Solution Manual For Macroeconomics 3rd Edition by Dean Karlan and Jonathan Morduch

Solution Manual For Macroeconomics 3e Dean Karlan and Jonathan Morduch Chapter 1-19With Appendix [A B C D E]

CHAPTER 1 ECONOMICS AND LIFE Solutions to End-of-Chapter Questions and Problems Review Questions 1. Suppose you are shopping for new clothes to wear to job interviews, but you’re on a tight budget. In this situation, what are your wants and constraints? What does it mean to behave rationally in the face of scarcity? [LO 1.1] Answer: If you are deciding what to buy for a job interview, your want is to buy clothing that looks clean and professional, so you can present the best possible impression to potential employers. Your constraint is the amount of money you can spend on this clothing. A person behaving rationally would buy the nicest clothes they could afford.

2. You are a student with a demanding schedule of classes. You also work part time and your supervisor allows you to determine your schedule. In this situation, what is your scarce resource? How do you decide how many hours to work? [LO 1.1] Answer: Your scarce resource is time. You need both time to study and time to work.

Presumably, you want to do well in school and also make money. You will try to balance your schedule so that you work as much as possible while still having enough time to study and do well in school.

3. Think about the definition of scarcity that you learned in this chapter. Name three ways that you confront scarcity in your own life. [LO 1.1] Answer: People face scarcity in many aspects of their lives. Some people love to travel and explore new places, so they face scarcity in both time and money that keeps them from traveling as often as they would like. Others face scarcity in their professional life, in that there are often many worthwhile projects to address, but the available resources are limited in terms of employees, time, and budget.

4. When shopping for your interview clothes, what are some trade-offs you face? What is the 1-1 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

opportunity cost of buying new clothes? What are the benefits? How do you balance the two?

[LO 1.2] Answer: The money you spend on clothes for a job interview could be spent on other things instead, so it is one opportunity cost. Another opportunity cost is the time you spend shopping, which could be spent preparing for your interview or playing Frisbee. The benefits include looking put-together during the interview, which provides a boost to your job prospects. You balance the costs and benefits by accepting costs that are less than (or no greater than) the benefits they provide.

5. You have an 8:30 class this morning but you are feeling extremely tired. How do you decide whether to get some extra sleep or go to class? [LO 1.2] Answer: If you are behaving rationally, you decide by comparing the trade-offs. The opportunity cost of going to class is missing out on some extra sleep. Depending on what else in on your schedule that day (perhaps an important interview), it may make sense to choose extra sleep over class. The opportunity cost of extra sleep is that you will miss the lecture. If your grade will suffer significantly by your absence, you may want to grab some coffee and go to class!

6. It’s Friday night. You already have a ticket to a concert, which cost you $30. A friend invites you to go out for a game of paintball instead. Admission would cost you $25, and you think you’d get $25 worth of enjoyment out of it. Your concert ticket is nonrefundable. What is your opportunity cost (in dollars) of playing paintball? [LO 1.2] Answer: The opportunity cost of going to play paintball is whatever amount of enjoyment (in dollars) you would get out of going to the concert. The $30 you paid for the concert ticket is not relevant to the decision, as it is a sunk cost and is nonrefundable regardless of what you do.

7. Suppose you have two job offers and are considering the trade-offs between them. Job A pays $45,000 per year and includes health insurance and two weeks of paid vacation. Job B pays $30,000 per year; it includes four weeks of paid vacation but no health insurance. [LO 1.2] a. List the benefits of Job A and the benefits of Job B. b. List the opportunity cost of Job A and the opportunity cost of Job B. Answer: a. The benefits of Job A are the extra pay and health insurance. For Job B, the benefit is two extra weeks of vacation.

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b. The opportunity cost of Job A is losing out on the extra two weeks of vacation that comes with Job B. For Job B, the opportunity costs are the extra $15,000 in salary and the health insurance that come with Job A.

8. Your former neighbors gave you their lawnmower when he moved. You are thinking of using this gift to mow lawns in your neighborhood this summer for extra cash. As you think about what to charge your neighbors and whether this idea is worth your effort, what opportunity costs do you need to consider? [LO 1.2] Answer: You need to consider the opportunity cost of your time. Your lawn mowing business would need to cover the opportunity cost of what you could earn in another summer job. You also need to consider the cost of gasoline for the mower and the value of the lawn mower itself. Just because it was a gift does not mean that it has no opportunity cost. The opportunity cost of using the lawnmower for your business is its sale value, if you decide to sell the gift rather than use it yourself. Your lawn mowing business needs to cover all of these costs (the value of your time in another job, gasoline, and the sale value of the lawnmower) in order for it to be a worthwhile endeavor.

9. Think of a few examples of incentives in your daily life. How do you respond to those incentives? [LO 1.3] Answer: An incentive is something that causes people to behave in a certain way by changing the trade-offs they face. No parking signs encourage people not to park in certain places and speed limit signs encourage people not to drive too fast. The consequence in either case is the risk of getting a ticket. The ability to devote a certain percentage of income to a 401(k) retirement account each month before paying taxes encourages people to save for retirement.

10. You supervise a team of salespeople. Your employees already receive a company discount.

Suggest a positive incentive and a negative incentive you could use to improve their productivity. [LO 1.3] Answer: For a positive incentive, you could offer a reward such as a bonus, a gift certificate, or an extra discount on company merchandise to the most productive employee of the month.

For a negative incentive, you could announce that employees who fail to meet targets will lose their company discount.

11. Your boss decides to pair workers in teams and offer bonuses to the most productive team.

Why might your boss offer team bonuses instead of individual bonuses? [LO 1.3] 1-3 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Answer: Your boss is creating a reward system for a project that requires group effort. Even if you are not motivated to compete for an individual bonus, you are likely to feel responsibility to your teammate and make a greater effort to be productive. Your teammate can encourage, pressure, and/or help you to achieve greater productivity.

12. Think of a public policy—a local or national law, tax, or public service—that offers an incentive for a particular behavior. Explain what the incentive is, who is offering it, and what they are trying encourage or discourage. Does the incentive work? [LO 1.3] Answer: The U.S. government places a subsidy on growing corn. This provides an incentive for farmers to plant corn on more of their land instead of alternative crops. The government is trying to encourage the production of domestic corn so that the United States can produce corn-based ethanol more cheaply.

13. Why do individuals or firms usually provide the goods and services people want? [LO 1.4] Answer: If firms didn’t produce goods that people want, no one would buy their goods.

These firms would lose money and go out of business, and would be replaced by firms that did produce goods that customers want.

14. You may have seen TV advertisements for products or programs that claim to teach a surefire way to make millions on the stock market. Apply the Why isn’t someone already doing it? test to this situation. Do you believe the ads? Why or why not? [LO 1.4] Answer: Guessing which stocks are going to perform well and which are going to tank is a hard, if not impossible, task which makes it very hard to make millions in the stock market.

You should not believe the ads for that reason. (If there really was a surefire way to make millions, you can bet everyone would already be doing it!)

15. Describe an innovation in technology, business, or culture that had a major economic impact in your lifetime. [LO 1.4] Answer: The Internet has completely changed the way people do business. While writing this textbook, we have collaborated with people all over the country, sharing documents online that we once would have had to send through the mail.

16. Why do people confuse correlation with causation? [LO 1.5] Answer: Correlation means that two events occur together. Since the two often occur together, people often believe that one causes the other, but this is not always true. People 1-4 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

once thought that ice cream caused polio, for example. The real relationship was that people ate more ice cream in the summer, and this also happened to be the time of year that the polio virus spread more rapidly.

17. Name two things that are positively correlated and two things that are negatively correlated.

[LO 1.5] Answer: Events that are positively correlated tend to occur together, or move in the same direction. For example, more people tend to carry an umbrella when the risk of rain is high.

When one event increases at the same time a related event decreases, then the two events are negatively correlated. According to auto insurers, good grades and the risk of getting in a car accident are negatively correlated. (People with higher grades tend to be safer drivers.)

18. Why is it important for a good economic model to predict cause and effect? [LO 1.6] Answer: A good model must predict cause and effect so that it can explain something about what we have observed and can help us anticipate what will happen in future observations.

19. Why is it important for a good economic model to make clear assumptions? [LO 1.6] Answer: A good model must make clear assumptions so we know when the model will do a good job at explaining or predicting our observations and when it will not.

20. What is the difference between disagreeing about a positive statement and disagreeing about a normative statement? [LO 1.7] Answer: A positive statement is something that is supposed by fact, whereas a normative statement is a value judgment. So disagreeing with a normative statement means you disagree with someone’s opinion. Disagreeing with a positive statement means disputing the truth of fact.

21. Would a good economic model be more likely to address a positive statement or a normative statement? Why? [LO 1.7] Answer: A good model predicts cause and effect and can be tested with evidence. Thus, positive statements are more likely to be addressed by a good model.

22. Write a positive statement and a normative statement about your favorite hobby. [LO 1.7] 1-5 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Answer: Positive statements are based on fact: For example, "Cultures around the world use food to convey social values."

Normative statements are based on opinion: For example, "Food is the best way to understand the social values of a culture."

Problems and Applications 1. Think about how and why goods and resources are scarce. Goods and resources can be scarce for reasons that are inherent to their nature at all times, that are temporary or seasonal, or that are artificially created. Separate the goods listed below into two groups; indicate which (if any) are artificially scarce (AS) and which (if any) are inherently scarce (IS). [LO 1.1] a. Air of any quality b. Land c. Patented goods d. Original Picasso paintings Answer: Goods and resources can be inherently scarce at all times if there is a limited or finite supply of the resource, or artificially scarce when access to the resource is restricted. a. Not scarce. Air (of any quality) is abundant and need not be rationed through prices or some other allocation mechanism. b. Inherently scarce. Land is finite in supply; land is available for development, but no new land can be created. c. Artificially scarce. Patented goods are scarce by law; only the patent holder may supply these goods. d. Inherently scarce. Original Picasso paintings are finite; no new Picasso’s can be created beyond those that currently exist.

2. You are looking for a new apartment in Manhattan. Your income is $4,000 per month, and you know that you should not spend more than 25 percent of your income on rent. You have come across the listings for one-bedroom apartments shown in Table 1P-1. You are indifferent about location, and transportation costs are the same to each neighborhood. [LO 1.1]

a. Which apartments fall within your budget?

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b. Suppose that you adhere to the 25 percent guideline but also receive a $1,000 cost-ofliving supplement because you are living and working in Manhattan. Which apartments fall within your budget now?

Answer: a. Delancey. Your income and income guidelines represent a constraint on the choices available. Under these guidelines, 25 percent of your monthly income is $1,000. So the only apartment you can afford within your budget is Delancey, at $950. All others are unattainable to you. b. Chelsea and Delancey. The $1,000 monthly cost-of-living supplement expands your set of living options. Your income is now effectively $5,000 per month, so you can afford any apartment that costs $1,250 or less (25 percent of $5,000). These choices now include Chelsea ($1,200) and Delancey ($950).

3. Suppose the price of a sweater is $26. Jaylen’s benefit from purchasing each additional sweater is given in the Table 1P-2. He gets the most benefit from the first sweater and less benefit from each additional sweater. If Jaylen is behaving rationally, how many sweaters will he purchase? [LO 1.2]

Answer: Jaylen will purchase all of the sweaters for which the marginal benefit is greater than the marginal cost. If the price of a sweater is $26, this is the marginal cost, as each additional sweater will cost $26. For the first four sweaters, the marginal benefit exceeds the marginal cost, so Jaylen will purchase four sweaters. For the fifth sweater, the marginal cost of $26 exceeds the marginal benefit. st

1 sweater 2nd sweater 3rd sweater 4th sweater 5th sweater 6th sweater

Marginal Benefit $60 $45 $40 $33 $22 $18

Marginal Cost $26 $26 $26 $26 $26 $26 1-7

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4. Sweaters sell for $15 at the crafts fair. Allie knits sweaters; her marginal costs are given in the Table 1P-3. Allie’s costs increase with each additional sweater. If Allie is behaving rationally, how many sweaters will she sell? [LO 1.2]

Answer: Allie will sell all of the sweaters for which the marginal benefit is greater than the marginal cost. If the price of a sweater is $15, this is the marginal benefit, as Allie will receive $15 for each additional sweater she sells. For the first 3 sweaters, the marginal benefit exceeds the marginal cost, so Allie will sell 3 sweaters.

1st sweater 2nd sweater 3rd sweater 4th sweater 5th sweater 6th sweater

Marginal Cost $5 $8 $12 $18 $25 $32

5. Last year, you estimated you would earn $5 million in sales revenues from developing a new product. So far, you have spent $3 million developing the product, but it is not yet complete.

Meanwhile, this year you have new sales projections that show expected revenues from the new product will actually be only $4 million. How much should you be willing to spend to complete the product development? [LO 1.2] a. $0. b. Up to $1 million. c. Up to $4 million. d. Whatever it takes.

Answer: You should spend up to $4 million. The $3 million you have spent already is a sunk cost and cannot be recovered. Therefore, the $3 million you have spent is irrelevant to the decision of how much to spend going forward. This year, the relevant decision is: How much are you willing to spend to have $4 million in revenue? If you had known that product development may cost you more than you will gain in revenues, you should not have started this project. But at this point, by thinking on the margin, you can see that you should be willing to move forward as long as the costs of going forward are not greater than the benefits of going forward ($4 million).

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6. Consider the following examples. For each one, say whether the incentive is positive or negative. [LO 1.3] a. Bosses who offer time-and-a-half for working on national holidays. b. Mandatory minimum sentencing for drug offenses. c. Fines for littering. d. Parents who offer their children extra allowance money for good grades.

Answer: A positive incentive like bonus compensation or monetary awards makes people more likely to do something. A negative incentive like fines, incarceration, and taxes makes them less likely to do something. a. Positive. b. Negative. c. Negative. d. Positive.

7. Consider the following events that change prices as described in Table 1P-4. For each one, say whether the opportunity cost of consuming the affected good increases or decreases.

[LO 1.3]

Answer: a. Decreases. b. Increases. c. Increases. d. Decreases.

8. Your best friend has an idea for a drive-through bar. Indicate the best explanation for why others have not taken advantage of her idea: true innovation, market failure, government intervention, or unprofitablity. [LO 1.4] Answer: Government intervention. In most places, drive-thru bars are (wisely) illegal.

9. Your best friend has an idea for a long-distance car service to drive people across the 1-9 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

country. Indicate the best explanation for why others have not taken advantage of her idea: true innovation, market failure, intervention, or unprofitablity. [LO 1.4] Answer: Unprofitable. There are alternatives for customers that can be cheaper than car service. For example, buses can offer cheaper prices than a car service could. While a car is less costly to operate than a bus, a bus can more than make up the difference in operation cost by accommodating many more passengers.

10. Determine whether each of the following questionable statements is best explained by coincidence, an omitted variable, or reverse causation. [LO 1.5] a. In cities that have more police, crime rates are higher. b. Many retired people live in states where everyone uses air conditioning during the summer. c. More people come down with the flu during the Winter Olympics than during the Summer Olympics. d. For the last five years, Punxsutawney Phil has seen his shadow on Groundhog Day, and spring has come late.

Answer: a. Reverse causation: Cities with higher crime rates will tend to have larger police departments. b. Omitted variable: Having a large number of retired people live in a state does not cause everyone to use their air conditioner. Retired people tend to move to warmer states and living in a warm-weather state causes everyone to use air conditioning in the summer. c. Omitted variable: The Winter Olympics do not cause the flu. The flu season falls during Winter months, which increases the incidence of flu cases at the Winter Olympics vs. the Summer (correlation without causation). d. Coincidence: There is no plausible cause-and-effect relationship here.

11. For each of the pairs below, determine whether they are positively correlated, negatively correlated, or uncorrelated. [LO 1.5] a. Time spent studying and test scores. b. Vaccination and illness. c. Soft drink preference and music preference. d. Income and education.

Answer: Two items are positively correlated if both variables increase at the same time, or if both variables decrease at the same time. Two items are negatively correlated if one is increasing while the other is decreasing, or vice versa.

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a. b. c. d.

Positively correlated. More time spent studying tends to lead to higher test scores.

Negatively correlated. More vaccinations result in less illness.

Uncorrelated. These preferences are not related in any predictable way.

Positively correlated. People who earn higher income tend to have higher levels of education.

12. Each statement below is part of an economic model. Indicate whether the statement is a prediction of cause and effect or an assumption. [LO 1.6] a. People behave rationally. b. If the price of a good falls, people will consume more of that good. c. Mass starvation will occur as population outgrows the food supply. d. Firms want to maximize profits.

Answer: a. Assumption. This is an assumption about how people behave. b. Prediction of cause and effect. This is a prediction of cause and effect because the decline in the price of the good will tend to cause people to consume more of the good, all else the same. One event leads to another. c. Prediction of cause and effect. This is a prediction of cause and effect because if population growth results in the demand for food exceeding the available supply of food, then mass starvation may occur. One event leads to another. d. Assumption. This is an assumption about how firms behave.

13. From the list below, select the characteristics that describe a good economic model. [LO 1.6] a. Includes every detail of a given situation. b. Predicts that A causes B. c. Makes approximately accurate assumptions. d. Fits the real world perfectly. e. Predicts things that are usually true.

Answer: A good model should predict cause and effect (b), describe the world accurately (c), and state its assumptions clearly (e). Economists test their models by observing what happens in the world and collecting data that can be used to support or reject their models.

14. Determine whether each of the following statements is positive or normative. (Remember that a positive statement isn’t necessarily correct; it just makes a factual claim rather than a moral judgment.) [LO 1.7] a. People who pay their bills on time are less likely than others to get into debt. b. Hard work is a virtue. c. Everyone should pay his or her bills on time. d. China has a bigger population than any other country in the world.

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e. China’s One-Child Policy (which limits families to one child each) helped to spur the country’s rapid economic growth. f. Lower taxes are good for the country.

Answer: A statement that makes a factual claim about how the world actually works is called a positive statement. A statement that makes a claim about how the world should be is called a normative statement. Economics is a field in which people frequently confuse positive statements with normative statements. However, you do not have to adopt a particular moral or political point of view to use economic concepts and models. a. Positive b. Normative c. Normative d. Positive e. Positive f. Normative

15. You just received your midterm exam results and your professor wrote the following note: ―You received a 70 on this exam, the average score. If you want to improve your grade, you should study more.‖ Evaluate your professor’s note. [LO 1.7] a. Is the first sentence positive or normative? b. Is the second sentence positive or normative?

Answer: A statement that makes a factual claim about how the world actually works is called a positive statement. A statement that makes a claim about how the world should be is called a normative statement. Economics is a field in which people frequently confuse positive statements with normative statements. However, you do not have to adopt a particular moral or political point of view to use economic concepts and models. a. Positive b. Normative

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CHAPTER 2 SPECIALIZATION AND EXCHANGE Solutions to End-of-Chapter Questions and Problems Review Questions 1. You’ve been put in charge of a bake sale for a local charity, at which you are planning to sell cookies and cupcakes. What would a production possibilities graph of this situation show?

[LO 2.1] Answer: On one axis, the production possibilities graph would show the total number of cookies you could bake if you spent all of your time and resources baking cookies. The other axis would show the total amount of cupcakes you could bake if you spent all of your time and resources baking cupcakes. The two endpoints would be connected by a downwardsloping line. The slope of this line would represent the tradeoff (opportunity cost) you face between baking cookies and baking cupcakes. If you bake more cupcakes, you must bake fewer cookies. The production possibilities graph would show all of the combinations of cookies and cupcakes you could produce with your time and resources.

2. You manage two employees at a pet salon. Your employees perform two tasks, giving flea baths and grooming animals. If you constructed a single production possibilities frontier for flea baths and grooming that combined both of your employees’ work efforts, would you expect the production possibilities frontier to be linear (a straight line)? Explain why or why not. [LO 2.1] Answer: You would not expect a production possibilities frontier that combined both of your employees' work efforts to be linear. Each worker would likely differ in her relative skills at grooming and giving flea baths and would therefore differ in the opportunity cost for performing each task.

3. You and another volunteer are in charge of a bake sale for a local charity, at which you are planning to sell cookies and cupcakes. [LO 2.2] a. What would it mean for one of you to have an absolute advantage at baking cookies or cupcakes? Could one of you have an absolute advantage at baking both items? b. What would it mean for you or the other volunteer to have a comparative advantage at baking cookies or cupcakes? Could one of you have a comparative advantage at baking both items?

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Answer: a. If you have an absolute advantage in the production of cupcakes (or cookies), it means that you can produce more cupcakes (or cookies) in total with the same amount of resources than the other volunteer. Absolute advantage is about having greater productivity. You could have an absolute advantage in baking both cupcakes and cookies if you are more productive in both goods than the other volunteer. b. If you had a comparative advantage in baking cookies, it would mean that you have a lower opportunity cost (you give up fewer cupcakes for each cookie you bake) than the other volunteer. It is not possible for you to have a comparative advantage in baking both goods. If you have a comparative advantage in baking cookies, the other volunteer will have a comparative advantage in baking cupcakes.

4. You and another volunteer are in charge of a bake sale for a local charity, at which you are planning to sell cookies and cupcakes. Suppose you have a comparative advantage at baking cookies, and the other volunteer has a comparative advantage at baking cupcakes. Make a proposal to the volunteer about how to split up the baking. Explain how you can both gain from specializing, and why. [LO 2.3] Answer: If you have a comparative advantage in baking cookies and the other volunteer has a comparative advantage in baking cupcakes, then you should specialize in baking cookies and the other volunteer should specialize in baking cupcakes. If you spend all of your time baking cookies and the other volunteer spends all of his time baking cupcakes, you will wind up with more cookies and cupcakes between you than you would have if you each spent half of your time baking each good.

