms will employ. Making information on job openings more available shortens the amount of time job seekers need to find a new job, which should reduce the amount of frictional unemployment

3.7

Henry Ford was paying his workers an efficiency wage, which can cut a firm’s cost by increasing the productivity of workers. Paying an efficiency wage results in an increase in the quality of workers willing to work for the firm and a decrease in the turnover of workers.

3.8

When Amazon voluntarily started paying a $15 wage when the federal minimum wage was only $7.25, the company was paying an efficiency wage to attract higher quality workers and to increase worker productivity by making it less likely that workers would fail to work hard.

Workers being paid an efficiency wage have an incentive not to slack off and lose their jobs because they know they are being paid a wage that’s higher than they are likely to earn at another firm. The higher wages would not decrease Amazon’s profits⸻if the quality of workers and worker productivity increased sufficiently to offset the higher costs associated with the $15 wage.

19.4

Measuring Inflation Learning Objective: Define the price level and the inflation rate and understand how they are computed.

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Review Questions 4.1

4.2 4.3

The GDP deflator is the broadest measure of the price level because it includes the prices of all final goods and services included in GDP. The consumer price index (CPI) measures the prices of goods and services purchased by a typical urban family of four. The producer price index (PPI) measures the prices of goods and services at all stages of the production process.

The government uses the consumer price index to measure changes in the cost of living because the CPI tracks changes in the prices paid by a typical urban family of four.

The potential biases in calculating the consumer price index include substitution bias, increase in quality curves bias, new product bias, and outlet bias. To have no substitution bias, the demand for the products in the market basket would need to be vertical (perfectly inelastic). With a vertical quantity demand curve, an increase in the price of a product would not decrease the demanded; therefore, there would be no substitution away from the product when its

relative Problems and Applications price rises. The Bureau of Labor Statistics updates the market basket every two years to 4.4

4.5

reduce The statement howbias, economists use the CPI totocalculate the inflation substitution biasmisinterprets and new product uses statistical methods reduce quality bias, andrate.

With a CPI for 2019 of 256, surveys the pricetolevel, as measured by the CPI, has increased 156 conducts point-of-purchase track where consumers actually make their purchases to percent since the base year. However, the inflation rate in 2019 is the percentage change in reduce outlet bias. the CPI since 2018⸻not since the base year.

There is no contradiction because the inflation rate measures the percentage change in the price level. may The inflation rate doesn’t measure the level of prices. Prices of goods and services

4.6

seem expensive even though those prices are increasing at a slow rate. As long as the

inflation Base Year (2010) 2021 2022 rate is positive, the CPI will increase and each year its value will be “thePrice highest it’s ever been.”

Price Product Quantity Price Expenditures Expenditures Expenditures

Haircuts Hamburgers Movies Total

2 10 6

$10.00 2.00 20.00

$ 20.00 20.00 120.00 160.00

$13.00 2.45 13.00

$ 26.00 24.50 78.00 128.50

$16.20 2.40 12.00

$ 32.40 24.00 72.00 128.40

a. The CPI for 2021 = [($128.50/$160) × 100] = 80.31; CPI for 2022 = [($128.40/$160) × 100] = 80.25. b. The inflation rate for 2022 = [(80.25 – 80.31)/80.31) × 100] = −0.07%. Each price in the 4.7

consumer price index is given a weight equal to the fraction of a typical family’s budget spent on that good or service. Ice cream would be more important than bacon in calculating inflation if households spent a higher fraction of their budgets on ice cream than on bacon. averageThe Wall Street Journal article referenced in the problem reported that in 2017 the dollar amount spent by U.S. households per year for ice cream was $54.04 and for bacon was $39.07.

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4.8 City New York Miami Phoenix Dallas San Francisco

December 2019 203.0 247.1 199.5 192.8 269.5

December 2020 223.0 269.8 228.2 209.1 293.0

Percentage Change 9.85% 9.19 14.39 8.45 8.72

a. The percentage change is calculated as [(December 2020 index value – December 2019 index value)/December 2019 index value] × 100. As is shown in the table in the book, housing prices in all five markets rose from December 2019 to December 2020. The largest increase in prices occurred in Phoenix (14.39 percent). The smallest increase in prices occurred in Dallas (8.45 percent). b. Since the base month January 2000, housing prices increased the fastest in San Francisco with a home price index of 293.0 and the slowest in Dallas with a home price index of 209.1.

The home price index measures how much housing prices in the city have changed since the base month. c. We cannot determine on the basis of these numbers which city had the most expensive homes in 2020 because the numbers are not dollar amounts but indexes that measure prices in each city in a given month relative to what they were in that city in the base month.

4.9

a. During the period from point B to C when the CPI did not change, the country experienced zero inflation. b. During the period from point C to D when the CPI decreased, the country experienced deflation. c. During the period from point A to B when the CPI increased at a decreasing rate, the country experienced a slowdown in inflation (disinflation). d. During the period from point 0 to A when the CPI increased at an increasing rate, the country experienced an increasing inflation rate.

4.10

4.11

a. Until the BLS updates the market basket of goods used to compute the CPI to include the new iPhone 12, the introduction of the new model will have no effect on the CPI. Once the iPhone 12 model is included in the CPI market basket, it will most likely contribute to the increase in quality bias that causes changes in the CPI to overstate the true inflation rate. Increases in the prices of a new model partly reflects its improved quality and partly reflects pure inflation.

The BLS attempts to make adjustments so that only the pure inflation part of price increase is included in the CPI. But these adjustments are difficult to make, so the recorded price increase overstates the pure inflation in some products. b. Keeping the prices of the phones constant while the quality increased would imply that when the BLS adjusts for the change in quality, the adjusted price of the iPhone 12 will decrease.

A phone with the same price but with more features is, in fact, a cheaper phone even if it sells for the same price. All else constant, the introduction of this phone will cause a decrease in the CPI. Consumer spending patterns changed during the Covid-19 pandemic. For instance, consumers were spending less on restaurant meals and gasoline and more on cleaning supplies and paper products. The BLS was aware that the weights in its market basket no longer reflected consumers'

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actual expenditure patterns. But the BLS was not able to adjust its market basket weight because it lacked sufficient data. Overall, the CPI during the months of the pandemic was less reflective of the prices consumers were actually paying than is true in normal periods.

19.5 Using Price Indexes to Adjust for the Effects of Inflation

Learning Objective: Use price indexes to adjust for the effects of inflation.

Review Questions 5.1

A nominal variable is a variable measured in current dollars, which means that it is measured using the actual prices from that time period. A real variable is a variable measured in constant dollars, which means that it is measured using prices from a base year. That is, a real variable is adjusted for the effects of inflation.

5.2

As prices of goods and services decrease during a period of deflation, nominal earnings are likely to realrise slowly and may even fall. Real earnings will not fall as much as nominal earnings, and earnings will rise if the decline in prices is greater than the decline in nominal earnings.

Therefore, real average hourly earnings are likely to increase faster than nominal average hourly

Problems and Applications earnings during a period of deflation.

5.3 Year 1929 1933

5.4

Nominal GDP (billions of dollars) $104.6 57.2

GDP Price Deflator (2012 = 100) 9.4 7.0

Real GDP (billions of 2009 dollars) $1,112.77 817.14

Real GDP for 1929 = (Nominal GDP/GDP price deflator) × 100 = ($104.6 billion/9.4) × 100 = $1,112.77 billion. Real GDP for 1933 = ($57.2 billion/7.0) × 100 = $817.14 billion. The percentage decline in real GDP between 1929 and 1933 = [($817.14 billion – $1,112.77 billion)/ $1,112.77 billion] × 100 = –26.6%.

We can convert F. Scott Fitzgerald’s 1924 nominal income of $36,000 to an equivalent income in 2018 by multiplying the 1924 nominal income by the ratio of the CPI for 2018 to the CPI for 1924: $36,000 × (251/17) = $531,529.41. So, you would have needed an income of $531,529.41 in 2018 to have the same purchasing power that Fitzgerald’s $36,000 had in 1924. a. The percentage increase in the price level was smaller in the United States than in France:

5.5 United States: [(251 – 27)/27] × 100 = 829.7 percent France: [(105 – 8)/8] × 100 = 1,212.50 percent. b. In the United States, the real minimum wage in 1957 was $3.70: [($1.00/27) × 100], and in 2020 it was $2.89: [($7.25/251) × 100]. In France, the real minimum wage in 1957 was €2.38: [(€0.19/8) × 100], and in 2020 it was €9.67: [(€10.15/105) × 100].

Between 1957 and 2020, there was a 21.9 percent decrease in the real minimum wage in the United States: [($2.89 – $3.70)/$3.70] × 100. And, there was a 306.3 percent increase in the

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CHAPTER 19 | Unemployment and Inflation real minimum wage in France: [(€9.67 – €2.38)/€2.38] × 100. The percentage increase in the minimum wage was higher in France.

5.6

5.7

Rank 1 2 3 4 5 6 7 8 9 10 11

12 13 14 15 16 17

5.8

c. It does not matter whether we have information about the base year as long as we have the CPI data. Whatever the base year is, we would get the same percentage increase in prices.

If three cups of coffee and a doughnut can be purchased in 2020 for $10 and for $2,000 in 2060, the CPI would have to be 200 times greater in 2058 than in 2018 because 200 × $10 = $2,000.

Therefore, the CPI in 2050 would be 259 × 200 = 51,800.

The real receipts in 2020 dollars for each film are listed in the last column below. The first column shows the rankings of the top ten films based on their earnings in 2020 dollars. Real receipts in 2020 dollars equal the nominal receipts reported in the third column multiplied by the CPI in 2020 divided by the CPI in the year that the movie was released.

Total Box Office Receipts Film Gone with the Wind 200,852,579 184,925,486 Snow White and the Seven Dwarfs 460,998,007 Star Wars 144,880,014 101 Dalmatians 260,758,300 435,110,554 Jaws ET: The Extra659,363,944 Terrestrial 936,662,225 Titanic 760,507,625 Star Wars: The Force Awakens 858,373,000 474,544,677 Avatar 700,426,566 Avengers: Endgame 652,270,625 Star Wars: Episode 623,357,910 I—The Phantom 678,815,482 Menace 620,181,382 Black Panther 608,581,744 Jurassic World Marvel’s The Avengers Avengers: Infinity War Star Wars: The Last Jedi Incredibles 2

Year Released 1939 1937 1977 1961 1975 1982 1997 2015 2009 2019 1999 2018 2015 2012 2018 2017 2018

CPI 14 14 61 30 54 97 161 237 215 256 167 251 237 230 251 245 251

Real Receipts (2020 dollars) $3,715,772,712 3,421,121,491 1,957,352,194 1,250,797,454 1,250,674,069 1,161,790,036 1,060,715,910

1,023,609,773 916,146,395 868,432,059 735,970,487 722,750,919 712,818,953

701,955,212 700,451,035 655,620,318 627,978,772

The economy of Venezuela was suffering from hyperinflation and on the verge of collapse. The hyperinflation meant that prices increased by substantially more than 300 percent increase in the minimum wage, leaving the real minimum wage much lower.

19.6 Nominal Interest Rates versus Real Interest Rates

Learning Objective: Distinguish between the nominal interest rate and the real interest rate.

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Review Questions 6.1

The nominal interest rate is the stated interest rate on a loan, while the real interest rate is the nominal interest rate minus the inflation rate.

6.2

The nominal interest rate equals the real interest rate plus the inflation rate. So, an

6.3

increase in expected inflation, inflation raises the nominal interest rate by the increase in the expected rate of assuming that the real interest rate remains constant.

It is impossible to know whether a particular nominal interest rate is “high” or “low”

6.4

without knowing nominal the inflation rate. The real interest rate matters to borrowers and lenders, not the interest rate. A nominal interest rate of 5 percent with an inflation rate of zero results in a higher

Problems and Applications real interest rate than a nominal interest rate of 20 percent with an inflation rate of 19 percent.

6.5

6.6

If the economy experiencing the of nominal interest rate will bewhen lowerthe than thelevel The reporter doesisnot understanddeflation, the definition deflation.

Deflation occurs price declines. Inflation, even if only half the national rate, increases the price level. It is not possible for realthe CPI to drop below zero. The reporter should have written that the change in the CPI drops below zero when deflation. interest rate.

Thethere real is interest rate equals the nominal interest rate minus the inflation rate, but a.

The real interest rate on arate loan a nominal interest rate of 20 percent and a 19 percent with deflation the inflation is with negative. inflation rate is 1 percent. The real interest rate on a loan with a nominal interest rate of 5 percent and a 2 percent inflation rate is 3 percent. Therefore, you should prefer the loan with the 20 percent nominal rate. b. JP Morgan Chase would earn a higher profit on a car loan with a 3 percent real interest rate than it would from a car loan with a 1 percent real interest rate, so it would prefer the 5 percent car loan.

6.7

The inflation rate from January 2020 to January 2021 as measured by the CPI was [(262 − 259)/259] × 100 = 1.16 percent. With the nominal interest rate on the one-year Treasury bill of 1.49 percent, the real interest rate equaled 1.49 percent – 1.16 percent = 0.33 percent.

6.8

If the monthly inflation rate is 4 percent, the annual inflation rate is about 60 percent. To see this, notice that at a 4 percent inflation rate, the price level is rising 4 percent per month. If the price level starts at 100: ▪ After 2 months, the inflation rate would have increased to 100 × 1.04 × 1.04 = 108.2.

After 3 months, the inflation rate would have increased to 100 × 1.04 × 1.04 × 1.04 = 112.5.

▪ After 12 months, the inflation rate would have increased to 100 × (1.04)12 = 160.1, or by 60.1 percent.

▪

So, the real interest rate would be 4% − 60% = –56%.

6.9

We can answer this problem by calculating the real interest rate: Real interest rate = Nominal interest rate – Inflation rate.

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CHAPTER 19 | Unemployment and Inflation With $1,000, you can purchase 500 bottles of premium water at the beginning of the year. If you lend $1,000 for one year at an interest rate of 5 percent, you will receive $1,050 at the end of the year. With the higher price of premium bottled water, at the end of the year you can buy $1,050/$2.08 = 504.8 bottles of premium water. So, you can purchase [(504.8 − 500)/500] × 100 = 0.96% more bottles. Therefore, the real interest rate you receive on the loan is 0.96 percent. Notice that this is very close to the real interest rate on the loan calculated by subtracting the 4 percent inflation in premium bottled water prices from the 5 percent nominal interest rate on the loan.

19.7 Does Inflation Impose Costs on the Economy?

Learning Objective: Discuss the problems that inflation causes.

Review Questions 7.1

7.2

We know from the circular flow of expenditures and income that when inflation increases the nominal value of expenditures, it must also increase nominal incomes. Consequently, inflation does not reduce the purchasing power of the average consumer.

Inflation affects the purchasing power of money. People with incomes that rise faster than the rate of inflation enjoy an increase in purchasing power, while people with incomes that rise more slowly than the rate of inflation are hurt by a decrease in purchasing power. In general,

7.3

inflation hurts fixed people on fixed incomes, such as retired persons who may be receiving a pension of a number of dollars each year. (As noted in the text, though, Social Security payments received

7.4

by retired workers increase every year by an amount equal to the percentage change in the CPI.) Unanticipated inflation is the greater problem. Anticipated inflation can be incorporated into nominal interest rates and nominal wage contracts. Unanticipated inflation causes the actual real

7.5

interest rate and actual real wage rate received to differ from the expected real interest rate and the expected real wage rate.

Menu costs are the costs to firms of changing prices. The Internet allows firms to change

Problems and Applications 7.6

7.7

prices at When thesoinflation rate turns out to be little cost that it has reduced the size ofmuch menu higher costs. than most people expected, then the real interest rate is lower than it was expected to be when loans were made. In these circumstances, Deflation cause you wouldcan rather be consumers a borrower.to reduce their current spending in anticipation of future a.

Real income is nominal income adjusted for increases in the price level. With inflation, the lower real income James will decrease he receives a fixed However, the the real prices, and for unanticipated deflationbecause increases the burden onincome. borrowers by raising interest interest income for Frank will likely increase with inflation. Therefore, it is likely that Frank rate abovea the expected real interest rate. will have higher real income 10 years from now.

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b. If James’s pension increases each year by the same percentage as the inflation rate, then it is likely that 10 years from now he will have a higher real income than Frank, whose interest income is originally $200 less per month than James’s pension income.

7.8

The real interest rate is the cost to Apple of borrowing funds from investors. A low real interest rate is good for Apple and bad for investors, much like a low price is usually good for consumers, but bad for producers. Inflation was expected to be 2 percent, but turned out to be 6 percent, causing the expected and actual real interest rates to differ. The expected real interest rate equals the nominal interest rate minus the expected inflation rate. The actual real interest rate equals the nominal interest rate minus the actual inflation rate. In this case, the expected real interest rate is 4 percent but the actual real interest rate equals 0 percent (6 percent nominal interest rate minus the 6 percent actual inflation rate). Because the actual real interest rate is less than the expected real interest rate, Apple pays less than it thought it would to borrow, and it gains. Because the investors are receiving a smaller payment than expected in return for lending funds to Apple, the investors lose.

7.9

Consumers would defer purchases if they expected deflation to continue so that they would pay even lower prices in the future. Consumers would buy more if they believed that inflation would follow a period of falling prices. This behavior is why governments and central banks prefer low stable inflation instead of deflation.

To the extent that the deflation was unanticipated, the actual real interest rate exceeded the expected real interest rate. The unanticipated deflation increased the real interest rate the farmers had expected to pay on their loans, thereby increasing the burden of these debts. Moreover, as the economy experienced deflation, the prices that the farmers received for their crops decreased, causing a decrease in the farmer’s nominal earnings. Unfortunately, while their nominal earnings decreased, the nominal value of their debts stayed the same, making it harder for the farmers to pay back their debts.

7.10

Real-Time Data Exercises D19.1 a. The CPI for August 2019 was 256.3 and for August 2018 was 251.9. b. The inflation rate as measured by the CPI from August 2018 to August 2019 equaled: [(256.3 – 251.9)/251.9] × 100 = 1.7 percent.

D19.2 a. and b. Data used in the graph in c. below covers the period from August 2013 to August 2019. c.

.

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CHAPTER 19 | Unemployment and Inflation Federal Reserve Economic Data (FRED) website (fred.stlouisfed.org).

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

D19.3 a. and b. Data used in the graph in c. below covers the period from July 2009 to August 2019. c.

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

d. The inflation rate as measured by the CPI was more volatile than the inflation rate as measured by the CPI less prices of food and energy. In July 2010 the inflation rate measured by the CPI was 1.34 percent, but measured by the CPI less food and energy prices was .96 percent. In February 2017, the inflation measured by the CPI was 2.73 percent, but measured by the CPI less food and energy prices it was 2.19 percent. In August 2019, the two inflation rates were 1.76 percent as measured by the CPI and 2.39 percent as measured by the CPI less food and energy prices.

The CPI for food and beverages in August 2019 was 258.2, and in August 2012, it was 234.1. The CPI for apparel in August 2019 was 125.1, and in August 2012, it was 125.3.

The CPI for transportation in August 2019 was 210.3, and in August 2012, it was 217.6. The CPI for medical care in August 2019 was 501.3, and in June 2012, it was 417.6. b. The inflation rate over the entire period from August 2012 to August 2019 for food and beverages was: [(258.2 – 234.1)/234.1] × 100 = 10.329 percent; for apparel, it was: [(125.1 – 126.3)/126.3] × 100 = −10.095 percent; for transportation, it was: [(210.3 – 217.6)/217.6] × 100 = −3.435 percent; for medical care, it was: [(501.4 – 417.6)/417.6] × 100 = 20.1 percent.

These inflation rates are the percentage changes over the entire five-year period, not annual inflation rates. c. Transportation experienced the lowest inflation rate (−3.35 percent), and medical care experienced the highest inflation rate (20.1 percent).

In August 2019, the number of unemployed equaled 6,044 thousand, the civilian labor force D19.5 a. equaled 163,922 thousand, and workers with part-time employment for economic reasons, slack work, or business conditions equaled 2,678 thousand. These data are reported monthly and measured in thousands of persons.

D19.4 a.

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b. The civilian unemployment rate equaled [(6,044 thousand/163,922 thousand) × 100] = 3.7 percent. The civilian unemployment rate including persons who are underemployed equaled: [(6,044 thousand + 2,678 thousand)/163,922 thousand] × 100 = 5.3 percent.

August 2019, the number of unemployed men equaled 3,233 thousand, the number of unemployed women equaled 2,812 thousand, the civilian labor force for men equaled 86,832 thousand, and the civilian labor force for women equaled 77,090 thousand. These data are reported monthly and are measured in thousands of persons.

The unemployment rate for men equaled: [(3,233thousand/86,832 thousand) × 100] = 3.7 b. percent, and the unemployment rate for women equaled: [(2,812 thousand/77,090 thousand) × 100] = 3.6 percent.

D19.6 a.

D19.7 a. In August 2019, the number of unemployed equaled 6,044 thousand, civilian employment equaled 157,878 thousand, and those not in the labor force equaled 95,510 thousand. b.The working-age population equals the labor force plus those not in the labor force. In August 2019, the labor force equaled: 6,044 thousand + 157,878 thousand = 163,922 thousand, and the working-age population equaled: 163,922 thousand + 95,510 thousand = 259,432 thousand. The employment-population ratio equals civilian employment divided by the working-age population, which for August 2019 equaled: [(163,922 thousand/259,432 thousand) × 100] = 63.18 percent. c. If the economy entered a recession, one would expect the employment-population ratio to decline as fewer people would have jobs.

The civilian unemployment rate equaled 3.6 percent in the second quarter of 2019, and it D19.8 a. equaled 4.4 percent in the second quarter of 2017. The natural rate of unemployment equaled 4.381 percent in the second quarter 2019 and 4.611 percent in the second quarter of 2017.

Note that the natural rate of unemployment is calculated on a quarterly, not monthly, basis.

The cyclical unemployment rate equals the unemployment rate minus the natural rate of b. unemployment. The cyclical unemployment rate equaled (3.6 percent − 4.4 percent) = −0.8 percent in the second quarter of 2019 and equaled (4.4 percent − 4.6 percent) = −0.2 percent in the second quarter of 2017.

The economy improved over the two-year period and the unemployment rate in the second c. quarter of 2019 was further below the natural rate of unemployment than in the second quarter of 2017.

D19.9 a.

In August 2019, the number of unemployed equaled 6,044,000, civilian employment equaled 157,878,000, employment level—part-time for economic reasons equaled 4,381,000, and not in the labor force, searched for work and available equaled 1,561,000.

b.The official unemployment rate equals the number of unemployed divided by the labor force, which equals the unemployed plus the employed. For August 2019, the official unemployment rate equaled: [(6,044,000/(6,044,000 + 157,878,000) × 100] = 3.7 percent. c. This broader measure of the unemployment rate would include as unemployed the three categories of unemployed: unemployed; employed but part-time for economic reasons; and not in the labor force, searched for work and available. In August 2019, this broader measure of the unemployment rate equaled: [(6,044,000 + 4,381,000 + 1,561,000)/(6,044,000 + 4,381,000 + 1,561,000 + 157,878,000)] × 100 = [11,986,000/169,864,000] × 100 = 7.1 percent.

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CHAPTER 19 | Unemployment and Inflation d. One would expect the gap between the official rate of unemployment and the broader rate of unemployment to widen during recessions and narrow during expansions. One would expect the number of part-time workers for economic reasons and discouraged workers to rise during a recession and fall during an expansion.

In September 2019, the 3-month Treasury bill interest rate equaled 1.89 percent and the D19.10 a.

University of Michigan inflation expectation equaled 2.70 percent.

The expected real interest rate equals the nominal interest rate minus the expected inflation b. rate. In September 2019, the expected real interest rate for the three-month Treasury bill equaled 1.89 percent − 2.70 percent = −0.81 percent. c. If the actual inflation rate is greater than the expected inflation rate, borrowers gain and lenders lose from the actual real interest (nominal interest rate minus the actual inflation rate) being below the expected real interest rate.

In August 2019 the CPI equaled 256.6 and average hourly earnings of private production and D19.11 a. nonsupervisory employees equaled $23.59, and in August 20198 the CPI equaled 252.1 and average hourly earnings equaled $22.80. b.The average hourly real wage in August 2019 equaled [($23.59/256.6) × 100] = $9.19, and in August 2018 equaled [($22.80/252.1) × 100] = $9.04. With the CPI having a base period of 1982–1984, the real wage is measured in 1982–84 dollars. c.

The percentage change in the average hourly nominal wage equaled: [(23.59 – 22.80)/22.80] × 100 = 3.46 percent, and the percentage change in the average hourly real wage equaled: [(9.19 – 9.04)/9.04] × 100 = 1.7 percent.

Given that the average hourly real wage increased 1.7 percent from August 2018 to August d.2019, the average worker was better off.

Suggestions for Critical Thinking Exercises CT19.1 The unemployment rate would likely increase as unemployment increased by a large number as people who were previously not looking for a job—and, therefore, weren’t counted as unemployed—begin to look for work. If you check the expansions after the recessions of 1991, 2001, 2007–2009, and 2020 on the FRED website (https://fred.stlouisfed.org/series/UNRATE), you’ll see the unemployment rate rising for a time.

CT19.2

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

CT19.3 This elderly individual would experience a higher inflation rate than what the CPI suggests.

The CPI is based on the expenditures of a typical urban family, but this elderly person is spending more on goods and services the prices of which are increasing rapidly. Although her expenditures experience a faster inflation rate than what the CPI suggests, her Social Security benefits are increasing at the same rate as the CPI increases. So, although she receives more money when her Social Security benefits increase, the amount of goods her Social Security benefits can buy decreases.

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CHAPTER 20 |

Economic Growth, the Financial System, and Business Cycles

Brief Chapter Summary and Learning Objectives 20.1 Long-Run Economic Growth Discuss the importance of long-run economic growth.

▪ The U.S. economy has experienced long-run economic growth due to rising productivity,

which resulted in increases in the average standard of living.

20.2 Saving, Investment, and the Financial System Discuss the role of the financial system in facilitating long-run economic growth.

▪ Financial markets and financial intermediaries comprise the financial system. A well-

functioning financial system is an important determinant of economic growth.

20.3 The Business Cycle Explain what happens during the business cycle.

▪ During the expansion phase of a business cycle, production, employment, and income

increase.

▪ Production, employment, and income decline during the recession phase of the business

cycle.

Key Terms Business cycle Alternating periods of economic expansion and economic recession.

Financial system The system of financial markets and financial intermediaries through which firms acquire funds from households.

Capital Manufactured goods that are used to produce other goods and services.

Crowding out A decline in private

Labor productivity The quantity of goods

expenditures as a result of an increase in government purchases. Financial intermediaries Firms,

and services that can be produced by one worker or

such as banks, mutual funds, pension funds, and insurance companies, that borrow funds from savers

Long-run economic growth The process by which rising productivity increases the average standard of living.

by one hour of work.

and lend them to borrowers.

Market for loanable funds The interaction of borrowers and lenders that determines the market interest rate and the quantity of

Financial markets Markets where financial securities, such as stocks and bonds, are bought

loanable funds exchanged.

and sold. .

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CHAPTER 20 | Economic Growth, the Financial System, and Business Cycles

Potential GDP The level of real GDP attained

when all firms are producing at capacity.

Chapter Outline Gen Z Experience the iPhone, Snapchat …. and a Pandemic Students who are part of Generation Z (born between 1997 and 2012) probably use a smartphone and apps like Twitter, Instagram, and Facebook. They may also use a smartphone to arrange a ride with Uber and Lyft rather than hail a taxi. To travel, they might use Airbnb to rent an apartment rather than book a room at a hotel. As these examples show, smartphones have changed the way we live, disrupted some industries, and helped create new industries. As a result of technological change, electric vehicles went from rare to common, as Tesla’s share of the car market continued to increase and older car companies like General Motors and Ford shifted away from gasoline-powered vehicles. Over the past 200 years, the process of long-run economic growth has lifted the average person in the United States from having just the basics of food, clothing, and housing to the much higher standard of living enjoyed today.

In addition to experiencing economic growth, Generation Z has also experienced the other big fact of macroeconomics: the business cycle. For many years after the end of World War II in 1945, most business cycle recessions were mild, seldom lasting more than a year, with the unemployment rate rarely rising above 10 percent. Unfortunately, this period of relative macroeconomic stability ended first with the Great Recession of 2007–2009 and then the Covid-19 recession of 2020. These two recessions were by far the worst since the Great Depression of the 1930s. As a result of the Great Recession, college graduates entered the worst job market the United States has experienced in many years. For workers aged 20 to 24, the unemployment rate reached 16 percent in late 2009 and didn’t drop below 10 percent until mid-2015. For workers aged 25 to 34, unemployment reached 10 percent in mid-2009 and wasn’t consistently below 7 percent until early 2014.

The Covid-19 pandemic was the worst the United States had experienced since the Spanish influenza pandemic of 1918. The effects of the Covid-19 pandemic were devastating for the job expectations of people graduating in 2020. At the beginning of that year, their prospects looked bright as the United States was experiencing the strongest labor market since the 1960s. But economic effects of the pandemic caused the overall unemployment rate to soar to 14.8 percent in April, with the unemployment rate for people aged 20 to 24 reaching a staggering 25.7 percent. It remained above 10 percent for the rest of the year. Clearly, long-term economic growth and the business cycle can have big effects on people’s lives.

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

A successful economy is capable of increasing production of goods and services faster than the growth in population. The U.S. economy has experienced periods of expanding production and employment followed by periods of recession, during which production and employment decline. The business cycle refers to alternating periods of economic expansion and economic recession. Each period of expansion is not the same length nor is each period of recession.

Most people in the United States, Western Europe, Japan, and other high-income countries expect that, over time, their standard of living will improve. Long-run economic growth is the process by which rising productivity increases the average standard of living. The best measure of the standard of living is real GDP per capita. We measure long-run economic growth by increases in real GDP per capita over long periods of time.

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A. Calculating Growth Rates and the Rule of 70 The growth rate of real GDP or real GDP per capita during a particular year is equal to the percentage change from the previous year. We can judge how rapidly an economic variable grows by calculating how many years it would take to double. An easy way to calculate how many years it will take real GDP per capita to double is to use the rule of 70. The formula for the rule is: Number of years to double =

.

Small differences in growth rates can have large effects on how rapidly the standard of living in a country increases.

B. What Determines the Rate of Long-Run Growth?

Increases in real GDP per capita depend on increases in labor productivity, which is the quantity of goods and services that can be produced by one worker or by one hour of work. Economists usually measure labor productivity as output per hour of work in order to avoid fluctuations in the length of the workday and in the fraction of the population employed. Economists believe two key factors determine labor productivity: (1) the quantity of capital per hour worked and (2) the level of technology. Capital refers to manufactured goods that are used to produce other goods and services. The total amount of physical capital available in a country is known as the country’s capital stock. As the capital stock per hour worked increases, worker productivity increases. Human capital refers to the accumulated knowledge and skills workers acquire from education and training or from their life experiences. Increases in human capital stimulate economic growth. Economic growth depends more on technological change than on increases in capital per hour worked. Technology refers to the processes a firm uses to turn inputs into outputs of goods and services. Technological change is an increase in the quantity of output firms can produce, using a given quantity of inputs. Most technological change is embodied in new machinery, equipment, or software.

In implementing technological change, entrepreneurs are important because they make the crucial decisions about whether to introduce new technology to produce better or lower-cost products.

Entrepreneurs also decide whether to allocate the firm’s resources to research and development that can result providein new technologies. A key requirement for economic growth is that the government must secure rights toGDP private property.

C. Potential Potential GDP is the level of real GDP attained when all firms are producing at capacity. Potential GDP will increase over time as the labor force grows, new factories and office buildings are built, new machinery and equipment are installed, and technological change takes place. From 1949 to 2020, potential real GDP in the United States grew at an average rate of 3.2 percent annually. The actual level of real GDP increased more or less than 3.2 percent as the economy moved through the business cycle.

Extra Solved Problem 20.1 Explaining Economic Growth in Singapore Between 1960 and 1995, real GDP per capita in Singapore grew at an average annual rate of 6.2 percent. This very rapid growth rate results in the level of real GDP per capita doubling about every 11.3 years. In 1995, Alwyn Young of the London School of Economics published an article in which he argued that Singapore’s growth depended more on increases in capital per hour worked, increases in the labor force participation rate, and the transfer of workers from agricultural to nonagricultural jobs than on .

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CHAPTER 20 | Economic Growth, the Financial System, and Business Cycles

technological change. If Young’s analysis was correct, predict what was likely to happen to Singapore’s growth rate in the years after 1995.

Solving the Problem Step 1:

Step 2:

Review the chapter material.

This problem is about what determines the rate of long-run growth, so you may want to review the section “What Determines the Rate of Long-Run Growth?” in the textbook.

Predict what happened to the growth rate in Singapore after 1995.

As countries begin to develop, they often experience an increase in the labor force participation rate, as workers who are not part of the paid labor force respond to rising wage rates. Many workers also leave the agricultural sector—where output per hour worked is often low—for the nonagricultural sector. These changes increase real GDP per capita, but they are “one-shot” changes that eventually come to an end, as the labor force participation rate and the fraction of the labor force outside agriculture both approach the levels found in high-income countries. Similarly, increases in capital per hour worked cannot sustain high rates of economic growth unless they are accompanied by technological change.

We can conclude that Singapore was unlikely to sustain its high growth rates in the years after the 1995. In fact, from 1996 to 2019 (the last year before the Covid-19 pandemic), growth of real GDP per capita slowed to an average rate of 3.0 percent per year.

Sources: Alwyn Young, “The Tyranny of Numbers: Confronting the Statistical Realities of the East Asian Growth Although Experience,” Quarterly Journal of Economics, Vol. 110, No. 3, August 1995, pp. 641–680; and International Monetary this rateDatabase, is comparable to rates experienced in high-income countries, such as Fund, World Economic Outlook April 2021. the growth

United States, it leads to a doubling of real GDP per capita only about every 23 years Question An article in the Economist magazine compares Panama to Singapore. It quotes Panama’s president asrather saying: “We copy a lot from Singapore and we need to copy more.” The article observes thanisabout everyone-fifth 11 years.as rich as its Asian model on a per-person basis. But Singapore that: “Panama not even would envy its growth: from 2005 to 2010 its economy expanded by more than 8% a year, the fastest rate in the Americas.” Judging from the experience of Singapore, if Panama is to maintain these high growth rates, what needs to be true about the sources of Panama’s growth?

Economist, July 14, 2011.

Source: “A Singapore for Central America?”

Answer Over the long run, Panama cannot sustain high rates of growth by shifting workers from agricultural to nonagricultural industries or by increasing capital per hour worked. If Panama is to maintain high growth rates, the sources of growth need to include technological change.

Teaching Tips The end of the chapter in the main text includes a special category of exercises titled Real-Time Data

(RTDA) Exercises. These exercises are well worth assigning and discussing in class because they help students become familiar with a key data source, learn how to locate data, and develop skills in interpreting data. Many RTDA exercises require more elaborate calculations than other problems and the use of Excel spreadsheets. .

CHAPTER 20 | Economic Growth, the Financial System, and Business Cycles

20.2

539

Saving, Investment, and the Financial System Learning Objective: Discuss the role of the financial system in facilitating long-run economic growth.

Economic growth depends on the ability of firms to expand their operations. Firms can finance their expansion from retained earnings, financial markets, and financial intermediaries. The financial system is the system of financial markets and financial intermediaries through which firms acquire funds from households.

A. An Overview of the Financial System Financial markets are markets where financial securities, such as stocks and bonds, are bought and sold. A financial security is a document that states the terms under which funds pass from the buyer of the security to the seller. Stocks are financial securities that represent partial ownership of a firm.

Bonds are financial securities that represent promises to repay a fixed amount of funds.

Financial intermediaries are firms, such as banks, mutual funds, pension funds, and insurance companies, that borrow funds from savers and lend them to borrowers. The financial system provides three key services for savers and borrowers: a. Risk sharing. Risk is the chance that the value of a financial security will change relative to what you expect. b. Liquidity. This is the ease with which a financial security can be exchanged for money. c. Information. The financial system collects and communicates facts about borrowers and expectations about returns on financial securities.

B. The Macroeconomics of Saving and Investment The total value of saving in the economy must equal the total value of investment. There are two categories of saving in the economy: private saving by households and public saving by the government. We can use some relationships from national income accounting to understand why total saving must equal total investment. We begin with the relationships between GDP (Y) and its components, consumption (C), investment (I), government purchases (G), and net exports (NX): Y = C + I + G + NX. In an open economy, there is interaction with other economies in terms of both trading of goods and services and borrowing and lending. In a closed economy, there is no trading or borrowing and lending with other economies. For simplicity, we develop the relationship between saving and investment for a closed economy. Net exports are zero, so: Y = C + I + G. If we rearrange this relationship, we have an expression for investment in terms of the other variables: I = Y – C – G. Private saving is equal to what households retain of their income after purchasing goods and services (C) and paying taxes (T). Households earn income for supplying the factors of production to firms (Y) and from government in the form of transfer payments (TR). We can write an expression for private saving (SPrivate): SPrivate = Y + TR – C – T.

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CHAPTER 20 | Economic Growth, the Financial System, and Business Cycles

Public saving (SPublic) equals the amount of tax revenue the government retains after paying for government purchases and making transfer payments to households: SPublic = T – G – TR. Total saving in the economy (S) is equal to: S = SPrivate + SPublic , or S = (Y + TR – C– T) + (T – G – TR ), or S = Y – C – G. We can conclude that total saving must equal total investment: S = I. When the government spends the same amount that it collects in taxes, there is a balanced budget. When the government spends more than it collects in taxes, there is a budget deficit, which means that public saving is negative. When the government runs a budget deficit, the U.S. Department of the Treasury sells Treasury bonds to borrow the money necessary to fund the gap between taxes and spending. With less saving, investment must be lower.

When the government spends less than it collects in taxes, there is a budget surplus. A budget surplus increases public saving and the total level of saving in the economy. A higher level of saving results in a higher level of investment spending.

C. The Market for Loanable Funds The market for loanable funds refers to the interaction of borrowers and lenders that determines the market interest rate and the quantity of loanable funds exchanged. The demand for loanable funds is determined by the willingness of firms to borrow money and to engage in new investment projects. The lower the interest rate, the more investment projects a firm can profitably undertake.

The supply of loanable funds is determined by the willingness of households to save and by the extent of government saving or dissaving. The higher the interest rate, the greater the reward for saving and the larger the amount of funds households will save. Because both borrowers and lenders are interested in the real interest rate they will receive or pay, equilibrium in the market for loanable funds determines the real interest rate.

We draw the demand curve for loanable funds by holding constant all factors, other than the interest rate, that affect the willingness of borrowers to demand funds. We draw the supply curve by holding constant all factors, other than the interest rate, that affect the willingness of lenders to supply funds. An increase in the demand for loanable funds increases the equilibrium interest rate. As a result, the equilibrium quantity of loanable funds increases. A government deficit reduces the level of total saving in the economy and, by increasing the interest rate, reduces the level of investment by firms. By borrowing the money to finance its budget deficit, the government will have crowded out some firms that would otherwise have been able to borrow to finance investment. Crowding out is a decline in private expenditures as a result of an increase in government purchases. The effect of government budget deficits and surpluses on the equilibrium interest rate is small, partly because of the importance of global saving in determining the interest rate.

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Extra Solved Problem 20.2 How Would a Consumption Tax Affect Saving, Investment, the Interest Rate, and Economic Growth?

Some economists and policymakers have suggested that the federal government shift from relying on an income tax to relying on a consumption tax. Under the income tax, households pay taxes on all income earned. Under a consumption tax, households pay taxes only on the income they spend.

Households would pay taxes on saved income only if they spend the money at a later time. Use the market for loanable funds model to analyze the effect on saving, investment, the interest rate, and economic growth of switching from an income tax to a consumption tax.

Solving the Problem Step 1:

Review the chapter material.

This problem is about applying the market for loanable funds model, so you may want to review the section “Explaining Movements in Saving, Investment, and the Interest Rate” in the textbook.

Explain the effect of switching from an income tax to a consumption tax.

Step 2:

Step 3:

Households are interested in the return they receive from saving after they have paid their taxes. For example, consider someone who puts his savings in a certificate of deposit at an interest rate of 4 percent and whose tax rate is 25 percent. Under an income tax, this person’s after-tax return to saving is 3 percent [= 4 – (4 × 0.25)].

Under a consumption tax, income that is saved is not taxed, so the return rises to 4 percent. We can conclude that moving from an income tax to a consumption tax would increase the return to saving, causing the supply of loanable funds to increase.

Draw a graph of the market for loanable funds to illustrate your answer.

The supply curve for loanable funds will shift to the right as the after-tax return to saving increases under the consumption tax. The equilibrium interest rate will fall, and the levels of saving and investment will both increase. Because investment increases, the capital stock and the quantity of capital per hour worked will grow, and the rate of economic growth should increase. Note that the size of the fall in the interest rate and the size of the increase in loanable funds shown in the following graph are larger than the effects that most economists expect would actually result from the replacement of the income tax with a consumption tax.

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CHAPTER 20 | Economic Growth, the Financial System, and Business Cycles

20.3 The Business Cycle

Learning Objective: Explain what happens during the business cycle.

Although there has been a tremendous increase in the standard of living of the average American over the past century, real GDP per capita did not increase every year.

A. Some Basic Business Cycle Definitions Since at least the early nineteenth century, the U.S. economy has experienced business cycles that consist of alternating periods of expanding and contracting economic activity. During the expansion phase of a business cycle, production, employment, and income are increasing. The period of expansion ends with a business cycle peak. Following the business cycle peak, production, employment, and income decline during the recession phase of the cycle. The recession comes to an end with a business cycle trough, after which another period of expansion begins.

B. How Do We Know When the Economy Is in a Recession?

The federal government does not officially decide when a recession begins and when it ends. Most economists accept the decisions of the Business Cycle Dating Committee of the National Bureau of Economic Research (NBER). The NBER is fairly slow in announcing business cycle dates because it takes time to gather and analyze economic statistics.

C. What Happens during the Business Cycle?

Although each business cycle is different, most business cycles share certain characteristics. Near the end of an expansion, interest rates are usually rising, and the wages of workers are usually rising faster than prices. As a result, profits of firms are falling. Typically, toward the end of an expansion both households and firms will have substantially increased their debts.

A recession often begins with a decline in spending by firms on capital goods or by households on housing and consumer durables. As sales decline, firms cut back on production and begin to lay off workers. As the recession continues, economic conditions gradually improve. Declines in spending eventually end, households and firms reduce their debts and firms begin to increase their spending on .

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capital goods as they anticipate additional production during the next expansion. Household spending on consumer durables and business spending on capital goods will bring the recession to an end.

Durables are goods expected to last three or more years. The business cycle affects durables more than nondurables.

People can continue to use the durable goods they already own, so during a recession they

are The moreEffect likely of to the postpone spending than nondurables. When firms experience D. Business Cycleononnew thedurables Inflation Rate The price level measures the average prices of goods and services in the economy. The inflation rate declining is the percentage increase in the price level from one year to the next (see Chapter 19, Section 19.4). sales and profitsfact during a recession, they often producer durables.

An important about the business cyclecutis back that on thepurchases inflationofrate usually increases during economic expansions—particularly near the end of an expansion—and the inflation rate usually decreases during recessions. This result is not surprising. During a business cycle expansion, spending by businesses and households is strong, and producers of goods and services find it easier to raise prices. As spending declines during a recession, firms have a more difficult time selling their goods and services and are likely to increase prices less than they otherwise might have.

E. The Effect of the Business Cycle on the Unemployment Rate Recessions cause the unemployment rate to rise. The unemployment rate continued to rise after the recessions of 1990–1991, 2001, and 2007–2009 ended. This pattern is due to two factors. First, though employment begins to increase as the recession ends, it may increase more slowly than the increase in the labor force from population growth. Second, some firms continue to operate well below their capacity even after a recession has ended and production has begun to increase. Firms may not hire back all the workers they had laid off and may continue for a while to lay off more workers.

F. Young Workers, Employment, and Recessions Because of the risk of losing workers who are laid off, firms try to retain the workers with the most experience and skills to avoid the expense of having to train newly hired workers. Therefore, millennials were particularly at high risk of losing their jobs during the Great Recession and Generation Z were at high risk of losing their jobs during the Covid-19 recessions of 2020.

G. Can the “Great Moderation” Return?

Before 1950, real GDP went through greater year-to-year fluctuations than it has since. By the early twenty-first century, some economists had begun referring to the absence of severe recessions in the United States as the Great Moderation. This view was questioned with the Great Recession of 2007–2009, which lasted 18 months, the longest of the post-1950 period.

Economists and policymakers remain unsure whether the steady increases in real GDP between 2009 and the start of the Covid-19 recession in 2020 represented a return of the stable growth seen during the Great Moderation.

H. Has the U.S. Economy Return to Stability?

Economists have offered several explanations why the U.S. economy experienced a period of relative stability from 1950 to 2007: ▪ The increasing importance of services and the declining importance of goods.

▪ The establishment of unemployment insurance and other government transfer programs that provide funds to the unemployed. federal stability government policies to stabilize ▪ Active The increased of the financial system. the economy.

▪

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The increased stability of the financial system. Most economists believe that the return of financial instability during the 2007–2009 recession is a key reason the recession was so severe.

Extra Solved Problem 20.3 Leading Indicators and the Business Cycle Predictions about the economy’s future, even from macroeconomic forecasters, are similar to a baseball writer’s prediction of who will play in the next World Series. The prediction can seem wellreasoned and logical, but it is hardly foolproof. Certain statistical series tend to move in similar ways through all business cycles. Knowledge of these series and their tendencies can provide some insight into future business cycle movements. The Conference Board, a not-for-profit organization, publishes monthly updates of what is called the “index of leading economic indicators.” The index is a weighted average of ten statistical series that usually lead, or begin turning upward and downward, before the overall economy does. Because not all the components of the index turn before the business cycle hits a peak or a trough, movements in the index are more reliable than the movement in any one of its components.

Among the most reliable of the leading indicators is an index of prices for 500 common stocks.

Investors want to buy stock shares when their prices are relatively low and sell shares when prices are relatively high. During a recession, stock prices fall due to sluggish sales and profits. Interest rates are relatively low during betweenthe last months of recessions because of reduced demand for investment. In choosing buying bonds and stocks, investors will favor stocks when: (a) stock prices have fallen to a point where there the is a strong possibility of future capital gains and (b) the opportunity cost of buying stocks— a. Scientists accurate of asteroids and comets.

Why interest rate on make bonds—is low.predictions Therefore,about pricesthe of movement common stocks will usually begin to risecan’t during economists make accurate predictions of business cycle movements? the b. Assume that the U.S. economy is in a recession. Mild weather results in lower demand for energy late full stages of a business cycle, before a business expansion begins. As the economy moves near and a reduction in the price of oil. Investors interpret this price decline as positive news for firms employment during an expansion, the situation is reversed. Strong demand for consumer goods and because their costs of production will be lowered. An increase in stock prices results. Will an investment will drive prices and interest rates upward. At some point, investors sell stocks to realize economic expansion follow? capital gains and buy bonds, rather than stocks, to take advantage of high interest rates. The

Solving the Problem downward movement in stock the prices will usually begin a recession Review chapter material.

Thisbefore problem is aboutbegins. the business cycle, so you may want to Step 1: review the section “The Business Cycle” in the textbook.

Step 2:

Answer part (a) by explaining why economists can’t make accurate predictions of business Astronomers can use mathematical formulas to explain the movement of cycle movements. heavenly bodies. Economists are social scientists who attempt to describe and predict the behavior of people. People do not fit neatly into mathematical formulas, nor do they behave as predictably as asteroids and comets.

Step 3:

Answer part (b) by explaining whether an economic expansion follows an increase in stock prices. Stock prices can rise and fall over days or weeks many times before the next turning

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point in the business cycle occurs. A sustained rise in stock prices and upward movement in other leading indicators will increase the probability of an expansion, but remember that economic forecasts, like World Series forecasts, are only certain after the fact.

Extra Apply the Can a Recession Be a Good Time For a Business to Expand?

Concept During a recession, business managers have to quickly make many decisions, such as whether to reduce production, cut prices, close stores or other facilities, or lay off workers. In addition to making decisions aimed at dealing with the immediate effects of the recession, managers have to consider how to prepare for the expansion that will follow. Managers know that every recession, even one as severe as the recession of 2007–2009, will be followed by an expansion during which demand for their products is likely to increase. But it can be difficult to commit resources to future expansion when current conditions are bleak and when the end of the recession is difficult to predict.

However, the payoff to preparing for future growth can be very large. For example, at the end of World War II in 1945, many economists and business managers expected that the U.S. economy would enter a severe recession. Sears and Montgomery Ward were the two largest department store chains in the country. Robert Wood, CEO of Sears, expected continued prosperity and moved to open new stores across the country. Sewell Avery, CEO of Montgomery Ward, expected falling incomes and rising unemployment and refused to authorize any new stores and closed a number of existing ones. As a result, when strong economic growth occurred during the late 1940s, Sears rapidly gained market share at Montgomery Ward’s expense.

Following the September 11, 2001, terrorist attacks in the United States, the managers of many hotels expected a prolonged period of reduced travel. They responded by laying off workers and postponing or canceling new construction. Isadore Sharp, the chairman and CEO of Four Seasons Hotels, decided that although the recession would severely hurt the hotel industry, the effects would be short-lived. He decided to finish construction of 18 hotels and begin construction of 10 more. By his own account: “We maintained or enhanced our market share in most regions, contrary to the predictions of various industry experts.” In a letter to his shareholders in March 2002, he wrote: “We are well positioned for the economic recovery expected later this year.”

During the severe recession of 2007–2009, managers had similar decisions to make. Based in Greensboro, North Carolina, VF Corporation is the largest apparel maker in the world. Among its brands are North Face, Timberland, and Wrangler. While many firms, such as J. Crew, Anne Klein, and Liz Claiborne, were closing stores or postponing opening new ones, Eric Wiseman, CEO of VF, pushed ahead, opening 89 stores in 2008 and 70 in 2009. One retail analyst was quoted as saying, “Unfortunately, many companies pull in the reins in a downturn, but these are often the best opportunities to grow.” Similarly, Intel, the computer chip manufacturer, decided in early 2009 to proceed with a $7 billion expansion of its factories in the United States, while many rival firms were reducing their spending on new factories as computer sales declined. Paul Otellini, CEO of Intel, was quoted as saying, “I thought it was important for a company like Intel to stand up and say we have confidence.” Heavy equipment manufacturer Caterpillar, Inc., announced that it would build several new facilities and expand some existing ones “to meet the expected increase in customer demand.”

By 2015, the recovery from the 2007–2009 recession was well underway, although it was slower than a typical recovery. VF’s decision to expand appeared to have been a good one as sales and profits continued to increase and its stock price was near an all-time high. The company continued to open new stores and

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was operating nearly 1,500 stores worldwide. The verdict for Caterpillar and Intel was more mixed, although both firms remained profitable. Intel’s announcement in mid-2015 that technical problems would delay its latest generation of computer chips until late 2017 might represent a temporary setback, or it could indicate that it was beginning to fall behind rival chipmakers. Caterpillar was being hurt by declining prices for coal, iron ore, oil, and other commodities, which reduced demand for equipment used for mining and oil exploration. Still, Caterpillar’s CEO expected that sales would increase in the future as growth in the world economy caused a turnaround in commodity prices.

Over the long run, betting on the future of the U.S. economy has paid off for most firms.

Sources: Lisa Beilfuss, “VF Corp. Tops Expectations on Strength in Outdoor Sales,” Wall Street Journal, July 24, 2015; Tiernan Ray, “Is Intel in Trouble?” Barrons, July 18, 2015; James R. Hagerty, “Caterpillar Resists Calls to Slash Spending,” Wall Street Journal, July 23, 2015; Robert Sobel, When Giants Stumble, Paramus, NJ: Prentice Hall, 1999; Isadore Sharp, Four Seasons: The Story of a Business Philosophy, New York: Portfolio, 2009; Bob Tita, “Caterpillar to Expand Kansas Plant,” Wall Street Journal, August 18, 2011; Rachel Dodes, “VF Dresses Up Its Operations, Bucking Recession,” Wall Street Journal, March 31, 2009; and Don Clark, “Intel to Spend Heavily on U.S. Plants,” Wall Street Journal, February 10, 2009.

Extra AN INSIDE LOOK News Article to Use in Class Visit Pearson’s MyLab Economics for current news articles.

Solutions to End-of-Chapter Exercises 20.1 Long-Run Economic Growth

Learning Objective: Discuss the importance of long-run economic growth.

Review Questions 1.1

Real GDP per capita measured in 2012 dollars increased from about $6,300 in 1900 to about $55,802 in 2020, representing an eightfold increase: [($55,802 − $6,300)/$6,300] × 100 = 786%.

The increase in real GDP per capita is likely to be smaller than the true increase in living standards because many of today’s goods and services, such as antibiotics, air conditioners, personal computers, and televisions, were not available in 1900.

1.2

1.3 1.4

The rule of 70 is a quick way to calculate the approximate number of years it will take for a quantity such as real GDP per capita to double. Dividing 70 by the growth rate per year yields the approximate number of years it takes to double. For example, if real GDP per capita grows at the rate of 5 percent per year, it will take 14 years (70/5) for real GDP per capita to double.

The two key factors that cause labor productivity to increase over time are the quantity of capital per hour worked and the level of technology.

Potential GDP is the level of real GDP attained when all firms are producing at capacity.

Historically, potential GDP has increased substantially over time as explained in this section.

Problems and Applications

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1.5

There is no one correct answer to this question, but here is what you should consider: An income of $1 million in 1900 represents 20 times more basic purchasing power than $50,000 in 2022. With an income of $1 million in 1900, you could have many more goods and services in 1900 than in 2022. Even though there were no automatic dishwashers, microwaves, or airplanes in 1900, with $1 million you could afford to hire servants to wash the dishes, cook, do the laundry, and provide other personal services. You could travel in private train cars and in luxurious suites on ocean liners. With an income of $1 million in 1900, you could live what in many ways would be a more luxurious life than with an income of $50,000 today.

However, you would not have a television, a personal computer, the Internet, movies, iPads, videogames, Blu-ray players, cell phones, or many other goods available that today we often think of as necessities. If you became ill in 1900, you would not be able to benefit from modern pharmaceuticals or medical procedures. So, a person living with an income of $50,000 in 2022 might enjoy a higher living standard than a person living with an income of $1 million in 1900.

1.6

GDP measures economic output, and the economy could return to the pre-pandemic level of output without employing the same number of workers. The pandemic probably induced structural changes in the labor market, which will keep some workers unemployed. For

1.7

example, consumers now shop more online than they did prior to the pandemic. This change reduces the demand for brick-and-mortar retail workers. Some firms shifted to using more capital, such as self-checkout kiosks, and they will likely not shift back to more labor. These changes may continue beyond the pandemic and permanently alter the employment landscape.

A positive relationship between economic prosperity and life expectancy may be due to

1.8

increased  $9, 355 − $9, 365  a.

Growth rate for 1991 =in an economy 100=−0.11% spending on health care with a higher income level. Therefore, greater economic $9,365



prosperity would imply a health care sector that is larger relative to the economy. In addition, Growth rate for 1992 = because the use of the health care system increases with age, as life expectancy increases and the average age of the population increases, we should expect that more people will use the Growth rate for 1993 = health care Statessystem for more years. These factors should cause the health care sector in the United Growth rate for 1994 = to expand relative to the size of the economy in the coming years.

 0.11% + 3.53% + 2.76% + 4.02%  = 2.55% 4   

b. Average annual growth =− 1.9

Using the rule of 70, it will take approximately 39 (= 70/1.8) years for real GDP per capita to double if it grows at an average annual rate of 1.8 percent a year. If the average annual growth rate increased to 2.2 percent, real GDP per capita would double in approximately 32 years (= 70/2.2).

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1.10

a. The government measure would understate the rate of growth of labor productivity because the government calculates labor productivity using the official measure of work hours, not the adjusted measure that Smith believes to be more accurate. If Smith is correct, workers are producing the measured level of output in fewer hours than the official work hours used in the calculation in the government statistics.

1.11

b.Increases in real GDP per capita as calculated by the Bureau of Economic Analysis, BEA, would understate increases in well-being. For any given level of output, workers are working fewer hours and consuming more leisure, increasing their well-being beyond that indicated by increases in real GDP per capita alone.

Economists would not agree that productivity is “just another term for efficiency.” As you a. can see by checking the definition of labor productivity in this chapter, it is a different concept than either allocative efficiency or productive efficiency. But the basic point Samuelson is getting at is correct: Someone who is more productive can produce more output with the same amount of inputs, which means that person is working efficiently.

Samuelson is correct that there must be an increase in productivity in order for real GDP per b. capita to increase. Increases in real GDP per capita are the key to raising a nation’s material standard of living.

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1.13

Farmers in India still use labor-intensive farming methods that do not produce high levels of a.output, which makes it difficult to produce enough to feed their families. The income of workers in agriculture is lower than the income of workers outside of agriculture in India because worker productivity is higher outside of agriculture. The higher worker productivity outside of agriculture comes from more investment in capital and from improvements in technology.

Having a large agricultural sector in India is a problem because low levels of labor b.productivity result in low levels of income. Having a large agriculture sector could be an opportunity for the Indian economy because as people move from working in the lowproductivity agricultural sector to the high-productivity non-agricultural sector, economic growth will automatically increase, even if productivity is growing slowly outside of agriculture. Most countries, including the United States and China, have experienced higher economic growth as their agricultural sectors shrank as a fraction of their economies. India is likely to follow this pattern. However, India’s government finds it difficult to implement policy reforms because the country has 15 official languages and has ethnic, religious, cultural, and geographic divisions.

The gap between nominal GDP per capita is larger than the gap between real GDP per capita. a.For this result to be true, China’s nominal GDP per capita must have grown at a faster rate relative to India’s than did its real GDP per capita. For nominal GDP to be growing faster in China than in India relative to real GDP must be due to the inflation rate in China being higher than the inflation rate in India.

Rattner is assuming that the growth rate of China’s real GDP per capita, which was as high as b.8 percent per year, would remain high during the same period. In order for India to catch up to the standard of living in China, its real GDP growth rate must be significantly higher than 8 percent per year. So, even a “sparkling growth rate” of, say 6 percent per year, would not allow India to catch up to the standard of living in China. Of course, a growth rate that high would allow India in the future to catch up to China’s standard of living today.

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a. Economists use potential GDP to measure an economy’s capacity. Potential GDP is the level of real GDP attained when all firms are producing at capacity. A firm’s capacity is measured by its production when operating on normal hours, using a normal workforce. b.The economy is in its “late-cycle” when the expansion is nearing its end and the economy is soon expected to head into a recession. During this phase, the economy’s real GDP is usually at or above its potential GDP, and it is expected to start falling below the potential GDP.

20.2

Saving, Investment, and the Financial System Learning Objective: Discuss the role of the financial system in facilitating long-run economic growth.

Review Questions 2.1

2.2

A financial system allows businesses to borrow funds to finance purchases of capital equipment, train workers, and adopt new technologies. Long-run economic growth depends on increases in the quantity of capital equipment, increases in the amount of human capital, and technological advances.

The financial system provides: (1) risk sharing by allowing savers to spread their savings among many makingfinancial investments either directly through financial markets or indirectly through deposits in financial intermediaries; (2) liquidity by providing savers with markets in which

2.3

they can sell their holdings of financial securities or withdraw their funds from financial intermediaries; and (3) information by specializing in gathering information on borrowers and communicating information on businesses by incorporating that information into the prices of stocks and bonds.

The equality between saving and investment follows from national income accounting and

2.4

the definitions of saving and investment. By rearranging the components of GDP for a closed economy (Y = C + I + G), investment equals income minus consumption minus

Problems and Applications government 2.5

2.6

purchases. Adding together private saving by households (SPrivate = Y + TR – C – T) and public You would have to take the time and incur the expense to gather information on the borrower and saving by likelihood government (SPublic Your = T –funds G – TR) yields total saving and also his or her of repaying. would not be liquid.

Although youequals might income want the money back before the loan was due, the borrower would not have to pay before the due date. If minus the borrower stopped paying, youpurchases, might have go to court to try to get your money back. Lastly, consumption minus government orto investment. your money would not be spread out across different investments to reduce risk.

Loanable funds are the money that households save and lend to businesses. Businesses a. The financial system allows savers to provide funds to firms by buying the firms’ stocks and demand bonds, either directly or through mutual funds and exchange-traded funds (ETFs), and by depositing fundsto in finance banks. Savings refers to the funds available to individuals after all funds of theirto loanable funds new investment projects.

Households supply loanable earn purchases and tax payments and to the f0075nds governments have available after subtracting interest and save for retirement or other needs in future years.

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CHAPTER 20 | Economic Growth, the Financial System, and Business Cycles their expenditures from their tax revenues. Investment, as used in this context, is expenditure on new capital and new technology. Firms finance this investment in part with funds savers provide them. Investment is not the same as buying bonds or stocks, although the word is widely used this way in finance. b. Firms use the funds they receive from savers to invest in new capital and new technologies, which increases worker productivity and economic growth.

2.7

a. Private saving: Sprivate = Y + TR – C – T = $11 trillion + $1 trillion – $8 trillion – $3 trillion = $1 trillion b. Public saving: Spublic = T – G – TR, but G is not given. Use I = Sprivate + Spublic; $2 trillion = $1 trillion + Spublic; Spublic = $1 trillion c. Government purchases: Solve for G by using Spublic = T – G – TR, or I = Y – C – G G = $1 trillion d. Government budget surplus = T – G – TR = $1 trillion

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a. Private saving: Sprivate = Y + TR – C – T, but TR is not given.

Use I = Sprivate + Spublic I = Y – C – G = $12 trillion – $8 trillion – $2 trillion = $2 trillion.

Spublic = − $0.5 trillion, so Sprivate = $2.5 trillion b. Investment spending: I = $2 trillion (see part a.) c. Transfer payments: Spublic = T – G – TR; − $0.5 trillion = $2 trillion − $2 trillion – TR, TR = $0.5 trillion d. Government budget deficit: T – G – TR = $2 trillion − $2 trillion − $0.5 trillion = – $0.5 trillion

2.9

S and I must decline by $0.5 trillion.

I = S = Y – C – G. With no change in Y and C, an increase in G must result in a decline in I and S by the same amount.

2.10

a. Graph 4 shows a situation where there would be a small increase in the quantity of loanable funds supplied from an increase in the real interest rate. b. Graph 1 shows a situation where there would be a substantial increase in the quantity of loanable funds demanded following a decrease in the real interest rate. c. Graph 2 shows that the elimination of 401(k) retirement accounts would reduce the after-tax return on saving, which would shift the supply curve for loanable funds to the left. d. Graph 3 shows that a reduction in the tax on corporate profits would increase the after-tax return on investment projects, which would shift the demand curve for loanable funds to the right.

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a. The supply of loanable funds is determined by the willingness of households to save and by the extent of government saving or dissaving. The decrease in the supply of loanable funds from S1 to S2 could be caused by an increase in the desire of households to consume today, a decrease in the tax benefits of saving, or an increase in the government’s budget deficit. b.The equilibrium quantity of loanable funds decreases from L1 to L2. c. The quantity of saving decreases as does the quantity of investment.

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2.13

Both the equilibrium interest rate and the equilibrium quantity of loanable funds increase. a.

The demand for loanable funds increased. For a given demand for loanable funds, an increase b.in the interest rate does decrease the quantity of loanable funds demanded. In the figure, we see this effect by the movement from point B to point C on demand curve D2, following the shift in the demand curve from D1 to D2.

If the interest rate had remained at i1, the quantity of loanable funds demanded would have c. increased from L1 to L3.

With the increase in the interest rate from i1 to i2, the quantity of loanable funds supplied d.increases from L1 to L2.

As shown in the following figure, by reducing the return to saving, a tax on savings will a.create a disincentive to save. We illustrate this result in the figure as a shift to the left of the supply curve for loanable funds. The shift in the supply curve for loanable funds results in a higher equilibrium interest rate and lower levels of loanable funds and investment.

b. A decline in investment means that firms have reduced their spending on robots, computers, and factories. Worker productivity depends on how much capital is available per worker and on technology. Lower levels of investment, relative to what they would have been in the absence of the tax, will result in less capital per worker and, likely, a slowing in the growth in technology. Because workers will be less productive than they would have been in the absence of the tax, their wages will be lower.

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CHAPTER 20 | Economic Growth, the Financial System, and Business Cycles c. Even if a tax on savings reduces investments, a policymaker may still support a tax if the policymaker believes that the revenues from the tax can be used to increase spending on infrastructure or schools, which may also increase productivity.

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2.15

2.16

Saving is necessary to fund investment, which promotes long-run economic growth. Income saved reduces the amount of current consumption. We could argue that it is more important to increase current consumption and short-run GDP growth, as the letter to the Wall Street Journal suggests, or we could argue that it is more important to increase long-run economic growth, as Landsburg does. If the economy is in a recession, boosting short-run GDP may seem most important. Over the long run, though, rising living standards are better attained through high savings rates that can increase the funds businesses require to increase their physical capital and to introduce new technologies.

The pre-reform Scrooge saved nearly all of his large income, which increased the supply of loanable funds and helped increase the quantity of investment goods and, therefore, economic growth. If the post-reform Scrooge bought food for poor people, the productivity of those poor people would increase, which would have a positive effect on economic growth. So, taking this factor into account, it becomes uncertain whether the pre-reform or post-reform Scrooge was better at boosting economic growth. a. The use of artificial intelligence (AI) represents a technological advance and would increase labor productivity in the financial system by allowing financial firms to offer the same number of mutual funds with fewer (human) employees or more mutual funds with the same number of employees. Moreover, with the use of AI, financial firms can perform more financial transactions with fewer mistakes than if AI were not available. b. Using AI will decrease the investment firms make to provide consumers with financial services. This reduction will lower the price of those services and make it likely that consumers will increase their saving. As we’ve seen, an increase in the supply of loanable funds will lower the equilibrium real interest rate and increase the level of investment. More investment means a larger capital stock and, likely, an increase in the introduction of new technology. New technology, in turn, leads to an increase in productivity and, therefore, in the rate of long-run economic growth.

2.17

a. In the following graph, a budget surplus shifts the supply curve for loanable funds to the right from S1 to S2. As a result, the equilibrium real interest rate decreases from i1 to i2, and the equilibrium quantity of loanable funds increases from L1 to L2. Because the equilibrium quantity of loanable funds increases, the equilibrium quantities of saving and investment will increase.

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b. If households increase their consumption in anticipation of lower taxes in the near future, they will also decrease their saving, which would partly or fully offset the increase in public saving caused by the federal budget surpluses. If the decrease in private saving matches the increase in public saving, the supply curve for loanable funds will not shift, and there will be no change in the real interest rate or the equilibrium quantity of loanable funds.

20.3 The Business Cycle

Learning Objective: Explain what happens during the business cycle.

Review Questions 3.1

a. Peak b. Trough c. Recession d. Expansion

3.2

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

3.3

The typical recession before 1950 was more severe than the typical recession after 1950.

Economists agree that three factors have lessened the severity of recessions: (1) The increasing importance in the economy of services relative to goods; (2) the establishment of government transfer payments; and (3) the increased stability of the financial system, other than during the 2007–2009 recession. Economists disagree on whether active federal government policies to stabilize the economy have actually made recessions less severe.

Problems and Applications 3.4

The following products are durable goods or used in the production of durable goods, and we expect production to fluctuate more than real GDP during the business cycle.

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CHAPTER 20 | Economic Growth, the Financial System, and Business Cycles (a) Ford F-150 trucks (c) Chevron’s advanced plastics to be used in automobile manufacturing (e) Maytag washing machines The following products are nondurable goods, and we would expect their production to fluctuate less than real GDP: (b) McDonald’s Big Macs (d) Huggies diapers Firms that produce durable goods are more likely to lay off workers during a recession. So, we would predict that Ford, Chevron, and Maytag would be more likely to lay off workers during a recession than would McDonald’s and Huggies.

