Solution Manual for Macroeconomics, 13th Edition Michael Parkin

SOLUTION MANUAL FOR MACROECONOMICS, 13TH EDITION MICHAEL PARKIN

Table of Contents

 Part 1 Introduction Chapter 1 What is Economics?

1 Appendix Graphs in Economics 9 Chapter 2 The Economic Problem 21 Chapter 3 Demand and Supply 39  Part 2 Monitoring Macroeconomic Performance Chapter 4Measuring GDP and Economic Growth 53 Chapter 5 Monitoring Jobs and Inflation 67  Part 3 Macroeconomic Trends Chapter 6 Economic Growth 81 Chapter 7 Finance, Saving, and Investment 93 Chapter 8Money, the Price Level, and Inflation 105 Chapter 9The Exchange Rate and the Balance of Payments 119  Part 4 Macroeconomic Fluctuations Chapter 10Aggregate Supply and Aggregate Demand 133 Chapter 11 Expenditure Multipliers 149 Chapter 12The Business Cycle, Inflation, and Deflation 165  Part 5 Macroeconomic Policy Chapter 13 Fiscal Policy 181 Chapter 14 Monetary Policy 195 Chapter 15 International Trade Policy 211

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C h a p t e r

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WHAT IS ECONOMICS?

Answers to the Review Quiz Page 2 1.

List some examples of the scarcity that you face.

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

2.

Find examples of scarcity in today’s headlines.

A headline in The Baltimore Sun on June 20, 2017 was ―Davis Says Special Deployment Helped Stall Violence.‖ The story presented Police Commissioner Kevin Davis stating that a week-long deployment of uniformed police officers on the streets of Baltimore helped reduce shootings in the city. But the story pointed out the role of scarcity when Commissioner Davis said that ―the deployment was not sustainable over the long term‖ due to its cost.

3.

Find an example of the distinction between microeconomics and macroeconomics in today’s headlines.

Microeconomics: On June 20, 2017 a headline in East Bay Times was ―Reality vs Fantasy: FTC to Block FanDuel-DraftKings Merger.‖ This story covers a microeconomic topic because it discusses how two online fantasy sports sites, which were trying to merge, now faced opposition by the Federal Trade Commission (FTC) which announced it would challenge the merger. Macroeconomics: On June 20, 2017, a headline in The Wall Street Journal was ―Ryan Talks Up Likelihood of Tax Overhaul.‖ This story covers a macroeconomic topic because it concerns taxes that affect every business and individual in the entire economy.

Page 7 1.

Describe the broad facts about what, how, and for whom goods and services are produced.

What gets produced is significantly different today than in the past. Today the U.S. economy produces more services, such as medical operations, teaching, and hair styling, than goods, such as pizza, © 2018 Pearson Education, Inc.

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automobiles, and computers. How goods and services are produced is by businesses determining how the factors of production, land, labor, capital and entrepreneurship, are combined to make the goods and services we consume. Land includes all natural resources, both renewable natural resources such as wood, and nonrenewable natural resources such as natural gas. Labor’s quality depends on people’s human capital. In the U.S. economy, human capital obtained through schooling has increased over the years with far more people completing high school and attending college than in past years.

Finally, for whom are goods and services to be produced depends on the way income is distributed to U.S. citizens. This distribution is not equal; the 20 percent of people with the lowest income earn about 5 percent of the nation’s total income while the 20 percent of people with the highest incomes earn about 50 percent of total income. On the average, men earn more than women, whites more than non-whites, and college graduates more than high school graduates.

2.

Use headlines from the recent news to illustrate the potential for conflict between self-interest and the social interest.

One example of an issue concerns the use of a school board’s credit card to make personal purchases. A June 20, 2017 headline from Star Tribune was ―Shakopee Board Approves Superintendent’s Resignation Will Pay Him $50,000.‖ This story discusses the superintendent’s use of a school board credit card to buy items such as a television and trip to Nashville. The superintendent was following his selfinterest because he may not have repaid the purchases had they not been uncovered. The school board chair said ―In light of the current issues facing the school district, the school board feel (sic) that a change in leadership is warranted.‖ The chair believes that the social interest is served by having a new superintendent without the issue of misuse of a credit card hanging over his or her head.

Page 10 1.

Explain the idea of a tradeoff and think of three tradeoffs that you have made today.

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

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WHAT IS ECONOMICS?

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3

Explain what economists mean by rational choice and think of three choices that you’ve made today that are rational.

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

3.

Explain why opportunity cost is the best forgone alternative and provide examples of some opportunity costs that you have faced today.

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

4.

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

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

5.

Explain why choices respond to incentives and think of three incentives to which you have responded today. © 2018 Pearson Education, Inc.

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

Page 11 1.

Distinguish between a positive statement and a normative statement and provide examples.

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

2.

What is a model? Can you think of a model that you might use in your everyday life?

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

3.

How do economists try to disentangle cause and effect?

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

4.

How is economics used as a policy tool?

Individuals, businesses, and governments use economics as a policy tool. Individuals use the economic ideas of marginal benefit and marginal cost when making decisions for such topics as attending © 2018 Pearson Education, Inc.

WHAT IS ECONOMICS?

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college, paying cash or credit for a purchase, and working.

Businesses also use the concepts of marginal benefit and marginal cost when making decisions about what to produce, how to produce, and even how many hours to stay open. Finally governments also use marginal benefit and marginal cost when deciding issues such as the level of property taxes, the amount to fund higher education, or the level of a tariff on Brazilian ethanol.

Page 13 1.

What types of jobs do economists do?

Economists are found in a large variety of jobs. Many of these jobs are analysts of various sorts. Some economists are market research analysts—they work with data on sales and try to predict a product’s success and the price that should be set for it. Other economists are financial analysts—they work with data on interest rates, stock and bond prices to try to forecast the cost of borrowing the returns that can be expected on investments. Still other economists work as budget analysts—they use data on an organization’s cash inflows (its receipts) and its outflows (its payments) in order to prepare plans forecasting future cash flows.

2.

What is the range and median level of economists’ pay?

Economists’ pay ranges from $41,226 to $124,177 and has a median salary of $72,279. Students who earn a PhD in economics typically earn about $100,000 by mid-career. Economists who work as analysts have incomes that range from an average of $62,000 for market research analysts to $80,000 for financial analysts.

3.

What are the skills needed for an economics job?

Economists need five important skills: 

Critical-thinking skills: Economists need the ability to use logical thinking to clarify and then solve real-world problems.



Analytical skills: Economists must be able to use economic ideas and tools to analyze data in order to determine important patterns and reach logical conclusions.



Math skills: Economists need to be able to use mathematical and statistical tools to explore and analyze data in order to reach valid conclusions.



Writing skills: Economists must be able to clearly write reports presenting ideas, conclusions from any analysis and reasons why the conclusions are valid.



Oral communication skills: Economists need the ability to orally explain ideas, conclusions, and the reasons why the conclusions are correct to a variety of people, including those with little knowledge of economics.

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Answers to the Study Plan Problems and Applications 1.

Apple Inc. decides to make iTunes freely available in unlimited quantities. a. Does Apple’s decision change the incentives that people face?

Apple’s decision changes people’s incentives. For example, it increases people’s incentives to buy an iPod to take advantage of the newly ―free‖ music available on iTunes.

b. Is Apple’s decision an example of a microeconomic or a macroeconomic issue?

Apple’s decision is a microeconomic decision because it affects a single company and a single market.

2.

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

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

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

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

3.

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

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

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

4.

The night before an economics test, you decide to go to the movies instead of staying home and working your MyEconLab Study Plan. Your grade on the test was 50 percent, lower than your usual 70 percent score. a. Did you face a tradeoff?

Yes, you faced a tradeoff. The tradeoff was between a higher test score and an evening with your friends at the movies.

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WHAT IS ECONOMICS?

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b. What was the opportunity cost of your evening at the movies?

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

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Cost of Rio Olympics Brazilian federal, state, and local governments spent R$2.8 billion and private sponsors spent R$4.2 billion on 17 new Olympic facilities, 10 of which will be used for sporting events after the Olympics.

Source: Financial Times, August 6, 2016 Was the opportunity cost of the Rio Olympics R$2.8 or R$7 billion? Explain your answer.

The R$7 billion spent on the 17 new Olympic facilities is an opportunity cost of the Olympics if the funds would not have spent otherwise. However, if there were already plans underway to build the 10 facilities that will be used after the Olympics, then their cost is not an opportunity cost of the Olympics because the cost would have been paid even if Rio did not host the Olympics.. The cost of the 7 facilities that will not be used afterwards, however, is definitely an opportunity cost of the Rio Olympics.

6.

Which of the following statements is positive, which is normative, and which can be tested? a. The United States should cut its imports.

The statement is normative and cannot be tested.

b. China is the largest trading partner of the United States.

The statement is positive and can be tested.

c. If the price of gasoline rises, people will drive less and use less gasoline.

The statement is positive and can be tested.

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WHAT IS ECONOMICS?

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Answers to Additional Problems and Applications 7.

Kanye West Offers Free Concert Tickets Kanye West has teamed with Los Angeles inner-city schools to offer free passes for students.

Source: consequenceofsound.net, November 27, 2016 When Kanye West gave away tickets, what was free and what was scarce? Explain your answer.

The seats in the arenas are scarce—there are only a limited number.

The time of school adminstrators used to distribute the tickets is also not free. In addition, if the students who are given the ―free‖ ticket attended the concert rather than sell their free tickets, they incurred the opportunity cost of the foregone ticket price. So the concert was far from ―free‖ for the concert-goers. The publicity that Kanye West receives is free to him but the publicity used reporters’ scarce time to report on the tickets rather than reporting on other news worthy events.

8.

How does the creation of a successful movie influence what, how, and for whom goods and services are produced?

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

9.

How does a successful movie illustrate self-interested choices that are also in the social interest?

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

10.

Before starring in Guardians of the Galaxy, Chris Pratt had appeared in 11 movies that grossed an average of $7 million on the opening weekend. Guardians of the Galaxy grossed $94 million. a. How will the success of Guardians of the Galaxy influence the opportunity cost of hiring Chris Pratt?

The salary that must be paid to Chris Pratt to appear in future movies increased because some of the success of Guardians of the Galaxy was attributed to Mr. Pratt. As a result the opportunity cost to movie producers of hiring Mr. Pratt increased.

b. How have the incentives for a movie producer to hire Chris Pratt changed?

There are two effects on the incentives of producers to hire Mr. Pratt. First, because the opportunity cost of hiring Mr. Pratt increased, the incentive to hire him decreased. However because part of the success of Guardians of the Galaxy was attributed to Mr. © 2018 Pearson Education, Inc.

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Pratt acting in the leading role, producers expect that his acting will lead to increased success for future movies. This belief increases producers’ incentives to hire Mr. Pratt.

11.

What might be an incentive for you to take a class in summer school? List some of the benefits and costs involved in your decision. Would your choice be rational?

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

12.

Look at today’s Wall Street Journal. What is the leading economic news story? With big economic questions and tradeoffs does it discuss or imply?

On June 20, 2017, the top economic news story discussed the Senates plan to vote on legislation repealing large parts of the Affordable Care Act. One option under consideration would cap the amount the federal government would pay toward the cost of Medicaid, the program that pays for healthcare for poor and disabled people.

This story clearly discusses the ―for whom‖ question: If Medicaid spending is reduced, fewer poor and disabled people will receive certain types of healthcare. It also discusses the ―what‖ question: If fewer Americans have health insurance, less goods and services related to health care will be produced.

The story implicitly illustrates a tradeoff: If choices are taken to limit the amount of healthcare poor and disabled people receive, their health will generally be worse than otherwise.

13.

Provide two microeconomic statements and two macroeconomic statements. Classify your statements as positive or normative, and explain your classifications.

Microeconomic statements are: Fewer deep water oil wells should be drilled in the Gulf of Mexico. If less oil is produced, the price of oil will rise. The first statement is normative because it relies on what the person thinks ―should‖ be done. The second statement is positive because it is possible to test the effect of less oil being produced.

Macroeconomic statements are: The currently unemployment rate is too high. The current unemployment rate is higher for blacks than for whites. The first statement is normative because it depends on what is deemed ―too high.‖ The second statement is positive because it can be checked to determine its validity.

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Appendix

Answers to Review

1

GRAPHS IN ECONOMICS

the Quiz

Page 30 1.

Explain how we ―read‖ the three graphs in Figs. A1.1 and A1.2.

The points in the graphs relate the quantity of the variable measured on the one axis to the quantity of the variable measured on the other axis. The quantity of the variable measured on the horizontal axis (the x-axis) is measured by the horizontal distance from the origin to the point. Similarly, the quantity of the variable measured on the vertical axis (the y-axis) is measured by the vertical distance from the origin to the point. The point relates these two quantities. For instance, in Figure A1.2, point A shows that at a price of $8.43 per ticket, 1.3 billion tickets are sold.

2.

Explain what scatter diagrams show and why we use them.

Scatter diagrams plot the value of one economic variable against the value of another variable for a number of different values of each variable. We use scatter diagrams because they quickly reveal if a relationship exists between the two variables. Moreover, if a relationship exists, scatter diagrams show whether increases in one variable are associated with increases or decreases in the other variable. © 2018 Pearson Education, Inc.

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APPENDIX 1

Explain how we ―read‖ the three scatter diagrams in Figs. A1.3 and A1.4.

The scatter diagram in Figure A1.3 shows the relationship between a film’s worldwide box office ticket sales and the film’s production budget. The figure shows that higher box office sales are associated with a higher production budget.

The scatter diagram in Figure A1.4a shows the relationship between income, in thousands of dollars per year, and expenditure, also in thousands of dollars per year, for the years 2001 to 2016. The scatter diagram shows that higher income leads to higher expenditure. The figure also shows that the relationship is relatively strong.

The scatter diagram in Figure A1.4b shows the relationship between the inflation rate and the unemployment rate for the years 2001 to 2016. The figure shows that for most of the years, there was a weak relationship between these variables, with perhaps higher inflation being associated with lower unemployment.

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4.

Draw a graph to show the relationship between two variables that move in the same direction.

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

5.

Draw a graph to show the relationship between two variables that move in opposite directions.

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

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APPENDIX 1

Draw a graph of two variables whose relationship shows (i) a maximum and (ii) a minimum.

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

7.

Which of the relationships in Questions 4 and 5 is a positive relationship and which is a negative relationship?

The relationship in Question 4 between the two variables that move in the same direction is a positive relationship. The relationship in Question 5 between the two variables that move in the opposite directions is a negative relationship.

8.

What are the two ways of calculating the slope of a curved line?

To calculate the slope of a curved line we can calculate the slope at a point or across an arc.

The slope of a curved line at a point on the line is defined as the slope of the straight line tangent to the curved line at that point.

The slope of a curved line across an arc—between two points on the curved line—equals the slope of the straight line between the two points.

9.

How do we graph a relationship among more than two variables?

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

10.

Explain what change will bring a movement along a curve.

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

11.

Explain what change will bring a shift of a curve.

A curve shifts when there is a change in the value of a relevant variable that is not graphed on the axes. In this case the entire curve shifts. © 2018 Pearson Education, Inc.

GRAPHS IN ECONOMICS13

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

1.

1 2 3 4 5 6 7 8 9 10 11

A 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

B 2.5 4.1 0.1 2.7 1.5 3.0 1.7 1.5 0.8 0.7 2.1

C 4.9 4.5 1.4 0.2 0.1 0.1 0.1 0.1 0.0 0.1 0.3

D 2.7 1.8 −0.3 −2.8 2.5 1.6 2.2 1.7 2.4 2.6 1.6

E 4.6 4.6 5.8 9.3 9.6 8.9 8.1 7.4 6.2 5.3 4.9

work spreadsheet economy: column B is C is the the growth unemployment

Draw a scatter diagram of the inflation rate and the interest rate. Describe the relationship.

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

2.

Draw a scatter diagram of the growth rate and the unemployment rate. Describe the relationship.

To make a scatter diagram of the growth rate and the unemployment rate, plot the growth rate on the x-axis and the unemployment rate on the y-axis. The graph will be a set of dots and is shown in © 2018 Pearson Education, Inc.

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Figure A1.5. The pattern made by the dots tells us that when the growth rate increases, the unemployment rate usually decreases so there is a negative relationship.

3.

Draw a scatter diagram of the interet rate and the unemployment rate. Describe the relationship.

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

Use the following news clip to work Problems 4 to 6.

Lego Shatters More Records: Source: Boxofficemojo.com, Data for weekend of March 10-12, 2017 4.

Draw a graph of the relationship between the revenue per theater on the y-axis and the number of theaters on the x-axis. Describe the relationship.

Figure A1.7 shows the relationship.

As the figure shows, there is a positive relationship.

5.

Movie Kong: Skull Island Logan Get Out The Shack

Calculate the slope of the relationship in Problem 4 between 3,846 and 4,071 theaters.

The slope equals the change in revenue per theater divided by the change in the number of theaters. The slope equals ($15,867  $9,362)/(3,846  4,071) which equals −$28.91 per theater.

6.

Calculate the slope of the relationship in Problem 4 between 4,071 and 3,143 theaters. © 2018 Pearson Education, Inc.

Theate rs (numbe r) 3,846

Revenue (dollars per theater)

4,071 3,143 2,888

$9,362 $6,600 $3,465

$15,867

GRAPHS IN ECONOMICS15

The slope equals the change in revenue per theater divided by the change in the number of theaters. The slope equals ($9,362  $6,600)/(4,071  3,143 which equals $2.98 per theater.

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APPENDIX 1

Calculate the slope of the relationship shown in Figure A1.8.

The slope is 5/4. The curve is a straight line, so its slope is the same at all points on the curve. Slope equals the change in the variable on the y-axis divided by the change in the variable on the x-axis. To calculate the slope, you must select two points on the line.

One point is at 10 on the y-axis and 0 on the x-axis, and another is at 8 on the x-axis and 0 on the y-axis. The change in y from 10 to 0 is associated with the change in x from 0 to 8.

Therefore the slope of the curve equals 10/8, which equals 5/4.

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

8.

Calculate the slope of the relationship at point A and at point B. The slope at point A is 2, and the slope at point B is 0.25.

To calculate the slope at a point on a curved line, draw the tangent to the curved line at the point. Then find a second point on the tangent and calculate the slope of the tangent.

The tangent at point A cuts the y-axis at 10. The slope of the tangent equals the change in y divided by the change in x. The change in y equals 4 (6 minus 10) and the change in x equals 2 (2 minus 0). The slope at point A is 4/2, which equals 2.

Similarly, the slope at point B is 0.25. The tangent at point B goes through the point (4, 2). The change in y equals 0.5, and the change in x equals 2. The slope at point B is 0.25. © 2018 Pearson Education, Inc.

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9.

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

Price (dollar s per ride) 5 10 15

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

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40 32 27

50 40 32

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APPENDIX 1

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

10.

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

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

11.

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

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GRAPHS IN ECONOMICS19

Answers to Additional Problems and Applications Use the spreadsheet to Problems 12 to 14. The provides data on oil and Column A is the year, the price of oil (dollars column C is the price of (cents per gallon), column production, and column E quantity of gasoline in millions of barrels per

12.

1 2 3 4 5 6 7 8 9 10 11

A 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

B 66 72 100 62 79 95 94 98 93 49 45

C 262 284 330 241 284 354 364 353 344 252 225

D 5.1 5.1 5.0 5.4 5.5 5.7 6.5 7.5 8.8 9.4 8.9

E 15.6 15.4 15.3 14.8 15.2 15.1 15.5 15.2 15.5 16.6 16.4

work spreadsheet gasoline: column B is per barrel), gasoline D is U.S. oil is the U.S. refined (both day).

Draw a scatter diagram of the price of oil and the quantity of U.S. oil produced. Describe the relationship.

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

13.

Draw a scatter diagram of the price of gasoline and the quantity of gasoline refined. Describe the relationship.

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

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14.

APPENDIX 1

Draw a scatter diagram of the quantity of U.S. oil produced and the quantity of gasoline refined.

Describe the relationship.

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

Use the following data to work Problems 15 to 17.

Draw a graph that shows the relationship between the two variables x and y in the table to the right.

To make a graph that shows the relationship between x and y, plot the x variable on the x-axis and the y variable on the y-axis.

Figure A1.15 shows this graph.

x y

0 25

2 1 24

22

15. a. Is the relationship positive or negative?

The relationship is negative because x and y move in opposite directions: As x increases, y decreases.

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

The slope becomes steeper as x increases.

c. Think of some economic relationships that might be similar to this one.

The less expensive a good, the greater is the number of people who buy it. The higher the interest rate, the smaller is the number of people who take out home mortgages. The less expensive gasoline, the greater the miles car owners drive.

16.

Calculate the slope of the relationship between x and y when x equals 3.

The slope equals 4.0. The slope of the curve at the point where x © 2018 Pearson Education, Inc.

3 18

5 4 12

0

GRAPHS IN ECONOMICS21

is 3 is equal to the slope of the tangent to the curve at that point. Plot the relationship and then draw the tangent line at the point where x is 3 and y is 18. Now calculate the slope of this tangent line by finding another point on the tangent. When x equals 5, y equals 10 on the tangent, so another point is x equals 5 and y equals 10. The slope equals the change in y, 8, divided by the change in x, 2, so the slope is 4.0.

17.

Calculate the slope of the relationship across the arc as x increases from 4 to 5.

The slope is –12. The slope of the relationship across the arc when x increases from 4 to 5 is equal to the slope of the straight line joining the points on the curve at x equals 4 and x equals 5. When x increases from 4 to 5, y falls from 12 to 0. The slope equals the change in y, 12 (12 minus 0), divided by the change in x, 1 (4 minus 5), so the slope across the arc is 12.0.

18.

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

The change in y from 18 to 0 is associated with the change in x from 0 to 9. Therefore the slope of the curve equals 18/9, which equals 2.

Use Figure A1.17to work Problems 19 and 20.

19. Calculate the slope at point A and at point B. The slope at point A is 4, and the slope at point B is 1. To calculate the slope at a point on a curved line, draw the tangent to the line at the point. Then find a second point on the

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APPENDIX 1

tangent and calculate the slope of the tangent.

The tangent at point A cuts the x-axis at 2.5. The slope of the tangent equals the change in y divided by the change in x. The change in y equals 6 (6 minus 0) and the change in x equals 1.5 (1 minus 2.5). The slope at point A is 6/1.5, which equals 4.

Similarly, the slope at point B is 1. The tangent at point B cuts the y-axis at 5. The change in y equals 3, and the change in x equals 3. The slope at point B is 1.

20.

Calculate the slope across the arc AB. The slope across the arc AB is 2. The slope across the arc AB equals the change in y, which is 4 (6 minus 2) divided by the change in x, which equals 2 (1 minus 3). The slope across the arc AB equals 4/2, which equals 2.

Use the following table to work Problems 21 to 23.

The table gives information about umbrellas: price, the number purchased, and rainfall in inches.

21.

Draw a graph to show the relationship between the price and the number of umbrellas purchased, holding the amount of rainfall constant at 1 inch. Describe this relationship.

Figure A1.18 shows the relationship. To draw a graph of the relationship between the price and the number of umbrellas when the rainfall equals 1 inch, keep the rainfall at 1 inch and plot the data in that column against the price. This curve is the relationship between price and number of umbrellas when the rainfall is 1 inches. The relationship between the price and the number of umbrellas is an inverse relationship; as the price rises, the number of umbrellas decreases.

22.

What happens in the graph in Problem 21 if the price rises and rainfall is constant?

If the price rises, the number of umbrellas decreases. In Figure A1.18, there is a movement upward along the (unchanged) curve.

23.

What happens in the graph in Problem 21 if the © 2018 Pearson Education, Inc.

Price (dollar s per umbrell a) 20 30 40

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

7 4 2

8 7 4

GRAPHS IN ECONOMICS23

rainfall As

C h a p t e r

increases from 1 inch to 2 inches?

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

Answers to Review Quizzes

the

Page 36 1.

How does the possibilities illustrate scarcity?

The

2

THE ECONOMIC PROBLEM

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production frontier

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unattainable combinations of production that lie beyond the PPF illustrate the concept of scarcity. There simply are not enough resources to produce any of these combinations of outputs.

Additionally, while moving along the PPF to increase the production of one good requires that the production of another good be reduced, which also illustrates scarcity.

2.

How does the production possibilities frontier illustrate production efficiency?

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

3.

How does the production possibilities frontier show that every choice involves a tradeoff?

Movements along the PPF frontier illustrate that producing more of one good requires producing less of other good. This observation reflects the result that a tradeoff must be made when producing output efficiently.

4.

How does the production possibilities frontier illustrate opportunity cost?

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

5.

Why is opportunity cost a ratio?

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

6.

Why does the PPF bow outward and what does that imply about the relationship between opportunity cost and the quantity produced?

Some resources are better suited to produce one type of good or service, like pizza. Other resources are better suited to produce other goods or services, like DVDs. If society allocates resources wisely, it will use each resource to produce the kind of output for which it is best suited. Consider a PPF with pizza measured on the x-axis and DVDs measured on the y-axis. A small increase in pizza output when pizza production is relatively low requires only a small increase in the use of those resources still good at making pizza and not good at making DVDs. This yields a small decrease in DVD production for a large increase in pizza production, creating a relatively low opportunity cost reflected in the gentle slope of the PPF over this range of output. However, the same small increase in pizza output when pizza production is relatively large will require society to devote to pizza production those resources that are less © 2018 Pearson Education, Inc.

THE ECONOMIC PROBLEM23

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

Page 39 1.

What is marginal cost? How is it measured?

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

2.

What is marginal benefit? How is it measured?

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

3.

How does the marginal benefit from a good change as the quantity produced of that good increases?

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

4.

What is allocative efficiency and how does it relate to the production possibilities frontier?

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

5.

What conditions must be satisfied if resources are used efficiently?

Resources are used efficiently when more of one good or service cannot be produced without producing less of some of another good or © 2018 Pearson Education, Inc.

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service that is valued more highly. This is known as allocative efficiency and it occurs when: 1) production efficiency is achieved, and 2) the marginal benefit received from the last unit produced is equal to the marginal cost of producing the last unit.

Page 44 1.

What gives a person a comparative advantage?

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

2.

Distinguish between comparative advantage and absolute advantage.

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

Absolute advantage is a measure of productivity in using inputs.

3.

Why do people specialize and trade?

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

4.

What are the gains from specialization and trade?

From society’s standpoint, the total output of goods and services available for consumption is greater with specialization and trade.

From an individual’s perspective, each person who specializes enjoys being able to consume a larger bundle of goods and services after trading with others who have also specialized, than would otherwise be possible under self-sufficiency. These increases are the gains from specialization and trade for society and for individuals.

5.

What is the source of the gains from trade?

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

6.

Why does specialization and the gains from trade make the economy’s PPF outward bowed?

Specialization and the gains from trade make the economy’s PPF bow outward because the resources that have the comparative advantage in producing a good or service are the first to be utilized to produce © 2018 Pearson Education, Inc.

THE ECONOMIC PROBLEM25

that good or service. Consequently when the good or service is first produced, its opportunity cost—the amount of the other good or service forgone—is small and so the PPF is relatively flat.

Ultimately, when so much of the good or service is produced such that resources without a comparative advantage in it must be utilized, the opportunity cost becomes larger so that the PPF becomes steeper. When the PPF starts out flatter and becomes steeper, it bows outward.

7.

Why is not specializing and reaping the gains from trade inefficient?

By not specializing and trading, some suppliers are not producing the good in which they have a comparative advantage. Consequently production occurs inside the PPF at a production inefficient point.

All of the economy’s resources might be employed but they are misallocated.

Page 47 1.

What generates economic growth?

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

2.

How does economic growth influence the production possibilities frontier?

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

3.

What is the opportunity cost of economic growth?

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

4.

Explain why Hong Kong has experienced faster economic growth than the United States.

Hong Kong chose to devote a greater proportion of its available resources to the production of capital than the United States. This allowed Hong Kong to grow at a faster rate than the United States.

By foregoing consumption and producing a greater proportion of capital goods over the last few decades, Hong Kong was able to achieve output per person equal to 94 percent of that in the United States.

5.

Does economic growth overcome scarcity?

Scarcity reflects the inability to satisfy all our wants. Regardless of the amount of economic growth, scarcity will remain present because it will never be possible to satisfy all our wants. For © 2018 Pearson Education, Inc.

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instance it will never be possible to satisfy all the wants of the several thousand people who all would like to ski the best slopes on Vail with only their family and a few best friends present. So economic growth allows more wants to be satisfied but it does not eliminate scarcity.

6.

How does economic growth change the patterns of production?

In low-income nations a large fraction of production is agriculture with distinctly less devoted to industry. For example, in Ethiopia agriculture accounts for 36 percent of production and industry for 17 percent. As the nation grows to middle income, investment in capital and new technology leads to an increase in the fraction of production that is industrial and a decrease in the fraction that is agricultural. For example, in China 9 percent of production is agriculture and 41 percent is industry. Finally, in high-income nations, services becomes an increasingly large proportion of production. In the United States, for example, services account for 80 percent of production while industry and agriculture together account for 20 percent of production.

7.

Why does economic growth destroy and create jobs?

Economic growth leads to changes in the pattern of production—some sectors and products increase while others decrease. In the areas that increase in size, new jobs are created while in those that decrease, jobs are destroyed. Often workers who lose their jobs in the declining sectors need to acquire new skills for the new jobs and/or uproot their life to move to a new location. Some unemployed workers are unwilling to incur these costs and, as a result, remain unemployed, leading the economy to produce at a point inside its PPF.

Page 49 1.

Why are social institutions such as firms, markets, property rights, and money necessary?

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

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THE ECONOMIC PROBLEM27

property rights to have confidence that their commitments to trade arrangements will be respected by everyone in the market.

2.

What are the main functions of markets?

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

3.

What are the flows in the market economy that go from firms to households and the flows from households to firms?

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

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Answers to the Study Plan Problems and Applications Use the following data to work Problems 1 to 3.

Brazil produces ethanol from sugar, and the land used to grow sugar can be used to grow food crops. The table to the right sets out Brazil’s production possibilities for ethanol and food crops.

1. a. Draw a graph of Brazil’s PPF and explain how your graph illustrates scarcity.

Figure 2.1 shows Brazil’s PPF. The production possibilities frontier indicates scarcity because it shows the limits to what can be produced. In particular, production combinations of ethanol and food crops that lie outside the production possibilities frontier are not attainable.

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

and and and and and and

b. If Brazil produces 40 barrels of ethanol a day, how much food must it produce to achieve production efficiency?

If Brazil produces 40 barrels of ethanol per day, it achieves production efficiency if it also produces 3 tons of food per day.

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

2. a. If Brazil increases ethanol production from 40 barrels per day to 54 barrels per day, what is the opportunity cost of the additional ethanol?

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

b. If Brazil increases food production from 2 tons per day to 3 tons per day, what is the opportunity cost of the additional food?

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

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

THE ECONOMIC PROBLEM29

c. What is the relationship between your answers to parts (a) and (b)?

The opportunity costs of an additional barrel of ethanol and the opportunity cost of an additional ton of food crop are reciprocals of each other. That is, the opportunity cost of 1 ton of food crops is 14 barrels of ethanol and the opportunity cost of 1 barrel of ethanol is 1/14 of a ton of food crops.

3.

Does Brazil face an increasing opportunity cost of ethanol? What feature of Brazil’s PPF illustrates increasing opportunity cost?

Brazil faces an increasing opportunity cost of ethanol production.

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

Use the above table (for Problems 1 to 3) to work Problems 4 and 5.

4.

Define marginal cost and calculate Brazil’s marginal cost of producing a ton of food when the quantity produced is 2.5 tons per day.

The marginal cost of a good is the opportunity cost of producing one more unit of the good. When the quantity of food produced is 2.5 tons, the marginal cost of a ton of food is the opportunity cost of increasing the production of food from 2 tons per day to 3 tons per day. The production of ethanol falls from 54 barrels per day to 40 barrels per day, a decrease of 14 barrels per day. The opportunity cost of increasing food production is the decrease in ethanol product, so the opportunity cost of producing a ton of food when 2.5 tons of food per day are produced is 14 barrels of ethanol per day.

5.

Define marginal benefit. Explain how it is measured and why the data in the table does not enable you to calculate Brazil’s marginal benefit from food.

The marginal benefit of a good is the benefit received from consuming one more unit of the good. The marginal benefit of a good or service is measured by the most people are willing to pay for one more unit of it. The data in the table do not provide information on how much people are willing to pay for an additional unit of food.

The table has no information on the marginal benefit of food.

6.

Distinguish between production efficiency and allocative efficiency. Explain why many production possibilities achieve production efficiency but only one achieves allocative efficiency.

Production efficiency occurs when goods and services are produced at the lowest cost. This definition means that production efficiency occurs at any point on the PPF. Therefore all of the production points on the PPF are production efficient. Allocative efficiency occurs when goods and services are produced at the lowest cost and in the quantities that provide the greatest possible benefit. The allocatively efficient production point is the single point on the PPF that has the greatest possible benefit.

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In an hour, Sue can produce 40 caps or 4 jackets and Tessa can produce 80 caps or 4 jackets. a. Calculate Sue’s opportunity cost of producing a cap.

Sue forgoes 4 jackets to produce 40 caps, so Sue’s opportunity cost of producing one cap is (4 jackets)/(40 caps) or 0.1 jacket per cap.

b. Calculate Tessa’s opportunity cost of producing a cap.

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

c. Who has a comparative advantage in producing caps?

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

d. If Sue and Tessa specialize in producing the good in which they have a comparative advantage, and they trade 1 jacket for 15 caps, who gains from the specialization and trade?

Tessa specializes in caps and Sue specializes in jackets. Both Sue and Tessa gain from trade. Sue gains because she can obtain caps from Tessa at a cost of (1 jacket)/(15 caps), which is 0.067 jacket per cap, a cost that is lower than what it would cost her to produce caps herself. Tessa also gains from trade because she trades caps for jackets for 0.067 jacket per cap, which is higher than her cost of producing a cap.

8.

Suppose that Tessa buys a new machine for making jackets that enables her to make 20 jackets an hour. (She can still make only 80 caps per hour.) a. Who now has a comparative advantage in producing jackets?

Sue forgoes 40 caps to produce 4 jackets, so Sue’s opportunity cost of producing one jacket is (40 caps)/(4 jackets) or 10 caps per jacket. Tessa forgoes 80 caps to produce 20 jackets, so Tessa’s opportunity cost of producing one jacket is (80 caps)/(20 jackets) or 4 caps per jacket. Tessa has the comparative advantage in producing jackets because her opportunity cost of a jacket is lower than Sue’s opportunity cost.

b. Can Sue and Tessa still gain from trade?

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

c. Would Sue and Tessa still be willing to trade 1 jacket for 15 caps? Explain your answer.

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

9.

A farm grows wheat and produces pork. The marginal cost of producing each of these products increases as more of it is produced.

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THE ECONOMIC PROBLEM31

a. Make a graph that illustrates the farm’s PPF. The PPF is illustrated in Figure 2.2 as PPF0. Because the marginal cost of both wheat and pork increase as more of the good is produced, the PPF displays increasing opportunity cost so it has the ―conventional‖ bowedoutward shape.

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

c. With the farm using the new technology in part (b), has the opportunity cost of producing a ton of wheat changed? Explain and illustrate your answer.

The opportunity cost of producing wheat has increased. The opportunity cost of a bushel of wheat is equal to the magnitude of 1/(slope of the PPF). As illustrated in Figure 2.2, for each quantity of wheat the slope of PPF1 has a smaller magnitude than the slope of PPF0 so the opportunity cost of a bushel of wheat is higher along PPF1. For a specific example, the opportunity cost of increasing wheat product from 600 bushels per week to 800 bushels per week along PPF1 is 6,000 pounds of pork but is only 3,000 pounds of pork along PPF0.

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

10.

For 50 years, Cuba has had a centrally planned economy in which the government makes the big decisions on how resources will be allocated. a. Why would you expect Cuba’s production possibilities (per person) to be smaller than those of the United States?

Cuba’s economy is almost surely less efficient than the U.S. economy. The Cuban central planners do not know people’s production possibilities or their preferences. The plans that are created wind up wasting resources and/or producing goods and services that no one wants. Because firms in Cuba are owned by the government rather than individuals, no one in Cuba has the self-interested incentive to operate the firm efficiently and produce goods and services that consumers desire. Additionally Cuba does not actively trade so Cuba produces most of its consumption goods rather than buying them from nations with a comparative advantage. Because Cuba uses its © 2018 Pearson Education, Inc.

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resources to produce consumption goods, it cannot produce many capital goods so its economic growth rate has been low.

b. What are the social institutions that Cuba might lack that help the United States to achieve allocative efficiency?

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

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THE ECONOMIC PROBLEM33

Answers to Additional Problems and Applications Use the table to work Problems 11 and 12.

Yucatan’s production possibilities are given 11. a. Draw a graph of Yucatan’s PPF and your graph illustrates a tradeoff.

Yucatan’s PPF is in Figure 2.3. The figure a tradeoff because moving Yucatan’s PPF producing

Food (pounds per month) 300 200 100 0

and and and and

Sunscreen (gallons per month) 0 50 100 150

Suppose that in the table. explain how illustrated illustrates along more of one

good requires producing less of the other good. Yucatan trades off more production of one good for less production of the other.

b. If Yucatan produces 150 pounds of food per month, how much sunscreen must it produce if it achieves production efficiency?

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

c. What is Yucatan’s opportunity cost of producing (i) 1 pound of food and (ii) 1 gallon of sunscreen?

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

Yucatan’s PPF is linear so the opportunity cost of producing 1 gallon of sunscreen is the same at all quantities. Calculate the opportunity cost of producing 1 gallon of sunscreen when increasing the production of sunscreen from 0 to 50 gallons per month. Between these two ranges of production, the quantity of food produced falls from 300 pounds per month to 200 pounds per month, a decrease of 100 pounds. The opportunity cost is 100 pounds of food to gain 50 gallons of sunscreen, or (100 pounds of food)/(50 gallons of sunscreen) which yields an opportunity cost of 2.0 pounds of food per gallon of sunscreen. © 2018 Pearson Education, Inc.

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e. What is the relationship between your answers to part (c)?

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

12.

What feature of a PPF illustrates increasing opportunity cost? Explain why Yucatan’s opportunity cost does or does not increase.

If opportunity costs increase, the PPF bows outward. Yucatan’s PPF is linear and along a linear PPF the opportunity cost is constant.

Yucatan does not face an increasing opportunity cost of food because the opportunity cost remains constant, equal to 0.5 gallons of sunscreen per pound of food. Yucatan’s resources must be equally productive in both activities.

13.

In problem 11, what is the marginal cost of 1 pound of food in Yucatan when the quantity produced is 150 pounds per day? What is special about the marginal cost of food in Yucatan?

The marginal cost of a pound of food in Yucatan is constant at all points along Yucatan’s PPF and is equal to 0.5 gallons of sunscreen per pound of food. The special point about Yucatan’s marginal cost is the fact that the marginal cost is constant. This result reflects Yucatan’s linear PPF.

14.

The table describes the preferences in Yucatan. a. What is the marginal benefit from sunscreen and how is it measured?

The marginal benefit from sunscreen is the benefit enjoyed by the person who consumes one more gallon of sunscreen. It is equal to the willingness to pay for an additional gallon. For example, in the table when 75 gallons of sunscreen are produced, the marginal benefit of a gallon is 2 pounds of food per gallon.

Sunscreen (gallons per month) 25 75 125

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

b. Use the table in Problem 11. What does Yucatan produce to achieve allocative efficiency?

To achieve allocative efficiency, the marginal benefit of a gallon of sunscreen must equal the marginal cost of a gallon of sunscreen.

Yucatan’s marginal cost of a gallon of sunscreen is 2 pounds of food per gallon. When Yucatan produces 75 gallons of sunscreen, the table shows that Yucatan’s marginal benefit is 2 pounds of food per gallon. Therefore allocative efficiency is achieved when 75 gallons of sunscreen and, from the PPF, 150 pounds of food are produced.

15.

Macy’s, Kmart, JCPenney: More Retailers Closing Brick-and-Mortar Stores As more people choose online shopping over brick-and-mortar stores, Macy’s, Kmart, JCPenney and others are closing stores.

Source: Springfield News-Sun, March 24, 2017 a. Draw the PPF curves for brick-and mortar retailers and online retailers before and after the Internet became available.

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Before there was an Internet, there were no online retailers and the production possibilities frontier was PPF0 in Figure 2.4, the flat line along the x-axis.

The only sales of retail goods were from brick-and-mortar retailers. After the Internet was developed, online retailers were created and started to sell goods and services. The Internet is a technological advance that changed the production possibilities frontier to PPF1 in Figure 2.4.

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b. Draw the marginal cost and marginal benefit curves for brick-and-mortar retailers and online retailers before and after the Internet became available.

The marginal benefit for the goods is the same regardless of whether they came from an online store or a brick-and-mortar store. Therefore in Figure 2.5 the marginal benefit curve for retail goods is MB. The marginal cost of brick-and-mortar stores increases as the quantity increases, so both pre-and postInternet, the brick-and-mortar marginal cost curve is MCB&M. Before the Internet, no online retailing could occur so the marginal cost curve is the vertical marginal cost curve MCPRE-INT running along the y-axis.

After the Internet was developed online retailers have a lower marginal cost than do brick-and-mortar retailers, so the marginal cost curve of online retailers is MCPOST-INT.

c. Explain how changes in production possibilities, preferences, or both have changed the way in which goods are retailed.

The change in production possibilities, which created lower-cost online retailers, have changed the way retail goods are purchased.

The expansion of the production possibilities did not change people’s preferences, so the marginal benefit does not change. But, with the lower cost of retailing, the quantity of retailing increases. Because the marginal cost of these goods is less using an online retailer, today consumers are purchasing increasingly larger amounts online. Consequently brick-and-mortar retailers are shrinking and disappearing as they go bankrupt.

Use the following news clip to work Problems 16 and 17.

Gates Doubles Down on Malaria Eradication The End Malaria Council, convened by Bill Gates and Ray Chambers, seeks to mobilize resources to prevent and treat malaria. The current level of financing is too low to end malaria. Bruno Moonen, deputy director for malaria at the Gates Foundation, says that more resources, more leadership, and new technologies are needed to eradicate malaria in the current generation.

Source: Catherine Cheney, Devex, January 20, 2017, 16.

Is Bruno Moonen talking about production efficiency or allocative efficiency or both?

Mr. Moonen is talking about allocative efficiency and production efficiency. The allocatively efficient quantity occurs when marginal cost equals marginal benefit. Mr. Moonen’s assessment is that from the current allocatively efficient quantity of malaria eradication more resources need to be devoted to malaria eradication if it is to © 2018 Pearson Education, Inc.

THE ECONOMIC PROBLEM37

be eliminated in the current generation. He suggests that production possibilities need to be increased by developing new technologies for fighting malaria. Once these technologies are developed, the production possibilities frontier and the production efficient points will shift outward. The new technologies will lower the cost of malaria eradication and thereby increase the allocatively efficient quantity of malaria eradication.

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17.

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Make a graph with the percentage of malaria cases eliminated on the x-axis and the marginal cost and marginal benefit of driving down malaria cases on the y-axis. On your graph, (i) Draw a marginal cost curve and marginal benefit curve that are consistent with Bruno Moonen’s opinion. (ii) Identify the quantity of malaria eradicated that achieves allocative efficiency.

Figure 2.6 shows a marginal cost curve and a marginal benefit curve that are consistent with Mr. Moonen’s views. According to Mr. Moonen, the current allocatively efficient quantity of malaria eradicated will not eliminate 100 percent of malaria in the current generation. In the figure, the allocatively efficient quantity is 60 percent of malaria cases eliminated because this is the quantity at which the marginal benefit equals the marginal cost.

Use the following data to work Problems 18 and 19.

Kim can produce 40 pies or 400 cakes an hour. Liam can produce 100 pies or 200 cakes an hour.

18. a. Calculate Kim’s opportunity cost of a pie and Liam’s opportunity cost of a pie.

If Kim spends an hour baking pies, she gains 40 pies but forgoes 400 cakes. Kim’s opportunity cost of 1 pie is (400 cakes)/(40 pies), or 10 cakes per pie. If Liam spends an hour baking pies, he gains 100 pies but forgoes 200 cakes. Liam’s opportunity cost of 1 pie is (200 cakes)/(100 pies), or 2 cakes per pie.

b. If each spends 30 minutes of each hour producing pies and 30 minutes producing cakes, how many pies and cakes does each produce?

Kim produces 20 pies and 200 cakes. Liam produces 50 pies and 100 cakes. The total number produced is 70 pies and 300 cakes.

c. Who has a comparative advantage in producing (i) pies and (ii) cakes?

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

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19. a

Draw a graph of Kim’s PPF and Liam’s PPF and show the point at which each produces when they spend 30 minutes of each hour producing pies and 30 minutes producing cakes.

Kim’s PPF is illustrated in Figure 2.7; Liam’s PPF is illustrated in Figure 2.8.

Point A in both figures shows their production points when each spends 30 minutes making cakes and 30 minutes making pies.

b. On your graph, show what Kim produces and what Liam produces when they specialize.

Kim will specialize in cakes and Liam will specialize in pies. Point B in both figures shows the production points when each specializes.

c. When they specialize and trade, what are the total gains from trade?

Kim will specialize in cakes and Liam will specialize in pies. If they specialize and trade, the total production of both cakes and pies increase. When each spends 30 minutes making cakes and 30 minutes making pies, together they produce 300 cakes and 70 pies.

When they specialize, together they produce 400 cakes and 100 pies.

The 100 increase in cakes and the 30 increase pies is the gains from trade.

d. If Kim and Liam share the total gains equally, what trade takes place between them?

Kim will trade 50 cakes (half of the gain in cake production) to Liam in exchange for 15 pies (half of the increase in pie production).

Tony’s Production Possibilities Snowboards Skis (units per (units per week) week) 25 and 0 20 and 10 15 and 20

Patty’s Production Possibilities Snowboards Skis (units per (units per week) week) 20 and 0 10 and 5 0 and 10

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10 5 0 20.

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and And And

30 40 50

Tony and Patty produce skis and snowboards. The tables show their production possibilities.

Tony produces 5 snowboards and 40 skis a week; Patty produces 10 snowboards and 5 skis a week. a. Who has a comparative advantage in producing (i) snowboards and (ii) skis? (i) Tony’s opportunity cost of a snowboard is (10 skis)/(5 snowboards), or 2 skis per snowboard. Patty’s opportunity cost of a snowboard is (5 skis)/(10 snowboards), or 0.5 skis per snowboard.

Patty’s opportunity cost of a snowboard is lower than Tony’s opportunity cost, so Patty has the comparative advantage. (ii) Tony’s opportunity cost of a ski is (5 snowboards)/(10 skis), or 0.5 snowboards per ski. Patty’s opportunity cost of a ski is (10 snowboards)/(5 skis), or 2.0 snowboards per ski. Tony’s opportunity cost of a ski is lower than Patty’s opportunity cost, so Tony has the comparative advantage.

b. If Tony and Patty specialize and trade 1 snowboard for 1 ski, what are the gains from trade?

Tony has a comparative advantage in producing skis, so he specializes in producing skis. Patty has a comparative advantage in producing snowboards, so she specializes in snowboards. Tony now produces 50 skis and Patty produces 20 snowboards. Before specializing they produced a total of 45 skis (Tony’s 40 plus Patty’s 5) and 15 snowboards (Tony’s 5 plus Patty’s 10). By specializing, the total production of skis increases by 5 and the total production of snowboards increases by 5. This increase in total production is the gains from trade. By trading 1 ski for 1 snowboard, they can share these gains. Tony obtains snowboards from Patty for less than it costs him to produce them and Patty obtains skis from Tony for less than it costs her to produce them.

21.

Capital accumulation and technological change bring economic growth: Production that was unattainable yesterday becomes attainable today; production that is unattainable today will become attainable tomorrow. Why doesn’t economic growth bring an end to scarcity one day?

Scarcity is always being defeated yet will never suffer defeat.

Scarcity reflects the existence of unmet wants. People’s wants are infinite—regardless of what a person already possesses, everyone can easily visualize something else he or she wants, if only more time in the day to enjoy their possessions. Because people’s wants are insatiable, scarcity will always exist regardless of economic growth.

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22.

SpaceX Plans to Send Two People Around the Moon SpaceX CEO Elon Musk announced that SpaceX has plans to send two private citizens on a one week, 300,000- to 400,000-mile trip around the moon in 2018.

Source: The Verge, February 27, 2017 a. What is the opportunity cost of creating the technology for trips around the moon?

The opportunity cost of creating the technology is the next best alternative forgone by the resources used to develop this technology. For example, the engineers who are working to develop SpaceX’s technology might otherwise be assisting in the production of technology used to more powerful batteries, so the opportunity cost is the more powerful battery.

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b. Sketch SpaceX’s PPF and production point in 2017 and its PPF and planned production in 2018.

Figure 2.9 shows SpaceX’s PPF in 2017 and in 2018. The increase in SpaceX’s technology shifts its PPF outward so that its PPF in 2018 lies beyond its PPF in 2017.

In 2017, a trip around the moon was beyond its PPF but with the technological advance it becomes possible. SpaceX’s production point in 2017 is labeled A, here it devotes all its resources to developing new technology. Its planned production in 2018 is labeled B, where it will produce 1 trip around the moon.

23.

On a graph of the circular flows in the market economy, indicate the real and money flows in which the following items belong: a. You buy an iPad from the Apple Store.

Figure 2.10 shows the circular flows in a market economy. Your purchase of an iPad from Apple is the purchase of a good from a firm. This flow is in the black arrow indicated by point a in the figure. When you pay for the iPad, the corresponding money flow is in the grey arrow in the opposite direction to the black arrow labeled a.

b. Apple Inc. pays the designers of the iPad. Apple’s payment to the designers of the iPad is the payment of a wage to a factor of production.

This flow is in the grey arrow indicated by point b in the figure.

The flow of design services from the designer to Apple is in the black arrow in the opposite direction to the grey arrow labeled b.

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THE ECONOMIC PROBLEM43

c. Apple Inc. decides to expand and rents an adjacent building.

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

d. You buy a new e-book from Amazon.

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

e. Apple Inc. hires a student to work as an intern.

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

Economics in the News 24.

After you have studied Reading Between the Lines on pp. 50–51, answer the following questions. a. How have robots changed the U.S. production possibilities?

Robots have increased the U.S. production possibilities and shifted the U.S PPF outward.

b. How have advances in technologies for producing services changed the U.S. production possibilities?

Advances in technologies for producing services have also increased U.S. production possibilities.

c. If robots had been the only technological advance, how would the PPF have changed?

If robots had been the only technological advance, the PPF would have rotated outward. The maximum quantity of other goods and services would not have changed but the maximum quantity of goods produced using robots, such as steel, would have increased. For any quantity of other goods and services, more steel could be produced after the introduction of robots.

d. If robots had been the only technological advance, how would the opportunity cost of producing steel have changed? Would it have been lower or higher than it actually was?