5. At the flower shop, where you manage two employees, your employees perform two tasks: caring for the displays of cut flowers and making flower arrangements to fill customer orders. Explain how you would approach organizing your employees and assigning them tasks. [LO 2.3] Answer: You would have your employees specialize in the task for which they have the lowest opportunity cost. The worker who has the lower opportunity cost of caring for the displays should switch to filling customer orders only if there are orders left to complete after all the cut flowers have been cared for (water changed, old blooms removed, etc.). You would assign making floral arrangements to fill customer orders to the worker who has the comparative advantage in that task. This worker should fill customer orders and switch to caring for the cut flower displays only if there is such work left to complete after customer orders have been filled.

6. Suppose two countries produce the same two goods and have identical production possibilities frontiers. Do you expect these countries to trade? Explain why or why not. [LO 2.4] 1-14 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Answer: We would not expect countries with the same production possibilities frontiers to trade. Identical production possibilities frontiers would indicate that the two countries faced the same opportunity costs. The basis for gains from trade is specializing according to differing opportunity costs.

7. Brazil is the largest coffee producer in the world, and coffee is one of Brazil’s major export goods. Suppose that in 20 years, Brazil no longer produces much coffee and imports most of its coffee instead. Explain why Brazil might change its trade pattern over time. [LO 2.4] Answer: Brazil would change from exporting to importing coffee if its comparative advantage changes. Over time, Brazil could lose its comparative advantage in coffee if its opportunity costs for growing coffee increase. If this were the case, we would expect Brazil to gain a comparative advantage elsewhere.

Problems and Applications 1. Your friend Sam owns a catering business and has been asked to prepare appetizers for a university reception during homecoming weekend. She has an unlimited amount of ingredients but only six hours to prepare them. Sam can make 300 mini-sandwiches or 150 servings of melon slices topped with smoked salmon and a dab of sauce per hour. [LO 2.1] a. Draw Sam’s production possibilities frontier. b. Now suppose that the university decides to postpone the reception until after the big game, so Sam has an extra four hours to prepare. Redraw her production possibilities frontier to show the impact of this increase in resources. c. Now, in addition to the extra time to prepare, suppose Sam’s friend Chris helps by preparing the melon slices. Sam can now make 300 mini-sandwiches or 300 melon appetizers per hour. Redraw Sam’s production possibilities frontier to show the impact of increased productivity in making melon appetizers.

Answer:

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a. 300 mini-sandwiches/hr = 1,800 mini-sandwiches in 6 hours. This is the endpoint on the Y-axis. 150 melon appetizers/hr = 900 melon appetizers in 6 hours. This is the endpoint on the X-axis. b. 300 mini-sandwiches/hr = 3,000 mini-sandwiches in 10 hours. This is the endpoint on the Y-axis. 150 melon appetizers/hr = 1,500 melon appetizers in 10 hours. This is the endpoint on the X-axis. c. 300 mini-sandwiches/hr = 3,000 mini-sandwiches in 10 hours. This is the endpoint on the Y-axis. 300 melon appetizers/hour = 3,000 melon appetizers in 10 hours. This is the endpoint on the X-axis.

2. Your friend Sam has been asked to prepare appetizers for the university reception. She has an unlimited amount of ingredients and six hours in which to prepare them. Sam can make 400 mini-sandwiches or 200 servings of melon slices topped with smoked salmon and a dab of sauce per hour. [LO 2.1] a. What is Sam’s opportunity cost of making one mini-sandwich? b. What is Sam’s opportunity cost of making one melon appetizer? c. Suppose the reception has been postponed, so Sam has an extra four hours to prepare.

What is the opportunity cost of making one mini-sandwich now? d. Suppose the reception has been postponed, so Sam has an extra four hours to prepare.

What is the opportunity cost of making one melon appetizer now?

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e. Suppose Sam’s friend Chris helps by preparing the melon slices, increasing Sam’s productivity to 400 mini-sandwiches or 400 melon appetizers per hour. What is the opportunity cost of making one mini-sandwich now? f. Suppose Sam’s friend Chris helps by pre-paring the melon slices, increasing Sam’s productivity to 400 mini-sandwiches or 400 melon appetizers per hour. What is the opportunity cost of making one melon appetizer now?

Answer: The opportunity cost is the value of what you have to give up in order to get something. It is the value of your next-best alternative. a. To make 1 more mini-sandwich you have to give up 1/2 melon appetizer. b. To make 1 more melon appetizer you have to give up 2 mini-sandwiches. c. To make 1 more mini-sandwich you still have to give up 1/2 melon appetizer. The opportunity cost has not changed. d. To make 1 more melon appetizer you still have to give up 2 mini-sandwiches. e. To make 1 more mini-sandwich you have to give up 1 melon appetizer. The opportunity cost has changed. f. To make 1 more melon appetizer you have to give up 1 mini-sandwich.

3. Suppose that Canada produces two goods: lumber and fish. It has 18 million workers, each of whom can cut 10 feet of lumber or catch 20 fish each day. [LO 2.1] a. What is the maximum amount of lumber Canada could produce in a day? b. What is the maximum amount of fish it could produce in a day? c. Draw Canada’s production possibilities frontier. d. Use your graph to determine how many fish can be caught if 60 million feet of lumber are cut.

Answer: a. The maximum amount of lumber Canada could produce in a day is 10 feet x 18 million workers = 180 million feet. b. The maximum amount of fish Canada could produce in a day is 20 fish x 18 million workers = 360 million fish. c. The two endpoints of the PPF are (0,180) and (360,0), as shown in the graph below.

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d. The opportunity cost of producing 1 foot of lumber is 2 fish. Therefore, the opportunity cost of producing 60 million feet of lumber is 120 million fish. If Canada produces 60 million feet of lumber, then it can only produce 360 - 120, or 240 million fish.

4. The graph in Figure 2P-1 shows Tanya’s weekly production possibilities frontier for doing homework (writing papers and doing problem sets). [LO 2.1]

a. What is the slope of the production possibilities frontier? b. What is the opportunity cost of doing one problem set? c. What is the opportunity cost of writing one paper?

Answer: a. The slope of the production possibilities frontier is -(6/2) = -3. b. The opportunity cost of doing one problem set is (2 papers/6 problems sets) = 1/3 paper.

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c. The opportunity cost of writing one paper is (6 problems sets/2 papers) = 3 problems sets.

5. Use the production possibilities frontier in Figure 2P-2 to answer the following questions.

[LO 2.1]

a. What is the slope of the PPF between point A and point B? b. What is the slope of the PPF between point B and point C? c. Is the opportunity cost of producing hammers higher between points A and B or between points B and C? d. Is the opportunity cost of producing screwdrivers higher between points A and B or between points B and C? Answer: a. The slope of the production possibilities frontier between Point A and Point B is -(5/1) = -5. b. The slope of the production possibilities frontier between Point B and Point C is -(10/1) = -10. c. The opportunity cost of producing hammers is lower between points A and B (5 hammers) than between points B and C (10 hammers). d. The opportunity cost of producing screwdrivers is higher between points A and B (1/5 screwdriver) than between points B and C (1/10 screwdriver).

6. For each point on the PPF in Figure 2P-3, note whether the point is attainable and efficient, attainable and inefficient, or unattainable. [LO 2.1] 1-19 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Answer: Points that lie on the frontier are called efficient, because they squeeze the most output possible from all available resources. Points within (inside) the frontier are inefficient because they do not use all available resources. Points outside the frontier are unattainable with current resources. a. Attainable and efficient b. Unattainable c. Attainable and inefficient d. Attainable and efficient.

7. For each point on the PPF in Figure 2P-4, note whether the point is attainable and efficient, attainable and inefficient, or unattainable. [LO 2.1]

Answer: Points that lie on the frontier are called efficient, because they squeeze the most output possible from all available resources. Points within (inside) the frontier are inefficient because they do not use all available resources. Points outside the frontier are unattainable with current resources.

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a. Attainable and efficient b. Attainable and efficient c. Attainable and efficient d. Attainable and inefficient e. Unattainable

8. The Red Cross and WIC (Women, Infants, and Children program) both provide emergency food packages and first-aid kits to New York City home-less shelters. Table 2P-1 shows their weekly production possibilities in providing emergency goods to NYC homeless shelters.

NYC homeless shelters need a total of 20 first-aid kits per week. Currently, they get 10 kits from the Red Cross and 10 kits from WIC. With their remaining resources, how many food packages can each organization provide to NYC homeless shelters? [LO 2.1]

Answer: From the table, we find that the Red Cross can produce 300 food packages OR 50 first-aid kits OR some combination in-between (for example, 150 food packages and 25 firstaid kits.) The opportunity cost of providing one first-aid kit is 6 food packages. The requirement of 10 kits from the Red Cross comes at a cost of 60 food packages (6 food packages per first-aid kit times 10). Out of the 300 food packages possible from the Red Cross 60 must be given up, leaving 240 (300 – 60) food packages available.

Likewise, the WIC can produce 200 food packages OR 20 first-aid kits OR some combination in-between. The opportunity cost for this organization of providing one first-aid kit is 10 food packages. The requirement of 10 first-aid kits from the WIC means giving up 100 food packages. Out of the 200 food packages possible, 100 (200 – 100) are still available.

9. Suppose that three volunteers are preparing cookies and cupcakes for a bake sale. Diana can make 26 cookies or 19 cupcakes per hour; Andy can make 24 cookies or 18 cupcakes; and Sam can make 9 cookies or 13 cupcakes. [LO 2.2] a. Who has the absolute advantage at making cookies? b. Who has the absolute advantage at making cupcakes?

Answer: If a producer can generate more output than others with a given amount of resources, that producer has an absolute advantage. When a producer can make a good at a 1-21 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

lower opportunity cost than other producers, we say it has a comparative advantage at producing that good. a. Of the three workers, Diana has the absolute advantage at making cookies. She can make the most cookies (26) in an hour compared with Andy (24) and Sam (9). b. Diana also has the absolute advantage at baking cupcakes. She can bake 19 cupcakes in an hour, whereas Andy can only bake 18 and Sam can only bake 13.

10. Paula and Carlo are coworkers. Their production possibilities frontiers for counseling clients and writing memos are given in Figure 2P-5. [LO 2.2]

a. b. c. d.

Which worker has an absolute advantage in counseling clients?

Which worker has a comparative advantage in counseling clients?

Which worker has an absolute advantage in writing memos?

Which worker has a comparative advantage in writing memos?

Answer: Absolute advantage is the ability to produce more of a good or service than others can with a given amount of resources. Comparative advantage is the ability to produce a good or service at a lower opportunity cost than others. a. Paula has the absolute advantage in counseling clients because she can produce more of this service than Carlo can with a given amount of resources. b. Paula has the comparative advantage in counseling clients because her opportunity cost of counseling a client is 0.25 memos compared to Carlo's opportunity cost of 0.33 memos.

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c. Paula has the absolute advantage in writing memos because she can write more of them than Carlo can with a given amount of resources. d. Carlo has the comparative advantage in writing memos because his opportunity cost of writing a memo is 3 counseled clients compared to Paula's opportunity cost of 4 counseled clients.

11. Two students are assigned to work together on a project that requires both writing and an oral presentation. Steve can write 1 page or prepare 4 minutes of a presentation each day. Anna can write 3 pages or prepare 2 minutes of a presentation each day. [LO 2.2] a. Who has a comparative advantage at writing? b. Suppose that Steve goes to a writing tutor and learns some tricks that enable him to write 3 pages each day. Now who has a comparative advantage at writing?

Answer: Absolute advantage is the ability to produce more of a good or service than others can with a given amount of resources. Comparative advantage is the ability to produce a good or service at a lower opportunity cost than others. a. Anna has a comparative advantage at writing because she has the lower opportunity cost.

She gives up 0.67 minutes of presentation for each page she writes, whereas Steve gives up 4 minutes of presentation for each page he writes. b. If Steve goes to a writing tutor and increases his productivity in writing, his opportunity costs change. If Steve is now able to write 4 pages a day, it means his opportunity cost for each page he writes is now 1 minute of presentation. However, Anna still has a comparative advantage at writing because she still only gives up 0.67 minutes of presentation for each page he writes.

12. Suppose that the manager of a restaurant has two new employees, Rahul and Henriette, and is trying to decide which one to assign to which task. Rahul can chop 20 pounds of vegetables or wash 100 dishes per hour. Henriette can chop 30 pounds of vegetables or wash 120 dishes.

[LO 2.3] a. Who should be assigned to chop vegetables? b. Who should be assigned to wash dishes?

Answer: Comparative advantage is the ability to produce a good or service at a lower opportunity cost than others. a. Henriette should chop vegetables, as she has the lower opportunity cost for chopping vegetables. Henriette’s opportunity cost for chopping 1 vegetable is a loss of 4 dishes washed, whereas Rahul’s opportunity cost for chopping 1 vegetable is a loss of 5 dishes washed.

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b. Rahul should be assigned to wash dishes, as she has the lowest opportunity cost for washing dishes. Rahul’s opportunity cost for washing 1 dish is a loss of 0.2 vegetables chopped, whereas Henriette’s opportunity cost for washing 1 dish is a loss 0.25 vegetables chopped.

13. The Dominican Republic and Nicaragua both produce coffee and rum. The Dominican Republic can produce 20,000 tons of coffee per year or 10,000 barrels of rum. Nicaragua can produce 30,000 tons of coffee per year or 5,000 barrels of rum. [LO 2.3] a. Suppose the Dominican Republic and Nicaragua sign a trade agreement in which each country would specialize in the production of either coffee or rum. Which country should specialize in producing coffee? Which country should specialize in producing rum? b. What are the minimum and maximum prices at which these countries will trade coffee?

Answer: a. If the Dominican Republic and Nicaragua sign a trade agreement in which each country would specialize in production, coffee and rum will be produced according to which country has a comparative advantage in the production of each good. Comparing their opportunity costs for producing coffee, we see that Nicaragua has a lower opportunity cost for producing coffee (1/6 of a barrel of rum, versus the Dominican Republic's opportunity cost of 1/2 barrel of rum). Nicaragua, therefore, should specialize in coffee.

Comparing their opportunity costs for producing rum, we see that the Dominican Republic has a lower opportunity cost for producing rum (2 tons of coffee, versus 6 tons for Nicaragua). The Dominican Republic, therefore, should specialize in rum. b. The minimum price at which these countries will trade coffee is 1/6 (0.167) of a barrel of rum per ton of coffee and the maximum price is 1/2 (0.500) of a barrel of rum per ton of coffee. The price of coffee will end up between the opportunity costs for the two countries. Nicaragua specializes in coffee because it has the lower opportunity cost (1/6 as compared to 1/2). It will not sell coffee for less than its opportunity cost. The Dominican Republic will not pay more than its opportunity cost (1/2) because if the price of coffee was higher than 1/2 of a barrel of rum, then it would be better off producing the coffee itself.

14. Eleanor and her little brother Josh are responsible for two chores on their family’s farm: gathering eggs and collecting milk. Eleanor can gather 9 dozen eggs or collect 3 gallons of milk per week. Josh can gather 2 dozen eggs or collect 2 gallons of milk per week. [LO 2.3] a. The family wants 2 gallons of milk per week and as many eggs as the siblings can gather.

Currently, Eleanor and Josh collect one gallon of milk each and as many eggs as they can. How many dozens of eggs does the family have per week?

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b. If the siblings were to specialize, which should collect the milk? c. If the siblings were to specialize, how many dozens of eggs would the family have per week?

Answer: Comparative advantage is the ability to produce a good or service at a lower opportunity cost than others. a. Eleanor’s opportunity cost for collecting a gallon of milk is 3 dozen eggs. Therefore Eleanor will gather 9 ‒ 3 = 6 dozen eggs. Josh’s opportunity cost for collecting a gallon of milk is 1 dozen eggs. Therefore, Josh will gather 2 ‒ 1 = 1 dozen eggs. Together the siblings will gather 7 dozen eggs. b. Josh should specialize in collecting milk because he has the lower opportunity cost. c. If they specialize, Josh will collect both gallons of milk and no eggs. Eleanor will collect 9 dozen eggs and no milk. The family will now have 9 dozen eggs with their 2 gallons of milk, more than they were able to have before the siblings specialized.

15. Suppose Russia and Sweden each produces only paper and cars. Russia can produce 8 tons of paper or 4 million cars each year. Sweden can produce 25 tons of paper or 5 million cars each year. [LO 2.4] a. Draw the production possibilities frontier for each country. b. Both countries want 2 million cars each year and as much paper as they can produce along with 2 million cars. Find this point on each production possibilities frontier and label it ―A.‖ c. Suppose the countries specialize. Which country will produce cars? d. Once they specialize, suppose they work out a trade of 2 million cars for 6 tons of paper.

Find the new consumption point for each country and label it ―B.‖ Answer: a. The production possibilities frontier identifies the different combinations of the two goods (cars and paper) that can be produced by each country. Russia can produce 8 tons of paper and 0 cars or 0 tons of paper and 4 million cars. These are the two endpoints of Russia's PPF. Sweden can produce 25 tons of paper and 0 cars or 0 tons of paper and 5 million cars. These are the two endpoints of Sweden's PPF. b. If Russia wants to produce 2 million cars then they are only able to produce 4 tons of paper. If Sweden wants to produce 2 million cars then they are only able to produce 15 tons of paper. Notice Russia's opportunity cost of producing 1 million cars is 2 tons of paper, and Sweden's opportunity cost of producing 1 million cars is 5 tons of paper 1-25 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

c. Russia will produce cars because Russia has a lower opportunity cost for producing cars than Sweden. d. Russia will produce 4 million cars (complete specialization is assumed) and trade 2 million cars to Sweden in exchange for 6 tons of paper. Therefore, Russia ends up consuming 2 million cars and 6 tons of paper. Sweden will produce 25 tons of paper and trade 6 tons of paper to Russia in exchange for 2 million cars. Therefore, Sweden ends up consuming 2 million cars and 19 tons of paper. Both counties are better of with trade because they still have 2 million cars each, but both end up with more paper than they had before trade. Notice the post-trade consumption point is outside the production possibilities frontier meaning each country was unable to achieve this point without trade.

16. Maya and Max are neighbors. They both grow lettuce and tomatoes in their gardens. Maya can grow 45 heads of lettuce or 9 pounds of tomatoes this summer. Max can grow 42 heads of lettuce or 6 pounds of tomatoes this summer. If Maya and Max specialize and trade, the price of tomatoes (in terms of lettuce) would be as follows: 1 pound of tomatoes would cost between __ and __ heads of lettuce.

Answer: If Maya and Max specialize and trade, the price of tomatoes (in terms of lettuce) would be: 1 pound of tomatoes would cost between 5 and 7 heads of lettuce. Maya will grow tomatoes because she has the lower opportunity cost. (Maya’s opportunity cost is 5 heads of lettuce for 1 pound of tomatoes, whereas Max’s is 7 heads of lettuce for 1 pound of tomatoes.) She must receive at least 5 heads of lettuce from Max for a pound of tomatoes or she is better off growing the lettuce herself. Max will buy tomatoes from Maya but only if she charges him no more than 7 heads of lettuce. Otherwise, Max is better off growing the tomatoes himself. If, for example, Maya charges Max 6 heads of lettuce for a pound of tomatoes both neighbors would be better off than what they can do on their own.

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CHAPTER 3 MARKETS Solutions to End-of-Chapter Questions and Problems Review Questions 1. Think about a competitive market in which you participate regularly. For each of the characteristics of a competitive market, explain how your market meets these requirements.

[LO 3.1] Answer: The market for eggs is competitive. There are many grocery stores where eggs can be purchased. Standardized good: Eggs are a standardized good. There are different kinds of eggs, of course, but each unit of a particular type of egg will be standardized. Full information: The ubiquity of grocery stores makes it easy for buyers and sellers to gather information about the price of eggs. No transaction costs: There are no transaction costs or other limits to buying and selling eggs. Buyers and sellers can easily find each other. Participants are price takers: I am one consumer among many and my purchase patterns have no effect on the market price. Likewise, there are so many places to buy eggs that sellers are also price takers.

2. Think about a noncompetitive market in which you participate regularly. Explain which characteristic(s) of competitive markets your market does not meet. [LO 3.1] Answer: I take the subway to work every day. Public transportation is not a competitive market. There is only one subway system, so there is no competition. The subway is a natural monopoly (students will learn about monopolies in a later chapter). For now, it is enough to know that without competition, the MTA (Metropolitan Transportation Authority)—which which operates the subway system—is not a price taker. The passengers are certainly price takers, but the operator is not.

3. Explain why a demand curve slopes downward. [LO 3.2] Answer: The demand curve slopes downward because as prices increase, quantity demanded decreases. Price and quantity move in opposite directions and have a negative relationship for demand. Think about your incentives when the price of a good you want to purchase increases. The quantity you demand of that good is likely to move in the other direction and decrease. When price and quantity move in opposite directions, the result is a downward sloping curve.

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4. In each of the following examples, name the factor that affects demand and describe its impact on your demand for a new cell phone. [LO 3.2] a. You hear a rumor that a new and improved model of the phone you want is coming out next year. b. Your grandparents give you $500. c. A cellular network announces a holiday sale on a data package that includes the purchase of a new smartphone. d. A friend tells you how great his new phone is and suggests that you get one, too.