3.5

3.6

There is no clear-cut definition of a recession, so dating recessions requires some judgment. As part of the federal government, the Bureau of Economic Analysis (BEA) could be pulled into politics if it were responsible for dating recessions. Politicians could pressure the BEA to set the start or the end of a recession to help the administration in power. a. Households typically borrow money to fund the purchase of long-lived goods like houses and cars. Households that are experiencing temporary financial problems, perhaps as the result of a household member losing his or her job, may also borrow—perhaps by running large balances on a credit card—to fund day-to-day living expenses. b. Typically, household debt is lower at the beginning of an expansion because recessions usually force households to cut their expenditures and reduce their debts. During an expansion, households often become more optimistic about their financial situation, in part because employment and wage growth are high. As a result, households are willing to take on debt to finance their purchases of houses and cars.

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3.8

3.9

3.10

You should disagree with this statement. Real GDP itself is not a measure of economic growth, which is the percentage change in real GDP from one year to the next. Despite the fact that $18.4 trillion for real GDP in 2020 is a large number, economic growth might have been small or negative. To calculate economic growth during 2020, we also need to know the value of real GDP in 2019. For example, if the real GDP in 2019 had been $19.0 trillion, the growth rate in real GDP for 2020 would not only have been low, it would have been negative.

Firms engage in oil exploration based on their forecasts of future crude oil demand, not current demand. The Great Recession of 2007-2009 was severe, but no one expected it to last forever.

Exploring for oil and then developing newly discovered oil fields takes several years, by which time Chevron was confident that the recession would be over and the world economy would be well into an economic expansion.

People who graduated from college and entered the labor force in 2009 did so when the economy was in a recession or when the recession was just ending. The overall unemployment rate reached 10 percent in 2009, but it was much higher for people who had just graduated from high school or college. These people found few jobs available, and some were unemployed for a significant period of time. The unemployment rate did not fall below the natural rate of unemployment until well into 2015.

Samuelson explained that households were willing to assume debt and lenders were willing to make loans during the Great Moderation because they were confident that continued economic

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growth would allow households to pay off the loans. But consumers were more reluctant to borrow, and lenders were more reluctant to make loans after experiencing the effects of the Great Recession of 2007-2009: “Consumers are not only…paying down debt but also trying to build up savings against possible future setbacks. Businesses are reluctant to invest in major expansions because they’re unsure of future demand.” Greater lending and debt prior to the recession of 2007–2009 increased the number of defaulted loans during the recession, making the recession worse than it might otherwise have been.

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

In the first quarter of 2021, nominal GDP equaled $22,061.5 billion, real GDP equaled $19,086.4 billion in chained 2012 dollars, and real potential GDP equaled $19,602.5 billion in chained 2012 dollars. These GDP values are at annual rates. b. The GDP price deflator in the first quarter of 2021 equaled: [($21,061.5 billion/$19,086.4 billion) × 100] = 110.35.

D20.1 a.

c. The percentage difference between real GDP and real potential GDP in the first quarter of 2021 equaled: [($19,086.4 billion – $19,602.5 billion)/$19,602.5 billion] × 100 = –2.63%.

Real GDP in the first quarter of 2021 was 2.63 percent below real potential GDP. d. Real GDP was below real potential GDP in 2011 as the economy continued to recover from a severe recession. Since the trough of the recession in the second quarter of 2009, real GDP has slowly climbed back up to and was above real potential GDP in 2019. However, real GDP fell below potential GPD in 2020 due to the Covid-10 pandemic and remained below potential GDP in the first quarter of 2021.

D20.2 a.Gross private saving equaled $7,951.9 billion in the first quarter of 2021, and equaled $4,447.7 billion in the first quarter of 2018. Gross government saving equaled − $3,654.0 billion in the first quarter of 2021, and it equaled − $537.5 billion in first quarter of 2018. Saving values are at annual rates. b. Total saving equals gross private saving plus gross public saving (gross government saving).

Total saving equaled $4,297.9 billion (= $7,951.9 billion − $3,654.0 billion) in the first quarter of 2021 and equaled $3,910.2 billion (= $4,447.7 billion − $537.5 billion) in the first quarter of 2018. c. The graph below shows the loanable funds market in equilibrium. The supply of loanable funds represents total saving.

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d. The decrease in total saving from the first quarter of 2018 to the first quarter of 2021 shifts the supply curve for loanable funds to the left from S1 to S2, which would decrease the equilibrium quantity of loanable funds and increase the real interest rate. This result assumes that the decrease in total saving was due to factors other than changes in the real D20.3 a. interest rate. b. c.

Gross government saving equaled −$3,654.0 billion in the first quarter of 2021, and equaled −$383.4 billion in the first quarter of 2017. Saving values are annual rates.

Government saving represents the government budget surplus if positive or budget deficit if negative.

In both the first quarter of 2021 and the first quarter of 2017, there was a government budget deficit. From the first quarter of 2017 to the first quarter of 2021, government saving decreased, going from −$383.4 billion to −$3,654.0 billion.

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d. The decrease in government saving resulting from the larger government budget deficit shifts the supply curve for loanable funds to the left, which raises the equilibrium real interest rate and lowers the equilibrium quantity of loanable funds (and the level of investment).

Suggestions for Critical Thinking Exercises CT20.1 Answers may vary, but some of the significant differences in the way a student’s parents or relatives did their homework include: (1) they took notes in class and did their homework using pens and notebooks, while some students today take notes and do their homework with computers; (2) your parents had to go to the library to access books that they needed for their research while many students today can use Google or other search engines; and (3) they typed their term papers using typewriters, while many students today use computer word processing software like Microsoft Word. Many of these changes have made homework easier to complete today and have made current students more productive.

After the Great Recession of 2007–2009, investment became a smaller and smaller share of the CT20.2 U.S. economy. With less investment, potential GDP will grow more slowly. Similarly, with slower growth in labor productivity, potential GDP will not grow as quickly.

The economy is unlikely to be in a strong expansion and still have unemployment above the CT20.3 natural rate and real GDP less than potential GDP. An economy that is currently experiencing a strong expansion is likely to also experience low unemployment rates, and real GDP is likely to be at or above potential GDP.

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Brief Chapter Summary and Learning Objectives 21.1 Economic Growth over Time and around the World Define economic growth, calculate economic growth rates, and describe global trends in economic growth.

▪ Economic growth occurs when real GDP per capita increases.

21.2 What Determines How Fast Economies Grow?

Use the economic growth model to explain why growth rates differ across countries.

▪ Labor productivity increases if there is an increase in the amount of capital available to each

worker or if there is an improvement in technology.

21.3 Economic Growth in the United States Discuss fluctuations in productivity growth in the United States.

▪ Productivity in the United States grew rapidly from the end of World War II until the mid-

1970s and has fluctuated since.

21.4 Why Isn’t the Whole World Rich?

Explain economic catch-up and discuss why many poor countries have not experienced rapid economic growth.

▪ The economic growth model predicts that poor countries will grow faster than rich countries.

21.5 Growth Policies Discuss government policies that foster economic growth.

▪ Governments can attempt to increase economic growth through policies that enhance

property rights and the rule of law, improve health and education, subsidize research and development, and provide incentives for savings and investment.

Key Terms Catch-up The prediction that the level of GDP per capita (or income per capita) in poor countries will grow faster than in rich countries.

Economic growth model A model that explains growth rates in real GDP per capita over the long run.

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Foreign direct investment (FDI) A firm’s purchasing or building of a facility in a foreign country.

Patent The exclusive right to produce a

Foreign portfolio investment The purchase by an individual or a firm of stocks or bonds issued in another country.

product for a period of 20 years from the date the patent

Globalization The process of countries becoming more open to foreign trade and investment.

application is filed with the government.

Human capital The accumulated knowledge and skills that workers acquire from education and training or from their life experiences.

and capital per hour worked, holding the level

Per-worker production function The relationship between real GDP per hour worked of technology constant.

Property rights The rights individuals or firms have to the exclusive use of their property, including the right to buy or sell it.

Industrial Revolution The application of mechanical power to the production of goods, beginning in England around 1750.

Rule of law The ability of a government to enforce the laws of the country, particularly with

Labor productivity The quantity of goods and services that can be produced by one worker or by one hour of work.

respect to protecting private property and enforcing contracts.

Technological change A change in the quantity of output a firm can produce using a given quantity of inputs.

New growth theory A model of long-run economic growth which emphasizes that technological change is influenced by economic

Chapter Outline Technological Change, Creative Destruction, and Rising Living Standards Will large and well-recognized firms like Apple, Facebook, Uber, and General Motors exist 30 years from now? It may seem difficult to imagine firms like these no longer existing, but the U.S. economy has witnessed the rise and fall of many firms. The list of once dominant firms that have since disappeared from the U.S. economy is long, but few had as spectacular a rise and fall as Blockbuster Video. In the late 1970s, first Sony, and then other firms, began selling videocassette recorders (VCRs), which for the first time allowed people to buy prerecorded movies that they could watch whenever they chose to rather than having to wait for them to be broadcast on TV. By the mid-1980s, video rental stores were common. In 1985, David Cook founded Blockbuster Video. Cook used sophisticated software to track inventories of movies and the rental habits of customers. But with the rise of DVDs, Netflix and other video streaming services, Blockbuster lost most of its customers and was forced to declare bankruptcy in 2010. In 2021, only a single Blockbuster store in Bend, Oregon, remained. The rise and fall of large firms is an example of creative destruction. In the 1940s, Joseph Schumpeter of Harvard University famously used the term creative destruction to refer to the process of new technologies advancing living standards while destroying many existing firms.

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

to the Present A. Economic Growth from 1,000,000 BC.E. .

No sustained economic growth occurred between 1,000,000 B.C.E. and C.E. 1300. Significant growth did not begin until the Industrial Revolution. The Industrial Revolution refers to the application of mechanical power to the production of goods, beginning in England around 1750. Before that time, production of goods had relied almost exclusively on human or animal power. First England, and then other countries, experienced long-run economic growth with sustained increases in real GDP per capita.

B. Small Differences in Growth Rates Are Important Because of compounding, in the long run small differences in economic growth rates result in big differences in living standards.

C. The Problem with Slow Economic Growth Growth rates matter because an economy that grows too slowly fails to raise living standards. In some countries in Africa and Asia, very little economic growth has occurred in the past 50 years, resulting in severe poverty.

D. The Variation in per Capita Income around the World The world can be divided into two groups: the high-income countries (or the industrial countries) and the poorer countries (or developing countries). The high-income countries include the countries of Western Europe, Australia, Canada, Japan, New Zealand, and the United States. The developing countries include most of the countries of Africa, Asia, and Latin America. In the 1980s and 1990s, a small group of countries, mostly East Asian countries such as Singapore, South Korea, and Taiwan, experienced high growth rates and are referred to as the newly industrializing countries.

E. Is Income All That Matters?

Income is an important aspect of the standard of living, but there are also other measures of the standard of living, including health, education, and civil and political liberties, that could be improved without an increase in income. Changes in attitudes, such as placing a greater value on education, particularly for girls, or increasing support for political freedoms, have also played a role in improving conditions in lowincome countries.

Extra Solved Problem 21.1 Economic Growth in the United States since 1929 The world’s average annual growth rate of real GDP per capita in the period 1800 to 1900 was 1.3 percent and was 2.3 percent in the period 1900 to 2000. The Bureau of Economic Analysis has estimated that the real GDP (in 2012 prices) of the United States in 1929 was $1,110.2 billion. The following table shows what real GDP would be for 1930 assuming that the growth rate of real GDP was 1.3 percent, 2.3 percent, and 3.3 percent from 1929 to 1930. The estimated values for 1930 were obtained by multiplying $1,110.2.6 billion by 1.013, 1.023 and 1.033, respectively.

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CHAPTER 21 | Long-Run Economic Growth: Sources and Policies Estimated Real GDP for the United States for Various Growth Rates 1.3% 1930

2.3%

$1,124.7 billion $1,135.7 billion

3.3% $1,146.8 billion

The differences in estimated real GDP for 1930 seem small, but how different would GDP be if these growth rates continued through 2020?

Estimate real GDP for the United States if the economy grew from 1930 to 2020 at three different growth rates: (a) 1.3 percent annually, (b) 2.3 percent annually, and (c) 3.3 percent annually.

Source: U.S. Bureau of Economic Analysis. http://www.bea.gov/

Solving the Problem Step 1:

Review the chapter material. This problem is about the importance of economic growth over time, so you may want to review the section “Economic Growth over Time and around the World” in the textbook.

Step 2:

Estimate real GDP for the United States if the economy grew from 1930 to 2021 at three different growth rates: (a) 1.3 percent, (b) 2.3 percent, and (c) 3.3 percent. The following table shows what real GDP would have been in 2020 if real GDP grew at the three different rates.

Estimated Real GDP for the United States for Various Growth Rates 1.3%

2.3%

3.3%

2020 $3,550.2 billion $8,594.3 billion $20,626.7 billion The estimated value for real GDP using a 3.3 percent growth rate is more than twice the estimated value for real GDP assuming a growth rate of 2.3 percent, and more than five times the estimated real GDP assuming a 1.3 percent rate of growth. These calculations show how apparently small differences in growth rates, compounded for 90 years, can result in very different levels of real GDP. (The actual real GDP in 2020 was $18,384.7 billion.)

Teaching Tips The end of the chapter in the main text includes a special category of exercises titled Real-Time Data (RTDA) Exercises. These exercises are well worth assigning and discussing in class because they help students become familiar with a key data source, learn how to locate data, and develop skills in interpreting data. Many RTDA exercises require more elaborate calculations than other problems and the use of Excel spreadsheets.

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What Determines How Fast Economies Grow?

Learning Objective: Use the economic growth model to explain why growth rates differ across countries.

The economic growth model explains growth rates in real GDP per capita over the long run. This model focuses on the causes of long-run increases in labor productivity, which is the quantity of goods and services that can be produced by one worker or by one hour of work. Economists believe that two key factors determine labor productivity: the quantity of capital per hour worked and the level of technology. Technological change is a change in the quantity of output a firm can produce using a given quantity of inputs. There are three main sources of technological change: 1. Better machinery and equipment.

2. Increases in human capital, which is the accumulated knowledge and skills that workers acquire from education and training or from their life experiences.

3. Better means of organizing and managing production.

A country’s standard of living will be higher the more capital workers have available on their jobs, the better the capital, the more human capital workers have, and the better the job business managers do in organizing production.

A. The Per-Worker Production Function The economic growth model can be illustrated by using the per-worker production function, which is the relationship between real GDP per hour worked and capital per hour worked, holding the level of technology constant. Increases in the quantity of capital per hour worked result in movements up along the per-worker production function. Holding technology constant, equal increases in the amount of capital per hour worked lead to diminishing increases in output per hour worked.

B. Which Is More Important for Economic Growth: More Capital or Technological Change?

Technological change helps economies avoid diminishing returns to capital. Replacing existing capital with more productive capital is an example of technological change. Reorganizing how production takes place so as to increase output is also an example of technological change.

C. Technological Change: The Key to Sustaining Economic Growth Technological change shifts up the per-worker production function and allows an economy to produce more real output per hour worked with the same quantity of capital per hour worked. In the long run, a country will experience an increasing standard of living only if it experiences continuing technological change.

D. New Growth Theory New growth theory is a model of long-run economic growth which emphasizes that technological change is influenced by economic incentives and so is determined by the working of the market system. Paul Romer developed the new growth theory. He argues that the rate of technological change is influenced by how individuals and firms respond to economic incentives. Firms add to an economy’s stock of knowledge capital when they engage in research and development or otherwise contribute to technological change. Romer argues that the accumulation of knowledge capital is subject to diminishing returns at the firm level⸻but at the level of the entire economy, knowledge capital is subject to increasing returns.

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The use of knowledge capital is nonrival because one firm’s use of that knowledge does not prevent another firm from using it. Romer points out that firms are unlikely to engage in research and development up to the point where the marginal cost of the research equals the marginal return from the knowledge gained because other firms will gain much of the marginal return. Government policy can increase the accumulation of knowledge capital in three ways: 1. Protecting intellectual property with patents and copyrights. A patent is the exclusive right to produce a product for a period of 20 years from the date the patent application is filed with the government.

2. Supporting research and development.

3. Subsidizing education.

These policies can bring the accumulation of knowledge capital closer to the optimal level.

E. Joseph Schumpeter and Creative Destruction The new growth theory revived interest in the ideas of Joseph Schumpeter, who developed a model of growth that emphasized his view that new products drive older products—and the firms that produce them—out of the market. For Schumpeter, the key to rising living standards is the development of new products that meet consumer needs in qualitatively different ways. Successful entrepreneurs can use their profits to finance the development of new products.

21.3 Economic Growth in the United States

Learning Objective: Discuss fluctuations in productivity growth in the United States.

The economic growth model can help us understand the record of growth in the United States.

A. Economic Growth in the United States since 1950 Productivity in the United States grew rapidly from the end of World War II until the mid-1970s.

Growth then slowed down for 20 years. Beginning in the mid-1990s, the growth rate picked up again, but beginning in 2006, growth slowed once more.

B. Is the United States Headed for a Long Period of Slow Growth?

Some economists argue that productivity has become more difficult to measure and that the United States is likely to experience high rates of growth in the long run. Other economists believe that productivity entered a long-run decline in the mid-1970s that was only briefly overcome by the effects of the revolution in information technology (IT).

Some economists argue that the development of information technology caused the higher rate of growth of on productivity in the 1990s. Those who believe that IT is having large, but difficult to measure, effects the economy are optimistic about future growth rates and that advances in semiconductor technology will result that in substantial gains in labor productivity. A somewhat different version of this argument is artificial intelligence (AI) is an example of a general purpose technology that has the potential to affect many sectors of the economy. When a general purpose technology is introduced, productivity may initially decline as businesses have to develop new processes to take advantage of the technology.

Once . these processes have been worked out, businesses can take full advantage of the technology and productivity will increase. The result is a productively J-curve, with productively first falling⸻the downward part of the J⸻before rising⸻the upward part of the J. Other economists doubt that the

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Some economists believe that insufficient demand for investment spending will result in secular stagnation. Those who subscribe to the secular stagnation scenario claim that the demand for loanable funds will be low because: 1. Slowing population growth will reduce the demand for housing.

2. Modern information technology firms will require less capital than older firms.

3. The price of capital has been falling relative to the prices of other goods. Firms can meet their capital needs with lower expenditures.

Critics of the secular stagnation view believe that the severity of the recession of 2007–2009 and the relatively slow recovery from that recession temporarily reduced the demand for investment. They note that higher levels of investment beginning in 2018 persisted into early 2021, despite the effects of the Covid-19 pandemic. In addition, they argue that economic growth in other countries may increase the demand for U.S. goods, allowing exports to increase, thereby offsetting the effects on GDP of lower production of investment goods.

Extra Solved Problem 21.3 U.S. Productivity Growth and Employment The textbook describes the productivity slowdown from 1974 to 1995 in which the annual growth rate of real GDP per hour worked in the United States was 1 percentage point per year lower than during the 1950–1973 period. Although the reasons for this anemic growth are still uncertain, the subsequent increase in productivity growth from 1996 to 2006 was welcome news to economists. But others have pointed to a dark lining in this silver cloud. News articles used the term “jobless recovery” to describe economic expansion that began after the 2001 recession. Some observers argued that faster productivity growth allowed employers to increase production without increasing employment. Although employment growth subsequently increased, the concern expressed for workers’ jobs highlights two different views of productivity. In the Federal Reserve Bank of San Francisco’s Economic Letter, Carl Walsh wrote: If higher productivity allows firms to shed workers, how can it raise wages and living standards? If productivity does lead to improved wages and living standards, why do so many feel the recent productivity growth has left workers behind?

Walsh notes that productivity growth and changes in technology cause structural changes that result in increased production and employment in some industries and reductions in production and employment in other industries. For example, the growth in demand for word processors and personal computers resulted in a decline in the demand for typewriters and some types of office workers. Small changes in overall employment mask what often are large increases in employment and unemployment in individual industries. In other words, the negative effect of productivity on employment occurs in the short run, while the positive effect of productivity on employment occurs in the long run.

Source: Carl E. Walsh, “The Productivity and Jobs Connection: The Long and the Short of It.” Economic Letter.

FRBSF July 16, 2004.

The average annual growth rate of real GDP per hour worked from 1950 to 1973 was 2.6 percent.

Examine the fluctuations in the annual unemployment rate for this period in Figure 20.5 in the textbook. Is the behavior of the unemployment rate consistent with Carl Walsh’s explanation of the effect of productivity growth on employment?

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Solving the Problem Step 1:

Review the chapter material. This problem is about fluctuations in productivity growth, so you may want to review the section “Economic Growth in the United States” in the textbook.

Step 2:

Determine whether the behavior of the unemployment rate is consistent with Carl Walsh’s explanation of the effect of productivity growth on employment. Yes, Walsh’s explanation is consistent with the behavior of unemployment. Despite the relatively large increases in productivity from 1950 to 1973, the rate of unemployment did not have an upward trend. Most of the fluctuation in the unemployment rate occurred as a result of business cycle fluctuations. This observation is consistent with the argument that increases in productivity lead to increased employment in the long run by raising the real wage workers receive. We need other data to show how much total employment changed and which industries experienced job gains and job losses.

21.4

Why Isn’t the Whole World Rich?

Learning Objective: Explain economic catch-up and discuss why many poor countries have not experienced rapid economic growth.

The economic growth model tells us that economies grow when the quantity of capital per hour worked increases and when technological change takes place. The profitability of using additional capital or better technology is generally greater in a developing country than in a high-income country. The economic growth model predicts that poor countries will grow faster than rich countries. Catch-up is the prediction that the level of GDP per capita (or income per capita) in poor countries will grow faster than in rich countries. The paradox is that lower-income industrial countries have been catching up to the higherincome industrial countries, but the developing countries as a group have not been catching up to the high-income countries as a group.

A. Catch-up: Sometimes but Not Always A graph can illustrate whether catch-up is happening. The initial level of GDP per capita is measured along the horizontal axis and the vertical axis shows the rate at which GDP per capita is growing. Low- income countries should be in the upper-left part of the graph and high-income countries should be in the lower-right part of the graph. Some countries that had low levels of real GDP per capita in 1960 had lower levels of real GDP per capita in 2014 than in 1960. Other countries that started with low levels of real GDP per capita grew rapidly.

B. Why Haven’t Most Western European Countries, Canada, and Japan Caught Up to the United States?

Over the past 25 years, other high-income countries have fallen further behind the United States.

Real GDP per capita in Canada, Japan, and the five largest countries in Western Europe increased relative to the United States between 1960 and 1990, but none of these countries has experienced catch-up since 1990. Many economists believe there are two explanations for the failure of these countries to catch-up with the United States: The greater flexibility of U.S. labor markets and the greater efficiency of the U.S. financial system.

C. Why Don’t More Low-Income Countries Experience Rapid Growth?

Many poor countries do not experience rapid growth for four main reasons: ▪ Failure to enforce the rule of law, which is the ability of a government to enforce the laws of the country, particularly with respect to protecting private property and enforcing contracts

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▪ Wars and revolutions ▪ Poor public education and health ▪ Low rates of saving and investment Property rights are the rights individuals or firms have to the exclusive use of their property, including the right to buy or sell it.

D. The Benefits of Globalization One way for a developing country to break out of the vicious cycle of low saving and investment and low growth is through foreign investment. Foreign direct investment (FDI) is the purchase or building by a firm of a facility in a foreign country. Foreign portfolio investment is the purchase by an individual or a firm of stocks or bonds issued in another country. Globalization is the process of countries becoming more open to foreign trade and investment. Developing countries that are more globalized have grown faster than countries that are less globalized.

21.5 Growth Policies

Learning Objective: Discuss government policies that foster economic growth.

A. Enhancing Property Rights and the Rule of Law A market system cannot work well unless property rights are enforced. Entrepreneurs are unlikely to risk their own funds, and investors are unlikely to lend their funds to entrepreneurs, unless property is safe from being arbitrarily seized by a corrupt government. In many developing countries, the rule of law and property rights are undermined by corruption. Research has shown that countries where corruption is most widespread grow much more slowly than countries where corruption is less of a problem.

B. Improving Health and Education As people’s health improves and they became taller, stronger, and less susceptible to disease, they also become more productive. Many economists believe that government subsidies to education have played an important role in promoting economic growth. The rising incomes that result from economic growth can help developing countries deal with brain drain, which occurs when highly educated and successful individuals leave developing countries for high-income countries.

C. Policies That Promote Technological Change Government policies that facilitate access to technology are crucial for low-income countries. The easiest way for developing countries to gain access to technology is through foreign direct investment. In highincome countries, government policies can aid the growth of technology by subsidizing research and development.

D. Policies That Promote Saving and Investment Governments can increase incentives for firms to engage in investment in physical capital by using investment tax credits. These credits allow firms to deduct from their taxes some fraction of the funds they have spent on investment.

E. Is Economic Growth Good or Bad? The arguments against further economic growth tend to be motivated either by concern about the effects of growth on the environment or by concern about the effects of the globalization process that has accompanied economic growth in recent years. Economic analysis can contribute to the debate over the consequences of economic growth, but it cannot resolve the issue.

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Teaching Tips The following graph shows that developing countries that were more open to foreign trade and investment grew much faster during the 1990s than developing countries that were less open.

Globalization and Growth, 1990s

Source: David Dollar, “Globalization, Inequality, and Poverty since 1980,” World Bank Research Observer , Vol. 20, No. 2, Fall 2005, pp. 145–175.

Extra Solved Problem 21.5 What Is the Proper Role for Government in Promoting Growth?

One popular explanation for the persistent poverty of developing nations is a lack of natural resources. But Hong Kong and Japan, with meager supplies of natural resources, experienced more rapid economic growth in recent decades than some nations that have more abundant supplies of resources. Economist Paul Romer has argued that it is ideas, not natural resources, that poor countries lack most: “If a poor nation invests in education and does not destroy the incentives for its citizens to acquire ideas from the rest of the world, it can rapidly take advantage of the publicly available part of… knowledge.”

In the United States and other developed countries, most economists support three government ▪ Subsidies for education policies Competitive grants for basic research Patents the andproduction copyrights that▪encourage and dissemination of new knowledge: ▪ Romer warns that it is important to limit government’s power over economic policy. He states that most economists favor government subsidies for education and private research, but if government officials have power over economic policy, they may use that power to divert the results of research to narrow special interests.

Source: Paul M. Romer, “Economic Growth,” The Concise Encyclopedia of Economics. http://www.econlib.org/library/Enc/EconomicGrowth.html

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a. Why do economists believe that governments should subsidize education and basic research? b. Paul Romer warns that government officials may use their power to divert the results of research to narrow special interests. Explain Romer’s concern.

Solving the Problem Step 1:

Review the chapter material. This problem is about policies that can foster economic growth, so you may want to review the section “Growth Policies” in the textbook.

Answer part (a) by explaining why economists believe that governments should subsidize

Step 2:

Step 3:

education and basic research. Private firms have little incentive to invest in activities that, if successful, are not profitable. The social returns to investment in education and basic research are significant, but these returns are spread throughout the economy. Therefore, firms may not undertake research that would increase economic growth and benefit the whole economy because the research would not be profitable for them. A government subsidy may be necessary to provide firms with the incentive to invest in basic research.

Answer part (b) by explaining Paul Romer’s concern that government officials may use Elected officials their power to divert the results of research to narrow special interests. are likely to favor projects that are located in their own states or districts rather than projects that have the greatest social returns. For example, politicians from Iowa are apt to favor subsidies for the use of ethanol as a source of energy because those subsidies benefits corn farmers in their state.

Extra Economics in Your Life & Career: Can Economic Growth in China Affect You? Question: China has enjoyed higher economic growth for the last decade than has the United States.

How can China’s rapid economic growth affect your welfare (assuming you live in the United States)?

Answer: The fact that China is experiencing rapid economic growth allows firms located in China to manufacture more products at a lower cost. So, consumers in the United States are able to buy lowerpriced imports from China, while growing prosperity in China will encourage consumers and firms to buy Extra AN INSIDE LOOK News Article to Use in Class more Unitedproducts from other countries, including the United States. Some firms and workers in the States will be made worse off if these close as aarticles. result of competition from Chinese firms.

Visit Pearson’s MyLab Economics forfirms current news

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Solutions to End-of-Chapter Exercises Economic Growth over Time and around the World

21.1

Learning Objective: Define economic growth, calculate economic growth rates, and describe global trends in economic growth.

Review Questions 1.1

1.2

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

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

Problems and Applications 1.3

1.4

GDP Shiue in 2019.and Keller’s finding of the importance of market efficiency in explaining long-run economic growth supports North’s argument that a government can promote economic growth by protecting private property rights, as the British government did begin with the Glorious Revolution of 1688.

The annual rate of economic growth is calculated as the percentage change in real GDP from the previous year. For example, the rate of economic growth for Mexico in 2018 equals: [(4,632 – 4,553)/4,553] × 100 = 1.74 percent. The average annual growth rateAnnual between 2018 and 2020 Average Growth Rate Country 2018 2019 2020 is –0.04% –8.68% Mexico 1.74% calculated as the simple average of the growth rates for each year.–2.33% 1.48% –8.33% –1.68% France 1.82% 5.22% –3.50% 1.93% United States 4.08% a. During 2018, the United States experienced the highest economic growth rate of 4.08 b

percent. .

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

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

Andover Bank Lowell Bank

Value of CD at End of Year 2022 2023 2024 $1,050.00 $1,102.50 $1,157.63 $1,020.00 $1,081.20 $1,156.88

1.6 Year 2016 2017 2018 2019 2020

Real GDP per Capita (2009 prices) $54,861 55,790 57,158 58,113 55,802

Annual Growth Rate — 1.69% 2.45 1.67 –3.98

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

1.7

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

1.8

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

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21.2

What Determines How Fast Economies Grow?

Learning Objective: Use the economic growth model to explain why growth rates differ across countries.

Review Questions 2.1

2.2

2.3

2.4

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

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

New growth theory is a model of long-run economic growth that emphasizes the effect of economic incentives on technological change, which is determined by the working of the market system. The Solow growth theory does not seek to explain what determines technological change, but instead assumes that technological change occurs because of chance scientific discoveries.

The new growth theory, besides seeking to explain factors that influence technological change, incorporates knowledge capital. Investments in knowledge capital result in increasing returns, unlike increases in physical capital, which are subject to diminishing returns.

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

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Problems and Applications 2.5

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

2.6

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

2.7

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

2.8

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

2.9

a. False, because technology is assumed constant along a given per-worker production function.

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

2.10

2.11

2.12

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

The Soviet Union’s growth strategy of pursuing very high rates of investment ran into the problem of diminishing returns to capital. There was little emphasis on technological change, which meant that the capital stock was increasing much more rapidly than technology.

Continuing rapid increases in capital per hour worked led only to diminishing increases in output per hour worked. With these diminishing returns, the growth rate of real GDP per capita in the Soviet Union stagnated. a. The success that Greenspan and Wooldridge are referring to is the sustained growth in labor productivity and real GDP per capita over many decades. Creative destruction played a major role in U.S. economic growth because a majority of growth can be attributed to the introduction and the adoption of new technology. Inventions such as the steam engine, electrification, telephones, and airplanes increased both productivity and the standard of living, while investment in universities and research institutions accelerated the rate of technological change that further contributed to more rapid growth rates.

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CHAPTER 21 | Long-Run Economic Growth: Sources and Policies b. While creative destruction leads to a country’s success, not everyone benefits from it. The introduction of new technologies and new products disrupts existing industries. For example, many people who built horse-drawn wagons and carriages lost their jobs when the automobile became widely available. Today, the introduction of robots and other new technologies have changed the way many products are made. For example, employment in the automobile industry has declined as companies have replaced workers with robots on their assembly lines.

2.13

a.

In Romer’s new growth theory, he argues that the accumulation of knowledge capital is a key determinant of economic growth. He notes that the accumulated knowledge, or stock of knowledge, of a country is more important than are the country’s natural resources.

Therefore, the more people there are, the more likely it is that additional knowledge will be accumulated, increasing the rate of economic growth.

b.The existence of the Portuguese, or of people in general, is more important in Romer’s new growth theory than in Solow’s original growth model. Although economic growth is dependent on technological change in both models, Solow’s model does not explain what causes technological change. The greater knowledge that is accumulated as a result of having more people helps to explain growth in Romer’s model but is not explicitly considered in Solow’s model.

21.3 Economic Growth in the United States

Learning Objective: Discuss fluctuations in productivity growth in the United States.

Review Questions 3.1

3.2

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

Some economists are optimistic that the increase in productivity that began in the mid-1990s from advances believe in information and communication technology will continue. These economists high rates of growth will come from higher productivity in the information technology (IT)

sector itself and in other sectors of the economy as the result of progress that IT advances made possible. Other economists argue that the IT revolution is now having a greater effect on consumer products, such as smartphones and tablets, than on labor productivity. These Problems and Applications economists also identify other factors ⸻such as an aging population, declining The growth rates would be lower if they were calculated for real GDP per capita instead of 3.3 educational per hour worked because the number of hours worked per person in the United States has achievement, and years the consequences increased regulations higher taxes⸻that decreased in the since 1800. of The denominator in theand expression for real GDP will per lead to capitaproductivity has increased morerates thancontinuing has the denominator in the expression for real GDP per lower growth into the future. hour worked.

3.4 Productivity growth enables workers to produce more output, which translates to a higher GDP, holding economiceverything else constant. The columnist noted the connection between overall output (GDP) and changes in productivity. Specific factors (such as advances in technology) can . increase worker productivity and drive economic growth. The second statement is an observation that the columnist does not see any changes coming in the next few years that will push

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productivity growth higher and therefore increase overall economic growth. So, there is a connection between the two observations. However, it is worth noting that many technological breakthroughs that lead to greater productivity and drive economic growth are difficult to predict.

3.5

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

3.6

a. There are benefits derived from Internet searches that affect GDP, but those benefits are probably not measured directly. Finding information more quickly and efficiently than was possible prior to the existence of the Internet results in more time and other resources available to produce new final goods and services. In other words, as the opportunity cost of finding information has declined, more resources have become available to produce additional output that is included in GDP.

3.7

21.4

b. There are measurement problems that could explain why productivity growth has declined in recent years, but some economists have pointed out that similar problems resulted in an underestimate of productivity growth in periods when measured productivity growth was higher. Improvements in technology lead to long-run increases in GDP per capita. If these increases occur, the implication will be that the recent decline in productivity was partly the result of measurement problems.

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

Why Isn’t the Whole World Rich?

Learning Objective: Explain economic catch-up and discuss why many poor countries have not experienced rapid economic growth.

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Review Questions 4.1

4.2

Increases in the quantity of capital per hour worked and the adoption of new technology should occur at a high rate in poor countries because the profitability of using additional capital or better technology is generally greater in a poor country than in a rich country.

Some poor countries have been catching up to rich countries, but many have not.

Foreign direct investment (FDI) occurs when a firm builds or purchases a facility in a foreign country. bonds Foreign portfolio investment occurs when an individual or a firm buys stocks or issued in another country. Foreign direct investment can give low-income countries access

4.3

to better technologies, as when a Japanese firm builds a clothing factory in Vietnam. Foreign portfolio investment can give a low-income country access to funds that otherwise would not be available, as when investors in the United States buy stock in a firm in Kenya.

Globalization is the process of countries becoming more open to foreign trade and

Problems and Applications 4.4

4.5

investment.

The catch-up effect predicts that countries with a lower level of GDP per capita will grow faster than countriescan withhelp a higher level of country GDP per capita. table, the data for saving Botswana, Globalization a developing break outIn ofthe a vicious cycle of low and Ireland, and the United States are consistent with the catch-up prediction because Botswana’s GDP per investment and low growth by providing access to funds and technology from foreign capita in 1960 was the lowest and its growth between 1960 and 2019 was the highest, while direct Ireland’s GDP per capita and growth rate in 1960 were between that of Botswana and the United investment portfolio investment.

States.

The and dataforeign for other countries, however, is not consistent with the catch-up prediction. For example, Uganda and Madagascar should have grown faster than Ireland and the United States, but they grew more slowly. a. No, these data do not support the catch-up prediction. The countries with the highest initial levels of real GDP per capita have growth rates of real GDP per capita similar to the countries with average initial levels of real GDP per capita. b. Yes, these data support the catch-up prediction. The countries with the lowest initial levels of real GDP per capita have the highest growth rates of real GDP per capita, and the countries with the highest initial levels of real GDP per capita have the lowest growth rates of real GDP per capita. c. No, these data do not support the catch-up prediction. The countries have roughly the same growth rates of real GDP per capita regardless of their initial levels of real GDP per capita.

4.6

a. The horizontal line in Graph 1 matches the experience of all countries, indicating that most of the world hasn’t been catching up. b. The slight upward-sloping line in Graph 3 matches the experience of Western Europe, Canada, and Japan, indicating that these high-income countries have stopped catching up to the United States. c. The downward-sloping line in Graph 2 matches the experience of current high-income countries, indicating that there has been catch-up among high-income countries.

4.7

a. Adopting “thoroughgoing innovation” means the country adopts the latest technology throughout its economy. Getting within “hailing distance of the West” means reaching a

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standard of living close to that of the countries of Western Europe, the United States, and Canada. b. No. Real GDP per capita in Haiti in 2069 would equal $1,245 × (1.065)50 = $29,017 which is c. below but Italy’s real GDP per capita in 2019 of $35,680. Haiti did gain substantial ground remains behind Italy even after two generations.

Failure to enforce the rule of law, wars and revolutions, poor systems of public education

4.8

and health, and low rates of saving and investment can prevent low-income countries from a. adopting widespread innovation. Even if a low-income country adopts widespread innovation, these same factors can prevent the country from achieving high rates of economic growth.

The article is referring to real GDP, not nominal GDP, because economists, b.

policymakers, journalists are typically referring to changes in real GDP when they discuss c. and growth.

Because changes in nominal GDP are partly the result of changes in the price level, they are not are as good an indicator of changes in a country’s production of goods and services as changes in real GDP. More slowly. Real GDP per capita will grow more slowly than the real GDP, as long 4.9

a. as a country is experiencing population growth.

Based on parts (a) and (b) and assuming that the Mexican central bank’s forecast is accurate, Mexican percent real GDP per capita definitely fell if population grew more rapidly than 1.8 in 2019 and definitely rose if population grew more slowly than 0.8 percent. The b.

central bank’s more forecast gives a range of possible increases in real GDP, so it isn’t possible to be specific. In fact, the population of Mexico was forecast to grow about 1 percent during

4.10

a.

2019.

So, GDPwhether real GDP per capita rose or fell depends on where actual growth in real ended up within the forecast range.

Goldman Sachs is an investment banking firm that specializes in raising funds for businesses through stock and bond offerings and also investing money for its clients. Therefore, the

b. analyst knows that government policies that encourage investment, both domestic and foreign, will result in higher economic growth rates. Specifically, foreign direct investment (FDI) is one of the easiest ways for a nation to gain access to technologies that increase . productivity and drive economic growth.

If Mexico adopted policies that encouraged FDI, it could increase its rate of economic growth.

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CHAPTER 21 | Long-Run Economic Growth: Sources and Policies inequality. As mentioned in the answer to part (a), critics believe that globalization, by promoting free trade and foreign investment, threatens to destroy the distinctive cultures of developing countries by replacing domestically produced goods with goods imported from foreign markets.

4.11

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

4.12

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

21.5 Growth Policies

Learning Objective: Discuss government policies that foster economic growth.

Review Questions 5.1

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

5.2

Economic growth is associated with higher living standards, improved health, improved working conditions, and longer life expectancy. However, some critics argue that economic growth has

contributed to income inequality, global warming, deforestation, and other environmental problems. Because it is a normative matter, economic analysis cannot settle the question of Problems andcontinued Applications whether economic growth will always improve economic well-being.

5.3

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

Taxing incomes does reduce the return to working (and saving and investing), but the effect on employment is smaller.

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c. A tax perk is a decrease in a firm’s tax obligation. Firms that receive tax perks are more likely to grow and expand than are firms that don’t receive tax perks because the return on investing in firms receiving tax perks is greater. Levy is assuming that the productivity of small firms is lower than the productivity of large firms, so favoring small firms with tax perks is likely to reduce the growth of the Mexican economy. d. Contract enforcement implies that agreements made by individuals and firms should be binding, and individuals and firms that do not fulfill their end of the bargain will face repercussions. Contract enforcement improves economic growth because the market becomes more efficient as individuals and firms take advantage of gains from trading with other people that they do not know. Without contract enforcement, individuals and firms would be reluctant to enter into an agreement, particularly a long-term agreement, with another individual or firm because they could not rely on the agreement being carried out.

5.4

5.5

China’s investment in residential housing will increase economic growth in the short run because construction of the housing employs labor and consumes building materials that may be manufactured in China. However, after the housing is built it is not used to produce other goods and services (other than providing shelter for its occupants). In contrast, investment in infrastructure, factories, equipment, and research and development does boost productivity in the long term if it is utilized. a. The rule of law refers to the ability of a government to enforce the laws of the country, particularly with respect to protecting property rights and enforcing contracts. b. Without the rule of law, particularly rules that protect property rights, the market cannot operate efficiently. If laws are not well enforced, buyers and sellers are hesitant to participate in market transactions for fear that they may be cheated in the transaction. Owners of firms are less likely to invest in their firms’ growth and expansion if they fear their firms may be confiscated by the government or they are forced to pay bribes to government officials. Firms may also be reluctant to enter into the long-term agreements that are essential to the operation of market economies if they do not have confidence in the agreements being enforceable in court. c. Neither China today nor the Soviet Union during the period before its collapse followed the rule of law. In both cases, the government made arbitrary decisions that affected businesses and businesses could not expect to necessarily receive impartial justice from the court system.

(In fact, the Soviet government allowed few private businesses to operate.) Both China and the Soviet Union achieved high rates of economic growth during the period in which large fractions of their populations moved out of lower-productivity agricultural occupations and into higher-productivity non-agricultural occupations. Both countries also benefited from increasing rapidly what had been very low levels of capital per hour worked. The failure to follow the rule of law and allow for property rights contributed to the eventual stagnation of Soviet economic growth and contributed to the collapse of the government. Whether China can successfully maintain high rates of economic growth without more fully establishing the rule of law remains to be seen.

5.6

a. The passage of an investment tax credit is likely to increase the rate of economic growth in the United States because the credit will give firms incentives to purchase more capital, thereby increasing the capital to labor ratio (K/L). In addition, if some of the new capital embodies new technologies, the tax credit may contribute to shifting the U.S. production function upward. b. Shortening the period of patent protection will decrease the incentive to invest in research and development because the length of time that a firm can have to recoup its investment declines

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CHAPTER 21 | Long-Run Economic Growth: Sources and Policies as well. The shorter period of patent protection will therefore decrease the amount of new technology that the country generates and will result in a decline in labor productivity and the rate of economic growth. c. Increasing education funds will result in a more educated workforce. More education increases productivity per worker and will increase economic growth.

5.7

5.8

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

These are funds that are donated by foreign countries that do not need to be repaid. He may also be referring to aid that helps develop infrastructure projects, such as roads, bridges, and dams. b. African countries need investment in new firms and in the expansion of existing firms.

Foreign portfolio investment can provide funds that African firms need to expand. Foreign direct investment can provide African countries with access to current technology as foreign firms build new factories and other facilities in African countries. As we’ve seen, economic growth depends on increasing the amount of capital per hour worked and on technological change. Traditional foreign aid programs have not had much success in raising African growth rates, which is why Adesina believes that investment is a better approach.

5.9

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

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

D21.1 a. Output per hour for all persons in the manufacturing sector in the United States was 44.437 in the first quarter 1987 and 97.53 in the first quarter of 2021. Output per hour for all persons in the non-farm business sector was 58.132 in the first quarter of 1987 and 112.729 in the first quarter of 2021. b.Labor productivity in manufacturing increased by 119.48 percent from 1987 to the first quarter of 2021. Labor productivity increased by 93.92 percent in the non-farm business sector from 1987 to first quarter of 2021.

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c. If the trend in other advanced countries is similar to that of the United States, labor productivity in these countries will decline in the future as the manufacturing sector shrinks relative to other industry sectors.

Using estimates for 2019, the country with the highest real GDP (purchasing power parity) was China at $22.53 trillion, and the country with the lowest real GDP (purchasing power parity) was Tuvalu at $49 million (Niue, Tokelau, and Saint Helena, Ascension and Tristan da Cunha were excluded because their GDPs were for earlier years).

Using estimates for 2019, the country with the highest per capita real GDP (purchasing power b. parity) was Macau with $123,965 (Note: Liechtenstein was higher with $139,100, but the estimate was for 2009), and the countries with the lowest per capital real GDP (purchasing power parity) was Burundi with $752.

The country with the most equal income distribution was Belarus with a Gini index of 25.2 c. (the latest value is for 2018), and the country with the least equal income distribution was Brazil with a Gini index of 53.9 (the latest value is for 2018). If you use 2014 estimates, then South Africa has the least income equality with a Gini index of 63.0 and Jersey has a Gini index of 0.3 indicating almost perfect income equality. If income were distributed with perfect equality, the Gini index would equal zero and if income were distributed with perfect inequality the Gini index would equal 100.

D21.2 a.

Using estimates for 2017, the country with the highest real GDP growth rate was Libya at 64 d. percent, and the country with the lowest real GDP growth rate was Venezuela at −19.67 percent (2018 estimates) (Note: Syria has a lower real GDP growth rate at 36.5 percent, but the estimate was for 2014.)

The United States had the second highest real GDP (purchasing power parity) among e. countries, the fifteenth highest per capita real GDP (purchasing power parity) at $62,530, the fifty-fourth least equal income distribution (41.1 for 2016), and the one hundred-thirtieth highest real GDP growth rate at 2.16 percent (2017 estimate).

Suggestions for Critical Thinking Exercises CT21.1 Answers may vary. Some answers that students may come up with are: cellular phones replacing landline phones; MP3 players replacing cassette and CD-players; Google searches replacing dictionaries and library visits; and streaming videos replacing video rental.

CT21.2 a. You should disagree. Moldova’s economy today is not heavily industrialized like the economy of the Soviet Union was in the 1980s. Given the low levels of capital in Moldova today, additional investments in more machinery and factories will increase their economy’s growth. b. Please refer to the following figure. Point A illustrates Moldova’s position before investments in machinery and factories. With its lower level of capital per worker, Moldova’s investment in capital moves up in the production function to point B, where the country experiences a large increase in the real GDP per hour worked. Point C illustrates the Soviet Union’s position before investments in machinery and factories. With its higher level of capital per worker, the Soviet Union’s investment in capital moves up in the production function to point D, where the country experiences a small increase in the real GDP per hour worked.

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

CT21.3 a. Please refer to the following figure.

Source: Statista.com b. No, the data above do not exhibit convergence or catch-up in income levels. New York and California have a high real GDP per capita level in 2018, yet they have a higher real GDP per capita growth rate than all the low-income states. Similarly, Arkansas and South Carolina have low real GDP per capita levels, yet their GDP per capita growth rates are much lower than all of the higher-income states. c. To more accurately test if states are catching up, we need to know about the economies of each state and group together those states with similar economic profiles. For example, states whose economies rely predominantly on agriculture should be grouped separately from states that have GDPs that rely mostly on manufacturing. To complete this grouping, we may need additional states in our sample. Adding more states will allow us to test if low-income states converge in income with high- income states with similar economic profiles.

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CHAPTER 22 | Aggregate Expenditure and Output in the Short Run Brief Chapter Summary and Learning Objectives The Keynesian income-expenditure approach (the “45°-line diagram” or “Keynesian cross”) is useful to introduce students to the short-run relationship between spending and production. Many instructors, however, prefer to omit this material. Therefore, the textbook uses the 45°-line diagram only in this chapter, “Aggregate Expenditure and Output in the Short Run.” The discussion of monetary and fiscal policy in later chapters uses only the AD-AS model, making it possible for instructors to skip this chapter.

22.1 The Aggregate Expenditure Model Explain how macroeconomic equilibrium is determined in the aggregate expenditure model.

▪ The aggregate expenditure model describes the relationship between total spending and real

GDP in the short run, assuming the price level is constant.

22.2 Determining the Level of Aggregate Expenditure in the Economy Discuss the determinants of the four components of aggregate expenditure and define marginal propensity to consume and marginal propensity to save.

▪ The most important determinant of consumption is the disposable income of households.

Investment spending, unlike consumption, does not follow a smooth upward trend.

22.3 Graphing Macroeconomic Equilibrium ° diagram to illustrate macroeconomic equilibrium.

Use a 45-line ▪ The 45°-line diagram shows all the points where aggregate expenditure equals real

GDP. Macroeconomic equilibrium occurs where the line representing aggregate expenditure crosses the 45°-line.

22.4 The Multiplier Effect Describe the multiplier effect and use the multiplier formula to calculate changes in equilibrium GDP. ▪ An autonomous change in expenditure causes rounds of induced changes in expenditure. An

autonomous change in expenditure will have a multiplier effect on equilibrium GDP.

22.5 The Aggregate Demand Curve Understand the relationship between the aggregate demand curve and aggregate expenditure.

▪ The aggregate demand curve shows the relationship between the price level and the level

of aggregate expenditure, holding constant all factors that affect aggregate expenditure other than the price level.

Appendix: The Algebra of Macroeconomic Equilibrium Apply the algebra of macroeconomic equilibrium.

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Key Terms Consumption function The relationship between consumption spending and disposable income.

Aggregate demand (AD) curve A curve that shows the relationship between the price level and the level of planned aggregate expenditure in the economy, holding constant all other factors that affect aggregate expenditure.

Inventories Goods that have been produced but not yet sold.

Marginal propensity to consume (MPC) The slope of the consumption function: The amount by which consumption spending changes when disposable income changes.

Marginal propensity to save (MPS) The amount by which saving changes when disposable income changes.

Aggregate expenditure (AE) Total spending in the economy: the sum of consumption, planned investment, government purchases, and net exports.

Aggregate expenditure model A macroeconomic model that focuses on the shortrun relationship between total spending and real GDP, constant.assuming that the price level is

Multiplier The change in equilibrium real GDP divided by the increase in autonomous expenditure.

Autonomous expenditure An expenditure that does not depend on the level of GDP. Cash flow The difference between the cash revenues received by a firm and the cash spending by a firm.

Multiplier effect The process by which a change in autonomous expenditure leads to a larger change in real GDP.

Chapter Outline Glamping and Airstream’s Ride on the Business Cycle Many cities and counties are affected by the swings in economic activity caused by the business cycle, but few experience the cycle like Elkhart County, Indiana, where more than 80 percent of the recreational vehicles (RVs) sold in the United States are manufactured. RVs are expensive and because they get low gas mileage, they’re more costly to operate than are cars or pickup trucks. The result is that RV manufacturers are particularly vulnerable to the business cycle. Because of the concentration of RV companies and their suppliers in Elkhart, the county depends more on manufacturing than most other counties in the country. As a result, unemployment in the county fluctuates widely during the business cycle. Unemployment in Elkhart County rose from a low of 3.9 percent in May 2007 to a high of 20 percent in March 2009, which was one of the highest rates in the country, and then fell to as low as 2.1 percent in 2018.

The arrival of the Covid-19 pandemic brought the strong labor market in Elkhart to an abrupt halt.

With production of RVs shut down to help contain the virus, the unemployment rate in Elkhart soared to 28.6 percent. Once factories reopened, unemployment declined. By December 2020, the unemployment rate in Elkhart was back down to 3.4 percent. The recession caused by the Covid-19 pandemic was unusual in that changes in total spending, or aggregate expenditure, played a smaller role in explaining fluctuations in keyproduction and unemployment than is typically true. Usually, aggregate expenditures do play the .

role in the business cycle, so in this chapter we’ll explore the link between aggregate expenditures and

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22.1

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

Aggregate expenditure (AE) is total spending in the economy: the sum of consumption, planned investment, government purchases, and net exports. The aggregate expenditure model is a macroeconomic model that focuses on the short-run relationship between total spending and real GDP, assuming that the price level is constant. The key idea of the model is that in any particular year, the level of GDP is determined mainly by the level of aggregate expenditure.

A. Aggregate Expenditure In 1936, John Maynard Keynes published The General Theory of Employment, Interest, and Money, a book that analyzed the relationship between changes in aggregate expenditure and changes in GDP. Keynes identified these four components of aggregate expenditure that together equal GDP: 1. Consumption (C) 2. Planned investment (I) 3. Government purchases (G) 4. Net exports (NX) We can write: Aggregate expenditure = Consumption + Planned investment + Government purchases + Net exports or: AE = C + I + G + NX.

B. The Difference between Planned Investment and Actual Investment Inventories are goods that have been produced but not yet sold. For the economy as a whole, we can say that actual investment spending will be greater than planned investment spending when there is an unplanned increase in inventories. Actual investment spending will be less than planned investment spending when there is an unplanned decrease in inventories. Actual investment will equal planned investment only when there is no unplanned change in inventories.

C. Macroeconomic Equilibrium For the economy as a whole, macroeconomic equilibrium occurs where aggregate expenditure equals total production, or GDP: Aggregate expenditure = GDP.

D. Adjustments to Macroeconomic Equilibrium When aggregate expenditure is greater than GDP, inventories will decline and GDP and total employment will increase. When aggregate expenditure is less than GDP, inventories will increase, and GDP and total employment will decrease. Only when aggregate expenditure equals GDP will firms sell what they expected to sell. In this case, their inventories will be unchanged, and firms will not have an incentive to increase or decrease production. The economy will be in macroeconomic equilibrium.

When economists forecast that aggregate expenditure is likely to decline, the federal government may implement macroeconomic policies in an attempt to head off the fall in expenditure and keep the economy from falling into recession.

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Teaching Tips It will help your students understand macroeconomic equilibrium if you briefly review how equilibrium is achieved in a market for a good or service. Remind students that if there’s a shortage or surplus in the market for a good or service, the price adjusts to return a market to equilibrium. In contrast, in the aggregate expenditure model, prices are constant and changes in inventories adjust to return the macroeconomy to equilibrium.

The end of the chapter in the main text includes Real-Time Data (RTDA) Exercises. These exercises are well worth assigning and discussing in class because they help students become familiar with a key data source, learn how to locate data, and develop skills in interpreting data. The exercise allows students and instructors to use the very latest data from the Web site of the Federal Reserve Bank of St. Louis (FRED). This and other RTDA exercises found in the textbook require more elaborate calculations than other problems and the use of Excel spreadsheets.

Extra Apply the Changes in Inventory Spending during the 2007 - 2009 Great Concept Recession Previewed Future GDP Growth Changes in inventories are a small part of total gross domestic product. In 2020, for example, the real value of changes in private inventories equaled −$42.3 billion, less than one-quarter of one percent of GDP (in absolute value). Nevertheless, inventory changes are often an important indicator of the future direction of GDP. In all recessions, as consumer spending slows, firms become reluctant to order new goods, so firms sell from their inventories. With consumer demand uncertain, inventories fell for eight straight quarters during and immediately after the 2007–2009 recession⸻the longest such decline in the United States since 1948. Spending on inventories finally began to rise in the second quarter of 2010 (see the following table).

Change in Inventories (billions of dollars, seasonally adjusted at annual rates) 2009 2010 2011 IV I II III IV I II III IV I II III −179.5 110.4 −228.3 −245.1 −56.8 −5.0 33.3 128.8 71.3 −17.7 72.1 32.8 When businesses increase production to build their inventories, employment increases. As workers earn more income, they spend more, leading to an increase in consumption, which is the largest component of GDP. “That’s how recoveries become self-sustaining,” said Dean Maki, then chief U.S. economist at Barclays Capital. In fact, growth of real GDP began to increase in the third quarter of 2009, though only at a meager 1.7 percent (see the following table). The recession of 2007–2009 officially ended in June 2009, so the third quarter of 2009 marked the beginning of the business cycle expansion that followed.

I −4.6

2009 II III −0.7 1.5

Percentage Change in Real GDP (seasonally adjusted at annual rates) 2010 IV I II III IV I 4.3 2.0 3.9 3.1 2.1 −1.0

2011 II III 2.7 −0.2

IV 4.6

Data from U.S. Bureau of Economic Analysis

The increase in inventories coincided with increases in the growth rate of real GDP. But GDP growth stalled in 2011, falling 1.0 percent in the first quarter, leading some to wonder if the economy was

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heading to another recession. These fears faded by the end of 2011 as GDP increased in the fourth quarter at an annual rate of 4.6 percent. Analysts were encouraged by the fact that spending on inventories increased in that quarter. This increase was consistent with firmness in consumer spending and optimism among firms that the economy would continue expanding.

Sources: Kelly Evans, “After the Tape: Don’t Ignore the Inventory Effect on GDP,” Wall Street Journal, January 29, 2010; Lucia Mutikani, “Third-Quarter Growth Cut on Weak Inventories,” Reuters, November 22, 2011; and U.S. Bureau of Economic Analysis.

Extra Solved Problem 22.1 Ace Computers and Aggregate Expenditure Ace Computers, Inc., produces high-performance servers, computers, and workstations for government agencies, firms, and households. Some of Ace’s sales are to Canada. Suppose the company produces $500 million of new computers in 2021. The following table represents three different scenarios for Ace Computers’ sales.

Sales to:

Scenario 1

Scenario 2

Scenario 3

U.S. Households U.S. Private firms U.S. Government Canada Total sales

$200 million 50 million 100 million 100 million $450 million

$250 million 50 million 100 million 100 million $500 million

$300 million 50 million 100 million 100 million $550 million

a. What is the contribution of Ace Computers to GDP for 2021 under each of the three scenarios? b. Based on the sales figures, predict how Ace Computers would change its rate of output in 2022 in each of the three scenarios. c. Use this example to describe how macroeconomic equilibrium is achieved in the aggregate expenditure model.

Solving the Problem Step 1:

Review the chapter material.

This problem is about aggregate expenditure, so you may want to review the section “The Aggregate Expenditure Model” in the textbook.

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Answer part (a) by explaining Ace Computer’s contribution to GDP for 2021 under each of the scenarios. Ace Computers’ sales contribute to consumption (C, sales to households); planned investment (I, sales to private firms); government purchases (G); and net exports (NX). In addition, unplanned investment (I) occurs when there are changes in inventories.

Scenario 1 Scenario 2 Scenario 3 C $200 million $250 million $300 million 50 million I 50 million 50 million G 100 million 100 million 100 million NX 100 million 100 million 100 million $450 million $500 million $550 million Total expenditures $0 million −$50 million Change in inventories +$50 million $500 million Contribution to GDP $500 million $500 million Total expenditures on Ace Computers are $450 million, $500 million, and $550 million in Scenarios 1, 2, and 3, respectively. The contribution of Ace Computers to GDP in 2021 is equal to $500 million in each scenario.

Step 3:

Answer part (b) by using the sales figures to predict how Ace Computers would change its In Scenario 1, Ace will likely decrease rate of output in 2022 in each of the three scenarios. its rate of output in 2022 because sales were only $450 million. The firm may want to sell the $50 million of computers produced, but not sold, before producing more computers in 2022.

In Scenario 2, there is no reason why Ace would change its rate of output from 2021 to 2022 because Ace sold exactly what it produced. In Scenario 3, the sales of Ace Computers exceeded what was produced in 2021 (sales in 2021 included $50 million worth of computers produced in 2020), so it will likely increase its rate of output in 2022.

Answer part (c) by using the Ace Computers example to describe how macroeconomic

Step 4: When for a given time equilibrium is achieved in the aggregate expenditure model. period⸻macroeconomic equilibrium is achieved when total spending, or aggregate expenditure, for the entire economy equals total production, or GDP. There is no unplanned change in investment in inventories, and firms will not change their rates of output in the future. This is consistent with Scenario 2.

Extra Apply the Do Changes in Housing Wealth Affect Consumption Spending?

Concept From 2000 to 2006, housing prices increased sharply in many parts of the United States. The following figure shows the S&P/Case-Shiller index of housing prices, which represents changes in the prices of single-family homes. As measured by this index, housing prices increased nearly 90 percent between the beginning of 2000 and the beginning of 2006. Housing prices then declined over 30 percent between the beginning of 2006 and the beginning of 2009. Housing wealth equals the market value of houses minus the value of loans people have taken out to pay for the houses. For example, someone who owns a house with a market price of $200,000 and who has a mortgage of $150,000 would have housing wealth of $50,000. Between 2000 and 2005, total housing wealth increased by about $5.5 trillion before falling by $7.0 trillion through mid-2011.

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Data from S&P/Case-Shiller, standardandpoors.com.

Did these big swings in housing wealth affect consumption spending? Economists are divided in their opinions. Charles Calomiris of Columbia University, Stanley Longhofer of the Barton School of Business, and William Miles of Wichita State University argued that changes in housing wealth have little or no effect on consumption. They argued that consumers do not consider houses to be assets similar to their holdings of stocks and bonds because they own houses primarily so they can consume the housing services a home provides. Only consumers who intend to sell their current house and buy a smaller one— for example, “empty nesters” whose children have left home—will benefit from an increase in housing prices. But taking the population as a whole, the number of empty nesters may be smaller than the number of first-time home buyers plus the number of homeowners who want to buy larger houses. These two groups are hurt by rising home prices. Although it appears that consumption increases when housing prices increase, in fact, increases in income are responsible for both the increases in housing prices and the increases in consumption; increases in housing prices have no independent effect on consumption.

(This is an example of the omitted variable problem discussed in the appendix to Chapter 1.)

Atif Mian and Amir Sufi, both of the University of Chicago, strongly disagreed with Calomiris, Longhofer, and Miles. Mian and Sufi tracked a sample of 70,000 consumers from 1998 to 2008 and found that consumers living in cities that experienced dramatic increases in housing prices borrowed heavily as their housing wealth increased. Consumers used these borrowed funds to increase their spending on goods and services.

Mian and Sufi believed that the sharp decline in consumption spending in 2008—the largest since 1980— occurred because falling housing prices resulted in lower housing wealth and lower consumer borrowing to finance spending. The debate over the effect of changes in housing wealth on consumption spending illustrates an important fact about macroeconomics: Many macroeconomic variables, such as GDP, housing prices, consumption spending, and investment spending, rise and fall at about the same time during the business cycle. Because many macroeconomic variables move together, economists sometimes have difficulty determining whether movements in one variable are causing movements in another variable.

Sources: Atif R. Mian and Amir Sufi, “House Prices, Home Equity–Based Borrowing, and the U.S. Household Leverage Crisis,” American Economic Review, Vol. 101, No. 5, August 2011, pp. 2132–2156; Atif Mian and Amir Sufi, “Housing Bubble Fueled Consumer Spending,” Wall Street Journal, June 25, 2009; Charles W. Calomiris, Stanley D. Longhofer, and William Miles, “The

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(Mythical?) Housing Wealth Effect,” National Bureau of Economic Research Working Paper 15075, June 2009; and Charles W. Calomiris, Stanley D. Longhofer, and William Miles, “The (Mythical?) Housing Wealth Effect,” Wall Street Journal, June 22, 2009.

Question Writing about the state of the British economy in 2009, an article in the Economist argued: “Spending will be hit...by weak stock-markets and shrinking housing wealth.” Would Calomiris, Longhofer, and Miles agree with this argument? Would Mian and Sufi? Briefly explain.

Economist, January 8, 2009.

Source: “Combating the Recession,”

Answer Calomiris, Longhofer, and Miles would disagree with this argument because they believe that changes in housing wealth have little or no effect on consumption. They believe that increases in income are responsible for increases in housing prices and increases in consumption, while increases in housing prices have no independent effect on consumption. Mian and Sufi would agree with the argument. They believe that the sharp decline in consumption spending in 2008 occurred because falling housing prices resulted in lower housing wealth and lower consumer borrowing to finance spending.

22.2

Determining the Level of Aggregate Expenditure in the Economy Learning Objective: Discuss the determinants of the four components of aggregate expenditure and define marginal propensity to consume and marginal propensity to save.

There are four components of aggregate expenditure. Each component is measured in Consumption is the largest component of aggregate expenditure.

real terms.

A. Consumption The following are the five most important variables that determine the level of consumption: 1. Current disposable income 2. Household wealth 3. Expected future income 4. The price level 5. The interest rate The consumption function is the relationship between consumption spending and disposable income.

The marginal propensity to consume (MPC) is the slope of the consumption function: The amount by which consumption spending changes when disposable income changes. We can write the expression for the MPC as: MPC=

C . = Change in disposable income  YD Change in consumption

B. The Volatility of Consumer Spending on Durables Spending on durable goods like cars and RVs is volatile for the following five reasons: 1. Durable goods are long-lived, so households can often postpone buying a new one.

2. Good substitutes exist. Used durables are often good substitutes for new durables.

3. High prices make them risky purchases, especially if households fear that they may lose their jobs in a recession.

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4. Pent-up demand following recessions, since many households postpone purchasing durables during a recession.

5. Fluctuating interest rates. Many households borrow to purchase durables and interest rates typically rise late in an economic expansion before declining during and immediately after a recession has ended.

C. The Relationship between Consumption and National Income Consumption spending by households depends on disposable income, but we want to focus on the relationship between consumption spending and GDP. The difference between GDP and national income is small and can be ignored. Disposable income is equal to national income plus transfer payments minus taxes. Taxes minus transfer payments are equal to net taxes so we can write: Disposable income = National income – Net taxes.

This equation can be rearranged as: National income = GDP = Disposable income + Net taxes.

D. Income, Consumption, and Saving For the economy as a whole: National income = Consumption + Saving + Taxes.

When national income increases, there must be a combination of increases in consumption, saving, and taxes: Change in national income = Change in consumption + Change in saving + Change in taxes.

Using symbols, where Y represents national income (and GDP), C represents consumption, S represents saving, and T represents taxes, we can write: Y = C + S + T, And:

ΔY = ΔC + ΔS + ΔT.

We can assume that taxes are always a constant amount, so the following is also true: ΔY = ΔC + ΔS. The marginal propensity to save (MPS) is the amount by which saving changes when disposable income changes. If we divide the previous equation by ΔY, we get: , Or: 1 = MPC + MPS. This equation tells us that when taxes are constant, the marginal propensity to consume plus the marginal propensity to save must always equal 1.

E. Planned Investment The four most important variables that determine the level of investment are as follows: .

CHAPTER 22 | Aggregate Expenditure and Output in the Short Run 1 .

2 .

3 .

4.

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Expectations of future profitability The interest rate Taxes: The federal government imposes a corporate income tax on the profits corporations earn, including profits from the new buildings, equipment, and other investment goods they purchase. A reduction in the corporate income tax increases the after-tax profitability of investment spending.

Investment tax incentives also increase investment spending. Cash flow: Cash flow is the difference between the cash revenues received by a firm and the cash spending by the firm.

F. Government Purchases Total government purchases include all spending by federal, state, and local governments for goods and services.

G. Net Exports Net exports equal exports minus imports. The following are the three most important variables that determine the level of net exports: 1. The price level in the United States relative to the price levels in other countries.

2. The growth rate of GDP in the United States relative to the growth rates of GDP in other countries.

3. The exchange rate between the dollar and other currencies.

22.3 Graphing Macroeconomic Equilibrium

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

We can use a 45°-line diagram to illustrate macroeconomic equilibrium. In a graph, the line represents all the points that are equal distances from both axes. Since macroeconomic equilibrium occurs where planned aggregate expenditure equals GDP, we know that all points of macroeconomic equilibrium must lie along the 45° line. We assume that the variables that determine planned investment, government purchases, and net exports all remain constant, as well as the variables other than GDP that affect consumption. The economy is in macroeconomic equilibrium at the level of GDP at which the aggregate expenditure (AE) line crosses the 45° line. At that point, planned aggregate expenditure is equal to GDP.