If robots had been the only technological advance, the PPF would have rotated so that for any quantity of services the slope of the new PPF would be smaller than the slope of the initial PPF. Consequently, the opportunity cost of producing steel would have decreased. For any quantity of services the opportunity cost of producing steel would be lower after the introduction of robots.

25.

YouTube Launches Live TV in the US Google has launched YouTube TV, a $35-amonth service that carries live streaming from all the major broadcast and sports networks as well as some cable networks and local sports and news © 2018 Pearson Education, Inc.

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channels. Users will be able to record an unlimited amount of content and multiple shows simultaneously, without using up any data space on mobile devices.

Source: Mediatel, March 1, 2017 a. How has live streaming changed the production possibilities of video entertainment and other goods and services?

Live streaming has increased the production possibilities. For any quantity of other goods and services, now more video entertainment can be produced. The production possibilities frontier has changed so that the maximum quantity of video entertainment has increased but the maximum quantity of other goods and services has not changed.

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b. Sketch a PPF for video entertainment and other goods and services before live streaming.

The PPF should have video entertainment on one axis and other goods and services on the other as illustrated in Figure 2.11. The PPF is bowed outward as a conventional PPF.

c. Show how the arrival of inexpensive live streaming has changed the PPF. The arrival of inexpensive live streaming shifts the PPF outward as shown by the change from PPF0 to PPF1 in Figure 2.11. The intersection of the new PPF along the axis measuring video entertainment increases and the intersection of the new PPF along the axis measuring other goods and services does not change.

d. Sketch a marginal benefit curve and marginal cost curve for video entertainment before and after live streaming.

In Figure 2.12, the marginal benefit and marginal cost from video entertainment is measured along the vertical axis and the quantity of video entertainment is measured along the horizontal axis. As the figure shows, the marginal benefit curve is a conventional downward-sloping marginal benefit curve and the marginal cost curve is a conventional upward-sloping marginal cost curve. The introduction of low cost live streaming does not change the marginal benefit curve—it remains MB. But it lowers the marginal cost and shifts the marginal cost curve from MC0 to MC1.

e. Explain how the efficient quantity of video entertainment has changed.

As Figure 2.12 shows, the allocatively efficient quantity of video entertainment increases. In Figure 2.12, the allocatively efficient quantity increases from 4 million units per year to 6 million units per year

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C h a p t e r

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DEMAND AND SUPPLY

Answers to the Review Quizzes Page 60 1.

What is the distinction between a money price and a relative price?

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

2.

Explain why a relative price is an opportunity cost.

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

3.

Think of examples of goods whose relative price has risen or fallen by a large amount.

Some examples of items where both the money price and the relative price have risen over time are gasoline, college tuition, and food.

Some examples of items where both the money price and the relative price have fallen over time are personal computers, HD televisions, and calculators.

Page 65 1.

Define the quantity demanded of a good or service.

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

2.

What is the law of demand and how do we illustrate it?

The law of demand states: ―Other things remaining the same, the higher the price of a good, the smaller is the quantity demanded; and the lower the price of a good, the greater is the quantity demanded.‖ The law of demand is illustrated by a downward-sloping demand curve drawn with the quantity demanded on the horizontal axis and the price on the vertical axis. The slope is negative to show that the higher the price of a good, the smaller is the quantity © 2018 Pearson Education, Inc.

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demanded and the lower the price of a good, the greater is the quantity demanded.

3.

What does the demand curve tell us about the price that consumers are willing to pay?

For any fixed quantity of a good available, the vertical distance of the demand curve from the x-axis shows the maximum price that consumers are willing to pay for that quantity of the good. The price on the demand curve at this quantity indicates the marginal benefit to consumers of the last unit consumed at that quantity.

4.

List all the influences on buying plans that change demand, and for each influence, say whether it increases or decreases demand.

Influences that change the demand for a good include:  The prices of related goods. A rise (fall) in the price of a substitute increases (decreases) the demand for the first good.

A rise (fall) in the price of a complement decreases (increases) the demand for the first good.

5.



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



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



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



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



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

Why does demand not change when the price of a good changes with no change in the other influences on buying plans?

If the price of a good falls and nothing else changes, then the quantity of the good demanded increases and there is a movement down along the demand curve, but the demand for the good remains unchanged and the demand curve does not shift.

Page 69 1.

Define the quantity supplied of a good or service.

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

2.

What is the law of supply and how do we illustrate it?

The law of supply states that ―other things remaining the same, the higher the price of a good, the greater is the quantity supplied; and the lower the price of a good, the smaller is the quantity supplied.‖ The law of supply is illustrated by an upward-sloping supply curve drawn with the quantity supplied on the horizontal axis © 2018 Pearson Education, Inc.

DEMAND AND SUPPLY41

and the price on the vertical axis. The slope is positive to show that the higher the price of a good, the greater is the quantity supplied and the lower the price of a good, the smaller is the quantity supplied.

3.

What does the supply curve tell us about the producer’s minimum supply price?

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

4.

List all the influences on selling plans, and for each influence, say whether it changes supply.

Changes in the price of the good change the quantity supplied. They do not change the supply of the good.

Influences that change the supply of a good include:  Prices of factor of production. A rise (fall) in the price of a factor of production increases firms’ costs of production and decreases (increases) the supply of the good.

5.



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



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



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



Technology. An advance in technology increases the supply.



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

What happens to the quantity of smartphones supplied and the supply of smartphones if the price of a smartphone falls?

If the price of a smartphones falls and nothing else changes, then the quantity of smartphones supplied will decrease and there is a movement down along the supply curve for smartphones. The supply of smartphones, however, remains unchanged and the supply curve does not shift.

Page 71 1.

What is the equilibrium price of a good or service?

The equilibrium price is the price at which the quantity demanded by the buyers is equal to the quantity supplied by the sellers.

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Over what range of prices does a shortage arise? What happens to the price when there is a shortage?

A shortage arises at market prices below the equilibrium price. A shortage causes the price to rise, decreasing quantity demanded and increasing quantity supplied until the equilibrium price is attained.

3.

Over what range of prices does a surplus arise? What happens to the price when there is a surplus?

A surplus arises at market prices above the equilibrium price. A surplus causes the price to fall, decreasing quantity supplied and increasing quantity demanded until the equilibrium price is attained.

4.

Why is the price at which the quantity demanded equals the quantity supplied the equilibrium price?

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

5.

Why is the equilibrium price the best deal available for both buyers and sellers?

The equilibrium price reflects that the highest price consumers are willing to pay for that amount of the good or service and is just equal to the minimum price that suppliers require for delivering it.

Demanders would prefer to pay a lower price, but suppliers are unwilling to supply that quantity at a lower price. Suppliers would prefer a higher price, but demanders are unwilling to pay a higher price for that quantity. Hence neither demanders not suppliers can do business at a better price.

Page 77 What is the effect on the price and quantity of smartphones if 1.

The price of a music-streaming subscription falls or the price of a wireless plan rises? (Draw the diagrams!)

Because a large majority of smartphone owners listen to streaming music on their smartphones (68 percent according to a study published by Digital Music News), streaming music is a complement of a smartphone. A fall in the price of a music-streaming subscription increases the demand for smartphones. The demand curve for smartphones shifts rightward. Supply remains unchanged. The price of a smartphone rises and the quantity increases. Figure 3.8 on page 72 illustrates this sort of change.

A rise in the price of a wireless plan decreases the demand for smartphones because a wireless plan is a complement of a smartphone.

The demand curve for smartphones shifts leftward. Supply remains unchanged. The price of a smartphone falls and the quantity decreases.

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2.

More firms produce smartphones or electronics workers’ wages rise? (Draw the diagrams!)

An increase in the number of firms that produce smartphones increases the supply of smartphones. The supply curve of smartphones shifts rightward. Demand remains unchanged. The price of a smartphone falls and the quantity of smartphones increases. You can illustrate this outcome by drawing a diagram like Figure 3.9 on page 74.

A rise in the wages of electronic workers decreases the supply of smartphones because it increases the cost of producing smartphones.

The supply curve of smartphones shifts leftward. Demand remains unchanged. The price of a smartphone rises and the quantity of smartphones decreases.

3.

Any two of these events in questions 1 and 2 occur together? (Draw the diagrams!)

There are six combinations: (1) If the price of a music streaming service falls and the price of a wireless plan rises, supply is unchanged and demand might increase, decrease, or not change so the outcome cannot be predicted.

(2) If the price of a music streaming service falls and more firms produce smartphones, demand increases and supply increases so the quantity increases and the price might rise, fall, or not change.

(3) If the price of a music-streaming service falls and the wages paid electronic workers rise, demand increases and supply decreases so the price rises and the quantity might increase, decrease, or not change.

(4) If the price of a wireless plan rises and more firms produce smartphones, demand decreases and supply increases so the price falls and quantity might increase, decrease, or remain the same.

(5) If the price of a wireless plan rises and the wages paid electronic workers rise, demand decreases and supply decreases so the quantity decreases and the price might rise, fall, or remain the same.

(6) If more firms produce smartphones and the wages paid electronics workers rise, demand is unchanged and supply might increase or decrease or remain unchanged, so the outcome cannot be predicted.

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Answers to the Study Plan Problems and Applications 1.

In April 2014, the money price of a carton of milk was $2.01 and the money price of gallon of gasoline was $3.63. Calculate the relative price of a gallon of gasoline in terms of milk.

The relative price of a gallon of gasoline in terms of milk equals ($3.63 per gallon of gasoline)/($2.01 per carton of milk) = 1.81 cartons of milk per gallon of gasoline.

2.

The price of food increased during the past year. a. Explain why the law of demand applies to food just as it does to other goods and services.

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

b. Explain how the substitution effect influences food purchases when the price of food rises and other things remain the same.

When the price of food rises, people substitute away from (some) foods and toward other foods and other activities. People substitute cheaper foods for more expensive foods and they also substitute diets for food.

c. Explain how the income effect influences food purchases and provide some examples of the income effect.

Food is a normal good so a rise in the price, which decreases people’s real incomes, decreases the quantity of food demanded. In the United States, restaurants suffer as the negative income effect from a higher price of food leads people to cut back their trips to restaurants. At home, people will buy fewer steaks and instead will buy more noodles. In poor countries (and among the poor in the United States), people literally eat less when the price of food rises and in extremely poor countries starvation increases.

3.

Which of the following goods are likely substitutes and which are likely complements? (You may use an item in more than once.): coal, oil, natural gas, wheat, corn, pasta, pizza, sausage, skateboard, roller blades, video game, laptop, iPad, smartphone, text message, email Substitutes include: coal and oil; coal and natural gas; oil and natural gas; wheat and corn; pasta and pizza; pasta and sausage; pizza and sausage (they type of sausage that cannot be used as a topping on pizza); skateboard and roller blades; skateboard and video game; roller blades and video game; laptop and iPad; and, text message and email.

Complements include: pizza and sausage (the type of sausage that can be used as a topping on pizza); skateboard and iPad; roller blades and iPad; video game (those played on a computer) and laptop; smartphone and text message; and, smartphone and email.

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4.

As the average income in China continues to increase, explain how the following would change: a. The demand for beef Beef is a normal good. The increase in income increases the demand for beef.

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

5.

In 2016, the price of corn fell and some corn farmers will switch from growing corn in 2017 to growing soybeans. a. Does this fact illustrate the law of demand or the law of supply? Explain your answer.

This fact illustrates the law of supply: the lower price of corn decreases the quantity of corn grown.

b. Why would a corn farmer grow soybeans?

Corn and soybeans are substitutes in production and soybeans have become more profitable. A corn farmer would switch to soybeans because the profit from growing soybeans exceeds that from growing corn.

6.

Dairies make low-fat milk from full-cream milk, and in the process they produce cream, which is made into ice cream. The following events occur one at a time: (i) The wage rate of dairy workers rises. (ii) The price of cream rises. (iii) The price of low-fat milk rises. (iv) With a drought forecasted, dairies raise their expected price of low-fat milk next year. (v) New technology lowers the cost of producing ice cream.

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

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The demand and supply schedules for gum are in the table. a. Suppose that the price of gum is 70¢ a pack. Describe the situation in the gum market and explain how the price adjusts.

Price (cents per pack) 20 40 60 80

Quantit Quantity y supplied demande d (millions of packs a week) 180 60 140 100 100 140 60 180

At 70 cents a pack, there is a surplus of gum and the price falls. At 70 cents a pack, the quantity demanded is 80 million packs a week and the quantity supplied is 160 million packs a week. There is a surplus of 80 million packs a week. The price falls until market equilibrium is restored at a price of 50 cents a pack.

b. Suppose that the price of gum is 30¢ a pack. Describe the situation in the gum market and explain how the price adjusts.

At 30 cents a pack, there is a shortage of gum and the price rises.

At 30 cents a pack, the quantity demanded is 160 million packs a week and the quantity supplied is 80 million packs a week. There is a shortage of 80 million packs a week. The price rises until market equilibrium is restored at a price of 50 cents a pack.

8.

The following events occur one at a time: (i) The price of crude oil rises. (ii) The price of a car rises. (iii) All speed limits on highways are abolished. (iv) Robots cut car production costs.

Explain the effect of each of these events on the market for gasoline. (ii) and (iii) and (iv) change the demand for gasoline. The demand for gasoline will change if the price of a car rises, all speed limits on highways are abolished, or robot production cuts the cost of producing a car. If the price of a car rises, the quantity of cars bought decrease and the demand for gasoline decreases. If all speed limits on highways are abolished, people will drive faster and use more gasoline. The demand for gasoline increases. If robot production plants lower the cost of producing a car, the supply of cars will increase. With no change in the demand for cars, the price of a car will fall and more cars will be bought. The demand for gasoline increases. (i) changes the supply of gasoline. The supply of gasoline will change if the price of crude oil (a factor of production used in the production of gasoline) changes. If the price of crude oil rises, the cost of producing gasoline rises and the supply of gasoline decreases.

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9.

In Problem 7, a fire destroys some factories that produce gum and the quantity of gum supplied decreases by 40 million packs a week at each price. a. Explain what happens in the market for gum and draw a graph to illustrate the changes.

As the number of gum-producing factories decreases, the supply of gum decreases. There is a new supply schedule and, in Figure 3.1, the supply curves shifts leftward by 40 million packs at each price to the new supply curve S1. After the fire, the quantity supplied at 50 cents is now only 80 million packs, and there is a shortage of gum. The price rises to 60 cents a pack, at which the new quantity supplied equals the quantity demanded. The new equilibrium price is 60 cents and the new equilibrium quantity is 100 million packs a week.

b. If, at the time as the fire the teenage population increases and the quantity of gum demanded increases 40 million packs a week at each price. What is the new market equilibrium? Show the changes on your graph.

The new price is 70 cents a pack, and the quantity is 120 million packs a week. The demand for gum increases and the demand curve shifts rightward by 40 million packs at each price. Supply decreases by 40 millions packs a week and the supply curve shifts leftward by 40 million packs at each price. These changes are shown in Figure 3.2 by the shift of the demand curve from D to D1 and the shift of the supply curve from S to S1. At any price below 70 cents a pack there is a shortage of gum. The price of gum rises until the shortage is eliminated.

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10.

CHAPTER 3

Singing the Blues: March Frost Destroys State Blueberry Crop Chris and Rhonda Luther had big plans for their small blueberry farm, but freezing temperatures killed these plans, reducing their usual output by about 95 percent. The Georgia Department of Agriculture estimates the freeze to have cut production 80 percent.

Source: Red and Black, March 25, 2017 Make a graph to illustrate the market for blueberries before and after the unusually cold March weather.

Figure 3.3 shows the effect of the freezing temperatures on the blueberry market. The demand curve is labeled D. The freeze did not affect the demand for blueberries, so the demand curve does not shift. The freeze was a bad state of nature and decreased the supply of blueberries, shifting the supply curve leftward. The supply curve labeled S0 reflects the supply before the freeze and the supply curve labeled S1 shows the supply after the freeze. The equilibrium price of a pound of blueberries rises from $0.60 per pound to $2.40 per pound and the equilibrium quantity decreases from 5 million pounds of blueberries 1 million pounds.

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Answers to Additional Problems and Applications 11.

What features of the world market for crude oil make it a competitive market?

The world oil market is a competitive market because there are a large number of sellers and a large number of buyers. There are so many sellers and so many buyers that no individual seller or individual buyer can influence the price of oil.

12.

The money price of a textbook is $90 and the money price of the Wii game Super Mario Galaxy is $45. a. What is the opportunity cost of a textbook in terms of the Wii game?

A textbook costs $90 and a Wii game costs $45. Purchasing 1 textbook forces the buyer to give up 2 Wii games. So the opportunity cost of a textbook in terms of Wii games is 2 Wii games per textbook.

b. What is the relative price of the Wii game in terms of textbooks?

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

13.

The price of gasoline has increased during the past year. a. Explain why the law of demand applies to gasoline just as it does to all other goods and services.

When the price of gasoline rises, people decrease the quantity of gasoline they demand. Both the substitution effect and the income effect lead consumers to decrease the quantity of gasoline demanded.

b. Explain how the substitution effect influences gasoline purchases and provide some examples of substitutions that people might make when the price of gasoline rises and other things remain the same.

When the price of gasoline rises, people substitute other goods and services for gasoline. For instance, people substitute public transport (such as buses), carpools, motorcycles, walking, and bicycles for driving alone in a car to work.

c. Explain how the income effect influences gasoline purchases and provide some examples of the income effects that might occur when the price of gasoline rises and other things remain the same.

When the price of gasoline rises, people’s real incomes fall. People respond by decreasing their demand for normal goods, such as gasoline. In the gasoline market, some people trade in large, fuel guzzling cars because they can no longer afford to fuel the large vehicle. Others will not purchase a car or truck because they are not able to afford the gasoline necessary to use it.

14.

Think about the demand for the three game consoles: Xbox One, PlayStation 4, and Wii U. Explain the effect of the following events on the demand for Xbox One games and the quantity of Xbox One games demanded, other things remaining the same. The events are: a. The price of an Xbox One falls.

An Xbox One and an Xbox One game are complements. When the price of an Xbox One falls, consumers respond by increasing the quantity of Xbox Ones demanded so the equilibrium quantity of Xbox Ones

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increases. Consumers increase their demand for Xbox one games because an Xbox One console is useless without Xbox One games.

b. The prices of a PlayStation 4 and a Wii U fall.

A PlayStation 4 and a Wii U are substitutes for an Xbox One. When these game consoles fall in price, the demand for Xbox One consoles decreases and so the equilibrium quantity of Xbox Ones decreases.

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

c. The number of people writing and producing Xbox One games increases.

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

d. Consumers’ incomes increase.

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

e. Programmers who write code for Xbox One games become more costly to hire.

The increase in the cost of programmers decreases the supply of Xbox One games. When the supply of a good or service decreases, the price of that good or service rises. Xbox One games are not an exception, so the price of an Xbox One game rises. The rise in the price of an Xbox One game decreases the quantity of Xbox One games demanded.

f.

The expected future price of an Xbox One game falls.

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

g. A new game console that is a close substitute for Xbox One comes onto the market.

The new game console decreases the demand for Xbox One consoles. As a result, the equilibrium quantity of Xbox One consoles decreases.

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

15.

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

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

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

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

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

16.

When a timber mill makes logs from trees it also produces sawdust, which is used to make plywood. a. Explain how a rise in the price of sawdust influences the supply of logs.

The rise in the price of sawdust motivates timber mills to make more sawdust, which thereby increases the demand for logs and raises the price of logs. There is no change in the supply of logs but instead a change in the quantity of logs supplied.

b. Explain how a rise in the price of sawdust influences the supply of plywood.

The rise in the price of sawdust motivates timber mills to make more sawdust, which thereby increases the supply of plywood.

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17.

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New Maple Syrup Sap Method With the new way to tap maple trees, farmers could produce 10 times as much maple syrup per acre.

Source: cbc.ca, February 5, 2014 Will the new method change the supply of maple syrup or the quantity supplied of maple syrup, other things remaining the same. Explain.

The new technology increases the supply of maple syrup. At each price, the new technology increases the quantity that will be supplied. The supply curve shifts rightward.

Use Figure 3.4 to work Problems 18 and 19.

18. a. Label the curves. Which curve shows the willingness to pay for a pizza?

The demand curve is the downward sloping curve and the supply curve is the upward sloping curve. The demand curve shows the willingness to pay for a pizza.

b. If the price of a pizza is $16, is there a shortage or a surplus and does the price rise or fall?

If the price of a pizza is $16, there is a surplus of pizza; the quantity supplied of pizzas exceeds the quantity demanded.

The surplus forces the price lower to the equilibrium price of $14 a pizza.

c. Sellers want to receive the highest possible price, so why would they be willing to accept less than $16 a pizza?

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

19. a. If the price of a pizza is $12, is there a shortage or a surplus and does the price rise or fall?

If the price of a pizza is $12, there is a shortage of pizza; the quantity demanded of pizzas exceeds the quantity supplied. The shortage forces the price higher to the equilibrium price of $14 a pizza.

b. Buyers want to pay the lowest possible price, so why would they be willing to pay more than $12 for a pizza?

If the price of a pizza is $12 the shortage means that not all buyers can buy a pizza. From their perspective they would rather pay more than $12 and be able to purchase a pizza than to keep the price at $12 and leave them without a pizza.

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

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Quantit Quantity y supplied demande d (millions of bags a week) 160 130 150 140 140 150 130 160 120 170 110 180

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

Figure 3.5 draws the supply and demand curves for this market. The equilibrium price is 65¢ a bag, and the equilibrium quantity is 145 million bags a week.

b. If the price is 60¢ a bag, is there a shortage or a surplus, and how does the price adjust?

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

21.

In Problem 20, a new dip increases the quantity of potato chips that people want to buy by 30 million bags per week at each price. a. Does the demand for chips change? Does the supply of chips change? Describe the change.

As the new dip comes onto the market, the demand for potato chips increases. Supply does not change. The demand curves shifts rightward.

b. How do the equilibrium price and equilibrium quantity of chips change?

Demand increases by 30 million bags a week. The demand curve shifts rightward as shown in Figure 3.6 by the shift from D to D1. The quantity demanded at each price increases by 30 million bags. The quantity demanded at 65¢ is now 175 million bags a week of potato chips. The price rises to 80¢ a bag, at which the quantity supplied equals the quantity demanded (160 million bags a week). The new equilibrium price is 80¢ per bag and the new equilibrium quantity is 160 million bags.

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22.

In Problem 20, if a virus destroys potato crops and the quantity of potato chips produced decreases by 40 million bags a week at each price, how does the supply of chips change?

The supply of potato chips decreases, and the supply curve shifts leftward by 40 million bags. The price rises to 85¢ a bag and the quantity decreases to 125 million bags a week.

23.

If the virus in Problem 22 hits just as the new dip in Problem 21 comes onto the market, how do the equilibrium price and equilibrium quantity of chips change?

The result by itself of the new dip entering the market is a price of 80¢ a bag and a quantity of 160 million bags. But now with the virus affecting the market, at this price there is a shortage of potato chips. The price of potato chips rises until the shortage is eliminated. The new equilibrium price is 100¢ a bag, and the new equilibrium quantity is 140 million bags a week.

24.

U.S. Craft Beer Bolsters U.K. Hop Production U.K. hop farmers stepped up production in response to a rapid growth of U.S. craft beer production. U.S. craft beer makers prefer the subtle taste of U.K. hop varieties.

Source: BBC, October 3, 2014 a. Describe the changes in the market for U.S. craft beer.

In the United States, the ―rapid growth of U.S. craft beer production‖ indicates that the supply of craft beers has increased, shifting the supply curve rightward. The increased supply results in a movement along the demand curve for beer so that there is an increase in the quantity demanded of U.S.-brewed craft beer.

b. Explain whether the increase in U.K. hop production is a change in supply or a change in the quantity supplied.

The increased demand for U.K. hops means that the demand curve for U.K. hops shifts rightward. There is a movement up along the U.K. hop supply curve, so there is a change in the quantity supplied.

c. What could be the impact on the price of U.K. hops if U.S. farmers switched to U.K. hop varieties.

If U.S. farmers switched to producing U.K. hop varieties and U.S. craft brewers switch from buying U.K.-produced hops to buying U.K. hop varieties produced in the United States, then the demand for U.K.-produced hops decreases so that the demand curve for U.K. produced hops shifts leftward. The price of U.K. produced hops falls.

25.

Vietnamese Farmers Switch to Pepper as Coffee Prices Fall The high pepper price and falling coffee price have made Vietnamese farmers replace coffee plants with pepper plants. Analysts fear farmers have used diseased pepper plants which could fail.

Source: VietNam News, May 28, 2016 a. Explain how the market for Vietnamese coffee will change as farmers switch to pepper.

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b. If pepper plants fail, what would happen to the price of pepper?

If the pepper plants fail, the supply of pepper decreases. The decrease in the supply of pepper results in the price of pepper rising and the quantity decreasing.

26.

Watch Out for Rising Dry-Cleaning Bills In the past year, the price of dry-cleaning solvent doubled. More than 4,000 dry cleaners across the United States disappeared as budget-conscious consumers cut back. This year the price of hangers used by dry cleaners is expected to double.

Source: CNN Money, June 4, 2012 a. Explain the effect of rising solvent prices on the market for dry cleaning.

Solvents are used to produce dry cleaning, so a rise in the price of solvents increases the cost of dry cleaning. The increase in the cost of dry cleaning decreases the supply of dry cleaning and the supply curve of dry cleaning shifts leftward. The demand for dry cleaning does not change. By itself, the decrease in the supply raises the equilibrium price of dry cleaning and decreases the equilibrium quantity of dry cleaning.

b. Explain the effect of consumers becoming more budget conscious along with the rising price of solvent on the price of dry cleaning.

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

c. If the price of hangers does rise this year, do you expect additional dry cleaners to disappear?

Explain why or why not.

The increase in the price of hangers raises the costs of dry cleaners but the cost increase is much smaller than the cost increase that resulted from the doubling of the price of drycleaning solvent. Therefore the decrease in supply is smaller, which means that the decrease in the equilibrium quantity of dry cleaning also is smaller. If the small decrease in the equilibrium quantity leads some additional dry cleaners to close, the number will be small.

Economics in the News 27.

After you have studied Economics in the news on pp. 78–79, answer the following questions: a. Would you classify frozen concentrated orange juice as a normal good or an inferior good?

Why? Frozen concentrated orange juice is an inferior good if, as incomes increase the demand for orange juice decreases. The article notes that as incomes have increased, the demand for frozen concentrated orange juice has decreased, which indicates it is an inferior good.

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b. What would wiped out

C h a p t e r

happen to the price of orange juice if citrus greening the Florida orange crop?

If citrus greening wiped out the Florida orange crop, the price of oranges rises. Oranges are an input into making orange juice, so a rise in their price represents an increase in the cost of making orange juice. Consequently the supply of orange juice would decrease. The decrease in supply raises the price of orange juice.

c. What are some of the substitutes for orange juice and what would happen to the demand, supply, price, and quantity in the markets for each of these items if citrus greening became more severe?

Substitutes for orange juice include other beverages, such as tropical smoothies and energy drinks. If citrus greening becomes more severe, the price of orange juice will rise. The rise in the price of orange juice will lead to consumers switching away from orange juice to its substitutes, so the demand for the substitute beverages will increase. The supply will not change so the price and quantity of the substitute beverages will increase.

d. What are some of the complements of orange juice and what would happen to the demand, supply, price, and quantity in the markets for each of these items if citrus greening became more severe?

Complements for orange juice include other ―classic‖ breakfast foods, such eggs and bacon. If citrus greening becomes more severe, the price of orange juice will rise. The rise in the price of orange juice decreases the demand for its complements. The supply will not change, so the price and quantity of the complements will decrease.

4

*

MEASURING GDP AND ECONOMIC GROWTH**

* This is Chapter 21 in Economics. © 2018 Pearson Education, Inc.

SOLUTION MANUAL FOR MACROECONOMICS, 13TH EDITION MICHAEL PARKIN

Answers to the Review Quizzes Page 90 1.

(page 498 in Economics)

Define GDP and distinguish between a final good and an intermediate good. Provide examples.

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

2.

Why does GDP equal aggregate income and also equal aggregate expenditure?

GDP equals aggregate income because one way to value production is by the cost of the factors of production employed. The cost of the factors production employed—wages, interest, rent, and profit—equal aggregate income and therefore aggregate income equals GDP. GDP equals aggregate expenditure because another way to value production is by the price that buyers pay for the production in the market.

Aggregate expenditure equals the sum of consumption expenditure, investment, government expenditure, and exports minus imports, which is the total amount spent buying the production in the market.

Therefore GDP equals aggregate expenditure.

3.

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

Page 93 1.

(page 501 in Economics)

What is the expenditure approach to measuring GDP? The expenditure approach measures GDP by focusing on aggregate expenditures. Data are collected on the different components of aggregate expenditure and then summed. Specifically, the Bureau of Economic Analysis collects data on consumption expenditure, C, © 2018 Pearson Education, Inc.

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investment, I, government expenditure on goods and services, G, and net exports, X − M. These expenditures are valued at the prices paid for the goods and services, called the market price. GDP is then calculated as C + I + G + X − M.

2.

What is the income approach to measuring GDP? The income approach measures GDP by focusing on aggregate income.

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

3.

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

4.

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

5.

How is real GDP calculated?

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

Page 99 1.

(page 507 in Economics)

Distinguish between real GDP and potential GDP and describe how each grows over time.

Real GDP is the value of final goods and services produced in a given year when valued at the prices of a reference base year.

Potential GDP is the maximum amount of real GDP that can be produced while avoiding shortages of labor, capital, land, and entrepreneurial ability that would bring rising inflation. So real GDP is the actual amount produced with the actual level of employment of the nation’s factors of production while potential GDP is the amount that would be produced if there were full employment of all factors of production with no shortages. Real GDP fluctuates from one year to the next, though it grows more often than it shrinks. Potential GDP grows from one year to the next because the quantity of the nation’s resources and technology increase from one year to the next.

2.

How does the growth rate of real GDP contribute to an improved standard of living? © 2018 Pearson Education, Inc.

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

3.

What is a business cycle and what are its phases and turning points?

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

4.

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

5.

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

Real GDP is sometimes used to measure the standard of living but real GDP can be misleading for several reasons. Real GDP does not include household production, productive activities done in and around the house by the homeowner. Because these tasks often are an important component of people’s work, this omission creates a major measurement problem. Real GDP omits the underground economy, economic activity that is legal but unreported or that is illegal.

In many countries the underground economy is an important part of economic activity, and its omission creates a serious measurement problem. The value of leisure time is not included in real GDP. People value their leisure hours and an increase in people’s leisure that enhances people’s economic welfare can lower the nation’s real GDP. Environmental damage is excluded from real GDP. So an economy wherein real GDP grows but at the expense of its environment, as was the case with Eastern European countries under communism, falsely appears to offer greater economic welfare than a similar economy that grows slightly more slowly but at less environmental cost.

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Answers to the Study Plan Problems and Applications 1.

Classify each of the following items as a final good or service or an intermediate good or service and identify each item as a component of consumption expenditure, investment, or government expenditure on goods and services:  Airline ticket bought by a student.

Airline tickets are intermediate goods that are used for the final service, airline flights. They are part of consumption expenditure.



New airplanes bought by Southwest Airlines.

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



Cheese bought by Domino’s.



Your purchase of a new iPhone.

Cheese bought by Domino’s is an intermediate good.

This purchase is a final good. It is part of consumption expenditure.



New house bought by Bill Gates.

A new house purchased by Bill Gates is a final good. It is part of investment.

Use the following figure illustrates the circular flow model.

2.

During 2014, flow A was $13.0 trillion, flow B was $9.1 trillion, flow D was $3.3 trillion, and flow E was –$0.8 trillion. Calculate (i) GDP and (ii) Government expenditure. (i) Flow A is aggregate income. GDP equals aggregate income, so GDP is $13.0 trillion.

(ii) Government expenditure is $1.4 trillion. Aggregate expenditure equals GDP, which from part (i) is $13.0 trillion. Aggregate expenditure is the sum of consumption expenditure (Flow B), investment (Flow D), © 2018 Pearson Education, Inc.

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government expenditure (Flow C), and net exports (Flow E). Therefore government expenditure equals aggregate expenditure minus consumption expenditure minus investment minus net exports. Government expenditure equals $13.0 trillion minus $9.1 trillion minus $3.3 trillion minus $0.8 trillion, which is $1.4 trillion.

3.     

Use the following data to calculate aggregate expenditure and imports of goods and services.

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

4.

The table lists some national accounts data for the United States in 2014. a. Calculate U.S. GDP in 2014.

GDP equals consumption expenditure plus investment plus government expenditure plus net exports, so GDP equals $11,729 billion + $2,714 billion + $3,139 billion − $538 billion, or $17,044 billion.

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

Item Wages Consumption expenditure Other factor incomes Investment Government expenditure Net exports Depreciation

Billions of dollars 9,109 11,729 4,173 2,714 3,139 −538 2,699

The expenditure approach was used.

Use the following data to work Problems 5 and 6.

Tropical Republic produces only bananas Quantities and coconuts. The base year is 2016, and Bananas the tables give the quantities produced Coconuts and the prices.

Prices 5.

Calculate nominal GDP in 2016 Bananas and 2017.

Coconuts In 2016, nominal GDP is

2016 800 bunches 400 bunches

2017 900 bunches 500 bunches

2016 $2 a bunch $10 a bunch

2017 $4 a bunch $5 a bunch

$5,600. In 2017, nominal GDP is $6,100.

Nominal GDP in 2016 is equal to total expenditure on the goods and © 2018 Pearson Education, Inc.

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services produced by Tropical Republic in 2016. Expenditure on Tropical Republic on bananas is 800 bunches of bananas at $2 a bunch, which is $1,600. Expenditure on coconuts is 400 bunches at $10 a bunch, which is $4,000. Total expenditure is $5,600, so nominal GDP in 2016 is $5,600.

Nominal GDP in 2017 is equal to total expenditure on the goods and services produced by Tropical Republic in 2017. Expenditure on Tropical Republic on bananas is 900 bunches of bananas at $4 a bunch, which is $3,600. Expenditure on coconuts is 500 bunches at $5 a bunch, which is $2,500. Total expenditure is $6,100, so nominal GDP in 2017 is $6,100.

6.

Calculate real GDP in 2017 expressed in base-year prices.

Real GDP in 2017 using base-year prices is $6,800. The base-year prices method calculates the market value of the 2017 quantities at the base-year prices of 2016. To value the 2017 output at 2016 prices, real expenditure on Tropical Republic on bananas is 900 bunches at $2 a bunch, which is $1,800, and real expenditure on coconuts is 500 bunches at $10 a bunch, which is $5,000. Adding these two expenditures shows that real GDP in 2017 using the baseyear prices method is $6,800.

7.

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

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

8.

An island economy produces only fish and crabs. Calculate the island’s chained-dollar real GDP in 2017 expressed in 2016 dollars.

Year 2006 2007 2008 2009

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

Quantities Fish Crabs

Population 300 million 302 million 304 million 307 million

2016 1,000 tons 500 tons

2017 1,100 tons 525 tons

Real GDP in 2017 is $27,300. The chained-dollar method uses the prices of Prices 2016 and 2017 to calculate Fish $20 a ton $30 a ton the growth rate in 2017.

Crabs $10 a ton $8 a ton The value of the 2016 quantities at 2016 prices is $25,000. The value of the 2017 quantities at 2016 prices is $1,100 tons of fish × $20 a ton + 525 tons of crab × $10 a ton, which is $27,250. Using 2016 prices, the increase in GDP for these two years is $2,250, so the percentage increase is ($2,250  $25,000)  100, which is 9.0 percent. © 2018 Pearson Education, Inc.

MEASURING GDP AND ECONOMIC GROWTH59

Next the value of the 2016 quantities at 2017 prices is 1,000 tons of fish × $30 a ton + 500 tons of crab × $8 a ton, which is $34,000.

The value of the 2017 quantities at 2017 prices is $37,200. Using 2017 prices, the increase in GDP for these two years is $3, 200 so the percentage increase is ($3,200 ÷ $34,000) × 100, which is 9.4 percent.

The chained dollar method calculates the growth rate as the average of these two percentage growth rates, which means that the growth rate in 2017 is 9.2 percent. So real GDP in 2017 is equal to $25,000, which is real GDP in the base year (and is equal to nominal GDP in that year) multiplied by one plus the growth rate. Real GDP in 2017 is $27,300.

© 2018 Pearson Education, Inc.

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Answers to Additional Problems and Applications 9.

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



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



Coffee beans bought by Starbucks



New coffee grinders bought by Starbucks

Coffee beans bought by Starbucks are an intermediate good.

A new coffee grinder bought by Starbucks is a final good. It is part of investment.



Starbuck’s grande mocha frappuccino bought by a student The Starbuck’s drink is a final good. It is part of consumption expenditure.



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

Use Figure 4.2 to work Problems 10 and 11.

10.

In 2013, flow A was $1,000 billion, flow C was $250 billion, flow B was $650 billion, and flow E was $50 billion. Calculate investment.

Investment is $50 billion. Aggregate expenditure equals aggregate income, which is flow A, $1,000 billion. Aggregate expenditure is the sum of consumption expenditure (Flow B), investment (Flow D), government expenditure (Flow C), and net exports (Flow E). Therefore investment equals aggregate expenditure minus consumption © 2018 Pearson Education, Inc.

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expenditure minus government expenditure on goods and services minus net exports. Investment equals $1,000 billion minus $650 billion minus $250 billion minus $50 billion, which is $50 billion.

11.

In 2014, flow D was $2 trillion, flow E was –$1 trillion, flow A was $10 trillion, and flow C was $4 trillion. Calculate consumption expenditure.

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

Use the following information to work Problems 12 and 13.

Mitsubishi Heavy Industries makes the wings of the new Boeing 787 Dreamliner in Japan. Toyota assembles cars for the U.S. market in Kentucky.

12.

Explain where these activities appear in the U.S. National Income and Product Accounts.

When the Dreamliner wings are sent from Japan to the United States, they are counted in the U.S. National Income and Product Accounts as imports, which is a negative entry in the expenditure approach to U.S. GDP. Toyota’s production of cars in Kentucky is included in U.S. GDP because it represents production within the United States.

Expenditure on the cars is counted as part of consumption expenditure (if the cars are purchased by U.S. consumers) or investment (if the cars are purchased by U.S. firms) or government expenditure (if the cars are purchased by a government) in the expenditure approach to GDP. If any of the parts of the cars are imported from Japan, the value of these parts is included among U.S. imports. The incomes earned by the factors of production that produce the cars are part of the wages, interest, rent, and profit income that are used in the income approach to GDP.

13.

Explain where these activities appear in Japan’s National Income and Product Accounts.

Mitsubishi Heavy Industries’ production of Dreamliner wings in Japan is included in Japanese GDP because it represents production within Japan. When these wings are sent to the United States, they are counted in the National Income and Product Accounts as part of Japanese exports. If any of the parts of wings are imported into Japan, the value of these parts is included among Japanese imports.

The incomes earned by the factors of production that produce the wings are part of the wages, interest, rent, and profit income that are used in the income approach to GDP. Toyota’s production of cars in Kentucky is not directly included in Japan’s GDP unless some of the parts for these cars are exported from Japan to the United States. In that case the value of the parts are included in Japan’s GDP as exports. © 2018 Pearson Education, Inc.

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Use the following news clip to work Problems 14 and 15, and use the circular flow model to illustrate your answers.

Boeing Doubles Outsourcing From India Three Indian firms are producing components for Boeing fighter jets F15 and F18 and for the Chinook heavy-lift helicopter in Bangalore, Hyderabad, and other places in India.

Source: The Economic Times, February 17, 2016 14.

Explain how Boeing’s activities and its transactions affect U.S. and Indian GDP. Goods and services produced within the United States are part of U.S. GDP. Boeing’s decision to produce parts in India means that this production is not produced within the United States and so it is not part of U.S. GDP. This production is, however, part of India’s GDP. The parts of the fighters and helicopters that are produced in India, purchased by Boeing, and sent to the United States for final assembly add to India’s GDP as exports and subtract from U.S. GDP as imports. When the U.S. government purchases the jet fighters from Boeing, the purchases are classified as government expenditure.

In terms of the circular flow diagram in Figure 4.3 and U.S. GDP, Boeing’s purchase of parts for its jet fighters and helicopter from firms in India is flow is Flow A, an import into the United States.

This flow travels through the goods market and goes to Boeing as Flow B. In terms of Indian GDP, the Boeing’s purchase of parts from Indian firms is an Indian export. This flow is the reverse of Flow B and of flow A because this flow is an export for the Indian economy.

15.

Explain how the Indian firms’ activities and its transactions affect U.S. and Indian GDP. The Indian firms’ production of components is counted in Indian GDP as exports. Boeing’s purchase of these parts is counted in U.S. GDP © 2018 Pearson Education, Inc.

MEASURING GDP AND ECONOMIC GROWTH63

as imports. In terms of the circular flow and U.S. GDP, in Figure 4.3, Boeing’s purchase of parts for its jet fighters and helicopter from firms in India is flow is Flow A, an import into the United States. This flow travels through the goods market and goes to Boeing as Flow B. For the Indian economy, the exports are represented by the reverse of Flow B and then flow A. Flows C and D for the Indian economy indicate that the Indian firms are paying households (through the factor market) for the factors of production the households supply to them.

Use the following data to work Problems 16 and 17.

The table lists some macroeconomic data for the United States in 2016.

16. Calculate U.S. GDP in 2016.

GDP equals consumption expenditure plus investment plus government expenditure plus net exports, so GDP equals $12,498 billion + $3,037 billion + $3,254 billion − $507 billion, or $18,282 billion.

17.

Item Wages Consumption expenditure Other factor incomes Investment Government expenditure Net exports

Billions of dollars 9,008 12,498 4,567 3,037 3,254 −507

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

Use the following data to work Problems 18 to 19.

An economy produces only apples and Quantities oranges. The base year is 2015, and the Apples table gives the quantities produced and Oranges the prices.

Prices 18. Calculate nominal GDP in 2015 Apples and 2016.

Oranges In 2015 nominal GDP is

2015 60 80

2016 160 220

2015 $0.50 $0.25

2016 $1.00 $2.00

$50 and in 2016 nominal GDP is $600. Nominal GDP in 2015 is equal to total value of the goods and services produced in 2015. The value of apples is 60 apples at $0.50 each, which is $30, and the value of oranges is 80 oranges at $0.25 each, which is $20. The total value is $50 so nominal GDP in 2015 is $50.

Nominal GDP in 2016 is equal to total value of the goods and services produced in 2016. The value of apples is 160 apples at $1.00 each, which is $160 and the value of oranges is 220 oranges at $2.00 each, which is $440. The total value is $600 so nominal GDP in 2016 is $600.

19.

Calculate real GDP in 2015 and 2016 expressed in base-year prices.

Real GDP in 2015 is $50 and in 2016 is $135. Real GDP in the base year, 2015, is equal to nominal GDP. Real GDP in 2016 using base© 2018 Pearson Education, Inc.

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year prices is equal to the quantities produced in 2016 valued at base-year, 2015, prices. Real GDP in 2016 is 160 apples at $0.50 each, which is $80, and the value of oranges is 220 oranges at $0.25 each, which is $55. The total value of 2016 production using 2015 prices is $135, so real GDP in 2016 is $135.

Use the following news clip to work Problems 20 and 21.

China’s Economy Accelerates as Retail, Investment Pick Up China’s real GDP increased 6.9 percent in the first quarter of 2017 from a year earlier. Investment grew by 9.2 percent and retail sales by 10.9 percent. In current prices, GDP increased by 11.8 percent from a year earlier.

Source: Bloomberg News, April 17, 2017 20.

Explain how China’s real GDP can grow at a 6.9 percent rate when consumption and investment grew faster than 6.9 percent.

Even though consumption and investment both grew more rapidly than 6.9 percent, the other components of GDP, government expenditure and net exports grew more slowly, so the net effect from all four parts of GDP was 6.9 percent growth.

21.

Explain why the growth rate of GDP in current prices does not provide information about how quickly the economy is really growing.

GDP in current prices can grow because both production grows and prices grow. The growth in prices does represent growth in the economy. Growth in the economy is measured using the growth rate of real GDP because real GDP measures only production.

22.

The United Nations’ Human Development Index (HDI) is based on real GDP per person, life expectancy at birth, and indicators of the quality and quantity of education. a. Explain why the HDI might be better than real GDP as a measure of economic welfare.

The HDI might be a better measure of economic welfare because it includes some important factors that affect welfare and which are omitted from GDP. In particular, life expectancy is included in the HDI but not in GDP and on this count the HDI is superior. The HDI also includes direct measures of the quality and quantity of education. These are indirectly included in GDP because they affect GDP per person, but it might be the case that the direct inclusion in the HDI is better.

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

So real GDP indirectly includes some of the education effects explicitly included in the HDI.

c. Do you think the HDI should be expanded to include items such as pollution, resource depletion, and political freedom? Explain.

Ideally factors such as pollution, political freedom, and so forth should be included in a broad measure of welfare. Two difficulties, however, occur. One difficulty comes when trying to measure these variables. For instance, how can political freedom be measured in a © 2018 Pearson Education, Inc.

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way that is accepted by all? A second difficulty is weighting these factors. For instance, how much political freedom should be weighted relative to GDP per person?

d. What other items should be included in a comprehensive measure on economic welfare?

Aside from the factors listed above, potentially some measure of culture might be included. Another set of factors might attempt to take into account sustainability. Religious freedom, discrimination, and civil and international conflict might also matter. But all these factors are hard to measure and to weight.

Use the following information to work Problems 23 and 24.

Comparing Real GDP Per Person The International Monetary Fund reported the following data on gross domestic product per capita, measured in U.S. dollars at market exchange rates in 2016: Canada $42,210, China $8,113, United Kingdom $40,096, and United States $57,436.

Source: International Monetary Fund, World Economic Outlook Database, April 2017 23.

Explain the special complications involved with attempting to compare the economic welfare in China and the United States by using the GDP for each country.

This comparison does not determine which nation has a higher standard of living. One reason is that the analysis uses the exchange rate to transform prices in one country into prices of the other country. But a more accurate analysis uses purchasing power parity (PPP) prices to value the goods and services in both countries. Relative prices in China and the United States are quite different. When looking at prices of identical or near-identical goods, more of these prices are lower in China than in the United States. So even if China and the United States produced the exact same quantities of these goods and services, China’s GDP, using China’s lower prices, would value China’s production at a smaller amount than would U.S. GDP, using U.S. higher prices. To have a valid comparison of Chinese and U.S. GDP, PPP prices must be used to value Chinese and U.S. production because then prices are the same for China and the United States. By using PPP prices, the analysis can better measure the goods and services available to citizens of each country.

Additionally, looking only at GDP per person omits the effects from household production, leisure time, and environmental quality, differences that probably loom large when comparing the United States and China. Because China is significantly less advanced than the United States, household production is probably larger in China than in the United States. On this count, Chinese economic welfare is closer to that in the United States than GDP per person would indicate. But U.S. residents enjoy more leisure time and better environmental quality than do their counterparts in China, which makes the relative U.S. standard of living higher than measured by GDP per person.

24.

Explain why the data reported here might be a poor indicator of the differences in economic © 2018 Pearson Education, Inc.

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welfare among Canada, the United Kingdom, and the United States, but nevertheless provide the correct ranking of the countries.

Using GDP per person to measure the economic welfare in Canada, the U.K. and the United States omits other factors, such as household production, underground economic activity, the value of leisure time, and environmental quality. Because Canada, the U.K. and the United States are all developed nations, the differences in these four factors are probably small, and almost surely are smaller than the differences in real GDPs per person. So, using real GDP per person will provide the correct the correct ranking of the counties.

25.

India to be Home to 437,000 Millionaires by 2018 India, with the world’s largest population of poor people, is creating millionaires at a rapid pace and by 2018 is projected to have 437,000 millionaires measured in U.S. dollars. That is 1 millionaire for about 1,600 people living on less than $2 a day.

Source: The Times of India, July 8, 2015 a. Why might real GDP per person misrepresent the standard of living of the average Indian?

There are a few reasons why this measurement of real GDP per person misrepresents the standard of living of the average Indian. First GDP includes only goods and services bought and sold in markets. In India many goods and services are produced by the household itself and this home production, while boosting the household’s standard of living, is not included in GDP. Second the prices used to value Indian production and thereby calculate Indian GDP are likely quite different than the prices used to value U.S. production and calculate U.S. GDP. When looking at prices of identical or nearidentical goods, it is likely that more of these prices are lower in India than in the United States. So, even if the actual quantities produced are the same, using Indian prices means that India’s production would be valued less than U.S. production and India’s GDP would be less than U.S. GDP. If the same prices, such as purchasing power parity prices, were used to value India’s GDP and U.S. GDP, India’s GDP per person would be closer to U.S. GDP per person.

b. Why might $2 a day underestimate the standard of living of the poorest Indians?

One important reason why the $2 a day estimate undervalues the standard of living of the poorest Indians is because much of these people’s transactions do not occur in markets. GDP is calculated using only goods and services bought and sold in markets. So if a poor, self-sufficient farmer grows only enough food for his or her family and does not buy or sell food in the market, the farmer will be estimated to have a very low income. But this low income vastly understates the farmer’s standard of living because it omits all the food the person produced on his or her land. Another reason why the standard of living of the poorest Indians is under estimated is because the estimate is made using prices that prevail in India and then compared to the standard of living in the United States. Prices in India are often much lower than in the United States, so comparing what the income can purchase in the United States understates the standard of living. © 2018 Pearson Education, Inc.

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Economics in the News 26.

After you have studied Economics in the News on pp. 100–104 (508–509 in Economics), answer the following questions. a. What does Martin Feldstein say is wrong with the growth rate of real GDP per person as a measure of the growth rate of the standard of living?

Mr. Feldstein says that GDP undervalues the quality improvements that are available in today’s products. If the quality improvements were correctly valued, then today’s real GDP would be higher and therefore the growth rate of real GDP per person would be higher.

b. How does the price of a smartphone today compared with the 1991 prices of items it has replaced support Feldstein’s argument?

A smartphone is included in today’s GDP at its price, roughly $200.

But the smartphone replaces 13 items in 1991’s GDP that together are valued at $5,292 2016 dollars. These calculations indicate that the quantity improvement from 1991 in today’s smartphone in today’s smartphone is worth $5,292 dollars, much more than the $200 dollars that it counts toward today’s GDP. Properly valuing the quality improvements would increase today’s GDP by a significant amount.

c. How does the falling share of household production in total production modify Feldstein’s argument?

Because household production is not counted in GDP, as people switch from household production to the labor force, where their production is counted, GDP rises even if total production does not change.

Consequently the falling share of household production leads to measured production—GDP—increasing at a faster rate than does actual total production,

d. What other reasons not addressed in the news story make the growth rate of real GDP per person an incomplete measure of the standard of living The news article mentions another reason that makes real GDP per person an incomplete measure of the standard of living.

