Solution Manual for Macroeconomics 2nd Edition by Daron Acemoglu, David Laibson, John List

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Solutions Manual Maggie Yellen

Macroeconomics Second Edition

Daron Acemoglu David Laibson John List

New York, NY

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Chapter 1

The Principles and Practice of Economics Questions 1. Why do we have to pay a price for most of the goods we consume?

Answer: The inputs we use to produce most goods and services (for example, capital and labor) are scarce. Therefore almost all goods and services are scarce compared to the quantity that consumers want to consume. In other words, at a price of zero the demand for most goods is higher than the available supply; our wants are unlimited but our resources are not. Prices act as a rationing mechanism to prevent the overconsumption of such scarce goods, making them available in the quantity such that the supply of these goods matches the demand.

2. Many people believe that the study of economics is focused on money and financial markets. Based on your reading of the chapter, how would you define economics?

Answer: Economics is the study of how agents (for example, households and firms) choose to allocate scarce resources and how these choices affect society. Although it is true that economics studies money and the financial markets, the study of economics is really focused on human behavior and choices. Given that we have limited resources, we need to choose between various options. Economic analysis is used to understand people‘s choices in order to describe what people do and recommend what people ought to do.

3. Examine the following statements and determine if they are normative or positive in nature. Explain your answer. a. Car sales in Europe rose 9.3 percent from 2014 to 2015. b. The U.S. government should increase carbon taxes to control emissions that cause global warming.

Answer: a. This is an objective statement about the rate of growth in the European automotive industry. Positive economics is analysis that generates objective descriptions or predictions about the world that can be verified with data.

Since data can be used here to verify the rate of growth, this is a positive statement. b. The statement that the government should increase carbon taxes to control emissions is normative since it states what the government ought to do.

Normative economics advises individuals and society on their decisions and is

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almost always dependent on subjective judgments.

4. How does microeconomics differ from macroeconomics? Would the supply of iPhones in the United States be studied under microeconomics or macroeconomics? What about the growth rate of total economic output in the national economy?

Answer: Microeconomics is the study of how individuals, households, firms, and governments make choices, and how those choices affect prices, the allocation of resources, and the well-being of other agents. Macroeconomics is the study of the economy as a whole. Macroeconomists study factors that affect overall – in other words, aggregate – economic performance.

The supply of iPhones refers to the supply of a good by an individual firm, Apple.

The iPhone market will be studied under microeconomics. Microeconomics studies how individuals, households, firms and governments make choices, and how those choices affect prices and the allocation of resources. The growth rate of total economic output, on the other hand, refers to the aggregate American economy, and is therefore studied under macroeconomics.

5. What does a budget constraint represent? How do budget constraints explain the trade-offs that consumers face?

Answer: A budget constraint is an equation representing the goods or activities that a consumer can choose given her limited budget. Tradeoffs arise when some benefits must be given up in order to gain others. In other words, a trade-off occurs when you give one thing up to get something else. Since a budget constraint shows the set of things that you can choose to do or buy with a fixed amount of money, it also shows that if you choose to buy more of one good, you will have to buy less of another.

Therefore, a budget constraint equation implies that a consumer faces a tradeoff.

6. This chapter introduces the idea of opportunity cost. a. What is meant by opportunity cost? b. What is the opportunity cost of taking a year after graduating from high school and backpacking across Europe? Are people who do so being irrational?

Answer: a. Opportunity cost is the best alternative use of a resource. The opportunity cost of a particular choice is measured in terms of the benefit foregone from the next best alternative. To facilitate comparison, the benefits and costs of various choices are translated into monetary units like dollars. b. The opportunity cost of backpacking across Europe, for a particular person, is the cost of anything else that could have been done in that year. The backpacker could have attended college or started working. These costs are the opportunity costs of the gap year. This, however, does not mean that backpackers are irrational, because the benefits may exceed the cost. Every action has an opportunity cost. The choices that people make are optimal based on their perceived costs and benefits.

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7. The costs of many environmental regulations can be calculated in dollars—for instance, the cost of ―scrubbers‖ that reduce the amount of air pollution emitted by a coal factory. The benefits of environmental regulations often are most directly expressed in terms of lives saved (reduced mortality) or decreases in the incidence of a particular disease (reduced morbidity). What does this imply about the cost-benefit analysis of environmental regulations? There is an old saying ―You can‘t put a price on a human life.‖ Do you agree or disagree? Explain.

Answer: Cost-benefit analysis can be used when there is a common unit, such as dollars. This method is less straightforward if there are two different units of measurement, such as dollars and lives. However, if a direct link can be drawn between dollars spent and lives saved then cost-benefit analysis becomes feasible.

When an environmental regulator places a value of 3 million dollars on a human life (for example), they are claiming that if 3 million dollars is not spent in one area, then it can instead be spent in another area where 3 million dollars is expected to save one life, on average. While some people may find this practice controversial, it does provide the most practical way to maximize the number of lives saved, given limited financial resources.

8. Suppose the market price of corn is $5.50 per bushel. What are the three conditions that will need to be satisfied for the corn market to be in equilibrium at this price?

Answer: For the market to be in equilibrium, three conditions will need to be satisfied. ● At the price of $5.50 per bushel, the amount of corn produced by sellers should be equal to the amount of corn purchased by buyers in the market. ● Farmers have chosen the optimal quantity of corn to produce given the price of $5.50 per bushel. ● Consumers have chosen the optimal quantity of corn to buy given the price of $5.50 per bushel.

9. Economists are often concerned with the free-rider problem. a. What is meant by free riding? Explain with an example. b. Are public parks subject to the free-rider problem? What about keeping city streets clean? Explain your answer.

Answer: a. A free rider is a person who receives the benefit of a good but avoids paying for it. People tend to pursue their own private interests and usually don‘t contribute voluntarily to the public interest. For example, watching a pirated copy of a movie is cheaper than buying one. Those who watch the pirated version are free riders because there are others who buy the movie or pay for movie tickets. If everyone watched pirated copies, making movies would not be profitable and the industry would not function. b. Cleaning of city streets may be subject to free riding. Suppose the streets are cleaned every day at a fixed cost. This cost is borne by those who pay taxes to the city government. However, they cannot prevent others who do not pay

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taxes from using the clean streets. This leads to the free rider problem.

However, not all free riding is necessarily problematic. For a park that already exists, it is good when many people enjoy its benefits, especially when there are no real costs associated with usage. The park example demonstrates that free riding is not a problem per se. Rather, it may lead to the underproduction of public goods -- but once a particular public good exists people should use it as much as possible, so long as they do not get in other people‘s way.

10. Explain the concept of causation with the help of a simple real-life example.

Answer: Causation is a relationship between two events or states, such that one brings about a change in the other. In short, it explains the cause and effect relationship between two variables or events. For example, people who go to college learn skills that are valuable to prospective employers. So a college degree causes someone‘s wages to rise.

11. Identify the cause and the effect in the following examples: a. A rise in the worldwide price of peaches and a drought in California. b. A surge in cocoa prices and a pest attack on the cocoa crop that year.

Answer: a. A drought in California causes a decrease in supply of peaches, and thus a rise in price. b. The pest attack is likely to have reduced the cocoa crop, leading to a rise in prices.

Problems 1. You have already purchased (non-refundable and unsellable) tickets to a concert on Friday night. A friend also invites you to her birthday party on Friday. While you like your friend, you politely decline because you really want to go to the concert. a. You learn that your friend is serving flank steak at her party, all-you-can eat and at no charge. Flank steak is your favorite food. Should this affect your decision to go to the concert? Explain by using the term ―opportunity cost.‖ b. Suppose instead that you notice that the non-refundable concert ticket (that you already purchased) cost you $10; previously you had mistakenly believed the price was $100. Should learning this information affect your decision to go to the concert?

Answer: a. This should affect your decision, or at least make you reconsider. The explicit cost of the concert has not changed, nor the benefit of the concert itself. However, the opportunity cost of missing the party is now higher than you previously thought.

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b. This should not affect your decision. Whether you paid ($10 or $100) in the past is irrelevant to the costs and benefits that you can affect by going (or not going) to the concert.

2. You are thinking about buying a house. You find one you like that costs $200,000.

You learn that your bank will give you a mortgage for $160,000 and that you would have to use all of your savings to make the down payment of $40,000. You calculate that the mortgage payments, property taxes, insurance, maintenance, and utilities would total $950 per month. Is $950 the cost of owning the house? What important factor(s) have you left out of your calculation of the cost of ownership?

Answer: You have ignored the opportunity cost of the funds you are using for the down payment. By using your $40,000 to buy the house, you give up the opportunity to earn interest on that money. If you could earn 5% interest, then the opportunity cost is 0.05 x $40,000 = $2,000 per year, or $167 per month. This does not imply that you should not buy this house. It does imply, however, that you need to think carefully about opportunity cost as you weigh this decision. An economist would tell you that the monthly cost of owning this home is $950 + $167 = $1,017.

3. You have 40,000 frequent flier miles. You could exchange your miles for a round trip ticket to Bermuda over spring break. Does that mean your flight to Bermuda would be free? Explain your reasoning.

Answer: It does not. You could use your miles for other travel and so there is an opportunity cost if you use your miles to fly to Bermuda. Suppose, for example, you are definitely going to fly to Chicago when the spring semester is over. You could use your 40,000 miles to fly to Chicago or you could purchase a ticket for $300. In this case, the opportunity cost of using your miles to fly to Bermuda is the $300 you will have to spend for the airfare to Chicago.

4. You have decided that you are going to consume 600 calories of beer and snacks at a party Saturday night. A beer has 150 calories and a snack has 75 calories. a. Create a table that shows the various combinations of beer and snacks you can consume. To keep things simple, use only round numbers (e.g., you could choose 1 or 2 beers but not 1.5 beers). b. What is the opportunity cost of a beer?

Answer: a. Suppose you choose to consume 0 beers. Then you could use all 600 calories on snacks. Since snacks have 75 calories you could consume 600 / 75 = 8 snacks.

Now suppose you choose 1 beer. A beer has 150 calories and so you would be left with 600 – 150 = 450 calories for snacks. You could therefore consume 450 / 75 = 6 snacks if you choose 1 beer. You can use the same logic to complete the table below.

Beer

Snacks

0

8

1

6

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2

4

3

2

4

0

b. If you consume 1 more beer you will have 150 fewer calories for snacks. Since a snack has 75 calories, consuming one more beer means that you will have to give up 150 / 75 = 2 snacks. The opportunity cost of a beer is therefore 2 snacks.

5. Suppose you are ready to check out and see two lines: Line A has 3 people, while line B has 5 people. a. Assume people just chose lines at random and have not yet had a chance to switch lines. Would you consider this situation to be in equilibrium? Why or why not? b. Assume that all 8 shoppers are optimizing (i.e., they have had a chance to switch), and that the situation is in equilibrium. What conclusions would you draw? c. Of all 8 shoppers, whose behavior is the most informative?

Answer: a. This situation is not in equilibrium. Assuming both lines move at the same speed, it would make sense for the last person in the longer line to switch to the shorter line. b. If the 8 shoppers know what they are doing, then it must be the case that the shorter line moves more slowly. c. The behavior of the last person in each line is the most informative. The assumption that these shoppers are optimizing allows an outside observer to draw conclusions about the speed of the two lines.

6. Consider the following three statements: i.

You can either stand during a college football game or you can sit. You believe that you will see the game very well if you stand and others sit but that you will not be able to see at all if you sit and others stand. You therefore decide to stand.

ii.

Your friend tells you that he expects many people to stand at football games.

iii.

An economist studies photos of many college football games and estimates that 75 percent of all fans stand and 25 percent sit.

Which of these statements deals with optimization, which deals with equilibrium, and which deals with empiricism? Explain.

Answer: The first statement involves optimization. You believe that you will be best off if you stand regardless of the decisions other people make. The second statement involves equilibrium. If many other people also reason as you did then we should expect many people will decide to stand. The third statement involves empiricism. Our theory tells us that we should expect many people to stand at games. This economist‘s empirical study supports the theory.

7. In 2014, California was in its third year of a major drought. With water supplies

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dwindling, Governor Brown issued a plea for a voluntary 20 percent reduction in water use. This target was not reached. In early 2015 Governor Brown issued an executive order requiring local water agencies to reduce water use by 25 percent, but no enforcement mechanism was specified. No taxes or fines were in the executive order. State officials hoped that they could achieve compliance without resorting to fines. a. From an individual homeowner‘s perspective, what are the costs and benefits of using water during a drought? Why do you think that the voluntary reduction order in 2014 didn‘t work? b. Using concepts from this chapter, explain how you might get individual homeowners to reduce water use during a drought. c. Eventually, many communities began levying fines on water use. However, while many middle income families dramatically cut water use, wealthy households cut back their water use relatively little. How can you explain this phenomenon from an economic perspective?

Answers: a. With no specific enforcement mechanism, there is low cost to using water. Water bills are not zero, but these prices were low enough in the past to create a water shortage, so clearly the financial cost is not high enough to prevent a shortage.

There may be some social stigma attached to watering a lawn, though this cost varies for each person and depends on their sense of civic responsibility. On the flip side, the benefits of using water are quite clear: Green lawns, pleasant showers, and odorless toilets. The fact that the 2014 plea did not work is because the cost of violating a call for civic responsibility is not very high for most people. b. Charging a higher price for water than in 2014 would likely result in a reduction in water usage. When the price goes up, people would discover that some of their usage is actually not that important. c. Fines are equivalent to a higher price for water. In this case, lower income individuals were more price elastic; they responded more sharply to a price change. This implies that the willingness to pay for the last gallon of water in a low-income household is less than the willingness to pay in a high-income household.

8. An economist observes that many students spend $100,000 to go to college. This researcher could ask whether such spending is worth it, or she could assume that it is worth it. In other words, she could assume that students are optimizing and that the education system is in equilibrium. What can the economist conclude about the value of a college education?

Answer: An economist will conclude that college increases earnings (over a lifetime) by at least $100,000 -- the increase may be higher, but it cannot be lower. If this were not the case then students would choose to skip college. This analysis assumes there are no other benefits to college besides higher income; as well as no other costs besides monetary costs. In reality there are many other costs and benefits of college. However, the main point stands: The observation that people are willing to pay a certain amount for college provides information about the economic value of college.

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9. It is the night before your economics final exam and you must decide how many hours to study. The total benefits column shows how many more points you expect to earn because of increased knowledge. The cost column shows how many points you will lose because of careless errors due to lack of sleep. (The ―marginal‖ columns show the effect of each additional hour spent studying. These marginal numbers are calculated by taking the difference within a column from one row to the next row.)

Hours Spent Studying

Total Benefit

Marginal Benefit

Total Cost

Marginal Cost

0

0

--

0

--

1

10

10

0

0

2

16

6

3

3

3

20

4

8

5

4

20

0

15

7

a. If you study in an optimal way, how many more points will you earn on the test? b. Explain how you can find the optimal number of hours by using the marginal benefits and marginal costs columns.

Answer: a. Total benefit minus total cost is maximized at 16 - 3 = 13 when you study for two hours. This difference is lower in all other rows. b. You can arrive at the answer of 2 hours by noticing that the first hour is well worth it since the marginal benefit of 10 is greater than the marginal cost of 0.

The second hour is also worth it since 6 > 3. However, the third hour is not worth it since 4 < 5, thus you will gain fewer points than you will lose. (This sort of ―marginal analysis‖ is a recurrent theme in economics.)

Chapter 2

Economic Methods and Economic Questions Questions 1. What does it mean to say that economists use the scientific method? How do economists distinguish between models that work and those that don‘t?

Answer: The scientific method is the name for the ongoing process that economists and

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other scientists use to develop models of the world, test those models with data, and evaluate how well the models predict behavior. While this process may not reveal the ‗true‘ model of the world, it does help identify models that are useful in understanding the world.

In order to decide whether models make accurate predictions or not, economists test them against real-world data. Data are facts, measurements, or statistics that describe the world. This process of testing models against data is called empiricism.

2. What is meant by empiricism?

Answer: Empirical evidence is a set of facts established by observation and measurement, which are used to evaluate a model. Empiricism refers to the practice of using data to test economic models. When conducting empirical analysis, economists refer to a model‘s predictions as hypotheses. Hypotheses are predictions (typically generated by a model) that can be tested with data.

3. What are two important properties of economic models? Models tend to be simplified descriptions of a real-world phenomenon. Does this mean that they are unrealistic?

Answer: A good economic model has two important properties. First, it is an approximation. The model predicts what would happen on average. Second, it makes predictions that can be falsified by data.

A model is a simplified description, or representation, of reality. Because models are simplified, they are not perfect replicas of reality. However, this does not mean that they are unrealistic. Models are usually simplified in order to be able to isolate the relationship between two variables. Even if a model is based on simplified assumptions, it may still help us make good predictions.

4. Suppose 5,000 people bought popsicles on a hot summer day. If the average number of popsicles that each person bought is 2, how many popsicles were sold that day?

Answer: The mean is calculated as the sum of all the different items divided by the number of items. The average value is the sum of all popsicles sold divided by the number of people who bought them. If each of the 5,000 people bought an average of 2 popsicles, that implies that 10,000 popsicles were sold that day.

5. How does the sample size affect the validity of an empirical argument? When is it acceptable to use only one example to disprove a statement?

Answer: The size of the sample used to test the argument can affect the results. A small sample may mean no conclusions can be drawn from a study. A key strength of economic analysis is the amount of data used. Using a large number of observations strengthens the force of an empirical argument. For example, if you collect information on consumption from 20,000 people as opposed to 20 people, you are likely to get a more representative result. However, a single example can be used to contradict a statement.

6. Explain why correlation does not always imply causation. Does causation always imply positive correlation? Explain your answer.

Answer: Correlation means that there is a relationship between two variables; as one variable changes, another variable changes. Causation occurs when one variable directly affects another through a cause-and-effect relationship. Correlation suggests that there is some kind of connection, but not necessarily a cause and an effect. For example, number of storks in a region might be correlated with the number of babies born in the region.

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But this doesn‘t mean that storks bring babies.

Positive correlation implies that two variables tend to move in the same direction.

However, causation need not only imply positive correlation. For example, sleeping an extra hour per night may improve your energy level at work. However, this positive relationship is swamped by the fact that people who sleep a ton tend to be low energy; thus hours of sleep and energy will be negatively correlated even though there is a positive causal link.

7. Give an example of a pair of variables that have a positive correlation, a pair of variables that have a negative correlation, and a pair of variables that have zero correlation.

Answer: A person‘s IQ and his or her telephone number are likely to show zero correlation. The number of winter coats sold and the average temperature in a region are likely to show a negative correlation. The quantity of fertilizers used and crop yield (e.g., the number of bushels of wheat grown per acre) are likely to have a positive correlation.

8. What is meant by randomization? How does randomization affect the results of an experiment?

Answer: Randomization is the assignment of subjects by chance, rather than by choice, to the effect of a treatment. Assigning participants randomly will ensure that the result of the experiment is not biased. When randomization is employed, correlation does imply causation: How else can a positive correlation be explained? There is no other way (assuming perfect random assignment) except with a causal link between the treatment and the outcome.

9. This chapter discussed natural and randomized experiments. How does a natural experiment differ from a randomized one?

Answer: A natural experiment is an empirical study in which some process – out of the control of the experimenter – has assigned subjects to control and test groups in a random or nearly random way. The process of randomization involves the assignment of subjects by chance, rather than by choice, to a test group or control group.

10. Suppose you had to find the effect of seat belt rules on road accident fatalities. Would you choose to run a randomized experiment or would it make sense to use natural experiments here? Explain.

Answer: It would be difficult (and, in many people‘s view, unethical) to conduct a randomized experiment. Instead, the study should use a natural experiment. You can study data on the causes of road accident fatalities in cities where seat belt rules were not enforced, or in cities that have recently adopted new, more stringent seat belt laws.

Controlling for other factors like an increase in the number of cars, etc., you can then look at similar data when seat belt rules have been implemented.

Problems 1. Although the mean and median are closely related, the difference between the mean and the median is sometimes of interest. a. Suppose country A has five families. Their incomes are $10,000, $20,000,

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$30,000, $40,000, and $50,000. What is the median family income in A? What is the mean income? b. Country B also has five families. Their incomes are $10,000, $20,000, $30,000, $40,000, and $150,000. What is the median family income in B? What is the mean income? c. In which country is income inequality greater, A or B? d. Suppose you thought income inequality in the US had increased over time. Based on your answers to this question, would you expect that the ratio of the mean income in the US to the median income has risen or fallen? Explain.

Answer: a. We can find the mean by summing the observations and dividing by the number of observations. So the mean income in Country A is ($10,000 + $20,000 + $30,000 + $40,000 + $50,000) / 5 = $30,000. The median income is the income of the family in the middle of the income distribution. The median income in Country A is $30,000. Two families have income below $30,000 and two have income above $30,000. b. A similar argument shows that the mean income in Country B is ($10,000 + $20,000 + $30,000 + $40,000 + $150,000) / 5 = $50,000. Median income in B is $30,000; as in Country A, two families have income below $30,000 and two have income above $30,000. c. Income inequality is higher in Country B. The highest income family in Country B earns $150,000, 60% of the total income in that country. The highest income family in A earns $50,000, just 33% of total income in A. We found that the median income in the two countries was the same but the mean income was very different. Means will be heavily influenced by extreme values such as the incomes of the very wealthy; median income is less sensitive to extremes.

Economists sometimes use the ratio of the mean to median income in a country as a rough measure of income inequality; higher values of this ratio reflect greater inequality. d. You should expect to find that the ratio of the mean to median income has risen.

As we argued above, the mean is more sensitive than the median to the incomes of the very wealthy.

2. Consider the following situation: your math professor tells your class (of five students) that the mean score on the final exam is 80 but the median is 100. How is that possible? Explain.

Answer: Typically, when the mean is lower than the median there is a skew in the data: The test scores that were below the median were way below the median. For example, with only five tests, the median may be 100 because three out of five people scored 100.

If the lower scorers received scores of 40 and 60 then the average (i.e. the mean) will be (40+60+100+100+100)/5 = 80.

3. Suppose you come across a study that has discovered a correlation between reading books and life expectancy: People who read more books live longer. Come up with at least one plausible way that this correlation exists even though there is no direct causal link.

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Answer: One possibility is that wealthier individuals can afford to spend more time reading; they also can afford better medical care. Another possibility is that sitting in a quiet place is good for health, and reading just happens to be one way to sit in a quiet place. Also, if you live longer you have more time to read more books (reverse causality), though any reasonable study would account for this effect before drawing conclusions.

4. Some studies have found that people who owned guns were more likely to be killed with a gun. Do you think this study is strong evidence in favor of stricter gun control laws? Explain.

Answer: Not necessarily. It is quite possible that people who thought they were at risk (perhaps because they live in dangerous neighborhoods) were more likely to buy a gun for self-protection. This is an example of a case where correlation may not imply causation. There has been a good deal of research on this question. See, for example, a Harvard School of Public Health 2011 interview with David Hemenway (http://www.hsph.harvard.edu/news/features/review-guns-politics-hemenway).

5. As the text explains, it can sometimes be very difficult to sort out the direction of causality. a. Why might you think more police officers would lead to lower crime rates? Why might you think that higher crime rates would lead to more police officers? b. In 2012, the New England Journal of Medicine published research that showed a strong correlation between the consumption of chocolate in a country and the number of Nobel Prize winners in that country. Do you think countries that want to encourage their citizens to win Nobel Prizes should increase their consumption of chocolate? c. A recent article in the Journal of Applied Physiology found that elderly runners had healthier muscles than a comparison group of the same age. Although the members of the comparison group were all still living independently, they had lower muscle mass and muscle strength than the athletes. The popular press framed the article as proof that exercise causes people to be healthier. Is that the only way to interpret causality in this example?

Answer: a. There is a great deal of evidence that increasing the number of police officers in a neighborhood can drive down crime. The police, for example, will deter criminals who realize the chances they will be caught have gone up and the police may be able to head off conflicts between gangs. Therefore more police could lead to less crime. Cities strategically assign more police to high crime areas (since by definition, those are the areas where crimes are more likely to occur). Therefore, more crime can lead to more police. b. Correlation does not necessarily imply causation. A strong positive correlation between chocolate consumption and Nobel Prize winners does not, by itself, suggest causation. It is possible that this is a chance correlation. It may also be case that certain variables that could explain this relationship have been omitted from the study. c. Another quite likely story that would generate the same correlation between running and muscle mass: Elderly people with enough muscle to go outside for a

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run are more likely to go outside for a run! It is likely some people who lose muscle mass and respond by not running as much; in fact, this almost surely happens. This argument is not definitive proof that the causal link from running to muscle mass is false, but the study is also not definitive proof that the causal link is true.

See the June 11, 2013 New York Times article ―Chicago Tactics Put Major Dent in Killing Trend‖ (http://www.nytimes.com/2013/06/11/us/chicago-homicides-fall-by34-percent-so-far-this-year.html?hp) on the relationship between police and crime rates. See http://www.reuters.com/article/2012/10/10/us-eat-chocolate-win-the-nobelprize-idUSBRE8991MS20121010 on the effects of eating chocolate.

6. The chapter shows that as a general rule people with more education earn higher salaries. Economists have offered two explanations of this relationship. The human capital argument says that high schools and colleges teach people valuable skills and employers are willing to pay higher salaries to attract people with those skills. The signaling argument says that college graduates earn more because a college degree is a signal to employers that a job applicant is diligent, intelligent, and persevering. How might you use data on people with 2, 3, and 4 years of college education to shed light on this controversy?

Answer: If the human capital explanation is correct, then we might expect to find that people who attend college but do not graduate earn salaries that are close to what college graduates earn. Consider the extreme case of people who drop out of college the week before graduation. It is very unlikely that they would have improved their job skills much in that last week. The human capital school of thought would suggest that they should therefore earn roughly the same salaries as college graduates. On the other hand, the signaling school of thought would argue that these people should earn significantly less than college graduates. Employers would interpret their failure to graduate as a signal they are not as diligent or persevering as people who see their college educations through to the end. There is substantial literature on what is often called the ―sheepskin effect‖ (college diplomas used to be written on sheepskin; Notre Dame continued to use sheepskin until 2012). That literature suggests that human capital and signaling both contribute to the returns to education that we observe in the data.

For recent evidence, see the Michael Greenstone and Adam Looney 2013 Brookings Institution study “Is Starting College and Not Finishing Really That Bad?‖ (http://www.brookings.edu/blogs/jobs/posts/2013/06/07-return-to-some-collegegreenstone-looney). They find that people with some college education but who do not graduate from college earn an average of $8,000 more per year than high school graduates who never attend college.

7. You decide to run an experiment. You invite 50 friends to a party. You randomly select 25 friends and tell them that there will be free food; most of them show up to your party. For the other 25 friends you do not mention the free food; none of these friends show up. Based on the correlation in your data, you conclude that free food causes people to come to parties. A buddy points out ―be careful, correlation does not imply causation.‖ How should you respond?

Answer: Assuming you really did choose the two groups randomly, then the correlation does in fact imply causation. If your friend challenges you, ask him ―what else could it be?‖ Given randomization, the relationship is not due to omitted variables, nor is it due to

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reverse causality. (It is possible that due to a small sample you just happened to get a spurious correlation, but this is another matter related to statistical inference, not correlation vs causation.)

8. Oregon expanded its Medicaid coverage in 2008. Roughly 90,000 people applied but the state had funds to cover only an additional 30,000 people (who were randomly chosen from the total applicant pool of 90,000). How could you use the Oregon experience to estimate the impact of increased access to health care on health outcomes?

Answer: The Oregon experience is a natural experiment. The state chose people randomly from the pool of applicants, and so on average the new Medicaid recipients were very similar to the people who applied but were turned down. By tracking the health outcomes of people in these two groups we can study the effect of better access to health care.

See ―Medicaid Access Increases Use of Care, Study Finds,‖ New York Times, May 1, 2013 (http://www.nytimes.com/2013/05/02/business/study-finds-health-care-use-riseswith-expanded-medicaid.html?_r=0).

9. A simple economic model predicts that a fall in the price of bus tickets means that more people will take the bus. However, you observe that some people still do not take the bus even after the price of a ticket fell. a. Is the model incorrect? b. How would you test this model?

Answer: a. The model is not necessarily incorrect. Models are only approximations of reallife behavior. Even very good models make predictions that are often correct. So, on average, more people will take the bus. The model is also likely to have made some assumptions, such as no change in costs of other types of transport, or that people have no specific preferences and cost is the only determinant of the mode of transport used. In reality, some of these assumptions may be violated which could explain why a fall in the price of bus tickets does not induce everyone to take the bus. That does not imply that the model‘s conclusion is incorrect. In situations where the assumptions it makes are satisfied, its prediction will often be correct. b. The hypothesis here states that as bus prices fall, the number of passengers who take the bus will increase. A natural experiment can be used to test this model.

You can use data on price changes and changes in revenues earned from tickets to see whether the model is accurate.

A1.How would you represent the following graphically? a. Income inequality in the U.S. has increased over the past 10 years. b. All the workers in the manufacturing sector in a particular country fit into one (and only one) of the following categories: 31.5 percent are high school dropouts, 63.5 percent have a high school diploma, and the rest have vocational training certificates. c. The median income of a household in Alabama was $43,464 in 2012, and the

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median income of a household in Connecticut was $64,247 in 2012.

Answer: a. Since the graph needs to show how income inequality increases over a period of time, a time-series graph needs to be used here. b. A pie chart is a circular chart split into segments to show the percentages of parts to the whole. Since the given data is in percentages, a pie-chart can be used to represent each category of workers. c. A bar chart would be a good way to compare income in Alabama and Connecticut. The height of each bar would represent the income in each one of the states.

A2.Consider the following data that shows the quantity of coffee produced in Brazil from 2004-2012.

Year

Production (in tons)

2004

2,465,710

2005

2,140,169

2006

2,573,368

2007

2,249,011

2008

2,796,927

2009

2,440,056

2010

2,907,265

2011

2,700,440

2012

3,037,534

a. Plot the data in a time series graph. b. What is the mean quantity of coffee that Brazil produced from 2009 to 2011? c. In percentage terms, how much has the 2012 crop increased over the 2009-2011 mean?

Answer: a. A time-series graph can be used to represent the quantity of coffee produced from 2004 to 2012.

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b. The average quantity of coffee that Brazil produced during the 2009-11 period is 2,682,589 587 tons. This is the sum of the total quantity produced divided by the number of years. c. The coffee crop in 2012 is 14.6% larger than the average coffee crop in 20092011. The increase in production is 3,073,534 – 2,682,589 = 390,945. In percentage terms, the change is 390,945 / 2,682,589 587 = 14.6%.

Data taken from: http://faostat.fao.org/site/567/default.aspx#ancor A3.Suppose the following table shows the relationship between revenue that the Girl Scouts earn and the number of cookie boxes that they sell.

Number of cookie boxes

Revenue ($)

50

200

150

600

250

1,000

350

1,400

450

1,800

550

2,200

a. Present the data in a scatter plot. b. Do the two variables have a positive relationship or do they have a negative relationship? Explain. c. What is the slope of the line that you get in the scatter plot? What does the slope imply about the price of a box of Girl Scout cookies?

Answer: a. The following line chart shows the relationship between the Girl Scouts‘ revenue and the number of cookie boxes that they sell:

b. Since the values of both variables increase together in the same direction, they have a positive relationship. This means that as more cookie boxes are sold, the revenue earned increases.

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c. The slope is constant in this problem and so we can choose any two points to calculate the slope. Suppose we use the first and last data points. The slope is calculated as . The slope implies that one extra box of cookies sold is associated with $4 more in revenue.

Chapter 3

Optimization: Doing the Best You Can Questions 1. What is meant by optimization? Compare and contrast optimization using total value and optimization using marginal analysis.

Answer: Optimization is the process that describes almost all of the choices that people, households, businesses, and governments make. Optimization involves assessing the expected costs and benefits and using them to make the best possible choice. Optimization can be done by looking at total value and comparing which option is largest: A firm might consider several levels of output and choose the one with the highest profit. However, this may not always be feasible, so optimization can also be achieved by simply looking and marginal benefits and marginal costs: A firm should continue to produce so long as marginal revenue is greater than marginal cost.

2. Does the principle of optimization imply that real people always choose the best feasible option?

Answer: Optimization is a good description of almost all human behavior, but this doesn‘t mean that people are always perfect calculators. Our decisions are roughly equal to the choices we would make if we knew all relevant information and how to employ it in complicated optimization calculations. To an economist, optimization is a good approximation of the decisions that people make.

3. Some people choose to live close to the city center; others choose to live away from the city and take a longer commute to work every day. Does picking a location with a longer commute imply a failure to optimize?

Answer: People will choose where to live depending on the costs and benefits of each available alternative. For those who choose to live in an apartment away from the central business district, the net benefit of that apartment must be higher than the net benefit from other apartments. Since costs include the opportunity cost of time and the cost of commuting, the direct and indirect costs vary for different people. This does not mean that they are not optimizing; they have different preferences and face different costs. As a result, they make different decisions.

4. Why does a change in one‘s opportunity cost of time imply a change in one‘s optimal apartment location?

Answer: When the opportunity cost of time is lower there is a lower cost to traveling a

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large distance to get to work and social activities. Thus somebody with a lower opportunity cost of time is likely to care less about where they live, and thus probably live farther from the places that he or she frequently visits. On the flip side, people who value their time greatly are more likely to pay a premium to live close to work.

5. Suppose you had information on the sales of similar homes just east and just west of the boundary between two school districts. How could you use those data to estimate the value parents place on the quality of their children‘s schools?

Answer: Families optimize when they choose homes. Suppose schools on the west side of the school boundary are better than the schools on the east side. Families are willing to buy homes on both sides of the boundary. This means that when families optimize they do just as well buying a home in either school district. Therefore, the prices of homes on the east side have to be just enough lower than the prices on the west side to persuade families to live in either district. A well-known study by Sandra Black relied on this line of argument and found that parents were willing to pay 2.5 percent more for a home if their children could attend schools with 5 percent higher test scores.

See Sandra E. Black ―Do Better Schools Matter? Parental Valuation of Elementary Education,‖ Quarterly Journal of Economics, May 1999.

6. There is a proverb ―anything worth doing is worth doing well.‖ Do you think an economist would agree with this proverb?

Answer: Probably not (unless this economist is one of your parents). An economist is likely to tell you that you should follow the Principle of Optimization at the Margin and that you should do something well only if the marginal benefits of doing it well are at least as large as the marginal costs. Suppose you are thinking of painting your room and you have three options: decide not to paint, paint but do a sloppy job, or paint and be meticulously careful. An economist would tell you to paint your room carefully if the marginal benefit of being careful (i.e., the difference between how your room would look if you are careful and how it would look if you are sloppy) is at least as large as the additional cost of painting carefully. Remember that because of scarcity, we cannot have everything we want. Suppose you get 95% of the benefit from painting your room to perfection while doing a sloppy job. The additional 5% in benefits from striving for perfection may well cost more than it is worth, in terms of alternative uses for your time.

7. Why is marginal analysis helpful for identifying the key aspects of an optimization problem?

Answer: For the sake of simplicity and intuition, economists mostly use optimization in differences, which is called marginal analysis. For example, suppose that two apartments are both near good restaurants, both have good access to public transportation, and both have a laundromat down the street. The two attributes that are different, for instance rent and street noise, are compared while ignoring all the attributes that are the same about the two apartments. When comparing two options, it makes sense to focus on what makes them different. Marginal analysis emphasizes this point, by comparing differences instead of levels.

8. Explain how the market for apartments allocates the scarce supply of apartments

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near the city center.

Answer: The free market for apartments resolves the question of who gets to live in the best apartments. The rental price of apartments provides incentives that effectively allocate economic resources. As the price of downtown apartments rises, only workers with the highest opportunity cost of time will be willing to rent them.

All other workers will prefer to move further away and accept the consequences of a longer commute.

9. Is optimization analysis positive, normative, or both? Explain your answer.

Answer: Optimization is a good positive (that is, descriptive) model of economic behavior in most, though not all, situations. Sometimes people fail to optimize, for example, when they use average net benefit instead of marginal net benefit to make a choice. On the other hand, optimization is always a useful normative model. People will be better off if they are taught to optimize.

Problems 1. Advances in wireless communication technology reduce the non-financial costs of long commutes: People who ride trains can get work done, and people who drive cars have more entertainment options. If this statement is true, explain the effect on the geographic area of cities. Focus on a person who must decide how close to live to the city center.

Answer: These advances in communication technology reduce the cost of commuting: Even though the literal commute time may not change, people waste less of their productive time as they sit on the train or sit in their car. The financial cost may be the same, but the non-financial costs have been reduced. This change makes living far from the city center less costly. Therefore, all else equal, there will be upward pressure on urban sprawl as more people are willing to make long commutes.

2. You are hired as a consultant for a local restaurant. It is considering whether to close at 9:00 p.m., or whether to stay open an extra hour (10:00 p.m.). Based on wages and utility bills, the added cost (the marginal cost) of staying open for each additional hour is $200. a. If the additional revenue (the marginal revenue) during the last hour of operation is $250, what would you recommend? By how much will profit change based on your recommendation? b. What if the additional revenue were only $100? c. What would you need to learn about marginal revenue for you to conclude that 9:00 p.m. is the ideal closing time?

Answers: a. Stay open an extra hour. If the restaurant makes this change then it will increase profit by $50 as it will increase revenue by $250 while only incurring an additional cost of $200.

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b. Close an hour earlier. Not only should the restaurant not stay open later, it should close earlier. It will forego $100 of additional revenue, but also save $200 in additional cost. The net effect will be an increase in profit of $100. c. If marginal revenue is exactly (or at least close to) $200 then 9:00 is probably a good time to close.

3. Determine whether the following statements better describe optimization using total value or optimization using marginal analysis. a. John is attempting to decide on a movie (all movies have the same ticket price).

He determines that the new Batman movie provides him with comparatively more of a benefit than the new Spiderman movie and that both the Batman and Spiderman movies have comparatively more of a benefit than the new Superman movie. b. Marcia finds that the net benefit of flying from Chicago to Honolulu on a nonstop United Airlines flight is $400, and the net benefit for the same trip flying on a one-stop American Airlines flight is $200. c. Nikki decided to jog 3 miles for exercise by reasoning that a 3-mile jog was better than either 2-mile jog ora 4-mile jog. d. At a yard sale, Reagan calculated that she was willing to pay $200 for a queen bed that was being sold for $100 (generating net benefit of $100) and that she was willing to pay $220 for a king bed that was being sold for $300 (generating net benefit of - $80).

Answers: a. As there are only two options this example may fall under either category, though it is closer to optimization by marginal analysis: Notice that John never considered the overall benefit of either move, he just considered the difference in benefits. b. This is an example of optimization using total values. Marcia has a higher net benefit from flying non-stop. c. This is an example of optimization by differences since Nikki probably decided against running a fourth mile because the costs would outweigh the benefits. d. Reagan has evaluated her choices of yard sale beds using the total net benefit from each option. Therefore, this is optimization using total value.

4. You are taking two courses this semester, biology and chemistry. You have quizzes coming up in both classes. The following table shows your grade on each quiz for different numbers of hours spent studying for each quiz. (For the purposes of this problem, assume that each hour of study time can‘t be subdivided.) For instance, the table implies that if you spent 1 hour on chemistry and 2 hours on biology, you would get a 77 on the chemistry quiz and a 74 on the biology quiz.

Hours of Study 0

Chemistry 70

Biology 60

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1

77

68

2

82

74

3

85

78

Your goal is to maximize your average grade on the two quizzes. Use the idea of optimization using marginal analysis to decide how much time you should spend studying for each quiz if you have only 1 hour in total to prepare for the two exams (in other words, you will study 1 hour for one exam and 0 hours for the other exam). How would you allocate that single hour of study time across the two subjects? Now repeat the analysis assuming that you have 2 hours in total to prepare for the two exams. How would you allocate those 2 hours across the two subjects? Finally, repeat the analysis assuming that you have 3 hours in total to prepare for the two exams. How would you allocate those 3 hours across the two subjects?

Answer: If you had just one hour, you should study biology since you would raise your biology grade by 68 – 60 = 8 points; if instead you studied chemistry you would raise your chemistry grade by just 77 – 70 = 7. If you had a second hour, you should study chemistry since you would raise your chemistry grade by 77 – 70 = 7; if instead you studied biology for a second hour you would raise your biology grade by just 74 – 68 = 6. If you had a third hour, you should study biology since you would raise your biology grade by 74 – 68 = 6; if instead you studied chemistry you would raise your chemistry grade by just 82 – 77 = 5.

As a check on your logic, you should see that you would have found the same answers if you had focused on optimization in levels instead of optimization in differences. If you had just one hour to study you would have two choices: 1. Study chemistry for one hour. Average score: (77 + 60) / 2 = 68.5 2. Study biology for one hour. Average score: (70 + 68) / 2 = 69.0 If you had two hours to study you would have three choices: 1. Study chemistry for two hours. Average score: (82 + 60) / 2 = 71.0 2. Study chemistry for one hour, study biology for one hour. Average score: (77 + 68) / 2 = 72.5 3. Study biology for two hours. Average score: (70 + 74) / 2 = 72.0 If you had three hours to study, you would have four choices: 1. Study chemistry for three hours. Average score: (85 + 60) / 2 = 72.5 2. Study chemistry for two hours, study biology for one hour. Average score: (82 + 68) / 2 = 75.0 3. Study chemistry for one hour, study biology for two hours. Average score: (77 + 74) / 2 = 75.5 4. Study biology for three hours. Average score: (70 + 78) / 2 = 74.0 5. Your total benefits from consuming different quantities of gasoline each week are shown in the table below:

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Gallons per Week

Total Benefit

Marginal Benefit

0

0

--

1

8

2

15

3

21

4

26

5

30

6

33

7

35

8

36 a. Complete the marginal benefit column.

b. Gasoline currently costs $4 per gallon. Use the Principle of Optimization at the Margin to find your optimal number of gallons of gas to consume each week. c. Some people have suggested a tax of $2 per gallon of gas as a way to reduce global warming (burning fossil fuels such as gas releases greenhouse gases which are a major cause of rising temperatures). Suppose the price of gas rises to $6 per gallon. Use the Principle of Optimization at the Margin to find your optimal number of gallons of gas given this new tax on gas.

Answer: a. The marginal benefit from consuming different quantities of gas each week are shown in the table below: Gallons per Week

Total Benefit

Marginal Benefit

0

0

--

1

8

8

2

15

7

3

21

6

4

26

5

5

30

4

6

33

3

7

35

2

8

36

1

b. The price per gallon of gasoline is the same as the marginal cost per gallon for the consumer. When the price is $4, the marginal benefit from an extra gallon is equal to the marginal cost when 5 gallons are consumed. This is the optimal quantity of gasoline that should be consumed each week.

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c. When the marginal cost or price of gasoline increases to $6, only 3 gallons should be consumed each week. At 3 gallons, the marginal cost equals the marginal benefit from an extra gallon of gasoline.

6. Scott loves to go to baseball games, especially home games of the Cincinnati Reds. All else equal, he likes to sit close to the field. He also likes to get to the stadium early to watch batting practice. The closer he parks to the stadium the more batting practice he is able to watch (the garages all open simultaneously).

Find Scott‘s optimal seat type and parking garage using the information that follows.

Location/Seat

Price

Scott’s Value of View

Diamond Seats

$235

$200

Club Home

$95

$130

Club Seating

$85

$128

Scout Box

$79

$120

Scout

$69

$100

Parking location

Parking Fee (game night)

Missed Batting Practice

Benefit of Arrival Time

Westin parking garage

$5

60 min

$0

Fountain Square South Garage

$10

50 min

$10

West river parking

$17

25 min

$35

East river parking

$25

10 min

$50

Under Stadium parking

$45

0

$60

Answer: Seat location: Scott will choose the Club Seating seats priced at $85 because this will maximize his value from closer view. The marginal cost of the Club Home seat is $10 but his marginal benefit is just $2, so he loses $8 by upgrading to Club Home seating. By buying Club Seating this seat location, his total benefit rises by $10, so he should stop at this point.

Parking location and arrival time for batting practice: This decision on where to park influences Scott‘s arrival time to see batting practice. Seeing the parking location chart, we note that the closer to the ballpark, the higher the parking fee. We also see that the closer the location of parking, the fewer minutes of batting practice are missed, which increases Scott‘s benefit. The marginal benefit of parking closer to the stadium is greater than the marginal cost of parking closer for the Fountain Square South Garage, West River Parking, and East River Parking. The marginal cost of under stadium parking is $45 - $25 = $20 and the marginal benefit is $60 - $50 = $10.

Since the marginal cost of under stadium parking is greater than the marginal benefit Scott should choose East River Parking.

Location/Seat

Price

Scott’s marginal cost of moving to

Scott’s value of closer view

Scott’s marginal benefit of closer

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the next seat

view

Diamond seats

$235

$140

$200

$70

Club Home

$95

$10

$130

$2

Club Seating

$85

$6

$128

$8

Scout Box

$79

$10

$120

$20

Scout

$69

X

$100

X

Parking fee (game night)

Marginal cost of parking

Missed batting practice

Benefit of arrival time

Marginal benefit of arrival time

$5

X

60 min

$0

X

Fountain Square South Garage

$10

$5

50 min

$10

$10

West river parking

$17

$7

25 min

$35

$25

East river parking

$25

$8

10 min

$50

$15

Under Stadium parking

$45

$20

0

$60

$10

Parking location Westin parking garage

7. Suppose the total benefit and total cost to society of various levels of pollution reduction are as follows: (1) Pollution Reduction

(2) Total Benefit

(3) Total Cost

0

0

0

1

20

9

2

38

20

3

54

33

4

68

48

5

80

65

6

90

84

(4) Total Net Benefit

(5) Marginal Benefit

(6) Marginal Cost

--

--

a. Complete Column (4). b. Use optimization in levels to show that if the US Environmental Protection Agency (EPA) wants to maximize total net benefit, then it should require 3 units of pollution reduction. c. Complete columns (5) and (6). d. Show that the Principle of Optimization at the Margin would also tell the EPA to require 3 units of reduction.

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Answers: a.