° A. Showing a Recession on the 45-Line Diagram At potential GDP, firms will be operating at their normal level of capacity, and the economy will be at the natural rate of unemployment. Planned aggregate expenditure must be great enough for equilibrium to occur at the level of potential GDP. If there is insufficient spending, equilibrium will occur at a lower level of GDP and the unemployment rate will be above the natural rate of unemployment. The shortfall in planned aggregate expenditure that leads to a recession can be measured by the vertical distance between the AE line and the 45° line at the level of potential GDP. The shortfall in aggregate expenditures is equal to the unplanned increase in inventories that would occur if the economy were initially producing a level of output equal to potential GDP. The economy will remain at a level of output less than potential GDP until there is an increase in one or more of the components of aggregate expenditure.

B. The Important Role of Inventories Whenever planned aggregate expenditure is less than real GDP, some firms will experience an unplanned increase in inventories. If firms accumulate excess inventories, then even if spending quickly returns to its normal levels, firms will have to sell these excess inventories before they can return to producing at normal levels.

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C. A Numerical Example of Macroeconomic Equilibrium In forecasting real GDP, economists rely on quantitative models of the economy. Table 22.4, “Macroeconomic Equilibrium,” shows several hypothetical combinations of real GDP and planned aggregate expenditure. Macroeconomic equilibrium occurs when the sum of consumption, planned investment, government purchases, and net exports equals GDP.

Teaching Tips As noted previously, your students may better understand macroeconomic equilibrium, as shown in Figures 22.10 through 22.12, if you compare it to an equilibrium in a market for a good or service. To achieve macroeconomic equilibrium, quantities adjust when an economy is not initially in equilibrium.

22.4

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

Any increase in autonomous expenditure will shift up the aggregate expenditure function and lead to a multiplied increase in equilibrium real GDP. Autonomous expenditure is an expenditure that does not depend on the level of GDP. In the aggregate expenditure model, planned investment spending, government spending, and net exports are all autonomous expenditures. Consumption has an autonomous component and an induced component (a component that does depend on the level of GDP).

The multiplier is the increase in equilibrium real GDP divided by the increase in autonomous expenditure.

The multiplier effect is the process by which a change in autonomous expenditure leads to a larger increase in real GDP.

A. A Formula for the Multiplier The general formula for the multiplier is: Change in equilibrium real GDP Multiplier= Change in autonomous expenditure =

1 1 − MPC

.

B. Summarizing the Multiplier Effect There are four key points about the multiplier effect: 1. The multiplier effect occurs both when autonomous expenditure increases and when it decreases.

2. The multiplier effect makes the economy more sensitive to changes in autonomous expenditure than it would otherwise be.

3. The larger the MPC, the larger the value of the multiplier.

4. The formula for the multiplier is oversimplified because it ignores real-world complications, such as the effect that increasing GDP can have on imports, inflation, interest rates, and individual income taxes.

C. The Paradox of Thrift In the short run, if households save more of their income and spend less of it, aggregate expenditure and real GDP will decline. John Maynard Keynes argued that if many households decide at the same time to increase their saving and reduce their spending, they make themselves worse off by causing aggregate expenditure to fall, thereby pushing the economy into a recession. Keynes coined the term “paradox of .

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thrift” to explain how lower incomes in the recession might mean that total saving does not increase ⸻ despite the attempts by many individuals to increase their saving.

22.5

The Aggregate Demand Curve

Learning Objective: Understand the relationship between the aggregate demand curve and aggregate expenditure.

We expect that an increase or decrease in aggregate expenditure will affect both real GDP and the price level. There are three reasons there is an inverse relationship between changes in the price level and changes in aggregate expenditure.

1. A rising price level decreases consumption by decreasing the real value of household wealth; a falling price level has the reverse effect.

2. If the price level in the United States rises relative to the price levels in other countries, U.S. exports will become relatively more expensive, and foreign imports will become relatively less expensive⸻causing net exports to fall. A falling price level in the United States will have the reverse effect.

3. When prices rise, firms and households need more money to finance buying and selling. If the money supply does not increase, the result will be an increase in the interest rate. A higher interest rate will reduce investment spending. A falling price level has the reverse effect.

The aggregate demand (AD) curve is a curve that shows the relationship between the price level and the level of planned aggregate expenditure in the economy, holding constant all other factors that affect aggregate expenditure.

Extra Solved Problem 22.5 Do Price Changes Affect Aggregate Expenditure?

When studying demand and supply, you learn that a price change is considered the most important determinant of the quantity demanded for a good or service. It may seem odd that in discussing the determinants of total spending or aggregate expenditure, the textbook states that the most important determinant of consumption is the current disposable income of households. If changes in price are important determinants of consumption in individual markets, why aren’t they important in determining total consumption expenditures? The key to answering this question is to understand the difference between a relative price change and a change in the price level, or the average of all prices.

In microeconomics, a change in the price of a good or service is a relative price change. For example, if the price of bottled waterfalls, it is assumed that the prices of other goods and services do not change.

Because bottled water becomes less expensive compared to other items, the quantity demanded of water will increase.

In macroeconomics, the focus is not on changes in prices and quantities in individual markets but changes in to the a economy as a whole. Therefore, when there is a change in the price level this does not refer change in one market but in all markets. An increase in the price level of 10 percent means there is no change well. in the relative price of bottled water because all other prices have increased by 10 percent as .

But if current disposable income were to increase by 10 percent, then consumers have more income to

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Changes in aggregate expenditure are related to changes in the price level. Economists use an aggregate demand (AD) curve to analyze this relationship. This curve shows the relationship between the level of planned expenditure and the price level, holding constant other factors such as interest rates and wealth that affect aggregate expenditure. The textbook shows the AD curve as a downward-sloping line, just as the demand curve for a single good or service is drawn as a downward-sloping line.

If the price level were to fall, the AD curve shows there will be an increase in planned aggregate expenditure or real GDP. One reason for this will be an increase in consumption. If relative prices do not fall as the price level falls, what would explain the increase in consumption?

Solving the Problem Step 1:

Step 2:

Review the chapter material.

This problem is about the relationship between the aggregate demand curve and aggregate expenditure, so you may want to review the section “The Aggregate Demand Curve” in the textbook.

Explain why there is an increase in consumption even though relative prices do not fall as The increase in consumption can be explained by the increase in the price level falls. purchasing power consumers experience as a result of a lower price level. (A decline in the price level, or deflation, rarely occurs over a period as long as a year. If the rate of increase in the price level is less in one year than in the previous year, this is called disinflation.) A fixed amount of wealth in the form of homes, stocks, bonds, savings accounts, and other assets will have more purchasing power as the price level falls.

Consumers will use some of this increased wealth to buy goods and services.

Extra Economics in Your Life & Career: Will Lower Net Exports Jeopardize Your Job? Question: Suppose you are a customer service representative of a large computer company and you read the following headline in your newspaper: “U.S. exports in July increased less than U.S. imports.” Should you be concerned about losing your job?

Answer: If U.S. exports increase less than U.S. imports, then net exports fall. Your job could be at risk if net exports continue to decrease, especially in the service sector. However, net exports usually decrease when the U.S. economy is expanding (and imports are rising), which should lead to an increase in the number of INSIDE jobs overall in News the U.S. economy.

If you do lose your job, you may be able to find Extra AN LOOK Article to Use in Class employment Visit Pearson’s MyLab Economics for current news articles. in another industry.

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Appendix The Algebra of Macroeconomic Equilibrium Learning Objective: Apply the algebra of macroeconomic equilibrium.

Graphs and tables are alternative means to illustrate the aggregate expenditure model of short-run real GDP. Graphs help us understand economic change qualitatively. We make it easier to make quantitative estimates when we write down an economic model using equations. When economists forecast future movements in GDP, they often rely on econometric models. An econometric model is an economic model written in the form of equations, where each equation has been statistically estimated. The following equations are based on the example from Table 22.3, “Components of Real Aggregate Expenditure, 2020.”

1. C = 1,000 + 0.65Y 2. I = 1,500 3. G = 1,500 4. NX = −500 5. Y = C + I + G + NX

Consumption function Planned investment function Government spending function Net export function Equilibrium condition

The parameters of the functions—such as the value of autonomous consumption and the value of the MPC in the consumption function—would be estimated statistically using data for the values of each variable over a period of years. To calculate equilibrium, we substitute equations 1 through 4 into equation 5. This gives us the following: Y = 1,000 + 0.65Y + 1,500 + 1,500 – 500.

This equation can be solved for Y to find equilibrium GDP: Y = 10,000.

To make this result more general, we can replace particular values with general values represented by letters: 1.

2.

3.

4.

5. Y = C + I + G + NX

Consumption function Planned investment function Government purchases function Net export function Equilibrium condition

The letters with bars over them represent fixed, or autonomous, values.

Solving for equilibrium Y: Y=

C + I + G + NX .

1 − MPC

All four variables in the numerator of the equation represent autonomous expenditure. An alternative expression for equilibrium GDP is

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CHAPTER 22 | Aggregate Expenditure and Output in the Short Run Equilibrium GDP = Autonomous expenditure × Multiplier.

Solutions to End-of-Chapter Exercises 22.1

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

Review Questions 1.1

The key idea of the aggregate expenditure model is that in any particular year the level of real GDP is determined mainly by the level of aggregate expenditure.

1.2

Inventories are goods that have been produced but not yet sold. Inventories usually rise at

1.3

the beginning of a recession because for many firms production is greater than sales. Inventories fall at the beginning of an expansion because for many firms sales are greater than production.

The aggregate expenditure model seeks to explain the business cycle, and by doing that also explain because cyclical unemployment. The model does not explain long-run economic growth

Problems and Applications 1.4

theConsumption model does not address the factors that cause potential GDP to increase, and the model a. b.

Government purchases does not explaininvestment inflation because the model assumes the price level is fixed. c. Planned d. Net exports e. Planned investment

1.5

The computer chips Intel sells to Dell are intermediate goods, so the chips would not be included in spending on goods and services or aggregate expenditure. Aggregate expenditure would increase if Dell sells the computers that include the computer chips as components.

1.6

If companies are increasing their inventories, we might expect that aggregate expenditure was lower than GDP. This conclusion is only accurate, though, if the increase in inventories was unplanned. Recall from Section 12.1 that planned increases inventories are included in aggregate expenditure but unplanned increases are not. So, in the fourth quarter of 2020, if the increase in inventories was planned, then aggregate expenditure was equal to GDP. If the increase in inventories was unplanned, then aggregate expenditure was lower than GDP. b. An “inventory correction cycle” refers to the process of companies decreasing or increasing actual inventories to match planned inventories. Companies need to adjust inventories when actual aggregate expenditure differs from planned aggregate expenditure.

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c. Companies cut or slow production to reduce their inventories. Once inventories reach desired levels, companies will increase production to match expected planned aggregate expenditures.

1.7

Inventories were at historically low levels because Thor’s dealers were selling more RVs than a.

Thor Industries was producing.

Thor Industries did not anticipate Covid-19 and the effect that the pandemic would have on b.

RV sales. People that could not vacation abroad or just wanted to isolate while on vacation began purchasing RVs in high numbers. c.The declining inventories in Thor Industries will force the company to increase production of RVs and will most likely result in more workers being hired in Elkhart, Indiana—where the company is headquartered. A look at the unemployment rate or the number of unemployment claims in the city and the state would verify if the firm did indeed hire more workers.

1.8

The article was reporting a 3.5 percent decrease in real GDP, not nominal GDP. Typically, a.economists measure economic growth by changes in real GDP because changes in nominal GDP reflect changes in both the quantity and the prices of goods and services produced in the economy. Changes in real GDP measure changes in just quantity of goods and services produced in the economy and so are a better indicator of economic growth.

Inventory investments, or changes in business inventories, are changes in the stocks of goods b.that have been produced but not yet sold. Changes in inventories are one component of GDP, so if the inventory change contributed to the contraction, then inventories decreased. Firms that were forced to shut down due to Covid-19 had no choice but to sell some of the goods they held in inventory if they were to continue selling products.

1.9

The BEA should have revised the GDP upward because it discovered higher levels of a.inventory investment—because investment is a component of GDP. Yes, there is a close connection between total production and total demand. If consumption b.rose less than previously estimated, sales of goods would have been lower. A decline in the sales of goods relative to production results in an increase in inventories.

Determining the Level of Aggregate Expenditure in the Economy 22.2

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

Review Questions 2.1

2.2

In the aggregate expenditure model, real GDP changes only when aggregate expenditure changes, so it is crucial to understand the factors that change each of the four categories of aggregate expenditure, which are: consumption spending, investment spending, government purchases, and net exports.

The five main determinants of consumption spending are: (1) current disposable income; (2) household wealth; (3) expected future income; (4) the price level; and (5) the interest rate.

Current disposable income is the most important determinant of consumption spending. A rise in stock prices or housing prices would increase household wealth, which would increase consumption spending. .

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2.3

Real consumption followed a smooth, upward trend and only declined slightly during recessions, with the exception of the 2007–2009 recession. Real investment followed a choppier path, with substantial declines during recessions.

2.4

The four main determinants of investment spending are: (1) expectations of future profitability; (2) ratethe interest rate; (3) business taxes; and (4) and cash flow. An increase in the interest

2.5

would decrease investment spending, and a decrease in the interest rate would increase investment spending.

The three main determinants of net exports are: (1) the price level in the United States relative to the the price levels in other countries; (2) the growth rate of GDP in the United States relative to

Problems andrates Applications growth of GDP in other countries; and (3) the exchange rate between the dollar and 2.6

2.7

other a. Most people borrow money to finance the purchase of a home. Low interest rates decrease currencies.

Anofincrease theon growth GDP in Canada Mexico, relative the the amount interest in paid a loanrate of a of given amount, whichand thereby decreases thetomonthly growth payment require States, on the would loan and increase rate of GDPlenders in the United increase U.S.the netquantity exports.of homes that households demand. b.Purchases of new houses are considered residential investment and fall in the category of investment spending. a.The forecasted demand for Thor Industries RVs would increase. The rise in consumer confidence that income growth will be increasing would likely increase consumption spending on RVs, which are durable goods and, therefore, sensitive to changes in household income. b.The forecasted demand for Thor Industries RVs would decrease. An increase in the real interest rate would decrease spending by households and firms on recreational vehicles because the interest expense on the loans to purchase them would rise. c. The forecasted demand for Thor Industries RVs will increase when Congress cuts the federal income tax because a decrease in the tax rate will result in an increase in disposable income.

Higher disposable income will increase consumption expenditures, including expenditures on RVs. d.The forecasted demand for Thor Industries RVs would increase. Because gasoline and RVs are complements, a decrease in gasoline prices will increase the demand for RVs. RV sales are particularly sensitive to changes in gasoline prices because RVs typically get very low gas mileage.

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2.8

In the following graph of the consumption function, an increase in income from Y1 to Y2 would increase consumption spending along the consumption function C1 (A to B). An increase in expected future income or household wealth would shift the consumption function upward, from C1 to C2.

2.9

The student’s reasoning is incorrect because he or she has confused investment in the economic sense—which involves purchasing machinery, factories, and houses—with financial investment in stocks and bonds or saving in a bank account.

2.10

Consumption will fluctuate less. The five main determinants of consumption spending are current disposable income, household wealth, expected future income, the price level, and the interest rate. Current disposable income is the most important determinant. Unemployment insurance benefits reduce fluctuations in income, thereby reducing fluctuations in consumption.

Y = C + S + T. With taxes equal to zero, this equation becomes Y = C + S, and can be used to fill in the saving column of the table. To fill in the MPC and MPS columns, use the expressions:

2.11

MPC = ΔC/ΔY MPS = ΔS/ΔY. For example, to calculate the value of the MPC in the second row: MPC = ΔC/ΔY = ($16,250 − $15,500)/($20,000 − $19,000) = $750/$1,000 = 0.75.

To calculate the value of the MPS in the second row: MPS = ΔS/ΔY = ($3,750 − $3,500)/($20,000 − $19,000) = $250/$1,000 = 0.25.

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National Income and Real GDP (Y) $19,000 20,000 21,000 22,000 23,000

Consumption (C) $15,500 16,250 17,000 17,750 18,500

Saving (S) $3,500 3,750 4,000 4,250 4,500

Marginal Propensity to Consume (MPC) — 0.75 0.75 0.75 0.75

Marginal Propensity to Save (MPS) — 0.25 0.25 0.25 0.25

2.12

a. Housing debt refers to mortgage loans from banks or other lenders. To buy a home, most households have to borrow by taking out a mortgage loan because they lack the funds to pay the entire price of the house at the time of purchase. Lenders look at the ratio of total monthly payments to monthly income to determine mortgage loan eligibility. Student loan debt can easily be much higher than credit card debt, so student loan debt could be the primary reason someone cannot qualify for a mortgage. b. Since 1990, spending on residential housing has averaged about 24 percent of all investment spending in the United States and represents about 4 percent of U.S. GDP. In addition, when people buy new homes, they often spend money on new furnishings and other goods.

Therefore, consumer spending on housing, which is classified as investment, has a significant effect on the U.S. economy.

2.13

a. A “weaker currency” means that the U.S. dollar falls in value relative to other currencies. If the dollar falls in value, it takes more dollars to buy Japanese yen, British pounds, euros, and other currencies. Conversely, with a strong U.S. dollar, it takes fewer dollars to buy a yen, pound, euro, or other currency. b. A weaker U.S. dollar lowers the foreign currency prices of U.S.-made goods in other countries. For example, California wine will sell for a lower pound price in London. As a result, sales of U.S. exports are likely to increase, which will increase the profits of U.S. exporters. A weaker U.S. dollar will also increase the dollar price of foreign imports to the United States, which will increase the sales of U.S. firms that compete against foreign imports. So, both U.S. firms that export and U.S. firms that compete against foreign imports will gain a competitive advantage from a weaker U.S. dollar.

2.14

Statement d. is correct. iPhones are made (assembled) in China using components produced by many firms located in several different countries. The BEA’s use of the “country of origin” concept to measure imports overstates the value of imports from China and other countries.

2.15

a. The other 70 percent of world trade is the import and export of intermediate inputs. b. With the global supply chains being used by large firms, the country that assembles the final good will often not produce the entire product and may produce a relatively small portion of the product, as in the case of the iPhone exported to the United States from China. Although the iPhone is labeled “Made in China,” Chinese assembly plants are responsible for only a small part of the value of the phones. c. The trade statistics might mislead policymakers (and the public) in terms of the magnitude of a country’s overall trade deficit or trade surplus, and also as to whether a country is running a trade surplus or deficit with another country.

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22.3 Graphing Macroeconomic Equilibrium

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

Review Questions 3.1

The 45° line represents all the points that are equal distances from both axes. In the 45°– line diagram, the 45° line shows all the points where planned real aggregate expenditure equals real GDP.

3.2

3.3

The slope of the aggregate expenditure line is the change in aggregate expenditure based on a change in real GDP (ΔAE/ΔReal GDP). The simple aggregate expenditure model assumes that taxes, planned investment spending, government purchases, and net exports are independent of income. So, the slope of the aggregate expenditure line equals the slope of the consumption function, which equals the marginal propensity to consume.

3.4

Firms will decrease production until they sell the unintended inventories.

3.5

Aggregate expenditure represents the total spending in the economy. Consumption spending is just one component of aggregate expenditure. The other components of aggregate expenditure are: planned investment, government purchases, and net exports.

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Problems and Applications 3.6

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

3.7

Net exports equal the value of exports minus the value of imports. Net exports would be graphed as a downward-sloping line. Although increases in U.S. real GDP will not directly affect U.S. exports, these increases will cause imports to increase and net exports to decline, holding other factors constant. As real GDP increases, net exports eventually become negative, which they typically have been for the United States in recent years.

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CHAPTER 22 | Aggregate Expenditure and Output in the Short Run 3.8

3.9

3.10

3.11

603

The phrase “shedding of unwanted inventories” refers to firms selling their unplanned increases in inventories from previous time periods. When sales are lower than expected in one time period, firms are likely to respond by cutting current production, which results in a decline in GDP. With goods like RVs or washing machines, if firms overestimate sales, they are likely to produce more of the good than they can sell, so the unsold units becoming inventories. In the following period, firms are likely to cut back substantially on production because some fraction of current sales can be met by selling off inventories. The opposite happens when firms underestimate sales: Their inventories fall and in the following period they have to produce enough to both meet that period’s sales and to rebuild their inventories. This instability in inventories means that Because fluctuations in sales during a business cycle have a magnified effect on output. underestimating or overestimating sales of services, such as haircuts or investment advice, doesn’t result in a change in inventories, an increase in the production of services relative to the production of goods can moderate the business cycle—which means both recessions and expansions will be milder.

Inventories climbed during 2007 as the economy slowed down and moved into recession. In 2008 and 2009, with the significant drop in aggregate expenditure in the economy during the recession, firms cut production to reduce the unintended increase in inventories they had experienced in previous quarters. As the economy began to slowly recover in the second half of 2009 and 2010, firms began to rebuild inventories in anticipation of higher sales. Some of the increase in inventories in 2010 could have been unintended due to the slow rate of recovery.

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

Calculate the missing values in the last two columns of the table by using these two equations:

3.12 •

Planned aggregate expenditure (AE) = Consumption (C) + Planned investment (I) + Government (G) + Net exports (NX) and

•

Unplanned change in inventories = Real GDP (Y) − Planned aggregate expenditure (AE)

Planned Real GDP Consumption Investment (Y) (C) (I ) $19,000 $15,600 $2,000 20,000 16,400 2,000 21,000 17,200 2,000 22,000 18,000 2,000 23,000 18,800 2,000

Planned Aggregate Government Purchases Net Exports Expenditure () (NX) (AE) G $2,200 $19,400 −$400 2,200 20,200 −400 2,200 21,000 −400 2,200 21,800 −400 2,200 22,600 −400

Unplanned Change in Inventories −$400 −200 0 200 600

a. The MPC equals the change in consumption divided by the change in income (real GDP, Y).

In this case, consumption changes by $800 billion for every $1,000 billion change in income.

So, the MPC = $800 billion/$1,000 billion = 0.8.

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CHAPTER 22 | Aggregate Expenditure and Output in the Short Run b. Equilibrium real GDP occurs where real GDP equals planned aggregate expenditure and the unplanned changed in inventories equals 0. The table above shows the equilibrium level of real GDP will be equal to $21,000 billion.

22.4

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

Review Questions 4.1

4.2

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

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

4.3

Multiplier =

.

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

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Problems and Applications 4.4

a. No. The economy will be at equilibrium when aggregate expenditure equals real GDP. This conclusion is illustrated in the graph by the point at which the new aggregate expenditure line AE2 intersects the 45° line, which occurs at $20.0 trillion, not at $19.4 trillion. b. When real GDP equals $19.4 trillion, aggregate expenditure is greater than $19.4 trillion. We know this because at real GDP of $19.4 trillion, the new aggregate expenditure line AE2 is above the 45° line. Because at real GDP of $19.4 trillion, aggregate expenditure is greater than real GDP, there will be an unplanned decrease in inventories. The decrease in inventories will give firms an incentive to increase production.

4.5

a. When individuals receive the checks, they will increase their consumption expenditures by the value of the check multiplied by the marginal propensity to consume. This increase in consumption expenditures, holding all else constant, will shift the aggregate expenditure up, resulting in an intersection with the 45° line at a higher level of real GDP. b. Sahm is describing what economists refer to as the multiplier effect. While the initial increase in spending shifts the aggregate expenditure line, the other rounds of spending result in a movement along the new aggregate expenditure line. The new equilibrium level of real GDP level will be larger than the sum of the original equilibrium level of real GDP level and the value of the stimulus payments mailed by the government.

4.6

From 1929 to 1933, real GDP declined $279 billion from $1,057 billion to $778 billion. If the multiplier was 4, then it would have taken a decrease of $69.75 billion ($279 billion/4 = $69.75 billion) in autonomous expenditure to cause a decline of $279 billion in real GDP. If the multiplier was 2, then it would have taken a decrease of $139.5 billion ($279 billion/2 = $139.5 billion) in autonomous expenditure to cause the same decline in real GDP.

4.7

We can answer this question by adding a column in the table for Aggregate Expenditure (AE).

Planned Real GDP Consumption Investment (Y) (C) (I ) $18,000 $15,500 $2,000 19,000 16,250 2,000 20,000 17,000 2,000 21,000 17,750 2,000 22,000 18,500 2,000

Government Aggregate Purchases Net Exports Expenditure () (NX) (AE) G –$500 $1,500 $18,500 −500 1,500 19,250 −500 1,500 20,000 −500 1,500 20,750 −500 1,500 21,500

a. Equilibrium real GDP is $20,000 billion because at this level real GDP equals aggregate expenditure. b.

c.

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Multiplier=

1

=

1

1− MPC 1 − 0.75

= 4.0

So, Change in equilibrium real GDP = Change in autonomous expenditure × 4.0 = $250 billion × 4.0 = $1,000 billion.

The new level of equilibrium real GDP = $20,000 billion + $1,000 billion = $21,000 billion.

4.8

a. Multiplier = b. Multiplier =

1

1

1

=1.5 = = 1-MPC 1-0.35 0.65

c. The change in equilibrium real GDP would be $13.2 billion (= 3.3 × $ 4 billion) if the MPC equaled 0.70. The change in equilibrium real GDP would be $6.0 billion (= 1.5 × $ 4 billion) if the MPC equaled 0.35.

4.9

4.10

a. The value of the multiplier would be smaller if an increase in real GDP increases imports because some of the increased consumption spending resulting from the increase in real GDP would be spent on imported goods and services rather than on domestically produced goods and services. b. The value of the multiplier would be smaller if an increase in real GDP increases interest rates. An increase in interest rates decreases planned investment spending, consumption spending on durable goods, and net exports (as a result of the appreciation in the value of the U.S. dollar). c. The value of the multiplier would be larger if an increase in real GDP increases the marginal propensity to consume (MPC) because the increase in consumption spending resulting from the increase in real GDP would be larger. Or more directly, we can see from the multiplier formula that the larger the value of the MPC, the larger the value of the multiplier. d. The value of the multiplier would be larger if an increase in real GDP causes the average tax rate paid by households to decrease. A lower tax rate would increase disposable income, which would increase consumption spending and make the multiplier effect larger. This conclusion assumes no change in the level of government purchases. e. The value of the multiplier would be smaller if an increase in real GDP increases the price level. An increase in the price level would decrease consumption spending, investment spending, and net exports. a. Falling consumer confidence would lower consumption as consumers cut spending because of concerns about the future. b. Increasing business optimism would increase investment expenditures as business owners and managers increased investment to produce more output. c. The effect on GDP depends on the relative magnitudes of the changes in investment and consumption. If the increase in investment expenditures is larger than the decrease in consumption expenditures, then autonomous expenditure and real GDP will increase. If the increase in investment expenditures is less than the decrease in consumption expenditures, then autonomous expenditure and real GDP will decrease.

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In the following figure, the graph on the right illustrates the effect on the AE curve when investment expenditures increase by more than consumption expenditures decrease.

The aggregate expenditure line will shift up from AE1 to AE2, causing equilibrium real GDP to increase from Y1 to Y2.

The graph on the left illustrates the effect on the AE curve when investment increases by less than consumption expenditures decrease. The aggregate expenditure line will shift down from AE1 to AE2, causing equilibrium real GDP to decrease from Y1 to Y2.

4.11 4.12

A larger multiplier would be likely to lead to longer and more severe recessions because it would magnify the effect on the economy of changes in autonomous expenditures.

An MPC of 0 results in no multiplier effect because an increase in income does not induce any additional consumption spending. An increase in autonomous expenditure results in a matching increase in income but no additional consumption spending, resulting in a multiplier of 1. An MPC of 1 results in an infinite multiplier because any additional income induces a matching increase in consumption spending, which leads to a matching increase in income and then a matching increase in consumption spending, and on and on.

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

4.13

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

Y $320 billion =1.8. I = $180 billion 4.14

a. $22 trillion b

MPC =

$23.6 trillion −$20.4 trillion $24 trillion−$20 trillion

=

$ 3.2 trillion = 0.8 $4 trillion

. c. Multiplier = d. i)

–$0.4 trillion

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CHAPTER 22 | Aggregate Expenditure and Output in the Short Run ii) 0 iii) $0.4 trillion

22.5

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

Review Questions 5.1 5.2

5.3

Aggregate expenditure is the total amount of spending in the economy, and aggregate demand is the relationship between the price level and the level of planned aggregate expenditure.

A change in the price level affects: (a) consumption by affecting the real value of household wealth; (b) net exports by affecting the domestic price level relative to foreign price levels; and (c) investment spending by affecting the interest rate.

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

Problems and Applications 5.4

5.5

5.6

An upward-sloping aggregate expenditure line reflects the positive relationship between real GDP and aggregate expenditure, while a downward-sloping aggregate demand curve reflects the inverse relationship between the price level and the level of planned aggregate expenditure.

Disagree. A higher overall price level means an equivalent increase in nominal income, so that consumers as a whole should be able to afford the same amount of goods and services as they could afford with a lower overall price level.

If exports become more sensitive to changes in the price level in the United States, then a

Real-Time givenData Exercises Note: FRED continues to update The solutions below thechange data available on FRED change in the price level indata. the United States will causecontain a greater in aggregate expenditure.

In this case, the aggregate demand curve becomes less steep. the first quarter of 2021.

D22.1 a. Download data from FRED on real exports from 1990 to the present. b. Real exports of goods and services decreased from $1,790.0 billion in the second quarter of 2008 to $1,535.3 billion in the first quarter of 2009, for a decline of $254.7 billion. With a multiplier of 2 and, holding everything else constant, the decline in exports would have decreased real GDP by $254.7 billion × 2 = $509.4 billion. c. Real exports of goods and services were $2,523.97 billion in the second quarter of 2018 and $2,554.36 billion in the first quarter of 2019. Between the two quarters, the real exports of goods and services increased by $30.39 billion. If the multiplier is 2, then the increase in the real exports of goods and services by $30.39 billion will increase GDP by $60.78 billion.

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D22.2 a. Download data from FRED on annual real consumption expenditures from 2000 to 2018. b.

Download data from FRED on annual real GDP from 2000 to 2018.

c.

The year with the highest MPC was 2001 with an MPC of 1.66. The year with the lowest value was 2012 with an MPC of 0.46.

Suggestions for Critical Thinking Exercises CT22.1 Answers will vary depending on what the students find confusing. Some of the topics students might find confusing are planned versus unplanned inventories, how the multiplier works, and how to calculate the marginal propensity to consume.

Here, equilibrium is achieved by changes in inventories. When aggregate expenditure exceeds real GDP, inventories decrease. That decrease sends a signal to firms to increase production.

When GDP exceeds aggregate expenditure, inventories increase. That increase sends a signal to firms to decrease production. In the market for a single product, equilibrium is achieved by changes in the price of a product. If there is excess demand, the price rises until the market reaches equilibrium. If there is excess supply, the price falls until the market reaches equilibrium.

The value for the multiplier will decrease because a higher interest rate when expenditures CT22.3 a. are increasing will reduce planned investment, making the increase in real GDP smaller than if the interest rate had remained constant.

CT22.2

b. The value for the multiplier will decrease because, as is explained in Section 22.5, a higher price level will reduce consumption, net exports, and investment, making the increase in real GDP smaller than if the price level had remained constant.

Solutions to Chapter 22 Appendix Review Questions 22A.1 AE = (

22A.2

++

+

) + MPC (Y)

The intercept would be ( + + + ) and the slope would be equal to the value of the MPC. Y = $2,000 + 0.75Y + $3,000 + $1,000 + (−$500); Y = $5,500+ 0.75Y; Y − 0.75Y = $5,500 Y (1 − 0.75) = $5,500 Y (0.25) = $5,500 Y = 3,750 × 4 = $22,000

22A.3

AE = $$5,500 + 0.75Y For GDP of $24,000, aggregate expenditure = $5,500 + 0.75($24000) = $5,500 + $18,000 = $23,500

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CHAPTER 22 | Aggregate Expenditure and Output in the Short Run The unintended change in inventories = $24,000 − $23,500 = $500.

For GDP of 20,000, aggregate expenditure = $5,500 + 0.75($20,000) = $5,500 + $15,000 = $20,500 The unintended change in inventories = $20,000 – $20,500 = −$500.

22A.4

Equilibrium GDP = Autonomous expenditure × multiplier Autonomous Expenditure = $1,000 + $2,000 + $2,250 + ($–250) = $5,000 Multiplier = 1/(1-MPC) = 1/(1 – 0.8) = 1/0.2 = 5 Equilibrium GDP = $5,000 × 5 = $25,000

.

CHAPTER 23 | Aggregate Demand and Aggregate Supply Analysis Brief Chapter Summary and Learning Objectives This book takes a fresh approach to the standard aggregate demand and aggregate supply model.

There is no good, simple alternative to using the AD-AS model when explaining movements in the price level and real GDP. But many instructors are dissatisfied with relying exclusively on the AD-AS model. The key problem, of course, is that AD-AS is a static model that attempts to account for dynamic changes in real GDP and the price level. The authors’ approach retains the basics of the ADAS model but makes it more accurate and useful by making it more dynamic by emphasizing these two points: 1. Changes in the position of the short-run (upward-sloping) aggregate supply curve depend mainly on the expectations that workers, firms, and investors have about the inflation rate.

2. The existence of growth in the economy means that the long-run (vertical) aggregate supply curve shifts to the right every year.

This “dynamic” AD-AS model provides students with a more accurate understanding of the causes and consequences of fluctuations in real GDP and the price level. The authors introduce this model in the final section of Chapter 23 (Section 23.4) and use it to discuss monetary policy in Chapter 25 (Section 25.4) and fiscal policy in Chapter 26 (Section 26.3). Note that the sections on the dynamic AD-AS model are self-contained in one section each of Chapters 23, 25, and 26, so you can omit these sections without any loss of continuity in the discussion of macroeconomic theory and policy.

23.1 Aggregate Demand Identify the determinants of aggregate demand and distinguish between a movement along the aggregate demand curve and a shift of the curve.

▪ The aggregate demand curve (AD) shows the relationship between the price level and

the quantity of real GDP demanded by households, firms, and the government. The

▪ variables that cause the aggregate demand curve to shift are as follows: changes in

government policies, changes in the expectations of households and firms, and changes in foreign variables.

23.2 Aggregate Supply Identify the determinants of aggregate supply and distinguish between a movement along the short-run aggregate supply curve and a shift of the curve.

▪ The long-run aggregate supply curve is a vertical line. The short-run aggregate supply

curve slopes upward because workers and firms often fail to accurately predict the future price level.

.

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

▪ In long-run macroeconomic equilibrium, the aggregate demand and short-run aggregate

supply curves intersect at a point on the long-run aggregate supply curve. In short-run macroeconomic equilibrium, the aggregate demand and short-run aggregate supply curves can intersect at a point away from the long-run aggregate supply curve.

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

▪ To make the aggregate demand and aggregate supply model dynamic, we assume that

1. Potential real GDP increases continually.

2. During most years, aggregate demand will shift to the right.

3. Except during periods when workers and firms expect high rates of inflation, the aggregate supply curve will shift to the right.

Appendix Macroeconomic Schools of Thought Compare macroeconomic schools of thought.

Key Terms Aggregate demand (AD) curve A curve that shows the relationship between the price level and the quantity of real GDP demanded by households, firms, and the government (both inside and outside of the country).

Aggregate demand and aggregate supply

Menu costs The costs to firms of changing prices.

Monetary policy The actions the Federal Reserve takes to manage the money supply and interest rates to achieve macroeconomic policy objectives.

Short-run aggregate supply (SRAS) curve A curve that shows the relationship in the short run between the price level and the quantity of real GDP supplied by firms.

Stagflation A combination of inflation and recession, usually resulting from a supply shock.

Supply shock An unexpected event that causes the short-run aggregate supply curve to shift.

model A model that explains short-run fluctuations in real GDP and the price level.

Fiscal policy Changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives.

Long-run aggregate supply (LRAS) curve A curve that shows the relationship in the long run between the price level and the quantity of real GDP supplied.

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Key Terms—Appendix Keynesian revolution The name given to the widespread acceptance during the 1930s and 1940s of John Maynard Keynes’s macroeconomic model.

Monetary growth rule A plan for increasing the quantity of money at a fixed rate that does not respond to changes in economic conditions.

New classical macroeconomics The macroeconomic theories of Robert Lucas and others, particularly the idea that workers and firms have rational expectations.

Real business cycle model A macroeconomic model that focuses on real, rather than monetary, causes of the business cycle.

Monetarism The macroeconomic theories of Milton Friedman and his followers, particularly the idea that the quantity of money should be increased at a constant rate.

Chapter Outline AMC and Toll Brothers Switch Places During a recession, households maintain their spending on services, like attending movies, while cutting back their home buying. For example, in the Great Recession of 2007–2009, consumer spending on services was higher at the end of the recession than at the beginning, while spending on residential construction had fallen by 36 percent. The situation was different during the 2020 Covid-19 recession.

From the fourth quarter of 2019 to the fourth quarter of 2020, consumer spending on services declined by 5 percent, while spending on residential construction increased by 20 percent. The key explanation is that the 2020 recession was the first to be caused by a pandemic in more than 100 years. Typically, recessions are caused by declines in total spending, as happened in the 2007–2009 recession when the housing market collapsed. But in 2020, the main cause of the recession was the decision by state and local governments to close or restrict the operations of many businesses to help contain the spread of Covid-19.

As a result, spending on services declined mainly because restaurants, hotels, movie theaters, and gyms were either closed or operating at a reduced capacity. Many consumers still wanted to buy the services these businesses offered but were unable to do so. In 2020, people in many professions were able to remain employed, although many worked from home. Other people who were laid off because the firms they worked for closed temporarily expected that they would soon return to work. In March 2020, Congress and President Donald Trump enacted the Coronavirus Aid, Relief, and Economic Security (CARES) Act, which, among other things, provided additional unemployment compensation to laid-off workers as well as sending $1,200 checks to many people, which offset some of the income declines unemployed workers usually experience. The pandemic convinced some families that they would be better off living outside big cities, which increased demand for housing in those areas. Toll Brothers benefitted from these unusual aspects of the 2020 recession. The company suffered a record $750 million loss during the 2007–2009 recession, as the housing market collapsed. In contrast, the firm made a profit of $447 million during the 2020 recession. AMC Entertainment had a very different experience. Ticket sales actually increased during the 2007–2009 recession but declined by nearly 90 percent in 2020, when the firm suffered a loss of $4.6 billion.

23.1

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

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The aggregate demand and aggregate supply model explains short-run fluctuations in real GDP and the price level. The aggregate demand (AD) curve shows the relationship between the price level and the quantity of real GDP demanded by households, firms, and the government (both inside and outside of the country). The short-run aggregate supply (SRAS) curve shows the relationship in the short run between the price level and the quantity of real GDP supplied by firms. In the short run, real GDP and the price level are determined by the interaction of the aggregate demand curve and the shortrun aggregate supply curve.

A. Why Is the Aggregate Demand Curve Downward Sloping?

GDP has four components: 1. Consumption (C) 2. Investment (I) 3. Government purchases (G) 4. Net exports (NX) If we let Y stand for GDP, we can write: Y = C + I + G + NX. The aggregate demand curve is downward sloping because a fall in the price level increases the quantity of real GDP demanded. Current income is the most important variable determining consumption by households. But consumption also depends on wealth. When the price level rises, the real value of household wealth declines and so will consumption. The effect of the price level on consumption is called the wealth effect and is one reason the aggregate demand curve is downward sloping.

When prices rise, households and firms need more money to finance buying and selling. Therefore, when the price level rises, households and firms will try to increase the amount of money they hold by withdrawing funds from banks, borrowing from banks, or selling assets. These actions drive up the interest rate. So, because a higher price level increases the interest rate and reduces investment spending, it also reduces the quantity of goods and services demanded. The effect of the price level on investment is known as the interest rate effect and is a second reason the aggregate demand curve is downward sloping.

If the price level rises in the United States relative to the price levels in other countries, U.S. exports will become relatively more expensive, and foreign imports will become relatively less expensive. U.S. exports will fall and U.S. imports will rise, causing net exports to fall. The effect of the price level on net exports is known as the international-trade effect and is a third reason the aggregate demand curve is downward sloping.

B. Shifts of the Aggregate Demand Curve versus Movements along It The aggregate demand curve tells us the relationship between the price level and the quantity of real GDP demanded, holding everything else constant. If the price level changes but other variables that affect the willingness of households, firms, and the government to spend are unchanged, the economy will move up or down a stationary aggregate demand curve. If any variable changes other than the price level, the aggregate demand curve will shift.

C. The Variables That Shift the Aggregate Demand Curve Three variables shift the aggregate demand curve: 1. Changes in government policies. The federal government uses monetary policy and fiscal policy to shift the aggregate demand curve. Monetary policy refers to the actions the Federal

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Reserve take to manage the money supply and interest rates to achieve macroeconomic policy objectives. Fiscal policy refers to changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives.

2. Changes in the expectations of households and firms 3. Changes in foreign variables Table 23.1 summarizes the most important variables that cause the aggregate demand curve to shift

Extra Apply the In a Global Economy, How Can You Tell the Imports from the Concept Domestic Goods?

Some U.S. firms appeal to the patriotism of U.S. consumers by urging them to buy products made in the United States. For example, an executive vice president of Ford Motor Company was quoted as saying, “Americans really do want to buy American brands. We will compete vigorously to be America’s car company.” What could be more All-American than a Ford Mustang sports car? And what is more obviously an import than the Toyota Sienna minivan? After all, Toyota’s headquarters are in Japan, and competition from cars made by Toyota, Honda, and Nissan has helped cause plummeting employment and production at Ford and the other U.S. “Big Three” automakers. But things are not so simple in the modern global economy. While Ford’s Mustang is assembled in Flat Rock, Michigan, Toyota’s Sienna is not assembled in Japan but in Princeton, Indiana. Most firms that sell products, such as automobiles, that have many parts, purchase those parts from suppliers that may be located anywhere in the world. According to the U.S. National Highway Traffic Safety Administration, 65 percent of the content of the Ford Mustang was produced by Ford itself or by firms located in the United States or Canada. The other 35 percent of the content was imported from firms located in other countries. By contrast, 90 percent of the content of the Toyota Sienna is produced in the United States or Canada, and only 10 percent is imported from firms located in other countries. A consumer in the United States who buys a Toyota Sienna actually contributes more to increasing U.S. aggregate demand than does a consumer purchasing a Ford Mustang.

The U.S. Bureau of Economic Analysis (BEA), which gathers data on imports, as well as the other components of aggregate demand, is well aware of this complication. The BEA is careful to include in the category of imports the parts purchased by U.S.-based firms from foreign suppliers even when the final product being sold is mainly composed of U.S.-made parts.

Source: Jathon Sapsford and Norihiko Shirouzu, “Mom, Apple Pie and . . . Toyota?”

Wall Street Journal, May 11, 2006.

Question Suppose that a consumer in Germany buys a Ford Mustang for a price of $30,000. Do U.S. exports increase by $30,000? Briefly explain.

Answer U.S. exports will increase by less than $30,000 because less than 100 percent of the content in a Ford Mustang is produced by firms located in the United States.

Teaching Tips The end of the chapter in the main text includes a special category of exercises titled Real-Time Data (RTDA) Exercises. These exercises are well worth assigning and discussing in class because they help students become familiar with a key data source, learn how to locate data, and develop skills in .

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interpreting data. Many RTDA exercises require more elaborate calculations than other problems and the use of Excel spreadsheets.

23.2

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

A. The Long-Run Aggregate Supply Curve Because changes in the price level do not affect the number of workers, the capital stock, and the available technology in the long run, changes in the price level do not affect the level of real GDP. The level of real GDP in the long run is called potential GDP or full-employment GDP. The long-run aggregate supply (LRAS) curve shows the relationship in the long run between the price level and the quantity of real GDP supplied. The LRAS curve is a vertical line. Because potential GDP increases each year, the long-run aggregate supply curve shifts to the right each year.

B. The Short-Run Aggregate Supply Curve The short-run aggregate supply curve is upward sloping because, over the short run, as the price level increases the quantity of goods and services firms are willing to supply increases. The main reason firms behave this way is that as the prices of goods and services rise, prices of inputs rise more slowly. Most economists believe that some firms and workers fail to accurately predict changes in the price level. The reasons for this include: 1. Contracts make some wages and prices “sticky.”

2. Firms are often slow to adjust wages.

3. Menu costs, the costs to firms of changing prices, make some prices sticky.

C. Shifts of the Short-Run Aggregate Supply Curve versus Movements along It If the price level changes but other variables are unchanged, the economy will move up or down a stationary aggregate supply curve. If any variable other than the price level changes, the aggregate supply curve will shift.

D. Variables That Shift the Short-Run Aggregate Supply Curve These are the most important variables that cause the short-run aggregate supply curve to: 1. Increases in the labor force and in the capital stock 2. Technological change 3. Changes in the expected future price level 4. Adjustments of workers and firms to errors in past expectations about the price level 5. Unexpected changes in the price of an important natural resource or the occurrence of a natural disaster or pandemic Table 23.2 summarizes the most important variables that cause the SRAS curve to shift.

A supply shock is an unexpected event that causes the short-run aggregate supply curve to shift. Supply shocks are often caused by unexpected increases or decreases in the prices of important natural resources.

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Extra Solved Problem 23.2 Sticky Prices and Wages Changes in real GDP occur in response to price level changes over short periods of time when input prices rise more slowly than output prices. Because real GDP responds to changes in the price level in the short run, the short-run aggregate supply curve is upward sloping. Economists use the phrases sticky wages and sticky prices to refer to the slow response of wages and other input prices, as well as some output prices, to price level changes. To help understand why prices and wages may be sticky, let’s use the example of Bill’s Glue Emporium, a fictional firm that sells other adhesives to businesses. Assume the price level increases by 10 percent in 2021. Bill does not plan to buy new equipment or tools during the year and the wages of Bill’s workers will not be adjusted until the end of the year. Explain why Bill would choose each of the following alternative responses to the price level change. a. Bill increases the price and output of his glue during 2021 but reduces output to its previous (2020) level in 2022. b. Bill does not raise the price of glue but does increase the output of glue in 2021. In 2022, he raises glue prices and reduces the production of glue to its former (2020) level.

Solving the problem Step 1:

Step 2:

Step 3:

Review the chapter material.

This problem is about the short-run aggregate supply curve, so you may want to review the section “Aggregate Supply” in the textbook.

Answer part (a) by explaining why Bill might increase the price and output of glue during 2021 but reduce the output of glue to its previous (2020) level in 2022.

The price level increase means that other output prices have risen. As a result, suppose that Bill believes that he will sell more glue, even at a higher price. If this price increase sticks (pun intended), then his profits will increase in 2021 because his capital and labor costs will not rise. But his workers will probably demand a wage increase in 2022 to compensate for the reduction in real income caused by the price level increase. Sellers of capital goods may also want to raise their prices. If Bill’s input prices rise by the same percentage as prices have risen, he will decide in 2022 to reduce his output of glue to its former (2020) level.

Answer part (b) by explaining why Bill might choose not to raise the price of glue during 2021 but would increase the output of glue during 2021 and reduce the production of glue to its former (2020) level in 2022.

Bill might choose this option if he is not sure if the increase in the price level will be sustained. If he raises prices in 2021, he risks losing customers to other glue sellers. In addition, if he raises his prices only to lower them later in the year, he will have incurred menu costs twice—costs that he can avoid by not raising his prices in the first place.

Because his labor and capital costs will not rise in 2021, he can earn a profit from selling a higher output of glue even without raising his prices. In 2022, his workers and capital goods suppliers will likely demand higher wages and prices to compensate for the reduction in real income caused by the price level increase. Bill will raise his prices and reduce his output of glue to its former (2020) level.

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Macroeconomic Equilibrium in the Long Run and the Short Run 23.3

Learning Objective: Use the aggregate demand and aggregate supply model to illustrate the difference between short-run and long-run macroeconomic equilibrium.

We can use the aggregate demand and aggregate supply model to analyze changes in real GDP and the price level. In the long run, the short-run aggregate supply curve and the aggregate demand curve intersect at a point on the long-run aggregate supply curve, and the economy produces its potential level of real GDP. At this point, firms are operating at their normal level of capacity, and everyone who wants a job will have one, except for the structurally and frictionally unemployed.

A. Recessions, Expansions, and Supply Shocks Assume that: 1. The economy has not been experiencing any inflation.

2. The economy is not experiencing any long-run growth.

Though unrealistic, these assumptions allow us to understand the key ideas of the aggregate demand and aggregate supply model. Assume that rising interest rates reduce investment and cause the aggregate demand curve to shift to the left, resulting in a recession. The recession will eventually end because there are forces that push the economy back to potential GDP in the long run. The shift in aggregate demand lowers the price level. Workers will be willing to accept lower wages, and firms will be willing to accept lower prices. This causes the SRAS curve to shift to the right. It may take the economy several years to return to potential GDP. Economists refer to this adjustment process as an automatic mechanism because it occurs without any actions by the government. An alternative to waiting for the automatic mechanism to work is for the government to use monetary and fiscal policy to shift the AD curve to the right and restore potential GDP more quickly.

If many firms become more optimistic about the future profitability of new investment, the resulting increase in investment shifts the AD curve to the right. Firms will operate beyond their normal capacity, and some workers who would ordinarily be structurally or frictionally unemployed are employed. An automatic mechanism will bring the economy back from a short-run equilibrium beyond potential GDP. Workers will push for higher wages, and firms will charge higher prices. As a result, the SRAS curve will shift to the left. The process of returning to potential GDP may last more than a year.

If oil prices were to increase substantially, this would increase many firms’ costs and cause the SRAS curve to shift to the left. The price level is higher in short-run equilibrium but real GDP is lower. This result is called stagflation, a combination of inflation and recession, usually resulting from a supply shock. The recession eventually results in workers accepting lower wages and firms accepting lower prices. As this occurs, the SRAS curve will shift to the right. The economy returns to potential GDP at the original price level. It may take the economy several years for this process to be completed. Alternatively, the government can use monetary and fiscal policy to restore potential GDP more quickly, but this would result in a permanently higher price level.

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Extra Solved Problem 23.3 Short-Run and Long-Run Equilibrium The following graph illustrates an economy in long-run equilibrium at a price level of 120 and real GDP of $17.0 trillion. Assume that an increase in real estate prices raises household wealth.

a. What two assumptions are used when the economy is said to be in initial long-run equilibrium at a price level of 120 and real GDP equal to $17.0 trillion? b. Draw a graph to explain the changes in aggregate demand and aggregate supply that result in a short-run and a long-run equilibrium following the increase in household wealth.

Solving the Problem Step 1:

Step 2:

Step 3:

Review the chapter material.

This problem is about the relationship between short-run and long-run macroeconomic equilibrium, so you may want to review the section “Macroeconomic Equilibrium in the Long Run and the Short Run.” Answer part (a) by explaining the two assumptions used when the economy is said to be in initial long-run equilibrium.

The first assumption is that the economy has not been experiencing any inflation since the price level is 120 and is expected to remain at this level. The second assumption is that potential GDP equals 17.0 trillion and will remain at this level. The economy is in long-run equilibrium at point A. Answer part (b) by drawing a graph to explain the changes in aggregate demand and aggregate supply that result in a short-run and a long-run equilibrium following the increase in household wealth.

The increase in wealth will increase consumption. This increase will cause the aggregate demand curve to shift to the right, from AD1 to AD2. The economy will reach shortrun equilibrium (point B) at a higher real GDP ($17.3 trillion) and at a higher price level (122).

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CHAPTER 23 | Aggregate Demand and Aggregate Supply Analysis Workers and firms will eventually adjust to the price level being higher than they had expected. Workers will push for higher wages—because each dollar of wages will buy fewer goods and services following the increase in the price level—and firms will charge higher prices. In addition, the low levels of unemployment resulting from the expansion will make it easier for workers to negotiate for higher wages, and the increase in demand will make it easier for firms to charge higher prices. As a result, the SRAS curve will shift to the left, from SRAS1 to SRAS2. The economy will be back in long-run equilibrium at point C. The economy’s new long-run equilibrium will have a higher price level but the same level of real GDP as before the increase in wealth occurred.

23.4

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

Section 23.4 may be omitted without loss of continuity. The basic aggregate demand and aggregate supply model leads to some misleading results because of these does assumptions: (1) the economy does not experience continuing inflation and (2) the economy not experience long-run growth. We can create a dynamic aggregate demand and aggregate supply ▪ Potential real GDP increases continually, shifting the long-run aggregate supply curve to the model by making changes to the basic model based on the following facts: right.

▪ During most years, the aggregate demand curve shifts to the right.

▪ Except during periods when workers and firms expect high rates of inflation, the short-run aggregate supply curve shifts to the right.

A. What Is the Usual Cause of Inflation?

The dynamic aggregate demand and aggregate supply model provides a more accurate explanation than the basic model of the source of most inflation. If total spending in the economy grows faster than total production, prices rise. Inflation can also result when there is a shift to the left of the short-run aggregate supply curve.

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B. The Recession of 2007–2009 Several factors contributed to the recession that began in 2007: ▪ The end of the housing bubble crisis in oil prices during 2008 ▪ The The financial rapid increase ▪

Teaching Tips Because the dynamic aggregate demand and aggregate supply model is more complicated than the basic model, you may need to spend some class time explaining it. The dynamic model provides a much more realistic account of macroeconomic events. The dynamic model avoids the unrealistic result of the basic model where a decline in aggregate demand leads to a fall in the price level.

Because the graphs of the dynamic model contain six curves (as opposed to three in the basic model), it is important to help students identify the movement from one short-run macroeconomic equilibrium to another. Figures 23.9 and 23.10 show the effects of changes in equilibrium using the dynamic model. Encourage students to watch the lecture-style figure animation videos of each of these figures. Students can stop, start, and replay the video as often as necessary. A Concept Check exercise follows each video so students can confirm their understanding with a multiple-choice or graph exercise.

Extra Economics in Your Life & Career: How Will Immigration and an Aging Labor Force Affect You? Question: Suppose that the friends you met on an international trip are thinking of moving to the United States. The number of immigrants living in the United States has risen in recent years. At the same time, the percentage of the U.S. population over 65 is increasing much faster than the percentage of the population under age 20. How will the increased immigration and the aging of America affect your standard of living?

Answer: Increased immigration over time leads to a larger supply of labor. Although many believe that immigration can hurt the United States in the short run, in the long run immigration will cause the aggregate supply curve to shift to the right. Increased immigration will cause the equilibrium real GDP to increase and the equilibrium price level to decrease. As a larger percentage of the population leaves the labor force because of retirement or illness, the aggregate supply curve will shift to the left. The aging of Extra AN INSIDE LOOK News Article to Use in Class

America, by itself, will cause the equilibrium GDP to fall and the price level to increase. Overall, it Visit Pearson’s MyLab Economics for currentreal news articles. is hard to predict which of the two effects on aggregate supply will be greater.

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Appendix Macroeconomic Schools of Thought

Learning Objective: Compare macroeconomic schools of thought.

Macroeconomics became a separate field of economics in 1936, with the publication of John Maynard Keynes’s book The General Theory of Employment, Interest and Money. The Keynesian revolution is the name given to the widespread acceptance during the 1930s and 1940s of John Maynard Keynes’s macroeconomic model. The aggregate demand and aggregate supply model developed by Keynes remains the most widely accepted approach to analyzing macroeconomic issues. Because the model has been modified from Keynes’s day, many economists who use the model today refer to themselves as new Keynesians. A significant number of economists, however, dispute whether using the aggregate demand and aggregate supply model is the best way to analyze macroeconomic issues. Four alternative schools of thought use models that differ significantly from the standard aggregate demand and aggregate supply model: 1. The monetarist model 2. The new classical model 3. The real business cycle model 4. The Austrian model

The Monetarist Model In the 1940s, Milton Friedman, an economist at the University of Chicago, developed the monetarist model—also known as the neo-quantity theory of money model. Friedman argued that the Keynesian approach overstates the amount of macroeconomic instability in the economy. Friedman recommended that the Federal Reserve, which is responsible for managing the quantity of money, should adopt a monetary growth rule, which is a plan for increasing the quantity of money at a fixed rate that does not respond to changes in economic conditions.

Monetarism refers to the macroeconomic theories of Milton Friedman and his followers, particularly the idea that the quantity of money should be increased at a constant rate.

Friedman’s ideas attracted significant support during the 1970s and early 1980s, when the economy experienced high rates of unemployment and inflation.

The New Classical Model New classical macroeconomics refers to the macroeconomic theories of Robert Lucas and others, particularly the idea that workers and firms have rational expectations. This concept asserts that workers and firms form their expectations of the future values of economic variables based on all available information. Some of the views held by the new classical macroeconomists are similar to those held by economists before the Great Depression. Supporters of the new classical model agree with supporters of the monetarist model that the Federal Reserve should adopt a monetary growth rule.

The Real Business Cycle Model The real business cycle model is a macroeconomic model that focuses on real, rather than monetary, causes of the business cycle. Proponents of this model argue that fluctuations in real GDP are caused by temporary shocks to productivity.

The Austrian Model The Austrian school of economics began in Austria in the late nineteenth century. The Austrian school is best known for arguing the superiority of the market system over government planning.

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Solutions to End-of-Chapter Exercises 23.1

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

Review Questions 1.1

The aggregate demand curve shows the relationship between the price level and the quantity of real GDP demanded by households, firms, and the government. The short-run aggregate supply curve shows the relationship in the short run between the price level and the quantity of real GDP supplied by firms, and the long-run aggregate supply curve shows the relationship in the long run between the price level and the quantity of real GDP supplied by firms.

1.2

The three reasons the aggregate demand curve slopes downward are the wealth effect, the interest-rate effect, and the international-trade effect. The wealth effect refers to the effect that a change in the price level has on wealth and, therefore, consumption. An increase in the price level decreases the real value of household wealth, which decreases consumption. The interestrate effect refers to the effect that a change in the price level has on interest rates and, therefore, investment spending and consumption. An increase in the price level raises interest rates, which decreases investment spending and consumption spending, particularly on durable goods.

The international-trade effect refers to the effect that a change in the price level has on spending on exports and imports. An increase in the domestic price level makes U.S. exports more

1.3

expensive and foreign imports less expensive, which decreases net exports.

These are not the reasons why the demand curve for an individual product, such as bananas, slopes downward. When the price of bananas rises, bananas become more expensive relative to other products and consumers substitute other products for bananas. When the overall price

Problems and Applications 1.4

level rises the aggregate demand curve, the aprices of allalong domestically produced goods and a.

An on increase in the price level would cause movement the aggregate demand curve. services rise, so there are no changes in relative prices that would result in a change in the quantity b An increase in government purchases would cause the aggregate demand curve to shift to the demanded of bananas. right. .A movement from point A to point B along the aggregate demand curve would be caused c. Higher federal corporate income taxes would decrease firms’ profits, thereby decreasing by ainvestment expenditures and causing the aggregate demand curve to shift to the left. decrease point C in the price level. A movement from point A on aggregate demand curve AD1 to on aggregate demand curve AD2 would be caused by any of the factors that shift the aggregate demand curve to the right, such as a decrease . in interest rates, an increase in government purchases, or a decrease in personal or business taxes.

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CHAPTER 23 | Aggregate Demand and Aggregate Supply Analysis d. Higher interest rates would decrease investment spending, net exports, and consumer spending, particularly on durable goods, causing the aggregate demand curve to shift to the left. e. Faster income growth in other countries would increase U.S. exports, causing the aggregate demand curve to shift to the right. f. An increase in the value of the U.S. dollar relative to foreign currencies would decrease U.S. net exports, causing the aggregate demand curve to shift to the left.

1.5

The increase in stock prices from March 2011 to March 2021 relative to the price level, as measured by the consumer price index, resulted in an increase in the real value of household wealth, holding constant other factors that might affect household wealth. The increase in household wealth would have increased consumption expenditures and shifted the aggregate demand curve to the right.

1.6

Some experts attribute the 2009 increase in movie ticket sales to consumers wanting to escape the economic environment at the time. Relative to other consumption expenditures, movie tickets provide low-cost entertainment. Other economists pointed out that most workers in 2009 retained their jobs and firms froze their wages for several years. In contrast, the 2020 recession was caused by mandatory shutdowns or reductions in the operations of nonessential services such as movie theaters. If the movie theaters are closed, you cannot buy a ticket and attend. As for other goods, a decline in aggregate demand can increase the sales of inferior goods as consumers switch consumption patterns. For example, you may eat more hamburger than steak if the recession lowers your income. Therefore, overall aggregate demand can fall while there is an increase in consumption of some goods.

You should disagree. The price level refers to average prices in the economy as a whole, so no substitution to other products is possible when the price level rises. As explained in the answer to Review Question 1.2, the aggregate demand curve is downward sloping because of the wealth effect, the interest-rate effect, and the international-trade effect. a. An increase in spending on industrial robots will shift the aggregate demand curve to the

1.7

1.8 right. b. An increase in taxes, holding everything else constant, will shift the aggregate demand curve to the left. c. Inflation is an increase in the price level. An increase in the price level causes a movement up along the aggregate demand curve; it does not shift the aggregate demand curve.

1.9

a. A strong dollar will buy more units of a foreign currency. Conversely, a weak dollar will buy fewer units of a foreign currency. b. “American multinationals” are American-owned firms that operate in other countries. The profits of these firms that are earned in other countries may stay the same if measured using the currency of the country where they operate—for instance, Proctor & Gamble’s profits in France. However, the value of their profits measured in U.S. dollars will decrease because the firms would receive fewer dollars in exchange for the foreign currency, such as the euro or the yen. c. A stronger, or appreciating, U.S. dollar will decrease U.S. net exports and shift the U.S. aggregate demand curve to the left.

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23.2

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U.S. net exports would increase if real GDP in the United States declined more than real GDP in Canada, China, and other trading partners. With the larger decline in real GDP, U.S. imports would decrease more than U.S. exports, and net exports would rise.

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

Review Questions 2.1

2.2

2.3

The long-run aggregate supply curve is vertical because in the long run changes in the price level do not affect the number of workers, the capital stock, or technology, which are the factors that determine potential GDP. The variables that will cause the long-run aggregate supply to shift are as follows: the size of the labor force, the size of the capital stock, and technology. An increase in each variable will increase potential real GDP and cause the long-run aggregate supply curve to shift to the right.

As the prices of final goods and services rise, the prices of inputs usually rise more slowly.

2.4

The higher price level increases profits and the willingness of firms to supply more goods and services. A second reason the SRAS curve slopes upward is that, as the price level rises, some firms level are slow to adjust their prices. A firm that raises its prices slowly when the price increases may find that its sales increase; therefore, the firm will increase production.

The variables that cause the short-run aggregate supply to shift are as follows: the size of

2.5

the labor level; force; the size of the capital stock; technological change; the expected future price workers and firms adjusting to having previously underestimated the price level; the expected price of an important natural resource; or the occurrence of a natural disaster or pandemic.

Increases in the labor force, increases in the capital stock, and technological advances will

Problems and Applications 2.6

cause the short-run aggregate supply curve to shift to the right. Increases in the expected future price a. A higher price level would cause a movement up along the long-run aggregate supply curve. level, increases in the price of an important natural resource, workers and firms adjusting to b An increase in the labor force would causelevel, the long-run aggregate supplyor curve to shift will to the having previously underestimated the price and a natural disaster pandemic cause right. .the short-run aggregate supply curve to shift to the left. c. An increase in the quantity of capital goods would cause the long-run aggregate supply curve As to output shift toincreases the right.along the short-run aggregate supply curve, the natural rate of unemployment remains the same but the cyclical rate of unemployment decreases. The natural rate of unemployment is held constant on any given short-run aggregate supply curve. As output . increases cyclical along the short-run aggregate supply curve, employment increases, causing the rate of unemployment to decrease.

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CHAPTER 23 | Aggregate Demand and Aggregate Supply Analysis d. Technological change, assuming it is a technological advance, would cause the long-run aggregate supply curve to shift to the right.

2.7

2.8

Menu costs are costs to firms of changing prices. If menu costs were eliminated, the short-run aggregate supply curve would still not be vertical because other factors, such as contracts and the inability of workers and firms to always accurately predict next year’s price level, can still make wages and prices sticky. a. A higher price level would cause a movement up along the short-run aggregate supply curve. b. An increase in what the price level is expected to be in the future would cause the short-run aggregate supply curve to shift to the left. c. A price level currently higher than expected would lead workers and firms to increase wages and prices, causing the short-run aggregate supply curve to shift to the left. d. An unexpected increase in the price of an important raw material would cause the short-run aggregate supply curve to shift to the left. e. An increase in the labor force participation rate would cause the short-run aggregate supply curve to shift to the right.

2.9

2.10

2.11

You should disagree. The increase in aggregate supply is shown by the shift from SRAS1 to SRAS2. This shift, which results in a decline in the price level from P1 to P2, will not cause a shift of the aggregate demand curve. Instead, the shift causes only a movement along the aggregate demand curve.

A movement from point A to point B along the short-run aggregate supply curve would be caused by an increase in the price level. A movement from point A on short-run aggregate supply curve SRAS1 to point C on short-run aggregate supply curve SRAS2 could be caused by any of the factors that shift the short-run aggregate supply curve to the right, such as an increase in the labor force, the capital stock, or productivity, or a decrease in the expected future price level or in the expected price of an important natural resource, or the end of a natural disaster or pandemic. a. Supply shocks are unexpected events that cause the short-run aggregate supply curve to shift.

They are usually caused by unexpected increases or decreases in the prices of important natural resources, such as oil but in this case the cause was the Covid-19 pandemic. b. The Covid-19 pandemic of 2020 was a rare example of a disease resulting in a supply shock to the U.S. economy. Because the pandemic affected all 50 states and resulted in many businesses temporarily closing or operating at reduced capacity, the short-run aggregate supply curve shifted to the left—firms were supply a smaller quantity of output at each price level. c. Because the pandemic reduced the supply of many goods as businesses shut down, the shortrun aggregate supply curve shifted to the left.

2.12

a. This scenario is consistent with graph 3, where the short-run aggregate supply curve shifts to the right, as workers, households, and firms adjust to lower costs and prices in the future, while the long-run aggregate supply curve does not shift. b. This scenario is consistent with graph 2, where the short-run aggregate supply curve shifts to the left as wages and other costs increase, while the long-run aggregate supply curve does not shift. c. This scenario is consistent with graph 1 because positive technological change will cause both the SRAS curve and the LRAS curve to shift to the right.

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2.13

When more firms widely adopt robots that can perform human tasks faster, the firms’ costs will decrease. This decrease in cost will shift the firms’ short-run supply curves to the right. When many firms in the economy experience a decrease in cost, the short-run aggregate supply curve will shift to the right. The long-run aggregate supply curve will also shift to the right because the use of robots is an improvement in technology that will increase the capacity of the economy.

2.14

a. Nominal wage rigidity refers to wages not declining even when unemployment increases. b. Wages were expected to fall during the Great Recession of 2007–2009 because the unemployment rates were at their highest to that point since World War II. High unemployment rates mean that the quantity of labor supplied is significantly greater than the quantity of labor demanded, so we would expect the price of labor—the wage—to fall. c. While cutting wages would lower firms’ costs and help them to reduce their losses, firms may be reluctant to cut wages because doing so may upset their employees, reducing productivity and possibly leading their best employees to quit. Some firms may also have signed union contracts that specify the wages their workers will receive.

2.15

d. Yes. Real wages are defined as nominal wages divided by the price level. Real wages may decline without a cut in the nominal wages when the price level increases, as it did between 2007 and 2009. a. Firms are reluctant to lay off workers who have skills that the firms would have to replace with new, less skilled workers after the recession ends and the demand for output rises.

Recruiting and training new workers to replace those who were previously laid off could be more costly than retaining and paying skilled workers during the recession. In addition, as the article notes, cutting nominal wages can hurt employee morale and productivity and could also lead to some workers quitting. The workers most likely to quit are those who believe they are most likely to be able to find another job—that is, the firm’s best workers, who are the most difficult to replace. b. “Cash value” refers to the workers’ nominal wages. Firms can reduce the purchasing power of wages–or real wages–by not increasing workers’ nominal wages during a period of inflation, or by increasing nominal wages by less than the rate of inflation.