Specifically, many tasks that used to take time and effort, such as depositing a check at a bank or even an ATM, can now be done with a click of the camera on a smartphone. The increased convenience of such chores adds to the standard of living but because they are free they are not included in real GDP.

27.

Five Measures of Growth That Are Better Than GDP Speaking at the World Economic Forum, Stewart Wallis, a self-described advocate of a new economic system, suggested five economic indicators that he says are better than GDP. His five are Good jobs, Well-being, Environment, Fairness, and Health.

Source: World Economic Forum, April 19, 2016 a. Explain the factors that the news clip identifies as limiting the usefulness of GDP as a measure of economic welfare.

GDP focuses on the amount of goods and services produced. While goods and services lead to improving people’s welfare, there are other factors that also come into play. Mr. Wallis suggests that his five economic indicators—good jobs, well-being, environment, © 2018 Pearson Education, Inc.

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fairness, and health—are included, at best, only indirectly in GDP and their omission limits the usefulness of GDP as a measure of economic welfare.

b.

What are the challenges involved in trying to incorporate measurements of those factors in an effort to better measure economic welfare?

There are two major difficulties. First, measuring some of these variables, say ―good jobs,‖ or ―well-being,‖ or ―fairness‖, would be very difficult. Second, even if the variables could be accurately measured determining the weighting scheme to be used is very difficult. For instance, how much should ―good jobs‖ be weighted compared to ―health‖?

c. Explain whether the United Nations’ Human Development Index captures any of the five indicators.

The Human Development Index includes people’s health. It also includes education, which is probably correlated with Mr. Wallis’ category of good jobs.

d. Explain which of the five indicators are included in GDP and increase the likelihood of a high correlation between GDP and Wallis’ indicators of economic welfare.

Presumably Mr. Wallis believes ―good jobs‖ are high-paying jobs.

High-paying jobs will be jobs in which people are productive and produce more goods and services, so real GDP and ―good jobs‖ are correlated. Spending on environmental protection is also part of real GDP but pollution-creating production is also part of GDP. For advanced countries, it is likely that production of environmental protection is larger than production of pollution-intensive products, so Mr. Wallis’ measure of ―environment‖ might be correlated with real GDP. So, too, for spending on health. Richer nations tend to spend more on health than do poorer nations, so ―health‖ is probably also correlated with real GDP.

28.

Use the information in Problem 18 to calculate the chained-dollar real GDP in 2016 expressed in 2015 dollars.

Real GDP in 2016 is $135.70. The chained-dollar method uses the prices of 2015 and 2016 to calculate the growth rate in 2016. The value of the 2015 quantities at 2015 prices is $50. The value of the 2016 quantities at 2015 prices is $135. Using 2015 prices, the increase in GDP for these two years is $85, so the percentage increase is ($85  $50)  100, which is 170.0 percent.

Next the value of the 2015 quantities at 2016 prices is 60 apples × $1.00 per apple + 80 oranges × $2.00 an orange, which is $220. The value of the 2016 quantities at 2016 prices is $600. Using 2016 prices, the increase in GDP for these two years is $380 so the percentage increase is ($380 ÷ $220) × 100, which is 1.727  100, which is 172.7 percent.

The chained dollar method calculates the growth rate as the average of these two percentage growth rates, which means that the growth rate in 2016 is 171.4 percent. So real GDP in 2016 is equal to $50, which is real GDP in the base year (and is equal to nominal GDP in © 2018 Pearson Education, Inc.

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that rate.

C h a p t e r

year) multiplied by one plus the growth Real GDP in 2016 is $135.70.

5

*

MONITORING JOBS AND INFLATION**

* This is Chapter 22 in Economics. © 2018 Pearson Education, Inc.

SOLUTION MANUAL FOR MACROECONOMICS, 13TH EDITION MICHAEL PARKIN

Answers to the Review Quizzes Page 116 1.

(page 524 in Economics)

What determines if a person is in the labor force?

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

2.

What distinguishes an unemployed person from one who is not in the labor force?

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

3.

Describe the trends and fluctuations in the U.S. unemployment rate from 1980 to 2017.

The unemployment rate has had several significant fluctuations around its average of 6.4 percent. It started by soaring to a high that exceeded 10 percent during the 1982 recession. Then there was a gradual downward trend particularly insofar as the peaks during the recessions in 1990-1991 and 2001 were much lower than in 1982. But that situation reversed itself with the severe and prolonged recession of 2008-2009 when the unemployment once more jumped (slightly) above 10 percent. Since that peak the unemployment rate has fallen to around 4.5 percent.

4.

Describe the trends and fluctuations in the U.S. employment-to-population ratio and labor force participation rate from 1980 to 2017.

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

Recently the labor force participation rate has leveled off and been near 63 percent and the employment-to-population ratio has turned back up and been near 60 percent. © 2018 Pearson Education, Inc.

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Describe the alternative measures of unemployment.

The Bureau of Labor Statistics keeps track of 6 alternative measures of unemployment:  U-1 measures long-term unemployment. It counts as unemployed only workers who have been unemployed for 15 or more weeks.  U-2 measures job losers; that is, only workers who lost their jobs (as opposed to quitting or reentering the labor market) are counted as unemployed.  U-3 is the conventional measure of unemployment.  U-4 adds discouraged workers to the conventional measure of unemployment.  U-5 adds all marginally attached workers to the U-4 measure of unemployment.  U-6 adds part-time workers who would like a full-time job (economic part-time workers) to the U-5 measure of unemployment.

Page 119 1.

(page 527 in Economics)

Why does unemployment arise and what makes some unemployment unavoidable?

In a dynamic economy some unemployment is unavoidable. For instance, growth means that some workers will always be entering the labor force without a job and therefore be unemployed. Consumers changing their demand for one good over another means workers in the newly less-favored industry will lose their jobs and also be unemployed.

Moreover some workers will always be leaving their current job to search for a better job and these workers, too, will be unemployed.

So some unemployment is unavoidable as the economy churns and reacts to changes.

2.

Define frictional unemployment, structural unemployment, and cyclical unemployment. Give examples of each type of unemployment.

Frictional unemployment is the unemployment that arises from the normal labor turnover from people entering and leaving the labor force and from the ongoing creation and destruction of jobs. For instance, newly graduated students entering the labor market looking for work are frictionally unemployed. Structural unemployment represents the unemployment created by changes in technology or international competition that change the skills needed to perform jobs or change the locations of jobs in the economy. For instance, workers are structurally unemployed if they lose their jobs because of changes in the amount of foreign competition and if they have different skills from those required by new jobs or if they live in a different region of the country from where new jobs are being created. Finally, cyclical unemployment is the unemployment created by business cycle fluctuations in economic activity. Specifically the higher than normal unemployment at a business cycle trough and the lower than normal unemployment at a business cycle peak is called cyclical unemployment. For instance, a worker laid off in 2009 because of the recession is cyclically employed. © 2018 Pearson Education, Inc.

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3.

What is the natural unemployment rate?

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

4.

How does the natural unemployment rate change and what factors might make it change?

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

5.

Why is the unemployment rate never zero, even at full employment?

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

6.

What is the output gap? How does it change when the economy goes into recession?

The output gap equals the difference between real GDP and potential GDP. When the economy goes into a recession, the output gap becomes negative.

7.

How does the unemployment rate fluctuate over the business cycle?

During a recession the unemployment rate is generally rising. During an expansion the unemployment rate is generally falling.

Page 125 1.

(page 533 in Economics)

What is the price level?

The price level is the average level of prices.

2.

What is the CPI and how is it calculated?

The CPI is the Consumer Price Index. The CPI equals (Cost of CPI basket at current prices ÷ Cost of CPI basket at base-period prices) ×100.

3.

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

4.

What are the four main ways in which the CPI is an upward-biased measure of the price level?

The CPI is biased upward because of the new goods bias; the quality change bias; commodity substitution bias; and outlet substitution © 2018 Pearson Education, Inc.

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bias. The new goods bias reflects the point that new goods, such as DVDs are generally more expensive than the old goods they replace, VHS tapes. The quality change bias points out that part of the reason goods and services rise in price is because their quality is improved. Commodity substitution bias occurs because consumers substitute away from goods and services that have risen in the price more than other goods and services. Outlet substitution bias occurs because consumers will use discount stores more frequently when goods and services rise in price.

5.

What problems arise from the CPI bias?

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

6.

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

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Answers to the Study Plan Problems and Applications 1.

The BLS reported the following data for January 2017: Labor force: 160 million Employment: 152 million Working-age population: 254 million

Calculate the a. Unemployment rate.

The unemployment rate is 5.0 percent. The unemployment rate is the percentage of the labor force that is unemployed. The labor force is the sum of the people unemployed and the people employed. So the number of people who are unemployed is 160 million minus 152 million, which is 8 million. The unemployment rate equals (the number of people unemployed divided by the labor force) multiplied by 100. That is, (8 million/160 million)  100, which is 5.0 percent.

b. Labor force participation rate.

The labor force participation rate is 63.0 percent. The labor force participation rate is the percentage of the working-age population that is in the labor force. The working-age population is 254 million and the labor force is 160 million, so the labor force participation rate is (160 million/254 million) 100, which equals 63.0 percent.

c. Employment-to-population ratio.

The employment-to-population ratio is 59.8 percent. The employmentto-population ratio is the percentage of the people of working age who have jobs. The employment-to-population ratio is equal to the number of people employed divided by the working-age population then multiplied by 100. The employment-to-population ratio is (152 million/254 million)  100, which is 59.8 percent.

2.

In July 2017, in the economy of Sandy Island, 10,000 people were employed, 1,000 were unemployed, and 5,000 were not in the labor force. During August 2017, 80 people lost their jobs and didn’t look for new ones, 20 people quit their jobs and retired, 150 unemployed people were hired, 50 people quit the labor force, and 40 people entered the labor force to look for work. Calculate for July 2017 a. The unemployment rate.

The unemployment rate in July is 9.1 percent. The unemployment rate is the number unemployed as a percentage of the labor force. The number of unemployed workers is 1,000. The labor force is the number employed plus the number unemployed so in July it is 11,000. The unemployment rate equals (1,000/11,000)  100, which is 9.1 percent.

b. The employment-to-population ratio.

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

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employment-to-population ratio is (10,000/16,000)  100, which is 62.5 percent.

And calculate for the end of August 2017 c. The number of people unemployed.

The number of people who are unemployed at the end of August is 840.

The number of people who are unemployed at the end of August equals the number unemployed in July plus the number of people who lost their job and who stayed in the labor market plus the number of people entering the labor market minus the number of people who were hired minus the number of people who left the labor market. So the number of people unemployed equals 1,000 + 40  150  50, which is 840.

d. The number of people employed.

The number of people who are employed at the end of August is 10,050. The number of people who are employed at the end of August equals the number employed in July minus the people whom lost their jobs plus the number of people who gained jobs.

e. The unemployment rate.

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

Use the following data to work Problems 3 and 4.

In June 2015, the U.S. unemployment rate was 5.2 percent. In June 2017, the unemployment rate was 4.4 percent. Predict what happened to: 3.

Unemployment between June 2015 and June 2017, if the labor force was constant.

If the labor force is constant, the only way the unemployment rate can decrease is if the number of unemployed workers decreases.

4.

The labor force between June 2015 and June 2017, if unemployment was constant.

If unemployment is constant, the only way the unemployment rate can decrease is if the labor force increases.

5.

Hiring Rise Sends U.S. Jobless Rate to a 10-Year Low The U.S. unemployment rate fell to 4.4 percent. There was also a drop in the numbers of discouraged workers, which lowered a broader measure of unemployment that includes this category.

Source: The New York Times, May 6, 2017 What is a discouraged worker? Explain how a decrease in discouraged workers influences the official unemployment rate and a broader measure. What is the broader measure?

A discouraged worker is a person who currently is not working, would like a job, has looked for one in the recent past, but has stopped looking for work because of repeated failures in finding a job. If a worker who had not been looking for work starts looking, the official unemployment rate, U-3, rises (until the worker finds a © 2018 Pearson Education, Inc.

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job). U-4 includes discouraged workers among the ranks of the unemployed so when the worker starts looking for work and is no longer a discouraged worker, the U-4 unemployment rate does not change.

Use the following news clip to work Problems 6 and 7.

A Tough Search for Workers as Hiring Lags Job Openings Job openings increased 82,000 to 5.43 million, and employers are having a tough time finding qualified workers to fill them. Hiring to fill openings increased 30,000 to 5.2 million. An economist commented that job openings are high relative to unemployment, which is a sign of a mismatch between the skills demanded and the skills available.

Source: The New York Times, January 13, 2016 6.

If the labor market is working properly, why would there be any unemployment at all?

Unemployment will always exist in the labor market because of normal labor market frictions. People newly entering the labor market, workers quitting a job to look for a better job, firms laying-off workers because consumers no longer want to buy the goods produced by the firms will always be part of the labor market. All of these events create unemployment, so even when the labor market is operating at peak efficiency, unemployment will always be present.

7.

Are workers who cannot find jobs because of mismatching in the labor market counted as part of the economy’s structural unemployment or part of cyclical unemployment?

These workers are unemployed as the result of a mismatch between their skills and the skills required for the available jobs. The mismatch means that these workers are part of the economy’s structural unemployment.

Use the following information to work Problems 8 and 9.

The people on Coral Island buy only juice and cloth. The CPI basket contains the quantities bought in 2013. The average household spent $60 on juice and $30 on cloth in 2013 when the price of juice was $2 a bottle and the price of cloth was $5 a yard. In 2014, juice is $4 a bottle and cloth is $6 a yard.

8.

Calculate the CPI basket and the percentage of the household’s budget spent on juice in 2013.

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

9.

Calculate the CPI and the inflation rate in 2014.

The CPI in 2014 is 173.3. To calculate the CPI, divide the value of the CPI basket in 2014 prices by the base-year value of the CPI basket and then multiply the resulting number by100. The value of the CPI basket in 2014 prices is: ($4  30) + ($6  6) = $156. The value in base-year prices is $60 + $30 (provided in the question), which equals $90. So the CPI is ($156/$90)  100 = 173.3.

The inflation rate in the 2014 is 73.3 percent. The inflation rate equals the CPI in 2014 year minus the CPI in the base year expressed as a percentage of the base-year CPI. Because the base-year CPI is 100, the inflation rate is [(173.3 – 100)/ 100] × 100 = 73.3 percent. © 2018 Pearson Education, Inc.

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Use the following data to work Problems 10 to 11.

The BLS reported the following CPI data: June 2014 238.3 June 2015 238.6 June 2016 241.0 10.

Calculate the inflation rates for the years ended June 2015 and June 2016. How did the inflation rate change in 2016?

The inflation rate for the year ended June 2015 is 0.1 percent; the inflation rate for the year ended June 2016 is 1.0 percent.

The inflation rate is the percentage change in the price level. It is equal to [(Pthis year – Plast year)/ Plast year]  100. For the year ended in June 2015 the inflation rate is [(238.6 – 238.3)/238.3]  100, which is 0.1 percent. For the year ended in June 2016 the inflation rate is [(241.0 – 238.6)/238.6]  100, which is 1.0 percent. The inflation rate increased in 2016.

11.

Why might these CPI numbers be biased? How can alternative price indexes avoid this bias?

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

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

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Answers to Additional Problems and Applications 12.

What is the unemployment rate supposed to measure and why is it an imperfect measure?

Ideally the unemployment rate would measure the underutilization of labor resources. But it is an imperfect measure for two reasons.

First the unemployment rate does not include some underutilized labor. In particular the unemployment rate completely omits marginally attached workers, such as discouraged workers. These workers are not included in the unemployment rate. Second the unemployment rate counts as fully employed workers who are working part time but who want full-time jobs. These workers are underutilized because they would like to work for more hours than is presently the case.

13.

The BLS reported the following data for February 2017: Labor force participation rate: 63 percent Working-age population: 254 million Employment-to-population ratio: 60

Calculate the a. Labor force.

The labor force participation rate equals the labor force divided by the working-age population then multiplied by 100. Rearranging this formula shows that the labor force equals the working-age population multiplied by the labor force participation rate then divided by 100. Using this last formula and the data given in the problem shows that the labor force equals 254 million × 63/100, which is 160.0 million.

b. Employment.

The employment-to-population ratio equals employment divided by the working-age population then multiplied by 100. Rearranging this formula shows that employment equals the working-age population multiplied by the employment-to-population ratio then divided by 100. Using this last formula and the data given in the problem shows that employment equals 254 million × 60/100, or 152.4 million.

c. Unemployment rate.

The unemployment rate equals the number of people unemployed divided by the labor force. The labor force, from part (a), is 160.0 million. The labor force equals the number of people employed plus the number of people unemployed. Employment, from part (b), is 152.4 million so the number of people unemployed is 7.6 million. The unemployment rate equals the number of people unemployed divided by the labor force, then multiplied by 100. Using this last formula shows that the unemployment rate equals (7.6 million/160.0 million) × 100, which is 4.8 percent.

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Jobs and Wages Notch Gains as the Economy Tries to Heal Hiring in recent months has hit a pace last seen during the late 1990s and the labor force participation rate has started to rise but it remains significantly below its pre-recession level of 2007.

Source: The New York Times, April 1, 2016 a. If all the newly hired people had been unemployed, how would the labor force participation rate and unemployment rate have changed?

The labor force would not have changed, so the labor force participation rate would not have changed. The number of people unemployed would have decreased so the unemployment rate would have fallen.

b. If all the newly hired people had previously given up on their job search, how would the labor force participation rate and unemployment rate have changed?

The labor force would have increased, so labor force participation rate would have risen. The number of people unemployed would not have changed but the increase in the labor force means that the unemployment rate would have fallen.

15.

The BLS reported that in the second quarter of 2016, employment increased by 100,000 to 150,959,000 and the unemployment rate fell from 5 percent to 4.9 percent. About 1.3 million people were marginally attached workers and 0.6 million of them were discouraged. a. Calculate the change in unemployment in the second quarter of 2016.

At the start of the second quarter employment was 150,959,000 − 100,000 = 150,859,000. The unemployment rate, which at the start of the second quarter was 5.0 percent, equals (Unemployment/[Unemployment + Employment]) × 100. Using the data for the start of the second quarter gives the result that 0.050 = (Unemployment/[Unemployment + 150,859,000]). Solving for the amount of unemployment shows that unemployment at the start of the second quarter was 7,939,947 workers. Similar calculations show that at the end of the second quarter the amount of unemployment was 7,778,118 workers. Unemployment decreased in the second quarter by 161,829 workers.

b. With 1.3 million marginally attached workers and 0.6 million of them discouraged workers, what are the characteristics of the other 0.7 million marginally attached workers?

The other 0.7 million marginally attached workers would like a job but have stopped looking for work. Because they are not discouraged workers, these 0.7 million workers have stopped looking for reasons other than their inability to find a job. For example, a stay-athome spouse might prefer working in the job market but have quit looking to undertake some home repairs.

16.

A high unemployment rate tells us that a large percentage of the labor force is unemployed but not why the unemployment rate is high. What unemployment measure tells us if (i) people are searching longer than usual to find a job, (ii) more people are economic part-time workers, or (iii) more unemployed people are job losers?

U-1 measures long-term unemployment of 15 weeks or more. If U-1 exceeds its normal value, then people are taking longer than usual © 2018 Pearson Education, Inc.

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to find a job. U-6 equals U-5 plus part-time workers who want fulltime jobs as unemployed, so the difference between U-6 and U-5 is the result of part-time workers who want a full-time job. If this difference is unusually large, then more workers than normal are working at part-time jobs. U-2 measures unemployment resulting from people losing their jobs. If U-2 is larger than normal, then more unemployment than normal results from people losing their jobs.

17.

U.S. Job Openings Rise but Hiring Slips U.S. job openings increased to 5.8 million in April but the number of workers hired decreased to a bit below 5.1 million.

Source: The Globe and Mail, June 9, 2016 a. Using the information in the news clip, how do you predict the labor force participation rate, employment-to-population ratio, and unemployment rate changed?

Because job openings increased, the labor force participation rate probably increased as more discouraged workers rejoined the labor force to search for a job. Even though it was lower than previously, because 5.1 million workers were hired, it is likely that the employment-to-population ratio increased. There are two effects on the unemployment rate. First, 5.1 million more workers were hired but, second, more discouraged workers rejoined the labor force to look for work and while they search they were now counted as unemployed. Taken together, the unemployment rate probably fell.

b. If the government slashed unemployment benefits, how would the numbers in the news clip change? Why? Slashing unemployment benefits increases the cost of being unemployed and thereby decreases the unemployment rate as people take less time to search for a new job. The number of job openings would not be directly affected but the number of workers hired would increase.

18.

Why might the unemployment rate underestimate the underutilization of labor resources?

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

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Use the following data to work Problems 19 to 21.

The IMF World Economic Outlook reports the unemployment rates in the table.

19.

What do these numbers tell us about the phase of the business cycle in the four countries in 2016?

Region United States Spain Venezuela Singapore

2015 5.3

2016 4.9

22.1 7.4 1.9

19.6 21.2 2.1

The unemployment rates were low in the United States and very low in Singapore, so it is probably the case that both countries were in an expansionary period. The unemployment rate in Spain fell, so Spain might be entering an expansionary period. The unemployment rate in Venezuela rose drastically, so Venezuela was in a recession.

20.

What do these numbers tell us about the relative size of their natural unemployment rates?

These numbers cover only two years, so making inferences about the relative size of the natural unemployment rates is potentially dangerous. To the extent that these data are representative, the natural unemployment rate is likely the highest in the Venezuela and Spain and the lowest in Singapore.

21.

Do these numbers tell us anything about the relative size of the labor force participation rates and employment-to-population ratios?

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

22.

Amazon Will Add 100,000 Jobs as Bricks-and-Mortar Stores Turn to Rubble Amazon says that it will hire 100,000 new employees in the next 18 months. Meanwhile, Macy’s, J. C. Penney, and other traditional retailers are closing stores and laying off workers.

And the workers that Amazon is hiring aren’t the ones being laid off by Macy’s and J. C. Penney.

Source: The New York Times, January 13, 2017 Why will the decisions reported in the news clip increase unemployment and what type of unemployment will increase?

The decisions reported in the news clip probably increase unemployment because the traditional retailers likely will lay off more than 100,000 workers. Since retailers are not laying off these workers due to recession, the unemployment is not cyclical.

Frictional unemployment will increase and to the extent that the laid off workers do not have the necessary skills for a job at Amazon or other similar positions, structural unemployment also increases.

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23.

Retraining Many people graduate with a bachelor’s degree that doesn’t open jobs doors. Acquiring a skill provides a way of getting a decent paycheck. But acquiring a skill isn’t a one-time event: It is an ongoing process. A skill doesn’t last for decades and retraining is required. Government-funded job training is a promising way to help individual workers, employers and the country as a whole.

Source: The New York Times, February 26, 2017 a. What is the main type of unemployment that retraining programs seek to avoid? Explain.

Retraining programs attempt to reduce structural unemployment. The education would retrain workers so that they have the skills that business need for the jobs that are available.

b. How might government funded retraining influence the natural unemployment rate? Explain.

If retraining is successful, it will decrease the natural unemployment rate. Natural unemployment is comprised of frictional and structural unemployment. By decreasing structural unemployment, the retraining decreases the natural unemployment rate.

24.

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

The CPI basket is 10 bottles of juice and 5 lengths of cloth.

b. The CPI in the current year.

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

c. The inflation rate in the current year.

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

25.

Amazon.com agreed to pay its workers $20 an hour in 2016 and $22 an hour in 2017. The price level for these years was 241 in 2016 and 245 in 2017. Calculate the real wage rate in each year.

What is the real wage increase received by these workers in 2017?

The real wage rate equals the nominal wage rate divided by the price level. In 2016 the real wage rate was $20/241 × 100, for a real wage rate of $8.30. In 2017 the real wage rate was $22/245 × 100, for a real wage rate of $8.98. The workers got a real pay raise between 2016 and 2017 of $0.68.

26.

News release In May 2017, real personal consumption expenditure (PCE) was $11,845 billion and the PCE deflator was 112.257. In June 2017, real personal consumption expenditure was $11,850 billion © 2018 Pearson Education, Inc.

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and personal consumption expenditure was $13,305 billion.

Source: BEA, July 31, 2017 Calculate personal consumption expenditure in May 2017 and the PCE deflator in June 2017.

Was the percentage increase in real personal consumption expenditure greater or smaller than that in personal consumption expenditure?

Personal consumption expenditure = (real personal consumption expenditure) × (PCE deflator) ÷ 100, so in May 2017 personal consumption expenditure was $11,845 billion × 112.257 ÷ 100 = $13,297 billion.

PCE deflator = ([personal consumption expenditure] ÷ [real personal consumption expenditure) × 100, so in June 2017 the PCE deflator = ($13,305 billion ÷ $11,850 billion) × 100 = 112.278.

The percentage increase in real personal consumption expenditure was smaller than the percentage increase in personal consumption expenditure. Personal consumption expenditure grows because real personal consumption expenditure grows and/or because the PCE deflator grows. During this period, both real personal consumption expenditure grew and because the PCE deflator grew so the percentage increase in (nominal) personal consumption exceeded the percentage increase in real personal consumption expenditure.

27.

Adjusted for Inflation, the Federal Minimum Wage is Worth Less than 50 Years Ago The federal minimum wage was raised to $7.25 an hour from $6.55 nearly seven years ago.

Despite periodic increases, its buying power hasn’t kept up with inflation. In 1968, the federal minimum was equivalent to $10.90 in 2015 dollars, nearly $4 higher than today’s rate.

Source: CNBC, July 21, 2016 Given the additional information that in 1968, the federal minimum wage was $1.60 an hour, by what percentage did the CPI increase between 1968 and 2015?

According to the problem, the minimum wage of $1.60 in 1968 is equivalent to $10.90 in 2015. This equality means that the real values of the federal minimum wage in 1968 and in 2015 are the same.

If we set 1968 as the base year, then the price level in 1968 is 100, and the real federal minimum wage in 1968 is equal to the nominal federal minimum wage in 1968, $1.60. So $1.60/1.00 = $10.90/P2015. Solving the equation for P2015 and multiplying the answer by 100 to get the index value gives P2015 = 681. The inflation rate is the percentage change in the price levels, so the inflation rate equals [(681 − 100)/100] × 100, which is 581 percent.

28.

After you have studied Economics in the News on pp. 126–127 (534–535 in Economics), answer the following questions. a. How many jobs must be created each month to keep pace with a growing population?

About 137,000 jobs per month must be created.

b. What normally happens to the unemployment rate when the pace of job creation exceeds the increase in population?

When the pace of job creation exceeds the increase in population, normally the unemployment rate falls.

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the increase in population?

The unemployment rate might increase because the relatively rapid pace of job creation brings more discouraged workers back into the labor force. Unless they immediately find jobs, these workers are counted as unemployed, which can increase the unemployment rate.

d. How would you expect the labor force participation rate to respond to job creation in excess of population growth?

One would expect the labor force participation rate to increase, which is indeed what occurred between May and June 2017.

e. How would you expect an increase in the growth rate of real GDP to affect jobs and unemployment?

An increase in the growth rate of real GDP increases the number of jobs and decreases unemployment.

29.

Older American Workers Are Still Struggling to Find Jobs Employers are creating new jobs but older workers are not getting them. In August 2016, 151,000 new jobs were created. But 2.5 million workers over 55 were either unemployed, in part time jobs but wanting full time, or had given up on seeking work. That’s a 12 percent unemployment rate. Age discrimination is illegal but hiring discrimination is hard to prove and economists at the University of California at Irvine and Tulane University say they have found evidence of age discrimination in hiring, particularly for older women.

Source: Fortune, September 8, 2016 a. What type of unemployment might older workers be more prone to experience?

Older workers are more likely to experience structural unemployment.

b. Explain how the unemployment rate of older workers is influenced by the business cycle.

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

c. Why might older unemployed workers become marginally attached or discouraged workers?

The news clip explains that older unemployed workers have a significantly more difficult time finding a new job than do younger unemployed workers. Older workers have a significantly higher unemployment rate than younger workers. It would be easy for some older workers to become discouraged about their job prospects and either quit looking entirely, thereby becoming marginally attached or discouraged workers.

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LXXXII

C h a p t e r

6

*

* This is Chapter 23 in Economics.

lxxxii

ECONOMIC GROWTH**

SOLUTION MANUAL FOR MACROECONOMICS, 13TH EDITION MICHAEL PARKIN

Answers to the Review Quizzes Page 138 1.

(page 546 in Economics)

What is economic growth and how do we calculate its rate?

Economic growth is the sustained expansion of production possibilities. It is measured by the increase in real GDP over a given time period. The economic growth rate is the annual percentage change in real GDP.

2.

What is the relationship between the growth rate of real GDP and the growth rate of real GDP per person?

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

3.

Use the Rule of 70 to calculate the growth rate that leads to a doubling of real GDP per person in 20 years.

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

Page 141 1.

(page 549 in Economics)

What has been the average growth rate of U.S. real GDP per person over the past 100 years? In which periods was growth most rapid and in which periods was it slowest?

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

2.

Describe the gaps between real GDP per person in the United States and in other countries. For which countries is the gap narrowing? For which is it widening? For which is it the same?

Some rich countries are catching up with the United States, but the gaps between the United States and many poor countries are not closing. Amongst the rich countries, for about the ten years after 1980 Japan closed the gap with the United States but then it widened back to what it was initially while the gaps between the United States and Canada, and the ―Europe Big 4‖ (France, Germany, Italy, and the United Kingdom) have tended to remain constant. The gap between Russia and the United States initially widened, then rapidly © 2018 Pearson Education, Inc.

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narrowed and recently has been widening again. The gap between Mexico and the United States has widened, though the rate of widening seems to have slowed. The gap between the United States and Nigeria has narrowed slightly. Some nations in Asia— including Hong Kong, Singapore, Korea, and China—have grown very rapidly. The gap between these nations and the United States has shrunk; indeed, Singapore has slightly surpassed the United States and Hong Kong has virtually tied the United States.

3.

Compare the growth rates in Hong Kong, Korea, Singapore, Taiwan, China, and the United States. In terms of real GDP per person, how far is China behind these others?

Since 1980, income per person in the nations of Hong Kong, Singapore, Korea, Taiwan, and China have grown very rapidly and are rapidly catching up to the United States. Income per person in Hong Kong is virtually the same as that in the United States and income per person in Singapore slightly exceeds that in the United States.

Income in Korea also is relatively close. Income in China is the lowest, though recently China has been growing the most rapidly.

China’s level of income in 2016 is similar to that of Hong Kong in 1980.

Page 147 1.

(page 555 in Economics)

What is the aggregate production function?

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

2.

What determines the demand for labor, the supply of labor, and labor market equilibrium?

The demand for labor is the relationship between the quantity of labor demanded and the real wage rate. A fall in the real wage rate increases the quantity of labor demanded because of diminishing returns. The demand for labor also depends on productivity. If productivity increases, the demand for labor increases.

The supply of labor is the relationship between the quantity of labor supplied and the real wage rate. An increase in the real wage rate increases the quantity of labor supplied because more people enter the labor force and the hours supplied per person increases.

The real wage adjusts so that the labor market is in equilibrium. If the real wage rate is above (below) its equilibrium, there is a surplus (shortage) of labor that then causes the real wage rate to fall (rise). For example, if the real wage rate is above the equilibrium level, there is a surplus of labor so the real wage rate falls until it reaches its equilibrium. The equilibrium quantity of employment is the full employment quantity of labor.

3.

What determines potential GDP? Potential GDP is determined from the labor market equilibrium. When the labor market is in equilibrium, there is full employment. The quantity of real GDP produced by the full employment quantity of labor is potential GDP. © 2018 Pearson Education, Inc.

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4.

What are the two broad sources of potential GDP growth?

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

5.

What are the effects of an increase in the population on potential GDP, the quantity of labor, the real wage rate, and potential GDP per hour of labor?

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

6.

What are the effects of an increase in labor productivity on potential GDP, the quantity of labor, the real wage rate, and potential GDP per hour of labor?

The increase in labor productivity shifts the aggregate production function curve upward. The demand for labor increases, and the demand for labor curve shifts rightward. The increase in the demand for labor raises the real wage rate and increases employment. The increase in employment as well as the upward shift of the aggregate production function increase potential GDP. Potential GDP per hour of labor increases.

Page 149 1.

(page 555 in Economics)

What are the preconditions for labor productivity growth?

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

2.

Describe the sources of economic growth and identify the source of the growth slowdown.

Economic growth can be divided into two sources: Growth in work hours and growth in labor productivity. Both sources contributed to the slowdown in economic growth in the 2000s. Growth in work hours, after growing slowly between 1989 and 1999, disappeared in the 2000s and contributed nothing to economic growth. Growth in productivity, while not totally disappearing, slowed compared to previous eras.

For both reasons, economic growth in the 2000s has been less than during other periods.

3.

Explain the influences on the pace of labor productivity growth.

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

Similarly advances in technology also lead to increases in labor productivity.

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Page 155 1.

(page 559 in Economics)

What is the key idea of classical growth theory that leads to the dismal outcome?

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

2.

What, according to neoclassical growth theory, is the fundamental cause of economic growth?

In neoclassical growth theory, growth results from technological advances, which are determined by chance.

3.

What is the key proposition of new growth theory that makes economic growth persist?

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

This innovation means that economic growth persists indefinitely.

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Answers to the Study Plan Problems and Applications 1.

Mexico’s real GDP was 14,461 billion pesos in 2016 and 14,702 billion pesos in 2017. Mexico’s population was 121 million in 2016 and 122 million in 2017. Calculate a. The growth rate of real GDP. Between 2016 and 2017 this growth rate equals [(14,702 billion pesos  14,461 billion pesos)/14,461 billion pesos]  100, which is 1.7 percent.

b. The growth rate of real GDP per person.

Mexico’s population grew at [(122 million  121 million)/121 million]  100, which is 0.8 percent. Mexico’s growth rate of real GDP is 1.7 percent, so the growth rate of real GDP per person is 1.7 percent  0.8 percent, or 0.9 percent.

c. The approximate number of years it takes for real GDP per person in Mexico to double if the 2017 growth rate of real GDP and the population growth rate are maintained.

Mexico’s real GDP per person is growing at 0.9 percent a year. The rule of 70 tells us that Mexico’s real GDP per person will double in 70/0.9 = 77.8 years.

2.

The IMF projects that China’s real GDP per person will be 57,163 yuan in 2017 and 60,334 yuan in 2018 and that India’s real GDP per person will be 98,028 rupees in 2017 and 104,191 rupees in 2018. By maintaining their current growth rates, which country will be first to double its standard of living and when will that happen?

China’s growth rate of real GDP per person is [(60,334 yuan  57,163 yuan)/57,163 yuan]  100, which is 5.5 percent. India’s growth rate of real GDP per person is [(104,191 rupees  98,028 rupees)/98,028 rupees]  100, which is 6.3 percent. China’s real GDP per person will double in approximately 70/5.5 = 12.7 years and India’s real GDP per person will double in approximately 70/6.3 = 11.1 years, so India’s standard of living will double first in about the year 2029.

3.

China was the largest economy for centuries because everyone had the same type of economy— subsistence—and so the country with the most people was economically biggest. Then the Industrial Revolution sent the West on a more prosperous path. Now the world is returning to a common economy, this time technology- and information-based, so once again population triumphs. a. Why was China the world’s largest economy until 1890?

GDP equals GDP per person multiplied by the number of people. Until 1890 most people in the world had approximately the same subsistence level of income so that every nation’s GDP per person was about the same. Because China had, by far, the world’s largest population, China also had the world’s largest GDP.

b. Why did the United States surpass China in 1890 to become the world’s largest economy?

The United States benefited from the industrial revolution that was sweeping Western nations at the time while China did not. U.S. economic growth accelerated well beyond Chinese economic growth so that the U.S. GDP became larger than China’s GDP.

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Use the following tables to work Problems 4 to 6.

The first table describes an economy’s labor market in 2018 and the second table describes its production function in 2018.

Real wage rate (dollars per hour) 80 70 60 50 40 30 20 4.

Labor hours supplied

Labor hours demanded

Labor (hours)

Real GDP (2009 dollars)

45 40 35 30 25 20 15

5 10 15 20 25 30 35

5 10 15 20 25 30 35 40

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

What are the equilibrium real wage rate, the quantity of labor employed in 2018, labor productivity, and potential GDP in 2018?

The equilibrium real wage rate is $40 per hour and the equilibrium quantity of labor employed is 25 hours. With employment of 25 hours, the production function shows that potential GDP is $1,625. Labor productivity equals $1,625  25 hours, or $65.00 per hour.

5.

In 2019, the population increases and labor hours supplied increase by 10 at each real wage rate.

What are the equilibrium real wage rate, labor productivity, and potential GDP in 2019?

The equilibrium real wage rate is $30 per hour and the equilibrium quantity of employment is 30 hours. With employment of 30 hours, the production function shows that real GDP is $1,800. Labor productivity equals $1,800  30 hours, or $60.00 per hour.

6.

In 2019, the population increases and labor hours supplied increase by 10 at each real wage rate.

Does the standard of living in this economy increase in 2019? Explain why or why not.

The standard of living does not increase. In fact, it decreases because real GDP per person falls. The economy moves along its production function so that potential GDP increases but real GDP per person decreases.

7.

Labor Productivity on the Rise The BLS reported the following data for the year ended March 2017: In the nonfarm sector, output increased by 2.5 percent and labor productivity increased 1.2 percent. In the manufacturing sector, output increased by 0.9 percent and labor productivity increased by 0.3 percent.

Source: bls.gov/news.release, June 5, 2017 In both sectors, output and labor productivity increased. Did the quantity of labor (aggregate hours) increase or decrease? In which sector was the change in the quantity of labor larger?

Labor productivity equals real GDP divided by aggregate labor hours, so aggregate labor hours equals real GDP divided by labor productivity. In terms of growth rates, this last formula means that the growth in aggregate labor hours approximately equals the growth © 2018 Pearson Education, Inc.

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in real GDP minus the growth in labor productivity. (This is the same calculation as on page 544 of the text for the approximation formula for growth in real GDP per person.) Using this equation, in the nonfarm sector labor hours rose by 2.5 percent – 1.2 percent = 1.3 percent and in the manufacturing sector labor hours rose by 0.9 percent – 0.3 percent = 0.6 percent. The change in the quantity of labor was the largest in the nonfarm sector.

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Explain the processes that will bring the growth of real GD P per person to a stop according to a. Classical growth theory.

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

b. Neoclassical growth theory.

In the neoclassical model, technological growth leads to increased saving so that capital accumulates and real GDP per person grows.

When technological growth stops, capital continues to accumulate but diminishing marginal returns drives the return on capital lower and so decreases investment and saving. Eventually the capital stock stops growing and economic growth stops.

c. New growth theory.

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

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Answers to Additional Problems and Applications 9.

In 2018 Brazil’s real GDP is growing at 1.7 percent a year and its population is growing at 0.7 percent a year. If these growth rates continue, in what year will Brazil’s real GDP per person be twice what it is in 2018?

The growth rate of real GDP per person equals the growth rate of real GDP minus the population growth rate. Brazil’s real GDP per person is growing at a rate of 1.7 percent – 0.7 percent = 1.0 percent. Then using the rule of 70, it will take 70/1.0 = 70 years for Brazil’s real GDP per person to double, which means it will double in approximately 2088.

10.

Canada’s real GDP was $C1,830 billion in 2017 and $C1,866 billion in 2018. Canada’s population was 36.7 million in 2017 and 37.1 million in 2018. Calculate a. The growth rate of real GDP. Between 2018 and 2017 this growth rate equals [($C1,866 billion  $C1,830 billion)/$C1,830 billion]  100, which is 2.0 percent.

b. The growth rate of real GDP per person.

Canada’s population grew at [(37.1 million  36.7 million)/36.7 million]  100, which is 1.1 percent. Canada’s growth rate of real GDP is 2.0 percent, so the growth rate of real GDP per person is 2.0 percent  1.1 percent, or 0.9 percent.

c. The approximate number of years it takes for real GDP per person in Canada to double if the 2018 growth rate of real GDP and the population growth rate are maintained.

Canada’s real GDP per person is growing at 0.9 percent a year. The rule of 70 tells us that Canada’s real GDP per person will double in 70/0.9 = 77.8 years.

11.

Australia’s real GDP was $A1,730 billion in 2017 and $A1,782 billion in 2018. Australia’s population was 24.6 million in 2017 and 25.0 million in 2018. Calculate a. The growth rate of real GDP. The growth rate of real GDP between 2017 and 2018 is [($A1,782 billion  $A1,730 billion)/$A1,730 billion]  100 = 3.01 percent.

b. The growth rate of real GDP per person.

Australia’s population growth rate is equal to [(25.0 million  24.6 million)/24.6 million]  100, which is 1.63 percent. Australia’s economic growth rate is 3.01 percent, so the growth rate of real GDP per person is 3.01 percent  1.63 percent, or 1.38 percent.

c. The approximate number of years it will take for real GDP per person in Australia to double if the current real GDP and population growth rate maintained.

Australia’s real GDP per person is growing at 1.38 percent a year.

The rule of 70 tells us that Australia’s real GDP per person will double in 70/1.38 = 50.7 years.

12.

A Shifting Global Economic Landscape Global growth for 2016 is estimated at 3.1 percent. Advanced economies are projected to grow by 1.9 percent in 2017 and 2.0 percent in 2018. The primary factor underlying the strengthening global outlook over 2017–18 is the projected pickup in developing economies’ growth estimated © 2018 Pearson Education, Inc.

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at 4.1 percent in 2016, and projected to reach 4.5 percent for 2017. A further pickup in growth to 4.8 percent is projected for 2018. Notably, the growth forecast for 2017 was revised up for China to 6.5 percent.

Source: International Monetary Fund, January 2017 Do the growth rates projected by the IMF indicate that gaps in real GDP per person around the world are shrinking, growing, or staying the same? Explain.

The data in the news clip indicate that the gap in real GDP between the advanced economies and the developing economies will decrease a bit in 2017 and 2018 because the developing economies are projected to grow about 2.5 percentage points more rapidly than the advanced economies. As long as the population in the developing economies grows less than 2.5 percentage points more rapidly than growth in the advanced economies, the gap in real GDP per person will also shrink.

13.

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

b. Employment.

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

c. The real wage rate.

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

14.

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

b. Employment.

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

c. The real wage rate.

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

Use the following tables to work Problems 15 to 17.

The first table describes an economy’s labor market in 2018 and the second table describes its production function in 2018.

Real wage rate (dollars per hour) 80 70 60 50

Labor hours supplied

Labor hours demanded

Labor (hours)

Real GDP (2009 dollars)

55 50 45 40

15 20 25 30

15 20 25 30

1,425 1,800 2,125 2,400

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40 30 20 15.

35 30 25

35 40 45

35 40 45 50

2,625 2,800 2,925 3,000

What are the equilibrium real wage rate and the quantity of labor employed in 2018?

The equilibrium real wage rate is $40 per hour and the equilibrium quantity of labor employed is 35 hours.

16.

What are labor productivity and potential GDP in 2018?

Potential GDP is $2,625, the quantity of real GDP produced with the equilibrium quantity of employment. Labor productivity equals $2,625  35 hours, or $75.00 per hour.

17.

Suppose that labor productivity increases in 2018.What effect does the increased labor productivity have on the demand for labor, the supply of labor, potential GDP, and real GDP per person?

The increase in labor productivity increases the demand for labor.

The supply of labor does not change. The equilibrium wage rate rises and equilibrium employment increases. Potential GDP increases for two reasons: First, the increase in labor productivity increases potential GDP; second, the increase in equilibrium employment increases potential GDP. Real GDP per person increases.

18.

India’s Economy Hits the Wall Just six months ago, India was looking good. Annual growth was 9%, consumer demand was huge, and foreign investment was growing. But now most economic forecasts expect growth to slow to 7%—a big drop for a country that needs to accelerate growth. India needs urgently to upgrade its infrastructure and education and health-care facilities. Agriculture is unproductive and needs better technology. The legal system needs to be strengthened with more judges and courtrooms.

Source: BusinessWeek, July 1, 2008 Explain five potential sources for faster economic growth in India suggested in this news clip.

One suggested source of increased economic growth is increased infrastructure investment. Infrastructure includes factors such as roads, ports, railways, and electricity transmission. The second suggestion mentioned is to raise education achievement. This recommendation, while not a short-term fix, would be quite powerful at raising India’s long-term growth. The third factor is to increase health-care facilities. Better health care for its citizens translates into increased labor productivity because India’s workers would be better able to work in the marketplace. The fourth source of increased economic growth is to increase productivity in agriculture. This suggestion, however, is not well detailed; in particular, it is much easier to suggest raising productivity than to actually do so. The last suggestion is to increase the number of judges and strengthen the legal system, and improve governance.

However, while a seemingly simple suggestion, this process is likely to wind up politically quite difficult.

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The Productivity Watch According to former Federal Reserve chairman Alan Greenspan, IT investments in the 1990s boosted productivity, which boosted corporate profits, which led to more IT investments, and so on, leading to a nirvana of high growth.

Source: Fortune, September 4, 2006 Which of the growth theories that you’ve studied in this chapter best corresponds to the explanation given by Mr. Greenspan?

Mr. Greenspan is describing the new growth theory. According to this theory, economic growth will persist indefinitely because of the perpetual pursuit of profit.

20.

Is faster economic growth always a good thing? Argue the case for faster growth and the case for slower growth. Then reach a conclusion on whether growth should be increased or slowed.

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

21.

Why Canada’s Industry Leaders Need to Embrace the Technology Mindset We are at a tipping point where technology— from software to hardware and everything in between—is weaving its way into all that we do and is about to touch every industry. Every day, we are reminded how quickly things are changing from connected cars, to wearable devices, to manufacturing. Just look at the rapid advance in China’s economy and standard of living driven in large part by an innovative spirit unleashed in the late 1990s.

Source: Financial Post, July 11, 2014 Explain which growth theory best describes the news clip.

The new growth theory stresses the role of innovation and the birth of new firms and the death of old ones. The new growth theory best describes the article because the article describes new products, such as connected cars and wearable devices. If these novel products are successful, then new firms that produce them will be born and old firms that produce outdated products will die. The news clip also describes new technology, and says that the rapid advance in China's economy and China's standard of living comes from innovation. Further innovation will lead to profit and even more further innovation.

22.

What is the fundamental fact that drives the new growth theory perpetual motion machine and keeps it in motion?

The fundamental fact that drives the perpetual motion machine is that our wants always exceed our ability to satisfy them. As firms innovate new ways to satisfy these wants and our standard of living grows, so too do our wants for an even higher standard of living.

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23.

Describe the components of the new growth theory perpetual motion machine and explain the role played by incentives in keeping the machine in motion.

Major components of the new growth theory are people’s insatiable wants and firms’ pursuit of profit. Because people’s wants always exceed what they have, firms, in search of profit, have the incentive to innovate new production techniques and create new products to satisfy these wants. As firms innovate new and better ways to produce new and better products, old firms and old jobs are destroyed while new firms and new jobs are created. The new jobs are more productive than the old ones, so they pay more than the old jobs, which gives people the incentive to take the new jobs. Along with the higher pay, the more productive techniques allow more leisure. The increased leisure and better products bring a higher standard of living. But people’s wants remain insatiable, so they want a still higher standard of living, which continues to give firms the incentive to continue to innovate.

24.

Why and how does new growth theory imply that technological change, even robots and artificial intelligence, will create as many jobs as it will destroy?

The creation new technology, including robots and artificial intelligence, is the result of people’s knowledge capital increasing. This sort of capital is not subject to diminishing returns, so the return from still more additional knowledge capital is still high. That means there will be more technological breakthroughs to satisfy people’s insatiable wants and hence more jobs producing these products, including the production of more robots and more artificial intelligence.

Economics in the News 22.

After you have studied Economics in the News on pp. 156–157 (564–565 in Economics), answer the following questions. a. How do the real GDP growth rates of Canada and the United States compare since 2006?

The growth rate of real GDP has been higher in Canada than in the United States.

b. How do the growth rates of real GDP per person in Canada and the United States compare since 2006?

The growth rate of real GDP per person has been higher in the United States than in Canada.

c. How do we measure labor productivity?

Labor productivity equals GDP per hour of work, so economists measure labor productivity by dividing real GDP by aggregate labor hours.

d. Why might work hours per person have decreased in both the United States and Canada, and why might the U.S. decrease be greater than the Canadian decrease?

Recently the percentage of workers who work part-time has increased in both the United States and Canada. The increase in the fraction of workers who are part time decreases the average work hours per © 2018 Pearson Education, Inc.

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person. This United States workers who work than in Canada.

C h a p t e r

decrease has been larger in the because the percentage of U.S. part time has increased by more

e. What is the source of the United States’ faster productivity growth and what must Canada do to replicate it?

The faster productivity growth in the United States is the result of U.S. adoption of more productive technologies at a faster clip than Canada. Canada needs to increase the speed with which it adopts better technologies. Canada might implement policies to increase saving, which can be used to finance the acquisition and implementation of the new technologies.

7

FINANCE, SAVING, AND INVESTMENT**

© 2018 Pearson Education, Inc.

WHAT IS ECONOMICS?XCV

*

* This is Chapter 24 in Economics. xcv

SOLUTION MANUAL FOR MACROECONOMICS, 13TH EDITION MICHAEL PARKIN

Answers to the Review Quizzes Page 168 1.

(page 576 in Economics)

Distinguish between physical capital and financial capital and give two examples of each.

Physical capital is the actual tools, instruments, machines, buildings and other items that have been produced in the past and are presently used to produce goods and services. Financial capital is the funds that businesses use to acquire their physical capital.

Examples of physical capital are the pizza ovens owned by Pizza Hut and the buildings in which the Pizza Huts are located. Examples of financial capital are the bonds issued by Pizza Hut to buy pizza ovens and the loans Pizza Hut has made to fund their purchases of new buildings.

2.

What is the distinction between gross investment and net investment?

Gross investment is the total amount spent on new capital; net investment is the change in the value of the capital stock. Net investment equals gross investment minus depreciation.

3.

What are the three main types of markets for financial capital?

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

4.

Explain the flows of funds that finance business investment.

The funds that finance business investment (I) can come from three sources: household saving (S), a government budget surplus (T – G), and borrowing from the rest of the world (M – X). In terms of the national income accounts, I = S + (T – G) + (M – X) These funds flow into the financial market, where financial institutions, such as commercial banks, government-sponsored mortgage lenders, mutual funds, pension funds, and insurance companies, use the funds to make loans to business that want to borrow to finance their investment.

Page 170 1.

(page 578 in Economics)

Define and distinguish between future value and present value.

The value of future dollars, that is, dollars to be received or paid in the future, is called future value, while the value of current dollars, that is, dollars currently being received or paid, is called present value. The present value of a future dollar is the current amount of dollars that, with interest, will grow to be as large as the future amount. Converting a future amount of money to its present value is called discounting.

2.