(1) Pollution Reduction

(2) Total Benefit

(3) Total Cost

(4) Total Net Benefit

0

0

0

0

1

20

9

11

2

38

20

18

3

54

33

21

4

68

48

20

5

80

65

15

6

90

84

6

(5) Marginal Benefit

(6) Marginal Cost

b. The highest value of Total Net Benefit in column (4) is 21. EPA achieves Total Net Benefit of 21 by requiring 3 units of pollution reduction. c. The table below shows the marginal benefits and costs from various levels of pollution reduction.

(1) Pollution Reduction

(2) Total Benefit

(3) Total Cost

(4) Total Net Benefit

(5) Marginal Benefit

(6) Marginal Cost

0

0

0

0

--

--

1

20

9

11

20

9

2

38

20

18

18

11

3

54

33

21

16

13

4

68

48

20

14

15

5

80

65

15

12

17

6

90

84

6

10

19

d. The Principle of Optimization at the Margin tells us that EPA should continue to increase reduction as long as the marginal benefit from reduction is greater than the marginal cost of reduction. The rule therefore implies that EPA should require firms to reduce the 3rd unit of pollution (because the marginal benefit is 16 and marginal cost is 13) but not the 4th.

8. It is possible to use equations to do marginal analysis. Suppose your firm has a marginal revenue given by MR = 10 - Q. This means that the seventh unit of output brings in 10 - 7 = $3 of additional revenue. The marginal cost for your firm is MC = 2 + Q. This means that the seventh unit of output increases cost by 2 + 7 = $9. a. Is it a good idea to produce the seventh unit of output? Why or why not? b. Find the Q that sets marginal cost equal to marginal revenue (MC=MR).

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As a preview of upcoming chapters, try to explain why this value maximizes profit.

Answers: a. At Q = 7 the marginal revenue is 10 - 7 = $3; the marginal cost is 2 + 7 = $10. Thus producing a 7th unit is a terrible idea as the additional cost is much greater than the additional benefit (revenue). b. 10 - Q = 2 + Q implies 8 = 2*Q, thus Q = 4. At Q = 4 profits will be maximized as marginal revenue equals marginal cost. At lower output levels, MR will exceed MR. For instance, at Q = 3, MR = 10 – Q = 7 and MC = 2 + Q = 5, so because MR > MC the firm definitely wants to produce the 3rd unit, and probably the 4th unit. At higher out levels, MR will be lower than MC. For example, at Q = 5, MR = 10 – 5 = 5, while MC = 2 + 5 = 7, so the first does not want to produce a 5th unit.

Chapter 4

Demand, Supply, and Equilibrium Questions 1. What is meant by holding all else equal? How is this concept used when discussing movements along the demand curve? How is this concept used when discussing movements along the supply curve?

Answer: Holding all else equal means that everything other than the variable in question is assumed to remain constant. When we move along a demand curve we are assuming that all of the determinants of the demand for a good other than the price of the good (e.g., income, the prices of other goods) remain constant. When we move along a supply curve we are assuming that all of the determinants of the supply of a good other than the price of the good (e.g., wage rates, the price of raw material, technology) remain constant.

2. What is meant by diminishing marginal benefits? Are you likely to experience diminishing marginal benefits for goods that you like a lot? Are there exceptions to the general rule of diminishing marginal benefits? (Hint: think about batteries that you would use in a flashlight that requires two batteries.) Explain your answer.

Answer: Diminishing marginal benefit from a good suggests that the willingness to pay for an additional unit declines as more is consumed. You are likely to experience diminishing marginal benefit even from goods that you like a lot, although you will probably consume more of those goods before diminishing marginal benefits sets in. The first ice cream is delicious. The second is still very tasty but not quite as good as the first.

The third might make you sick to your stomach.

Yes, there could be exceptions to the rule of diminishing marginal returns. If a flashlight does not function without both batteries, you would experience increasing marginal benefits; the first battery is useless but the second makes the flashlight work.

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3. How is the market demand schedule derived from individual demand schedules? How does the market demand curve differ from an individual demand curve?

Answer: We would derive the market demand schedule by summing the individual demands at every possible price. So, for example, if Consumer 1 would buy 6 units of a good when the price is $5 and Consumer 2 would buy 4 units, then the market demand at $5 is 10 units.

The market demand curve is the sum of the individual demand curves of all the potential buyers. The market demand curve plots the relationship between the total quantity demanded and the market price, holding all else equal.

4. Explain how the following factors will shift the demand curve for Gillette shaving cream. a. The price of a competitor‘s shaving cream increases. b. With an increase in unemployment, the average level of income in the economy falls. c. Shaving gels and foams, marketed as being better than shaving creams, are introduced in the market.

Answer: a. Since Gillette and other shaving creams are substitutes, an increase in the price of a competitor‘s shaving cream should lead to an increase in the demand for Gillette shaving cream. This means that the demand curve for Gillette shaving cream will shift to the right. b. With a fall in the average income level, the demand for shaving cream is likely to fall. The demand curve for Gillette shaving cream will shift to the left. c. Shaving gels and foams would be considered substitutes for shaving cream. The demand curve for Gillette shaving cream will shift to the left.

5. What does it mean to say that we are running out of ―cheap oil‖? What does this imply for the price of oil in the future?

Answer: To say that we are running out of ―cheap oil‖ means that much of the oil that is needed to meet the demand for oil in the future is relatively expensive to find and extract.

This suggests that the price of oil will increase in the future. There is an enormous amount of oil under the surface of the earth, but for firms to profitably drill for oil, the price of oil needs to be high enough to pay for the costs of drilling.

6. What does the Law of Supply state? What is the key feature of a typical supply curve?

Answer: The law of supply states that in most cases, the quantity supplied of a good rises when the price of the good rises. A typical supply curve is upward sloping which shows the positive relationship between price and quantity supplied.

7. What is the difference between willingness to accept and willingness to pay? For a trade to take place, does the willingness to accept have to be lower, higher, or equal to the willingness to pay?

Answer: Willingness to accept is the lowest price that a seller is willing to receive to sell an extra unit of a good, while willingness to pay is the highest price that a buyer is

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willing to pay for an extra unit of a good. For a trade to take place, the buyer‘s willingness to pay must be greater than or equal to the seller‘s willingness to accept.

8. Explain how the following factors will shift the supply curve for sparkling wine: a. New irrigation technology improves the average yield of a vineyard. b. Following an increase in the immigration of unskilled labor, the wages of winegrape pickers fall. c. The government sets a minimum wage for seasonal employment.

Answer: a. With an increase in yield, the supply curve of grapes used to make sparkling wine will shift to the right. The price of grapes will fall. Since the price of an input falls, the supply curve for sparkling wine will shift to the right. b. A fall in the wages of wine-grape pickers implies that the cost of producing sparkling wine has decreased. The supply curve for sparkling wine will shift to the right. c. A minimum wage is likely to be higher than the equilibrium wage. Since winegrape picking is a seasonal occupation, the wage paid to a wine-grape picker is likely to increase. This will shift the supply curve to the left.

9. How do the following affect the equilibrium price in a market? a. A leftward shift in demand b. A rightward shift in supply c. A large rightward shift in demand and a small rightward shift in supply d. A large leftward shift in supply and a small leftward shift in demand Answers: a. Everything else remaining unchanged, a leftward shift in demand will lower the equilibrium price in the market. b. Everything else remaining unchanged, a rightward shift in supply will lower the equilibrium price in the market. c. Both the demand and supply curves will shift to the right but the shift in the demand curve will be greater. This means that that equilibrium price is likely to increase. d. Both the demand and supply curves will shift to the left but the shift in the supply curve is greater than the shift in the demand curve. This means that the equilibrium price is likely to increase.

10. Why was a fixed price of $50 not the best way of allocating used laptops? Suggest other possible ways of distributing the laptops that would be efficient.

Answer: At the price of $50, the quantity of laptops demanded far exceeded the quantity supplied. This excess demand led to long queues and a stampede at the Richmond International Raceway. One of the other ways of allocating the laptops would have been to use flexible prices. Those who valued the laptops the most would have paid the most for them. An auction would have raised revenue and allocated the laptops better than a

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fixed price. Henrico County could also have used a random lottery to allocate the used laptops. Those who got the laptops through the lottery could have then sold it to anyone who valued them more than they did. The lottery would not, however, lead to an efficient outcome if people who won the lottery were not allowed to sell the laptops.

Problems 1. Suppose the following table shows the quantity of laundry detergent that is demanded and supplied at various prices in Country 1.

P ($)

Quantity Demanded (million oz.)

Quantity Supplied (million oz.)

2

65

35

4

60

40

6

55

45

8

50

50

10

45

55

12

40

60

14

35

65

a. Use the data in the table to draw the demand and supply curves in the market for laundry detergent. b. What is the equilibrium price and quantity in the market? c. The following tables give the demand and supply schedules for two of its neighboring countries, Country 2 and Country 3. Suppose these three countries decide to form an economic union and integrate their markets. Use the data in the table to plot the market demand and supply curves in the newly formed economic union. What is the equilibrium price and quantity in the market?

Country 2: P ($)

2

Quantity Demanded (million oz.)

35

Quantity Supplied (million oz.)

5

4

30

10

6

25

15

8

20

20

10

15

25

12

10

30

14

5

35

Country 3:

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P ($)

Quantity Demanded (million oz.)

Quantity Supplied (million oz.)

2

40

10

4

35

15

6

30

20

8

25

25

10

20

30

12

15

35

14

10

40

Answers: a. The following figure shows the domestic market for laundry detergent: b. The and the oz.

equilibrium price in the market is $8 equilibrium quantity is 50,000,000

c. If the the supply arrive at

three countries decide to integrate, individual country demand and curves need to be aggregated to the demand and supply curves in the economic union. The following shows the demand (DM) and supply curves in the economic union:

figure (SM)

As can be seen in the figure, the equilibrium price remains $8 while the total quantity sold is equal to 95 million oz.

2. Demand for books is given by the following table.

Price ($)

Quantity of books demanded

0

1000

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20

600

40

200

60

0

a. Plot each point on a well-labeled diagram, with quantity on the x-axis and price on the y-axis. b. Assume that the demand curve is linear between each of the points in the demand schedule above. Using this assumption, connect the dots with straight lines. What is the quantity demanded when the price is $10? c. Assume the Law of Demand is true. Also assume the information provided by the demand schedule is correct. However, make no other assumptions. In particular, you should no longer assume that the demand curve is linear between the points in the demand schedule. What can you say about the quantity demanded when the price is $25?

Answers:

a. See graph. b. When you connect the dots with a straight line between each dot you are assuming that there is a linear relationship between price and quantity. (In this example, however, the relationship is not linear everywhere since no single straight line includes all four points.) Since $10 is halfway between $0 and $20, we assume that quantity will be halfway between 1000 and 600, which is 800. c. A price of $25 falls between $20 and $40. The quantity demanded cannot be more than 600, nor can it be less than 200. However, any value between 200 and 600 is consistent with the Law of Demand.

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3. Explain how simultaneous shifts in demand and supply curves could explain these situations: a. The price of insulin injection kits, used by diabetic patients, increases from $45 to $52, but the equilibrium quantity remains the same. b. A pest attack on the tomato crop increases the cost of producing ketchup. A mild winter causes cattle herds to be unusually large, causing the price of hamburgers to fall. The equilibrium quantity of ketchup is unchanged.

Answers: a. A leftward shift in the supply of insulin and a rightward shift in the demand for insulin would raise the equilibrium price of insulin but could leave the equilibrium quantity unchanged. The shift in supply and the shift in demand would both raise the equilibrium price. The shift in demand would lead to an increase in the equilibrium quantity and the shift in supply would lead to a decrease in equilibrium quantity. It is therefore possible that the equilibrium quantity would remain unchanged. A more likely explanation, however, is that the demand for insulin is perfectly inelastic but supply has shifted to the left and demand has remained unchanged. b. The increase in the cost of producing ketchup would shift the supply curve to the left. Hamburgers and ketchup are complements. The decrease in the price of hamburgers would therefore shift the demand for ketchup to the right. The shift in demand would lead to an increase in the equilibrium quantity and the shift in supply would lead to a decrease in equilibrium quantity. It is therefore possible that the equilibrium quantity would remain unchanged.

4. Sketch generic supply and demand curves for the housing market and label the equilibrium price and quantity. a. A booming economy increases the demand for housing. Show the shift in the demand curve on your graph. What does this do to the price and quantity in the market? b. You and a friend both notice that more houses are built in response to this change.

Your friend says, ―this is a sign that the supply curve is shifting as well.‖ You respond, ―no, this is actually just a shift along the supply curve.‖ To help your friend understand, demonstrate what you mean on your graph. c. As it turns out, there actually is a shift in the supply curve due to an unrelated breakthrough in construction that lowers the cost of building houses. In what direction does the supply curve shift? Show this on your graph. d. Relative to the original price and quantity, what is the overall effect of both shifts on price and quantity?

Answers: a. The price increases and the quantity increases. See first diagram. b. See the two red arrows on the supply curve; this represents a shift along the supply curve, which is different from a shift of the supply curve. c. A reduction in cost lowers the supply curve vertically, which is the same as a shift to the right, or an increase in the supply. See second diagram below.

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d. Quantity increases unambiguously. The overall effect on price is ambiguous as it depends on the size of the supply shift relative to the demand shift. As drawn, there is a slight increase in price, but with a slightly larger supply shift, price could remain the same or be even lower.

5. Brazil is the world‘s largest coffee producer. There was a severe drought in Brazil in 2013-14 that damaged Brazil‘s coffee crop. The price of coffee beans doubled during the first three months of 2014. a. Draw and discuss a supply and demand diagram to explain the increase in coffee prices. b. Are coffee and tea substitutes or complements? Explain. c. What do you think the impact of this drought has been on the equilibrium price and quantity of tea? Draw a supply and demand diagram for the tea market to explain your answer.

Answers: a. The drought will cause the supply curve to shift to the left from S to S′. As a result the equilibrium price of coffee rises from P1 to P2.

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b. For many people, coffee and tea are substitutes; they are different ways to take in caffeine. An increase in the price of coffee will therefore lead to an increase in the demand for tea. c. Since coffee and tea are substitutes, the increase in the price of coffee leads to an increase in the demand for tea. As a consequence the price of tea rises from P3 to P4 and the equilibrium quantity of tea rises from Q3 to Q4.

6. There is a sharp freeze in Florida that damages the orange harvest and as a result, the price of oranges rises. Will the equilibrium price of orange juice rise, fall, or remain constant? Will the equilibrium quantity of orange juice rise, fall, or remain constant?

Present a supply and demand curve diagram to defend your answers.

Answer: The freeze raises the price of oranges, one of the major inputs in the production of orange juice. As a result, the supply curve shifts to the left from S to S′. As a consequence the equilibrium price rises from P1 to P2 and the equilibrium quantity falls from Q1 to Q2.

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7.

For each of the following situations, sketch the demand curve as accurately as possible. a. Appendectomy is a life-saving operation that some people need. Regardless of the price, the quantity demand is 300,000 every year. b. For any price above $5 absolutely nobody will buy your lemonade, but for any price below $5 you find that you are able to sell as much lemonade as you like. c. There is only one buyer. For any price above $100 this buyer wants nothing. For any price at or below $100 this buyer wants exactly 20 units.

Answers: a. A vertical (―perfectly inelastic‖) demand curve. b. A horizontal (―perfectly elastic‖) demand curve. Note that above $5 the quantity demanded is zero (drawn explicitly in the graph, but often only implied in other graphs). c. This is a step ―function‖ that jumps at the price of $100. At a price of exactly $100 the buyer is willing to buy any number of units, so it is actually preferable -not just permissible -- to fill in this region with a horizontal line. (Also, technically speaking, the demand is not a ―function‖ in the mathematical sense because the price of $5 maps into multiple quantities demanded.)

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8. Land in Sonoma, California, can be used to either grow grapes for pinot noir wine or to grow Gravenstein apples. The demand for pinot noir shifts suddenly and sharply to the right. What will be the effect of the increase in demand for pinot noir on the equilibrium price and quantity of Gravenstein apples?

Answer: The increase in the demand for pinot noir increases the demand for land in

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Sonoma, which increases the equilibrium price of land in Sonoma. The increase in the price of land leads to a decrease in the supply of Gravenstein apples. As a result, the equilibrium price of Gravensteins rises and the equilibrium quantity falls. In the diagram below, the price of Gravenstein apples rises from P1 to P2 and the equilibrium quantity falls from Q1 to Q2.

See http://www.nytimes.com/2011/09/02/us/02apples.html 9. Suppose one of your friends offered the following argument: A rightward shift in demand will cause an increase in price. The increase in price will cause a rightward shift of the supply curve, which will lead to an offsetting decrease in price. Therefore, it is impossible to tell what effect an increase in demand will have on price. Do you agree with your friend? If not, what is the flaw in your friend‘s reasoning?

Answer: The given argument is flawed because it claims that an ―increase in price will cause a shift of the supply curve...‖ The increase in price will cause a movement along the supply curve and not movement of the curve.

10. New York decides to reduce the consumption of sugary soda by imposing a minimum price of $2.50 per soda. The current equilibrium price is $1.50. Sketch the supply and demand for soda and show the effect of this policy. Clearly label the excess supply in your diagram.

Answer:

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11. Lobsters are plentiful and easy to catch in August but scarce and difficult to catch in November. In addition, vacationers shift the demand for lobsters further to the right in August than in any other month. Compare the equilibrium price and quantity of lobsters in August to the equilibrium price and quantity of lobsters in November.

Present and discuss a supply-and-demand diagram to explain your answers.

Answer: The August demand and supply curves are DA and SA and therefore the August equilibrium price and quantity are PA and QA. As we move to November, the demand curve shifts to the left to DN and the supply curve shifts to the left to SN. The decrease in demand and decrease in supply both decrease the equilibrium quantity and therefore the November quantity QN is definitely less than QA. The decrease in demand decreases the equilibrium price but the decrease in supply increases the equilibrium price. Therefore, in general, we cannot know if the November price PN is less than, equal to, or greater than PA. In the diagram above, PN is less than PA but if the decrease in demand were small relative to the increase in supply we would have found that PN is greater than PA.

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12. As part of U.S. sugar policy (in 2013), the government offered to buy raw sugar from domestic sugarcane mills at an average price of 18.75 cents per pound. The government offer was made for as much raw sugar as sugar mills produced. Any raw sugar purchased by the government was not sold in the domestic market, as this might have caused raw sugar prices to fall. The price of 18.75 cents per pound was above the equilibrium price. a. Under this policy, what do you think the government‘s demand curve for sugar looks like? b. What impact does this policy likely have on domestic sugar prices?

Answers: a. Since the government is willing to buy any quantity of raw sugar at the 18.75 cents per pound, the demand curve is horizontal at that price. The government‘s demand curve is shown in the following figure:

b. Since the government guarantees that mills will get 18.75 cents per pound of raw sugar, they do not have an incentive to sell sugar to any buyer who offers less than that price. In effect, the government is raising the price of raw sugar to 18.75 cents per pounds. Also note that when the price falls below 18.75 cents, the millers sell the sugar to the government. Since the government does not re-sell this sugar in the open market, the domestic market price is very likely to increase.

See http://www.npr.org/2013/03/28/175569499/farm-bills-sugar-subsidy-moretaxing-than-sweet-critics-say

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13. Suppose demand in a market is described by the equation QD = 6 - P. a. Sketch demand. b. Write out the demand schedule for each integer price up to $6: ($0, $1, $2, . . . , $6).

Answers: a. See below. The demand is shown to the right. Here are some tips for graphing this: (i) Given there is a linear equation; the graph will be a straight line. (ii) Given it is demand (and thus there is a negative sign in front of the P), it will be downwards sloping. (ii) P=0 implies Q=6, thus the horizontal (quantity-) intercept will be 6 (as labeled). (iv) When Q=0, P must be 6, thus the vertical (price-) intercept is $6.

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b. Plug in the price to get the quantity. Also, implicit is the idea that for any price higher than $6, the quantity demanded is 0, not negative.

Price (P)

Quantity (Q)

$0

6

$1

5

$2

4

$3

3

$4

2

$5

1

$6

0

14. Note: This problem requires some basic algebra. The demand for computers is QD = 15 – 2P, where P is the price of computers. Initially, the supply of computers is QS = P. a. Find the original equilibrium price and quantity. b. Suppose the prices of memory chips and motherboards (two important components in computers) rise and as a consequence, the supply curve for computers becomes QS = -3 + P. Find new equilibrium price and quantity.

Answers: a. Equilibrium requires that demand equals supply and therefore in equilibrium, 15 – 2P = P. If we solve for P, we find that the equilibrium price is $5. If we then substitute P = $5 into either the supply or demand equation, we find that the equilibrium quantity is 5 units. b. Equilibrium now requires 15 – 2P = -3 + P. The new equilibrium price is therefore $6 and the new equilibrium quantity is 3 units.

Chapter 5

The Wealth of Nations: Defining and Measuring Macroeconomic Aggregates

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Questions 1. Find and list three recent stories in the media that would typically be studied in macroeconomics. (Cite the date and source of the stories you choose.) Discuss why they would fall within the subject matter of macroeconomics.

Answer: Solutions may vary.

2. How is gross domestic product defined?

Answer: Gross domestic product is defined as the market value of the final goods and services produced within the borders of a country during a particular period.

3. What is an accounting identity? Explain the accounting identity Production = Expenditure = Income.

Answer: Variables are related by an accounting identity when they are defined in a way that makes them mathematically identical. The circular flow diagram demonstrates that total production in the economy in a given year, total expenditure on goods and services over the year, and the total income received by all factors of production, will always be equal. Hence, GDP can be measured by any of the three.

4. Use the circular flow diagram to show how expenditure, production, and income relate to one another.

Answer: The concept of the circular flow between households and firms highlights the four kinds of flows that connect households and firms—production, factors of production, expenditure, and income.

Households provide the factors of production that firms need—labor and capital. In turn, firms supply households with goods and services.

These flows of goods and services are balanced by reverse flows of payments. Firms make factor payments to households for their labor and capital, which constitutes households‘ incomes. The households use this income to make payments for the goods and services purchased from the firms, which constitutes aggregate expenditure on goods and services. Therefore, the value of production is equal to the value of expenditure, which is equal to the value of income. This means that GDP estimated using the income-based accounting approach will be equal to the estimate calculated using the expenditure-based accounting approach, which will also be equal to the estimate of GDP calculated using the production-based accounting approach.

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5. How is production-based accounting used to estimate GDP? Discuss the role of value-added.

Answer: Production-based accounting sums up the value that is added by each domestic firm in the production process. From the total revenue earned by a firm from the sale of a good, all of the productive activity of other firms in the supply chain is deducted to arrive at the value added by the firm.

6. How is GDP calculated using expenditure-based accounting?

Answer: Expenditure-based accounting tracks the purchases of the goods and services produced in the economy. These purchases come in three key categories: goods and services that are bought by households (C); investment goods that are bought by households and firms (I); goods and services that are purchased by the government (G); and the expenditure of foreign agents on exports minus the value of domestic expenditure on imported goods (X – M). GDP can be calculated as the sum of these components: Y = C + I + G + (X – M).

7. Which category of expenditure accounts for the highest share of GDP in the United States?

Answer: Consumption expenditure has consistently represented about two thirds of economic activity. In 2013, consumption represented 68.5 percent of U.S. GDP. 8. How is the level of economic activity calculated using the income method?

Answer: The income-based accounting system calculates the aggregate level of economic activity in an economy by measuring the income generated as a result of such activity.

Income payments come in two key categories: labor income and capital income. Labor income includes wages, salary, workers‘ health insurance, and workers‘ retirement benefits. It also includes every other way that people are explicitly or implicitly paid for their labor. Capital income includes dividends paid to shareholders, interest paid to lenders, earnings retained by corporations, rent payments made to landlords, and the benefits of living in one‘s own house.

9. If the level of aggregate expenditure was $16.8 trillion in 2013, what was the level of aggregate income? Explain your answer Answer: The level of aggregate income in the economy will also be equal to $16.8 trillion. In an economy, production = expenditure = income. Because this is an accounting identity, aggregate expenditure in the economy will be equal to aggregate income.

10. What is meant by capital depreciation?

Answer: Capital depreciation refers to the loss in value of capital over time due to wear and tear on capital equipment and structures.

11. Explain three important factors that GDP leaves out.

Answer: GDP does not account for capital depreciation, which is the loss in the value of capital over time as it gets used. It also excludes the value of home production. Activities like cooking your own meals, doing your laundry, or cleaning your house are not accounted for. Economic transactions that take place in the black market are also

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excluded from GDP estimates. Negative externalities, such as pollution, are not accounted for. The value of leisure is also not included in the estimates of a country‘s national income, although leisure is a key ingredient in human well-being.

12. You decide to cook your own meal rather than eat in a restaurant. How will this affect GDP? Answer: GDP does not include home production because there is no market transaction, market price, or measurable quantity that accompanies home production. Therefore, if you cook your own meal rather than eating in a restaurant, it will not be included in GDP. GDP would thus be lower than if you ate in a restaurant.

13. When would a country‘s gross domestic product exceed its gross national product?

Answer: Although gross domestic product includes the market value of everything produced within the borders of a country, gross national product includes the market value of production generated by the factors of production possessed or owned by the residents of a particular nation.

Domestic Gross National Product (GNP) = GDP + production of domestic country-owned capital/labor within the borders of foreign countries – production of foreign country-owned capital/labor within the domestic country‘s borders.

GDP is likely to exceed GNP when production by domestic factors within the borders of foreign countries is lower than production by foreign factors within domestic borders.

14. Nobel laureate Simon Kuznets, who did significant work on national income accounts in the 1930s, said that the welfare of a nation can scarcely be inferred from a measurement of national income. Would you agree with him? Why or why not?

Answer: GDP is a summary figure of the level of economic activity in the economy, but per capita GDP is often used as a proxy for determining the well-being of a society. This is because per capita GDP shows a strong positive correlation with life satisfaction; countries with higher levels of per capita GDP report higher levels of life satisfaction.

The same relationship also shows up within each country. In other words, low-income households report substantially lower life satisfaction than high-income households.

15. Why is it essential to differentiate between real and nominal growth rates of GDP? Answer: It is essential to differentiate between real and nominal growth rates of GDP in order to understand whether output has actually grown from one year to the next. An increase in the nominal value of GDP could have been due to an increase in prices rather than an increase in output. The growth rate of real GDP, however, shows the increase in the actual quantity of goods and services produced.

16. What are the key differences between the Consumer Price Index (CPI) and the GDP deflator?

Answer: The main difference between the CPI and the GDP deflator is the basket of goods that each formula considers. The GDP deflator is based on a country‘s total GDP, the basket of goods that is produced domestically. In other words, the GDP deflator

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utilizes the basket of goods that represents the total output of the domestic economy.

Therefore, it includes many goods not ordinarily purchased by consumers. In contrast, the CPI is based on the basket of goods and services that an ―average‖ consumer typically buys. This basket is constructed to reflect the types and quantities of goods that are purchased by a typical household.

As a result, the CPI includes items that are purchased by households—like imported goods—that are not included in GDP. And because they are not included in GDP, their prices are not reflected in the GDP deflator.

Another difference involves the weighting of goods in the two indices. Housing, for example, represents a major portion of a typical household‘s budget; hence, it has a high weighting in the calculation of the CPI. However, it has a much smaller weighting in the calculation of the deflator.

A final difference is that the CPI is announced monthly, whereas the GDP deflator is only released quarterly. Hence, the CPI is more timely.

17. How is the Consumer Price Index similar to the GDP Deflator?

Answer: Both the CPI and the GDP deflator use current prices in the numerator and baseyear prices in the denominator. The formulas for the CPI and the GDP deflator both contain a ratio that compares what it would cost to buy goods in the current year (in the numerator) to what it would have cost to buy the same goods using base-year prices (in the denominator). Both formulas also have the same interpretation: A higher ratio implies a greater price increase from the base-year to the current year.

Problems 1. Which of the following would be considered a final good in the calculation of U.S. GDP? Explain your answers. a. Processors manufactured in California for Apple‘s new range of laptops (that will be sold in the United States) b. Foot massages at spas in California c. Predator drones purchased by the federal government Answer: a. In this case, Apple‘s new range of U.S. laptops will be included as a final good in the calculation of GDP. The value of the processors would not be included in GDP estimates because they are an input used in the production of a final good. b. Foot massages at spas are an example of a final good and so would be included in GDP estimates. c. Predator drones purchased by the federal government will be counted as a final good as the government purchases them for its own use.

2. By how much would GDP change as a result of each of the following changes?

Briefly explain your answers.

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a. A parent switches from buying pre-made ham and cheese sandwiches for a family dinner, which would have cost $20, to buying the raw ingredients, which cost only $6, and making the same ham and cheese sandwiches at home. b. On the rebound again, a famous rock star marries her butler, whom she formerly paid $50,000 a year. After they are married, her husband continues to wait on her as before, and she continues to support him as before—but as a husband rather than as an employee, that is, not with a regular salary. c. Tired of biking to work every day, the millennial decides to start using Uber three times a week; each one-way ride costs her 8.50.

Answer: a. The purchase of pre-made sandwiches for $20 added $20 to GDP. Now that the parent buys the ingredients for $6 and makes the sandwiches at home, the addition to GDP is only $6. This is because services provided within the household (in this problem, making sandwiches) are not included in the calculation of GDP. Hence, the switch from pre-made to homemade sandwiches would reduce GDP by $14. b. In this case, a transaction that formerly took place in the market becomes a nonmarket transaction. Hence, GDP in the year they were married would go down by $50,000; it would be $50,000 lower than it otherwise would have been. Work that is done in the home by family members, which is not compensated through the market, is not counted as part of GDP. c.

This example demonstrates a shift from a non-market transaction to a market transaction. Each day the millennial uses Uber, she now spends $17 (two one-way rides) when before she spent nothing; in a year, then, this switch increases GDP by approximately $2,652 ($17 * 3 days/week * 52 weeks/year).

3. In order to generate estimates of GDP, the Bureau of Economic Activity must aggregate a variety of data sources, such as expenditure surveys. a.

What measurement problems might the government face in trying to estimate GDP? Consider the three accounting methods we discussed in this chapter; what kinds of information would you need for each?

b. In its quarterly estimates, the BEA uses both expenditures-based and incomebased accounting; in order to differentiate between the two, it refers to the expenditures-based estimate as GDP and the income-based estimate as GDI. What would we expect the relationship between GDP and GDI to be? c. Now, go to the BEA NIPA tables (https://www.bea.gov/iTable/index_nipa.cfm), and compare the actual estimates for GDP (table 1.1.5) and GDI (table 1.10).

What are the estimates for GDP and GNI in the first quarter of 2016? What factors could explain any differences you notice?

Answer: a. Solutions may vary, but should touch on the concepts introduced in the chapter.

For example, the government may have trouble measuring informal or blackmarket production. The three accounting methods should be listed: productionbased accounting, income-based accounting, and expenditure-based accounting.

To measure production, the government would need information on both

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48

quantities produced and market prices, for every good produced in the U.S. economy. To measure income, the government would need all investment and labor income (including, for an accurate estimate, any wages paid in cash).

Finally, to measure expenditure, the government would need information on all sales, including the size of all inventories in every company. b. Although, in theory, we would expect them to be equal, in practice they likely vary due to the measurement issues discussed in part a. c. GDI is around 200-300 billion dollars higher than GDP, at least in the last few years. This discrepancy could be due to limitations in, for example, measuring company inventories or certain kinds. (solutions may vary)

4. Suppose that there are only two small countries in the world: Ascot, with a population of 30,000 people, and Delwich, with a population of 20,000 people. Ascot‘s GDP is equal to $150 million, while Delwich‘s GDP is $250 million. Delwich‘s GNP has been estimated to be equal to $280 million. Use this information to calculate Ascot‘s GNP, the GDP per capita in Ascot, and the GNP per capita in Delwich.

Answer: Because there are only two countries in the world, the total of the two country‘s GDP has to equal the total of the two country‘s GNP. The total GDP is $150M + $250M = $400M. Because Delwich‘s GNP = $280M, Ascot‘s GNP must equal $120M. Per capita GDP in Ascot = 150,000,000/30,000 = $5,000.

Per capita GNP in Delwich = 120,000,000/20,000 = $6,000.

5. The following table gives data for a small country, Magnolia.

Component

Expenditure (in thousands)

Social Security payments

$250

Depreciation

$47

Private investment

$630

Exports

$260

Imports

$300

Salaries earned by foreigners working in Magnolia

$160

Household consumption

$850

Purchases of raw materials

$270

Government purchases

$900

Capital income

$290

Salaries earned by Magnolian citizens working abroad

$350

Use the data to calculate GDP for this economy using the expenditure method.

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Calculate the value of Magnolia‘s GNP. Does Magnolia‘s GDP differ from its GNP? Why? Answer: a. According to the expenditure approach, GDP = C + G + I + (X – M). Here, C represents household consumption expenditure, G represents government expenditure on goods and services, I represents investment, and (X – M) represents net exports. The value of Magnolia‘s GDP = household consumption + gross private investment + government purchases + (exports – imports) = 850,000 + 630,000 + 900,000 + (260,000 – 300,000) = $2,340,000. b. Gross National Product (GNP) is the market value of production generated by the factors of production—both capital and labor—possessed or owned by the citizens of a particular nation. Therefore, Magnolia‘s gross national product = Magnolia‘s GDP + salaries earned by Magnolian citizens working abroad – salaries earned by foreigners working in Magnolia. Magnolia‘s GNP = 2,340,000 + 350,000 – 160,000 = $2,530,000.

Magnolia‘s GNP is a little higher than its GDP because the production of Magnolian factors of production within the borders of foreign countries exceeds the production of foreign factors of production within Magnolia‘s borders.

6. In 2013, the value of the Consumer Price Index (CPI) in a certain country, Polonia, was 230 index points and median (nominal) household income was $31,200. In 1950, the CPI was 51 index points and median (nominal) household income was $9,500. a. Calculate median real household income in 1950 and in 2013, using 2013 as the base year. b. In which year was life satisfaction likely to be higher? Explain your answer.

Answer: a. Median real household income in 1950, using 2013 as the base year

b. Median real household income in 2013, using 2013 as the base year

Note that median real household income in 1950 is greater than median real household income in 2013. Because per capita income is positively correlated with life satisfaction, life satisfaction is likely to be higher in the year that has the higher level of median real household income. This means that life satisfaction is most likely to have been higher in 1950 than in 2013.

7. With the rise of globalization, supply chains now spread across the world. Consider the following simplified stages of production for a smartphone: ● The U.S.-based smartphone company develops the designs for the new smartphone.

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● A rare minerals broker in China buys 15 billion dollars worth of minerals from around the world, including 5 billion from U.S. mines. ● A microchip producer Japan buys half of these minerals for 10 billion dollars; a camera and screen producer in South Korea buys the other half for 10 billion dollars. ● A manufacturing factory in China buys the microchip, cameras and screens for 22 billion dollars; it obtains the rest of the assembly materials domestically, for a total of 3 billion dollars. ● The U.S. based smartphone company pays the factory 28 billion dollars for the manufactured phones. It programs and uploads the software. Any updates from previous versions of the software are available for existing phone-owners as a free download. ● The company keeps 10 billion worth of smartphones in inventory, then sells the rest to U.S. retailers for 25 billion. ● The retailers sell the phones within the U.S., for a total of 30 billion in revenue. a. Calculate how much this process contributes to U.S. GDP. Explain your calculation. b. What sources of value might not be captured in your calculation in part a.?

Answer: a. 17 billion. To calculate this number, we have to look at the value added by U.S. entities. First, there‘s the 5 billion from U.S. mines for raw materials. Next, we jump to the smartphone company, which bought the phones for 28 billion and produced 35 billion dollars worth of value: 7 billion of value added. Finally, the U.S. retailers buy 25 billion worth of smartphones and sell 20 billion: 5 billion dollars of value added. Overall, then, that‘s 5 + 5 + 7 = 17 billion in value added. b. Primarily, we‘re missing any added value from technological development—if this phone is a large technological improvement over the former phone, then we would ideally like to capture that in GDP. We‘re also not considering any depreciation of the phones in inventory. (additional answers may vary).

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51

8. The country of Sylvania produces and consumes only three goods: Red Bull, pizza, and T-shirts. The quantity produced and price of each good in 2011 and 2012 is given in the following table: 2011

2012

Quant ity

Pri ce

Quant ity

Pri ce

T-Shirts

100

$25

110

$25

Red Bull (cans)

500

$1

500

$1.

50

Pizza (slices)

1000

$2

900

$4

a. Calculate nominal GDP for 2011 and 2012. b. Using 2011 as the base year, calculate real GDP for 2011 and 2012. c. Based on your answer from part (b), by what percentage did real GDP grow between 2011 and 2012? d. Now calculate real GDP for 2011 and 2012 using 2012 as the base year. e. Based on your answer from part (d), by what percentage did real GDP grow between 2011 and 2012? f. Using 2011 as the base year, what was the GDP deflator in 2011 and 2012? g. Based on your answer from part (f), by what percentage did prices change between 2011 and 2012?

Answer: a. For 2011: Nominal GDP = (100 T-shirts) × ($25) + (500 cans Red Bull) × ($1) + (1000 slices pizza) × $2 = $5,000 For 2012: Nominal GDP = (110 T-shirts) × ($25) + (500 cans Red Bull) × ($1.50) + (900 slices pizza) × $4 = $7,100 b. Base year = 2011 For 2011: Real GDP = (100 T-shirts) × ($25) + (500 cans Red Bull) × ($1) + (1000 slices pizza) × ($2) = $5,000 = 2011 Nominal GDP (because 2011 is the base year) For 2012: Real GDP = (110 T-shirts) × ($25) + (500 cans Red Bull) × ($1) + (900 slices pizza) × ($2) = $5,050 c. To calculate the percentage change, or growth rate, between 2011 and 2012, we simply take:

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So, real GDP grew by 1 percent from 2011 to 2012. d. For this exercise, the base year has been switched. Now the real GDP calculation for 2012 is simply the calculation of 2012 nominal GDP, which is $7,100.

The calculation of 2011 real GDP, using 2012 as a base, is as follows: Base year = 2012 For 2011: Real GDP = (100 T-shirts) × ($25) + (500 cans Red Bull) × ($1.50) + (1000 slices pizza) × ($4) = $7,250 For 2012: Real GDP = (110 T-shirts) × ($25) + (500 cans Red Bull) × ($1.50) + (900 slices pizza) × ($4) = $7,100 = 2012 Nominal GDP (because 2012 is the base year) Notice how sensitive these calculations are to what year is chosen as the base. e. The calculation is now:

Because the base year on which our calculations are based has changed, we get a very different picture of the performance of Sylvania‘s economy between 2011 and 2012. f. The GDP deflator is calculated as follows:

Thus, the deflator for 2011 is

.

(This will always be the case when calculating the deflator for the base year, i.e., the deflator will always be 100.)

The GDP deflator for 2012 is

g. The percentage change in prices between 2011 and 2012 can be calculated just like any other percentage change:

Hence, prices changed by about 40 percent from 2011 to 2012. This is one measure of the inflation rate over the year.

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9.

a.

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In additional to the national CPI that we discussed in this chapter, the BLS produces several regional CPI indices. These are constructed in the same way as the national CPI, just at a smaller scale: in a given city, researchers gather prices of a bundle of goods every month, then construct an index to track price changes of that bundle within the city. The following table shows the CPI indices (Base period 1982-84 =100) for San Francisco-Oakland-San Jose and Los AngelesRiverside-Orange County, from 2007 to 2014: Year

San Francisco-Oakland-San Jose

Los Angeles-Riverside-Orange County

2007 2008 2009 2010 2011 2012 2013 2014

216.048 222.767 224.395 227.469 233.390 239.650 245.023 251.985

217.338 225.008 223.219 225.894 231.928 236.648 239.207 242.434

In 2014, the SF-Oakland-SJ CPI was 251.985, while the LA-Riverside-OC CPI was 243.434.

From this information, can we assert that 2014 prices were higher in SF-Oakland-SJ than in LARiverside-OC? Explain.

b. Suppose a San Francisco Resident and a Los Angeles Resident each make the same nominal wage every year from 2007 to 2014: $60,000.00 a year. Using the table above, determine the percent change in real wage in each city from 2007 to 2014 (hint: start by determining how much the 60,000 in 2007 dollars would be worth in 2014 dollars, then compare it to what was actually earned in 2014).

Answer: a. No; the CPI shows relative growth in prices within one place. We know, then, that prices have increased more in SF-Oakland-SJ than in LA-Riverside-OC since the base period. However, we can‘t say anything about the relative level of prices.

Indeed, prices could be higher in LA-Riverside-OC than in SF-Oakland-SJ. b. As suggested by the hint, we convert the 60,000 to 2014 dollars, then compare to the 60000 in 2014. To convert, we take the ratio of the 2014 CPI with the 2007 CPI: SF-Oakland-SJ: 60000 * (251.985/216.048) = 69980.28 Calculate percent change: 100*(60,000 – 69980.28)/69980.28 = -14.26% LA-Riverside-OC: 60000 * 242.434/217.338 = 66928.19 Calculate percent change: 100 * (60,000 – 66928.19)/66928.19 = -10.35% Thus, in SF-Oakland-SJ, the real wage fell by 14.26%; in LA-Riverside-OC, the real wage fell by 10.35%.

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10.

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Social Security payments in the United States are currently linked to the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W).

This means that as the CPI-W shows an increase in the price level, Social Security payments will also increase, keeping the real value of the payment constant. The following table shows the weighting given to the different components in the CPIW consumption basket.

Item

Weigh t

Food and Beverages

15.94 8

Housing

39.86 7

Apparel

3.623

Transportation

18.99 1

Medical care

5.767

Recreation

5.528

Education and communication

6.766

Other goods and services

3.510

Total

100.0 00

It has been suggested that using the CPI-W to adjust Social Security payments understates inflation for seniors. Do you agree? Why might this be the case?

Answer: Yes, it is possible that using the CPI-W understates inflation for senior citizens.

The CPI studies a particular basket of consumer goods that a typical household purchases. Each item in this basket is given a certain weighting depending on its relative importance in consumption. As can be seen from the table given in the question, medical care is given a relatively low weighting in the CPI-W. However, most seniors are likely to spend a substantial amount on medical care and perhaps lower amounts on the other categories in the basket. So if the rate of health care inflation is higher than the rate of inflation for the other items in the basket, the CPI-W would understate inflation for seniors.

Based on: http://www.economist.com/blogs/democracyinamerica/2013/04/barackobamas-budget Data taken from: http://www.bls.gov/cpi/cpiri2012.pdf 11.

Recall the method of calculating real GDP detailed in the chapter. As you may already have noticed, this method has a problem: In calculating aggregate output, this method weights the output of the various goods and services by their relative prices in the base year.

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Say, for example, a textbook cost $100 in the base year, and a laptop cost $2,000.

This means that the laptop would have 20 times the weight of a book in calculating aggregate output.

But what happens when relative prices change? As you know, the prices of most high-tech items, including laptops, have generally been decreasing over time.

Suppose the price of a laptop declined from $2,000 to $1,000 in the period from the base year to the current year. Now a laptop only costs 10 times as much as the book. So, using base-year relative prices would overweight laptops in calculating real GDP in the current year.

In response to this problem, in 1996 the BEA switched to what is called a chainweighted method of calculating real GDP. Say the base year is 2008. To calculate the growth rate of real GDP between 2008 and 2009, for example, the BEA calculates real GDP for 2008 using 2008 as the base, and then real GDP for 2008 using 2009 as the base. Then, the Bureau calculates real GDP for 2009 using 2009 as the base, and real GDP for 2009 using 2008 as the base. For each base, the growth rate is then calculated as:

,

.

So, they end up with two different growth rates, which are then averaged. Given this averaged growth rate, and the level of GDP in 2008 at 2008 prices, the Bureau then calculates real GDP for 2009 as one plus the average growth rate previously calculated, times 2008 output in 2008 dollars. The growth rate between 2009 and 2010 is then calculated similarly.

Suppose that laptops, economics textbooks, and energy drinks are the only three goods produced in the United States. The following table gives the quantity of each produced (in millions) and their price in the years from 2014 to 2016: PLapt ops

QLapto PText ps s

QText s

PEng. Drnk

QEng. Drnk

2014

1500

7

100

7

2

25

2015

1200

9

110

9

4

30

2016

1000

9

120

10

4

35

a. Calculate nominal GDP and real GDP (using 2014 as the base year) for each year. b. Calculate real GDP for 2015 and 2016 using the chain-weighted method outlined above.

Answer: a. (these should be 2014/15/16)

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b.

12. On May 22, 2013, Forbes magazine reported that Bill Gates had overtaken Mexican businessman Carlos Slim as the ―richest man in the world.‖ Gates‘ fortune on that date was estimated at $70 billion, whereas Slim‘s was a mere $69.86 billion. (http://www.forbes.com/sites/erincarlyle/2013/05/22/bill-gates-is-worlds-richestbumps-slim/) But, does this make Gates the richest American who ever lived?

John D. Rockefeller, the founder of Standard Oil, is usually credited with this distinction. At the time of his death in 1937, the founder of the Standard Oil empire had an estimated net worth of $1.4 billion. a. Go to the BLS CPI site at http://data.bls.gov/cgi-bin/surveymost?cu. Under ―Consumer Price Index-All Urban Consumers,‖ select ―US All Items, 1982-84=100‖ and click the ―Retrieve data‖ button at the bottom of the page. Adjust the years to retrieve data from 1937 through 2013. Use the data under the ―Annual‖ column to calculate Gates‘s 2013 net worth measured in 1937 dollars. You should find that Gates‘s wealth does have more buying power than Rockefeller‘s wealth. b. Some analysts say that Rockefeller‘s net worth was economically equivalent to $250 billion today. However, this figure is arrived at in a particular way. First, his net worth in 1937 is calculated as a percentage of total U.S. GDP in 1937. That percentage is then multiplied by the current level of GDP to arrive at the equivalent figure in current dollars. See if you can approximate the $250 billion figure. You can find the relevant GDP figures at http://research.stlouisfed.org/fred2/data/GDPA.txt c. What are the pros and cons of the two different methods—reviewed in the previous parts of this question—of adjusting Rockefeller‘s net worth to make it comparable to the wealth of business leaders today?