23.3

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

Review Questions 3.1

When the economy is in long-run macroeconomic equilibrium, the short-run aggregate supply curve and the aggregate demand curve intersect at a point on the long-run aggregate supply curve.

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3.2

Stagflation is the combination of recession (or stagnation) and inflation. An adverse supply shock causes the short-run aggregate supply curve to shift to the left, from SRAS1 to SRAS2, resulting in an increase in the price level, from P1 to P2, and a decrease in real GDP, from Y1 to Y2.

3.3

Alternative iv. is likely to result. The unemployment rate will rise in the short run as real GDP and income decline during the recession. Rising unemployment and lower output will result in lower wages and prices. Eventually the short-run aggregate supply curve will shift to the right, returning GDP to its potential level and unemployment to the natural rate of unemployment. Even if government policymakers do not respond to a recession, the economy will return to potential GDP in the long run, although the process may take several years.

Problems and Applications 3.4

a. “Argentina’s economy contracted” means that the economy was in a recession during the period. Typically, economists use changes in real GDP to gauge whether an economy is in a recession. As we saw in Chapter 20, Section 20.3, in the United States, in defining a recession, the National Bureau of Economic Research focuses on changes in a range of variables beyond real GDP: “A recession is a significant decline in activity spread across the economy, lasting more than a few months, visible in industrial production, employment, real income, and wholesale–retail trade.” b. The graph following assumes that the Argentine economy was initially in long-run equilibrium reduction (P1 and Y1) prior to the decrease in private spending. As a result of the in private spending—which refers consumption spending and investment spending—the aggregate demand curve shifts to the left, from AD1 to AD2. The price level falls to P2 and real GDP falls to Y2. c.

As workers and firms adjust their wages and prices to the decline in aggregate demand, the short-run aggregate supply curve shifts to the right, from SRAS1 to SRAS2. The economy will reach long-run equilibrium at P3 and Y1.

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a. The large increase in the demand for U.S. exports shifts the aggregate demand curve to the right, from AD1 to AD2, moving short-run equilibrium from point A to point B with a higher price level and higher real GDP. The unemployment rate is lower because real GDP has increased with no change in potential real GDP. Workers and firms will eventually adjust to the price level being higher than they expected. Workers will push for higher wages, and firms will charge higher prices, causing the short-run aggregate supply curve to shift to the left, from SRAS1 to SRAS2. In the long run, the economy will be in equilibrium at point C with a higher price level, P3, and the same level of real GDP (Y1). The unemployment rate will return to what it was at point A.

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

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CHAPTER 23 | Aggregate Demand and Aggregate Supply Analysis short-run aggregate supply curve shifts from SRAS2 back to SRAS1, and equilibrium moves from point B back to point A. When the economy has adjusted back to equilibrium at point A, real GDP, the price level, and the unemployment rate are back to their original values.

3.6

3.7

Spending on housing is likely to fluctuate more than spending on consumer durables or spending by firms on plant and equipment because housing usually consumes the largest portion of a household’s income. The greater the percentage of income a good or service consumes, the more sensitive purchasers of those goods or services will be to changes in economic conditions. In addition, spending on housing is sensitive to changes in interest rates because the size of a household’s monthly payment on its mortgage loan depends on interest rates at the time the household takes out the mortgage to buy a home. Because the Federal Reserve changes interest rates as part of monetary policy, spending on housing fluctuates more than it otherwise would. a. If firms operate beyond their normal capacity, then actual real GDP can be above potential GDP. b. The unemployment rate increased from 1969 to 1970 because the increase in actual real GDP was not as large as the increase in potential GDP. c. If the recession was caused by a shift in aggregate demand (in fact, it was), the inflation rate was likely to have been lower in 1970 than in 1969 (in fact, it was higher).

3.8

a. Points A and C represent long-run equilibrium points because they are on the LRAS curve where the SRAS curve and the AD curve intersect. b. Point D represents the short-run equilibrium, and point C represents the eventual long-run equilibrium. After a time, workers and firms will adjust to the price level being higher than they expected. Workers will push for higher wages, and firms will charge higher prices, causing the short-run aggregate supply curve to shift to the left until it reaches SRAS1 and long-run equilibrium is restored at point C.

3.9

The exceptionally long economic expansion ended due to Covid-19 economic shutdowns.

Business activity plummeted worldwide as nations shut down economic activity to prevent the spread of the virus. No one should have expected a recession to occur despite the abnormally long

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economic expansion. Most economists now believe that real GDP is ordinarily equal to potential GDP, unless the economy experiences a shock to aggregate demand or aggregate supply. After a shock, the economy gradually returns to potential GDP. Unless the economy experiences a shock, there is no reason for an economic expansion to end and a recession to begin. As former Fed Chair Janet Yellen put it: “I think it’s a myth that expansions die of old age. I do not think that they die of old age.”

3.10

Most economists today disagree with Joseph Schumpeter. Economists believe that real GDP will be equal to potential GDP unless the economy experiences a shock to aggregate demand or aggregate supply. Economic expansions result from real GDP growing along with potential

3.11

GDP. Recessions Following a are caused by negative shocks to aggregate demand or aggregate supply. a. i.

An increase in the expected price would match 1, where the short-run shock, there are automatic forces in level the economy thatgraph cause real GDP to eventually aggregate supply curve shifts to the left, causing the price level to increase and real GDP return to to decrease in the short run. potential GDP. During this transition period, real GDP may expand, or increase, at a faster rate ii. An increase in households’ expectations of their future income would match graph 4, than potential GDP is growing. where the aggregate demand curve shifts to the right, causing the price level and real GDP to increase in the short run. iii. A decrease in the price of an important natural resource would match graph 2, where the short-run aggregate supply curve shifts to the right, causing the price level to decrease and real GDP to increase in the short run. iv. A decrease in firms’ expectations of the future profitability of investment spending would match graph 3, where the aggregate demand curve shifts to the left, causing the price level and real GDP to decrease in the short run. b. i.The economy experiences a recession would match graphs 1 and 3, where real GDP declines in the short run. ii. The economy experiences short-term inflation would match graphs 1 and 4, where the price level increases. iii. The economy experiences stagflation would match graph 1, where the price level increases and real GDP decreases.

3.12

a. Stagflation occurs when the economy experiences a combination of inflation and recession, usually resulting from a supply shock. b. If government policymakers are more concerned with unemployment than inflation, they would use policies that would increase aggregate demand. By increasing real GDP, these policies will decrease the unemployment caused by the supply shock. But the policies will increase the inflation rate by increasing the price level. If government policymakers are more concerned with inflation than unemployment, they will use policies that will decrease aggregate demand. These policies will reduce the increase in the price level caused by the supply shock, thereby reducing the inflation rate. But by reducing real GDP, the policies will increase the unemployment rate.

3.13

The Covid-19 pandemic was a rare example of a disease resulting in a supply shock to the U.S. economy. Because the pandemic affected all 50 states and resulted in many businesses temporarily closing or operating at reduced capacity, the short-run aggregate supply curve shifted to the left. On the demand side, the pandemic resulted in a large segment of the U.S. workforce .

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CHAPTER 23 | Aggregate Demand and Aggregate Supply Analysis experiencing a decline in income. This income decline, coupled with business shutdowns that prevented consumers from spending money, resulted in an aggregate demand shock.

This aggregate demand shock would be represented as the aggregate demand curve shifting to the left.

23.4

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

Review Questions 4.1

4.2

In the dynamic model, potential real GDP increases continually, shifting the LRAS curve to the right; the aggregate demand curve shifts to the right during most years, and except during periods when workers and firms expect high rates of inflation or there is a large adverse supply shock, the short-run aggregate supply curve will shift to the right.

Assume that the economy starts in long-run equilibrium. If aggregate demand increases more than potential real GDP increases, the economy will experience inflation and real GDP will exceed

4.3

potential GDP. If aggregate demand increases less than potential real GDP increases, the economy will experience a lower rate of inflation and real GDP will be below potential GDP. The factors that brought on the recession of 2007–2009 were the collapse of the housing bubble, the financial crisis, and the rapid increase in oil prices during 2008. The collapse of the housing bubble dramatically decreased spending on new and existing houses and resulted in falling housing defaultedprices. The decline in housing prices increased the number of borrowers who

Problems and Applications on mortgage loans and, ultimately, along with changes in the mortgage industry, led to the 4.4

financial crisis and the resulting credit crunch. The rapid increase in oil prices added a negative To move from potential GDP in 2023 to potential GDP in 2024 without inflation, supply shock to an already faltering economy. aggregate demand, long-run aggregate supply, and short-run aggregate supply must all increase—or shift to the right—by the same amount.

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4.5 Year

Actual Real GDP

Potential GDP

Price Level

1929

$1,109.4 billion

$1,056.6 billion

9.4

1930

1,015.1 billion

1,148.9 billion

9.1

a. The table shows that the price level declined in 1930 after the economy experienced a decline in real GDP. The price level hasn’t declined from one year to the next during any recession of the past 50 years. b. In the following graph, we assume that aggregate demand decreased from 1929 to 1930, while both short-run and long-run aggregate supply increased.

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4.6

a. Potential GDP increased by [($19.3 trillion – $18.9 trillion) / $18.9 trillion) × 100] = 2.1%.

So, to be consistent with the economists’ forecast, the value of real GDP would have to grow by this amount during 2020. The real GDP in 2019 is $19.1 trillion, so if it grows by 2.1 percent, then its value in 2020 would be $19.1 trillion × 1.021 = $19.5 trillion. A 1.9 percent increase in the GDP deflator means that its value in 2020 would be about 112.3 × 1.019 = 114.4. We can fill in the table with these values and draw a dynamic aggregate demand and aggregate supply graph that is consistent with them.

Year 2019 2020

Real GDP $19.1 trillion $19.5 trillion

Potential GDP $18.9 trillion $19.3 trillion

GDP Deflator 112.3 114.4

b.

4.7

($19.7 trillion − $19.3 trillion) a. Growth rate of potential real GDP =( )×100=2.1% $19.3 trillion

b The unemployment rate is higher in year 2 because the economy is below potential GDP. . c. Inflation rate in year 2 =

d. Growth rate of real GDP in year 2 = 4.8

You should disagree because the statement confuses the inflation rate with the price level. The decline in aggregate demand in 2008 did cause the inflation rate to fall, but the inflation rate was still positive, meaning that the price level increased.

4.9

a. A housing bubble is an increase in the prices of homes that far outpaces the increase in the incomes of people in the economy, or other variables that determine housing demand. A

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housing bubble occurs when people become less concerned with the underlying value of a home and focus instead on expectations of the price of homes increasing. b. Housing prices can increase for a variety of reasons, including higher demand due to increased income or increased population. Housing prices, however, can also increase because households expect the prices to increase in the future and increase the demand for the homes. When the economy is in an expansion, it is difficult to separate these reasons from c. each other. Yes. A housing bubble burst and sent the economy into a deep recession in

4.10

2008-2009. If another bubble bursts today, it could have repercussions similar to what the economy a. experienced in 2008-2009. An increase in productivity shifts the short-run aggregate supply curve to the right as firms produce more output with the same inputs. The long-run aggregate supply curve would also b. shift to the right, assuming the productivity increase was permanent. An increase in government spending will shift the aggregate demand curve to the right, c. holding all else equal.

In the following graph, the increase in productivity will shift the short-run aggregate supply curve for to the right, from SRAS2020 to SRAS2021. The productivity increase also shifts the long-run aggregate supply curve for 2021 to the right, from LRAS2020 to LRAS2021 because it will will also increase potential GDP. At the same time, the increase in government spending shift the aggregate demand curve to the right. The shifts of both the SRAS curve and the AD curve will cause the price level to change, but whether the price level increases or decreases depends on the relative magnitude of those shifts. In this graph, we show the price level increasing from P1 to P2 under the assumption that the shift in aggregate demand is greater than the shift in aggregate supply. The shift in the SRAS will cause the level of real GDP to increase and the shift in the AD curve will also cause the level of real GDP to increase. In the graph, we show the level of real GDP increasing from Y1 to Y2,

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Real-Time Data Exercises D23.1 a. The following graph shows the economy at equilibrium at potential GDP in 1960 and in 2019. With real GDP rising from $3,262.0 billion in 1960 to $19,032.7 billion in 2019, the long-run and the short-run aggregate supply curves shifted to the right. With the GDP price deflator (2015 = 100) rising from 15.9 in 1960 to 107.3 in 2019, aggregate demand grew more than long-run aggregate supply.

b. Given that real GDP declined from $5,687.2 billion in 1973 to $5,644.8 billion in 1975 and that the GDP price deflator rose from 24.0 in 1973 to 28.5 in 1975, the short-run aggregate supply curve shifted to the left from 1973 to 1975. For simplicity, the following graph shows for 1975 only the shift to the left of the short-run aggregate supply curve.

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As indicated in the exercise, download monthly data on the personal consumption expenditure price index and calculate the percentage change from the same month in the previous year. Calculate this percentage change over the entire 1982 through 2007 period.

b. The average inflation rate from 1982 through 1994 was 3.49 percent and from 1995 c.

through 2007 it was 2.03 percent.

The decline in the inflation rate from 1995 through 2007 compared to 1982 through 1994

D23.3 a. is b. consistent increase with a continuing positive supply shock after 1994. Positive supply shocks aggregate supply, decreasing the inflation rate.

Data gathered for use in part (b).

The United Kingdom has had a similar experience to the United States since 2007. The United Kingdom experienced a larger drop in real GDP in late 2008 and early 2009 and has had slower growth in real GDP since 2009. From 2007 to 2011, the United Kingdom experienced higher inflation and lower unemployment than the United States. The data in the following graph show data for the United Kingdom over this period of time. Source: Federal Reserve Economic Data (FRED) website (fred.stlouisfed.org),

Suggestions for Critical Thinking Exercises CT23.1 There are no common factors that shift both microeconomic demand curves and the aggregate demand curve. There is one factor that shifts both microeconomic supply curves and the aggregate supple curve: productivity. We can also note that the expected future price of a good and of the price level are clearly analogous. We can conclude from these observations that many of the concepts and principles you learned in microeconomics do not carry over to macroeconomics. This question targets a persistent student confusion about the differences between microeconomics and macroeconomics.

CT23.2 There are no factors that shift both the AD curve and the SRAS curve because the curves deal with different sectors of the economy. Students often have difficulty with AD and SRAS; this question helps them explore the factors that shift these curves by comparing them.

CT23.3 The table shows that both the real GDP and the GDP deflator increased every year from 2013 to 2020. However, in 2020 the real GDP declined while the GDP deflator increased. This result is .

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CHAPTER 23 | Aggregate Demand and Aggregate Supply Analysis illustrated in the figure below, which shows the short-run aggregate supply, the long-run aggregate supply and the aggregate demand curves all shifting to the right for the overall period of time running from 2013 to 2020. Keep in mind that the curves would have been further to the right if the data ended in 2019. The decline in real GDP during 2020 resulted in part from the SRAS and the LRAS shifting to the left slightly. The aggregate demand curve had to shift more than both the short-run aggregate supply and the long-run aggregate supply to result in both real GDP and the price level increasing.

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CHAPTER 24 | Money, Banks, and the Federal Reserve System Brief Chapter Summary 24.1 What Is Money, and Why Do We Need It? Define money and discuss the four functions of money.

▪ Money is anything that people are generally willing to accept in exchange for goods or

services or in payment of debts. Money functions as a medium of exchange, a unit of account, a store of value, and a standard of deferred payment.

24.2 How Is Money Measured in the United States Today?

Discuss the definitions of the money supply used in the United States today.

▪ The narrower definition of the money supply in the United States today is M1, which

includes currency and checking account and savings account balances. M2 is a broader definition of the money supply and includes M1 plus small-denomination time deposits and noninstitutional money market fund shares.

24.3 How Do Banks Create Money?

Explain how banks create money.

▪ By accepting deposits and making loans, banks create checking account deposits.

24.4 The Federal Reserve System Describe how the Fed manages the money supply.

▪ The Federal Reserve (Fed) is the central bank of the United States. The Fed’s three monetary

policy tools are open market operations, discount policy, and reserve requirements.

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

▪ In the long run, inflation results from the money supply growing at a faster rate than real

GDP.

Key Terms Asset Anything of value owned by a person or a firm.

Bank run A situation in which many depositors simultaneously decide to withdraw money from a bank.

Bank panic A situation in which many banks experience runs at the same time.

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Commodity money A good used as money that also has value independent of its use as money.

interest rates to pursue macroeconomic policy objectives.

Discount loans Loans the Federal Reserve makes to banks.

Discount rate The interest rate the Federal Reserve charges on discount loans.

Excess reserves Reserves that banks hold over the legal requirement.

Federal Open Market Committee (FOMC).

The Federal Reserve committee responsible for open market operations and managing the money supply in the United States.

Federal Reserve The central bank of the United

Money Assets that people are generally willing to accept in exchange for goods and services or for payment of debts.

Open market operations The buying and selling of Treasury securities by the Federal Reserve in order to control the money supply.

Quantity theory of money A theory about the connection between money and prices that assumes that the velocity of money is constant.

Required reserve ratio The minimum fraction of deposits banks are required by law to keep as reserves.

States.

Fiat money Money, such as paper currency, that is authorized by a central bank or governmental body and that does not have to be exchanged by the central bank for gold or some other commodity money.

Required reserves Reserves that a bank is legally required to hold, based on its checking account deposits.

Reserves Deposits that a bank keeps as cash in its vault or on deposit with the Federal Reserve.

Securitization The process of transforming loans or other financial assets into securities.

Security A financial asset—such as a stock or a bond—that can be bought and sold in a financial market.

Fractional reserve banking system A banking system in which banks keep less than 100 percent of deposits as reserves.

M1 The narrower definition of the money supply: the sum of currency in circulation and checking account and savings account deposits in banks.

M2 A broader definition of the money supply:

Simple deposit multiplier The ratio of the amount of deposits created by banks to the amount of new reserves.

It includes M1 plus savings account deposits, small-denomination time deposits and noninstitutional money market fund shares.

Monetary policy The actions the Federal Reserve takes to manage the money supply and

Velocity of money The average number of times each dollar in the money supply is used to purchase goods and services included in GDP.

Chapter Outline Is Venmo the End of Money?

When economists refer to the quantity of money in the U.S. economy, they usually are referring to the total value of currency plus checking account balances. Although you may have a checking account, many students have never written out a check and many rarely use cash. One way that people buy goods and services today without using cash or checks is with smartphone apps such as Venmo. Once a user has set up a Venmo account linked to a bank checking account, debit card, or credit card, the app

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allows people to directly transfer funds to another Venmo user. In the United States and other highincome countries, avoiding using cash and checks is usually a matter of convenience. Venmo's use jumped during the Covid-19 pandemic that began in 2020. By 2021, the company had more than 60 million active users. In some developing countries, peer-to-peer payment apps such as Venmo can help increase living standards. A country needs a well-functioning financial system if its economy is to prosper and grow.

24.1 What Is Money, and Why Do We Need It?

Learning Objective: Define money and discuss the four functions of money.

Money refers to assets that people are generally willing to accept in exchange for goods and services or for payment of debts. An asset is anything of value owned by a person or a firm.

A. Barter and the Invention of Money

Economies where goods and services are traded directly for other goods and services are called barter economies. For a barter trade to take place between two people, each person must want what the other one has, known as a double coincidence of wants. A good used as money that also has value independent of its use as money is called commodity money. The high income levels in modern economies are based on the specialization that money makes possible. By making exchange easier, money allows for specialization and greater productivity.

B. The Functions of Money Anything used as money must serve four key functions: 1. Medium of exchange: Sellers are willing to accept it in exchange for goods or services.

2. Unit of account: Each good has a price in terms of money.

3. Store of value: Money allows value to be stored easily.

4. Standard of deferred payment: Money can facilitate exchange over time.

C. What Can Serve as Money?

There are five criteria that make a good suitable for use as a medium of exchange: 1. It must be acceptable to most people.

2. It should be of standardized quality.

3. It should be durable.

4. It should be valuable relative to its weight.

5. It should be divisible.

Dollar bills meet all of these criteria. Commodity money—gold, for example—has two significant problems: (1) its value depends on its purity and (2) the money supply is difficult to control because it depends partly on unpredictable discoveries of new gold fields. Paper money is generally issued by a central bank. The Federal Reserve is the central bank of the United States. Paper currency has no value unless it is used as money, so it’s not a commodity money. Fiat money is money, such as paper currency, that is authorized by a central bank or governmental body and that does not have to be exchanged by the central bank for gold or some other commodity money.

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Extra Solved Problem 24.1 Money in the Eighteenth Century Americans use paper money because it meets the five criteria that make any good suitable as a medium of exchange. Paper money is: 1. Acceptable to most people 2. Of standardized quality 3. Durable 4. Valuable relative to its weight 5. Divisible Other commodities have served as money, including animal skins. The following is a list of prices for goods supplied to a Native American tribe in upstate New York in 1703: Item One yard of broadcloth Two yards of cotton Five pecks of corn Two pints of powder Ten pounds of pork One hat with hatband One shirt One sword blade Six knives

Price 3 beaver skins 1 beaver skin 1 beaver skin 1 beaver skin 1 beaver skin 3 beaver skins 1 beaver skin 1 ½ beaver skins 1 beaver skin

Source: Hudson Historical Bureau.

a. What function of money does this list demonstrate? b. Why did some people use animal skins as money in the eighteenth century?

Solving the Problem Step 1:

Review the chapter material.

This problem is about the definition and functions of money, so you may want to review the section “What Is Money, and Why Do We Need It?” Explain the function of money the list demonstrates.

Step 2:

Step 3:

The list of prices demonstrates the use of beaver skins as a unit of account, or a way of measuring value in terms of money.

Explain why some people used animal skins as money in the eighteenth century.

It is important to consider this question in the context of the alternatives that were available to serve as money in the early eighteenth century. There was no central bank that could issue and regulate the supply of money, and trading was much less sophisticated than it is today. Individuals developed a system that was suitable to their purposes.

Animal skins were recognized as valuable commodities by both Native Americans and colonial settlers. Relative to other goods, skins were relatively durable—they would not melt or spoil in hot weather

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CHAPTER 24 | Money, Banks, and the Federal Reserve System and were not harmed by cold weather—and easily transported. Individual pelts were similar to each other (standardized) and fairly small so that divisibility was not a serious problem. An additional attribute was that the supply of skins could not be increased without cost. People had to hunt for animals, and skins were difficult to counterfeit. This natural limitation on the supply of skins enhanced their acceptability among traders. In a period before the availability of inexpensive clothing made from cotton and wool, people could use animal skins to make useful items such as coats, hats, blankets, and rugs. Therefore, the animal skins were a commodity money.

Extra Apply the Apple Didn’t Want My Cash!

Concept If Federal Reserve Notes are legal tender, doesn’t that mean that everyone in the United States, including every business, has to accept paper money? The answer to this question is “no,” as a woman in California found out in 2010 when she went to an Apple store in Palo Alto and tried to buy an iPad using $600 in currency. The store refused to sell her the iPad for cash. At that time, the iPad had just been released, and Apple did not want to sell large numbers to people who were buying them to resell on eBay, Craigslist, or elsewhere. So, a customer wanting to buy an iPad had to pay with either a credit card or a debit card, which would make it easier for Apple to keep track of anyone attempting to buy more than the limit of two per customer.

Because Federal Reserve Notes are legal tender, creditors must accept them in payment of debts, and the government will accept them in payment of taxes. However, as this incident demonstrates, firms do not have to accept cash as payment for goods and services. As the U.S. Treasury Department explains There is … no Federal statute mandating that a private business, a person or an organization must on its accept currency or coins as payment for goods and/or services. … For example, a bus line may Web site: prohibit payment of fares in pennies or dollar bills. In addition, movie theaters, convenience stores and gas stations may refuse to accept large denomination currency (usually notes above $20) as a matter of policy.

The woman who tried to buy an iPad for cash was disabled and on a limited income, so the incident led to negative publicity for Apple. As a result, Apple decided to lift its ban on paying for iPads with cash⸻ provided that the customer was willing to set up an Apple account at the time of purchase. In addition, Apple with presented a free iPad to the customer who was originally turned down when she tried to pay cash.

Teaching TipsWinter, “Apple Ends No-Cash Policy and California Woman Gets Free iPad,” www.usatoday.com, Sources: Michael May 20, 2010; and U.S. Treasury, “FAQs: Currency,” www.treasury.gov/resourceThe end of the chapter in the main text includes a special category of exercises titled Real-Time center/faqs/Currency/Pages/edu_faq_currency _index2.aspx

Data (RTDA) Exercises. These exercises are well worth assigning and discussing in class because they help students become familiar with a key data source, learn how to locate data, and develop skills in interpreting data. Many RTDA exercises require more elaborate calculations than other problems and the use of Excel spreadsheets.

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24.2

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How Is Money Measured in the United States Today?

Learning Objective: Discuss the definitions of the money supply used in the United States today.

A. M1: A Narrower Definition of the Money Supply M1 is the narrower definition of the money supply: the sum of currency in circulation and checking account deposits and savings account deposits in banks. Checking account deposits are used more often than currency to make payments.

B. M2: A Broader Definition of Money M2 is a broader definition of the money supply: It includes M1 plus small-denomination time deposits and noninstitutional money market mutual fund shares.

Here are two key points about the money supply: 1. The narrower definition of the money supply consists of currency and checking account and savings account deposits.

2. Because balances in checking account and savings account deposits are included in the money supply, banks play an important role in the way the money supply increases and decreases.

C. What about Credit Cards and Debit Cards?

Credit cards are not included in the definitions of the money supply because they are considered loans from banks that issue the cards. With a debit card, the funds to make a purchase are taken directly from a checking account. Neither credit cards nor debit cards themselves represent money.

Extra Apply the Do We Still Need the Penny?

Concept We have seen that fiat money has no value except as money. Governments make a profit from issuing fiat money because fiat money is usually produced using paper or low-value metals that cost far less than the face value of the money. For example, it costs only about 4 cents for the federal Bureau of Engraving and Printing to manufacture a $20 bill. The government’s profit from issuing fiat money— which is equal to the difference between the face value of the money and its production cost—is called seigniorage.

With small-denomination coins—like pennies or nickels—there is a possibility that the coins will cost more copperto produce than their face value. This was true in the early 1980s, when the rising price of meant the federal government was spending more than 1 cent to produce a penny. That led the government to switch from making pennies from copper to making them from zinc. By 2007, however, the rising price of zinc meant that once again, the penny cost more than 1 cent to produce. Although the price of zinc later declined, many economists began to ask whether the penny should simply be abolished.

Not only does it sometimes cost more to produce than it is worth, but inflation has eroded its purchasing power bother to to such an extent that some people find the penny to be a nuisance. Many people will not pick up a penny from the sidewalk. In fact, several other countries, including Great Britain, Australia, .

and the European countries that use the euro, have eliminated their lowest-denomination coins.

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estimates have put the cost to consumers of the rounding tax as high as $600 million a year. But Robert Whaples, an economist at Wake Forest University, after analyzing almost 200,000 transactions from a convenience store chain, concludes that “the ‘rounding tax’ is a myth. In reality, the number of times consumers’ bills would be rounded upward is almost exactly equal to the number of times they would be rounded downward.”

François Velde, an economist at the Federal Reserve Bank of Chicago, has come up with perhaps the most that ingenious solution to the problem of the penny: The federal government would simply declare Lincoln pennies are now worth 5 cents. There would then be two 5-cent coins in circulation—the current Jefferson Lincoln nickels and the current Lincoln pennies—and no 1-cent coins. In the future, only the coins—now worth 5 cents—would be minted. This would solve the problem of consumers and retail stores than itshaving to deal with pennies, it would make the face value of the Lincoln 5-cent coin greater cost of production, and it would also deal with the problem that the current Jefferson nickel frequently costs cents more than 5 cents to produce. But will Lincoln pennies actually be accepted as being worth 5 simply because the government says so? The answer is “yes” because as long as the government is willing to exchange 20 Lincoln coins for a paper dollar, everyone else will be willing to do so as well.

Of course, if this plan were adopted, anyone with a hoard of pennies would find that their money Question In the nineteenth century, the Canadian government had difficulty getting banks and the would be accept the penny, which had been introduced a few years before. As a result, the government public to worth times for as much overnight! offeredfive pennies sale at a 20 percent discount. One account of this episode describes this sale as “negative seigniorage.”

What is seigniorage?

Why might thevery Canadian penniesthe at Whether or not pennies get turned into nickels, it seems likely government’s that one wayselling or another, a 20 percent discount be considered “negative seigniorage”?

Source: Nicholas Kohler, “A Penny Dropped,” macleans.ca, January 14, 2011.

penny will eventually disappear from the U.S. money supply.

Sources: Robert Whaples, “Why Keeping the Penny No Longer Makes Sense,” USA Today, July 12, 2006; Austan Goolsbee, Seigniorage “Now That a Penny Worth Much,profit It’s Time to Make It Worth Cents,” and New equals York Times, 1, Answer is theIsn’t government’s from issuing fiat 5money the February difference 2007; François Velde, “What’s a Penny (or a Nickel) Really Worth?” Federal Reserve Bank of Chicago, Chicago Fed between the face value of the money and its production cost.

The Canadian government selling Letter, No. 235a, February 2007; and Nicholas Kohler, “A Penny Dropped,” macleans.ca, January 14, 2011.

pennies at a 20 percent discount would be negative seigniorage if the production cost of the penny exceeded the face value of the penny after the 20 percent discount.

24.3 How Do Banks Create Money?

Learning Objective: Explain how banks create money.

The key role that banks play in the economy is to accept deposits and make loans.

A. Bank Balance Sheets The key assets on a bank’s balance sheet are its reserves, loans, and holdings of securities, such as U.S. Treasury bills. Reserves are deposits that a bank keeps as cash in its vault or on deposit with the Federal Reserve. Required reserves are reserves that a bank is legally required to hold, based on its checking account deposits. The required reserve ratio is the minimum fraction of deposits banks are required by law to keep as reserves. Excess reserves are reserves that banks hold over the legal requirement. Banks

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make consumer loans to households and commercial loans to businesses. A loan is an asset to a bank because it represents a promise by the person taking out the loan to make specified payments to the bank. A bank’s reserves and its holding of securities are also assets. A bank’s largest liability is its deposits, which include checking accounts, savings accounts, and certificates of deposit.

B. Using T-Accounts to Show How a Bank Can Create Money A T-account is a stripped-down version of a balance sheet that shows how a transaction changes a bank’s balance sheet. When a bank accepts a deposit, it keeps only a fraction of the funds as reserves and loans out the remainder. In making a loan, banks increase the checking account balance of the borrower. When the borrower uses a check to buy something with the funds the bank has loaned, the seller will deposit the check in his bank. The seller’s bank will keep part of the deposit as reserves and loan out the remainder. This process will continue until no banks have excess reserves. In this way, the process of banks making new loans increases the volume of checking account balances and the money supply.

C. The Simple Deposit Multiplier The simple deposit multiplier is the ratio of the amount of deposits created by banks to the amount of new reserves. The formula for the simple deposit multiplier is: Simple deposit multiplier =

,

where RR is the required reserve ratio. (As discussed in the chapter, in March 2020, the Fed eliminated the reserve requirement by setting it equal to 0 percent of a bank’s checking account deposits. We can make the discussion consistent with traditional terminology by continuing to use RR to stand for the ratio of reserves to deposits that banks voluntarily decide to hold.) We can use this formula to calculate the total increase in checking account deposits from an increase in bank reserves due, for instance, to currency being deposited in a bank: Change in checking account deposits = Change in bank reserves

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D. The Simple Deposit Multiplier versus the Real-World Deposit Multiplier The explanation for the way an increase in reserves in the banking system leads to the creation of new deposits and an increase in the money supply is simplified in two ways. First, we assumed that banks always want to keep the same ratio of reserves to deposits. In fact, banks vary the amount of reserves they hold relative to their deposits. Second, we assumed that the whole amount of every check is deposited in a bank. But households and firms keep roughly constant the amount of currency they hold relative to the value of their checking account balances. The effect of these two factors is to reduce the real-world multiplier to about 1.6 during normal times.

We can summarize two important conclusions: 1. When banks gain reserves, they make new loans, and the money supply expands.

2. When banks lose reserves, they reduce their loans, and the money supply contracts.

Extra Apply the Banks Create Money—Who Prints Money?

Concept When economists describe how “banks create money,” they don’t mean that banks literally print money—currency—but that by lending reserves, banks create new deposits that become part of the

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money supply. The Federal Reserve does not print money either, though on each bill “Federal Reserve Note” is printed. The Department of the Treasury’s Bureau of Engraving and Printing (BEP) literally prints money at its facilities in Washington, D.C. and Fort Worth, Texas. Each year, the Federal Reserve orders various quantities of each bill denomination to be printed by the BEP. The BEP also prints other documents. Visitors can view the money printing process and even buy sheets of currency or other printed documents such as President Abraham Lincoln’s Gettysburg Address at BEP gift shops at its two locations. Consumers can also purchase printed documents online. The BEP ships bundles of Federal Reserve Notes to the twelve Federal Reserve banks for distribution to commercial banks in their districts. Commercial banks ship old, torn bills to the Federal Reserve banks to be shredded and destroyed. Another department of the Treasury is in charge of minting coins.

Source: Bureau of Engraving and Printing. http://www.moneyfactory.gov/

24.4

The Federal Reserve System Learning Objective: Compare the three policy tools the Federal Reserve uses to manage the money supply.

In a fractional reserve banking system, banks keep less than 100 percent of deposits as reserves.

When people deposit money in a bank, the bank lends most of the money to someone else. On a typical day, about as much money is deposited in a bank as is withdrawn. A bank run is a situation in which many depositors simultaneously decide to withdraw money from a bank. A bank panic is a situation in which many banks experience runs at the same time. It is possible for one bank to handle a run by borrowing from other banks. A central bank, like the Federal Reserve in the United States, can help stop a bank panic by acting as a lender of last resort. In this case, a central bank makes loans to banks that cannot borrow funds elsewhere. The bank can use these loans to pay off depositors. When the panic ends and the depositors put their money back in their accounts, the bank can repay the loan to the central bank.

A. The Establishment of the Federal Reserve System With the intention of putting an end to banking panics, in 1913 Congress passed the Federal Reserve Act, setting up the Federal Reserve System, (often referred to as “the Fed”). Discount loans are loans the Federal Reserve makes to banks. The discount rate is the interest rate the Federal Reserve charges on discount loans. The Fed’s first significant test as a lender of last resort came in the early years of the Great Depression of the 1930s, but Fed officials declined to make loans to many banks because they were worried that banks experiencing runs had made bad loans and other investments. In 1934, Congress established the Federal Deposit Insurance Corporation (FDIC) to insure deposits in most banks up to a limit, which is currently $250,000 per deposit.

In 1913, Congress divided the country into 12 Federal Reserve districts. The real power of the Fed lies with are the Board of Governors in Washington, D.C. The seven members of the Board of Governors appointed by the president of the United States to 14-year terms. The Fed acts as a bankers’ bank, providing services such as check clearing, and manages the nation’s money supply.

B. How the Federal Reserve Manages the Money Supply

Monetary policy refers to the actions the Federal Reserve takes to manage the money supply and interest rates to pursue macroeconomic policy objectives. To manage the money supply, the Fed uses six monetary policy tools: 1. Open market operations 2. Discount policy 3. Reserve requirements

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4. Interest on reserves 5. Overnight reverse repurchase agreement facility 6. Term deposit facility All of the Fed’s policy tools are aimed at affecting the reserves of banks as a means of changing the volume of checking account deposits.

The Federal Open Market Committee (FOMC) is the Federal Reserve committee responsible for open market operations and managing the money supply in the United States. The FOMC meets eight times a year to discuss monetary policy. The committee has 12 members: • • •

The 7 members of the Board of Governors The president of the Federal Reserve Bank of New York 4 presidents from the other Reserve banks

To increase the money supply, the FOMC directs the trading desk at the Federal Reserve Bank of New York to buy U.S. Treasury securities. To decrease the money supply, the FOMC directs the trading desk to sell Treasury securities. Open market operations refers to the buying and selling of Treasury securities by the Federal Reserve in order to control the money supply. There are three reasons the Fed traditionally conducted monetary policy principally through open market operations: 1. The Fed initiates open market operations; the Fed completely controls their volume.

2. Open market operations are easily reversible.

3. The Fed can implement its open market operations quickly, with no administrative delay or required changes in regulations.

By lowering the discount rate, the Fed can encourage banks to take additional loans and increase their reserves. Raising the discount rate will have the opposite effect. When the Fed reduces the required reserve ratio, it converts required reserves into excess reserves. If the Fed raises the reserve requirement, it will have the opposite effect. The Fed changes reserve requirements much more rarely than it conducts open market operations or changes the discount rate. However, in March 2020, the Fed reduced the ratio from 10 percent to zero percent, effectively abolishing the reserve requirement. Since 2008, the Fed has paid banks interest on their reserves. When the Fed decreases the interest rate it pays on reserves, it increases the incentive for banks to create loans. Raising this interest rate has the opposite effect. With repurchase agreements, banks borrow and lend with each other and with the Fed for very short periods.

(Note that how the Fed uses the overnight reverse repurchase agreement facility to as a tool of monetary policy is explained more fully in Chapter 15, Section 15.2.) When the Fed sells term deposits to banks, banks have fewer funds to loan.

C. The “Shadow Banking System” and the Financial Crisis of 2007–2009 In the past 25 years, two important developments have occurred in the financial system: 1. Banks have begun to resell many of their loans rather than keeping them until they are paid off.

2. Financial firms other than commercial banks have become sources of credit to businesses.

Traditionally, when a bank made a residential mortgage loan to a household to buy a home or made a commercial loan to a business, the bank would keep the loan and collect the payments until the loan was paid off. A financial asset—such as a stock or a bond—that can be bought and sold in a financial market is a security. When a financial asset is first sold, the sale takes place in a primary market. Subsequent sales take place in a secondary market. After 1970, loans began to be securitized. Securitization is the

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process of transforming loans or other financial assets into securities. Figure 24.5 shows the process of securitization.

The financial system was also transformed in the 1990s and 2000s by the increasing importance of (1) nonbank financial firms, such as investments banks; (2) money market mutual funds; and (3) hedge funds.

Investment banks concentrate on advising firms that are issuing stocks and bonds and considering mergers with other firms. In the 1990s, investment banks began bundling large numbers of their mortgages and reselling them to investors. Mortgage-backed securities became popular because they often paid higher interest rates than similar securities. Money market mutual funds sell shares to investors and use the money to buy short-term securities. Hedge funds raise money from wealthy investors and use sophisticated investment strategies that often involve significant risk. By raising money from individual investors and providing it directly or indirectly to firms and households, investment banks, money market mutual funds, hedge funds, and other financial firms—the “shadow banking system”—were carrying out a function that at one time was almost exclusively the domain of commercial banks.

The firms in the shadow banking system differed from commercial banks in two ways: First, the government agencies that regulated the commercial banking system did not regulate these firms.

Second, these firms were more highly leveraged than were commercial banks. Beginning in 2007, some firms in the to shadow banking system experienced runs. As housing prices began to fall, some borrowers began default on their mortgages, which caused mortgage-backed securities to lose value. Investment banks and Teaching Tips other financial firms that had borrowed short term and invested the funds long term were in trouble.

In the The Web site of the Federal Reserve System, http://www.federalreserve.gov/ has the latest information on fall of 2008, the process of securitization had ground to a halt.

The resulting credit crunch monetary policy and regulation.

Look for “Information Regarding Recent Federal Reserve Actions.” significantly worsened the recession that had begun in December 2007.

Extra Solved Problemwith 24.4the U.S. Treasury, took action to deal with the financial panic. In the The Fed, in combination

Open Market Operations and Changes in the Supply of Money

fall of Suppose that the Federal Reserve would like to increase the money supply by $500,000. How can the Fed 2008, the under the Troubled Asset Relief Program (TARP), the Fed and Treasury began to stabilize use open market operations to accomplish this goal? Assume the required reserve ratio is 10 percent. commercial banking system by providing funds to banks in exchange for stock. The Fed modified its Solving Problem discount the policy to make it possible to grant loans to financial firms that had not previously been eligible.

Step 1:

Review the chapter material.

This problem is about the Fed’s use of open market operations, so you may want to review the section “The Federal Reserve System.”

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Determine the level of deposits that can be created from excess reserves.

When the Federal Reserve uses open market operations to increase the supply of money, the Fed buys securities from the public. When the public deposits the proceeds from these sales in their banks, the level of deposits and the level of reserves in the banking system increase. Because banks only have to keep a fraction of the deposits they receive as reserves, the level of excess reserves will increase. Assume that ΔD is the change in deposits, ΔR is the change in reserves, and RR is the required reserve ratio. The total amount of deposits that can be created from these excess reserves is determined by the formula: .

Step 3:

Calculate the change in reserves.

If the Fed would like to increase the money supply by $500,000, it needs to increase deposits by $500,000. Using the 10 percent required reserve ratio (RR = 0.10), the formula for determining the change in deposits is: .

Solving this equation for ΔR results in a value of ΔR = $50,000. If the Fed buys $50,000 of securities from the public, reserves will increase by $50,000. As banks create new loans based on these new reserves, the quantity of bank loans and deposits will increase.

Extra Apply the Paying Interest on Reserves Gives the Fed an Additional Policy Concept Tool The financial crisis that led to the recession of 2007–2009 caused the Federal Reserve to take extreme measures to stabilize the U.S. economy. While it did not make headlines, the U.S. Congress gave the Fed a new tool that may allow the Fed help to mitigate the effects of future crises. This new tool is the ability of the Fed to pay interest on reserves that banks have on deposit with the Fed. Many analysts believe that this tool will allow the central bank to have greater control over interest rates and to better manage bank reserves. Michael Feroli, a JPMorgan Chase economist believes “[i]t’s incredibly important that they have this tool.” Because of the recession and actions taken by the Fed and U.S. Treasury in 2008, banks had historically high levels of excess reserves. By the end of 2015, excess reserves had climbed to about $2.3 trillion. As demand for loans increases, those reserves have the potential to cause a massive increase in the money supply and, eventually, high rates of inflation. To slow the growth of the money supply, the Fed can pay banks a higher interest rate on their reserves, which will result in banks lending less of their reserves. Former Federal Reserve chairman Ben Bernanke commented on the importance of the new policy in a speech he made to Congress. “Raising the rate of interest paid on reserve balances will give us substantial leverage over the federal funds rate…banks generally will not supply funds to the market at an interest rate significantly lower than they can earn risk free by holding balances at the Federal Reserve.”

Sources: Michael S. Derby, “Interest on Reserves Seen as Key Fed Tool,” Wall Street Journal, September 11, 2009; David Wessel, “Fed Paying Interest on Reserves: A Primer,” Wall Street Journal, September 16, 2009.

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Extra Apply the The 2001 Bank Panic in Argentina Concept Argentina suffered a bank panic in 2001. Some unusual aspects of the Argentine banking system made it very difficult for the Argentine central bank to act as a lender of last resort. As an alternative policy to stop the bank panic, the Argentine government limited the amount of Argentine currency that depositors could withdraw to $1,000 per account per month. Consumers cut back on their spending because much of the money in their bank accounts could not be withdrawn. Firms like McDonald’s experienced declining sales as the country’s recession worsened.

The inability of the Argentine central bank to act as a lender of last resort resulted from a decision made by theatArgentine government in 1991 to fix the value of the Argentine peso relative to the U.S. dollar one to one. The goal of the policy was to restore public faith in the ability of the Argentine currency to retain its value. Argentina had suffered through several periods of high inflation. In 1990, for example, the inflation rate had been a staggering 2,300 percent. These inflationary episodes caused the purchasing power of the currency to decline rapidly. Although the policy of fixing the value of the peso against the dollar was successful in greatly reducing inflation, it ultimately placed the banking system in an awkward position.

After 1991, Argentine banks were encouraged to take in U.S. dollar deposits and to make U.S. dollar loans, and U.S. dollars were legally recognized as a means of payment within Argentina. By 1994, 60 waspercent of time deposits and 50 percent of loans were in U.S. dollars. The Argentine central bank allowed to issue pesos only in exchange for dollars, which limited its ability to provide pesos to banks experiencing a bank run.

By 2000, many observers began to doubt the ability of the Argentine government to maintain the one-toone exchange rate. Assuffered a result, aArgentine households and2001. firms,The as well as foreign began a Question Argentina severe bank panic in United States investors, has not suffered moving funds out of pesos and into dollars.

By late 2001, fully 80 percent of time deposits in commercial bank panic since the 1930s. What differences between the Argentine and U.S. financial systems can account for their differing vulnerability to bank panics?

Argentine banks Answerwere in dollars rather than in pesos. In addition, many depositors began withdrawing money from their accounts. By December 2001, 47 of the top 50 Argentine banks experienced major withdrawals.

One banksignificant difference between the U.S and Argentine financial systems that accounted for the In panic in 2001 was the inability of the Argentine central bank to act as lender of last resort. This was January 2002, the crisis was ended when the government abandoned its commitment to the one-toone due exchange rate between and the dollar and to decreed that dollar in banks would be U.S. to a 1991 by the the peso Argentine government fix the value of deposits the Argentine peso to the dollar at decision converted to peso deposits at a rate of 1.4 pesos to the dollar.

Although some financial stability was a ratio of one to one. After 1991, Argentine banks were encouraged to take in U.S. dollar deposits restored, the damage to the banking system from the crisis contributed to a decline in real GDP of and to 11.5 make U.S. dollar loans. By 1994, 60 percent of time deposits and 50 percent of loans were in U.S. dollars. percent during 2002.

Source: Kathryn M. E. Dominguez and Linda Tesar, “International Borrowing and Macroeconomic Performance in .

Argentina,” in Sebastian Edwards, ed., Capital Controls and Capital Flows in Emerging Economies: Policies, Practices, and Consequences (Chicago: University of Chicago Press, 2007).

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The Argentine central bank was allowed to issue pesos only in exchange for dollars, which limited its ability to provide pesos to banks experiencing a bank run.

24.5

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

A. Connecting Money and Prices: The Quantity Equation In the early twentieth century, Irving Fisher formalized the connection between money and prices using the quantity equation. The equation states that the money supply (M) multiplied by the velocity of money (V) equals the price level (P) multiplied by real output (Y).

M × V = P × Y. The velocity of money is the average number of times each dollar in the money supply is used to purchase goods and services included in GDP. Rewriting the original equation by dividing both sides by M, the equation for velocity is: .

The left side of this equation must equal the right side. Fisher turned the quantity equation into the quantity theory of money by asserting that the velocity of money was constant. The quantity theory of money is a theory about the connection between money and prices that assumes that the velocity of money is constant.

B. The Quantity Theory Explanation of Inflation We can use a mathematical rule that states that an equation where variables are multiplied together is equal to an equation where the growth rates of the variables are added together.

Therefore, the quantity equation can be transformed to: Growth rate of the money supply + Growth rate of velocity = Growth rate of the price level + Growth rate of output.

The growth rate of the price level is the inflation rate, so we can rewrite the quantity equation to understand the factors that determine inflation: Inflation rate = Growth in the money supply + Growth of velocity – Growth rate of real output.

If velocity is constant, then the growth rate of velocity is zero. This allows us to rewrite the equation as: Inflation rate = Growth in the money supply – Growth rate of real output.

This equation leads to the following predictions: 1. If the money supply grows at a faster rate than real GDP, there will be inflation.

2. If the money supply grows at a slower rate than real GDP, there will be deflation.

3. If the money supply grows at the same rate as real GDP, the price level will be stable.

We can draw the conclusion that in the long run, inflation results from the money supply growing at a faster rate than real GDP.

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C. How Accurate Are Estimates of Inflation Based on the Quantity Theory?

If velocity is not constant, then there may not be a tight link between increases in the money supply and increases in the price level. Because velocity can move erratically in the short run, the quantity equation can’t provide good forecasts of inflation. But over the long run, there is a strong link between changes in the money supply and inflation. The decade from 2011–2020 is an exception, with relatively rapid growth in the money supply but mild inflation. The relationship in this decade is somewhat distorted by the very rapid rate of growth of M2 (19.1 percent) during 2020 as a result of actions the Fed took to fight the economic effects of the Covid-19 pandemic.

D. High Rates of Inflation Hyperinflation is caused by central banks increasing the money supply at a rate far in excess of the growth rate of real GDP. A high rate of inflation causes money to lose its value so rapidly that households and firms avoid holding it. Economies suffering from high inflation usually also suffer from very slow growth, if not severe recession.

Extra Solved Problem 24.5 Growth in the Money Supply and the Inflation Rate Suppose that during a particular year, the money supply grows at a rate of 20 percent, velocity grows at a rate of 5 percent, and real GDP grows at a rate of 1 percent. Calculate the resulting inflation rate.

Solving the Problem Step 1:

Step 2:

Review the chapter material.

This problem is about the link between increases in the money supply and the inflation rate, so you may want to review the section “The Quantity Theory of Money.”.

Use the quantity equation to state the relationship between the inflation rate and the other variables given.

We can rewrite the quantity equation to give us the following relationship between the inflation rate and the other variables given: Inflation rate = Growth rate of the money supply + Growth rate of velocity – Growth rate of real output.

Step 3:

Calculate the inflation rate.

Substituting the numbers from the problem into the equation given in Step 2, we have: Inflation rate = 20% + 5% – 1% = 24%.

Extra Economics in Your Life & Career: If We Never Used Cash, How Much Money Could Banks Create?

Question: Suppose you live in a society where people never withdraw cash from their banks. In this case, how much money could the banking system create? What might limit deposit creation in this case?

Answer: If there were never any withdrawals of cash, the banking system could potentially have unlimited becoming apotential to create money. This situation could develop if we were successful in .

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cashless society where all transactions were paid via check or credit card. This is one possibility. If the banking system did have an unlimited ability to create money, it could only create money if there were a demand for loans. Another limiting factor can be the fact that banks could not loan out more than their excess reserves.

Extra AN INSIDE LOOK News Article to Use in Class Visit Pearson’s MyLab Economics for current news articles.

Solutions to End-of-Chapter Exercises 24.1 What Is Money, and Why Do We Need It?

Learning Objective: Define money and discuss the four functions of money.

Review Questions 1.1 1.2

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

Commodity money, such as gold coins, has value independent of its use as money, while

1.3

fiat money, typically paper currency, does not have value independent of its use as money.

The four functions are medium of exchange, unit of account, store of value, and

1.4

standard of deferred payment. In the long run, something will not serve as money if it does not fulfill all four functions.

Businesses accept paper currency because they believe paper currency is acceptable to their Problems and Applications 1.5

1.6

customers and to other businesses. Paper currency serves as money because people believe that In French Polynesia in the 1880s, the food the French singer received as payment served as a others will accept it from them. medium of exchange, but the food did not serve well as a store of value, a unit of account, or a standard of deferred payment. a. Fiat currency is money, such as paper currency, that is authorized by a central bank or governmental body and that does not have to be exchanged by the central bank for gold or some other commodity money. b. The currency made from the bark of Mulberry trees was fiat money because that currency had no other use other than as money, and it required a decree from Kublai Khan’s government in order to achieve acceptance. c. Executing those who did not accept the fiat currency was not necessary. Modern governments get the public to accept their fiat money by requiring that it be accepted in payment of debts and by requiring that cash or checks denominated in dollars be used in payment of taxes.

Governments, however, do have to convince individuals and firms that the fiat money will

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CHAPTER 24 | Money, Banks, and the Federal Reserve System not lose significant value during the time they hold it. Typically, governments ensure that fiat money does not lose significant value by avoiding issuing too much of it.

1.7

a. Eggs in Venezuela were serving as money in that people were accepting them in exchange for goods and services.

Judging eggs by criteria for money set out in the text: 1. Eggs were accepted by most people, though it was out of necessity because people did not want to accept bolivars, the Venezuelan currency.

2. Eggs do not possess standardized quality. Some eggs are larger than others and eggs that are laid by one breed of chicken may not look and taste the same as those laid by other breeds.

3. Eggs are not durable. Not only can the shells crack easily, but eggs can also lose freshness after a period of time and eventually will spoil and give off a bad odor.

4. Eggs are not valuable relative to their weight. Someone would need a large number of eggs to buy a motorcycle.

5. Eggs are not divisible. You can’t easily split an egg unless you hard boil it and slice it up, which people at the professor’s university weren’t doing. b. Eggs are more durable than some fruits and vegetables. At the correct temperature, eggs can last a few weeks. Eggs however, require extra care in handling. Aside from breaking easily, they need to be stored in refrigerated trucks in order to extend their shelf life. c. Using eggs was still more efficient than trading directly with other people because trading directly requires a double coincidence of wants. Trades done using eggs as a medium of exchange bypass the need for a double coincidence of wants and allow individuals to complete trades faster and with lower search costs.

1.8

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

1.9

1.10

Legally requiring all firms to accept paper currency in exchange for whatever they are selling would help people who do not use credit cards or debit cards, and it would help people who want to leave little or no record of their purchases. The requirement could hurt issuers of credit cards and debit cards, and it would hurt businesses like Apple that want to prevent customers from buying large numbers of their products to resell on eBay, craigslist, or elsewhere. Some firms— for instance, a car dealership—might also find it awkward to have to accept large amounts of currency in exchange for the goods they are selling. In addition, some firms would worry about robberies if they were known to have large amounts of cash in their stores. a. To “ditch cash” means that the business would not accept cash for payment for goods and services. b. Mobile wallet smartphone apps and the development of technology that makes it easy for stores to accept credit card payments on smartphones or tablets make it possible for businesses to ditch cash.

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c. The pros to a business of ditching cash include faster speed of service and a deterrent to robberies. The cons include losing some customers who strongly prefer using cash.

24.2

How Is Money Measured in the United States Today?

Learning Objective: Discuss the definitions of the money supply used in the United States today.

Review Questions 2.1

2.2

M1 equals currency in circulation and the value of checking account and savings accounts.

M2 includes M1 plus small-denomination time deposits, and noninstitutional money market fund shares.

Wealth equals the value of assets minus the value of liabilities, or debts; income equals earnings during plus a period of time, such as a year; and money (using the M1 definition) equals currency checking account and savings account deposits. The central bank controls the quantity of

Problems and Applications 2.3

money.

The actions bank have only annot indirect effect income and wealth. a., b., c., andofd.the arecentral all counted in M1. e. is counted in on either M1 or M2 because credit cards are not part of the money supply.

2.4

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

2.5

2.6

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

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

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2.7

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

2.8

2.9

Funds in money market mutual funds are included in M2 but not in M1. Therefore, this transaction will increase M1 by $1,000. M2 is not affected because money market mutual funds and funds in checking accounts are both included in M2. a. The U.S. dollar is formally accepted as a medium of exchange in a number of other countries and territories—including East Timor, Ecuador, El Salvador, and Zimbabwe—and is widely used in the underground economy in other countries. Many economists believe that the majority of U.S. currency is in circulation outside of the United States. b. The Federal Reserve’s measures of the currency component of the money supply (M1 and M2) overstate the amount of currency held domestically.

2.10

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

2.11

The monetary value of 1.4 billion pennies is $14 million. If all the pennies were worth five cents each, then M1 would increase by $56 million. Such a change would represent a small fraction in the total value of $3.8 trillion for M1 (see Figure 24.1) and, therefore, would have a negligible effect on the economy.

24.3 How Do Banks Create Money?

Learning Objective: Explain how banks create money.

Review Questions 3.1

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

3.2

3.3

Assets

Liabilities

Reserves –$100

Deposits –$100

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

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3.4

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The simple deposit multiplier is, where RR is the required reserve ratio (or, with the required reserve ratio currently at 0, the level of reserves banks want to hold relative to their deposits). The maximum increase in checking account deposits would be $20,000 × (1/0.20), or $20,000 × 5 = $100,000. The maximum increase is unlikely to occur because some of the checking account deposits will be converted into currency and banks are likely to hold some excess reserves rather than use all of their reserves to create new loans, which create new checking account deposits.

Problems and Applications 3.5

Many small businesses borrow relatively small amounts of money compared to the amounts large corporations often borrow. However, small businesses are more reliant on these funds because they lack the ability to sell stocks and bonds on financial markets. Large corporations often borrow by selling bonds or other financial securities. Startups and small businesses are rarely able to borrow in this way. Small business has more success getting loans from community bankers because community bankers have an understanding of the circumstances that affect local firms and typically have long-term relationships with local businesses. As a result, community bankers can more easily assess local businesses’ creditworthiness, which can facilitate the processing and approval of small business loans.

3.6

a. Lender-specific relationships refer to local banks extending loans to borrowers based on the history of the borrower with the bank. As a borrower conducts more business with the bank, the bank uses the borrower’s payment record to approve loans that other banks may not extend. b. A small business may have difficulty obtaining loans from other banks because other banks will not have as much information regarding the creditworthiness of the firm. Local banks typically obtain this information on small businesses only after having a long-term banking relationship with the firm. Small businesses frequently rely on loans from banks (or reinvesting their profits) because they are unable to obtain funds in financial markets.

Investors typically are only willing to buy the stocks and bonds of large firms whose creditworthiness is much easier to evaluate.

3.7

3.8

Using your savings to make loans rather than keeping the funds in bank accounts that earn very low rates of interest involves more default risk, less liquidity, and requires more information and monitoring. The loans have a higher chance of default and are not liquid because you won’t receive your money back until the loan is paid off. Also, you would want to research the loan recipient; research what the funds will be used for; monitor the loan payments; and take steps— perhaps even going to court—if the borrower misses payments. a. Refinancing a loan means that someone is taking out a new loan in order to pay off an old loan. Borrowers usually refinance a loan in order to get a lower interest than they were paying on the previous loan. b. Unlike a conventional bank, SoFi does not have customers who make deposits into the bank.

The “base of deposits” refers to the customer deposits that banks use to make loans. Lacking deposits, SoFi has to borrow from banks the money that it lends out. c. Conventional banks need to maintain multiple branches in order to attract depositors. SoFi does not have branches like conventional banks do, and therefore SoFi avoids having to pay tellers and incur the other costs of running a conventional bank. Because its costs are lower than the costs of conventional banks, SoFi can pay interest on loans to banks and still make a profit on the loans SoFi makes to recent graduates.

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3.9

With a required reserve ratio of 10 percent, Wells Fargo would have to hold $10,000 of reserves against Deja’s $100,000 deposit, leaving Wells Fargo with $90,000 of excess reserves.

The maximum loan that Wells Fargo can make would equal the $90,000 of excess reserves.

3.10

a. Excess reserves = $10,000 – ($70,000 × 0.10) = $3,000. b. The maximum amount by which this single bank can expand its loans is the amount of its excess reserves, or $3,000. c. The following balance sheet shows the immediate effect of the loan. The entry for loans and the entry for deposits have both increased by $3,000.

3.11

3.12

3.13

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

You should disagree with the statement because the balance in a checking account represents something the bank owes to the owner of the account and is a liability for the bank. The car loan represents something that the borrower owes to the bank and is an asset for the bank. a. T-accounts show only the changes in a balance sheet that result from relevant transactions, with assets listed on the left side and liabilities on the right side. Because the bank now has your $2,000 in currency in its vault, its reserves (and, therefore, its assets) have risen by $2,000. This transaction also increases your checking account balance by $2,000. Because the bank owes you this money, the bank’s liabilities have also increased by $2,000.

Bank of America Assets Reserves +$2,000

Liabilities Deposits +$2,000

b. The problem tells you to assume that Bank of America has no excess reserves and that the bank wants to keep 20 percent of the value of its deposits as reserves. So, if the bank’s checking account deposits go up by $2,000, the bank will keep $400 as reserves and will loan out the remaining $1,600. The first line of the following T-account shows the transaction from part (a). The second line shows that Bank of America has loaned out $1,600 by increasing the checking account of the borrower by $1,600. (Remember, new loans usually take the form of an increase in the borrower’s checking account balance.) The loan is an asset for Bank of America because it represents a promise by the borrower to make certain payments stated in the loan agreement.

Bank of America Assets

Liabilities

Reserves +$2,000

Deposits +$2,000

Loans +$1,600

Deposits +$1,600

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c. The following T-accounts show the effect of the borrower having spent the $1,600 he received as a loan from Bank of America. The person who received the $1,600 check deposits it in her account at Citibank. In the first T-account, once Citibank sends the check written by the borrower to Bank of America, Bank of America loses $1,600 in reserves (which it transfers to Citibank). Bank of America also deducts the $1,600 from the account of the borrower. In the second T-account, Citibank has an increase in deposits of $1,600 and an increase in reserves of $1,600, which it receives from Bank of America.

Bank of America Assets Reserves +$400

Liabilities Deposits +$2,000

Loans +$1,600 Citibank Assets Loans +$1,600

Liabilities Deposits +$1,600

d. The formula for the simple deposit multiplier is: Change in checking account deposits = change in bank reserves

.

Because bank reserves rose by $2,000 as a result of your initial deposit and the bank is keeping 20 percent of deposits as reserves (essentially the same result as if there were a required reserve ratio of 20 percent), the change in checking account deposits is: $2,000 ×

= $2,000 × 5 = $10,000.

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

24.4 The Federal Reserve System

Learning Objective: Describe how the Fed manages the money supply.

Review Questions 4.1

Congress established the Federal Reserve System in 1913 to be a lender of last resort to banks in order to prevent bank panics.

4.2

The six monetary policy tools are open market operations, discount policy, reserve

4.3

requirements, interest on reserves, the overnight reverse purchase agreement facility, and the term deposit facility. The traditional monetary policy tools used by the Fed are the first three listed. The Fed began using the last three monetary policy tools after the financial crisis of 2007–2009.

When the Federal Reserve buys Treasury securities from the public, the sellers of the .

securities deposit Treasurythe funds in their banks, which increases bank reserves. When the Fed sells

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4.4

CHAPTER 24 | Money, Banks, and the Federal Reserve System securities to the public, the buyers of the securities pay with checks, decreasing bank reserves. Typically, the Fed buys and sells Treasury securities from banks. When the Fed buys securities from banks, the Fed pays for the securities by depositing the funds in the reserve accounts that banks maintain with the Fed. When the Fed sells securities to banks, the Fed receives the payment by deducting the funds from these same reserve accounts that banks maintain with the Fed. The “shadow banking system” is a term that refers to investment banks, money market mutual funds, hedge funds, and other nonbank financial firms. These firms raise funds from individual investors and from other financial firms and lend or invest the funds, either directly or indirectly.

In thedoing so, these firms are carrying out a function that at one time was almost exclusively

domain of commercial banks. The financial firms of the shadow banking system were more vulnerable than commercial banks to runs during the 2007-2009 financial crisis because: (1) Problems they and Applications 4.5

4.6

are more highly leveraged; (2) they do not have federal deposit insurance; and (3) the Federalism in the United States refers to the relationship between the federal government government and state governments. Many members of Congress wanted the central bank to be located agencies, including Federal Reserve, the commercial bankingbesystem have in their own states,the while others fearedthat thatregulate their states’ interests would slighted if the traditionally not regulated firms in the showdown banking was system as closely. bank were located in some other state.

A compromise reached by creating a system that included 12 Federal Reserve Banks located through the United States. This is the “federalism” solution Representative Kevin Brady referred to that convinced enough members of Congress to pass the Federal Reserve Act. a.

First National Bank (FNB) Assets Liabilities Reserves +$10,000,000 Discount Loans +$10,000,000 b. FNB can loan out the entire $10 million. c. If banks are keeping 10 percent of their deposits as reserves, the simple deposit multiplier is (1/0.10) = 10. The money supply can increase by a maximum of: (the discount loan × the multiplier) or ($10 million × 10) = $100 million.

4.7

4.8

The Federal Reserve can create money by printing currency (although actually it is the U.S. Treasury that physically prints the currency at the Fed’s request), but the Fed creates most of the money supply by buying Treasury securities (primarily Treasury bills). Purchasing Treasury securities increases the reserves of banks. As bank reserves increase, the banks make more loans, which increases checking account balances. Because checking account balances are part of the money supply, the Fed’s actions have created money.

In the T-account for the Federal Reserve, assets decrease by $25 million in Treasury bills and liabilities decrease by $25 million in bank reserves. In the T-account for the banking system, assets increase by $25 million in Treasury bills and decrease by $25 million in reserves as the Federal Reserve deducts the payment for the Treasury bills from bank reserves.

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4.9

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a. By the “nonbank financial system,” Geithner was referring to investment banks, money market mutual funds, hedge funds, and other firms that are part of the “shadow banking system.” b. A “classic type of bank run” is a situation in which many depositors simultaneously decide to withdraw money from a commercial bank. Institutions in the nonbank financial system (or shadow banking system) were vulnerable to a run of this type for several reasons. First, they often borrowed short-term and lent long-term, which meant that they were illiquid. As a result, if the individuals and financial firms who lent to them short term decided not to renew their loans, shadow banks would be forced to sell off their long-term investments, which might prove difficult in a financial crisis. Second, shadow banks were not closely regulated by government agencies, including the Federal Reserve, that regulate commercial banks.

Third, Congress had not authorized the Federal Reserve to act as a lender of last resort to these financial firms in the way that it did to commercial banks. Fourth, these financial firms were more highly leveraged than commercial banks. Finally, unlike depositors in commercial banks, lenders to firms in the nonbank financial system were not covered by the federal deposit insurance program. c. Deposit insurance reassures depositors that their deposits are safe even if their banks go out of business. This insurance significantly reduces the likelihood of a bank run.

4.10

Money market mutual funds are not protected by deposit insurance, as commercial banks’ deposits are through the Federal Deposit Insurance Corporation (FDIC). Customers of a bank with FDIC insurance are guaranteed that if the bank fails their individual deposits will be insured for amounts up to $250,000. There would be no need for depositors in such banks to “rush to the exits.”

4.11

a. Nonbank financial firms include investment banks, hedge funds, money market mutual funds, insurance companies, and other financial firms that do not accept deposits from individuals or firms and are not legally considered to be banks. b. A subprime auto loan is a loan extended to a borrower who has a credit score below a certain value. Using the FICO credit score, most lenders consider people with scores less than 650 to be subprime borrowers. Subprime loans usually involve greater risk than prime loans because subprime borrowers have flawed credit histories that might include having failed to make payments on previous loans. As a result, the interest rate lenders charge on subprime loans is higher than the interest rate that they charge on prime loans. c. Banks pay almost nothing on deposits because the interest rates that they offer to depositors are very low—sometimes zero—especially on checking accounts. d. Commercial banks like Wells Fargo are regulated by the federal government, in part because their deposits are covered by federal deposit insurance. Federal regulators do not typically

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CHAPTER 24 | Money, Banks, and the Federal Reserve System allow commercial banks to make very high-risk loans, even if the interest rates the banks earn on these loans are much higher than on safer loans.

24.5

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

Review Questions 5.1

The quantity theory of money starts from the quantity equation: M × V = P × Y, where M is the money supply, V is the velocity of money, P is the price level, and Y is the real output. Because velocity is equal to (P × Y)/M, the quantity equation must always hold true.

Irving Fisher turned the quantity equation into the quantity theory of money by asserting that velocity was constant. With velocity constant, inflation occurs whenever the growth rate of the money supply is greater than the growth rate of real output.

5.2 5.3

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

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

Problems and Applications 5.4

5.5

5.6

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

The quantity theory of money states that the money supply (M) multiplied by the velocity of money (V) equals the price level (P) multiplied by real GDP (Y), or M × V = P × Y. Note that P × Y equals nominal GDP. If velocity does not change, an increase in the money supply must increase nominal GDP. But real GDP may or may not increase. The increase in M × V could lead to an increase in the price level (P) with no change in real GDP. a. The quantity equation indicates that the growth rate in a nation’s money supply plus the growth rate of velocity will equal the inflation rate plus the growth rate of real GDP. Because we are given values only for the average annual growth rate of the money supply and for the average inflation rate, we can’t determine whether the values are consistent with the quantity equation. To make this determination, we also need data for the average annual growth rate of velocity and the average annual growth rate of real GDP. Because the quantity equation is an identity, though, the values for the growth rate of velocity and the growth rate of real GDP would be consistent with the quantity equation.