What is the present value of $500, three years in the future if the interest rate is 5 percent?

The present value of $500 three years in the future when the interest rate is 5 percent is equal to: © 2018 Pearson Education, Inc.

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Present value =

3.

= $431.92.

What is net present value and how is it used in financial decisions?

Net present value is the present value of all the future flows of money that result from a financial decision minus the initial cost of the decision. Net present value is used to make financial decisions. Setting aside risk, if the net present value of a decision is positive, the decision should be undertaken but if it is negative, the decision should not be undertaken. If risk and uncertainty play a role, then the decision should be undertaken if the net present value is sufficiently positive that a loss is sufficiently unlikely.

4.

Explain the relationship between asset prices and the interest rate.

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

5.

Explain why the real interest rate is the opportunity cost of loanable funds.

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

Page 175 1.

(page 583 in Economics)

What is the loanable funds market?

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

2.

How do firms make investment decisions?

To determine the quantity of investment, firms compare the expected profit rate from an investment to the real interest rate. The expected profit from an investment is the benefit from the investment. The real interest rate is the opportunity cost of investment. If the expected profit from an investment exceeds the cost of the real interest rate, so that the net present value is positive, then firms make the investment. If the expected profit from an investment is less than the cost of the real interest rate, so that the net present value is negative, then firms do not make the investment.

3.

What determines the demand for loanable funds and what makes it change?

The demand for loanable funds depends on the real interest rate and expected profit. If the real interest rate falls and nothing else © 2018 Pearson Education, Inc.

FINANCE, SAVING, AND INVESTMENT95

changes, the quantity of loanable funds demanded increases.

Conversely, if the real interest rate rises and everything else remains the same, the quantity of loanable funds demanded decreases.

Movements along the loanable funds demand curve illustrate these events. If the expected profit increases and nothing else changes, the demand for loanable funds increases and the demand for loanable funds curve shifts rightward. If the expected profit decreases and everything else remains the same, the demand for loanable funds decreases and the demand for loanable funds curve shifts leftward.

4.

How do households make saving decisions?

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

5.

What determines the supply of loanable funds and what makes it change?

The supply of loanable funds depends on the real interest rate, disposable income, expected future income, wealth, and default risk.

An increase in the real interest rate increases the quantity of loanable funds supplied; a decrease in the real interest rate decreases the quantity of loanable funds supplied. An increase in disposable income increases the supply of loanable funds; a decrease in disposable income decreases the supply of loanable funds. An increase in wealth decreases the supply of loanable funds; a decrease in wealth increases the supply of loanable funds. An increase in expected future income decreases the supply of loanable funds; a decrease in expected future income increases the supply of loanable funds. Finally, an increase in default risk decreases the supply of loanable funds; a decrease in default risk increases the supply of loanable funds.

6.

How do changes in the demand for and supply of loanable funds change the real interest rate and quantity of loanable funds?

The real interest rate is determined by the supply of loanable funds and the demand for loanable funds. The equilibrium real interest rate is the real interest rate at which the quantity of loanable funds supplied equals the quantity of loanable funds demanded.

Changes in the demand for or supply of loanable funds change the equilibrium real interest rate and equilibrium quantity of loanable funds. If the demand for loanable funds increases and the supply does not change, the real interest rate rises and the quantity of loanable funds increases. If the demand for loanable funds decreases and the supply does not change, the real interest rate falls and the quantity of loanable funds decreases. If the supply of loanable funds increases and the demand does not change, the real interest rate falls and the quantity of loanable funds increases. If the supply of loanable funds decreases and the demand does not change, the real interest rate rises and the quantity of loanable funds decreases. © 2018 Pearson Education, Inc.

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Page 177 1.

(page 585 in Economics)

How does a government budget surplus or deficit influence the loanable funds market?

A government budget surplus adds to the supply of loanable funds. A government budget deficit adds to the demand for loanable funds.

2.

What is the crowding-out effect and how does it work?

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

3.

What is the Ricardo-Barro effect and how does it modify the crowding-out effect?

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

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Answers to the Study Plan Problems and Applications Use the following data to work Problems 1 and 2.

Michael, an Internet service provider, bought an existing business worth $400,000 on December 31, 2017. During 2018, his business grew and he bought $500,000 of new servers. The market value of his older servers fell by $100,000.

1.

What was Michael’s gross investment, depreciation, and net investment during 2018?

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

2.

What is the value of Michael’s capital at the end of 2018?

Michael’s capital at the end of 2018 is equal to his capital at the beginning of 2018, $400,000, plus his net investment during the year, also $400,000, for a total of $800,000.

3.

Lori is a student who teaches golf on Saturdays. In a year, she earns $20,000 after paying her taxes. At the beginning of 2017, Lori owned $1,000 worth of books, DVDs, and golf clubs and she had $5,000 in a savings account at the bank. During 2017, the interest on her savings account was $300 and she spent a total of $15,300 on consumption goods and services. There was no change in the market values of her books, DVDs, and golf clubs. a. How much did Lori save in 2017?

Lori’s saving equals her disposable income minus her consumption expenditure. Lori’s disposable income is $20,000 plus the interest on her savings account, $300, for a total of $20,300.Her consumption expenditure is $15,300, so her saving is $5,000.

b. What was her wealth at the end of 2017?

Lori’s wealth at the end of 2017 is equal to the value of her wealth at the beginning of 2017 plus her saving during the year. At the beginning of 2017 Lori’s wealth is $6,000—the value of her books, DVDs, golf clubs, and savings account. Lori saved $5,000 during 2017 so her wealth at the end of the year is $11,000.

4.

Tom took out a $2,000 loan to buy a boat at an interest rate of 10 percent a year. He plans to repay the loan after 2 years. How much will he have to pay?

Tom will have to pay the future value of his loan, ($2,000) × (1.10) = $2,420.

5.

Joe has a term deposit that pays 10 percent a year and its value after two years will be $5,000.

What is the present value of Joe’s term deposit?

The present value of the term deposit is

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= $4,132.23.

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Use the following information to work Problems 6 and 7.

First Call, Inc., a smartphone company, plans to build a factory—one that costs $10 million if the real interest rate is 6 percent a year; a larger plant that costs $12 million if the real interest rate is 5 percent a year; or a smaller plant that costs $8 million if the real interest rate is 7 percent a year.

6.

Draw a graph of First Call’s demand for loanable funds curve.

Figure 7.1 shows First Call’s demand for loanable funds curve.

7.

First Call expects its profit to double next year.

Explain how this increase in expected profit influences First Call’s demand for loanable funds.

When First Call expects its profit to increase, First Call increases its investment. The increase in its investment leads First Call to increase its demand for loanable funds.

8.

The table sets out data for an economy when the government’s budget is balanced. a. Calculate the equilibrium real interest rate, investment, and private saving.

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

Loanable funds demanded

Loanable funds supplied

(trillions of 2009 dollars) 8.5 5.5 8.0 6.0 7.5 6.5 7.0 7.0 6.5 7.5 6.0 8.0 5.5 8.5

The equilibrium real interest rate is 7 percent per year. The equilibrium quantity of investment equals the quantity of loanable funds demand, $7.0 trillion and the equilibrium quantity of saving equals the quantity of loanable funds supplied, $7.0 trillion.

b. If planned saving increases by $0.5 trillion at each real interest rate, explain the change in the real interest rate.

The increase in saving increases the supply of loanable funds. The equilibrium real interest rate falls. In the table, the new equilibrium real interest rate is 6.5 percent per year.

c. If planned investment increases by $1 trillion at each real interest rate, explain the change in © 2018 Pearson Education, Inc.

FINANCE, SAVING, AND INVESTMENT99

the real interest rate.

The increase in investment increases the demand for loanable funds.

The equilibrium real interest rate rises. In the table, the new equilibrium real interest rate is 8 percent per year.

Use the data in Problem 8 along with news that the government now has a budget deficit of $1 trillion to work Problems 9 and 10.

9.

What is the real interest rate? How much investment occurs? Does crowding out occur?

The equilibrium real interest rate becomes 8 percent and the equilibrium quantity of investment is $6.5 trillion. There is crowding out of $500 billion of investment.

10.

If the Ricardo-Barro effect occurs, what are the real interest rate and investment?

The equilibrium real interest rate remains 7 percent and the quantity of investment remains $7.0 trillion. There is no crowding out because the $1 trillion increase in the budget deficit leads to an offsetting $1 trillion increase in private saving.

Use the loanable funds data in Problem 8 and the following data to work Problems 11 and 12.

Suppose that the quantity demanded increases by $1 trillion at each real interest rate and the quantity supplied increases by $2 trillion at each interest rate.

11.

12.

If the government budget remains balanced, what are the real interest rate, investment, and private saving? Does any crowding out occur?

The table to the right, Real Loanable Loanable which shows the new interest funds funds demand for loanable funds rate demanded supplied and new supply of (percent (trillions of 2009 loanable funds schedules, per year) dollars) is helpful to answer the 4 9.5 7.5 problem. The new real 5 9.0 8.0 interest rate is 6 6 8.5 8.5 percent. Investment and 7 8.0 9.0 private saving are both 8 7.5 9.5 $8.5 trillion. There is 9 7.0 10.0 no crowding out.

10 6.5 10.5 If the government’s budget is a deficit of $1 trillion, what are the real interest rate and investment? Does any crowding out occur?

The equilibrium real interest rate becomes 7 percent. The equilibrium quantity of investment is $8.0 trillion. There is crowding out of $500 billion of investment.

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Answers to Additional Problems and Applications 13.

On January 1, 2017, Terry’s Towing Service owned 4 tow trucks valued at $300,000. During 2017, Terry’s bought 2 new trucks for a total of $180,000. At the end of 2017, the market value of all of the firm’s trucks was $400,000. What was Terry’s gross investment? Calculate Terry’s depreciation and net investment.

His gross investment was $180,000. His depreciation was $80,000. His net investment, equal to gross investment minus depreciation, was $100,000.

Use the following information to work Problems 14 and 15.

The Bureau of Economic Analysis reported that the U.S. capital stock was $56.1 trillion at the end of 2013, $58.2 trillion at the end of 2014, and $59.3 trillion at the end of 2015. Depreciation in 2014 was $2.7 trillion, and gross investment during 2015 was $3.1 trillion.

14. Calculate U.S. net investment and gross investment during 2014.

Net investment equals the change in the capital stock. In 2014, U.S. net investment was $58.2 trillion  $56.1 trillion, which is $2.1 trillion. Gross investment equals net investment plus depreciation.

In 2014, U.S. gross investment was $2.1 trillion + $2.7 trillion, which is $4.8 trillion.

15.

Calculate U.S. depreciation and net investment during 2015.

Net investment equals the change in the capital stock. In 2015, U.S. net investment was $59.3 trillion  $58.2 trillion, which is $1.1 trillion. Depreciation equals gross investment minus net investment.

In 2015, U.S. depreciation was $3.1 trillion  $1.1 trillion, which is $2.0 trillion.

16.

Annie runs a fitness center. On December 31, 2016, she bought an existing business with exercise equipment and a building worth $300,000. During 2017, business improved and she bought some new equipment for $50,000. At the end of 2017, her equipment and buildings were worth $325,000. Calculate Annie’s gross investment, depreciation, and net investment during 2017.

Annie’s net investment during 2017 is $25,000 because that is the change in her capital stock. Annie’s gross investment is $50,000 because that is her total purchase of capital equipment in 2017.

Annie’s depreciation during 2017 is $25,000 because Annie’s net investment, $25,000, equals her gross investment, $50,000, minus her depreciation.

17.

Karrie is a golf pro, and after she paid taxes, her income from golf and interest from financial assets was $1,500,000 in 2017. At the beginning of 2017, she owned $900,000 worth of financial assets. At the end of 2017, Karrie’s financial assets were worth $1,900,000. a. How much did Karrie save during 2017?

Karrie’s wealth increased by $1,000,000 in 2017. So her saving in 2017 is $1,000,000. (This answer assumes no capital gains or losses on her stocks and bonds.)

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b. How much did she spend on consumption goods and services?

Her income after taxes was $1,500,000. Her consumption equals her income minus her saving, which is $1,500,000  $1,000,000 = $500,000.

18.

In a speech at the CFA Society of Nebraska, William Poole (former Chairman of the St. Louis Federal Reserve Bank) said: Over most of the post-World War II period, the personal saving rate averaged about 6 percent, with some higher rates from the mid-1970s to mid-1980s. The negative trend in the saving rate started in the mid-1990s, about the same time the stock market boom started. Thus it is hard to dismiss the hypothesis that the decline in the measured saving rate in the late 1990s reflected the response of consumption to large capital gains from corporate equity [stock]. Evidence from panel data of households also supports the conclusion that the decline in the personal saving rate since 1984 is largely a consequence of capital gains on corporate equities. a. Is the purchase of corporate equities part of household consumption or saving? Explain your answer.

The purchase of corporate equities, that is, shares of corporate stock, is part of household saving. Consumption refers to the purchase of goods and services that are then consumed, but corporate equities are not consumable goods or services.

b. Equities reap a capital gain in the same way that houses reap a capital gain. Does this mean that the purchase of equities is investment? If not, explain why it is not.

The purchase of equities is not an investment because investment refers to the purchase of physical capital. Equities are not physical capital and so they are not investment.

19.

Draw a graph to illustrate the effect of an increase in the demand for loanable funds and an even larger increase in the supply of loanable funds on the real interest rate and the equilibrium quantity of loanable funds.

Figure 7.2 shows the effect of an increase in the demand for loanable funds and an even larger increase in the supply of loanable funds. The demand curve for loanable funds shifts rightward from DLF0 to DLF1, and the supply curve of loanable funds shifts rightward from SLF0 to SLF1. The increase in supply is larger than the increase in demand, so the real interest rate falls (from 6 percent to 5 percent in the figure) and the quantity of loanable funds increases (from $2.3 trillion to $2.7 trillion in the figure).

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Draw a graph to illustrate how an increase in the supply of loanable funds and a decrease in the demand for loanable funds can lower the real interest rate and leave the equilibrium quantity of loanable funds unchanged.

Figure 7.3 shows the effect of an increase in the supply of loanable funds and a decrease in the demand for loanable funds.

The supply of loanable funds curve shifts rightward from SLF0 to SLF1, and the demand for loanable funds curve shifts leftward from DLF0 to DLF1. The magnitude of the increase in supply is equal to the magnitude of the decrease in demand, so the real interest rate falls (from 7 percent to 4 percent in the figure) and the quantity of loanable funds does not change (staying at $2.5 trillion in the figure).

Use the following information to work Problems 210 and 22.

In 2017, the Lee family had disposable income of $80,000, wealth of $140,000, and an expected future income of $80,000 a year. At a real interest rate of 4 percent a year, the Lee family saves $15,000 a year; at a real interest rate of 6 percent a year, they save $20,000 a year; and at a real interest rate of 8 percent, they save $25,000 a year.

21.

Draw a graph of the Lee family’s supply of loanable funds curve.

Figure 7.4 shows the Lee family’s supply of loanable funds curve.

22.

In 2018, suppose that the stock market crashes and the default risk increases. Explain how this increase in default risk influences the Lee family’s supply of loanable funds curve.

If default risk increases the Lee family will decrease its saving.

As a result, the Lee family’s supply of loanable funds decreases and its supply of loanable funds curve shifts

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leftward.

23.

TransCanada Deal with U.S. Carrier Worth $13 Billion TransCanada working with Columbia Pipeline Group aims to create giant natural gas transmission business. The deal will create a 91,000-kilometer natural gas pipeline system.

Source: The Toronto Star, March 18, 2016 Show on a graph the effect of TransCanada going to the loanable funds market to finance the deal with Columbia. Explain the effect on the real interest rate, private saving, and investment.

Keystone’s demand for financial capital to fund its pipeline increases the demand for loanable funds. As Figure 7.5 illustrates, the demand curve for loanable funds shifts rightward from DLF0 to DLF1. The real interest rate rises, in the figure from 2 percent per year to 3 percent per year. Private saving and investment both increase.

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24.

CHAPTER 7

The table sets out the data for an economy when the government’s budget is balanced. a. Calculate the equilibrium real interest rate, investment, and private saving.

Real interest rate (percent per year) 2 3 4 5 6 7 8

Loanable Loanable funds funds demanded supplied (trillions of 2009 dollars) 8.0 4.0 7.0 5.0 6.0 6.0 5.0 7.0 4.0 8.0 3.0 9.0 2.0 10.0

The equilibrium real interest rate is 4 percent per year. Equilibrium investment equals the quantity of loanable funds demanded, $6.0 trillion. Equilibrium saving equals the quantity of loanable funds supplied, (also) $6.0 trillion.

b. If planned saving decreases by $1 trillion at each real interest rate, explain the change in the real interest rate and investment.

If planned saving increases by $1 trillion, the supply of loanable funds increases. Consequently the equilibrium real interest falls and the equilibrium quantity of investment increases. In the table, the equilibrium real interest rate falls to 3.5 percent and equilibrium investment increases to $6.5 trillion.

c. If planned investment decreases by $1 trillion at each real interest rate, explain the change in saving and the real interest rate.

If planned investment decreases by $1 trillion, the demand for loanable funds decreases. Consequently the equilibrium real interest falls and the equilibrium quantity of saving decreases. In the table, the equilibrium real interest rate falls to 3.5 percent and equilibrium saving decreases to $5.5 trillion.

Use the following information to work Problems 25 to 27.

India’s Budget Seeks Fiscal Restraint The government of India set a budget deficit target of 3 percent of GDP for 2017–2018, down from 3.5 percent in 2016–2017. Economists predict the 3 percent target will be missed. India’s public debt is the highest in Asia.

Source: CNBC, January 30, 2017 25.

If the Indian government reduces its deficit and achieves its target, how will the demand for or supply of loanable funds in India change?

If the Indian government reduces its deficit, the demand for loanable funds decreases.

26.

If the Indian government misses its deficit target, how will the demand for or supply of loanable funds in India change?

If the Indian government misses its deficit target, the demand for loanable funds will either not change or, if the deficit increases, the demand for loanable funds increases.

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27.

If India’s economic growth slows and incomes grow more slowly, and if other things remain the same, how will the demand or supply of loanable funds in India change?

If economic growth slows, the major effect will be an increase in the supply of loanable funds as households’ increase their saving in response to lower expected future incomes. If the slower growth also reduces the expected future profit, then the demand for loanable funds will decrease.

28.

Budget Deficit Jumps $30 Billion as Federal Spending Outpaces Revenue The U.S. budget deficit rose to $88.4 billion in May from $53 billion a year earlier, as government spending in areas such as Medicaid and defense rose at a faster pace than revenue.

Source: MSNBC, June 12, 2017 Explain the effect of the U.S. budget deficit on U.S. investment, the real interest rate, and economic growth.

The U.S. budget deficit increases the demand for loanable funds and, in the absence of a Ricardo-Barro effect, raises the real interest rate and crowds out investment. The decrease in investment means that the U.S. capital stock is lower than would otherwise be the case, which will decrease U.S. economic growth.

Economics in the News 29.

After you have studied Economics in the News on pp. 178–179 (586–587 in Economics), answer the following questions. a. Why do bond prices and interest rates move in opposite directions?

Bond prices and interest rates move in opposite directions because the interest rate is the interest received as the percentage of the price of the asset. In terms of a formula, if INT is the interest received and PRICE is the price of the asset, then the interest rate is (INT ÷ PRICE) × 100. Therefore, if the price of the asset rises, the percentage of the asset price received as interest, which is the interest rate, falls.

b. Looking at Fig. 1 on p. 179 (587 in Economics), what must have happened to either the demand for or the supply of loanable funds during 2011, 2012, 2013, 2014, and 2015?

In 2011 and 2012 the real interest rate fell, started to rise in 2013 only to fall again in 2014 and then rise once more in 2015. In 2011, 2012, and 2014, one possibility is that either the demand for loanable funds decreased or the supply of loanable funds increased.

Alternatively, if both the demand and supply of loanable funds changed, then if the demand for loanable funds increased, in these years the supply increased even more. Finally in 2013 and 2015, again either the demand for loanable funds increased or the supply of loanable funds decreased or, if both changed, then if the supply of loanable funds increased, the demand for loanable funds increased even more.

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c. If the assumption in Fig. 2 demand for loanable funds during 2016, how does that loanable funds changed?

C h a p t e r

on p. 179 (587 in Economics), that the did not change is wrong and it increased change the story about how the supply of

If the demand for loanable funds increased, it remains the case that the real interest rate fell from 2.9 percent to 1.7 percent and the quantity of loanable funds increased from $37 trillion to $38 trillion. So the demand for loanable funds curve must be steeper than the curve illustrated in the figure but there is no change in the story about the supply of loanable funds: It increased.

d. If an economic expansion gets going in 2018, what will happen to the demand for loanable funds and the real interest rate?

An economic expansion increases the demand for loanable funds. The increase in the demand for loanable funds raises the real interest rate.

30.

Investors Help the Rich Pay Off Student Loans Innovative financial institutions are buying student loans, bundling the loans into securities, and selling the securities to people looking for a higher interest rate.

Source: CNN Money, July 28, 2014 a. How does the financial innovation described in the news clip influence the supply of and demand for loanable funds and the equilibrium real interest rate?

Student loans, per se, are not very marketable because a buyer must worry that the student who is paying on the loan might be unable to make the required payments. As the loans are bundled into securities, the risk from any one student’s inability to pay is decreased. Therefore savers are more willing to buy these new assets, which means that the supply of loanable funds increases. The equilibrium real interest rate falls.

b. If the securitization of student loans lowers the real interest rate faced by students, how would you expect it to influence the demand for human capital and the equilibrium quantity of human capital?

As the real interest rate on student loans falls, more (potential) students will be willing to take out loans to attend college. The demand to attend college increases. By attending college, students’ human capital increases. Therefore, a fall in the real interest rate paid on student loans increases the demand for human capital and increases the equilibrium quantity of human capital.

MONEY, THE PRICE LEVEL, AND INFLATION**

8 *

* This is Chapter 25 in Economics.

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WHAT IS ECONOMICS?CVII

Answers to the Review Quizzes Page 188 1.

(page 596 in Economics)

What makes something money? What functions does money perform? Why do you think packs of chewing gum don’t serve as money?

Money is anything that is generally acceptable as a means of payment. Money has three functions: medium of exchange (money is accepted in exchange for goods and services), unit of account (prices are quoted in terms of money), and store of value (money can be held and exchanged for goods and services later). Packs of chewing gum do not function as money because they are not particularly good as a store of value—gum deteriorates.

Additionally, packs of gum are not generally accepted in exchange for goods and services, so packs of gum are not a medium of exchange.

2.

What are the problems that arise when a commodity is used as money?

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

3.

What are the main components of money in the United States today?

The main components of money in the United States today are currency and deposits at banks and other depository institutions.

4.

What are the official measures of money? Are all the measures really money?

The official measures of money are M1 (the sum of currency, traveler’s checks, and checking deposits owned by individuals and businesses) and M2 (the sum of M1, savings deposits, time deposits, and money market mutual funds and other deposits). All of the components of M1 are truly money because all the components serve as a means of payment. Some of the components of M2 are not truly money because they are not a means of payment. (For instance, funds at money market mutual funds cannot be used as a means of payment for cvii

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small purchases.) But all of these ―non-money‖ assets are highly liquid so they are operationally similar to money.

5.

Why are checks, debit cards, and credit cards not money?

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

Page 192 1.

(page 600 in Economics)

What are depository institutions?

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

2.

What are the functions of depository institutions?

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

3.

How do depository institutions balance risk and return?

Banks earn a higher return by using the funds they acquire from their deposits to buy higher-yielding, riskier assets such as loans.

But these assets are risky. If the loans fail, then the bank might not have sufficient funds to repay their depositors. If the bank undertakes too much risk, then its depositors might rush to withdraw their deposits, which would cause the bank to fail. But if the bank forgoes all risky assets its profit will be much lower. So the bank must balance its search for higher return against the risk earning the return entails.

4.

How do depository institutions create liquidity, pool risks, and lower the cost of borrowing?

Liquidity is the property of being easily convertible into a means of payment without loss in value. Depository institutions create liquidity when they offer deposits that can be withdrawn as money at short (or no) notice and then use these deposits to make long-term loans.

Depository institutions pool risk because they use funds obtained from many depositors to make loans to many borrowers. As a result, if a borrower defaults, no one depositor bears the entire loss because the loss is spread over all depositors. By spreading the risk, depository institutions are pooling risk.

Depository institutions lower the cost of borrowing because they specialize in borrowing. For instance, a firm that wants to borrow a large sum of money need only visit one depository institution to arrange such a loan. In the absence of depository institutions, the firm would need to undertake many transactions with many lenders, which would be a costly process.

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5.

How have depository institutions made innovations that have influenced the composition of money?

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

Page 196 1.

(page 604 in Economics)

What is the central bank of the United States and what functions does it perform?

The Federal Reserve System is the central bank of the United States.

The Federal Reserve conducts the nation’s monetary policy and regulates the nation’s depository institutions. The Fed provides banking services to commercial banks.

2.

What is the monetary base and how does it relate to the Fed’s balance sheet?

The monetary base is the sum of Federal Reserve notes, coins, and depository institutions’ deposits at the Fed. Aside from coins, the rest of the monetary base consists of Federal Reserve liabilities.

Federal Reserve notes and depository institutions’ deposits are liabilities of the Federal Reserve.

3.

What are the Fed’s three policy tools?

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

4.

What is the Federal Open Market Committee and what are its main functions?

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

5.

How does an open market operation change the monetary base?

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

Page 198 1.

(page 606 in Economics)

How do banks create money?

Banks within the banking system create money by creating deposits, which are part of the nation’s money. Banks create deposits by making loans because part or all of the loans they make will be deposited in another bank. For instance, a student given a loan may purchase books at the local bookstore. The bookstore will then © 2018 Pearson Education, Inc.

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deposit the proceeds into its bank as part of the bookstore’s checking account. Thus the loan has created new deposits at the bookstore’s bank.

2.

What limits the quantity of money that the banking system can create?

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

3.

A bank manager tells you that she doesn’t create money. She just lends the money that people deposit. Explain why she’s wrong.

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

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(page 611 in Economics)

What are the main influences on the quantity of real money that people and businesses plan to hold?

The quantity of real money demanded depends on four factors: the price level, the nominal interest rate, real GDP, and financial innovation. An increase in the price level increases the nominal demand for money but the quantity of real money demanded is independent of the price level. An increase in the nominal interest rate decreases the quantity of real money demanded, because the nominal interest rate is the opportunity cost of holding money. An increase in real GDP increases the demand for real money, because more real GDP implies more transactions and an increase in the demand for money to finance the transactions. And, financial innovations that make it less costly to get by with less money on hand decrease the demand for money.

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2.

Show the effects of a change in the nominal interest rate and a change in real GDP using the demand for money curve.

An increase in the nominal interest rate decreases the quantity of real money demanded.

The slope of the demand for money curve shows how the quantity of real money demanded depends on the nominal interest rate. As illustrated in Figure 8.1, a decrease in the nominal interest rate results in a movement downward along the demand for money curve.

A change in real GDP changes the demand for money. An increase in real GDP increases the demand for money and shifts the demand for curve for real money rightward from MD0 to MD1, as shown in Figure 8.2.

3.

How is money market equilibrium determined in the short run?

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

4.

How does a change in the quantity of money change the interest rate in the short run?

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

5.

How does a change in the quantity of money change the interest rate in the long run?

In the long run a change in the quantity of money does not change the interest rate. For example, suppose the Federal Reserve increases the quantity of money (the effects from a decrease in the quantity of money are the reverse of an increase). In the short run the nominal interest rate and the real interest rate fall. Both households and firms increase their demand for goods. The resulting shortages force prices higher and therefore the price level rises.

As the price level rises, the quantity of real money decreases, which raises the nominal interest rate and real interest rate. The rise in the interest rate decreases the demand for goods. Eventually the price level rises so that the quantity of real money equals the initial amount. At this point, the nominal interest rate and real interest rate have risen to equal their initial values so there is no long-run effect on the interest rate from a change in the quantity of money.

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(page 613 in Economics)

What is the quantity theory of money?

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

2.

How is the velocity of circulation calculated?

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

3.

What is the equation of exchange?

The equation of exchange is the formula that MV = PY, where M is the quantity of money, V is the velocity of circulation, P is the price © 2018 Pearson Education, Inc.

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level, and Y is real GDP. The equation of exchange is always true by definition because the velocity of circulation is defined as PY/M.

4.

Does the quantity theory correctly predict the effects of money growth on inflation?

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

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Answers to the Study Plan Problems and Applications 1.

Money in the United States today includes which of the following items?  Cash in Citibank’s cash machines Money includes currency outside the banks. Currency inside cash machines is not money.



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



Your Visa card The Visa card is not money.



Your loan to pay your college tuition The loan is not money.

2.

In May 2017, currency held by individuals and businesses was $1,469 billion; traveler’s checks were $2 billion; checkable deposits owned by individuals and businesses were $2,034 billion; savings deposits were $8,958 billion; time deposits were $355 billion; and money market funds and other deposits were $1,746 billion. Calculate M1 and M2 in May 2017.

M1 consists of currency and traveler’s checks plus checking deposits owned by individuals and businesses. In May, 2017 M1 equaled $1,469 billion + $2 billion + $2,034, or $3,505 billion.

M2 consists of M1 plus time deposits, savings deposits, and money market mutual funds and other deposits. In May, 2017 M2 equaled $3,505 + $355 billion + $8,958 billion + $1,746 billion, or $14,564 billion.

3.

Banks Ordered to Hold More Capital UK banks must hold more capital as their holdings of consumer debt soars.

Source: The Guardian, June 27, 2017 The ―capital‖ means owners’ capital; that is, funds the owners have invested in the bank.

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

4.

The FOMC sells $20 million securities to Wells Fargo. Enter the transactions that take place to show the changes in the following balance sheets.

The first balance sheet to the Federal Reserve Bank of New York right shows the balance sheet Assets Liabilities of the Federal Reserve Bank of (millions) (millions) New York. The Fed’s assets Securities Wells Fargo reserve decrease by $20 million $20 deposit $20 because the Fed now has $20 million less securities. The Fed’s liabilities also decrease by $20 million because Wells Fargo pays for its purchases using the reserves that it has on deposit at the Fed.

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The second balance sheet to the right shows the balance sheet of Wells Fargo Bank. Wells Fargo gains assets in the form of securities of $20 million.

Simultaneously it also losses reserve deposit assets of $20 million because it pays for the government securities using its reserve deposits at the Fed.

5.

Wells Fargo Assets (millions)

Liabilities (millions)

Securities +$20 Reserve deposit $20

In the economy of Nocoin, bank deposits are $300 billion, bank reserves are $15 billion of which two thirds are deposits with the central bank. Households and firms hold $30 billion in bank notes. There are no coins. Calculate a. The monetary base and the quantity of money.

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

The monetary base is $45 billion.

The quantity of money is $330 billion. In Nocoin, deposits are $300 billion and currency is $30 billion, so the quantity of money is $330 billion.

b. The banks’ desired reserve ratio and the currency drain ratio (as percentages).

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

The currency drain is 10 percent. The currency drain is the ratio of currency to deposits. In Nocoin, currency is $30 billion and deposits are $300 billion, so the currency drain equals ($30 billion/$300 billion)  100, which is 10 percent.

6.

China Cuts Banks’ Reserve Ratios The People’s Bank of China announces it will cut the required reserve ratio for five big banks.

Source: Reuters, January 20, 2017 Explain how lowering the required reserve ratio will impact banks’ money creation process.

Lowering the required reserve ratio decreases banks’ desired reserves. Because their desired reserves decrease while their actual reserves do not change, banks have more unplanned reserves. When banks’ unplanned reserves increase they will make more loans so the quantity of money in China increases. (The Mathematical Note shows that an decrease in the desired reserve ratio increases the money multiplier.)

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The spreadsheet provides data about the demand for money in Minland. Columns A and B show the demand for money schedule when real GDP (Y0) is $10 billion and Columns A and C show the demand for money schedule when real GDP (Y1) is $20 billion.

The quantity of money is $3 billion. What is the interest rate when real GDP is $10 billion? Explain what happens in the money market in the short run if real GDP increases to $20 billion.

1 2 3 4 5 6 7 8

A r 7 6 5 4 3 2 1

B Y0 1.0 1.5 2.0 2.5 3.0 3.5 4.0

C Y1 1.5 2.0 2.5 3.0 3.5 4.0 4.5

When real GDP is $10 billion, the equilibrium nominal interest rate is 6 percent because that is the interest rate that sets the quantity of money demanded equal to $3 billion. If real GDP increases to $20, the quantity of money demanded exceeds the quantity supplied, so people want to hold more money than is available. They try to increase the amount of money held by selling bonds. The prices of bonds fall, and the interest rate rises to its new equilibrium of 5 percent.

8.

In year 1, the economy is at full employment and real GDP is $400 million, the GDP deflator is 200 (a price level is 2), and the velocity of circulation is 20. In year 2, the quantity of money increases by 20 percent. If the quantity theory of money holds, calculate the quantity of money, the GDP deflator, real GDP, and the velocity of circulation in year 2.

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

Mathematical Note 9.

In Problem 5, the banks have no unplanned reserves. Suppose that the central bank of Nocoin increases bank reserves by $0.5 billion. a. Explain what happens to the quantity of money and why the change in the quantity of money is not equal to the change in the monetary base.

The quantity of money increases by $3.67 billion. The quantity of money increases by the change in the monetary base multiplied by the money multiplier. The money multiplier is 7.33 (see part b), so when the monetary base increases by $0.5 billion, the quantity of money increases by $3.67 billion.

The change in the quantity of money is not equal to the change in the monetary base because of the multiplier effect. The open market operation increases bank reserves and creates unplanned reserves, © 2018 Pearson Education, Inc.

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which banks use to make new loans. New loans are used to make payments and some of these loans are placed on deposit in banks. The increase in bank deposits increases banks’ reserves and increases desired reserves. But the banks now have unplanned reserves which they loan out and the process repeats until unplanned reserves have been eliminated.

b. Calculate the money multiplier.

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

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Answers to Additional Problems and Applications 10.

Sara withdraws $1,000 from her savings account at the Lucky S&L, keeps $50 in cash, and deposits the balance in her checking account at the Bank of Illinois. What is the immediate change in M1 and M2?

M1 increases by $1,000; M2 does not change. M1 is the sum of currency, traveler’s checks, and checking deposits held by individuals and businesses. M2 is the sum of M1, savings deposits, time deposits, and money market mutual funds and other deposits. The withdrawal of $1,000 from a savings account leaves M2 unchanged because the $1,000 goes into M1 types of money, which is part of M2.

The $50 held as cash and the $950 held in a checking account increase M1 by $1,000.

11.

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

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

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

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

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

12.

How to Pay for Everything With Your Smartphone Many people stopped using cash in the early 2000s because they found debit cards were more convenient. Smartphones are now doing to plastic what cards did to cash.

Source: USA Today, July 24, 2016 If people can use their smartphone to make payments, will currency disappear? How will the components of M1 change?

People will probably carry less currency because their cell phone will substitute for currency, but currency won’t disappear because currency is used in the underground economy. As a component of M1,

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currency and traveler’s checks will be smaller and most of M1 will be checkable deposits.

Use the following news clip to work Problems 13 and 14.

American Bank Profits Are Higher than Ever American banks made record profits in 2016 in a continued recovery from the financial crisis of 2008.

The Federal Deposit Insurance Corporation (FDIC) reported strong loan growth. The FDIC also said that of 5,913 institutions it insures, 59% earned profits in the fourth quarter of 2016. The FDIC’s deposit insurance fund protects customer accounts up to $250,000 against bank failure.

CNNMoney, March 3, 2017 13.

Explain the role of loans in the balancing act that a bank performs in the pursuit of profit.

The bank knows that its profit will be higher the more loans are made. But loans are risky. Other assets, such as government securities pay a lower interest rate but are less risky. Banks must balance their holdings of high-yielding, risky loans with their holdings of lower-yielding, less-risky other assets.

14.

How does FDIC insurance help minimize the cost of bank failure? Does it bring more stability to the banking system?

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

15.

Explain the distinction between a central bank and a commercial bank.

A central bank is basically a ―bank for banks.‖ It will conduct business with commercial banks, such as making loans to them and holding their reserves. A central bank does not accept deposits from private citizens. A central bank also regulates the nation’s depository institutions and conducts the nation’s monetary policy.

A commercial bank conducts business with firms and households. It accepts deposits from individuals and then makes loans to other people or firms. Commercial banks are privately owned and have as their objective the maximization of their profit.

16.

If the Fed makes an open market sale of $1 million of securities to a bank, what initial changes occur in the economy?

If the Fed sells $1 million of securities to a bank, both the Fed’s balance sheet and the bank’s balance sheet change. The Fed’s holding of securities falls by $1 million and the bank’s holding of securities rises by $1 million. The bank pays for the purchase with © 2018 Pearson Education, Inc.

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its reserves, so the reserves held by the Fed fall by $1 million and the bank’s reserves fall by $1 million. The amount of the bank’s assets does not change, though the composition changes (more securities, fewer reserves). The Fed’s assets and liabilities both fall by an equal amount ($1 million in this case).

17.

Set out the transactions that the Fed undertakes to increase the quantity of money.

The Fed has three procedures by which it can increase the quantity of money:  The Fed could use an open market purchase of securities from banks. When the Fed buys securities, it pays for the purchase by increasing banks’ reserves. The increase in banks’ reserves increases the monetary base and allows banks to make more loans, which then increase the quantity of money.  The Fed could make a last resort loan to a bank. When the Fed makes a loan to a bank, the bank’s reserves increase. The increase in reserves increases the monetary base and allows the bank to make more loans, which then increase the quantity of money.  The Fed could lower the required reserve ratio. By lowering the required reserve ratio, the Fed lowers the reserves banks must hold and thereby lowers their desired reserve ratio. Banks respond by increasing their loans, which then increase the quantity of money.

18.

Describe the Fed’s assets and liabilities. What is the monetary base and does it relate to the Fed’s balance sheet?

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

19.

Federal Reserve Wants to Start Unwinding the $4.5 Trillion in Bonds on its Balance Sheet This Year The Federal Reserve bought Treasury bonds and mortgage-backed securities during three rounds of quantitative easing following the financial crisis. Chair Janet Yellen said the Fed will soon start the process of selling the $4.5 trillion in bonds on its balance sheet. Shrinking the Fed’s balance sheet will impact markets in a similar way to a rise in the interest rate. No timetable was announced and some Fed board members want to wait until the economy hits unemployment and inflation targets. There also is a lack of clarity on how gradual the phase should be.

Source: CNBC, April 5, 2017 a. What would the Fed do to shrink its balance sheet?

To shrink its balance sheet, the Fed would sell some of the securities it owns. It could sell government securities and/or mortgage backed securities. © 2018 Pearson Education, Inc.

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b. How would the monetary base change, and how would bank reserves change?

These sales would decrease both the monetary base and banks’ reserves.

20.

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

Banks loan $1,200 billion because the entire increase in reserves is unplanned reserves.

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

c. How much of the initial amount lent does not return to the banks but is held as currency?

Currency increases by $400 billion. The currency drain, which is the percentage of currency to deposits, is 50 percent. Of the $1,200 billion that has been loaned, $800 billion is deposited and 50 percent of the deposits, $400 billion, is kept as currency.

d. Why does a second round of lending occur?

A second round of lending takes place because the $800 billion flowing back to the banks as new deposits means that banks have unplanned reserves. Of the $800 billion flowing back to the banks, 10 percent, or $80 billion, is kept as reserves leaving $720 billion that will be loaned in a second round of lending.

21.

Explain the change in the nominal interest rate in the short run if a. Real GDP increases.

The nominal interest rate rises. When real GDP increases, the demand for money increases. At the initial interest rate people are holding less money than the quantity they demand. People sell bonds to increase the money they hold. The price of a bond falls and the nominal interest rate rises.

b. The money supply increases.

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

c. The price level rises.

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

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Figure 8.3 shows the demand for money curve. If the Fed decreases the quantity of real money supplied from $4 trillion to $3.9 trillion, explain how the price of a bond will change.

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

23.

Use the data in Problem 7 to work this problem. The interest rate is 4 percent a year. Suppose that real GDP decreases from $20 billion to $10 billion and the quantity of money remains unchanged. Do people buy bonds or sell bonds? Explain how the interest rate changes.

When real GDP decreases, the demand for money decreases. At the initial interest rate of 4 percent, the quantity of money people are holding exceeds the quantity of money they want to hold. People buy bonds to decrease the quantity of money they are holding. When people demand bonds, the price of a bond rises, and the interest rate falls. When the interest rate equals 3 percent a year, people are holding exactly the quantity of money that they want to hold so 3 percent is the new equilibrium interest rate.

24.

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

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

1869 $1.3 billion $7.4 billion X

1879 $1.7 billion Z

4.50

4.61

54

Using the formula MV = PY gives ($1.3 billion  4.5) = (P  $7.4 billion) so that P equals 0.79, or, transformed to an index number, P = 79. © 2018 Pearson Education, Inc.

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b. Calculate the value of Z in 1879.

Using the formula MV = PY gives ($1.7 billion  4.61) = (0.54  Y) so that Y equals $14.5 billion.

c. Are the data consistent with the quantity theory of money? Explain your answer.

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

25.

When he was the U.S. Federal Reserve chairman, Ben Bernanke said that financial innovation and the spread of U.S. currency throughout the world had broken down the relationships between money, inflation, and output growth, which made monetary aggregates less useful gauges for policy makers. Some other central banks use monetary aggregates as a guide to policy decisions, but Bernanke believed reliance on monetary aggregates would be unwise. He said that there are differences between the United States and Europe in terms of the stability of money demand. a. Explain how the debate surrounding the quantity theory of money could make ―monetary gauges a less useful tool for policy makers.‖ The European Central Bank (ECB) policymakers believe that the quantity theory and its relationship between the monetary growth rate and the inflation rate are a useful guide for policy. As a result they pay greater attention to the quantity of money than does the Federal Reserve. Mr. Bernanke’s believes that velocity is less stable in the United States because of instability of the demand for money and financial innovation. Because velocity is less stable, Mr. Bernanke believes that the quantity theory, and emphasis on monetary aggregates, is less useful in the United States than in Europe.

Indeed, Mr. Bernanke perhaps believes that ECB policymakers pay too much attention to monetary aggregates.

b. What do Ben Bernanke’s statements reveal about his view on the accuracy of the quantity theory of money?

At the least Mr. Bernanke believes that velocity changes make the short-run tie between growth in the quantity of money and the inflation rate unreliable. The article, however, sheds no light on Mr. Bernanke’s views about the validity of the quantity theory in the long run.

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Economics in the News 26.

After you have studied Reading Economics in the News on pp. 20–207 (614–615 in Economics,) answer the following questions. a. What changes in the interest rate and the quantities of currency and of M2 occurred between 2006 and 2016?

The interest rate plummeted from almost 5 percent per year to near 0 percent per year. Meanwhile the quantity of M2 soared from about $7 trillion to $11 trillion and the quantity of currency skyrocketed from about $0.8 trillion to almost $1.5 trillion.

b. Explain why and how the change in the interest rate changed the opportunity cost of holding money and using cash in transactions.

The massive fall in the interest rate decreased the opportunity cost of holding money and using cash in transactions.

c. How would you expect the use of cash and cards to change if an outbreak of inflation took interest rates to 10 percent per year?

If inflation raised interest rates to 10 percent per year, the opportunity cost of using money to make transactions would rise.

Because credit cards must eventually be repaid using money and because debit cards simply allow immediate access to money, people would respond to the higher opportunity cost by holding less money and therefore using less cash and cards.

Mathematical Note 27.

In the United Kingdom, the currency drain ratio is 38 percent of deposits and the reserve ratio is 2 percent of deposits. In Australia, the quantity of money is $150 billion, the currency drain ratio is 33 percent of deposits, and the reserve ratio is 8 percent of deposits. a. Calculate the U.K. money multiplier.

The money multiplier equals 3.45. The money multiplier is equal to (1 + C/D)/(R/D + C/D), where C/D is the currency drain ratio and R/D is the banks’ reserve ratio. From the problem, C/D = 38 percent and R/D = 2 percent, so the money multiplier equals (1 + 0.38)/(0.38 + 0.02), which equals 3.45.

b. Calculate the monetary base in Australia.

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

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WHAT IS ECONOMICS?CXXIII

C h a p t e r

*

9

THE EXCHANGE RATE AND THE BALANCE OF PAYMENTS**

* This is Chapter 26 in Economics. cxxiii

SOLUTION MANUAL FOR MACROECONOMICS, 13TH EDITION MICHAEL PARKIN

Answers to the Review Quizzes Page 222 1.

(page 630 in Economics)

What are the influences on the demand for U.S. dollars in the foreign exchange market?

The demand for U.S. dollars depends on four main factors: the exchange rate, the world demand for U.S. exports, the interest rate in the United State and other countries, and the expected future exchange rate.

2.

What are the influences on the supply of U.S. dollars in the foreign exchange market?

The supply of U.S. dollars depends on four main factors: the exchange rate, the U.S. demand for imports, the interest rate in the United States and other countries, and the expected future exchange rate.

3.

How is the equilibrium exchange rate determined?

The equilibrium exchange rate is the exchange rate that sets the quantity of U.S. dollars demanded equal to the quantity of U.S. dollars supplied. At the equilibrium exchange rate there is neither a shortage nor a surplus of U.S. dollars.

4.

What happens if there is a shortage or a surplus of U.S. dollars in the foreign exchange market?

If there is a shortage of U.S. dollars, the quantity of U.S. dollars demanded exceeds the quantity supplied. As long as there is a shortage, this upward pressure on the price automatically forces the price higher to its equilibrium.

If there is a surplus of U.S. dollars, the quantity of U.S. dollars demanded is less than the quantity supplied. As long as there is a surplus, this downward pressure on the price automatically forces the price lower to its equilibrium.

5.

What makes the demand for U.S. dollars change?

Three factors change the demand for U.S. dollars: the world demand for U.S. exports, the interest rate in the United States and other countries, and the expected future exchange rate. If world demand for U.S. exports increases, the demand for U.S. dollars increases.

If the interest rate in the United States rises relative to interest rates in other countries, the demand for U.S. dollars increases. And if the expected future exchange rate rises, the demand for U.S. dollars increases.

6.

What makes the supply of U.S. dollars change?

Three factors change the supply of U.S. dollars: U.S. demand for imports, the interest rate in the United States and other countries, and the expected future exchange rate. If U.S. demand for imports increases, the supply of U.S. dollars increases. If the interest © 2018 Pearson Education, Inc.

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rate in the United States falls relative to interest rates in other countries, the supply of U.S. dollars increases. And if the expected future exchange rate falls, the supply of U.S. dollars increases.

7.

What makes the U.S. dollar exchange rate fluctuate?

Changes in the demand for U.S. dollars and the supply of U.S. dollars lead to fluctuations in the U.S. dollar exchange rate.

Because the demand for dollars and the supply of dollars generally change at the same time and in opposite directions, exchange rate fluctuations are frequently large.

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What is arbitrage and what are its effects in the foreign exchange market?

Arbitrage is seeking to profit by buying in one market and selling for a higher price in another market. Arbitrage has several effects:  Law of one price: At any one time, an exchange rate is the same in all markets.  No round-trip profit: It is impossible to make a profit by using currency A to buy currency B and then selling currency B to buy currency A. It is impossible to make a profit if even longer chains of currency are used.  Interest rate parity: For risk-free transactions, the rate of return earned by a unit of currency is the same in different nations.  Purchasing power parity: Purchasing power parity occurs when a unit of money buys the same amount of goods and services in different nations.

2.

What is interest rate parity and what happens when this condition doesn’t hold?

Interest rate parity occurs when, for risk-free transactions, the rate of return earned by a unit of currency is the same in different nations. If the rate of return for the U.S. dollar is higher than that for, say, the Japanese yen, interest rate parity does not hold.

In this case people will expect the value of the dollar to fall against the yen (that is, the U.S. dollar is expected to depreciate over time) so that interest rate parity is restored because the rate of return earned by a unit of currency is the same in both nations.

3

What makes an exchange rate hard to predict?

The exchange rate depends on the expected future exchange rate. The expected future is volatile. For example, the U.S. expected future exchange rate changes when news occurs that changes the future demand and/or supply of U.S. dollars. Consequently the current demand and supply of U.S. dollars changes, thereby changing the U.S. exchange rate.

4.

What is purchasing power parity and what happens when this condition doesn’t hold?

Purchasing power parity means equal value of money. If prices of goods and services are higher in the United States than the (exchange rate adjusted) prices of goods and services in, say, Japan, purchasing power parity does not occur because a unit of © 2018 Pearson Education, Inc.

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currency buys less in the United States than in Japan. The demand for U.S. dollars decreases and the supply of U.S. dollars increases so that the value of the dollar falls against the yen to restore purchasing power parity.

5.

What determines the real exchange rate and the nominal exchange rate in the short run?

The real exchange between the United States and Japan, RER, equals E  P/P* where P is the U.S. price level, P* is the Japanese price level, and E is the nominal exchange rate in yen per dollar. In the short run, changes in the nominal exchange rate bring an equal change in the real exchange rate because the price levels in Japan and the United States do not adjust instantly to a change in the nominal exchange rate.

In the short run, the nominal U.S. exchange rate is determined in the foreign exchange market as the exchange rate that sets the quantity of U.S. dollars demanded equal to the quantity of U.S. dollars supplied.

6.

What determines the real exchange rate and the nominal exchange rate in the long run?

In the long run, the real exchange rate is determined by demand and supply in the goods market. Identical goods in the United States and Japan sell for the same price once adjusted for the (nominal) exchange rate. The relative prices of goods that are not identical are determined by the supply and demand for them and so the relative price levels in different countries are determined by supply and demand. These relative price levels determine the real exchange rate.

In the long run, changes in the real exchange rate and changes in the price levels change the nominal exchange rate. In the long run, the price level is determined by the quantity of money. So changes in the U.S. or the Japanese quantity of money change the price level and also bring an offsetting change in the nominal exchange rate.

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What is a flexible exchange rate and how does it work?

A flexible exchange rate policy is an exchange rate that is determined by demand and supply with no direct intervention in the foreign exchange market by the central bank. In this arrangement, the forces of supply and demand with no direct central bank intervention are the only factors that influence the exchange rate.

2.

What is a fixed exchange rate and how is its value fixed?

A fixed exchange rate policy is an exchange rate that is pegged at a value decided by the government or central bank. The central bank directly intervenes in the foreign exchange market to block the unregulated forces of supply and demand from changing the exchange rate away from its pegged value. For instance, if a central bank wanted to hold the exchange rate steady in the presence of diminished demand for its currency, the central bank props up demand by buying its currency in the foreign exchange market to keep the exchange rate from falling. If the demand for its currency © 2018 Pearson Education, Inc.

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increases, the central bank increases the supply by selling its currency and keeps the exchange rate from rising.

3.

What is a crawling peg and how does it work?