Answer: a. Gates‘ net worth = $70B in 2013. 1937 CPI = 14.4. May 2013 CPI = 232.957.

Adjustment factor = 14.4/232.957 = 0.062. So, Gates‘ 2013 fortune in 1937 = $70B × 0.062 = $4.3B. b. Rockefeller‘s net worth in 1937 = $1.4B. 1937 GDP = $93B. Percentage of GDP represented by Rockefeller‘s net worth = 1.4/93 × 100 = 0.015 = 1.5%. 2013 GDP was equal to $16,768 billion. 1.5% of $16,768 billion is $252 billion. So, if

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Rockefeller was alive in 2013, and his net worth was 1.5% of 2013 GDP, he would be worth $252 billion. c. The main advantage to this method of updating Rockefeller‘s net worth is that it expresses it relative to the economy as a whole. In other words, given that Rockefeller‘s wealth was 1.5 percent of 1937 GDP, a net worth today that represented an equivalent percentage of GDP would be around $250 billion.

However, a disadvantage is that this method might actually overstate Rockefeller‘s standard of living in 1937 compared to the present. Even someone with his resources did not have such modern essentials as air conditioning, computers, the Internet, or a host of life-saving drugs and medical procedures. So while his net worth was extraordinary when translated to a comparable contemporary figure, it is important to remember that people‘s lives have been transformed by the progress of technology unavailable even to the wealthiest individuals in Rockefeller‘s time. This is not accounted for in a simple numerical calculation of dollar values.

Chapter 6

Aggregate Incomes Questions 1. Suppose you are comparing GDP per capita in the United States and Ghana. You first convert the values into U.S. dollars using the current exchange rate between the U.S. dollar and the Ghanaian cedi. You also convert both values to U.S. dollars using the purchasing power parity-adjusted exchange rate. Which measure is likely to give you a more accurate picture of the living standards in both countries? Explain your answer.

Answer: The nominal exchange rate converts Ghanaian cedi into U.S. dollars but does not take into account differences in prices and consumption patterns. Also, the nominal exchange rate can fluctuate for reasons that are not related to the relative price levels in either country. The purchasing power parity-adjusted exchange rate, however, is estimated by calculating how much a representative bundle of commodities costs in various countries. So, the purchasing power parity-adjusted exchange rate will show how much it will cost residents of the United States and Ghana to purchase the same bundle of goods. This means that the purchasing power parity-adjusted exchange rate is likely to be a more accurate measure of living standards in the United States and Ghana.

2. What are the disadvantages of using Big Macs to measure purchasing power parity?

Answer: The price of a Big Mac is used as an alternative measure of the exchange rate between two countries. One of the problems with using Big Macs to measure purchasing power parity is that, instead of a bundle of diverse goods, this index simply compares a bundle consisting of just one good. Also, Big Macs are only a very small fraction of people‘s consumption, so their prices will not reflect true cost-of-living differences across countries.

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3. Suppose that country A has higher income per capita than country B. Explain why this does not imply that most citizens of country A have higher income than most citizens of country B. Try to construct an example in which both countries have 10 citizens to demonstrate this point.

Answer: Although income per capita does correlate strongly with various measures of the quality of life, it does not give a complete picture of the standard of living of all of a country‘s citizens. Income inequality can make income per capita a deceptive measure of economic well-being. Individual incomes can vary widely within a country and may not be reflected in a simple measure of income per capita.

Perso n

Country A Income

Country B Income

1

$ 1,000

$ 5,000

2

$ 1,500

$ 6,000

3

$ 2,000

$ 7,000

4

$ 2,500

$ 9,000

5

$ 3,000

$ 9,500

6

$ 3,500

$10,000

7

$ 4,000

$11,000

8

$15,000

$12,000

9

$30,000

$14,000

10

$45,000

$15,000

Imagine that countries A and B each have ten people (or ten equally large groups of people) with incomes distributed as follows:

Country A‘s GDP per capita is $10,750, while country B‘s is only $9,850. But notice that GDP appears to be much more equally distributed in country B than in country A. The median income in country A is $3,250, whereas the median in country B is $9,750. Hence, most of the citizens in country B have a higher income than most citizens in country A have.

4. Is GDP per capita more relevant in understanding differences in international living standards than GDP per worker?

Answer: Yes, GDP per capita is likely to be a better measure of differences in living standards. GDP per capita is estimated by dividing the country‘s aggregate output by the total population, while GDP per worker divides aggregate output by the number of people in employment. GDP per worker is a good measure of how productive an economy is as it considers the average output produced by the workforce. GDP per capita, however, might be a better measure of welfare as it considers the conditions of the whole population, including children and the elderly.

5. What is the correlation between GDP per capita and welfare measures like absolute poverty and life expectancy? What does this suggest about GDP per capita as a measure of welfare?

Answer: GDP per capita shows a strong correlation with measures like absolute poverty and life expectancy. However, GDP per capita might hide inequalities between countries and within countries. Also, it doesn‘t take into account factors like the quality of health

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care, the environment, and public safety. Although GDP per capita is by itself not a perfect measure of welfare, it does give us a lot of information about the living standards in a country. Therefore, it makes sense to first focus on GDP per capita and then look more deeply into data on health, education, poverty, and inequality within and across countries.

6. What does the Human Development Index measure? What is the correlation between this index and GDP per capita in a country?

Answer: The Human Development Index was developed by the United Nations to measure living standards across various countries. It combines GDP per capita, life expectancy, and measures of education (the mean of years of schooling for adults aged 25 years and expected years of schooling for children of school-entering age). Data on GDP per capita and HDI of various countries show a strong positive correlation between HDI and income per capita.

7. What is productivity? Why does it vary across countries?

Answer: Productivity refers to the value of goods and services that a worker generates for each hour of labor.

There are three main reasons why productivity differs across countries: i. Human capital: Workers differ in terms of human capital, which is their stock of skills to produce output or economic value. Differences in human capital across countries result in differences in productivity. ii. Physical capital: Physical capital is any good, including machines (equipment) and buildings (structures) used for production. Workers will be more productive when the economy has a bigger physical capital stock, enabling each worker to work with more (or better) equipment and structures. iii. Technology: An economy with better technology uses its labor and capital more efficiently and thus achieves higher productivity 8. What are the two components of technology?

Answer: Technology has two very distinct components: the first is knowledge that society has acquired and applied to its production process. This knowledge is embedded partly in the capital stock of firms. The second component has to do with the efficiency of production. The efficiency of production refers to the ability of society to produce the maximal amount of output at a given cost or for given levels of factors of production.

9. What are factors of production? What does the aggregate production function describe?

Answer: A factor of production is an input used in producing output in an economy. An aggregate production function describes the relationship between a nation‘s GDP (Y) and its factors of production, such as physical capital (K) and total efficiency units of labor (H). It is written as follows: A is an index of technology. A higher level of A implies that the economy produces more GDP with the same level of physical capital stock and total efficiency units of labor.

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10. What are the total efficiency units of labor? What is the relationship between this concept and human capital?

Answer: Because the workers in an economy have different levels of human capital, we would not be able to gauge how much the economy can produce only by looking at the number of workers it has. Total efficiency units of labor accounts for the number of workers as well as the level of human capital. Denoting total efficiency units by H, the total number of workers in the economy by L, and the average efficiency or human capital of workers by h, total efficiency units of labor is calculated using the formula:

11. Use the following diagram to explain the relationship between a country‘s physical capital stock and GDP, holding all else constant.

Answer: The diagram shows the aggregate production function, holding total efficiency units of labor constant. This graph shows both the positive relationship between capital and output as well as the law of diminishing marginal product. Holding labor constant, if capital stock increases, the level of output produced also increases. However, the marginal contribution of an additional unit of capital to output—how much output increases as a result of a unit increase in the capital stock—eventually decreases. This can be seen by comparing a unit increase in output at two different points on the aggregate production function. At a point closer to the origin, when there is less capital in the economy, an increase in capital stock will lead to a relatively large increase in output.

When we have the same unit increase starting with a larger capital stock—farther to the right on the horizontal axis—the corresponding increase in output is smaller.

12. Explain the difference between the terms ―physical capital‖ and ―human capital.‖ Answer: Physical capital is any good, including machines (equipment) and buildings (structures), used for production. Human capital, on the other hand, refers to workers‘ skills that enable them to produce output or economic value.

13. Explain what distinguishes physical capital from natural resources.

Answer: Physical capital is not given to a country by nature; it must be produced. In fact, it is sometimes called ―produced means of production.‖ This is what the authors mean

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when they say that capital is not given to us as an ―endowment,‖ as are natural resources.

14. How do increases in technology affect the aggregate production function?

Answer: An increase in technology means that the economy can generate more output from the same set of inputs. Exhibit 6.9 shows the implications of better technology for the aggregate production function: Again holding the efficiency units of labor, H, constant, the relationship between GDP and the physical capital stock shifts upward.

Therefore, for every level of K, the physical capital stock, a better technology implies that the economy will be able to produce more GDP. 15. What does Moore‘s law state? Is Moore‘s law borne out by historical data?

Answer: Moore‘s Law, named after Intel cofounder Gordon Moore, predicts that the number of transistors on a chip will double approximately every two years. The number of transistors is a key determinant of how fast a computer processor is. So Moore‘s Law implies that computer processor power should double approximately every two years.

Gordon Moore made this prediction in 1965. Moore‘s law has turned out to be fairly accurate, with the number of transistors packed in a computer chip doubling approximately every two years. Several other measures of technological advances in computing have also behaved according to Moore‘s Law. 16. Why is the average American so much richer than the average Indian?

Answer: The difference between the average income of an American and an Indian can be explained by differences in physical capital stock per worker, total efficiency units of labor, and technology in the United States and in India. Compared to the United States, India‘s aggregate production function shows that India has significantly lower levels of capital stock per worker, human capital, and technology. If an Indian had access to the same level of technology as an American does, the average income level in India would more than double.

17. What policies can be used to raise GDP in a country?

Answer: Four types of policies can be used to raise a country‘s GDP: i. Increasing physical capital: Countries can increase their capital stock by increasing their savings rate. ii. Raising efficiency units of labor: Increasing the levels of schooling and education would help countries increase their levels of human capital thus their efficiency units of labor. iii. Improving efficiency in the allocation of resources to improve the efficiency of production: By increasing the competitiveness of markets, countries can make resource allocation more efficient. iv. Improving technology: Investing in research and development as well as using technology transfers can improve the technology that is used in the production process.

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Problems 1. You read a newspaper report that compares wages paid to employees at Starbucks in India and in the United Kingdom. At the time, 1 pound was equal to 87 rupees. The report says that Starbucks baristas in India are paid a mere 56 pence an hour, which is lower than the cheapest coffee that Starbucks sells in the United Kingdom. A friend of yours who read the report is appalled by this information and thinks that Starbucks ought to raise its salaries substantially in India. Is your friend necessarily correct?

Explain your answer.

Answer: No, your friend is not necessarily correct. The flaw in the report is that it converts the wages paid in India to pounds using the current exchange rate but does not account for the cost of living (or the prices of goods) in India. So, while the wages paid to Starbucks employees in India may seem extremely low or exploitative, it is entirely possible that the cost of living in India is lower than the cost of living in the United Kingdom. If the cost of living in India is substantially lower than that in the United Kingdom, then the Starbucks employee in India is not necessarily worse off than a Starbucks employee in the United Kingdom.

Based on: http://www.firstpost.com/business/is-starbucks-milking-its-employees-notreally-522717.html & http://www.mirror.co.uk/news/world-news/starbucks-paying-staff25p-an-hour-1429212 2. The following table lists 2012 GDP per capita for four countries. The data are given in the national currencies of the countries. It also lists the price of a Big Mac burger in local currency in each country in 2012.

The price of a Big Mac in the United States in 2012 was $4.20.

Using the Big Mac burger as a representative commodity common to the countries, calculate the purchasing power parity (PPP)-adjustment factor for each country, and then the PPP level of per capita GDP in each country.

Answer: Following the procedure given in the text, we first calculate the ratio of the U.S. Big Mac price and the Big Mac price in the country in question. For example, for Norway, the calculation would be $4.20/41 krone = 0.102. This is the PPP adjustment factor, which we then multiply by per capita GDP stated in the local currency. For Norway, the calculation is 0.102 × 579,162 = $59,328.79.

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Here is the table showing the results for all the countries:

Country (currency)

2012 GDP per Capita

2012 Big Mac Price

PPP Adjustment Factor (rounded)

Norway (krone)

579,162

41

0.102

59,328.79

Poland (zloty)

41,398

9.1

0.462

19,106.77

Turkey (Turkish lira)

19,580

6.6

0.636

12,460.00

United Kingdom (British pound)

24,740

2.49

1.687

41,730.12

PPP GDP/Capit a

3. Let us use what we have learned in the first part of the chapter to compare living standards in the United States and a hypothetical country, Argonia, in 2008. a. The U.S. GDP in 2008 was approximately 14 trillion dollars and the U.S. population was approximately 300 million. What was the per capita GDP in the United States in 2008? b. Suppose that in the local currency, Argonian dollars, Argonia‘s GDP in 2008 was 1 trillion, and its population was 10 million. What was Argonia‘s GDP per capita in Argonian dollars? What problems do you foresee in comparing this number to the United States‘ GDP per capita in U.S. dollars computed in part (a)? c. The Argonian dollar/U.S. dollar exchange rate was equal to 6 on January 1, 2008 (meaning that 1 U.S. dollar is worth 6 Argonian dollars) and reached 9 on August 1, 2008. Compute an exchange-rate-based measure of the GDP per capita in Argonia in U.S. dollars on these two dates. Do you think the change in Argonia‘s exchange-ratebased measure of GDP per capita between these two dates reflects a true change in living standards? d. McDonald‘s has a thriving business in Argonia and sold a Big Mac for 7 Argonian dollars in 2008, while at the same time, a Big Mac sold for $3.50 in the United States. Using this information, provide an alternative estimate of GDP per capita in Argonia. Would you trust this estimate better than the one based on exchange rates? Why or why not?

Answer:

a.

=

b.

=

= $46,667

= 100,000 Argonian dollars U.S. per capita GDP, which is in dollars, cannot be compared to the per capita GDP in Argonia, which is in Argonian dollars. To facilitate comparison, we would have to convert both values into a common unit of

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measurement. c.

January 1, 2008: Argonia‘s per capita GDP in U.S. dollars = 100,000 × 1/6 = $16,666.67 August 1, 2008: Argonia‘s per capita GDP in U.S. dollars = 100,000 × 1/9 = $11,111.11 No, the change in Argonia‘s exchange-rate-based measure of per capita GDP is unlikely to reflect a change in living standards. This fluctuation is likely to have little to do with changes in prices in Argonia or the United States; instead, the significant fluctuation in the GDP per capita in Argonia relative to the United States is just a consequence of converting Argonian incomes into dollars using the current exchange rate, which fluctuates for a variety of reasons unrelated to differences in costs of living.

d.

This information can be used to arrive at a PPP-adjusted exchange rate between the United States and Argonia. If a Big Mac costs $7 in Argonia and $3.50 in the United States, then 1 U.S. dollar = 2 Argonian dollars. It follows that the per capita GDP in Argonia in U.S. dollars = 100,000 × 1/2 = $50,000.

Yes. The Big Mac index is commonly used as an alternative measure of exchange rates. It is a very simple example of purchasing power parity adjustment. PPP-adjustments account for the relative differences in the cost of living in various countries. Because it involves the prices of an actual good in the two countries, it is more reliable than the estimate based on exchange rates.

4. Suppose you are given the following information for the country, Lusitania: 2011 Population; total in Lusitania

190 million

Employment

80 million

Gross Domestic Product (GDP)

2,476 billion U.S. dollars

a. What is the GDP per capita in Lusitania? b. What is the GDP per worker in Lusitania?

The following table gives you the same information for the country, Arctica.

2011 Population; total in Arctica

80 million

Employment

40 million

Gross Domestic Product (GDP)

3,600 billion U.S. dollars

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c. What is the GDP per capita in Arctica? d. What is the GDP per worker in Arctica? e. Based on the given information, would Arctica be considered more productive than Lusitania? Explain your answer. f. How would you use the information given in both these tables to compare living standards in Lusitania and Arctica?

Answer:

a. = =

= $13,032 (approx.)

b.

=

= $30,950

c. = = $45,000

d. =

= $90,000

e.

GDP per worker in Arctica is much higher than Lusitania. Therefore, it can be concluded that workers in Arctica are more productive than workers in Lusitania.

f.

GDP per capita takes into account the whole population, including children and the elderly, and so can be used to understand differences in living standards. The GDP per capita in Arctica is higher than that in Lusitania.

This implies that the standard of living in Arctica is higher than that in Lusitania.

5. Suppose that the GDP in current dollars for Polonia is higher than Ruritania‘s GDP. However, using purchasing-power-parity-adjusted dollars, Ruritania‘s GDP is higher than Polonia‘s GDP. Based on this information, what would you conclude about living standards in Polonia and Ruritania?

Answer: The purchasing-power-parity adjustment constructs the cost of a representative

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bundle of commodities in each country and uses these relative costs for comparing income across countries. This means that purchasing-power-parity measures adjust nominal GDP for the cost of living in a country. So, if Ruritania‘s PPP-adjusted GDP is higher, this means that the standard of living in Ruritania is likely to be better than Polonia‘s standard of living.

6. In 2011, China revised its poverty line upward to 2,300 yuan per year, or 6.3 yuan per day. At the prevailing exchange rate, this was equal to a little less than a single U.S. dollar. Some commentators felt that China‘s poverty line fell short of the World Bank‘s poverty line of $1.25 per day, in 2005 purchasing-power-parity (PPP) U.S. dollars. Would you agree? What other information would you need to evaluate this claim?

Answer: The World Bank‘s poverty line is based on PPP-adjusted U.S. dollars. This means that people whose purchasing power is so low that they cannot afford to buy the same goods and services that could be bought in the United States in 2005 for $1.25 are considered to be below the poverty line. To check whether China‘s poverty line falls below the World Bank‘s poverty line, we need to use the PPP-adjusted exchange rate for Chinese yuan and the U.S. dollar.

Based on http://www.economist.com/blogs/freeexchange/2011/12/chinas-poverty-line 7. In this question, we will use what you learned in the second part of the chapter to compare the performance of an economy in two different time periods, as its physical capital stock and efficiency units of labor change. a. Suppose that from period 1 to period 2, the unemployment rate in the economy increases. Everything else remains unchanged. What happens to the total efficiency units of labor? Express your results formally as an inequality, using the formula for total efficiency units of labor presented in the chapter (in particular, recall that total efficiency units of labor in two periods can be written as H1 = L1 × h1 and H2 = L2 × h2; where L is the total number of employed workers). b. What are the consequences of this increase in unemployment for GDP? Express your results formally as an inequality, using the aggregate production function presented in the chapter. c. What are the consequences for GDP per capita and GDP per worker? d. Suppose that there is a technological advance from period 1 to period 2 but, at the same time, a decrease in physical capital stock? Can you say whether GDP will increase or decrease? Why or why not?

Answer: a. The total efficiency units of labor is the product of average efficiency units of workers and the total number of workers in the economy. An increase in unemployment implies a decrease in the number of workers. Everything else remaining unchanged, a decrease in the number of workers reduces the total efficiency units of workers. This can be expressed formally as follows: L1 > L2 implies H1 = L1 × h1 > H2 = L2 × h2 b. The aggregate production function is expressed as Y =A×F(K,H), where Y stands for GDP, K is capital stock, H is efficiency units of labor, and A is a technology

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index. With an increase in unemployment in period 2, the efficiency units of labor will fall. This means that GDP will also fall as there is a direct relationship between capital, labor, and aggregate output. Formally, this can be expressed as follows: H2 < H1 implies F(K,H2) < F(K,H1), which implies A×F(K,H2)< A×F(K,H1), which implies Y2 < Y1. c. Other things remaining the same, the fall in GDP will reduce GDP per capita. The effect on GDP per worker is harder to determine. That is because both GDP and the number of workers are decreasing. d. Technological progress means that the economy can generate more output from the same set of inputs. It is difficult to conclude whether GDP will increase when physical capital stock falls but technology progresses. This is because with technological progress, more output can be produced with a smaller level of capital. It is also possible that, with technological progress, the same (or even a higher) level of GDP can be achieved, even if the capital stock declines.

8. Assume that the country Lusitania has two industries, clothing production and computer chip production. At first, both industries have identical aggregate production functions: the following table shows how the output of each industry is affected by a change in efficiency units of labor.

GDP (in millions of dollars)

Stock of physical capital (units)

Efficienc y units of labor

100

15,000

16,000

150

15,000

20,000

180

15,000

24,000

200

15,000

28,000

210

15,000

32,000

a.

Using the data in the table, draw a graph showing how output (on the y axis) changes with efficiency units of labor (on the x axis). What explains the shape of the graph? Why is it valid in this case to plot output against the efficiency units of labor and leave the stock of physical capital in the background?

b. A Lusitanian inventor has produced a new technology that doubles output of computer chips for any combination of Capital and Labor. Explain, using an equation, how this invention affects the production of computer chips. Write a new table for computer chip production and compare it to the (unchanged) table for clothing production. c. If you were a central planner, would you make any changes to the allocation of labor, holding capital fixed? If so, what factors might prevent you from implementing your policy?

Answer: a. The graph should look approximately like the figure below:

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GDP increases with an increase in the efficiency units of labor. However, the rate of increase in GDP gradually decreases as the efficiency units of labor increase.

The student should explain that this shape is due to the decreasing marginal product: holding the stock of physical capital constant, the relationship between aggregate product and efficiency units of labor becomes less and less steep as the total efficiency units of labor increases. b. Here, in effect, we‘re multiplying A by 2. So now, any combination of labor and capital produces double the output it did before. We show this in the table below: GDP (in millions of dollars)

Stock of physical capital (units)

Efficienc y units of labor

200

15,000

16,000

300

15,000

20,000

360

15,000

24,000

400

15,000

28,000

420

15,000

32,000

c. A central planner would re-allocate workers to computer chips—because now marginal product of labor has increased at each level. We‘ll be able to get more bang for our buck with workers in computer chip industry. However, it may be that higher training is required for workers to produce computer chip, so it might not be possible to simply re-allocate employees.

9. The old Soviet Union devoted enormous resources exclusively to increasing its physical capital stock, and yet eventually the increase in the country‘s GDP came to an end. Based on the discussion in the chapter, explain why this was inevitable.

Answer: The Soviet Union had many problems that would have slowed economic growth: corruption, lack of incentives, etc. Even without these issues, however, the emphasis on capital accumulation could not have spurred robust economic growth indefinitely.

Recall from the chapter that capital is subject to the law of diminishing marginal product.

This means that each additional unit of capital produces less and less additional output. In

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the absence of technological innovation, the increase in GDP per hour worked as capital accumulates gets smaller and smaller until it is virtually constant. Thus, economic growth in the Soviet Union was doomed to slow and eventually to stagnate.

10. According to U.S. census projections, the percentage of U.S. citizens over the age of 65 will increase from 14.9% in 2015 to 22.1% in 2050, due, in part, to both prolonged life expectancy and declining fertility rates. How would you expect such a demographic shift to affect productivity? What about GDP per capita?

Answer: Productivity will likely decrease--as the workforce ages, its members will become less productive (alternatively, students could argue that there are ambiguous effects, since an older workforce may be more qualified overall, for some industries; for others, which perhaps involve manual labor, they will indeed decrease in productivity).

Here, the effects are ambiguous—so multiple, well-reasoned answers are acceptable.

Likely it will go down slightly, all else equal, due to a decline in the workforce and decreased productivity; in addition, the increase in life expectancy may lead to higher populations. This could, of course, be offset entirely be declining fertility; another acceptable answer, then, could be that both GDP and population will be lower, all else equal, so the overall effect depends on what dominates.

11. In ―Dead Aid,‖ economist Dambisa Moyo argues that humanitarian aid—provision of food or medicine to poor families, for example—is an ineffective tool for promoting growth in the developing world. Instead, she argues in favor of foreign aid policies that encourage/subsidize foreign investment in the businesses of developing countries. Using the concepts in this chapter, evaluate her approach. Your answer should consider the short-term and long-term effects of such policies on both poverty rates and aggregate growth. If you were trying to improve macroeconomic growth and lower poverty rates in the developing world, what kind of programs would you encourage the U.S. government to fund? What trade offs would you weigh in making your recommendation?

Answer: In the short term, any infusion of capital will boost GDP mechanically—we should see, then, an increase in GDP and GDP per capita, all else equal. Perhaps more importantly, if these investments enhance productivity, then they will, as we‘ve seen in this chapter, boost GDP in the long run (and GDP per capita, all else equal). However, it‘s not clear how these increases will affect the poorest segments of the population— while GDP will increase, poverty rates may stay the same (or even potentially increase, if the investments come at the expense of aid). This persistence of poverty will be particularly likely in countries without mechanisms for redistribution (like any kind of government-run welfare programs). In the long run, high poverty rates may actually hamper the growth of GDP—a starving, sick population may be unable to work or innovate.

The second part of this answer may vary—multiple well-reasoned arguments are acceptable. For example: In developing programs, then, we may, based on funding constraints, face a short-term trade-off between alleviating poverty and increasing GDP. Ideally, a mix of well-targeted programs would bolster productivity—perhaps partially through training programs and improved technology, and partially through aid to poor

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segments of the population.

12. Give an algebraic and an intuitive explanation of the concept of ―efficiency of production.‖ Why is efficiency of production so important to GDP? Answer: Given the aggregate production, function Y=A×F(K,H), higher productive efficiency implies that A is higher. Therefore, for a given level of K and H, a higher level of A implies a higher level of Y, or GDP. ―Efficiency of production‖ is defined as the ability of an economy to produce the maximal amount of output at a given cost or from a given amount of factors of production.

This is important for GDP because the greater productive efficiency in an economy, the more goods and services that can be produced from a given input, or combination of inputs. For example, with a given labor force, a country with greater efficiency will be able to produce more goods and services than a country with lower efficiency and, therefore, will have a larger GDP than a country where such efficiency remains low.

When a nation‘s workers are more productive, real GDP (Y) is larger, and therefore incomes are higher than they would otherwise have been. Higher incomes mean higher living standards. So, when the efficiency of production grows rapidly, so do living standards.

Chapter 7

Economic Growth Questions 1. What is meant by economic growth? How has the U.S. economy grown over the past 200 years?

Answer: Economic growth refers to an increase in real GDP per capita in a country. Over the last 200 years, there has been a marked increase in real GDP per capita in the United States, though the increase is not entirely steady. One of the major economic fluctuations in the United States was the Great Depression, which started in 1929 and recorded a major contraction in real U.S. GDP per capita. However, this was a temporary event, and the sustained and steady growth of real GDP per capita characterizes the U.S. economy both before and after it.

2. What are catch-up growth and sustained growth? Explain with examples.

Answer: Catch-up growth refers to a growth process whereby relatively poorer nations increase their incomes by taking advantage of knowledge and technologies already invented in other, technologically more advanced countries. For example, South Korea, Spain, and China were poorer relative to the United States by 1970. But over the last 40 years, these countries grew faster than the United States, closing the gap that had opened up previously. Sustained growth refers to a growth process in which real GDP per capita

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grows at a positive and relatively steady rate for long periods. For example, the United States demonstrated sustained growth between 1820 and 2007. This means that there was a positive and relatively steady growth rate in every 50-year period, and the growth rate for the entire period was significantly positive.

3. According to the aggregate production function, how does GDP increase?

Answer: The aggregate production function Y = A × F(K,H) links aggregate output to physical capital (K), total efficiency units of labor (H), and technology (A). To increase GDP, a nation can increase its stock of physical capital, K; increase the human capital of its workers, H (so that it has greater efficiency units of labor for the same workforce); or improve its technology, A. 4. The chapter emphasizes the importance of saving in economic growth. a. How is the saving rate in an economy defined? b. What factors help households decide whether to consume or save their income? c. How do household saving decisions impact investment in the economy?

Answer: a. The saving rate is the fraction of total income that households save. b. Saving is a way of allocating some of today‘s resources for consumption tomorrow. So, in deciding how much to save, households are trading off consumption today for consumption tomorrow. These choices are affected by several factors: The first one is the interest rate. The interest rate determines how much households will earn on their savings. Higher interest rates typically encourage more saving.

Second, expectations about future income will affect savings: Households that expect rapid income growth in the future will have less reason to save to finance future consumption (because future income growth will enable them to do this).

Third, expectations about taxes will also impact saving decisions: If households expect high taxes in the future, they may save more in order to be able to pay these taxes without reducing future consumption. c. An increase in the saving in an economy facilitates an increase in investment.

This, in turn, can lead to an increase in the economy‘s stock of physical capital, which we have seen is a key to economic growth.

5. Holding all else equal, will increasing the efficiency units of labor lead to sustained growth? Why or why not?

Answer: Increasing the efficiency units of labor by itself is not likely to lead to sustained growth. Efficiency units of labor are calculated as the product of the number of workers and the level of human capital in the economy. Suppose the number of workers in the economy increases. Holding other factors constant, every additional worker will increase output by less and less because of the diminishing marginal product of labor.

Likewise, increasing only the level of human capital will not achieve sustained growth.

Because each individual has a finite life, there is a limit to how many years of schooling

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he or she can obtain. Thus, achieving greater levels of efficiency units by continuously increasing the years of schooling of the workforce does not appear feasible.

6. What explains economic growth in the United States over the past few decades?

Answer: Data on the contribution of physical capital, human capital, and technology to the growth of output per hours worked shows that technology is the single most important contributor to economic growth in the United States. Although physical and human capital did contribute to growth, technology played a central role in U.S. economic growth.

7. Why was there no sustained economic growth before modern times, that is, before 1800?

Answer: The period before modern times was not stagnant, but it was not characterized by sustained growth. One of the possible explanations is the fact that the pace of technological change was much slower than in more recent times. Also, any increases in aggregate income were offset by increases in population, keeping per capita income low.

8. What did Malthus predict about economic growth? Did his predictions come true?

Why or why not?

Answer: According to Thomas Malthus, the number of children per woman or per family would always adjust so that income remained close to a subsistence level. Whenever living standards were above this subsistence level, couples would increase their number of children, and this, in turn, would push incomes down toward the subsistence level.

When population increases too much, income per capita falls below subsistence and induces famines and/or wars that kill a large fraction of the population. This cycle would then repeat to ensure that incomes always remained close to subsistence.

Malthus‘ predictions failed to come true. Although the Malthusian model was a good representation of how the world was before 1800, it failed to account for the demographic transition. In several countries, population growth rapidly increased due to increased life expectancy and migration. Around the same time, fertility declined, with families having fewer children. This process, which has both economic and social causes, is referred to as the demographic transition. The demographic transition, combined with the Industrial Revolution, enabled economies to break away from the Malthusian cycle. This led to relatively sustained growth in income per capita in many economies, particularly in the Western world.

9. How did the Industrial Revolution affect economic growth?

Answer: The Industrial Revolution is the term given to the series of innovations and their implementation in the production process that started to take place at the end of the eighteenth century in Britain. The Industrial Revolution is important both as an event in itself (because it was the first time technology and scientific methods were used in production in such a coordinated manner) and also as heralding the wave of industrialization that affected many other countries around the world. It was the Industrial Revolution that opened the way for steady and rapid technological changes that have underpinned modern economic growth.

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10. Does an increase in GDP per capita of a nation imply that all its citizens have become richer? Explain.

Answer: A nation‘s GDP per capita at a particular point in time is not the same as the income of every individual in that nation. So although the economy is growing on the whole, there will always be some households and individuals with significantly greater incomes than the average and some with significantly lower incomes.

11. Based on your understanding of the chapter, how can poverty best be reduced?

Answer: Economic analysis suggests several potentially useful approaches to reducing poverty. For poor countries that have natural resources and agricultural sectors, international trade could help raise aggregate incomes. Trade does create certain distributional conflicts, but the overall benefit is positive. Improvements in knowledge and the technologies available in the world economy will also help in raising living standards around the world.

12. What factors explain the dramatic increases in life expectancy that we saw in most countries in the twentieth century?

Answer: Scientific advances in the United States and Western Europe were primarily responsible for the increase in life expectancy throughout the world in the last century.

Three were highlighted in the chapter: (1) the development of new drugs, especially antibiotics; (2) the discovery of DDT, which was very effective in attempts to control malaria; and (3) the proliferation of basic but effective medical and public health practices, like boiling water, in poor countries.

Problems 1. In the second half of the 20th century, post-war Japan experienced exceptional growth. According to World Bank data, in 1985, Japan‘s GDP was 3.67 trillion, and its annual growth rate was 6.33%. The GDP in this problem is in constant 2010 dollars. a. Assuming an exponential annual growth rate of 6.33%, calculate Japan‘s projected GDP in 2010. b. In fact, Japan‘s 2010 GDP was 5.7 trillion. What could explain any discrepancy between this number and your answer to part (a)?

Answer: a. Every year between 1985 and 2010, Japan‘s GDP grows by 6.33%. If we write down the equations for every year, we get: Year 1 (1986) = 3.67 * 1.0633 Year 2 (1987) = 3.67 * 1.0633 * 1.0633 Year 3 (1988) = 3.67 * 1.0633 * 1.0633 * 1.0633 …. And so on. We see a pattern—every year, we multiply by an additional 1.0633. In

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year x, then, the GDP will be: In 2010 (or year 25 = 2010 – 1985), gdp will be equal to: b. This number is clearly substantially lower than what we calculated above. In fact, this makes sense; as we discussed, countries experiencing catch-up growth often experience high, then declining growth rates. While the initial post-war growth may have been high, then, it clearly declined in later years.

2. Currently, some of the fastest growing countries in the world remain desperately poor. For example, of the top five fastest-growing economies in 2016, three—Iraq, Burma, and Nauru—had real per capita GDP that were 101th, 162nd and 112th in the world, respectively. (Source: CIA Factbook estimates for 2016, PPP basis) This seems like something of a contradiction.

Using the equations for growth given in the chapter, explain why a country that has a very low real per capita GDP can also have a very high growth rate.

Answer: Recall that the equation for growth from year t to year t +1 is .

So a lower number in the denominator means that even a small figure in the numerator will result in a large growth rate. For example, in 2016, Burma had a GDP of only $311 B and a population of 56.9 M, resulting in a per capita GDP of around $5,466. However, an increase in per capita GDP of just $100 (which hardly makes Niger a rich country) would result in a GDP figure of $316.69 B, and a GDP growth rate of By contrast, a $100 increase in U.S. GDP per capita (from $57,300 to $57,400) reflects a GDP growth rate of only 0.2 percent.

Mathematically, these results are due to the fact that we are starting from a much larger base in the United States and a much smaller one in Niger.

3. The following table lists GDP per capita from 1970 to 2010 for South Korea and the United States. As you can see, both grew substantially over that 40-year period.

Year

South Korea GDP per Capita

U.S. GDP per Capita

1970

317

5247

1980

1778

12598

1990

6642

23955

2000

11948

36467

2010

22151

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[Data from the World Bank, World Development Indicators] a. Plot the five data points for each country on a graph using a nonproportional scale, as in Exhibit 7.3 in the chapter. Connect the points to create a line graph. b. Plot the five data points for each country on a graph using a proportional scale, that is, a scale where equal distances represent equal percentage changes. Connect the points to create a line graph. c. Interpret the differences you see in the two graphs.

Answer: a.

Nonproportional Scale

b.

Proportional Scale

c. The graph using a nonproportional scale shows an upward-sloping line that gets steeper over time, especially for South Korea. The line in the graph using a proportional scale, on the other hand, is also upward sloping, but flattens out over

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time, especially for the United States.

This difference in the shape of the lines illustrates the difference between a proportional and a nonproportional scale. Recall that on a proportional scale, equal vertical distances represent equal percentage changes. In the graph from part b, this means that the distance from 300 to 3,000 (a ten-fold increase) is the same as the distance from 3,000 to 30,000. This in turn implies that the slope of the line indicates that rate at which a given quantity is growing. So, for both South Korea and the United States, the rate of growth slowed over the 40-year period, shown by the flatter slopes of the lines in the later years.

Note also that the line is steeper for South Korea than the United States, especially in earlier years. This shows that South Korea was growing more rapidly than the United States, that is, at a higher rate. And this explains why South Korean GDP per capita was only 6 percent of the U.S. level in 1970, but by 2010 had grown to be 46 percent of the U.S. level.

4. Economists Andrew McAfee and Erik Brynjolfsson have written about ―The Great Decoupling‖—the divergence between productivity growth and employment. Since the mid-1990‘s, labor productivity and real GDP have continued to increase, while employment and wages have remained stagnant. Use the concepts from this chapter to explain how this ―Decoupling‖ might work; how could productivity and real GDP continue to increase, even with the declining employment? Why might it be the case that employment has not increased while real GDP has continued to grow? How might this dynamic influence inequality?

Answer: As we saw in the chapter, technology can improve productivity at any level of employment (by increasing A in the production function); the rise in technology, then, is likely responsible for this phenomenon. Indeed, if labor allows for capital to substitute for labor, then we would expect unemployment to remain stable or even increase. Ultimately, this dynamic will likely increase inequality, particularly if the jobs lost to technology are lower skill jobs; the owners of capital will benefit of the substitution toward capital, and the employed will make more money while the unemployed rely on transfers.

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5. The graph below shows an index of world GDP per capita from 1000 B.C. to the year 2000.

Source: Jeff Speakes, ―Economic History of the World,‖ Center for Economic Research and Forecasting, California Lutheran University As you can see, over most of that period, global economic growth was virtually nonexistent. While there were periods that experienced some increase in per capita income, sustained growth begins only in the mid-eighteenth century, and explodes after that—by the year 2000, income per capita is 12 times what it had been 250 years before.

Explain what accounts for such a dramatic change in economic growth beginning in the eighteenth century.

Answer: As detailed in the chapter, the development of technology is crucial for economic growth. For centuries, technology did not change much. The main source of power was human or animal muscle, which severely constrains the ability to build, transport, and manufacture. People in this era lived in much the same way as their ancestors had. However, beginning with the Industrial Revolution in England in the mideighteenth century, other sources of power were harnessed—first steam and then electricity. Humankind‘s power was magnified many times over in a relatively brief time.

Moreover, these changes affected almost every dimension of life and led to still more powerful technology and still faster growth.

6. Economists have long debated the causes of the slowdown in productivity (real GDP per hour worked) in the United States during the 1970s and 1980s. This slowdown can be clearly seen in Exhibits 7.10 and 7.11. a. Based on the data in Exhibit 7.10, is it physical capital, human capital, or technology that is most responsible for the overall decline in the annual growth rate of real GDP per hour worked in these two decades? Explain your answer with

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reference to the exhibit. b. An interesting study of the slowdown has been done by Yale economist William Nordhaus, which is summarized at http://www.nber.org/digest/jun05/w10950.html. What are the two main conclusions that Nordhaus reaches concerning the 1970s slowdown? Which industries were most affected by the slowdown, and why?

Answer: a. The data in column (4) (labeled ―Growth resulting from physical capital (K)‖) of Exhibit 7.10 show that the share of growth attributable to increases in the capital stock has remained remarkably consistent throughout the decades. So changes in physical capital cannot explain the productivity slowdown. However, note that the growth resulting from human capital (H) and from technology (A) both declined precipitously during both the 1970s and 1980s, rebounding somewhat in subsequent decades. Hence, changes in human capital and technology are most implicated in the overall slowdown in U.S. productivity during the 1970s and 1980s. b. First, Nordhaus finds that the productivity slowdown of the 1970s was not unique but has parallels in the early 1900s. More importantly, he locates the primary source of the decline in industries like oil and gas extraction and auto repair.

These have in common that they were all affected by the spike in oil prices—and the resulting energy crisis—that occurred during the 1970s.

7. The concept of diminishing returns to a factor of production applies not only to physical capital but to labor as well. Use the concept of diminishing returns to labor to explain and illustrate why there was no sustained growth in living standards prior to the Industrial Revolution. Draw a graph to illustrate the relationship between population and real GDP, where population is measured on the horizontal axis.

Explain how your graph changes after the Industrial Revolution.

Answer: The relevant graph is below:

Note that real GDP increases at a decreasing rate, as is also the case with capital. Barring technological change, this does not allow for an increase in living standards, especially as the population continues to grow.

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The Industrial Revolution led to the invention of capital and technology that shifted the production function upward in terms of both labor and capital.

8. In 1968, Paul Ehrlich, a Stanford University professor, claimed that overpopulation would lead to famines and starvation in the 1970s and 1980s. In his book, The Population Bomb, he said that unless population growth was curbed, millions around the world would die. However, as we now know, this did not happen. What do you think was the flaw in Ehrlich‘s argument?

Answer: Paul Ehrlich did not account for the role that technology can play in increasing food supply. Advances in agricultural technology have reduced the cost of producing food and increased access to food for a large proportion of the world‘s population. New varieties of high-yield, pest-resistant crops, as well as technological progress in agricultural tools and methods, have all ensured that life expectancy has increased even while population has grown.

9. The ―Letting the Data Speak‖ box on levels versus growth points out how one important index of health—life expectancy—has changed in various countries over time.

To see a dramatic animation of the data mentioned in the box, go to http://www.gapminder.org/videos/200-years-that-changed-the-worldbbc/#.U8aTaJRdXTo Hans Rosling is an expert in global health and is known for his creative presentation of statistics. Watch the brief video, and answer the following questions. a. What was the upper limit on life expectancy in almost all countries in 1810?

Which two countries were slightly better off? b. Which countries failed to improve much in life expectancy and income as a result of the Industrial Revolution? c. As of 1948, had disparities in life expectancy and income between countries narrowed or widened? Which were some of the countries that had not made much improvement in either measure by 1948? d. As of 2009, what was the general situation regarding the distribution of countries in terms of health and income? What countries still lagged behind? e. Based on the video, how can country averages disguise the wide variation in living standards within a country? Give an example from the video.

Answer: a. The upper limit on life expectancy in almost all countries in 1810 was 40. Only Britain and the Netherlands were slightly better off. b. Countries in Asia and Africa did not realize much improvement in either life expectancy or income during the Industrial Revolution. The benefits of that period

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were confined mostly to European nations. c. By 1948, the differences in life expectancy and income between countries were higher than ever. Europe and North America, followed by Japan, had made great strides on both measures, while such countries as China, India, Indonesia, Bangladesh, and most of the African countries were still characterized by short life expectancies and poverty. d. By 2009, most Asian and some African countries had made great improvements in life expectancy and income. Rosling comments that by then, most people in the world were ―in the middle‖ between the richest countries with the highest life expectancy (Europe, North America, and Japan) and the poorest countries, like many in sub-Saharan Africa that had endured civil strife or the HIV epidemic (Congo and South Africa). e. When the data are examined in more detail, significant differences emerge within countries. For example, life expectancy and income in China range all the way from the situation in Shanghai, which has figures comparable to those of Italy, and the poor inland province of Guizhou, whose rural areas have the same health and wealth as Ghana, a very poor country. Hence, although taken as a whole, China has made great strides in living standards, there are still enormous regional disparities that are hidden in the countrywide data.

10. Increasingly, independent programmers are making their code ―open-source.‖ The statistical programming language ―R,‖ for example, is completely free and open; anyone can submit a new ―package‖ of specialized functions. How might open source technology affect growth in developing countries? Imagine every technology company in the United States suddenly made their code open-source; would this increase growth in developing countries? Explain.

Answer: Open source technology likely has the potential to boost growth in developing countries—it makes productivity-enhancing tools available to a broader group of people, increasing A in countries around the world. Indeed, the chapter discussed the importance of infusing technology in stimulating growth. However, suddenly making all code opensourced wouldn‘t necessarily boost growth immediately in developing countries— software, in particular, needs the appropriate hardware. The technologies of foreign economies may not be immediately useful. In addition, any code that‘s open-sourced and available off-the-shelf could go directly to consumers with technology—and wouldn‘t be counted in GDP. 11. Suppose that a 10 percent increase in the physical capital stock increases GDP by 10 percent. Now consider an additional 8 percent increase in the physical capital stock.

Will this increase GDP by less than 8 percent, 8 percent, or more than 8 percent?

Explain.

Answer: The second, 8 percent increase in the physical capital stock will increase the capital stock by less than 8 percent. This is due to the diminishing marginal product of physical capital. Each additional increment in the stock of physical capital leads to smaller and smaller increases in GDP. 12. Challenge Problem: Refer to Exhibit 7.4. If the United States, Mexico, China, Rwanda, and Haiti continue to grow at the rates given in the exhibit, how many years (starting from 2010) would it take each to catch up to the United States in terms of

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PPP-adjusted per capita GDP? Answer: First of all, look carefully at the table. PPP-adjusted U.S. per capita GDP is growing at 2 percent per year. Hence, any country that starts from a lower PPP-adjusted GDP per capita, and has a growth rate of 2 percent or less, will never catch up—it is simply a mathematical impossibility.

This means that, if the growth rates listed continue to prevail, Mexico, Rwanda, and Haiti will never catch up to the United States in terms of PPP-adjusted per capita GDP. So that leaves China, whose PPP-adjusted per capita GDP is growing at 4.72 percent.

To see how long it will take China to catch up to the United States, we can use the formula provided in the hint: ln y(t) = ln y(0) + gt, where y(0) is GDP per capita in 2010.

Substituting in the 2010 value for y(0) and the value for g in the United States gives the following: ln yUS(t) = ln 41,365 + 0.02t The comparable equation for China is as follows: ln yChina(t) = ln 7,746 + 0.0472t We want to find how many years (t) it will take for China to catch up to the United States in terms of PPP-adjusted per capita GDP. We must keep in mind that PPP-adjusted U.S. per capita GDP is continuing to grow, just not as fast as China‘s.

To find how long it will take for China to catch up, we simply set the above equation for the United States equal to the equation for China: ln 41,365 + 0.02t = ln 7,746 + 0.0472t Solving this equation for t:

So if the rates of growth of PPP-adjusted GDP per capita listed in the table persist from 2010 on, China would catch up with the United States in around 62 years.