Answer: a. Expectations. Your current demand will decrease in the present as you postpone purchasing under the expectation that a new model will be released next year. b. Incomes. Your purchasing power has increased due to the money given to you by your grandparents. Your demand will increase. c. Price of a Related Good. When the price of a data package (a complementary good) goes down due to the sale, demand for smartphones increases. d. Consumer Preferences. Your friend influences your interest in purchasing a phone. Your friend’s enjoyment of his phone and suggestion that you also purchase a phone increases your demand.

5. Consider the following events: a. The price of cell phones goes down by 25 percent during a sale. b. You get a 25 percent raise at your job.

Which event represents a shift in the demand curve? Which represents a movement along the curve? What is the difference? [LO 3.3] Answer: The relationship between price and quantity demanded is directly reflected in the demand curve. A change in price will mean a movement along an existing curve. Factors of demand that are held constant, such as income, cause a shift in the demand curve when they change. a. When the price of cell phones goes down by 25 percent, this is a movement along the demand curve for cell phones. b. When your income increases by 25 percent, there is a shift in the demand curve, as income is a factor of demand held constant in any given demand curve.

6. What is the difference between a change in demand and a change in quantity demanded?

[LO 3.3]

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Answer: When we refer to a change in demand, we are referring to a shift of the entire curve.

This happens when a non-price factor changes—such as income, expectations, prices of related goods, consumer preferences or the number of buyers. A change in quantity demanded refers to a change in the specific numerical quantity demanded due to a change in price.

7. Explain why a supply curve slopes upward. [LO 3.4] Answer: The supply curve slopes upward because as prices increase, quantity supplied also increases. Price and quantity move in the same direction and have a positive relationship for supply. Think about the incentives facing a producer when the price of the good she is producing increases. The quantity she is willing and able to supply of that good is likely to also increase. When price and quantity move in the same direction, the result is an upward sloping curve.

8. In each of the following examples, name the factor that affects supply and describe its impact on the supply of cell phones. [LO 3.4] a. Economic forecasts suggest that the demand for cell phones will increase in the future. b. The price of plastic goes up. c. A new screen technology reduces the cost of making cell phones.

Answer: a. Expectations. If demand for cell phones is expected to increase in the future, then the price of cell phones is expected to increase in the future. Current supply of cell phones may decrease if supplies are able to withhold inventory waiting on prices to increase.

Supply of cell phones will eventually increase as prices do rise. b. Prices of Inputs. Plastic is an input in the production of cell phones. If the price of plastic increases, production costs increase and supply decreases. c. Technology. If advancement in screen technology reduces the cost of making cell phones, supply of cell phones will increase.

9. Consider the following events: a. A fruitworm infestation ruins a large number of apple orchards in Washington state. b. Demand for apples goes down, causing the price to fall.

Which event represents a shift in the supply curve? Which represents a movement along the curve? What is the difference? [LO 3.5] Answer: Factors of supply that are held constant, such as number of suppliers, cause a shift in the supply curve when they change. The relationship between price and quantity supplied is directly reflected in the supply curve. A change in price will mean a movement along an existing curve.

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a. A fruitworm infestation will cause a shift in the supply of apples, as the number of orchards (sellers) able to supply to the market will decrease. b. When demand decreases and prices fall, there is a movement along the supply curve.

10. What is the difference between a change in supply and a change in quantity supplied? [LO 3.5] Answer: When we refer to a change in supply, we are referring to a shift of the entire curve.

This happens when a non-price factor changes—such as technology, expectations, prices of related goods, prices of inputs or the number of sellers. A change in quantity supplied refers to a change in the specific numerical quantity supplied due to a change in price.

11. What is the relationship between supply and demand when a market is in equilibrium?

Explain how the incentives facing cell phone companies and consumers cause the market for cell phones to reach equilibrium. [LO 3.6] Answer: When a market is in equilibrium, quantity supplied equals quantity demanded. We say that supply and demand are in agreement at market equilibrium. Cell phone sellers have an incentive for prices to rise and cell phone consumers would like for prices to fall. Because their incentives are not aligned, each side will create opposing pressure on market prices.

Equilibrium represents the price at which both consumers and suppliers of cell phones agree to buy/sell a given quantity.

12. Explain why the equilibrium price is often called the market-clearing price. [LO 3.6] Answer: The equilibrium price is often called the market clearing price because it is the price at which the market ―clears‖ in the sense that there is neither excess demand nor excess supply. Quantity supplied equals quantity demanded at this price. Every buyer who wants to buy at this price can find supply and every supplier who wants to sell at this price can find a buyer.

13. Suppose an economic boom causes incomes to increase. Explain what will happen to the demand and supply of phones, and predict the direction of the change in the equilibrium price and quantity. [LO 3.7] Answer: If incomes increase, there will be an increase in demand for cell phones. If no other shifts occurred, both the price of cell phones and the quantity of cell phones traded would rise.

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14. Suppose an economic boom drives up wages for the sales representatives who work for cell phone companies. Explain what will happen to the demand and supply of phones, and predict the direction of the change in the equilibrium price and quantity. [LO 3.7] Answer: If an increase in wages causes an increase in production costs for sellers of cell phones, supply of cell phones will decrease. If no other shifts had occurred, a decrease in supply would cause prices to rise and the number of cell phones traded to decrease.

15. Suppose an economic boom causes incomes to increase and at the same time drives up wages for the sales representatives who work for cell phone companies. Explain what will happen to the demand for and supply of phones and predict the direction of the change in the equilibrium price and quantity. [LO 3.7] Answer: When both an increase in demand and a decrease in supply occur, we know that the price of cell phones will rise. It is unclear whether the quantity of cell phones traded will increase or decrease. It depends on whether the shift in demand is larger or smaller than the shift in supply.

Problems and Applications 1. Consider shopping for cucumbers in a farmers’ market. For each statement below, note which characteristic of competitive markets the statement describes. Choose from: standardized good, full information, no transaction costs, and participants are price takers.

[LO 3.1] a. All of the farmers have their prices posted prominently in front of their stalls. b. Cucumbers are the same price at each stall. c. There is no difficulty moving around between stalls as you shop and choosing between farmers. d. You and the other customers all seem indifferent about which cucumbers to buy.

Answer: A standardized good is a good for which any two units have the same features and are interchangeable. In a competitive market, you have full information about the price and features of the good being bought and sold. In competitive markets, there are no transaction costs, meaning that you don’t have to pay anything for the privilege of buying or selling in the market. In economic terminology, a buyer or seller who cannot affect the market price is called a price taker. a. Full information b. Participants are price takers c. No transaction costs d. Standardized good 1-31 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

2. Suppose two artists are selling paintings for the same price in adjacent booths at an art fair.

By the end of the day, one artist has nearly sold out of her paintings while the other artist has sold nothing. Which characteristic of competitive markets has not been met and best explains this outcome? [LO 3.1] a. Standardized good. b. Full information. c. No transaction costs. d. Participants are price takers.

Answer: A standardized good is a good for which any two units have the same features and are interchangeable. In a competitive market, you have full information about the price and features of the good being bought and sold. In competitive markets, there are no transaction costs, meaning that you don’t have to pay anything for the privilege of buying or selling in the market. In economic terminology, a buyer or seller who cannot affect the market price is called a price taker. This is not a standardized good. The booths are adjacent with prices clearly posted so full information is available without transaction costs. The prices of the paintings are the same, which may indicate that the artists are price-takers. The best explanation for the difference in sales is that the paintings are not standardized. The artists may have very different styles or levels of talent.

3. Using the demand schedule in Table 3P-1, draw the daily demand curve for slices of pizza in a college town. [LO 3.2] Answer:

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4. Consider the market for cars. Which determinant of demand is affected by each of the following events? Choose from: consumer preferences, prices of related goods, incomes, expectations, and the number of buyers. [LO 3.2] a. Environmentalists launch a successful One Family, One Car campaign. b. A baby boom occurred 16 years ago. c. Layoffs increase as the economy sheds millions of jobs. d. An oil shortage causes the price of gasoline to soar. e. The government offers tax rebates in return for the purchase of commuter rail tickets. f. The government announces a massive plan to bail out the auto industry and subsidize production costs.

Answer: The non-price determinants of demand can be divided into five major categories: consumer preferences, the prices of related goods, incomes, expectations of future prices, and the number of buyers in the market. a. b. c. d. e. f.

Consumer preferences Number of buyers Incomes Prices of related goods Prices of related goods Expectations

5. If a decrease in the price of laptops causes the demand for tablets to increase, are laptops and tablets substitutes or complements? [LO 3.2] Answer: If a decrease in the price of laptops causes the demand for tablets to increase, laptops and tablets are complements. A decrease in the price of laptops increases the quantity demanded for laptops (a movement along the curve). If the demand for tablets also increases (a shift of the curve), consumers use laptops and tablets together.

6. If rising incomes cause the demand for beer to decrease, is beer a normal or inferior good?

[LO 3.2] Answer: If rising incomes cause the demand for beer to decrease, beer is an inferior good. If this is the case for beer, this could be because consumers substitute preferred drinks such as wine or liquor when their income rises.

7. Consider the market for corn. Say whether each of the following events will cause a shift in the demand curve or a movement along the curve. If it will cause a shift, specify the direction. [LO 3.3] a. A drought hits corn-growing regions, cutting the supply of corn. b. The government announces a new subsidy for biofuels made from corn.

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c. A global recession reduces the incomes of consumers in poor countries, who rely on corn as a staple food. d. A new hybrid variety of corn seed causes a 15 percent increase in the yield of corn per acre. e. An advertising campaign by the beef producers’ association highlights the health benefits of corn-fed beef.

Answer: A change in the price of a good will cause a movement along the demand curve. A change in a nonprice determinant will cause a shift of the demand curve. a. Movement along the curve: There is a decrease in supply, which causes an increase in price and a decrease in quantity demanded. b. Shift in the curve: There is an increase in demand (rightward shift). c. Shift in the curve: There is a decrease in demand (leftward shift). d. Movement along the curve: There is an increase in supply, which causes a decrease in price and an increase in quantity demanded. e. Shift in the curve: There is an increase in demand (rightward shift).

8. The demand curve in Figure 3P-1 shows the monthly market for sweaters at a local clothing store. For each of the following events, draw the new outcome. [LO 3.3] a. Sweaters fall out of fashion. b. There is a shortage of wool. c. The winter is particularly long and cold this year. d. Sweater vendors offer a sale.

Answer:

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a. Point D: This is a change in a nonprice determinant. The demand curve will shift to the left because people prefer to buy fewer sweaters. b. Point B: A shortage of wool will increase the price of sweaters and the supply curve will shift left, causing a movement up along the demand curve. c. Point E: This is a change in a nonprice determinant. The demand curve will shift to the right as people prefer to buy more sweaters. d. Point C: The price of sweaters decreases and the supply curve will shift right, causing a movement down along the demand curve.

9. Using the supply schedule found in Table 3P-2, draw the daily supply curve for slices of pizza in a college town. [LO 3.4]

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Answer: The supply schedule shows the quantity of pizza slices that firms are willing and able to sell (supply) at various prices. Each price/quantity combination from the supply schedule can be plotted on the graph to illustrate the supply curve.

10. Consider the market for cars. Which determinant of supply is affected by each of the following events? Choose from: prices of related goods, technology, prices of inputs, expectations, and the number of sellers in the market. [LO 3.4] a. A steel tariff increases the price of steel. b. Improvements in robotics increase efficiency and reduce costs. c. Factories close because of an economic downturn. d. The government announces a plan to offer tax rebates for the purchase of commuter rail tickets. e. The price of trucks falls, so factories produce more cars. f. The government announces that it will dramatically rewrite efficiency standards, making it much harder for automakers to produce their cars.

Answer: Several non-price factors determine the supply of a good at any given price: They include the prices of related goods, technology, prices of inputs, expectations about the future, and the number of sellers in the market. a. b. c. d. e. f.

Prices of inputs Technology Number of sellers Expectations Prices of related goods Technology

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11. Consider the market for corn. Say whether each of the following events will cause a shift in the supply curve or a movement along the curve. If it will cause a shift, specify the direction.

[LO 3.5] a. A drought hits corn-growing regions. b. The government announces a new subsidy for biofuels made from corn. c. A global recession reduces the incomes of consumers in poor countries, who rely on corn as a staple food. d. A new hybrid variety of corn seed causes a 15 percent increase in the yield of corn per acre. e. An advertising campaign by the beef producers’ association highlights the health benefits of corn-fed beef.

Answer: A change in the price of a good will cause a movement along the supply curve. A change in a non-price determinant will cause a shift of the supply curve. a. Shift in the curve: There is a decrease in supply (leftward shift). b. Movement along the curve: There is an increase in demand. c. Movement along the curve: There is a decrease in demand. d. Shift in the curve: There is an increase in supply (rightward shift). e. Movement along the curve: There is an increase in demand.

12. The supply curve in Figure 3P-2 shows the monthly market for sweaters at a local craft market. For each of the following events, draw the new outcome. [LO 3.5] a. The price of wool increases. b. Demand for sweaters decreases. c. A particularly cold winter is expected to begin next month. d. Demand for sweaters increases.

Answer: A change in the price of a good will cause a movement along the supply curve. A change in a nonprice determinant will cause a shift of the supply curve.

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a. Point C: This is a change in a nonprice determinant. The supply curve will shift to the left because input prices have increased. b. Point E: A decrease in the demand for sweaters will decrease the price of sweaters, causing a movement down along the supply curve. c. Point B: This is a change in a nonprice determinant. The supply curve will shift to the right because firms expect the demand for sweaters to increase. d. Point D: An increase in the demand for sweaters will increase the price of sweaters, causing a movement up along the supply curve.

13. Refer to the demand and supply schedule shown in Table 3P-3. [LO 3.6]

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a. If pizza parlors charge $3.50 per slice, will there be excess supply or excess demand?

What is the amount of excess supply or excess demand at that price? b. If pizza parlors charge $1.00 per slice, will there be excess supply or excess demand?

What is the amount of excess supply or excess demand at that price? c. What are the equilibrium price and quantity in this market?

Answer: a. When the price is above the equilibrium price there is an excess supply. In this case, there is an excess supply of 400 slices. b. When the price is below the equilibrium price there is an excess demand. In this case when the price is $1.00, quantity demanded is 250 slices and the quantity supplied is 150 slices, there is an excess demand of 100 slices. c. The equilibrium price occurs where the quantity demanded equals the quantity supplied, at $1.50. The equilibrium quantity is 200 slices.

The graph in Figure 3P-3 shows the weekly market for pizzas in a small town. Use this graph to answer Problems 14–16.

14. Which of the following events will occur at a price of $20? [LO 3.6] a. Equilibrium. b. Excess demand. c. Excess supply. d. No pizzas supplied. e. No pizzas demanded.

Answer: There is an excess supply. $20 is above the equilibrium price, which will lead to an excess supply because quantity supplied is greater than quantity demanded.

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15. Which of the following events will occur at a price of $10? [LO 3.6] a. Equilibrium. b. Excess demand. c. Excess supply. d. No pizzas supplied. e. No pizzas demanded.

Answer: There is an excess demand. $10 is below the equilibrium price, which will lead to excess demand because quantity supplied is less than quantity demanded.

16. What are the equilibrium price and quantity of pizzas? [LO 3.6] Answer: Graphically the equilibrium price and quantity are found at the point where the supply curve intersects the demand curve. At this equilibrium price, the quantity demanded by buyers is equal to the quantity supplied by the sellers and there is no incentive for the sellers to change the price of the good. In other words, there is no excess demand or excess supply for the good. The equilibrium price is $15, and the equilibrium quantity is 150 pizzas.

17. The graph in Figure 3P-4 shows supply and demand in the market for automobiles. For each of the following events, draw the new market outcome, and say whether the equilibrium price and quantity will increase or decrease. [LO 3.7] a. b. c. d. e. f.

Environmentalists launch a successful One Family, One Car campaign.

A steel tariff increases the price of steel.

A baby boom occurred 16 years ago.

An oil shortage causes the price of gasoline to soar.

Improvements in robotics increase efficiency and reduce costs.

The government offers a tax rebate for the purchase of commuter rail tickets.

Answer:

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a. If more families decide to own only one car instead of two or three cars then there is a decrease in the demand for cars. As a result, there will be an excess demand for cars at the existing price and firms will have an incentive to reduce the price of cars.

Equilibrium price and quantity will both decrease and the new equilibrium is at point A. b. The increase in the price of steel will increase the cost of producing cars and this will increase the price of cars. The supply curve will shift to the left (a decrease in supply), and the new equilibrium is at point B. The price increases and quantity decreases. c. As these children turn 16, they will learn to drive and some of them will buy cars. The demand for cars will increase and the new equilibrium is at point C. Price increases and quantity increases. d. An increase in the price of gas will make driving more expensive and this will decrease the demand for cars. The new equilibrium is at point A. Price decreases and quantity decreases. e. If the cost of production falls, then firms are willing to sell cars for a lower price. The supply curve will shift to the right (increase in supply) and equilibrium is at point D. The price decreases and quantity increases. f. A tax rebate on rail tickets will reduce the cost of train travel (a substitute for driving) and this will decrease the demand for cars. The new equilibrium is at point A. The price decreases and quantity decreases.

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and quantity, or whether the effect cannot be predicted. [LO 3.7] a. Demand increases; supply remains constant. b. Supply increases; demand remains constant. c. Demand decreases; supply remains constant. d. Supply decreases; demand remains constant. e. Demand increases; supply increases. f. Demand decreases; supply decreases. g. Demand increases; supply decreases. h. Demand decreases; supply increases.

Answer: In the first four parts, only one curve is shifting, so the impact on equilibrium price and quantity can be predicted. In the last four parts, two changes are occurring at the same time, so the impact on either equilibrium price or quantity cannot be predicted. Consider a simultaneous increase in demand and increase in supply. The increase in demand will increase equilibrium price and quantity. The increase in supply will decrease equilibrium price and increase equilibrium quantity. Both changes lead to an increase in equilibrium quantity, so this can be predicted. The two changes have opposite impacts on equilibrium price, so this cannot be predicted. a. The equilibrium price increases, and the equilibrium quantity increases. b. The equilibrium price decreases, and the equilibrium quantity increases. c. The equilibrium price decreases, and the equilibrium quantity decreases. d. The equilibrium price increases, and the equilibrium quantity decreases. e. The equilibrium price cannot be predicted, and the equilibrium quantity increases. f. The equilibrium price cannot be predicted, and the equilibrium quantity decreases. g. The equilibrium price increases, and the equilibrium quantity cannot be predicted. h. The equilibrium price decreases, and the equilibrium quantity cannot be predicted.

CHAPTER 4 ELASTICITY Solutions to End-of-Chapter Questions and Problems Review Questions 1. You are advising a coffee shop manager who wants to estimate how much sales will change if the price of a latte rises. You tell her that she should measure the change in sales using the percentage change in quantity of coffee sold rather than the number of cups of coffee or the 1-42 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

total ounces of coffee sold. Similarly, you tell her that she should measure the price increase in percentage terms rather than in terms of absolute dollars. Explain why she should measure elasticity in percentage terms rather than in terms of dollars and cups. [LO 4.1] Answer: If the coffee shop manager measures elasticity in percentage changes, she will have an understanding of the price sensitivity of demand for lattes that will be consistent regardless of the units of measure. By using percentage changes to calculate elasticity, she will have the same sense of price sensitivity regardless of whether lattes are measured in cups, gallons, or ounces and whether price is measured in dollars or cents.

2. Explain why the coffee shop manager should calculate elasticity using the mid-point method. [LO 4.1] Answer: Using the mid-point method to calculate elasticity is useful because the coffee shop manager will have a single measure of the price sensitivity of demand over a particular range of prices regardless of the direction price is moving. For example, she would know how sensitive demand is to a price change between $3 and $5 regardless of whether price increases from $3 to $5 or decreases from $5 to $3. Because the mid-point method considers the average of these prices ($4) as the base, she will have the same elasticity measure over that price range, whichever direction price moves.

3. You are working as a private math tutor to raise money for a trip during spring break. First explain why the price elasticity of demand for math tutoring might be elastic. Then explain why the price elasticity of demand for math tutoring might be inelastic. [LO 4.2] Answer: This would depend on the availability of other tutors who might charge prices lower than you and how desperate your students are for tutoring. If your students can easily switch to another tutor and/or think of tutoring as a luxury they can do without if prices rise, the price elasticity of demand would be elastic. If there are no other tutors your students can turn to or if they feel they cannot possibly pass their course without tutoring, the price elasticity of demand could be inelastic.

4. You are working as a private math tutor to raise money for a trip during spring break. You want to raise as much money as possible. Should you should increase or decrease the price you charge? Explain. [LO 4.2] Answer: Whether you should raise or lower your prices depends on the price elasticity of demand. If demand is elastic, you will increase your revenue by lowering prices. With elastic demand, lower prices mean that people will hire enough additional tutoring hours from you to offset the lower price. If demand is inelastic, you will raise prices by increasing prices. With inelastic demand, people will reduce tutoring hours a bit when you raise prices, but not enough to offset your gain from charging more.

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5. You have been hired by the government of Kenya, which produces a lot of coffee, to examine the supply of gourmet coffee beans. Suppose you discover that the price elasticity of supply is 0.85. Explain this figure to the Kenyan government. [LO 4.3] Answer: A price elasticity of supply of 0.85 would mean that supply of gourmet coffee beans is inelastic, or not very responsive to prices. For example, if the price of gourmet coffee beans rose by 5 percent, the supply of gourmet coffee beans would increase by less than 5 percent in the short run. This could be because it takes a long time to increase supply and/or there may be other constraints like limitations on land. You could advise the Kenyan government to explore the factors that make supply less responsive to price changes.