A crawling peg exchange rate policy selects a target path for the exchange rate and then uses direct central bank intervention in the foreign exchange market to achieve that path. A crawling peg works like a fixed exchange rate except that the central bank changes the target value of the exchange rate in accord with its target path.

4.

How has China operated in the foreign exchange market, why, and with what effect?

From 1997 until 2005, the People’s Bank of China fixed the Chinese yuan exchange rate. Over this time, the demand for the yuan increased, so the People’s Bank of China supplied additional yuan to keep the exchange rate constant. By supplying yuan, the People’s Bank acquired large amounts of foreign currency. In addition, by fixing its exchange rate China essentially pegged its inflation rate to equal the U.S. inflation rate. Since 2005 the yuan has been on a crawling peg exchange rate policy. The exchange rate has not been allowed to change much, so over the long run the Chinese inflation rate remains closely tied to U.S. inflation.

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What are the transactions that the balance of payments accounts record?

The current account records payments for imports of goods and services from abroad, receipts from exports of goods and services sold abroad, net interest income paid abroad, and net transfers abroad (such as foreign aid payments). The capital and financial account records foreign investment in the U.S. minus U.S. investment abroad. Any statistical discrepancy is also recorded in the capital account. The official settlements account records the change in U.S. official reserves.

2.

Is the United States a net borrower or a net lender? Is it a debtor or a creditor nation?

The United States is a net borrower and is a debtor nation.

3.

How are net exports and the government sector balance linked?

Net exports is the value of exports of goods and services minus the value of imports of goods and services. Net exports is equal to the sum of government sector surplus or deficit plus the private sector surplus or deficit. The government sector balance is equal to net taxes minus government expenditure on goods and services. If the government sector balance is negative, then the government sector has a deficit, that is, a budget deficit. Because net exports equals the sum of the government sector balance plus private sector balance, if the government budget deficit increases and the private sector balance does not change, the value of net exports becomes more negative.

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Answers to the Study Plan Problems and Applicatio ns Use the following data to work Problems 1 to 3.

The U.S. dollar exchange rate increased from $1.24 Canadian in June 2015 to $1.29 Canadian in June 2016, and it decreased from 121 Japanese yen in June 2015 to 108 yen in June 2016.

1.

Did the U.S. dollar appreciate or depreciate against the Canadian dollar? Did the U.S. dollar appreciate or depreciate against the yen?

The U.S. dollar appreciated against the Canadian dollar and it depreciated against the yen.

2.

What was the value of the Canadian dollar in terms of U.S. dollars in June 2015 and June 2016?

Did the Canadian dollar appreciate or depreciate against the U.S. dollar over the year June 2015 to June 2016?

One Canadian dollar was worth 81 U.S. cents in June 2015 and 78 U.S. cents in June 2016. The Canadian dollar depreciated against the U.S. dollar.

3.

What was the value of 100 yen in terms of U.S. dollars in June 2015 and June 2016? Did the yen appreciate or depreciate against the U.S. dollar over the year June 2011 to June 2012?

One hundred yen was worth 83 U.S. cents in June 2015 and 93 U.S. cents in June 2016. The yen appreciated against the U.S. dollar.

4.

On June 23, 2016, the U.S. dollar was trading at 0.68 U.K. pounds per U.S. dollar on the foreign exchange market. On June 25, 2016, the U.S. dollar was trading at 0.76 U.K. pounds per U.S. dollar. a. What events in the foreign exchange market could have brought this change in the value of the U.S. dollar?

The rise in the U.S. exchange rate is the result of an increase in the demand for U.S. dollars and/or an decrease in the supply of U.S. dollars. Factors that increase the demand for U.S. dollars include an increase in the U.K. demand for U.S. exports; a rise in the U.S. interest rate relative to the U.K. interest rate; and, a rise in the expected future exchange rate. Factors that decrease the supply of U.S. dollars include a decrease in the U.S. demand for U.K. imports; a rise in the U.S. interest rate relative to the U.K. interest rate; and, a rise in the expected future exchange rate.

b. Did the events you’ve described change the demand for U.S. dollars, the supply of U.S. dollars, or both demand and supply in the foreign exchange market?

An increase in the U.K. demand for U.S. exports leads to only an increase in the demand for U.S. dollars. An increase in the U.S. demand for U.K. imports leads only to a decrease in the supply of U.S. dollars. The other factors, a rise in the U.S. interest rate relative to the U.K. interest rate and a rise in the expected future exchange rate, change both the demand for U.S. dollars and the supply of U.S. dollars.

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Colombia is the world’s biggest producer of roses. The global demand for roses increases and at the same time Colombia’s central bank increases the interest rate. In the foreign exchange market for Colombian pesos, what happens to a. The demand for pesos?

The demand for the peso increases because the Colombian interest rate differential increases and because the demand for Colombia’s export, roses, increases.

b. The supply of pesos?

The supply of the pesos decreases because the Colombian interest rate differential increases.

c. The quantity of pesos demanded?

The Colombian exchange rate rises. The rise in the exchange rate creates a movement upward along the new demand curve, so along the new demand curve for pesos, the quantity of pesos demanded decreases.

d. The quantity of pesos supplied?

The Colombian exchange rate rises. The rise in the exchange rate creates a movement upward along the new supply curve, so along the new supply curve of pesos, the quantity of pesos supplied increases.

e. The peso-U.S. dollar exchange rate?

The U.S. exchange rate depreciates (and the Columbian exchange rate appreciates) because the demand for Colombian pesos increases and the supply decreases.

6.

If a euro deposit in France earns 4 percent a year and a yen deposit in Japan earns 0.5 percent a year, other things remaining the same, what is the exchange rate expectation of the Japanese yen against the E.U. euro?

For interest rate parity to hold, the Japanese yen must be expected to appreciate by the difference in the interest rates. So the Japanese yen must be expected to appreciate by 4.0 percent minus 0.5 percent, or 3.5 percent.

7.

The U.K. pound is trading at 1.50 U.S. dollars per U.K. pound and purchasing power parity holds. The U.S. interest rate is 1 percent a year and the U.K. interest rate is 3 percent a year. a. Calculate the U.S. interest rate differential.

The U.S. interest rate differential equals 1 percent minus 3 percent, or 2 percent per year.

b. What is the U.K. pound expected to be worth in terms of U.S. dollars one year from now?

For interest rate parity to hold, the U.K. pound must be expected to depreciate 2 percent per year. Therefore next year the U.K. pound is expected to be equal to 0.98  1.50 U.S. dollars per U.K. pound, which is 1.47 U.S. dollars per U.K. pound.

c. Which country more likely has the lower inflation rate? How can you tell?

The U.S inflation rate is likely to be lower than the U.K. inflation rate. The U.K. pound is expected to depreciate by 2 percent, that is, fall in value by 2 percent. For purchasing power parity to hold, prices in the United Kingdom must grow by 2 percent more than prices in the United States. If U.K. prices grow by less than 2 percent © 2018 Pearson Education, Inc.

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more than U.S. prices, goods and services will be cheaper to buy in the United Kingdom than in the United States and if they grow by more than 2 percent more, goods and services will be cheaper to buy in the United States than in the United Kingdom. The inflation rate measures the growth rate in prices, so the U.S. inflation rate is expected to be 2 percentage points than the U.K. inflation rate.

8.

The U.S. price level is 115, the Japanese price level is 92, and the real exchange rate is 98.75 Japanese real GDP per unit of U.S. real GDP. What is the nominal exchange rate?

The real exchange rate equals (E × P)/P* in which E is the nominal exchange rate, P is the U.S. price level, and P* is the Japanese price level. Rearranging this formula gives E = (real exchange rate × P*)/P. Using the rearranged formula, the nominal exchange rate equals (98.75 × 92)/115 = 79.0 yen per dollar.

9.

With the strengthening of the yen against the U.S. dollar, Japan’s central bank did not take any action. A Japanese politician called on the central bank to take actions to weaken the yen, saying it will help exporters in the short run and have no long-run effects. a. What is Japan’s current exchange rate policy?

Japan’s current exchange rate policy is a flexible exchange.

b. What does the politician want the exchange rate policy to be in the short run? Why would such a policy have no effect on the exchange rate in the long run?

The politician wants the exchange rate to be a crawling peg by lowering it over a period of time. This policy has no effect on the exchange rate in the long run because in the long run the real exchange rate is determined by supply and demand for the nation’s goods. In addition, the nominal exchange rate adjusts to make the ratio of the nations’ price levels equal to the real exchange rate.

Item Imports of goods and services Foreign investment in the United States Exports of goods and services U.S. investment abroad Net interest income Net transfers Statistical discrepancy

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Billions of U.S. dollars 2,764 502 2,264 175 193 −127 101

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The table gives some information about the U.S. international transactions in 2015. a. Calculate the balance on the three balance of payments accounts.

The current account balance equals exports of goods and services ($2,264 billion) minus imports of goods and services ($2,764 billion) plus net interest income ($193 billion) plus net transfers ($127 billion). So the current account balance is $434 billion.

The capital and financial account balance equals foreign investment in the United States ($502 billion) minus U.S. investment abroad ($175 billion) plus the statistical discrepancy ($101 billion). So the capital and financial account balance is $428 billion.

The official settlements account balance equals  current account balance ($434 billion)  capital and financial account balance ($428 billion). So the official settlements account balance is $6 billion.

Because the official settlements account is positive, U.S. official reserves are decreasing.

b. Was the United States a net borrower or a net lender? Explain your answer.

The United States was a net borrower because foreign investment in the United States exceeded U.S. investment abroad.

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Answers to Additional Problems and Applications 11.

Suppose that yesterday, the U.S. dollar was trading on the foreign exchange market at 0.75 euros per U.S. dollar and today the U.S. dollar is trading at 0.80 euros per U.S. dollar. Which of the two currencies (the U.S. dollar or the euro) has appreciated and which has depreciated today?

The U.S. dollar appreciated because its exchange rate rose. The euro depreciated because its exchange rate fell (from 1.33 U.S. dollars per euro to 1.25 U.S. dollars per euro).

12.

Suppose that the exchange rate fell from 80 yen per U.S. dollar to 70 yen per U.S. dollar. What is the effect of this change on the quantity of U.S. dollars that people plan to buy in the foreign exchange market?

The fall in the exchange rate increases the quantity of U.S. dollars that people plan to buy in the foreign exchange market.

13.

Suppose that the exchange rate rose from 80 yen per U.S. dollar to 90 yen per U.S. dollar. What is the effect of this change on the quantity of U.S. dollars that people plan to sell in the foreign exchange market?

The rise in the exchange rate increases the quantity of U.S. dollars that people plan to sell in the foreign exchange market.

14.

Today’s exchange rate between the yuan and the U.S. dollar is 6.40 yuan per dollar and the central bank of China is buying U.S. dollars in the foreign exchange market. If the central bank of China did not purchase U.S. dollars would there be excess demand or excess supply of U.S. dollars in the foreign exchange market? Would the exchange rate remain at 6.40 yuan per U.S. dollar? If not, which currency would appreciate?

In the absence of the purchases by the central bank of China there would be an excess supply of U.S. dollars in the foreign exchange market. Without these purchases, the exchange rate would fall from 6.40 yuan per dollar to something lower. The Chinese yuan would appreciate (and the U.S. dollar would depreciate).

15.

Yesterday, the current exchange rate was $1.05 Canadian per U.S. dollar and traders expected the exchange rate to remain unchanged for the next month. Today, with new information, traders now expect the exchange rate next month to fall to $1 Canadian per U.S. dollar. Explain how the revised expected future exchange rate influences the demand for U.S. dollars, or the supply of U.S. dollars, or both in the foreign exchange market.

The revision in the expected future exchange rate lowers the expected profit from holding U.S. dollars and thereby affects both the demand for U.S. dollars and the supply of U.S. dollars. The fall in the expected profit from holding dollars decreases the demand for U.S. dollars because people would rather hold more profitable currencies. It also increases the supply of U.S. dollars as people supply dollars in order to buy other, more profitable currencies.

16.

In 2016, the exchange rate changed from 108 yen per U.S. dollar in April to 104 yen per U.S. dollar in May, and to 109 yen per dollar in June. What information would you need to determine the factors that caused these changes in the exchange rate? Which factors would change both demand and supply?

The factors that influence the U.S. exchange rate include the Japanese demand for U.S. exports; the U.S. demand for Japanese imports; the U.S. interest rate relative to the Japanese interest © 2018 Pearson Education, Inc.

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rate; and, the expected future exchange rate. Changes in any of these factors will change the U.S. exchange rate. Changes in the U.S. interest rate differential and the excepted future exchange rate change both demand and supply.

17.

Australia produces natural resources (coal, iron ore, natural gas, and others), the demand for which has increased rapidly as China and other emerging economies expand. a. Explain how growth in the demand for Australia’s natural resources would affect the demand for Australian dollars in the foreign exchange market.

The growth in demand for Australia’s natural resources increases the demand for Australian dollars.

b. Explain how the supply of Australian dollars would change.

Absent any change in the expected future exchange rate, the supply of Australian dollars does not change (there is a change in the quantity supplied).

c. Explain how the value of the Australian dollar would change.

The increase in demand for Australian dollars raises the value of the Australian dollar.

d. Illustrate your answer with a graphical analysis.

Figure 9.1 illustrates the effect of the increase in demand for Australian dollars. The demand curve for Australian dollars shifts rightward, from D0 to D1. The supply curve does not shift. The exchange rate rises from 90 yen per Australian dollar to 95 yen per Australian dollar.

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Use the following news clip to work Problems 18 and 19.

Brexit Vote Could Mean U.S. Real Estate Boom Property investors are looking outside London in the uncertain climate created by the U.K. vote to leave the European Union—Brexit. New York could gain from this changed outlook, but that’s not all good news. It could add further upward momentum to an already overheated U.S. property market. A fall in the U.K. pound might moderate some of these predictions.

Based on an article in The Guardian, July 2, 2016 18.

Explain why property investors are expected to sell in London and buy in New York and why a fall in the pound might make this predicted effect of Brexit less likely.

The British vote to leave the E.U. (Brexit) increased the uncertainty about the future value of real estate in London.

Consequently property investors, looking to avoid uncertainty and risk, sell property in London and buy it in the now relatively safer New York. A fall in the pound makes it more expensive for these investors to acquire dollars and thereby makes buying real estate in New York more expensive. The increase in the price of real estate in New York will decrease the quantity purchased by property investors.

19.

Explain what will happen if the expectation of rising prices in New York and falling prices in London becomes widespread. Might expectations become self-fulfilling?

If the expectation of rising prices in New York becomes widespread, more property investors will want to buy real estate in New York, thereby driving the price of real estate in New York higher. If the expectation of falling prices in London becomes widespread, more property investors will want to sell real estate in London, thereby driving the price of real estate in London lower. These expectations might become self-fulfilling as the expectation of higher prices drives prices higher and the expectation of lower prices forces prices lower.

Use the following information to work Problems 20 and 21.

Is the Loonie Going Up or Down?

The price of a Big Mac is $C6.00 in Toronto and $US5.30 in New York and the exchange rate is $C1.28 per U.S. dollar. The interest rate on 3-month Treasury bonds is 0.72 percent per year in Canada and 1.00 percent per year in the United States.

Source: The Economist, The Federal Reserve System, and the Bank of Canada, July 2017 20.

Does purchasing power parity hold? If not, does PPP predict that the $C (loonie) will appreciate or depreciate against the U.S. dollar? Explain.

Purchasing power parity (PPP) does not hold because a Big Mac is significantly more expensive in New York than in Canada. In Canada it takes ($C6.00) ÷ ($C1.28 per U.S. dollar) = $U4.69 to buy a Big Mac. PPP predicts that the Canadian dollar will appreciate against the U.S. dollar. Appreciation will increase the number of U.S. dollars it takes to buy a Canadian dollar and thereby increase the number of U.S. dollars it takes to purchase a Big Mac in Canada back to equality with the number of dollars it takes to purchase a Big Mac in New York. © 2018 Pearson Education, Inc.

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Does interest rate parity hold? If not, why not? Will the Canadian dollar appreciate further or depreciate against the U.S. dollar if the Fed raises the interest rate while the Canadian interest rate remains at 0.72 percent a year?

Interest rate parity holds. The difference in the interest rates is offset by the expected depreciation of the US dollar, so the U.S. dollar is expected to depreciate by (1.00 percent)  (0.72 percent) = 0.28 percent a year. If the Fed raises the U.S. interest rate, interest rate parity will continue to hold. Because the U.S. interest rate is now higher, the Canadian dollar depreciates. The higher U.S. interest rate means that the U.S. interest rate differential increases. The demand for dollars increases and the supply decreases, so the dollar immediately appreciates which means the Canadian dollar immediately depreciates. The Canadian dollar is still expected to appreciate in the future, and the expected future appreciation is more than 0.28 percent a year because the interest rate differential is larger.

22.

When the Chips Are Down The Economist magazine uses the price of a Big Mac to determine whether a currency is undervalued or overvalued. In July 2017, the price of a Big Mac was $5.30 in New York, 19.80 yuan in Beijing, and 6.50 Swiss francs in Geneva. The exchanges rates were 6.79 yuan per U.S. dollar and 0.96 Swiss francs per U.S. dollar.

Source: www.economist.com/content/big-mac-index July 2017 a. Was the yuan undervalued or overvalued relative to purchasing power parity?

Changing the price of a Big Mac in China into U.S. prices shows that the Chinese Big Mac has a dollar price of 19.80 yuan ÷ 6.79 yuan per dollar which is $2.92. The yuan was undervalued relative to purchasing power parity.

b. Was the Swiss franc undervalued or overvalued relative to purchasing power parity?

Changing the price of a Big Mac in Switzerland into U.S. prices shows that the Swiss Big Mac has a dollar price of 6.50 francs ÷ 0.96 francs per dollar which is $6.77. The Swiss franc was overvalued relative to purchasing power parity.

c. Do you think the price of a Big Mac in different countries provides a valid test of purchasing power parity?

The price of a Big Mac is the price of only one good. Purchasing power parity applies to national price levels not to the price of an individual good. Using an individual good means that local supply and demand conditions might lead the price to diverge from purchasing power parity.

Use the following news clip to work Problems 23 to 25.

Calling Out China’s Tricks In 2016, the U.S. trade deficit with China hit an ever rising $350 billion, the largest deficit with any U.S. trading partner. Chinese currency, the yuan, has risen in value by 24 percent against the U.S. dollar since the Chinese government loosened its currency system in July 2005. However, U.S. manufacturers contend the yuan is still undervalued, making Chinese goods more competitive in this © 2018 Pearson Education, Inc.

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country and U.S. goods more expensive in China. China buys U.S. dollar denominated securities to maintain the value of the yuan in terms of the U.S. dollar.

Source: The New York Times, April 12, 2017 23.

What was the exchange rate policy adopted by China until July 2005? Explain how it worked.

Draw a graph to illustrate your answer.

The actions in the foreign exchange market of the People’s Bank allowed China to maintain a fixed exchange rate with the United States. If, at the fixed exchange, there was surplus of dollars (which implies there is a shortage of yuan), the People’s Bank bought the dollars using yuan. Without this action by the People’s Bank, the surplus of dollars would have depreciated the dollar and appreciated the yuan; with this action by the People’s Bank, the exchange rate stayed fixed.

Figure 9.2 shows the foreign exchange market. At the fixed exchange of 7.00 yuan per dollar, there is a surplus of $0.2 trillion U.S. dollars. If the market is allowed to reach its equilibrium exchange rate, the dollar would depreciate to 5.00 yuan per dollar, which means that the yuan would appreciate. But the People’s Bank purchased the $0.2 trillion U.S. dollar surplus and thereby kept the exchange rate pegged at 7.00 yuan per dollar. By fixing its exchange rate in order to keep the yuan from appreciating, the People’s Bank accumulated U.S. dollars.

24.

What was the exchange rate policy adopted by China after July 2005? Explain how it works.

After July 2005 China has not allowed a truly flexible exchange rate. Instead China uses a crawling peg policy, in which the Chinese government intervenes in the market for foreign exchange so as to allow the Chinese exchange rate to make only small changes.

25.

Explain how fixed and crawling peg exchange rates can be used to manipulate trade balances in the short run, but not the long run.

Changes in fixed and crawling peg exchange rates can affect the trade balance in the short run because these changes affect the relative price of the domestically-produced good and the foreign good. But changes in fixed and crawling peg exchange rates cannot affect the trade balance in the long run because the trade balance is (ultimately) determined by the real exchange rate. In the long run, the price levels will adjust to create a real exchange rate that balances trade.

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Concern in Denmark as Crown’s Peg to Euro Is Strained Since 1982, Denmark has pegged the exchange rate for the Danish crown against the German mark first and later against the euro. In recent weeks, the fixed exchange-rate regime has come under strain as the euro has fallen sharply, leading to speculation that Denmark’s currency peg to the euro will break.

Source: The New York Times, February 13, 2015 a. What is Denmark’s exchange rate policy? Explain why expectations about a possible break in the link of the crown and euro might put the crown under strain.

Denmark’s exchange rate policy is a fixed exchange rate policy. To maintain the link between the falling euro and the Danish crown, Denmark’s currency must depreciate. However, the central bank of Denmark might not believe this is the optimal policy, which could lead investors to think that the link will be broken. With this belief, investors will immediately sell Euros to buy crowns, thereby immediately putting more pressure on the crown to appreciate.

b. To avoid a break in the link between the crown and the euro, what action must the central bank of Denmark take?

To avoid breaking the link between the crown and the Euro, the central bank of Denmark needs to depreciate its currency, which it can do by selling Danish crowns.

Use the table to work Problems 27 and 28. The table gives some data about the U.K. economy: 27.

Calculate the private sector and government sector balances.

Item Consumption expenditure Exports of goods and services Government expenditure Net taxes Investment Saving

Billions of U.K. pounds 721

The private sector balance 277 equals saving (£162 billion) minus investment (£181 230 billion), which is £19 billion.

217 The government sector balance 181 is equal to net taxes (£217 162 billion) minus government expenditures on goods and services (£230 billion), which is £13 billion.

28.

What is the relationship between the government sector balance and net exports?

The government sector balance plus the private sector balance equals net exports. Therefore the net exports equals the private sector balance (£19 billion) plus the government sector balance (£13 billion), which is £32 billion. The U.K. had a net export deficit of £32 billion.

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Economics in the News 29.

After you have studied Economics in the News on pp. 236–237 (644–645 in Economics), answer the following questions. a. What are the U.S. trade balances with Mexico and Canada and how have those balances changed since 2000?

In 2016, the United States had a trade deficit of $63.1 billion with Mexico and a trade surplus of $7.7 billion with Canada for a combined trade deficit of $55.4 billion. Since 2000, the United States has had a combined balance of trade deficit with the two countries but, as a fraction of GDP, the deficit has been decreasing in size.

b. What are the concerns of the Trump administration about these balances?

The concern of the Trump administration is that the trade deficit with the NAFTA countries means that U.S. manufacturing jobs are leaving the United States to move to Canada and especially to Mexico.

c. What action does the Trump administration propose taking to change these balances?

The Trump administration wants to renegotiate aspects of the NAFTA treaty. The Trump administration wants to impose tariffs on imports from Mexico and Canada.

d. What is the source of the international trade balance of the United States? Explain the fundamental equation that determines the balance.

The source of the trade balance deficit results from the failure of the United States to save enough to fund U.S. investment and the U.S. government budget deficit. So the United States must borrow from foreigners. The basic equation that demonstrates this result is derived from national income accounting and is (X – M) = (T – G) + (S − I) which can be rearranged to (X – M) = S – (I +(G – T)) in which (X – M) equals exports minus imports, or the trade balance, S is U.S. saving, I is U.S. investment, and (G – T) is the U.S. government deficit.

e. What effect will the Trump administration’s proposed action have on the balances of trade with Mexico and Canada?

The proposed actions will reduce imports from Mexico and Canada but will also reduce exports to these countries by similar amounts. The net result will be no change in the trade balance.

f.

What other effects will the proposed actions have on trade with Mexico and Canada?

The proposed actions will raise the prices of imports into the United States as well as the prices of imports into Mexico and Canada. The higher prices would make people in all three countries worse off.

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C h a p t e r

10

*

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* This is Chapter 27 in Economics.

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SOLUTION MANUAL FOR MACROECONOMICS, 13TH EDITION MICHAEL PARKIN

Answers to the Review Quizzes Page 249 1.

(page 657 in Economics)

If the price level and the money wage rate rise by the same percentage, what happens to the quantity of real GDP supplied? Along which aggregate supply curve does the economy move?

If the price level and the money wage rate rise by the same percentage, there is no change in the quantity of real GDP supplied and a movement occurs up along the LAS curve.

2.

If the price level rises and the money wage rate remains constant, what happens to the quantity of real GDP supplied? Along which aggregate supply curve does the economy move?

If the price level rises and the money wage rate remains constant the quantity of real GDP supplied increases and the economy moves along the SAS curve.

3.

If potential GDP increases, what happens to aggregate supply? Does the LAS curve shift or is there a movement along the LAS curve? Does the SAS curve shift or is there a movement along the SAS curve?

If potential GDP increases both long-run aggregate supply and shortrun aggregate supply increase and the LAS curve and SAS curve shift rightward.

4.

If the money wage rate rises and potential GDP remains the same, does the LAS curve or the SAS curve shift or is there a movement along the LAS curve or the SAS curve?

If the money wage rate rises and potential GDP remains the same there is a decrease in short-run aggregate supply and no change in long-run aggregate supply. The SAS curve shifts leftward and the LAS curve is unchanged.

Page 253 1.

(page 661 in Economics)

What does the aggregate demand curve show? What factors change and what factors remain the same when there is a movement along the aggregate demand curve?

The aggregate demand curve shows the relationship between the quantity of real GDP demanded and the price level when other influences on expenditure plans remain the same. When there is a movement along the aggregate demand curve, the price level changes and other factors such as expectations, fiscal and monetary policy, and the world economy remain the same.

2.

Why does the aggregate demand curve slope downward?

The aggregate demand curve slopes downward because of the wealth effect and two substitution effects. First, a rise in the price level decreases real wealth, which brings an increase in saving and a decrease in spending—the wealth effect. Second, a rise in the price level raises the interest rate, which decreases borrowing and © 2018 Pearson Education, Inc.

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spending—an intertemporal substitution effect as people decrease current spending in favor of future spending—and increases the price of domestic goods and services relative to foreign goods and services, which decreases exports and increases imports—an international substitution effect.

3.

How do changes in expectations, fiscal policy and monetary policy, and the world economy change aggregate demand and the aggregate demand curve?

Aggregate demand increases and the AD curve shifts rightward if: expected future income, expected future inflation, or expected future profits increase; government expenditure increases or taxes are cut; the quantity of money increases and the interest rate is cut; the exchange rate falls; or foreigners’ income increases. The reverse changes decrease aggregate demand and shift the AD curve leftward.

Page 259 1.

(page 667 in Economics)

Does economic growth result from increases in aggregate demand, short-run aggregate supply, or long-run aggregate supply?

Economic growth results from increases in long-run aggregate supply.

Economic growth occurs because the quantity of labor increases, capital is accumulated and there are technological advances over time. All three of these factors increase potential GDP and shift the LAS curve rightward.

2.

Does inflation result from increases in aggregate demand, short-run aggregate supply, or longrun aggregate supply?

Inflation results from increases in aggregate demand that exceed the increase in long-run aggregate supply. As the aggregate demand curve shifts rightward the price level rises. Increases in AD that exceed increases in LAS produce inflation.

3.

Describe three types of short-run macroeconomic equilibrium.

Short-run macroeconomic equilibrium occurs when the quantity of real GDP demanded equals the quantity of real GDP supplied. There are three types of short-run equilibrium: below full-employment equilibrium where a recessionary gap exists with real GDP less than potential GDP; above full-employment equilibrium where an inflationary gap exists with real GDP greater than potential GDP; full-employment equilibrium where no gap exists and real GDP equals potential GDP.

4.

How do fluctuations in aggregate demand and short-run aggregate supply bring fluctuations in real GDP around potential GDP? Fluctuations in aggregate demand with no change in short-run aggregate supply bring fluctuations in real GDP around potential GDP. For instance, starting from full employment, a decrease in aggregate demand decreases the price level and real GDP and creates a recessionary gap. In the long run the money wage rate (and the money prices of other resources) falls so that short-run aggregate supply increases and the economy returns to its full employment equilibrium. Starting from full employment, a decrease in short-run © 2018 Pearson Education, Inc.

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aggregate supply decreases real GDP and raises the price level. The fall in real GDP combined with a rise in the price level is a phenomenon called stagflation.

Page 261 1.

(page 669 in Economics)

What are the defining features of classical macroeconomics and what policies do classical macroeconomists recommend?

Classical macroeconomists believe that the economy is selfregulating and always at full employment. Classical macroeconomists assert that the proper government policy is to minimize the disincentive effects of taxes on employment, investment, and technological change.

2.

What are the defining features of Keynesian macroeconomics and what policies do Keynesian macroeconomists recommend?

Keynesian macroeconomists believe that if the economy was left alone, it would rarely operate at full employment. To achieve and maintain full employment the economy needs active help from fiscal and monetary policy. Aggregate demand fluctuations combined with a very sticky money wage rate are the major sources of the business cycle. Keynesian macroeconomists assert that active fiscal and monetary policy, designed to offset fluctuations in aggregate demand, are the proper government policies.

3.

What are the defining features of monetarist macroeconomics and what policies do monetarist macroeconomists recommend?

Monetarists believe that the economy is self-regulating and will typically operate at full employment if monetary policy is not erratic and the money growth rate is kept steady. The major source of business cycle fluctuations are similar to the Keynesian view, that is, changes in aggregate demand combined with a sticky money wage rate. However, according to monetarists, the changes in aggregate demand are the result of fluctuations in the growth rate of money caused by the Federal Reserve. Monetarists assert that the proper government policies are low taxes, to avoid the disincentive effects stressed by classical macroeconomists, and steady monetary growth.

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Answers to the Study Plan Problems and Applications 1.

Explain the influence of each of the following events on the quantity of real GDP supplied and aggregate supply in India and use a graph to illustrate.  U.S. firms move their call handling, IT, and data functions to India.

Moving call-handling, IT, and data functions to India increases short-run and long-run aggregate supply because it increases the amount of employment at full employment and (probably) also increases the capital stock. As Figure 10.1 shows, both the short run aggregate supply curve and long-run aggregate supply curve shift rightward, from SAS0 to SAS1 and from LAS0 to LAS1.



Fuel prices rise.

The rise in fuel prices raises firms’ costs. Short-run aggregate supply decreases and the shortrun aggregate supply curve shifts leftward. Long-run aggregate supply does not change. Figure 10.2 shows the leftward shift of the short-run aggregate supply curve from SAS0 to SAS1.



Wal-Mart and Starbucks open in India.

When Starbucks and Wal-mart open in India, short-run and long-run aggregate supply increase. When these stores open, employment at © 2018 Pearson Education, Inc.

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full employment increases and India’s capital stock increases. Both the short-run and long-run aggregate supply curves shift rightward, as illustrated in Figure 10.1.



Universities in India increase the number of engineering graduates.

Increasing the number of engineering graduates increases India’s human capital. Both the short-run and long-run aggregate supply increases, as shown in Figure 10.1 by the rightward shifts in the short-run and long-run aggregate supply curves.



The money wage rate rises.

An increase in the money wage rate increases firms’ costs. Short-run aggregate supply decreases but long-run aggregate supply does not change. Long-run aggregate supply does not change because in the long run the price level rises by the same percentage the money age rate increased, so in the long run employment does not change. This situation is illustrated in Figure 10.2, in which the short-run aggregate supply curve shifts leftward and the long-run aggregate supply curve does not change.



The price level in India increases.

In the short run, an increase in the price level increases the quantity of real GDP supplied. In the long run, the money wage rate rises by the same percentage so in the long run there is no change in the quantity of real GDP supplied. These results are illustrated in Figure 10.3 by the grey arrows showing the movement along the short-run aggregate supply curve, SAS, and the movement along the long-run aggregate supply curve, LAS.

2.

Labor productivity is rising at a rapid rate in China and wages are rising at a similar rate.

Explain how a rise in labor productivity and wages in China will influence the quantity of real GDP supplied and aggregate supply in China.

The rise in labor productivity increases potential GDP and increases aggregate supply. The short-run and long-run aggregate supply curves shift rightward. The rise in the money wage rate in China decreases short-run aggregate supply and shifts the short-run aggregate supply © 2018 Pearson Education, Inc.

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curve leftward. It has no effect on potential GDP or on the long-run aggregate supply curve.

3.

Canada trades with the United States. Explain the effect of each of the following events on Canada’s aggregate demand.  The government of Canada cuts income taxes.

Cutting income taxes increases aggregate demand because it increases people’s disposable incomes.



The United States experiences strong economic growth.

Strong growth in the United States increases U.S. demand for Canadian exports. Canadian exports are a component of Canada’s aggregate demand so the increase in demand for Canada’s exports means that Canada’s aggregate demand increases.



Canada sets new environmental standards that require power utilities to upgrade their production facilities.

To upgrade their facilities, power utilities must increase their investment. Investment is a component of aggregate demand so an increase in investment means that Canada’s aggregate demand increases.

4.

The Fed cuts the quantity of money and all other things remain the same. Explain the effect of the cut in the quantity of money on aggregate demand in the short run.

A decrease in the quantity of money decreases aggregate demand and shifts the AD curve leftward. By cutting the quantity of money, the interest rate rises, so firms decrease their investment and households cut back their expenditure on new homes, new cars, and other big-ticket items. The decrease in consumption expenditure and investment both decrease aggregate demand.

5.

Gross Domestic Product for the Second Quarter of 2012 The increase in real GDP in the first quarter primarily reflected increases in personal consumption expenditures, exports, and investment. Government spending decreased.

Source: Bureau of Economic Analysis, June 29, 2017 Explain how the items in the news clip influence U.S. aggregate demand.

The increase in consumption expenditures, exports, and investment all increase U.S. aggregate demand. The decrease in government spending decreases U.S. aggregate demand.

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Use Figure 10.4 to work Problems 6 to 8.

Initially, the short-run aggregate supply curve is SAS0 and the aggregate demand curve is AD0.

6.

Some events change aggregate demand from AD0 to AD1. Describe two events that could have created this change in aggregate demand. What is the equilibrium after aggregate demand changed?

If potential GDP is $1 trillion, the economy is at what the type of macroeconomic equilibrium?

Aggregate demand increases when the aggregate demand curve shifts from AD0 to AD1. Aggregate demand increases if expected future income, expected future inflation, or expected future profit increases; if the government cuts taxes, increases its expenditure on goods and services, or increases its transfer payments; if the Fed lowers the interest rate; or if the U.S. exchange rate falls or foreign income increases. After the change in aggregate demand, equilibrium is at point C: real GDP is $1.1 trillion and the price level is 105. The economy is at an above full-employment equilibrium with an inflationary gap.

7.

Some events change aggregate supply from SAS0 to SAS1. Describe two events that could have created this change in aggregate supply. What is the equilibrium after aggregate supply changed?

If potential GDP is $1 trillion, does the economy have an inflationary gap, a recessionary gap, or no output gap?

Aggregate supply decreases when the aggregate supply curve shifts from SAS0 to SAS1. Aggregate supply decreases if potential GDP decreases; if the money wage rate rises; or if the money prices of other resources rise. After the change, equilibrium is at point A: real GDP is $0.9 trillion and the price level is 105. The economy is at a below full-employment equilibrium with a recessionary gap.

8.

Some events change aggregate demand from AD0 to AD1 and aggregate supply from SAS0 to SAS1. What is the new macroeconomic equilibrium?

After the changes, equilibrium is at point D: real GDP is $1.0 trillion and the price level is 110. The economy is at a fullemployment equilibrium.

9.

Describe the policy change that a classical macroeconomist, a Keynesian, and a monetarist would recommend for U.S. policymakers to adopt in response to each of the following events: a. Growth in the world economy slows.

Classical economists probably would recommend no policy action. If they suggested any policy at all, the policy would involve cutting taxes. Monetarist economists would recommend an increase in the quantity of money, which lowers the interest rate. Keynesian © 2018 Pearson Education, Inc.

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economists likely would suggest several policies, such as the U.S. government should increase aggregate demand by increasing its expenditure on goods and services or by cutting taxes. Keynesian economists also would suggest that the Fed should increase the quantity of money and lower interest rates.

b. The world price of oil rises.

Classical and monetarist economists probably would recommend no policy action. If they suggested any policy at all, the policy would involve cutting taxes. Keynesian economists likely would suggest several policies, such as the U.S. government should increase aggregate demand by increasing its expenditure on goods and services or by cutting taxes. Keynesian economists also would suggest that the Fed should increase the quantity of money and lower interest rates.

c. U.S. labor productivity declines.

Classical economists probably would recommend no policy action. If they suggested any policy at all, the policy would involve cutting taxes. Monetarist economists would recommend an increase in the quantity of money, which lowers the interest rate. Keynesian economists likely would suggest several policies, such as the U.S. government should increase aggregate demand by increasing its expenditure on goods and services or by cutting taxes. Keynesian economists also would suggest that the Fed should increase the quantity of money and lower interest rates.

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Answers to Additional Problems and Applications 10.

Explain for each event whether it changes the quantity of real GDP supplied, short-run aggregate supply, long-run aggregate supply, or a combination of them.  Automotive firms in the United States switch to a new technology that raises productivity.

When firms switch to a new technology, both the short-run aggregate supply and the long-run aggregate supply increase.



Toyota and Honda build additional plants in the United States.

Building new plants in the United States increases the U.S. capital stock and thereby increases both the short-run aggregate supply and the long-run aggregate supply.



The prices of auto parts imported from China rise.

The increase in the price of auto parts imported from China decreases the short-run aggregate supply because the cost of producing automobiles increases. There is no effect on the long-run aggregate supply.



Autoworkers agree to a lower money wage rate.

The lower money wage rate increases short-run aggregate supply because the cost of producing automobiles falls. There is no effect on the long-run aggregate supply.



The U.S. price level rises.

The increase in the price level increases the short-run quantity of real GDP supplied. It has no effect on the long-run quantity of real GDP supplied.

11.

Explain for each event whether it changes the quantity of real GDP demanded or aggregate demand in the United States.  U.S exports to the European Union boom.

The increase in U.S. exports increases U.S. aggregate demand.



U.S. firms build new gas-fuel utilities.

Building new plants in the United States increases U.S. aggregate supply, which brings a change in the quantity of real GDP demanded.

Building the new plants also increases investment, which increases aggregate demand.



U.S. inflation rate is expected to rise next year.

The increase in the expected inflation rate increases aggregate demand.



The U.S. price level rises.

The rise in the U.S. price level leads to a change in the quantity of real GDP demanded.

12.

Inventory Investment Decreases When real GDP increased in the first quarter of 2017, consumption expenditure, exports, and fixed investment increased but business inventory investment fell.

Source: Bureau of Economic Analysis, June 29, 2017 Explain how a fall in inventories influences aggregate demand.

Inventories are a component of investment and investment is a component of aggregate demand. When inventories decrease, investment decreases so that aggregate demand decreases. © 2018 Pearson Education, Inc.

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Exports and Imports Increase Real exports of goods and services increased 7 percent in the first quarter of 2017, compared with a decrease of 4 percent in the last quarter of 2016. Real imports of goods and services increased 5 percent in the first quarter of 2017, and by 4 percent in the last quarter of 2016.

Source: Bureau of Economic Analysis, 2017 a. Explain how the changes in exports and imports reported here influence the quantity of real GDP demanded and aggregate demand.

Net exports is part of aggregate demand, which means that an increase in net exports increases aggregate demand. Net exports equals exports minus imports, so an increase in exports increases aggregate demand while an increase in imports decreases aggregate demand. Consequently the increase in exports in the first quarter of 2017 increased aggregate demand and the decrease in exports in the last quarter of 2016 as well as the increases in imports in the last quarter of 2016 and in the first quarter of 2017 all decreased aggregate demand.

b. In which of the two quarters reported did exports and imports make the greater contribution to aggregate demand growth?

Exports and imports changed the most in the first quarter of 2017, so in that quarter both had their largest effect on aggregate demand. In that quarter, the increase in exports increased economic growth while the increase in imports decreased economic growth.

Use the following information to work Problems 14 to 16.

The following events have occurred at times in the history of the United States:  The world economy goes into an expansion.  U.S. businesses expect future profits to rise.  The government increases its expenditure on goods and services in a time of war or increased international tension.

14.

Explain for each event whether it changes short-run aggregate supply, long-run aggregate supply, aggregate demand, or some combination of them.

The expansion in the world economy increases U.S. exports and increases aggregate demand. The expectation of higher profits in the future increases investment and increases aggregate demand. An increase in government expenditure on goods and services increases aggregate demand.

15.

Explain the separate effects of each event on U.S. real GDP and the price level, starting from a position of long-run equilibrium.

The expansion in the world economy increases U.S. exports and increases aggregate demand, which increases real GDP and raises the price level. The expectation of higher profits in the future increases investment and boosts aggregate demand, which increases real GDP and raises the price level. The increase in government expenditure on goods and services increases aggregate demand, which increases real GDP and raises the price level.

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16.

Explain the combined effects of these events on U.S. real GDP and the price level, starting from a position of long-run equilibrium.

The combined effect of an expansion in the world economy, the expectation of higher profits in the future, and an increase in government expenditures increase aggregate demand, which increases real GDP and raises the price level.

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Use the following information to work Problems 17 and 18.

In Japan, potential GDP is 600 trillion yen.

The table shows the aggregate demand and short-run aggregate supply schedules.

Price 17. a. Draw a graph of the aggregate level demand curve and the short-run 75 aggregate supply curve.

85 Figure 10.5 shows the 95 aggregate demand curve 105 and the short-run 115 aggregate supply curve.

125 135 b. What is the short-run equilibrium real GDP and price level?

Real GDP demanded

Equilibrium real GDP is ¥500 trillion and the price level is 95. Short-run macroeconomic equilibrium occurs at the intersection of the aggregate demand curve and the short-run aggregate supply curve.

18.

Does Japan have an inflationary gap or a recessionary gap and what is its magnitude?

Equilibrium real GDP is less than potential GDP, so Japan has a recessionary gap. The recessionary gap equals the difference between potential GDP and real GDP, which is ¥100 trillion.

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Real GDP supplied in the short run (trillions of 2005 yen) 600 400 550 450 500 500 450 550 400 600 350 650 300 700

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Use the following information to work Problems 19 and 20.

Millennials Are Starting to Spend More Millennials, who spend an average of $85 a day, are expected to spend at a higher rate in the next fifteen years. Only 37 percent of Americans report higher spending today than a year ago, while 42 percent of millennials say they are spending more. Millennials are spending more on rent or mortgages and leisure activities than they were spending a year ago.

Source: Business Journal, May 25, 2016 19. Explain the effect of a rise in expenditure by millennials on real GDP and the price level in the short run.

Figure 10.6 shows the effect from the increase in consumption expenditure by millennials.

Consumption expenditure is one of the components of aggregate demand, so an increase in consumption expenditure increases aggregate demand and shifts the aggregate demand curve rightward.

In the figure the aggregate demand curve shifts from AD0 to AD1. Because aggregate demand increased, equilibrium real GDP increases (in Figure 10.6 from $17 trillion to $19 trillion) and the price level rises (in the figure from 117 to 119).

20.

Describe the macroeconomic equilibrium after the change in spending by millennials: a. If the economy had been operating below full-employment equilibrium.

If the economy had been operating below full-employment equilibrium before the increase in consumer expenditure, after the increase equilibrium real GDP will be closer to potential GDP. Ideally real GDP will equal potential GDP.

b. If the economy had been operating at a fullemployment equilibrium.

If the economy had been operating at a full-employment equilibrium before the increase in consumer expenditure, after the increase equilibrium real GDP exceeds potential GDP. The economy is at an above full-employment equilibrium with an inflationary gap.

c. Explain and draw a graph to illustrate how the © 2018 Pearson Education, Inc.

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economy adjusts in the two situations described in parts a and b.

Figure 10.7 shows how the economy can adjust to its long-run equilibrium.

If the economy starts at point A, a below full employment equilibrium, then an increase in aggregate demand from AD0 to AD1 moves the economy to point B. This point also is the long-run equilibrium because it is where the aggregate demand and short-run aggregate supply curves intersect and at that point real GDP equals potential GDP, $17 trillion.

If the economy starts at point B, a full employment equilibrium, then an increase in aggregate demand from AD1 to AD2 moves the economy to point C. In the short run, real GDP exceeds potential GDP. Employment exceeds full employment. The tight labor market means that the money wage rate starts to rise. As the money wage rate rises, short-run aggregate supply decreases and the short-run aggregate supply curve shifts leftward. Real GDP and employment decrease. Even though employment is decreasing, as long as employment exceeds full employment, the money wage rate continues to rise and the short-run aggregate supply continues to decrease. The process ultimately ends when real GDP has decreased back to equal potential GDP and employment equals full employment. Short-run aggregate supply has decreased and the short-run aggregate supply curve has shifted from SAS0 to SAS1. At this point the price level has risen (to 121 in Figure 10.7) and real GDP has returned to potential GDP ($17 trillion).

21.

Suppose that the E.U. economy goes into an expansion. Explain the effect of the expansion on U.S. real GDP and unemployment in the short run.

When the E.U. economy moves into an expansion, U.S. exports to the E.U. increase. The increase in U.S. exports increases U.S. aggregate demand, thereby increasing U.S. real GDP and lowering U.S. unemployment.

22.

Explain why changes in consumer spending and business investment play a large role in the business cycle.

Changes in consumer spending play a large role in business cycles because consumption expenditure is by far the largest part of GDP. A small percentage change in consumption expenditure is a large change in aggregate demand which can lead to a large change in real GDP. Changes in investment spending are also important because investment spending is quite volatile and subject to large changes.

Consequently a decrease in investment often leads to a large decrease in aggregate demand and a recession while an increase frequently results in a large increase in aggregate demand and an expansion.

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23.

Fed Raises Rates As Job Gains, Firming Inflation Stoke Confidence The U.S. Federal Reserve raised interest rates on Wednesday. The rate rise was the second in three months. This second rise comes in an economy that is growing faster and creating jobs at a more rapid pace. These gains are accompanied by a rising inflation rate.

Source: Reuters, March 15, 2017 a. Describe the process by which the Fed’s action reported in the news clip flows through the economy.

An increase in the interest rate makes loans more costly. The higher interest rate leads businesses to decrease their investment and households to decrease spending on new homes and other consumer durables. All these effects decrease aggregate demand and thereby lower real GDP.

b. Draw a graph to illustrate the state of the economy that prompted the Fed to take the action described in the news clip.

Figure 10.8 shows what the Fed believes the state of the economy is. Real GDP of $17.0 trillion (determined by the intersection of AD0 and SAS0) exceeds potential GDP of $16.8 trillion. There is an inflationary gap.

c. Draw a graph to illustrate the Fed’s action and its effect.

Figure 10.9 shows how the Fed’s action decreases aggregate demand, shifting the aggregate demand curve leftward from AD0 to AD1. Real GDP decreases from $17.0 trillion (to potential GDP of $16.8 trillion. The Fed’s action removes the inflationary gap.

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Cut Taxes and Boost Spending? Raise Taxes and Cut Spending? Cut Taxes and Cut Spending This headline expresses three views about what to do to get the U.S. economy growing more rapidly and contribute to closing a large recessionary gap. Economists from which macroeconomic school of thought would recommend pursuing policies described by each of these views?

The first policy, cut taxes and boost spending, would be endorsed by the Keynesian and new Keynesian schools. The second policy, raise taxes and cut spending, is endorsed by no school of thought. The third policy, cut taxes and cut spending, would be endorsed by the classical and new classical schools.

Economics in the News 25.

After you have studied Economics in the News on pp. 262–263 (670–671 in Economics), answer the following questions. a. What are the main features of the U.S. economy in the second quarter of 2017?

The main feature of the U.S. economy in the second quarter of 2014 was relatively rapid growth. The economy grew at a faster than average rate of 3.0 percent in that quarter.

b. Did the United States have a recessionary gap or an inflationary gap in 2017? How do you know?

The U.S. economy had a recessionary gap. Actual GDP was below potential GDP.

c. Use the AS-AD model to show the changes in aggregate demand and aggregate supply that occurred in 2016 and 2017 that brought the economy to its situation in mid-2017.

Figure 10.10 shows the changes between 2016 and 2017. In 2016 there was a recessionary gap so in the figure the aggregate demand curve, AD16, and the short-run aggregate supply curve, SAS16, intersect to the left of the long-run aggregate supply curve, LAS16.

Potential GDP was $16.8 trillion in 2016 and actual real GDP was only $16.7 trillion. The economy still had a recessionary gap in 2017 though it is smaller. In 2016 and 2017 fiscal and monetary policy as well as an expanding world economy increased aggregate demand. Short-run aggregate supply did not change because © 2018 Pearson Education, Inc.

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the increase in potential GDP (which increases short-run aggregate supply) was small and probably offset by a higher money wage rate (which decreases short-run aggregate supply). The aggregate demand curve shifted rightward, to AD17 in Figure 10.10. The economy remained a bit below full employment because the long-run aggregate supply curve had shifted rightward to LAS17. Real GDP was $17.03 trillion but potential GDP was $17.06 trillion.

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d. Use the AS-AD model to show the changes in aggregate demand and aggregate supply that will have occurred when full employment is restored.

Figure 10.11 shows this result. In it the aggregate demand curve has shifted rightward from AD17 to ADfull.

Equilibrium real GDP is $17.06 trillion, the same as potential GDP. The price level is 113.2.

e. Use the AS-AD model to show the changes in aggregate demand and aggregate supply that would occur if the federal government increased its expenditure on goods and services or cut taxes by enough to restore full employment.

Fiscal policy of increasing government expenditure on goods and services or cutting taxes increases aggregate demand and shifts the aggregate demand curve rightward. Figure 10.11 shows this policy. In it the aggregate demand curve has shifted rightward to ADfull.

Equilibrium real GDP is $17.2 trillion, the same as potential GDP. The price level is 114.

f.

Use the AS-AD model to show the changes in aggregate demand and aggregate supply that would occur if the economy moved into an inflationary gap. Show the short-run and the longrun effects.

If government policy leads to an inflationary gap, the aggregate demand curve will have shifted rightward so that it intersects the short-run aggregate supply curve at a point to the right of potential GDP. In Figure 10.12, the government policy would shift the aggregate demand curve to ADpolicy. The price level is 114 and equilibrium real GDP is $17.2 trillion while potential GDP is only $17.06 trillion. The © 2018 Pearson Education, Inc.

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economy has an inflationary gap. In the long run, the inflationary gap will be eliminated. For simplicity, presuming that neither potential GDP nor aggregate demand increase, the tight labor market leads to increases in the money wage rate. As the money wage rate rises, firms’ costs increase. The short-run aggregate supply decreases and the short-run aggregate supply curve shifts leftward.