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b. The quantity theory of money assumes that the growth rate of velocity is constant. In that case, we have: Inflation rate = Growth rate of the money supply − growth rate of real GDP. Here we have: 1.7 percent = 7.5 percent − growth rate of real GDP, or, Growth rate of real GDP = 7.5 percent − 1.7 percent = 5.8 percent.

5.7

Although such a high average annual growth rate of real GDP is possible, it has not been experienced in the United States since World War II and is higher than the actual average annual growth rate experienced by the U.S. economy during the years 2011 to 2020. We can conclude that the data given are not consistent over this period of time with the quantity theory of money. a. Price deflation occurs when the price level declines from one year to the next. b. Price deflation increases the burden of a debt because it means that the debt must be repaid in money that is increasing in value. If borrowers have to divert more funds to repaying debts, they will have less available to buy goods and services. The resulting decrease in spending can make an economic recession worse. c. Gesell’s proposal would increase the incentive that households and firms have to spend money because, effectively, holdings of currency are being taxed at a rate of 5 percent per year. The result would be an increase in velocity, or the average number of times that a unit of currency is spent. The quantity equation shows us that if velocity (V) increases, for a given level of the money supply (M) and level of real output (Y), the price level (P) must increase.

As a consequence, the deflation would end, or at least the size of price decreases (and increases in the real burden of debts) would be reduced.

5.8

The large quantity of Confederate dollars during the Civil War would have generated high inflation, which would have decreased the value of the Confederate currency. With the war drawing to an end, Southerners would have been less and less willing to accept Confederate dollars. Southerners could have made barter exchanges or used dollars issued by the federal government of the United States. a. A country experiences hyperinflation when its central

5.9

bank increases the country’s money supply much faster than the growth rate of real GDP. b. Yes, because when a country experiences hyperinflation, its money loses much of its value and households and firms become reluctant to accept it in exchange for goods and services.

The only alternatives are to use a foreign currency, such as the U.S. dollar, or to engage in barter trades. Both those choices are less efficient than using a stable domestic currency. As a result, economic activity is likely to slow and real GDP will decline.

5.10

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

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

D24.1 a.

December 2020 M1 money stock (billion $) $17,834.7 M2 money stock (billion $) $19,131.4 0.93 M1/M2

December 2015 $3,096.3 $12,344.3 0.25

December 2010 $1,836.7 $8,802.2 0.21

b. M1 as a proportion of M2 increased over the ten-year period. The exceptionally low interest rates of the recent period probably account for M1 rising as a proportion of M2. However, beginning in May 2020 the definition of M1 changed to include savings accounts so the proportion of M1 to M2 will be much higher from that point forward.

D24.2 a.

4th Quarter, 2020 4th Quarter, 1985 Nominal GDP (billion $) $21,494.7 $4,294.9 Velocity of M1 1.221 7.247 Velocity of M2 1.134 1.792 M1 (billion $) $17,60427 $592.6 M2 (billion $) $18,954.8 $2,396.7 Using the equation of exchange, M1 equals nominal GDP divided by the velocity of M1, and M2 equals nominal GDP divided by the velocity of M2. b. From the fourth quarter of 1985 to the fourth quarter of 2020, both the M1 velocity and the M2 velocity declined.

D24.3 a .

b. The scatterplot shows that the money growth rate and the CPI growth rate do not behave as predicted by the quantity equation. This is because the growth rate of GDP and the velocity of money for the U.K. were not constant during this period.

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D24.4 For the second quarter of 2019, Real Gross Domestic Product equaled $19,021.86 billion in chained 2012 dollars and for the second quarter of 2027 Real Potential Gross Domestic Product equals $22,014.9 billion in chained 2012 dollars. a. The average annual rate of change for real GDP over this eight-year period, assuming that real GDP equals potential GDP at the end of the eight-year period equals {[($22,104.9 billion/$19,021.86 billion)1/8] – 1} × 100 = 1.84 percent. b. For the annual inflation rate to average 2 percent, the growth rate of M1, if the velocity of money is constant, would have to be 3.84 percent. The equation of exchange indicates that the growth rate of the money supply equals the inflation rate plus the growth rate of real GDP, when velocity is constant: 2 percent + 1.84 percent = 3.84 percent. c. If M1 grows at 3.84 percent and real GDP grows at 1.84 percent, then if actual inflation averages more than 2 percent, the velocity of money will have increased.

Suggestions for Critical Thinking Exercises CT24.1 In general, students seem to count far too much as money and often conflate it with income and wealth. The cognitive scientist Dan Willingham is fond of the phrase “memory is the residue of thought,” and hopefully thinking here will lead to a correct memory on this topic.

CT24.2 a. Students’ answers may vary. Some students will say that they use only cash, others may say that they use only credit or debit cards, while some students may use only Venmo or Apple Pay. b. Answers will vary, depending on students’ preferences and on whether stores accept alternative forms of payment. Some students may also state that they prefer paying by using their smartphones with an app like Apple Pay. c. Answers will vary. d. Again, answers will vary, depending on students’ familiarity with the different alternative payment methods and on their preferences among those methods that they are familiar with.

CT24.3 Answers will vary depending on the state of hyperinflation in Venezuela at the time this exercise is assigned. Based on the discussion in this chapter, the Venezuelan government should reduce the rate at which it is printing Venezuelan bolivars. To credibly make such a commitment, the government will likely have to announce a means of eliminating or sharply reducing its government budget deficit so that the government will no longer have to rely on selling bonds to the central bank to pay its bills. Without reducing the rate of growth of the money supply, the government will be unable to end hyperinflation.

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CHAPTER 25 | Monetary Policy Brief Chapter Summary and Learning Objectives The authors use the dynamic aggregate demand-aggregate model to discuss monetary policy in Section 4 of this chapter. This section is self-contained so you can omit it without any loss of continuity in your discussion of monetary policy.

25.1 What Is Monetary Policy?

Define monetary policy and describe the Federal Reserve’s monetary policy goals.

▪ The Federal Reserve’s monetary policy goals are: price stability, high employment, stability

of financial markets and institutions, and economic growth.

25.2 The Money Market and the Fed’s Choice of Monetary Policy Targets Describe the Federal Reserve’s monetary policy targets and explain how expansionary and contractionary monetary policies affect the interest rate.

▪ The main monetary policy targets are the money supply and the interest rate. The Fed has

most often chosen to use the interest rate as its monetary policy target.

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

▪ The ability of the Fed to usemonetary policy to affect real GDP depends on its ability to affect

long-term interest rates.

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

▪ The dynamic aggregate demand and aggregate supply model can account for the economy experiencing inflation and annual increases in potential GDP.

25.5 A Closer Look at the Fed’s Setting of Monetary Policy Targets Describe the Fed’s setting of monetary policy targets.

▪ Many economists and central bankers propose using inflation targeting as a framework for

monetary policy.

25.6 Fed Policies during the 2007–2009 and 2020 Recessions Describe the policies the Federal Reserve used during the 2007–2009 and 2020 recessions.

▪ The Federal Reserve used new policies to combat the financial crisis that accompanied the recession of 2007–2009 and the recession that accompanied the Covid-19 pandemic.

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CHAPTER 25 | Monetary Policy

Key Terms Contractionary monetary policy The Federal Reserve’s policy of increasing interest rates to reduce inflation.

Monetary policy The actions the Federal Reserve takes to manage the money supply and interest rates to achieve macroeconomic policy goals.

Expansionary monetary policy The Federal Reserve’s policy of decreasing interest rates to increase real GDP.

Taylor rule A rule developed by John Taylor that links the Fed’s target for the federal funds rate to economic variables.

Federal funds rate The interest rate banks charge each other for overnight loans.

Inflation targeting A framework for conducting monetary policy that involves the central bank announcing its target level of inflation.

Chapter Outline The Fed Deals with Two “Once in a Lifetime” Crises within 15 years Most economists believe the chair of the Fed’s Board of Governors is the second most powerful person in the world economy, behind only the U.S. president. The Fed is not mentioned in the U.S. Constitution and Congress could change its structure or even abolish it by revising the Federal Reserve Act. The Fed focuses on the federal funds rate, which is the interest that banks charge each other on overnight loans. Changes in the federal funds rate frequently lead to changes in other interest rates, such as the rates on home mortgages, car loans, U.S. Treasury securities, and corporate bonds.

The financial crisis of 2007–2009 was the first to hit the United States since the bank panics of the early 1930s. The Covid-19 pandemic of 2020–2021 was the first disease outbreak to push the U.S. economy into a recession since the 1918 influenza pandemic. Congress and the president are responsible for the economic policy of the United States, but only the Federal Reserve can move quickly enough in a crisis to keep the financial system from imploding and taking the economy with it.

In this chapter, we see how the Fed took measures in both 2007–2009 and 2020 far beyond its usual monetary policy actions.

25.1

What Is Monetary Policy?

Learning Objective: Define monetary policy and describe the Federal Reserve’s monetary policy goals.

In 1913, Congress passed the Federal Reserve Act, creating the Federal Reserve System (the Fed).

The main responsibility of the Fed was to make discount loans to banks to prevent bank panics. As a result of the Great Depression, Congress amended the Federal Reserve Act to give the Fed’s Board of Governors broader responsibility to act “so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” Monetary policy refers to the actions the Federal Reserve takes to manage the money supply and interest rates to achieve macroeconomic policy goals.

A. The Goals of Monetary Policy The Fed has four monetary policy goals that are intended to promote a well-functioning economy: 1. Price stability 2. High employment (or a low rate of unemployment)

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3. Stability of financial markets and institutions 4. Economic growth

Extra Solved Problem 25.1 Monetary Policy and Economic Growth The textbook lists the Federal Reserve’s four monetary policy goals: (1) price stability, (2) high employment, (3) stability of financial markets and institutions, and (4) economic growth. The control the Fed has over the supply of money and interest rates is the source of its ability to achieve goals (1) and (3), but how much control does the Fed have over real variables such as employment and economic growth? The textbook argues that increases in per capita real GDP are the result of the growth of labor productivity. In turn, increases in labor productivity are caused by increases in the quantity of capital per hour worked and the level of technology, not changes in the money supply.

Lawrence H. Meyer made the following comments in a speech while he served as a member of the Federal Reserve’s Board of Governors (from June 24, 1996 until January 31, 2002). …monetary policy cannot influence real variables—such as output and employment…This is often referred to as the principle of the neutrality of money…The Fed…cannot raise the long-run rate of economic growth. It should not try.

Source: Lawrence H. Meyer, “Come with Me to the FOMC,” The Federal Reserve Board, April 2, 1998. http://www.federalreserve.gov/boarddocs/Speeches/1998/199804022.htm

Is Lawrence Meyer correct in stating that the Federal Reserve cannot affect output (or economic growth) and employment?

Solving the Problem Step 1:

Step 2:

Review the chapter material.

This problem is about monetary policy, so you may want to review the section “What Is Monetary Policy?”

Is Lawrence Meyer correct in stating that the Federal Reserve cannot affect output (or economic growth) and employment.

An important phrase was left out of Meyer’s comments: “…monetary policy cannot influence real variables—such as output and employment—in the long run (except via the contribution of price stability to living standards).” In the same speech Meyer explained that because prices in many markets are “sticky,” shocks to the economy can lead to persistent departures from full employment. This means there is potential for monetary policy to smooth business cycles. In other words, monetary policy can affect output and employment—but only in the short run. In the long run, a country’s economic growth is determined by real factors such as investment in capital and the level of technology⸻ not by monetary policy.

Extra Apply the The Federal Reserve System’s Monetary Policy Goals Concept The Federal Reserve publishes a book titled Purposes & Functions that offers a detailed description of the operations of the central bank. Here is a passage from that publication describing the Fed’s monetary policy goals.

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CHAPTER 25 | Monetary Policy The goals of monetary policy are spelled out in the Federal Reserve Act, which specifies that the Board of Governors and the Federal Open Market Committee should seek to “promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” Stable prices in the long run are a precondition for maximum sustainable output growth and employment…

Beyond influencing the level of prices and the level of output in the near term, the Federal Reserve can contribute to financial stability and better economic performance by acting to contain financial disruptions and to prevent further problems outside the financial sector. Modern financial systems are highly complex and interdependent and may be vulnerable to systemic disruptions, such as those that can occur as a result of a sudden plunge in stock prices. The Federal Reserve can enhance the financial system’s resilience to such shocks through its regulatory policies. If a disturbance develops, the Federal Reserve can also cushion the negative effect on financial markets and the economy by providing funds to commercial banks through open market operations or discount window lending.

Source: The Federal Reserve System Purposes & Functions , http://www.federalreserve.gov/pf/pf.htm

Teaching Tips The end of the chapter in the main text includes a special category of exercises titled Real-Time Data (RTDA) Exercises. These exercises are well worth assigning and discussing in class because they help students become familiar with a key data source, learn how to locate data, and develop skills in interpreting data. Many RTDA exercises require more elaborate calculations than other problems and the use of Excel spreadsheets.

25.2

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

A. Monetary Policy Targets The Fed can’t affect unemployment and inflation rates directly. The Fed uses variables called monetary policy targets to keep the unemployment rate and inflation rate low. The two main monetary policy targets are the money supply and the interest rate. The Fed typically uses the interest rate as its policy target. The Fed was forced to develop new policy tools because of the disruption that U.S. financial markets suffered during the 2007–2009 recession. The Fed faced this potential conflict in 2021 as it attempted to reduce the unemployment rate that had resulted from the effects of the Covid-19 pandemic without causing a significant increase in inflation.

B. The Demand for Money The demand curve for money slopes downward because a lower interest rate causes households and firms to switch from financial assets, such as U.S. Treasury bills, to money. When interest rates on Treasury bills and other financial assets are low, the opportunity cost of holding money is low, so the quantity of money demanded by households and firms will be high. The opportunity cost of holding money is the interest rate.

C. Shifts in the Money Demand Curve The two most important variables that cause the money demand curve to shift are real GDP and the price level. An increase in real GDP means that the amount of buying and selling of goods and services has increased, which increases the quantity of money demanded at each interest rate, shifting the money .

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demand curve to the right. A decrease in real GDP decreases the quantity of money demanded at each interest rate, shifting the money demand curve to the left. An increase in the price level increases the quantity demanded of money at each interest rate, shifting the demand curve for money to the right. A decrease in the price level decreases the quantity demanded of money at each interest rate, shifting the money demand curve to the left.

D. How the Fed Manages the Money Supply: A Quick Review Eight times per year, the FOMC meets in Washington, D.C. If the FOMC decides to increase the money supply, it orders the trading desk at the Federal Reserve Bank of New York to purchase U.S. Treasury securities. The sellers of these securities deposit the funds they receive from the Fed in banks, which increases their reserves. In normal times, banks loan out most of their reserves, which creates new checking account deposits and expands the money supply. If the FOMC decides to decrease the money supply, it orders the trading desk to sell Treasury securities, which decreases banks’ reserves and contracts the money supply.

E. Equilibrium in the Money Market For simplicity, we assume that the Fed can fix the money supply. Therefore, the money supply curve is a vertical line and changes in the interest rate have no effect on the quantity of money supplied.

Equilibrium in the money market occurs where the money demand curve crosses the money supply curve. When the Fed increases the money supply, the short-term interest rate must fall until it reaches a level at which households and firms are willing to hold the additional money.

F. A Tale of Two Interest Rates We need two models of the interest rate. The loanable funds model is concerned with the long-term real rate of interest, and the money-market model is concerned with the short-term nominal rate of interest. The long-run real rate of interest is the interest rate that is relevant when savers consider purchasing a long-term financial investment such as a corporate bond. When conducting monetary policy, however, the short-term nominal interest rate is the most relevant interest rate because it is the interest rate most affected by increases and decreases in the money supply. When the Fed takes actions to increase the short-term nominal interest rate, the long-term interest rate usually also increases.

G. Choosing a Monetary Policy Target The Fed chooses the money supply or the interest rate as its monetary policy target. The Fed has generally focused more on the interest rate than on the money supply. There are many interest rates in the economy but for purposes of monetary policy, the Fed has targeted the interest rate known as the federal funds rate.

H. The Importance of the Federal Funds Rate The Fed no longer requires banks to hold reserves and pays banks only a low interest rate on their reserve deposits. But banks have continued to hold substantial reserves for three key reasons: (1) Although the interest rate the Fed pays on reserves is low, the investment is risk free, and the interest rate is competitive with the returns on other safe short-term investments the banks can make; (2) during and immediately after the financial crisis of 2007–2009 and during the Covid-19 pandemic of 2020, historically high levels of uncertainty in the financial system led many banks to increase their liquidity; and (3) large banks are required by regulation to be more liquid than they were prior to 2007. As a result, these large banks are unable to rely on borrowing reserves overnight from other banks in the federal funds market but must instead keep substantial balances in their reserve accounts with the Fed. Therefore, balances that are technically excess reserves—in the sense that they are not needed to meet the Fed’s reserve requirements (which have been zero since March 2020)—are, in effect, still required for large banks to satisfy their liquidity requirements. During times when banks keep few excess reserves or when they need additional

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reserves, they borrow in the federal funds market from other banks that have reserves available.

The federal funds rate is the interest rate banks charge each other for overnight loans. The Fed does not set the federal funds rate. Instead, the federal funds rate is determined by the supply of reserves relative to the demand for them. The FOMC announces a target for the federal funds rate after each meeting. No households or firms, except banks, can borrow or lend in the federal funds market. However, changes in the federal funds rate usually result in changes in interest rates on other short-term financial assets, such as Treasury bills, and changes in interest rates on long-term financial assets, such as corporate bonds and mortgages.

I. Managing the Federal Funds Rate Today Prior to the financial crisis of 2007–2009, the Fed increased and decreased the federal funds rate by selling and buying Treasury securities to decrease or increase bank reserves. Because banks have ample excess reserves, the Fed’s increasing or decreasing them through open market purchases and sales of Treasury securities has no effect on interest rates. The Fed now relies on a more complicated mechanism. Beginning in 2008, the Fed began paying banks interest on their reserve holdings. The interest rate that the Fed pays on reserves sets a floor for the federal funds rate. When the Fed engages in open market operations, it buys and sells Treasury securities electronically with primary dealers, which are commercial banks, investment banks, and securities dealers. Rather than buy or sell securities outright, sometimes the Fed engages in temporary transactions called repurchase agreements. With a repurchase agreement, the Fed buys a security from a financial firm, which promises to buy it back from the Fed the next day.

With a reverse repurchase agreement, the Fed does the opposite: It sells a security to a financial firm, while at the same time promising to buy it back from the firm the next day. In effect, the Fed is borrowing funds overnight from the firm that purchases the security. By raising the interest rate it is willing to pay on these loans, the Fed reduces the willingness of the financial firms it deals with to lend at a lower rate. Note that because the primary dealers are not eligible to receive interest on deposits at the Fed, the Fed needs to use changes in the interest rate it pays on reverse repurchase agreements as an additional means of controlling short-term interest rates.

Extra Apply the Why Did the Fed’s Monetary Policy Fail During the Great Concept Depression?

Many economists have criticized the Federal Reserve for its monetary policy decision-making during the Great Depression. Instead of pursuing an expansionary monetary policy, as the Federal Reserve typically does now during recessions, critics claim that the Fed “sat on its hands.” Allan H. Meltzer of Carnegie Mellon University has written A History of the Federal Reserve in which he studies why the Federal Reserve acted as it did. In an interview that appeared in The Region, a magazine published by the Federal Reserve Bank of Minneapolis, Professor Meltzer made the following comments about the Fed’s behavior during the Great Depression.

Interviewer: [In your book] you clearly…describe the Fed’s early failures to do precisely what it was intended [to do]: stabilize the economy…Why were policymakers unable to see what was happening during the Great Depression and implement the right tools?

Meltzer: …they did what many so-called sensible people at the time would have done…the Federal Reserve Act was written to create a passive institution…they were not supposed to engage in countercyclical policy…they didn’t think that was their responsibility [and] the authors of the Federal Reserve Act relied on the gold standard to maintain stability…The strong belief was that…when banks want to borrow, we’ll be there to lend. But until they want to borrow then .

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it’s wrong to increase reserves…their idea of inflation was not that prices were rising— because during 1929…prices were falling. But they worried about inflation.

Source: Douglas Clement, “An Interview with Allan H. Meltzer,” The Region, Federal Reserve Bank of Minneapolis, September 2003.

25.3

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

The ability of the Fed to use monetary policy to affect economic variables depends on its ability to affect real interest rates. Because the federal funds rate is a short-run nominal interest rate, the Fed sometimes has difficulty affecting long-term interest rates.

A. How Interest Rates Affect Aggregate Demand Changes in interest rates affect aggregate demand, which is the total level of spending in the economy. Changes in interest rates will not affect government purchases, but those changes will affect consumption, investment, and net exports in the following ways: ▪ ▪

▪

Consumption: Lower interest rates lead to increased spending on durables and reduce the return to saving, leading households to save less and spend more.

Investment: Lower interest rates make it less expensive for firms to borrow, so they will undertake more investment projects. Lower interest rates can also increase investment by affecting stock prices. Spending by households on new homes falls when interest rates rise and increases when interest rates fall.

Net exports: If interest rates in the United States decline relative to interest rates in other countries, the value of the dollar will fall and net exports will rise.

B. The Effects of Monetary Policy on Real GDP and the Price Level Expansionary monetary policy is the Federal Reserve’s policy of decreasing interest rates to increase real GDP. Contractionary monetary policy is the Federal Reserve’s policy of increasing interest rates to reduce inflation. The Fed can use monetary policy to affect the price level and, in the short run, the level of real GDP.

C. Can the Fed Eliminate Recessions?

Keeping recessions shorter and milder than they would otherwise be is usually the best the Fed can do. The Fed needs to be able to recognize the need for a change in monetary policy. If the Fed acts too late, it may destabilize the economy. There can be a lag before the Fed recognizes that a recession has begun because it takes months for government agencies to gather economic statistics.

D. Fed Forecasts It can take a long time for a change in monetary policy to affect real GDP, so the Fed tries to set policy according to what it forecasts the state of the economy will be. For the Fed to succeed in reducing the severity of business cycles, it must often act before a recession or an acceleration of inflation shows up in the economic data.

E. A Summary of How Monetary Policy Works A contractionary monetary policy does not cause the price level to fall, but instead causes the price level to rise by less than it would have without the policy. An expansionary monetary policy is sometimes .

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called a loose or easy policy. A contractionary policy is sometimes called a tight policy. Figure 25.9 compares the steps involved in expansionary and contractionary monetary policies.

Extra Apply the Why Does Wall Street Care about Monetary Policy?

Concept You may have seen newspaper headlines similar to these: ▪ “Fed Rate Cut Fuels Stock Gains” ▪ “Stocks Fall in Anticipation of Fed Rate Increase” ▪ “Worries of Fed Rate Increase Send Stocks Lower” Before most meetings of the FOMC, newspapers report stock traders’ predictions of possible Fed actions and whether those actions will cause stock prices to increase or decrease. Some Wall Street analysts are known as Fed watchers because they study the Fed and attempt to forecast future changes in the target for the federal funds rate. There are two main explanations of why changes in the federal funds rate affect the stock market. In thinking about both explanations, remember that changes in the federal funds rate usually cause changes in other interest rates. The first reason that stock prices react to the Fed raising or lowering interest rates is that changes in interest rates affect the economy. As we have seen, lower interest rates usually result in increases in real GDP. The value of a share of stock depends on the profitability of the firm that issued the stock. When real GDP is increasing, the profitability of many firms is also increasing.

Stock prices tend to rise when investors expect that the Fed will be lowering interest rates to stimulate the economy. When investors expect that the Fed will be raising interest rates to slow down an economy at risk of rising inflation, stock prices tend to fall.

The second reason that stock prices react to changes in interest rates is that changes in interest rates make it more or less attractive for people to invest in stocks rather than in other financial assets. Investors look for the highest return possible on their investments, holding constant the risk level of the investments. If the interest rates on Treasury bills, bank certificates of deposit, and corporate bonds are all low, an investment in stocks will be more attractive. When interest rates are high, an investment in stocks will be less attractive.

Question The following excerpt is from an article in the Wall Street Journal: The immediate catalyst for yesterday’s gains [in stock prices] was a Federal Reserve report…

Some investors interpreted the comments to mean that if the economy proves resilient, the Fed won’t stifle it with a rate increase and if it proves weaker than expected, the Fed might even cut rates.

Wall Street Journal, May 31, 2007.

Source: Peter A. McKay and E. S. Browning, “S&P Joins Record Club,”

Why would stock prices increase if investors believe that the Federal Reserve will not be raising interest rates and may even be cutting them?

Answer Two reasons stock prices rise if investors believe that the Fed will not raise interest rates or will even cut them are: (1) low interest rates lead to increases in aggregate demand and, therefore, real GDP and (2) low interest rates make stocks more attractive than bonds or other interest-paying financial assets.

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Extra Apply the The Fed Responds to the Terrorist Attacks of September 11, Concept 2001 When the Fed was founded, its main purpose was to make discount loans to banks suffering from deposit withdrawals. Today, discount loans have become relatively less important in the operations of the Fed. For example, the average weekly amount of discount loans outstanding in 2001 through September 11 was only $34 million.

Yet, discount loans remain an effective way for the Fed to make funds available quickly to banks in an emergency.

The banks can use these funds to provide cash or loans to households and firms. The day after the terrorist attacks of September 11, 2001, in New York, Washington, D.C., and Pennsylvania, the Fed made $45.5 massive discount loans to banks. Discount loans rose from $99 million on September 5 to billion on September 12—which was 500 times their normal level. In the end, households and firms did not withdraw excessive amounts from their bank accounts following the attacks, and the volume of discount loans returned to normal levels very quickly. By September 19, discount loans had fallen to $2.6 billion, and by September 26, they had fallen to only $20 million. The Fed also relied on discount loans Source:to Federal Reserve Board of Governors, Statistical Release H.4.1, various weekly issues. cushion the banking and financial systems from potential instability during the subprime mortgage Question crisis Some of 2007economists and 2008. and members of Congress have argued that because of deposit insurance, bank runs and bank panics no longer occur, and the Fed no longer needs to act as a lender of last resort.

Although modern Reserve Fed concentrates its objectives for inflation and of economic growth, Therefore, the the Federal Act should on be amended to eliminate the ability the Fed to make discount loans. Briefly evaluate this argument. which Answerit implements through open market operations, it still retains its original purpose of dealing with potential Discount loans effective way for theloans Fed can to make available financial panics.are Foran this purpose, discount be anfunds effective tool. to banks in an emergency, and therefore, they remain an important tool for the Fed to deal with potential financial panics arising from unexpected events, such as the September 11, 2001, terrorist attacks.

Monetary Policy in the Dynamic Aggregate Demand and Aggregate 25.4 Supply Model

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

In Chapter 24, we developed a dynamic aggregate demand and aggregate supply model to take account of the following facts: (1) The economy experiences continuing inflation and (2) the economy experiences long-term growth, with the LRAS curve shifting to the right every year.

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A. The Effects of Monetary Policy on Real GDP and the Price Level: A More Complete Account During some periods, aggregate demand (AD) does not increase enough to keep the economy at potential GDP. Economists at the Fed closely monitor the economy and continually update forecasts of real GDP and the price level. When these economists forecast that aggregate demand is not growing fast enough to allow the economy to remain at full employment, they present their findings to the FOMC, which decides whether to change monetary policy.

B. Using Monetary Policy to Fight Inflation The Fed can also use a contractionary monetary policy to keep aggregate demand from expanding so rapidly that the inflation rate begins to increase. During 2005, the economy was at equilibrium at potential GDP, but members of the FOMC were concerned that the continuing boom in the housing market could increase inflation. When Ben Bernanke became Fed chair in 2006, he advocated continued increases in the federal funds rate to slow the growth of aggregate demand. By June 2006, the FOMC had raised the target for the federal funds rate to 5.25 percent, where it remained until September 2007, when concern about financial markets led it to cut the target to 4.75 percent. Because the Fed kept aggregate demand from increasing as much as it otherwise would have, short-run equilibrium occurred closer to potential GDP and the inflation rate was held to 3 percent.

Extra Apply the Trading with the Fed Concept The textbook describes how the Federal Open Market Committee (FOMC) uses open market operations as a tool of monetary policy. Open market operations are carried out by the trading desk at the Federal Reserve Bank of New York, which buys and sells Treasury securities by interacting with private securities dealers. Visitors to the trading desk (which is really a room) who expect to see shouting traders crowded around each other may be disappointed. Trading takes place quietly via computers and phone calls. Only a small number of firms—called primary dealers—engage in trades of government securities with the Federal Reserve. In 2021 the primary dealers included the following companies: 1. Amherst Pierpont Securities LLC 2. Bank of Nova Scotia, New York Agency 3. BMO Capital Markets Corp.

4. BNP Paribas Securities Corp.

5. Barclays Capital Inc. 6. BofA Securities, Inc. 7. Cantor Fitzgerald & Co. 8. Citigroup Global Markets Inc. 9. Credit Suisse Securities AG, New York Branch 10. Daiwa Capital Markets America Inc. 11. Deutsche Bank Securities Inc. 12. Goldman, Sachs & Co. LLC 13. HSBC Securities (USA) Inc.

14. Jefferies LLC 15. J. P. Morgan Securities LLC Incorporated 16. Mizuho Securities USA LLC 17. Morgan Stanley & Co. LLC 18. NatWest Markets Securities Inc..

19. Nomura Securities International, Inc. 20. RBC Capital Markets, LLC 21. Societe Generale, New York Branch 22. TD Securities, (USA) LLC 23. UBS Securities LLC 24. Wells Fargo Securities, LLC

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The Web page of Federal Reserve Bank of New York explains that primary dealers: …are trading counterparties of the New York Fed in its implementation of monetary policy. They are also expected to make markets for the New York Fed on behalf of its official accountholders as needed, and to bid on a pro-rata basis in all Treasury auctions at reasonably competitive prices.

Source: Federal Reserve Bank of New York, https://www.newyorkfed.org/markets/primarydealers.html

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

A. Should the Fed Target the Money Supply?

Some economists have argued that rather than using an interest rate as its monetary policy target, the Fed should use the money supply. These economists belong to a school of thought known as monetarism. Followers of monetarism favor replacing monetary policy with a monetary growth rule.

A monetary growth rule is a plan for increasing the money supply at a constant rate that does not change in response to economic conditions. The monetarists claim that the Fed would greatly increase economic stability by keeping the money supply growing at a constant rate.

B. Why Doesn’t the Fed Target Both the Money Supply and the Interest Rate?

Most economists believe that an interest rate is the best monetary policy target. The Fed can’t target both the interest rate and the money supply at the same time. The Fed controls the money supply, but it does not control money demand. Money demand is determined by decisions of households and firms as they weigh the trade-off between money, with its low interest rate, and bonds and other financial assets.

C. The Taylor Rule The Taylor rule is a rule developed by John Taylor that links the Fed’s target for the federal funds rate to economic variables. According to the Taylor rule, the Fed should set the target for the federal funds rate so that it is equal to the sum of the inflation rate, the equilibrium real federal funds rate, and two additional terms: the inflation gap (which is the difference between the current inflation rate and the target inflation rate) and the output gap (which is the percentage difference between real GDP and potential real GDP).

The inflation gap and output gap are each given “weights” that reflect their influence on the federal funds Federal funds target rate of = ½ for both gaps, we have the following Taylor rule: target rate.

With weights Current inflation rate + Equilibrium real federal funds rate + [(½) × Inflation gap + (½) Output gap] During the mid-2000s, the actual federal funds rate was lower than the predicted federal funds rate. Some economists, including Taylor, argue that these low targets for the federal funds rate contributed to an excessive increase in spending on housing.

D. Inflation Targeting and the Fed’s New Monetary Policy Strategy Inflation targeting is a framework for conducting monetary policy that involves the central bank announcing its target level of inflation. After many years of not having an inflation target, the Fed announced in 2012 that it would attempt to maintain an average inflation rate of 2 percent per year.

With inflation targeting, the Fed can still respond to periods of economic problems without following an inflexible rule. But an inflation target allows monetary policy to focus on inflation and inflation forecasts except during severe recessions. Those economists who support inflation targeting argue that announcing .

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a target draws public attention to what the Fed can achieve in practice and provides an anchor for inflationary expectations and that inflation targets promote accountability for the Fed. Opponents of inflation targeting are concerned that numerical targets diminish the Fed’s flexibility to address other goals. Because monetary policy affects inflation with a lag, targeting requires the Fed to use forecasts of inflation that may not be accurate. Opponents also claim that holding the Fed accountable for a goal of low inflation can make it more difficult for elected officials to monitor the Fed’s support for good overall economic policy. Finally, inflation targets may increase uncertainty over whether the Fed will take prompt action to return the economy to full employment following a recession. In August 2020, the Fed released a “Statement on Longer-Run Goals and Monetary Policy Strategy,” which outlined a policy of average-inflation targeting. Under this approach, monetary policy will automatically be expansionary during recessions and contractionary during periods of unexpectedly high inflation. If households and firms accept that the Fed is following this policy, then during a recession, when the inflation rate falls below the target, they would expect the Fed to take action to increase the inflation rate. A higher inflation rate would result in a lower real interest rate, which would have an expansionary effect on the economy. Similarly, if the inflation rate were above the target, households and firms would expect future inflation rates to be lower, raising the real interest rate, which would have a contractionary effect on the economy. Some economists were disappointed the Fed did not adopt nominal GDP targeting rather than average- inflation targeting. Nominal GDP equals the GDP price deflator multiplied by real GDP. The growth rate of nominal GDP is approximately equal to the growth rate of the price level (or the inflation rate) plus the growth rate of real GDP. • If the Fed expected 3 percent annual growth in real GDP and wanted an inflation rate of 2 percent, it would set a target for nominal GDP growth of 5 percent per year.

• If real GDP growth slowed, as during a recession, the Fed would automatically pursue an • expansionary monetary policy in an attempt to hit its nominal GDP target.

If the inflation rate increased above 2 percent, the Fed would automatically pursue a contractionary policy to keep nominal GDP from rising above its target.

Nominal GDP targeting has drawn support from some economists who in past years had supported a money growth rule. Critics of the proposal note that GDP is subject to sometimes large revisions, so that the Fed might be making decisions based on inaccurate data, although the same argument has been made about following a Taylor rule.

Extra Solved Problem 25.5 Targeting Inflation On February 1, 2006, Ben S. Bernanke was sworn in as the chair of the Federal Reserve Board, a position he held until 2014. Although Bernanke is a respected macroeconomist, he succeeded a chair, Alan Greenspan, who received high marks for his leadership of the Fed during a period (1987–2006) of prosperity and low inflation. In the months leading up to the end of Greenspan’s tenure, much speculation surrounded how the Reserve Board would operate under its new chair. Long before his appointment as chair, Bernanke proposed that the Fed engage in inflation targeting. In a 2004 interview, Bernanke was asked if the Fed’s prior commitment to price stability was not a de facto inflation targeting policy. Bernanke gave the following response.

It’s true that the Federal Reserve is already practicing something close to de facto inflation targeting…My main suggestion is to…give an explicit objective…to provide the public with a working definition of price stability in the form of a number or a numerical range for inflation. …First, such a step would increase the coherence of policy…Second, there’s…evidence now that tightly anchored public expectations of inflation are very beneficial not only for stabilizing

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inflation but also in reducing the volatility of output…Third, from a communications viewpoint, financial markets would be well served by knowing the…inflation objective of the Fed… Source: Interview with Ben S. Bernanke, The Region, Federal Reserve Bank of Minneapolis, June 2004; https://www.minneapolisfed.org/publications/the-region/interview-with-ben-s-bernanke

In 2012, the Fed announced that it would target inflation at 2 percent. What purpose does setting an explicit inflation target serve?

Solving the Problem Step 1:

Review the chapter material.

This problem is about the monetary policy targets of the Federal Reserve System, so you may want to review the section “A Closer Look at the Fed’s Setting of Monetary Policy Targets.”

What purpose does setting an explicit target for inflation serve?

Step 2: The main reason for establishing an inflation rate target is that it strengthens the commitment of the Federal Reserve to price stability. Central banks can come under political pressure to engage in expansionary monetary policy in order to increase real GDP and employment in the short run, even though the result of the policy may also be an increase in inflation. An explicit target for inflation may help the Fed resist this political pressure. An explicit inflation target will also make it easier for the public to appraise the Fed’s performance in meeting its inflation target.

25.6 Fed Policies during the 2007–2009 and 2020 Recessions Learning Objective: Describe the policies the Federal Reserve used during the 2007–2009 and 2020 recessions.

The severity of the recession of 2007–2009 complicated the Fed’s job. By December 2008, the Fed had effectively lowered the target for the federal funds rate to zero. The Fed also took actions in 2020 to deal with the economic effects of the Covid–19 pandemic.

A. The Inflation and Deflation of the Housing Market Bubble The Fed lowered the target for the federal funds rate during the 2001 recession to stimulate the demand for housing. The policy was successful, but by 2005 many economists argued that a “bubble” had formed in the housing market. The price of a house should reflect the value of the services the house provides. By 2005, some economists believed that in some cities prices had risen so much that monthly mortgage payments were far above the rent on comparable homes. During 2006 and 2007, prices of new and existing homes in most markets were declining. When lenders foreclosed on some mortgage loans, those lenders then sold the homes, causing prices to fall further. Subprime loans are loans granted to borrowers with flawed credit histories. Mortgage lenders that had concentrated on making subprime loans suffered heavy losses. Most other banks and other lenders tightened the requirements for borrowers. This credit crunch made it more difficult for potential homeowners to obtain mortgages. The decline in the housing market affected other markets such as furniture, appliances, and home improvements.

B. The Changing Mortgage Market Until the 1970s, the commercial banks and savings and loans that granted mortgages kept the loans until the borrowers paid them off. Many members of Congress believed that home ownership could be increased by creating a secondary market in mortgages. If a bank or savings and loan granted a mortgage and then resold it to an investor, the bank could use the funds to grant another mortgage.

In this way,

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banks and savings and loans could grant more mortgages because they would no longer depend only on deposits for the funds needed for the loans. However, most investors were unwilling to buy mortgages because they were afraid of losing money if borrowers defaulted on their loans.

To reassure investors, Congress used two government-sponsored enterprises (GSEs): the Federal National Mortgage Association (“Fannie Mae”) and the Federal Home Loan Mortgage Corporation (“Freddie Mac”). By the 1990s, a large secondary market existed in mortgages, with funds flowing from investors C. The Role of Investment Banks through money Fannie Mae and Freddie Mac to banks and, ultimately, individuals and families borrowing By the 2000s, further changes had taken place in the mortgage market. First, investment banks to buy houses. became significant participants in the secondary market for mortgages. Investment banks bought mortgages, bundled large numbers of them together as bonds known as mortgage-backed securities, and resold them to investors. Mortgage-backed securities became popular with investors because they paid higher interest rates than other securities with comparable default risk. In the previous chapter, Figure 24.5 illustrates the process of securitization.

Second, lenders had loosened the standards for obtaining a mortgage loan. By 2005, many mortgages were being issued to subprime borrowers with flawed credit histories. Lenders created new types of adjustable-rate mortgages that allowed borrowers to pay a very low interest rate for the first few years of the mortgage and a higher rate in later years. Both borrowers and lenders anticipated that housing prices would continue to rise. But the decline in housing prices led to rising defaults and the value of mortgagebacked sharply. Department Many commercial and investment banks owned mortgage-backed D. Thesecurities Fed anddeclined the Treasury Respond securities, so the decline in the value of these securities caused these banks to suffer losses.

The Fed entered into an unusual partnership with the U.S. Treasury Department to heavy develop new policies.

The financial crisis significantly worsened after the bankruptcy of the investment bank By Lehman Brothers in September 2008. Prior to this, some economists criticized the Fed and Treasury mid-2007, the decline in the value of mortgage-backed securities and the large losses suffered by for arranging the sale of Bear Stearns to JP Morgan Chase. They were concerned with the moral commercial and investment banks caused concern among investors and policymakers. hazard problem, which is the possibility that large financial firms such as Bear Stearns would make riskier investments if they believed the government would save them from bankruptcy. When Lehman Brothers was near bankruptcy, the Fed and Treasury had to weigh the moral hazard problem against the possibility that the failure of Lehman Brothers would endanger the positions of other firms. The Fed and Treasury decided to let Lehman Brothers fail.

The adverse reaction to Lehman’s failure led the Fed to provide an $85 billion loan to the insurance company effectively American International Group (AIG) in exchange for an 80 percent ownership stake, giving the government control of the company. The Treasury announced a plan to provide insurance for deposits in money market mutual funds. The Fed announced that it would lend directly to corporations by purchasing three-month commercial paper. In October 2008, Congress passed the Troubled Asset Relief Program system by (TARP), under which the Treasury attempted to stabilize the commercial banking providing funds in exchange for stock. .

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Extra Solved Problem 25.6 The Fed Uses New Policy Tools to Respond to the Financial Crisis of 2007 - 2009 While serving as chair of the Board of Governors of the Federal Reserve System, Ben Bernanke explained how the Federal Reserve used new policy tools to respond to the financial crisis and recession that occurred between 2007 and 2009. The following are excerpts from a speech Bernanke gave at the London School of Economics in January 2009: The Federal Reserve has responded aggressively to the crisis since…the summer of 2007…One important tool is communication…the [FOMC] should be able to influence longer-term interest rates by informing the public’s expectations about the future course of monetary policy…the Federal Reserve… [has used other] policy tools… [that] all make use of the asset side of the Federal Reserve’s balance sheet…

The first set of tools…involve the provision of short-term liquidity to sound financial institutions…These actions include creating new facilities for auctioning credit and making primary securities dealers, as well as banks, eligible to borrow at the Fed’s discount window. …[to] address instability…in critical nonbank markets…the Federal Reserve… developed a second set of policy tools…we have introduced facilities to purchase highly rated commercial paper at a term of three months and to provide backup liquidity for money market mutual funds…the Federal Reserve and the Treasury have jointly announced a facility that will lend against AAA-rated asset-backed securities collateralized by student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration…

The Federal Reserve’s third set of policy tools…involves the purchase of longer-term securities for the Fed’s portfolio…

Some observers have expressed concern that, by expanding its balance sheet, the Federal Reserve is effectively printing money, an action that will ultimately be inflationary. The Fed’s lending activities have indeed resulted in a large increase in excess reserves held by banks …. However, banks are choosing to leave the great bulk of their excess reserves idle…

As lending programs are scaled back, the size of the Federal Reserve’s balance sheet will decline, implying a reduction in excess reserves…the Federal Reserve will be able to return to its traditional means of making monetary policy—namely, by setting a target for the federal funds rate. a. How did the policies the Federal Reserve used to respond to the financial crisis and the recession of 2007–2009 differ from policies it used during earlier recessions? b. What risk did the Federal Reserve take by “responding aggressively” to the economic crisis of 2007–2009?

Source: Board of Governors of the Federal Reserve System, “The Crisis and the Policy Response”; http://www.federalreserve.gov/newsevents/speech/bernanke20090113a.htm

Solving the Problem Step 1:

Review the chapter material.

This problem is about the policies the Federal Reserve used during the 2007–2009 recession so you may want to review the section “Fed Policies during the 2007–2009 Recession.”

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Step 2:

Step 3:

Answer part (a) by explaining how the policies the Federal Reserve used to respond to the financial crisis differed from policies it used during earlier recessions.

The Federal Reserve policies during the financial crisis differed in these four ways: 1. It allowed primary securities dealers (broker-dealers that trade in Treasury securities with the Federal Reserve Bank of New York) to borrow from the Fed’s “discount window” 2. It purchased commercial paper (short-term loans made between firms) and provided backup liquidity for money market mutual funds; 3. The Fed made loans against AAA-rated asset-backed securities collateralized by student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration 4. The Fed purchased longer-term securities for its asset portfolio (the Fed typically buys and sells Treasury bills, with maturities of less than one year, when it conducts open market operations) Answer part (b) by discussing the risk the Federal Reserve took by “responding aggressively” to the economic crisis of 2007–2009.

Most of the actions Ben Bernanke described caused an increase in bank reserves. There was a large increase in banks’ excess reserves, which can be used to expand deposits and the money supply. So, the Fed was risking an increase in the rate of inflation.

E. The Fed Responds to the Covid-19 Recession The Fed responded to the 2020 recession caused by the Covid–19 pandemic by cutting its target for the federal funds rate to zero and by introducing temporary lending facilities that would allow it to make loans to businesses other than the commercial banks that can borrow from the Fed using discount loans. The Fed had used some of these lending facilities during the 2007–2009 recession, but others were new. By using these facilities, the Fed was able to ensure that funds flowed to firms and to state and local governments that might otherwise have had difficulty borrowing. As a result, the U.S. financial system largely avoided a credit crunch like the one that increased the length and severity of the 2007–2009 recession.

Extra Economics in Your Life & Career: Should You Hold Bonds or Savings/Checking Accounts?

Question: Suppose most of your savings are in bonds and, according to an article in the Wall Street Journal, the Fed announces that it will carry out a contractionary monetary policy. What should you do? Should you continue to hold your bonds, or should you move your funds into bank accounts?

Answer: Holding bonds has several advantages. Their prices may rise. In addition, they pay interest that is greater firms than you are likely to receive on savings or checking accounts. Let’s assume that some produce beyond their normal capacity and the unemployment rate is very low. In this case, wages and prices are increasing. To reach its goal of price stability, the Fed needs to carry out a contractionary monetary policy by decreasing the money supply and increasing interest rates. Higher interest rates

Extra AN INSIDE LOOK News Article to Use in Class

will Visit Pearson’s MyLab Economics for current news articles. cause beforea decline in the selling price of bonds. So, you will be better off if you sell your bonds interest rates begin to rise and move your funds into bank accounts. Of course, by the time you read . the news in the Wall Street Journal, it may be too late and bond prices may already have declined.

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Solutions to End-of-Chapter Exercises 25.1

What Is Monetary Policy?

Learning Objective: Define monetary policy and describe the Federal Reserve’s monetary policy goals.

Review Questions 1.1

1.2

When Congress established the Fed in 1913, the main responsibility of the Fed was to prevent bank panics by making discount loans to banks. Congress broadened the Fed’s responsibilities in response to the Great Depression in the 1930s.

The Fed’s four monetary policy goals are price stability, high employment, economic growth, and the the stability of financial markets and institutions. The Federal Reserve has a dual mandate in sense that the Employment Act of 1946 explicitly mentioned that it is the responsibility of

1.3

the federal stable government (including the Federal Reserve) to promote maximum employment and prices.

Problems and Applications 1.4

1.5

Investment banks can be subject to liquidity problems because they often borrow short A bank panic occurs when large numbers of depositors simultaneously make withdrawals from many banks. When the Fed was founded, its primary responsibility was to deal with bank panics term— by making as discount to banks. The failure of a single large bankinvestments. can lead to a bank panic as sometimes short asloans overnight—and invest the funds in longer-term depositors (or lenders in the case of shadow banks) become concerned about their deposits (loans). Bank panics in the United States historically have led to recessions. Bank failures disrupt the flow of credit to small and medium-size businesses and to households. Failures of restaurants or clothing stores do not spread to other stores in the way that bank failures spread to other banks (when the government does not provide deposit insurance), and restaurants and clothing stores do not play as important a role in the economy as banks and financial intermediaries do by providing credit to households and firms. a. Congress and the president gave the Fed the dual mandate in the Employment Act of 1946. b. By suggesting that the Fed needs to “read the labor market correctly,” Kashkari means that the Fed needs to be able to gauge how much more employment can expand without causing inflation to accelerate. The main measure of the labor market is the unemployment rate. But if, for instance, the employment-population ratio for prime-age workers is lower than its longrun average, employment may still grow significantly without causing an acceleration in inflation even if the unemployment rate is low. It’s important to the Fed’s dual mandate of price stability and high employment that the Fed read the labor market correctly so that it doesn’t either allow employment to be significantly less than it could be or push employment to such high levels that inflation accelerates. c. The Fed’s dual mandate does not require a zero percent unemployment rate. Instead, the Fed should attempt to reduce cyclical unemployment to zero while accepting some level of structural and frictional unemployment as unavoidable.

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1.6

Nominal interest rates tend to be lower when inflation is low, and they tend to be higher when inflation is high. (The nominal interest rate equals the real interest rate plus the expected inflation rate.) Therefore, if the Fed achieves price stability, long-term interest rates are likely to be low.

1.7

a. “Stock and bond volatility” means substantial swings in the prices of stocks and bonds.

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

25.2

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

Review Questions 2.1

2.2

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

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

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2.3

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

2.4

The federal funds rate is the interest rate banks charge each other for overnight loans. It is the interest rate that the Federal Reserve targets to conduct monetary policy.

The Fed’s two new policy tools are: (1) the interest rate it pays on reserves held at the Fed by banks and (2) the interest rate it offers on reverse repurchase agreements. The Fed relies on these two interest rates to change the federal funds rate because of the extremely large amount of excess reverses held by banks.

2.5

Problems and Applications 2.6

A decrease in the money supply from MS1 to MS2 could be caused by the Federal Reserve selling U.S. government securities, raising the discount rate, or raising the required reserve ratio. An increase in money demand from MD1 to MD2 could be caused by an increase in the price level or an increase in real GDP.

2.7

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

2.8

An increase in the money supply will lower interest rates. When the Fed lowers the target for the federal funds rate, the Fed buys Treasury bills, which increases banks’ reserves (this increase is

2.9

what economist Price Fishback means by “pouring more money into the banking system”),

2.10

bank loans, and the money supply.

The Fed was targeting the federal funds rate. The Fed gave up targeting the money supply because people require less currency and smaller balances in their checking accounts. because the relationship between M1 and M2 and other key economic variables, such as the inflation rate and the growth of GDP, weakened after 1980. a. Scenario 3. Widespread use of mobile wallets shifts the money demand curve to the left .

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CHAPTER 25 | Monetary Policy b. Scenario 4. The decrease in the required reserve ratio shifts the money supply curve to the right because converting required reserves to excess reserves is likely to increase the loans banks make, which will increase checking account deposits. c. Scenario 2. The Fed selling Treasury securities shifts the money supply curve to the left because it pulls reserves from the banking system. d.Scenario 1. An increase in real GDP shifts the money demand curve to the right because households and firms require more currency and checking account deposits to finance their higher level of spending.

25.3

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

Review Questions 3.1

3.2

An increase in interest rates decreases three of the four components of aggregate demand.

Higher interest rates decrease investment spending, including spending on new homes, and consumption spending, particularly spending on durable goods. Net exports also decline as higher interest rates increase the exchange rate between the dollar and foreign currencies.

Government purchases are not affected by increases in interest rates.

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

3.3

growth of the money supply) and increasing interest rates.

Quantitative easing refers to the buying of securities (such as 10-year Treasury notes and mortgage-backed securities) with longer maturities than short-term Treasury securities (Treasury bills) that the Fed usually buys in open market operations. The Fed cannot reduce the federal

funds rateApplications below zero, so it has used quantitative easing to reduce long-term interest rates.

Problems and Other 3.4

3.5

central banks are in the same situation of being unable to reduce their short-term interest The Fed typically uses contractionary monetary policy in situations where it believes that rate real GDP has increased beyond potential GDP, resulting in an increase in the inflation targets below zero, so they haveabove also potential used quantitative easing to reduce rate. Real GDP cannot remain GDP indefinitely.

Rather long-term than wait interest for the rates. automatic mechanism to return real GDP to the level of potential GDP—which would result in the price level being driven even higher—the Fed uses contractionary monetary policy by raising its target for the federal funds rate. By promptly enacting a contractionary policy, the Fed can bring real GDP back to potential GDP more quickly and with a smaller increase in the price level.

Apparently, banks in Japan were not lending out the new reserves being created by the Bank of Japan’s expansionary monetary policy. For an expansionary monetary policy to be successful, banks have to lend out the reserves created by the central bank. Banks in Japan were . either reluctant to make loans to their existing customers—perhaps because they believed that the risk

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of borrowers defaulting on loans had increased—or the banks were having difficulty finding firms optimistic enough to be willing to borrow to purchase new machinery, equipment, and buildings.

3.6

a. The Fed uses expansionary monetary policy to stimulate consumption and investment. This practice will shift the aggregate demand curve to the right and increase both real output and the price level. An increase in the price level is inflation.

Since the recession of 2007–2009, the Fed has been very aggressive is using expansionary b. monetary policy. During the years following the crisis, the Fed successive rounds of quantitative easing to increase the money supply by trillions of dollars. The Fed had been slowly easing its expansionary policy prior to the pandemic but rapidly responded to the Covid–19 pandemic by cutting its target for the federal funds rate to near zero in 2020. By early 2021, the U.S. economy appeared to be recovering, but the Fed maintained its expansionary policies. The stock market responded so favorably that many experts forecast a stock market bubble and high inflation. However, the Fed appeared to be more concerned that the economic recovery might derail and push the economy back into recession. The fear of more aggressive strains of Covid–19 emerging appears to have been more important to the Fed’s decisions that was concerns about inflation.

3.7

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

3.8

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

3.9

a. Rounds of quantitative easing (QE) by the Fed, the European Central Bank (ECB), and other central banks around the world had driven long-term interest rates to very low levels.

Eventually, investors bid up the prices of some long-term bonds issued by European governments to such high levels that the yields on the bonds were actually negative— investors would receive less when the bonds matured than they were paying to buy them. In these conditions, the ECB believed that to spur banks to make loans it needed to make the interest rates on bank reserves negative. b. With interest rates on many corporate bonds and on bank deposits being at very low levels, investors did not believe that the interest rates were sufficiently high to compensate for the default risk on those bonds and deposits. So, investors were willing to receive a negative

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CHAPTER 25 | Monetary Policy nominal interest rate from the on German government bonds because they believed there was no chance that the German government would default on the bonds. c. Negative interest rates in Germany should push depositors to pull most of their money out of banks. Individuals would probably begin using more cash for transactions.

3.10

d. People can get by without a bank for most transactions and some demographic groups remain largely unbanked and rely on other mechanisms, such as Venmo or similar smartphone apps, to transfer funds. a. The Federal Reserve’s balance sheet is a financial statement that lists all the assets and liabilities of the Fed. b. The Fed increases its balance sheet when it buys financial assets such as Treasury securities or mortgage-backed securities. These purchases increase the reserves banks hold because the funds the Fed uses to pay for the securities are typically deposited in banks. c. By “bank credit,” William Dudley means banks making loans to consumers and businesses.

Higher bank reserves mean that banks have funds they can use to make more loans. However, following the financial crisis, government regulators were requiring banks to hold safer assets, like bank reserves, and low interest rates on loans and bonds meant that the opportunity cost to banks of holding more reserves was low. For this reason, most banks increased their bank reserves. If the Fed wants to reduce bank lending, it can simply raise the interest rate it pays on the bank reserves hold on deposit at the Fed. Conversely, the Fed can encourage bank lending by lowering or eliminating the interest rate it pays banks on their reserve deposits.

3.11

The Fed was not successful in preventing the U.S. economy from entering a recession. The National Bureau of Economic Research Business Cycle Dating Committee announced that the longest U.S. economic expansion on record ended in February 2020. No monetary policy action could have prevented the recession given the actions of state and local governments to close many businesses to try to contain the pandemic and the unwillingness of many consumers to enter those businesses that did remain open. Monetary policy cannot avoid a recession cause by such a severe pandemic.

3.12

Forecasting anything as complex as the effects of a new virus or correctly forecasting that a recession will occur are both very difficult. Because Covid-19 was a previously unknown virus, biologists lacked the data necessary to fully understand its effects. As the economy evolves over time, economic institutions may change, which complicates the difficulty of forecasting the likelihood of a recession that results from a shock to aggregate demand or to aggregate supply.

For instance, because prior to the 1970s, the U.S. economy had not experienced the effects of a sharp increase in oil prices, few economists predicted the severity of the recession of 1974–1975.

Similarly, because the United States had not experienced a significant decline in housing prices since the 1930s and because economists did not fully understand the importance of the growth of the banking system, many economists, including Fed policymakers, were surprised by the severity of the 2007–2009 recession.

3.13

a. Economic growth was negative. Real GDP declined in 2008 by 0.1 percent. b. Economic forecasts are subject to error, especially when the forecasts are made prior to or during a business cycle turning point. Many economists, including members of the president’s Council of Economic Advisors, did not predict the recession of 2007–2009. This error does not mean that policymakers should ignore economic forecasts, but it does mean they should realize that forecasts are subject to error.

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3.14

Policymakers at the Fed believe that, although it is not perfect, active monetary policy is still able to play an important role in stabilizing the economy. Many Fed policymakers believe that the monetary growth rule Friedman proposed has become less useful as a guide to policy because the relationship between money growth and real GDP and the price level has weakened.

3.15

You should disagree because the statement is incorrect. An increase in the money supply does not affect supplyreal GDP directly, and certainly not dollar-for-dollar. An increase in the money increases real GDP by lowering interest rates, which in turn increases spending. When interest rates are are lower, households are more likely to buy new homes and automobiles, and firms more likely to buy new factories and computers. Lower interest rates also lead to a lower

Monetary Policy in the Dynamic Aggregate Demand and Aggregate foreign 25.4 Supply Model

exchange rate for the dollar, which lowers the prices of exports in foreign currencies and raises Learning Objective: Use the dynamic aggregate demand and aggregate supply model to the pricesmonetary of imports in dollars, thereby increasing net exports. Because the exact size of analyze policy.

Reviewthese Questions

effects is uncertain, the Fed’s job is much more difficult than the statement suggests.

4.1

4.2

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

Problems and Applications contractionary monetary policy will cause a decline in both real GDP and the price level. In 4.3

the dynamic aggregate demand and argument. aggregate supply a contractionary policy You should disagree with this In the model, basic aggregate demandmonetary and aggregate

supply model, a contractionary monetary policy causes the price level to fall. In the more will accurate model, however, monetary cause realdynamic GDP andAD-AS the price level to increase abycontractionary less than they would havepolicy in the causes absencethe of the price level to rise by less than it would have in the absence of the policy. In the dynamic policy.

AD-AS model, the short- run aggregate supply curve, the long-run aggregate supply curve, and the aggregate demand curve all typically shift to the right each year. In the dynamic AD-AS model, a contractionary monetary policy causes the aggregate demand curve to shift to the right by less than it would in the absence .

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CHAPTER 25 | Monetary Policy of policy. As a result, the price level will still increase, but by less than it would have in the absence of the policy.

4.4

a. Without policy action, aggregate demand will shift from AD2024 to AD2025 (without policy).

Real GDP increases from $20.1 trillion to $20.6 trillion, and the price level increases from 120 to 124. b. Because real GDP will be greater than potential GDP in 2025, the Fed should use a contractionary policy to keep real GDP at its potential level. To implement a contractionary policy, the trading desk needs to sell Treasury bills. Selling Treasury bills will decrease reserves in the banking system. Banks will decrease their loans, which will decrease the money supply and increase the interest rate. c. If the Fed takes no policy action, the price level will increase from 120 in 2024 to 124 in 2025. The rate of inflation would equal [(124 – 120)/120] × 100 = 3.3 percent. If the Fed uses monetary policy to keep real GDP at its full employment level, the price level will increase from 120 in 2024 to 122 in 2025. The rate of inflation would equal [(122 – 120)/120] × 100 = 1.7 percent.

4.5

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

If policy is successful, real GDP in 2025 will decrease from the level given in the table of $21.4 trillion to its potential level of $21.2 trillion. ii. Monetary policy does not affect potential GDP, so its value will not change. iii. The contractionary monetary policy will shift the AD curve to the left . Therefore, the price level will decrease more than it would have had the Fed not acted. iv. Because the level of real GDP will be lower, the unemployment rate will be higher than it would have been without policy.

c. Equilibrium in 2024 is at point A, with the AD and SRAS curves intersecting along the LRAS2024 curve. Real GDP is at its potential level of $20.8 trillion, and the price level is 124.

Without monetary policy, the AD curve shifts to AD2025 (without policy), and short-run equilibrium occurs at point B. Because potential real GDP has increased from $20.8 trillion to $21.2 trillion, short-run equilibrium real GDP of $21.4 trillion is above the potential level.

The price level has increased from 124 to 130. With policy, the AD curve shifts to the left to AD2025(with policy), and equilibrium is at point C. At point C, real GDP is equal to its potential level of $21.2 trillion. The equilibrium price level will be at P2025 (with policy), which will be lower than 130. Without policy, the inflation rate in 2025 would have been 4.84 percent [(130 − 124)/124 × 100). With policy, it will be less than 4.84 percent.

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4.6

691

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

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

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

Review Questions

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5.1

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

5.2

The Fed can’t hit both targets because it can achieve only combinations of the interest rate

5.3

and the not money supply that represent equilibrium in the money market. Because the Fed does control money demand, it cannot target both the federal funds rate and the money supply at the same time.

The Taylor rule is a rule developed by John Taylor, an economist at Stanford University,

which Problems and Applications 5.4

5.5

links theofFederal Reserve’s target for the federal funds rate to economic variables. The purpose The Federal Reserve the money supply but not the demand forthe money. the Taylor rule is to can haveaffect a convenient way to determine approximately targetThe for Fed the currently targets interest rates, but while the late Paul Volcker was chair of the Federal Reserve federal Board it chose to reduce the growth of the money supply in order to reduce the rate of inflation, meant that approximation it could not alsoto target rates.

This the is why Paulfederal Volcker said funds ratewhich and to use that help interest evaluate whether actual funds rate “…we will stop the money supply from increasing as rapidly as it was…and interest rates went target set by the Federal Reserve is too high or too low. up a lot…”

Federal funds target rate

= 6% + 1% + 0.5% = 7.5 % 5.6

The Taylor Rule can be written as:

Fed funds rate target = 1% + 2% + [(1/2) × (−1%)] + [(1/2) × 0%] = 3% + [−(1/2)%] + [0] = 2.5% 5.7

a. The central bank is inflation rate targeting if it announces the inflation rate, say 2 percent, that it believes is consistent with its goal of price stability and implements policies that will keep the inflation rate around that target. b. When the central bank announces a target, households and firms need to understand the inflation target so that they will expect the targeted inflation rate will prevail when they make decisions about prices, wages, and interest rates.

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c. Once a central bank establishes a credible inflation target, it reduces the uncertainty that firms and households would otherwise have about future inflation rates. The result will be that firms and households will be more likely to enter into long-term contracts, thereby reducing uncertainty over future spending. In addition, households and firms will be less likely to experience losses or gains when the actual inflation rate is significantly different from the expected inflation rate. Households and firms generally consider gains resulting from unexpectedly high or low inflation to be unfair.

5.8

5.9

a.Recall that the growth rate of nominal GDP is approximately equal to the growth rate of the price level (or the inflation rate) plus the growth rate of real GDP. If the Fed expected 3 percent annual growth in real GDP and wanted an inflation rate of 2 percent, it would set a target of nominal GDP growth of 5 percent per year. If real GDP growth slowed, as during a recession, the Fed would automatically pursue an expansionary monetary policy in an attempt to hit its nominal GDP target. If the inflation rate increased above 2 percent, the Fed would automatically pursue a contractionary policy to keep nominal GDP from rising above its target.

Because real GDP and the inflation rate declined during the 2007-2009 recession, nominal b.

GDP targeting would have resulted in a more expansionary monetary policy because the Fed would have needed to implement an expansionary policy to increase the growth rate of real GDP and the inflation rate.

It would be easier to follow a nominal GDP target if a central bank was concerned with both c. unemployment and inflation than if it were concerned with just inflation because the central bank could conduct an expansionary monetary policy to hit its nominal GDP target even if it had already achieved its inflation target.

Both the consumer price index (CPI) and the personal consumption expenditures (PCE) price a. index measure prices paid by consumers, but the PCE price index is broader. The PCE price index includes all goods and services that are in the consumption component of GDP, while the CPI includes only the goods and services that are in the market basket that the Bureau of Labor Statistics uses in calculating the CPI. To set monetary policy, the Fed wants to use the best measure it can of the underlying b. inflation rate. For this reason, the Fed uses the core PCE price index as its preferred measure of inflation. Because food and energy prices tend to be more volatile than other prices, using the CPI or the PCE price index as its target for inflation could lead the Fed to use either: 1) a more contractionary monetary policy than would be warranted to reach its goal of price stability or 2) a more expansionary monetary policy than would be warranted to achieve its goal of high employment.

25.6 Fed Policies during the 2007–2009 and 2020 Recessions

Describe the policies the Federal Reserve used during the 2007–2009 and 2020 recessions.

Review Questions 6.1

A mortgage is a loan a borrower takes out to buy a house. (Technically, a residential mortgage is a loan that uses a house or residence as collateral for the loan, while a commercial mortgage is a loan that uses a commercial building as collateral for the loan.)

Prior to 1970, mortgages were not considered securities—financial assets that are bought and sold in secondary markets. After 1970, Congress helped to create a secondary market in mortgages to stimulate the housing market by establishing the Federal National Mortgage Association (“Fannie Mae”) and the Federal Home .

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CHAPTER 25 | Monetary Policy Loan Mortgage Corporation (“Freddie Mac”). These institutions sell bonds to investors and use the proceeds to buy mortgages from banks and savings and loans. By the 1990s, these developments led to a large secondary market for mortgages. By the 2000s, investment banks had become significant participants in the secondary market for mortgages.

Investment banks began buying mortgages, bundling them together as mortgage-backed securities and selling the securities to investors. Also, by the mid-2000s lenders had greatly loosened the standards to qualify for a mortgage loan so that subprime borrowers, Alt-A borrowers, and borrowers with small down payments had a much easier time obtaining loans.

6.2

Among the actions the Fed and Treasury took were the following: In March 2008: ▪ The Fed announced it would temporarily make discount loans to primary dealers–firms that participate in open market transactions with the Fed. ▪ The Fed announced that it would loan up to $200 billion of Treasury securities in exchange for mortgage-backed securities to primary dealers.

▪ The Fed and the Treasury took direct action to keep large financial institutions from bankruptcy by helping JP Morgan Chase acquire the investment bank Bear Stearns.

In September 2008: ▪ The Treasury moved to have the federal government take control of Fannie Mae and Freddie Mac. Fannie Mae and Freddie Mac were each provided with up to $100 ▪

billion in exchange forto80 ownership of theGroup firms.(AIG) The Fed agreed to provide an $85 billion loan thepercent American International

▪

insurance company in exchange for an 80 percent ownership stake, effectively giving

▪

the federal company. provide government insurance forcontrol depositsof in the money market The Treasury announced a plan to

mutual funds, similar to the existing insurance on bank deposits.

The Fed announced that it would lend directly to corporations by purchasing threemonth In October 2008: paperthe issued by nonfinancial corporations.

▪ commercial Congress passed Troubled Asset Relief Program (TARP), under which the Treasury attempted to stabilize the commercial banking system by providing funds to banks in exchange for stock.

6.3

The Fed responded to the 2020 recession caused by the Covid–19 pandemic by cutting its target for the federal funds rate to zero and by introducing temporary lending facilities that would allow it to lend to businesses that are not commercial banks and so are not typically eligible to borrow from the Fed. The Fed had used some of these lending facilities during the 2007–2009 recession, but others were new. By using these facilities, the Fed was able to ensure that funds flowed to firms and to state and local governments that might otherwise have had difficulty borrowing.

Problems and Applications 6.4

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

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695

a. The establishment of Fannie Mae and Freddie Mac by Congress spurred the development of a secondary market in mortgage-backed securities. The existence of a secondary market, in turn, greatly expanded the sources of funding for mortgages. These developments meant that borrowers have been able to choose from a greater variety of lenders and small local banks face greater competition. Quoting further from the article by McDonald and Thornton: “For the borrower, robust mortgage trading allows for more intense ‘competition’ . . . . [T]he Internet has provided an outlet to quickly compare mortgage rates.” Small local banks that had little competition for mortgage loans in the 1960s and 1970s now face much greater competition because potential customers can shop for mortgages from their home computers.