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Appendix to Chapter 7 Problems A1.Use a diagram to represent the Solow growth model using the aggregate production function and the relationship between the physical capital stock and aggregate saving. a. Which point in the figure represents the steady-state equilibrium? Why? b. Use the diagram to show the impact of an increase in human capital on GDP. Answer: The following figure represents the Solow growth model. The straight line represents the value of depreciated capital, d × K. The curve labeled Y = A × F(K,H) represents the aggregate production function, or more specifically, the relationship between aggregate incomes and the (physical) capital stock, for a given level of efficiency units of labor (and for a given technology). The curve labeled s × A × F(K, H) shows the relationship between the level of investment and the capital stock given the saving rate of households, s. The distance between this curve and the horizontal axis at a given level of capital stock corresponds to aggregate saving or investment, while the distance between the curve labeled s × A × F(K, H) and the curve labeled Y = A × F(K, H) represents consumption.

a. In the figure, there is a unique point where the straight line labeled (d × k) intersects the curve labeled s × A × F(K,H), representing investment. This intersection gives the steady-state equilibrium capital level on the horizontal axis, marked as K*, and the steady-state equilibrium output level on the vertical axis is Y*. When the economy is in steady-state equilibrium, the level of investment (saving) and the value of depreciated capital are equal.

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b. The following figure shows the effect of an increase in human capital on aggregate output.

When the human capital of workers increases, the total efficiency units of labor also increases. This implies that the economy can produce more with the same capital stock and technology, so the curve for the aggregate production function shifts up.

This leads to a new steady-state equilibrium with higher capital stock and aggregate income. In particular, the capital stock increases from K* to K** and aggregate income from Y* to Y**.

A2.In the 1980s, the saving rate in Japan was extremely high. Gross saving as a percentage of GDP ranged between 30 percent and 32 percent. Can such a high saving rate lead to sustained economic growth? Use the Solow model to explain your answer.

Data source: http://data.worldbank.org/indicator/NY.GNS.ICTR.ZS/countries/JP?page=5&display =default

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Answer: No, a high saving rate cannot sustain economic growth. With given levels of total efficiency units of labor and technology, there is a maximum amount of aggregate income that an economy can achieve by increasing saving because we can never go above a saving rate of 100 percent. This can be explained using the following figure.

In the figure, the Solow model shows that economies with higher saving rates have higher aggregate incomes, but increases in the saving rate cannot be the source of sustained growth. This is because there is a maximum to how much an economy can save and thus a limit to what aggregate income it can achieve by just saving more.

A3.India‘s GDP per capita increased from $310 in 1991 to $1,489 in 2012.

Data source: http://data.worldbank.org/indicator/NY.GDP.PCAP.CD a. Calculate the arithmetic average annual rate of growth of the Indian economy during this period using the arithmetic average. b. Calculate the geometric average annual growth rate of India during this period.

How does the number you find differ from the number given in Exhibit 7.3?

Speculate on what accounts for any difference.

Answer: a. India‘s growth between 1991 and 2012

3.803 = 380.3%

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India‘s average annual growth rate b.

18%

Recall the formula for a geometric average:

In this case, Indian GDP per capita in the later year (2012) was $1,489, and in the earlier year (1991) was $310. Plugging in these numbers:

Recall from Exhibit 7.3 that the geometric growth rate in India from 1960 to 2009 was only 3.14 percent. This difference implies that the rate must have increased significantly in the later period (i.e., in the 1990s and 2000s) versus the earlier period (1960s–80s). Other data bear out this conclusion.

A4.The appendix details the important distinction between arithmetic and geometric averages in determining growth rates. a. Using the procedure outlined in the Appendix for geometric average growth rates (in the section titled ―Calculating Average (Compound) Growth Rates,‖ see if you can reproduce the ―Implied (average) annual growth‖ figures given in the last column of Exhibit 7.4 for the following countries: France, Singapore, Botswana, India, and Kenya. b. Using the procedure outlined in the Appendix for finding arithmetic average growth rates, calculate the arithmetic average growth rate for the five countries.

Compare these with the rates you obtained in part a. Does the arithmetic average understate or overstate the actual growth rate? Explain.

Answer: a. From the formula in the Appendix, we know that to find the geometric average growth rate (g) over the 50-year period listed in the table, we start by finding the ratio of GDP per capita in 2010 to GDP per capita in 1960. We then plug that ratio into the following equation:

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Below are the calculations for the five countries given in the problem:

b. From the formula in the Appendix, we know that to find the arithmetic average growth rate over the 50-year period listed in the table is to use the following equation:

Using this formula yields the following arithmetic growth rates:

In each case, the calculated arithmetic average growth rate overstates the actual growth rate that is consistent with the observed data for per capita GDP in 2010.

This is due to the fact that using the arithmetic average does not account for compounding and, therefore, ignores the cumulative effects of growth

Chapter 8

Why Isn't the Whole World Developed?

Questions 1. How are the proximate causes of prosperity different from the fundamental causes of prosperity?

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Answer: Proximate causes link high levels of prosperity to high levels of factors such as physical capital, human capital, and technology but don‘t provide an explanation for why the levels of these inputs are high. On the other hand, the underlying factors that explain the proximate causes of prosperity are known as the fundamental causes of prosperity.

Fundamental causes of prosperity explain why some countries are either unable or unwilling to invest in different amounts of physical capital, human capital, and technology.

2. What does the geography hypothesis state?

Answer: The geography hypothesis states that differences in geography, climate, and ecology are ultimately responsible for the differences in prosperity observed across the world. According to this hypothesis, some countries have highly unfavorable geographical, climatic, or ecological circumstances that are outside of their control. These conditions make it impossible or unlikely for such countries to accumulate or effectively use the factors of production.

3. According to the geography hypothesis, what could be done in order to improve incomes in poor countries? Explain.

Answer: If geography is the major fundamental basis of prosperity, then the poor nations of the world have little reason to expect much improvement in living standards. They are permanently disadvantaged and would not be expected to catch up with the rest of the world and become economically developed anytime soon. However, some variations of the geography hypothesis stipulate that large-scale investments in transport technology or disease eradication may partially redress these geographic disadvantages.

4. What does the culture hypothesis state?

Answer: According to the culture hypothesis, different societies respond differently to incentives because of specific shared experiences, religious teachings, the strength of family ties, or unspoken social norms. For example, some societies may have values that encourage investment, hard work, and the adoption of new technologies, while other societies may encourage creative tactics to avoid work or nurture suspicion of new inventions. Because culture is viewed as a key determinant of the values, preferences, and beliefs of individuals and societies, the culture hypothesis maintains that these differences play a key role in shaping economic performance.

5. In the context of this chapter, what is meant by an institution? What are the three important elements that define institutions?

Answer: As defined by economic historian Douglass North, institutions are the rules of the game in a society or, more formally, are the humanly devised constraints that shape human interaction. This definition captures three important elements that define institutions: ● They are determined by individuals as members of a society. In contrast to geography, which is largely outside of human control, and culture, which changes very slowly, institutions are determined by man-made factors.

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● They place constraints on behavior. The ―rules of the game‖ determine people‘s behavior. Policies, regulations, and laws that punish or reward certain types of behavior will naturally have an effect on behavior. ● They affect incentives. The constraints that institutions place on individuals— whether formal constraints, such as banning certain activities, or informal ones, such as discouraging certain types of behavior through customs and social norms—shape human interaction and affect incentives.

6. How does the institutions hypothesis explain the difference in prosperity among nations?

Answer: The institutions hypothesis claims that differences in institutions—how societies have organized themselves and shaped the incentives of individuals and businesses—are at the root of the differences in prosperity across the world. In other words, the institutions hypothesis is based on the notion that it is the way that humans themselves decide to organize their societies that determines whether or not they prosper. Some ways of organizing societies encourage people to innovate, to take risks, to save for the future, to find better ways of doing things, to learn and educate themselves, to solve problems of collective action, and to provide public goods.

7. What does it mean to say that private property rights are well-enforced in an economy? How does it foster economic development?

Answer: Secure private property rights means that a country‘s citizens can hold property like businesses, houses, cars, and many other things without fearing that the government or anyone else will arbitrarily take them away. Well-enforced property rights help economic development by encouraging entrepreneurship. Entrepreneurs know that the income they generate belongs to them. This gives them the incentive to borrow money, invest, and start businesses. When property is well-protected, law and order are buttressed and contracts are enforced. All of these factors promote economic activity and development.

8. How do inclusive economic institutions differ from extractive economic institutions?

Answer: Inclusive economic institutions provide secure property rights, set up a judicial system that enforces contracts and upholds the law, allow private parties to sign contracts for economic or financial transactions, and maintain relatively open and free entry into different businesses and occupations. Such institutions are said to be inclusive because they encourage the participation of a majority of the population in economic activities in a way that makes an efficient use of their talents and skills. On the other hand, extractive economic institutions fail to ensure protection of property rights, create barriers to entry in an industry, and restrict the free functioning of markets. Such institutions are often controlled by those who wield political power and extract resources from the rest of the society.

9. What does the return-to-entrepreneurship curve show? What is meant by the opportunity cost of entrepreneurship?

Answer: The return-to-entrepreneurship curve ranks potential entrepreneurs in descending order according to the return they will make if they enter into the business for which they have a comparative advantage. The opportunity cost of entrepreneurship

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indicates the value to a potential entrepreneur of her best alternative activity.

10. How does the existence of extractive institutions discourage entrepreneurship in an economy?

Answer: The existence of extractive institutions in an economy discourages entrepreneurship in two ways. First, they create insecure property rights and fail to provide proper legal backup to firms, reducing their profitability. Second, they create entry barriers, discouraging entrepreneurs from starting companies that would compete and innovate in the market.

11. Suppose a country has well-enforced private property rights for entrepreneurs, but a large fraction of the population does not have access to education and thus cannot become entrepreneurs. Moreover, their productivity as workers is low. Would you say that this country has inclusive economic institutions? Is it likely to achieve a high level of economic development?

Answer: Well-enforced property rights are only one element, although a very important one, of inclusive economic institutions. Other components include a disinterested and efficient judiciary and accessibility of businesses and occupations to a wide variety of citizens. However, almost a prerequisite of this accessibility is an educational system that allows people to acquire the training and skills necessary to found and manage businesses successfully. Without this vital element, low productivity and the squandering of entrepreneurial talent are inevitable, and a country‘s institutions cannot be called fully inclusive. And in the absence of truly inclusive institutions, economic growth and development might be substantially impeded.

12. What is meant by political creative destruction? How would this concept explain the existence of extractive institutions?

Answer: Political creative destruction refers to the process in which economic growth destabilizes existing regimes and reduces the political power of rulers and monarchs. This would explain why a society adopts extractive institutions even though it seems to lead to relative poverty and a lack of economic development. New technology and economic growth may bring new actors on the scene who may make political demands. New economic activities may fall outside of the control of existing rulers. If the process of economic growth is also associated with political creative destruction, then the politically powerful, who fear losing their privileged positions, will be opposed to this process. This would ensure that extractive institutions remain in place.

13. Parts of the world that were relatively more prosperous 500 years ago have experienced a reversal of fortune and are relatively poorer today. What factors could explain this?

Answer: Taking data on urbanization as a proxy for the prosperity of a nation, we can see that, in 1500, places like Mexico, Peru, North Africa, and India were relatively more prosperous than places such as the United States, Canada, Australia, New Zealand, and Argentina. The areas that were relatively more prosperous have experienced a reversal of fortune and are generally poorer today. This reversal of fortune can be seen as the consequence of an ―institutional reversal‖ attributed to European colonization. The Europeans established more extractive institutions in places that were previously more developed and set up more inclusive institutions in places that were previously less

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developed. As a result, the lands of the former Aztecs and Inca Empires—Mexico, Peru, and their surroundings—ended up with extractive institutions, while Europeans who settled in the lands that were later to become the United States and Canada ended up with more inclusive institutions. This institutional reversal then led to the reversal of prosperity.

Problems 1. In July 2014, the founder of Facebook, Mark Zuckerberg, announced the launch of internet.org, a project aimed at spreading Internet access worldwide. Internet.org encourages mobile service providers to partner with Facebook to provide free, basic Internet services (including, of course, Facebook access) in developing countries.

Long-term, Zuckerberg hopes to deploy drones to expand access in remote areas.

Discuss how this effort, if successful, might impact proximate and fundamental sources of growth—is free, ubiquitous Internet a growth panacea?

Answer: Open Internet, as a technology, most clearly contributes as a proximate source of growth—it can increase productivity across industries by allowing for better connections and access to information. In a country with extractive economic institutions, however, this contribution would have limits; without property rights or other institutions conducive to entrepreneurship, citizens would likely be unable to leverage the now-open Internet. In particular, government censorship of the Internet could prevent users from reaching useful websites.

In the long term, however, Internet access could potentially lead to improvements in fundamental sources of growth. Indeed, the website twitter played a key role in some of the Arab Spring uprisings; perhaps a further extension of internet access could provide populations worldwide with a new channel through which to press for democracy.

2. After the Second World War, Germany was divided into two parts, East Germany and West Germany. East Germany was controlled by the former Soviet Union, while West Germany was controlled by the other Allied governments: the United States, the United Kingdom, and France. The war had destroyed most of Germany‘s economy.

The Soviet Union as well as the Allied occupation forces sought to rebuild the economies of their respective parts. Before the fall of the Berlin Wall reunited East and West Germany in 1990, West Germany‘s economy grew at an annual average growth rate of 4.4 percent, which was about three times higher than East Germany‘s rate. Draw the parallel between the natural experiment discussed in the chapter and the case of East and West Germany. Based on the information given in the question and your own research, why do you think two otherwise similar areas had such divergent growth rates?

Answer: The case of East and West Germany is similar to that of North and South Korea.

Splitting Germany into two separate areas was a natural experiment—an experiment of history. This episode in history illustrates the key feature of a natural experiment: geography and culture were more or less identical, while institutions were the only factor that was different.

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The two newly formed areas of East and West Germany exhibited very different levels of development although they were culturally and geographically similar. The war had ravaged both, but West Germany took steps toward becoming a market economy. Price controls were abandoned, currency reforms were undertaken, inflation was brought under control, and tax rates were slashed. East Germany, on the other hand, adopted central planning. Price controls and production quotas were administered by the state. By 1990, East Germany had stagnated, while West Germany showed impressive rates of growth. It is this difference in economic and political institutions that stands out as the key explanation for the divergence in growth paths.

3. Suppose the country of Burondo is one of the poorest countries in the world. Its economy is heavily reliant on income from the export of oil. There are only two oilextracting companies in Burondo. Both are owned by the government. A large part of the earnings from oil exvports goes toward financing the president‘s lifestyle and entourage. Burondo has not had a single democratic election ever since it gained independence 50 years ago. Although Burondo is said to have abundant oil resources, only a small proportion is extracted every year because the extraction process is so inefficient. Transporting goods in and out of the country is costly, as Burondo is surrounded by lofty mountain ranges. School enrollment in this country is very low and as a result, most of the adult population is illiterate. Life expectancy is also quite low. Agriculture is collectivized in Burondo and so food shortages are common in the country.

Using the information given, distinguish between the fundamental and proximate causes of prosperity (or its absence) in Burondo.

Answer: The proximate causes of prosperity are high levels of such factors as physical capital, human capital, and technology, which result in a high level of GDP per capita.

Fundamental causes of prosperity are factors that are at the root of the differences in the proximate causes of prosperity. In other words, fundamental causes explain why some countries have accumulated more physical capital, invested more in human capital, and developed and adopted better technologies than other countries.

In the case of Burondo, two of the proximate causes of the lack of prosperity that could be cited are the following: ● The oil extraction process is inefficient; this could mean that the level of technology or capital accumulation is low. ● The school enrollment ratio is low, and most of the adult population is illiterate.

This means that the workforce is not likely to be skilled, and the level of investment in human capital is likely to be inadequate. Food shortages are also likely to affect health and social indicators in the country.

The fundamental causes that could explain the proximate causes are the following: ● From the given information, it seems that Burondo‘s government is an extractive political institution. A few people hold political power and decide how the country‘s resources are used. Burondo does not hold democratic elections, which implies that there are very few constraints to the exercise of power.

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● Agriculture is collectivized—this does not give farmers the incentives to increase agricultural output and bring their produce to the market. History has shown that collectivization of farms usually leads to food shortages. ● Burondo also seems to be geographically disadvantaged, a fact that makes the transportation of goods costly. This, however, can be resolved with adequate investment in infrastructure.

4. Look at the following map of Nogales, a twin city that is divided by the U.S. border.

One part of Nogales lies in the United States, in Arizona, and the other part lies in Sonora, Mexico. Life in Nogales, Mexico is very different from life in Nogales, Arizona. The average income in Nogales, Mexico is about one-third the average income in Nogales, Arizona. Education levels, life expectancy, and health conditions are better in Nogales, Arizona than in Nogales, Mexico. Unlike Nogales in Arizona, Nogales in Mexico has only recently adopted political reforms, bringing it closer to functioning as a democracy. Crime rates are also lower in Nogales, Arizona than in Nogales, Mexico. Since both cities are located so close to each other, they share similar geographical conditions and climate. The inhabitants of both cities also share a common ancestry and enjoy the same types of food and music. Based on this information and your own research, what factors do you think can explain why Nogales, Arizona is so much more prosperous than Nogales, Mexico?

Answer: One of the obvious reasons for the difference in prosperity between the two cities divided by the border is the border itself. Nogales, Arizona, is a part of the United States, which has very different institutions compared to those in Mexico. The United States generally has inclusive economic institutions that promote economic activity and development. U.S. citizens can take part in elections that allow them to elect their government democratically and hold it responsible for its actions. Much of the important infrastructure, as well as key public services, are provided by the government. Economic institutions encourage employers in the United States to invest in technology, hire the best talent, and contribute to economic growth in the country. Citizens acquire education and are free to work in occupations to which they are best suited.

Unlike the United States, Mexico does not have many of these inclusive institutions; even

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where they are present, they are often incomplete or compromised by political factors. It is these institutional factors that could explain why life is so different for people who live in two areas that are otherwise very similar.

Map credit: http://www.nytimes.com/2012/02/26/travel/nogales-mexico-a-few-steps-anda-whole-world-away.html?_r=0 Adapted from: Why Nations Fail: The Origins of Power, Prosperity and Poverty (James A. Robinson, Daron Acemoglu).

5. Zimbabwe, formerly known as Rhodesia, was a British colony for around ninety years. It became independent in 1980. The prime minister of newly formed Zimbabwe, Robert Mugabe, implemented a forced land redistribution policy, in which commercial farms were confiscated from white farmers. Mugabe also proceeded to confiscate shares in companies owned by whites. In the following years, agricultural production in the country fell sharply. Zimbabwe, the country that used to be called the breadbasket of Africa, is now seeing food shortages in certain parts of the country. a. Would Zimbabwe be considered to have extractive or inclusive institutions?

Explain your answer. b. Why would a government undertake policies that would adversely affect the lives of its citizens? Explain your answer with reference to the Zimbabwean situation.

Answer: a. Inclusive economic institutions protect private property, uphold law and order, allow and enforce private contracts, and allow free entry into new lines of business and occupations. Extractive institutions, on the other hand, do not protect private property rights, do not uphold contracts, interfere with markets, and erect significant entry barriers into businesses and occupations. A government, such as Zimbabwe‘s under Mugabe, that confiscates private property, whether farms or businesses, is an example of an extractive political institution. Farmers, traders, businessmen, and workers will be discouraged from investing and producing when they have no property rights. b. Extractive, predatory governments know that capital accumulation, investing in human capital, and technological progress can raise living standards in a country.

But it is in their best interests to maintain the status quo because economic growth may shift the center of power in the country. Political creative destruction refers to the process in which economic growth destabilizes existing regimes and reduces the political power of rulers and monarchs. The politically powerful would prefer holding power in a stagnant economy to losing power by reforming institutions and enhancing growth. In the case of Zimbabwe, the Mugabe regime has depended critically on the support of political functionaries, the military, and landless agricultural workers. Hence, a ―spoils‖ system, in which land and other resources were redistributed from white-owned businesses and farms, was very popular with Mugabe‘s base of support, although the evidence indicates that it was disastrous for the economy as a whole.

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6. Since gaining independence from Malaysia in 1965, Singapore has had an impressive growth performance, achieving an average annual growth rate of real GDP per capita of 7.46 percent. State Owned Enterprises (SOEs) have featured prominently in its burgeoning economy; even today, many of its powerful companies are partially controlled by the highly centralized government. a. Based on what we learned in this chapter, how would you expect the presence of SOEs to affect the returns to and opportunity cost of entrepreneurship? Use the curves we developed in Exhibit 22.5 to explain. b. Some of Singapore‘s SOEs focused on developing shipping and transportation infrastructure. How might this fact change your answer to part a? c. Does the example of Singapore contradict what we learned in this chapter about institutions and growth? Explain.

Answers: a. As we saw with extractive economic institutions in the example of 22.5, we‘d expect SOEs to push up the opportunity cost of entrepreneurship; new entrepreneurs would have trouble competing against powerful, state-supported companies. In addition, we might expect the return-to-entrepreneurship curve to shift to the left; it might be more expensive to conduct business with statesupported monopolies, and, if the state absorbed some of the profits from business ventures, entrepreneurs would not reap all of the returns. b. While we could still see the same effects for would-be shipping and transportation entrepreneurs, these infrastructure projects could actually reduce the costs of entrepreneurship in other industries—by easing exporting or the integration of supply chains. Thus, we could actually see a reduce in the opportunity cost of entrepreneurship. c. No—we saw that good institutions can encourage growth. While, as we discussed in this chapter, too much state interference can stymie growth, wellmanaged, productivity-enhancing SOEs could actually facilitate the development of entrepreneurship.

7. Using a graph like the one in the chapter showing returns to entrepreneurship and the opportunity cost of entrepreneurship, illustrate how each of the following historical events shifted one (or both) of the curves. a. Between 1959 and 1963, the Cuban government passed a series of laws called the Agrarian Reform Laws. These laws expropriated any landholdings above a certain size and turned them over to peasants and cooperatives. b. From independence in 1947 until the 1990s, there was in place in India that came to be known as the ―Permit Raj.‖ The term referred to a series of rules and regulations that put strict controls on business, and forced business owners to navigate a bureaucratic labyrinth in order to start and run their companies. For example, one entrepreneur complained that simply to import a computer, he had to make 50 trips to New Delhi to get the necessary permits.

Starting in the 1990s, many of these restrictions were abolished. A series of reforms made it much easier for firms to conduct business. (Based on the series Commanding Heights, PBS, 2002.)

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c. In 2007 and 2008, the Venezuelan dictator Hugo Chavez nationalized many large firms in several key sectors of the country‘s economy, including telecommunications, electric utilities, steel, and banking. Subsequently, taxes on banking and other activities were also raised significantly.

Answer: a. The seizure of private property by the Communist government significantly reduced the returns to be realized from entrepreneurship for any number of entrepreneurs. Recall that the protection of property rights is vital to encourage the development and growth of enterprise. If the government itself does not recognize such rights, there is little reason for anyone to found or grow a business.

This results in a leftward shift in the return-to-entrepreneurship curve, as shown below.

b. Bureaucratic red tape, like licenses and permits, increases the cost of doing business. This is reflected in an opportunity cost curve that is quite high, leading to a small equilibrium number of entrepreneurs.

However, with the reforms of the 1990s, the opportunity cost curve shifted down, and the number of business people, and therefore the number of businesses, increased. This is shown in the graph below.

c. Chavez‘s actions simultaneously reduced returns to entrepreneurship (reflected in

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a leftward shift of the returns-to-entrepreneurship curve) and increased the cost of doing business (resulting in an upward shift of the opportunity cost curve), changing the equilibrium from E1 to E2.

8. Suppose the return and cost of entrepreneurship curves are described by the following equations (with numbers measured in the thousands): R = 250,000 – 50,000 N C = 50,000 + 150,000 N where R = returns to entrepreneurship, C = cost of entrepreneurship, N = number of entrepreneurs a. Based on the equations given, how does the cost of entrepreneurship curve differ (in overall shape) from the one drawn in the chapter? Explain how this difference might arise. b. Find the equilibrium number of entrepreneurs in this economy and the equilibrium returns to entrepreneurship. c. The government now enacts a license fee of $50,000 to file the paperwork necessary to start a firm. What is now the equilibrium number of entrepreneurs and the equilibrium returns to entrepreneurship?

Answer: a. The opportunity cost line is now upward sloping instead of horizontal. As the number of entrepreneurs increases, the opportunity cost of entrepreneurship increases. This could be the case for several reasons. For example, it might be that the greater the number of entrepreneurs in an economy, the greater the opportunities for employment of additional entrepreneurs, and hence the greater the opportunity cost. b. N* = 1,000

R* = $200,000

c. The new opportunity cost line is described by C = 100,000 + 150,000 N. Hence, it

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has shifted upward by 50,000. Setting this equal to the equation for returns: N* = 750, R* = $212,500.

9. Jointly published by the Wall Street Journal and The Heritage Foundation, ―The Freedom Index‖ gives an annual ranking of most of the countries of the world based on their level of economic freedom. Factors considered in the rankings include the status of property rights, the extent of corruption, and the ease of starting and running a business. The Index can be found at http://www.heritage.org/index/. a. Go to http://www.heritage.org/index/ranking and find three countries in each of the freedom categories (―Free,‖ ―Mostly Free,‖ etc.). Click on the country name in the table for each country you select, and read about the rationale for their ranking. Provide a summary for the nations you selected. b. Now go to http://www.heritage.org/index/explore?view=by-variables. Note the per capita GDP of the three countries you selected in each category, and calculate the average of the three you selected in each category.

What pattern do you notice? What preliminary conclusions can you draw concerning the relationship between economic freedom and economic development? Which of the three hypotheses mentioned in the chapter do your results tend to support? Explain. c. Sub-Saharan Africa is known to be one of the poorest regions of the world. Go to the ―Interactive Freedom Heat Map‖ at http://www.heritage.org/index/heatmap.

Into which freedom categories do the majority of countries of the region fall?

Which two countries are the exceptions to the overall pattern?

Answer: a. Students will select three countries in each of the five categories: ―Free,‖ ―Mostly Free,‖ ―Moderately Free,‖ ―Mostly Unfree,‖ and ―Repressed.‖ The summary should include the salient characteristics mentioned in the write-up on each country. b. Students should notice the positive correlation between economic freedom and per capita GDP. This supports the institutional hypothesis, which posits the importance of such indicators of freedom as protection of property rights and the rule of law, open markets, and regulatory efficiency. c. The vast majority of the countries fall into either the ―Mostly Unfree‖ or ―Repressed‖ categories. The two exceptions are Mauritius and Botswana (both of which have experienced rapid economic growth).

10. Sometimes, development aid goes toward disaster relief. For example, after the Indian Ocean tsunami of 2004, NGOs helped devastated countries with rebuilding. Is this type of aid vulnerable to the criticisms we explored in the chapter? Discuss.

Answer: No, not entirely, though it depends how the aid is distributed. The critiques in the chapter pointed to foreign aid as both insufficient and inefficient. If the aid is given directly to the government, then the critiques hold: an extractive government might simply squander the aid, rather than use it productively. However, if this aid is used directly to rebuild destroyed capital and get industries moving again, then we might

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expect it to have a larger impact on growth.

11. Which of the three hypotheses developed in the chapter would be most likely to view foreign aid as essential for economic development? Explain.

Answer: The geography hypothesis is most congenial to the view that aid is essential. If the fundamental causes of poverty lie in a country‘s geography, then only outside assistance can begin to overcome such geography-related problems as tropical disease, lack of resources, and inadequate infrastructure.

12. In his book The Elusive Quest for Growth, development economist William Easterly discusses the relationship between foreign aid and investment in poor countries. He posits that to establish the effectiveness of aid in promoting investment, two tests should be passed: First, there should be a positive statistical association between aid and investment; second, aid should pass into investment 1 for 1, that is, a 1 percent (of GDP) increase in aid should result in a 1 percent (of GDP) increase in investment.

Using a data set of 88 countries from 1965 to 1995, he finds that only 17 of 88 countries pass the first test, and of them, only 6 pass the second.

Based on the information in the chapter, and perhaps your own reading, explain why foreign aid designed to spur investment usually does not work.

Answer: As detailed in the chapter, there are three basic reasons for the ineffectiveness of foreign aid. First, amounts are usually insufficient to increase physical or human capital or improve technology to the extent necessary to sustain economic growth. Second, aid is frequently diverted to corrupt officials and their friends. Lastly, foreign aid does not fix— and indeed may strengthen—extractive institutions. It does nothing to remedy the dysfunctional institutions often found in poor countries, and little to spur the development of inclusive institutions.

Chapter 9

Employment and Unemployment Questions 1. Unemployment statistics are measured and released by the Bureau of Labor Statistics (BLS), a division of the U.S. Department of Labor. a. When does the Bureau of Labor Statistics (BLS) officially classify a person as being employed? When are potential workers classified as being unemployed? b. What do the following terms mean and how are they calculated? i.

The unemployment rate

ii.

The labor force participation rate

Answer: a. According to the BLS, a person who is a part of the civilian non-institutional

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population aged 16 and over and holds a full-time or part-time paid job is considered employed. A potential worker is considered unemployed if he or she does not have a paid job, has actively looked for work in the prior four weeks, and is currently available for work. b. i. The unemployment rate is defined as the percentage of the labor force that is unemployed:

ii. The labor force participation rate is defined as the percentage of the population of potential workers that is in the labor force:

2. Explain whether each of these individuals will be counted as a part of the labor force. a. Jane is working full-time toward a Ph.D. in philosophy, but volunteers at nursing homes during her spare weekends. b. Kristen left her full-time job as a journalist to spend more time with her kids, and now makes some income working part-time for a children‘s magazine. c. In the past four weeks, Harry did not respond to a call from a firm seeking to interview him for a job opening. But he recently applied for another job that he feels will better suit his qualifications.

Answer: a. Jane will not be included in the labor force because she is a student who is doing unpaid work. b. Kristen will be included in the labor force because she is working part time and is getting paid for her work. c. Although he did not respond to the interview call, Harry will be included in the labor force because he is applying for other jobs.

3. Consider Exhibit 9.2. What were the two highest rates of unemployment since 1948?

When did they occur?

Answer: The two highest rates of unemployment since 1948 were 10.8 percent, which occurred during the 1981–1982 recession, and 10.0 percent, which occurred during the 2007–2009 recession. (Note: Student answers may be somewhat inexact because the exhibit is such that precise rates and times are difficult to determine. However, students should still see the peaks around the times indicated in the answer.)

4. What could explain why unemployment is lower among workers with a relatively higher level of education?

Answer: As the chapter points out, multiple factors explain why more educated workers have lower rates of unemployment. One such factor is the fact that unemployment is lower among workers with a higher level of education is consistent with the principle of optimization. More educated workers tend to earn higher wages than less educated workers when working outside the home. More educated workers, therefore, have a much

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higher opportunity cost of time. An unskilled worker who is unemployed is more likely to be indifferent between staying at home or working at a low-paying job. But for a skilled worker, the opportunity cost of staying at home is much higher. He or she would be better off getting back to work as quickly as possible. This is because higher wages make the opportunity cost of unemployment much higher for workers with more education.

5. What is the value of the marginal product of labor? Explain how it is computed with an example.

Answer: The value of a worker‘s marginal product is the additional revenue that a worker will generate for the firm. In a competitive market, it is calculated as the marginal product of labor multiplied by the market price of the product. In a competitive equilibrium, a profit-maximizing firm will pay a worker a wage that is equal to the value of his or her marginal product.

Consider a tailor, who makes $4,000 in revenues when he works alone. Suppose the tailor hires a new worker and this increases the tailor‘s total revenue to $5,300. He then hires a second worker and his total revenue increases to $6,000. This means that the value of the marginal product of the first worker is $1,300, and the value of the marginal product of the second worker is $700.

6. List two factors that can cause a shift in the labor demand curve. Explain why a change in each factor can lead to a shift of the curve.

Answer: Each of the following factors affects the entire schedule relating the quantity of labor demanded to the wage, which is equal to the value of the marginal product of labor.

Hence a change in any of these factors will shift the labor demand curve. ● Changing output prices: When the price of a final good increases, the value of the marginal product of labor also increases for every quantity of labor demanded.

This shifts the labor demand curve to the right. Similarly, when the price of a final good falls, the demand for labor curve shifts to the left. ● Changing technology and productivity: Technology used in production can increase productivity and the marginal product of labor, increasing the value of that marginal product, and shifting the labor demand curve to the right. Similarly, a decline in productivity can shift the labor demand curve to the left. ● Changing input prices: Firms use labor and other factors of production, like machines and tools, to produce goods and services. When the prices of these other factors fall, businesses purchase more of these other factors. This usually increases the marginal product of labor, shifting the labor demand curve to the right. Conversely, if the prices of other factors rise, the marginal product of labor falls, shifting the labor demand curve to the left. ● Changing demand for the output good or service: For example, if the demand for a product or service declines, the value of the marginal product of labor declines.

This will shift the labor demand curve to the left.

7. Why does the labor supply curve slope upward, and what can cause the labor supply curve to shift?

Answer: The labor supply curve represents the relationship between the quantity of labor supplied and the wage. As the wage increases, the quantity of labor (hours) supplied

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rises: The opportunity cost of activities other than paid employment increases when the wage increases. So, workers have an incentive to work more hours as their wage increases. Accordingly, the labor supply curve is upward sloping.

Each of the following factors affects the entire schedule relating the quantity of labor supplied to the wage and will therefore shift the labor supply curve. ● Changing tastes and social norms: Changing social norms affect people‘s willingness to take a paid job. For example, factory work during the Second World War was one early step in a worldwide shift toward acceptance of female labor force participation. This increase in the number of workers shifts the labor supply curve to the right. ● Changing opportunity cost of time: Household appliances, like dishwashers and vacuum cleaners, lower the opportunity cost of working outside the home. This encourages people to shift more time out of home production into paid employment, generating a rightward shift in the labor supply curve. ● Changes in population: For example, the influx of immigrants to a country will increase a country‘s population and shift the labor supply curve to the right.

8. Should a country with a healthy economy have a zero unemployment rate?

Answer: The process of matching jobs and workers is time-consuming and results in frictional unemployment being present in any economy at any point of time. Therefore, a zero unemployment rate is totally impractical and should not be regarded as a policy goal.

9. What is meant by job search? How does it lead to frictional unemployment?

Answer: Finding the right job is not easy; a job seeker would need to determine which firms are hiring and learn how pay, benefits, and other job characteristics vary among them. He or she would also have to line up references and send out resumes. Interviews will need to be set up, but in most cases, someone else gets chosen, and then the job candidate needs to start all over again. These job-hunting activities are referred to as job search. Unemployment arising from job search is called frictional unemployment.

Frictional unemployment arises because it takes time for an unemployed worker to find a firm with a well-matched job vacancy.

10. What is the difference between frictional and structural unemployment?

Answer: When firms and workers lack important information about the labor market, workers cannot always be quickly matched to open jobs, which will cause unemployment. This type of unemployment is called frictional unemployment. On the other hand, structural unemployment arises when the quantity of labor supplied is persistently higher than the quantity of labor demanded. This is often due to institutional factors (e.g., minimum-wage laws) that result in wage rigidity, thus preventing the market wage from adjusting to bring the market to equilibrium.

11. Sometimes new technology in production reduces the time that a worker takes to complete a task. Technological innovations can also completely replace a factory worker. Does this mean that technological progress will lead to large-scale unemployment? Explain your answer.

Answer: New technology can replace factory workers and make jobs redundant in a certain industry. However, historical evidence shows that technological progress does not

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produce unemployment in a country as a whole. Technological progress increases productivity and incomes in the overall economy. Higher incomes lead to higher demand for goods and labor. As a result, workers who lose jobs in one industry will be able to find jobs in others, though for many of them this might take time and some of them will have to accept lower wages in their new jobs.

12. What is wage rigidity? List and explain two factors that can increase wage rigidity in the labor market.

Answer: Wage rigidity refers to the situation in which wages are held above the level that clears the labor market. Because firms will not be able to hire workers who would have been willing to work at the equilibrium wage, wage rigidity leads to unemployment.

Some of the factors that increase wage rigidity are the following: ● Minimum-wage legislation: The minimum wage is a legislated price floor that prevents the market price from falling to the equilibrium price. Minimum-wage legislation prevents employers from hiring workers at wages that would equalize the quantity supplied and demanded, leading to unemployment in the market. ● Collective bargaining: Collective bargaining refers to contract negotiations between an employer and a labor union representing workers. Collective bargaining agreements between unions and employers often result in wages that are above equilibrium. ● Efficiency wages: Efficiency wages are set above the market wage in order to increase worker productivity. Firms might find it profitable to pay a higher wage than the market clearing wage in order to boost productivity, lower absenteeism and turnover, boost worker morale, etc. Moreover, paying efficiency wages may well attract higher quality applicants for the available positions. ● Downward wage rigidity: Workers tend to resist a decline in their wage. In order to maintain productivity and morale, firms often prefer to fire workers than try to cut everyone‘s wages. This leads to downward wage rigidity.

Problems 1. The following table shows the annual averages of the employment level, unemployment level, and the labor force participation rate in the United States in the years from 2001 to 2011. Use the given data to complete the table and answer the following questions.

(Note: Adult population is for individuals 16 years and over, not in the military, and not institutionalized. All rates are in percent.)

Year

Number Unemployed (in thousands)

Number Employed (in thousands)

Labor Force Participat ion Rate

2001

6,830,000

136,939,00 0

66.8%

2002

8,375,000

136,481,00 0

66.6%

2003

8,770,000

137,729,00 0

66.2%

Employmen t Rate

Unemployme nt Rate

Labor Force

Adult Populat ion

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2004

8,140,000

139,240,00 0

66.0%

2005

7,579,000

141,710,00 0

66.0%

2006

6,991,000

144,418,00 0

66.2%

2007

7,073,000

146,050,00 0

66.0%

2008

8,951,000

145,370,00 0

66.0%

2009

14,301,000

139,888,00 0

65.4%

2010

14,815,000

139,070,00 0

64.7%

2011

13,743,000

139,873,00 0

64.1%

Note: Annual averages based on data from the Bureau of Labor Statistics (Series: LNS12000000, LNS11300000, LNS13000000) a. In which year did the economy witness the sharpest change in the unemployment rate? What could possibly explain this? b. Use the data on the size of the labor force and potential workers to compute the percentage of adults out of the labor force for the year 2002. Verify that your calculation is equal to one minus the labor force participation rate. c. What are the general trends that you observe in the data?

Answer: The completed table is given below.

Labor Force Participa tion Rate

Employmen t Rate

Unemployme nt Rate

Labor Force

Adult Populatio n

Year

Number Unemploye d

2001

6,830,000

136,939, 000

66.8%

95.25%

4.75%

143,769,00 0

215,223,0 00

2002

8,375,000

136,481, 000

66.6%

94.22%

5.78%

144,856,00 0

217,502,0 00

2003

8,770,000

137,729, 000

66.2%

94.01%

5.99%

146,499,00 0

221,298,0 00

2004

8,140,000

139,240, 000

66.0%

94.48%

5.52%

147,380,00 0

223,303,0 00

2005

7,579,000

141,710, 000

66.0%

94.92%

5.08%

149,289,00 0

226,195,0 00

2006

6,991,000

144,418, 000

66.2%

95.38%

4.62%

151,409,00 0

228,715,0 00

2007

7,073,000

146,050, 000

66.0%

95.38%

4.62%

153,123,00 0

232,005,0 00

2008

8,951,000

145,370, 000

66.0%

94.20%

5.80%

154,321,00 0

233,820,0 00

Number Employed

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2009

14,301,00 0

139,888, 000

65.4%

90.72%

9.28%

154,189,00 0

235,763,0 00

2010

14,815,00 0

139,070, 000

64.7%

90.37%

9.63%

153,885,00 0

237,844,0 00

2011

13,743,00 0

139,873, 000

64.1%

91.05%

8.95%

153,616,00 0

239,651,0 00

In order to calculate the employment and unemployment rate, the size of the labor force needs to be computed. The total number of employed and unemployed adults constitutes the labor force. The labor force as a percentage of the total adult population gives the labor force participation rate. Using the data on the labor force participation rate and the size of the labor force, the total population aged 16 years and above can be calculated.

The number of unemployed people as a percentage of the labor force gives the unemployment rate. Similarly, the number of employed people as a percentage of the labor force gives the employment rate. Or a simpler method in this case would be to subtract the unemployment rate from 100 to obtain the employment rate. a. The economy recorded the highest increase in unemployment in 2009, with the unemployment rate increasing from 5.8 percent in 2008 to 9.28 percent in 2009.

The financial crisis, which started in late 2007and led to a recession in 2008, is likely to explain this sharp increase in unemployment. b. The percentage of adults not in the labor force is given by the following:

For 2002, the percentage of adults not in the labor force can be calculated as:

This answer can be checked by subtracting the labor force participation rate (as a decimal) from 1, which also gives the percentage of adults not in the labor force: 1 – 0.666 = 0.334 = 33.4% c. Student answers may vary, but some of the general trends are as follows: ● The total adult population has shown a steady increase in the last twenty years. ● Unemployment also increased sharply in the years 2001–2003. This could be attributed to the recession at the beginning of that period. ● Although the total adult population has been steadily increasing, the labor force participation rate has not increased substantially in the past twenty years. ● The data for 2008–2011 diverges from the general trends observed before this period. The level of unemployment is at its highest during this time, while the labor force participation rate is at its lowest. ● From 2008 to 2010, the labor force participation rate fell, which could have been due in part to an increase in the number of discouraged workers during the period.

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3.

A new study suggests that technology might provide improved leisure options, like video games, to potential workers, and that young men with low levels of education are increasingly staying home and playing video games instead of working. There has also been a concurrent decline in the labor force participation of young men with low levels of education. a. Could the rapid rise in video game playing be a cause of the decreased labor force participation of low-education young men? What other factors might explain these two simultaneous trends? In your response, you should use the labor market equilibrium figure (e.g., Exhibit 23.8) and also utilize the concepts of voluntary and involuntary unemployment. b. The authors of this new study also find that these young men, as a group, have experienced an increase in self-reported happiness through the 2000s (according to the General Social Survey).

How does this factor into your explanations in part a?

Answer: a.

Certainly, improved leisure options could change individual preferences, tilting them from work to leisure this could, in turn, increase voluntary unemployment. However, it could be that involuntarily unemployed young men are simply playing video games instead of idling; that is, the increase in video games could be an effect, rather than a cause, of unemployment. As the problem directs, students should also provide at least one chart showing the possible decrease in labor supply due to improved video game technology (see example below). Ideally, they will provide an additional chart showing the alternative explanation; a shock, for example, to demand for young workers, leading to involuntary unemployment.

b. This fact could perhaps support the authors‘ contention that these individuals are voluntarily unemployed. However, it could also simply be the case that overall happiness has been improving in this age group, for reasons unrelated to employment. Alternatively, this average trend could be driven by a small group of super-happy, super-successful young men. Overall, then, this fact doesn‘t necessarily help us pick between the explanations in part a.

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4. Suppose Die Cast Aluminum Co. is a subcontractor for the auto industry and makes specialized auto parts. There is a bracket it manufactures that it sells for $1.50. The following table shows the number of brackets that can be produced from a given number of labor hours. Assume that the company cannot hire labor for a fraction of an hour.

Hrs. Labor

Q

0

0

1

50

2

90

3

120

4

140

5

150

6

155

7

157

a. Find the marginal product (in brackets) and the value of the marginal product (in dollars), of each hour of labor. b. If the wage paid to workers in Die Cast‘s plant is $25/hour, how many hours of labor should the firm employ? How many hours will be employed if the wage increases to $35/hour? Explain. c. How many hours will be employed if the wage is $35/hour, but the price of a bracket declines to $1?

Answer: a. The relevant figures are provided in the following table: Hrs. Labor

Q

0

0

1

MPL

VMPL

50

50

75

2

90

40

60

3

120

30

45

4

140

20

30

5

150

10

15

6

155

5

7.5

7

157

2

3

b. Recall that a firm will keep hiring hours of labor as long as the additional revenue that an additional hour produces is at least as great as the wage the additional hour earns. If the wage paid for each hour of labor is $25, then the firm will hire 4 hours of labor to make the brackets. The fourth hour generates $30 in additional revenue (VMPL) but only costs the firm $25. If the firm hired a fifth hour, it would only generate $15 in additional revenue, but would still cost the firm $25.

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Hence, Die Cast would lose $10 on that hour.

However, if the wage increases to $35/hr., then Die Cast will only hire 3 hours.

The fourth hour still only generates $30 in additional revenue, but now costs the firm $35. c. If the price of a bracket is only $1 instead of $1.50, the value of the marginal product of labor must be recalculated. The results are shown below: Hrs. Labor 0 1 2 3 4 5 6 7

Q

MPL

VMPL

0 50 90 120 140 150 155 157

50 40 30 20 10 5 2

50 40 30 20 10 5 2

Given the lower values for the value of the marginal product of labor, only two hours will be employed. The third hour now only generates $30 in additional revenue, but would cost the firm $35. Hence, it will not be hired.

5. In a recent study for the National Bureau of Economic Research (NBER), four researchers looked at the effect of generous unemployment benefits on the local unemployment rate. They compared the unemployment situation in adjoining counties, which happened to lie in two different states with different laws regarding the amount and duration of unemployment benefits.

The authors of the study found that the unemployment rate ―rises dramatically in the border counties belonging to the states that expanded unemployment benefit duration‖ during the Great Recession. Why might this be so?

Based on Hagedorn, Karahan et al., ―Unemployment Benefits and Unemployment in the Great Recession: The Role of Macro Effects.‖ NBER Working Paper 19499, October 2013.

Answer: The researchers found that the existence of longer duration unemployment benefits gave workers an incentive to hold out for better paying jobs, extending the duration of unemployment in the border counties in states that had expanded benefit duration.

6. Every month, statistics on employment and unemployment are compiled by the Bureau of Labor Statistics. a. The unemployed worker whose frustration was discussed at the beginning of section 9.1 had been unemployed for 17 months. Go to www.bls.gov and consult Table A-12. Find the average (mean) duration of unemployment (seasonally adjusted) in the most recent month. Based on what you find, is 17 months higher or lower than average? b. List some possible reasons for the quoted worker‘s unemployment that would make his joblessness qualify as frictional unemployment. List reasons that would

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fall in the category of structural unemployment.