Eventually aggregate supply decreases so that the short-run aggregate supply curve has shifted to SAS in Figure 10.12. At that moment, the economy is back to full employment: Equilibrium real GDP, $17.06 trillion, equals potential GDP, also $17.06 trillion.

The price level has risen, in the figure to 115.3.

26.

Brazil’s Worst Recession: 8 Consecutive Quarters of Contraction Brazil is experiencing a collapse in business investment, rising unemployment, and falling consumer spending. Business and consumer confidence are low.

Source: CNNMoney March 7, 2017 a. Explain and draw a graph to illustrate the state of Brazil’s economy.

Falling consumer spending decreases aggregate demand. In addition, the first effect of a decrease in investment is a decrease in aggregate demand. The decrease in aggregate demand decreases real GDP. Focusing on the short run, Figure 10.13 shows the effect of the decrease in aggregate demand. Equilibrium real GDP, where aggregate demand equals short-run aggregate supply, is 1.2 trillion reals but potential GDP, determined by long-run aggregate supply, is 1.8 trillion reals, for a recessionary gap of 0.6 trillion reals. The decrease in aggregate demand also lowers the price level to 117.

b. Explain how business and consumer confidence influence aggregate supply and aggregate demand.

The decrease in business confidence leads businesses to decrease their investment. The decrease in investment decreases the Brazil’s aggregate demand and, eventually, Brazil’s aggregate supply.

Similarly, the decrease in consumer confidence lowers consumer expenditure, thereby again decreasing Brazil’s aggregate demand.

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* This is Chapter 28 in Economics.

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EXPENDITURE MULTIPLIERS**

SOLUTION MANUAL FOR MACROECONOMICS, 13TH EDITION MICHAEL PARKIN

Answers to the Review Quizzes Page 273 1.

(page 681 in Economics)

Which components of aggregate expenditure are influenced by real GDP? Consumption expenditure and imports are influenced by real GDP. Both increase when real GDP increases.

2.

Define and explain how we calculate the marginal propensity to consume and the marginal propensity to save.

The marginal propensity to consume is the proportion of an increase in disposable income that is consumed. In terms of a formula, the marginal propensity to consume, or MPC, can be calculated as C/YD, where  means ―change in.‖ The marginal propensity to save is the proportion of an increase in disposable income that is saved. In terms of a formula, the marginal propensity to save, or MPS, can be calculated as S/YD.

3.

How do we calculate the effects of real GDP on consumption expenditure and imports by using the marginal propensity to consume and the marginal propensity to import?

The effects of real GDP on consumption expenditure and imports are determined respectively by the marginal propensity to consume and the marginal propensity to import. In particular, the effect of a change in real GDP on consumption expenditure equals the marginal propensity to consume multiplied by the change in disposable income.

Similarly, the effect of a change in real GDP on imports equals the marginal propensity to import multiplied by the change in real GDP.

Page 277 1.

(page 685 in Economics)

What is the relationship between aggregate planned expenditure and real GDP at equilibrium expenditure?

Equilibrium expenditure occurs when aggregate planned expenditure equals real GDP.

2.

How does equilibrium expenditure come about? What adjusts to achieve equilibrium?

Equilibrium expenditure results from adjustments in real GDP. For instance, if aggregate planned expenditure exceeds real GDP, firms find that their inventories are below their targets. In response, firms increase production to meet their inventory targets, As production increases, real GDP increases. The increase in real GDP increases aggregate planned expenditure but by less than the increase in real GDP. Eventually real GDP increases sufficiently so that it equals aggregate planned expenditure and, at that point, equilibrium expenditure occurs.

3.

If real GDP and aggregate expenditure are less than equilibrium expenditure, what happens to firms’ inventories? How do firms change their production? And what happens to real GDP? If real GDP and aggregate expenditure are less than their © 2018 Pearson Education, Inc.

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equilibrium levels, an unplanned decrease in inventories occurs. The unplanned decrease in inventories leads firms to increase production to restore inventories to their planned levels. The increase in production increases real GDP.

4.

If real GDP and aggregate expenditure are greater than equilibrium expenditure, what happens to firms’ inventories? How do firms change their production? And what happens to real GDP? If real GDP and aggregate expenditure are greater than their equilibrium levels, an unplanned increase in inventories occurs. The unplanned increase in inventories leads firms to decrease production to restore inventories to their planned levels. The decrease in production decreases real GDP.

Page 282 1.

(page 690 in Economics)

What is the multiplier? What does it determine? Why does it matter?

The multiplier is the amount by which a change in autonomous expenditure is multiplied to determine the change in equilibrium expenditure and real GDP. A change in autonomous expenditure changes real GDP by an amount determined by the multiplier. The multiplier matters because it tells us how much a change in autonomous expenditure changes equilibrium expenditure and real GDP.

2.

How do the marginal propensity to consume, the marginal propensity to import, and the income tax rate influence the multiplier?

The marginal propensity to consume, the marginal propensity to import, and the income tax rate all influence the magnitude of the multiplier. The multiplier is smaller when the marginal propensity to consume is smaller, when the marginal propensity to import is larger, and when the income tax rate is larger.

3.

How do fluctuations in autonomous expenditure influence real GDP? Fluctuations in autonomous expenditure bring business cycle turning points. When autonomous expenditure changes, the economy moves from one phase of the business cycle to the next. For example, if autonomous expenditure decreases, equilibrium expenditure and real GDP decrease and, as a result, the economy enters the recession phase of the business cycle.

Page 287 1.

(page 695 in Economics)

How does a change in the price level influence the AE curve and the AD curve?

A change in the price level shifts the AE curve and creates a movement along the AD curve.

2.

If autonomous expenditure increases with no change in the price level, what happens to the AE curve and the AD curve? Which curve shifts by an amount that is determined by the multiplier and why?

A change in autonomous expenditure with no change in the price level shifts both the AE curve and the AD curve. The AE curve shifts by an amount equal to the change in autonomous expenditure. The multiplier determines the magnitude of the shift in the AD curve. The AD curve shifts by an amount equal to the change in autonomous expenditure multiplied by the multiplier. © 2018 Pearson Education, Inc.

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3.

How does an increase in autonomous expenditure change real GDP in the short run? Does real GDP change by the same amount as the change in aggregate demand? Why or why not?

In the short run, an increase in aggregate expenditure increases real GDP. However, the increase in real GDP is less than the increase in aggregate demand because the price level rises. The more the price level rises (the steeper the SAS curve) the smaller the increase in real GDP.

4.

How does real GDP change in the long run when autonomous expenditure increases? Does real GDP change by the same amount as the change in aggregate demand? Why or why not?

In the long run, an increase in aggregate expenditure has no effect on real GDP, that is, real GDP does not change. The change in real GDP—zero—is less than the change in aggregate demand. The change in real GDP is nil because, in the long run, the economy returns to its full-employment equilibrium. In the long run, an increase in aggregate expenditure raises the price level but has no effect on real GDP.

Page 293

(page 701 in Economics)

In an economy, autonomous consumption expenditure is $50 billion, investment is $200 billion, and government expenditure is $250 billion. The marginal propensity to consume is 0.7 and net taxes are $250 billion. Exports are $500 billion and imports are $450 billion. Assume that net taxes and imports are autonomous and the price level is fixed. a. What is the consumption function?

The consumption function is the relationship between consumption expenditure and disposable income, other things remaining the same.

In this case the consumption function is C = 50 + 0.7(Y – 250) where the ―50‖ is $50 billion and the ―250‖ is $250 billion.

b. What is the equation of the AE curve?

The equation of the AE curve is AE = 375 + 0.7Y, where Y is real GDP and the 375 is $375 billion. Aggregate planned expenditure is the sum of consumption expenditure, investment, government purchases, and net exports. Using the symbol AE for aggregate planned expenditure, aggregate planned expenditure is AE = 50 + 0.7(Y – 250) + 200 +250+ 50 AE = 50 + 0.7Y – 175 + 200 + 250 + 50 AE = 375 + 0.7Y

c. Calculate equilibrium expenditure.

Equilibrium expenditure is $1,250 billion. Equilibrium expenditure is the level of aggregate expenditure that occurs when aggregate planned expenditure equals real GDP. That is, AE = 375 + 0.7Y and AE = Y. Solving these two equations for Y gives equilibrium expenditure of $1,250 billion.

d. Calculate the multiplier.

The multiplier equals 1/(1  the slope of the AE curve). The equation of the AE curve tells us that the slope of the AE curve is 0.7. So the multiplier is 1/(1  0.7), which is 3.333.

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e. If investment decreases to $150 billion, what is the change in equilibrium expenditure?

Equilibrium real expenditure decreases by $166.67 billion. From part d the multiplier is 3.333. The change in equilibrium expenditure equals the change in investment, $50 billion, multiplied by 3.333.

f.

Describe the process in part (e) that moves the economy to its new equilibrium expenditure.

When investment decreases by $50 billion, aggregate planned expenditure is less than real GDP. Firms find that their inventories are accumulating above target levels. As a result, they decrease production to reduce inventories. Real GDP decreases. The decrease in real GDP decreases disposable income so that consumption expenditure falls. In turn, the decrease in consumption expenditure leads to a further decrease in aggregate planned expenditure. Real GDP still exceeds aggregate planned expenditure though by less than was initially the case. Nonetheless unwanted inventories are still accumulating and firms continue to cut production, further reducing real GDP. This process continues until eventually real GDP will decrease enough to equal aggregate planned expenditure.

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Answers to the Study Plan Problems and Applications 1.

In an economy, when income increases from $400 billion to $500 billion, consumption expenditure changes from $420 billion to $500 billion. Calculate the marginal propensity to consume, the change in saving, and the marginal propensity to save.

The marginal propensity to consume is the fraction of a change in disposable income that is consumed. In this economy, when income increases by $100 billion per year, consumption expenditure increases by $80 billion per year. The marginal propensity to consume equals $80 billion ÷ $100 billion, or 0.8.

Saving equals disposable income minus consumption expenditure.

Therefore from the $100 billion increase in income, consumption expenditure increased by $80 billion, leaving a $20 billion increase in saving. The marginal propensity to save is the fraction of a change in disposable income that is saved. In this economy, for the increase in income of $100 billion, saving increases by $20 billion, so the marginal propensity to save is $20 billion ÷ $100 billion, which is 0.2.

Use Figure 11.1 to work Problems 2 and 3.

Figure 11.1 illustrates the components of aggregate planned expenditure on Turtle Island. Turtle Island has no imports or exports, no incomes taxes, and the price level is fixed.

2.

Calculate autonomous expenditure and the marginal propensity to consume.

Autonomous expenditure is $2 billion. Autonomous expenditure is expenditure that does not depend on real GDP. Autonomous expenditure equals the value of aggregate planned expenditure when real GDP is zero.

The marginal propensity to consume is 0.6. When the country has no imports or exports and no income taxes, the slope of the AE curve equals the marginal propensity to consume. When income increases from zero to $6 billion, aggregate planned expenditure increases from $2 billion to $5.6 billion. That is, when real GDP increases by $6 billion, aggregate planned expenditure increases by $3.6 billion. The marginal propensity to consume is $3.6 billion ÷ $6 billion, which is 0.6.

3. a. What is aggregate planned expenditure when real GDP is $6 billion?

Figure 11.1 shows that aggregate planned expenditure is $5.6 billion when real GDP is $6 billion.

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b. If real GDP is $4 billion, what is happening to inventories?

Firms’ inventories are decreasing. When real GDP is $4 billion, aggregate planned expenditure exceeds real GDP, so firms sell all that they produce and more. As a result, inventories decrease.

c. If real GDP is $6 billion, what is happening to inventories?

Firms are accumulating inventories. That is, unplanned inventory investment is positive. When real GDP is $6 billion, aggregate planned expenditure is less than real GDP. Firms cannot sell all that they produce and inventories pile up.

4.

Explain the difference between induced consumption expenditure and autonomous consumption expenditure. Why isn’t all consumption expenditure induced expenditure?

Induced consumption expenditure is consumption expenditure that changes when disposable income changes. Autonomous consumption expenditure is consumption expenditure that would occur in the short run even if disposable income was zero. Not all consumption expenditure is induced consumption expenditure because, in the short run, even if someone has no income they still will have some (autonomous) consumption expenditure, if for nothing else, for food.

5.

Explain how an increase in business investment at a constant price level changes equilibrium expenditure.

Investment is a component of autonomous aggregate expenditure. An increase in investment increases aggregate expenditure so the AE curve shifts upward. Equilibrium expenditure increases.

Use the following data to work Problems 6 and 7.

An economy has a fixed price level, no imports, and no income taxes. MPC is 0.80, and real GDP is $150 billion. Businesses increase investment by $5 billion.

6.

Calculate the multiplier and the change in real GDP. With no imports and no income taxes, the multiplier equals 1/(1  MPC). So the multiplier is 1/(1  0.8), which is 5.0 Then the $5 billion increase in investment increases real GDP by 5.0 × $5 billion, which is $25 billion.

7.

Calculate the new real GDP and explain why real GDP increases by more than $5 billion.

Real GDP was initially $150 billion. The increase in investment increased real GDP by $25 billion, so real GDP increases to $175 billion. Real GDP increases by more than the initial increase in investment because the increase in investment increases disposable income which induces additional increases in consumption expenditure. So real GDP increases both because investment increases and also because of induced increases in consumption expenditure.

8.

An economy has a fixed price level, no imports, and no income taxes. An increase in autonomous expenditure of $2 trillion increases equilibrium expenditure by $8 trillion. Calculate the multiplier and explain what happens to the multiplier if an income tax is introduced.

The multiplier is defined as the change in equilibrium expenditure divided by the change in autonomous expenditure. In this problem the multiplier equals $8 trillion ÷ $2 trillion which is 4.0.

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If an income tax is introduced, the multiplier decreases in value.

With an income tax, at each spending round less disposable income is created leading to smaller increases in induced expenditure.

Use the following data to work Problems 9 to 13.

Suppose that the economy is at full employment, the price level is 100, and the multiplier is 2.

Investment increases by $100 billion.

9.

What is the change in equilibrium expenditure if the price level remains at 100?

The initial change in equilibrium expenditure is $200. The initial effect of the increase in investment increases equilibrium expenditure by the change in investment times the multiplier. The multiplier is 2 and the change in investment is $100 billion, so the initial change in equilibrium expenditure is $200 billion.

10. a. What is the immediate change in the quantity of real GDP demanded?

The quantity of real GDP demanded increases by $200 billion. The increase in investment shifts the aggregate demand curve rightward by the change in investment times the multiplier. The multiplier is 2 and the change in investment is $100 billion, so the aggregate demand curve shifts rightward by $200 billion.

b. In the short run, does real GDP increase by more than, less than, or the same amount as the immediate change in the quantity of real GDP demanded?

In the short run, real GDP increases by less than $200 billion. Real GDP is determined at the intersection of the AD curve and the SAS curve. In the short run, the price level will rise and real GDP will increase but by an amount less than the shift of the AD curve.

11.

In the short run, does the price level remain at 100? Explain why or why not.

In the short run, the price level rises. Real GDP is determined at the intersection of the AD curve and the SAS curve. In the short run, the increase in aggregate demand means that the price level will rise as the economy moves along its upward-sloping SAS curve.

12. a. In the long run, does real GDP increase by more than, less than, or the same amount as the immediate increase in the quantity of real GDP demanded?

In the long run, real GDP equals potential GDP, so real GDP does not increase. Real GDP is determined at the intersection of the AD curve and the SAS curve. After the initial increase in investment, money wages increase, the SAS curve shifts leftward, and in the long run, real GDP moves back to potential GDP.

b. Explain how the price level changes in the long run.

Real GDP is determined at the intersection of the AD curve and the SAS curve. In the long run, money wages increase so the SAS curve shifts leftward, raising the price level by more than it rose in the short run.

13.

Are the values of the multipliers in the short run and the long run larger or smaller than 2?

The multiplier in the short run is less than the multiplier of 2 because the short-run increase in real GDP is less than $200 billion. The long-run multiplier is even smaller. It equals zero.

14.

Use the data in the Worked Problem on p. 293 (page 702 in Economics). Calculate the change in © 2018 Pearson Education, Inc.

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equilibrium expenditure when investment decreases by $150 billion.

The multiplier equals 4. Consequently the change in equilibrium expenditure equals (4) × (−$150 billion), or a decrease of $600 billion.

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Answers to Additional Problems and Applications Use the following data for the Australian economy to work Problems 15 and 16.

15.

Calculate the marginal propensity to save.

The marginal propensity to save is the fraction of a change in disposable income that is saved. In Australia, when disposable income increases by $100 billion per year, saving increases by $25 billion per year. The marginal propensity to save is $25 billion ÷ $100 billion, which is 0.25.

16.

Disposable income Saving (billions of dollars per year) 0 0 100 25 200 50 300 75 400 100

Calculate consumption at each level of disposable income. Calculate the marginal propensity to consume.

The table to the right shows Disposable Consumption Australia’s consumption expenditure income expenditure schedule. Consumption expenditure (billions of dollars equals disposable income minus saving. per year) For each increase in disposable income 0 0 of $100 billion, consumption 100 75 expenditure increases by $75 billion.

200 150 The marginal propensity to consume is 300 225 0.75. The marginal propensity to 400 300 consume plus the marginal propensity to save equals 1. Because the marginal propensity to save equals 0.25, the marginal propensity to consume equals 0.75.

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Use the following news clip to work Problems 17 to 19.

U.S. Households Added $2.35 Trillion in Wealth The Federal Reserve reported that household wealth increased by $2.35 trillion or $20,000 per household in the first quarter of 2017. This rise is the largest since 2004. The rise came from a 5.5 percent gain in the Standard & Poor’s 500 Index and house price appreciation.

Separately, the Bureau of Economic Analysis reported that consumption expenditure increased by $56 billion in the first quarter of 2017.

Sources: Bloomberg, June 8, 2017, and the Bureau of Economic Analysis 17. Explain and draw a graph to illustrate how the increase in household wealth would be expected to influence the consumption function and saving function.

Figure 11.2a shows the effect of an increase in wealth on the consumption function and Figure 11.2b shows the effect on the saving function. Consumption expenditure increases so the consumption function shifts upward from CF0 to CF1 while saving decreases so the saving function shifts downward from SF0 to SF1.

18.

What factors might explain the actual changes in consumption expenditure and wealth that occurred in the first quarter of 2017?

According to the article, consumption increased. This change is in line with the effect from the increased wealth. In addition, at least two other factors could also contribute to an increase in consumption expenditure. First, disposable income might have increased. This change would lead to a movement upward along the (new) consumption function so that consumption expenditure increased. Alternatively people’s expected future incomes might have risen. The upward revision in expected future income also would lead to an upward shift of the consumption function.

19.

Draw a graph of a consumption function and show at what points consumers were actually © 2018 Pearson Education, Inc.

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operating in the second and third quarters. Make any necessary assumptions and explain your answer.

In Figure 11.2a the consumption function shifts upward from CF0 to CF1. It is likely that disposable income also increased. So the economy moves from disposable income of $16.0 trillion and consuming at point A on consumption function CF0 to disposable income of $17.0 trillion and consuming at point B on consumption function CF1.

A 1 2 3 4 5 6 7

A B C D E F

B Y 100 200 300 400 500 600

C C 110 170 230 290 350 410

D I 50 50 50 50 50 50

E G 60 60 60 60 60 60

F X 60 60 60 60 60 60

G M 15 30 45 60 75 90

Use the spreadsheet above, which lists real GDP (Y ) and the components of aggregate planned expenditure in billions of dollars, to work Problems 20 and 21.

20.

Calculate autonomous expenditure. Calculate the marginal propensity to consume.

Autonomous expenditure equals the value of aggregate planned expenditure when real GDP is zero. Because the spreadsheet does not list GDP of zero, we must extrapolate to calculate the value of consumption expenditure and imports when GDP equals zero. From the spreadsheet, consumption expenditure falls by $60 billion for every $100 billion decrease in GDP. So when GDP equals zero, autonomous consumption expenditure is $50 billion. Similarly, from the spreadsheet, imports decrease by $15 billion for every $100 billion decrease in GDP. So when GDP equals zero, imports equal zero.

Autonomous expenditure is $50 billion (consumption expenditure) plus $50 billion (investment) plus $60 billion (government expenditure) plus $60 billion (exports), which equals $220 billion.

The marginal propensity to consume is 0.6. When income increases from $100 billion to $200 billion, consumption expenditure increases from $110 billion to $170 billion. A $100 billion increase in GDP increases consumption expenditure by $60 billion. So the marginal propensity to consume is $60 billion ÷ $100 billion, which is 0.6.

21. a. What is aggregate planned expenditure when real GDP is $200 billion?

Aggregate planned expenditure is $310 billion. Aggregate planned expenditure is the sum of consumption expenditure ($170 billion) plus planned investment ($50 billion) plus government expenditure ($60 billion) plus exports ($60 billion) minus imports ($30 billion), which is $310 billion.

b. If real GDP is $200 billion, explain the process that moves the economy toward equilibrium expenditure.

Inventories are decreasing so that the unplanned inventory change is negative. When real GDP is $200 billion, aggregate planned expenditure is $310 billion. Because aggregate planned expenditure © 2018 Pearson Education, Inc.

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exceeds real GDP, firms sell all that they produce and even more so that inventories are decreasing. Firms then increase their production, to restore their inventories, and real GDP increases.

c. If real GDP is $500 billion, explain the process that moves the economy toward equilibrium expenditure.

Firms are accumulating inventories so that the unplanned inventory change is positive. When real GDP is $500 billion, aggregate planned expenditure is $445 billion. Firms cannot sell all that they produce so that unplanned inventories increase. Firms respond by decreasing their production, to lower their inventories, and real GDP decreases.

22.

U.S. Wholesale Inventories Post Biggest Gain in Six Months The Commerce Department reported that wholesale inventories rose 0.7 percent in May and by 0.6 percent in June. Inventory investment had a neutral effect on second quarter GDP growth.

Source: U.S. News and World Report, August 9, 2017 Explain why an increase in inventories might bolster economic growth, while a fall in inventories might be a sign of recession. In your explanation, distinguish between planned and unplanned changes in business inventories.

Inventories are part of investment. If the increase in inventories reflects an increase in planned inventories, then planned investment increases which increases aggregate expenditure and real GDP. If, however, the increase is unplanned, it could reflect a decrease in aggregate expenditure, which could lead to a decrease in real GDP. Similarly, if a fall in inventories reflects a decrease in planned inventories, then planned investment decreases, which lowers aggregate expenditure and real GDP. Alternatively, if the fall in inventories is unplanned, it might indicate an increase in aggregate expenditure which would then lead to an increase in real GDP.

23.

South Korea Plans $10 Billion Stimulus Package to Boost Jobs The government of South Korea announced a $10 billion (11.2 trillion won) fiscal stimulus package, which will increase social welfare subsidies for maternity leave and for the healthcare needs of older people and will also create new public sector jobs.

Source: CNBC, June 4, 2017 If the slope of the AE curve is 0.7, calculate the immediate change in aggregate planned expenditure and the change in real GDP in the short run if the price level remains unchanged.

The increase in government expenditure will have a multiplier effect on aggregate expenditure and real GDP. The multiplier equals 1/(1  the slope of the AE curve). The slope of the AE curve is 0.7 so the multiplier is 1/(1  0.7), which is 3.3. With this multiplier, the $10 billion increase in government expenditure increases aggregate expenditure by 3.3 × $10 billion, or $33 billion. In the short run, when the price level is constant, real GDP increases by the same amount, $33 billion.

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24.

Japan Cabinet Approves $132 Billion in Fiscal Stimulus Japan’s government will spend $132 billion (13.5 trillion yen) on cash handouts to low-income earners and on infrastructure projects.

Source: CNBC, August 2, 2016 If Japan spends $66 billion (half the total) on cash handouts and $66 billion on infrastructure projects, which of these expenditures would have the larger effect on equilibrium expenditure, other things remaining the same?

The spending on infrastructure projects will have the larger effect on equilibrium expenditure. The effect on equilibrium expenditure is larger from the infrastructure spending because in the first round all of the increased infrastructure expenditure increases aggregate expenditure. Some of the cash handouts, however, will be saved so the first round only part of the cash handouts is spent so only part goes to increase aggregate expenditure. Because the multiplier effect applies only to the funds that are spent, the effect on equilibrium expenditure from the infrastructure spending will be larger than that from the cash handouts.

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Use the following news item to work Problems 25 to 27.

The BEA reported that in the second quarter of 2017 U.S. exports increased by $20 billion.

25.

Explain and draw a graph to illustrate the effect of an increase in exports on equilibrium expenditure in the short run.

The increase in exports increases aggregate expenditure because exports is a component of aggregate expenditure. As shown in Figure 11.3, the aggregate expenditure curve shifts upward from AE0 to AE1.

Because aggregate expenditure has increased, real GDP increases, In Figure 11.3 the increase in aggregate expenditure increases real GDP from $17.0 trillion to $17.2 trillion.

26.

Explain and draw a graph to illustrate the effect of an increase in exports on equilibrium real GDP in the short run.

The increase in exports increases aggregate expenditure and creates an increase in the aggregate demanded. Figure 11.4 illustrates the effect on real GDP. The aggregate demand curve shifts rightward, from AD0 to AD1. The price level rises and equilibrium real GDP increases from $17.0 trillion to $17.1 trillion. The economy is in an above full-employment equilibrium.

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Explain and draw a graph to illustrate the effect of an increase in exports on equilibrium real GDP in the long run.

In the short run, the economy is in an above full-employment equilibrium. As time passes, the money wage rate rises, which decreases short-run aggregate supply and shifts the short-run aggregate supply curve leftward.

Eventually the short-run aggregate supply decreases enough so that the economy returns to full employment. In Figure 11.5, this analysis means that the short-run aggregate supply curve eventually shifts from SAS0 to SAS1 and the economy returns to full employment, with real GDP of $17.0 trillion and a price level of 122.

28.

Compare the multiplier in the short run and the long run and explain why they are not identical.

The long-run multiplier is zero, which means that the short-run multiplier is larger than the long-run multiplier. The long-run multiplier equals zero because in the long run the economy returns to full employment. For example, in the short run an increase in aggregate demand increases real GDP, which means that the short-run multiplier is positive. But the economy is at a greater than fullemployment equilibrium. Therefore the money wage rate starts to rise. The rise in the money wage rate decreases short-run aggregate supply and thereby decreases real GDP. The short-run aggregate supply continues to decrease until the economy reaches full employment, at which point it stops decreasing. But the ultimate change in real GDP is zero, which means the long-run multiplier is zero.

Use the following news clip to work Problems 29 to 31.

Consumer Sentiment in U.S. Rose to Three Month High Consumer sentiment was up in August helped by merchant discounts, especially from auto dealerships who received incentives from automakers Honda, General Motors, and Toyota to lower prices.

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But consumers are worried about the future. They are worried about tax changes and government budget cuts that are on the horizon. Capital spending fell somewhat.

Source: Bloomberg, September 1, 2012 29.

For each of the expenditures listed in the news clip, say which is a part of induced expenditure and which is part of autonomous expenditure?

Induced consumption expenditure changes with changes in disposable income. Autonomous consumption expenditure does not change when disposable income changes. For many consumers, purchasing new cars increase when their incomes rise. For these consumers, these items are induced expenditure. Other Americans plan to buy automobiles regardless of the change in their income perhaps because their consumer sentiment is ―up,‖ or perhaps because prices of cars have fallen. For these consumers, these expenditures are autonomous.

Capital spending is part of autonomous expenditure.

30.

Which of the events reported in the news clip would change aggregate demand and which would change the quantity of real GDP demanded? Provide a graphical illustration of the distinction.

The increase in consumption expenditure induced by increased income, the autonomous increase in consumption, and the increase in capital spending all increase aggregate demand and shift the aggregate demand curve rightward. The increase in consumption expenditure that results from lower prices reflects a change in consumption from a lower price level and creates a change in the quantity of real GDP demanded. Figure 11.6 illustrates these differences. The change from point A to point B reflects a change in aggregate demand. The movement from point B to point C reflects a change in the quantity of real GDP demanded.

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Explain and draw a graph to illustrate how increasing consumer confidence influences aggregate expenditure and aggregate demand.

Increasing consumer confidence increases autonomous consumption. It increases aggregate expenditure and aggregate demand. As illustrated in Figure 11.7a, the aggregate expenditure curve shifts upward, from AE0 to AE1 and in Figure 11.7b the aggregate demand curve shifts rightward, from AD0 to AD1.

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32.

Japan Slides Into Recession In Japan, consumer prices slid at a faster pace in July and industrial production unexpectedly slumped.

Source: Bloomberg, September 1, 2012 Contrast what the news clip says is happening in Japan with what is happening in the United States in Problem 29 and provide a graphical analysis of the differences.

The news clip suggests that in Japan aggregate demand is decreasing so that both the price level and real GDP are decreasing. Figure 11.8a shows this situation. The information in Problem 29 suggests that consumption expenditure is increasing and, while investment (capital spending) is decreasing. However it seems that the change in consumption expenditure exceeds the change in investment so U.S. aggregate demand is increasing. Figure 11.8b shows this situation.

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Economics in the News 33.

After you have studied Economics in the News on pp. 288–289 (696–697 in Economics), answer the following questions. a. If the unplanned change in inventories was $0.06 trillion, what was the planned change, and what role did it play in shifting the AE curve and changing equilibrium expenditure? Use a two-part figure (similar to that on p. 684) to answer this question.

The total change in inventories was $1.8 billion. If the unplanned change was $0.6 billion, then the planned change was $1.2 billion.

Figure 11.9a shows aggregate planned expenditure; Figure 11.9b shows unplanned inventory change. When aggregate planned expenditure is given by AE0, unplanned inventory change is equal to zero when real GDP is $17.0 trillion, so unplanned inventory change is given by the top line in Figure 11.9b. The increase in planned investment increased aggregate planned expenditure. The increase in aggregate planned expenditure shifts the aggregate expenditure curve upward, as illustrated by the shift from AE0 to AE1 in Figure 11.9a. It shifts the unplanned inventory change line downward to the lower curve, Unplanned inventory change1, in Figure 11.9b. The increase in aggregate expenditure increases equilibrium real GDP. In figure 11.9a, real GDP increases from $17.0 trillion to $17.2 trillion. In Figure 11.9b, at real GDP of $17.2 trillion, along the new unplanned inventory change curve line, unplanned inventory change is $0.6 trillion.

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b. The BEA data show that exports of goods and services were up 3.7 percent and imports of goods and services were up 1.6 percent. Were these increases in expenditure increases in autonomous expenditure or increases in induced expenditure, and how do they influence the magnitude of the multiplier?

Changes in exports are autonomous expenditure and changes in imports are induced expenditure. Changes in exports have no effect on the magnitude of the multiplier. Changes in imports do affect the size of the multiplier. The larger the quantity of imports that are induced by a change in income, the smaller the multiplier.

c. Using the assumptions made in Figure 2 on p. 285 (p. 697 in Economics), what is the value of the autonomous expenditure multiplier?

The autonomous expenditure multiplier equals 1/(1 – slope of AE line). In the figure, the slope along the top red line is equal to ($17.03 trillion − $16.96 trillion)/($17.03 trillion − $16.90 trillion) = ($0.07 trillion)/(($0.13 trillion) = 0.54. So the autonomous expenditure multiplier equals 1/(1 – 0.54) = 2.2.

34.

In an economy with a fixed price level, autonomous spending is $20 trillion and the slope of the AE curve is 0.6. a. What is the equation of the AE curve?

The equation of the AE curve is AE = 20 + 0.6Y, where Y is real GDP and the 20 is $20 trillion.

b. Calculate equilibrium expenditure.

Equilibrium expenditure is $50 trillion. Equilibrium expenditure is the level of aggregate expenditure that occurs when aggregate planned expenditure equals real GDP. That is, AE = 20 + 0.6Y and AE = Y. Solving these two equations for Y gives equilibrium expenditure of $50 trillion.

c. Calculate the multiplier.

The multiplier equals 1/(1  the slope of the AE curve). The equation of the AE curve tells us that the slope of the AE curve is 0.6. So the multiplier is 1/(1  0.6), which is 2.5.

d. Calculate the shift of the aggregate demand curve if investment increases by $1 billion.

The shift of the aggregate demand curve equals the multiplier multiplied by the change in investment, or 2.5 × $1 billion, which is $2.5 billion.

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THE BUSINESS CYCLE, INFLATION, AND DEFLATION**

SOLUTION MANUAL FOR MACROECONOMICS, 13TH EDITION MICHAEL PARKIN

Answers to the Review Quizzes Page 304 1.

(page 712 in Economics)

Explain the mainstream theory of the business cycle.

Mainstream business cycle theory attributes business cycles to fluctuations in aggregate demand growth. According to the mainstream view, potential GDP grows steadily and aggregate demand, while generally growing slightly faster that potential GDP, at times grows more slowly than potential GDP and at other times grows significantly more rapidly than potential GDP. When aggregate demand grows more slowly than potential GDP, the inflation rate is low and, because money wages are sticky and do not adjust to the lower the inflation rate, the economy slides into a recessionary gap so that real GDP is less than potential GDP. When aggregate demand grows more rapidly than potential GDP, the inflation rate is high and the economy moves into a strong expansion accompanied by inflation.

2.

What are the four special forms of the mainstream theory of the business cycle and how do they differ?

The four special forms of the mainstream theory are the Keynesian cycle theory, the monetarist cycle theory, the new classical cycle theory, and the new Keynesian cycle theory. These theories differ according to the factors they believe are the most responsible for causing fluctuations in the growth of aggregate demand. Keynesian cycle theory asserts that fluctuations in aggregate demand growth are the result of fluctuations in investment driven by fluctuations in business confidence. The monetarist cycle theory says that fluctuations in both investment and consumption expenditure lead to fluctuations in aggregate demand growth and that the basic source of the fluctuations in investment and consumption expenditure is fluctuations in the growth rate of the quantity of money. New classical cycle theory claims that the money wage rate and the position of the short-run aggregate supply curve are determined by the rational expectation of the price level, which in turn is determined by potential GDP and the expected aggregate demand. As a result, only unexpected changes in aggregate demand growth lead to business cycles. Finally, new Keynesian cycle theory says that money wage rates and the position of the short-run aggregate supply are determined by rational expectations of the price level from the past. As a result, both expected and unexpected fluctuations in aggregate demand growth lead to business cycles.

3.

According to RBC theory, what is the source of the business cycle? What is the role of fluctuations in the rate of technological change?

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fluctuate. Fluctuations in the rate of technological change are the impulse that creates the business cycle.

4.

According to RBC theory, how does a fall in productivity growth influence investment demand, the market for loanable funds, the real interest rate, the demand for labor, the supply of labor, employment, and the real wage rate?

According to real business cycle theory, a fall in productivity growth decreases investment demand and the demand for labor. The decrease in investment demand decreases the demand for loanable funds and lowers the real interest rate. Via the intertemporal substitution effect, the lower real interest rate decreases the supply of labor. Because both the demand for labor and the supply of labor decrease, employment decreases. The real wage rate also falls because the decrease in the demand for labor exceeds the decrease in the supply of labor.

5.

What are the main criticisms of RBC theory and how do its supporters defend it?

Critics of the real business cycle theory level three criticisms at it: 1) the money wage rate is sticky; 2) the intertemporal substitution effect is small so that the small changes in the real wage rate cannot account for large changes in employment; and, 3) measured productivity shocks are likely to be caused by changes in aggregate demand so that business cycle fluctuations cause the measured productivity shocks. Real business cycle supporters respond that 1) the real business cycle theory is consistent with the facts about economic growth and it explains the facts about business cycles; and 2) real business cycle theory is consistent with a wide range of microeconomic evidence about labor supply, labor demand, investment demand, and the distribution of income between labor and capital.

Page 310 1.

(page 718 in Economics)

How does demand-pull inflation begin?

Demand-pull inflation begins with an increase in aggregate demand.

The increase in aggregate demand increases real GDP and the price level.

2.

What must happen to create a demand-pull inflation spiral?

When the economy is at an above full-employment equilibrium, the money wage rate rises which decreases the short-run aggregate supply. The decrease in the short-run aggregate supply decreases real GDP and raises the price level. If nothing else changes, the price level eventually stops rising. To create a demand-pull inflation spiral, aggregate demand must persistently increase, and the only way in which aggregate demand can persistently increase is if the quantity of money persistently increases.

3.

How does cost-push inflation begin?

Cost-push inflation begins with an increase in the money wage rate or an increase in the money prices of raw materials, which decreases short-run aggregate supply. The decrease in short-run aggregate supply raises the price level and decreases real GDP. © 2018 Pearson Education, Inc.

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4.

What must happen to create a cost-push inflation spiral?

If the Fed responds to each decrease in short-run aggregate supply by increasing the quantity of money, aggregate demand increases and freewheeling cost-push inflation ensues.

5.

What is stagflation and why does cost-push inflation cause stagflation?

Stagflation occurs when real GDP decreases and the price level rises. Cost-push inflation causes stagflation when short-run aggregate supply decreases because a decrease in short-run aggregate supply raises the price level and decreases real GDP.

6.

How does expected inflation occur?

Expected increases in aggregate demand or expected decreases in short-run aggregate supply create expected inflation because they change the expected price level. For example, in anticipation of an increase in aggregate demand, the money wage rate rises by the same percentage as the price level is expected to rise. With the correct expectation, real GDP remains equal to potential GDP and unemployment remains at its natural rate.

7.

How do real GDP and the price level change if the forecast of inflation is incorrect?

If the actual inflation rate exceeds the forecasted inflation rate, the price level rises by more than expected and real GDP exceeds potential GDP. If the actual inflation rate falls short of the expected inflation rate, the price level rises by less than expected and real GDP is less than potential GDP.

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(page 721 in Economics)

What is deflation?

Deflation is a persistently falling price level.

2.

What is the distinction between deflation and a one-time fall in the price level?

Deflation is a persistently falling price level; that is, the price level continually falls. A one-time fall in the price level occurs when the price level falls but thereafter starts to grow once again.

3.

What causes deflation?

Deflation occurs if aggregate demand increases at a persistently slower rate than aggregate supply. This situation typically occurs when the quantity of money grows slowly so that aggregate demand also grows slowly.

4.

How does the quantity theory of money help us to understand the process of deflation?

The equation of exchange shows that the growth rate of the price level equals the money growth rate plus the rate of change of velocity minus the growth rate of real GDP. The quantity theory adds two assumptions to the equation of exchange: The trend rate of change of velocity does not depend on the money growth rate and the trend growth rate of real GDP equals the growth rate of potential GDP, which also does not depend on the money growth rate. With these assumptions, the quantity theory predicts that a nation’s deflation (or inflation) rate equals the money growth rate plus the trend growth in velocity minus the trend growth in real GDP. The situation © 2018 Pearson Education, Inc.

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in Japan illustrates that this prediction is close to what actually occurred.

5.

What are the consequences of deflation?

Unanticipated deflation means that workers who have long-term wage contracts receive a higher real wage rate. But firms respond to the higher real wage by hiring fewer workers, so employment and output fall. The reduction in output decreases profits. Firms respond by decreasing investment, which reduces the growth rate of the capital stock, thereby slowing growth in potential GDP. The deflation also lowers the nominal interest rate, which increases the quantity of money people hold, which decreases the velocity of circulation, further adding to deflation.

6.

How can deflation be ended?

Deflation can be ended by increasing the money growth rate. In particular, the money growth rate must be changed to equal the target inflation rate plus the growth rate of potential GDP minus the growth rate of the velocity of circulation.

Page 315 1.

(page 723 in Economics)

How would you use the Phillips curve to illustrate an unexpected change in inflation?

An unexpected change in inflation results in a movement along the short-run Phillips curve. In particular, an unexpected increase in the inflation rate lowers the unemployment rate and an unexpected decrease in the inflation rate raises the unemployment rate.

2.

If the expected inflation rate increases by 10 percentage points, how do the short-run Phillips curve and the long-run Phillips curve change?

A 10 percentage point increase in the expected inflation rate shifts the short-run Phillips curve vertically upward by 10 percentage points. (Each point on the new short-run Phillips curve lies 10 percentage points above the point on the old Phillips curve directly below it). A 10 percentage point increase in the expected inflation rate does not change the long-run Phillips curve.

3.

If the natural unemployment rate increases, what happens to the short-run Phillips curve and the long-run Phillips curve?

An increase in the natural unemployment rate shifts both the shortrun and long-run Phillips curves rightward by an amount equal to the increase in the natural unemployment rate.

4.

Does the United States have a stable short-run Phillips curve? Explain why or why not.

The United States does not have a stable short-run Phillips curve.

The U.S. short-run Phillips curve shifts with changes in the expected inflation rate and the natural unemployment rate, so it is not stable.

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Answers to the Study Plan Problems and Applications 1.

Debate on Causes of Unemployment Two economists are debating the cause of a high unemployment rate. One economist argues that there is not enough government spending. The other says high unemployment is a structural problem—people who can’t move to take new jobs because they are tied down to burdensome mortgages or firms that can’t find workers with the skills they need to fill job openings. a. Which business cycle theory would say that the first economist is correct and why?

It is likely that most of the mainstream business cycle theories would say that the first economist is correct. Most of the mainstream models believe high unemployment is the result of a business-cycle recession. These models, especially the Keynesian cycle theory and new Keynesian cycle theory, agree that a recession can be combatted by an increase in government spending, so these theories say that the high unemployment results because there is not enough government spending to lower it.

b. Which business cycle theory would say that the second economist is correct and why?

The real business cycle theory would say the second economist is correct. It regards all unemployment as natural unemployment and so it would assert that the rise in the unemployment rate reflects a rise in the natural rate because of a rise in structural unemployment.

2.

U.S. Inflation Rises at Faster Pace With the consumer price index rising at a faster pace, President-elect Donald Trump wants to slash taxes and boost infrastructure spending, which could cause inflation to rise further.

Source: Washington Post, January 19, 2017 Explain what type of inflation the news clip is describing and provide a graphical analysis of it.

The news clip is describing a demand-pull inflation. Slashing taxes and boosting infrastructure increase aggregate demand and thereby raise the price level resulting in inflation. Figure 12.1 illustrates a demand-pull inflation. In it the aggregate demand curve has shifted rightward, from AD0 to AD1 and the price level has risen from 122 to 124.

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Use Figure 12.2 to answer Problems 3 to 5. The economy starts out on the curves labeled AD0 and SAS0.

3.

Some events occur and the economy experiences a demand-pull inflation. What might those events have been? Describe their initial effects and explain how a demand-pull inflation spiral results.

Anything that increases aggregate demand can be the factor that starts a demand-pull inflation.

For instance, an increase in the quantity of money, an increase in government expenditure, a tax cut, or an increase in exports could all be the start of a demand-pull inflation. To sustain the inflation, the quantity of money must keep increasing.

Starting at the intersection of AD0 and SAS0, the price level is 120 and real GDP is at potential GDP of $16 trillion. Aggregate demand increases and the AD curve shifts rightward to AD1. The new equilibrium is at the intersection of AD1 and SAS0, so the price level rises and real GDP increases. There is an inflationary gap.

Starting at the intersection of AD1 and SAS0, there is an inflationary gap so the money wage rate rises and short-run aggregate supply decreases. The SAS curve starts to shift leftward toward SAS1. The price level keeps rising, but real GDP now decreases. If the central bank responds with persistent increases in the quantity of money, the process repeats: AD shifts to AD2, an inflationary gap opens again, the money wage rate rises again, and the SAS curve shifts toward SAS2.

4.

Some events occur and the economy experiences a cost-push inflation. What might those events have been? Describe their initial effects and explain how a cost-push inflation spiral results.

Anything that decreases short-run aggregate supply can set off a cost-push inflation. For instance, an increase in the money wage rate or an increase in the money price of raw materials could be the start of a cost-push inflation. But to sustain such an inflation, the quantity of money must keep increasing.

Starting at the intersection of AD0 and SAS0, the price level is 120 and real GDP is at potential GDP of $16 trillion. Short-run aggregate supply decreases and the SAS curve shifts leftward to SAS1.

The price level rises and real GDP decreases. There is now a recessionary gap.

Starting out at the intersection of AD0 and SAS1, there is a recessionary gap so real GDP is below potential GDP and unemployment is above the natural rate. In an attempt to restore full employment, the central bank increases the quantity of money. The aggregate © 2018 Pearson Education, Inc.

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demand curve shifts rightward to AD1. Real GDP returns to $16 trillion and the price level rises to 160. A further cost increase occurs, which shifts the short-run aggregate supply curve to SAS2 and a recessionary gap opens up again. The economy is again below potential GDP. In an attempt to restore full employment, the central bank increases the quantity of money. The aggregate demand curve shifts rightward to AD2. Real GDP returns to $16 trillion and the price level rises to 200.

5.

Some events occur and the economy is expected to experience inflation. What might those events have been? Describe their initial effects and what happens as an expected inflation proceeds.

Anything that increases aggregate demand can set off an expected inflation as long as the event is expected. For instance, an expected increase in the quantity of money, an increase in government expenditure, a tax cut, or an increase in exports could all be the start of an expected inflation. But to sustain such an expected inflation, the quantity of money must keep increasing along its expected path.

Starting at the intersection of AD0 and SAS0, the price level is 120 and real GDP is at potential GDP of $16 trillion. Aggregate demand increases, and the AD curve shifts rightward to AD1. The increase in aggregate demand is expected so the money wage rate rises and the SAS curve shifts to SAS1. The price level rises, and real GDP remains equal to potential GDP. Starting at the intersection of AD1 and SAS1, a further expected increase in aggregate demand occurs. The AD curve shifts to AD2, and because the increase in aggregate demand is expected, the money wage rate rises again and the SAS curve shifts to SAS2. Again, the price level rises and real GDP remains equal to potential GDP.

6.

Suppose that the velocity of circulation of money is constant and real GDP is growing at 3 percent a year. a. To achieve an inflation target of 2 percent a year, at what rate would the central bank grow the quantity of money?

To achieve a target inflation rate, the growth rate of the quantity of money must equal the inflation target plus real GDP growth minus growth in velocity. In the situation at hand, the growth in the quantity of money should equal 2 percent a year plus 3 percent a year minus 0 percent, or 5 percent a year.

b. At what growth rate of the quantity of money would deflation be created?

Deflation occurs if the inflation rate is less than zero. Inflation rate = Money growth rate + Rate of velocity change - Real GDP growth rate. The rate of velocity change is zero and the real GDP growth rate is 3 percent a year. So the inflation rate is negative when the money growth rate is less than the real GDP growth rate, which is 3 percent a year.

7.

Central Bankers are Baffled Another month with a low unemployment number and with no rise in the inflation rate has the © 2018 Pearson Education, Inc.

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Federal Reserve baffled. The Phillips curve has disappeared.

Source: The Financial Times, July 27, 2017 a. What does the Phillips curve model say about the relationship between the unemployment rate and the inflation rate?

The Phillips curve model says that if the expected inflation rate and the natural unemployment rate do not change, then an increase in the inflation rate results in a decrease of the unemployment rate.

So, with constant expected inflation and constant natural unemployment, unemployment is low when inflation is high.

b. Explain the event in the news clip in terms of what is happening to the short-run and long-run Phillips curves.

If the natural unemployment rate is decreasing and/or the expected inflation rate is falling, then the short-run Phillips curve shifts downward. As the short-run Phillips curve shifts downward, the unemployment rate can remain low with no rise in the inflation rate.

8.

From the Fed’s Minutes FOMC participants saw the data on aggregate expenditure and unemployment as little changed since June but expected the unemployment rate to fall. Participants expected that inflation would remain below 2 percent per year in the near term but stabilize around the 2 percent objective over the medium term.

Source: FOMC Minutes, July 25–26, 2017 Are FOMC participants predicting that the U.S. economy will move along a short-run Phillips curve or that the short-run Phillips curve will shift through 2017 and 2018? Explain.

The Fed is predicting that the U.S. economy will move leftward along a generally flat short-run Phillips curve. The Fed expects that the unemployment rate will fall because of a small increase in the inflation rate as it stabilizes somewhat higher around the Fed’s 2 percent objective.

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Answers to Additional Problems and Applications Use the following information to work Problems 9 to 11.

Suppose that the business cycle in the United States is best described by RBC theory and that a new technology increases productivity.

9.

Draw a graph to show the effect of the new technology in the market for loanable funds.

The advance in technology makes investment in industries that can utilize the new technology more profitable. Investment demand increases, which increases the demand for loanable funds. As Figure 12.3 shows, the increase in the demand for loanable funds shifts the demand for loanable funds curve rightward from DLF0 to DLF1. The increase in the demand for loanable funds raises the equilibrium real interest rate and increases the equilibrium quantity of loanable funds. In Figure 12.3 the real interest rate rises from 4 percent a year to 5 percent a year and the quantity of loanable funds increases from $2.5 trillion to $2.7 trillion.

10.

Draw a graph to show the effect of the new technology in the labor market.

The advance in technology directly increases the demand for labor as firms look to hire more workers to exploit the technology. In addition, the supply of labor increases as workers respond to the higher real interest rate. The increase in the supply of labor, however, is less than the increase in the demand for labor. As Figure 12.4 shows, the demand for labor curve shifts rightward from LD0 to LD1 and the supply of labor curve shifts rightward from LS0 to LS1.

Both changes increase the equilibrium quantity of employment. In Figure 12.4 © 2018 Pearson Education, Inc.

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employment increases from 300 billion hours to 330 billion hours.

The effect on the real wage rate is ambiguous, but if, as illustrated in the figure, the increase in demand exceeds the increase in supply, then the net effect raises the real wage rate.

In Figure 12.4 the real wage rate rises from $20 per hour to $30 per hour.

11.

Explain the when-to-work decision when technology advances.

The when-to-work decision is an important part of the real business cycle theory. The increase in technology raises the real interest rate. Changes in the real interest rate create an ―intertemporal substitution effect,‖ which is the ―when-to-work‖ decision. If the real interest rate rises, the return to current work increases because any funds saved reap a higher real interest rate. (The effect is called ―intertemporal‖ because in the future the increased saving influences people to work less.) As a result, a higher real interest rate increases the current supply of labor, which shifts the supply of labor curve rightward and increases equilibrium employment.

12.

Workers: You’ve Never Had It So Bad Working men and women had not had it so bad since the middle of the 19th century. During the 1860s, like the 2000s and 2010s, real wages grew slowly. Those mid-Victorian years were a lost decade for workers, disrupted by new technology such as steam engines and the telegraph.

Today’s lost decades are disrupted by information technologies.

Source: The Globe and Mail, December 9, 2016 Explain the relationship between wages and technology in this news clip in terms of real business cycle theory.

The real business cycle theory focuses on the effects from technological changes. If technological change is particularly large, as it was in the 1860s and as it has been in the 2000s and 2010s, a large amount of capital, including human capital, has become obsolete. As a result, labor productivity temporarily falls.

When the productivity of labor falls, the demand for labor decreases, which, by itself, leads to a decrease in the real wage rate. If workers believe that eventually the new technology will increase productivity and thereby increase the demand for labor, hence raising the real wage, the current supply of labor also decreases. But if the decrease in demand is larger than the decrease in supply, which is likely the case, then the real wage rate either falls or else, if it grows, it grows slowly.