6. You have noticed that the price of tickets to your university’s basketball games keeps increasing but the supply of tickets remains the same. Why might supply be unresponsive to changes in price? [LO 4.3] Answer: It may not be possible to increase the supply of tickets. The number of tickets is likely fixed in the short run. There are usually a specific number of seats in a sports arena that won’t change as prices fluctuate. In this case, supply is perfectly inelastic and the same number of seats will be supplied, even as prices rise. In a longer term, your university could build a bigger arena.

7. Which will have a more price-elastic supply over six months: real estate in downtown Manhattan or real estate in rural Oklahoma? Explain your reasoning. [LO 4.4] Answer: Real estate in rural Oklahoma will be more price-elastic in the short run than real estate in Manhattan. Land is scarce in Manhattan, making it difficult to increase real estate.

Higher buildings can often replace smaller ones, but this takes more time. Land is more easily available for development in rural Oklahoma, making this area better able to respond quickly to changes in the price of real estate.

8. Certain skilled labor, such as hair cutting, requires licensing or certification, which is costly and takes a long time to acquire. Explain what would happen to the price elasticity of supply for haircuts if this licensing requirement were removed. [LO 4.4] Answer: The price elasticity of supply would increase (become more elastic). If the requirement for licensing were removed, a hair salon could expand its staff more easily in response to increasing prices because they would not be limited to only hiring licensed haircutters.

9. Although we could describe both the cross-price elasticity of demand between paper coffee cups and plastic coffee lids and the cross-price elasticity of demand between sugar and 1-44 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

artificial sweeteners as highly elastic, the first cross-price elasticity is negative and the second is positive. What is the reason for this? [LO 4.5] Answer: Goods that are strong complements like coffee cups and coffee lids will have a more elastic cross-price elasticity. Likewise, goods that are strong substitutes like sugar and artificial sweeteners will also have a more elastic cross-price elasticity. In both cases the goods are closely related so quantity demanded of one good (such as coffee cups) will be more responsive to changes in the price of the other good (coffee lids) than if the two goods were less related. However, complements and substitutes will have different signs. For complements, like coffee cups and coffee lids, the sign will be negative. When the price of coffee lids increases, we buy fewer coffee cups. With substitutes, the sign is positive. As the price of artificial sweeteners increases, quantity demanded of sugar will also increase.

10. Name two related goods you consume that would have a positive cross-price elasticity. What happens to your consumption of the second good if the price of the first good increases?

[LO 4.5] Answer: When I am craving something sweet, I like cookies and donuts. These treats are substitutes for me. If the price of cookies at my local bakery increases, I will choose donuts.

11. Name two related goods you consume which would have a negative cross-price elasticity.

What happens to your consumption of the second good if the price of the first good increases? [LO 4.5] Answer: One of my favorite snacks is chips and guacamole. These goods are complements for me because I consume them together. They have a negative cross-price elasticity for me.

If the price of chips increases, I purchase less guacamole.

12. In France, where cheese is an important and traditional part of people’s meals, people eat about six times as much cheese per person as in the United States. In which country do you think the demand for cheese will be more income-elastic? Why? [LO 4.6] Answer: Demand for cheese will be more income-elastic in the United States. While people in the United States also enjoy cheese, it is not as culturally important as it is in France.

People in France already prioritize cheese and eat a lot of cheese. If incomes rise, they are unlikely to significantly increase how much cheese they consume. Conversely, if incomes fall, they will try to avoid significantly deceasing consumption of cheese. They may choose to make other sacrifices before they reduce cheese consumption.

13. Name a good you consume for which your income elasticity of demand is positive. What happens when your income increases? [LO 4.6] 1-45 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Answer: Most goods are normal and behave this way. I love dining out at nice restaurants with my friends and family, but eating out at nice restaurants is expensive. When my income increases, I tend to increase the number of meals I eat at nice restaurants. For me, a meal at nice restaurants is a normal good and my income elasticity of demand is positive.

14. Name a good you consume for which your income elasticity of demand is negative. What happens when your income increases? [LO 4.6] Answer: I have always loved to travel. When I was a student, I would stay at youth hostels because they are much less expensive than hotels. I worked part-time as a student and couldn’t afford the luxury of hotels. These days, I earn more than I did as a student, so I tend to stay in hotels. For me, hostels are an inferior good and my income elasticity of demand is negative. When my income increased, my demand for hostel stays decreased.

Problems and Applications 1. When the price of a bar of chocolate is $1.00, the quantity demanded is 100,000 bars. When the price rises to $1.50, the quantity demanded falls to 60,000 bars. Calculate the price elasticity of demand using the mid-point method. [LO 4.1] a. Suppose price increases from $1 to $1.50. Calculate the price elasticity of demand. b. Suppose price decreases from $1.50 to $1. Calculate the price elasticity of demand.

Answer: a. [(60,000 − 100,000)/80,000]/[(1.50 − 1.00)/1.25] = -1.25. b. [(100,000 − 60,000)/80,000]/[(1.00 − 1.50)/1.25] = -1.25. Using this method, the price elasticity of demand calculation is the same whether price increases or decreases.

2. If the price elasticity of demand for used cars priced between $4,000 and $6,000 is –1.2 (using the mid-point method), what will be the percent change in quantity demanded when the price of a used car falls from $6,000 to $4,000? [LO 4.1] Answer: −1.2 = % change in Qd/(4,000 − 6,000)/ [(4,000 + 6,000)/2] −1.2 = % change in Qd/−0.4 (−0.4) × (−1.2) = % change in Qd 0.48 × 100 = % change in Qd 48 percent = % change in Qd 3. Three points are identified on the graph in Figure 4P-1. [LO 4.2] a. At point A, demand is ____. b. At point B, demand is ____.

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c. At point C, demand is ____.

Answer: For any linear demand curve, the mid-point represents demand being unit-elastic.

At any point on the upper portion of the curve, demand is price elastic. At any point on the lower portion of the curve, demand is price inelastic. a. Elastic. b. Unit-elastic. c. Inelastic.

4. Which of the following has a more elastic demand in the short run? [LO 4.2] a. Pomegranate juice or drinking water? b. Cereal or Rice Krispies®? c. Speedboats or gourmet chocolate?

Answer: a. Pomegranate juice. Demand for pomegranate juice would be much more elastic than demand for drinking water (a necessity). b. Rice Krispies. There are more substitutes for a particular type of cereal like Rice Krispies than there are for cereal itself. c. Speedboats. Even though both goods could be considered luxuries, a speedboat is a much higher portion of a household budget than chocolate. Therefore, demand for speedboats will be more sensitive to price changes.

5. In each of the following instances, determine whether demand is elastic, inelastic, or unitelastic. [LO 4.2] a. If price increases by 10 percent and quantity demanded decreases by 15 percent, demand is _______.

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b. If price decreases by 10 percent and quantity demanded increases by 5 percent, demand is _______.

Answer: a. Elastic. b. Inelastic.

6. In each of the following instances, determine whether quantity demanded will increase or decrease, and by how much. [LO 4.2] a. If price elasticity of demand is -1.3 and price increases by 2 percent, quantity demanded will ______ by ______ percent. b. If price elasticity of demand is -0.3 and price decreases by 2 percent, quantity demanded will ______ by ______ percent.

Answer: a. Quantity demanded will decrease by > 2 percent. b. Quantity demanded will increase by < 2 percent.

Problems 7 and 8 refer to the demand schedule shown in Table 4P-1. For each price change, say whether demand is elastic, unit-elastic, or inelastic, and say whether total revenue increases, decreases, or stays the same.

7. Consider each of the following price increase scenarios. [LO 4.2] a. Price increases from $10 to $20. Demand is _____ and total revenue _____. b. Price increases from $30 to $40. Demand is _____ and total revenue _____. c. Price increases from $50 to $60. Demand is _____ and total revenue _____.

Answer: a. Demand is inelastic: [(300 – 350)/325] / [(20 – 10)/15] = -0.15/0.67 = -0.22. Because elasticity is less than 1 in absolute value, demand is inelastic. Because demand is 1-48 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

inelastic, total revenue will increase after a price increase. Total revenue increases from ($10 × 350 = $3,500) to ($20 × 300 = $6,000). b. Demand is inelastic: [(200 – 250)/225] / [(40 – 30)/35] = -0.22/0.29 = -0.76. Because elasticity is less than 1 in absolute value, demand is inelastic. Because demand is inelastic, total revenue will increase after a price increase. Total revenue increases from ($30 × 250 = $7,500) to ($40 × 200 = $8,000). c. Demand is elastic: [(100 – 150)/125] / [(60 – 50)/55] = -0.40/0.18 = -2.22. Because elasticity is greater than 1 in absolute value, demand is elastic. Because demand is elastic, total revenue will decrease after a price increase. Total revenue decreases from ($50 × 150 = $7,500) to ($60 × 100 = $6,000).

8. Price decreases from $60 to $50. Demand is ______ and total revenue ______. [LO 4.2] Answer: Demand is elastic: [(150 – 100)/125] / [(50 – 60)/55] = 0.4/-0.18 = -0.45. Total revenue increases from ($60 × 100 = $6,000) to ($50 × 150 = $7,500).

Problems 9–12 refer to Figure 4P-2.

9. Draw the price effect and the quantity effect for a price change from $60 to $50. Which effect is larger? Does total revenue increase or decrease? No calculation is necessary. [LO 4.2] Answer: The quantity effect is larger and total revenue increases.

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10. Draw the price effect and the quantity effect for a price change from $30 to $20. Which effect is larger? Does total revenue increase or decrease? No calculation is necessary. [LO 4.2] Answer: The price effect is larger, and total revenue decreases.

11. Draw the price effect and the quantity effect for a price change from $60 to $70. Which effect is larger? Does total revenue increase or decrease? No calculation is necessary. [LO 4.2] Answer: The quantity effect is larger, and total revenue decreases.

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12. Draw the price effect and the quantity effect for a price change from $10 to $20. Which effect is larger? Does total revenue increase or decrease? No calculation is necessary. [LO 4.2] Answer: The price effect is larger, and total revenue increases.

13. Use the graph in Figure 4P-3 to calculate the price elasticity of supply between points A and B using the mid-point method. [LO 4.3]

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Answer: The price elasticity of supply between points A and B is [(10 − 8)/9] / [(15 − 12)/13.5] = 1.00.

14. If the price of a haircut is $15, the number of haircuts provided is 125. If the price rises to $30 per haircut, barbers will work much longer hours, and the supply of haircuts will increase to 200. What is the price elasticity of supply for haircuts between $15 and $30?

[LO 4.3] Answer: The price elasticity of supply for haircuts between $15 and $30 using the mid-point method is (200 − 125) / [(125 + 200)/2] / ($30 − $15) / [($15 + $30)/2)] = 0.46/0.67 = 0.69.

15. Which of the following has a more elastic supply in the short run? [LO 4.4] a. Hospitals or mobile clinics? b. Purebred dogs or mixed-breed dogs? c. On-campus courses or online courses?

Answer: a. Mobile clinics. The supply of mobile clinics can be modified much more easily than the supply of hospitals. Mobile clinics require much less in the way of inputs and infrastructure. b. Mixed-breed dogs. Increasing the quantity of purebred dogs requires other purebred dogs. Mixed-breed dogs do not require a specific breed so it is much easier to increase their quantity. c. Online courses. Courses online are easier to expand because they have fewer constraints on the availability of classroom space and may also have fewer constraints on instructor availability.

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16. In each of the following instances, determine whether supply is elastic, inelastic, or unit‐ elastic. [LO 4.4] a. If price increases by 10 percent and quantity supplied increases by 15 percent, supply is ______. b. If price decreases by 10 percent and quantity supplied decreases by 5 percent, supply is ______.

Answer: a. Elastic. b. Inelastic.

17. In each of the following instances, determine whether quantity supplied will increase or decrease, and by how much. [LO 4.4] a. If price elasticity of supply is 1.3 and price increases by 2 percent, quantity supplied will _____ by _____ percent. b. If price elasticity of supply is 0.3 and price decreases by 2 percent, quantity supplied will _____ by _____ percent.

Answer: a. Quantity supplied will increase by > 2%. b. Quantity supplied will decrease by < 2%.

18. Suppose that the price of peanut butter rises from $2 to $3 per jar. [LO 4.5] a. The quantity of jelly purchased falls from 20 million jars to 15 million jars. What is the cross-price elasticity of demand between peanut butter and jelly? Are they complements or substitutes? b. The quantity of jelly purchased increases from 15 million jars to 20 million jars. What is the cross-price elasticity of demand between peanut butter and jelly? Are they complements or substitutes?

Answer: a. The cross-price elasticity of demand between peanut butter and jelly using the mid-point method is [(15 million – 20 million)/17.5 million] / [(3 − 2)/2.5] = −0.71. Since the crossprice elasticity of demand is negative, peanut butter and jelly are complements. b. The cross-price elasticity of demand between peanut butter and jelly using the mid-point method is [(20 million – 15 million)/17.5 million] / [(3 − 2)/2.5] = 0.71. Since the crossprice elasticity of demand is positive, peanut butter and jelly are substitutes.

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19. For each of the following pairs, predict whether the cross-price elasticity of demand will be positive or negative: [LO 4.5] a. Soap and hand sanitizer. b. CDs and MP3s. c. Sheets and pillowcases.

Answer: a. Positive. Soap and hand sanitizer are substitutes. If the price of soap increases, the demand for hand sanitizer will increase. If the price of soap decreases, the demand for hand sanitizer will decrease. b. Positive. CDs and MP3s are substitutes. If the price of CDs increases, the demand for MP3s will increase. If the price of CDs decreases, the demand for MP3s will decrease. c. Negative. Sheets and pillowcases are complements. If the price of sheets increases, the demand for pillowcases will decrease. If the price of sheets decreases, the demand for pillowcases will increase.

20. Suppose that when the average family income rises from $30,000 per year to $40,000 per year, the average family’s purchases of toilet paper rise from 100 rolls to 105 rolls per year.

[LO 4.6] a. Calculate the income-elasticity of demand for toilet paper. b. Is toilet paper a normal or an inferior good? c. Is the demand for toilet paper income-elastic or income-inelastic?

Answer: a. The income-elasticity of demand is [(105 − 100)/102.5]/[(40,000 − 30,000)/35,000] = 0.17. b. Toilet paper is a normal good because the income elasticity is positive. c. Toilet paper is an income-inelastic good because the income elasticity is greater than zero but less than one.

21. In each of the following instances, determine whether the good is normal or inferior, and whether it is income‐elastic or income‐inelastic. [LO 4.6] a. If income increases by 10 percent and the quantity demanded of a good then increases by 5 percent, the good is ______ and ______. b. If income increases by 10 percent and the quantity demanded of a good then decreases by 20 percent, the good is ______ and ______.

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a. If income increases by 10 percent and the quantity demanded of a good then increases by 5 percent, the good is normal (income elasticity is positive) and income-inelastic (income elasticity of 5/10 is less than one). b. If income increases by 10 percent and the quantity demanded of a good then decreases by 20 percent, the good is inferior (income elasticity is negative) and income-elastic (income elasticity of 20/10 is greater than one).

CHAPTER 5 EFFICIENCY Solutions to End-of-Chapter Questions and Problems Review Questions 1. Sangjay is a professional photographer. His camera is broken, and he needs a new one within the next hour, or he will miss an important deadline. Keiko is a high-school student who doesn’t have a camera but wants to get one to take pictures at her prom next month. Who do you think would have a higher willingness to pay for a particular camera today? Why? [LO 5.1] Answer: Sangjay will have the higher willingness to pay. He needs a camera for his job and he has no time to spare looking. Meeting his important deadline depends on him finding a camera within the next hour. Sangjay’s options are limited and his willingness to pay will reflect that. While Keiko would like to have a camera for her prom night, Keiko has time to look for the best deal. And if she never found a camera priced at or below her reservation price, Keiko could rely on friends and Facebook for prom photos. The fact that Lisa has more time and other options for photos will make her willingness to pay less than Sangjay’s.

2. You are in the market for a new couch and have found two advertisements for the kind of couch you want to buy. One seller notes in her ad that she is selling because she is moving to a smaller apartment, and the couch won’t fit in the new space. The other seller says he is selling because the couch doesn’t match his other furniture. Which seller do you expect to buy from? Why? (Hint: Think who would be the more motivated seller.) [LO 5.1] Answer: You would expect to buy from the seller whose couch won’t fit in the new space.

This seller will probably be willing to sell at a lower price because she does not have the option of keeping the couch if she can’t get a higher price. She needs to sell the couch and has revealed as much to you in her advertisement. The other seller may not like the fact that his couch doesn’t match his other furniture, but he does have the option of keeping the couch if he can’t find a buyer to pay what he thinks it’s worth. You will probably get a better deal from the first seller.

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3. Suppose you are at a flea market and are considering buying a box of vintage records. You are trying to bargain down the price, but the seller overhears you telling a friend that you are willing to pay up to $50. Why is your consumer surplus now likely to be lower than it would have been if the seller hadn’t overheard you? [LO 5.2] Answer: Now that the seller knows your highest willingness to pay (how much the records are worth to you), she knows she doesn’t have to accept your lower offers. She will charge you $50, knowing that you are going to purchase at that price. If you pay exactly what something is worth to you, you will have no consumer surplus. Your surplus would be greater if you were able to buy the box for less than $50, but you have unknowingly revealed your willingness to pay more.

4. Consider a market in equilibrium. Suppose supply in this market increases. How will this affect consumer surplus? Explain. [LO 5.2] Answer: If supply increases, equilibrium price will decrease. This is a movement along the demand curve. The lower equilibrium price will mean more consumer surplus.

5. You currently have a television that you want to sell. You can either pick a price and try to sell it at a yard sale or auction it off on eBay. Which method do you think will yield a higher producer surplus? Why? [LO 5.3] Answer: Auctioning the television on eBay should yield a higher price. eBay will give you access to many more consumers than those who might stop by your yard sale. And auctioning the television will force consumers to compete with each other for your television and reveal their willingness to pay.

6. Consider a market in equilibrium. Suppose demand in this market decreases. How will this affect producer surplus? Explain. [LO 5.3] Answer: If demand decreases, equilibrium price will decrease. This is a movement along the supply curve. The lower equilibrium price will mean less producer surplus.

7. Consider the market for plane tickets to Hawaii. A bad winter in the mainland United States increases demand for tropical vacations, shifting the demand curve to the right. The supply curve stays constant. Does total surplus increase or decrease? (Hint: Sketch out a generic supply and demand curve and look at what happens to the size of the triangle that represents total surplus when the demand curve shifts right.) [LO 5.4]

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Answer: Willingness to buy is represented by the demand curve. When demand increases and supply (willingness to sell) stays the same, total surplus increases. You can see this by sketching a graph like the one below and looking at what happens to total surplus when the market demand shifts. When demand = D1, total surplus = Area A. When demand = D2, total surplus = Area A + Area B.

8. You need to paint your fence but you really hate this task. You decide to hire the kid next door to do it for you. You would be willing to pay him up to $100, but you start by offering $50, expecting to negotiate. To your great surprise, he accepts your $50 offer. When you tell your friend about the great deal you got, she is shocked that you would take advantage of someone. What can you tell your friend to assure her that you did not cheat the kid next door? [LO 5.4] Answer: You can tell your friend that the kid next door accepted your offer without hesitation or apprehension, the trade was voluntary. You certainly received surplus from the exchange since you would have been willing to pay more. But just because you hate painting and were willing to pay more does not mean that it was a zero-sum game. The kid next door might like to paint and be outdoors and may have been willing to do the job for even less than $50. By accepting your offer, the kid signaled that $50 was at least equal to his reservation price. If he would have accepted less than $50 to do the job, then he had surplus from the exchange as well.

9. New York City has a long-standing policy of controlling rents in certain parts of the city—in essence, a price ceiling on rent. Is the market for apartments likely to be efficient or inefficient? What does this imply for the size of total surplus? [LO 5.5] 1-57 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Answer: The market for apartments under the maximum price policy is inefficient.

Efficiency means maximizing total surplus. If the maximum price policy moves the price away from its equilibrium price (which it does), surplus will not be maximized. Any price other than the equilibrium price will not maximize surplus. It should be noted that the goal of placing a maximum price on apartments is not to make the market efficient. It is an attempt to make the market more equitable. We will address the tradeoff between efficiency and equity more as we move forward.

10. Total surplus is maximized at the equilibrium price and quantity. When demand increases, price increases. Explain how total surplus is still maximized if price increases due to an increase in demand. [LO 5.5] Answer: When demand increases, the market moves to a new equilibrium. The price will be higher but surplus will still be maximized because the market is still functioning at its (new) equilibrium price.

11. When the price of gasoline was very high in the summer of 2008, several U.S. presidential candidates proposed implementing a national price ceiling to keep fuel affordable. How would this policy have affected producer and consumer surplus? How would it have affected total surplus? [LO 5.6] Answer: A price ceiling (maximum price) below the equilibrium price would reduce producer surplus. There would be fewer trades and the trades that did occur would happen at a lower price. For consumers, the story is a bit more complicated. Some consumers would gain and some would lose surplus. Consumers who were able to trade would do so at a lower price. They would gain surplus. However, because there would be fewer trades, some consumers would no longer be able to trade and would lose surplus. In the end, the losers (producers and some consumers) would lose more than the winners (consumers able to find trades) would gain, and total surplus would decrease.