Answer: a. The answer will depend on when the table is consulted, but a typical seasonally adjusted duration is around 33 weeks, or a bit longer than 8 months. So the worker quoted had been unemployed about twice as long as the average. b. (Various scenarios are possible. The following are examples of issues that would fall into the two categories.)

Frictional Unemployment ● The worker‘s job search has been protracted due to insufficient or faulty information about job opportunities in her area. ● The worker has not been proactive about sending out resumes, gathering references, lining up interviews, networking, or following up on all opportunities. ● The positions for which the worker has applied have received multiple applications, and it is taking the employers longer than usual to process all of the applications.

Structural Unemployment ● The worker has applied for jobs in a region that has a high minimum wage—one that is set above the equilibrium wage for the labor market in which she is applying. ● Wages in the labor market in which the worker is applying are above equilibrium and downwardly rigid due to the fact that many employers in that market pay efficiency wages. ● The industry in which the worker is applying is heavily unionized, and wages are kept consistently above equilibrium.

7.

In recent years, countries around the world have faced a youth unemployment crisis.

According to a report by the International Labour Organization, the global youth unemployment rate in 2016 was 2.9 times higher than the global adult rate. a. In Exhibit 23.5, we compared the curves for two types of labor, low-skill and high-skill. Suppose that the curves show the labor market for workers over the age of 22, with a minimum wage of $10. Use new charts to demonstrate two ways in which the youth labor market might feature greater structural unemployment at the same minimum wage. b. How would you distinguish between the two different explanations you proposed in part a: what kind of data would you need to test these different explanations? c. Some countries, like the UK, have attempted to reduce youth unemployment by implementing a lower minimum wage for workers under the age of 20. Discuss how this might influence youth unemployment, linking your answer to the two explanations discussed in parts a and b as well as to the different types of unemployment discussed in this chapter. Do you think efforts to reduce youth unemployment by setting lower minimum wages for young workers is likely to be effective?

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Answer: a.

There are a few options here. For example, the student could, as in exhibit 23.5, change the elasticity of supply for the youth labor market—the youth labor market could be more elastic because young people have fewer job options. They could also shift the labor supply for the youth labor to the right, reflecting an influx of young workers; or they could shift the labor demand for the youth labor to the left, suggesting that fewer employers want to hire unskilled workers.

b. Again, this depends on the answers given in part a. A great answer will distinguish between supply-side/demand-side effects (and perhaps give some of the explanations offered in the part a. answer here, instead). The data sources should be, for example, data on how many youth are hired across industries and the associated wages—or data on wages for jobs that youth accept. Ideally, hourly wage data could give a disaggregated look at the willingness of youth to substitute work for leisure. c. Given the features of the market discussed in a. and b. (specific answer here will depend on student‘s answer to a/b), the adult minimum wage seems to generate particularly high unemployment for young people. A lower minimum wage would address structural unemployment, as we saw in this chapter, by coming closer to the equilibrium wage; we would also expect it to slightly increase voluntary unemployment, as some people wouldn‘t want to work for the lower wage (because they find leisure more valuable). It‘s hard to say whether it will be effective—the amount of employment generated will depend somewhat on the elasticities of supply and demand. If both are extremely elastic, then we could see a large effect of even a small decrease in minimum wage (particularly if firms are simply hiring the cheapest labor, with no preference for age/experience).

However, if young people are not good substitutes for older, more experienced, workers, then the minimum wage decrease may not make a big difference.

8. The following graph shows the demand for and supply of labor in a market with a minimum wage set at $10 per hour. Use the graph to answer the following questions.

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a. How many workers will be unemployed due to the minimum wage? What kind of unemployment is this? b. What would happen to the quantity of labor demanded and supplied if the minimum wage were less than $6? c. Who are the winners and the losers when the minimum wage is $10? d. In the United States, does minimum wage legislation have a significant impact on unemployment in the overall labor force? Why or why not?

Answer: a. At a wage of $10, the quantity of labor supplied is 400, but the quantity of labor demanded is only 200. Hence, there will be structural unemployment of 200 workers in this market as a result of the minimum wage. b. A minimum wage that is set below the equilibrium wage in the market, which is $6, will not affect the quantity of labor demanded and supplied. Because the market is already paying wages that are higher than the minimum wage, the minimum wage law will have no impact on the labor market. c. In a labor market with a minimum wage, the winners are the workers who keep their jobs and are employed at the minimum wage when they would have been willing to work at the lower market-clearing wage. The losers are the low-wage workers who lose their jobs due to the fall in the quantity of labor demanded as well as the firms (and by implication their shareholders) who are now forced to pay higher wages. d. Currently, minimum-wage laws do not significantly affect the employment picture in the United States. This is due to the fact that the vast majority of workers already make more than the federal or state minimum wages. In fact, only about 1 percent of all workers are paid the minimum wage. Hence, although there may be some impact on the market for low-skilled labor, the overall impact

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on the labor market is very minor.

9. The Earned Income Tax Credit (EITC) provides low-income workers with a refundable tax credit (reducing the tax obligations of the worker). The recipient must have a job, and the amount of the credit depends on marital status, income, and number of children. How might an expansion of this policy compare to an increase in the minimum wage in terms of the impact on labor markets? What might be potential downsides of the EITC? Answer: The EITC, unlike the minimum wage, shouldn‘t lead to involuntary unemployment—because the additional income is offered by the government through a tax credit, rather than through the private sector through a wage increase, the EITC won‘t lead to a gap between labor supply and labor demand. However, the EITC could still alter the labor market by dis-incentivizing work around the eligibility cut-offs: for example, individuals just below the income cut-off may restrict their labor market participation in order to keep the EITC money.

10. According to salary.com, the average salary for a software engineer level III (a higher-level position in software design and implementation) in the Silicon Valley area of California is $120,086. However, Google pays its level III software engineers an average salary of $132,869. Explain why Google would pay a salary higher than the equilibrium salary for equivalent positions in the same area.

(Salary data from http://swz.salary.com/SalaryWizard/Software-Engineer-III-SalaryDetails-Mountain-View-CA.aspx; http://www.glassdoor.com/Salary/Google-SalariesE9079.htm) Answer: This salary differential can be explained using the concept of efficiency wages.

Paying a wage above the ―going rate‖ for a certain category of labor serves to increase the productivity of workers and the profitability of the firm. This is due to several factors: Reduction of worker turnover, lower worker absenteeism, enhancement of worker morale, and the ability to attract higher quality applicants.

11. The following figure shows the demand and supply curves in the market for workers in Starbucks coffee shops, (called ―baristas‖). The hourly wage in this market has been fixed at $7.25, and cannot be changed.

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a. Suppose that, due to concerns about the high number of calories in many Starbucks drinks, the demand for Starbucks products declines. Use a graph to explain what will happen to employment in the market for baristas. b. Now suppose the wage is flexible. How would your answer to part (a) change?

Answer: a. A fall in demand for Starbucks coffee will reduce the demand for labor by coffee shops. The demand for labor curve will shift to the left, as illustrated below.

Because the wage in the market is fixed at $6 per hour, the quantity of labor supplied at that wage will exceed the quantity demanded, leading to unemployment. For example, in the graph below, 100,000 workers would be unemployed as a result of the inflexible wage.

b. With flexible wages, a shift to the left in the demand for labor reduces the equilibrium wage and employment but does not cause unemployment. The

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demand curve will shift to the left, the wage will fall—say, to $5 per hour as illustrated above—and the level of employment will be equal to 250,000 baristas.

But at this lower wage, the number of baristas demanded will be equal to the number of baristas supplied; there will be no unemployment in the market.

12. The period from 2007 to 2009 was a time of economic contraction that some called the ―Great Recession.‖ During periods of recession, most firms experience a decline in demand for their product. All other things being equal, macroeconomic theory predicts that the wage of most workers should decline in recessionary periods.

However, this was not the case in the 2007-2009 recession, or during many other economic downturns throughout recent history.

Based on the discussion in the chapter, explain why this might be so, and what the implications are for unemployment.

Answer: As explained in the chapter, wages often do not adjust downward in response to a decline in demand. Workers are resistant to such adjustments, and employers try to avoid them.

During economic downturns like the 2007–2009 recession, the labor demand curve shifts to the left. Because of downward wage rigidity, wages do not decline to a level that would result in the quantity of labor supplied matching the quantity of labor demanded, which in turn contributes to an increase in unemployment.

Chapter 10

Credit Markets Questions 1. What is the difference between nominal and real interest rates?

Answer: The nominal interest rate is the interest rate you pay on a loan or receive on a savings account, while the real interest rate is the nominal interest rate adjusted for

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inflation.

Real interest rate = Nominal interest rate – Inflation rate Or using symbols, r = i – π, where r is the real interest rate, i is the nominal interest rate, and π stands for the inflation rate.

2. Firms, households, and governments use the credit market for borrowing. The credit demand curve shows the relationship between the quantity of credit demanded and the real interest rate. a. Why does the credit demand curve slope downward? b. What can cause a shift in the credit demand curve?

Answer: a. The downward slope of the credit demand curve implies that the higher the real interest rate, the lower the quantity of credit demanded. This is because the higher the rate of interest a firm or household must pay to borrow money, the lower the firm‘s profit. So, fewer borrowers will be willing to obtain a loan at a higher rate of interest. b. Although a change in the real interest rate will lead to a movement along the credit demand curve, the following factors will lead to a shift of the curve: ● Changes in perceived business opportunities for firms: Businesses borrow to fund their expansions. When more opportunities for expansion are available, the demand for credit at a given real interest rate increases, leading to a rightward shift in the economy-wide, or aggregate, credit demand curve. The opposite—a leftward shift—would occur if perceived business opportunities decreased. ● Changes in households’ borrowing needs: If households grow more optimistic about the future, they‘ll be more willing to borrow now because they expect that they‘ll be in a good position to pay back those loans later.

This will shift the aggregate credit demand curve to the right. Conversely, if households become more pessimistic about the future, the aggregate credit demand curve will shift to the left. ● Changes in government policy: All other things being equal, an increase in government borrowing shifts the credit demand curve to the right, while a decrease in government borrowing will shift it to the left.

3. What factors explain why people save for the future?

Answer: People save for many reasons, some of which are listed below: ● Retirement: Because the Social Security program pays the typical U.S. household a bit less than half of the household‘s pre-retirement income, most people save some of their pre-retirement income to keep consumption levels more or less the same after retirement as before retirement. ● Bequests: Some parents save to leave money for their children. These intergenerational transfers are called bequests. Parents may also save money for their kids‘ college education, etc.

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● Homes and durable goods: People save to buy a home or to buy durable goods, like a new washing machine or a car. ● Starting a business: In cases where outside funding can‘t be obtained, small business owners need to use their own savings to fund their business idea. ● Saving for a rainy day: People save for unexpected events—they may lose their jobs or need money for a medical expense.

4. Households and firms with savings lend money to banks and other financial institutions. The credit supply curve shows the relationship between the quantity of credit supplied and the real interest rate. a. Why does the credit supply curve slope upward? b. What can cause a shift in the credit supply curve?

Answer: a. The credit supply curve is upward sloping because a higher real interest rate encourages more saving, increasing the amount of funds that banks can lend, and thereby increasing the quantity of credit supplied. b. Although a change in the real interest rate will lead to a movement along the credit supply curve, the following factors will lead to a shift of the curve: ● Changes in the saving motives of households: Households save for many reasons, but these motives change over time, shifting the credit supply curve. For example, if households are generally optimistic about their future income, they may spend more now and save less, shifting the credit supply curve to the left. Conversely, if households decide that they want to increase the amount that they leave to their children, the credit supply curve will shift to the right. ● Changes in the saving motives of firms: When firms distribute part of their earnings back to shareholders through dividends, the credit supply curve shifts to the left because passing earnings back to shareholders can be thought of as dissaving. On the other hand, when firms are at all nervous about their ability to fund their business in the future, they tend to hold on to, or retain, any earnings. In this case, the credit supply curve shifts to the right. This is much the same as when households save for a rainy day.

5. What are the key categories on a bank‘s balance sheet? Illustrate using a table.

Answer: A bank‘s balance sheet has the following categories of assets and liabilities: Balance Sheet Assets

Liabilities and Stockholders' Equity

Reserves

Demand deposits

Cash equivalents

Short-term borrowing

Long-term investments

Long-term debt Total Liabilities

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Stockholders' Equity Total Assets

Total Liabilities + Stockholders' Equity

6. What is the shadow banking system?

Answer: The shadow banking system is made up of financial institutions, such as investment banks, that do not fulfill traditional banking functions: They don‘t accept deposits from the public. Nevertheless, they act like banks in the sense that these firms raise money and then make loans with the funds. Lehman Brothers, an investment bank whose bankruptcy fueled the 2008 financial crisis, was one example of a shadow bank.

Instead of taking common deposits, Lehman would take loans from large investors, like insurance companies, and use the money to trade stocks, bonds, and derivatives based on those securities. Institutions in the shadow banking system also make loans to businesses and devise new financial products that they can sell to other institutions and wealthy investors.

7. What functions do banks perform as financial intermediaries in the economy?

Answer: Banks perform three interrelated functions as financial intermediaries: ● Banks identify profitable investment opportunities by bringing together creditworthy borrowers and depositors and channeling depositors‘ savings to borrowers. ● Banks transform short-term liabilities, like deposits, into long-term investments in a process called maturity transformation. Maturity transformation allows the economy to undertake significant long-term investments. ● Banks transfer risk from depositors to the bank‘s stockholders and, in severe financial crises, to the U.S. government.

8. What is maturity transformation?

Answer: The process by which banks take short-term liabilities, such as demand deposits, and use them to invest in long-term assets, like loans, is called maturity transformation.

Demand deposits have a 0-year maturity because the depositor can take back his or her money at any time. In contrast, when banks lend to borrowers, such loans usually have a maturity of 5–30 years.

9. What is stockholders‘ equity? Who bears the risk that a bank faces when stockholders‘ equity is greater than zero?

Answer: Stockholders‘ equity is defined as the difference between a bank‘s total assets and total liabilities. Stockholders are the primary risk takers, but it should be noted that if their equity is wiped out, any losses cascade down to either lenders or the government.

Hence, undercapitalized banks, that is, banks whose stockholder equity is a very small proportion of assets, run a significant risk that a decline in asset values could not only wipe out stockholders, but also impact others.

10. What is a bank run?

Answer: A bank run is a situation where a large proportion of a bank‘s depositors try to withdraw their money at the same time. If the bank has mostly long-term, illiquid assets, it may not be able to pay out all the withdrawals. As word gets out that the bank‘s cash is

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running low, more depositors will try to make withdrawals in the hope that they can get what little cash remains.

11. What is deposit insurance? Is deposit insurance successful in preventing bank runs?

Answer: Deposit insurance is offered by the government and protects depositors‘ balances up to a certain amount. All deposits at or below the cap are paid out in full by the government in the event that a bank cannot meet its obligations.

In the United States, bank runs have been relatively rare since the 1930s because of the deposit insurance provided by the Federal Deposit Insurance Corporation (FDIC).

However, institutional bank runs—where large lenders fear default by their borrowers— did occur during the financial crisis of 2007–2009. Unlike households, institutions make deposits and short-term loans that are far too large to be insured fully by the FDIC. 12. As the Choice and Consequence box on ―Too Big to Fail‖ notes, bank regulators worry about the prospect of the failure of large institutions, dubbed ―systemically important financial institutions‖ (SIFIs). a. How would the failure of a SIFI affect the economy? b. What steps do bank regulators take to prevent SIFIs from failing or to minimize the effect of such failures?

Answer: a. A SIFI‘s failure could have repercussions for the entire banking sector and the economy as a whole. All of the banks to which the failed bank owes money will suffer losses. In turn, these losses can cause runs on the banks involved or wipe out the capital (stockholders‘ equity) of these banks, leading to bankruptcy. As one bank after another fails, the ripple effects of financial losses keep spreading through more and more banks. In theory, the failure of one SIFI could bring down the whole financial system. b. To protect the economy from the effects of the failure of a SIFI, bank regulators have adopted two strategies. First, they now require large banks to set up ―living wills‖ that spell out how the bank would sell its assets and pay off its creditors in the event that it needed to end its business operations. Such living wills are designed to make it more credible and easier for a government to shut down a failing bank, including a failing mega-bank. Second, regulators are now requiring banks to take on less risk and hold more stockholders‘ equity, reducing the likelihood that a large bank will get into trouble in the first place.

13. Banks fail when they invest in long-term assets that subsequently fall in price. What are the two views on why asset prices fluctuate so much that they lead to financial crises and bank failures?

Answer: The theory of efficient markets asserts that asset prices are based exclusively on fundamentals. This theory implies that all movements in asset prices reflect a rational appraisal of new information, not a tendency for investors to let their emotions get in the way. In this view, fluctuations in asset prices are interpreted as episodes in which important new information becomes available to investors. An alternative view links asset price fluctuations to bubbles in asset prices, which occur when asset prices depart from fundamentals. In this view, substantial asset price bubbles can arise, partly driven

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by psychological factors and biases, particularly during specific episodes such as extended economic and stock market booms.

Problems 1. Optimizing economic agents use the real interest rate when thinking about the economic costs and returns of a loan. a. Recently, the average rate paid by banks on savings accounts was 0.45%.

However, at the same time, inflation was around 1.5%. What was the average saver‘s real rate of interest on his or her savings? b. Banks expect that the rate of inflation in the coming year will be 3%. They want a real return of 5%. What nominal rate should they charge borrowers? Explain, using the Fisher equation.

Answer: a. Recall that the real rate of interest is defined as: where r is the real interest rate, i is the nominal interest rate, and π is the rate of inflation. Substituting the values in the problem, i = 0.45%, π = 1.5%, which implies that r = 0.45% – 1.5% = –1.05%. So, the average saver is losing 1.05 percent in buying power every year. b. In this question, r = 5%, and πe = 3%, where πe stands for the expected inflation rate. Rearranging the equation for the real interest rate, this implies that banks should set the nominal rate they charge on loans at:

2. The 1970s was a period of high inflation in many industrialized countries, including the United States. a. Due to the increase in the rate of inflation, lenders, including credit card companies, revised their nominal interest rates upward. How is the rate of inflation related to the nominal interest rate that credit card companies charge?

Why would lenders need to increase the nominal interest rate when the inflation rate increases? b. Usury laws place an upper limit on the nominal rate of interest that lenders can charge on their loans. In the 1970s, in order to avoid usury laws, some credit card companies moved to states where there were no ceilings on interest rates. Why would credit card companies move to states without usury laws during a period of high inflation like the 1970s?

Answer: a. It is the real rate of interest that matters to lenders and borrowers. The real interest rate is calculated by subtracting the inflation rate from the nominal interest rate.

When the rate of inflation increases, the nominal interest rate needs to increase to

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keep the real interest rate constant. b. Usury laws do not constrain lenders when the inflation rate is low because a reasonable real interest rate does not require a high nominal interest rate in a lowinflation environment. However, as the inflation rate rises, it is necessary to increase the nominal interest rate one-for-one to maintain the real interest rate. In such a situation, an upper limit on the nominal interest rate could constrain a lender.

Adapted from an article by the Federal Reserve Bank of Chicago found here: http://www.math.utah.edu/~zobitz/pdf_files/Fall04_teaching/interest_rate.pdf 3. In August 1979, the annual rate of inflation in the United States was nearly 12%, and the U.S. short-term nominal interest rate was nearly 10%. Over the next 35 years, both the rate of inflation and short-term nominal interest rate tended to fall. By August 2014, the rate of inflation was about 2% and the short-term nominal interest rate was close to 0%. How has the real short-term interest rate changed from 1979 to 2014? Why do the inflation rate and the nominal interest rate tend to move together over the long run?

Answer: Recall that the relationship between the real interest rate, the nominal interest rate, and the rate of inflation is given by: where r = the real interest rate, i = the nominal interest rate, and π = the rate of inflation.

Substituting in the August,1979 values from the problem, r = 10% – 12% = –2%. For August 2014, the calculation is r = 0% – 2% = –2%, the same as in 1979.

Hence, as of August 2014 the real short-term interest rate is unchanged from its value in August 1979. The nominal inflation rate fell as the inflation rate fell, which kept the real rate constant.

The equilibrium real rate of interest is ultimately determined by the intersection of the credit demand and supply curves in the credit market. The real rate changes only if either of those curves (or both) shift, as detailed in the chapter. If we rearrange the above equation to read it can be seen that, given r as determined by equilibrium in the credit market, an increase in π results in an equal increase in i such that r stays constant.

4. Many kinds of loans, like student loans and mortgages, can be taken out at either a fixed or variable rate. A fixed rate loan allows the borrower to pay the same nominal interest rate for the entire lifetime of the loan, while a variable rate loan may experience changes in in the nominal interest rate as the rate that banks charge each other for overnight loans changes. For this problem, assume that this variable nominal interest rate adjusts such that the associated real interest rate remains constant over time. a. In the first year, inflation is 2.75 percent and the nominal interest rate for both the fixed and variable rate loans is 5 percent. What is the real interest rate for the fixed rate loan? What about for the variable rate loan? b. In the second year, inflation rises to 3 percent. Calculate the nominal and real

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interest rates for the fixed rate and the variable rate loans described in part a. c. What happens if the inflation rate falls? Could a borrower end up facing a much higher real interest rate with a variable rate loan? With a fixed rate loan? d. Suppose you are deciding between a fixed rate and a variable rate loan and that you dislike risk (variability) in the real interest rate you pay. Should you opt for a fixed rate or a variable rate loan? Are there any reasons for a borrower to dislike variability in the nominal interest rate rather than the real interest rate she faces?

Answer: a. The real interest rate for the fixed rate loan is given by where r = the real interest rate, i = the nominal interest rate, and π = the rate of inflation. Plugging in, then, we get that the real interest rate for both the fixed and variable rate loans is 2.25 percent. b. Again, we use the equation from above. The fixed rate loan is simple—the nominal rate is still 5 percent, so the real interest rate is 2 percent. For the variable rate loan, the nominal rate should adjust so that the real interest rate remains at 2.25 percent. Rearranging the equation above, we get that the nominal rate for the variable rate loan should be at 5.25 percent. c. The real interest rate could, indeed, go up with a fixed rate loan (particularly with deflation, when inflation would be negative and the real interest rate would be higher than the nominal interest rate). With a variable interest rate, however, the real interest rate will always remain the same. d. If you dislike variability in the real interest rate, then you‘re better off choosing the variable rate loan, because it will adjust to keep the real interest rate constant.

It‘s possible, though, that you want to keep the nominal interest rate constant, perhaps because you get paid in nominal dollars and like the predictability of paying a certain percentage of your wage each month.

5. Explain how the equilibrium real interest rate and the equilibrium quantity of credit would change in each of the following scenarios, and illustrate your answer with a well-labeled graph of the credit market. a. As the real estate market recovers from the 2007 – 2009 financial crisis, households begin to buy more houses and condominiums, and apply for more mortgages to enable those purchases. b. Congress agrees to a reduction in the federal deficit, which results in a significant decrease in the amount of government borrowing. c. Households begin to fear that the recovery from the 2007-2009 recession will not last, and become more pessimistic about the economy. d. Businesses become more optimistic about the future of the economy, and decide to distribute more of their earnings as dividends to their shareholders.

Answer: a. As households apply for more mortgages to purchase real estate, the demand for credit increases, and the credit demand curve shifts to the right. This increases the

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equilibrium real interest rate as well as the quantity of credit, as shown in the graph below.

b. As government borrowing decreases, there is a consequent decrease in the demand for credit. The credit demand curve shifts to the left, lowering the equilibrium interest rate and the equilibrium quantity of credit. This is illustrated in the graph below.

c. The increase in household pessimism would result in a decline in borrowing by households, reflected in a leftward shift in the credit demand curve. By itself, this would lower the equilibrium real interest rate and the equilibrium quantity of credit.

However, households would also tend to increase their saving, thus shifting the credit supply curve to the right. This action further lowers the real interest rate but increases the quantity of credit.

Hence, the combination of a decrease in credit demand and an increase in credit supply would definitely lower the equilibrium real interest rate but have an ambiguous effect on the quantity of credit. (Note: The graph below shows a small decrease in the equilibrium quantity of credit because the credit demand curve shifted to the left by a greater horizontal distance than the credit supply curve shifted to the right.)

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d. If the business community becomes more optimistic about the economy, they will tend to increase their borrowing to fund investment and expansion. This will shift the credit demand curve to the right. At the same time, distributing more of their earnings to shareholders as dividends will decrease the supply of credit (assuming that the shareholders spend those dividends), shifting the credit supply curve to the left.

The net result of these two effects is shown in the graph below. The equilibrium real interest rate will definitely increase, but the effect on the equilibrium quantity of credit is ambiguous, and depends on which curve shifts by the greater horizontal distance. (Note: The graph below shows a situation where the leftward shift in the credit supply curve is exactly offset by the rightward shift in credit demand, resulting in no change in the equilibrium quantity of credit.)

6. Households, like banks, maintain balance sheets. Although these assets and liabilities may not be written down in a neat table, they still influence household decisionmaking. a. We saw in this chapter that for banks, assets are equal to liabilities. Do you expect the same to be true for a household? Explain. b. What kinds of assets might the average household have? Of these, which do you think are the most liquid? c. How would a one-time loan made to a relative affect a household‘s annual balance sheet? What about purchasing a car with cash? d. During the financial crisis of 2007–2008, the federal government decided to bail out the big banks, but not any of the households that had lost money because of their investments or house purchases. What kinds of justifications might there be for this type of federal government policy?

Answer: a. Not necessarily. In fact, we saw that shareholder‘s equity makes up the difference between assets and liabilities for the bank—households, of course, don‘t have shareholder‘s equity. Indeed, many American households do face large debts (e.g. credit card debt) and likely have liabilities greater than assets. Other households— young home renters, for example—may have assets greater than liabilities.

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b. Households can have cash, investments (e.g. equities, bonds, retirement accounts), physical investments like cars or jewelry, or houses. Cash and checking accounts are the easiest to use quickly, which makes them the most liquid. c. A one time loan would decrease available cash on the lender‘s asset side, and replace it with a loan on the asset side (representing the expectation of future payment). This loan, of course, is much less liquid than the cash. Purchasing a car with cash would have a similar effect; a decrease in cash on the asset side, replaced with the long-term physical asset of the car. d. In the chapter, we discussed the importance of systemic risk in justifying government intervention. Households, while perhaps interconnected to some degree, have much smaller, simpler balance sheets than banks—thus, you could argue that the impact of a government intervention would be smaller, with minimal impact. In addition, the government imposes restrictions on banks—it would be much harder to monitor the finances of individuals.

7. Banks that practice narrow banking match the maturity of their investments with the term of the deposits that they collect from the public. In other words, narrow banks take short-maturity deposits and invest in assets that carry a low level of risk and are also of short-term maturity, like short-term government debt. a. Suppose that all FDIC-insured banks decide to adopt narrow banking. How would narrow banking reduce the level of risk in the banking system? b. If narrow banking reduces systemic risk, why do banks still practice maturity transformation?

Answer: a. Narrow banking would reduce the level of risk in the banking system by reducing the likelihood of bank runs and liquidity problems for banks. Narrow banks match the maturity of their deposits with that of their investments. Because depositors‘ money is in the form of short-term, liquid investments, banks will be able to convert these investments into cash easily and return money to their depositors when they ask for it. b. Banks take short-term deposits from savers and make long-term loans to investors. This crucial function allows the economy to undertake significant longterm investments. Maturity transformation allows banks to match savers with investors.

8. If you have studied microeconomics, you may recall a concept called ―moral hazard.‖ Moral hazard occurs when an economic agent is incentivized to take risks because some (or all) of the losses that might result will be borne by other economic agents.

Discuss how federal deposit insurance, administered by the FDIC as described in the chapter, might lead to moral hazard.

Answer: Moral hazard occurs whenever a policy changes incentives, which in turn changes behavior. Because of federal deposit insurance, the majority of depositors need not pay any attention to the lending practices of their bank. Depositors are more likely to decide where to bank based on the interest rate offered, or on convenience. Consequently, a bank‘s customers won‘t worry about whether a bank is badly run, nor will they worry

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about whether a bank is making unprofitable long-term investments. The depositors will get their deposits back in any case because of deposit insurance.

Likewise, knowing that their depositors‘ funds are covered gives banks‘ management more incentive to acquire riskier assets, e.g., to make riskier loans than they otherwise would. If the assets perform well, the bank will earn higher profits. If the assets decline in value, and lead to losses, the bank‘s depositors are still covered.

9. Recall from the chapter that banks in the United States hold a fraction of their checking deposits as reserves, either as vault cash or as deposits with the Federal Reserve (where they earn very little interest). Regulations require them to hold a certain percentage (currently 10 percent) of their checking deposits as reserves.

However, banks are free to hold additional reserves if they choose. The latter are called excess reserves. Ordinarily, banks held very few excess reserves. However, starting in the financial crisis of 2007 –2009, the amount of excess reserves held by banks went from virtually zero to over 1.8 trillion dollars. a. Explain why banks would be expected to try to minimize the amount of excess reserves that they hold. b. Based on what you learned about banking in the chapter, explain why you think that the crisis prompted banks to dramatically expand the amount of excess reserves they held.

Answer: Note: This question anticipates material to come in the next chapter on the monetary system. a. Ordinarily, banks would seek to keep their level of excess reserves as low as possible—often at zero. Indeed, this is exactly what we have seen during and after the financial crisis of 2007–2008.

Recall that reserves are held in the form of vault cash, or as deposits at the Federal Reserve. Cash earns no return, and up to October of 2008, deposits at the Fed earned no interest either. Even when the Fed began to pay interest on banks‘ reserve deposits, the rate paid was well below the rate that banks could make on loans or on most other assets. So, holding more reserves than required would involve a significant opportunity cost for banks: They are giving up the higher returns they could earn if they used their excess reserves to make new loans. b. Perhaps the most important factor that prompted banks to increase their excess reserves so dramatically was the uncertain and chaotic financial environment during the crisis. As many residential mortgages, and other financial instruments related to those mortgages, began to decline in value or even default, banks faced a significant fall in the value of the assets on their balance sheets. Recall that a decline in the value of assets, when not offset by any concurrent decline in liabilities, means that bank capital, or shareholders‘ equity, also declines. And if shareholders‘ equity approaches zero, or even becomes negative, the bank is considered insolvent. Hence, banks sought to create a ―buffer‖ to compensate for the decline in the value of key assets on their balance sheets. And the fastest, most certain way to do that was to drastically curtail lending. As old loans were paid off, no new loans were made to replace them. On top of that, banks were nervous about the creditworthiness of potential borrowers, even other banks. This

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provided yet another brake on lending. Moreover, the demand for credit dried up.

Businesses, as well as families who would ordinarily be in the market for mortgages in order to buy a home, were wary of taking on more debt, and hence the demand for loans declined.

So, all of these factors meant that any funds that came into the bank were retained as reserves, which led to the dramatic increase in excess reserves that we have witnessed since 2007–2008.

10. In this problem, consider a simple mutual fund. Households and businesses invest in the fund by buying shares; the fund uses this money, in turn, to invest in a range of assets, including equities and bonds. If an investor wishes to divest from the fund, she can ―redeem‖ her shares. Redeeming involves selling the shares back to the mutual fund for a price called the ―net asset value‖ (NAV). The NAV is equal to the difference between assets and liabilities, divided by the total number of investors in the fund (similar to the shareholders‘ equity discussed in this chapter). The NAV is updated at the end of each day. Thus every investor who redeems on a given day will get the same price. a. What does this fund‘s balance sheet look like? b. Suppose several large investors in the mutual fund start getting nervous about market conditions and decide to redeem, all on the same day. How will these redemptions affect the fund‘s balance sheet? c. Suppose now that investors anticipate that other (large) investors will redeem.

How will this affect their incentives to redeem? Link your answers to the notion of bank runs discussed in this chapter. d. Assume that the economy has 15 other, identical mutual funds. As the fund in part b begins selling assets to pay back investors, the market price of those assets drops. How would this price drop affect the balance sheets of the other mutual funds that invest in those assets? Does this also relate to bank runs? Clarify the differences between your answers to this part and part c.

Answer: a. On the liabilities side, we have the money given by the individual investors—they can redeem at any point, so it becomes a liability. On the assets side, we have all of investments that the manager has chosen; the difference between the two sides is the NAV. (It‘s also acceptable if students put different, more traditional liabilities, and say that the NAV is the only place where the investors in the fund enter in—which is closer to how mutual funds actually work). b. Now, the fund will have to get the money to pay its investors. Thus, it will need to sell some of the assets side; it may have some cash on hand to pay investors, but, if enough people redeem, it will need to sell off more. c. As the problem describes, anyone who redeems on a given day will get the Net Asset Value from the night before. However, as we saw in part b, redemptions will actually pull down the NAV because of reductions in the assets; at the end of a day with many redemptions, the NAV will be lower than the day before. An investor, then, who expects a large number of redemptions in a day, will also want to redeem on that day, particularly if she thinks that the redemptions are occurring because of negative sentiment about the fund. As we saw in the chapter with bank

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runs, individuals can seek to take their money away if they believe that everyone else is—and if they think their investments might not be safe tomorrow. d. Now, we‘ll see the value of the assets of those other mutual funds go down— leading to a decrease in their NAVs. This effect, itself, does not relate to bank runs—this is more of an example of systemic risk, in that an event at one institution has impacts that reverberate throughout the system. In part c, sentiment played a primary role in pushing investors to redeem, leading to a downward spiral. Here, while the systemic decrease in NAV could generate negative sentiment, the primary phenomenon of interest is the systemic impact of a price decrease on the assets of similar financial institutions.

11. The ―Choice and Consequence‖ box on ―Asset Price Fluctuations and Bank Failures‖ discusses the relationship between the prices of things like oil and real estate, and the solvency of lending institutions like banks.

Consider the following two scenarios. Supply the missing entries, and answer the questions that follow.

Assume that Securitas Bank is a large bank in the country of Hyponatremia. The bank‘s only assets and liabilities at the beginning of the year are given in the following balance sheet: Securitas Bank Balance Sheet Assets

Liabilities

Reserves and Cash Equivalents

$ 20 Demand Deposits Billion

$200 Billion

Long-term investments

$330 Borrowing from Billion Other Banks

$ 50 Billion

Total Assets

?

Stockholders’ Equity ?

Philopericulum Bank is another large bank whose only assets and liabilities are summarized in their balance sheet: Philopericulum Bank Balance Sheet Assets

Liabilities

Reserves and Cash Equivalents

$ 10 Demand Deposits Billion

$450 Billion

Long-term investments

$650 Borrowing from Billion Other Banks

$200 Billion

Total Assets

?

Stockholders’ Equity ?

Assume now that due to an economic downturn, the value of each bank‘s long-term investments declines by 10%. Show the resulting situation on each bank‘s balance

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sheet. How would you describe the resulting situation for each bank? Relate your answer to the discussion in the chapter of the concept of ―Too Big to Fail.‖

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Answer: Before the decline in the banks‘ investments, these were the complete balance sheets: Securitas Bank Balance Sheet Assets

Liabilities

Reserves and Cash Equivalents

$ 20 Demand Deposits Billion

$200 Billion

Long-term investments

$330 Borrowing from Billion Other Banks

$ 50 Billion

Total Assets

$350 Billion

Stockholders’ Equity $100 Billion

Philopericulum Bank Balance Sheet Assets

Liabilities

Reserves and Cash Equivalents

$ 10 Demand Deposits Billion

$450 Billion

Long-term investments

$650 Borrowing from Billion Other Banks

$200 Billion

Total Assets

$660 Billion

Stockholders’ Equity $10 Billion

After a 10 percent decline in each bank‘s long-term investments, here are the resulting balance sheets: Securitas Bank Balance Sheet Assets

Liabilities

Reserves and Cash Equivalents

$ 20 Demand Deposits Billion

$200 Billion

Long-term investments

$297 Borrowing from Billion Other Banks

$ 50 Billion

Total Assets

$317 Billion

Stockholders’ Equity $67 Billion

Philopericulum Bank Balance Sheet

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Assets

Liabilities

Reserves and Cash Equivalents

$ 10 Demand Deposits Billion

$450 Billion

Long-term investments

$585 Borrowing from Billion Other Banks

$200 Billion

Total Assets

$595 Billion

Stockholders’ Equity –$55 Billion

Securitas Bank is still solvent, with stockholders‘ equity at $67 Billion. This is because the ratio of their assets to equity started at $350 Billion / $100 Billion = 3.5:1; it had $1 of equity for each $3.50 worth of assets.

Philopericulum Bank, on the other hand, started with a ratio of assets to equity of $660 Billion / $10 Billion, or 66:1; each dollar of equity supported $66 worth of assets. In other words, Philopericulum Bank had borrowed a much larger proportion of the funds it used to make its investments. In finance jargon, we would say that it had much higher ―leverage.‖ As discussed in the chapter, any loss of value in assets comes right out of the equity portion of a bank‘s balance sheet. And when equity falls to zero or below, it means that the bank is insolvent, or has failed. As seen in the balance sheets above, the 10 percent decline in the value of Philopericulum‘s investments resulted in the bank‘s failure; it now has negative stockholders‘ equity.

This illustrates the danger involved in high leverage. Furthermore, it provides the rationale behind regulatory requirements regarding the amount of stockholders‘ equity that a bank must have as a proportion of its total assets.

12. The sharpest one-day percentage decline in the Dow Jones Industrial Average (DJIA) took place on October 19, 1987. The DJIA fell 23% on this one day. Foreign exchange markets and other asset markets also exhibit large fluctuations on a daily basis. Based on the information given in this chapter, discuss some factors that could explain why asset prices fluctuate.

Answer: According to theory of efficient markets, asset prices are based exclusively on fundamentals. In this view, any fluctuation in a stock price is attributed to a rational appraisal of new information about the profitability of the company, not a tendency for investors to let their emotions get in the way. On the other hand, another view has been gaining traction in recent decades. Asset bubbles occur when asset prices deviate from their fundamental value. This can occur due to a herd effect, limited investor rationality, or other psychological factors or biases. Bubbles are also likely to be followed by a market crash. This can be another source of fluctuations in asset prices.

Based on: http://www.phil.frb.org/research-and-data/publications/businessreview/1996/january-february/when-the-bubble-bursts.cfm

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Chapter 11

The Monetary System Questions 1. List and explain the three functions of money in a modern economy.

Answer: Money is used to conduct market transactions in a modern economy. Money is what people usually use to make and receive payments when buying and selling goods and services. Specifically, money serves three functions: ● Money is a medium of exchange. Money is the most common medium of exchange. The use of money allows for a convenient, universally acceptable way of buying and selling goods. ● Money is a store of value. A store of value is an asset that enables people to transfer purchasing power into the future. Money that is received today will be accepted as a form of payment even a decade from now. ● Money is a unit of account. Money is a universal yardstick that is used for expressing the worth (price) of different goods and services. The cost of a good is measured by the number of dollars it takes to buy the good.

2. How does fiat money differ from commodities like gold and silver that were used as money?

Answer: Fiat money is intrinsically worthless but is used as legal tender by government decree. Whereas gold and silver have intrinsic value, fiat or paper money is valuable only because other people will accept it as money.

3. How is the M2 money supply defined?

Answer: The money supply or M2 adds together currency in circulation, checking accounts, travelers‘ checks, savings accounts, and money market accounts.

4. Recall the discussion in the chapter about the ―quantity theory of money.‖ a. Explain the quantity theory of money. b. Explain how the predictions of the quantity theory of money are borne out by historical data.

Answer: a. The quantity theory of money assumes that the ratio of money supply to nominal GDP is constant. This implies that, if money supply grows by 10 percent, then nominal GDP also needs to grow by 10 percent to keep the ratio of money supply divided by nominal GDP constant. It follows that the growth rate of money supply and the growth rate of nominal GDP will be the same.

Growth Rate of Money Supply = Growth Rate of Nominal GDP

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Substituting the growth rate of money supply for the growth rate of nominal GDP, we find that: Growth Rate of Money Supply = Inflation Rate + Growth Rate of Real GDP Rearranging this equation, Rate= Growth Rate of Money Supply – Growth Rate of Real GDP So, according to the quantity theory of money, inflation is equal to the gap between the growth rate of the money supply and the growth rate of real GDP. When this gap widens, the inflation rate increases. b. Exhibit 11.2 in the text examines data on inflation and the value of the growth rate of money supply minus the growth rate of real GDP from 110 countries over the period 1960–1990. The exhibit shows that a 45-degree line passes through the inflation rate and the value of the growth rate of money supply minus the growth rate of real GDP. The quantity theory of money predicts that inflation should rise one-forone with the growth rate of money supply minus the growth rate of real GDP. The fact that the data points lie approximately along a 45-degree line with a slope of one confirms the key long-run prediction generated by the quantity theory of money.

5. What are the differences among inflation, deflation, and hyperinflation?

Answer: Inflation refers to an increase in an economy‘s overall price level, whereas deflation is a decrease of an economy‘s overall price level. Hyperinflation refers to a level of inflation so high that a country‘s price level doubles within three years.

6. What is the most common cause of hyperinflation?

Answer: Hyperinflation is always related to extremely rapid growth of the money supply.

In almost all cases, such extreme monetary growth is brought about by large government budget deficits. If a government‘s tax revenues fall short of its expenditures, it meets its obligations by borrowing more from the public or printing money. Printing more money and using it to buy goods and services increases the money supply in the economy, leading to rapid increases in the price level.

7. What are the costs associated with inflation?

Answer: Inflation imposes the following types of costs on consumers and firms. ● High rates of inflation create logistical costs: Even moderate rates of inflation will necessitate multiple changes to price lists, price tags, and so on over the course of the year. The costs associated with such changes are referred to as ―menu costs.‖ ● Higher inflation distorts relative prices, reducing economic efficiency: As a consequence of volatile inflation, firms may adjust their prices differently, causing relative prices to fall out of alignment. Distortion of relative prices leads to economic inefficiencies. ● Inflation often leads to counterproductive policies like price controls: High rates of inflation are a politically sensitive issue, which may prompt governments to enact economically destructive policies such as price controls. As discussed in earlier chapters, price controls can result in supply disruptions, long lines, and expansion of the underground economy.

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8. Does inflation have any benefits? Explain.

Answer: Yes, inflation does have certain benefits. ● Government revenue is generated when the government prints money. The government revenue that is obtained from money creation is called seignorage.

Seignorage is the difference between the cost of printing paper money and the value of the goods and services that the government can purchase with the newly printed money. ● Inflation can sometimes stimulate economic activity. If inflation increases when the nominal wage is fixed, a worker‘s real wage falls. This increases firms‘ willingness to hire more workers. Inflation may therefore give the government a way to stimulate the economy temporarily, which is a useful policy lever during economic slowdowns. In addition, inflation lowers the real interest rate, which increases consumption and investment.

9. What is the federal funds rate? What are the factors that would shift the demand curve for reserves?

Answer: The federal funds rate is the interest rate in the federal funds market where banks obtain overnight loans of reserves from one another. The funds that are lent in this market are reserves at the Federal Reserve Bank.

The demand curve for reserves plots the net quantity of reserves held by private banks.

Because the demand curve relates the quantity of reserves demanded by private banks for each level of the federal funds rate, if some factor other than the federal funds rate changes, the entire demand curve shifts. There are five such factors that can shift the curve: ● An economic expansion or contraction: The value of reserves will rise in a booming economy because banks will need to make more loans to their customers. This will shift the demand curve to the right. Similarly, in a contracting economy, the demand curve will shift to the left. ● Changing liquidity needs: If the deposit base is expected to fall very quickly in the near future, for example due to a substantial increase in withdrawals, this will increase the demand for reserves and shift the demand curve to the right. ● Changing deposit base: A bank in the United States needs to hold 10 percent of its deposits as reserves. So as deposits increase, the demand curve for reserves will shift to the right. Similarly, as the deposit base shrinks, the demand curve for reserves will shift to the left. ● Changing reserve requirement: In the rare event that the Fed raises the reserve requirement, demand for reserves would increase, and the demand curve for reserves would shift to the right. Conversely, if the Fed lowered the reserve requirement, the demand curve for reserves would shift to the left. ● Changing interest rate paid by the Fed for having reserves on deposit at the Fed: A change in the modest interest rate that the Fed pays banks on reserves held at the Fed could change the demand for reserves. For example, if the Fed raises this rate, reserves become more beneficial to private banks, shifting the demand curve for reserves to the right. If the Fed lowers this rate, reserves become less valuable, shifting the demand curve for reserves to the left.

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10. What is an open market operation? Why does the Federal Reserve conduct open market operations?

Answer: An open market operation is an exchange between a private bank and the Federal Reserve. The Fed buys or sells government bonds to private banks in exchange for reserves held by those private banks at the Fed. The Fed uses open market operations when it wants to influence the federal funds rate.

Banks need to give the Fed assets in exchange for the reserves held at the Fed. These assets are usually government bonds. When the Fed offers to buy government bonds from private banks, it gives banks more electronic reserves. Similarly, when the Fed sells government bonds to private banks, it reduces the level of electronic reserves that banks hold. Suppose the Fed wants to obtain a particular value for the federal funds rate. It first chooses the federal funds rate and then finds that point on the demand curve that corresponds to that federal funds rate. The Fed makes available the exact level of reserves associated with that point on the demand curve.

11. Why is the Federal Reserve referred to as the ―lender of last resort‖?

Answer: Banks usually meet their liquidity needs by borrowing from each other in the federal funds market. Every morning, the banks assess their liquidity needs for the coming business day and borrow or lend accordingly. During extraordinary times, say during a financial crisis, the federal funds market can ―freeze‖ or break down. Banks with excess reserves may be unwilling to lend out these reserves. When this happens, banks can borrow from the Federal Reserve instead. Banks borrow reserves from the Fed at the ―discount window.‖ Since borrowing from the Fed is more costly than borrowing on the federal funds market, it is a bank‘s last resort for borrowing reserves.

12. How does the Federal Reserve influence the long-term real interest rate?

Answer: The long-term real interest rate is defined as the long-term nominal interest rate minus the long-term inflation rate.