This greater competition has reduced the interest rates borrowers have to pay on mortgages. b.

In addition, the supply of funds available to finance mortgages has also increased as investors purchase mortgage-backed securities. The increased supply of funds has also contributed to lower mortgage interest rates.

Source: Daniel J. McDonald and Daniel L. Thornton, “A Primer on the Mortgage Market and Mortgage Finance,” Federal Reserve Bank of St. Louis Review, January/February 2008.

6.6

6.7

In hindsight, we can state that the U.S. economy was far from “turning the corner in terms of financial disruption” in April 2008. It may have seemed to be a reasonable analysis at the time if members of the Board of Governors believed that other firms that were part of the “shadow banking system” were not going to be adversely affected by the financial crisis. Not since the 1930s had the United States experienced such a severe financial crisis, so few economists or policymakers anticipated it. a. A “subprime mortgage” is a mortgage granted to a borrower with a poor credit history who makes a small down payment or otherwise represents a higher- than- average risk of default. b. A deeper pool of capital refers to greater potential financing for borrowers, which was the result of the increased securitization of the mortgage market after 1970. c. Because of the greater risk of default, a subprime borrower typically would pay a higher interest rate than a borrower with a better credit history. d. A lender would prefer to lend to a borrower with a poor credit history if the lender believed the higher interest rate would more than compensate for the greater risk of default.

6.8

a. The key events that many economists believe led to the financial crisis were the following: ▪ The increased securitization of mortgage loans increased availability of mortgage loans toby subprime and Alt-A borrowers The investment in mortgage-backed securities shadow banks ▪ The Shadow banks financing their investment in long-term mortgage-backed securities with ▪ short-term loans ▪ The lack of supervision of shadow banks by government regulators ▪ Answers will vary as to whether the events leading to the financial crisis should have been anticipated. In fact, few economists or policymakers did anticipate them. In particular, few economists or policymakers anticipated the dramatic decline in housing prices—by far the largest decline since the 1930s—that led to widespread defaults on mortgage loans. b. “Cheap loans” were encouraged by two government-sponsored enterprises—Fannie Mae and Freddie Mac—that sold bonds to investors and used the funds to buy mortgages from banks in secondary markets. By 2005, lenders were issuing many mortgages to subprime borrowers

.

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CHAPTER 25 | Monetary Policy with flawed credit histories and Alt-A borrowers who were required to make only small down payments and who were not required to document their incomes in order to qualify for mortgage loans. The “American dream” that Fuld refers to is owning a home.

6.9

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

6.10

a. During typical recessions, the Fed engages in expansionary monetary policy, cutting its target for the fed funds rate to encourage consumption and investment. The most common Fed tool was using open market operations.

In b. both recessions, the Fed rapidly cut its target for the federal funds rates nearly to zero and directly intervened in financial markets by buying securities, such as corporate bonds, that it typically doesn’t buy in conducting monetary policy. c. The Fed’s response to the Great Recession included facilitating acquisitions of large financial firms, including JP Morgan’s purchase of Bear Stearns. The Fed did not take similar actions during the recession caused by the pandemic. The Fed’s response to the recession caused by the pandemic included creating new lending and credit facilities. By using these facilities, the Fed was able to ensure that funds flowed to firms and to state and local governments that might otherwise have had difficulty borrowing. The result was that the U.S. financial system largely avoided the credit crunch that had increased the length and severity of the 2007–2009 recession.

6.11

a. The Fed is not set up to make small business loans. The Fed’s focus is on macroeconomic policy rather than microeconomic policy. Without the proper infrastructure in place, it is difficult for the Fed to funnel money to these firms. This difficulty is highlighted by the problems of the Fed’s Main Street Lending Program. During that facility’s first months of operation, banks were reluctant to make loans for fear of taking losses if the borrowers defaulted and the terms of loans that were offered were not attractive to many businesses. The difficulties this program encountered exposed the Fed to the criticism that it had done more to help large firms and banks than to help small and medium-sized businesses that were struggling to survive the pandemic. b. Raising money on Wall Street is done by selling stocks and bonds. Small and medium-sized firms do not have the ability to tap this source of funds because most investors lack enough information about these firms to assume the risk of buying the firms’ stocks or bonds. c. Small and medium-sized businesses needed the financial resources to survive the recession caused by the Covid–19 pandemic. These firms employ millions of workers and needed financial aid to survive the mandatory shutdowns or sharp reductions in capacity that many state and local governments imposed in trying to contain the pandemic.

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Real-Time Data Exercises D25.1 a.

In its press release of July 29, 2019, the FOMC did not change the target for the federal funds rate. The FOMC maintained the target range at 2 ¼ to 2 ½.

b. The FOMC was more concerned with slow economic growth as the economy experienced a slowdown in the new jobs created and the inflation rate was below the Fed’s target.

The FOMC advocated keeping their current for monetary policy, keeping eye c. The FOMC maintained its existing intereststance rate target is appropriate forwhile the time beinganand that on it would “act when appropriate” to sustain the economic expansion. theFOMC uncertainties in the outlook. d. The reported thateconomic the interest rate paid on bank excess reserves is slightly below the effective fed funds rate. The report did not mention interest rates on repurchase agreements, though they did point out that the usage of the overnight reverse repurchase agreement facility has remained low.

D25.2 Other than December 31, 2015 through January 3, 2016—when the effective federal funds rate was below the lower limit—and on September 17, 2019—when the effective federal funds rate was above the upper limit—the Fed has been able to keep the effective federal funds rate within the target range.

D25.3 a.

See the following table: August 2019 CPI 256.30 PCE 109.95 PCE, excluding food and energy 112.039

August 2018 251.879 108.496 110.086

Inflation Rate (Year over year) 1.75% 1.34% 1.77%

b. The inflation rate using the PCE without food and energy was highest at 1.77 percent and the inflation rate using the PCE was the lowest at 1.34 percent. The measures of inflation differ because the price indexes include somewhat different goods and services and are not calculated in the same manner. The personal consumption expenditures price index includes a broader range of goods and services than the consumer price index and is a chain-type price

.

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CHAPTER 25 | Monetary Policy index, as opposed to the market-basket approach used in constructing the consumer price index. The so-called core personal consumption expenditure price index excludes food and energy.

D25.4 a.

In the second quarter of 2009, the output gap was −−5.9 percent, or the GDP was 5.9 percent below Federalthe potential GDP. Because the output gap was negative, we expect that the

lowered the of federal rate during this0.85 period to help bring the was economy out of b. InReserve the second quarter 2019,funds the output gap was percent, or the GDP 0.84 percent above thethe potential GDP. Because the output gap was positive, we expect that the Federal Reserve raised the federal funds rate during this period to help prevent future inflation. recession.

D25.5 In the chart from the website of the Federal Reserve Bank of Cleveland, students can clearly see an increase in lending to financial institutions (the yellow area) to nearly $1.5 trillion while quantitative easing is shown by the purchase of “federal agency debt and mortgage-based securities” and “long-term Treasury” assets. Before the recession, the Fed had less than $1 trillion in assets and by 2014 they had about $3.5 trillion more in assets.

Suggestions for Critical Thinking Exercises CT25.1 Answers to this question will vary depending on the date of the article that the student gets.

For instance, here is an excerpt from a Wall Street Journal article published on October 13, 2021: “Minutes of their Sept. 21–22 Fed meeting, released Wednesday, revealed a stronger consensus over scaling back the $120 billion in monthly purchases of Treasury and mortgage securities amid signs that higher inflation and strong demand could call for tighter monetary policy next year” Source: Nick Timiraos, “Fed Worried About Inflation Risk as It Firmed Up Tapering Plan,” wsj.com, October 13, 2021.

The Federal Reserve is the central bank of the United States and is able to control both the money CT25.2 supply and the level of interest rates. The interest rate the Fed controls is the federal funds rate, which influences other interest rates in the economy such as those on car loans and home mortgages. The Fed has influence over these rates, and when they rise or fall, private spending changes and, in turn, employment also changes. So, the Fed can have a substantial effect on the level of employment in the economy even though it directly hires very few people.

CT25.3 a. Answers may vary depending on the bank and the date when the student checks the rates in their financial institution. However, their answers will most likely show that the interest rates for home loans and auto loans are lower than credit card rates and personal loan rates. Home loans and auto rates have lower interest rates because these loans are secured by collateral (for instance, the house or car that you plan to buy), while credit card loans and personal loans are not secured by collateral, so they are considered to be more risky. Moreover, the interest rate on loans with a shorter term may be lower than on loans with a longer term (for example, 3-year auto loans in comparison with 5-year auto loans), particularly if interest rates are expected to rise in the future. b. The students will observe that interest rates that banks pay when they borrow from each other or from the Fed are lower than the interest rates that the banks charge consumers who borrow from them. Banks accept more risk when they lend to consumers than when they lend to each other, and banks have higher costs to administer loans to consumers. Banks also need to charge a higher interest rate than the fed funds rate because banks also need to make a profit from the loans.

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CHAPTER 26 | Fiscal Policy Brief Chapter Summary and Learning Objectives The authors use the dynamic aggregate demand-aggregate supply model to discuss fiscal policy in Section 26.3 of this chapter. This section is self-contained, so you can omit it without any loss of continuity in your discussion of fiscal policy.

26.1 What Is Fiscal Policy?

Define fiscal policy.

▪ Fiscal policy involves changes in federal taxes and purchases that are intended to achieve

macroeconomic policy goals.

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

▪ Congress and the president can increase government purchases or cut taxes to fight recession

and decrease government purchases or raise taxes to fight inflation.

26.3 Fiscal Policy in the Dynamic Aggregate Demand and Aggregate Supply Model Use the dynamic aggregate demand and aggregate supply model to analyze fiscal policy. the ▪ The dynamic AD-AS model recognizes that every year the price level rises and LRAS curve shifts to the right.

26.4 The Government Purchases, Tax, and Transfer Payments Multipliers Explain how the government purchases, tax, and transfer payments multipliers work.

▪ An increase in government purchases or a cut in taxes will cause equilibrium real GDP to

increase by a multiple of the increase in government purchases or cut in taxes.

26.5 The Limits to Using Fiscal Policy to Stabilize the Economy Discuss the difficulties that can arise in implementing fiscal policy.

▪ Obtaining approval from Congress for a new fiscal policy can be a long process, and it can

take months for an increase in authorized spending to take place.

26.6 Deficits, Surpluses, and Federal Government Debt Define federal budget deficit and federal government debt and explain how the federal budget can serve as an automatic stabilizer.

▪ A budget deficit occurs when the federal government’s expenditures are greater than its

tax revenues. A budget surplus occurs when the federal government’s expenditures are less than its tax revenues.

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700 CHAPTER 26 | Fiscal Policy

26.7 Long-Run Fiscal Policy and Economic Growth Discuss the effects of fiscal policy in the long run.

▪ Some fiscal policy actions expand the productive capacity of the economy and increase the

rate of economic growth.

Appendix: A Closer Look at the Multiplier Apply the multiplier formula.

Key Terms Cyclically adjusted budget deficit or surplus The deficit or surplus in the federal government’s budget if the economy were at potential GDP.

Automatic stabilizers Government spending and taxes that automatically increase or decrease along with the business cycle.

Budget deficit The situation in which the government’s expenditures are greater than its tax revenue.

Fiscal policy Changes in federal taxes and purchases that are intended to achieve macroeconomic policy goals.

Budget surplus The situation in which the government’s expenditures are less than its tax revenue.

Multiplier effect The process by which a change in autonomous expenditures leads to a larger change in real GDP.

Crowding out A decline in private expenditures as a result of an increase in government purchases.

Tax wedge The difference between the pretax and posttax return to an economic activity.

Chapter Outline Desperate Times Call for Desperate Measures Until the Covid-19 pandemic began in 2020, the United States had not experienced a recession caused by a pandemic in more than 100 years (since the recession caused by the Spanish flu epidemic of 1918– 1919). During 2020 and into 2021, many service businesses, including restaurants and hotels, either closed or reduced operations. In an attempt to offset the worst effects of the recession, Congress and the Trump and Biden administrations enacted by far the largest discretionary fiscal policy actions in U.S. history, including supplementing state unemployment insurance payments; loans to small businesses to help them retain employees; tax refunds to individuals; and payments to families with children. As a result of the fiscal policy actions that Congress passed in March 2020, December 2020, and March 2021, the federal government distributed about $800 billion directly to households. These funds, combined with the closure of many service businesses, resulted in a very different pattern of consumer spending than is usual during a recession.

During a typical recession, consumers cut back spending on durable goods, like cars and appliances, and on new houses. Consumer spending on services, in contrast, rarely declines, except during the worst recessions—and even then the decline will be much less than the decline in spending on durables. As a result, 2020 and 2021 were surprisingly good years for many sellers of durable goods.

While spending on services declined by 5 percent from the fourth quarter of 2019 to the fourth quarter of

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CHAPTER 26 | Fiscal Policy 701 2020, spending on durable goods increased by more than 12 percent, and residential construction was 20 percent higher at the end of 2020 than at the end of 2019.

Although fiscal policy actions provided much-needed support for households and firms, some economists and policymakers were critical of the actions—particularly the $1.9 trillion American Rescue Plan that Congress passed in March 2021. Harvard economist Lawrence Summers, who served as secretary of the Treasury in the Clinton administration, called the American Rescue Plan “the least responsible fiscal macroeconomic policy we’ve had for the last 40 years.” Summers and other critics of the policy were concerned by the potential effects of the increased spending on inflation and the federal budget deficit. When the federal government spends more than it collects in taxes, the result is a federal budget deficit. The increased federal spending during 2020 and 2021 caused the federal budget deficit to increase to levels not seen since the 1940s, during World War II. The 2020 deficit was $3.1 trillion, or about 15 percent of GDP, and the Congressional Budget Office projected the 2021 deficit to be $3.4 trillion, or about 13 percent of GDP. In this chapter, we examine discretionary fiscal policy and the federal budget deficit, as well as the debate over their effects on the economy.

26.1 What Is Fiscal Policy?

Learning Objective: Define fiscal policy.

Fiscal policy refers to changes in federal taxes and purchases that are intended to achieve macroeconomic policy goals.

A. What Fiscal Policy Is and What It Isn’t

State and local governments sometimes change their taxing and spending policies to aid their local economies, but these are not fiscal policy actions because they are not intended to affect the national economy. Some of the decisions the federal government makes about taxes and spending are not fiscal policy actions because they are not intended to achieve macroeconomic policy goals.

B. Automatic Stabilizers versus Discretionary Fiscal Policy Automatic stabilizers are government spending and taxes that automatically increase or decrease along with the business cycle. Changes in these types of spending and taxes happen without actions by the government. For example, when the economy is expanding and employment is increasing, government spending on unemployment insurance payments to workers who have lost their jobs will automatically decrease. With discretionary fiscal policy, the government takes actions to change spending or taxes.

C. An Overview of Government Spending and Taxes Before the Great Depression, most government expenditures took place at the state and local levels.

Since 1990, the federal government's expenditures had averaged about 65 percent of total government expenditures until they jumped to more than 75 percent in 2020 during the recession caused by Covid19. Total federal expenditures as a percentage of GDP rose from 1950 to the early 1990s and fell between 1992 and 2001 before rising again. In addition to purchases, there are three other categories of federal government expenditures: Interest on the national debt, grants to state and local governments and transfer payments.

In the 1960s, transfer payments were about 25 percent of federal government expenditures. By 2020, transfer payments were 50.5 percent of federal government expenditures.

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Teaching Tips The end of the chapter in the main text includes a special category of exercises titled Real-Time Data (RTDA) Exercises. These exercises are well worth assigning and discussing in class because they help students become familiar with a key data source, learn how to locate data, and develop skills in interpreting data. Many RTDA exercises require more elaborate calculations than other problems and the use of Excel spreadsheets.

26.2

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

The federal government uses macroeconomic policies to offset the effects of the business cycle on the economy. When the economy is in recession, increases in government purchases or decreases in taxes increase aggregate demand. Decreasing government purchases or raising taxes slow the growth of aggregate demand and reduce the inflation rate.

A. Short-run Expansionary and Contractionary Fiscal Policy Expansionary fiscal policy involves increasing government purchases or decreasing taxes. An increase in government purchases will increase aggregate demand directly. A cut in taxes has an indirect effect on aggregate demand. Cutting the individual income tax will increase household disposable income and consumption spending. Cutting taxes on business income can increase aggregate demand by increasing business investment. The goal of both expansionary monetary policy and expansionary fiscal policy is to increase aggregate demand relative to what it would have been without the policy.

Contractionary fiscal policy involves decreasing government purchases or increasing taxes.

Policymakers use contractionary fiscal policy to reduce increases in aggregate demand that seem likely to lead to inflation.

B. The Policy Dilemma in Dealing with the 2020 Covid-19 Recession

Congress and Presidents Trump and Biden met the recession caused by the Covid-19 pandemic with fiscal policy actions in March 2020, December 2020, and March 2021. The March 2021 fiscal policy action, the enactment of the American Rescue Plan, was the largest of the three fiscal policy actions and received criticism from some economists and policymakers. While other economists and policymakers were supportive of the plan, believing that it was needed to respond to the deepest economic downturn since the Great Depression of the 1930s, critics focused on the possibility that it might lead to a significant increase in inflation. (Recall from Chapter 15, Section 15.5 that in 2020 the Fed adopted a monetary policy strategy of average inflation targeting under which it was willing to accept an inflation rate that was temporarily higher than 2 percent.) Some critics of the size of the government spending increase resulting from the American Rescue Plan, such as Larry Summers of Harvard University and Olivier Blanchard of the Peterson Institute for International Economics, argued that the increase in spending was likely to push real GDP beyond potential GDP. In the fall of 2021, it was too early to know whether the fears of the critics of the American Rescue Plan were correct, but the dilemma facing policymakers when the economy experiences a supply shock is clear: Expansionary fiscal policy can return real GDP to potential GDP but only at the expense of a— possibly temporary—increase in the inflation rate.

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C. A Summary of How Fiscal Policy Affects Aggregate Demand The impact of fiscal policy assumes that monetary policy and all other factors affecting the variables involved are held constant. A contractionary fiscal policy does not cause the price level to fall. A contractionary fiscal policy causes the price level to rise less than it would have without the policy.

Fiscal Policy in the Dynamic Aggregate Demand and Aggregate Supply 26.3 Model Learning Objective: Use the dynamic aggregate demand and aggregate supply model to analyze fiscal policy.

The overview of fiscal policy in the previous section ignores two facts about the economy: (1) The economy experiences continuing inflation, with the price level rising every year and (2) the economy experiences long-run growth, with the long-run aggregate supply curve shifting to the right every year.

The factors that cause the long-run aggregate supply curve to shift also cause firms to supply more goods and services at any given price level in the short run, which is shown by shifting the short-run aggregate supply curve to the right. During most years, the aggregate demand curve shifts to the right, indicating that aggregate expenditure is higher at every price level.

The goal of both expansionary monetary policy and expansionary fiscal policy is to increase aggregate demand involves relative to what it would have been without the policy. Contractionary fiscal policy decreasing government purchases or increasing taxes. Policymakers use contractionary fiscal policy to Extra Solved Problem 26.3 Fiscal Policy in a Dynamic Aggregate Demand and reduce increases in aggregate demand that seem likely to lead to inflation.

Aggregate Demand Model

The following graph illustrates the dynamic version of an aggregate demand and aggregate supply model for an economy with a potential GDP equal to $17.0 trillion. The initial long-run aggregate supply curve (LRAS1) is a vertical line at this level of output. Without an expansionary fiscal policy, aggregate demand will shift from AD1 to AD2 (without policy). The long-run aggregate supply curve will shift (to LRAS2) to reflect the increase in potential GDP (to $18.0 trillion) as a result of increases in the labor force, capital stock, and technology. The factors that shift LRAS will also shift short-run aggregate supply, from SRAS1 to SRAS2.

Because thefederal shift ingovernment LRAS is greater thanpolicy the shift in AD, the equilibrium will beatonly a. How can the use fiscal so that the economy reachesoutput equilibrium $17.5 trillion and GDP? the equilibrium price level will equal 122. The economy is in a recession. potential b. Draw a graph that illustrates the effect of this fiscal policy.

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704 CHAPTER 26 | Fiscal Policy

Solving the Problem Step 1:

Step 2:

Step 3:

Review the chapter material.

This problem is about the use of fiscal policy, so you may want to review the section “Fiscal Policy in the Dynamic Aggregate Demand and Aggregate Supply Model.”.

Answer part (a) by explaining how the federal government can use fiscal policy so that the economy reaches equilibrium at potential GDP. Increasing government purchases or decreasing taxes will increase aggregate demand.

Government spending is a direct increase in aggregate demand, whereas changes in taxes affect spending indirectly through changes in disposable income, so the dollar value of a tax reduction would have to be greater than a government spending increase to achieve the same increase in aggregate demand.

Answer part (b) by drawing a graph that illustrates the effect of this fiscal policy.

The following graph shows the effect of a change in spending or taxes that shifts aggregate demand from to AD2 (without policy) to AD3 (with policy). The increase in aggregate demand increases the price level from 122 to 125 and increases real GDP from $17.5 trillion to $18.0 trillion.

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26.4

The Government Purchases, Tax, and Transfer Payments Multipliers Learning Objective: Explain how the government purchases, tax and transfer multipliers work.

If the federal government decides to use discretionary fiscal policy to increase aggregate demand by, for example, increased infrastructure spending, the initial increase in aggregate demand should lead to additional increases in income and spending. Economists refer to the initial increase in government purchases as autonomous because it is not directly caused by changes in the level of real GDP. The increases in consumption spending that result from the initial increase in autonomous expenditures are induced. The multiplier effect is the series of induced increases in consumption spending that results from an initial increase in autonomous expenditures.

There are three fiscal policy multipliers: 1. Government purchases multiplier The ratio of the change in equilibrium real GDP to the initial change in government purchases is known as the government purchases multiplier:

2. Tax multiplier Tax cuts also have a multiplier effect because they increase the disposable income of households. The expression for the tax multiplier is:

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The tax multiplier is a negative number because changes in taxes and changes in real GDP move in opposite directions.

3. Transfer payments multiplier Finally, we can use our analysis of the tax multiplier to understand the transfer payments multiplier.

Recall that transfer payments are spending by the federal government for which it doesn’t receive a good or service in return. For instance, the $1,400 checks that many people received following passage of the American Rescue Plan in March 2021 were transfer payments. An increase in transfer payments increases household disposable income, which will increase consumption spending. The increased consumption spending will increase real GDP and income, which will increase consumption, and so on in the familiar multiplier process. The expression for the transfer payments multiplier is: Change in equilibrium real GDP .

Change in transfer payments

Transfer payments multiplier=

A. The Effect of Changes in the Tax Rate A change in the tax rate has a more complicated effect on equilibrium real GDP than does a tax cut of a fixed amount. The higher the tax rate, the smaller the amount of any increase in income that households have available to spend, and the smaller the multiplier effect. A cut in tax rates affects equilibrium real GDP through two channels: (1) A cut in tax rates increases the disposable income of households, which leads them to increase their consumption spending, and (2) a cut in the tax rate increases the size of the multiplier effect.

B. Taking into Account the Effects of Aggregate Supply We know that when the AD curve shifts to the right, the price level will rise. As a result of the rise in the price level, equilibrium GDP will not increase by the full amount that the multiplier effect indicates. The actual change in real GDP resulting from an increase in government purchases or a cut in taxes will be less than that indicated by the simple multiplier with a constant price level.

C. The Multipliers Work in Both Directions Increases in government purchases and cuts in taxes have a positive multiplier effect on equilibrium real GDP. Decreases in government purchases and increases in taxes also have a multiplier effect on equilibrium real GDP, but in this case the effect is negative.

26.5 The Limits to Using Fiscal Policy to Stabilize the Economy Learning Objective: Discuss the difficulties that can arise in implementing fiscal policy.

Poorly timed fiscal policy, like poorly timed monetary policy, can do more harm than good. Getting the timing right can be more difficult for fiscal policy. Control over monetary policy is concentrated in the hands of the Federal Open Market Committee. The president and a majority of the 535 members of Congress have to agree on a change in fiscal policy. Even after a fiscal policy decision has been approved, it takes time to implement the policy. Delays may push spending beyond the end of the recession the spending was supposed to fight.

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CHAPTER 26 | Fiscal Policy 707

A. Does Government Spending Reduce Private Spending?

Using government purchases to increase aggregate demand poses another problem. The size of the multiplier effect may be limited if the increase in government purchases causes consumption, investment, or net exports to fall. Crowding out is a decline in private expenditures as a result of an increase in government purchases.

B. Crowding Out in the Short Run The greater the sensitivity of consumption, investment, and net exports to changes in interest rates, the more crowding out will occur. In a deep recession, many firms may be so pessimistic about the future and have so much excess capacity that investment spending falls to very low levels. In this case, crowding out is unlikely to be a problem. If the economy is close to potential GDP, however, and firms are optimistic about the future, an increase in interest rates may result in a significant decline in investment spending.

C. Crowding Out in the Long Run Most economists agree that, in the short run, an increase in government spending results in partial crowding out. In the long run, any permanent increase in government spending as a percentage of GDP must come at the expense of private expenditures.

D. Fiscal Policy in Action: Did the Stimulus Package of 2009 Succeed?

As of mid-2021, it's too early to evaluate the success of the measures the federal government took during 2020 and early 2021 to deal with the recession caused by the Covid-19 pandemic, but it’s useful to review how economists have evaluated the measures the federal government took in response to the 2007–2009 recession.

In early 2008, economists advising President Bush believed that the housing crisis and rising oil prices were pushing the economy into a recession. These economists proposed cutting taxes. Congress enacted a tax cut in the form of rebates that were sent to taxpayers. One-time tax rebates increase consumers’ current income but not their permanent income. Therefore, a tax rebate is likely to increase consumption less than would a permanent tax cut.

The recession worsened in September 2008. Congress passed the American Recovery and Reinvestment Act (ARRA) in February 2009. The ARRA was an $840 billion package of tax cuts and spending increases that was the largest fiscal policy action in U.S. history. About two-thirds of the package took the form of government expenditures, and one-third took the form of tax cuts. At the time the stimulus package was passed, administration economists estimated that the increase in aggregate demand resulting from the the package would increase real GDP by 3.5 percent and increase employment by 3.5 million by end of 2010. In fact, between 2009 and the end of 2010, real GDP increased by 4.0 percent, while employment declined by 3.3 million. Isolating the effects of the stimulus package from other factors is difficult, which is why economists differ in their views about how effective the stimulus package was.

Economists at the Congressional Budget Office (CBO) estimated the effectiveness of the 2009 stimulus package.

If these estimates are accurate, then this .fiscal policy action significantly reduced the severity of the recession. However, compared to the severity of the recession, the effect of the package was relatively

708 CHAPTER 26 | Fiscal Policy

Extra Solved Problem 26.5 Fiscal Policy Lags The Obama administration and Congress passed the American Recovery and Reinvestment Act of 2009 in response to the severity of the 2007–2009 recession. In recent years, fiscal policy measures such as this have become less important than automatic stabilizers—spending and taxes that change automatically during the business cycle—and monetary policy in stabilizing the economy. The main reason for the diminished importance of discretionary fiscal policy is the difficulty government officials have in recognizing and reacting to business cycle movements. Carl Walsh, visiting scholar at the Federal Reserve Bank of San Francisco, has described the long lags involved in changing fiscal policy in the United States:

Most postwar recessions have been short, lasting on average just under 11 months. By the time…policymakers recognize that economic growth has slowed, propose a fiscal package, debate it, pass it, and send it to the President for his signature—the economy is already likely to be recovering. For this reason, discretionary fiscal policy in the U.S. is generally viewed as too unwieldy for dealing with the typical, mild recessions experienced in recent decades…

Both fiscal and monetary policies affect aggregate demand. But because changes in discretionary fiscal policy in the United States are often difficult to enact in a timely fashion, automatic fiscal stabilizers and discretionary monetary policy are viewed as the primary means of macroeconomic stabilization.

However, there are situations in which monetary policy might be unable to stimulate the economy, and discretionary fiscal policy would be needed to combat a recession. In the face of a recession, central banks reduce interest rates⸻ but no central bank can lower interest rates below zero.

Source: Carl Walsh, “The Role of Fiscal Policy,” Federal Reserve Bank of San Francisco Economic Letter , Number 2002-26, September 6, 2002, pp. 1–3.

Discretionary fiscal policy is often associated with Keynesian Economics. John Maynard Keynes advocated discretionary fiscal policy as a response to a severe recession, such as the Great Depression of the 1930s.

Why would discretionary fiscal policies be more effective during the Great Depression or the 2007– 2009 recession than during other recessions of the post–World War II era?

Solving the Problem Step 1:

Step 2:

Review the chapter material.

This problem is about the limitations of fiscal policy, so you may want to review the section “The Limits to Using Fiscal Policy to Stabilize the Economy.”

Explain why discretionary fiscal policies might be more effective during the Great Depression or the 2007–2009 recession than during other recessions of the post–World War II era.

In the United States, the Great Depression refers to the period following a business cycle peak that occurred in August 1929. The following contraction lasted for 43 months, from August 1929 to March 1933. Although a recovery followed this contraction, the economy operated well below its potential throughout the 1930s.

Even with lags in recognizing and reacting to a severe contraction such as the Great Depression, fiscal policy could have

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CHAPTER 26 | Fiscal Policy 709 increased aggregate demand well before the end of the 43-month contraction. Also, interest rates during the Great Depression were very low. Monetary policy is relatively ineffective in this environment because it relies on reducing interest rates to increase spending by firms on factories, office buildings, and machinery and by households on new housing and durable goods. In the post–World War II era, recessions have been shorter and much less severe. Shorter recessions increase the likelihood that a contraction would have ended before an expansionary fiscal policy affected the economy. But the 18-month 2007–2009 recession was longer and deeper that the average for post–World War II recessions and short-term interest rates fell to low levels, which limited the ability of the Federal Reserve to increase aggregate demand by lowering interest rates further. The severity of the Great Depression and the recession of 2007– 2009 made it more likely that fiscal policy would be effective than it would be for other recessions of the post–World War II era.

Extra Apply the Do We Depend Too Much on the Fed during the 2007–2009 Concept Recession?

We have seen that the recovery from the Great Recession of 2007–2009 was slower than many economists had expected. As then Fed Chair Janet Yellen noted in a speech in 2014, “Five years after the end of the recession, the labor market has yet to fully recover.” The $840 billion American Recovery and Reinvestment Act (ARRA) of 2009 was by far the largest fiscal policy action in U.S. history. However, the following figure shows that in 2015, real GDP had not yet returned to potential GDP. The gap between potential GDP and real GDP, which had been as large as 7 percent during the worst of the recession, was still nearly 3 percent—unusually high so far into an economic recovery.

The U.S. economy was still operating well below capacity, producing fewer goods and services and creating fewer jobs than it would have at potential GDP. By 2011, most of the effects of ARRA on real GDP and employment had already occurred. If macroeconomic policy were to help bring the economy back to potential GDP, it appeared that it would therefore be up to the Federal Reserve. As we saw in Chapter 26, the Fed used innovative policies, including multiple rounds of quantitative easing (QE), in an attempt to increase aggregate demand.

With the Fed having ended the last round of QE in October 2014, some economists and policymakers argued that fiscal policy actions were necessary to expand production and employment. Reports of crumbling bridges and railroad accidents led some policymakers to argue that increased infrastructure spending on highways, bridges, and railroad lines would provide both a short-term boost to aggregate demand and longer-term gains to productivity and economic growth. In 2015, President Obama proposed $478 billion in additional infrastructure spending to be paid for by a new tax on the foreign earnings of U.S. corporations. However, not all economists are convinced of the effectiveness of infrastructure spending, particularly if members of Congress direct the spending to projects in their states or districts that might not produce large benefits relative to their costs.

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710 CHAPTER 26 | Fiscal Policy

Supporters of infrastructure projects argue that long-term spending might convince businesses that aggregate demand increases would be maintained over a period of years, providing them with the confidence to expand production and employment. Supporters of tax reform to increase economic growth propose lowering tax rates on businesses to spur investment in new innovations and shifting toward consumption-based taxes to spur saving. Some economists argue that trade policy, although not traditionally fiscal policy, could be used to increase the efficiency of the economy and spur exports, while immigration policy could attract high-skilled immigrants, which would increase long-run growth. The slow recovery from the Great Recession of 2007–2009 inspired a wide-ranging debate over the use of monetary and fiscal policies to manage the economy.

Sources: Michael D. Shear, “Obama Proposes Tax for Upgrade of Infrastructure,” New York Times, February 2, 2015; R. Glenn Hubbard, “Stop Depending on the Fed,” politico.com, August 20, 2014; Martin S. Feldstein, “Saving the Fed from Itself,” New York Times, December 8, 2013; Mark Magnier, “Benefits of Infrastructure Spending Not So Clear-Cut, Economists Say,” Wall Street Journal, February 1, 2015; and Janet L. Yellen, “Labor Market Dynamics and Monetary Policy,” Talk delivered at the Federal Reserve Bank of Kansas City Economic Symposium, Jackson Hole, Wyoming, August 22, 2014.

Teaching Tips

Because macroeconomic statistics were not yet available in the 1930s, John Maynard Keynes provided only a rough estimate of 10 for the value of the multiplier He did note that Simon Kuznets’s early estimates of national income and investment for the United States implied a value for the multiplier of 2.5, but Keynes believed that the value of the marginal propensity to consume used by Kuznets to make his estimates was “implausibly low” given the economic conditions in the United States during the 1930s.

Source: The General Theory of Employment, Interest, and Money , London: Macmillan, 1936, p. 51 and p. 56.

26.6

Deficits, Surpluses, and Federal Government Debt

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

A budget deficit is the situation in which the government’s expenditures are greater than its tax revenue. A budget surplus is the situation in which the government’s expenditures are less than its tax revenue.

As with other macroeconomic variables, it is useful to consider the size of the surplus or deficit relative to the size of the overall economy. From 2009 to 2011, the federal budget deficit was greater than 8 percent .

CHAPTER 26 | Fiscal Policy 711 of GDP. The economic recovery from the 2007–2009 recession, tax increases, and reductions in federal spending lowered the deficit to about 3 percent of GDP in 2017.

A. How the Federal Budget Can Serve as an Automatic Stabilizer Most of the increase in the deficit during a typical recession takes place without the president and Congress taking any action. Deficits occur automatically during recessions for two reasons: First, during a recession wages and profits fall, causing tax revenues to fall. Second, the government automatically increases its spending on transfer payments when the economy moves into recession.

Because budget deficits automatically increase during recessions and decrease during expansions, economists often look at the cyclically adjusted budget deficit or surplus to provide a more accurate measure of the effects of the government’s spending and tax policies than the actual budget deficit or surplus. The cyclically adjusted budget deficit or surplus is the deficit or surplus in the federal government’s budget if the economy were at potential GDP. Automatic budget surpluses and deficits can help to stabilize the economy.

B. Should the Federal Budget Always Be Balanced?

Few economists believe that the federal government should have a balanced budget every year.

Some economists argue that the federal government should normally run a deficit, even at potential GDP. When the federal budget is in deficit, the U.S. Treasury sells bonds to raise the funds necessary to pay the government’s bills. Borrowing is not a bad policy if the purpose is to invest in long-lived capital goods.

C. The Federal Government Debt When the federal government runs a budget deficit, the Treasury must borrow funds from investors by selling Treasury securities. When the federal government runs a surplus, the Treasury pays off some existing bonds. The total value of U.S. Treasury bonds outstanding is called the federal government debt or the national debt.

D. Is Government Debt a Problem?

The federal government is not in danger of defaulting on its debt. The government can raise the funds it needs by taxing households and firms to pay interest on its debt. However, if the debt becomes large relative to the economy, the government may have to raise taxes to very high levels or cut back on other types of spending to make interest payments on the debt. In the long run, a debt that increases in size relative to GDP can pose a problem. Crowding out of investment spending can occur if an increasing debt drives up interest rates.

Extra Solved Problem 26.6 The Effect of Economic Fluctuations on the Budget Deficit The federal government’s budget deficit was $379.5 billion in 2004 and declined to $283.0 billion in 2005. A student comments: “The government must have acted during 2005 to raise taxes or cut spending or both.” Do you agree? Briefly explain.

Solving the Problem Step 1:

Review the chapter material.

This problem is about the federal budget as an automatic stabilizer, so you may want to review the section “How the Federal Budget Can Serve as an Automatic Stabilizer.”

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712 CHAPTER 26 | Fiscal Policy Step 2:

Explain how changes in the budget deficit can occur without Congress and the president acting. If Congress and the president take action to raise taxes or cut spending, the federal budget deficit will decline. But the deficit will also decline automatically when GDP increases, even if the government takes no action. When GDP increases, rising household incomes and firm profits result in higher tax revenues. Increasing GDP also usually means falling unemployment, which reduces government spending on unemployment insurance and other transfer payments. So, you should disagree with the comment. A falling deficit does not mean that the government must have acted to raise taxes or cut spending.

Extra Credit: Although you don’t have to know it to solve this problem, GDP did increase from $12.3 trillion in 2004 to $13.1 trillion in 2005.

Question The federal government’s budget surplus was $236.2 billion in 2000 and $128.2 billion in 2001. What does this information tell us about fiscal policy actions that Congress and the president took during those years?

Answer This information seems to indicate that Congress and the president must have increased government purchases or cut taxes during 2001. But remember that during a recession the federal government’s budget surplus automatically decreases. The economy was in recession in 2001. When GDP decreases, as it does in a recession, lower household incomes and firms’ profits result in lower tax revenues. Also, in a recession, rising unemployment results in increased government spending on unemployment insurance and other transfer payments.

26.7 Long-Run Fiscal Policy and Economic Growth Learning Objective: Discuss the effects of fiscal policy in the long run.

Some policy actions are intended to have long-run effects by expanding the productive capacity of the economy and increasing the rate of economic growth. Policy actions that affect aggregate supply rather than aggregate demand are called supply-side economics.

A.Explaining Long-Run Increases in in Real GDP The tax wedge is the difference between the pretax and posttax return to an economic activity. The tax wedge is determined by the marginal tax rate, which is the fraction of each additional dollar of income that must be paid in taxes. Here is how tax cuts affect aggregate supply: ▪ Individual income tax. Reducing marginal tax rates on individual income will reduce the tax wedge faced by workers, thereby increasing the quantity of labor supplied. Cutting ▪

individual income tax rates also raises the return to entrepreneurship andwould the return to saving. Corporate income tax.

Reducing the marginal corporate income tax rate encourage

▪

investment spending by increasing the return corporations receive from new investments in equipment, factories, andand newcapital technology. gains. Reducing the taxoffice rates buildings on dividends gains Taxes on dividends and capital increases the supply of loanable funds from households to firms, increasing saving and investment and lowering the equilibrium real interest rate.

B. Tax Simplification If the tax code were greatly simplified, the economic resources currently used by the tax preparation industry would be available to produce other goods and services. In addition to wasting resources, the

.

CHAPTER 26 | Fiscal Policy 713 complexity of the tax code may also distort the decisions made by households and firms. A simplified tax code would increase economic efficiency by reducing the number of decisions made by households and firms solely to reduce their tax payments.

C. The Economic Effect of Tax Reform If tax reduction and simplification are effective, the economy will experience increases in labor supply, saving, investment, and the formation of new firms. Economic efficiency will also be improved. A successful policy of tax reductions and simplifications will benefit the economy by increasing output and employment and, at the same time, may result in smaller increases in the price level.

D. How Large Are Supply-Side Effects?

Most economists agree that there are supply-side effects to reducing taxes: Decreasing marginal income tax rates will increase the quantity of labor supplied, decreasing the corporate income tax will increase investment spending, and so on. The magnitude of the effects is subject to considerable debate. The size of the supply-side effects of tax policy can be determined only by carefully studying the effects of differences in tax rates on labor supply and saving and investment decisions.

Extra Apply the Should the United States Adopt a “Flat Tax”?

Concept Some economists and policymakers have advocated simplifying the individual income tax by adopting a “flat tax.” A flat tax would replace the current individual income tax system, with its several tax brackets with a new system containing a single tax rate and few or no deductions and exemptions. While the United States has considered a flat tax, other countries have adopted it. In 1994, Estonia became the first country to adopt a flat tax when it began imposing a single tax rate of 26 percent on individual income. As the following table shows, other countries in Eastern Europe have followed Estonia’s lead. Although all these countries have a flat tax rate on income, they vary in the amount of annual income they allow to be exempt from the tax and on which income is taxable. For example, Estonia does not tax corporate profits directly, although it does tax dividends paid by corporations to shareholders.

Year the Country Introduced the Flat Tax Country Flat Tax Rate Estonia 26% 1994 Lithuania 33 1994 Latvia 25 1995 Russia 13 2001 Serbia 14 2003 Ukraine 13 2004 Slovakia 19 2004 Georgia 12 2005 Romania 16 2005 Governments in Eastern Europe are attracted by the simplicity of the flat tax. It is easy for taxpayers to understand and relatively easy for the government to administer. The result has been greater compliance with the tax code. A study of the effects of Russia moving to a flat tax found that, before tax reform, Russians whose incomes had placed them in the two highest tax brackets had, on average, been reporting

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714 CHAPTER 26 | Fiscal Policy only 52 percent of their income to the government. In 2001, with the new single 13 percent tax bracket in place, these high-income groups on average reported 68 percent of their income to the government.

In the United States and Western Europe, proponents of the flat tax have focused on the reduction in paperwork and compliance costs and the potential increases in labor supply, saving, and investment that would result from a lower marginal tax rate. Opponents of the flat tax believe it has two key weaknesses.

First, they point out that many of the provisions that make the current tax code so complex were enacted for valid reasons. For example, in the United States taxpayers are allowed to deduct from their taxable income their contributions to charitable organizations. Similarly, the partial deduction for educational expenses increases the ability of many people to further their or their children’s educations. These Economist, April 14, 2005; and Juan Carlos Conesa and Dirk Krueger, “On the Optimal and Journal of Monetary Economics , Vol. 53, No. 7, October 2006, pp. 1425–1450. other the deductions would be eliminated under most flat tax proposals, thereby reducing the ability of

government to pursue some policy goals. Second, opponents of the flat tax believe that it would make

Extra Economics in Your Life & Career: the Does a Cutofinincome My Income Tax Rate Lowerthe Government Revenue? distribution more unequal by reducing marginal tax rate on high-income taxpayers.

Because high-income taxpayers now can use the intricacies of the tax code to shelter some of their income from taxes, that it is the unclear whether decides the amount of income taxes paid

by Does high-income people actually Question: Suppose government to cut taxes. this reduction in your would income tax rateanecessarily decrease under flat tax. reduce the government’s tax revenues?

Sources: for Flat Income TaxinCode,” Answer:“The OneCase effect of aTaxes,” cut inProgressivity tax rates isof athereduction tax collections from the same amount of

income.

But lower income tax rates also increase consumption, which causes equilibrium national income to increase and may cause tax receipts to increase because more income is taxed at the new lower rates.

So, it is possible that your income tax rate cut could lead to higher tax revenues. Typically, though, a lower

Extra AN INSIDE LOOK News Article to Use in Class tax leads toMyLab the government collecting less news tax revenue.

Visitrate Pearson’s Economics for current articles.

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CHAPTER 26 | Fiscal Policy 715

Solutions to End-of-Chapter Exercises Is Fiscal Policy?

26.1 What Learning Objective: Define fiscal policy.

Review Questions 1.1

1.2

Fiscal policy refers to changes in federal government purchases and taxes that are intended to achieve macroeconomic policy objectives. The president and Congress are responsible for fiscal policy.

Automatic stabilizers refer to government spending and taxes that automatically increase or decrease along with the business cycle. Two examples of automatic stabilizers are unemployment insurance payments, which increase during a recession as more workers become unemployed,

1.3

and income taxes, which decrease during a recession as incomes fall. During expansions unemployment insurance payments decrease and income taxes increase.

Federal purchases refer to federal spending where the federal government receives a good,

such as an aircraft carrier, or a service, such as the services of an FBI agent, in return. Federal expenditures include federal purchases plus interest on the national debt, grants to state and Problems and Applications 1.4

1.5

local Fiscal policy refers to changes in federal and taxes that are are intended governments, and transfer payments.

As government a percentagepurchases of GDP, federal purchases lower today to achieve macroeconomic policy objectives, such as high employment, price stability, and than 1960,ofbut federal expenditures are higher thangovernment in 1960. high in rates economic growth. Because thetoday federal paid for “clunkers,” government spending increased. If Congress and the president used this legislation to increase employment and stimulate economic growth, the program could be considered an example of fiscal policy. However, if the goal was to reduce pollution by replacing the “clunkers” with vehicles that get better gas mileage and have lower tailpipe emissions, the program should be considered an example of environmental policy rather than fiscal policy. a. Not part of fiscal policy because the action is not intended to affect the national economy. b. Not part of fiscal policy, but is instead an example of monetary policy. c. An automatic stabilizer because government spending on unemployment insurance automatically decreases as unemployment declines during an expansion. d. An automatic stabilizer because income taxes paid automatically decline with the fall in income during a recession. However, if the decline in tax revenue was the result of Congress and the president enacting a cut in income tax rates to stimulate the economy, then this action would be an example of discretionary fiscal policy. e. Not part of fiscal policy, but is an example of environmental policy. f.

Discretionary fiscal policy if the temporary cut in payroll taxes was intended to stimulate spending and increase real GDP.

g. Not fiscal policy. This spending is an infrastructure investment by a state government.

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716 CHAPTER 26 | Fiscal Policy 1.6

1.7

1.8

Not necessarily. Federal income tax revenue changes as tax rates change and as incomes change.

A reduction in tax revenue can be the result of lower tax rates or lower incomes. For example, during a recession, federal income tax revenues will decline even if Congress and the president take no policy action. In fact, nominal GDP grew by 8.76 percent from 1982 to 1983, so lower tax revenue was likely a result of Congress and the president cutting tax rates.

Birth rates were high between the end of World War II and the early 1960s (the so-called “baby boom” period) and much lower in the years before and after the baby boom. As a result, there are a large number of baby boomers and as they have reached retirement age, the over-65 population has been increasing as a fraction of the total population. The increase in the over-65 population has resulted in spending on Social Security and Medicare increasing as a percentage of GDP. Policymakers must eventually decide whether to reduce benefits for Social Security and Medicare recipients, raise taxes to pay for these benefits, or some combination of the two. a. The “fatal financial flaws” that the article refers to are the long-run problems that Medicare has experienced as the number of retired people has increased and medical costs have been rising. Because of declining birth rates, there are fewer workers per Medicare beneficiary than in past decades, which means that government revenues from payroll taxes have not been increasing rapidly enough to meet the rising costs of Medicare. b. The federal government is on track to eventually spend more on Social Security, Medicare, and Medicaid than it currently spends on all programs combined. Medicare costs are rising the most of these three programs because the cost of medical care has been rising rapidly. The nation will not go bankrupt paying for Medicare, but the federal government will eventually have to either cut benefits or sharply increase taxes. The author is right to be concerned about how Medicare will be funded in the future, but the costs of that program will not bankrupt the nation. The government will be forced to take action before that occurs. c. Congress and the president need to either reduce Medicare benefits, increase payroll taxes, or begin financing Medicare from general individual income and corporate income tax revenues.

Some proposals would also shift more of the cost of Medicare on to higher-income beneficiaries.

26.2

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

Review Questions 2.1

2.2

If policymakers decide to implement an expansionary policy, then they should raise government purchases or lower taxes. If they decide to implement a contractionary policy, then they should lower government purchases or raise taxes. a. The expansionary fiscal policy shifts the aggregate demand curve to the right. Real GDP will increase. b. The increase in real GDP will decrease the unemployment rate. c. The shift of the aggregate demand curve to the right will increase the price level.

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CHAPTER 26 | Fiscal Policy 717

Problems and Applications 2.3

2.4

You should disagree. A decrease in taxes increases aggregate demand and real GDP, and an increase in taxes reduces aggregate demand and real GDP. The statements are incorrect because an expansionary fiscal policy involves a decrease instead of an increase in taxes, and a contractionary fiscal policy involves an increase instead of a decrease in taxes. a. This is an example of contractionary fiscal policy. b. Although an increase in defense spending will lead to an increase in aggregate demand, it is not an example of fiscal policy because Congress’s intention in increasing defense spending isn’t to achieve a macroeconomic policy goal. c. Not an example of fiscal policy but is instead an example of expansionary monetary policy. d. Although reducing taxes in this way will lead to an increase in aggregate demand, this action is not an example of fiscal policy because the reduction in taxes is not intended by Congress to achieve a macroeconomic policy goal. e. An example of expansionary fiscal policy because it will result in an increase in consumption spending.

2.5

Equilibrium is initially at the intersection of LRAS, SRAS, and AD1 (point A). The aggregate demand curve shifts to the left from AD1 to AD2, and short-run equilibrium moves to point B. Congress and the president can engage in an expansionary fiscal policy by increasing government purchases or reducing taxes (or both), to shift AD to the right, from AD2 back to AD1.

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718 CHAPTER 26 | Fiscal Policy 2.6

a. “Fiscal stimulus” refers to an expansionary fiscal policy undertaken by a government to increase aggregate demand and real GDP. Expansionary fiscal policies involve increasing government purchases or decreasing taxes, or a combination of the two.

b. The Australian government’s stimulus package will shift the aggregate demand curve to the right from Aggregate demand(without stimulus) to Aggregate demand(with stimulus), increasing real GDP to the level of potential GDP. The new equilibrium with the stimulus is represented by point B in the graph above.

2.7

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

2.8

a. No, increases in federal spending will not increase real GDP if the economy experiences full crowding out. Increases in federal spending have a larger effect on real GDP and employment the further the economy is below potential GDP. As the economy nears or exceeds potential GDP, increases in federal spending result in more crowding out and increases in the price level. b. Federal government policymakers may not want to increase spending, even if the result is an increase in GDP and employment in the short run, if they feared the result would be higher inflation rates in the future. Some policymakers might also oppose increased spending because they believe it would lead to a greater federal deficit and an increase in the national debt.

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CHAPTER 26 | Fiscal Policy 719

Fiscal Policy in the Dynamic Aggregate Demand and Aggregate Supply 26.3 Model Learning Objective: Use the dynamic aggregate demand and aggregate supply model to analyze fiscal policy.

Review Questions 3.1

3.2

In the basic aggregate demand and aggregate supply model, we illustrate an expansionary fiscal policy by shifting the aggregate demand curve to the right, while not shifting either the short-run aggregate supply curve or the long-run aggregate supply curve. In the dynamic model, we shift the aggregate demand curve to the right, but by more than we would have in the absence of the expansionary fiscal policy. We also shift the short-run aggregate supply curve and the long-run aggregate supply curve to the right because, in this dynamic model, potential GDP and short-run aggregate supply increase as the economy grows.

In the basic aggregate demand and aggregate supply model, we illustrate a contractionary fiscal policy run by shifting the aggregate demand curve to the left, while not shifting either the shortaggregate supply curve or the long-run aggregate supply curve. In the dynamic model, we shift the the aggregate demand curve to the right but by less than we would have in the absence of contractionary fiscal policy. We also shift the short-run aggregate supply curve and the longrun aggregate aggregate supply curve to the right because in this model, potential GDP and short-run

supply as the economy grows. So, in the basic aggregate demand and aggregate Problems andincrease Applications 3.3

supply a. It is possible for the economy to produce more than its potential GDP, but a level of model, a contractionary fiscal policy will cause a decline in both real GDP and the price level.

In output that high would not be sustainable in the long run because it could result in the higher dynamic aggregate demand and aggregate supply model, a contractionary fiscal policy inflation rates. will cause the real GDP and the price level to increase by less than they would have in the absence of policy.

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720 CHAPTER 26 | Fiscal Policy b.

3.4

a. The value of real GDP will be $21.1 trillion, and the price level will be 123. b

The government can conduct an expansionary fiscal policy by increasing government purchases or decreasing taxes.

. c. Without expansionary fiscal policy, the inflation rate in 2025 will equal [(123 − 120)/120]

3.5

× a. 100 [(126= 2.5 percent. With expansionary fiscal policy, the inflation rate in 2025 will equal − 120)/120] × 100 = 5 percent. Because real GDP is below potential GDP in 2025, Congress and the president should use expansionary fiscal policy to keep real GDP at its potential level. Expansionary fiscal policy includes increasing government purchases and decreasing taxes. Policymakers can use either policy or both policies to keep real GDP at its potential level.

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CHAPTER 26 | Fiscal Policy 721 b. If Congress and the president are successful in keeping real GDP at its potential level in 2025, (i) real GDP will increase; (ii) potential GDP will not change; (iii) the inflation rate will increase; and (iv) the unemployment rate will decrease.

3.6

26.4

The economy does not have to be in a recession during 2026 for deflation to take place. As is shown on the following graph, aggregate demand increases from 2025 to 2026, but the shift to the right in short-run aggregate supply is greater than the shift to the right in aggregate demand, resulting in an increase in real GDP but also a decrease in the price level (point A to point B).

The Government Purchases, Tax, and Transfer Payments Multipliers Learning Objective: Explain how the government purchases, tax, and transfer payments multipliers work.

Review Questions 4.1

A $1 increase in government purchases initially increases real GDP and national income by $1. The $1 increase in national income increases consumption spending by, for example, $0.50. The $0.50 increase in consumption spending increases production and income, which increases consumption spending again. The process continues as increases in production and income lead to increases in consumption spending, which lead to increases in production and income, which lead to increases in consumption spending, and on and on. This process is called the multiplier effect.

4.2

The government purchases multiplier is the ratio of the change in equilibrium real GDP to the change in government purchases. The tax multiplier is the ratio of the change in equilibrium real GDP to the change in taxes. The transfer payments multiplier is the ratio of the change in equilibrium real GDP to the change in government transfer payments. The three fiscal policy multipliers have different values. The government purchases multiplier is larger with the same sign as the transfer payments multiplier. That is, both an increase in government purchases and an increase in transfer payments will result .in a multiple increase in equilibrium real GDP but the increase will be larger for an increase in government purchases of a given dollar amount than for

722 CHAPTER 26 | Fiscal Policy multiplier will be the same size as the value of the tax multiplier but will have the opposite sign because an increase in taxes results in a decrease in equilibrium real GDP. 4.3

At each round of the multiplier process, a higher income tax rate reduces the amount of income after taxes, or disposable income, that households receive. The lower disposable income reduces

Problems and Applications additional consumption at each round of the multiplier process, decreasing the multiplier 4.4

4.5

4.6

effect.

The Caldecott Tunnel and similar construction projects represent an increase in government purchases, which increases aggregate demand, real GDP, and employment in the short run. The “ripple effect” refers to the multiplier effect as the initial increase in government purchases sets off additional rounds of increased income and consumption.

Keynes described the multiplier effect. By repercussions, he meant the rounds of spending and new production set off by an initial increase in autonomous expenditure. Keynes believed that the government purchases multiplier was about 10. Therefore, even wasteful government spending would result in a substantial increase in the production of goods and services and in employment. a. To bring the economy to equilibrium at potential GDP, government purchases need to be increased by the needed change in real GDP divided by the government purchases multiplier: ($20.4 trillion − $20.1 trillion)/2 = $0.15 trillion, or $150 billion. b. To bring the economy to equilibrium at potential GDP, the change in taxes required is the needed change in real GDP divided by the tax multiplier: ($20.4 trillion − $20.1 trillion)/−1.6 = −$0.1875 trillion, or −$187.5 billion. c. To bring the economy to equilibrium at potential GDP, the change in transfer payments required is the needed change in real GDP divided by the transfer payments multiplier: ($20.4 trillion − $20.1 trillion)/1.6 = $0.1875 trillion, or $187.5 billion. d. One example is to increase government purchases by $74 billion and decrease taxes by $95 billion: ($74 billion × 2) + (−$95 billion × −1.6) = $300 billion.

4.7

The statement is incorrect because it ignores the multiplier effect. Equilibrium real GDP would decrease by more than $300 billion following a $300 billion decrease in government purchases or a $300 billion increase in taxes. Because of the multiplier effect, a decrease in government purchases or an increase in taxes of less than $300 billion is necessary to decrease equilibrium real GDP by $300 billion.

4.8

a. The author’s comment regarding the “state of the economy” refers to whether the economy is above the potential GDP or below the potential GDP. When real GDP is close to potential GDP, an increase in government purchases or a cut in taxes may have a greater effect on the price level than on real GDP. When real GDP is far away from potential GDP, an increase in government purchases or a cut in taxes may have a greater effect on real GDP than on the price level. In addition, the level of interest rates may have an effect on the size of the multiplier with the multiplier being larger when interest rates are very low. b. As we’ve seen, during the 2007–2009 recession, interest rates were very low, with the Federal Reserve having cut its target for the federal funds rate almost to zero. Because interest rates being this low was a “historical rarity,” it’s unclear whether estimates of the multiplier from this period provide us with good information on its size during more normal times when interest rates are not near zero.

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CHAPTER 26 | Fiscal Policy 723 4.9

The multiplier effects would be larger if the SRAS curve is horizontal than if it is upward sloping. Compared with a horizontal SRAS curve, an upward-sloping SRAS curve results in a smaller change in equilibrium real GDP for a given increase in government purchases or decrease in taxes because the quantity of goods and services demanded would be reduced as the price level rose.

26.5 The Limits to Using Fiscal Policy to Stabilize the Economy

Learning Objective: Discuss the difficulties that can arise in implementing fiscal policy.

Review Questions 5.1

5.2

Monetary policy can be changed more quickly than fiscal policy. The Federal Open Market Committee can change monetary policy at any of its meetings, which are scheduled to occur eight times per year—or more frequently, if need be. Fiscal policy has to go through the legislative process of the president and Congress approving a change in government purchases or in taxes. Even when approved, it takes time to implement the fiscal policy change.

Crowding out refers to a decline in private expenditures—consumption, investment, and net exports—due government to an increase in government purchases. In the short run, an increase in purchases results in partial crowding out, but in the long run, an increase in government purchases results in the complete crowding out of an equal amount of private expenditures.

Problems and Applications 5.3

5.4

A recession accompanied by a financial crisis involves more than simply a decrease in aggregate expenditure leading to a recession. A recession with a financial crisis involves credit crunches where firms and households have difficulty obtaining loans to finance investment projects and purchases of houses and consumer durables. It takes time for banks and shadow banking firms to resolve the problems they encounter during a financial crisis. The large budget deficits of 2009 and 2010 were partly the result of the stimulus package of 2009 but were primarily the result of the severe recession. The recession caused both a sharp decline in tax revenues as incomes and profits fell and increases in federal government spending on unemployment insurance and other transfer payments. a. This outcome will most likely occur if investment spending is crowded out because accumulating more machinery, equipment, and structures increases economic growth. b. Increased spending on infrastructure such as highways and bridges may aid economic growth, whereas increased spending on national parks is unlikely to do so.

5.5

a. To evaluate the effectiveness of the stimulus package, economists attempt to estimate its effect on real GDP and unemployment. The closer the package pushed real GDP closer to potential GDP and the more it reduced cyclical unemployment, the more effective the package was. The difficulty in estimating the effectiveness of the stimulus package is that at the same time as government purchases were being increased and taxes were being cut as a result of the stimulus package other factors were also causing the aggregate demand curve and aggregate supply curve to shift. Disentangling the effects of the stimulus package from the effects of these other factors is difficult. b. As indicated in the answer to part a., even economists have difficulty estimating the effect of the stimulus package. Many of the people who felt that the stimulus package was having no effect may have held that belief because the recession was very severe despite the stimulus

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724 CHAPTER 26 | Fiscal Policy package. Because the stimulus package failed to end the recession and restore full employment, these people may have considered the package to have had no effect even if, in fact, the package lessened the severity of the recession. Some people might also have believed that the stimulus package damaged the economy because they disliked large federal budget deficits and they were reacting to the news that the package had significantly increased the budget deficit.

5.6

a. The government purchases multiplier can have a value less than 1 if an increase in government spending results in a decline in private expenditures: private investment spending, consumption spending, and net exports. If the government purchases multiplier were only 0.4, a $10 billion increase in government purchases would result in only a $4 billion increase in real GDP. One way in which the government purchases multiplier might be less than 1 is if an increase in government purchases results in an increase in interest rates that crowds out (decreases) private investment, consumption, and net exports. b. In evaluating the effects of an expansionary fiscal policy, an estimate of the size of the multiplier matters because the multiplier indicates how much real GDP will increase as a result of an increase in government purchases. In particular, an estimate of the size of the multiplier will indicate to policymakers how much government purchases will need to be increased to ultimately increase real GDP to its potential level.

5.7

An expansionary fiscal policy will tend to cause the equilibrium rate of interest to increase. An expansionary monetary policy will cause the equilibrium rate of interest to decrease. An expansionary monetary policy will therefore lessen the effect of crowding out in the short run by reducing the increase in the interest rate that would otherwise result from an expansionary fiscal policy.

5.8

a. If the government is spending money on investments, it can increase the productive capacity of the economy and therefore offset some of the lower levels of private investment. b. If an economy is producing output below its potential GDP, then it is operating below capacity. During these periods, many firms may be pessimistic about the future and have so much excess capacity that investment spending will fall to very low levels and will be unlikely to fall much further, even if interest rates rise. In this case, crowding out is unlikely to be a problem.

26.6

Deficits, Surpluses, and Federal Government Debt Learning Objective: Define federal budget deficit and federal government debt and explain how the federal budget can serve as an automatic stabilizer.

Review Questions 6.1

When real GDP falls below potential GDP, households and firms pay less in taxes to the federal government and the federal government makes more transfer payments to the unemployed and to people whose incomes have declined. These changes in taxes and transfer payments make the decline in income smaller than it would otherwise be, which results in a smaller decline in consumption spending. With aggregate demand not declining by as much as it otherwise would, the decline in real GDP is reduced. When real GDP increases above potential GDP, households and firms pay more in taxes and the federal government makes fewer transfer payments. These changes reduce the increase in income that would otherwise take place, which results in a smaller

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CHAPTER 26 | Fiscal Policy 725 increase in consumption spending. With aggregate demand not increasing by as much as it otherwise would, the increase in real GDP is reduced. By reducing the size of changes in real GDP, the federal budget serves to stabilize the economy.

6.2

The cyclically adjusted budget deficit or surplus measures what the budget deficit or surplus would be if the economy were at potential GDP. A recession would decrease government tax

6.3

revenues and increase government spending on transfer payments, which would lead to a federal budget deficit.

Balancing the government’s budget during a recession would require raising taxes or

6.4

reducing government purchases. These actions would reduce aggregate demand and make the recession worse. Similarly, if an economic expansion had pushed real GDP above potential GDP, leading to a budget surplus, eliminating the surplus would require increasing government purchases or cutting taxes, which would push real GDP further beyond potential GDP.

Problems and Applications 6.5

The federal budget deficit is the annual amount by which federal government expenditures Josh Zumbrun and Nick Timiraos provided the following responses to these questions: exceed funds federal tax revenues. To finance the budget deficit, the U.S. Treasury must borrow a. lot ofTreasury people want to makeThe this analogy between individuals government.of past by“A selling securities. federal government debt isand thethe accumulation Economists think this is a really bad analogy. The U.S. government is 238 years old and isn’t budget to retire one day. If you were going to live forever, and bring in revenue forever, planning deficits minus past surpluses and equals the total value of U.S. Treasury and issue bonds in budget money that you print, then you’d have a much more similar securities situation. But outstanding. you don’t and so the logic of personal finance doesn’t apply.” b. “I don’t think it’s obvious that governments ever need to pay off their debt entirely, since governments aren’t like people. They can fail, yes, but they don’t need to pay off their mortgage to enjoy a comfortable retirement. The goal is for the government to be a going concern. With that in mind, the only thing the government needs to do is hold its debt at a sustainable level. If your interest payments are stable at 3% or less of the economy, for example, there’s no reason you couldn’t carry this debt forever.”

Source: Josh Zumbrun and Nick Timiraos, “Q&A: What the $18 Trillion National Debt Means for the U.S. Economy,” Wall Street Journal, February 1, 2015.

6.6

a. The causes for budget deficits differ in the short run and in the long run. In the short run, budget deficits can occur during a recession when federal government expenditures automatically increase and tax revenues automatically fall. In addition, in the short run, budget deficits may increase as the result of temporary stimulus programs, such as the American Recovery and Reinvestment Act of 2009. In the long run, budget deficits are the result of Congresses and presidents having decided to keep expenditures above tax revenues for a prolonged period. b. Higher levels of debt can eventually drive up interest rates as bond buyers demand higher returns higher to compensate for perceived higher risk or if the U.S. Treasury has to pay interest in order to attract enough buyers to buy its larger supply of bonds. Higher interest rates increase the cost of borrowing for. everyone.

726 CHAPTER 26 | Fiscal Policy c. Government borrowing can crowd out private investment, particularly if the funds raised by issuing the debt are not spent on infrastructure improvements or something else that increases capital stock. Over time, the lower levels of private investment will slow the growth of the economy. d. A fiscal crisis is a situation in which investors lose confidence in the U.S. government’s ability to pay interest on its debt and repay the principal of the debt when the debt matures.

This development would cause interest rates to increase abruptly. However, the federal government is not in danger of defaulting on its debt. Ultimately, the government can raise the funds it needs through taxes to make the interest payments on the debt. If the debt becomes very large relative to the economy, however, the government may have to raise taxes to high levels or cut back on other types of spending to make the interest payments on report; the debt. (For more information, see page 10 of the followings https://www.cbo.gov/system/files/2021-03/56977-LTBO-2021.pdf) To reduce long-run e. budget deficits, Congress and the president need to either reduce expenditures or increase taxes—or both. Reducing expenditures and raising taxes are politically unpopular, which is why budget deficits can persist in the long run.

6.7

Balancing the federal government’s budget in 1932 was not a good idea because the economy was in the midst of the Great Depression. Increasing taxes and cutting government purchases would reduce aggregate demand and further reduce real GDP.

6.8

a. Because the value of the automatic stabilizer is −$168 billion, the part of the deficit attributable to the state of the economy was $168 billion. Had the economy been at potential GDP, the deficit would have only been $485 billion − $168 billion = $317 billion. b. Because the state of the economy resulted in higher government expenditures and lower government revenues that together contributed to $168 billion to the deficit, real GDP must have been below the potential GDP in 2014.

6.9

a. The level of GDP and employment affect federal tax revenue and the amount of federal government spending on transfer payments such as unemployment insurance and food stamps. Interest rates affect the budget because the U.S. Treasury has to pay interest on the bonds it sells. If interest rates in the U.S. economy increase, the Treasury will have to increase its spending on interest payments. b. It is likely that the economic growth was higher than expected. Higher economic growth increases federal tax revenues and decreases federal government spending on transfer payments, reducing the budget deficit below the level that had been projected.

6.10

A budget deficit occurs when a government’s tax revenues are less than the government’s expenditures. Mitsotakis’ proposal to cut taxes to businesses and households will decrease tax revenues and will increase the deficit, holding everything else the same. Mitsotakis, however, apparently believes that the tax cuts will increase real GDP and employment enough that tax revenues will remain the same (the tax cuts will “pay for themselves”). The Greek economist quoted in the article disagrees that the tax cut will increase real GDP and employment by enough to keep the government’s budget deficit from increasing.

6.11

a. MMT economists would advise the policymakers to reduce the reliance on taxes to pay for government expenditures and allow the Federal Reserve to print the money to pay for those expenditures. MMT economists are less concerned about the possibly negative effects of government budget deficits on the economy than are most economists.

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CHAPTER 26 | Fiscal Policy 727 b. Most mainstream economists do not agree that the Federal Reserve can print money to pay for government expenditures without causing inflation in the long run. These economists also believe that large government budget deficits will eventually lead to higher interest rates, which will reduce investment spending and lead to slower economic growth.

26.7 Long-Run Fiscal Policy and Economic Growth Learning Objective: Discuss the effects of fiscal policy in the long run.