12. Consider a policy to help struggling farmers by setting a minimum trade price for wheat. Will this be an effective way to increase their surplus? Explain. [LO 5.6] Answer: Minimum prices are also inefficient and cause fewer trades to occur than would occur at the equilibrium price. In the case of a minimum price for wheat, some farmers would gain because they will receive a higher price than the equilibrium price. However, fewer trades will occur and some farmers will be unable to trade. Remember that at a price above equilibrium, quantity supplied exceeds quantity demanded and there is excess supply.

13. If rent control creates deadweight loss for both consumers and suppliers of housing, why are consumers often in favor of this policy? [LO 5.7] 1-58 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Answer: Even though rent control causes fewer trades and deadweight loss, some consumers will benefit by the lower prices. Consumers support the policy if they believe they will be among those who are able to find housing at lower prices.

14. Suppose price is 5 percent above equilibrium in two markets: a market for a necessity and a market for a luxury good. All else equal (including supply conditions), in which market do you expect deadweight loss to be greater? Explain. [LO 5.7] Answer: Deadweight loss would be greater in the market for the luxury good. This is because demand will be more elastic. Consumers will react more (in terms of buying less of a good) to a higher price when demand is elastic.

15. Your grandmother likes old-fashioned yard sales and doesn’t understand why everyone is so excited about eBay. Explain to her why the creation of a market that enables people who don’t live in the same town to buy and sell used goods increases total surplus over the yardsale market. [LO 5.8] Answer: Yard sales are nice because you get to meet people and chat with them face to face, but eBay helps people connect across great distances. If you are looking to buy something in particular and are limited to looking at yard sales in your town, you may not find what you’re looking for. If you do a search on eBay, though, your chances are much greater that you will find somebody selling that item. And if you want to sell something, you will have access to many more buyers on eBay than those that might wander by your yard sale. It’s also possible that more than one person will be interested in what you are selling and their competition for your item will get you a much better price.

16. At Zooey’s elementary school, children are not allowed to trade lunches or components of their lunches with other students. Lunchroom monitors watch closely and strictly enforce this policy. Help Zooey make an argument about the inefficiency of this policy to her principal.

[LO 5.8] Answer: The school policy is preventing a market that would generate mutually beneficial trades. A student who likes bologna sandwiches better than tuna sandwiches might trade her tuna sandwich to another student who thinks the bologna sandwich in her lunch pail is gross.

Both students are happier after this trade. The ban on lunch trading prevents the surplus that would be generated by allowing lunch items to be allocated according to voluntary trades from being realized. (Of course, the principal might care less about the preferences of the students than those of their parents!)

Problems and Applications

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1. Use the information in Table 5P-1 to construct a step graph of the six consumers’ willingness to pay. [LO 5.1]

Answer:

At a price of $16, one consumer is willing to buy the good (Morgan).

At a price of $12, two consumers are willing to buy the good (Morgan and Andre).

At a price of $8, three consumers are willing to buy the good (Morgan, Andre, and Fadel).

At a price of $4, four consumers are willing to buy the good (Morgan, Andre, Fadel, and Hanson).

At a price of $2, all six consumers are willing to buy the good.

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2. Use the information in Table 5P-2 to construct a step graph of the six sellers’ willingness to sell. [LO 5.1]

Answer:

At a price of $10, one producer is willing to sell the good (Peter).

At a price of $20, two producers are willing to sell the good (Peter and Juan).

At a price of $25, four producers are willing to sell the good (Peter, Juan, Joseph, and Candice).

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At a price of $50, five producers are willing to sell the good (Peter, Juan, Joseph, Candice, and Solomon).

At a price of $60, all six producers are willing to sell the good.

3. Answer the following questions based on Tables 5P-3 and 5P-4. [LO 5.1] a. What is the quantity demanded at $10? What is the quantity supplied at $10? b. What is the quantity demanded at $25? What is the quantity supplied at $25?

Answer: a. Quantity demanded is 8 units. All consumers except for consumer I are willing to pay at least $10. Quantity supplied is 2 units. Only suppliers A and B are willing to sell at a price of $10. b. Quantity demanded is 3 units. Only consumers A, B, and C are willing to pay $25.

Quantity supplied is 7 units. Suppliers A, B, D, E, F, H, and I (all but C and G) are willing to sell at a price of $25.

4. Based on Table 5P-5, calculate consumer surplus for each consumer when the price is $17.

What is the total consumer surplus at this price? [LO 5.2]

Answer: Consumer A: $0 (WTP < $17).

Consumer B: $10 ($27 – $17 = $10).

Consumer C: $0 (WTP < $17).

Consumer D: $4 ($21 – $17 = $4).

Consumer E: $16 ($33 – $17 = $16).

Consumer F: $18 ($35 – $17 = $18).

Consumer G: $0 (WTP < $17).

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Consumer H: $0 (WTP < $17).

Consumer I: $5 ($22 – $17 = $5).

Total consumer surplus: 0 + 10 + 0 + 4 + 16 + 18 + 0 + 0 + 5 = $53.

5. Use the demand curve represented in Figure 5P-1 to draw the consumer surplus when the market price is $8. What is the value of consumer surplus at this price? [LO 5.2]

Answer: The consumer surplus is the area under the demand curve and above $8. The value of consumer surplus at this price is 0.5 base × height = 0.5(30)(3) = $45.

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6. Based on Figure 5P-2, consumer surplus is $0 when price is greater than or equal to what price? [LO 5.2]

Answer: Consumer surplus is $0 when price is ≥ $11.

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7. Use the market represented in Figure 5P-2 to plot the equilibrium price and quantity and to draw the consumer surplus when the market is in equilibrium. What is the value of consumer surplus at the equilibrium price? [LO 5.2]

Answer: The equilibrium price is $7. The consumer surplus is the area under the demand curve and above $7. The value of consumer surplus at this price is 0.5 base × height = 0.5(40)(4) = $80.

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8. Use the market represented in Figure 5P-2 to draw the consumer surplus when the price is $5. What is the value of consumer surplus at this price? [LO 5.2]

Answer: At a price of $5, sellers are only willing to sell 20 units of the good. Consumer surplus is measured as the area below the demand curve and above the price. This area is a polygon shape. We can calculate consumer surplus by dividing this shape into a triangle and a rectangle.

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The area of the triangle is 0.5(base)(height) = 0.5(11 – 9)(20) = $20.

The area of the rectangle is (9 – 5)(20) = $80.

The value of consumer surplus at a price of $5 is 20 + 80 = $100.

9. Based on Figure 5P-2, producer surplus is $0 when price is less than or equal to what price?

[LO 5.3]

Answer: Producer surplus is $0 when price is ≤ $3.

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10. Use the market represented in Figure 5P-2 to plot the equilibrium price and quantity and to draw the producer surplus when the market is in equilibrium. What is the value of producer surplus at the equilibrium price? [LO 5.3]

Answer: The equilibrium price is $7. The producer surplus is the area above the supply curve and below $7. The value of producer surplus at this price is 0.5 base × height = 0.5(40)(4) = $80.

11. Use the market represented in Figure 5P-2 to draw the producer surplus if the price is $9.

What is the value of producer surplus at this price? [LO 5.3] 1-68 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Answer: At a price of $9, consumers are only willing to purchase 20 units of the good. The producer surplus is measured as the area above the supply curve and below the price. To calculate this area, we can divide the shape into a triangle and a rectangle.

The area of the rectangle is (9 – 5)(20) = $80 The area of the triangle is 0.5(base)(height) = 0.5(20)(5 – 3) = $20.

The value of producer surplus at this price is 80 + 20 = $100.

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12. Based on Table 5P-6, calculate producer surplus for each producer when the price is $20.

11What is total producer surplus at this price? [LO 5.3]

Answer: Seller A: $0 (WTS > $20).

Seller B: $16 ($20 – $4 = $16).

Seller C: $0 (WTS > $20).

Seller D: $6 ($20 – $14 = $6).

Seller E: $8 ($20 – $12 = $8).

Seller F: $5 ($20 – $15 = $5).

Seller G: $0 (WTS > $20).

Seller H: $11 ($20 – $9 = $11).

Seller I: $0 (WTS > $20).

Total producer surplus = 0 + 16 + 0 + 6 + 8 + 5 + 0 + 11 + 0 = $46.

13. Use the supply curve represented in Figure 5P-3 to draw the producer surplus when the market price is $5. What is the value of producer surplus at this price? [LO 5.3]

Answer: The producer surplus is the area above the supply curve and below $5. The value of producer surplus at this price is 0.5 base × height = 0.5(20)(2) = $20.

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14. Use the market represented in Figure 5P-4 to draw the consumer and producer surplus when the market is in equilibrium. What is the value of total surplus at equilibrium? [LO 5.4]

Answer: The total surplus is equal to the sum of consumer and producer surplus. We can calculate total surplus as one large triangle or as two smaller triangles.

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



As two triangles, calculate consumer surplus and producer surplus first, and then sum them to get total surplus: Consumer surplus = 0.50(60)(40 – 20) = 0.50(60)(20) = 600.

Producer surplus = 0.50(60)(20 – 10) = 300.

Total surplus = Consumer surplus + Producer Surplus = 900.

A faster way to calculate total surplus is to calculate the area of the entire triangle at once.

In this case, the "base" of the triangle is measured on the y-axis: 40 – 10 = 30. The "height" is measured along the x-axis: 60 – 0 = 60.

Total surplus = 0.50(base)(height) = 0.50(30)(60) = 900.

15. Consider the market represented in Figure 5P-5. [LO 5.4] a. Calculate total surplus when demand is D1. b. Calculate total surplus when demand decreases to D2.

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Answer: Total surplus when demand is D1: 0.5(100)(22 – 6) = $800.

Total surplus when demand decreases to D2: 0.5(50)(16 – 6) = $250.

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16. Consider the market represented in Figure 5P-6. [LO 5.4] a. Calculate total surplus when supply is S1. b. Calculate total surplus when supply increases to S2.

Answer: Total surplus when supply is S1: 0.5(50)(50 – 20) = $750.

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Total surplus when supply increases to S2: 0.5(75)(50 – 10) = $1,500.

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17. Consider the market represented in Figure 5P-7. [LO 5.5]

a. Draw the consumer surplus and the producer surplus at the equilibrium price and quantity. What is the value of total surplus at equilibrium? b. Draw the consumer surplus and the producer surplus if the price is $30. What are the values of consumer surplus, producer surplus, and total surplus at this price? c. Draw the consumer surplus and the producer surplus if the price is $10. What are the values of consumer surplus, producer surplus, and total surplus at this price?

Answer: a. Total surplus = 0.50(40)(4) = $80.

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b. Consumer surplus = 0.50(40 – 30)(2) = $10. Producer surplus = (30 – 10)(2) + 0.50(10)(2) = $50. Total surplus = $60.

c. Consumer surplus = 0.50(40 – 30)(2) + (30 – 10)(2) = $50. Producer surplus = 0.50(10)(2) = $10. Total surplus = $60.

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18. Assume the market for wine is functioning at its equilibrium. For each of the following situations, say whether the new market outcome will be efficient or inefficient. [LO 5.5] a. A new report shows that wine is good for heart health. b. The government sets a minimum price for wine, which increases the current price. c. An unexpected late frost ruins large crops of grapes. d. Grape pickers demand higher wages, increasing the price of wine.

Answer: a. Efficient. Demand increases and the market functions at its new equilibrium. b. Inefficient. Setting a minimum price will move the market away from its equilibrium. c. Efficient. Supply decreases and the market functions at its new equilibrium. d. Efficient. Supply decreases and the market functions at its new equilibrium.

19. Based on Figure 5P-8, choose all of the following options that are true. [LO 5.5, 5.6]

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a. b. c. d. e.

The market is efficient.

Total surplus is higher than it would be at market equilibrium.

Total surplus is lower than it would be at market equilibrium.

Producer surplus is lower than it would be at market equilibrium.

Consumer surplus is lower than it would be at market equilibrium.

Answer: C and E. Total surplus is lower than it would be at market equilibrium. Consumer surplus is lower than it would be at market equilibrium.

20. In which of the following situations can you say, without further information, that consumer surplus decreases relative to the market equilibrium level? [LO 5.6] a. Your state passes a law that pushes the interest rate (i.e., the price) for payday loans below the equilibrium rate. b. The federal government enforces a law that raises the price of dairy goods above the equilibrium. c. Your city passes a local property tax, under which buyers of new houses have to pay an additional 5 percent on top of the purchase price. d. The government lowers the effective price of food purchases through a food-stamp program.

Answer: B and C. The federal government enforces a law that raises the price of dairy goods above the equilibrium. Your city passes a local property tax, under which buyers of new houses have to pay an additional 5 percent on top of the purchase price.

21. Use the areas labeled in the market represented in Figure 5P-9 to answer the following questions. [LO 5.6] 1-79 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

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

What area(s) are consumer surplus at the market equilibrium price?

What area(s) are producer surplus at the market equilibrium price?

Compared to the equilibrium, what area(s) do consumers lose if price is P2?

Compared to the equilibrium, what area(s) do producers lose if the price is P2?

Compared to the equilibrium, what area(s) do producers gain if the price is P2?

Compared to the equilibrium, total surplus decreases by what area(s) if the price is P2?

Answer: a. A, B, C. b. D, E. c. B, C. d. E. e. B. f. C, E. 22. Figure 5P-10 shows a market for cotton, with the price held at $0.80 per pound. Calculate the dead-weight loss caused by this policy. [LO 5.7]

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Answer: Deadweight loss = 0.5(30/100)(20m) = $3 million

23. Consider the market represented in Figure 5P-11. [LO 5.7]

a. Suppose the government sets a minimum price of $25 in the market. Calculate the deadweight loss. b. Suppose the government sets a maximum price of $25 in the market. Calculate the deadweight loss.

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a. The equilibrium price would be $20, but the price cannot be lower than $25. Deadweight loss = 0.5(10)(12) = $60.

b. Deadweight loss = $0. If the maximum price is $25, the market will function at its equilibrium price, which is $20.

24. What is the value of the existence of the market represented in Figure 5P-12. [LO 5.8]

Answer: The total surplus is 0.50(70)(44 – 2) = $1,470.

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25. We can consider the market for traveling to Mars to be missing, because no technology exists that allows this service to be bought and sold. Suppose that someone has invented spacetravel technology that will enable this service to be provided. Figure 5P-13 shows the estimated market for trips to Mars. Calculate the surplus that could be generated by filling in this missing market. [LO 5.8]

Answer: Since the market does not currently exist, the surplus gained would be the area of total surplus: 0.5(40)($310,000 – $150,000) = $3,200.

CHAPTER 6 GOVERNMENT INTERVENTION Solutions to End-of-Chapter Questions and Problems Review Questions 1. You are an advisor to the Egyptian government, which has placed a price ceiling on bread.

Unfortunately, many families still cannot buy the bread they need. Explain to government officials why the price ceiling has not increased consumption of bread. [LO 6.1] Answer: The price ceiling has not increased the consumption of bread because it reduces the quantity supplied. A price ceiling below the equilibrium price will mean that some families will be able to purchase bread at a lower price, but on the whole fewer families will be able to purchase bread at all because there will be a shortage.

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2. Suppose there has been a long-standing price ceiling on housing in your city. Recently, population has declined and demand for housing has decreased. What will the decrease in demand do to the efficiency of the price ceiling? [LO 6.1] Answer: A binding price ceiling keeps the price below the equilibrium quantity and creates both a shortage and a deadweight loss. If demand decreases, the equilibrium price would fall.

This will make the shortage and deadweight loss smaller. If demand decreases enough, the price ceiling could become non-binding and there would be no shortage or deadweight loss.

3. Suppose the United States maintains a price floor for spinach. Why might this policy decrease revenues for spinach farmers? [LO 6.2] Answer: A binding price floor will guarantee a minimum price for spinach above the equilibrium price. Farmers will receive a higher price for the spinach that they are able to sell. However, the price floor will create excess supply, as quantity demanded will decrease due to the higher price. If demand for spinach is elastic, revenues would decrease.

4. Suppose Colombia maintains a price floor for coffee beans. What will happen to the size of the deadweight loss if the price floor encourages new growers to enter the market and produce coffee? [LO 6.2] Answer: If additional producers enter the market, the supply curve would shift right and the equilibrium price would fall. That is, the price that would prevail in the absence of the floor would be even lower than the original equilibrium. This means the price floor is even more distortionary than it was before. The size of the deadweight loss would increase.

5. Many states tax cigarette purchases. Suppose that smokers are unhappy about paying the extra charge for their cigarettes. Will it help smokers if the state imposes the tax on the stores that sell the cigarettes rather than on smokers? Why or why not? [LO 6.3] Answer: No. The statutory incidence does not matter. If sellers were taxed instead of buyers of cigarettes, the price that consumers pay would remain exactly the same. The tax incidence, or burden of the tax, is a function of the relative elasticities of supply and demand and is not determined by which side of the market is officially taxed.

6. Consider a tax on cigarettes. Do you expect the tax incidence to fall more heavily on buyers or sellers of cigarettes? Why? [LO 6.3] Answer: The tax incidence will fall more heavily on the side of the market that is less elastic.

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addictive and consumers may have a harder time reducing consumption than producers would have reducing supply.

7. In the United States, many agricultural products (such as corn, wheat, and rice) are subsidized. What are the potential benefits of subsidizing these products? What are the costs?

[LO 6.4] Answer: Subsidizing agricultural production will increase both consumer and producer surplus. Consumers will be able to buy at a lower price and producers will receive a higher price. Therefore, the domestic equilibrium quantity will increase. Government will have to pay for the subsidy, however, which may come at the expense of taxpayers.

8. A subsidy will increase consumer and producer surplus in a market and will increase the quantity of trades. Why, then, might a subsidy (such as a subsidy for producing corn in the United States) be considered inefficient? [LO 6.4] Answer: A subsidy might be considered inefficient because the prices that consumers pay are artificially low and the prices sellers receive are artificially high. These prices would not occur without the subsidy, which comes at a cost to taxpayers. Looking at the market equilibrium, a subsidy will encourage trades to occur past this point. But for each unit to the right of the market equilibrium quantity, the cost of supplying that unit or exceeds the willingness to pay. This is why these trades don’t occur in the absence of the subsidy. The subsidy encourages the market to move beyond the point where willingness to pay is greater than or equal to willingness to sell. It is always a good idea to ask why we want a market to function beyond its equilibrium. If we think the market equilibrium quantity is too low and we want more trades to occur, the cost of the subsidy might be worth it. If not, the subsidy is inefficient.

9. Suppose the government imposes a price ceiling on gasoline. One month after the price ceiling, there is a shortage of gasoline, but it is much smaller than critics of the policy had warned. Explain why the critics’ estimates might still be correct. [LO 6.5] Answer: Elasticity is greater over a longer time horizon. In the first month, supply and demand are less responsive to a price control than they will be over a longer time horizon.

Over time the shortage of gasoline is likely to grow as elasticity in the market increases. The critics’ estimate of a larger shortage than was seen after one month might turn out to be on target if measured over a longer time frame.

10. A state facing a budget shortfall decides to tax soft drinks. You are a budget analyst for the state. Do you expect to collect more revenue in the first year of the tax or in the second year?

Why? [LO 6.5]

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Answer: You would expect to collect more tax revenue in the first year. You collect taxes only on trades that occur. Taxes will reduce the number of trades. In the first year, the number of trades reduced due to the tax will be smaller than in the second year because elasticity is larger over a longer time frame.

Problems and Applications 1. Many people are concerned about the rising price of gasoline. Suppose that government officials are thinking of capping the price of gasoline below its current price. Which of the following outcomes do you predict will result from this policy? Check all that apply. [LO 6.1] a. Drivers will purchase more gasoline. b. Quantity demanded for gasoline will increase. c. Long lines will develop at gas stations. d. Oil companies will work to increase their pumping capacity.

Answer: B and C. Quantity demanded for gasoline will increase at a price below the equilibrium price. Drivers will not purchase more gasoline, however, because quantity supplied will be below the equilibrium quantity. As a result, there will be a shortage of gasoline and long lines will develop at gas stations. With a ceiling on price, oil companies will not have an incentive to increase supply.

2. Consider the market shown in Figure 6P-1. The government has imposed a price ceiling at $18. [LO 6.1]

a. At a price ceiling of $18, what is quantity demanded? Quantity supplied?

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b. At this price ceiling, is there a shortage or a surplus? By how many units?

Answer: a. If there is a price ceiling of $18, the quantity demanded is 140, and the quantity supplied is 40. b. There is a shortage of 100 units.

3. Figure 6P-2 shows a market in equilibrium. [LO 6.1]

a. Draw a price ceiling at $12. What is the amount of shortage at this price? Draw and calculate the deadweight loss. b. Draw a price ceiling at $4. What is the amount of shortage at this price? Draw and calculate the deadweight loss.

Answer: a. The price ceiling is non-binding because it is above the equilibrium quantity. There is no shortage, and there is no deadweight loss. The market will function at its equilibrium.

Shortage = 0 and DWL = $0. b. The shortage due to the price ceiling is Qd – Qs = 8 – 2 = 6.

The deadweight loss is 0.5(6 – 2)(16 – 4) = $24.

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4. Decades of overfishing have dramatically reduced the world supply of cod (a type of whitefish). Farm-raised halibut is considered a close substitute for ocean-fished cod. Figure 6P-3 shows the market for farm-raised halibut. [LO 6.1]

a. What effect will overfishing cod have on the price of cod? On the graph, show the effect of overfishing cod on the market for farmed halibut. b. A fast-food chain purchases both cod and halibut for use in its Fish ’n’ Chips meals.