The Fed influences the long-term nominal interest rate through the short-term federal funds rate. A long-term loan is effectively made up of many short-term loans. The nominal interest rate for the long-term loan can be seen as the average of these short-term loans. Because several of the short-term loans are affected by a change in the federal funds rate, the long-term nominal rate moves in the same direction.

The long-term expected inflation rate depends on the effect of monetary policy on inflationary expectations.

If the inflation expectations don‘t change and nominal interest rates fall, then the expected real interest rate falls. Therefore, a fall in the federal funds rate lowers the longterm nominal interest rate and lowers the expected long-term real interest rate. Even when inflation expectations do change, the long-term expected real interest rate often falls in response to a reduction in the federal funds rate.

13. What are the two models that are used to describe inflationary expectations?

Answer: Adaptive expectations and rational expectations are the two models that are used to describe inflationary expectations. The adaptive expectations model assumes that inflationary expectations are determined by the level of inflation in the recent past.

Adaptive expectations are a backward-looking way of describing how inflationary expectations are formed. The rational expectations approach, on the other hand, assumes

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that people have inflation expectations that incorporate all of the information that is available when the inflation expectations are being formed and use that information in the most sophisticated way possible. If agents have rational expectations, they are masterful forecasters who make the best possible forecast using a sophisticated understanding of the workings of the economy.

Problems 1. Barter is a method of exchange whereby goods or services are traded directly for other goods or services without the use of money or any other medium of exchange. a. Suppose you need to get your house painted. You register with a barter Web site and want to offer your car cleaning services to someone who will paint your house in return. What are the problems you are likely to encounter? b. Some barter Web sites allow the use of ―barter dollars.‖ The registration fee that you pay to a barter Web site gets converted into barter dollars that can be exchanged with other users to buy goods and services. Would the use of barter dollars resolve the problems you listed in part (a)? Explain.

Answer: a. You might find it difficult to find people who need you to wash their car and are also willing to paint your house in return. You may find people who need their car washed but are not necessarily willing to paint your house in return. Or you may find people who are willing to paint your house but do not need their car washed. b. Yes. If you could convert your services into a common currency, you could avoid the problems in part (a). Even if the other person does not want his car washed, you could compensate him with ―barter dollars.‖ You could also wash a car for someone in exchange for barter dollars that you can then use to get your house painted. Using barter dollars would allow mutually beneficial trades to take place. Of course, all of this assumes that many people are using barter dollars. If only a small number of people use barter dollars, then the problems of part (a) will reappear.

2. Money makes a variety of economic transactions possible. In the following three situations, determine whether money is involved in the transaction.

In prison camps during World War II, and in some prisons today, cigarettes circulate among prisoners. For example, a cell phone might cost six hundred cigarettes, whereas a magazine might cost only two cigarettes. Discuss whether cigarettes are fulfilling all three functions of money in this case. a.

b. Over the past 50 years, credit cards have become an increasingly popular way for people to purchase goods and services. Are credit cards money? Explain your reasoning. c. Many people have retirement savings accounts, in which they hold stocks and bonds. Do these balances constitute money? Why or why not?

Answer: a. Recall the three key functions of money: Medium of exchange, store of value, and unit of account. Also, you will remember from the chapter that many different commodities have served this function in the past and, in some isolated or

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exceptional environments, can continue to do so today. Prison is one such environment. Prisoners have limited access to ordinary currency or checking accounts, so other items begin to serve the functions of money. Cigarettes exchange for goods and services, so they constitute a medium of exchange.

Because they can last almost indefinitely, they can serve as a store of value. And since the ―price‖ of a good or service can be just as easily quoted in terms of cigarettes as dollars, they are also serving as a unit of account. Hence, in the context of the question, cigarettes constitute a kind of commodity money. b. Credit cards are not money! Students often have difficulty understanding this because these cards are so commonly used in transactions. When you pay cash or use your debit card to purchase an item, the transaction is complete. You have transferred your money, in the form of currency or funds from your checking account, to the seller in exchange for the good or service. However, when you use a credit card, you are not spending your money. You are in fact taking a shortterm, unsecured loan, extended to you by the bank that issued the card. You have to pay these funds back. How? Typically, by eventually transferring funds from your checking account, either by check or electronically, to the bank to which you owe the debt. You eventually have to pay money to discharge your debt, so credit cards do not count as money. c. No—though stocks and bonds do have a value, and can be exchanged, they are not ―money‖ per se. While a ten dollar bill doesn‘t change value over time (nominally, at least), a stock or a bond can change value depending on the performance of a company; thus, these investment instruments don‘t store value in the same way as money in a checking account. These retirement savings can change value over time—indeed, you want them to become more valuable over time!

3. In some parts of the world, salt—the stuff sitting on your kitchen table—was once used as currency. In ancient Ethiopia, for example, blocks of salt were used to purchase goods and pay salaries. The value of the salt block was based on weight, and it was physically transferred as part of the transaction. In part, salt was valuable because of its scarcity and its usefulness: before the introduction of refrigeration, many civilizations used salt to preserve food. a. Discuss how salt did or did not fulfill the three purposes of currency. b. Suppose several new salt mines opened in ancient Ethiopia. How would you expect the rapid infusion of currency into society to affect the economy? Explain.

Answer: a. As the problem describes it, salt was a medium of exchange. However, it‘s not clear to what degree it was a store of value or a unit of account. Since it could be used and, thus, depleted, the student could argue that it did not store a fixed amount of value. In addition, we don‘t know whether it really served as a unit of account; if it was primarily a valuable commodity that everyone wanted, then it was, perhaps, the centerpiece of a barter-based system rather than a true currency. b. If we viewed this as a traditional currency, then we could characterize the opening of new mines as a potential source of hyper-inflation; the value of a given amount of salt would weaken, leading to rising ―prices‖ in salt. Given the context, however, the opening of new mines could make salt useless as a currency—given a new abundance

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of salt, it may lose almost all of its value in a barter-based system. Either way, the value of salt would be severely weakened—leading, likely, to its abandonment as a currency.

4. Bitcoins are defined as a ―peer-to-peer decentralized digital currency.‖ The supply of bitcoins is not controlled by the government or any other central agency. The value of each bitcoin is determined on the basis of supply and demand and is defined in terms of dollars. New bitcoins can be generated through a process called ―mining.‖ However, new bitcoins will not be created once there are a total of 21 million bitcoins in existence. Some commentators feel that bitcoins can eventually replace most of the major currencies in the world. Would you agree? Explain your answer.

Answer: The bitcoin in its present form is not likely to replace any of the major currencies of the world. Bitcoin deposits, unlike bank deposits, are not insured by the government. Also, the value of a bitcoin is highly volatile, so bitcoins may not serve as a reliable store of value.

Source: http://bitcoin.org/en/ and http://www.livemint.com/Opinion/fEXo8r2OcAIZHWOMbZmmfO/Investors-beware-ofBitcoin.html 5. Imagine that the chairperson of the Federal Reserve announced that, as of the following day, all currency in circulation in the United States would be worth 10 times its face denomination. For example, a $10 bill would be worth $100; a $100 bill would be worth $1,000, etc. Furthermore, the balances in all checking and savings accounts are to be multiplied by 10. So, if you have $500 in your checking account, as of the following day, your balance would be $5,000, etc.

Would you actually be 10 times better off on the day the announcement took effect?

Why or why not?

Answer: Many people would not really be any ―richer‖ on the day the announcement took effect. This is due to the fact that, as soon as the nominal value of the currency increased by a factor of ten, many prices would increase by (approximately) a factor of ten. Hence, a bottle of soda that cost $1.50 before the change would cost $15 very shortly afterward; a $700 IPad would now cost $7,000, etc. The increase might take longer for some goods than for others, but sooner or later, all prices would increase by a factor of ten.

In terms of the goods whose prices can change quickly in response to the chairperson‘s announcement, you are no better off than before the change in currency and deposit denomination. Money‘s ultimate value is the goods and services for which it can be exchanged. For many goods, this will not have changed when the money stock and prices have increased by the same factor.

However, this does not mean that all people will be unaffected by the change. If the prices of some of the goods you buy cannot increase in response to the announcement, then you are definitely richer, and the seller of the goods is definitely poorer. This would be especially true with regard to some loan arrangements. For example, if you have a $200,000 mortgage on a home at an interest rate of 4 percent, then you owe $8,000 each year, which is stipulated in the mortgage contract. This amount cannot change in response to the Fed‘s announcement. After that announcement, that $8,000 obligation will not change, but $8,000 in nominal terms buys considerably less in real terms than it did before the announcement. Hence, the bank is definitely poorer, while the borrower is definitely richer.

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However, the prices of the majority of goods and services will increase by a factor of ten fairly quickly, and eventually, the prices of all goods and services will increase by that factor.

6. According to the BBC, inflation in the country of Zimbabwe reached an annualized rate of 231,000,000 percent in October of 2008. Prices got so high that in January of 2009 the country‘s central bank—the Reserve Bank of Zimbabwe—introduced a $100 trillion bill.

(Sources: http://news.bbc.co.uk/2/hi/africa/7660569.stm; http://news.bbc.co.uk/2/hi/africa/7832601.stm) Read the summary of Zimbabwe‘s experience with hyperinflation in Wikipedia (http://en.wikipedia.org/wiki/Hyperinflation_in_Zimbabwe). How does the history of hyperinflation in the country illustrate the points made in the chapter regarding the root causes, costs, and benefits of inflation? What were some of the adaptations that citizens of the country used to cope with the situation?

Answer: The chapter stresses that, in accordance with the quantity theory of money, the root cause of inflation is a rate of increase in the money supply that exceeds the rate of growth of real GDP. This was certainly the case in Zimbabwe. According to the article, Zimbabwe was printing money aggressively in order to fund its involvement in foreign wars, as well as to pay higher salaries to military and political officials.

Costs to the Zimbabwe economy were also in line with those detailed in the chapter.

Businesses faced such severe logistical problems and uncertainty that many ceased to function. People were forced to spend significant time and effort simply to carry out routine errands. Basically, the country‘s economy faced such chaos that it simply collapsed.

Also mentioned in the chapter are the undesirable political consequences that can follow from inflation, as the government introduces counterproductive policies to cope with the situation. These reached an extreme in Zimbabwe, where the government introduced higher and higher denomination banknotes, stifled political opponents, and tried to declare price increases ―illegal,‖ the ultimate form of price controls!

The only beneficiary of Zimbabwe‘s hyperinflation (temporarily, at least) was the government of dictator Robert Mugabe, which did reap the seignorage mentioned in the chapter.

Wikipedia mentions several of the adaptations that evolved to meet the crisis: initially, redenomination of the currency; later, the use of foreign currencies—especially the U.S. dollar; and the flourishing of an underground economy in U.S. dollars.

7. The following table shows the cost of producing dollar notes of various denominations. As you can see in the table, it costs only 12.7 cents to produce a $100 bill. Suppose the government decides that it will print new notes to fund its fiscal deficit as well as all its ongoing expenditures. What would be the effects of such a policy?1

1

These data are from the Federal Reserve Board: https://www.federalreserve.gov/faqs/currency_12771.htm

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Note Denomination

Cost of Production

$1 and $2

5.4 cents per note

$5

11.5 cents per note

$10

10.9 cents per note

$20

12.2 cents per note 19.4 cents per note

$50 $100

15.5 cents per note

Answer: Printing paper money has small direct cost to the Bureau of Engraving and Printing and gives the government money to spend. But printing too much money can backfire. If a currency has a very high rate of inflation, nobody will want to hold it, not even the country‘s own citizens. People will start to switch to other less inflationary currencies. Consequently, printing too much money will cause a currency to lose value sharply. However, there may a lag between when a government prints and spends the money, and when inflation becomes a serious problem. So initially at least, government benefits, but eventually, everyone, including the government, won‘t be able to get many goods and services in exchange for the newly printed currency.

Data taken from: http://www.federalreserve.gov/faqs/currency_12771.htm 8. After every meeting, the FOMC releases a statement that summarizes their policy decisions. For this problem we‘ll use the statement from December 16th, 2015, which announced the beginning of ―normalization.‖ Carefully read through the statement here: https://www.federalreserve.gov/newsevents/pressreleases/monetary20151216a.htm a. According to the statement, what factors did the committee consider in making their decision? Explain how these factors relate to the Federal Reserve‘s mandate. b. What decision did the FOMC reach in this meeting? c. The FOMC used open market operations to reach its new goal. What kind of open market operations would move the federal funds rate in the desired direction? Using a chart, show the resulting change in the market for bank reserves. d. Ultimately, how would you expect this policy change to affect the long-term real interest rate, employment, and the money supply? Walk through the steps, as in Exhibit 25.11.

Answers: a. The statement describes current market conditions, with an emphasis on improvements in employment numbers and a promising increase in inflation, with expected inflation right around the 2% target. These two factors relate directly to the dual mandate: low inflation and maximum employment. Indeed, they even mention this mandate in the announcement, though they refer to a goal of 2% inflation: ―the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation.‖ As the governors consider an increase in rates, they need to ensure that inflation and maximum employment are close enough to their targets to justify normalization.

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Overall, given that risks are balanced and the labor market and inflation numbers are improving, they decide to act. b. The FOMC decides to raise the target federal funds rate range to ¼ to ½ percent—they note, though, that policy will remain accommodative for now. c. In order to raise the federal funds rate using open market operations, the fed must reduce the supply of reserves by selling bonds to private banks. In return, they give up some of their reserves. The following chart shows the resulting shift in the supply of reserves and increase in the federal funds rate.

d. First, the Fed uses open market operations (in this case, selling bonds) to reduce the supply of reserves and increase the federal funds rate. Now, it costs banks more to borrow money, leading them to offer their loans at higher interest rates.

Thus, the long-term nominal interest rate increases, because it‘s effectively made up of shorter-term loans. Assuming long-term expected inflation remains the same, we‘ll also see an increase in the long-term real interest rate. This increase in borrowing costs will slow investment, leading to a decrease in the growth rate of employment. In addition, the higher interest rates will slow loan origination, reduce the growth rate of deposits and thus, ultimately, lead to a decrease in the growth rate of the money supply.

9. From 2001 to 2006, Japan‘s central bank, the Bank of Japan (BOJ), engaged in a monetary policy program called quantitative easing. The BOJ increased the quantity of the excess reserves that commercial banks held with the central bank by buying assets from these commercial banks. Use a graph to show how this policy is likely to have affected the overnight call rate. The overnight call rate in Japan is similar to the federal funds rate in the United States.

Answer: The federal funds rate is a short-term nominal interest rate at which banks lend to each other in the federal funds market. The overnight call rate is Japan‘s federal funds rate. When the BOJ increases the level of reserves held at commercial banks, it buys assets like government bonds from these banks. In turn, it gives private banks electronic

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reserves. This shifts the supply curve for reserves from S1 to S2. Assuming that the demand for reserves remains the same, the overnight call rate will fall from R1 to R2.

Through its quantitative easing program, the BOJ had intended to lower the overnight call rate to close to 0 percent.

10. During the financial crisis of 2007-2008, many central banks, including the Federal Reserve and the Bank of Japan, lowered their federal funds rate (or the non-U.S. equivalent) to around zero. The Bank of Japan took an additional, unusual measure: it introduced a negative short-term interest rate on excess reserves. Faced with a negative interest rate, banks must pay to lend their excess reserves to other banks.

How would this policy change the incentives of banks? Based on what we learned in this chapter, why might a central bank choose to lower interest rates on reserves below zero?

Answer: If banks now have to pay to lend their excess reserves to other banks, they‘re better off reducing their excess reserves and lending that money to consumers. Thus, the demand for reserves will shift to the left, leading to a lower federal funds rate—and, ultimately, lower nominal and real long-term interest rates. We‘ve seen that, in times of economic downturns, central banks lower interest rates as a stimulus-allowing companies to more easily take out loans and hire employees, allowing individual consumers to spend more money. However, if the interest rates are already close to zero, the bank would be limited in its policy options. With limited maneuverability, central banks might be tempted to take the extreme measure of using negative interest rates—here, on excess reserves—to further manipulate the federal funds market and continue to stimulate the economy.

11. As the U.S. economy continues to recover from the effects of the recession of 2007– 2009, it is widely anticipated that the Fed will keep raising the federal funds rate.

Suppose the current federal funds rate is 1.5 percent and that this rate is expected to prevail for one more year. Then, the expectation is that the Fed will raise the federal funds rate by 0.5 percentage points each year for 4 years, reaching 3.5 percent in year five, and then maintaining the federal funds rate at that level for another five years.

What will be the 10-year nominal interest rate as a result of these expectations?

Explain and show your work.

Answer: Recall from the chapter that a long-term nominal interest rate can be thought of

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as the average of the one-year interest rates, which are expected to prevail over a given long-run period.

I

n this question, the short-term (one-year) rates are as follows: Year

Rate

1

1.5%

2

2%

3

2.5%

4

3%

5

3.5%

6

3.5%

7

3.5%

8

3.5%

9

3.5%

10

3.5%

Calculating the 10-year average using these numbers, we get the 10-year nominal rate:

Hence, even though the current short-term nominal rate is only 1.5 percent, the expectation of higher short-term rates to come will result in a higher long-term nominal rate.

12.

The chapter discusses different models of how people form their expectations regarding inflation. Consider the following two investors, who are trying to forecast what inflation will be for next year. Sean reasons as follows: ―Inflation was 2.5 percent last year. Therefore, I think it is likely to be 2.5 percent this year.‖ Carlos, on the other hand, thinks this way: ―The economy has recovered from recession sufficiently that inflationary pressures are likely to build. Likewise, a weaker dollar means that imports are going to be more expensive. I don‘t think the Fed will risk slowing the recovery and raising unemployment by raising interest rates to fight inflation. So, in light of all these factors, I expect inflation to increase to 5 percent next year.‖ Using the terminology mentioned in the chapter, explain how you would best describe how each investor is forming his expectations of inflation. Which description better fits your own forecasts of inflation?

Answer: Sean is typical of those who formulate their forecasts using adaptive expectations. This involves using past patterns or trends to project what is likely to

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happen in the future. Carlos, however, is forming his opinion based on what economists call rational expectations. In this approach, expectations are formed not just based on the past, but on all information available at the time. So in forming expectations of inflation, an investor considers such things as the state of the macroeconomy as a whole, various monetary policies, the behavior of exchange rates, etc.

Adaptive expectations are necessarily backward looking. They assume that the past is the best guide to the future. Economic history is replete with examples where this has not been the case. Dramatic unexpected events can occur, past trends abruptly reverse, and patterns that have been reliable guides in the past can suddenly disappear. All of this makes adaptive expectations a problematic way to formulate forecasts.

Rational expectations, on the other hand, require a level of rationality and objectivity that few people can actually achieve. Moreover, the sheer volume of information involved and the degree of sophistication necessary to understand and process that information are beyond the ability of most people.

Of course, student answers to the last part of the question will vary.

Chapter 12

Economic Fluctuations Questions 1. What are economic fluctuations? What is the difference between an economic expansion and a recession?

Answer: Short-run changes in the growth of GDP are referred to as economic fluctuations or business cycles. Recessions are periods in which the economy contracts, while economic expansions are defined as the periods between recessions, characterized by positive growth in GDP. Accordingly, an economic expansion begins at the end of one recession and continues until the start of the next recession. In the United States, recessions are informally defined as two consecutive quarters of negative growth in real GDP. (The term depression is used for a prolonged recession that features unemployment in excess of 20 percent of the labor force.)

2. What does it mean to say that an economic fluctuation involves the co-movement of many aggregate macroeconomic variables? Name four variables that exhibit comovement during an economic expansion.

Answer: Co-movement of aggregate macroeconomic variables implies that these variables grow or contract together during booms and recessions. Employment and GDP move together with consumption and investment, while unemployment varies inversely with GDP. Thus, during an expansion, consumption, investment, employment and GDP all rise, while unemployment falls.

3. The duration of an economic fluctuation is completely unpredictable. Explain why this statement is only partially true.

Answer: Economic fluctuations have highly variable lengths—a fact that makes it

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difficult to precisely predict when an expansion will turn into a recession or when a recession will turn into an expansion. However, by using sophisticated statistical techniques, economists can achieve some degree of predictive power. For example, economists are able to predict the end of a recession roughly a month or two before the actual end. As a result, economic fluctuations are said to have ―limited predictability‖ rather than ―no predictability.‖ 4. Does the Great Depression illustrate the three characteristics of economic fluctuations? Explain your answer.

Answer: The Great Depression does illustrate the three key properties of economic fluctuations. 

 

It featured strong co-movement in economic aggregates. Exhibit 12.5 in the chapter shows that real GDP, real consumption, and real investment started to fall in 1929 and bottomed out in 1932 and 1933. Simultaneously, unemployment moved in the opposite direction.

It featured limited predictability. The Great Depression came as a surprise to leading economists, policymakers, and business leaders, none of whom foresaw this event.

It featured a great deal of persistence. The period of negative growth in real GDP lasted for four years, starting in 1929 and ending in 1933.

5. How do wage flexibility and downward wage rigidity affect the extent of unemployment in the economy when the demand for labor shifts to the left?

Answer: Suppose the labor demand curve shifts to the left when wages are flexible. A new equilibrium will be established at a lower wage (assuming a downward-sloping labor demand curve). Although the level of employment will have declined, everyone who wants to work at the new, lower wage will be able to find a job, so there is no unemployment.

However, if wages are downwardly rigid, a shift to the left of the labor demand curve has an amplified effect, as shown in Exhibit 12.6(c) in the chapter. The overall level of employment declines more than if wages had been able to adjust. Moreover, the quantity of labor supplied at the rigid wage is now higher than the quantity of labor demanded.

Hence, there is now unemployment.

6. How does real business cycle theory explain economic fluctuations?

Answer: Real business cycle theory emphasizes the effect of changing productivity and technology on economic fluctuations. Certain types of technological improvements can lead to increases in investment and consumption. Although technological regress seems an unlikely explanation for recessions, the rate of technological progress is believed to play a key role in long-run variation in economic growth. Real business cycle theory also emphasizes the importance of changing input prices—especially the price of oil. Because oil price changes can be abrupt, this factor does help to explain recessions.

7. How did John Maynard Keynes use the concepts of animal spirits and sentiments to explain economic fluctuations?

Answer: Animal spirits are what Keynes called the psychological factors that lead to changes in the mood of consumers or businesses and affect consumption, investment, and GDP. Animal spirits represent the overall level of optimism or pessimism in the economy and affect expectations of how future events will play out. For example, suppose firms are pessimistic about the future and cut back employment and investment. Households

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will face a heightened risk of losing their jobs because of the fall in investment and are likely to decrease their consumption and save for a rainy day. This translates into a decline in the current demand for the products of many firms, shifting the labor demand curve at those firms to the left, thereby reducing production and employment. Animal spirits are an example of changing sentiments, which include changes in expectations and changes in the (real or perceived) uncertainty facing firms and households. Changes in sentiments lead to changes in household consumption and firm investment, which affect aggregate expenditure and output.

8. The concept of multipliers was one of the key elements of John Maynard Keynes‘s theory of fluctuations. What is a multiplier? Explain with an example.

Answer: The working of a multiplier magnifies a modest negative or positive shock to the economy and generates a cascade of follow-on effects that ultimately causes a larger contraction or expansion, respectively. Multipliers are the economic mechanisms that cause an initial shock to be amplified by follow-on effects. For example, suppose a drop in consumer confidence reduces households‘ willingness to spend. Firms will cut back production and lay off employees. Those newly unemployed workers will be unable to buy goods and services, leading firms that previously sold goods to these consumers to scale back production even more. Such cascades of effects will amplify the impact of the initial shock.

9. How can contractionary monetary policy lead to an economy-wide recession?

Answer: Contractionary monetary policy causes the money supply to fall. A decline in the money supply causes the price level to fall. Wages will be downwardly rigid because firms typically avoid cutting wages to prevent morale problems at work. So when the aggregate price level falls, firms will cut their output prices but won‘t cut the wages that they pay their workers. Firms will reduce employment, as the fall in their output prices causes their labor demand curve to shift to the left. Contractionary monetary policy also causes the real interest rate to rise. This increases production costs for firms and also causes a leftward shift in the demand for labor, lowering the quantity of labor hired at the downward rigid wage. These effects put together cause a fall in employment and GDP, leading to a recession.

10. What are two important mechanisms that reverse the effects of a recession in a modern economy?

Answer: In the medium run, two factors tend to reverse the effects of a recession. 

The labor demand curve shifts back to the right.

This can happen for several reasons: Excess inventory has been sold off in the course of the recession; technological advances create new business opportunities that enable firms to expand their activities; or the banking system and other financial intermediaries recuperate, increasing the credit available to finance expanded business operations. 

Government pursues expansionary monetary and fiscal policies to stimulate the economy.

Expansionary monetary policy can be used to lower interest rates, stimulating both consumption and investment. Likewise, government spending can be increased, or taxes reduced, as part of expansionary fiscal policy. The inflationary pressures that can result from either of these policies serve to raise the prices for firms‘ products, thus making their operations more profitable at a given wage. This also acts as a stimulus to increased

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employment.

11. How can the 2007–2009 recession be explained?

Answer: When housing prices fell sharply from 2006 to 2009, homebuilders reduced their rate of new construction because they already held a large inventory of new homes and the falling prices made new construction unprofitable. Consequently, their labor demand curves shifted sharply to the left. The fall in housing prices reduced consumers‘ wealth, and most households curtailed spending. The labor demand curves for firms that produced goods and services that consumers buy shifted to the left. Home owners also defaulted on mortgages, which adversely affected bank balance sheets. Credit to the private sector fell. The decline in credit to households and firms reduced consumption and investment and triggered another round of adverse labor demand shifts.

12. Between 2000 and 2006, housing prices in the United States increased by about 90 percent. As detailed in the chapter, this increase abruptly reversed. a. Why is the rise in housing prices between the late 1990s and 2006 characterized as a bubble by some economists? b. How did the fall in housing prices cause the financial system in the United States to freeze up?

Answer: a. When a large increase in the price of an asset can‘t be justified by the true economic value of the asset, the price increase is likely to be temporary, and economists refer to this situation as a bubble. b. With the fall in housing prices, many families found that their mortgages were ―underwater‖; they owed more on their home than it was worth. Some households in this situation have a strong incentive to default on their mortgage payments. Home foreclosures rose sharply. Banks were left with outstanding mortgages that they could not recoup as the underlying asset, the house in this case, was worth less than the value of the mortgage. Consequently, banks suffered enormous losses on their portfolios of mortgages and many banks failed, disrupting their ability to extend credit. Even the surviving banks were hesitant to make loans, afraid that these new loans—to households and businesses—would soon end up in default. In summary, the decline in housing prices (and other asset prices) caused banks to suffer enormous losses, disrupting the banks‘ ability and willingness to make loans to consumers and firms.

Problems 1. Consider the data in Exhibit 12.3. a. List the recessions since 1929 by duration, with the longest recession first and the shortest last. b. List the recessions since 1929 according to decline in real GDP from peak to trough, with the greatest decline first and the smallest decline last. Note which recessions are first and second on your list from part (a) and first and third on your list from part (b). Can you think of a reason why the fall in real GDP at the end of World War II (1945; second recession on your list from part (b)) was so

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deep even though that recession was very short?

Answer: a.

Starting Month

Ending Month

Duration

Decline in Real GDP

August 1929

March 1933

43 Months

26.7%

December 2007

June 2009

18 Months

4.3%

November 1973

March 1975

16 Months

3.1%

July 1981

November 1982

16 Months

2.5%

May 1937

June 1938

13 Months

3.3%

November 1948

October 1949

11 Months

1.5%

December 1969

November 1970

11 Months

0.2%

July 1953

May 1954

10 Months

1.9%

April 1960

February 1961

10 Months

0.3%

February 1945

October 1945

8 Months

12.7%

August 1957

April 1958

8 Months

3.0%

July 1990

March 1991

8 Months

1.3%

March 2001

November 2001

8 Months

0.3%

January 1980

July 1980

6 Months

2.2%

Starting Month

Ending Month

Duration

Decline in Real GDP

August 1929

March 1933

43 Months

26.3%

February 1945

October 1945

8 Months

12.7%

December 2007

June 2009

18 Months

4.3%

May 1937

June 1938

13 Months

3.3%

November

March 1975

16 Months

3.1%

b.

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1973 August 1957

April 1958

8 Months

3.0%

July 1981

November 1982

16 Months

2.5%

January 1980

July 1980

6 Months

2.2%

July 1953

May 1954

10 Months

1.9%

November 1948

October 1949

11 Months

1.5%

July 1990

March 1991

8 Months

1.3%

April 1960

February 1961

10 Months

0.3%

March 2001

November 2001

8 Months

0.3%

December 1969

November 1970

11 Months

0.2%

After almost every war, there is usually a sharp recession. This was especially true of World War II. During the conflict, production went into overdrive. Workers worked double shifts, and factories sometimes stayed busy 24 hours a day. With the end of the war, however, the surge of output abruptly diminished. There was no longer demand for war materiel, and the government spending that paid for it quickly dried up. The economy eventually transitions to normal, peacetime production, but that takes a bit of time. In the interim, there can be a deep, if brief, recession, as output and employment drop.

2. The University of Michigan runs monthly surveys of households around the United States. Some of the questions gauge consumer optimism by asking how households feel about their own financial situation, as well as the economy more broadly. These responses are used to generate a monthly measure of Consumer Sentiment. Look at a chart of this measure over time here: https://fred.stlouisfed.org/series/UMCSENT/. Note that the shaded areas represent recessions. a. How does the consumer sentiment measure behave during recessions? Explain what you see in the chart using Keynes‘ animal spirits view of economic fluctuations. b. Does this chart prove that Keynes‘ theory is correct? Explain. Why is it hard to determine the direction of causality? Do recessions cause drops in consumer sentiment, or, do drops in consumer sentiment cause recessions?

Answer: a. The chart shows a dip in consumer sentiment during recessions. This dip fits in well with the animal spirits view, which posits that declining sentiment can lead to multiplier effects and the deepening of recessions. According to that view, we‘d expect the initial decline in consumer sentiment to be exacerbated by the resulting decline in economic conditions. b. It does not prove that Keynes‘ theory is correct. This chart merely shows the

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correspondence between the consumer sentiment and recession timing—and, even there, it‘s not clear how tightly they‘re related. After all, the series dips dramatically outside of recessions, as well. Without understanding the timing—or related variables—it‘s extremely difficult to determine the direction of causality. There are too many other factors, and there‘s too much interplay between sentiment and recessions. Recessions, certainly, may cause dips in sentiment; indeed, this mechanism is key to Keynesian multipliers. However, from this chart, we don‘t know to what degree sentiment is, in turn, driving recessions. Ultimately, because both directions of causality could be present, it‘s hard to disentangle the relative strength of the two effects—or to establish whether another macroeconomic force set off the recession and decline in consumer sentiment.

3. The Conference Board publishes data on Business Cycle Indicators (BCI). The Composite Index of Leading Economic Indicators is one of the three components of the BCI. Changes in leading economic indicators usually precede changes in GDP. Some of the variables tracked by the index are listed below.

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i.

The average weekly hours worked by manufacturing workers

ii.

The average number of initial applications for unemployment insurance

iii.

The amount of new orders for capital goods unrelated to defense

iv.

The number of new building permits for residential buildings

v.

The S&P 500 stock index

vi.

Consumer sentiment

Consider each variable and explain whether it is likely to be positively or negatively correlated with real GDP. Answer: All of the variables that are listed are likely to be positively correlated with GDP except the average number of initial applications for unemployment insurance. i.

The average weekly hours worked by manufacturing workers depends on the quantity of goods that are being manufactured. This is likely to be low in a recession and high during a boom or expansion, when output is high. ii.

Unemployment is negatively correlated with real GDP. Unemployment falls when GDP rises, and unemployment rises when GDP falls. The number of applications for unemployment insurance will rise when unemployment rises.

Therefore, the average number of initial applications for unemployment insurance is negatively correlated with real GDP. iii.

An increase in the amount of orders for capital goods unrelated to defense indicates an increase in investment and is usually undertaken when firms are optimistic about future demand for the goods and services that they produce. As real GDP rises, firms will increase capital investment in anticipation of future sales and revenue. Defense is excluded from this indicator as defense orders are usually undertaken by the government irrespective of changes in real GDP. iv.

Firms that construct residential buildings are likely to request new building permits when they expect demand for housing to be strong. The demand for housing is usually strong in a growing economy in which increasing incomes allow consumers to invest in residential housing. Therefore, this variable moves positively with real GDP. v.

Stock prices tend to move positively with other measures of economic activity. Therefore, the S&P 500 stock index is also likely to be positively correlated with real GDP. vi.

Consumer sentiment is likely to be positively correlated with real GDP. When real GDP and incomes are rising, consumers are optimistic about the prospects of the economy.

Data on BCI taken from: http://www.investopedia.com/university/conferenceboard/conferenceboard2.asp

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4. Suppose that the mythical country of Moricana has a downward rigid wage. Moricana is in a recession; capacity utilization in the economy is at an all-time low, and surveys show that firms do not expect economic conditions to improve in the coming year. a. Firms in the country are cutting back on capital spending and investment. Use a graph to show how this would affect the labor demand curve (ignore the effects of multipliers). b. Is unemployment in Moricana likely to be classified as voluntary or involuntary?

Explain your answer.

Answer: a. Given the information in the question, wages in Moricana are likely to be rigid.

When firms cut back on capital spending and investment, the demand for labor will fall. This shifts the labor demand curve to the left. As shown in the following graph, the economy is initially in equilibrium at point 1, where the level of employment is L. The demand curve for labor shifts from D1 to D2. Because wages are rigid and cannot adjust, the economy moves to point 2 on D2. The level of employment falls from L to L". Had wages been flexible, employment would have only fallen to L'.

b. When wages are rigid, a left shift of the demand curve leads to involuntary unemployment. At the going wage W in the graph, the number of workers who are willing to work at the going wage exceeds the number of jobs that firms are willing to fill. The number of workers who would like to work at the market wage but can‘t find a job is equal to the gap between L and L" in the graph from part a.

5. Imagine a new technology emerged, allowing for increased productivity and driving U.S. real GDP growth from 2.5% one year to 3% in the next year. a. How will this change in the growth rate of GDP affect unemployment? Use Okun‘s Law to generate a numerical estimate. b. Use the real business cycle approach to explain how the new technology could affect both unemployment and GDP. Why might this new technology lead to higher unemployment than we estimated using Okun‘s Law? Answer: a. Okun‘s law tells us that Year to Year change in rate of unemployment = -.5(g –

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2), where g is the rate of real GDP growth. Originally, then, the change in the unemployment rate was -.5(2.5-2) = -.25%. With the increase of GDP, we have .5(3-2) = -.5%. Thus, this increase in the growth rate of GDP will lead to a more rapid decrease in the rate of unemployment—now, it‘s falling more quickly (-.5% per year) than it was before (-.25% per year). b. The real business cycle approach credits growth to new, improved technology. In particular, improved technology increases the value of the marginal product of labor, increasing demand for laborers as well as output. Thus, this new technology would stimulate both employment and GDP would, leading to higher growth of both.

However, as we‘ve seen in previous chapters, technology, particularly automation technology, can push employment down in certain sectors. Thus, while the growth rate may increase, the associated movement in unemployment may be moderated by substitution toward capital from labor.

6. Assume that labor supply and labor demand are described by the following equations: Labor Supply:

LS = 5 × w

Labor Demand:

LD = 110 – 0.5 × w

where w = wage expressed in dollars per hour, and LS and LD are expressed in millions of workers. a. Find the equilibrium wage and the equilibrium level of employment. b. Assume that there is a shock to the economy, such that the labor demand curve is now described by the equation: LD = 55 – 0.5 ×w. If wages are flexible, what will be the new equilibrium wage and level of employment? Show your work. c. Now assume that wages are rigid at the level you found in part (a). What will employment be at this wage? How many workers will be unemployed?

Answer: a. LS = 5w LD = 110 – 0.5 × w In equilibrium: LS = LD 5 × w = 110 – 0.5 × w Solving for the equilibrium wage, w*: 5.5 × w = 110 w* = 20 Plug in w* to find L* using either LS or LD: LS = 5w* = 5 × 20 = 100 = L* LD = 110 – 0.5 × w = 110 – 0.5 × 20 = 100 = L*

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b. LS = LD 5 × w = 55 – 0.5 × w Solving for the equilibrium wage, w*, assuming the wage is flexible: 5.5 × w = 55 w* = 10 Plug in w* to find L* using either LS or LD: LS = 5 × w* = 5 × 10 = 50 = L* LD = 55 – 0.5 × w = 55 – 0.5 × 10 = 50 = L* c. From part (a), we already know that the wage will be 20, and LS at 20 = 100.

However, labor demand at the previous wage of w = 20 will be: LD = 55 – 0.5 × 20 = 55 – 10 = 45 Given that LS = 100, unemployment will be: LS – LD = 100 – 45 = 55 7. In 1973, the major oil-producing nations of the world declared an oil embargo. The price of oil, a key source of energy, increased. In many countries, this led to a fall in real GDP and employment. Which of the three business cycle theories explained in the chapter – real business cycle theory, Keynesian theory, and monetary theory – would best fit this explanation of the 1973 recession?

Answer: Real business cycle theory emphasizes the role of technology in causing economic fluctuations. Proponents of real business cycle theory tend to emphasize the importance of changing input prices on aggregate output. Because almost all firms use oil in one form or another, oil price changes function like technology changes. An increase in the price of oil in 1973 led to a decrease in the productivity of firms that used oil.

Large and abrupt increases in oil prices can cause a recession. Thus, the real business cycle theory best fits the explanation given in the problem.

8. An old saying goes: ―Nothing succeeds like success.‖ Explain how this could relate to Keynes‘s animal spirits view of economic fluctuations.

Answer: Keynes‘s theory of animal spirits highlights the psychological elements that are important determinants of everyone‘s decisions, including their economic and financial decisions. Optimism and pessimism are inevitable components of our thinking and, in the aggregate, can affect the macroeconomy.

In periods when a majority of consumers and business people are optimistic about the economy, their actions will reflect that optimism. Consumers increase their spending, businesses increase their investment, and this, in turn, stimulates the economy. This is the ―self-fulfilling prophecy‖ phenomenon mentioned in the chapter. Furthermore, this

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success can stimulate further success. As the chapter points out, the multiplier process can be linked to this interplay of attitudes and results. Optimism about the economy leads businesses to increase output and thus their demand for labor. Wages rise, and employment increases, which increases workers‘ incomes. As workers spend their increased income on consumption goods, demand rises further and feeds back into another round of increases in labor demand. The initial boost to the economy resulting from a more optimistic view of the future spurs further optimism and, via the multiplier, a further boost to the economy. Success stimulates further success.

9. Use a detailed graph to show the effect of a negative shock on the labor demand curve in an economy. Assume that wages in the economy are rigid and cannot fall in the short run. Compare the point of trough employment on the graph with the point of trough employment if wages were flexible.

Answer: The following graph shows how a negative shock affects the economy‘s labor demand curve. The economy is initially in equilibrium at point 1 at the employment level L. Following the shock, the demand curve shifts to the left from D1 to D2. Because wages are rigid, the economy is at a new equilibrium at point 2, where the level of employment is L'. Had wages been flexible, the economy would have moved from point 1 to point A where the level of employment is higher than L'. Given that a negative shock is likely to be amplified by multiplier effects, the labor demand curve could shift even farther leftward from D2 to D3. The equilibrium level of employment in the economy further falls from L' to L" and the economy is now at point 3. L", corresponding to point 3, is the level of trough employment. Had wages been flexible, the economy would have moved to point B instead, where the level of trough employment would be higher than L".

10.

Republicans and Democrats fiercely debate the economic legacy of President Obama‘s presidency: Republicans point to low GDP growth during his presidency, while Democrats laud improvements in labor markets since the great recession.

Recall that President Obama took office in January 2009, a few months after the collapse of Lehman brothers in September 2008. Does it make sense to attribute the deepening of the recession—or, ultimately, its end—entirely to the actions of the president? Explain, for example, how the recession might have been alleviated in the absence of any governmental action at all.

Answer: No, it doesn‘t make sense to attribute macroeconomic fluctuations entirely to the actions of the president. While governmental actions, like tax cuts, may impact the macroeconomy, we saw in this chapter how recessions can form and recede without any

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governmental intervention at all. Labor demand can increase due to a variety of market forces. For example, company inventories may run down, leading them to, once again, boost production; capital might be finally transferred from weak companies to more resilient ones. (the student should mention two or three of the market-driven factors discussed on p. 648-649). Even with government stimulus, we can‘t attribute all of a recovery or downturn to the government: the impact of these policies is magnified through multipliers, which the government cannot easily control.

11. In the early 1980s, the unemployment rate in the United States rose above 10percent.

The United States was in a severe recession. Both fiscal and monetary policies were used to stimulate the economy. Government spending increased by 18.9percent, while the Federal Reserve cut interest rates by nearly 11 percentage points. How would these policies affect the labor demand curve and the overall labor market? Assuming wages are rigid, use a graph to explain your answer. Be sure to show the prerecession equilibrium, the situation at the trough of the recession, and the effect of the government policies.

Answer: Both policies will shift the labor demand curve to the right, leading to higher equilibrium employment and wage. As shown in the following figure, the economy is initially in equilibrium at L level of employment where the labor demand curve, D1, intersects the labor supply curve, S. A shock to the economy moves the labor demand curve from D1 to D2, reducing employment to L". Because wages are rigid, the D2 curve intersects S at point 2. L" is the level of trough employment. Policy interventions by the government and the Federal Reserve shift the labor demand curve from D2 to D3, partially reversing the impact of the shock. Although the employment level is not fully restored, the partial recovery in the labor demand curve takes the economy from point 2 to point 3, where employment is at L'.

Data from: http://www.epi.org/publication/bp355-five-years-after-start-of-greatrecession/ 12. The Evidence-Based Economics feature in the chapter identifies three key factors that caused the recession of 2007–2009. a. How would Keynes‘ concept of animal spirits explain the creation of a housing bubble? b. Explain how the recession of 2007–2009 affected the consumption and investment components of the national income identity.

Answer:

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a. According to Keynes, animal spirits is a psychological phenomenon. It represents the overall level of optimism or pessimism in the economy. In the book Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism, George Akerlof and Robert J. Shiller explain that the idea that everyone should own a house and that a house is a worthwhile investment played a part in creating a bubble. This belief, which gained momentum in the 1990s and the early 2000s, pushed housing prices up and also led many to ignore the possibility of a decline in housing prices. The housing bubble showed that animal spirits in an economy can fluctuate sharply even as the underlying fundamental features of the economy change relatively little. b. The national income identity is: Y = C + I + G + NX. The Great Recession primarily affected the C and I components of the national income identity. The fall in housing prices reduced consumers‘ wealth and led to a drop in consumption. Because falling prices made new construction unprofitable, construction of new houses dropped, which reduced I. The decline in housing prices also led to millions of mortgage defaults. These mortgage defaults led to bank failures. Bank lending fell sharply, causing further reductions in C and I. Based on: http://chronicle.com/article/How-Animal-Spirits-Wrecked/15656 13. Some economists stress the role of monetary policy in the period leading up to the recession of 2007–2009. Between 2001 and 2003, the Federal Reserve lowered the target Fed Funds rate from 6.5 percent to 1 percent and kept it there through much of 2004. This resulted in a substantial decline in real interest rates throughout the economy, including mortgage rates.

Based on the chapter‘s discussion of monetary and financial factors, explain how the Federal Reserve‘s policies could have contributed to the economic ―bubble‖ of the pre-recession years of 2000–2006.

Answer: The historically low interest rates that resulted from Fed policy from 200 –2004 were mirrored by very low mortgage rates. This, in turn, stimulated the housing market as families took advantage of low rates to finance home purchases. Demand for real estate increased, which drove up real estate prices throughout the United States. Moreover, partially in response to government initiatives to increase home ownership, mortgage lending standards were relaxed, which, coupled with the very low rates on mortgages, contributed to the ―bubble‖ mentioned in the chapter.

Chapter 13

Macroeconomic Policy Questions 1. What are the similarities and the differences between monetary and fiscal policies?

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Answer: Monetary policy is conducted by the central bank, whereas fiscal policy is undertaken by the legislative and executive branches of government. Monetary policy manipulates monetary aggregates (such as bank reserves and M2), credit access, and interest rates, while fiscal policy adjusts government spending and taxes. Though monetary and fiscal policies work differently in different situations, both sets of policies cause shifts in the labor demand curve.

2. How do expansionary policies differ from contractionary policies?

Answer: During a recession, expansionary policy aims to reduce the severity of the downturn by shifting labor demand to the right and ―expanding‖ economic activity.

Contractionary policy, on the other hand, shifts the labor demand curve to the left and sometimes is used to reduce the rate of inflation or slow down the economy when it grows too fast or ―overheats.‖ 3. Briefly explain how expansionary monetary policy shifts the labor demand curve to the right.

Answer: Expansionary monetary policy lowers short-run interest rates and increases access to credit in order to stimulate economic activity. The fall in short-run interest rates usually causes the long-term expected real interest rate to fall. A fall in the long-term expected real interest rate encourages households and firms to make more investments (such as building new homes and factories) because a lower real interest rate implies that the cost of a loan has fallen. Lower interest rates also stimulate consumption spending, especially on durable goods, because loans to finance those purchases cost consumers less. To satisfy an increase in demand for investment and consumption goods, firms seek to hire more workers, shifting the labor demand curve to the right.

4. What is quantitative easing? Why do central banks undertake quantitative easing programs?

Answer: Quantitative easing involves primarily a change in the way that the Fed conducts open market operations. Rather than buying just short-term Treasury bonds, which is the usual way that the Fed increases bank reserves in a standard open market operation, the Fed buys other assets as well, including long-term bonds and mortgage-backed securities.

This pushes up the price on the long-term bonds and thereby drives down long-term interest rates.

Such purchases also increase the quantity of bank reserves, with the goal of increasing bank lending, and ultimately, stimulating the economy. Quantitative easing is one of the major factors behind the significant increase in bank reserves that occurred from 2008 to 2014.

5. Other than open market operations and quantitative easing, what tools does the Federal Reserve use to manipulate interest rates in the economy?

Answer: The Federal Reserve has several tools in addition to open market operations to affect interest rates.