Review Questions 7.1

Growth rate of real GDP = Growth rate of hours worked + Growth rate of labor productivity. As a matter of arithmetic, real GDP = Number of hours worked × (Real GDP/number of hours worked). Real GDP/number of hours worked is labor productivity, so real GDP = Number of hours worked × labor productivity. Using the mathematical rule that states that an equation in which variables are multiplied together is equal to an equation in which the growth rates of these variables are added together, yields the equation that the growth rate of real GDP equals the growth rate of hours worked plus the growth rate of labor productivity.

7.2

Supply-side economics refers to fiscal policy actions intended to have long-run effects by expanding the productive capacity of the economy and increasing the rate of economic growth.

7.3

The “tax wedge” is the difference between the pretax and posttax return to an economic activity.

Problems and Applications To reduce the size of the tax wedge, the president and Congress could cut the marginal tax 7.4

7.5

rate.

The statement reflects the equation for the growth rate of real GDP, where the growth rate of real GDP equals the growth rate of hours worked plus the growth rate of labor productivity.

To reach 3 percent growth in real GDP the growth rate of hours worked or the growth rate of labor productivity (or both) must increase.

The high growth in the 1960s may be difficult to achieve today because of a decline in the growth of worked. The growth of hours worked has dropped due to: (1) a slower birth rate; (2) hours a decline in the employment-population ratio due to the aging of the population; (3) a rising number of disabled people; and (4) a declining number of prime-age people being in the workforce. In addition, rates of labor productivity growth were at historically high levels

7.6

during the of 1960s. The key to increasing the growth rate of real GDP will be whether the growth rate labor productivity can return to the high rates of the mid-1990s to the mid-2000s.

Two arguments in favor of a flat tax would be the reduction in the paperwork and compliance costs of the income tax system and the potential increases in labor supply, saving, and investment

7.7

that would result from a lower marginal tax rate. There are also two arguments against the flat tax. First, the complexities in the current tax code exist because the government is pursuing policy goals, such as promoting home ownership by allowing the deductibility of mortgage interest with a payments, that it could not easily pursue if the current tax system were replaced .

flat tax. Second, the income distribution might become more unequal if Congress reduced the

728 CHAPTER 26 | Fiscal Policy can increase even with the lower tax rates. The “behavioral response” refers to the idea that marginal tax rates influence people’s behavior by changing their incentives to work, save, invest, and start a business.

7.8

a. You should agree with the columnist that increasing aggregate demand can increase real GDP only in the short run. In the long run, conventional tax cuts or stimulus spending will not have much effect on real GDP and unemployment because what determines the level of real GDP in the long run is the potential GDP. b. Policies that increase labor productivity include increasing the incentives to work, save, invest in capital and technology, and start a business.

7.9

a. Spending on capital goods is a key driver of economic growth because investment in capital goods is an important source of increases in labor productivity. b. The reasons for the slowdown do matter. If firms think that the economic slowdown will come to an end in the near future, then spending on capital goods may revive, which would be good news for future economic growth. The Covid-19 recession was caused by governments in many cities closing businesses or restricting the capacity of businesses and by consumers being reluctant to shop indoors, attend movies, or work out in gyms. Most businesses appear to have adopted a wait-and-see approach but increased consumer spending may indeed increase business investment more rapidly than it would following a typical recession. Therefore, looking only at its effect on spending, the fact that the reduction in spending was due to the pandemic is good news with respect to future economic growth.

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

D26.1 The following table reports the output gaps as a percentage of potential GDP for Japan, the United Kingdom, and the United States.

Country

2019

2020

2021

2022

2023

2024

2025

2026

−1.530 Japan 0.106 United 0.967 Kingdom United States

−2.686 −4.361 −3.118

−1.541 −3.108 0.589

−0.238 −1.492 1.376

0.016 −0.676 0.996

0.005 −0.005 0.763

−0.027 −0.029 0.656

−0.035 −0.018 0.524

a. In 2021, the United Kingdom had the largest output gap of −3.108 percent, and the United States had the smallest output gap of 0.589 percent. The US output gap is positive, which indicates that the U.S. real GDP is above potential GDP. b. To bring the negative output gaps of Japan and the United Kingdom to zero, the countries could use expansionary fiscal policies with increases in government purchases and decreases in taxes.

Expansionary fiscal policies increase budget deficits and the national debt and could c. encounter political obstacles from politicians and their constituents concerned about rising national debt. Political issues could also arise regarding whether the expansionary fiscal policy should primarily be increases in government purchases or decreases in taxes. And due

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CHAPTER 26 | Fiscal Policy 729 to the lags in fiscal policy, getting the timing right such that the expansionary fiscal policy helps the economy can be difficult.

D26.2 a.

Automatic stabilizers do not operate when the economy is at potential GDP, so the cyclically adjusted budget budget deficit or surplus is not affected by automatic stabilizers. The actual deficit or surplus does not assume that the economy is at potential GDP as the

b.

cyclically adjusted budget deficit or surplus does, so it includes the effect of automatic stabilizers on government spending and tax revenues. See the following graph.

c. For 2000–2020, the average budget deficit (with stabilizers) was −$594.67 billion, and the average cyclically adjusted budget deficit (without stabilizers) was −$508.90 billion. The average budget deficit was larger in absolute terms because it includes the effect of automatic stabilizers. The automatic stabilizers made the average deficit larger because real GDP was below potential GDP for a large part of the period.

D26.3 a.

France relied on discretionary fiscal policy the most in response to the financial crisis of 2008 and 2009. Of the four countries, France had the highest cyclically adjusted budget deficit as a percent of potential GDP in 2008 of −3.9 percent and in 2009 of −5.6 percent.

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730 CHAPTER 26 | Fiscal Policy D26.4 a. The federal government had a budget surplus in 2000 and 2001. From 2002 until 2020, the federal government experienced a budget deficit. b. The federal government experienced a larger deficit in 2020 than in 2019. The larger deficit was caused by the lower tax receipts the federal government received in 2020 due to the Covid-19 recession, and because of the higher federal expenditures on transfers programs, including unemployment insurance payments and personal stimulus checks.

Suggestions for Critical Thinking Exercises CT26.1 You should ask students to refer again to a table in Chapter 25, Figure 25.9, “Expansionary and Contractionary Monetary Policies.” The students will need to add two rows to the figure in order to take into account that they are being asked to consider both the effect of a change in taxes and the effect of a change in government purchases. So, the first box in the first row would read something like “Congress and the president decrease taxes.” The second box would read “Consumption spending increases” and the last two boxes would remain the same. The first box in the second row would read something like “Congress and the president increase government purchases.” Because an increase in government purchases directly increases aggregate demand, the next two boxes in this row will be the same as the last two boxes in the first row of Figure 25.9. The last two rows in their new figure will be similar to the first rows but will trace the effects of an increase in taxes and a decrease in government purchases.

CT26.2 Complete crowding out occurs when an increase in government purchases leads to no change in real GDP. In this case, the value of the government purchases multiplier is 0. Complete crowding is more likely to happen in the long run because in the long run, real GDP is determined by potential GDP. Increases in aggregate demand caused by an increase in government purchases will not affect the level of real GDP in the long run, but only the composition of real GDP, unless the increase in the share of GDP accounted for by government purchases comes at the expense of investment spending, thereby slowing the growth rate of real GDP. CT26.3 You should disagree with the student. A budget deficit that occurs during a recession can serve as an automatic stabilizer, potentially shortening the depth and length of the recession. Government deficits that are the result of an increase in infrastructure spending may increase the productive capacity of the economy. The government’s borrowing to finance infrastructure spending is analogous to firms borrowing to finance spending on new factories or on research and development or households borrowing to finance the purchase of a house.

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CHAPTER 26 | Fiscal Policy 731

Appendix A Closer Look at the Multiplier Learning Objective: Apply the multiplier formula.

When economists forecast the effect of a change in spending or taxes, they often rely on econometric models.

An Expression for Equilibrium Real GDP We can write a set of equations that includes the key macroeconomic relationships we studied in this and previous chapters. We assume that taxes, T, do not depend on the level of real GDP, Y. There are no government transfer payments to households, and there are no exports or imports. The numbers represent billions of dollars.

(1) C = $2,000 + 0.75(Y – T) (2) I = $2,000 (3) G = $2,500

Consumption function Planned investment function Government purchases function Tax function Equilibrium condition

(4) T = $2,000 (5) Y = C + I + G

To calculate a value for equilibrium real GDP we need to substitute equations (1) through (4) into (5).

To make the result more general, we can replace particular values with general values represented by letters.

Consumption function Planned investment function Government spending function Tax function Equilibrium condition

Y=C+I+G Solving for equilibrium:

A Formula for the Government Purchases Multiplier To find a formula for the government purchases multiplier, rewrite the last equation for changes in each variable, rather than levels:

Y=

C−(MPCT)+I+G .

1 − MPC

If we hold constant the changes in autonomous consumption spending, planned investment spending, and taxes, we can find a formula for the government spending multiplier, which is the ratio of the change in equilibrium real GDP to the change in government purchases:

1 Y . =  G 1 − MPC

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732 CHAPTER 26 | Fiscal Policy

A Formula for the Tax Multiplier To derive a formula for the tax multiplier start with the equation:

 Y=



C− MPC ( T )+  I +  G .

1 −MPC

We hold constant the values of autonomous consumption spending, planned investment and government purchases, but allow the value of taxes to change:

The tax multiplier is a negative number because an increase in taxes causes a decrease in equilibrium real GDP, and a decrease in taxes causes an increase in equilibrium real GDP.

The “Balanced Budget” Multiplier We can use the formulas for the government purchases multiplier and the tax multiplier to calculate the net effect of increasing government purchases by the same amount as taxes are increased.

The government purchases multiplier is larger (in absolute value) than the tax multiplier. Equal dollar increases and decreasesBalanced in government and lead to the same Budget purchases Multiplier = (1 taxes – MPC)/(1 – MPC) = 1.dollar increase in real GDP in the short run.

The Effects of Changes in Tax Rates on the Multiplier We consider the effect of a change in the tax rate, as opposed to a change in a fixed amount of taxes. Changing the tax rate changes the value of the multiplier. In general, an increase in income can be multiplied by (1 – t) to find the change in disposable income, where t is the tax rate. We can rewrite the consumption function as: We can use this equation to find an expression for the government purchases multiplier:

1 Y Government Purchases Multiplier . = = 1 − MPC(1 − t ) G

The Multiplier in an Open Economy We can consider the case of an open economy by including net exports in our analysis. We assume that exports are autonomous.

Exports= Exports.

Imports will increase as real GDP increases because households will spend some portion of an increase in income on imports. The marginal propensity to import (MPI) is the fraction of an increase in income that is spent on imports: Imports = MPI × Y.

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CHAPTER 26 | Fiscal Policy 733 We can substitute our expressions for exports and imports into the expressions derived previously for equilibrium real GDP:

Y=C+MPC(1−t)Y+I+G+Exports−(MPIY).   We can now find an expression for the government purchases multiplier:

Government Purchases Multiplier =

1 Y . =  MPC(1 −t)−MPI  G 1 −

The multiplier is a short-run effect that assumes that the economy is below the level of potential GDP. In the long run, the economy is at potential real GDP, so an increase in government purchases causes a decline in the nongovernmental components of real GDP but leaves the level of real GDP unchanged.

Solutions to Chapter 26 Appendix Problems and Applications

26A.1 Government purchases multiplier = Tax multiplier =

= 2.5.

= −1.5.

Balanced budget multiplier = 1.

26A.2 Government purchases multiplier 26A.3 a. Transfer payments multiplier = 1 1 – (MPC[1 − t) – MPI) b. Transfer payments multiplier = 1 = 1.57 1 – (0.75 [1 − 0.25] – 0.2) 26A.4 The aggregate demand curve will shift to the right by the change in government purchases multiplied by the government purchases multiplier.

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734 CHAPTER 26 | Fiscal Policy

26A.5 An increase in the tax rate decreases the size of the government purchases multiplier because it increases the amount of taxes households must pay on any additional income they earn and, therefore, reduces the amount of consumption spending in each period. A decrease in the marginal propensity to import increases the size of the government purchases multiplier because households buy fewer imports and, therefore, more domestically produced goods and services with any additional income they earn.

The government purchases multiplier would be higher, other things being equal, in the United 26A.6 States than in Belgium given that the United States. imports much less, as a percentage of GDP, than Belgium. With a much larger amount of imports, Belgium would have a larger marginal propensity to import and therefore a smaller government purchases multiplier.

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CHAPTER 27 |

Inflation, Unemployment, and Federal Reserve Policy

Brief Chapter Summary and Learning Objectives 27.1 The Discovery of the Short-Run Trade-off between Unemployment and Inflation Describe the Phillips curve and the nature of the short-run trade-off between unemployment and inflation.

▪ The Phillips curve illustrates the short-run trade-off between the unemployment rate and the

inflation rate.

27.2 The Short-Run and Long-Run Phillips Curves Explain the relationship between the short-run and long-run Phillips curves.

▪ It is not possible to buy a permanently lower unemployment rate at the cost of a permanently

higher inflation rate.

27.3 Monetary Policy and Expectations of the Inflation Rate Discuss how expectations of the inflation rate affect monetary policy.

▪ Workers and firms tend to have adaptive expectations when the inflation rate is stable.

▪ Rational expectations are formed by using all available information about an economic

variable.

27.4 Federal Reserve Policy from the 1970s to the Present Use a Phillips curve graph to show how the Federal Reserve can permanently lower the inflation rate.

▪ The Fed uses contractionary monetary policy to reduce inflation, which pushes the economy down a short-run Phillips curve.

Key Terms Disinflation A significant reduction in the inflation rate.

Phillips curve A graph showing the short-run relationship between the unemployment rate and the inflation rate.

Natural rate of unemployment The normal rate of unemployment rate, consisting of frictional unemployment and structural unemployment.

Nonaccelerating inflation rate of

Rational expectations Expectations formed by using all available information about an economic variable.

Real business cycle models Models that focus on real rather than monetary explanations of fluctuations in real GDP.

unemployment (NAIRU)rate at which the The unemployment inflation rate has no tendency to increase or decrease.

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736

CHAPTER 27 | Inflation, Unemployment, and Federal Reserve Policy

Structural relationship A relationship that depends on the basic behavior of consumers and firms and that remains unchanged over long periods.

Too-big-to-fail policy A policy under which the federal government does not allow large financial firms to fail, for fear of damaging the financial system.

Chapter Outline Inflation and Unemployment Always Move in Opposite Directions ⸻ or Do They?

In 2019, the unemployment rate was 3.7 percent—its lowest level since 1969—and wages were increasing in most industries. Software publishers like Adobe and game producers like Activision employed 400,000 people in the United States, at an average annual salary of over $100,000. Wages in the software industry were rising at a rate of 5 percent per year. Oil refiner Phillips 66 was offering oil field workers annual wages of nearly $200,000 and needed to rapidly increase wages to fill its job openings. In the economy as a whole, wages were increasing at a rate of more than 3 percent per year.

With inflation at less than 2 percent, real wages were increasing, so workers were experiencing a slow but steady rise in their standard of living. Faced with higher labor costs, some firms, including CocaCola, Kellogg’s, and Procter & Gamble, were raising prices. Despite the increased prices of these products, the inflation rate remained below the Fed’s target rate of 2 percent and had actually declined since 2018. Some economists and policymakers wondered why 2019 didn’t fit the usual pattern first analyzed by New Zealand economist A.W. Phillips in the 1950s: When the unemployment rate drops to very low levels, inflation usually increases. In Chapter 15, Figure 15.1, we saw why the period from the late 1960s to the early 1980s is known as the Great Inflation. As we will discuss in this chapter, many economists and policymakers took four lessons from that period: 1. High and variable inflation rates could lead to slower growth in real GDP and higher unemployment.

2. Monetary policy only affects the economy with a lag, so to keep the inflation rate from accelerating, the Fed needs to act well before inflation begins to increase.

3. If the unemployment rate drops below the natural rate of unemployment, the inflation rate will accelerate.

4. If the inflation rate is higher for a significant period—a year or more—firms, households, and investors will come to expect that the higher inflation rate will persist.

During the financial crisis of 2007–2009, the Fed cut its target for the federal funds rate to a range of 0 to 0.25 percent, and it remained there for more than seven years. In December 2015, the Fed began raising its target for the federal funds rate in a series of steps that ended in December 2018. Although in December 2015 the unemployment rate was still 5.0 percent and the inflation rate was only 1.2 percent, then Fed Chair Janet Yellen and the Federal Open Market Committee (FOMC) believed it was necessary to move to a less expansionary policy, given the lags with which policy affects the economy. In 2021, Yellen became secretary of the Treasury in the Biden administration. At that time, she stated that the Fed should not have started to raise interest rates in 2015 because doing so kept the unemployment rate from falling as quickly as it otherwise would have. She believed that despite Congress having passed substantial increases in federal government spending, which we discussed in Chapter 16, and a very expansionary monetary policy implemented by Fed Chair Jerome Powell and the FOMC, inflation was unlikely to significantly increase. Other economists disagreed, arguing that the economy might be on the edge of an inflationary period similar to what had occurred in the late 1960s. In this chapter, we will explore this important policy debate.

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The Discovery of the Short-Run Trade-off between Unemployment and 27.1 Inflation Learning Objective: Describe the Phillips curve and the nature of the short-run trade-off between unemployment and inflation.

In the short run, there is usually a trade-off between unemployment and inflation. In the long run, this trade-off will disappear and the unemployment rate is independent of the rate of inflation.

Today, the short-run trade-off between unemployment and inflation plays a role in the Fed’s monetary policy decisions, but the trade-off was not widely recognized until the 1950s. A Phillips curve is a graph showing the short-run relationship between the unemployment rate and the inflation rate .

A. Explaining the Phillips Curve with Aggregate Demand and Aggregate Supply Curves The inverse relationship between unemployment and inflation is consistent with the aggregate demand and aggregate supply (AD-AS) analysis we developed in Chapter 23. The AD-AS model indicates that slow growth in aggregate demand leads both to higher unemployment and lower inflation. The AD-AS model and the Phillips curve are different ways of illustrating the same events. The Phillips curve has an advantage over the AD-AS model when we want to analyze explicitly changes in the inflation and unemployment rates.

B. Is the Phillips Curve a Policy Menu?

Some economists argued during the 1960s that the Phillips curve represented a structural relationship in the economy. A structural relationship is a relationship that depends on the basic behavior of consumers and firms and that remains unchanged over long periods. If the Phillips curve were a structural relationship, it would present policymakers with a reliable menu of combinations of unemployment and inflation. They could use expansionary monetary policies and fiscal policies to choose a point on the curve that had lower unemployment and higher inflation. Or, policymakers could use contractionary monetary and fiscal policies to choose a point that had lower inflation and higher unemployment. Economists have come to realize that the Phillips curve does not represent a permanent trade-off between unemployment and inflation.

C. Is the Short-Run Phillips Curve Stable?

In his 1968 presidential address to the American Economic Association (AEA), Milton Friedman argued that the Phillips curve did not represent a permanent trade-off between unemployment and inflation. Edmund Phelps made a similar argument. Friedman and Phelps noted that economists had come to agree that the long-run aggregate supply curve was vertical. If this were true, the Phillips curve could not be downward sloping in the long run. Friedman and Phelps argued, in essence, that there is no trade-off between unemployment and inflation in the long run.

D. The Long-Run Phillips Curve At potential real GDP, firms operate at their normal level of capacity, and everyone who wants a job will have one, except the structurally and frictionally unemployed. Friedman defined the natural rate of unemployment as the unemployment rate that exists when the economy is at potential GDP. The actual unemployment rate will fluctuate in the short run but will come back to the natural rate in the long run and a higher or lower price level has no effect on real GDP. Therefore, the long-run aggregate supply curve is a vertical line at potential GDP and the long-run Phillips curve is a vertical line at the natural rate of unemployment.

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E. The Role of Expectations of Future Inflation Friedman argued that the experience of the 1950s and 1960s, which showed a stable trade-off between unemployment and inflation, actually showed only a short-run trade-off. The short-run trade-off existed because workers and firms sometimes expected the inflation rate to be either higher or lower than it turned out to be. Differences between the expected inflation rate and the actual inflation rate could lead the unemployment rate to rise above or dip below the natural rate.

If actual inflation is higher than expected inflation, actual real wages in the economy will be lower than expected real wages, and many firms will hire more workers than they planned to hire. The unemployment rate will fall. If actual inflation is lower than expected inflation, actual real wages will be higher than expected, so many firms will hire fewer workers than they had planned to hire, and the unemployment rate will rise. Friedman and Phelps concluded that an increase in the inflation rate increases employment (and decreases unemployment) only if the increase in the inflation rate is unexpected.

Extra Solved Problem 27.1 The Policy Menu View of the Phillips Curve In 1960, Paul Samuelson and Robert Solow wrote the first article using the Phillips curve model to explain the relationship between unemployment and inflation in the United States. They concluded that: [P]rice stability is seen to involve about 5½ percent unemployment; whereas…3 percent unemployment is seen to involve a price rise of about 4½ percent per annum. We rather expect that the tug of war of politics will end us up in the next few years somewhere in between these selected points.

Source: Paul A. Samuelson and Robert M. Solow, “Analytical Aspects of Anti-Inflation Policy,” American Economic Review, Vol. 50, No. 2, May 1960, pp. 192–193.

a. What did Samuelson and Solow mean by “price stability”? b. What does the “tug of war of politics” have to do with what happens to the unemployment and inflation rates?

Solving the Problem Step 1:

Step 2:

Step 3:

Review the chapter material.

This problem is about how the Phillips curve was understood in the 1960s, so you may want to review the section “Is the Phillips Curve a Policy Menu?”

Answer part (a) by explaining what Samuelson and Solow meant by “price stability.”

When prices are stable, the price level does not change. So, price stability is another term for zero inflation.

Answer (part b) by explaining what the “tug of war of politics” has to do with what happens to the unemployment and inflation rates.

By the “tug of war of politics,” Samuelson and Solow were referring to the policy menu view of the Phillips curve. Some politicians prefer expansionary policies that would result in very low unemployment at the cost of higher inflation. Other politicians prefer low inflation at the cost of higher unemployment. Political compromise would result in the economy ending up somewhere in between. Although the policy menu view of the Phillips curve was popular

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among economists and policymakers during the 1960s, most economists now believe that view is mistaken.

Teaching Tips The end of the chapter in the main text includes a special category of exercises titled Real-Time Data (RTDA) Exercises. These exercises are well worth assigning and discussing in class because they help students become familiar with a key data source, learn how to locate data, and develop skills in interpreting data. Many RTDA exercises require more elaborate calculations than other problems and the use of Excel spreadsheets.

27.2

The Short-Run and Long-Run Phillips Curves Learning Objective: Explain the relationship between the short-run and long-run Phillips curves.

A. Shifts in the Short-Run Phillips Curve A new, higher expected inflation rate can become embedded in the economy, meaning that workers, firms, consumers, and the government all take the inflation rate into account when making decisions. There is a short-run Phillips curve for every level of expected inflation. The short-run trade-off between unemployment and inflation now takes place from this higher, less favorable level.

B. How Does a Vertical Long-Run Phillips Curve Affect Monetary Policy?

By the 1970s, most economists accepted the argument that the long-run Phillips curve is vertical and that the common view of the 1960s had been wrong: It was not possible to buy a permanently lower unemployment rate at the cost of a permanently higher inflation rate. In the long run, there is no trade-off between unemployment and inflation. The unemployment rate always returns to the natural rate, no matter what the inflation rate is. The nonaccelerating inflation rate of unemployment (NAIRU) is the unemployment rate at which the inflation rate has no tendency to increase or decrease.

27.3 Monetary Policy and Expectations of the Inflation Rate Learning Objective: Discuss how expectations of the inflation rate affect monetary policy.

The experience of the last 70 years indicates that how workers and firms adjust to their expectations of inflation depends on how high the inflation rate is. There are three possibilities: 1. Low inflation. When the inflation rate is low, workers and firms tend to ignore it.

2. Moderate, but stable inflation. People are said to have adaptive expectations of inflation if they assume that future rates of inflation will follow the pattern of rates of inflation in the past.

3. High and unstable inflation. Workers and firms that failed to accurately anticipate the fluctuations in inflation during years of high inflation could experience substantial declines in real wages and profits. Expectations formed by using all available information about an economic variable are called rational expectations.

A. The Implications of Rational Expectations for Monetary Policy Robert Lucas of the University of Chicago and Thomas Sargent of New York University pointed out an important consequence of rational expectations: An expansionary monetary policy would not work, and there might not be a trade-off between unemployment and inflation⸻even in the short run. By the mid1970s, most economists believed that expansionary monetary policy could cause the actual inflation rate to be higher than the expected rate. This gap would cause the actual real wage to fall below the expected

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real wage, and the unemployment rate would be below the natural rate. The economy’s short-run equilibrium would move up the short-run Phillips curve. Lucas and Sargent argued that this assumption requires workers and firms to ignore inflation or to use adaptive expectations in making their inflation forecasts. If workers and firms have rational expectations, they will use all available information, including knowledge of the effects of Federal Reserve policy. As a result, the short-run Phillips curve will be vertical.

B. Is the Short-Run Phillips Curve Really Vertical?

The claim by Lucas and Sargent that the short-run Phillips curve is vertical and that an expansionary monetary policy cannot reduce the unemployment rate below the natural rate surprised many economists. The experience of the 1950s and 1960s seemed to show that the shortrun Phillips curve was downward sloping. Lucas and Sargent explained that the apparent shortrun trade-off was the result of unexpected changes in monetary policy. They argued that a policy that was announced ahead of time would not cause a change in unemployment. Many economists have remained skeptical of the argument that the short-run Phillips curve is vertical. These economists raise two main objections: 1. Workers and firms may not have rational expectations.

2. The rapid adjustment of wages and prices needed for the short-run Phillips curve to be vertical will not actually take place.

C. Real Business Cycle Models During the 1980s, some economists argued that Lucas was correct in assuming that workers and firms formed their expectations rationally and that wages and prices adjust quickly but that Lucas was wrong in assuming that fluctuations in real GDP are caused by changes in the money supply.

These economists argued that fluctuations in “real” factors, particularly technology shocks, explained deviations of real GDP from its potential level. Technology shocks are changes to the economy that make it possible to produce either more output or less output with the same number of workers, machines, and other inputs. Real business cycle models focus on real rather than monetary explanations of fluctuations in real GDP.

Extra Solved Problem 27.3 Stagflation and the Short-run Phillips Curve Stagflation is the simultaneous increase in inflation and unemployment (or an increase in inflation and slower economic growth). Given the negative slope of the short-run Phillips curve, how is it possible for the inflation rate and the unemployment rate to increase at the same time? Use Phillips curve graphs to illustrate your answer.

Solving the Problem Step 1:

Step 2:

Review the chapter material.

This problem is about the role that changing expectations play in shifting the position of the short-run Phillips curve, so you may want to review the section “Expectations of the Inflation Rate and Monetary Policy.”

Use a graph to illustrate the change in the inflation rate and the unemployment rate along a short-run Phillips curve.

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The short-run Phillips curve shows the short-run trade-off between inflation and unemployment. On any particular short-run Phillips curve, an increase in inflation will be accompanied by a decrease in unemployment. The movement from point A to point B in the following graph shows a decrease in the unemployment and an increase in the inflation rate.

Step 3:

Use a second graph to illustrate how an adverse supply shock can cause both the unemployment rate and the inflation rate to increase.

Periods of stagflation are often the result of adverse supply shocks caused by rapid increases in the prices of resources, such as oil. An adverse supply shock that shifts the SRAS curve to the left will also shift the short-run Phillips curve upward. This is shown in the following graph.

As the graph shows, a shift in the short-run Phillips curve creates the possibility of a simultaneous increase in inflation and unemployment. Stagflation is shown as a movement from point A to point B in the graph.

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27.4

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

A. The Effect of a Supply Shock on the Phillips Curve Oil prices rose in 1974, following actions by the Organization of Petroleum Exporting Countries (OPEC), to reduce the supply of oil. As a result, the short-run aggregate supply curve to shifted to the left. The result was a higher price level and a lower level of real GDP. On a Phillips curve graph, the short-run Phillips curve shifted up, as both the inflation rate and the unemployment rate increased.

The combination of rising unemployment and rising inflation placed the Federal Reserve in a difficult position. If the Fed used expansionary monetary policy to fight unemployment, the aggregate demand curve would shift to the right. Real GDP would increase, but at the cost of higher inflation. If the Fed used a contractionary monetary policy, the aggregate demand curve would shift to the left, causing a movement down the short- run Phillips curve leading to higher unemployment. In the end, the Fed decided to fight unemployment with expansionary monetary policy, even though this decision worsened the inflation rate.

B. Paul Volcker and Disinflation By the late 1970s, the Federal Reserve had gone through a two-decade period of increasing the rate of growth of the money supply. In August 1979, President Carter appointed Paul Volcker as chairman of the Board of Governors of the Federal Reserve System. Volcker was convinced that high inflations rates were damaging the economy. Volcker began reducing the growth rate of the money supply. Interest rates rose, causing a decline in aggregate demand. The Fed’s contractionary monetary policy shifted short-run equilibrium down the short-run Phillips curve and reduced inflation from 11 percent in 1979 to 6 percent in 1982. But the unemployment rate rose to 10 percent. As workers and firms lowered their expectations of future inflation, the shortrun Phillips curve shifted down. By 1987, the economy was back to the natural rate of unemployment.

Under Volcker’s leadership, the Fed had reduced the inflation rate from more than 10 percent to less than 5 percent. A significant reduction in the inflation rate is called disinflation. This episode is often called the “Volcker disinflation.” The disinflation had come at a very high price. From September 1982 through June that a1983, the unemployment rate was above 10 percent. Robert Lucas and Thomas Sargent argued

C. From Greenspan to Powell: Recent Fed Chairs less painful disinflation would have occurred if workers and firms had believed Volcker’s

In 1987, President Ronald Reagan appointed Alan Greenspan to succeed Paul Volcker as Fed chairman.

Greenspan served in this position for 18 years. Ben Bernanke was appointed chairman in announcement 2006.

In 2014, Janet Yellen succeeded Bernanke.

2017, YellenFed became Treasury in the that hetowas fighting inflation.

The problem was(In that previous chairmen had Secretary made promises similar Biden Administration).

Under Greenspan’s leadership, inflation was reduced nearly to the levels Volcker’s the 1960s.

1970s, but inflation worsened. reached inthroughout the 1950s and When Greenspan left office in 2006, he was widely applauded for his leadership. However, the severity of the recession of 2007–2009 led some critics to question whether decisions made during Greenspan’s leadership might have played a role in bringing on the crisis.

In addition to lowering the target for the federal funds rate (to keep interest rates low), there were two other developments in monetary policy over the past 20 years: 1. Deemphasizing the money supply. Before 1987, the Fed would announce annual targets for how much M1 and M2 would increase during the year. In February 1987, near the end of Paul Volcker’s term, the Fed announced that it would no longer set targets for M1. In 1993, Alan

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Greenspan announced that the Fed would no longer set targets for M2. The Federal Open Market Committee (FOMC) has since relied on setting targets for the federal funds rate.

2. The importance of Fed credibility. During the 1970s the Fed learned that workers, firms, and investors have to view Fed announcements as credible if monetary policy is to be effective.

Over the past 25 years, the Fed has taken steps to enhance its credibility. Whenever a change in Fed policy is announced, the change has actually taken place. Greenspan revised the previous policy of keeping secret the target for the federal funds rate. The minutes of the FOMC meetings are made public after a brief delay. In February 2000, the Fed helped make its intentions for future policy clearer by announcing at the end of each FOMC meeting whether it considered the economy in the future to be at greater risk of higher inflation or recession. In 2011, Ben Bernanke began holding press conferences following some FOMC meetings, the first time a Fed chair had done so.

Extra Apply the Did Greenspan Intervene Too Much? The Story of Long-Term Concept Capital Management Alan Greenspan was Fed Chair from August 1987 to January 2006. He was criticized for the Fed’s role in saving the financial firm Long-Term Capital Management (LTCM). In the spring of 1998, LTCM suffered heavy losses on its investments, and other financial firms that had loaned money to LTCM feared that the firm would go bankrupt and began to push for repayment of their loans. We have seen that a run on a financial firm can cause widespread problems in the financial system. With the support of Greenspan, William McDonough, president of the Federal Reserve Bank of New York, persuaded the financial firms to which LTCM owed money to give the firm enough time to slowly sell off—or “unwind”—its investments to keep the prices of those investments from falling too rapidly and to avoid a financial panic.

Some critics argued that the Fed’s intervention had negative consequences in the long run because it allowed the owners of LTCM and the firms that had loaned LTCM money to avoid the full consequences of the firm’s failed investments. These critics argued that the Fed’s intervention set the stage for other firms—particularly highly leveraged financial firms—to take on excessive risk, with the expectation that

D. the Natural Rateonoftheir Unemployment thesuffer Bestheavy Guide to on Monetary Policy? The the Is Fed would intervene behalf should they losses the investments.

Fed's New Monetary Policy Strategy

In December 2015, then Fed Chair Janet Yellen and the FOMC raised the target for the federal funds rate, which had remained 0 to 0.25 percent since December 2008. The FOMC raised the target several more times during the following years, until it reached 2.25 to 2.50 percent in December 2018. (Jerome Powell succeeded Janet Yellen as Fed Chair in February 2018.) These actions were consistent with the Phillips curve analysis we just discussed.

When the FOMC met in December 2015, the unemployment rate was 5.0 percent. The average of the FOMC members’ estimates of the natural rate of unemployment was 4.9 percent. The inflation rate in December 2015 was 1.2 percent—well below the Fed’s target inflation rate of 2 percent. Although it might seem that with such a low inflation rate, the FOMC should not have been increasing the federal funds rate target, doing so was consistent with one of the lessons from the Great Inflation of the late 1960s to the early 1980s: Because monetary policy affects the economy with a lag, it’s important for the Fed to react before inflation begins to increase and a higher inflation rate becomes embedded in the

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economy. With many FOMC members believing that the NAIRU had been reached in December 2015, raising the federal funds rate from effectively 0 seemed like an appropriate policy.

At least until the end of 2018, some members of the FOMC indicated publicly that they still believed that the Fed should pay close attention to the relationship between the natural rate of unemployment and the actual rate of unemployment. One potential consequence of overheating is that inflationary pressures inevitably build up, leading the central bank to take a much more “muscular” stance of policy at the end of these high-pressure periods to combat rising nominal pressures. Economic weakness follows. You might argue that the simple answer is [for the Fed] to not respond so aggressively to building signs of inflation, but that would entail risks that few responsible central bankers would accept. It is true that the Fed and most other advancedeconomy central banks have the luxury of solid credibility for achieving and maintaining their price stability goals. But don’t forget that such credibility was hard won.

Inflation expectations are reasonably stable for now, but we know little about how far the scales can tip before it is no longer so. Because of problems in measuring the actual unemployment rate and in estimating the natural rate of unemployment, some economists inside and outside the Fed have argued that the employment–population ratio for prime-aged workers (age 25-54) is a better measure of the state of the labor market.

In 2019, the Fed began to cut its target for the federal funds rate as the growth in real GDP slowed. In March 2020, following the start of the Covid-19 pandemic, the Fed cut the target back to 0 to 0.25 percent. During that time, some members of the FOMC and some economists outside the Fed concluded that it was a mistake for the Fed to have raised the target for the federal funds rate multiple times between 2015 and 2018.

In August 2020, the Fed announced the results of a review of its monetary policy. In a speech that accompanied the statement, Fed Chair Jerome Powell noted that in attempting to achieve its mandate of high employment, the Fed faces the difficulty that “the maximum level of employment is not directly measurable and changes over time for reasons unrelated to monetary policy. The significant shifts in estimates of the natural rate of unemployment over the past decade reinforce this point.”

Powell noted that in the Fed’s new monetary policy statement, policy will depend on the FOMC’s “’assessments of the shortfalls of employment from its maximum level’ rather than . . . ‘deviations from its maximum level’ as in our previous statement. This change may appear subtle, but it reflects our view that a robust job market can be sustained without causing an outbreak of inflation.”

The details of how the Fed’s new monetary policy strategy would be implemented were uncertain in mid-2021. But it seemed clear that the Fed had ended its approach dating back to the early 1980s of raising its target for the federal funds rate when the unemployment rate declined to or below the FOMC’s estimate of the natural rate of unemployment. Particularly after Congress and the Biden administration passed the $1.9 trillion American Rescue Plan in March 2021, some economists wondered whether the Fed’s new strategy might make it more difficult to counter an increase in inflation without pushing the U.S. economy into a recession. For instance, Olivier Blanchard of the Peterson Institute for International Economics argued that the combination of very expansionary fiscal and monetary policies might lead to a situation similar to that in the late 1960s, when there was a steady decrease in the unemployment rate down to less than 4 percent. Inflation increased but not very much, from 1 percent to just below 3 percent, suggesting to many a permanent trade-off between inflation and unemployment. In 1967, however, inflation expectations started adjusting, and by 1969, inflation had increased to close to 6 percent and was then seen as a major issue. Fiscal and monetary policies tightened, leading to a recession from the end of 1969 to the end of 1970. Fed Chair Jerome Powell was confident, however, that any increase in inflation would be temporary. One economic columnist called these opposing opinions the Great Overheating Debate of 2021. Only time will tell which opinion turns out to be correct.

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E. Should the Fed Be Independent of Congress and the President?

While most economists and policymakers gave the Fed credit for keeping the financial crisis of 2007– 2009 from leading to a downturn as severe as the Great Depression of the 1930s, some argued that the

Fed had overstepped its authority as specified in the Federal Reserve Act. In response to some of the Fed’s actions during the 2007–2009 financial crisis, Congress in 2010 passed the Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), which put new restrictions on the Fed’s actions.

One provision of the act limited the Fed’s ability to make loans except to commercial banks. In particular, the Fed is no longer allowed to make loans “for the purpose of assisting a single and specific company avoid bankruptcy.” During the crisis, the Fed took action to save the Bear Stearns investment bank and the AIG insurance company under what is called the too-big-to-fail policy, which holds that the federal government should not allow large financial firms to fail if the firms are so big that their failure might damage the financial system. Some economists believe that this policy increases moral hazard because managers of financial firms may make riskier investments if they believe that the federal government will save them from bankruptcy. The Dodd-Frank Act makes it much more difficult for the Fed to use a too- big-to-fail policy. In 2019, President Trump raised a more central issue: Should the Fed be allowed to operate independently of the president, or should it operate as a department of the executive branch, like the Department of Justice or the Department of Defense? If the Fed operated like the Department of Defense, the president would be free to replace the Fed chair or other members of the Board of Governors at any time, just as the president is free to replace the secretary of defense.

▪ Require the Fed to adopt a formal policy rule. Make price stability the Fed’s sole policy goal.

Audit the Fed’s monetary policy actions. The General Accounting Office (GAO) audits the Arguments against Fed Independence: ▪ Fed’s ▪ finances as well as the finances of other government agencies. Congress has not given the GAO authority other Fed to audit monetary policy, but the Dodd-Frank Act allows the GAO to audit activities, such as loans made to a single firm. Senator Rand Paul of Kentucky proposed that the GAO are be given authority to audit monetary policy actions. Many economists and Fed officials critical of this proposal as it might lead Congress to pressure the Fed to avoid making Arguments in Favor of Fed Independence: policy ▪ actions Ability that to carry monetary policy regard to possible political pressure from Congress wereout in the economy’s bestwithout interests but were politically unpopular. or the president ▪ Avoid inflation Prevent the government from using control of the central bank to further ▪ its political interests.

Extra Apply the Paul Volcker and the Fed’s Fight for Independence Concept In his brief history of the Federal Reserve System, Tim Todd, an economist with the Federal Reserve Bank of Kansas City, describes the withering criticism leveled at Paul Volcker during his term as chairman of the Federal Reserve Board between 1979 and 1987. Volcker began his term when the U.S. economy suffered from double-digit inflation. He immediately announced that the Fed would begin targeting the growth of the money supply⸻rather than interest rates⸻ and would slow money growth to combat inflation. The Fed’s bold action ultimately resulted in two recessions, the second of which, from 1981 to 1982, was the result of high interest rates (the federal funds rate reached a record high of 20

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percent in 1981) that resulted directly from contractionary monetary policy. Todd described the reaction of the public to Fed policies: Farmers surrounded the Federal Reserve building to protest high interest rates…Auto dealers sent in coffins with car keys to symbolize the vehicles that went unsold because of high interest rates.

Volcker…would read…letters that people wrote…about how they had saved for years to buy a house for their parents, but…because of the high rates, could not…

As the Reagan administration took office in 1981, the president’s staff sought a meeting between the president and the chairman. “‘We offered to have the president go to the Federal Reserve,’ Reagan aide Martin Anderson said…Volcker was…upset about that…The reason was that it would in some way be seen as compromising their independence if the president went over there…”

Todd described the invective directed at Volcker and the Fed by Members of Congress between 1981 and 1982: ‘We are destroying the small business man…We are destroying the American dream,’ conservative Congressman George Hansen said…Democrat Frank Annunzio shouted and pounded his desk, accusing the Fed of favoring big business, and…Henry Gonzales threatened to impeach Volcker and most of the Fed’s other governors…By the summer of 1982, House Majority Leader James C. Wright, Jr., was calling for Volcker’s resignation…Sen. Alan Cranston told a press conference…that Congress had to curb the Fed’s independence. ‘It’s inconsistent with representative democracy…to have seven people appointed to 14-year terms with vast sweeping powers over the lives…of the American people who are accountable to no one.’

Senator Ted Kennedy agreed with Cranston’s call for greater control…‘Put (the Federal Reserve) in the Treasury where it belongs.’

However, not all of the comments regarding Volcker were negative. One Wall Street trader told the New York Times: Interference with the central bank would be taken very poorly in the investment community…

Paul Volcker…has become the whipping boy for high interest rates and the administration is delighted to have somebody they can point the finger at. But, in truth, the administration would be lost without him—and so would the credibility of the fight against inflation.

Apparently aware of the support Volcker had in the financial world, the administration’s public stance regarding the Fed softened. “Treasury Secretary Regan… [said] during a press conference, ‘I think the Fed’s independence is a good thing.’”

Source: Tim Todd, “The Balance of Power – The Political Fight For An Independent Central Bank, 1790–present.”

Federal ReserveExtra Bank of Kansas City, 2009.

Apply the The Debate over Quantitative Easing during 2007–2009 Concept Recession

The decision by Fed Chairman Ben Bernanke and the FOMC to engage in a policy of quantitative easing (QE) beginning in November 2008 caused extended debate among economists and policymakers. Under the QE policy, the Fed purchased long-term Treasury securities and mortgagebacked securities to reduce long-term interest rates (see Chapter 25). Lower long-term interest rates on corporate bonds and mortgages could increase investment spending and aggregate demand.

Lower interest rates might also lead investors to switch from buying bonds to buying stocks, thereby increasing stock prices. Higher

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stock prices make it easier for firms to finance expansion by issuing new shares and, by increasing wealth, may lead households to increase their consumption spending.

Most economists believe that QE contributed to declining long-term interest rates, although the severity of thethe 2007–2009 recession and the weakness of the recovery also kept interest rates low by reducing demand for loanable funds. As the Fed persisted with the policy of QE more than four years after the end 1. A prolonged period of low interest rates could lead to speculative bubbles. Some economists argued that as critics interestargued rates fell and prices of long-term Treasury bonds rose, financial markets of the recession, that the policy might be damaging the economy.

Critics of QE raised were experiencing a “Treasury bubble.” These economists worried that investors, banks, other several points:firms, and pension funds, were underestimating the likelihood that long-term interest financial rates would eventually rise to more normal levels, causing substantial declines in the prices of Treasury bonds. The resulting capital losses might cause problems for anyone who owned Treasury bonds.

2. A prolonged period of low-interest rates could lead to excessive risk-taking. Treasury securities are a relatively safe investment. When interest rates on these securities dropped to low levels, some investors and financial firms turned to low-rated corporate bonds, gold, and very long-term government and corporate bonds, that offered higher returns—but also higher risks. As interest rates return to more normal levels, the prices of many of these investments are likely to fall and thereby cause capital losses to investors. In addition, default rates on low-rated corporate bonds and other risky loans would increase if the economy enters another recession.

3. Low interest rates reduce the return to saving and hurt the incomes of retired people. As we have seen, high rates of saving can contribute to long-run growth. One key reason people save is to finance their retirement. Retired people typically favor low-risk investments, such as bank certificates of deposit or Treasury bonds. But with the interest rates on these assets reduced to historically low levels, many retired people were forced to either cut their spending or make riskier investments.

4. Quantitative easing deviates from rules-based monetary policy. Prior to the financial crisis, Fed policy focused on the target for the federal funds rate. The target the Fed chose was usually consistent with the Taylor rule (see Chapter 25). This approach was generally successful in allowing the Fed to achieve its dual mandate of high employment and price stability. By 2017, the Fed was still keeping the target for the federal funds rate below the rate indicated by the Taylor rule. Failing to follow a monetary policy rule can lead to uncertainty among households and firms concerning the future course of policy. Such uncertainty can lead households to postpone purchases and firms to postpone hiring and investment, thereby slowing the growth of aggregate demand.

Policymakers at the Fed were aware of the potential problems with maintaining a policy of QE over several them toyears. A majority of the FOMC was convinced, however, that their dual mandate required take unusual policy actions in the face of the worst recession and first domestic financial crisis since the 1930s.

Sources: Martin Feldstein, “The Fed Should Start to ‘Taper’ Now,” Wall Street Journal, July 1, 2013; John Taylor, “Once Again, the Fed Shies Away from the Exit Door,” Wall Street Journal, July 11, 2013; Eilene Zimmerman, “4% Rule for Retirement Withdrawals Is Golden No More,” New York Times, May 14, 2013; and Arvind Krishnamurthy and Annette Vissing-Jorgensen, “The Effects of Quantitative Easing on Interest Rates: Channels and Implications for Policy,” Brookings Papers on Economic Activity, Fall 2011, pp. 215–288.

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Questions In an opinion column in the Wall Street Journal, Martin Feldstein of Harvard University argued the following about quantitative easing: “low interest rates are generating excessive risk-taking by banks and other financial investors.” He also warned that the risks could have serious negative effects on the value of pension funds. a. What is quantitative easing? b. Why might quantitative easing have led investors, banks, and pension funds to engage in excessive risk-taking? c. Why might this risk reduce the value of pension funds?

Wall Street Journal, July 1, 2013.

Source: Martin Feldstein, “The Fed Should Start to Taper Now,”

Answers a. Quantitative easing is a central bank policy that attempts to stimulate the economy by buying long-term securities. b. Quantitative easing, along with an exceptionally low federal funds rate, pushed interest rates to very low levels. Seeking higher returns, investors, banks, and pension funds undertook investments with higher risk. c. If these riskier investments default or become even more risky, then the value of the pension funds will fall.

Extra Economics in Your Life & Career: Would Your Job Be at Risk as a Result of an Expansionary Monetary Policy?

Question: Suppose you have rational expectations about future inflation. You see an article in the Wall Street Journal noting that the Fed has decided to pursue an expansionary monetary policy.

How would the Fed’s decision affect the rate of unemployment? Do you have to worry about losing your job?

Answer: If you and other workers have rational expectations, an expansionary monetary policy will cause the inflation rate to rise without any change in unemployment. If workers have contracts with their employers that keep wages and prices from adjusting quickly, then even if workers and firms have rational expectations an expansionary monetary policy may still reduce the unemployment rate in the

Extra ANSo, INSIDE News Article to Use in losing Class your job. short run. in thisLOOK case, you should not worry about Visit Pearson’s MyLab Economics for current news articles.

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Solutions to End-of-Chapter Exercises The Discovery of the Short-Run Tradeoff between Unemployment and 27.1 Inflation Learning Objective: Describe the Phillips curve and the nature of the short-run trade-off between unemployment and inflation.

Review Questions 1.1

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

1.2

The Fed would undertake an expansionary monetary policy, which would increase aggregate demand, causing both real GDP and the price level to increase. An increase in real GDP will increase employment, lowering the unemployment rate.

1.3

The Phillips curve had been stable during the 1960s, so it appeared that policymakers could permanently reduce unemployment if they were willing to accept permanently higher inflation.

Economists were wrong to think of the Phillips curve as a policy menu because the long-run Phillips curve is a vertical line at the natural rate of unemployment. In other words, the Phillips curve does not represent a policy menu because in the long run there is no tradeoff between unemployment and inflation.

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

1.4

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Problems and Applications 1.5

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

1.6

a. Point E on the Phillips curve graph best represents the same economic situation as point B on the aggregate demand and aggregate supply graph because the smaller increase in aggregate demand results in an inflation rate of 2 percent (= [123.4 – 121.0]/121.0 × 100]), a lower level of real GDP (compared with point C), and a higher level of unemployment. b. Point D on the Phillips curve graph best represents the same economic situation as point C on the aggregate demand and aggregate supply graph because the larger increase in aggregate demand results in an inflation rate of 4 percent (= [125.8 – 121.0]/121.0 × 100]), a higher level of real GDP (compared with point B), and a lower level of unemployment.

1.7

The aggregate demand and aggregate supply model and the Phillips curve provide two different ways of illustrating the same macroeconomic events, but the Phillips curve has an advantage when we want to explicitly analyze changes in the inflation rate and the unemployment rate, which are not directly shown on an aggregate demand and aggregate supply graph.

In the 1960s, the Phillips curve was widely viewed as a stable relationship representing a menu of policy choices between low inflation and high unemployment and between high inflation and low unemployment. A party that cares primarily about price stability would want low inflation at the cost of high unemployment and the other party that cares more about keeping unemployment low would be willing to accept higher inflation. Today, the Phillips curve is not viewed as a policy menu, and most economists believe that in the long run there is no tradeoff between inflation and unemployment.

1.8

1.9

1.10

Negotiations between a union such as the UAW and General Motors, or any other company, usually take considerable amounts of time. Annual negotiations would impose a much greater time commitment on both partiers than is required for three-year contracts. Multi-year contracts also provide a greater amount of certainty for workers and firms, particularly when inflation rates have been low and stable in the recent past. Some multi-year contracts include a cost-of-living adjustment (COLA) that increases wages by an agreed amount (for example, 2 or 3 percent annually) plus an amount equal to the percentage increase in prices (this is often based on changes in the consumer price index) in the previous year. The COLA helps insulate companies and union members from the effects of unanticipated changes in the rate of inflation.

If inflation is higher than households and firms had expected, then real wages will be lower than expected. The lower real wage will cause employment to be higher in the short run than it would be with a higher real wage because firms will increase the quantity of labor that they will demand.

In the long run, households and firms will adjust to the higher inflation and employment will return to its full-employment level.

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1.12

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As discussed in the “Apply the Concept: Do Workers Understand Inflation?”, there is some evidence that the general public does not think that nominal wages keep up with inflation, which means real wages fall. If this conclusion was correct, inflation would be a more important problem than most economists believe it is.

Inflation is caused by movements in aggregate demand and aggregate supply, not by greed. If greed causesin inflation, then fluctuations in the inflation rate would be caused by fluctuations the extent of greed in the economy. It’s implausible that the extent of greed in the

The Short-Run and Long-Run Phillips Curves economy 27.2 fluctuates Learning Objective: Explain the relationship between the short-run and long-run Phillips as much as the inflation rate does. curves.

Review Questions 2.1

2.2

Along the short-run Phillips curve, the expected inflation rate is constant. When the expected inflation rate changes, the short-run Phillips curve shifts. The long-run Phillips curve is a vertical line at the natural rate of unemployment. The short-run Phillips curve intersects the long-run Phillips curve at the expected inflation rate. If the expected inflation rate increases from 2 percent to 3 percent, the short-run Phillips curve would shift up so that it intersects the long-run Phillips curve at a 3 percent inflation rate.

A vertical long-run aggregate supply curve implies that changes in the price level—inflation— do not change potential GDP and the natural rate of unemployment. In order for the long-run Phillips curve to be downward sloping, changes in the price level (inflation) would have to affect

Problems the and Applications 2.3

unemployment rate in the long run.

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2.4

A movement from point A to point B would be caused by a decline in aggregate demand— this decline could result from contractionary monetary policy—that decreased the inflation rate and increased the unemployment rate, without changing the expected inflation rate. A movement from point A to point C would be caused by a decrease in the expected inflation rate.

2.5

Because there is no trade-off in the long run between unemployment and inflation, Herbert Stein’s statement is correct. Most economists in 1968 believed that there was a long-run tradeoff between unemployment and inflation, so they would not have agreed with Stein’s statement.

2.6 a. Graph 3 matches because athe decrease theof proportion of younger andthe less-skilled the labor force decreases naturalinrate unemployment, shifting long-runworkers and shortrun Phillips curves to the left. in b. Graph 4 matches because expansionary monetary policy increases the inflation rate and decreases the unemployment rate. c. Graph 1 matches because significant new legal barriers to firing workers increases the natural rate of unemployment, shifting the long-run and short-run Phillips curves to the right. d. Graph 2 matches because a decrease in the expected inflation rate shifts the short-run Phillips curve downward.

2.7

a. NAIRU is the nonaccelerating inflation rate of unemployment: the unemployment rate at which the inflation rate has no tendency to increase or decrease. It equals the natural rate of unemployment. b. It is hard to estimate NAIRU because there are factors beyond just the unemployment that determine whether the inflation rate is increasing or decreasing. In addition, the value for the NAIRU changes over time with changes in: (1) demographic factors, such as the age mix of the labor force; (2) labor market institutions, such as the extent of unionization and the value of the minimum wage; and (3) whether the unemployment rate has recently been very high or low. c. Not having a firm estimate of the NAIRU makes it difficult for the Fed to control inflation because the NAIRU is the unemployment rate that the Fed targets to avoid seeing the inflation rate either increase or decrease. If the Fed underestimates the value of NAIRU, for example, it will unnecessarily pursue expansionary monetary policy to lower the unemployment rate. Doing so could lead to ever-increasing inflation if the Fed persists in trying to keep the unemployment rate below the NAIRU.

2.8

a. The Board of Governors’ estimates for the NAIRU can vary for a number of reasons including (1) changes in unemployment benefits or Social Security disability benefits, which may cause some people to remain unemployed for longer periods; (2) changes in the amount of structural and frictional unemployment due to the effects of technological change or globalization on the creation and destruction of jobs; (3) demographic changes, such as an increase or decrease in the proportion of the labor force made up of younger workers who typically have higher unemployment rates; and (4) the prolonged effects of past high rates of unemployment on the current unemployment rate. b. When the actual NAIRU was higher than the fixed estimate of 5.5 percent, monetary policy would have been more expansionary than it should have been in an attempt to lower the unemployment rate below the actual NAIRU. The result would have been an increase in the rate of inflation above the target level. When the actual NAIRU was lower than the fixed estimate of 5.5 percent, monetary policy would have been more contractionary than it should

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have been in an attempt to raise the unemployment rate above the actual NAIRU. The result would have been a decrease in the rate of inflation below the target level.

2.9

a.

When an economy experiences a severe recession, we would expect workers in occupations that the require greater skills or training would have less difficulty in finding a job after recession ends because the greater the skills a worker has, the fewer other workers who are able have to compete with the worker for job openings. However, if these skilled occupations experienced a permanent reduction in the number of workers employed—for instance, if skilled bricklayers were being replaced by bricklaying machines or a declining number of newspapers was reducing the number of journalism jobs available—then workers with

b.

these skills will have difficulty being employed unless they acquire new skills or accept employment in an unskilled job. The research by Victor Ortego-Marti also indicates that if technical workers are unemployed for a significant period during a severe recession, their skills may decline. In that case, the normal advantages that skilled workers have in

2.10

a. finding new jobs may shrink or even disappear for workers in these occupations. Additional information on the effect of the recession on different occupations would make it easier to answer the question.

If jobs in the United States require increasing amounts of skill, unskilled workers may b. have greater increase,difficulty finding jobs. As a result, the level of structural unemployment may thereby increasing the NAIRU. In these circumstances, the Fed may achieve its dual

2.11

mandate of high employment and price stability at a higher unemployment rate. a.

Flexibility of the labor market refers to the ability of firms to freely hire and fire workers and to set their wages; for workers to easily move among jobs; and for firms to be free to change the requirements of jobs without being hindered by government regulations or union contracts.

A country with a more flexible labor market is likely to have a lower natural rate of b.

unemployment and, therefore, a lower NAIRU than would a country with a less flexible labor market.

Other availability of factors, including the age structure of the population and the unemployment insurance and other transfer payments also determine the NAIRU. When the unemployment rate drops below the natural rate of unemployment, firms have more difficulty in filling their job openings and are forced to pay a higher wage to attract more workers. The competition among . firms to hire the remaining workers in the market will drive the wages up, increasing firms’ costs and causing firms to increase the prices of goods

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CHAPTER 27 | Inflation, Unemployment, and Federal Reserve Policy less than 2 percent at the beginning of the recession. A 2 percent inflation rate also means that nominal interest rates will be higher than if the inflation rate is less than 2 percent.

Higher nominal interest rates make it easier for the Fed during a recession to follow an expansionary policy of lowering interest rates.

2.12

a. When Powell references “a robust job market,” he means a job market that has pushed the unemployment rate below historical average unemployment or below the unemployment rate that was previously considered full employment. b. The Fed would normally expect inflation to increasing as tight labor markets forced firms to offer higher wages to attract new employees. However, during 2019, the labor market had very low levels of unemployment and the inflation rate was also below the Fed’s 2 percent target rate. Low unemployment and low inflation do not typically coincide, so Fed policymakers were optimistic about maintaining low unemployment rates without significantly increasing the inflation rate.

2.13

In the late 1960s, the Fed seemed to have believed that there was a stable long-run trade-off between unemployment and inflation. The “current environment” refers to the situation in the early 1970s where the unemployment rate and the inflation rate had both increased. An increase in both the unemployment rate and the inflation rate seemed inconsistent with earlier thinking about the Phillips curve that did not recognize that the short-run Phillips curve would shift over time as households and firms changed their expectations of the future inflation rate and as oil prices rapidly increased.

27.3 Monetary Policy and Expectations of the Inflation Rate

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

Review Questions 3.1

3.2

Workers, firms, banks, and investors care about real, inflation-adjusted values. The future inflation rate affects real wages, real profits, and real interest rates. During periods of moderate and stable inflation, workers, firms, banks, and investors are most likely to form their expectations adaptively, basing them on the pattern of inflation rates in the recent past.

During periods of high and unstable inflation, they are more likely to incorporate all available information, including current Federal Reserve policy.

Rational expectations mean that workers and firms form current expectations using not only information from the past, but all available information. In forming expectations of inflation, rational expectations mean that workers and firms don’t use just information on recent inflation rates but also other information, such as knowledge of the Federal Reserve’s current monetary

3.3

policy.

With rational expectations, workers and firms may correctly anticipate any change in the inflation rate then caused by monetary policy. If the actual inflation rate equals the expected inflation rate, the unemployment rate equals the natural rate of unemployment and the short-run Phillips curve is vertical. If the Phillips curve is vertical in the short run, then expansionary monetary policy cannot reduce the unemployment rate even in the short run. .

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Problems and Applications 3.4

3.5

Rational expectations are likely to give the more accurate forecasts. When inflation is increasing over time, adaptive expectations that rely on only past information will always result in a forecast of a lower inflation rate than the actual inflation rate will turn out to be. a. The economic framework that Lucas’s arguments changed was that workers and firms formed their expectations adaptively, without taking into account the likely effects of monetary policy. Lucas argued that if expansionary monetary policy was anticipated and credible, and if workers and firms had rational expectations, they would adjust their expectations of inflation so that there would be no decrease in unemployment. b. Many economists do not agree with Lucas’s main conclusion that anticipated monetary policy will not affect the unemployment rate because they believe that workers and firms may not have rational expectations and wages and prices may not be able to adjust rapidly to an unexpected change in inflation.

3.6

This characterization of Lucas’ position is accurate because Lucas argued that people have rational expectations and will make use of all available information about whatever economic variable they are interested in. So, for instance, the Fed would be unable to permanently expand output and reduce unemployment by keeping the inflation rate higher than workers and firms expect. Workers and firms would incorporate information on Fed policy into their expectations of future inflation making ineffective the Fed’s attempt to run an expansionary monetary policy by “tricking” people.

3.7

a. Lucas, Sargent, and Prescott all belong to the new classical macroeconomics school of thought because they share the assumptions that people have rational expectations and that wages and prices adjust rapidly. b. Stabilizing the economy means the Fed implements policies that result in real GDP being equal to potential GDP, reducing the severity of—or even eliminating—the business cycle.

The new classical economists doubt the Fed’s ability to stabilize the economy because they believe that change in “real” factors, such as technology shocks, and not monetary policy, explain movements in real GDP.

3.8

a. The reasoning is that an unanticipated increase in inflation will lower the real wage below its expected level. As a result, firms will hire more workers and increase output. Therefore, an unanticipated increase in inflation will have led to economic growth. b. If the increase in inflation is unanticipated, then the actual real wage will be below its expected level and employment and output are likely to increase. If the increase in inflation was anticipated, then firms and workers would have taken it into account when bargaining over real wages. As a result, the increase in inflation would not result in a decrease in the expected real wage or an increase in employment. Some economists would argue, though, that even an anticipated increase in inflation can cause a decline in the real wage if workers and firms have entered multiyear wage contracts.

27.4

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

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Review Questions 4.1

4.2

The “Volcker disinflation” refers to the reduction in the inflation rate from about 11 percent in 1979 to 6 percent in 1982 as a result of contractionary monetary policy during those years. The disinflation was accompanied by a severe recession, as the unemployment rate increased from about 6 percent in 1979 to above 10 percent in 1982.

The Fed’s traditional approach was to enact monetary policies designed to keep the economy at the as anatural rate of unemployment. For example, the Fed would use unemployment rates signal to shift monetary policy. Tight labor markets would invoke an automatic

4.3

contractionary action. when However, the Fed’s approach of targeting unemployment rates changed in 2020 Jerome Powell announced that the Phillips curve had flattened and that tight labor markets did not automatically signal higher inflation and the need to enact contractionary monetary policies.

The main reason to keep a country’s central bank independent of the rest of the government is to avoid must inflation. Whenever a government is spending more than it is collecting in taxes, it borrow the difference by selling bonds. The governments of many developing countries have Critics of the Fed’s independence argue that monetary policy should be under the control of difficulty bonds a finding anyone other than their central banks to buy their bonds. The more elected officials, just as, for instance, defense policy and environmental policy are. In the United central bank buys, the faster the money supply grows and the higher the inflation rate will States, for example, if Congress and the president conducted monetary policy, they could easily be. coordinate monetary policy with fiscal policy, which they already control.

Another reason to keep a central bank independent from the government is that elected officials

Problems may and makeApplications monetary policy decisions to further their political interests. It is difficult in any 4.4

democratic country for a government in power to be reelected at a time of high unemployment. a. A supply chainIfis a network of firms that are involved in the production and sale of a good or the service. government controls the central bank, elected officials may be tempted just before an election b. i. A demand shock that decreases aggregate demand will result in a higher unemployment to increase the money supply and drive down interest rates to increase production and rate. Abut supply shock decreases aggregate supply will also result in a higher employment, by doing sothat increase the risk of higher future inflation. unemployment rate. ii. A demand shock that decreases aggregate demand will result in a lower inflation rate. A supply shock that decreases aggregate supply will result in a higher inflation rate. iii. A demand shock that decreases aggregate demand will result in a decline in real GDP (relative to what real GDP would have been in the absence of the shock). A supply shock that decreases aggregate supply will also result in a decline in real GDP (relative to what real GDP would have been in the absence of the shock). c. You should agree. A negative supply shock forces the Fed to choose between: (1) stimulating aggregate demand to reduce the unemployment rate, but thereby making the inflation rate worse, and (2) decreasing aggregate demand to reduce the inflation rate, but thereby making the unemployment rate worse. With a negative aggregate demand shock, the Fed can focus on

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stimulating aggregate demand to restore both the unemployment rate and the inflation rate to their previous levels.

4.5

Not according to the usual definition of disinflation. There was deflation in 1933 because the price level in 1933 was lower than the price level in 1932. Disinflation refers to a situation in which the inflation rate declines.

4.6

To reduce the inflation rate from 4 percent to 3 percent, the Fed will have to raise its target for the federal funds rate. Higher interest rates will reduce aggregate demand, raise unemployment, and cause a movement down the initial short-run Phillips curve, where the expected inflation rate is 3 percent (see arrow 1 on the following graph). As unemployment stays above the full-employment level at U1 and the actual inflation rate is 3 percent, workers and firms will lower their expectations of future inflation, and the short-run Phillips curve will shift to the left (see arrow 2 on the graph). With the new short-run Phillips curve, the unemployment rate will be back at the natural rate of unemployment of 4.3 percent and workers and firms will expect the inflation rate to be 3 percent.

4.7

As measured by changes in the CPI, the inflation rate rose to 14.6 percent in March 1980, the highest the United States has experienced during peacetime. The Fed, under the leadership of Chair Paul Volcker, used a contractionary policy of raising the target for federal funds rate to a high of 20 percent in 1981 to reduce the inflation rate. The increase in the fed funds rate successfully lowered the inflation rate to less than 5 percent. Although Volcker’s policy of disinflation was successful, the U.S. economy experienced a severe recession during 1981-1982. a. In the following graph, the decrease in the unemployment rate from 8 percent to 6 percent leads to an increase in the inflation rate from 1 percent to 2 percent. During the mid-to-late 1960s, the Federal Reserve forced the unemployment rate below 4 percent and the result was accelerating inflation rate, as the short-run Phillips curve shifted up.

4.8

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b. Lower expectations of inflation shift the short-run Phillips curve down. In the following graph, the Phillips curve shifts down from Short-run Phillips curve1 to Short-run Phillips curve2, which causes the inflation rate to fall from 2 percent to 1 percent with no change in the unemployment rate.

4.9

a. The natural rate of unemployment can change over time and be affected by a number of variables including trade policy, changes in population demographics, and technological change that eliminates some types of jobs. Because the exact effect of changes in these variables is difficult to determine, the Fed has trouble accurately estimating the natural rate of unemployment. b. If the natural rate of unemployment cannot be predicted with accuracy, the Fed may have to rely on measures other than the unemployment rate to gauge the state of the labor market.

The Fed can use the employment-population ratio, particularly the employment-population c. ratio for prime-age workers, and the labor force participation rate, again particularly for prime-age workers to gauge the state of the labor market.

4.10

a. Many economists wondered whether the short-run Phillips curve trade-off between unemployment and inflation still holds because the unemployment rate had fallen below 4

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percent for more than a year beginning in April 2018 without resulting in much increase in the inflation rate. b. Some economists note that the short-run Phillips curve trade-off still exists for wage inflation, although not for price inflation, raising the possibility that firms are no longer passing higher wage costs through to higher price increases to the extent that they did in previous decades.

Some argue economists and policymakers, like Minneapolis Fed President Neel Kashkari, 4.11

a.

that there may be more slack in the labor market for a given unemployment rate than was true in earlier years. If this slack in the labor market eventually disappears, the short-run relationship between inflation and unemployment may begin to show a more typical

b. Phillips curve pattern.

The Fed is able to operate independently from the president because, unlike other federal c. government agencies, under the Federal Reserve Act, the president cannot fire or replace the Federal Reserve chair at will. The Fed chair, once confirmed by the U.S. Senate, serves a

4.12

4year term.

Previous presidents typically have not commented on the Fed’s decisions regarding the a. federal funds rate targets because they believed that the Federal Reserve should be allowed to make monetary policy decisions without pressure from Congress and the president.

Presidents implement generally accepted the argument that central banks are better able to successful monetary policy when they can act independently of the rest of the government. b. Critics of the Fed’s independence argue that the implementation of monetary policy should be c. under the control of the president, as head of the executive branch of the federal government, just as the implementation of defense policy or agricultural policy is. Bringing monetary policy directly under the control of the president might also improve the coordination of monetary policy and fiscal policy.

4.13

a.