Already hurt by the reduced supply of cod, the fast-food chain has lobbied aggressively for price controls on farmed halibut. As a result, Congress has considered imposing a price ceiling on halibut at the former equilibrium price—the price that prevailed before overfishing reduced the supply of cod. What will happen in the market for farmed halibut if Congress adopts the price control policy? Draw and label the price ceiling, quantity demanded, quantity supplied, and deadweight loss.

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Answer: a. Due to the reduced supply of cod, the price of cod will rise. Because they are substitutes, if the price of cod goes up, demand for farmed halibut will increase. This will cause the price and quantity of farmed halibut to increase. b. Demand for halibut has increased due to the reduced supply of cod. If the price of halibut is not allowed to increase accordingly, the quantity demanded will exceed quantity supply and there will be a shortage of QD – QS. The deadweight loss is the total surplus that is lost when the quantity is less than the equilibrium (efficient) quantity.

5. Consider the market shown in Figure 6P-4. The government has imposed a price floor at $36.

[LO 6.2] a. At a price floor of $36, what is quantity demanded? Quantity supplied? b. At this price floor, is there a shortage or a surplus? By how many units?

Answer: a. If there is a price floor of $36, the quantity demanded is 90 and the quantity supplied is 225.

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b. Because quantity supplied exceeds quantity demanded, there is a surplus. The surplus is equal to QS - QD = 225 – 90 = 135.

6. The Organization for the Promotion of Brussels Sprouts has convinced the government of Ironia to institute a price floor on the sale of brussels sprouts, at $8 per bushel. Demand is given by P = 9 − Q and supply by P = 2Q, where Q is measured in thousands of bushels. [LO 6.2] a. What will be the price and quantity of brussels sprouts sold at market equilibrium? b. What will be the price and quantity sold with the price floor? c. How big will be the excess supply of brussels sprouts produced with the price floor?

Answer: a. Solve for equilibrium. P = 9 − Q = 2Q; 9 = 3Q; Q = 3 thousand bushels. P = $6. b. The price floor is above the equilibrium price, so it is binding. The price will be P = $8 = 9 - Qd; so Qd = 1 thousand bushels. At this price of $8, quantity supplied is $8 = 2Qs, Qs = 4 thousand bushels, but quantity demanded is only 1 thousand. Therefore, the quantity sold is 1 thousand bushels. c. The amount of excess is supply is Qs - Qd = 4 − 1 = 3 thousand bushels.

7. The traditional diet of the citizens of the nation of Ironia includes a lot of red meat, and ranchers make up a vital part of Ironia’s economy. The government of Ironia decides to support its ranchers through a price floor, which it will maintain by buying up excess meat supplies. Table 6P-1 shows the supply and demand schedule for red meat; quantities are given in thousands of pounds. [LO 6.2]

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a. How many thousands of pounds of meat would you recommend that the government purchase to keep the price at $4/pound? b. How much money should the government budget for this program?

Answer: a. At a price of $4, quantity supplied = 60,000 but quantity demanded equals 35,000. So excess supply is 25,000. This is what the government will need to purchase. b. If the government buys 25,000 of excess supply at $4 per unit, it will need to budget $100,000.

8. The market shown in Figure 6P-5 is in equilibrium. Suppose there is a $15 per unit tax levied on sellers. [LO 6.3]

a. Draw the after-tax supply curve. b. Plot the after-tax price paid by consumers and the after-tax price paid by sellers.

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Answer: a. Each unit of the good is now $15 more costly to produce and sell. Thus, the supply curve increases (up along the y-axis) by $15. b. Buyers now pay the market price ($40). Sellers must then give the government $15, so the after-tax price received by sellers = 40 – 15 = $25.

9. The market shown in Figure 6P-6 is in equilibrium. Suppose there is a $1.50 per unit tax levied on sellers. [LO 6.3]

a. Draw the after-tax supply curve. b. Plot the after-tax price paid by consumers and the after-tax price paid by sellers. c. Draw consumer surplus, producer surplus, tax revenue, and deadweight loss after the tax.

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d. Calculate deadweight loss. e. Calculate total surplus.

Answer:

a. Each unit of the good is now $1.50 more costly to produce and sell. Thus, the supply curve increases (up along the y-axis) by $1.50. b. The new market price is $3.50. This is the price paid by buyers. Sellers then receive $3.50 – tax = $3.50 – $1.50 = $2.00. c. CS = 0.5($5.50 – $3.50)(40 – 0) = $40.

PS = 0.5($2.00 – $1.00)(40 – 0) = $20.

Tax Revenue = (tax)(quantity) = $1.50 × 40 = $60. d. DWL = 0.5(base)(height) = 0.5(3.50 – 2.00)(60 – 40) = 0.5(1.50)(20) = $15 million. e. Total surplus is the sum of CS, PS, and Tax Revenue.

CS = 0.5(40)(5.50 – 3.50) = 40.

PS = 0.5(40)(2.00 – 1.00) = 20.

Tax Revenue = (Tax)(Q) = (1.50)(40) = 60.

Total surplus = 40 + 20 + 60 = 120 million.

10. Suppose the government is considering taxing cigarettes. Because it is often politically more popular to tax the producers of cigarettes than the consumers of cigarettes, the government 1-93 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

first considers the impact on the market as a result of taxing the producers of cigarettes.

Figure 6P-7 shows the market in equilibrium. [LO 6.3]

a. Draw the after-tax supply curve if the government chooses to tax cigarette producers $2.50 per pack of cigarettes. b. Plot the after-tax price received by sellers. c. Do consumers or producers bear the greater burden of this tax? d. Now suppose the government considers taxing the consumers of cigarettes instead of the producers of cigarettes. Draw the after-tax supply curve if the government chooses to tax cigarette consumers $2.50 per pack of cigarettes. e. Plot the after-tax price paid by consumers and the after-tax price received by sellers. f. Do consumers or producers bear the greater burden if this tax? g. Is the price sellers receive when the government taxes consumers of cigarettes more than, less than, or the same as the price sellers receive when the government taxes producers of cigarettes? h. Is the price buyers pay when the government taxes consumers of cigarettes more than, less than, or the same as the price buyers pay when the government taxes producers of cigarettes?

Answer: a. The supply curve shifts up (vertically) by the amount of the tax, $2.50.

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b. Because sellers are paying this tax, they will charge the new equilibrium price to consumers ($8.00), but they then must give the $2.50 tax per unit to the government.

Thus, the seller only receives $8.00 – $2.50 = $5.50.

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c. Compared to the market equilibrium price with no tax ($6.00), consumers are paying $2.00 more while sellers are only receiving $0.50 less. Consumers bear the burden of this tax. d. The demand curve shifts down (vertically) by the amount of the tax, $2.50. e. Because consumers are paying this tax, they are not willing to pay as high of a price to sellers as before. The consumers give the sellers the new equilibrium price ($5.50), but they then have to give the government the $2.50 tax per unit. Thus, the after-tax price paid by consumers is $5.50 + $2.50 = $8.00. f. Compared to the market equilibrium price with no tax ($6.00), consumers are paying $2.00 more while sellers are only receiving $0.50 less. Consumers bear the burden of this tax. g and h. The statutory (legal) incidence of a tax does not determine who bears the economic burden of the tax. In each case, buyers pay $8.00 and sellers receive $5.50.

11. Suppose you have the information shown in Table 6P-2 about the quantity of a good that is supplied and demanded at various prices. [LO 6.3], [LO 6.5]

a. Plot the demand and supply curves on a graph, with price on the y-axis and quantity on the x -axis. b. What are the equilibrium price and quantity? c. Suppose the government imposes a $15 per unit tax on sellers of this good. Draw the new supply curve on your graph. d. What is the new equilibrium quantity? How much will consumers pay? How much will sellers receive after the tax? e. Calculate the price elasticity of demand over this price change. f. If demand were less elastic (holding supply constant), would the deadweight loss be smaller or larger?

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Answer: a. See graph below, curves D1 and S1.

b. The equilibrium price is $20, and the equilibrium quantity is 60. Check this against the table provided. c. See the graph in part a, curve S2. d. The new equilibrium quantity is 40. Consumers will pay $30 and suppliers will receive $15. e. Price elasticity of demand = (% change in Qd)/(% change in Pc). Pc is the price consumers pay. % change in Qd = (60 - 40)/[60 + 40)/2] = -0.4. % change in Pc = (30 - 20)/[(30 + 20)/2] = 0.4. P Price elasticity of demand = -0.4/0.4 = -1. f. The DWL would be smaller if demand were less elastic.

12. The weekly supply and demand for fast-food cheeseburgers in your city is shown in Figure 6P-8. In an effort to curb a looming budget deficit, the mayor recently proposed a tax that would be levied on sales at fast-food restaurants. [LO 6.3] 1-97 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

a. The mayor’s proposal includes a sales tax of 60 cents on cheeseburgers, to be paid by consumers. What is the new outcome in this market (how many cheeseburgers are sold and at what price)? Illustrate this outcome on your graph. b. How much of the tax burden is borne by consumers? How much by suppliers? c. What is the deadweight loss associated with the proposed tax? d. How much revenue will the government collect? e. What is the loss of consumer surplus from this tax?

Answer: a. Quantity supplied and demanded with the tax = 30 thousand. Price paid by consumers = $1.40. Price received by sellers = $0.80.

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b. The pre-tax price is $1.10. Consumers pay $0.30 of the tax ($1.40 – $1.10). Suppliers pay $0.30 of the tax ($1.10 – $0.80). The tax burden is therefore shared equally by consumers and producers. c. The efficiency costs of the tax are the mutually beneficial trades between 30,000 and 45,000 cheeseburgers that do not occur. DWL = ½ (45,000 – 30,000) × ($0.60) = $4,500. d. The government will collect $0.60 on each cheeseburger sold. Therefore, tax revenue will be 0.60(30,000) = $18,000. e. The loss of consumer surplus is the portion of tax revenue that is borne by consumers as well as the portion of deadweight loss that comes from consumers. The consumer potion of the tax burden is $0.30, so 0.30(30,000) = $9,000. This is the consumer surplus that is lost to tax revenue. The consumer portion of the deadweight loss is 0.5(15,000)(0.30) = $2,250. The total amount of surplus consumers lose is $9,000 + $2,250 = $11,250.

13. The market shown in Figure 6P-9 is in equilibrium. Suppose there is a $15 per unit subsidy given to buyers. [LO 6.4]

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a. Draw the after-subsidy demand curve. b. Plot the after-subsidy price paid by consumers and the after-subsidy price paid by sellers.

Answer: a. Each unit of the good is now $15 less expensive to buy. Thus, the demand curve increases (up along the y-axis) by $15. b. Sellers receive the market price ($35). Buyers then receive $15 from the government, making the after-subsidy price paid by consumers = 35 – 15 = $20.

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14. The market shown in Figure 6P-10 is in equilibrium. Suppose there is a $15 per unit subsidy given to sellers. [LO 6.4]

a. Draw the after-subsidy supply curve. b. Plot the after-subsidy price paid by consumers and the after-subsidy price paid by sellers.

Answer: a. Each unit of the good is now $15 cheaper to produce and sell. Thus, the supply curve decreases (down along the y-axis) by $15. b. Buyers pay the sellers $35 per unit. The sellers then receive an additional $15 from the government, such that the price the sellers receive is 35 + 15 = $50.

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15. Demand and supply of laptop computers are given in Figure 6P-11. The quantity of laptops is given in thousands. Suppose the government provides a $300 subsidy for every laptop computer that consumers purchase. [LO 6.4]

a. What will be the quantity of laptops bought and sold at the new equilibrium? b. What will be the price consumers pay for laptops under the subsidy? c. What will be the price that sellers receive for laptops under the subsidy? d. How much money should the government budget for the subsidy?

Answer: a. The quantity of laptops bought and sold at the new equilibrium is 14,000.

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b. Consumers will pay $500. c. Sellers will receive $800. d. Government should budget $300 for each computer sold: $300(14,000) = $4,200,000.

16. The market shown in Figure 6P-12 is in equilibrium. Suppose there is a $1.50 per unit subsidy given to buyers. [LO 6.4] a. b. c. d.

Draw the after-subsidy demand curve.

Plot the after-subsidy price paid by consumers and the after-subsidy price paid by sellers.

Draw government expenditures for the subsidy.

Calculate government expenditures.

Answer: a. Each unit of the good is now $1.50 less expensive to buy. Thus, the demand curve increases (up along the y-axis) by $1.50. b. Sellers now receive the market price ($4.00). The government gives each buyer a $1.50 subsidy, making the after-subsidy price paid by consumers = $4.00 – $1.50 = $2.50. c. The amount of the subsidy can be seen between the price paid by consumers and the price received by sellers. The quantity is 60. The area of the resulting rectangle is government expenditures. d. Government Expenditures = (Subsidy)(Quantity) = (1.50)(60) = $90.

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17. The market shown in Figure 6P-13 is in equilibrium. Suppose there is a $3 per unit subsidy given to buyers. [LO 6.4]

a. Draw the after-subsidy demand curve. b. Plot the after-subsidy price paid by consumers and the after-subsidy price paid by sellers. c. Draw the deadweight loss after the subsidy.

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d. Calculate deadweight loss.

Answer: a. Each unit of the good is now $3.00 less expensive to buy. Thus, the demand curve increases (up along the y-axis) by $3.00. b. The new market price is the after-subsidy price received by the sellers: $10.00.

Consumers then receive $3.00 from the government. Thus, the after-subsidy price paid by consumers is $10.00 – $3.00 = $7.00. c. The units from 80 to 100 are consumed unnecessarily. The additional government expenditure that does not become either consumer or producer surplus is the deadweight loss. d. DWL = 0.5(base)(height) = 0.5(10.00 – 7.00)(100 – 80) = 0.5(3.00)(20) = $30.

18. Suppose government offers a subsidy to laptop sellers. Say whether each group of people gains or losses from this policy. [LO 6.4] a. Laptop buyers. b. Laptop sellers. c. Desktop computer sellers (assuming that they are different from laptop manufacturers). d. Desktop computer buyers.

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a. Gain: The subsidy will lower the price consumers pay. b. Gain: The subsidy will increase the price sellers receive. c. Lose: If laptops are a substitute for desktops, the subsidy for laptops will reduce demand for desktops and drive the price down. d. Gain: If laptops are a substitute for desktops, the subsidy for laptops will reduce demand for desktops and drive the price down. Those who still wish to purchase a laptop can do so at a lower price.

19. Suppose that for health reasons, the government of the nation of Ironia wants to increase the amount of broccoli citizens consume. Which of the following policies could be used to achieve the goal? [LO 6.1], [LO 6.4] a. A price floor to support broccoli growers. b. A price ceiling to ensure that broccoli remains affordable to consumers. c. A subsidy paid to shoppers who buy broccoli. d. A subsidy paid to farmers who grow broccoli.

Answer: C and D. Price controls will reduce the quantity traded in a market. A price ceiling will mean that quantity demanded is greater than quantity supplied but the number of trades will be lower than the equilibrium quantity. A subsidy, however, will increase consumer purchases by the same amount whether the subsidy is given to consumers or to producers.

20. The following scenarios describe the price elasticity of supply and demand for a particular good. In which scenario will a subsidy increase consumption the most? Choose only one.

[LO 6.5] a. Elastic demand, inelastic supply. b. Inelastic demand, inelastic supply. c. Elastic demand, elastic supply. d. Inelastic demand, elastic supply.

Answer: C. Quantity will change the most when both supply and demand are elastic. With elastic demand, consumers will respond more to price falling. With elastic demand, suppliers will respond more to price rising. Both sides of the market will respond strongly to the favorable price conditions they receive with the subsidy.

21. The market shown in Figure 6P-14 is in equilibrium. If a tax was imposed on this market, would buyers or sellers bear more of the burden of the tax? Why? [LO 6.5]

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Answer: If a tax is imposed, consumers' quantity demanded will not be as responsive to the price change as the supplier. Thus, the price consumers pay will be pushed up by more than the price sellers receive is reduced.

22. The following scenarios describe the price elasticity of supply and demand for a particular good. All else equal (equilibrium price, equilibrium quantity, and size of the tax), in which scenario will government revenues be the highest? Choose only one. [LO 6.5] a. Elastic demand, inelastic supply. b. Inelastic demand, inelastic supply. c. Elastic demand, elastic supply. d. Inelastic demand, elastic supply.

Answer: B. All else equal, the government will raise more revenue taxing goods that are inelastically supplied and demanded. Inelastic supply and demand mean that neither side of the market is very responsive to price changes. Consumers pay a higher price after the tax, but inelastic demand means that quantity demanded does not decline much. Producers receive less after a tax, but inelastic supply means that quantity supplied does not decline much. Consumers and producers are stuck paying the tax when supply and demand are inelastic.

CHAPTER 7 MEASURING GDP Solutions to End-of-Chapter Questions and Problems 1-107 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Review Questions 1. U.S. car dealers sell both used cars and new cars each year. However, only the sales of the new cars count toward GDP. Why does the sale of used cars not count? [LO 7.1] Answer: The production of the car was already included in GDP when it was first manufactured. To include the sale of the used car would serve to double-count the car, once as a new car, once as a used car.

2. There is an old saying, ―You can’t compare apples and oranges.‖ When economists calculate GDP, are they able to compare apples and oranges? Explain. [LO 7.1] Answer: The old saying refers to the fact that an apple is different than an orange, although both are types of fruit. Economists compare goods like apples and oranges by calculating the dollar value of oranges and apples produced. If the economy produces 10 apples selling at $1.50 each and 5 oranges selling at $1 each, the economy has produced 10 × $1.50 = $15 worth of apples and 5 × $1 = $5 worth of oranges. It can be concluded that the value of apple production is greater than the value of orange production. To compare goods like apples and oranges, a common denominator must be found and this is why production is converted to dollar terms using market price.

More broadly, when economists calculate GDP, they add up the dollar value of production. If the economy produces 10 apples selling at $1.50 each and 5 oranges selling at $1 each, the economy has produced (10 × $1.50) + (5 × $1) = $20 of economic production.

3. When Americans buy goods produced in Canada, Canadians earn income from American expenditures. Does the value of this Canadian output and American expenditure get counted under the GDP of Canada or the United States? Why? [LO 7.2] Answer: GDP is the total sum of goods and services produced within a country’s borders.

Goods produced in Canada count in Canada’s GDP even if they are consumed in the U.S. 4. Economists sometimes describe the economy as having a ―circular flow.‖ In the most basic form of the circular flow model, companies hire workers and pay them wages. Workers then use these wages to buy goods and services from companies. How does the circular flow model explain the equivalence of the expenditure and income methods of valuing an economy? [LO 7.2] Answer: In this basic model all firm revenues are turned into wages, and all wages are spent on the firms’ products. Thus, total production in the economy can either be measured by summing up all of the firms’ sales (expenditure method) or all of the workers’ wages (income method).

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5. In 2017, the average baseball player earned $4 million per year. Suppose that these baseball players spend all of their income on goods and services each year, and they save nothing.

Argue why the sum of the incomes of all baseball players must equal the sum of expenditures made by the baseball players. [LO 7.2] Answer: If nothing from income is left over after spending, then spending must exactly equal income.

6. Determine whether each of the following counts as consumption, investment, government purchases, net exports, or none of these, under the expenditure approach to calculating GDP. Explain your answer. [LO 7.3] a. The construction of a courthouse. b. A taxicab ride. c. The purchase of a taxicab by a taxicab company. d. A student buying a textbook. e. The trading of municipal bonds (a type of financial investment offered by city or state governments). f. A company’s purchase of foreign minerals.

Answer: a. Courthouses are public institutions and are thus counted as part of government expenditure. In this case, the expenditure is technically an investment by the government. b. A taxicab ride is a service, so it is counted as consumption. c. The purchase of a taxicab by the company is an investment. d. The purchase of a textbook counts as consumption. e. Neither: Trading financial investments is considered a transfer, which does not go into the calculation of GDP. f. The purchase of raw materials from a foreign country is considered an import and is therefore counted as part of net exports.

7. If car companies produce a lot of cars this year but hold the new models back in warehouses until they release them in the new-model year, will this year’s GDP be higher, lower, or the same as it would have been if the cars had been sold right away? Why? Does the choice to reserve the cars for a year change which category of expenditures they fall under? [LO 7.3] Answer: If the cars are produced this year, they count in this year’s GDP even if they aren’t sold until next year. If the cars are sold right away, they count as consumption (or as government purchases if they are sold to the government, or as investment if they are sold to 1-109 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

a firm). If the cars are not sold but instead put into inventory, then the production is counted as investment.

8. The value-added method involves taking the cost of intermediate outputs (i.e., outputs that will in turn be used in the production of another good) and subtracting that cost from the value of the good being produced. In this way, only the value that is added at each step (the sale value minus the cost of the goods that went into producing it) is summed up. Explain why this method gives us the same result as the standard method of counting only the value of final goods and services. [LO 7.3] Answer: The only difference between the valued-added method and the final-goods method is that the production of the economy is added up along the way instead of being totaled at the end. For example, the height of a staircase is the same whether one measures each individual stair and adds them up as one climbs the stairs or whether one simply climbs all of the way to the top and then measures the total height traveled.

9. Imagine a painter is trying to determine the value she adds when she paints a picture. Assume that after spending $200 on materials, she sells one copy of her painting for $500. She then spends $50 to make 10 copies of her painting, each of which sells for $100. What is the value added of her painting? What if a company then spends $10 per copy to sell 100 more copies, each for $50? What is the value the painter adds then? If it’s unknown how many copies the painting will sell in the future, can we today determine the value added? Why or why not?