First, it can change the reserve requirement, the percentage of checking deposits that banks are required to keep on reserve. If the requirement is increased, banks must keep more in reserves, and the demand for reserves curve shifts to the right, increasing the fed funds rate. Conversely, if the requirement is decreased, the reserves demand curve shifts to the left, decreasing the fed funds rate.

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Second, the Fed can change the interest rate it pays banks on the reserves banks hold at the Fed. A decrease in that rate lowers the demand for reserves and shifts the reserves demand curve to the left, thus lowering the fed funds rate. An increase in the rate paid would have the opposite effect.

Third, the Federal Reserve can change interest rates by using the discount window through which it can provide short-term liquidity to banks. Banks use the discount window when they can‘t find a lender in the federal funds market. Such lending occurs frequently during financial crises.

6. Does the effectiveness of monetary policy depend on inflation expectations? Explain.

Answer: Yes, inflation expectations are linked closely with the long-term expected real interest rate. The federal funds rate, which is the annualized interest rate on overnight loans between banks, is a short-term nominal interest rate that the Fed directly controls using monetary policy. However, the interest rate that is relevant for consumers‘ and firms‘ investment decisions—for instance, the mortgage interest rate—is the long-term expected real interest rate.

Long-term expected real interest rate = Long-term nominal interest rate – Long-term expected inflation rate.

For the Fed to lower the long-term expected real interest rate, it has to either lower the long-term nominal interest rate or raise long-term expectations of the inflation rate (or both). To do this, the Fed can communicate that it will maintain an expansionary monetary policy, holding down the federal funds rate and increasing the money supply, for a long period of time. If the Fed promises to keep the federal funds rate low and households and firms believe that the federal funds rate will remain low for several years, then the long-term nominal interest rate will also be low. Inflation expectations are likely to be high when the Fed creates expectations of inflation by promising to conduct expansionary monetary policy for several years. High inflation expectations will then lower the long-term expected real interest rate.

7. Briefly explain how an increase in the quantity of reserves that commercial banks hold at the Federal Reserve could lead to inflation.

Answer: The Federal Reserve buys government bonds from commercial banks and electronically increases the quantity of reserves held by these commercial banks. Because banks now have a higher quantity of reserves, they can create more loans. Those loans circulate through the economy and return to the banking system as deposits. Rising bank deposits enable banks to make even more loans. The resulting total increase in deposits generates an increase in monetary aggregates like M2. If the stock of money grows faster than the real level of GDP, the aggregate price level will rise, generating inflation.

8. How does the zero lower bound on interest rates affect the working of monetary policy?

Answer: The zero lower bound is a barrier that nominal interest rates cannot cross; when nominal interest rates have been lowered to zero, the central bank cannot lower rates any further.

When the rate of inflation is low or negative, the zero lower bound is a problem for the working of monetary policy. When the nominal interest rate is stuck at or above zero and the inflation rate is negative, the real interest rate will be positive. If the inflation rate keeps falling, the real interest rate will rise, reducing investment and shifting the labor

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demand curve to the left.

9. When nominal interest rates have hit the zero lower bound, can central banks use interest rates to stimulate the economy? Explain.

Answer: Yes, the central bank can try to influence expectations of future nominal interest rates and future inflation. By promising to keep nominal interest rates low for many years and promising to keep inflation low in the long term, the central bank can influence the long-term expected real rate of interest, even if the current interest rate is at zero and can‘t be lowered any further.

10. What does the Taylor rule state?

Answer: The Taylor rule shows that the federal funds rate should be set at the level where: Federal funds rate = Long-run federal funds rate target + 1.5[inflation rate –Inflation rate target] + 0.5[Output gap in percentage points] 11. According to the Taylor rule, when should the Federal Reserve lower or raise the federal funds rate?

Answer: The Taylor rule contains two relationships: ● The Fed should raise the federal funds rate as the inflation rate rises. A larger inflation rate leads the Fed to engage in less stimulus by raising the federal funds rate. Specifically, the formula says that every percentage point increase in the inflation rate should translate into a 1.5 percentage point increase in the federal funds rate. ● The Fed should set a higher federal funds rate the higher the output gap. A larger output gap leads the Fed to engage in more contractionary monetary policy by raising the federal funds rate. Specifically, the formula says that every percentage point increase in the output gap should translate into a 0.5 percentage point increase in the federal funds rate.

12. What are the automatic and discretionary components of fiscal policy?

Answer: Fiscal policy can be divided into automatic and discretionary components. ● Automatic components are aspects of fiscal policy that automatically partially offset fluctuations in economic activity. These automatic components do not require deliberate action on the part of the government. For example, tax collection falls automatically during a recession because unemployed workers don‘t owe income tax. ● Discretionary components are aspects of fiscal policy that policymakers deliberately enact in response to economic fluctuations. In most cases, these new policies introduce a package of specific, temporary tax cuts or spending increases to reduce economic hardship and stimulate aggregate economic activity.

13. How can expansionary expenditure-based fiscal policy lead to crowding out in the economy?

Answer: Expansionary expenditure-based fiscal policy is implemented by increasing government spending or by cutting taxes. Both government expenditure and tax cuts can partially or even fully displace expenditures by households and firms. This is called crowding out of private consumption and private investment. Crowding out occurs

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because the government borrows from credit markets to fund its increased expenditure.

As the government borrows to pay its bills, the interest rate in the credit market rises. At higher interest rates, private consumption and investment will fall. Private savings will now be lent to the government and will not be used in funding private consumption and investment. In effect, the private expenditure is crowded out by the government borrowing.

14. What could explain why a decrease in taxes could lead to a less-than- proportionate increase in output?

Answer: Expansionary fiscal policy is implemented by increasing government spending or by cutting taxes. A decrease in taxes could lead to a less-than-proportionate increase in output for the following reasons. ● Tax cuts might generate crowding out effects. As consumers try to spend more, resources that would have previously gone to investment may now be redirected to consumption. The extra goods might be provided by an increase in imports, lowering net exports. ● Consumers may not actually spend much of their tax cut right away and may choose to save instead. Consumers may try to smooth their consumption by spreading the ―extra‖ spending over the long term rather than consuming the proceeds of a tax cut all at once. They may also recognize that the government will eventually have to raise taxes in the future to pay for the current tax cut. This may lead them to save the tax cut now to pay for the tax raise later.

15. Why is the Troubled Asset Relief Program (TARP) considered an example of a countercyclical policy that represents a mix of fiscal and monetary effects?

Answer: A program like TARP is an example of a policy that includes both fiscal and monetary effects. The TARP was developed jointly by the Federal Reserve and the Treasury Department. The TARP legislation required that the Fed Chairman be consulted during TARP‘s implementation. The U.S. Congress passed the legislation authorizing the Treasury Department to spend $700 billion to stabilize the financial system. This money was used to infuse capital into the banking system. The increase in capital stabilized banks that were close to bankruptcy and prevented financial contagion. Therefore, the fiscal component of TARP involved the increase in government expenditure, while the monetary component was the fact that banks and the financial system were affected by this program.

Problems 1. The former chairman of the Federal Reserve, Alan Greenspan, used the term ―irrational exuberance‖ in 1996 to describe the high levels of optimism among stock market investors at the time. Stock market indexes such as the S&P Composite Price Index were at an all-time high. Some commentators believed that the Fed should intervene to slow the expansion of the economy. Why would central banks want to clamp down when the economy is growing? What policies could the government and the central bank use to achieve the goal of slowing down the economic expansion?

Answer: To quote Greenspan, ―But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?‖ Policymakers may want to limit

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growth because factors such as irrational optimism about the economy can result in unsustainable increases in asset values. Bubbles or irrational increases in asset prices are usually not supported by corresponding changes in fundamentals. Unsustainable expansions can subsequently lead to very severe downturns because irrational optimism can implode suddenly and severely (due to multiplier effects).

The government and the central bank can use contractionary policies to slow or even reverse an economic expansion. Contractionary monetary policy can be implemented to raise interest rates, thereby increasing the cost of borrowing and reducing investment and consumer spending. Contractionary fiscal policy, such as tax increases or reductions in government spending, could also be employed to dampen aggregate economic activity.

Either of these policies will serve to slow an economic expansion and avoid the dangers of unsustainable increases in asset prices Alan Greenspan‘s speech: http://www.federalreserve.gov/boarddocs/speeches/1996/19961205.htm 2. The following figures show the Federal Reserve‘s balance sheet as well as the balance sheet of a commercial bank, BHZ Bank. Suppose the Federal Reserve wants to lower bank reserves by $1 billion. Assuming that BHZ Bank is willing to transact with the Federal Reserve, show how the Fed‘s as well as BHZ‘s balance sheet will change.

THE FEDERAL RESERVE Assets Treasury Bonds Other bonds

Liabilities and Shareholders' Equity $1,500 billion Reserves

$1,500 billion

$500 billion Currency

$ 500 billion

$2,000 billion Total liabilities

Total assets

$2,000 billion

BHZ BANK Assets

Liabilities and Shareholders' equity

Reserves

Deposits and other $200 billion liabilities

$700 billion

Bonds and other investments

$800 billion Shareholders' equity

$300 billion

Total assets

$1,000 Liabilities + shareholders' billion equity

$1,000 billion

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Answer: To lower bank reserves by $1 billion, the Fed engages in an open market operation with BHZ Bank. The Fed deducts $1 billion from the reserves that BHZ holds with the Fed and gives BHZ $1 billion in bonds instead. On the liability side of the Fed‘s balance sheet, the reserves (held by BHZ) fall by $1 billion. On the asset side, the Fed has $1 billion less in bonds (sold to BHZ Bank).

THE FEDERAL RESERVE Assets Treasury Bonds Other bonds Total assets

Liabilities and Shareholders' Equity $1,499 billion Reserves

$1,499 billion

$500 billion Currency

$ 500 billion

$1,999 billion Total liabilities

$1,999 billion

BHZ Bank buys $1 billion in bonds from the Fed, paying for them by a reduction of $1 billion in the bank‘s reserve account at the Fed. Nothing changes on the liability (and shareholders‘ equity) side of BHZ‘s balance sheet. On the asset side, total assets don‘t change, but the composition of assets does. After the trade, BHZ has another $1 billion in bonds and $1 billion less in reserves.

BHZ BANK Assets

Liabilities and Shareholders' Equity

Reserves

$199 billion Deposits and other liabilities

$700 billion

Bonds and other investments

$801 billion Shareholders' equity

$300 billion

Total assets

$1,000 billion

Liabilities + shareholders' equity

3. Suppose that, in the United States, the inflation rate is at 3.2%. Rapidly rising prices and low interest rates have spurred business to hire more workers and invest in new facilities. a. Why might the Federal Reserve be worried about these developments? b. Given the circumstances, what would countercyclical monetary policy seek to accomplish? Explain the different mechanisms that the Fed can use to implement this policy. c. Based on your answers to part a. and part b., explain why having an independent central bank might be useful. Do you think this countercyclical policy would still be enacted if central bankers were appointed by popular vote? What would happen if they were political appointees that could be hired and fired by the president? Explain.

Answer: a. One part of the fed‘s dual mandate is to ensure low inflation—as we discussed in

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this chapter, the target inflation rate is generally around 2%. At 3.2% inflation, the economy could be experiencing unsustainable expansion, which could ultimately result in a sharp downturn. The Federal Reserve, then, would be worried about inflation continuing to grow and the economy ―overheating.‖ It may also be concerned about maintaining its own reputation for controlling inflation. b. Given that the economy is experiencing an expansion, countercyclical policy would be contractionary—that is, the Fed would raise the federal funds rate through one of the following mechanisms: (1) Selling bonds in an open market operation. This reduces the money supply because an open market bond sale decreases bank reserves, thus restricting the amount of lending that banks can do. This is reflected by a leftward shift in the supply of reserves curve, resulting in an increase in the federal funds rate.

(2) Increasing the reserve requirement. This will increase banks‘ demand for reserves, shifting the reserves demand curve to the right and resulting in a higher federal funds rate.

(3) Increasing the rate it pays on bank reserves held at the Fed. This results in an increased demand for reserves, a rightward shift in the reserves demand curve, and a higher equilibrium fed funds rate.

(4) Restricting discount lending, for example, by raising the interest rate (called the discount rate) that the Fed charges banks to borrow from it. Recall from the chapter that the Federal Reserve can lend to banks so that they can meet their reserve requirement. An increase in the discount rate will induce banks to increase reserves and/or reduce lending.

(5) The Fed can reduce the supply of credit previously expanded through the process known as quantitative easing, which is described in the chapter. c. During an expansion, it likely wouldn‘t be politically popular for the Fed to raise the federal funds rate—an increase in rates, after all, would lead to a contraction in the labor market and increased unemployment. If the Fed didn‘t have independence, it would likely be unable to keep inflation in check using countercyclical policies. If the governors were elected by popular vote, their incentives would depend on the length of their terms. If the terms were still 14 years, then they would likely want to pursue the optimal countercyclical policies—after all, if they failed to cool down an overheated economy, they would certainly receive blame from the public. With shorter terms, however, they might care more about the immediate appearance of their policies—which is why political appointees might be extremely hesitant to enact contractionary countercyclical policy. The president would likely fire governors who enacted policies that hurt his or her public popularity before the next election (here, again, there would be a distinction between a first term and second term president— though the president might care regardless about the popularity of his or her party).

4. You and a friend are debating the merits of using monetary policy during a severe recession. Your friend says that the central bank needs to lower interest rates all the way down to zero. According to him, zero nominal interest rates will boost lending and investment; consumers and firms will surely borrow and spend when interest rates are zero. Would you agree with his reasoning? How does the level of inflation affect your answer? Explain your conclusions.

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Answer: Yes, zero nominal interest rates could boost spending and act as an economic stimulus. Households and firms make investment decisions based on the real interest rate.

When the nominal interest rate is zero and the inflation rate is positive, the real interest rate will be negative. Suppose the inflation rate is 2 percent. The real interest rate would be equal to 0% – (2%) = –2%. This provides a significant incentive for consumers and firms to borrow, which stimulates consumption expenditure and investment expenditure.

5. Some pundits have advocated for a ―rules-based‖ monetary policy. This problem considers one extreme possibility: a world in which the FOMC decides on a new federal funds rate simply by applying the Taylor rule, which we discussed on page 672. a. How will market participants form their expectations in such an environment?

Suppose that the next FOMC meeting is coming up in a few days, and the official inflation and output gap numbers have just been released. The current federal funds rate is 1.25%, the long term fed funds rate target is 3%, and the inflation rate target is 2%. According to the release, inflation is currently at 1.25% and the output gap is -.5 percentage points. How will expectations of future inflation change based on this information? Explain. b. Why might the Federal Reserve not want to set their policy by mechanically applying the Taylor rule? Discuss some of the benefits and drawbacks of this approach.

Answer: a. Now, market participants will form their expectations by using economic news releases to calculate exactly what the Fed will do to the federal funds rate. In this particular example, we can apply the Taylor rule to the released numbers. Recall that the Taylor rule is: Federal funds rate = Long-run federal funds rate target + 1.5 * (Inflation rate Inflation rate target) + 0.5 * (Output gap in percentage points) Plugging in the numbers from above, we get: Federal funds rate = 3 + 1.5 * (1.25 – 2) + 0.5*(-.5) = 1.625% Thus, we know that the Fed will choose, in its next meeting, to raise the federal funds rate from 1.25% to 1.625%. This increase will, as we saw in previous chapters, lead to a decrease in loan origination (because funds are now more expensive) and, in turn, a decrease in money supply. Inflation expectations, then, should decrease when the news comes out. b. Answers may vary. One example: Although a mechanical application of the Taylor Rule would introduce consistency and predictability, it may not provide adequate flexibility to respond to changing economic conditions. After all, the Taylor rule is a rough equation—it may not always produce an appropriate federal funds rate.

In addition, it doesn‘t take into account the various other tools that the Fed can use, which we discussed in the previous chapters (e.g. quantitative easing). Finally, as we discussed in earlier chapters, the Fed often targets a range for the federal funds rate— this approach would force them to micromanage the federal funds rate, rather than let it move slightly with economic conditions.

6. The following graph shows actual and projected estimates of potential GDP and

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GDP. Potential GDP is also a measure of trend GDP. When is the output gap, defined as the percent difference between GDP and potential GDP, negative? According to the Taylor rule, how should a negative output gap affect the federal funds interest rate?

Answer: The output gap is the percentage difference between trend GDP, or potential output, and the actual level of GDP. When the economy is producing less GDP than it can, or when actual GDP is lower than potential GDP, the output gap is negative. A negative output gap implies a weaker economy, and therefore the Fed should set a lower federal funds rate the more negative the output gap. The graph given above shows that the output gap was negative from the year 2008 onward and is projected to remain negative until after 2016. It follows that, according to the Taylor rule, other things remaining unchanged, the Fed should keep the federal funds rate below its long-term target level.

Graphs and data from: http://www.cbo.gov/sites/default/files/cbofiles/ftpdocs/51xx/doc5191/03-16-gdp.pdf http://www.economist.com/node/9972453 http://online.wsj.com/public/resources/documents/policy090307.pdf

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7. Two economists estimate the government expenditure multiplier and come up with different results. One estimates the multiplier at 0.75, while the other comes up with an estimate of 1.25. a. What do these different estimates imply about the consequences of government expenditure? b. If the current value of GDP is $13.28 trillion and the government is planning to increase spending by $800 billion, what is the percentage increase in GDP for each of the two estimates for the multiplier? Assume the increase in spending occurs all in one year.

Answer: a. The economist who estimates the multiplier at 1.25 is likely to be assuming that the increased government spending will lead to an increase in consumption. The increase in government spending can stimulate business activity, which will increase the income of workers and hence consumption spending in the economy. The other economist is likely to be assuming that the increase in government spending will lead to more government borrowing, which will divert resources away from consumption and investment. The resulting higher interest rates dampen consumption and investment spending. According to the economist who estimates the multiplier at 0.75, a $1 increase in government spending will not even generate a $1 increase in equilibrium GDP. b. 4.52 percent, 7.53 percent If the multiplier is 0.75, an $800 billion increase in government spending will result in an increase in GDP of 0.75 × $800 billion = $600 billion. GDP would increase from $13.28 trillion to $13.88 trillion, an increase of 4.52 percent.

If the multiplier is 1.25, then an $800 billion increase in government spending will result in a 1.25 × $800 billion = $1,000 billion increase in GDP. GDP would increase from $13.28 trillion to $14.28 trillion, which is an increase of 7.53 percent.

8. In 2005, $320 million of the federal government‘s budget was allocated toward building a ―bridge to nowhere‖ in Alaska that connected two small towns. In 2006, $500,000 was allocated toward a teapot museum in North Carolina, $1 million toward a water-free urinal initiative in Michigan, and $4.5 million toward a museum and park at an abandoned mine in Maine. These projects were requested by specific legislators in order to boost their popularity in their constituencies. a. What is this type of expenditure called? b. Since government spending increases employment by shifting the labor demand curve to the right, is it always a good idea for the government to increase expenditure? Explain your answer.

Answer: a. Public spending that politicians value because it increases their popularity is called pork barrel spending. Pork barrel spending is seen as an inefficient use of government funds; most people who benefit from these projects pay a very small fraction of its cost but enjoy all of its benefits. b. The effectiveness of additional government expenditure would depend on whether

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the economy is operating at full capacity or whether it is contracting. When the economy is already working at full capacity, it is likely that additional government expenditure will substantially crowd out other kinds of economic activity. Most economists believe that the government expenditure multiplier is close to zero when the economy is already booming. When the economy is contracting, however, factories are likely to be running below capacity and there are likely to be a significant number of unemployed workers. The government expenditure multiplier is likely to be above 1 because additional government expenditure will not crowd out private consumption or investment. In this situation, additional government expenditures encourage the utilization of some of the idle capacity and unemployed workers.

Data on pork barrel spending: http://query.nytimes.com/gst/fullpage.html?res=990CEEDA153FF933A05757C0A9609 C8B63 http://articles.chicagotribune.com/2006-04-06/news/0604060195_1_pork-barrel-petprojects-watchdog-group http://www.heritage.org/research/reports/2005/10/the-bridge-to-nowhere-a-nationalembarrassment 9. Milton Friedman, the renowned monetary economist, gave the following analogy about the Fed: ―Imagine your house is being heated by a heater. The heater is controlled by a thermostat. The way it‘s set up, when the house gets a little too warm, the thermostat turns off the heater; if it gets too cold, the thermostat turns the heater back on. If everything works as planned, the room temperature in the house should roughly be the targeted temperature all the time.

Now suppose the thermostat is not in the same room as the heater. In fact, it‘s in the last room that is affected by the heater. Say, the attic. And the radiators through which the heater works are really old, and it takes them at least twenty minutes to react.

Then, instead of making the temperature more stable, the thermostat would make the temperature swing wildly. For example, if the house is cold, then the thermostat will turn the heater on. But it will turn the heater off only when the attic is warm. By then, the entire house will be scorching hot. When it turns the heater off, it will not turn it back on until the attic is cooler. By then, the house will be freezing.‖ (In this analogy, the thermostat is the Fed; the house is the entire economy.) a. What do you think Milton Friedman was trying to say about monetary policy?

(Hint: you do not need to draw any graphs for this question.) b. As in the thermostat analogy, what might be some possible unintended consequences of monetary policy? Might there be a similar effect for fiscal policy? If yes, how does it differ from monetary policy?

Answers: a. Milton Friedman is referring to lags in monetary policy, more specifically, what are called impact lags. This is the time that elapses between when a policy is decided, when it is implemented, and when it has an impact. The impact may occur when the economy has already begun to move by itself in the desired direction. Thus, monetary policy can exaggerate a swing in the business cycle instead of dampening it. b. Due to lags in monetary policy, the danger is that any action, such as

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expansionary monetary policy, will have an effect when the economy is already climbing out of recession. The effect of monetary policy will then overheat the economy. Conversely, if the Fed moves to raise interest rates and ―tighten‖ the availability of credit, the policy may have its greatest effect when the economy is already cooling and thus cause a more pronounced recession than had been planned.

The impact of fiscal policy tends to be more immediate than that of monetary policy.

However, fiscal policy often involves a considerable delay in its formulation and implementation. This is sometimes called a ―decision lag.‖ As is the case with monetary policy, the effect on the economy might occur when it is no longer needed.

10. The European Central Bank (ECB) manages monetary policy for the eurozone.

Following the financial crisis of 2007-2008, the ECB, like the Fed, lowered interest rates to around zero. a.

Using the concept of the zero lower bound, explain how low interest rates could constrain countercyclical monetary policy. b. Though fiscal policies are controlled by individual governments in the eurozone, the European Union‘s Stability and Growth Pact places strict limits on country-level deficit spending. Explain how the confluence of the zero lower bound and restrictions on the fiscal deficit might be problematic for countercyclical macroeconomic policy.

Answer: a.

As interest rates approach the zero lower bound, central banks become limited in their options. If the economy is in a recession, the bank would, ideally, want to lower the interest rate more to mitigate unemployment and deflation during the recession. However, because of the zero lower bound, that policy has a limit—at some point, the central bank will be unable to further lower the federal funds rate equivalent. b. As we saw in part a, the zero lower bound limits countercyclical monetary policy during a recession. The alternative, generally, might be countercyclical fiscal policy—during a recession, that might include tax cuts or increased government spending. However, both of these policies increase spending without a compensating increase in government income. Deficit restrictions, then, could prevent central governments from enacting the appropriate countercyclical policies. Combined, then, deficit restrictions and interest rates close to the ZLB could severely limit a country‘s options during a recession.

11. Challenge Problem. The chapter mentions that an open market operation by the Fed can increase or decrease the quantity of deposits in banks, and therefore the money supply. (See, for example, Exhibit 27.8.)

The expansion in the money supply from a Fed open market operation is given by the following equation (under the simplifying assumption that households don‘t hold cash so the money supply is equal to demand deposits): Change in money supply = (Change in reserves) × (1 / (RR + ER’)) where RR = the percentage of deposits that banks are required to keep as reserves (expressed as a decimal), and ER = the percentage of deposits that banks voluntarily hold as excess reserves (expressed as a decimal). 1/(RR + ER) is called the ―money multiplier.‖

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Suppose the Fed decides to sell $14 billion in Treasury bonds. Assume that the reserve requirement is 8 percent and banks hold 4 percent in excess reserves, so RR = 0.08 and ER = 0.04.

What is the total increase or decrease in the money supply that would result from the Fed‘s action? Explain your answer and show your calculations. Verify that the quantity of new deposits (which is the change in the money supply in this example) is backed up by an adequate quantity of new reserves: (RR + ER) × (Change in deposits) = (Change in reserves).

Answer: Since RR = 0.08, and ER = 0.04:

.

The Fed's bond sale decreases the reserves in the banking system by $14B. With a reserve requirement of 8 percent, and banks holding 4 percent of their deposits as excess reserves, the money supply will fall by as much as $116.2 billion because of the ―reverse money multiplier‖ process. The initial bond sale by the Fed takes reserves out of the banking system. This, in turn, reduces bank reserves, which sets the reverse money multiplier in motion. The resulting cycle of withdrawal then loan reduction then withdrawal Then loan reduction will decrease total deposits in the banking system by the amount shown below: Change in money supply

= Change in deposits

= (Change in reserves) × (Money multiplier) = −$14B × 8.33333….. = −$116.6666….. B Verifying: (RR + ER) × (Change in deposits)

= (0.08 + 0.04) × (–$116.6666…. B)

= (0.12) × (–$116.6666…… B) = –$14B = Change in reserves 12. Challenge Problem. Assume that the public in the small country of Sylvania does not hold any cash. Commercial banks, however, hold 5 percent of their checking deposits as excess reserves, regardless of the interest rate. In the questions that follow, use the ―money multiplier‖ equation from Problem 11. a. Consider the balance sheet of one of several identical banks: Assets

Liabilities & Net Worth

Reserves

$ 400

Checking Deposits

Loans

$1,600

Net Worth

$2,000 $ 0

What is the required reserve ratio in the country of Sylvania? b. If the total money stock (supply) is $100,000, find the total amount of reserves held in the banking system. Show your work.

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c. The Sylvania Central Bank decides that it wants to cut the money stock in half. It is considering an open market operation. How many dollars‘ worth of bonds should the Central Bank buy or sell? Assume that excess reserves are 5 percent and the required reserve ratio is what you found in part a. Show your work.

Answers: a.

Assets

Liabilities & Net Worth

Cash Reserves

$ 400

Checking Deposits

Loans

$1,600

Net Worth

$2,000 $ 0

The ratio of total reserves to deposits is 400/2000, which equals 20 percent. Because the excess reserve ratio is 5 percent, the required reserve ratio must be 15 percent. b. Total reserves in all banks will be 20 percent of the money supply ($100,000), which is $20,000.

Here is the logic in detail: The money multiplier = 1/(RR + ER).

Here, RR = 15% and ER = 5%. So, RR + ER = 20%, or 0.2, and the money multiplier = 1/0.2 = 5.

Because the public does not hold cash, it will be the case that MS = Total reserves in the banking system × Money multiplier.

Substituting for MS and the money multiplier gives $100,000 = Total reserves of all banks in the banking system × 5.

Hence, the total reserves of all banks = $100,000/5 = $20,000. c. Because the Central Bank wants to cut the money stock in half, it should undertake contractionary monetary policy; that is, it should sell bonds to the public. To pay for these bonds, the public will have to make withdrawals from their checking deposits with commercial banks, and this will lead to a contraction of MS. The money multiplier in this economy is 5, as was found in part b above. The public does not hold any cash. Thus, any reduction in MS has to come through a reduction in deposits.

Keeping this in mind, and remembering that a withdrawal is just a negative deposit, we can use the equation: ∆ Money supply = ∆ Deposits = (Initial change in reserves) × (Money multiplier) We are told that the Central Bank wants to cut the money stock in half, or by $50,000. We can substitute this on the left-hand side of the above equation and substitute 5 for the money multiplier on the right-hand side: − $50,000 = (Initial change in reserves) × 5.

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Solving for the required amount of the initial change in reserves, we see that Amount of initial deposits = − $50,000 / 5 = − $10,000.

Hence, a sale of bonds worth $10,000 will result in initial withdrawals totaling $10,000 from banks. This will start the ―money destruction‖ process as the multiplier effect works through the economy. This will result in a decline of the money stock of $50,000, as the Sylvania Central Bank wanted.

Chapter 14

Macroeconomics and International Trade Questions 1. How does comparative advantage differ from absolute advantage?

Answer: Although absolute advantage refers to the actual number of goods or services that a seller can produce, comparative advantage looks at the opportunity cost of the goods and services that a seller can produce. A seller has an absolute advantage in producing a good if he can produce more units of a good or service per hour than other sellers. A seller has a comparative advantage in the production of a good or service when he has a lower opportunity cost compared to that of another seller.

2. How does trade allow buyers and sellers to exploit gains from specialization?

Answer: Gains from specialization are the economic gains that the society can obtain by having some individuals, regions, or countries specialize in the production of certain goods and services. Trade enables sellers to specialize in the production of the good or service for which they have a comparative advantage. Through trade, the goods and services for which they do not have a comparative advantage in producing can be obtained from others who do.

3. Engaging in trade increases overall economic efficiency. Does this also imply that everyone in an economy gains from trade equally?

Answer: Although trade does generate substantial benefits to both trading partners, everyone does not gain equally from it. Trade produces some winners and some losers.

For example, international trade may cause routine assembly jobs to move to developing countries like Taiwan, and as a result, fewer assembly jobs are left in the United States.

As a consequence, workers previously working in assembly jobs are typically worse off.

However, the efficiencies created from trade are so great that the winners will be far more numerous than the losers. In principle, the winners could compensate the losers, so that everyone—both the winners and losers—would be better off as a result of free trade.

4. Explain the following terms: a. Open economy

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b. Closed economy c. Imports d. Exports e. Tariffs Answer: a. An open economy trades freely with the rest of the world. b. A country that doesn‘t trade with other countries—that is, does not have any imports or exports—is said to be a closed economy. c. Imports are the goods and services that are produced abroad and consumed domestically. d. Exports are the goods and services that are produced domestically and consumed abroad. e. A tariff is an example of a trade restriction. Tariffs are taxes levied only on imports.

5. Has trade been increasing or decreasing over the past few decades? What could explain why the ratio of imports to GDP in the United States fell sharply after 1929 before rebounding shortly thereafter?

Answer: Global trade has been increasing over the past few decades. As Exhibit 14.6 in the chapter shows, the ratio of imports to GDP has risen sharply in some of the largest economies in the world. Almost every country in the world is much more open today than it was 60 years ago. With the onset of the Great Depression in 1929, trade collapsed.

Tradable goods are disproportionately comprised of luxury goods, and luxury goods are the first to be cut when a household‘s income falls. Also, at the outset of the Great Depression, many countries passed legislation restricting imports in an effort to increase demand for domestic production. Tariffs imposed by one country led to a noncooperative ―trade war‖ between countries, and trade collapsed further.

6. How is the trade balance defined? When is a country said to be running a trade deficit or a trade surplus?

Answer: Net exports, also known as the trade balance, are the value of the country's exports minus the value of its imports. A country has a positive trade balance and runs a trade surplus when the value of its exports exceeds the value of its imports. A country has a negative trade balance and runs a trade deficit when the value of its imports exceeds the value of its exports.

7. The international accounting system maintains a clear distinction between residency and citizenship. a. Who would be considered a domestic resident of the United States, according to the international accounting system? b. Suppose a U.S. citizen lives and works in Nigeria. Would he be considered a ―foreigner‖ or a domestic resident in the U.S. international transactions accounts?

Answer: a. The international accounting system is built upon the concept of residency, not

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the concept of citizenship, so domestic residents are people who reside in the United States whether or not they are U.S. citizens. In the same way, an immigrant Australian citizen living in the United States is defined as a domestic resident of the United States in the official international trade accounts. b. Residents of foreign countries—―foreigners‖—are people who reside outside the United States, whether or not they are actually citizens of foreign countries. So a U.S. citizen who resides in Nigeria is counted as a ―foreigner‖ with respect to the United States as far as the international trade accounts are concerned.

8. List the sources of income-based payments that domestic residents make to foreigners and the ways that domestic residents can receive income-based payments from foreigners.

Answer: There are three ways that domestic residents can receive income-based payments from foreigners. ● Receiving payments from the sale of goods and services to foreigners—exports.

Exports are the goods and services that domestic residents produce and then sell in foreign countries. ● Receiving income from assets that the domestic resident owns in foreign countries—factor payments from foreigners. ● Receiving transfers from individuals who reside abroad or from foreign governments—transfers from foreigners. These transfers are ―gifts‖ like aid or remittances from foreign residents or foreign governments.

There are also similar types of financial flows that move in the opposite direction. ● Making payments to foreigners in return for their goods and services—imports.

Imports are the goods and services that foreigners produce and then sell to domestic agents. ● Paying income on assets that foreign residents own in the domestic economy— factor payments to foreigners. ● Making transfers to individuals who reside abroad or to foreign governments— transfers to foreigners. Transfers to foreigners are ―gifts,‖ which include foreign aid from the U.S. government, donations from U.S. citizens to foreign charitable organizations, and remittances from legal and illegal residents of the United States.

9. What does the current account include? Describe each of its components. Are all of these components included in GDP? Explain.

Answer: The current account adds together the different sources of payments into and out of a country. It consists of the sum of net exports, net factor payments from abroad, and net transfers from abroad.

Current Account = Net exports + Net factor payments from abroad + Net transfers from abroad.

Net exports are the value of the country‘s exports minus the value of its imports.

Net factor payments from abroad = Factor payments from abroad – Factor payments to foreigners.

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Factor payments from abroad = Income received from assets that the domestic resident owns in foreign countries.

Factor payments to foreigners = Income paid on assets that foreign residents own in the domestic economy.

Net transfers from abroad = Transfers from abroad – Transfers to foreigners.

Transfers from abroad = Transfers received from individuals who reside abroad or from foreign governments.

Transfers to foreigners = Transfers made to individuals who reside abroad or to foreign governments.

Not all of these components are included in GDP. Specifically, transfers and factor payments won‘t be captured in GDP which, as we saw in earlier chapters, focuses on domestic production. While net exports will be included, then, payments made to U.S. citizens from foreign assets should not be included in GDP. 10. What is included in a country‘s financial account? How is the financial account related to the current account?

Answer: Financial Account = Increase in domestic assets held by foreigners – Increase in foreign assets held domestically The financial account is defined so that the net flows in the financial account exactly offset the net flows in the current account.

Current Account + Financial Account = 0 This means that if foreigners receive net payments in the current account, then they must do something with those funds. They use the dollars that they received to make dollar deposits in banks, or to buy assets from U.S. residents, including U.S. Treasury bonds, shares in U.S. companies, or other U.S. assets, all of which are recorded in the financial account.

11. What are Net Capital Outflows? Use an example to explain how they are related to net exports.

Answer: Net capital outflows are the net investments flowing from one country to another; that is, they are the difference between the amount that the home country invests in foreign countries and the amount that foreign countries invest in the home country.

They are equal to net exports because any foreign exchange in goods or services involves an exchange in capital, as well. For example, suppose Mexico exports avocados to a United States grocery store chain. The grocery store, in return, will pay Mexico—perhaps in USD, perhaps with an IOU. Either way, Mexico now effectively holds an ―investment‖ in the United States. An increase in net exports for Mexico, then, is accompanied by an equal increase in net capital outflows.

12. What is foreign direct investment? Explain with an example. How does foreign direct investment benefit the recipient country?

Answer: Foreign direct investment refers to investments by foreign individuals and companies in domestic firms and businesses. Foreign direct investment must generate an ownership stake in a local firm for the foreign investors. For example, foreign direct investment in India occurs when a foreign company opens a factory in India.

Foreign direct investment enables technology transfer. Although technology transfer may

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not be the intended purpose of investment, when a foreign firm opens a factory in a country, it brings its know-how and technology to the country. Both countries are not only trading goods and services and having their firms and banks borrow from and lend to each other, but they are also technologically interlinked. Innovations and technological improvements in one country can ultimately improve productivity in many countries.

13. Are multinational companies harming factory workers in the developing world by hiring them at low wages?

Answer: For many workers in developing countries, working in a factory is a better alternative to working in jobs like those in the agricultural sector. Most factory jobs pay twice as much as agriculture jobs and have moved many workers out of poverty.

However, working conditions in a factory are not anywhere close to U.S. safety standards, and many factory workers are underage. Even then, employment by multinational firms appears to contribute to an increase in employment, wages, and living standards in most countries.

Problems 1. The economist Alan Blinder said that any economist who mows his own lawn probably has not understood the concept of comparative advantage. Would you agree with Professor Blinder?

Answer: Alan Blinder is referring to the fact that comparative advantage should determine what a person does, not absolute advantage. It is entirely possible that economists are very good at mowing their lawns. However, they are likely to be much better at doing what they do as economists. Given that the opportunity cost of their time is very high, it is perfectly rational for them to hire someone else to do other things.

Based on: http://freakonomics.com/2010/01/05/are-economists-cheap-or-do-we-justbelieve-in-comparative-advantage/ 2. You and your roommate are enrolled in the same course: Postmodern Deconstruction of Postmodern Deconstructionism. The course requires a term paper. Since the professor encourages collaboration on the paper, you decide to work on it together, ―trading‖ tasks.

In 8 hours, you can type 18 pages, whereas your roommate can type only 10. If you do outlining instead of typing, in the same 8 hours you could produce 6 summary outlines of the course readings, while your roommate could produce only 2. a. Who has the absolute advantage in typing? In outlining? Explain your answers. b. Who should do the typing, and who should do the outlining? Explain.

Answer: a. Because you are more productive in both typing and outlining, you have the absolute advantage in both. b. The comparative advantage can be determined by using the following table showing the opportunity cost of typing and outlining for you and your roommate: Opportunity Cost of 1 Page of Typing (in terms of

Opportunity Cost of 1 Outline (in terms of typed

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outlines)

pages)

You

1/3 outline

3 typed pages

Roomie

1/5 outline

5 typed pages

You have a lower opportunity cost of outlining, and your roommate has a lower opportunity cost of typing. Therefore, you should outline, and your roommate should type. You can trade outlines for typing, and your roommate can trade typed pages for outlines.

3. Suppose that United States and India are the only two countries in the world.

Suppose also that in India, an acre of land can produce 40 tons of sugar cane or 65 bushels of corn per season, while in the United States, an acre of land can produce 20 tons of sugar cane or 150 bushels of corn per season. a. Which country has the absolute advantage in the production of sugar cane? Of corn? Explain. b. Explain the concept of comparative advantage. What is India‘s comparative advantage in this case? What about the United States? c. Suppose U.S. scientists have developed a groundbreaking new technology that increases the productivity of sugar cane in the United States to 75 tons of sugar cane (and has no effect on U.S. corn productivity or Indian productivity in sugarcane or corn). How does this change India‘s comparative advantage?

Answer: a. Because the United States has higher productivity (output per acre of land) in corn (i.e., American land can produce more corn per acre in a season than Indian land), the United States has an absolute advantage in corn. India, however, has absolute advantage in producing sugar: it has higher productivity in sugar than the United States. b. A country has a comparative advantage in a good if it has a lower opportunity cost of producing that good. Thus, a country has a comparative advantage in producing good X if its relative productivity (relative to good Y) is higher in the production of good X. Opportunity Cost of Corn

Opportunity Cost of Sugar

United States

2/15 ton

15/2 bushels

India

8/13 ton

13/8 bushels

The United States has the comparative advantage in corn. India has the comparative advantage in sugar. c. It doesn‘t change—India still has comparative advantage in sugar. Although the opportunity cost of sugar has decreased to 2 for the United States, the opportunity cost of sugar in India is still lower (13/8 < 2). Thus, the comparative advantage of India is still in sugar.

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4. Assume that an American worker can produce 5 cars per year, or 10 tons of grain per year, whereas a Japanese worker can produce 15 cars per year, or 5 tons of grain per year. Assume labor is the only input used in car and grain production. a. Which country has the absolute advantage in producing cars? In producing grain? b. For the United States, what is the opportunity cost of producing a car? What is the opportunity cost of a ton of grain? Show how you arrived at your numbers. c. For Japan, what is the opportunity cost of producing a car? What is the opportunity cost of producing a ton of grain? Show how you arrived at your numbers. d. If free trade is allowed, which country will import cars? Which country will import grain? Explain.

Answer: a. The following table summarizes the numbers given in the problem.

Cars

Grain (tons)

United States

5

10

Japan

15

5

Because Japanese workers can produce 15 cars in a year versus only 5 for a U.S. worker, Japan has an absolute advantage in auto production. An American worker can produce 10 tons of grain, while a Japanese worker can produce only 5. So the United States has an absolute advantage in producing grain.

(For b. and c., students should have made calculations of the opportunity cost for each country and each good, which result in the numbers in the following table.)

Opportunity Cost of Cars

Opportunity Cost of Grain

U.S.

2 tons of grain

1/2 car

Japan

1/3 ton of grain

3 cars

b. Based on the productivity numbers given in the problem, the opportunity cost of a car in the United States is found by simply calculating the number of tons of grain that could have been produced in the United States with the labor used to produce one car. Likewise, the opportunity cost of a ton of grain in the United States is found by calculating the number of cars that could have been produced in the United States with the labor used to produce one ton of grain.

These calculations result in the numbers for the United States shown in the previous table. The opportunity cost of a car in the United States is 2 tons of grain, and the opportunity cost of a ton of grain is 1/2 car. c. Based on the productivity numbers given in the problem, the opportunity cost of a

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car in Japan is found by simply calculating the number of tons of grain that could have been produced in Japan with the labor used to produce one car. Likewise, the opportunity cost of a ton of grain in Japan is found by calculating the number of cars that could have been produced in Japan with the labor used to produce one ton of grain.

These calculations result in the numbers for Japan shown in the previous table.

The opportunity cost of a car in Japan is 1/3 ton of grain, and the opportunity cost of a ton of grain is 3 cars. d. Under free trade, a country will specialize in the good in which it has a comparative advantage, defined as lower opportunity cost.

The United States has a lower opportunity cost of grain production (1/2 car versus 3 cars for Japan), so it will specialize in grain production and import cars.

Conversely, Japan has a lower opportunity cost of car production (1/3 ton of grain versus 2 tons in the United States), so it will specialize in car production and import grain.

5. David Ricardo, the British political economist, used the example of two commodities—wine and cloth—produced by England and Portugal to explain trade.

The following table shows the number of labor hours it would take England and Portugal to produce one unit each of wine and cloth.

Portugal

England

Wine

80

120

Cloth

90

100

Portugal can produce both wine and cloth using fewer labor hours than England. A group of Mercantilists, who believe that nations build their wealth by exporting more than they import, suggests that Portugal has nothing to gain from trading with England. Would you agree? Explain your answer.

Answer: No, gains from trade are determined on the basis of comparative advantage, not absolute advantage. Portugal produces both wine and cloth using fewer labor hours than England, and Portugal so has an absolute advantage in the production of both goods.

However, gains from trade and specialization depend on each country‘s comparative advantage in producing either good.

Suppose England devotes the 100 hours of labor it takes to produce one unit of cloth to the production of wine. It can produce 100/120 = 5/6 units of wine.

Suppose Portugal devotes the 90 hours of labor it takes to produce one unit of cloth to the production of wine. It can produce 90/80 = 9/8 units of wine.

Since 5/6 < 9/8, England gives up less wine when it produces an additional unit of cloth.

This means that England‘s opportunity cost of producing an additional unit of cloth is lower than Portugal‘s, and so England should specialize in producing cloth.

Suppose England devotes the 120 hours of labor it takes to produce one unit of wine to the production of cloth. It can produce 120/100 = 6/5 units of cloth. Suppose Portugal devotes the 80 hours of labor it takes to produce one unit of wine to the production of

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cloth. It can produce 80/90 = 8/9 units of cloth.

Since 8/9 < 6/5, Portugal gives up less cloth when it produces an additional unit of wine.

This means that Portugal‘s opportunity cost of producing wine is lower than England‘s, and so Portugal should specialize in producing wine.

6. Tire production in the United States has been on the decline, in both absolute and relative terms. Imported tires are replacing most of the domestically manufactured tires in the market. Trade unions in the United States have claimed that over 7,000 jobs have been lost due to Chinese tire imports. You read a blog post that uses this example to say that this is exactly why countries should not engage in free trade; cheaper imports will flood the domestic market and unemployment in the country will increase. Do you think the blogger‘s conclusions are entirely correct? Explain.

Answer: The blogger‘s conclusions are not entirely correct. It is true that the gains from trade are not distributed equally in the economy. Some groups of people, like factory workers in the United States, will lose jobs with trade. Other groups, like factory workers in China and consumers in the United States, gain from the employment and lower prices that international trade brings. Because the efficiencies achieved by exploiting comparative advantage and specialization are so great that the winners are likely to be far more numerous than the losers, it is not necessarily in everyone‘s best interests to stop free trade. In this particular case, under pressure from unions, the United States imposed tariffs on Chinese tire imports. Imports of Chinese tires fell but were replaced by imports from other countries, and the higher prices of tires were passed on to U.S. consumers.

Adapted from: http://www.ft.com/intl/cms/s/0/f67c6fe6-a024-11de-b9ef00144feabdc0.html#axzz2rhHdwgMS http://online.wsj.com/news/articles/SB10001424052970204301404577171130489514146 7. During the 2016 election, Donald Trump argued that China was exploiting the United States. In particular, he decried the large trade deficit with China—in debates, he liked to say that China was ―killing‖ the U.S. on trade. Is having a trade deficit with another country inherently bad? Explain why a trade deficit may not be a bad thing for the United States. What are the scenarios under which a trade deficit may be a problem?

Answer: No, having a trade deficit with another country is not inherently bad—that is, trade is not a zero-sum game. It is not necessary for the United States and China to buy exactly the same quantity of goods and services from each other, just as it is not necessary for a grocer to buy the same quantity of goods from you that you buy from him. There are other countries, like Brazil, to which the United States sells goods and services and from which the United States buys relatively little. In addition, the trade deficit is balanced out by capital inflows, which could be beneficial to a country‘s economy, as well.