The Fed is the “guardian of the economy” in the sense that Congress has given the Fed a dual mandate of maintaining high employment and price stability. The structure of the Fed also means that it is easier for it to quickly implement macroeconomic policy because monetary policy decisions are made by the FOMC, while fiscal policy decisions require the action of Congress and the president, which typically require a longer period to arrive at a decision.

Partisan politics refer to pressure from politicians to conduct policy in a way that will . enhance their party’s chances for political success.

For monetary policy to be effective, households, firms, and investors in financial

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CHAPTER 27 | Inflation, Unemployment, and Federal Reserve Policy b. Warsh is concerned that the Fed will simply become another branch of government by engaging in activities beyond its usual monetary policy actions to control interest rates and the money supply. c.

An independent Fed is not subject to election cycles and political pressure, so it can implement monetary policies that may not be politically popular. The Fed may need to tighten monetary policy to combat inflation, which is typically not popular because it results in higher interest rates and slower economic growth. Losing its independence would threaten the Fed’s ability to take the necessary monetary actions required to meet its policy goal

4.14

a. of a stable price level. b. The output gap is the percentage difference between real GDP and potential GDP, and it is difficult to estimate potential GDP. A preannounced rule, such as the Taylor rule, sets the target for the federal funds rate

a Real-TimebyData Exercises

chosen weight between 0 and 1 multiplied by the output gap, such as, 0.5 × output

Note: FREDgap. continues to update data. The solutions below contain the data available on FRED Differences in the estimate of the output gap lead to different targets for the federal the first quarter of 2021. funds D27.1 See the plot in the following graph of the annual unemployment rate and the annual inflation rate rate. In conducting monetary policy, recent Fed chairs have preferred to rely on sincemeasures 1962. of tightness in labor markets and trends in the underlying rate of inflation, rather than on a mechanical rule.

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

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d. For the 2000–2002 period, the unemployment rate rose and the inflation rate declined, which implies a movement down along the short-run Phillips curve.

D27.2 See the plot in the following graph of consumers’ expectations of the inflation rate and the actual inflation rate as measured by the consumer price index. Consumers did a good job forecasting the inflation rate in the mid-1990s and mid-2000s. Consumers did a poor job forecasting the inflation rate in the late 1970s and early 1980s when the expected inflation rate was lower than the actual inflation rate and between 2009 and 2020 when the expected inflation rate was typically higher than the actual inflation rate. Consumer expectations of the inflation rate tend to be less volatile than the actual inflation rate.

Source: fred.stlouisfed.org Please refer to the following graph. The dark almost horizontal line graphs the estimated natural rate of unemployment (long-term), while the other more volatile line graphs the unemployment rate. In the graph, we can see that the unemployment rates from January 2019 to early 2020 are well below the natural rate of unemployment. However, the beginning of the pandemic pushed the unemployment rate rapidly higher where it remains above the natural rate of unemployment. b. Because the most recent unemployment rates are above the natural rate, we would expect that the inflation rate would fall in the future as wages would be expected to decrease.

D27.3 a.

Source: fred.stlouisfed.org

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CHAPTER 27 | Inflation, Unemployment, and Federal Reserve Policy

Suggestions for Critical Thinking Exercises CT27.1 Answers may vary, but many students will cite unemployment and inflation rate data for OECD countries from the FRED website. Countries like Germany, Japan, and Canada have low inflation rates and unemployment rates that are between 3 percent and 6 percent. Other countries, like France and Italy, have low inflation rates but unemployment rates close to 10 percent. For these countries, students may suggest that their central banks conduct expansionary monetary policy to lower their unemployment rates. (In the case of France and Italy, their governments would have to convince the European Central Bank (ECB) to follow such policies because countries that use the euro cannot conduct independent monetary policies.)

CT27.2Recall from this chapter that the Taylor rule includes both the inflation gap (the difference between the current inflation rate and the Fed's target) and the output gap (the percentage difference between real and potential GDP). Both of these terms are on the right side of the equation.

If the Fed changed to a single mandate, where it only targeted inflation, then the term Bill 2232gap called for be theeliminated Comptroller theequation.

Currency to audit the Federal Reserve CT27.3involving a. Senatethe output would fromofthe Board of Governors and Federal Reserve district banks and submit the findings to Congress.

The audit would include Fed operations, including discount loans, open market operations, and Fed lending to foreign banks. The bill was introduced in the Senate Rand Paul of Kentucky and was co-sponsored by 26 other senators. Opponents of the bill included then Fed Chair Janet Yellen and former Chair Ben Bernanke. b. Some economists and politicians would support the bill because they believe that the Fed’s accountability for monetary policy should be increased. Proponents of the bill would also dislike that some of the Fed’s actions are taken in private and the results are made public often only after long delays.

Many economists, including former Fed Chair Ben Bernanke, argue that the term “audit” is not being used in its traditional meaning of a review of a firm’s financial statements. Instead, these economists believe that Congress wants to review monetary policy decisions very soon after they are made and that the audit might lead to Congress influencing the Fed – which could worsen outcomes for the economy.

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Macroeconomics in an Open Economy

Brief Chapter Summary and Learning Objectives 28.1 The Balance of Payments: Linking the United States to the International Economy Explain how the balance of payments is calculated.

▪ The balance of payments is the record of a country’s trade with other countries in goods, services, and assets.

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

▪ An exchange rate is determined in the foreign exchange market by the demand and supply of

a country’s currency.

28.3 Exchange Rate Systems Discuss the three key features of the current exchange rate system.

▪ A currency floats when its exchange rate is determined by demand and supply. Under a fixed exchange rate system, countries agree to keep their currencies’ exchange rates fixed.

Under the current system, the U.S. dollar floats against other major currencies; most countries in Western Europe have adopted a common currency; and some developing countries have fixed their currencies’ exchange rates against another currency.

28.4 The International Sector and National Saving and Investment Define and apply the saving and investment equation.

▪ A current account deficit must be exactly offset by a financial account surplus.

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

▪ When the government runs a budget deficit, national saving will decline unless private saving

increases by the full amount of the deficit.

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

▪ In a closed economy, the main effect of lower interest rates is on domestic investment

spending and purchases of consumer durables. In an open economy, lower interest rates will also cause an increase in net exports.

Appendix: The Gold Standard and the Bretton Woods System Explain the gold standard and the Bretton Woods system.

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Key Terms Balance of payments The record of a country’s trade with other countries in goods, services, and assets.

value of most currencies is determined by demand and supply, with occasional government intervention.

Capital account The part of the balance of payments that records relatively minor transactions, such as migrants’ transfers and sales and purchases of nonproduced, nonfinancial assets.

Net foreign investment The difference between capital outflows from a country and capital inflows, also equal to net foreign direct investment plus net foreign portfolio investment.

Nominal exchange rate The value of one country’s currency in terms of another country’s currency.

Closed economy An economy that has no interactions in trade or finance with other countries.

Open economy An economy that has interactions in trade or finance with other countries.

Currency appreciation An increase in the market value of one currency relative to another currency.

Pegging A policy by which a country keeps fixed the exchange rate between its currency and another country’s currency.

Currency depreciation A decrease in the market value of one currency relative to another currency.

Purchasing power parity The theory that in the long run exchange rates move to equalize the purchasing power of different currencies.

Current account The part of the balance of payments that records a country’s net exports, net income on investments, and net transfers.

Quota A numerical limit that a government imposes on the quantity of a good that can be imported into the country.

Euro The common currency of many European countries.

Exchange rate system An agreement among countries about how exchange rates should be determined.

Real exchange rate The price of domestic goods in terms of foreign goods.

Saving and investment equation An equation that shows that national saving is equal to domestic investment plus net foreign investment.

Speculators Currency traders who buy and sell foreign exchange in an attempt to profit from changes in exchange rates.

Financial account The part of the balance of payments that records purchases of assets a country has made abroad and foreign purchases of assets in the country.

Fixed exchange rate system A system under which countries agree to keep the exchange rates among their currencies fixed for long periods.

Tariff A tax imposed by a government on imports.

Trade balance The difference between the value of the goods a country exports and the value of the goods a country imports.

Floating currency The outcome of a country allowing its currency’s exchange rate to be determined by demand and supply.

Managed float exchange rate system The current exchange rate system, under which the

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Chapter Outline Covid-19 Disrupts the Global Economy Why would a surge in automobile production in 2020 in China cause a decline in automobile production in the United States in 2021? The short answer is globalization. Globalization is the process of U.S. firms selling goods in other countries and foreign firms selling goods in the United States and also involves many firms relying on global supply chains for the inputs they need to make their products. In 2020 and 2021, we experienced two clear examples of supply chain vulnerabilities.

The Chinese automobile market is the largest in the world, with more than 25 million new vehicles sold in 2020.The majority of these cars are assembled in Chinese factories, but the computer chips used in these cars to regulate their engines and operate their airbags and brakes are produced in firms located in Germany, Taiwan, Japan, and the United States. Once Covid-19 began to spread globally in 2020, chip manufacturers expected that demand for chips would decline as auto sales fell.

Surprisingly, Chinese automobile production increased rapidly during the summer of 2020, leading Chinese firms to demand more chips than they had forecast. As a result, during late 2020 and early 2021, U.S. automobile firms had difficulty buying chips and were forced to reduce output. The worldwide shortage of computer chips reduced production of cars and trucks by about 1 million during the first three months of 2021.

A second example of the vulnerability of global supply chains occurred when the gigantic container ship Evergreen became stuck in the Suez Canal and shut that important link in world trade for several days in March 2021. In recent decades, global supply chains have been operated according to the just-in-time system, in which firms receive shipment of inputs—such as computer chips in automobiles— as close as possible to the time the firms need them. Even a temporary interruption in the flow of parts, as happened with the Evergreen blocking the Suez Canal, can disrupt production of final goods for months.

Operating in the global economy can also cause headaches for firms that sell in multiple countries.

When Jeff Bezos started Amazon in a warehouse in Seattle in 1995, he had only three employees and sold only books, almost exclusively to consumers in the United States. By 2020, when Amazon had 1.3 million employees and revenue of $386 billion, 30 percent of its sales were in foreign markets. As a result, fluctuations in the value of the dollar in exchange for other currencies affect Amazon’s profit.

In some years, converting revenue from foreign currencies yields more dollars than in other years. For example, in 2020, Amazon’s global profit was $820 million higher when measured in dollars than when measured in local currencies, such as pounds in Great Britain, euros in Germany, and pesos in Mexico. Why the discrepancy? During 2020, the value of the dollar had increased relative to most foreign currencies, so converting sales in foreign currencies into dollars increased Amazon’s profit.

Operating in a global economy involves risk, but firms do it for two reasons: First, firms can pursue their comparative advantage. Second, by selling in many markets, firms are not dependent on economic conditions in one market. In this chapter, we will look more closely at macroeconomic issues in the global economy—including how exchange rates are determined.

The Balance of Payments: Linking the United States to the International 28.1 Economy Learning Objective: Explain how the balance of payments is calculated.

Nearly all economies are open economies. An open economy is an economy that has interactions in trade or finance with other countries. A closed economy is an economy that has no interactions in trade or finance with other countries. A good way to understand the interactions between one economy and other economies is through the balance of payments, which is the record of a country’s trade with other countries in goods, services, and assets. The balance of payments contains three accounts: the current account, the financial account, and the capital account.

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A. The Current Account The current account is the part of the balance of payments that records a country’s net exports, net income on investments, and net transfers. Any payments received by U.S. residents are positive numbers in the current account, and any payments made by U.S. residents are negative numbers in the current account. The balance of trade is the difference between the value of the goods a country exports and the value of the goods a country imports. If a country exports more than it imports, it has a trade surplus. If a country exports less than it imports, it has a trade deficit.

Net exports are a component of aggregate expenditure. We can calculate net exports by adding together the the balance of trade and the balance of services. The balance of services is the difference between

B. The Financial Account

value of the services a country value of of services a country imports.

The financial account is the exports part of and the the balance payments that records purchases of assets a country has made abroad and foreign purchases of assets in the country. The financial account records long-term flows of funds into and out of a country. There is a capital outflow from the United States when an investor in the United States buys a bond issued by a foreign company or government or when a U.S. firm builds a factory in another country. There is a capital inflow into the United States when a foreign investor buys a bond issued by a U.S. firm or by the government or when a foreign firm builds a factory in the United States. When firms build or buy facilities in foreign countries, they are engaging in foreign direct investment. When investors buy stocks or bonds issued in another country, they are engaging in foreign portfolio investment. Net capital flows are the difference between capital inflows and capital outflows. Net foreign investment is the difference between capital outflows from a country and capital inflows, also equal to net foreign direct investment plus net foreign portfolio investment. When net capital flows are positive, net foreign investment is negative; when net capital flows are negative, net foreign investment is positive.

C. The Capital Account The capital account is the part of the balance of payments that records relatively minor transactions, such as migrants’ transfers and sales and purchases of nonproduced, nonfinancial assets. Prior to 1999 the capital account recorded all the transactions now included in both the financial account and the capital account.

D. Why Is the Balance of Payments Always Zero?

The sum of the current account balance, financial account balance, and the capital account balance equals the balance of payments. The balance of payments is always zero. To make the balance on the current account equal the balance on the financial account, the balance of payments includes an entry called the statistical discrepancy. Changes in foreign holdings of dollars are known as official reserve transactions. Foreign investment in the United States and additions to foreign holdings of dollars both show up as positive entries in the U.S. financial account. Therefore, a current account deficit must be exactly offset by a financial account surplus, leaving the balance of payments equal to zero.

Teaching Tips The end of the chapter in the main text includes a special category of exercises titled Real-Time Data (RTDA) Exercises. These exercises are well worth assigning and discussing in class because they help students become familiar with a key data source, learn how to locate data, and develop skills in interpreting data. Many RTDA exercises require more elaborate calculations than other problems and the use of Excel spreadsheets.

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

A multinational corporation may sell its products in many different countries and receive payments in many different currencies. The nominal exchange rate is the value of one country’s currency in terms of another country’s currency. The real exchange rate corrects the nominal exchange rate for changes in prices of goods and services.

The market exchange rate is determined by the interaction of demand and supply. There are three sources 1. Foreign firms and households that want to buy goods and services produced in the United States. of foreign currency demand for the U.S. dollar: 2. Foreign firms and households that want to invest in the United States either through foreign direct investment or through foreign portfolio investment.

3. Currency traders who believe that the value of the dollar in the future will be greater than its value today.

A. Equilibrium in the Market for Foreign Exchange The demand curve for dollars in exchange for a foreign currency has the normal downward slope, while the supply curve has the normal upward slope. Equilibrium occurs in the foreign exchange market where the quantity supplied equals the quantity demanded. Surpluses and shortages in the foreign exchange market are eliminated quickly because the volume of trading in major currencies such as the dollar and yen is very large, and currency traders are linked together by computer.

Currency appreciation is an increase in the market value of one currency relative to another currency. Currency depreciation is a decrease in the market value of one currency relative to another currency.

B. Shifts in Demand and Supply in the Foreign Exchange Market Three main factors cause the demand and supply curves in the foreign exchange market to shift: 1. Changes in the demand for U.S.-produced goods and services and changes in the demand for foreign produced goods and services.

2. Changes in the desire to invest in the United States and changes in the desire to invest in foreign countries.

3. Changes in the expectations of currency traders about the likely future value of the dollar and the likely future value of foreign currencies.

Some buyers and sellers in the foreign exchange market are speculators, who are currency traders who buy and sell foreign exchange in an attempt to profit from changes in exchange rates. The demand curve for dollars shifts to the right when incomes in a foreign country rise, when interest rates in the U.S. rise, or when speculators decide that the value of the dollar will rise relative to the value of the foreign currency.

The factors affecting the supply curve for dollars are similar to those that affect the demand curve for dollars. A recession in the United States will decrease the demand for a foreign country’s products and cause the supply curve for dollars to shift to the left. A decrease in interest rates in a foreign country will make financial investments in that foreign country less attractive and cause the supply curve of dollars to shift to the left. Whether the exchange rate increases or decreases depends on the direction of and size of the shifts in the demand curve and supply curve.

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C. How Movements in the Exchange Rate Affect Exports and Imports A depreciation of the domestic currency will increase exports and decrease imports, thereby increasing net exports. An appreciation of the domestic currency will have the opposite effect: exports should fall and imports should rise, which will reduce net exports, aggregate demand, and real GDP.

D. The Real Exchange Rate The relative prices of two countries’ goods are determined by two factors: The relative price levels in the two countries, and the nominal exchange rate between the two countries’ currencies. Economists combine these two factors in the real exchange rate, which is the price of domestic goods in terms of foreign goods. We can calculate the real exchange rate between two currencies as:

Real exchange rates are reported as index numbers, with one year chosen as the base year. The main value of the real exchange rate is in tracking changes over time—in this case, changes in the relative prices of domestic goods in terms of foreign goods.

E. Exchange Rates in the Long Run In the short run, the two most important causes of exchange rate movements are changes in interest rates and changes in investors’ expectations about the future values of currencies. Purchasing power parity is the theory that in the long run exchange rates move to equalize the purchasing power of different currencies. Three real-world complications keep purchasing power parity from being a complete explanation of exchange rates, even in the long run: 1. Not all products can be traded internationally.

2. Products and consumer preferences are different across countries.

3. Countries impose barriers to trade. A tariff is a tax imposed by a government on imports. A quota is a numerical limit a government imposes on the quantity of a good that can be imported into the country.

Here are the four determinants of exchange rates in the long run: 1. Relative price levels 2. Relative rates of productivity growth 3. Preferences for domestic and foreign goods 4. Tariffs and quotas Because these four factors change over time, the value of one country’s currency can increase or decrease by substantial amounts over the long run.

Extra Solved Problem 28.2 A Subaru Benefits from a Weak Yen Most Japanese automobile companies have manufacturing plants in the United States. Honda, for example, exports from Japan only 21 percent of the cars it sells in the United States. Fuji Heavy Industries, whose main car brand is Subaru, is an exception in still producing most of its cars in Japan. An

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article in the Wall Street Journal observed that for Fuji Heavy Industries in 2014, “the plunging yen has turned a problem—a shortage of production in the U.S.—into an unexpected boon.” a. What does the article mean by a “plunging yen”? b. Why would a plunging yen be a boon for Fuji Heavy Industries? c. Briefly explain whether a plunging yen would help or hurt Honda.

Solving the Problem Step 1:

Review the chapter material.

This problem is about changes in the value of a currency, so you may want to review the section “How Movements in the Exchange Rate Affect Exports and Imports.”

Answer part (a) by explaining what the article means by a “plunging yen.”

Step 2:

Step 3:

Step 4:

In this case, a plunging yen means a yen that is worth less in exchange for the U.S. dollar. With a plunging yen, a larger number of yen would be required to exchange for one U.S. dollar.

Answer part (b) by explaining how a plunging yen would affect Fuji Heavy Industries.

When Fuji Heavy Industries manufactures cars in Japan, it uses yen to pay production costs, including the salaries of its assembly line workers and its suppliers. With a falling value of the yen, the dollar price of cars Fuji sells in the United States decreases. As a result, Fuji will gain sales from other companies, particularly those that produce their cars in the United States. If Fuji had produced its cars in the United States, it would not have had this advantage.

Answer part (c) by explaining how a plunging yen would help or hurt Honda.

Because most of the cars Honda sells in the United States are also produced here, most of the company’s production costs and most of the revenue it earns are in dollars. So, Honda will not be directly affected by fluctuations in the yen–dollar exchange rate. Honda will, however, likely lose some sales to Fuji as the dollar prices of Subarus declines.

Extra Credit: Managers at Honda, Toyota, and Nissan are aware that when the value of the yen declines against the dollar, they would be better off producing in Japan the cars they planned to sell in the United States. But, unlike the managers of Fuji, the managers of these firms decided that moving production to the United States would allow them to plan better and to stabilize their profits because their sales would no longer be affected as much by fluctuations in the exchange rate.

Wall Street Journal, November 15, 2014.

Source: Yoko Kubota, “Subaru Rides a Weaker Yen into the U.S.,”

Extra Solved Problem 28.2 B Toyota Rides the Exchange Rate Rollercoaster Toyota assembles some of its automobiles in the United States and some in Japan. The company exports to the United States and other countries some of the automobiles it assembles in Japan. In 2019, an article on bloomberg.com noted the following about Toyota’s profits: “A stronger yen is lowering Toyota and other Japanese exporters’ . . .profits.”

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a. What did the article mean by a “stronger yen”? b. Why would a stronger yen have reduced Toyota’s profit? c. If Toyota produced in Japan all of the cars and trucks it sells in the United States, would its profit be affected more or less by fluctuations in the exchange value of the yen? Briefly explain.

Solving the Problem This problem is about changes in the value of a currency, so you may want to review the Step 1: Review the chapter material. section “How Movements in the Exchange Rate Affect Exports and Imports.”

Step 2: Answer In thispart case,(a) a by explaining what the article means by a “stronger yen.” stronger yen means that the yen is worth more in exchange for the U.S. dollar and other currencies. With a stronger yen, one U.S. dollar would exchange for fewer yen.

Step 3: Answer part (b) by explaining why a stronger yen would have reduced Toyota’s profit.

A stronger yen reduced Toyota’s profit in two ways: (1) Cars the firm produced in Japan would sell for higher prices in other countries’ currencies, including the U.S. dollar, thereby reducing Toyota’s sales, and (2) when Toyota exchanged the dollars it earned in the United States from selling cars produced there, the firm would receive fewer yen.

Step 4: Answer part (c) by explaining whether fluctuations in the exchange value of the yen would affect Toyota’s profit more or less if it produced in Japan all of the cars sold in the United States.Toyota would be more exposed to risk from fluctuating exchange rates if it produced in Japan all of the cars and trucks it sells in the United States. Currently, an increase in the value of the yen has no effect on the dollar price of the cars that Toyota assembles in Georgetown, Kentucky; San Antonio, Texas; and other U.S. factories. If all those cars and trucks were assembled in Japan for export to the United States, Toyota would be vulnerable to a decline in sales and profit when the value of the yen increases against the dollar. In fact, a key reason that the managers at Toyota have moved production of many cars and trucks to the United States is to reduce exposure to exchange rate risk.

28.3 Exchange Rate Systems

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

An exchange rate system is an agreement among countries about how exchange rates should be determined. A floating currency is the outcome of a country allowing its currency’s exchange rate to be determined by demand and supply. A managed float exchange rate system is the current exchange rate system, under which the value of most currencies is determined by demand and supply, with occasional government intervention. Historically, the two most important alternatives to the managed float exchange rate system were the gold standard and the Bretton Woods system. These were both fixed exchange rate systems. A fixed exchange rate system is a system under which countries agree to keep the exchange rates among their currencies fixed for long periods. Under the gold standard, exchange rates were determined by the relative amounts of gold in each country’s currency and the money supply was determined by the amount of gold available. By the mid-1930s most countries had abandoned the gold standard.

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A conference was held in Bretton Woods, New Hampshire, in 1944 to set up an exchange rate system in which the United States pledged to buy or sell gold at a fixed price of $35 per ounce. The central banks of all other members of the new Bretton Woods system pledged to buy and sell their currencies at a fixed rate against the dollar. Unlike the gold standard, neither the United States nor any other country was willing to redeem its paper currency for gold domestically. By the early 1970s, the difficulty of keeping exchange rates fixed led to the end of the Bretton Woods system.

The current exchange rate system has three features: 1. The United States allows the dollar to float against other major currencies.

2. Nineteen countries in Europe have adopted a single currency, the euro. The euro is the common currency of many European countries.

3. Some developing countries fix their currencies’ exchange rates against the dollar or another major currency.

A. The Floating Dollar Since 1973, the value of the U.S. dollar has fluctuated widely against other major currencies.

Extra Apply the The Canadian Province of...Arizona?

Concept In 2011, there seemed to be a lot of Canadians buying houses in Phoenix and other cities in Arizona.

For many years, some Canadians found buying a second home in Arizona or Florida a good way to avoid the harsh Canadian winters. The value of the U.S. dollar had been declining relative to the Canadian dollar. Although the value of the U.S. dollar soared by more than 30 percent relative to the Canadian dollar during the height of the financial crisis in 2008, it declined during most of the period after the crisis ended. The falling value of the U.S. dollar helped Canadian buyers of U.S. homes.

In late 2001, it took 1.60 Canadian dollars to purchase 1 U.S. dollar. So, a Canadian purchasing a house in Phoenix priced at $125,000 would have had to pay $200,000 in Canadian dollars. In the summer of 2011, it took only 0.95 Canadian dollars to purchase 1 U.S. dollar. The stronger Canadian dollar meant that a Canadian Canadian could now purchase a house in Phoenix priced at $125,000 for only $118,750 in dollars. In other words, the decline in the value of the U.S. dollar resulted in a more than 40 percent reduction vacation in the price of the house in Canadian dollars. As one Canadian who was buying a home in Desert Ridge, Arizona, put it: “It’s purchasing power, plain and simple. In the days when our dollar was 60 or 65 [U.S.] cents, I wouldn’t even be talking to you. The strong Canadian dollar has created a lot of opportunities for Canadians.” In addition to the decline in the value of the U.S. dollar, many the Canadians found Arizona to be an ideal place to buy a second home because overbuilding in state during the housing bubble had resulted in many property owners being willing to accept sharply lower prices (in U.S. dollars). Little wonder that by 2011, restaurants and bars in Arizona began staging .

Canada Day celebrations to attract the growing Canadian population.

In addition to individual Canadians looking to buy second homes in Arizona, some Canadian

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Canadians buying and investing in the United States. For example, if the value of the U.S. dollar were to continue to decline, then Canadians who bought second homes in the United States or Canadian investors buying multiple U.S. homes would take a loss in terms of Canadian dollars should they decide to sell. An increase in the value of the U.S. dollar would be good news for Canadian owners of U.S. houses but bad news for Canadian manufacturers if they intended to export goods to Canada from their U.S. plants.

Sources: Chana R. Schoenberger, “Canadians Warm to Phoenix,” Wall Street Journal, October 8, 2011; Julie Schmit, “Foreign Buyers Lifting U.S. Home Sales,” USA Today, July 14, 2011; and Barrie McKenna, “For Canadian Manufacturers, Foreign Assets Tantalizingly Cheap,” (Toronto) Globe and Mail, June 12, 2011.

B. The Euro Most countries in Western Europe have adopted a single currency. By2021, 27 countries were members of the European Union (EU). (The United Kingdom left the EU in January 2020.) On January 1, 1999, the exchange rates of 12 countries were permanently fixed against each other and against the common currency, the euro. On January 1, 2002, euro coins and paper currency were introduced. A new European Central Bank (ECB) was established with responsibility for monetary policy and issuing currency. The ECB represents a unique experiment in allowing a multinational organization to control the domestic monetary policies of independent countries.

C. Pegging against the Dollar Some developing countries have attempted to keep their exchange rates fixed against the dollar or another major currency. When the exchange rate is fixed, business planning becomes easier. In the 1980s and 1990s the flow of foreign investment funds to developing countries increased substantially.

It became possible for firms in some of these countries to borrow dollars directly from foreign investors or indirectly from foreign banks. In the 1980s and 1990s, some countries feared the inflationary consequences of a floating exchange rate.

Pegging refers to a policy by which a country keeps fixed the exchange rate between its currency and another country’s currency. When a developing country has pegged the value of its currency against the dollar, the responsibility for maintaining the peg has been entirely with the developing country. A currency pegged at a value above the market equilibrium exchange rate is said to be overvalued. A currency pegged at a value below the market equilibrium exchange rate is said to be undervalued.

When investors make it more difficult to maintain a fixed exchange rate, it is referred to as destabilizing speculation. Most countries that continue to use pegged exchange rates are small and trade primarily

Extra

with Apply the Why Did Iceland Recover So Quickly from the Financial Crisis of Concept a single, much larger, country.

– Overall, the trend has been toward replacing pegged exchanges rates with

20072009?

managed floating exchange rates.

No country may have been more severely affected by the global financial crisis of 2007–2009 than Iceland. Although a country with a population of only 300,000 and a GDP smaller than that of Jamaica or Estonia, Iceland temporarily played an important role in the global financial system during the mid-2000s.

In 2006, at the height of the worldwide housing bubble, Iceland’s two largest banks began to accept online deposits from households and firms outside of the country. Having accepted billions of dollars in foreign deposits, Icelandic banks used them to make loans in Iceland and elsewhere in Europe, often to finance housing. By 2007, Icelandic banks had made loans equal to nine times the country’s GDP. Fueled by bank loans, the value of shares on the Icelandic stock market increased by a factor of nine between 2003 and 2007, while the value of real estate in the capital of Reykjavik more than tripled. Two .

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factors caused the financial bubble resulting from this bank lending to burst. First, as in other countries, including the United States, banks in Iceland had made real estate loans to people with poor credit histories or who made very small down payments. When housing prices began to decline, many borrowers defaulted on their loans. Second, Icelandic banks held deposits that were far larger than the amounts available in deposit insurance funds and far larger than the resources available to the Icelandic central bank in its role as a lender of last resort. As a result, in 2008 the banks were subject to runs that forced them to close. The government of Iceland took over the banks but was faced with resolving the banks’ debts of about $100 billion—or more than $300,000 for each citizen of Iceland.

The following figure shows the results of the devastating financial collapse. Real GDP declined in Iceland by real13 percent between the third quarter of 2007 and the fourth quarter of 2010. The figure also shows GDP for other European countries that were hit hard by the financial crisis: Greece, Ireland, Italy, and Spain.

(To aid in comparing the countries, the values for real GDP in each country were set equal to 100 for the first quarter of 2007.) Note that although Iceland suffered a larger decline in real GDP than the other countries during the first two years of the downturn, by 2012 real GDP had returned to its precrisis level. In 2013, real GDP in the other four countries was still 5 percent or more lower than in 2007.

The unemployment statistics tell a similar story: The unemployment rate in Iceland in early 2013 was only 4.1 percent, as compared to more than 10 percent in Ireland and Italy, and more than 20 percent in Greece and Spain.

Why did Iceland recover more quickly than other European countries, despite the severity of its financial crisis? One reason is that, unlike the other countries, Iceland does not use the euro. Therefore, it was possible for the value of its currency, the krona, to decline versus the euro, thereby spurring Iceland’s exports. As the following figure shows, between the second quarter of 2007 and the fourth quarter of 2009, the value of the krona fell by more than 50 percent versus the euro. As a result, although Iceland’s exports fell during the first part of 2007, by 2012 the country’s exports had soared by more than 30 percent compared with precrisis levels. Rising exports were a key to Iceland’s recovery from the financial crisis. European countries using the euro were unable to gain the advantage of having the value of their currencies decline versus their major trading partners because most of their major trading partners also use the euro.

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As we have seen, there are advantages to countries using the euro. In 2013, Iceland considered abandoning the krona and entering the euro zone. But Iceland’s experience following the financial crisis shows that a flexible exchange rate can have important advantages. As of 2021, Iceland has not joined the euro zone or adopted the euro as its currency.

Sources: R.A., “The Iceland Question,” Economist, July 2, 2012; OECD, Economic Surveys: Iceland 2011, June 2011; Michael Lewis, Boomerang: Travels in the New Third World, New York: W.W. Norton and Company, 2011; and Federal Reserve Bank of St. Louis.

Question A report from the Organization for Economic Cooperation and Development (OECD) notes that: “Iceland appears to have the smallest independent, floating currency in the world. Other countries the size of Iceland either do not have their own currency (Estonia, Luxembourg, Malta) or peg their currency to that of another country (Barbados, Bahamas, Belize, Brunei, Latvia, Lithuania, Maldives, the Netherlands Antilles).” a. Why might small countries decide to not allow their currencies to float? b. The report also noted that: “Joining the euro area would significantly lower the volatility of traded good prices and lower overall inflation volatility as nearly half of Iceland’s external trade is with countries in the euro area or pegged to it.” Why would joining the euro area have these effects? Are there any reasons why Iceland might not want to join the euro area?

Source: OECD, Economic Surveys: Iceland 2011, June 2011, p. 18.

Answer a. Small countries rely heavily on trade with other countries, and fixed exchange rates reduce the uncertainty of buying, selling, and investing across borders. b. Movements in exchange rates cause volatility in the prices of traded goods and the prices of imported goods and services, which adds volatility to a country’s inflation rate. By joining the euro area, where all countries use the same currency, Iceland would be reducing the volatility in prices of nearly half of its overall trade with other countries. However, by joining the euro area, Iceland would forfeit the ability to conduct independent monetary policy and the ability to allow its currency to depreciate during economic downturns.

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

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A. Net Exports Equal Net Foreign Investment When a country imports more than it exports, the country must finance the difference by selling assets or by borrowing. When a country sells more assets to foreigners than it buys from foreigners, or when it borrows more from foreigners than it lends to foreigners, the country experiences a net capital inflow and a financial account surplus. When imports are greater than exports, net exports are negative, and there will be net capital inflow as people in the United States sell assets and borrow to pay for the excess of imports over exports. Therefore, net capital flows will be equal to net exports (but with the opposite sign), and net foreign investment will also be equal to net exports (and with the same sign). In summary: Current account balance + Financial account balance = 0, or Current account balance = –Financial account balance, or Net exports = Net foreign investment.

This equation tells us that countries that import more than they export must borrow more from abroad than they lend abroad. If net exports are negative, net foreign investment will also be negative by the same amount.

B. Domestic Saving, Domestic Investment, and Net Foreign Investment The total saving in any economy is equal to saving by the private sector plus saving by the government sector (public saving). When the government runs a budget surplus by spending less than it receives in taxes, it is saving. When the government runs a budget deficit, public saving is negative. We can write the following equation for the level of saving in the economy: National saving = Private saving + Public saving, or S = Sprivate + Spublic.

Private saving is equal to what households have left of their income after spending on consumption goods and paying taxes (assume that transfers are zero): Private saving = National income – Consumption – Taxes, or Sprivate = Y – C – T. Public saving is equal to the difference between government spending and taxes: Government saving = Taxes − Government spending, or Spublic = T − G. The basic macroeconomic equation for GDP or national income is: Y = C + I + G + NX.

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We can now write the saving and investment equation, an equation that shows that national saving is equal to domestic investment plus net foreign investment.

National saving = Domestic investment + Net foreign investment, or S = I + NFI. This equation is an identity because it must always be true, given the definitions we used. The saving and investment equation tells us that a country’s saving will be invested either domestically or overseas. A country such as the United States that has negative net foreign investment must be saving less than it is investing domestically.

Extra Question: A Current Account Deficit or a Financial Account Apply the Surplus?

Concept Answer: Both Table 28.1 in the textbook (reproduced below) shows that in 2020 the United States had a negative balance on its current account—the part of the balance of payments equal to net exports, plus net income on investments, plus net transfers—of –$647 billion. This means that there was a surplus in the financial account. This surplus, $741 billion, plus the balance on the capital account and the statistical discrepancy equaled –$88 billion, so the balance of payments netted out to zero. The current account has been in deficit since 1992. Many people have expressed concern that so long as this negative balance continues, the country is selling assets to foreigners, net of its purchases of foreign assets, in an amount equal to the deficit. Cletus C. Coughlin, Michael R. Pakko, and William Poole offer an alternative view: Investors buy U.S. assets because they are sound investments.

One could argue that the deficit on the current account is the result of a financial account surplus, rather than that the financial account surplus is the result of the current account deficit. As the demand by

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foreign investors for U.S. assets increases, the exchange rate of the dollar is greater than it would otherwise be. A stronger dollar reduces exports and increases imports, which results in a greater deficit in the current account.

U.S. investors have been very active in purchasing foreign assets in recent years. But foreign investors have and been even more eager buyers of real and financial capital in the United States. Coughlin, Pakko, Poole point outextent that over of U.S. currency outstanding is circulating in effect other on countries, andof To the that one-half the foreign exchange value of the dollar declines, the the values over U.S. and foreign asset holdings works…as… [a] self-correcting mechanism…The composition of 90 percent international claims on the United States are denominated the of U.S. international investment account, therefore, contributes in to dollars. stability rather than to instability…

Source: Cletus C. Coughlin, Michael R. Pakko and William Poole, “How Dangerous Is the U.S. Current Account Deficit,” The Regional Economist, Federal Reserve Bank of St. Louis, April 2006.

28.5

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

When the government runs a budget deficit, national saving will decline unless private saving increases by the amount of the budget deficit. As the saving and investment equation shows, the result of a decline in national saving must be a decline in either domestic investment or net foreign investment.

If the federal government runs a budget deficit, the U.S. Treasury must raise an amount equal to the deficit on its by selling bonds. To attract investors, the U.S. Treasury may have to raise the interest rates bonds. As interest rates on Treasury bonds rise, other interest rates, including those on corporate bonds and fundsbank to loans, will also rise. Higher interest rates will discourage some firms from borrowing build new factories or to buy new equipment. Higher interest rates on financial assets in the United States will attract foreign investors, who will buy U.S. dollars in order to purchase bonds in the United States.

The greater demand for dollars will increase their value relative to other currencies. Exports from the United States will fall, and imports to the United States will rise. Net exports and net foreign investment will fall.

When a government budget deficit leads to a decline in net exports, the result is sometimes called the twin deficits, account which refers to the possibility that a government budget deficit will also lead to a current deficit. The twin deficits idea first became widely discussed in the United States during the early 1980s when the federal government ran a large budget deficit that resulted in high interest rates, a high exchange value of the dollar, and a large current account deficit. .

The experience of the United States and other countries shows only mixed support for the twin deficits

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Extra Solved Problem 28.5 U.S. Budget Deficits and Investment In a 2005 speech, Ben Bernanke, shortly before he became chairman of the Federal Reserve, offered an explanation for changes that had occurred in the federal budget and current account of the United States. He explained that in the previous decade there had been a large increase in saving worldwide, which made up for a low level of saving the United States. In many foreign countries, aging populations and a strong motive for saving led many investors to seek investment opportunities in other countries. At the same time, many developing nations changed from being net users to net suppliers of saving to international capital markets. The increase in current account deficit of the United States from 1996 to 2004 was matched by an increase in the current account surplus of other countries, with much of the increase coming from developing countries, as shown in the table below. Bernanke explained that: “The development…of new technologies…rising productivity… [and] lower political risk…made the U.S. economy exceptionally attractive to international investors…” As investment flowed into the United States, stock prices and the exchange rate of the dollar rose.

Bernanke argued that the pattern of international capital flows he described—the developing world lending large amounts of saving to developed countries—has some benefits but could prove counterproductive if the pattern were to persist.

Global Account Balances (billions of dollars) Countries Industrial United States Japan European Area Developing

1996 $41.5 −120.2 65.7 78.5 – 90.4

2000 −$331.5 −413.4 119.6 −71.7

2004 −$400.3 −665.9 171.8 53.0 326.4

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Source: Ben S. Bernanke. “The Global Savings Glut and the U.S. Current Account Deficit.” The Federal Reserve Board, April 14, 2005; http://www.federalreserve.gov/boarddocs/speeches/2005/20050414/default.htm

Why would it be better for the United States and developing countries if the pattern of capital flows Bernanke described is eventually reversed?

Solving the Problem Step 1:

Step 2:

Review the chapter material.

This problem is about the effect of a government budget deficit, so you may want to review the section “The Effect of a Government Budget Deficit on Investment.”

Why would it be better for the United States and developing countries if the pattern of capital flows Bernanke described is eventually reversed?

In the United States and other high-income countries, workers have large quantities of capital to work with. Population is growing slowly and workforces are aging. These countries have very good reasons to save to support their future retirees. In contrast, lowincome countries have younger and more rapidly growing populations and offer relatively high returns to capital. Therefore, in the long run it would be more efficient for highincome countries to run current account surpluses and lend some of their savings to lowincome countries.

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

Economists use the term policy channels to refer to the ways in which monetary and fiscal policy affect the domestic economy. An open economy has more policy channels than does a closed economy.

A. Monetary Policy in an Open Economy When the Federal Reserve engages in an expansionary monetary policy, it buys Treasury securities to lower interest rates and stimulate aggregate demand. In a closed economy, the main effect of lower interest rates is on domestic investment spending and consumer durables. In an open economy, lower interest rates will also affect the exchange rate between the dollar and foreign currencies. Lower interest rates will cause some investors in the United States and abroad to switch from investing in U.S. financial assets to investing in foreign financial assets. This switch will cause the dollar to depreciate and net exports to increase. This additional policy channel will increase the ability of an expansionary monetary policy to affect aggregate demand.

When the Fed wants to reduce aggregate demand to reduce inflation, it engages in contractionary monetary policy. In a closed economy, the main effect is on domestic investment and purchases of durables. In an open economy, higher interest rates lead to a higher exchange value of the dollar.

Net exports demand.will fall. The contractionary monetary policy will have a larger effect on aggregate Monetary policy has a greater effect on aggregate demand in an open economy than in a closed To engage in an expansionary fiscal policy, the federal government increases its purchases or cuts economy. taxes. Increases in government purchases directly increase aggregate demand. Tax cuts increase aggregate demand

by Open increasing household disposable income and business income. An B. Fiscal Policy in an Economy expansionary fiscal policy may result in higher interest rates. In a closed economy, the main effect of higher interest rates is to reduce investment spending and purchases of consumer durables. In an open economy, higher interest rates will lead to an increase in the foreign exchange value of the dollar and a decrease in net exports. Therefore, in an open economy, an expansionary fiscal policy may be less effective because the crowding out effect may be larger. In a closed economy, only consumption and investment are crowded out by an expansionary fiscal policy. In an open economy, net exports may also be crowded out.

A contractionary fiscal policy cuts government purchases or raises taxes to reduce household income and consumption. Contractionary fiscal policy also reduces the federal budget deficit (or increases the surplus), which may lower interest rates. Lower rates increase domestic investment and purchases of consumer durables. In an open economy, lower interest rates will also reduce the foreign exchange rate of the dollar and increase net exports. In an open economy, a contractionary fiscal policy will have a

Extra Solved Problem 28.5

smaller Monetary and Fiscal Policy a be Recession effect on aggregate demand that in will less effective in slowing down an economy. Fiscal policy has a Assumeeffect that the United States, an open has slipped a recession.

Policymakers consider smaller on aggregate demand in aneconomy, open economy than ininto a closed economy. two different strategies for increasing aggregate demand. First, the Federal Reserve can use open market operations to lower the federal funds rate by 0.5 percent (50 basis points). Second, Congress and the president can pass legislation to cut income taxes.

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CHAPTER 28 | Macroeconomics in an Open Economy a. If the United States were a closed economy, would the Federal Reserve have to lower the federal funds rate by more or less than 50 basis points in order to have the same effect on aggregate demand as in an open economy? b. In an open economy, as national income or GDP increases, so will spending on imports. Define the marginal propensity to import (MPI) as the increase in imports divided by the increase in GDP. Assume two different values for the MPI for the United States: MPI = 0.10 and MPI = 0.20. For which value of the MPI would an income tax cut have a greater effect on aggregate demand? Explain your answer.

Solving the Problem Step 1:

Step 2:

Step 3:

Review the chapter material.

This problem is about the effect of fiscal policy and monetary policy, so you may want to review the sections “Monetary Policy in an Open Economy” and “Fiscal Policy in an Open Economy” Answer part (a) by assuming that the United States switches to being a closed economy and explain whether the Federal Reserve would have to lower the federal funds rate by more or less than 50 basis points in order to have the same effect on aggregate demand as in an open economy?

Because the United States has an open economy, open market operations that reduce the federal funds rate will cause some investors to switch from investing in U.S. financial assets to foreign assets that have higher yields. As investors sell dollars to buy foreign currencies, the value of the dollar will fall relative to other currencies.

The depreciation of the dollar will eventually cause U.S. exports to rise. If the United States had a closed economy, lowering the federal funds rate would have no effect on the exchange rate or exports. Therefore, the Federal Reserve would have to lower the federal funds rate by more than 50 basis points to have the same effect on aggregate demand.

Answer part (b) by explaining for which value of the MPI, 0.10 or 0.20, an income tax cut would have the greater impact on aggregate demand.

In an open economy, the larger the value of the MPI the larger the increase in imports as GDP increases and the larger the decline in net exports and aggregate demand. Therefore, a given tax cut will have a greater effect on aggregate demand if the MPI equals 0.10 than if the MPI equals 0.20, because with the smaller MPI there will be a smaller decrease in net exports.

Extra AN INSIDE LOOK News Article to Use in Class Visit Pearson’s MyLab Economics for current news articles.

Appendix | The Gold Standard and the Bretton Woods System Learning Objective: Explain the gold standard and the Bretton Woods System.

A. The Gold Standard By 1913, every country in Europe, except Spain and Bulgaria, and most countries in the Western .

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Hemisphere, had adopted the gold standard. Under the gold standard, the currency of a country consisted of gold coins and paper currency that could be redeemed for gold. The exchange rate between two currencies was automatically determined by the quantity of gold in each currency.

B. The End of the Gold Standard The greatest drawback of the gold standard was that the central bank lacked control of the money supply. Because the central bank could not control how much gold was discovered, it lacked the control of the money supply necessary to pursue an active monetary policy. When the Great Depression began in 1929, governments came under pressure to abandon the gold standard to allow their central banks to pursue active monetary policies. In 1931, Great Britain became the first major country to abandon the gold standard. The United States remained on the gold standard until 1933, and a few countries, including France, Italy, and Belgium, stayed on even longer. By the late 1930s, the gold standard had collapsed. The earlier a country abandoned the gold standard, the easier time it had fighting the Depression with expansionary monetary policies.

C. The Bretton Woods System The global economy suffered during the 1930s from tariff wars. As World War II came to an end, economists and government officials in the United States and Europe concluded that they needed to restore the international economic system. In 1947, most major nations began participating in the General Agreement on Tariffs and Trade (GATT), under which they worked to reduce trade barriers.

To develop a new exchange rate system to replace the gold standard, a conference was held in Bretton Woods, New Hampshire in 1944. The conference created the Bretton Woods system, an exchange rate system that lasted from 1944 to 1973, under which countries pledged to buy and sell their currencies at a fixed rate against the dollar.

Under the Bretton Woods system, central banks were committed to selling dollars in exchange for their own out ofcurrencies. This commitment required them to hold dollar reserves. If a central bank ran reserves, it could borrow them from the newly created International Monetary Fund (IMF)—an international organization that provides foreign currency loans to central banks and oversees the operation of the international monetary system. Under the Bretton Woods system, a fixed exchange rate was known as a par exchange rate. A persistent shortage or surplus of a currency under the Bretton Woods system was seen as evidence of a fundamental disequilibrium in a country’s exchange rate. Countries in this position were allowed to adjust their exchange rates. Many countries found that their currencies were overvalued versus the dollar. A reduction in a fixed exchange rate is a devaluation. An increase in a fixed exchange rate is a revaluation.

D. The Collapse of the Bretton Woods System By the late 1960s, the Bretton Woods System faced two severe problems. First, after 1963 the total number of dollars held by foreign central banks was larger than the gold reserves of the United States.

The basis of the system was a credible promise by the United States to redeem dollars for gold if called upon to do so. Second, some countries with undervalued currencies were unwilling to revalue their currencies. Governments resisted revaluation because it would have increased the prices of their countries’ exports.

During the 1960s, most European countries relaxed their capital controls, which are limits on the flow of foreign exchange and financial investment across countries. Loosening capital controls made it easier for . investors to speculate on changes in exchange rates.

In August 1971, President Nixon decided to

abandon the U.S. commitment to redeem dollars for gold. Attempts were made over the next two years to

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Solutions to End-of-Chapter Exercises The Balance of Payments: Linking the United States to the International 28.1 Economy Learning Objective: Explain how the balance of payments is calculated.

Review Questions 1.1

1.2 1.3

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

The current account balance includes net exports plus net income on investments and net transfers. a. The current account records: (1) the value of a country’s net exports (exports of goods and services minus imports of goods and services); (2) net income on investments (income received on foreign investments minus income payments on investments); and (3) net transfers. b. The following answers explain why in each case a country is likely to have a deficit in its current account. Note that because net exports are part of a country’s current account, anything that causes net exports to become negative makes it more likely, holding other factors constant, that the country will have a deficit in its current account. i. A higher price level would make a country’s exports more expensive and its imports less expensive. ii. Higher interest rates would increase a country’s exchange rate, which would make the prices of its exports higher in foreign currencies and the prices of its imports lower in domestic currency. iii. Lower import barriers would encourage firms and households in the country to increase their imports. iv. More attractive investment opportunities would increase foreign demand for the country’s currency, thereby increasing the country’s exchange rate. A higher exchange rate will decrease net exports.

Problems and Applications 1.4

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

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The best way to answer this question is by placing the values given into a table in a format similar to that of Table 29.1: Current Account $856 Exports of goods −1,108 Imports of goods Balance of trade 325 Exports of services –256 392 Imports of services –315 Balance of services Income received on investments Income payments on investments Net income on investments Net transfers Balance on current account Financial Account Increase in foreign holdings of assets in the United States 1,181 Increase in U.S. holdings of assets in –1,040 foreign countries Balance on financial account Balance on Capital Account Statistical discrepancy Balance of payments

–252 69 77 –60 –166

141 0 25 0

1.6

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

1.7

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

1.8

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

1.9

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

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1.10

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

28.2

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

Review Questions 2.1

2.2

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

The three main sets of factors are: (1) changes in the demand for U.S.-produced goods and services and changes in the demand for foreign-produced goods and services; (2) changes in the desire to invest in the United States and changes in the desire to invest in foreign countries;

2.3

and (3) andchanges in the expectations of currency traders about the likely future value of the dollar the likely future value of foreign currencies.

The theory of purchasing power parity holds that in the long run, exchange rates move to equalize the purchasing power of different currencies. Three real-world complications keep purchasing

Problems and Applications power parity from being a complete explanation of exchange rates in the long run: (1) not 2.4

all 1.9558 marks = 1 euro and 2.0938 marks = 1 dollar. First, convert the euro and the dollar exchange rates in terms of 1 German (2) mark: (1/1.9558) = 1 mark, or 0.5113 =1 products are traded internationally; products andeuros consumer preferences areeuros different across mark, and (1/2.0938) dollars = 1 mark, or 0.4776 dollars = 1 mark. So, 0.5113 euros = 0.4776 countries; and (3) countries impose barriers to trade. dollars, or 1.07 euros = $1.

Similar results would follow if we use one of the other currencies, for example French francs.

Put both 0.1524the euro and the dollar in terms of 1 French franc: 6.5596 French francs = 1 euro, or euros = 1 French franc, and 7.0223 French francs = 1 dollar, or 0.1424 dollars = 1 French franc.

So, 0.1524 euros = 0.1424 dollars, or 1.07 euros = $1.

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

2.6

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

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2.7

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

2.8

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

2.9

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

2.10

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

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

2.12

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

2.13

2.14

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

To calculate the purchasing power exchange rate, divide the foreign currency price of a Big Mac by the U.S. price ($5.66).

Country Chile Israel Russia New Zealand

Big Mac Price 2,940 pesos 17 shekels 135 rubles 6.8 NZ dollars

Implied Exchange Rate 519.43 3.00 23.85 1.20

Actual Exchange Rate 719.43 pesos per dollar 3.18 shekels per dollar 74.63 rubles per dollar 1.40 NZ dollars per U.S. dollar

The U.S. dollar is overvalued if the actual exchange rate is greater than the implied exchange rate and undervalued if the actual exchange rate is less than the implied exchange rate. In this case, the U.S. dollar is overvalued against the Chilean peso, the Israeli shekel, the Russian ruble, and the New Zealand dollar. Overvaluation of the U.S. dollar would lead us to predict that the value of the dollar will fall in the future relative to the value of all four currencies.

The implied exchange rate between the Russian ruble and the New Zealand dollar is 135 rubles/6.8 NZ dollars, or 19.85 rubles per New Zealand dollar. The actual exchange rate between the two currencies is 53.31 rubles per NZ dollar (74.63/1.40 = 53.31). Therefore, in terms of Big Mac purchasing power parity, the New Zealand dollar is overvalued.

2.15

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

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2.16

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

28.3 Exchange Rate Systems

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

Review Questions 3.1

3.2

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

Countries such as France, Germany, Spain, and Italy decided to adopt a common currency in order makesto increase trade with other countries using the same currency. A common currency

3.3

it easier for consumers and firms to buy and sell across borders and, therefore, should reduce production and transactions costs and increase competition.

One currency is pegged against another currency when a country decides to keep the

exchange rate between its currency and another currency fixed. Countries peg their currencies for the following reasons: (1) to make planning easier for firms with extensive trade with another Problems and(2) Applications country; to aid firms that have borrowed foreign investment funds denominated in other currencies; and (3) to reduce inflation. Countries that peg can find that their currencies a. To alleviate recession in Germany, interest rates should be lowered.

3.4 become b.

To curb inflation or in Ireland, interest rates should raised. either overvalued undervalued relative to thebeequilibrium exchange rate. A pegged currency c.

Because they use the same currency, Germany and Ireland cannot have different that is overvalued can lead to capital flight and a destabilizing speculative attack. monetary policies, which means they cannot have different interest rate policies.

3.5

Between January 2007 and July 2008, the euro appreciated against the U.S. dollar. This appreciation was good news for U.S. firms exporting goods and services to Europe as the euro prices of U.S. goods and services decreased. The euro’s appreciation was also good news for European consumers buying goods and services imported from the United States as the euro prices of those imports fell.

3.6

a. South Korea would not want its currency to appreciate too much relative to the Chinese yuan because it would worsen their trade balance with China. If the won appreciated against the yuan, Korean exporters to China would be hurt because their products would have a higher

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price in yuan. As a result, businesses and firms in China would be likely to buy fewer Korean imports. b. If the won appreciated against the yuan, the Korean central bank would want to sell won in exchange for yuan. Doing so would increase the supply of won, lowering the exchange rate between the won and the yuan.

3.7

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

3.8

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

3.9

The following graph assumes that the Chinese central bank pegs the exchange rate for the yuan below the market equilibrium exchange rate. As a result, the yuan is undervalued. Compared to the equilibrium exchange rate, an undervalued yuan will increase exports and decrease imports.

As shown in this graph, the Chinese central bank would have to supply Y2 – Y1 yuan each trading period to maintain the exchange rate peg.

3.10

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

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International Sector and National Saving and Investment 28.4 The Learning Objective: Define and apply the saving and investment equation.

Review Questions 4.1

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

4.2

National saving = Domestic investment + Net foreign investment, or S = I + NFI. If

national saving declines, the sum of domestic investment and net foreign investment will decline.

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

Problems andSApplications 4.3

4.4

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

4.5

a. “Excess saving” means that national saving exceeds domestic investment, or S > I.

4.6 4.7

b. Recall that National saving = Domestic investment + Net foreign investment, or S = I + NFI. Because NFI = Net Exports, then S = I + NX. If the current account is roughly equal to net exports, we arrive at the equation S = I + CA or CA = S − I. Based on this equation, a country with “excess saving” is or S >SI)− will current account surplus, while−a 21.5 country that = 5.7 We know that S = I +(that NFI, I = have NFI. aSo, for Germany: 27.2 percent percent invests than itGerman saves willnet have a current account percent.more Therefore, foreign investment in deficit.

2020 was 5.7 percent of GDP. You should disagree. The statement is incorrect because national saving as a percentage of GDP is not equal to domestic investment as a percentage of GDP due to the presence of net foreign investment. So, it could be the case that in 2020 the United States had larger net foreign investment than did the United Kingdom. If that was true, then domestic investment in the United States might have been smaller than domestic investment in the United Kingdom, even though national saving was larger in the United States.

The four equations become:

4.8 Sprivate = (Y + TR) − C − T. Spublic = T − (G + TR).

Y = C + I + G + NX. NX = NFI.

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National saving now becomes:

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

4.9

4.10

28.5

Investment in the United States was greater than saving in the United States in the late 1990s, so net foreign investment was negative. Net foreign investment equals net exports, which approximately equals the current account balance. Negative net foreign investment implies a current account deficit.

If the proposal of Congressman Gephardt were enacted, net foreign investment would be zero. As a result, domestic investment would have to fall to the level of national saving.

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

Review Questions 5.1

National saving increases when the government runs a budget surplus unless private saving decreases by the amount of the budget surplus, which is unlikely. The twin deficits idea is that a government budget deficit will lead to a current account deficit. The twin deficits did not hold in the 1990s, when government budget deficits fell and eventually became budget surpluses, while the current account deficit rose.

5.2

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

Problems and Applications 5.3

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

5.4

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

Because domestic investment equals national saving minus net foreign investment (I = S − NFI), if the current account were balanced in the late 1990s, then net foreign investment would have become zero instead of negative. As a result, domestic investment in the United States would have been smaller.

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

5.5

5.6

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5.7

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

5.8

a. In this context (stating that the financial account surplus “goes to finance an investment shortfall in the United States, especially government borrowing”), the editorial means a shortfall in U.S. financial investment, that is, a shortfall in national saving, which is caused by government saving being negative as a result of a federal budget deficit. b. The editorial means that the financial capital from foreign investments could be used to finance U.S. private investment instead of being used to finance the federal budget deficit. c. Possibly. The federal budget deficit could raise interest rates, which increases the foreign exchange value of the dollar, decreasing net exports and increasing the current account deficit. This is the twin deficits idea. Leaving aside the statistical discrepancy and the capital account, the current account plus the financial account equals zero, so an increase in the current account deficit increases the financial account surplus. From the perspective of the financial account, the higher U.S. interest rates resulting from the federal budget deficit attract foreign investment into the United States, which increases the financial account surplus.

5.9

28.6

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

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

Review Questions 6.1

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

6.2

In an open economy, changes in interest rates that result from monetary policy will not only affect investment spending and consumer spending on durable goods but also net exports through

6.3

changes in the exchange rate. For instance, lower interest rates from expansionary monetary policy decreasewill increase investment spending and consumer spending on durables and will the exchange rate, which increases net exports. Fiscal policy has a smaller effect in an open economy than in a closed economy because of a larger policy crowding out effect. In an open economy, through its effect on interest rates, fiscal affects the exchange rate and net exports. For example, higher interest rates as a result of

Problems and Applications an 6.4

An open economy an economy that has interactions in trade with in other expansionary fiscal is policy lead to an increase in the exchange rateand andfinance a decrease net exports, countries.

Fiscal policy in Switzerland is likely to be less effective than it would be in a less thereby offsetting some of the effect of the expansionary fiscal policy. open economy. The crowding out effect of an expansionary fiscal policy is typically higher in a more open economy where net exports represent a larger percentage of GDP.

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

6.6 6.7

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

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

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

D28.1 a. The value of the euro increased from 1.09 dollars per euro in May 2020 to 1.21 dollars per euro in May 2021. The euro appreciated by 11.0 percent against the dollar. b. The dollar depreciated in value against the euro because it took more dollars to purchase the same number of euros in May 2020 than it did in May 2021.

D28.2 See the following graphs of the U.S. dollar-euro exchange rate, the yen-U.S. dollar exchange rate, and the Canadian dollar-U.S. dollar exchange rate. Note that the U.S. dollar-euro exchange rate has been converted to euros per dollar. The yen-U.S. dollar exchange rate is yen per U.S. dollar, and the Canadian dollar-U.S. dollar exchange rate is Canadian dollars per U.S. dollar.

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

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The long-term trend in the exchange value of the dollar from 2006 to July 2021 has been upward, moving from approximately 100 to 113 in July 2021. The appreciation of the dollar over this period would have tended to increase U.S. net imports, holding all other factors constant.

b. Over the past year the exchange value of the dollar went from 118.9 to 113.3. The slight depreciation of the dollar would have tended to increase U.S. net exports, holding all other factors constant. In reality the difference is likely insignificant for most exports.

D28.4 From April 2020 to April 2021, the Japanese/U.S. foreign exchange rate went from 107.7 yen to the dollar to 109.0 yen to the dollar, and U.S. exports of goods to Japan went from $5,442.5 million to $6,324.9 million. Over this one-year period, the increase in U.S. exports to Japan was not consistent with the appreciation of the dollar. However, much of this increase in U.S. exports to Japan over this time period can be attributed to the Covid-19 pandemic.

D28.5 From April 2020 to April 2021, the Japanese yen/U.S. dollar exchange rate went from 107.7 yen to the dollar to 109.0 yen to the dollar, and U.S. imports of goods from Japan went from $9,858.6 million to $12,424.1 million. Over this one-year period, the increase in U.S. imports from Japan was consistent the appreciation of the dollar. However, much of this increase in U.S. imports from Japan over this time period can be attributed to the Covid-19 pandemic.

D28.6 a. In the third quarter of 2016, the U.S. dollar depreciated about 2.2 percent relative to the other currencies in the basket. The U.S. current account deficit decreased by 9.0% relative to the previous year. b. In the first quarter of 2018 to the second quarter of 2021, the trade weighted U.S. dollar index increased from 108.0 to 112.1. During the same period, the current account deficit increased from −$97.3 billion to −$195.7 billion. c. Yes. The results are consistent with the theory presented in the chapter. From the first quarter of 2018 to the second quarter of 2021, the U.S. dollar appreciated and the current account deficit increased.

Suggestions for Critical Thinking Exercises CT28.1 You would hope that between now and the time you convert your U.S. dollars into euros that the dollar appreciates so that you will have more for living expenses. If you have any euros left over after the semester, you would hope that the euro appreciated so you would be able to convert them into more dollars on your return to the United States.

CT28.2 a. If you invest in the United States, you will have $100,000 × 1.05 = $105,000. If you invest in Japan, your $100,000 will be worth ¥120/$ × $100,000 = ¥12,000,000. After 1 year, your Japanese bond is worth ¥12,000,000 × 1.03 = ¥ 12,360,000. Converting it back to U.S. dollars will yield ¥12,360,000 × $1/¥120 = $ 103,000. b. If the exchange rate is expected to change to $1 = ¥110, your investment in Japan will now be worth ¥12,360,000 × $1/¥110 = $ 126,300. Because your return on your investment in U.S. bonds will still be $105,000, it would be more profitable to invest in Japanese bonds. c. No. Investments are not based solely on interest rates but are also based on the expected appreciation or expected depreciation of the home or foreign currency. The example in this problem shows that investing in a country with a lower interest rate on government bonds is still more profitable than investing at home if the home currency is expected to depreciate by more than the interest rate difference between the bonds of the two countries.

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Appendix Solutions |

The Gold Standard and the Bretton Woods System

Review Questions 28A.1 Under the gold standard, the exchange rate between two currencies was determined by the quantity of gold in each currency. The gold standard collapsed during the Great Depression because central banks wanted to fight the Depression with expansionary monetary policy, but under the gold standard central banks had only limited control of their countries’ money supplies.

28A.2 Under the Bretton Woods System of fixed exchange rates, the United States pledged to buy or sell gold at a fixed price of $35 per ounce, and the central banks of the member countries pledged to buy and sell their currencies at a fixed rate against the dollar. If a shortage or surplus 28A.3 of a country’s currency occurred at the fixed exchange rate (also known as the par exchange rate), the central bank of the member country would buy or sell dollars with their currency to maintain 28A.4 the fixed exchange rate.

28A.5 A devaluation is a reduction in a fixed exchange rate. A revaluation is an increase in a fixed exchange rate.

28A.6 Capital controls are limits on the flow of foreign exchange and financial investment across countries.

The International Monetary Fund provided loans to central banks that were short of dollar reserves, oversaw the operation of the Bretton Woods system, and approved adjustments to fixed exchange rates.

Problems and Applications Destabilizing speculation refers to actions by investors that make it more difficult to 28A.7 With the $4 = £1 exchange rate, you would buy gold in London for £1 per ounce and sell the gold a inmaintain the New York for $5. You could then exchange $4 for £1 and have a $1 profit per ounce of gold.

You could make unlimited profit by buyingingold London and to New fixed rate.an Destabilizing speculation 1971ininvolving theshipping Germanitmark ledYork. to the theexchange With $6 = £1 exchange rate, you would buy gold in the United States for $5 per ounce and collapse Bretton Woods system. that sell the goldofin the London for £1.

You could thenInvestors exchangebecame £1 for $6convinced and have ain$1early profit1971 per ounce ofGermany gold. You could make an unlimited profit by buying gold in New York and shipping it to London. would demandhave to allow a revaluation of the mark against the dollar. Investors increased their Afor discovery new gold deposits causeofthe moneyThe supply increase.government Unless the increase marks,ofwhich increased thewould shortage marks.

WesttoGerman finally 28A.8 inopted the money supply was matched by an increase in output, the new gold discovery would lead to inflation, which not be a desirable result. out of the fixedwould exchange-rate system and allowed the mark to float against the dollar.

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28A.9 Countries on the gold standard during the Great Depression of the 1930s could not pursue monetary policies that were expansionary enough to counteract the severity of the downturn.

28A.10 Both the gold standard and the euro are fixed-exchange rate systems. Under fixed-exchange rate systems, countries are not free to pursue independent monetary policies and to allow their currencies to depreciate to stimulate their economies during economic downturns.

28A.11 The author was incorrect about what the United States abandoned in the 1970s. It was the Bretton Woods fixed exchange rate system that the United States abandoned rather than the gold standard, which the United States abandoned in 1933. Two problems led to the collapse of the Bretton Woods system. First, the total number of dollars held by foreign central banks had become much larger than the gold reserves of the United States. The basis of the Bretton Woods system was a credible promise by the United States to redeem dollars for gold if called upon to do so by foreign central banks. Second, some countries with undervalued currencies, particularly West Germany, were unwilling to revalue their currencies, which would have raised the foreign currency prices of their countries’ exports.

28A.12 a. The gold standard did not allow countries to stimulate their economies by pursuing expansionary monetary policies that would have allowed for lower interest rates and the depreciation of their exchange rates. b. Fixed exchange rates can provide important advantages to businesses involved in international trade. When the exchange rate is fixed, business planning becomes much easier.

For instance, businesses that export products abroad do not need to be concerned about an appreciation of their country’s currency raising the prices of their products abroad.

28A.13 By a. using the phrase “zealous money printing” the writer of this column means that the Federal Reserve increased the money supply more at a rate that exceeded the rate of increase in U.S. real GDP in the 1960s. Inflation results when a country’s money supply increases more rapidly than its rate of output. b. With the United States pursuing zealous money printing, the theory of purchasing power parity implies that the underlying equilibrium exchange rates would get out of alignment if the other countries did not follow suit with similar inflationary monetary policies. Not wanting to incur higher inflation, some of the other countries, particularly West Germany, were reluctant to follow suit. Pressure mounted for a revaluation of their currencies at a higher exchange rate. Not wanting an increase in the foreign currency prices of their exports, countries resisted revaluation. c. Domestically, under the Bretton Woods system, the dollar was already fiat money because U.S. residents could not redeem paper dollars for gold. Internationally, though, under the Bretton Woods system foreign central banks could redeem dollars for gold. With the collapse of the Bretton Woods system, there was no longer any link between dollars and gold, either domestically or internationally. So, the dollar (and the other currencies involved in the Bretton Woods system) became complete fiat money.

28A.14 The Bretton Woods system broke down because countries were not able to maintain exchange rates that were either above or below equilibrium exchange rates; fixed exchange rates are difficult to maintain in the long run. By pegging their currencies to the dollar, East Asian countries were following a fixed exchange rate policy.

For a country to leave its currency to the “whims of the markets” means that the currency floats 28A.15 with the exchange rate determined by demand and supply. A floating exchange rate makes doing business across countries more difficult, and large fluctuations in the exchange rate significantly

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CHAPTER 28 | Macroeconomics in an Open Economy affect the prices of a country’s exports and imports. Most European Union member countries eventually replaced their floating exchange rates by adopting the euro, a single currency. The adoption of the euro is equivalent to adopting a fixed exchange rate system within the euro zone.

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

D28A.1 a.Until mid-1971, the United States fixed the price of gold at $35 ounce so it did not fluctuate much until the United States abandoned that policy. To keep the price of gold at $35 the U.S. government bought and sold gold. b.It would be difficult to return to the gold standard since fixing the dollar price of gold would require constant market intervention to maintain the price. Notice how volatile gold prices are over that period of time. The same would be true for any other currency. In October 2021, the price of gold was about $1,800 per ounce.

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