[LO 7.3] Answer: The value-added approach determines the value of a good or service by subtracting the value of the inputs from the value of the outputs. In this case, the painter originally sold $1,500 worth of paintings, at a cost of $700, which implies that she added $800 in value by painting. After the company sells another $5,000 worth of paintings at a cost of $1,000, we can add $4,000 to the original $1,500. If we can’t know how many copies the painting will sell in the future and at what price, we cannot today know the final value the painter adds through painting.

10. In a press conference, the president of a small country displays a chart showing that GDP has risen by 10 percent every year for five years. He argues that this growth shows the brilliance of his economic policy. However, his chart uses nominal GDP numbers. What might be wrong with this chart? If you were a reporter at the press conference, what questions could you ask to get a more accurate picture of the country’s economic growth? [LO 7.4] Answer: There are many potential problems here. The biggest is that the president is talking only about nominal GDP and not real GDP. If prices are rising 10 percent per year, then the country is not experiencing any real growth; GDP is getting bigger only because prices are rising.

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11. Suppose that the GDP deflator grew by 10 percent from last year to this year. That is, the inflation rate this year was 10 percent. In words, what does this mean happened in the economy? What does this inflation rate imply about the growth rate in real GDP? [LO 7.5] Answer: A 10 percent growth rate in the GDP deflator means that, overall, prices in the economy have risen by 10 percent. This inflation rate implies the growth rate in real GDP is essentially 10 percent less than the growth rate in nominal GDP.

12. An inexperienced researcher wants to examine the average standard of living in two countries. In order to do so, he compares the GDPs in those two countries. What are two reasons why this comparison does not lead to an accurate measure of the countries’ average standards of living? [LO 7.4, 7.6] Answer: Two obvious problems are price levels and population. First, if one country has higher price levels than the other, then the nominal GDPs of the two countries are not directly comparable. The country with higher price levels will have a comparably lower real GDP than a country with low price levels. Second, standard of living is better reflected by GDP per capita, not simply total GDP. For example, India’s GDP is 15 times larger than Norway’s, but the average Indian person is quite poor compared with the average Norwegian since there are 1.2 billion Indians and only about 5 million Norwegians. The average Norwegian earns almost 15 times that of the average Indian.

13. In 2018, according to the International Monetary Fund, India had the world’s 7th-highest nominal GDP, the 142th-highest nominal GDP per capita, and the 7th-highest real GDP growth rate. What does each of these indicators tell us about the Indian economy and how life in India compares to life in other countries? [LO 7.6] Answer: With the seventh largest nominal GDP, this statistic tells us that India has a huge economy that produces lots of goods and services. With the 142th highest nominal GDP per capita, this tells us that India is still fairly poor. Its high GDP is a result of being a large country with a huge population, not the result of being rich. Having the seventh highest GDP growth rate means that the standard of living in India is rising rapidly and that the country is becoming more productive.

14. China is a rapidly growing country. It has high levels of bureaucracy and business regulation, low levels of environmental regulation, and a strong tradition of entrepreneurship. Discuss several reasons why official GDP estimates in China might miss significant portions of the country’s economic activity. [LO 7.7] Answer: In order to avoid the bureaucracy and regulation, small business owners may operate their firms in the black market. The economic activity created by these small business owners is real but may be hidden from the view of the government officials 1-111 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

collecting economic data. Similarly, official government GDP statistics are not likely to include the costs of environmental destruction in their estimates.

15. Suppose a college student is texting while driving and gets into a car accident causing $2,000 worth of damage to her car. Assuming the student repairs her car, does GDP rise, fall, or stay constant with this accident? What does your answer suggest about using GDP as a measure of well-being? [LO 7.7] Answer: GDP will rise by $2,000 since car repairs are a service produced by the economy.

Obviously, the economy is not $2,000 better off because of this accident; $2,000 worth of automobile was destroyed and replaced, but only the replacement, and not the destruction, was included in the basic measure of GDP. This is an example of where GDP is a distinctly imperfect measure of well-being.

Problems and Applications 1. Suppose a gold miner finds a gold nugget and sells the nugget to a mining company for $500.

The mining company melts down the gold, purifies it, and sells it to a jewelry maker for $1,000. The jewelry maker fashions the gold into a necklace that it sells to a department store for $1,500. Finally, the department store sells the necklace to a customer for $2,000. How much has GDP increased as a result of these transactions? [LO 7.1, 7.3] Answer: Only the market value of final goods and services count in GDP, as including the earlier transactions counts the gold multiple times. Thus, GDP has increased by $2,000, the price of the final necklace produced. Importantly, GDP has not increased by $500 + $1,000 + $1,500 + $2,000 = $5,000. Counting the price at each intermediate step serves to double- (or triple- or quadruple-) count the production. If one chose to use the value-added method of GDP, $500 of value is added by the miner; $500 is added by the mining company ($1,000 − $500); $500 is added by the jewelry maker ($1,500 − $1,000); and $500 is added by the retailer ($2,000 − $1,500). Total value added is $500 + $500 + $500 + $500 = $2,000, the same as in the final-goods method.

2. Table 7P-1 shows the price of inputs and the price of outputs at each step in the production process of making a shirt. Assume that each of these steps takes place within the country.

[LO 7.1, 7.3]

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a. What is the total contribution of this shirt to GDP, using the standard expenditure method? b. If we use a value-added method (i.e., summing the value added by producers at each step of the production process, equal to the value of outputs minus the price of inputs), what is the contribution of this shirt to GDP? c. If we mistakenly added the price of both intermediate and final outputs without adjusting for value added, what would we find that this shirt contributes to GDP? By how much does this overestimate the true contribution?

Answer: a. Using the standard expenditure method, the total contribution of this shirt to GDP is $18 because that is the value of the final product. b. If we use a value-added method (i.e., summing the value added by producers at each step of the production process, equal to the value of output minus the price of inputs), the contribution of this shirt to GDP is $1.10 + $2.40 + $14.50 = $18.00. c. If we add the totals at each step we wind up with $1.10 + $3.50 + $18.00, or $22.60 in total production: an overestimate of $4.60

3. The U.S. government gives income support to many families living in poverty. How does each of the following aspects of this policy contribute to GDP? [LO 7.2] a. Does this government’s expenditure on income support count as part of GDP? If so, in which category of expenditure does it fall? b. When the families buy groceries with the money they’ve received, does this expenditure count as part of GDP? If so, in which category does it fall? c. If the families buy new houses with the money they’ve received, does this count as part of GDP? If so, in which category does it fall?

Answer: a. Government income support does not count as part of GDP. Government expenditures on goods and services count as part of G (government spending), but transfers of income from one group to another do not count as part of G. b. When recipients of government transfers spend the money on groceries, this spending counts as C (consumption). The fact that the spending of the government assistance counts as part GDP is why the transfer itself doesn’t count as part of GDP. Counting the government assistance as part of G when it is transferred and then again as C when it is spent would be double-counting the money. c. When recipients of government transfers spend the money building new housing, this spending counts as I (investment).

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4. Given the following information about each economy, either calculate the missing variable or determine that it cannot be calculated. [LO 7.2, 7.3] a. If C = $20.1 billion, I = $3.5 billion, G = $5.2 billion, and NX = –$1 billion, what is total income? b. If total income is $1 trillion, G = $0.3 trillion, and C = $0.5 trillion, what is I? c. If total expenditure is $675 billion, C = $433 billion, I = 105 billion, and G = $75 billion, what is NX? How much are exports? How much are imports?

Answer: The expenditure method of calculating the size of an economy involves adding up all spending on goods and services produced in an economy and subtracting spending on imports. The sum of these categories and the equivalence of income (Y) and expenditure give us the equation Y = C (consumption) + I (investment) + G (government purchases) + NX (net exports). a. Total income = C + I + G + NX = $20.1 + $3.5 + $5.2 − $1 = $27.8 billion. b. Total income = C + I + G + NX. $1t = $0.5t + I + $0.3t + NX. Solving this, I = $0.2 − NX. Since there are two unknowns (I and NX), neither can be determined. c. Total income = C + I + G + NX. $675 = $433 + $105 + $75 + NX. Solving for NX, you get NX = $62 billion. Exports and imports cannot be determined. Since NX is positive, exports are greater than imports, but we cannot figure out exact amounts with the information given.

5. Using Table 7P-2, calculate the following. [LO 7.2, 7.3]

a. Total gross domestic product and GDP per person. b. Consumption, investment, government purchases, and net exports, each as a percentage of total GDP. c. Consumption, investment, government purchases, and net exports per person.

Answer: a. GDP = C + I + G + NX = $770,000 + $165,000 + $220,000 − $55,000 = $1,100,000.

GDP per person = $1,100,000 ÷ 50 = $22,000.

(Mathematical note: since both GDP and population are measured in millions this will cancel out so we can ignore it. In other words $1,100,000/50 is the same as $1,100,000 million divided by 50 million. This same principle applies in parts b and c below.)

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b. C as a % of GDP = $770,000/1,100,000 = 0.7, or 70%. I as a % of GDP = $165,000/1,100,000 = 0.15, or 15%. G as a % of GDP = $220,000/1,100,000 = 0.2, or 20%. NX as a % of GDP = −$55,000/1,100,000 = 0.05, or 5%. c. C/person = $770,000/50 = $15,400. I/person = $165,000/50 = $3,300. G/person = $220,000/50 = $4,400. NX/person = −$55,000/50 = −$1,100

6. Determine which category each of the following economic activities falls under: consumption (C), investment (I), government purchases (G), net exports (NX), or not included in GDP. [LO 7.3] a. The mayor of Chicago authorizes the construction of a new stadium using public funds. b. A student pays rent on her apartment. c. Parents pay college tuition for their son. d. Someone buys a new Hyundai car produced in South Korea. e. Someone buys a used Hyundai car. f. Someone buys a new General Motors car produced in the United States. g. A family buys a house in a newly-constructed housing development. h. The U.S. Army pays its soldiers. i. A Brazilian driver buys a Ford car produced in the United States. j. The Department of Motor Vehicles buys a new machine for printing drivers’ licenses. k. An apple picked in Washington in October is bought at a grocery store in Mississippi in December. l. Hewlett-Packard produces a computer and sends it to a warehouse in another state for sale next year.

Answer: a. The stadium is a government purchase. b. The student is consuming housing services. c. The parents are purchasing education services. d. Someone buys a new Hyundai car produced in South Korea and this decreases net exports. e. Not included in GDP. Only the initial production of a good is included in GDP (in this case, South Korea’s GDP). f. g. h. i.

The person is consuming an automobile.

New home construction is included in GDP as residential investment.

The government is spending on national defense services.

Net exports rise for the United States. In Brazil, net exports fall and consumption rises, leading to no net change in the Brazilian GDP. j. The government is spending money on goods and services.

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k. The apple is produced and consumed in the United States, increasing consumption. l. The computer is counted as inventory.

7. Table 24P-3 shows economic activity for a very tiny country. Using the expenditure approach determine the following. [LO 7.3]

a. b. c. d. e.

Consumption.

Investment.

Government purchases.

Net exports.

GDP.

Answer: a. $707,000. b. $600,000. c. $800,000. d. -$200,000. e. $1,907,000.

8. During the 2008 recession sparked by financial crisis, the U.S. economy suffered tremendously. Suppose that, due to the recession, the U.S. GDP dropped from $14 trillion to $12.5 trillion. This decline in GDP was due to a drop in consumption of $1 trillion and a drop in investment of $500 billion. The U.S. government, under the current president, responded to this recession by increasing government purchases. [LO 7.3] 1-116 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

a. Suppose that government spending had no impact on consumption, investment, or net exports. If the current presidential administration wanted to bring GDP back up to $14 trillion, how much would government spending have to rise? b. Many economists believe that an increase in government spending doesn’t just directly increase GDP, but that it also leads to an increase in consumption. If government spending rises by $1 trillion, how much would consumption have to rise in order to bring GDP back to $14 trillion?

Answer: a. To counteract a $1 trillion drop in C and a $0.5 trillion drop in I, you need to raise G by $1.5 trillion (assuming the increase in G doesn’t affect any other variables in the equation—expenditures = C + I + G + NX). b. To counteract a $1 trillion drop in C and a $0.5 trillion drop in I with only $1 trillion in increased G, C would also have to rise by $0.5 trillion.

9. Assume Table 7P-4 summarizes the income of Paraguay. [LO 7.3]

a. b. c. d.

Calculate profits.

Calculate the GDP of Paraguay using the income approach.

What would GDP be if you were to use the value-added approach?

What would GDP be if you were to use the expenditure approach?

Answer: a. Profits = Total business expenditures – Total business revenues = $9 billion. b. Wages + Interest + Rental income + Profits = $8.3 + $0.7 + $9 = $18 billion. c. $18 billion: All methods of calculating GDP result in the same value. d. $18 billion: All methods of calculating GDP result in the same value.

10. Table 7P-5 provides information about the cost of inputs and the value of output for the production of a road bike. Note there are four different stages of production. [LO 7.3] a. What value is added by the supplier of the raw materials?

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b. c. d. e. f.

What value is added by the tire maker?

What value is added by the maker of the frame and components?

What value is added by the bike mechanic?

What value is added by the bike store?

What is the total contribution of the bike to GDP?

Answer: a. $190 = ($20 × 2) + $80 + $70. The raw materials include the rubber for two tires, the aluminum, and the other component materials. b. $20 = ($30 – $20) × 2. Value added is the difference between the value of the good produced ($30 per tire in this case) and the cost of purchased materials ($20 per tire). c. $100 = $250 – ($80 + $70). d. $40 = $350 – [$250 + ($30 × 2)]. e. $150 = $500 – $350. f. $500 = Value of final good = sum of value added = $190 + $20 + $100 + $40 + $150

11. Imagine that the United States produces only three goods: apples, bananas, and carrots. The quantities produced and the prices of the three goods are listed in Table 7P-6. [LO 7.4] a. Calculate the GDP of the United States in this three-goods version of its economy. b. Suppose that a drought hits the state of Washington. This drought causes the quantity of apples produced to fall to 2. Assuming that all prices remain constant, calculate the new U.S. GDP. c. Assume, once again, that the quantities produced and the prices of the three goods are as listed in Table 7P-6. Now, given this situation, carrot sellers decide that the price of carrots is too low, so they agree to raise the price. What must be the new price of carrots if the U.S. GDP is $60?

Answer: a. GDP is the sum of the dollar value of the goods and services produced in a country. In this case, GDP = $2 × 5 (apples) + $1 × 10 (bananas) + $1.50 × 20 (carrots) = $50. b. The new GDP = $2 × 2 (apples) + $1 × 10 (bananas) + $1.50 × 20 (carrots) = $44.

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c. After carrot sellers raise the price of carrots, the equation becomes $2 × 5 + $1 × 10 + P × 20 = $60, where P is the price of carrots. We must solve for P, subtracting 20 from both sides leaving 20(P) = 40. Now divide both sides by 20, leaving P = $2.

12. Suppose that the British economy produces two goods: laptops and books. The quantity produced and the prices of these items for 2017 and 2018 are shown in Table 7P-7. [LO 7.4, 7.5]

a. Let’s assume that the base year was 2017, so that real GDP in 2017 equals nominal GDP in 2017. If the real GDP in Britain was $15,000 in 2017, what was the price of books? b. Using your answer from part a, if the growth rate in nominal GDP was 10 percent, how many books must have been produced in 2018? c. Using your answers from parts a and b, what is the real GDP in 2016? What was the growth rate in real GDP between 2017 and 2018?

Answer: a. GDP is the sum of the dollar value of the goods and services produced in a country. In 2017: $15,000 = 50($200) + 1,000(P), where P is the price of books. Solving for P, we get a price per book of $5. b. The first thing we need to do is calculate nominal GDP in 2018 if nominal GDP has grown 10%. GDP(2018) = GDP(2017) × 1.1 = $16,500. Now set $16,500 = 100($150) + Q($10), where Q is the quantity of books produced. Solving for Q, we find that 150 books must have been produced. c. Using 2017 as the base year, to find real GDP in year 2018, you take the quantities produced in year 2018 multiplied by the prices in 2017. Real GDP(2018) = 100($200) + 150($5) = $20,750. The change in real GDP = (New GDP − Old GDP)/Old GDP = ($20,750 − $15,000)/$15,000 = 0.383 = 38.3%.

13. Based on Table 7P-8, calculate nominal GDP, real GDP, the GDP deflator, and the inflation rate in each year, and fill in the missing parts of the table. Use 2016 as the base year. [LO 7.4]

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Answer: Nominal GDP = Sum of quantity × Price for each year. Real GDP = Sum of quantity in each year × Price in base year (2016). GDP deflator = (Nominal GDP/Real GDP) × 100 for each year. Inflation rate = [(New deflator − Old deflator)/Old deflator] × 100.

14. Based on Table 7P-9, calculate nominal GDP per capita in 2017 and 2018, and the real GDP growth rate between the two years. Which countries look like they experienced recession in 2017–2018? [LO 7.6]

Answer: Nominal GDP/capita = Nominal GDP/Population Real GDP growth rate = (Real GDPnew – Real GDPold)/Real GDPold A recession is defined as a period of significant decline in economic activity. Only Argentina had negative real GDP growth year over year indicating that they are likely experiencing a recession. Egypt and Ghana are both experiencing significant growth, so they are clearly not in recession.

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15. Table 7P-10 describes the real GDP and population of a fictional country in 2017 and 2018.

[LO 7.6]

a. b. c. d.

What is the real GDP per capita in 2017 and 2018?

What is the growth rate in real GDP? What is the growth rate in population?

What is the growth rate in real GDP per capita?

Answer: a. Real GDP per capita equals real GDP divided by population. The only trick here is to get the right number of zeroes on the billions and millions. The real GDP per capita in 2017 is $10 billion/1.0 million = $10,000. The real GDP per capita in 2018 is $12 billion/1.1 million = $10,909. b. The growth rate of GDP is [($12 million – $10 million)/$10 million] × 100 = 20 percent. c. The growth rate in population is [(1.1 million – 1.0 million)/1 million] × 100 = 10 percent. d. The growth rate in per capita GDP is [(10,909 – 10,000)/10,000] × 100 = 9 percent.

16. Table 7P-11 shows data on population and expenditures in five countries, as well as the value of home production, the underground economy, and environmental externalities in each. [LO 7.6, 7.7] a. Calculate GDP and GDP per capita in each country. b. Calculate the size of home production, the underground economy, and environmental externalities in each country as a percentage of GDP. c. Calculate total and per capita ―GDP-plus‖ in each country by including the value of home production, the underground economy, and environmental externalities. d. Rank countries by total and per capita GDP, and again by total and per capita ―GDPplus.‖ Compare the two lists. Are the biggest and the smallest economies the same or different?

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Answer: a. GDP = C + I + G + NX. GDP per capita = GDP/population.

b. The size of home production, the underground economy, and environmental externalities in each country as a percentage of GDP is the value of each term divided by GDP. The total can be found by summing up the individual percentages.

c. GDP-plus = GDP + home production + underground economy + environmental externalities (which are generally negative so this subtracts from GDP). GDP-plus per capita = GDP-plus/Population.

d. As can be seen from the table, the parts in GDP-plus that are not counted in GDP can make a big difference. The biggest change comes in comparing Bohemia and Saxony.

Under GDP per capita Bohemia is about two-thirds richer than Saxony. Under GDP-plus per capita, Bohemia is more than 2.8 times richer than Saxony.

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17. Suppose a parent was earning $20,000 per year working at a local firm. The parent then decides to quit his job in order to care for his child, who was being watched by a babysitter for $10,000 per year. Does GDP rise, fall, or stay constant with this action, and how much does GDP change (if at all)? [LO 7.7] Answer: GDP falls because the parent is not working in the labor force and is providing a do-it-yourself service. Previously, GDP generated by the father and the babysitter (by the income method) would have been $20,000 (from the father’s job) + $10,000 (from the babysitter’s job) = $30,000. After the change, the GDP generated is $0 since the father watching his own children is not a market transaction and therefore not counted in GDP. Thus, GDP falls $30,000. The fact that household work is not counted as part of GDP if conducted by a member of the family but is counted as part of GDP if a market transaction takes place is a clear failing of using GDP as a way to measure economic well-being.

CHAPTER 8 THE COST OF LIVING Solutions to End-of-Chapter Questions and Problems Review Questions 1. If we want to measure changes in the cost of living, why don’t we track difference in each household’s actual expenditures from one year to the next, rather than the difference in the cost of a market basket? Offer several reasons why this method would fail to capture changes in the overall price level accurately. [LO 8.1] Answer: We don’t track changes in actual expenditures from year to year because we want to be sure we are measuring changes in prices and not changes in quantities. Households change the types and amounts of goods and services they buy for several reasons. First, as certain goods become more expensive, consumers may substitute away to different goods whose prices have not increased as rapidly. Furthermore, people’s consumption patterns may change due to tastes or changes in income that have nothing to do with changing prices.

Finally, innovation can lead to the introduction of new products or improvements in existing products. Changes in spending on these goods are difficult to attribute to simple changes in price.

2. There are many different types of market baskets that economists measure. For example, the market basket for consumers—called the Consumer Price Index—tracks the prices associated with the typical consumer’s purchases of goods and services. The Producer Price Index tracks the prices of the goods and services purchased by firms. A third type of market basket 1-123 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

is the Home Price Index, which tracks the value of residential housing. In what scenarios would each of these market baskets be useful? [LO 8.1] Answer: Measuring the cost of living for a typical consumer is probably best addressed through a broad-based index like the CPI. Besides being helpful in examining price changes that might affect businesses, the PPI is also useful as a gauge of future CPI inflation since businesses typically pass on some of their increases in input costs to consumers. A Home Price Index is useful for measuring differences in the cost of living between different cities. It is well known that some cities like New York City and San Francisco are more costly to live in than other regions of the country, but it is difficult to easily and accurately measure every price difference between cities. By measuring the difference in housing prices, which are a large portion of a typical household's budget and are also the budget item that varies most widely from city to city, differences in the overall cost of living can be approximated.