A trade deficit could be an issue if, as we discussed in this chapter, gains from trade are not distributed equally. If the U.S. loses exporting industry jobs, groups of workers— perhaps concentrated in certain states—may lose their jobs. In the absence of national redistribution, these individuals may suffer. Ultimately, they may also negatively impact national trade policy. As we saw in the 2016 election, groups of disgruntled workers supported anti-trade candidates, even pushing Hillary Clinton to renounce the TPP. Stringently anti-trade policies may, in turn, harm even broader swaths of the U.S. population.

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Adapted from: http://archive.mises.org/2408/do-only-sellers-benefit-from-exchange/ 8. Suppose the following table shows data on transactions between the United States and the rest of the world for the month of May 2013. Assuming the list is exhaustive, use the information given to fill in the table showing the current and financial accounts for May 2013.

U.S. aid to earthquake-hit Haiti Payments made to Indian software companies for services rendered by workers in India to U.S. customers Payments made to U.S. producers for ethanol exports

$8,000,000 $850,000 $3,000,000

Dividend payment from Walmart in China to a U.S. resident

$10,500

Salary earned by a team of IT consultants from the U.K. who were working in the United States for a few days

$120,000

Sale of U.S. Treasury bonds from U.S. Treasury to foreign governments

$15,000,00 0

Remittances from U.S. residents to other family members in Mexico

$30,000

Payments made to Chinese producers for steel imports

$8,000,000

Purchases of foreign assets by the U.S. government

$1,040,500

A U.S. citizen, who is a resident of Dubai, sends money to a charity in the United States

$30,000

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Current and Financial Accounts for May 2013 Payments from Foreigners

Payments to Foreigners

Increase in domestic assets held by foreigners

Increase in foreign assets held domestically

Net Payments

Trade in goods and services Factor payments Net transfer payments Current account

Net sales to foreigners Financial account Answer: ● U.S. aid to earthquake-hit Haiti. This is an example of a transfer made to a foreign government. ● Payments made to Indian software companies for services rendered by workers in India to U.S. customers. This is an example of an income-based payment to a foreign company in return for its services. ● Payments made to U.S. producers for ethanol exports. This is an example of income received by domestic residents from the sale of goods. ● Dividend payment from Walmart in China to a U.S. resident. This is an example of income earned from assets that a domestic resident owns in a foreign country. ● Salary earned by a team of IT consultants from the U.K. who were working in the United States for a few days. This is an example of a factor payment to a foreigner. ● Sale of U.S. Treasury bonds from U.S. Treasury to foreign governments. This leads to an increase in in foreigners‘ holdings of domestic assets. ● Remittances from U.S. residents to other family members in Mexico. This is an example of a transfer made to individuals who reside abroad. ● Payments made to Chinese producers for steel imports. This is an example of income paid to foreigners in return for their goods. ● Purchases of foreign assets by the U.S. government. This leads to an increase in foreign assets held domestically. ● A U.S. citizen, who is a resident of Dubai, sends money to a charity in the United States. This is an example of a transfer from an individual who resides abroad.

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Current and Financial Accounts for May 2013 Payments from Foreigners

Payments to Foreigners

Net Payments

Payments made to U.S. producers for ethanol exports

Payments made to Indian software companies for services rendered in the United States Payments made to Chinese producers for steel imports

(3,000,000) – (850,000 + 8,000,000) = – 5,850,000

Factor payments Dividend payment from Walmart in China to a U.S. resident

Salary earned by team of IT consultants from the U.K. who were working in the United States for a few days

(10,500) – (120,000) = –109,500

Net transfer payments

U.S. aid to earthquake-hit Haiti Remittances from U.S. residents to other family members in Mexico

(30,000) – (8,000,000 + 30,000) = –8,000,000

Trade in goods and services

A U.S. citizen, who is a resident of Dubai, sends money to a charity in the United States

–$13,959,500

Current account

Net sales to foreigners

Increase in domestic assets held by foreigners

Increase in foreign assets held domestically

Sale of U.S. Treasury bonds from U.S. Treasury to foreign governments

Purchases of foreign assets by the U.S. government

(15,000,000) – (1,040,500) = 13,959,500

9. In the fourth quarter of 2016, the U.S. current account deficit was 112.4 billion dollars, while the trade deficit was 132.3 billion dollars. a. Why are the trade deficit and the current account deficit different? b. Based on the information in this problem, what were U.S. net capital outflows in 2016? Carefully show how you got your answer and explain, in words, the concept of net capital outflows.

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c. Suppose Apple (based in the U.S.) sold an additional $0.5 billion in iPhones to retailers in Spain. How would this transaction affect the trade deficit? What about net capital outflows? Explain. d. How would an increase in the U.S. real interest rate affect the trade deficit? Net capital outflows? Explain.

Recall the national income accounting identity (in Chapter 5): Y = C + I + G + X – M, where X – M is net exports, given by exports – imports. We have seen from the chapter that net exports is equivalent to the trade balance, but not to the current account. Hence, aggregate expenditure does not include the current account balance.

Discuss why the entire current account is not included in the calculation of GDP. Answer: a. You will remember from the chapter that the current account is composed of the trade balance (net exports) as well as factor payments and international transfers.

Thus, trade is only one component of the current account. It is possible, for example, to have a trade deficit but a current account surplus, if surpluses in factor payments and international transfers outweigh the trade deficit. b. Based on this problem, U.S. net capital outflows were -132.3 billion dollars (that is, more capital was flowing in than out). As we saw in this chapter, we can rearrange the National Income Identity (Y = C + I + G + X – M), so that we get (Y – C – G ) – I = X – M, or, if we substitute in savings, S – I = X – M. X – M, here, is net exports; we defined S – I as net capital outflows. Net capital outflows tell us how much money, on net, is flowing out of the country—this money could be in the form of investments, for example. The intuition behind the equality between NCOs and net exports is that the money obtained during a trade exchange constitutes, on its own, an investment in the foreign country. This investment could simply be an IOU, as we saw in the chapter; it could also, more tangibly, be a range of foreign assets. Either way, the exporting country is now investing in its trade partner. c. An additional .5 billion in exports to Spain, all else equal, would reduce the deficit by .5 billion—using the number given in the problem, it would now be at 131.8 billion dollars. The money used by Spain to purchase the iPhones would represent a increase in U.S. net capital outflows (e.g. Spain might issue an IOU to the United States); now, the NCOs would be -131.8 billion dollars for the United States. d. An increase in the U.S. real interest rate would attract more foreign investors, decreasing Net Capital Outflows. Because of the relationship we derived in part b., net exports would also decrease (deepening any existing trade deficit).

10. Throughout the 1950s and 1960s, many poor countries pursued a policy called ―import-substituting industrialization,‖ or ISI for short. India, and many nations in Africa and Latin America, closed themselves off to trade in order to promote the development of domestic industries.

As noted in the Economist article ―Grinding the Poor,‖ (September 27, 2001), ―(o)n the whole, ISI failed; almost everywhere, trade has been good for growth.‖ The article discusses how growth was disappointing in countries that pursued ISI. Nations that were open to trade—primarily in Asia—grew much more rapidly.

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Based on the discussion in the chapter, speculate on why ISI was ultimately a failure and why integration with the global economy promotes economic growth and development.

Answer: The chapter highlights the benefits of specialization and its corollary, trade.

Exploiting a comparative advantage allows a country to produce those goods or services in which it is most efficient. Scarce resources are directed to their most productive uses.

Moreover, openness to the global economy facilitates flows of capital into poorer regions.

Domestic businesses in developing regions have access to the financing they need to expand. Capital can flow from countries in which investment opportunities are more limited, to countries where such opportunities abound. Foreign direct investment (FDI) can boost a poor nation‘s development, employment, and urbanization. As the chapter notes, FDI is a major conduit for technology transfer. Developing countries don‘t have to invest in the R&D necessary to invent new products or processes. They can adopt and adapt technologies that were developed elsewhere. The resulting boost to productivity is instrumental in promoting economic growth.

Restricting or prohibiting trade denies a country these benefits. Inefficient domestic producers are protected from competition, and resources are not directed to their most productive uses. Failure to integrate a nation into the broader world economy inevitably retards economic growth and usually does not even achieve the immediate objective of fostering the development of particular industries.

11. Foreign direct investment (FDI) in several sectors in India is still heavily regulated.

After much debate, the government of India recently relaxed restrictions on FDI in the retail sector. For purported reasons like national security and possible job losses, many sectors of the economy such as defense, nuclear power, and oil refining are not fully open to foreign direct investment. Suppose you are hired to serve on the government‘s Working Group on Foreign Direct Investment. What would you suggest to the government? Defend your position.

Answer: [Obviously, student answers will vary because they are basically asked to render an opinion on the question. However, a good answer should clearly use concepts from the chapter in support of whatever position they state. The following answer is an example that takes the position in favor of FDI, but a more contrary argument is certainly possible.]

One of the biggest arguments in support of FDI is that it is a major conduit for technology transfer, though in most cases this transfer is not the goal of the foreign firm that is making the investment. A company that owns a factory or a retail outlet in India would also bring its technical know-how and business practices to the country. For example, suppose Walmart decides to open stores in India. To ensure that its operations run smoothly, Walmart would bring in its own expertise in supply chain management and operations. This would increase overall efficiency and benefit the host country. FDI is a method to ensure that innovations and technological improvements are transferred between countries. Even in sensitive industries like those connected with national defense, technology transfer can provide a compelling rationale to be more open to FDI. Moreover, employment losses in one industry due to trade are almost always made up by the addition of new jobs in other industries in which a country has a comparative advantage, so the jobs issue does not constitute a sufficient reason to curtail foreign direct investment.

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12. The coffee market is one of the most globalized and volatile commodity markets in existence. In terms of the value of trade, it is second only to oil. Coffee is produced in over seventy countries, primarily lower-income nations in Latin American, Africa, and Asia. In recent years, a movement has developed supporting ―fair trade coffee,‖ which seeks to better the conditions and increase the incomes of coffee producers in poor countries.

Read the following on-line sources, and list the main arguments for and against the fair trade coffee movement, as delineated in the articles. Comment on any similarities you see between fair trade coffee policy and the case of Nike in Vietnam (as discussed in the chapter‘s Evidence-Based Economics feature). ―The Fair Trade Debate,‖ in Wikipedia: http://en.wikipedia.org/wiki/Fair_trade_debate ―Coffee,‖ from Fair Trade International: http://www.fairtrade.net/coffee.html ―Fair Trade Coffee Enthusiasts Should Confront Reality,‖ from the Cato Institute: http://object.cato.org/sites/cato.org/files/serials/files/cato-journal/2007/1/cj27n19.pdf ―The Pros and Cons of Fair Trade Coffee‖ from the Organic Consumers Association: http://www.organicconsumers.org/articles/article_4738.cfm Answer: Obviously, student answers will vary depending on how carefully they read the articles, which points they see as important, and perhaps even their prior attitudes or commitments. However, some of the salient points they should mention include the following: Arguments in Favor of the Fair Trade Coffee Movement ● Fair trade coffee ensures that poor coffee farmers will have enough income to provide for their families and have a decent standard of living. ● Coffee produced under fair-trade certification or licensing helps to ensure safer working conditions for those working in the coffee industry. ● Volatility in the market is dampened by putting a price floor under world coffee prices and by reducing the opportunity for speculation. ● The higher price offered for fair trade products allows farmers and their descendants to stay on their traditional land and continue to produce, rather than seek better paid jobs in urban areas.

Criticisms of the Fair Trade Coffee Movement ● The amount that growers are paid for their coffee is only slightly higher than the free market price. Growers can often sell their coffee for higher prices if they don‘t honor their contracts with fair trade organizations. ● Very little of the higher prices consumers pay for fair trade coffee actually ends up with coffee growers. ● There is insufficient and ineffective monitoring of the cooperatives that sell fair trade coffee. ● The fair trade marketing system is riddled with inefficiency and corruption.

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● Fair-trade agreements can hurt other coffee farmers not covered by the agreements.

The section of the chapter that is most relevant to student answers is the discussion of the role of Nike in Vietnam. They should relate the fair trade movement to the criticisms of multinational firms like Nike operating in developing countries. In particular, students should be alert to the idea that when it comes to international commerce, well-intentioned policies might have unintended negative consequences for the very people the policies are designed to help.

Chapter 15

Open Economy Macroeconomics Questions 1. How is the nominal exchange rate between two currencies defined?

Answer: The nominal exchange rate is the price of one country‘s currency in units of another country‘s currency. Specifically, the nominal exchange rate is the number of units of foreign currency that can be purchased with one unit of domestic currency.

The nominal exchange rate (e) is calculated as 2. When is a currency said to appreciate or depreciate?

Answer: When the nominal exchange rate goes up, the domestic currency appreciates against the foreign currency, and the domestic currency is said to be strong. When the nominal exchange rate goes down, the domestic currency depreciates against the foreign currency, and the domestic currency is said to be weak. For example, suppose the nominal exchange rate between the U.S. dollar and the Chinese yuan changes from10 yuan to 1 U.S. dollar to 8 yuan to the dollar. The dollar has become ―cheaper‖ in terms of yuan; it takes fewer yuan to ―buy‖ one dollar. So, the dollar has depreciated. Conversely, the Chinese yuan is said to have appreciated against the U.S. dollar.

3. Distinguish among flexible, fixed, and managed exchange rates.

Answer: If the government does not intervene in the foreign exchange market, then the country has a flexible exchange rate, which is also referred to as a floating exchange rate.

If the government sets a long-run value for the exchange rate and intervenes to defend that value, then the country has a fixed exchange rate. If the government intervenes actively in the foreign exchange market without setting a particular value for the exchange rate, then the country has a managed exchange rate. The values of managed exchange rates do change, but the fluctuations are relatively smooth when they occur.

4. What does the demand curve for dollars show? Why does the demand curve for dollars slope downward?

Answer: The demand curve for dollars represents the relationship between the quantity of dollars demanded and the nominal exchange rate between the dollar and another

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currency—say, the euro. The demand for dollars in exchange for euros is downward sloping because a higher exchange rate increases the price of U.S. goods faced by European firms and consumers, reducing their quantity of goods demanded and thus the quantity of dollars demanded.

5. What does the supply curve for dollars show? Why does the supply curve for dollars slope upward?

Answer: The dollar supply curve represents the relationship between the quantity of dollars supplied and the nominal exchange rate between the dollar and another currency—say, the euro. The supply of dollars in exchange for euros is upward sloping because a higher exchange rate increases the quantity of goods supplied by European firms to the U.S. market, thus raising their dollar earnings and the quantity of dollars supplied to the foreign exchange market.

6. What does it mean to say that, at an exchange rate of 1 USD = 60 INR, the U.S. dollar is overvalued and the Indian rupee (INR) is undervalued?

Answer: When we say that the dollar is overvalued with respect to the rupee, we mean that the dollar is worth more rupees than it would have been under a flexible exchange rate regime. Currencies may be overvalued or undervalued in a fixed or managed exchange rate regime. Suppose the Indian central bank pegs the rupee to the dollar. An undervalued rupee means that the exchange rate (rupee per dollar) at this peg is higher than the exchange rate that would have prevailed under a flexible exchange rate regime.

When the price in the foreign exchange market is higher than the equilibrium price, the quantity of dollars supplied to the market is greater than the quantity demanded in exchange for rupees. In order to maintain the peg, the Indian authorities need to buy up these surplus dollars in exchange for rupees.

7. Why might a country peg its exchange rate at a level that overvalues its own currency?

Answer: In many cases, countries maintain overvalued exchange rates. There are several reasons for this: ● Most countries regularly borrow from foreign lenders. In developing countries like Mexico, these loans are typically denominated in dollars. Thus, Mexican borrowers receive dollars when they take out their loan and pay back dollars, not pesos, at the end of the loan period. If the peso is overvalued and allowed to depreciate, the number of pesos that are needed to pay back dollar-denominated debts will increase. ● An undervalued dollar—and by implication, an overvalued peso—lowers the cost that Mexican consumers pay in pesos to import goods from the United States.

Consequently, the Mexican government can keep prices and inflation low by keeping the dollar undervalued and the peso overvalued. ● Another reason why countries maintain an overvalued fixed exchange rate is because a fall in the value of a currency is often perceived as a failure of government policies. This perception can be a problem for incumbent politicians in democratic countries.

8. How did George Soros exploit the overvaluation of the British pound?

Answer: George Soros bet against the overvalued British pound just before the

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government devalued the pound. In 1979, to limit fluctuations in the values of their exchange rates, most Western European countries formed an exchange rate regime called the European Exchange Rate Mechanism. In 1990, Britain also joined this system. The ERM countries agreed to keep their exchange rates trading in tight bands around target values. In 1992, changing market forces put pressure on the German mark to appreciate and the other European currencies to depreciate. The British authorities spent about $24 billion of foreign currency reserves trying to defend the pound. Eventually, as it began running low on reserves, the British government gave up trying to prop up its currency and accepted a sharp depreciation. Soros had borrowed in pounds and then sold the pounds in the market to buy German marks, accelerating the pace of the British government‘s reserve losses. He is believed to have made more than $1 billion on his bet against the pound, following which the press called Soros ―the man who broke the Bank of England.‖ 9. How is the real exchange rate for the United States calculated?

Answer: The real exchange rate for the United States is defined as the ratio of the dollar price of a basket of goods and services in the United States divided by the dollar price of the same basket of goods and services in a foreign country. The real exchange rate between the U.S. dollar and the Indonesian rupiah is calculated as follows:

or

10. How does a change in a country‘s real exchange rate affect its net exports?

Answer: When the real exchange rate increases, a country imports more from and exports less to foreign economies, reducing its net exports. Conversely, when the real exchange rate depreciates, a country imports less from and exports more to foreign economies, increasing its net exports. For example, when the U.S. dollar appreciates against the Chinese yuan, the United States imports more from China and exports less to China.

11. All else being equal, explain how an increase in the real interest rate is likely to affect a country‘s net exports, labor demand, and level of employment.

Answer: An increase in interest rates in the United States, relative to rates in other countries, implies that foreign investors will receive higher returns on their investments than they could elsewhere. Hence, with the increase in interest rates, foreigners will increase their demand for U.S. assets. Because assets in the United States are denominated in U.S. dollars, the demand for dollars will increase. This will shift the demand curve for dollars to the right. Given flexible exchange rates, this leads to an appreciation of the dollar relative to other currencies. An appreciation of the U.S. dollar means that American goods are more expensive for foreigners to buy, so exports will decline. Conversely, foreign goods are cheaper for Americans to buy, so imports increase. An increase in imports coupled with a decrease in exports means that net exports decline.

The decrease in demand for U.S. products due to lower exports results in a decrease in demand for the labor to produce those products. This is reflected in a leftward shift of the

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labor demand curve, and the new equilibrium level of employment will thus be lower.

12. The economy of Freedonia is currently faced with negative net exports and high unemployment. Explain two measures that the Freedonian central bank could take to increase net exports and lower unemployment.

Answer: Two measures the bank could pursue are as follows: ● Enact expansionary monetary policy to lower interest rates. The overall stimulatory effects of this policy were discussed in previous chapters but also relate to the open economy issues that are the subject of the present chapter.

Lower rates mean a decreased demand for domestic assets and therefore a decreased demand for domestic currency. This, in turn, leads to a decline in the nominal exchange rate and thus a decline in the real exchange rate. The decline in the real exchange rate means that domestic goods are cheaper for foreigners to buy and that foreign goods are more expensive for domestic purchasers to buy.

Exports will increase, imports decline, so net exports go up. As net exports increase, demand for domestic goods increases, and so the demand for labor to produce those goods increases. This results in an increase in employment as the labor demand curve shifts to the right. ● Intervene in the foreign exchange market so as to depreciate the Freedonian currency. The chapter discussed such interventions on the part of the Chinese central bank in recent years. Domestic currency is supplied to the market by the central bank, which increases its holdings of foreign reserves by buying foreign currency and selling domestic currency. The result of such policies is to depress the nominal exchange rate and thereby decrease the real exchange rate. As the real exchange rate declines, the same consequences for GDP and unemployment described in the previous paragraph come into play.

Problems 1. Suppose that the country Argonia follows a flexible exchange rate regime. The exchange rate between the Argonian dollar (AGD) and the U.S. dollar (USD) is currently 3 USD = 1 AGD. a. Use a graph to show the equilibrium in the foreign exchange market with the U.S. dollar -Argonian dollar exchange rate on the vertical axis and the quantity of Argonian dollars on the horizontal axis. b. Suppose that the global demand for apricots grown in Argonia increases sharply.

Other things being unchanged, how would this affect the value of the Argonian dollar? Use the graph to explain.

Answer: a. The following graph shows the foreign exchange market in Argonia. The supply curve for Argonian dollars in exchange for U.S dollars is shown as an upwardsloping curve. The demand curve for Argonian dollars in exchange for U.S. dollars is shown as a downward-sloping curve. The y-axis shows how many U.S. dollars can be exchanged per Argonian dollar, while the x-axis shows the quantity of Argonian dollars traded in the foreign exchange market. Because Argonia

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follows a flexible exchange rate regime, the market is in equilibrium at the point where the supply and demand curves intersect at an exchange rate of 3 USD = 1 AGD.

b. Suppose Argonia faces an increase in the demand for apricot exports from the country. This means that global buyers will need AGD to pay apricot producers in Argonia. As buyers buy more AGD and sell USD in exchange, the demand for Argonian dollars in exchange for U.S. dollars will increase, shifting the demand curve to the right. The Argonian dollar will appreciate, for example to a level of 5 USD = 1 AGD as shown in the following graph, and therefore the U.S. dollar will depreciate. This means that the number of U.S. dollars needed to buy an Argonian dollar will increase.

2. Recall from Chapter 6 that the Big Mac index is used as a rough measure of purchasing power parity across countries. The Economist magazine recently included the Vietnamese dong (VND) in its calculation of the Big Mac index. A Big Mac costs $5.06 in the United States but only 60,368 dong or $2.66 in Vietnam (at the current exchange rate).

What does this data suggest about the value of the real exchange rate of the U.S. dollar relative to the Vietnamese dong (treating the U.S. as the domestic economy, so the nominal exchange rate is expressed dong per dollar)? Is the real exchange rate likely to be greater than or less than one?

Answer: A Big Mac costs $2.84 or 60,000 dong at the current exchange rate. This means

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191

that the current exchange rate is , or 1 USD = 22,694.74 VND. Because the Big Mac costs $5.06 in the United States, for purchasing power parity to hold, the equilibrium exchange rate should be VND.

, or 1 USD = 11,930.43

Because the current VND/USD exchange rate is above the rate implied by purchasing power parity, the U.S. dollar is said to be overvalued against the dong, and the dong is said to be undervalued against the U.S. dollar. This means that the dollar is worth more dong than it would be under a flexible exchange rate regime.

To calculate the real exchange rate given the current nominal exchange rate of 22,694.74 VND/1 USD, we can use the formula for the real exchange rate:

Adapted from: http://www.economist.com/blogs/graphicdetail/2014/02/big-mac-index 3. In 2011, the government of Argentina developed a new policy (sometimes called the ―dollar clamp‖) to prevent Argentines from exchanging pesos, the local currency, for U.S. dollars. New restrictions hampered currency exchange: for example, buying dollars required advance approval from the national tax authority. a. How would you expect these restrictions to affect the foreign exchange market for pesos? Explain using a supply and demand chart, as in 29.3, but this time put pesos per dollar on the y-axis. b. Consider that Argentina has had a tumultuous economic history, with periods of high inflation and economic volatility. In particular, right before the restrictions were put in place, foreign investors (who were holding Argentinian assets) were starting to get skittish. Given this environment, why might the government put these exchange restrictions in place? c. Even with the restrictions in place, dollars were still available in the flourishing black market (if you‘re interested, the twitter feed @dolarblue posts the daily black market exchange rate in Argentina). In these circumstances, would you expect the black market exchange rate (pesos per dollar) to be higher or lower than the official exchange rate? Explain. d. At the end of 2015, the new President of Argentina, Mauricio Macri, eliminated the restrictions. Examine a five year chart of the Peso-dollar exchange rate here: https://www.bloomberg.com/quote/USDARS:CUR. What happened to the official exchange rate when Macri enacted his policy of unrestricted foreign exchange transactions? Explain.

Answer: a. We would expect this to limit the demand for dollars by putting up expensive (time or money) restrictions on exchange. In the supply and demand chart (see below) this policy would drive a left shift in the demand curve for dollars, leading to a lower peso-dollar exchange rate. In other words, the peso would appreciate. b. As we saw in this chapter, currency appreciation increases the value of a

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country‘s assets, leading to increased foreign investment. If the government was worried about investors selling off their assets, it might want to appreciate the currency. In addition, nervous Argentinian citizens might also, in volatile times, want to exchange pesos for the more stable USDs. This increase in demand would cause a devaluation—and, if the devaluation sparked more concerns, a downward spiral of continued devaluation. By restricting exchange, the government can stymie this channel for devaluation. c. We would expect the black market exchange rate to be higher (pesos per dollar) than the official exchange rate—because the government is stifling demand, we expect demand to be at its normal, unimpeded level in the black market. Thus, it should take more pesos to buy one dollar in the black market. d. When Macri eliminated the restrictions, the peso-dollar exchange rate shot upwards. This makes sense, because we would expect the elimination of the restrictions to cause the demand for dollars to shift back to its initial level, leading to a depreciation of pesos.

4. The Evidence-Based Economics feature in the chapter discusses how George Soros‘s hedge fund made money by betting on the devaluation of the British pound.

Interestingly, Soros also made money betting against the Thai baht.

In 1997, the baht had been continually falling against the U.S. dollar. The Bank of Thailand attempted to defend its overvalued exchange rate by pegging the baht to the U.S. dollar at a rate of 25 bahts per dollar. Explain how each of the following factors made it difficult for the Thai authorities to continue to defend their exchange rate, leading eventually to a sharp devaluation of the baht. a. The Thai government‘s reserves of U.S. dollars fell to a 2-year low in 1997. b. A very large quantity of corporate debt in Thailand was denominated in U.S. dollars.

Answer:

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a. When we say that the Thai baht is overvalued and the U.S. dollar is undervalued, we mean that the dollar is worth fewer baht than it would have been under a flexible exchange rate regime. When the exchange rate in the market is below the market-clearing rate, the quantity of dollars demanded will exceed the quantity of dollars supplied. Thai authorities will have to supply dollars to the market to purchase baht. This implies that overvalued exchange rates can be defended only as long as the Thai authorities have dollar reserves. Given that the government‘s reserves of U.S. dollars fell to a two-year low in 1997, it would have been increasingly difficult for the authorities to continue to defend the exchange rate, prompting a devaluation. b. When debt is denominated in dollars, borrowers in Thailand will have to sell baht and buy dollars to pay back the debt and make interest payments. This will further increase the demand for dollars. As the demand for dollars increased in Thailand, the authorities would have found it difficult to supply dollars to the foreign exchange market and defend the pegged exchange rate.

Data from: http://www.wright.edu/~tdung/asiancrisis-hill.htm 5. Using the net exports curve and the labor demand and labor supply curve, explain how a fall in the real exchange rate can lead to an increase in employment in a country.

Answer: The net exports curve shows the relationship between the real exchange rate and net exports. When the real exchange rate between, say, the U.S. dollar and the euro, declines to R", the United States will export more to European countries. Net exports is defined as the difference between a country‘s exports and imports. As exports increase, the value of U.S. net exports will also increase. The economy moves to point A' in the following graph.

Because the foreign demand for U.S. goods and services increases, producers in the United States will increase employment in the face of greater demand for their products. The demand for labor curve will shift to the right from D to D'. Assuming that wages are flexible, the real wage as well as the level of employment in the United States will increase to W' and L', respectively.

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6. Econia trades with its neighbors, the countries of Governmentia and Sociologia. In Econia, the currency is called the econ; in Governmentia, the currency is called the gov; and in Sociologia, the currency is the soc.

Nominal exchange rates follow: 200 econ = 1 gov 4 socs = 1 gov, 100 econ = 1 soc A good that is produced and consumed in all three countries is the Mack Burger. The price of Macks in the three countries is as follows: 1 Mack costs 2 govs in Governmentia, 16 socs in Sociologia, and 600 econs in Econia. a. From the perspective of Governmentia, calculate the real exchange rate in Mack Burgers between Governmentia and Sociologia, using the nominal exchange rate (4 socs per gov) and prices listed above. Explain in words what the number you calculated means. b. If these three currencies can be freely traded so that their exchange rates are flexible or floating, can the nominal exchange rates listed above persist over time?

Why or why not? (Hint: Show that currency traders could make unlimited profits if they could trade at these exchange rates.)

Answer: a. The equation for the real exchange rate (denoted by E) is as follows:

Where Domestic price = the domestic price of the Mack Burger e = Nominal Exchange Rate, expressed in units of foreign currency per unit of domestic currency Foreign price = the foreign price of the Mack Burger Governmentia is the domestic country, and Sociologia is the foreign country, as stated in the question. We know that the PDom is equal to 2 govs and that the

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195

PFor is equal to 16 socs. The nominal exchange rate is 4 socs/gov. Substituting these values into the real exchange rate equation yields: R = (2 × 4) / 16 = ½ We find the real exchange rate is equal to ½, which is the price of goods in Governmentia in terms of the price of goods in Sociologia. In other words, the real exchange rate is the relative price of goods in the two countries, or it is the rate at which we can trade goods in Governmentia for goods in Sociologia: A Governmentia Mack costs ½ of a Sociologia Mack. b. No, in a freely traded market currency traders have an opportunity to conduct arbitrage trades. (Arbitrage means that a trader can lock in a price differential for the same asset and make a profit without taking any risk.) The exchange rates as given allow for arbitrageurs to make money. For instance, starting with 1 gov, you could first trade the 1 gov for socs in the currency markets and receive 4 socs.

Next, you could trade the 4 socs in the currency markets for 400 econs. Lastly, you could trade the 400 econs in the currency markets for 2 govs. There is an arbitrage opportunity to make a 1 gov profit by trading govs into socs into econs and then back into govs.

For floating currencies, arbitrageurs will capitalize on the market inefficiencies and drive all nominal exchange rates to a consistent level; thus, the exchange rates as listed cannot persist over time. If they did, traders could continue the arbitrage trading given previously, and make unlimited profits. They would have discovered a money machine!

7. Challenge Problem: The beautiful, mythical country of Coloradial uses the teo as its currency, and the gritty, post-industrial country of Oheo uses the eren. Exactly 1 year ago, you could get 100 teos in exchange for 5 erens in the foreign exchange market.

Since then, though, the real interest rate in Coloradial has increased, while staying constant in Oheo. a. All other things being equal, would you expect the eren to have appreciated or depreciated with respect to the teo? In other words, what would you expect to happen to the exchange rate of teo per eren? Explain your reasoning. b. Assume that the change in the value of the eren with respect to the teo (appreciation or depreciation depending on your previous answer) was 50 percent.

What is the current nominal exchange rate expressed in teos/eren? c. One year ago, you borrowed 100,000 teos from a Coloradial bank at a rate of 3 percent per year. You then traded the 100,000 teos for erens at the nominal exchange rate that prevailed at the time (100 teos = 5 erens), and invested those erens in Oheo at 5 percent interest.

After the year was over, your intention was to exchange the erens back for teos, repay the loan to the Coloradial bank, and keep a tidy profit. (This strategy is called a ―carry trade‖ and is often popular with foreign exchange traders.) i. How much would you have made on this strategy if the interest rates did not change and if the exchange rate had not changed from 100 teos = 5 erens? ii. What will be your profit (or loss) on the trade given the changes in the

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exchange rate you found in parts (a) and (b)? (Assume the interest rate you paid to the Coloradial bank was fixed in your loan agreement, and so did not change.)

Answer: a. Because the real interest rate in Coloradial has increased, Coloradian assets, denominated in teos, become more attractive relative to Oheoan assets denominated in erens. Investors will want to buy Coloradian assets and therefore need teos. The increased demand for teos will increase their price in terms of erens. Hence, the teo will appreciate, and the eren will depreciate. That is, the exchange rate of teo per eren will decrease. b. The fact that you could exchange 5 erens for 100 teos implies that the nominal exchange rate last year was 1 eren = 20 teos. After a 50 percent depreciation, the value of the eren is half its original value; thus, 1 eren buys 50 percent fewer teos.

Therefore, the new nominal exchange rate is 1 eren = 10 teos; i.e., E = 10 teos/eren. c. i.

If the exchange rate had remained unchanged at 20 teos per eren, you would have made 2,000 teos (= 100 erens) on the trade. You borrow 100,000 teos from a Coloradial bank at 3 percent; in one year you will owe 103,000 teos.

You convert the 100,000 teos you borrowed into 5,000 erens, and invest that sum in Oheo at 5 percent. In one year‘s time you will have a total of (1.05)(5,000) = 5,250 erens. If the exchange rate were still 20 teos per eren, you could convert the 5,250 erens into 105,000 teos. You owe the Coloradial bank 103,000 teos, and after you repay your loan, you are left with a profit of 2,000 teos, or 100 erens.

Alternatively, you may calculate your profit by focusing on the difference between the interest rates in the two countries. You make a profit of 5 percent – 3 percent = 2 percent on the 100,000 teos you borrowed. This yields a profit of 2,000 teos, which, if the exchange rate is still 20 teos per eren, is equal to 100 erens. ii.

This part of the question illustrates the great risks inherent in any carry trade. If the eren depreciates by 50percent−from 20 teos per eren to 10 teos per eren,then when you go to change your 5,250 erens into teos at the end of the year, you only get 52,500 teos for your 5,250 erens. However, remember that you owe the Coloradial bank 103,000 teos. Hence, you lose 103,000 teos – 52,500 teos = 50,500 teos, or 5,050 erens.

8. The graph below shows the Japanese yen per U.S. dollar exchange rate between 2008 and 2014. The table that follows shows the real interest rates in these two countries during the same period.

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Real Interest Rate in the United States and Japan Year

2009

2010

2011

2012

2013

United States

2.5

2

1.3

1.5

1.7

Japan

2.2

3.8

3.4

2.3

1.9

What could explain why the U.S. dollar first depreciated and then appreciated with respect to the Japanese yen between 2008 and 2013? Explain your answer with the help of the information given in the table.

Answer: The interest rate in Japan was consistently higher than the interest rate in the United States between 2010 and 2013. This suggests that investors who invested in Japanese interest-bearing assets received higher returns than those who invested in U.S. assets, other things being equal. This is likely to have increased the demand for Japanese assets. To invest in the Japanese assets, investors would have had to exchange dollars for Japanese yen. The greater demand for Japanese yen would shift the demand curve for yen to the right. Given that the exchange rate between the yen and the U.S. dollar is flexible, this would have caused an appreciation of the yen relative to the U.S. dollar, or a depreciation of the dollar vis-à-vis the yen.

In 2012, however, the interest rate in Japan began to fall, while the U.S. real interest rate began to rise. These changes would attract additional investors to the U.S.; while the interest rate is still technically higher in Japan than in the U.S. in 2013, the relative changes might spook investors away from Japan and increase their confidence in the dollar. This increased demand for U.S. dollars would cause the dollar to appreciate relative to the Yen. Graph credit: http://research.stlouisfed.org/fred2/series/DEXJPUS/ Data from: http://data.worldbank.org/indicator/FR.INR.RINR?page=1&order=wbapi_data_value_20 09%20wbapi_data_value%20wbapi_data_value-first&sort=desc

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9. Since 2008, the dollar has appreciated against the euro. a. Suppose that in the short run the Fed wanted both to weaken the dollar (that is, stop its appreciation and/or cause it to depreciate) and stimulate investment.

Based on what you have learned in this chapter and in Chapter 13, discuss whether the Fed can achieve both of these goals simultaneously through monetary policy. b. Suppose instead that the European Central Bank (ECB) conducts contractionary monetary policy. What is the short-run effect, if any, of this policy on the euro/dollar nominal exchange rate and on the real exchange rate between the United States and the European Monetary Union? In your answer regarding the real exchange rate, state any assumptions you are making.

Answer: a. We are told that the dollar has depreciated relative to the euro. Facing this situation, the Federal Reserve wants both to weaken the dollar and to stimulate investment.

To weaken the dollar, the Fed must conduct expansionary monetary policy—e.g., buy bonds in an open-market operation, which would increase reserves in the banking system and thereby increase the money supply. The supply of reserves would shift to the right, resulting in a lower equilibrium fed funds rate, and lower interest rates in general, in the United States.

Holding everything else constant, an decrease in the U.S. real interest rate makes investment in U.S. financial markets a less attractive opportunity than investment Europe, and thus leads to capital flowing out of the United States and into Europe.

As investors abandon dollar-denominated assets for those denominated in the euro, they sell dollars and buy euros, thus causing the dollar to depreciate (and the euro to appreciate).

In addition, the decrease in interest rates necessary to defend the dollar is consistent with the Fed‘s second goal of stimulating investment. Investment is, among other things, negatively related to the real interest rate.

Therefore, the Fed can achieve both goals simultaneously through expansionary monetary policy. b. Contractionary monetary policy carried out by the European Central Bank (ECB) will raise interest rates in those European countries over which the ECB has jurisdiction—that is, the countries that belong to the European Monetary Union (EMU). These are the countries that use the euro.

An increase in EMU interest rates will lead to capital flowing into EMU countries from the United States. Because euro-denominated assets will become more attractive relative to dollar-denominated assets, investors will demand more eurodenominated assets, and hence demand more euros to buy those assets. This will cause an appreciation of the euro, and a depreciation of the dollar. The euro/dollar nominal exchange rate will decrease—it will take fewer euros to buy one dollar.

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From the standpoint of the United States, the real exchange rate is equal to , where e is equal to the nominal exchange rate (the number of euros per dollar). A decrease in e will lead to a decrease in the real exchange rate, assuming no increase in relative prices in the United States and European Monetary Union, i.e., assuming that does not increase, or if it does increase, it does not do so enough to offset the decrease in e.

10. Thailand and Taiwan are both rapidly growing economies in East and Southeast Asia that trade actively with other countries. a. Suppose a computer circuit board is the only good produced in Thailand and Taiwan. This circuit board costs 100 baht in Thailand and 200 NT (New Taiwan dollars) in Taiwan. The nominal exchange rate is 2 NT per baht.. Calculate the real exchange rate from Thailand‘s perspective (that is, using Thailand as the domestic economy, so the nominal exchange rate is 2 NT per baht). Show your work. Intuitively, what does this number represent? b. The Taiwanese current account with the rest of the world is initially balanced –in other words, it is running neither a deficit nor a surplus. Taiwan alone experiences an economic boom and its real interest rate rises at the same time. Thoroughly explain the mechanisms by which the Taiwanese current account is affected by its boom and the increase in its real interest rate. c. Assume that the change in the value of the NT-per-baht exchange rate was 50 percent, which, depending on your answer in part (b), was either appreciation or depreciation. What is the current nominal exchange rate expressed in NT per baht? Show your work.

Answer: a. The real exchange rate is 1 Taiwanese computer circuit board per Thai computer circuit board.

The real exchange rate formula is where e is the nominal exchange rate and E is the real exchange rate. The nominal exchange rate from the Thai perspective is 2 NT per bhat. Therefore, E = [(100 bhat) × (2 NT per bhat)] / 200 NT = 1. This represents the number of Taiwanese computer circuit boards it takes to buy one Thai computer circuit board. b. Both the economic boom and the rise in the real interest rate cause a current account deficit in Taiwan. The economic boom raises domestic income or output, which increases imports because domestic income is one of the determinants of import demand. Since NX = X – IM, an increase in imports decreases net exports, which leads to a current account deficit (or negative current account). The rising Taiwanese interest rates increase the attractiveness of Taiwanese or NTdenominated assets compared to foreign assets. The NT appreciates relative to other currencies, causing a rise in the nominal exchange rate. Therefore, the real exchange rate also rises according to the exchange rate formula. An increase in the real exchange rate makes Taiwanese exports relatively more expensive to

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foreigners and makes foreign imports relatively less expensive to the Taiwanese.

This decreases exports and increases imports, which decreases net exports. Thus, the rise in interest rates also contributes to a Taiwanese current account deficit. c. From (b) we know that the NT appreciates. In part (a) you could exchange 2 NT for 1 baht. After the 50 percent appreciation of the NT, the value of the nominal exchange rate is 4/3 bhat per NT (e = 4/3 NT per baht). You can now exchange 4/3 NT for one baht.

11. You may have seen the term ―Capital Flight‖ in news articles about developing countries. ―Capital Flight‖ occurs when foreign investors, often spooked by political instability, lose confidence in a country‘s assets and decide to sell them.

This phenomenon is particularly concerning to the many developing countries that rely on Foreign Direct Investment, which we discussed in Chapter 28. a. Using Exhibit 23.13, show how capital flight—a reduction of demand for a country‘s assets at every interest rate—would affect the real exchange rate.

Assume that the domestic credit market (panel a) doesn‘t change so that the real interest rate is held fixed (for example, the capital flight is caused by political instability). Explain why capital flight is represented by a rightward shift of the curve in panel b. Then explain how this rightward shift in panel b coincides with a movement along the curve in panel c and, therefore, a fall in the real exchange rate. b. Suppose the local government maintains a fixed exchange rate by changing the domestic interest rate. Faced with capital flight, how would the government need to change the interest rate to maintain its exchange rate? Explain using the charts from the previous part of this question.

Answer: a. Capital Flight first causes a rightward shift of the panel b curve. This shift occurs because now, at every interest rate, foreign investors will be less likely to invest in the home country. Thus, the country will have increased net capital outflows which, as we‘ve seen in the previous chapter, is equal to net exports. As we can see in the chart below, net exports/NCOs will now increase at the equilibrium interest rate. As foreign investors transition their investments outside of the home country, they sell the home currency, leading to a depreciation of the home currency. We see this in panel c of the chart: the exchange rate decreases from to E*.

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b. In order to counteract the depreciation caused by capital flight, the home country now needs to cause appreciation. They can achieve this appreciation by increasing domestic interest rates through, for example, contractionary monetary policy. We can see this in the charts below: the real interest rate increases from r* to , ultimately causing the real exchange rate to return to .

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11. Imagine that there are two economies in the world: Bostonia and New Yorkland.

Bostonia‘s currency is the sock, and New Yorkland‘s is the yank. Despite the longstanding rivalry between their citizens, Bostonia and New Yorkland are trading partners.

The Central Bank of New Yorkland decides to conduct contractionary monetary policy. Explain the short-run effect, if any, on the following: a. The sock/yank nominal exchange rate b. New Yorkland‘s net exports c. Bostonia‘s net exports d. GDP in New Yorkland recently plummeted. At first, the citizens in Bostonia cheered, happy to see their rivals taken down a notch. But then an economist (always a killjoy) asserts that the fall in New Yorkland‘s GDP is likely to hurt Bostonia‘s GDP in the short run. Could the economist be correct? Why or why not?

Answer: a. Contractionary monetary policy carried out by the New Yorkland Central Bank will increase nominal and real interest rates (holding expected inflation constant) in New Yorkland. An increase in New Yorkland interest rates will lead to capital flowing into New Yorkland and out of Bostonia. Because yank-denominated assets will become more attractive relative to sock-denominated assets, investors will demand more yank-denominated assets, and hence demand more yanks to

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buy those assets. This will cause an appreciation of the yank, and a depreciation of the sock.

An appreciation of the yank means that the sock/yank nominal exchange rate will increase—it will take fewer yanks to buy one sock, i.e., one yank is worth more socks. b. An appreciation of the yank relative to the sock will lead to a fall in net export demand for New Yorkland. Bostonia goods become more attractive to New Yorkland consumers as the purchasing power of the yank abroad increases (increasing imports), while New Yorkland goods become less attractive to Bostonia consumers (the purchasing power of the sock decreases). Hence, New Yorkland‘s net exports will decrease. c. A decrease in New Yorkland‘s net exports implies an increase in the net exports of its trading partner, Bostonia. d. Yes, the economist could be correct. Income abroad is a determinant of net exports. When New Yorkland‘s GDP decreases, citizens of New Yorkland will have less money to spend on goods, including imports from Bostonia, so there will be less demand for goods and services in Bostonia and less demand for the labor to produce them. GDP is likely to go down in the short run, and unemployment likely to go up, due to the falloff in exports to New Yorkland.

12.

Sometimes, countries abandon their own currency entirely and adopt the currency of another country. For example, Ecuador adopted the U.S. dollar in 2000; El Salvador did the same in 2001. Indeed, because countries often choose the U.S. dollar, this strategy is called ―dollarization.‖ Based on the discussion in this chapter and in previous chapters, evaluate ―dollarization‖ as a policy. Why might a government benefit from adopting the U.S. dollar? How might the use of the U.S. dollar limit a country in addressing a domestic economic downturn?

Answer: By tying themselves to the dollar, countries can gain stability at the expense of flexibility. In times of economic turmoil and uncontrolled inflation, countries might be able to calm down markets by adopting the relatively stable dollar. In addition, using dollars might impose some consistency on trade between the country and the U.S. (or other dollarized countries); exporters won‘t need to worry about the exchange rate unpredictably fluctuating. However, using dollars ties a country‘s monetary policy to the decisions of the Federal Reserve—a central bank that makes decisions based primarily on U.S. economic conditions. This lack of autonomy would jeopardize a country‘s ability to conduct countercyclical monetary policy: during a domestic downturn, a country might need expansionary monetary policy when, perhaps, the U.S. needs contractionary monetary policy. Without its own currency, the country would be tied to the Fed‘s contractionary approach.

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Table of Chapter 1 Chapter 2 Chapter 3 Chapter 4 Chapter 5 Chapter 6 Chapter 7 Chapter 8 Chapter 9 Chapter 10 Chapter 11 Chapter 12 Chapter 13 Chapter 14 Chapter 15

Contents

The Principles and Practice of Economics 1 Economic Methods and Economic Questions 8 Optimization: Doing the Best You Can 16 Demand, Supply, and Equilibrium 25 The Wealth of Nations: Defining and Measuring Macroeconomic Aggregates 40 Aggregate Incomes 54 Economic Growth 67 Why Isn’t the Whole World Developed?

83 Employment and Unemployment 95 Credit Markets 109 The Monetary System 124 Economic Fluctuations 136 Macroeconomic Policy 148 Macroeconomics and International Trade 161 Open Economy Macroeconomics 175

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