Use the following information to work Problems 13 and 14.

Inflation Should Be Feared Economist John H. Cochrane thinks the Fed must be careful not to over-stimulate the economy. He thinks inflation remains a danger because U.S. debt is skyrocketing, with no visible plan to pay it back.

For the moment, foreigners are buying that debt. But they are buying out of fear that their governments are worse. They are short-term investors, waiting out the storm, not long-term investors confident that the United States will pay back its debts. If their fear passes, or they decide some other haven is safer, the Fed must watch out. For in that situation, inflation will come with a vengeance. It’s not happening © 2018 Pearson Education, Inc.

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yet: Interest rates are low now. But if inflation takes off, it will happen with little warning, the Fed will be powerless to stop it, and it will bring stagnation rather than prosperity.

13. What type of inflation process does John Cochrane warn could happen? Explain the role that inflation expectations would play if the outbreak of inflation were to ―happen with little warning.‖ Mr. Cochrane is concerned that a cost-push inflation could occur.

Mr. Cochrane worries that if foreigners decide to sell their U.S. government securities, the U.S. exchange rate will fall as foreigners try to sell dollars to purchase their currency. With the fall in the U.S. exchange rate, the costs of goods imported into the United States will rise, thereby starting a cost-push inflation. If the inflation starts with little warning, people’s inflation expectations will not change so that inflation expectations will play a small role in the inflation.

14.

Explain why the inflation that John Cochrane fears would ―bring stagnation rather than prosperity.‖ Mr. Cochrane is fearful of a cost-push inflation. In a cost-push inflation, real GDP decreases and the unemployment rate rises, being ―stagnation rather than prosperity.‖

15.

Europe’s Deflation Risk Consumer prices in the Eurozone fell in January for a second consecutive month reinforcing fears of sustained deflation, higher unemployment, and stagnant incomes, Source: The New York Times, January 31, 2015 a. Explain the process by which deflation occurs.

Deflation occurs when aggregate demand persistently grows more slowly than aggregate supply. This situation occurs when the money growth rate grows too slowly, which leads to slower growth in aggregate demand.

b. How might Europe boost its aggregate demand? Might the boost to aggregate demand create demand-pull inflation?

Europe can persistently boost aggregate demand by persistently increasing the growth rate of the quantity of money. If this growth rate is raised too high, then the boost to aggregate demand runs the risk of creating a demand-pull inflation.

Use the following data to work Problems 16 and 17.

An economy has an unemployment rate of 4 percent and an inflation rate of 5 percent a year at point A in Figure 12.5. Then some events occur that move the economy from A to B to D to C and back to A. 16.

Describe the events that could create this sequence. Has the economy experienced demandpull inflation, cost-push inflation, expected © 2018 Pearson Education, Inc.

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inflation, or none of these?

First the inflation rate increases from 5 percent a year to 15 percent a year and the unemployment rate does not change. Then the unemployment rate increases from 4 percent to 8 percent and the inflation rate does not change. Next the inflation rate falls from 15 percent a year to 5 percent a year and the unemployment rate does not change. Finally the unemployment rate falls from 8 percent to 4 percent and the inflation rate does not change. This set of changes could be the result of an expected increase in the inflation rate from 5 percent to 15 percent, followed by an increase in the natural unemployment rate from 4 percent to 8 percent, followed by an expected fall in the inflation rate from 15 percent to 5 percent, finally followed by a decrease in the natural unemployment rate from 8 percent to 4 percent.

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Draw in the figure the sequence of the economy’s short-run and long-run Phillips curves.

Figure 12.6 shows these short-run and long-run Phillips curves. The initial increase in the expected inflation rate moves the economy up its (stationary) long-run Phillips curve LRPC0 from point A to point B. The short-run Phillips curve shifts upward from SRPC0 to SRPC1 and intersects the long-run Phillips curve at point B. Then the increase in the natural unemployment rate shifts both the long-run and short-run Phillips curves rightward to LRPC1 and SRPC2 so that they intersect at point D. Next the fall in the expected inflation rate moves the economy along its (stationary) new long-run Phillips curve LRPC1 from point D to point C. The short-run Phillips curve shifts downward from SRPC2 to SRPC3 and intersects the long-run Phillips curve at point C. Finally, the fall in the natural unemployment rate shifts both the long-run and short-run Phillips curves leftward back to LRPC0 and SRPC0 so that they intersect at point A.

Use the following information to work Problems 18 and 19.

The Reserve Bank of New Zealand signed an agreement with the New Zealand government in which the Bank agreed to maintain inflation inside a low target range. Failure to achieve the target would result in the governor of the Bank (the equivalent of the chairman of the Fed) losing his job.

18. Explain how this arrangement might have influenced New Zealand’s short-run Phillips curve.

The Reserve Bank of New Zealand’s arrangement with New Zealand’s government affected the short-run Phillips curve because it affected people’s expectations of the inflation rate. In particular, since the agreement was credible and had significant sanctions for the governor of the Reserve Bank of New Zealand, the public likely kept their expected inflation rates lower than might otherwise have been the case. As a result, the short-run Phillips curve was lower than it otherwise would have been and, in addition, was probably less likely to shift higher if the inflation rate temporarily rose.

19.

Explain how this arrangement might have influenced New Zealand’s long-run Phillips curve.

The long-run Phillips curve is independent of the inflation rate and of people’s inflationary expectations, so the arrangement probably had little direct effect on the long-run Phillips curve. The only way in which the long-run Phillips curve could have been affected was if the arrangement affected the natural unemployment rate. If the agreement lowered the natural unemployment rate, the long-run Phillips curve shifted leftward. © 2018 Pearson Education, Inc.

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20.

Where Is the Phillips Curve?

One of the central propositions of macroeconomic theory is the Phillips curve, a pressure cooker model of the inflationary process. If the economy runs too hot, inflation will follow. If the economy cools and the pressure drops, wage and price inflation will ease. Yet in the United States, United Kingdom, and Japan, unemployment is low but inflation is nowhere in sight. The Phillips curve has gone flat.

Source: The Financial Times, July 27, 2017 a. Evaluate the claim that the Phillips curve has gone flat.

This claim is likely incorrect. In the United States, the United Kingdom, and Japan inflation has been low and that has lowered the expected inflation rate. The short-run Phillips curve shifts downward if the expected inflation rate falls. Because the short-run Phillips curve has shifted downward, low unemployment rates are associated with lower inflation rates, which is the experience in these three countries.

b. How does the Phillips curve model account for the facts reported in the news clip?

The low inflation rates experienced in the United States, the United Kingdom, and Japan inflation has lowered the expected inflation rate. When the expected inflation rate falls the short-run Phillips curve shifts downward so that low unemployment rates are associated with lower inflation rates than before, which is what has occurred in these three countries.

Use the following information to work Problems 21 and 22.

Because the Fed doubled the monetary base in 2008 and the government spent billions of dollars bailing out troubled banks, insurance companies, and auto producers, some people are concerned that a serious upturn in the inflation rate will occur, not immediately but in a few years time. At the same time, massive changes in the global economy might bring the need for structural change in the United States.

21.

Explain how the Fed’s doubling of the monetary base and government bailouts might influence the short-run and long-run Phillips curves. Will the influence come from changes in the expected inflation rate, the natural unemployment rate, or both?

The doubling of the monetary base might lead to significant inflation at some point in the future. If the inflation is unexpected, it will not change either the short-run Phillips curve or the long-run Phillips curve. But if at some point the inflation becomes expected, the short-run Phillips curve will shift upward. In either case, however, the long-run Phillips curve is not affected.

The government bailouts probably decreased the amount of cyclical unemployment that otherwise would have occurred. In this case they forestalled a movement downward along the short-run Phillips curve.

As long as the bailed out companies operate efficiently, the bailouts by themselves did not affect the natural unemployment rate and thereby did not change the long-run Phillips curve.

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Explain how large scale structural change might influence the short-run and long-run Phillips curves. Will the influence come from changes in the expected inflation rate, the natural unemployment rate, or both?

Large-scale structural changes increase structural unemployment, thereby increasing the natural unemployment rate. The long-run and short-run Phillips curves shift rightward, worsening the tradeoff between unemployment and inflation.

Economics in the News 23.

After you have studied Economics in the news on pp. 316–317 (724–725 in Economics), answer the following questions. a. What are the macroeconomic problems in the Eurozone economy that the ECB is seeking to address?

In the Eurozone economy the unemployment rate is falling from high levels but there is concern that the inflation rate may rise above the target rate of 2 percent.

b. Is the European unemployment problem structural, cyclical, or both and how can we determine its type?

The European unemployment problem has both structural and cyclical components. The Eurozone unemployment rate has been persistently higher than the U.S. unemployment rate. This difference represents structural unemployment, the result of high European minimum wages, generous unemployment and welfare payments, and massive regulation of the labor market. But the faltering economic growth rate in Europe has also lead to cyclical unemployment.

c. Explain which type of unemployment the ECB can help with.

The ECB can use its monetary policy to increase aggregate demand and lower cyclical unemployment.

d. Use the AS-AD model to show the changes in aggregate demand and/or aggregate supply that created the Eurozone’s macroeconomic problems.

Figure 12.7 shows the situation in the Eurozone. Starting at point A, equilibrium real GDP is €14.5 trillion and potential GDP is €15 trillion. Real GDP is less than potential GDP by €0.5 trillion.

Over time potential GDP increased by €3 trillion, from €15 trillion to €18 trillion. But the aggregate demand increased by less. The aggregate demand curve shifted from AD0 to AD1, an increase of only €2.5 at every price level.

The equilibrium moved to point B. At point B equilibrium real GDP is €17 trillion and potential GDP is €18 trillion. Equilibrium real GDP is now less than potential GDP by © 2018 Pearson Education, Inc.

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€1 trillion. The recession has worsened and Eurozone unemployment has risen.

e. Use the AS-AD model to show the changes in aggregate demand and/or aggregate supply that the ECB must bring about to achieve its goal.

The ECB’s goal is to increase the quantity of money sufficiently so that aggregate demand increases enough to restore the economy to full employment at potential GDP. Figure 12.8 shows the ECB’s goal.

Starting from point B, with a recessionary gap of €1 trillion, potential GDP will increase by €3 trillion from €18 trillion to €21 trillion. The ECB’s goal is to increase aggregate demand by even more. If the ECB can increase aggregate demand from AD1 to AD2, an increase of €4.5 at every price level, the new equilibrium point will be at point C. At this equilibrium the Eurozone will have returned to potential GDP and employment will equal full employment.

24.

British Economy Suffers Slowdown The UK economy grew by 0.3 percent in the second quarter of 2017 after 0.2 percent growth in the first quarter. These slow growth rates are seen as confirming the predicted effects of the country exiting the European Union. Some worry that Britain might be heading toward recession. Household saving and business investment have fallen, credit card borrowing is at record high, wages are stagnating, and consumer confidence is crashing.

Source: CNN, July 26, 2017 a. How does a fall in business investment influence Britain’s aggregate demand, aggregate supply, unemployment, and inflation?

A decrease in investment decreases Britain’s aggregate demand. There is no immediate impact on aggregate supply. The decrease in aggregate demand lowers the price level and decreases real GDP. The fall in the price level means that the inflation rate falls; the decrease in real GDP means that unemployment rises.

b. Use the AS-AD model to illustrate your answer to part (a).

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Figure 12.9 illustrates this situation. Aggregate demand decreases and the aggregate demand curve shifts leftward, from AD0 to AD1. The economy moves from point A to point B. Real GDP decreases and the price level falls.

c. Use the Phillips curve model to illustrate your answer to part (a).

In part (a) the inflation rate fell and the unemployment rate increased. People’s inflation expectations likely did not change so the British economy moved along its short-run Phillips curve. Figure 12.10 shows the effect of the decrease in investment as the movement from point A on the short-run Phillips curve SRPC to point B on the same short-run Phillips curve. The inflation rate falls and the unemployment rate rises.

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d. What does the news clip mean by ―Britain might be heading toward recession‖?

The clip is implicitly predicting that aggregate demand will decrease as a result of the decrease in investment and possibly also consumption expenditure. Aggregate supply might also change but the emphasis in the news clip is on aggregate demand. The decrease in aggregate demand decreases real GDP and lowers the price level. The decrease in real GDP raises the unemployment rate and the decrease in the price level lowers the inflation rate. The decrease in real GDP and rise in the unemployment can signal that Britain is in a recession.

e. Use the AS-AD model to illustrate your answer to part (d).

Figure 12.11 illustrates this situation. Aggregate demand decreases because of the decrease in investment and consumption expenditure and the aggregate demand curve shifts leftward, from AD0 to AD1. The economy moves from point A to point B. Real GDP decreases and the price level falls.

f.

Use the Phillips curve model to illustrate your answer to part (d).

In part e the inflation rate fell and the unemployment rate increased. People’s inflation expectations likely did not change so the British economy moved along its short-run Phillips curve. Figure 12.12 shows the effect of the decrease in investment and consumption expenditure as the movement from point A on the short-run Phillips curve SRPC to point B on the same short-run Phillips curve. The

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inflation rate increases.

C h a p t e r

falls and the unemployment rate

Ec3e

13

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FISCAL POLICY**

* This is Chapter 30 in Economics. © 2018 Pearson Education, Inc.

SOLUTION MANUAL FOR MACROECONOMICS, 13TH EDITION MICHAEL PARKIN

Answers to the Review Quizzes Page 331 1.

(page 739 in Economics)

What is fiscal policy, who makes it, and what is it designed to influence?

Fiscal policy is the use of the federal budget to achieve macroeconomic objectives. Fiscal policy is made by the president and Congress. It is designed to influence employment, economic growth, and price level stability.

2.

What special role does the president play in creating fiscal policy?

Each year the president proposes the budget that Congress amends and enacts.

3.

What special roles do the Budget Committees of the House of Representatives and the Senate play in creating fiscal policy?

Each year the Budget Committees of the House of Representatives and the Senate consider the budget proposed by the president, and develop their own ideas of how it should be modified. Eventually, formal conferences between the two houses resolve the differences between them and a series of spending acts and an overall budget act passed.

4.

What is the timeline for the U.S. federal budget each year? When does a fiscal year begin and end?

Consider the budget for 2018 as an example in answering this question. In February 2017 the president proposes a budget to Congress. Then, from February until October 1, 2017, the Congress debates the budget, amends it, and eventually passes the necessary budget bills. The president then signs or vetoes the budget bills that were presented to him. When the president vetoes bills, the Congress may over-ride the veto or pass other bills acceptable to the president. Fiscal year 2018 begins on October 1, 2017 and runs until September 30, 2018. During this year the Congress may pass—and the president may sign—supplementary bills. Then, after the fiscal year ends, accounts are prepared and the ―official‖ amounts of outlays, receipts, and budget deficit or surplus are reported.

5.

Is the federal government budget today in surplus or deficit?

Currently, the U.S. federal government is running a (large) budget deficit.

Page 335 1.

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How does a tax on labor income influence the equilibrium quantity of employment?

A tax on labor income drives a wedge between the after-tax wage rate of workers and the before-tax wage rate paid by firms. The tax on labor income decreases the supply of labor. That is, for each © 2018 Pearson Education, Inc.

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before-tax wage rate, workers provide a lower quantity of labor when faced with a tax that lowers their after-tax wage. The decrease in labor supply raises the before-tax wage rate, even though the aftertax wage rate received by workers falls. The decrease in labor supply also means that the quantity of employment at full employment (i.e., equilibrium employment in the labor market) falls.

2.

How does the tax wedge influence potential GDP? By decreasing employment, the tax wedge lowers potential GDP.

3.

Why are consumption taxes relevant for measuring the tax wedge?

A tax on consumption raises the price paid for consumption goods and services and so is equivalent to a cut in the real wage rate from the perspective of workers.

4.

Why are income taxes on capital income more powerful than those on labor income?

Given positive inflation, what appears to be a moderate tax on interest income dramatically decreases the real after-tax interest rate, which is the interest rate that influences investment and saving plans. In particular, by driving a wedge between the real interest rate savers receive and firms pay, the tax on interest income decreases the supply of loanable funds, which lowers investment and saving in the economy.

5.

What is the Laffer curve and why is it unlikely that the United States is on the ―wrong‖ side of it?

The Laffer curve is the relationship between the tax rate and the amount of tax revenue collected. The amount of tax revenue collected increases with the tax rate only up to a certain tax rate, after which, further increases in the tax rate cause tax revenue to fall.

When tax rates are higher than the tax rate that maximizes tax revenue, a country is said to be on the wrong side of the Laffer curve. It is unlikely that the United States is on the wrong side of the Laffer curve because U.S. tax rates are among the lowest in the industrial world and past changes in U.S. tax rates have produced changes in tax revenues in the same direction.

Page 338 1.

(page 746 in Economics)

What is a present value?

A present value is the amount of money that, if invested today, will grow to equal a given future amount when the interest that it earns is taken into account.

2.

Distinguish between fiscal imbalance and generational imbalance.

Fiscal imbalance is the present value of the government’s commitments to pay benefits minus the present value of its tax revenues. Generational imbalance is the division of the fiscal imbalance between the current and future generations, assuming that the current generation continues to enjoy the current levels of taxes and benefits.

3.

How large was the estimated U.S. fiscal imbalance and how does it divide between current and future generations? © 2018 Pearson Education, Inc.

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In 2014, the fiscal imbalance was estimated to be $68 trillion. The generational imbalance estimates suggest that the current generation will pay 83 percent and future generations will pay 17 percent of the fiscal imbalance.

4.

What is the source of the U.S. fiscal imbalance and what are the painful choices that we face?

The source of the fiscal imbalance is the social security and, especially, the Medicare obligations made under current law. The painful choices are to raise income taxes, raise social security taxes, cut social security benefits, or cut federal government discretionary spending.

5.

How much of U.S. government debt is held by the rest of the world?

U.S. government debt held by the rest of the world is about $6.1 trillion.

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What is the distinction between automatic and discretionary fiscal policy?

Automatic fiscal policy is triggered by the state of the economy with no need for any government action. Discretionary fiscal policy, however, requires an act of Congress to either change government spending and/or change taxes.

2.

How do taxes and needs-tested spending programs work as automatic fiscal policy to dampen the business cycle?

Taxes, such as income taxes, and needs-tested spending programs both work as automatic fiscal policy because they decrease the effect a change in income has on aggregate expenditure. For instance, when income decreases, consumption expenditure and aggregate expenditure decrease. But with the fall in income, income taxes decrease and needs-tested spending increase so that disposable income does not fall as much as does income. The smaller fall in disposable income means that the fall in consumption expenditure is smaller, so that the fall in aggregate expenditure is likewise smaller.

3.

How do we tell whether a budget deficit needs discretionary action to remove it?

A budget deficit needs discretionary government action to remove it when the deficit is a structural deficit. If the deficit is a structural deficit, then even when the economy is at full employment, the deficit will remain. However, if the deficit is a cyclical deficit, then when the economy returns to full employment, the deficit will disappear.

4.

How can the federal government use discretionary fiscal policy to stimulate the economy?

If the economy has a recessionary gap, the government can increase its expenditure or lower taxes to increase aggregate demand and move the economy back toward potential GDP.

5.

Why might fiscal stimulus crowd out investment?

Fiscal stimulus, such as an increase in government expenditure or a decrease in taxes, increases the budget deficit. The increase in the budget deficit increases the (government’s) demand for loanable

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funds, thereby raising the real interest. The higher real interest rate decreases—crowds out—investment.

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Answers to the Study Plan Problems and Applications Use the following news clip to work Problems 1 and 2.

U.S. Ran $43 Billion Budget Deficit in July The U.S. government received $232 billion and spent $275 billion in July. The deficit of $43 billion edged the government’s debt closer to the federal borrowing limit.

Source: The Wall Street Journal, August 10, 2017 1.

How did U.S. government debt change in July 2017?

The total amount of U.S. government debt increased by the amount of the deficit, $43 billion.

2.

What would Congress do if it wanted to stop the government’s debt from increasing?

Congress can stop the debt from increasing by raising tax revenue and/or cutting government expenditure.

3.

The government is considering raising the tax rate on labor income. Explain the supply-side effects of such an action and use appropriate graphs to show the directions of change, not exact magnitudes. What will happen to: a. The supply of labor and why?

The supply of labor will decrease. As shown in Figure 13.1, the supply of labor curve shifts leftward from LS0 to LS1.

The supply of labor decreases because at each real wage rate, the hike in the tax rate on labor income lowers the after-tax wage rate received by workers.

b. The demand for labor and why?

The demand for labor will remain the same so in Figure 13.1 the demand for labor curve remains LD. The demand for labor depends on the productivity of labor, which does not change after the increase in the tax rate on labor income.

c. Equilibrium employment and why?

As Figure 13.1 shows, the equilibrium level of employment decreases.

In the figure, employment decreases from 310 billion hours per year to 300 billion hours per year.

d. The equilibrium before-tax wage rate and why?

As Figure 13.1 shows, the equilibrium before-tax wage rate increases from $34 per hour to $35 per hour. The before-tax wage rate rises because the leftward shift of the supply of labor curve leads to a movement up along the demand for labor curve.

e. The equilibrium after-tax wage rate and why?

The equilibrium after-tax wage rate decreases. The tax wedge in the figure is $2 per hour, so the after-tax wage rate falls from $34 per © 2018 Pearson Education, Inc.

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hour to $33 per hour. The increase in the tax rate on labor income increases the wedge between the before-tax wage rate and the aftertax wage rate. The before-tax wage rate increases but not by as much as the increase in tax. So the after-tax wage rate decreases.

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f.

Potential GDP? Potential GDP decreases. The equilibrium level of employment is full employment. So as full employment decreases, potential GDP decreases along the aggregate production function. Figure 13.2 shows this change as the movement along the aggregate production function, PF, from point A, with 310 billion hours of employment and potential GDP of $16.2 trillion, to point B, with 300 billion hours of employment and potential GDP $16.1 trillion.

4.

What fiscal policy action might increase investment and speed economic growth? Explain how the policy action would work.

A decrease in the tax on capital income will increase investment and thereby increase economic growth. A decrease in the tax on capital income increases the supply of loanable funds. The real interest rate falls and investment increases. The increase in investment increases economic growth.

5.

Suppose that instead of taxing nominal capital income, the government taxed real capital income. Use appropriate graphs to explain and illustrate the effect that this change would have on: a. The tax rate on capital income.

The nominal interest rate is the (nominal) income from capital. If the government changes the tax code to subtract the inflation rate from the (nominal) interest rate before taxes are imposed, the true tax rate on capital income falls because the part of the capital income—the inflation rate—that is received in compensation for inflation is no longer taxed.

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With a lower tax rate on capital income, the supply of loanable funds increases as the after-tax real interest rate rises. This change is illustrated in Figure 13.3 by the rightward shift of the supply of loanable funds curve from the initial supply of loanable funds curve, SLF0, to SLF1.

The demand for loanable funds generally remains the same because it depends in large part on investment demand. Firms’ investment demand depends on how productive capital is and the productivity of capital does not necessarily change when the tax code changes. In Figure 13.3, the demand for loanable funds curve does not shift.

c. Investment and the real interest rate.

As shown in Figure 13.3, the increase in the supply of loanable funds shifts the supply of loanable funds curve rightward. This change leads to a lower real interest rate and a higher amount of loanable funds and investment.

6.

Under current policies, a plausible projection is that U.S. public debt will reach 250 percent of GDP in 30 years and 500 percent in 50 years. a. What is a fiscal imbalance? How might the U.S. government reduce the fiscal imbalance?

The fiscal imbalance is the present value of the government’s commitments to pay benefits minus the present value of its tax revenues. To reduce the fiscal imbalance, the government needs to decrease its benefit payments—both its present payments and those promised in the future—and increase its tax revenue—both its current tax revenue and tax revenue in the future. While the annual government budget deficit is not the fiscal imbalance, it is related because, in general, the larger the budget deficit the larger the fiscal imbalance. Additionally, the larger the budget deficit, the larger the accumulated public debt becomes.

b. How would your answer to part (a) influence the generational imbalance?

The generational imbalance is the division of the fiscal imbalance between the current and future generations, assuming that the current generation will enjoy the existing levels of taxes and benefits. The changes in part (a) of cutting benefits and raising taxes will affect the generational imbalance if the reduction in benefits and/or the hike in taxes affects the current generation. In that case the generational imbalance would change so that more of the fiscal imbalance is paid by the current generation and less by future generations.

7.

The economy is in a recession, and the recessionary gap is large. a. Describe the discretionary and automatic fiscal policy actions that might occur.

Fiscal policy that increases government expenditure or decreases taxes would boost aggregate demand. In terms of automatic fiscal policy, needs-tested spending increases in recessions and tax revenue falls. Congress might also use discretionary policy by passing a new spending bill or a cut in tax rates.

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b. Describe a discretionary fiscal stimulation package that could be used that would not bring an increase in the budget deficit.

An increase in government expenditure with an offsetting increase in tax rates to boost tax revenue would not bring a budget deficit and would increase aggregate demand because the increase in government expenditure increases aggregate demand by more than the increase in taxes decreases aggregate demand.

c. Explain the risks of discretionary fiscal policy in this situation.

The risk of discretionary policy is that, because of time lags, it takes effect too late and ends up moving the economy away from potential GDP.

8.

An economy is in a recession with a large recessionary gap and a government budget deficit. a. Do we know whether the budget deficit is a structural deficit or a cyclical deficit? Explain.

We know that at least some of the budget deficit in a recession is a cyclical deficit as needs-tested spending is higher and tax revenue is lower than at potential GDP. However, some of the budget deficit might be a structural deficit. The structural deficit is the deficit that would exist if real GDP equaled potential GDP and the economy was at full employment.

b. Explain how automatic fiscal policy is changing the output gap?

Automatic fiscal policy is decreasing the output gap relative to what it would be otherwise in a recession because they increase aggregate demand relative to what it would be otherwise in a recession. That is, aggregate demand decreases in a recession, but it would decrease by more without the increase in needs-tested spending and the decrease in tax revenue that produce the cyclical deficit.

c. If the government increases its discretionary expenditure, explain how the structural deficit might change.

A discretionary increase in government expenditure, if not reversed following the end of the recession, moves the budget balance toward a structural deficit.

Use the following news clip and fact to work Problems 9 to 11.

Senate Approves Tax Cut Plan The U.S. Senate has passed legislation extending Bush-era tax cuts for high-income earners to middleclass Americans earning up to $250,000 per year.

Source: Financial Times, July 26, 2012 Fact: Middle and low-income earners spend almost all their disposable incomes. High-income earners save a significant part of their disposable incomes.

9. a. Explain the intended effect of extending tax cuts for middle-class Americans but not for high-income families. Draw a graph to illustrate the intended effect.

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increasing consumption expenditure, which increases aggregate demand. Figure 13.4 shows the intended effect of this policy where, including the multiplier effect, the aggregate demand curve shifts rightward from AD0 to AD1. As a result real GDP increases, in the figure from $15.7 trillion to $15.9 trillion. In the figure real GDP remains below potential GDP but the recessionary gap becomes smaller.

b. Explain why the effect of tax cuts depends on who receives them.

The effect of this fiscal policy depends on the size of the impact on aggregate demand. The more of the tax cut that is spent (which means the less that is saved) the larger the magnitude of the effect on aggregate demand. If the tax rebates go to people who spend more of the rebate, that is, middle and low-income earners, the effect of this fiscal policy is larger.

10.

What would have a larger effect on aggregate demand: extending the Bush-era tax cuts to everyone; extending them for middle-class only; or extending them for high-income earners only? How would each alternative compare with no tax cuts but an equivalent increase in government expenditure?

Extending the income tax cuts to everyone will have the largest effect on aggregate demand. Middle-income tax payers will spend most of the tax cut and high-income tax payers, while spending only a small fraction of their income, still spend some. In general, tax cuts have a larger effect on real GDP than do increases in government expenditure because the tax cuts have stronger supplyside effects. So whichever tax cut policy—extending the tax cuts to everyone, to only middle-class taxpayers, or to only high-income tax payers—has the largest supply-side effect also has the largest effect on real GDP.

11.

Compare the impact on equilibrium real GDP of a same-sized decrease in taxes and increase in government expenditure on goods and services.

According to the aggregate demand/aggregate supply model, the government expenditure multiplier exceeds the tax multiplier, so government expenditure has a larger impact on real GDP. Some economists, such as Robert Barro and Harald Uhlig disagree and assert that the tax multiplier exceeds the government expenditure multiplier because taxes affect aggregate demand and aggregate supply. In this case the decrease in taxes has a larger impact on real GDP.

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Answers to Additional Problems and Applications 12.

How the President’s Proposals Affect the Federal Budget The Congressional Budget Office (CBO) estimates that federal budget deficits would shrink over the coming decade to between 2.6 percent and 3.3 percent of GDP. By 2027, debt held by the public would total 80 percent of GDP. Source: The Congressional Budget Office, July 13, 2017 What is the CBO forecasting will happen to the relative magnitudes of federal government receipts, federal government outlays, and GDP? Currently, the U.S. federal budget deficit is approximately 3.5 percent of GDP. The CBO is estimating that the deficit will fall to between 2.6 and 3.3 percent, so the CBO is predicting that GDP will grow more rapidly than the deficit. This forecast means that the CBO is forecasting that difference between federal government receipts and outlays will grow less rapidly than GDP.

Use the following information to work Problems 13 and 14.

Suppose that investment is $1,600 billion, saving is $1,400 billion, government expenditure on goods and services is $1,500 billion, exports are $2,000 billion, and imports are $2,500 billion.

13.

Calculate the amount of tax revenue and the government budget balance.

Tax revenue equals $1,200 billion. From the circular flow of expenditure and income, we know that I = S + T – G + M – X. Rearranging the equation gives T = I– S + G + X – M, which equals $1,200 billion.

14. a. Explain the impact of the government budget balance on investment.

The government has a budget deficit. It is exerting a negative influence on investment by increasing the demand for loanable funds, which increases the real interest rate and crowds out investment.

b. What fiscal policy action might increase investment and speed economic growth? Explain how the policy action would work.

A decrease in the budget deficit by increasing taxes or decreasing government expenditure decreases the demand for loanable funds, which lowers the real interest rate and increases investment. The increase in investment increases economic growth.

15.

Suppose that capital income taxes are based (as they are in the United States) on nominal interest rates. If the inflation rate increases by 5 percent a year, explain and use appropriate graphs to illustrate the effect of the rise in inflation on: a. The tax rate on capital income.

The increase in the inflation rate increases the true tax rate on capital income because the interest income that is received in compensation for inflation is larger so that the tax paid on capital income increases.

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b. The supply of loanable funds.

With a higher tax rate on capital income, the supply of loanable funds decreases and the after-tax real interest rate falls. This change is illustrated in Figure 13.5 by the leftward shift of the supply of loanable funds curve from the initial supply of loanable funds curve SLF0 to the new supply, SLF1, when the inflation rate is higher.

c. The demand for loanable funds.

The demand for loanable funds generally remains the same because it depends in large part on investment demand. Firms’ investment demand depends on how productive capital is and the productivity of capital does not change when the tax code changes.

d. Equilibrium investment.

As illustrated in Figure 13.5, when the supply of loanable funds decreases, the supply of loanable funds curve shifts leftward from SLF0 to SLF1. The real interest rate rises from 4 percent a year to 5 percent a year, and the equilibrium quantity of loanable funds deceases from $2.5 trillion to $2.4 trillion. Investment decreases.

e. The equilibrium real interest rate.

The decrease in the supply of loanable funds leads to a higher equilibrium real interest rate. In the figure the real interest rate rises from 4 percent to 5 percent.

Use the following data to work Problems 16 and 17.

Fiscal Policy Changes When Congress passed a Job Creation Act following the 2008–2009 recession, it increased the level of unemployment benefits and lowered the Social Security payroll tax by 2 percentage points. These temporary measures expired after three years.

16.

Explain the supply-side effects of allowing unemployment benefits and the Social Security payroll tax cut to expire.

Allowing emergency unemployment benefits to expire decreases job search by making unemployed workers more likely to accept employment offers, thereby boosting employment. Allowing the Social Security payroll tax cuts to expire increases the income tax on labor, which decreases the supply of labor, thereby decreasing employment.

17. a. Explain the potential demand-side effects of extending unemployment benefits and not increasing the Social Security payroll tax.

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unemployed workers who cannot find jobs. Extending the Social Security payroll tax cut increases the income of employed workers.

The increase in income for both classes of workers boosts their consumption expenditure higher than what it would be if the policies expired, so aggregate demand increases from what it would be otherwise.

b. Explain the potential supply-side effects of the fiscal policy actions in part (a).

Compared to the situation of allowing these policies to expire, extending emergency unemployment benefits increases job search by making unemployed workers less likely to accept employment offers, thereby reducing employment. Allowing the Social Security payroll tax cuts to continue continues the decreases the income tax on labor, which means that the supply of labor will not decrease and hence employment will not decrease.

c. Draw a graph to illustrate the combined demand-side and supply-side effect of the fiscal policy actions in part (a).

Figure 13.6 shows the combined effects of these policies compared to what the situation would be if the policies were allowed to expire. Aggregate demand unambiguously increases, so the aggregate demand curve shifts rightward from AD0 to AD1.

The effect on aggregate supply is ambiguous. Continuing the unemployment benefits decreases aggregate supply; continuing the Social Security payroll tax cuts increases aggregate supply.

Presuming that the effects from extending the unemployment benefits and Social Security payroll tax cuts just offset each other, aggregate supply does not change so the aggregate supply curve does not shift. In Figure 13.6 the shift of the aggregate demand curve increases real GDP, in the figure from $15.4 trillion to $15.8 trillion, and the price level rises, in the figure from 122 to 126.

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Use the following news clip to work Problems 18 and 19.

Should the U.S. Adopt a Value-Added Tax? The United States is one of the few developed nations that does not have a value-added tax (VAT). A VAT is a tax on a producer’s total revenue minus the cost of inputs purchased from other producers.

The final price paid by consumers includes the VAT paid by all the firms that have had a hand in producing the good.

Source: The Wall Street Journal, February 28, 2016 18.

Explain the potential supply-side effects of a VAT on the U.S. economy.

A VAT effectively lowers the tax on business income. By decreasing the tax on profits, business’s demand for investment increases, which increases the nation’s capital stock. Aggregate supply and potential GDP both increase.

19.

How do the effects of a VAT depend on which side of the Laffer curve the U.S. economy lies?

Explain your answer.

The effect on the government’s tax revenue from imposing a VAT depends on which side of the Laffer curve the U.S. economy lies. If the tax rate lies beyond the rate that maximizes U.S. tax revenue, then adding a VAT will increase government tax revenue but if the tax rate is less than the rate that maximizes U.S tax revenue, then government tax revenue will decrease.

20. Mandatory Spending Is Hard to Contain In Fiscal 2018, mandatory spending—mainly on the big three entitlement programs, Social Security, Medicare, and Medicaid—was $2.5 trillion. This expenditure is projected to rise by 56 percent to $3.9 trillion by 2027. Over that same period, discretionary expenditure, mainly national defense, is projected to be held steady at $1.2 trillion. The deficit is projected to fall from $0.4 trillion to a balanced budget.

Source: Congressional Budget Office, 2018 If politicians continue to avoid legislating changes that lower the projected increases in the three big entitlement programs, how do you think the fiscal imbalance will change? If Congress introduced changes that slowed the growth of expenditure on the three entitlement programs, who would benefit and who would pay?

If politicians avoid tackling spending from the three big entitlement programs, the fiscal imbalance will increase because their scheduled spending will skyrocket. If Congress introduces changes that slow the growth of expenditures on the three entitlement programs, the current generation would pay because they do not receive the benefit from any growth in the programs. The future generation would benefit because they do not have to pay higher taxes.

21.

The economy is in a boom and the inflationary gap is large. a. Describe the discretionary and automatic fiscal policy actions that might occur.

Fiscal policy that decreases expenditure or increases taxes would decrease aggregate demand. In terms of automatic fiscal policy, need-tested spending decreases in expansions and tax revenue © 2018 Pearson Education, Inc.

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increases. Congress might also use discretionary policy by cutting spending programs or increasing tax rates.

b. Describe a discretionary fiscal restraint package that could be used that would not produce serious negative supply-side effects.

A decrease in government expenditure with an offsetting decrease in autonomous taxes would not bring a change in government saving and so would not change investment and the growth of real GDP.

c. Explain the risks of discretionary fiscal policy in this situation.

The risk of discretionary policy is that, because of time lags, it takes effect too late and ends up moving the economy away from potential GDP.

22.

The economy is growing slowly, the inflationary gap is large, and there is a budget deficit. a. Do we know whether the budget deficit is structural or cyclical? Explain your answer.

The economy is at an above full-employment equilibrium because there is an inflationary gap. Real GDP exceeds potential GDP. There is a budget deficit, but with potential GDP greater than real GDP there is a cyclical surplus. The structural deficit is larger than the total budget deficit because the cyclical surplus offsets some of structural deficit. So the budget deficit is composed of a structural deficit and a cyclical surplus.

b. Do we know whether automatic stabilizers are increasing or decreasing aggregate demand?

Explain your answer.

We know that automatic stabilizers are decreasing aggregate demand relative to what it would be otherwise in an inflationary gap.

c. If a discretionary decrease in government expenditure occurs, what happens to the structural budget balance? Explain your answer.

A discretionary decrease in government expenditure decreases the structural deficit. Following the change in fiscal policy, government outlays would be smaller even when the economy returned to full employment.

Use the following news clip to work Problems 23 to 25.

China’s Reliance on Infrastructure Stimulus at Record High China’s reliance on infrastructure spending to drive overall investment hit a new high in 2017. Chinese economic planners have turned more heavily to infrastructure as stimulus since 2015, preferring this approach over further investment in manufacturing, where earlier stimulus brought excess capacity in steel and coal. Stimulus spending is bringing increased government debt.

Source: The Financial Times, August 24, 2017 23.

Explain the possible reasons why fiscal stimulus is needed in China.

China needs fiscal stimulus because the growth rate of the Chinese economy has slowed.

24.

Is the stimulus described in the news clip discretionary or automatic? Explain your answer.

The stimulus in the news clip is discretionary. The spending on investment in manufacturing or on infrastructure does not happen automatically. It depends on whether the government officials want to make this spending or not. © 2018 Pearson Education, Inc.

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What are some of the challenges that make fiscal stimulus difficult to implement that the news clip illustrates? What are the potential consequences of a stimulus being too much and being pursued for too long?

The news clip shows the effect of the impact lag, the time it takes from passing a tax or spending change to its effects on real GDP being felt. By the time China invested in steel and coal, there was excess capacity, capacity that is not utilized. The news clip also points out that the stimulus spending is increasing government debt, which can have negative effects on private investment. If the stimulus spending is too much or pursued for too long, aggregate demand may increase so much that higher prices and inflation become a significant problem.

Economics in the News 26.

After you have studied Economics in the News on pp. 344–345 (752–753 in Economics), answer the following questions. a. On which factor incomes does the corporate income tax fall?

The tax falls on the income from capital because it decreases the quantity of capital as well as lowering the return from capital.

b. How does the corporate income tax influence investment and saving and the real interest rate? Draw a graph to illustrate your answer.

The corporate income tax places a wedge between the interest rate borrowers pay and the interest rate savers receive. In Figure 13.7, without a corporate tax rate, the equilibrium real interest rate is 3.5 percent and the equilibrium quantity loanable funds is $2.4 trillion.

With a 40 percent corporate tax rate, the interest rate firms pay rises to 4.0 percent and the interest rate savers receive falls to 2.4 percent. The equilibrium quantity of loanable funds decreases to $2.1 trillion which means that the quantity of saving and investment both decrease.

c. How does the corporate income tax influence potential GDP and the real GDP growth rate?

The corporate tax rate decreases investment so that the capital stock is less than it otherwise would be. In turn, the decrease in the capital stock decreases potential GDP and the decrease in investment decreases the growth rate of real GDP.

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d. Explain why a cut in the U.S. corporate income tax rate might speed economic growth. What does the evidence from Canada and Ireland imply about the strength of the effect?

A cut in the corporate tax rate reduces the tax wedge and increases the equilibrium quantity of loanable funds. The increase in loanable funds increases investment and, eventually, the capital stock, thereby increasing the rate of economic growth. The evidence from Canada and Ireland, where the corporate tax rates are lower than in the United States, indicates that the effect on the economic growth rate is small.

27. More Fiscal Stimulus Needed?

In New York Times articles and in blogs, economists Paul Krugman and Joseph Stiglitz say there is a need for more fiscal stimulus in both the United States and Europe despite the large federal budget deficit and large deficits in some European countries. a. Do you agree with Krugman and Stiglitz? Why? Students who agree with Mr. Krugman and Mr. Stiglitz likely believe that the U.S. economy will not return to full employment rapidly without further government stimulus. Students who disagree with Mr. Krugman and Mr. Stiglitz likely believe that the U.S. economy is on track to return to full employment.

b. What are the dangers of not engaging in further fiscal stimulus?

If the economy is not returning to full employment, fiscal stimulus might be necessary. In this situation, if there is no fiscal stimulus, the economy will remain mired in a recessionary gap and unemployment will exceed natural unemployment.

c. What are the dangers of embarking on further fiscal stimulus when the budget is in deficit?

The fiscal stimulus will further increase the budget deficit. The rise in the deficit increases the government’s demand for loanable funds and thereby raises the real interest rate. The higher real interest rate decreases—crowds out—investment. The net effect on aggregate demand is uncertain: The fiscal stimulus increases aggregate demand; however, the decrease in investment expenditure decreases aggregate demand. If aggregate demand does not change, there is no immediate effect on real GDP. But the decrease in investment lowers the future capital stock, which means that aggregate supply does not increase as much as otherwise so that U.S. economic growth will be slower.

28. Irma? Harvey?—We Need to Talk About Infrastructure. Now. Shortly after President Trump took office, bipartisan hopes were raised of a $1 trillion infrastructure plan that the president said he’d like to see implemented. The hopes have gone. The president’s $4.1 trillion budget now proposes spending of $200 billion in infrastructure over the next 10 years.

Source: Natural Resources Defense Council, September 8, 2017 a. Explain how $1 trillion of infrastructure spending could be paid for.

The $1 trillion of spending can be financed by either increasing taxes and/or cutting other spending.

b. Explain the effects of $1 trillion in infrastructure spending on employment and unemployment.

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and decreases unemployment. In the longerrun, an increase in C h a p t e r infrastructure spending increases the nation’s productive resources, which increases potential GDP and short-run aggregate supply. The increase in short-run aggregate supply increases employment and decreases unemployment.

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SOLUTION MANUAL FOR MACROECONOMICS, 13TH EDITION MICHAEL PARKIN

Answers to the Review Quizzes Page 356 1.

(page 762 in Economics)

What are the objectives of monetary policy?

As set out in law, the objectives of monetary policy are to achieve ―maximum employment, stable prices, and moderate long-term interest rates.‖

2.

Are the goals of monetary policy in harmony or in conflict (a) in the long run and (b) in the short run?

The monetary policy goals are essentially in harmony for the long run. In the long run, stable prices will bring about maximum employment because firms and households can make the best possible decisions against a backdrop of stable prices. With stable prices, the inflation rate is low—perhaps even zero if prices are precisely stable. The nominal interest rate equals the real interest rate plus the (expected) inflation rate. If the inflation rate is low, then the nominal interest rate will be as low as possible. In the short run, however, the monetary policy goals might conflict with each other. In the short run, in a recession the Federal Reserve might lower the federal funds rate and increase the growth rate of the quantity of money to combat the recession. The Fed’s policy will increase employment and real GDP but also increase the price level and eventually the nominal interest rate.

3.

What is the core inflation rate and how does it differ from the overall CPI inflation rate?

The core inflation rate is the rate of increase in the core PCE deflator. The core PCE deflator is the personal consumption expenditure deflator excluding food and fuel The Federal Reserve believes that food and fuel prices are more volatile than other prices and largely respond to factors other than the state of inflation in the general economy. Accordingly, the core inflation rate is smoother, that is, less volatile than the actual inflation rate.

4.

Who is responsible for U.S. monetary policy and what are the roles of the Fed, Congress, and the President?

The Governors of the Federal Reserve System and the Federal Open Market Committee (FOMC) are responsible for the conduct of U.S. monetary policy. The President’s formal role is to appoint the members and the chair of the Board of Governors. Some Presidents, however, have also tried to influence Fed decisions. The Congress plays no direct role but the Fed must make two reports about its monetary policy to Congress each year.

Page 356 1.

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While the Fed could use the monetary base or the short-term interest rate at which banks borrow and lend the monetary base overnight, the Fed chooses to use a short-term interest rate, in particular, the federal funds rate. The federal funds rate is the interest rate on overnight loans of reserves (which are part of the monetary base) that commercial banks make to each other.

2.

What are the main influences on the FOMC federal funds rate decision?

Though the Federal Reserve does not use an explicit formula to determine changes in its targeted federal funds rate, the Fed responds to the inflation rate, the unemployment rate, and the output gap when determining its federal funds target rate.

3.

How is the federal funds rate determined in the market for reserves?

The federal funds rate is determined by equilibrium in the reserve markets. The federal funds rate is the rate that sets the quantity of reserves demanded equal to the quantity of reserves supplied. The equilibrium federal funds rate is bounded by the discount rate above and the interest rate on reserves below.

Page 367 1.

(page 775 in Economics)

Describe the channels by which monetary policy ripples through the economy and explain how each channel operates.

When the Federal Reserve lowers the federal funds rate, other shortterm interest rates also fall. As a result, the exchange rate falls because investors decrease their demand for U.S. dollars since the interest yield on dollars is lower. When the Federal Reserve lowers the federal funds rate it does so by buying securities in the open market. Bank reserves increase so that banks have excess reserves.

Because banks have excess reserves, they loan the excess. Loans increase and a multiple expansion of the quantity of money results.

The supply of loanable funds increases so that the long-term real interest rate falls and consumption and investment increase. Net exports increase because of the lower exchange rate. All three of these changes increase aggregate demand, so that real GDP growth and the inflation rate both increase.

2.

How do the Fed’s actions influence real GDP and how long does it take for real GDP to respond to the Fed’s policy changes?

The Fed’s actions affect real GDP by changing expenditure plans. For instance, an expansionary policy by the Fed that lowers the interest rate increases consumption expenditure, investment, and net exports.

All three of these changes boost aggregate demand so that real GDP growth increases. The effect on real GDP is far from immediate because there are time lags in the process. Real GDP initially responds about two years after the policy is initiated.

3.

How does inflation targeting work?

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expects the inflation rate will be. This will help anchor and manage inflation expectations.

4.

How would using the Taylor rule have changed the Fed’s interest rate setting?

From 2002 to 2005, the actual federal funds rate was lower than what the Taylor rule called for. Then, in 2006 and 2007 the Taylor rule called for 1 to 2 percentage point lower interest rate than the Fed actually set. But the major difference occurs from 2010 onward.

Since 2010 the Taylor rule suggests that the Fed should have raised the federal funds rate to near 4 percent while the Fed kept the federal funds rate near 0 percent. And, even as the Fed started to raise the federal funds rate in 2016, the Taylor rule would have set the federal funds rate about 3 percentage points higher.

Page 369 1.

(page 777 in Economics)

What are the three ingredients of a financial and banking crisis?

A financial and banking crisis occurs when there is a widespread fall in assets prices, a significant currency drain, and a run on banks. When these events occur, banks and other financial institutions face incipient failure and so they drastically decrease their lending activities.

2.

What are the policy actions taken by the Fed and the U.S. Treasury in response to the financial crisis of 2007-2008?

The Fed and the U.S. Treasury have undertaken eight policies designed to combat the financial crisis. The Fed conducted massive open market operations to provide liquidity to banks. To provide liquidity to money market funds, the Fed also created an assetbacked commercial paper money market mutual fund liquidity facility.

To provide liquidity to other financial institutions, the Fed allowed created programs that allowed term auction credit and also primary dealer and other broker credit. The U.S. Treasury engaged in two Troubled Asset relief Programs, TARP 1 and TARP 2. TARP 1 was designed to give banks more liquidity. Under it banks were to sell troubled assets to the U.S. Treasury in exchange for U.S. government assets. This program did not work well and was replaced by TARP 2.

Under TARP 2 the U.S. Treasury directly purchased stock in financial institutions, thereby increasing their solvency and making their failure less likely. Finally, accounting rules were changed to allow financial institutions to use fair value accounting rather than mark-to-market accounting to value assets. This change also increased their solvency and made failure less likely.

3.

Why was the recovery from the 2008–2009 recession so slow?

The recovery from the recession has been slow because investment has not rebounded. Investment has remained low because of uncertainty about the future.

4.

What is macroprudential regulation and how does is contrast with microprudential regulation?

Macroprudential regulation is financial regulation designed to lower the risk that the financial system will collapse, thereby leading to severe macroeconomic issues. Microprudential regulation aims to © 2018 Pearson Education, Inc.

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lower the risk that individual financial institutions fail.

Macroprudential regulation focusses on the interconnections among individual financial institutions because it is these interconnections that can cause the entire system to fail. For example, a macroprudential regulation might require banks to increase the ratio of their net worth to loans when the economy is in a recession thereby making each individual firm—and hence the entire system—less likely to fail.

5.

What are the main provisions of Dodd–Frank?

The Dodd-Frank Act, passed in 2010, has two main provisions: the Volcker Rule, and the Orderly Liquidation Authority. The Volcker Rule limits the amount of funds a bank can invest in hedge funds and private equity funds to a maximum of 3 percent of the bank’s capital. This rule essentially separates commercial banking and investing banking insofar as one bank cannot do both. The Orderly Liquidation Authority allows the Financial Stability Oversight Council to determine if the liquidation of a financial institution is necessary for the macro-stability of the financial system. If a forced liquidation is necessary, the Federal Deposit Insurance Corporation can use an Orderly Liquidation Fund to manage it.

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Answers to the Study Plan Problems and Applications 1.

―Unemployment is a more serious economic problem than inflation and it should be the focus of the Fed’s monetary policy.‖ Evaluate this statement and explain why the Fed’s primary policy goal is price stability.

The Fed’s primary goal is price stability because price stability helps the Fed reach all three of its goals of maximum employment, stable prices, and moderate long-term interest rates. Price stability directly meets the second goal of price stability. And because price stability means that the inflation rate is low, it helps keep nominal long-term interest rates close to the long-term real interest rate. Finally price stability helps consumers and businesses make better decisions about saving and investment and thereby keep unemployment close to the natural rate.

2.

―Monetary policy is too important to be left to the Fed. The President should be responsible for it.‖ How is responsibility for monetary policy allocated among the Fed, the Congress, and the President?

The Fed has primary responsibility for the nation’s monetary policy.

It is the FOMC that decides upon monetary policy. The Congress plays, at best, a minor role. Each year the Fed must make two reports to Congress about its monetary policy and the Fed chairman testifies before Congress at these times. The President’s role is limiting to appointing the members and the chairman of the Board of Governors, though Presidents have tried to influence the Fed’s decisions.

3.

QT1 Will Lead to QE4 Quantitative easing (QE1, 2, and 3) was stimulative and when the Fed shrinks the monetary base (quantitative tightening QT1), it will have a big impact and bring on QE4.

Source: Daily Reckoning, September 21, 2017 a. What does the Federal Reserve Act of 2000 say about the Fed’s control of the quantity of money?

The Federal Reserve Act of 2000 says that the Fed ―shall maintain long-run growth of the monetary and credit aggregates commensurate with the economy’s long-run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.‖

b. How can massive changes in the monetary base resulting from QE and QT be reconciled with the Federal Reserve Act of 2000?

The Fed is charged with setting monetary growth to ―promote effectively the goal(s) of maximum employment, stable prices, …‖ The massive increases in the monetary base during the QEs attempted to decrease the unemployment rate from its level at the time, near 9.5 percent, to something closer to the natural unemployment rate, thereby helping to achieve its goal of maximum employment. The QT that follows is an effort to head off potential high inflation rates, thereby helping to achieve the goal of stable prices.

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What are the two possible monetary policy instruments, which one does the Fed use, and how has its value changed since 2000?

The Fed could use either the monetary base or the federal funds rate as its monetary policy instrument. The Fed has chosen to use the federal funds rate. Since 2000 the federal funds rate has been on a roller coaster. Starting from about 6.5 percent in early 2000, the federal funds rate fell for the next four years until it reached 1 percent in the second quarter of 2004. From that time the federal funds rate rose to slightly more that 5 percent in 2006 and 2007.

After 2007 the federal funds rate fell until it hit its historic low, 0.2 percent in 2008. From 2008 until 2016, the federal funds rate has stayed at this historic low. Since then the federal funds rate has risen to somewhat less than 1.0 percent.

5.

How does the Fed hit its federal funds rate target? Illustrate your answer with an appropriate graph.

To hit its federal funds rate target, the Fed uses open market operations to change the quantity of reserves. Figure 14.1 illustrates this process.

Initially the federal funds rate target is 5.25 percent. The quantity of reserves is $100 billion, as indicated by RS0. If the Fed wants to lower the federal funds rate to 2 percent, the Fed will use open market purchases of government securities to increase reserves to $200 billion. These open market operations will shift the supply of reserves curve to RS1 and thereby lower the equilibrium federal funds rate to the targeted value, 2.00 percent.

6.

What does the Fed do to determine whether the federal funds rate should be raised, lowered, or left unchanged?

The Fed changes in the federal funds rate based on its forecasts of the three economic variables: the inflation rate, the unemployment rate, and the output gap. If the inflation rate is forecasted to rise, the unemployment rate is forecasted to fall, or the output gap is forecasted to fall and perhaps become an inflationary gap, the Fed might be concerned about inflation and push the federal funds rate up. If the inflation rate is forecasted to fall, the © 2018 Pearson Education, Inc.

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unemployment rate is forecasted to rise, or the output gap is forecasted to rise, the Fed might be concerned about unemployment and push the federal funds rate down.

Use the following news clip to work Problems 7 and 8.

Fed Sees Low Unemployment and Low Inflation Fed officials don’t understand the sources of low inflation and low unemployment persisting together and are puzzled about what comes next.

Source: The New York Times, August 16, 2017 7.

Explain why the Fed was puzzled.

The Fed expects low unemployment to bring higher inflation and low inflation to bring higher unemployment. Consequently the Fed was puzzled by the co-existence of low unemployment and low inflation.

8. a. Why might the Fed decide to cut the federal funds rate in 2017?

The Fed might decide to cut the federal funds rate in 2017 if it believed that unemployment is a larger problem than inflation.

b. Why might the Fed decide to raise the Federal Funds rate in 2017?

The Fed might decide to raise the federal funds rate in 2017 if it believed that inflation is a larger problem than unemployment.

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Use the following data to work Problems 9 to 11.

The Bureau of Economic Analysis reported that business investment in the second quarter of 2017 was $2.3 trillion—$0.1 trillion more than in 2015.

9.

Explain the effects of the Fed’s low interest rates on business investment and use a graph to illustrate your explanation.

The low interest rates are achieved by increasing banks’ reserves, which leads to an increase in the supply of loanable funds. Then, as illustrated in Figure 14.2, the increase in the supply of loanable funds lowers the real interest rate, in the figure from 5 percent per year to 3 percent per year. The fall in the real interest rate increases firms’ purchase of investment items, such as factories, plants, machine tools, and so forth, because it makes their purchase less expensive.

10.

Explain the effects of business investment on aggregate demand. Would you expect it to have a multiplier effect? Why or why not?

The increase in investment increases aggregate demand as illustrated in Figure 14.3. It is likely that the increase in investment has a multiplier effect. The initial increase in investment increases real GDP and consumers’ disposable income. In turn the increase in disposable income induces additional consumption expenditure, which serves to further increase aggregate demand and real GDP.

11.

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The Fed might commit to keeping the inflation rate low by stating that it will raise the interest rate at some specified point in the future if inflation starts to pick up. This commitment would help dispel fears of inflation. It would also make clear that buying investment goods will be cheaper at the present time, when the interest rate is low, then in the future, when the interest rate rises. This belief would lead firms to increase their investment at the present time.

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Use the following news clip to work Problems 12 to 14.

IMF Sees Global Economic Speedup Global economic activity is picking up with a cyclical recovery in investment, manufacturing, and trade. World real GDP growth is expected to rise from 3.1 percent in 2016 to 3.6 percent in 2018.

Source: International Monetary Fund, April, 2017 12. If the IMF forecasts turn out to be correct, what would most likely happen to the output gap and unemployment in 2018?

The increase in global economic activity means that the output gap will decrease and the unemployment rate will fall.

13. a. What actions taken by the Fed in 2015 and 2016 would you expect to have influenced real GDP growth in 2018? Explain how those policy actions would transmit to real GDP. In 2015 and 2016, the Fed has started to slowly raise the federal funds rate. The Fed’s policy has been slightly contractionary because the Fed’s goal is to decrease aggregate demand in order to avoid the possibility of high inflation.

b. Draw a graph of aggregate demand and aggregate supply to illustrate your answer to part (a).

Figure 14.4 shows the outcome described in part (b). In the absence of the Fed’s policy, economic growth would have been very strong so that the aggregate demand curve would be AD0 and the aggregate supply curve would be SAS. The Fed’s mildly contractionary policies slightly lowered economic growth by decreasing aggregate demand so the aggregate demand curve shifts only to AD1. In the absence of the Fed’s policies, real GDP would be $17.9 trillion and the price level would be 121. The Fed’s policies have lowered the price level to 120 and thereby reduced any inflation. The policy also decreased real GDP to $17.8 trillion.

14.

What further actions might the Fed take in 2017 to influence the real GDP growth in 2018?

(Remember the time lags in the operation of monetary policy.)

The time lags in the operation of monetary policy suggest that any policy the Fed takes in 2017 likely will have a small effect in 2018. If, early in 2017 the Fed decides to undertake an expansionary policy by slowing its planned sales of assets, there might be a small positive impact on real GDP and employment in late 2018.

Alternatively, if the Fed sticks to its plan to sell assets and unwind the monetary stimulus, there might be a small negative impact on real GDP and employment in late 2018.

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Wall Street Hates the Volcker Rule. Will Trump Finally Kill It? The banks hate the Volcker Rule. They say it is too complex and does more harm than good.

With Republicans in Congress and the White House, this key part of Dodd–Frank financial regulation could die.

Source: CNN, January 9, 2017 What is the Volcker Rule? Why would it be considered to be a part of macroprudential regulation? Why would the banks oppose it?

The Volcker Rule is part of the Dodd-Frank Bill. It prohibits banks from investing more than 3 percent of their capital in hedge funds and private equity funds. In essence, it prohibits banks from combining commercial banking and investment banking, that is, taking an ownership position in a business. This rule is a macroprudential regulation because it attempts to limit the potential harm a recession might inflict on the financial sector and thereby reduce the severity of the recession. Banks oppose this provision because it potentially reduces their profits since it limits the amount they can invest in businesses.

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Answers to Additional Problems and Applications Use the following information to work Problems 16 to 18.

The Fed’s mandated policy goals are ―maximum employment, stable prices, and moderate long-term interest rates.‖ 16. Explain the harmony among these goals in the long run.

In the long run, stable prices bring about maximum employment because firms and households can make the best possible decisions against a backdrop of stable prices. With stable prices, the inflation rate is low—perhaps even zero if prices are precisely stable. The nominal interest rate equals the real interest rate plus the (expected) inflation rate. If the inflation rate is low, then the nominal interest rate will be as low as possible.

17.

Explain the conflict among these goals in the short run.

In the short run, the monetary policy goals might conflict with each other. In the short run, during a recession the Federal Reserve lowers the federal funds rate and increases the growth rate of the quantity of money to combat the recession. The Fed’s policy increases employment and real GDP but at the cost of also increasing the price level and, eventually, the inflation rate and the nominal interest rate. Conversely in an expansion the Fed raises the federal funds rate to decrease inflation but at the cost of decreasing employment and real GDP.

18.

Based on the performance of U.S. inflation and unemployment, which of the Fed’s goals appears to have taken priority since 2000?

It appears that the Fed put more emphasis on keeping prices stable because over this period the core inflation rate was either within or very close to the Fed’s comfort zone for inflation.

19.

What is the core inflation rate and why does the Fed regard it as a better measure on which to focus than the CPI? The core inflation rate is the rate of increase in the core personal consumption expenditure (PCE) deflator. The core PCE deflator is the personal consumption expenditure deflator excluding food and fuel.

The Federal Reserve believes that food and fuel prices are more volatile than other prices and largely respond to factors other than the state of inflation in the general economy. Accordingly, the core inflation rate is the inflation rate over which the Fed believes it has the greatest control.

20.

Suppose Congress decided to strip the Fed of its monetary policy independence and legislate interest rate changes. How would you expect the policy choices to change? Which arrangement would most likely provide price stability?

If interest rates are determined by Congress, there would be a bias toward persistently increasing monetary growth to keep the interest rate low and help the re-election prospects of legislators. While this policy is successful in the short run, in the long run the higher monetary growth leads to higher inflation. In turn, the higher inflation rate leads to a higher nominal interest rate.

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Keeping the Fed independent of Congress is most likely to provide price stability.

Use the following CBO report to work Problems 21 to 23.

Fiscal 2016 Deficit Up More Than GDP In Fiscal 2016, for the first time since 2009, the federal budget deficit as a percentage of GDP increased. CBO projects that over the next decade, accumulating deficits will drive government debt to its highest percentage of GDP since after World War II. Source: Congressional Budget Office 21. How does the federal government get funds to cover its budget deficit? How does financing the budget deficit affect the Fed’s monetary policy?

The federal government borrows the funds. Borrowing, by selling government securities, is how the federal government funds its budget deficit. When the government borrows to fund its deficit, the increased demand for loanable funds raises the real interest rate.

The budget deficit has no direct impact on the Federal Reserve’s monetary policy. But the budget deficit might exert an indirect effect. For its monetary policy, the Federal Reserve targets the federal funds rate and uses open market operations to meet the target. When government borrowing raises the real interest rate, the federal funds rate rises. The rise in the federal funds rate might affect the Fed’s assessment of the level at which to target the federal funds rate.

22.

How was the budget deficit of 2016 influenced by the Fed’s low interest rate policy?

The Fed’s low interest rate policy lowered the interest payments the federal government had to make on its debt. Therefore the low interest rate policy decreased the amount of government spending and hence decreased the size of the government budget deficit.

23. a. How would the budget deficit change in 2018 and 2019 if the Fed moved interest rates up?

If the Fed boosts interest rates, the government payments on its debt will increase. The higher payments increase the amount of government spending and therefore increase the size of the budget deficit.

b. How would the budget deficit change in 2018 and 2019 if the Fed’s monetary policy led to a rapid depreciation of the dollar?

A rapid depreciation of the dollar can have two effects on the budget deficit. First it can increase the U.S. inflation rate. With the increase in the inflation rate, inflation expectations would increase, thereby increasing interest rates. The increase in the interest rate increases the budget deficit because the government must increase the interest payments it makes on its debt. Second, a rapid depreciation of the dollar can also increase U.S. net exports which decreases the U.S. unemployment rate. A decrease in unemployment decreases the needs-based expenditure the government must make and thereby lowers the budget deficit.

24.

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potential to increase production.‖ a. Has the Fed followed this instruction?

The Fed would argue that it has tried to follow this instruction.

The Fed would point to the relatively low inflation rate as evidence that it did not let the growth rate of the quantity of money get out of hand. And the Fed would argue that the financial crisis and ensuing recession is not the fault of its monetary policy.

b. Why might the Fed increase money by more than the potential to increase production?

During a recession the Fed increases the quantity of money by more than the ―long-run potential‖ in an effort to conduct a monetary policy that moves real GDP back to its ―long-run potential.‖

25.

Looking at the federal funds rate since 2000, identify periods during which, with the benefit of hindsight, the rate might have been kept too low. Identify periods during which it might have been too high.

Some analysts assert that the federal funds rate was too low during the period from 2001 to 2005. During this period house prices skyrocketed. It was the following rapid fall in house prices, starting in 2006, that helped lead to the financial crisis. These analysts say that if the Fed had raised interest rates earlier, then demand for housing would have not been as strong, thereby limiting the rise in house prices.

Some observers believe that the Fed kept interest rates too high at the start of in 2000 and in 2006-2007. In both periods the economy was poised to enter a recession. These observers say that if the Fed had lowered the interest rate before the economy entered the recession, the following recession would have been milder and might have been avoided all together.

26.

Now that the Fed has created $3 trillion of bank reserves, how would you expect a further open market purchase of securities to influence the federal funds rate? Why? Illustrate your answer with an appropriate graph.

The Fed’s immense creation of $3 trillion of bank reserves might mean that further open market operations would have no effect on the federal funds rate. The $3 trillion of reserves has sent the federal funds to virtually 0 percent, so there is little room for it to fall further. At this exceedingly low federal funds rate, banks might be willing to hold any quantity of additional reserves. In this situation, as Figure 14.5 illustrates, the demand curve for reserves is horizontal. If the demand curve for reserves is flat, then © 2018 Pearson Education, Inc.

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increasing the quantity of reserves has no effect on the federal funds rate because banks merely hold the additional reserves. Banks hold the reserves because the opportunity cost of holding them rather than loaning them in the federal funds market is so low.

27.

What is the Beige Book and what role does it play in the Fed’s monetary policy decision-making process?

The Beige Book is a key element in the Fed’s monetary policy decision-making process. The Beige Book summarizes economic conditions within each of the Federal Reserve districts. It provides the FOMC important information about the current state of the economy that, together with forecasts of the future evolution of the economy, determines the nation’s monetary policy.

To work Problems 28 to 30, use the information that during 2017 the inflation rate increased slightly but remained in the ―comfort zone‖ and the unemployment rate was low.

28.

Explain the challenge that low inflation and low unemployment poses for the Fed. Low inflation and low unemployment pose a challenge for the Fed because the Fed believes that these two outcomes are unlikely to persist together for long. The Fed believe that low inflation brings high unemployment and that low unemployment brings high inflation.

So if the Fed fears higher inflation, the Fed must raise the interest rate and decrease growth in the quantity of money. But this policy raises the unemployment rate. However, if the Fed fears high unemployment the Fed needs to lower the interest rate and increase the growth rate of the quantity of money. But this expansionary policy raises the inflation rate.

29.

Why might the Fed decide to raise interest rates in this situation?

The Fed might raise the interest rate if it perceives that inflation will rise outside of its comfort zone and if it perceives the rising inflation as a larger problem than the high unemployment.

30.

Why might the Fed decide to try to lower interest rates (or stimulate in other ways) in this situation?

The Fed might lower the interest rate because it perceives high unemployment as a larger problem than inflation because inflation, while increasing, was in the ―comfort zone.‖

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Use the following information to work Problems 31 to 33.

From 2009 through 2017, the long-term real interest rate paid by the safest U.S. corporations fell from 5.5 percent a year to 4 percent a year. During most of that period, the federal funds rate was roughly constant at 0.25 percent a year.

31. What role does the long-term real interest rate play in the monetary policy transmission process?

The long-term real interest rate plays an important part in the monetary transmission process. Both consumption expenditure and investment respond to the long-term real interest rate. When the long-term real interest rate falls, consumption expenditure and investment both increase. The increase in consumption expenditure and investment increase aggregate demand and thereby increase real GDP and the price level.

32.

How does the federal funds rate influence the long-term real interest rate?

The long-term interest rate is an expected average of short-term interest rates. People can either borrow or save by making a longterm commitment or by making successive short-term commitments.

Adjusted for risk, the average of the interest rates on the shortterm commitments must equal the long-term interest rate. If they were not equal one method of borrowing would be more or less expensive than the other. People would stream to borrow using the less expensive method, pushing that interest rate higher, back toward equality. Simultaneously other people would stream to save using the method with the higher return, pushing that interest rate lower, back toward equality. When the Fed lowers the federal funds rate, other short-term interest rates also fall. This fall makes borrowing by using a series of short-term loans less expensive and saving using a series of short-term commitments less profitable. The demand for long-term loans falls, which lowers the long-term interest rate and the supply of long-term saving commitments rises, which also lowers the long-term interest rate. So a fall in the federal funds rate lowers the long-term real interest rate.

33.

What do you think happened to inflation expectations between 2009 and 2017 and why?

Inflation expectations probably increased. The expected inflation rate equals the nominal interest rate minus the real interest rate.

Over this time period, the federal funds rate did not change, so the nominal interest rate did not change. But the real interest rate fell. Therefore inflation expectations increased.

34.

U.S. Dollar Falls as FOMC Holds Rates, Raises Concern Over Low Inflation As expected, the FOMC announced it would hold the federal funds rate steady in the range of 1.00–1.25 percent. But the Fed’s remark that inflation is expected to stay ―somewhat below‖ 2 percent in the near term spooked the foreign exchange market and the dollar fell.

Source: DailyFX, July 26, 2017 a. How does the federal funds rate influence the U.S. dollar exchange rate, other things remaining the same?

The federal funds rate affects other interest rates, which, in turn, affect the U.S. dollar exchange rate. For example, if the federal funds rate falls, other U.S. interest rates also fall. In this case, © 2018 Pearson Education, Inc.

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the U.S. interest rate differential falls so that U.S. savers will sell dollars to acquire foreign exchange to save abroad, so the supply of dollars increases. Foreign savers will not buy dollars to save in the United States, so the demand for dollars decreases. On both counts the U.S. exchange rate falls

b. How does an expected future change in the federal funds rate influence the U.S. dollar exchange rate, other things remaining the same?

An expected future change in the federal funds rate affects future expected interest rates, which will change the U.S. dollar exchange rate. For example, if people expect the Fed to either lower U.S. interest rates or else keep U.S. interest rates lower for a longer period of time, U.S. savers will sell dollars to acquire foreign exchange to save abroad, so the supply of dollars increases. Foreign savers will not buy dollars to save in the United States, so the demand for dollars decreases. On both counts the U.S. exchange rate falls

c. Explain why the Fed’s remark about expected future inflation changed expectations about the federal funds rate and how that change influenced the U.S. dollar exchange rate The Fed’s remark suggests that the Fed does not see inflation becoming a problem in the near term. That means that the Fed is less likely to raise the federal funds interest rate in the near term, so that future U.S. interest rates are lower than previously expected.

This fall in future expected U.S. interest rates lowers the U.S. dollar exchange rate.

35.

Suppose that the Reserve Bank of New Zealand is following the Taylor rule and in 2018, it sets the official cash rate (its equivalent of the federal funds rate) at 4 percent a year. If the inflation rate in New Zealand is 2 percent a year, what is its output gap?

The Taylor rule sets the official cash rate according to CASH = 2 + INF + 0.5(INF  2) + 0.5GAP. So the with a cash rate of 4 percent and an inflation rate of 2 percent, the Taylor rule is that 4 = 2+ 2 + 0.5(2 – 2) + 0.5GAP, or 4 = 4 + 0.5GAP. The last equation shows that the output gap is 0 percent.

Use the following news clip to work Problems 36 and 37.

Bernanke on Inflation Targeting Inflation targeting promotes well-anchored inflation expectations, which facilitate more effective stabilization of output and employment. Thus inflation targeting can deliver good results with respect to output and employment as well as inflation.

Source: Federal Reserve Board, remarks by Ben Bernanke to the National Association of Business Economists 36.

What is inflation targeting and how do ―well anchored inflation expectations‖ help to achieve more stable output as well as low inflation?

Inflation targeting is a monetary policy strategy in which the central bank makes a public commitment to achieve a specific inflation rate goal. Inflation rate targeting helps ―anchor expectations‖ because the public has a good idea of hat the inflation rate will be. There are fewer gyrations in inflation expectations which lead to fewer changes in the real interest rate © 2018 Pearson Education, Inc.

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and, accordingly fewer changes in investment and consumption expenditure. Because aggregate demand is more stable, so, too, is output.

37.

Explain how inflation targeting as described by Ben Bernanke is consistent with the Fed’s dual mandate.

The Fed’s dual mandate is to maintain stable prices and maximum employment. By setting a low inflation rate target, the Fed directly helps achieve its goal of stable prices , which is the best environment for households and firms to make the saving and investment decisions. By limiting fluctuations in aggregate demand, the Fed can keep real GDP growing at a rate that more closely approximates its long-term trend.

38.

If the Fed had adopted inflation targeting and used the Taylor rule to hit its target, how would the course of the federal funds rate have been different from the course that it did take? How would inflation and the output gap have been different?

Before the recession of 2007-2008, according to the Taylor rule the federal funds rate was raised too high in response to the recession of 2000, kept too low during the expansion of 2001 to 2005, and then kept significantly too low after 2010.

On average, the federal funds rate set according to the Taylor rule is higher than the federal funds rate that actually occurred, which means that the inflation rate would have been lower and would have had smaller fluctuations if the Taylor rule had been followed.

According to proponents of the Taylor rule, the Fed’s actions led to the boom and bust of the past decade, so setting the federal funds rate according to the Taylor rule would have resulted in smaller output gaps.

39.

Philly Fed’s Plosser Opposes QE3 Federal Reserve Bank of Philadelphia president Charles Plosser does not think that monetary policy can ―do much to speed up the slow progress‖ in the labor market and opposes the Fed’s latest round of stimulus, known as QE3, saying he does not think it prudent to risk the Fed’s hard-won credibility.

Source: Philadelphia Inquirer, September 25, 2012 a. Describe the QE3 asset purchases that are causing Charles Plosser concern.

Mr. Plosser is concerned about the Fed’s large purchases of mortgage-backed securities.

b. How might asset purchases damage the Fed’s credibility?

The asset purchases might cause people to doubt the Fed’s commitment to price level stability. The asset purchases increase banks’ reserves and if banks loan these reserves, the money supply could expand significantly and with it the price level and inflation rate might jump higher.

Economics in the News 40.

After you have studied Economics in the News on pp. 370–371 (778–779 in Economics) answer the following questions. a. What was the state of the U.S. economy in the summer of 2017 when the Fed made the © 2018 Pearson Education, Inc.

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decision to keeping the federal funds rate steady?

The economy was close to full employment. The output gap was virtually zero and was forecast to be a very small inflationary gap in 2018. The economy was believed to have returned to full employment.

b. What was the FOMC majority expectation about future employment, real GDP, and inflation in June 2017?

The majority view was that the output gap was essentially zero and the economy was at full employment. The majority expected that Fed policy would lead to the economy staying close to full employment with low inflation.

c. How would an earlier and faster rise in interest rates influence aggregate demand, the output gap, and inflation?

An earlier and faster rise in interest rates would lead to an earlier and stronger restraint on the growth of consumption expenditure and investment and, thereby, an earlier and stronger restraint on the growth of aggregate demand.

41.

Fed’s Evans: Offers Full Support for New Stimulus Federal Reserve Bank of Chicago President Charles Evans expressed strong support for the new stimulus provided by the central bank saying, ―This was the time to act‖ and adding, ―I am optimistic that we can achieve better outcomes through more monetary policy accommodation.‖ Source: The Wall Street Journal, September 18, 2012 a. Why, in the economic conditions of September 2012, was Charles Evans happy to see the Fed stimulating the economy?

Mr. Evans was concerned that the economy still had a large recessionary gap and that the economy might even move into another recession.

b. What would be the effects of the Fed’s QE3 and other stimulative actions? Explain the immediate effects and the ripple effects.

If the Fed buys securities, banks’ reserves increase. The federal funds rate falls and along with it other short-term interest rates fall. The exchange rate also falls. The supply of money and the supply of loanable funds increase. The increase in the supply of loanable funds lowers the real interest rate. Consumption expenditure, investment, and net exports increase, which increases aggregate demand. Real GDP increases and the price level rises.

c. What are the risks arising from greater monetary stimulus?

The risk from greater monetary stimulus is significantly higher inflation. If the monetary stimulus is too great, it could propel the United States into a situation in which inflation and inflation expectations soar.

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Answers to the Review Quizzes Page 380 1.

Describe the situation in the market for a good or service that the United States imports.

The goods and services the United States will import are those in which the United States has a higher opportunity cost of production relative to other countries. In those markets the U.S. no-trade price is higher than the world price. With trade the quantity produced in the United States is less than the quantity consumed and the difference is imported.

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Describe the situation in the market for a good or service that the United States exports.

The goods and services the United States will export are those in which the United States has a lower opportunity cost of production relative to other countries. In those markets the U.S. no-trade price is lower than the world price. With trade the quantity produced in the United States exceeds the quantity consumed and the excess is exported.

Page 381 1.

How is the gain from imports distributed between consumers and domestic producers?

Consumers gain from imports and domestic producers lose from imports.

2.

How is the gain from exports distributed between consumers and domestic producers?

Consumers lose from exports and domestic producers gain from exports.

3.

Why is the net gain from international trade positive?

The net gain from international trade is positive because the gain to the winners exceeds the losses to the losers. For instance, in the case of an imported good, the gain to consumers exceeds the loss to producer so society gains on net. The situation is similar for exports: The gain to producers exceeds the loss to consumers..

Page 387 1.

What are the tools that a country can use to restrict international trade?

A country can use tariffs, import quotas, other import barriers such as health, safety, and regulation barriers, and voluntary export restraints to restrict international trade. Export subsidies also decrease other countries’ exports and restrict their international trade.

2.

Explain the effects of a tariff on domestic production, the quantity bought, and the price.

A tariff raises the domestic price of the product. The higher price increases domestic production and decreases the domestic quantity purchased.

3.

Explain who gains and who loses from a tariff and why the losses exceed the gains.

Domestic consumers lose from the tariff. Domestic producers gain from the tariff. The government also gains revenue from the tariff.

But the gain to producers plus the gain in government revenue is less than the loss to consumers, so on net a tariff creates a social loss. There is a social loss for two reasons: First, high-cost domestic production expands, so society uses more resources producing some high-cost units of the good than it would use if lowcost foreign units were purchased. Second the high price leads domestic consumers to decrease their consumption of the good, thereby robbing society of the benefits these units would have produced.

4.

Explain the effects of an import quota on domestic production, consumption, and price.

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An import quota raises the domestic price of the product. The higher price increases domestic production and decreases domestic purchases.

5.

Explain who gains and who loses from an import quota and why the losses exceed the gains.

Domestic consumers lose from the import quota. Domestic producers gain from the import quota. The importers also gain additional profit from the import quota. But the gain to producers plus the importers’ profits is less than the loss to consumers, so on net an import quota creates a social loss. There is a social loss for two reasons: First, high-cost domestic production expands, so society uses more resources producing some high-cost units of the good than it would use if low-cost foreign units were purchased. Second the high price leads domestic consumers to decrease their consumption of the good, thereby robbing society of the benefits these units would have produced.

Page 391 1.

What are the infant industry and dumping arguments for protection? Are they correct?

The attempt to stimulate the growth of new industries is the infantindustry argument for protection, which states that it is necessary to protect a new industry from import competition to facilitate the growth of that industry, making it competitive in the world markets.

This argument is based on the concept of dynamic competitive advantage. Learning-by-doing is a powerful engine of productivity growth. However the learning-by-doing argument for protection only works if the benefits also spill over into other industries and other parts of the economy. This is rarely the case, as the entrepreneurs of infant industries and their financial supporters take this risk into account and all returns usually accrue only to them, not to other industries. And it is more efficient to subsidize the infant industry needing protection than it is to protect it by restricting trade.

The dumping argument for protection states that a foreign firm is selling its exports at a lower price than its cost of production.

Foreign firms trying to monopolize the international market may use this practice. Once the competition is gone, the foreign firm will raise prices and reap profits. This argument fails for several reasons. First, it is virtually impossible to detect the occurrence of dumping since it is impossible to verify a firm’s production costs. The test most commonly used is if the export price is lower than the import price. This test only examines the supply side of the two markets and ignores the demand side. If the domestic market is inelastic and the export market is elastic (which is almost always the case) then it is natural for a firm to price the domestic goods higher than the exports. Second, it is difficult to see how a global firm could have a monopoly for the goods or services it exports. There are too many foreign suppliers (and potential suppliers), making global competition too extensive for a monopoly to exist in the global market. And, even if there is global monopoly © 2018 Pearson Education, Inc.

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it is more efficient to regulate it than to impose trade restrictions on its products.

2.

Can protection save jobs and the environment and prevent workers in developing countries from being exploited?

There are many myths about trade restrictions. The problem mentions three of them, all false reasons often offered as reasons to restrict international trade. These arguments are: 





3.

Trade restrictions save domestic jobs: This argument ignores the fact that, under free trade, consumers in the importing country will have greater disposable income and citizens in the exporting countries will have greater incomes. This means total demand for the goods and services that are exported by our domestic industry increases, increasing the number of jobs created in the domestic industries under free trade.

Trade restrictions penalize lax environmental standards: Not all developing countries have lax environmental standards. Also, a clean environment is a normal good. Countries that are relatively poor and have lax pollution standards do not care as much about the environment because imposing clean air, water, and land standards have a high opportunity cost because they will slow economic development. The best way to encourage environmental quality is not to restrict economic development but to encourage rapid economic growth, which will more quickly increase citizen demand for a cleaner environment in those developing countries.

Trade restrictions prevent rich countries from exploiting poorer countries: Importing goods made in countries with low wage levels increases the demand for labor in those countries, increasing the number of jobs available and raising wages over time. The more free trade that occurs with these countries, the more quickly the wages will rise and the working conditions will increase in quality and safety.

What is offshore outsourcing? Who benefits from it and who loses?

Offshore outsourcing occurs when a firm in the United States buys finished goods, components, or services from firms in other countries. Workers who have skills for jobs that have been sent abroad lose from offshore outsourcing. Consumers who consume the goods and services produced abroad and imported into the United States benefit.

4.

What are the main reasons for imposing a tariff?

There are two main reasons for imposing tariffs on imports. First the government receives tariff revenues from imports, which can be useful when revenues from income taxes and sales taxes are less effective ways of gaining government revenue. Second rent seeking by individuals in industries that would be hurt by foreign competition can influence the government to impose tariffs.

5.

Do the winners from free trade win the political argument? Why or why not?

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that foreign competition might have a negative impact on their industry, firm, or jobs. The anti-trade groups are easily organized and have much to gain from trade restrictions, whereas the vast millions of consumers, who would win from free trade, are difficult to organize because each individual has only a small amount of loss when trade restrictions are imposed. Hence the winners from free trade frequently lose the political argument because the winners from trade restrictions out-lobby the winners from free trade.

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Answers to the Study Plan Prob lems and Applications Use the following data to work Problems 1 to Price Quantity Quantity 3. (dollars demanded supplied Wholesalers buy and sell roses in containers per (millions of that hold 120 stems. The table provides containe containers per year) r) information about the wholesale market for 100 15 0 roses in the United States. The demand 125 12 2 schedule is the wholesalers’ demand and the 150 9 4 supply schedule is the U.S. rose growers’ 175 6 6 supply. Wholesalers can buy roses at auction 200 3 8 in Aalsmeer, Holland, for $125 per container.

225 0 10 1. a. Without international trade, what would be the price of a container of roses and how many containers of roses a year would be bought and sold in the United States?

Without international trade, in the United States the price of a container of roses is $175 and 6 million containers of roses are bought and sold.

b. At the price in your answer to part (a), does the United States or the rest of the world have a comparative advantage in producing roses?

The price of roses in the United States exceeds the price in the rest of the world, so the rest of the world has a comparative advantage in producing roses.

2.

If U.S. wholesalers buy roses at the lowest possible price, how many do they buy from U.S. growers and how many do they import?

The price of roses in the United States is $125 per container. At this price, U.S. rose growers supply 2 million containers per year and U.S. wholesalers demand 12 million containers of roses. U.S. wholesalers buy the 2 million containers from U.S. growers and purchase 10 million containers from foreign sources, which are imported into the United States.

3.

Draw a graph to illustrate the U.S. wholesale market for roses. Show the equilibrium in that market with no international trade and the equilibrium with free trade. Mark the quantity of roses produced in the United States, the quantity imported, and the total quantity bought.

In Figure 15.1, the equilibrium without international trade is determined at the intersection of the demand curve and the supply curve. Without international trade the equilibrium price is $175 per container and 6 million containers per year are bought and produced. With international trade the world price is $125 per © 2018 Pearson Education, Inc.

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container, as shown in Figure 15.1. The quantity produced in the United States is 2 million containers and the quantity bought in the United States is 12 million containers. Imports into the United States account for the difference between the quantity bought and the quantity produced, 10 million containers.

4.

Use the information on the U.S. wholesale market for roses in Problem 1 to a. Explain who gains and who loses from free international trade in roses compared to a situation in which Americans buy only roses grown in the United States.

U.S. rose wholesalers, who are the consumers in the problem, gain from free international trade. U.S. rose growers lose from free international trade.

b. Calculate the value of the roses imported into the United States.

The United States imports 10 million containers of roses per year.

The price of a container is $125, so the value equals (10 million containers) × ($125 per container), $1.25 billion.

Use the information on the U.S. wholesale market for roses in Problem 1 to work Problems 5 to 10.

5.

If the United States puts a tariff of $25 per container on imports of roses, explain how the U.S. price of roses, the quantity of roses bought, the quantity produced in the United States, and the quantity imported changed.

The U.S. price of roses rises from $125 per container (the price with free trade) to $150 per container. The quantity of roses produced in the United States increases from 2 million containers (the quantity produced with free trade) to 4 million containers. The quantity of roses consumed in the United States decreases from 12 million containers (the quantity consumed with free trade) to 9 million containers. The quantity imported decreases from 10 million containers to 5 million containers.

6.

Who gains and who loses from this tariff?

U.S. rose consumers lose from the tariff. U.S. rose producers gain from the tariff. The U.S. government gains revenue from the tariff.

7.

Draw a graph of the U.S. market for roses to illustrate the gains and losses from the tariff and on the graph identify the gains and losses, and the tariff revenue.

Figure 15.2 shows the effect of the tariff. The amount of the tariff is equal to the height of the light gray arrow. In the United States, the price of a container of roses rises from $125 per container to $150 per container. Before the tariff U.S. rose producers grew 2 million containers per year; after the tariff they increase their production to 4 million containers per year. This change is shown in the figure by the movement from point a to point © 2018 Pearson Education, Inc.

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b. Before the tariff U.S. rose wholesalers, the consumers in this problem, purchased 12 million containers per year; after the tariff they decrease their consumption to 9 million containers per year.

This change is shown in the figure by the movement from point c to point d. The quantity of roses imported decreases from 10 million containers per year before the tariff to 5 million per year after the tariff and a tariff of $25 per container is imposed. The tariff revenue is equal to 10 million containers × $25 per container, which is $250 million and is illustrated in Figure 15.5 as the area of the grey rectangle.

8.

If the United States puts an import quota on roses of 5 million containers, what happens to the U.S. price of roses, the quantity of roses bought, the quantity produced in the United States, and the quantity imported?

The U.S. price of roses rises to $150 per container. 9 million containers of roses are purchased in the United States and 4 million containers of roses are produced in the United States. The difference, 5 million containers, is imported into the United States.

9.

Who gains and who loses from this quota?

U.S. rose growers and importers of roses gain from the quota. U.S. rose wholesalers lose from the quota.

10.

Draw a graph to illustrate the effects of the import quota and on the graph identify the importers’ profit.

Figure 15.3 shows the effect of the import quota. The amount of the quota is equal to the length of the grey arrow. The price in the United States rises from $125 per container to $150 per container. Before the import quota U.S. rose producers grew 2 million containers per year; after the import quota they increase their production to 4 million containers per year.

This change is shown in the figure by the movement from point a to point b. Before the import quota U.S. rose wholesalers, the consumers in this problem, purchased 12 million containers per year; after the import quota they decrease their consumption to 9 million containers per year. This change is shown in the figure by the movement from point c to point d. The quantity of roses imported decreases from 10 million containers per year before the import quota to 5 million per year after the tariff. U.S. producers receive $150 per container while foreign producers receive the world price, $125 per container. The difference, $25 per container, goes to the © 2018 Pearson Education, Inc.

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importers as added profit. The total added profit is equal to 10 million containers × $25 per container, which is $250 million and is illustrated in Figure 15.5 as the area of the grey rectangle.

11.

China Drug Sales to the U.S. Grow Despite Safety Concerns at Homes Chinese exports of pharmaceutical products and health supplements worldwide jumped 3 percent to $56 billion last year. Chinese pharma exports to the U.S. rose 4 percent. Questions are being asked in China about the safety of its medicines.

Source: Bloomberg News, August 30, 2016 a. What does the news clip imply about the comparative advantage of producing pharmaceuticals in the United States and China?

Because the pharmaceutical products and health supplements are produced in China, the news clip suggests that China has the comparative advantage in producing these pharmaceutical products and health supplements.

b. Could product quality be a valid argument against free trade? If it could, explain how.

Product quality is not a valid argument against free trade. Quality is a valid concern for consumers. If consumers cannot judge quality themselves, then government inspection might be necessary. But in that case government inspection of both imported and domestically produced goods is required. To single out imported goods or services makes little sense.

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Answers to Additional Problems and Applications 12.

Suppose that the world price of sugar is 10 cents a pound, the United States does not trade internationally, and the equilibrium price of sugar in the United States is 20 cents a pound. The United States then begins to trade internationally. a. How does the price of sugar in the United States change?

The price of sugar in the United States falls.

b. Do U.S. consumers buy more or less sugar?

As a result of the lower price, U.S. consumers buy more sugar.

c. Do U.S. sugar growers produce more or less sugar?

As a result of the lower price, U.S. growers produce less sugar.

d. Does the United States export or import sugar and why?

The United States imports sugar. The quantity of sugar demanded increases while quantity supplied decreases. The difference is made up by imports.

13.

Suppose that the world price of steel is $100 a ton, India does not trade internationally, and the equilibrium price of steel in India is $60 a ton. India then begins to trade internationally. a. How does the price of steel in India change?

The price of steel in India rises to equal the world price.

b. How does the quantity of steel produced in India change?

Producers respond to the higher price by increasing the quantity of steel produced.

c. How does the quantity of steel bought by India change?

Steel users in India respond to the higher price by decreasing the quantity of steel bought.

d. Does India export or import steel and why?

Because the price of steel in India is lower than the world, India has a comparative advantage in the production of steel. India will export steel.

14.

A semiconductor is a key component in your laptop, cell phone, and iPod. The table provides information about the market for semiconductors in the United States. Producers of semiconductors can get $18 a unit on the world market. a. With no international trade, what would be the price of a semiconductor and how many semiconductors a year would be bought and sold in the United States?

With no international trade the price of a semiconductor in the United States is $12 per unit. 20 billion units are bought and sold in the United States.

Price (dollars per unit) 10 12 14 16 18 20

Quantity Quantity demanded supplied (billions of units per year) 25 0 20 20 15 40 10 60 5 80 0 100

b. Does the United States have a comparative advantage in producing semiconductors?

The United States has a comparative advantage in producing semiconductors because the U.S. price is lower than the price in the world market.

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Biofuel Goals Could Require All the World’s Crops Biofuels to combat global warming and cut carbon emissions are diverting corn from food to fuel, and a World Resources Institute report says meeting a 20 percent bioenergy target in 2050 would need the world’s annual harvest of plant material to double.

Source: CBS News, January 29, 2015

a. What is the effect on the world price of corn of the increased use of corn to produce biofuel?

The use of corn to produce ethanol increased the demand for corn, thereby raising the price of corn.

b. How does the change in the world price of corn affect the quantity of corn produced in a poor developing country with a comparative advantage in producing corn, the quantity it consumes, and the quantity that it either exports or imports?

The higher world price of corn decreases the consumption of corn and increases the production of corn in poor developing countries.

Because the country has a comparative advantage it will export corn.

The higher price leads the country to increase its exports.

16.

Draw a graph of the market for corn in the poor developing country in Problem 15(b) to show the changes in the price of corn, the quantity produced, and the quantity consumed by people in that country.

In Figure 15.4, the initial world price of corn was $6 per bushel. With the use of biofuels that require corn, the world price rises to $8 per bushel.

The higher world price increases the production of corn.

Production moves from point a on the supply curve to point b; that is, production in the poor country increases from 5 million bushels to 6 million bushels.

Consumption of corn, however, decreases. Consumption in the poor country moves from point c on the demand curve to point d; that is, consumption decreases from 3 million bushels per year to 2 million bushels.

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Use the following news clip to work Problems 17 and 18.

Watch Out USA—Haggis Could Be on Its Way Scottish haggis made from sheep’s heart, liver, and lungs, mixed with oatmeal and spices, has been banned in the United States since 1971. The Scottish government expects the ban to soon be lifted.

Source: CNNMoney, November 23, 2016 17. a. Explain how the U.S. import ban on haggis affected haggis producers and consumers in Scotland.

The U.S. import ban lowered the price of haggis in Scotland. The lower price led to decreased production in Scotland, which made Scottish producers worse off. The lower price also led to increased consumption in Scotland, which made Scottish consumers better off.

b. Draw a graph of the market for haggis in Scotland to illustrate your answer to part (a).

Identify the changes in the price of haggis, the quantity produced and the quantity consumed in Scotland.

Figure 15.5 shows the effect of the U.S. import ban. Prior to the ban, presuming the only Scottish exports of haggis were to the United States, the price of haggis in Scotland was $5 per pound. At this price the quantity consumed in Scotland was 30,000 pounds of haggis per year (point a on the demand curve) and the quantity produced in Scotland was 80,000 pounds per year (point b on the supply curve). The difference, 50,000 pounds per year, was exported to the United States. With the import ban, the price of haggis in Scotland falls to $4 per pound. At this price 60,000 pounds of haggis per year are produced and consumed in Scotland (point c). There are no exports.

18. a. Explain how lifting the U.S. import ban on haggis affects producers and consumers of haggis in the United States.

Lifting the U.S. ban lowers the price of haggis in the United States. U.S. consumption increases and U.S. production decreases so U.S. consumers are better off and U.S. producers are worse off.

b. Draw a graph of the U.S. market for haggis to illustrate your answer to part (a).

Figure 15.6 shows the situation in the U.S. market for haggis.

With no trade the U.S. price of haggis is $6 per pound. The © 2018 Pearson Education, Inc.

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United States produces and consumes 30,000 pounds of haggis. When the U.S. import ban is eliminated, the price in the United States falls to $5 per pound. U.S. production falls to 20,000 pounds per year and U.S. consumption rises to 50,000 pounds. The difference, 30,000 pounds, is imported from Scotland.

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Use the following information to work Problems 19 to 21.

Before 1995, trade between the United States and Mexico was subject to tariffs. In 1995, Mexico joined NAFTA and all U.S. and Mexican tariffs have gradually been removed.

19. Explain how the price that U.S. consumers pay for goods from Mexico and the quantity of U.S. imports from Mexico have changed. Who are the winners and who are the losers from this free trade?

With NAFTA, the prices that U.S. consumers pay for goods from Mexico have fallen and, as a result, the quantity of imports from Mexico have increased. Winners from this free trade are Mexican producers of goods exported to the United States and U.S. consumers of these goods. Losers are Mexican consumers of the goods and U.S. producers of the goods.

20.

Explain how the quantity of U.S. exports to Mexico and the U.S. government’s tariff revenue from trade with Mexico have changed.

The prices of U.S. goods in Mexico have fallen and, as a result, the quantity of U.S. goods exported to Mexico has increased. The U.S. government’s tariff revenue from tariffs imposed on trade with Mexico decreased.

21.

Suppose that in 2015 tomato growers in Florida lobby the U.S. government to impose an import quota on Mexican tomatoes. Explain who in the United States would gain and who would lose from such a quota.

U.S. tomato growers gain from such a quota. The importers who hold the quota rights also gain. U.S. consumers of tomatoes lose from such a quota.

Use the following information to work Problems 22 and 23.

Suppose that in response to huge job losses in the U.S. textile industry, Congress imposes a 100 percent tariff on imports of textiles from China.

22.

Explain how the tariff on textiles will change the price that U.S. buyers pay for textiles, the quantity of textiles imported, and the quantity of textiles produced in the United States.

The tariff raises the U.S. price of textiles. As a result, the quantity of textiles consumed in the United States decreases and the quantity produced increases. Imports of textiles into the United States decrease.

23.

Explain how the U.S. and Chinese gains from trade will change. Who in the United States will lose and who will gain?

The decrease in trade means that the U.S. and Chinese gains from trade decrease. In the United States, U.S. producers gain from the tariff. The U.S. government also gains revenue from the tariff. U.S. textile consumers lose.

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Use the following information to work Problems 24 and 25.

With free trade between Australia and the United States, Australia would export beef to the United States. But the United States imposes an import quota on Australian beef.

24.

Explain how this quota influences the price that U.S. consumers pay for beef, the quantity of beef produced in the United States, and the U.S. and the Australian gains from trade.

The quota raises the price of beef in the United States. By raising the U.S. price, the quota increases the quantity of beef produced in the United States and decreases the quantity of beef consumed in the United States. The U.S. and Australian gains from trade decrease.

25.

Explain who in the United States gains from the quota on beef imports and who loses.

U.S. beef producers gain from the quota. The people who hold the import quota rights also gain. U.S. beef consumers lose from the quota.

26.

The Cost of Bringing Home American Jobs Donald Trump says he’ll bring home jobs lost to China and Mexico. It is possible but costly.

American consumers would face higher prices and those on low incomes would suffer most because they spend a high share of their income on clothes, shoes, and toys—things that are made at low cost and imported.

Source: CNNMoney, April 14, 2016 a. What are the arguments for bringing jobs back to America? Explain why these arguments are faulty.

The primary argument advanced for being jobs back to America is that it will increase employment in America and the benefits to the U.S. workers who gain these jobs outweigh the costs of restricting trade.

The fact this argument is off base is demonstrated by comparing the cost of saving a job to the wage paid on the job. The cost of restricting trade falls on American consumers, especially low-income Americans, who would face higher prices for imported products such as clothes, shoes, and toys. The cost inflicted on U.S. consumers from higher prices outweighs the benefit of a job to the worker, that is, the wage rate paid on the job.

b. Is there any merit in bringing jobs back?

There is merit to the workers whose jobs are being brought back and who might not receive any government assistance if their jobs are not protected. There also is merit to the politicians who can obtain a reward from lobbyists for the protection. There is no merit, however, to society as a whole.

Economics in the News Economics in the News 27.

After you have studied Economics in the News on pp. 392–393, answer the following questions. a. What was the value of U.S. imports from Mexico in 2015 and why would the value of imports fall if a 20 percent tariff were imposed on them?

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quantity of goods and services imported as U.S. consumers decrease the quantity they demand while U.S. producers increase the quantity they supply.

b. How do the elasticities of demand and supply influence the revenue that a tariff generates?

The elasticities of demand and supply affect the revenue a tariff will raise because they determine the quantity that will be imported after the tariff is imposed. Imposing a tariff on Mexican imports raises their price in the United States. If the U.S. demand and U.S. supply for these imports are very inelastic, then the quantity demanded will decrease only slightly while the quantity supplied will increase only a little. Both effects lead to a small decrease in imports and, accordingly, a large amount of tariff-generated revenue.

c. Who in the United States would benefit and who would lose from a 20 percent tariff on imports from Mexico?

U.S. producers of import-competing products would benefit from a tariff. So, too, would the U.S. government because it would gain revenue. U.S. consumers would lose. Overall the United States loses.

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d. Illustrate your answer to part (c) with an appropriate graphical analysis.

Figure 15.7 shows the effect of the tariff. Before the tariff, the price is $50 per unit, indicated by the line labeled PW. The United States produces 1.67 million units and consumes 7 million units, so the United States imports 5.33 million units from Mexico. The 20 percent tariff raises the price in the United States to $60 per unit, shown by the line labeled PW + tariff. At this price the United States produces 2.33 million units and consumes 5 million units, thereby importing 2.67 million. U.S. producers gain because of the rise in price and U.S. consumers lose because of the rise in price. The government gains because it gains tariff revenue.

28.

Argentina’s Lesson for Trump: Tariffs Made Poverty Worse In 2011, Argentina wanted to protect manufacturing workers, so it imposed a 35 percent tariff on imported smartphones, computers, and tablets. Blackberry moved jobs to Argentina, but Apple and others passed. Compare Argentine and U.S. prices: iPhone 7 Plus $1,400 versus $869; iPad Pro $1,300 versus $699. Argentina is now removing this tariff.

Source: CNNMoney, April 7, 2017 a. Explain how Argentina’s tariff on smartphone and tablet imports changes the country’s production, consumption, and imports of these items. Illustrate your answer with an appropriate graphical analysis.

The tariff on smartphone and tablet imports raises their price in Argentina. The higher price increases Argentinian production and decreases both Argentinian consumption and importation.

Figure 15.8 illustrates the situation for an iPad Pro. With no tariff, the price would be $699, indicated by the line labeled PW. Argentinian producers would © 2018 Pearson Education, Inc.

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manufacture 1 million iPads and Argentinian consumers would purchase 6 million iPads, so 5 million iPads would be imported. The tariff raises the price to $1,300, shown by the line labeled PW + tariff.

At this price, Argentinian producers manufacture 2.5 million iPads and Argentinian consumers purchase 3 million iPads, so 500,000 iPads are imported.

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b. Show on your graph the changes that result from the tariff on smartphones and tablets.

Before there is a tariff, the Argentinian consumers pay a lower price, $700 per iPad Pro, and buy more iPads, 6 million, then after the tariff, when they pay $1,300 for an iPad pro and consume only 3 million iPad Pros. The tariff harms Argentinian consumers. Before the tariff, Argentinian producers receive a lower price, $700 per iPad Pro, and produce fewer iPads, 1 million, then after the tariff, when they receive $1,300 for an iPad pro and manufacture 2.5 million. The tariff benefits Argentinian producers.

c. Who in Argentina will oppose the tariff cuts?

Opposing the tariff cuts will be those who gain from the tariffs, specifically the producers and perhaps some in the government, which gains tariff revenue.

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