3. Why is the list of the highest-grossing films of all time dominated by movies made within the last 10 years? (Hint: Did Black Panther, released in 2018, really sell considerably more movie tickets than the classic Gone with the Wind, or is something else going on?) [LO 8.2] Answer: Given the price of tickets has risen over time, studios can make more money, in nominal terms, selling tickets now than in the past. It’s a lot easier to sell $100 million worth of tickets when tickets are $15 each than when they are only 25 cents apiece. A second reason, although not related to the topic of prices, is that the population has grown over time.

In 1939, the year Gone with the Wind was released, the U.S. population was only about 131 million; in contrast, the U.S. population in 2018 was about 327 million. That’s 196 million additional ticket buyers now as opposed to 75 years ago.

4. How would you use the concept of the Consumer Price Index to compare prices across different locations? [LO 8.2] Answer: You could use the concept of the CPI to compare prices across locations by creating a basket with the same goods in two different places and then measuring how the prices changed in each basket over a set period of time. For example, if you wanted to compare the prices in Iowa City and Kansas City, you would compare the prices of the same goods in both cities over time.

5. What types of goods and services would a basket measuring the inflation rate for farmers include? Why doesn’t the BLS calculate the price levels for a market basket approximating the purchases of farmers? [LO 8.3] Answer: A basket for farmers might include many of the goods we normally buy—bread or jeans, for example—but it might include fewer eggs or vegetables than the basket for the average urban consumer. (Farmers would be able to raise or grow these things themselves.)

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The market basket probably also would include fertilizers and seeds to grow crops. The BLS does not measure price increases for farmers because less than 1 percent of the current American population are farmers. It would be a lot of work and effort to explicitly measure the price level for such a small segment of the population.

6. Does the CPI represent the actual change in the cost of living for any given household?

Explain why or why not. [LO 8.3] Answer: No. The CPI measures the cost living for an average (urban) household. Every household consumes slightly different types of goods, which may be more or less expensive than another household’s consumption basket. The CPI measures the cost of living for a typical household, but individual households may experience inflation that is higher or lower than that measured by the change in the CPI. 7. Suppose wages rise in China, leading to an increase in the price of toys imported from China.

How would this change affect the CPI, PPI, and the GDP deflator in the United States? [LO 8.4] Answer: In the United States, imported Chinese toys are part of the CPI (since Chinese toys are part of the basket of goods and services an average household might consume) but are not part of the GDP deflator (since Chinese toys are not part of the U.S. GDP). Typically, toys are not used as inputs for producers, so they would not be part of the PPI either. Thus, the U.S. CPI would rise, but the PPI and GDP deflator would be unchanged. In China, if all of these toys are exported, the CPI (and PPI) would not change, but the GDP deflator would rise. Of course, an increase in wages would likely affect other industries outside of exporting sectors, leading to increases in the CPI and PPI of China as well.

8. If the growth rate in nominal income is larger than the inflation rate (as measured by the change in the CPI or the GDP deflator), has the real value of income grown? [LO 8.4] Answer: Any time a nominal value is rising faster than the inflation rate, the real value will be rising. The intuition is that real income is rising by the rate of nominal income growth but falling by the rate of inflation. As long as nominal income growth outpaces inflation, real incomes will be rising. To convince yourself of this, try a simple numerical example. Think back to the equation earlier in the chapter for the value of 1969 income in 2014 dollars: 1969real2014 = 1969nominal × (CPI2014/CPI1969) To make the calculations easier, suppose 1969nominal = 10,000 and CPI1969 = 100. Now suppose 2014nominal rises by 10% over 1969nominal and CPI2014 rises 5% over CPI2014: 2014nominal = 11,000 (10% higher than 1969), and CPI2014 = 105 (5% higher than 1969) Now calculate 1969real and see whether it is higher or lower than 2014real: 1-125 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

2009real = 2014nominal = 11,000 1969real = 10,000 × (105/100) = 10,500 So, real income has risen between 1969 and 2014. You can try this with any combination of numbers. As long as nominal income is rising faster than the CPI, 2014real will be greater than 1969real.

9. What is the better measure of inflation to determine how much should be paid to employees for cost-of-living adjustments: the Producer Price Index (PPI) or the CPI? Why? [LO 8.5] Answer: Remember that the typical employee, when he or she leaves work, becomes a typical consumer. Thus, an employee’s cost of living is closely approximated by the CPI, and therefore employee’s wages should be adjusted by the CPI, not the PPI. 10. Why are people unlikely to buy Big Macs in the places where they are relatively cheap according to purchasing power parity and sell them where they are relatively more expensive, in order to make a profit? [LO 8.4, LO 8.6] Answer: The transaction costs would be too high. It would be expensive to transport Big Macs from one country to another just to make a few cents. Furthermore, there is little resale market for used Big Macs, not to mention the fact that the Big Macs would spoil quickly.

Thus, we would not expect the price of Big Macs to equalize around the world. Commodities like gold, however, are generally sold at very similar prices all over the globe, since gold can be cheaply transported, easily resold, and doesn’t degrade over time.

11. In many poor countries, even middle-class families may have full-time servants, a luxury reserved for only the very wealthiest households in rich countries like the United States. How does the existence of low-cost domestic help affect PPP-adjusted GDP statistics in poor countries? [LO 8.7, 25.8] Answer: Domestic help is relatively cheap in poor countries, but due to immigration laws and other factors, it cannot easily be imported into rich countries, so the price of domestic help doesn’t tend to equalize across countries. Thus, since consumption baskets include domestic help (and other services that can be provided cheaply in poor countries), prices tend to be lower in poor countries. This tends to increase the PPP-adjusted GDP in poor countries relative to non-adjusted GDP statistics.

12. Would Kentucky, a state with a very low cost of living, have a PPP-adjusted GDP higher or lower than its GDP calculated without PPP-adjustment? Why? [LO 8.8]

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Answer: Kentucky will have a higher GDP after adjusting for PPP. Since Kentucky has a low cost of living, a given number of dollars will purchase more goods and services in Kentucky than in a state with a higher cost of living. GDP without a PPP adjustment simply counts up the number of dollars earned in Kentucky, while GDP with a PPP adjustment accounts for how much those dollars can buy. Since dollars can buy more in Kentucky than in some other places, Kentucky’s PPP-adjusted GDP will be higher than its non-adjusted GDP.

Problems and Applications 1. Subscribing to the theory that life is indeed a beach, the residents of La Playa spend all of their money on three things: Every year, they collectively buy 250 bathing suits, 600 tubes of sunscreen, and 400 beach towels. Using the data in Table 25P-1, calculate the following. [LO 8.1] a. The total cost of this basket each year from 2015 through 2018. b. How much the price of this basket has changed from year to year in percentage terms.

Answer: To find the price of each basket, multiply the quantities in the first column by the corresponding price in each of the other columns and then sum the results. To find the change in the price of the baskets, simply subtract each year’s sum from the previous year’s sum. To find the percentage change from year to year, subtract the current year’s sum from the previous year’s sum, and then divide this amount by the previous year’s sum. To convert a decimal to a percentage, simply multiply the decimal by 100.

2. Suppose a typical American consumer purchases three goods, creatively named good A, good B, and good C. The prices of these goods are listed in Table 8P-2. [LO 8.1]

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a. If the typical consumer purchases two units of each good, what was the percentage increase in the price paid by the consumer for this basket between 2017 and 2018? b. If the typical consumer purchases 10 units of good B and 2 units of both good A and good C, what was the percentage increase in the price paid by the consumer for this basket? c. Given your answers to parts a and b, what is the relationship between the market basket and the percentage price change?

Answer: a. Cost of basket in 2017 = 2($10) + 2($6) +2($2) = $36.

Cost of basket in 2018 = 2($15) + 2($5) +2($3) = $46.

Prices have increased by ($46 – $36)/$36 = 0.2777, or 27.77%. b. Cost of basket in 2017 = 2($10) + 10($6) +2($2) = $84.

Cost of basket in 2018 = 2($15) + 10($5) +2($3) = $86.

Prices have increased by ($86 – $84)/$84 = 0.0238, or 2.38%. c.

The overall change in the cost of the market basket is affected by how many units of each good one purchases. If two goods are rising in price at different rates, but the market basket contains more of good A than good B, then the rate of increase of the overall market basket will be closer to the rate of increase of A rather than B. In part a, the market basket contains the same number of units of each good, so the price changes are weighted equally. In this case, the rate of inflation is just the average of the percentage change in the three prices. In part b, the market basket contains more units of good B, so the large increase in the price of good A does not carry as much weight as it did in part a. As a result, the inflation rate is much lower.

3. Using the data in Table 8P-3, calculate the CPI in each year, using 2010 as a base year. [LO 8.2]

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Answer: CPI in year X = (Cost of basketyear x /Cost of basketbase year) × 100 Inflation rate = percent change in CPI = [(CPInew – CPIold)/CPIold] × 100 Note: when calculating the inflation rate it is best to use the calculated CPI values and not the rounded values to avoid rounding error.

4. Table 8P-4 lists the prices and quantities consumed of three different goods from 2016– 2018. [LO 8.2]

a. For 2016, 2017, and 2018, determine the amount that a typical consumer pays each year to purchase the quantities listed in the table. b. Using the amounts you found in part a, calculate the percentage change in the amount the consumer paid from 2016 to 2017, and from 2017 to 2018.

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c. Why is it problematic to use your answers to part b as a measure of inflation? d. Suppose we take 2016 as the base year, which implies that the market basket is fixed at the 2016 consumption levels. Using 2016 consumption levels, now find the rate of inflation from 2016 to 2017 and from 2017 to 2018. (Hint: First calculate the cost of the 2016 market basket using each year's prices and then find the percentage change in the cost of the basket.) e. Repeat the exercise from part d, now assuming that the base year is 2017. f. Why were your answers from parts d and e different?

Answer: a. Multiply the quantity by the price for each good and then sum up for each year.

In 2016, the consumer pays $10(10) + $5(18) + $1(10) = $200.

In 2017, the consumer pays $16(8) + $3(30) + $2(5) = $228.

In 2018, the consumer pays $18(5) + $4(25) + $5(10) = $240. b. The change between 2016 and 2017 is ($228 – $200)/$200 = 0.04, or 4%.

The change between 2017 and 2018 is ($240 – $228)/$228 = 0.053, or 5.3%. c. It is problematic to use your answers to part b as a measure of inflation because the growth found in part b includes both price changes as well as consumption changes. d. Using 2016 as the base year, one needs to calculate the price of the market basket in each year using the quantities in 2014 but the prices for each year.

In 2016, the consumer pays $10(10) + $5(18) + $1(10) = $200.

In 2017, the consumer pays $16(10) + $3(18) + $2(10) = $200.

In 2018, the consumer pays $18(10) + $4(18) + $5(10) = $302.

The change between 2016 and 2017 is ($234 – $200)/$200 = 0.17, or 17%.

The change between 2017 and 2018 is ($302 – $234)/$234 = 0.29, or 29%. e. Using 2017 as the base year, one needs to calculate the price of the market basket in each year using the quantities in 2017 but the prices for each year.

In 2016, the consumer pays $10(8) + $5(30) + $1(5) = $235.

In 2017, the consumer pays $16(8) + $3(30) + $2(5) = $228.

In 2018, the consumer pays $18(8) + $4(30) + $5(5) = $289.

The change between 2016 and 2017 is ($228 – $235)/$235 = −0.030, or −3.0%.

The change between 2017 and 2018 is ($289 – $228)/$228 = 0.268, or 26.8%. f. The answers from parts d and e are different because using 2016 and 2017 as base years puts different weights on the goods.

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5. Which of the following goods have likely required hedonic quality adjustment over time if they were included in the Consumer Price Index (CPI) [LO 8.3] a. Laptop computers. b. Cellphones. c. Salt. d. Televisions. e. Housing. f. Tennis rackets.

Answer: A hedonic quality adjustment is required when the features of the good being measured change over time. The hedonic quality adjustment method removes any price differential attributed to a change in quality by adding or subtracting the estimated value of that change from the price of the old item. a. Yes. Laptop computers have changed over time. Older models were larger, heavier, and slower to operate. b. Yes. More features have been added to cell phones over time, and cell phones now are a part of every basket. That wasn’t the case when they had spotty reception, cost $4,000, and were purchased only by high-level executives. c. No. Salt likely doesn’t need hedonic adjustment; it will always be the same chemical formula. d. Yes. The televisions of today are far more complex and offer a far more vivid display than the TVs of just a decade ago. e. No. In general, housing in terms of shelter doesn’t need any sort of adjustment. Over time, the quality of the goods within the house changes, but the housing itself doesn’t change very much. f. Yes. Today’s tennis rackets use space-age materials, like carbon fiber and titanium, while the rackets of yesteryear were made of wood.

6. Use Table 8P-5 to calculate core and headline inflation in each time frame relative to the base year, assuming that each category is weighted equally in the calculation of headline inflation. [LO 8.2, 8.4]

a. 2014 to a base year.

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b. 2018 to a base year. c. 2014 to 2018.

Answer: Headline inflation includes food and energy whereas core inflation does not. Since food and energy prices are much more volatile than the prices of other goods and services, these items are removed to get a better measure of what is happening to the prices of other goods and services. a. We know the CPI value in the base year is equal to 100. From the base year to 2014: Core: (102 − 100)/100 = 0.02, or 2%.

Headline: We know core inflation is 2%. The percentage change in the prices of food and energy is (116 − 100)/100 = 0.16, or 16%. Since the overall CPI is equally weighted between the two, we can take an average of the two inflation rates. Headline inflation is therefore (16% + 2%)/2 = 9%. b. From the base year to 2018: Core: (107 − 100)/100 = 0.07, or 7%.

Headline: Core inflation is 7% and the percentage change in the prices of food and energy is 5%. Therefore, headline inflation is (7% + 5%)/2 = 6%. c. 2014 to 2018: Core: (107 − 102)/102 = 0.049, or 4.9%.

Headline: 4.9% core and (105 − 116)/116 = -0.11 or −11% food and energy.

Weight: 50/50, so the average of the two = [4.9% + (−11%)]/2 = −8%.

7. Table 8P-6 shows the GDP deflator and CPI over five recent years. How much did prices change between years in each measure? By what percent did prices change between years for each measure? Calculate the annual inflation rate and then the inflation rate across the entire time period. [LO 8.4]

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Answer: Percent change in CPI = (CPInew – CPIold)/CPIold. The same equation holds for the GDP deflator.

8. The median American household earned $9,387 in 1973 and $60,336 in 2017. During that time, though, the CPI rose from 44.4 to 245.1. [LO 8.5] a. Calculate the total growth rate in nominal median household income from 1973 to 2014. b. Calculate the total growth rate in real median household income from 1973 to 2014.

Answer: It is worth noting that these are the real numbers from the U.S. Census. The fact that the median household has experienced almost no real income growth over the past 40 years is a primary concern for modern macroeconomists. a. Nominal growth rate = (60,336 – 9,387)/9,387 = 5.428, or 542.8%. b. First one needs to calculate the real income in 1973 and 2014 in 2014 dollars.

1973real2014 = 1973nominal × (CPI2014/CPI1973) = 9,387 × (245.1/44.4) = 51,819.

Real income in 2014 in 2014 dollars is by definition the same as nominal income.

Alternatively, it may help to see the numbers: 2014real2014 = 2014nominal × (CPI2014/CPI2014) = 60,336 × (245.1/245.1) = 60,336.

Next one needs to calculate the increase in real income.

Real growth rate = (60,336 – 51,819)/51,819 = 0.164, or 16.4%.

It is worth noting that these are real numbers from the U.S. Census. The fact that the median household has experienced almost no real income growth over the past 44 years is a primary concern for modern macroeconomists.

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9. Using Table 8P-7, find the real value of a $1,200 payment to be received each year given the following CPI values. Next, find the amount that this $1,000 should be adjusted to, in order to keep its real value at $1,000. [LO 8.5, LO 8.6]

Answer: To find the purchasing power of $1,200 in various years, use the equation from the chapter and calculate the real values in 2015 dollars.

Example: Value of $1,200 received in 2016 in 2015 dollars: 2016real2015 = 2016nominal × (CPI2015/CPI2016) Use 2015 as the base year. To find the cost of living adjusted payment, one simply needs to increase the payment at the same rate as the CPI. This can be done by multiplying the original $1,200 payment by the current year CPI and then dividing by the original year (2015) CPI. Year

CPI

Real value of $1,200 (in $2015)

2015

100

2016

103

2017

105

2018

110

2015real2015 = 2015nominal × (CPI2015/CPI2015) = 1,200 × (100/100) = $1,200 2016real2015 = 2016nominal × (CPI2015/CPI2016) = 1,200 × (100/103) = $1,165.05 2017real2015 = 2017nominal × (CPI2015/CPI2017) = 1,200 × (100/105) = $1,142.86 2018real2015 = 2018nominal × (CPI2015/CPI2018) = 1,200 × (100/110) = $1,090.91

Cost of living adjusted payment = 1,200 × (CPI2015/CPI2015) = 1,200 × (100/100) = $1,200 = 1,200 × (CPI2016/CPI2015) = 1,200 × (103/100) = $1,236 = 1,200 × (CPI2017/CPI2015) = 1,200 × (105/100) = $1,260 = 1,200 × (CPI2018/CPI2015) = 1,200 × (110/100) = $1,320

10. Suppose General Electric paid its line workers $10 per hour in 2017 when the Consumer Price Index was 100. Suppose that deflation occurred and the aggregate price level fell to 80 in 2018. [LO 8.5, LO 8.6] a. What must GE pay its workers in 2018 in order to keep the real wage fixed? b. What did GE need to pay its workers in 2018 if it wanted to increase the real wage by 10 percent? c. If GE kept the wage fixed at $10 per hour in 2018, in real terms, what percentage increase in real wages did its workers get?

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Answer: a. We need the real hourly wage in 2018 measured in 2017 dollars to be equal to $10.

The equation is 2018real2017 = 2018nominal × (CPI2017/CPI2018) = $10.

Plugging in the CPIs, we get $10 = 2018nominal × (100/80).

Multiplying both sides by (80/100), we get $8 = 2018nominal. b. GE needed to pay its workers 10 percent more than the answer in part a, or $8.80 per hour (= $8 × 1.1). c. First, we need to find out what the real wage was in 2018 in 2017 dollars.

The equation is 2018real2017 = 2018nominal × (CPI2017/CPI2018), so 2018real2017 = $10 × (100/80) = $12.50.

The real wage in 2017 measured in 2017 dollars is the same as the nominal wage by definition.

Alternatively, it may help to see the numbers: 2017real2017 = 2017nominal × (CPI2017/CPI2017) = $10 × (100/100) = $10.

Next, we need to calculate the increase in real wages.

Real growth rate = ($12.50 – $10)/$10 = 0.25, or 25%.

11. Table 8P-8 shows the prices of a tall Starbucks latte in countries around the world. Using the data, and the fact that a latte costs $3 in the United States, calculate how much a country’s currency is under- or overvalued according to purchasing power. First, calculate the implied exchange rate for each country. Next, calculate the "latte index" for each country using the Big Mac index formula from the chapter. [LO 8.7]

Answer: The first step is to calculate what the exchange rate would have to be if the theory of purchasing power parity holds true. To do this, we divide the cost of a latte in the foreign currency by the cost of the latte in the United States. Next, we use the equation from the ―Big Mac Index‖ from the chapter = [(PPP implied exchange rate – official exchange rate)/official exchange rate] × 100.

Country

Price

Official

Implied exchange rate

Cost of US latte

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Thailand Argentina U.K. Japan

60 baht 15 pesos 2 pounds 450 yen

exchange rate 30 baht/$ 6 pesos/$ 0.5 pounds/$ 80 yen/$

if PPP holds 60/3 = 20 baht/$ 15/3 = 5 pesos/$ 2/3 = 0.67 pounds/$ 450/3 = 150 yen/$

(20 − 30) × 100/30 = −33.3% (5 − 6) × 100/6 = −16.7% (0.67 − 0.5) × 100/0.5 = 34.0% (150 − 80) × 100/80 = 87.5%

12. An employee asks her boss whether she can transfer offices so that she can work in a different part of the country. The boss responds positively and says that the employee can choose to work in Cleveland, Miami, or New York City. The boss then hands the employee a list, as shown in Table 8P-9, of the salaries that she would earn in the different cities and the average price levels in those same cities [LO 8.7, 8.8]

a. From a standpoint of maximizing the employee’s consumption possibilities, which office should she choose? b. What would be the minimum salary in New York City the boss could offer the employee to make the employee indifferent between moving to Cleveland and to New York City?

Answer: a. We cannot just compare the salaries in the three locations directly because the price levels are different. We need to calculate the real salary in each location and we will choose to do this by adjusting all salaries to Cleveland dollars. Using the equation from the chapter: 1969real2014 = 1969nominal × (CPI20149/CPI1969), switch 1969 for New York City or Miami and 2014 for Cleveland.

Now the value of New York City income in Cleveland dollars is NYCrealCleveland = NYCnominal × (CPICleveland/CPINYC).

Cleveland = 80,000 × (100/100) = $80,000.

Miami = 120,000 × (100/155) = $77,419.

New York City = 150,000 × (100/210) = $71,429.

The employee makes the most money in Cleveland after adjusting for the cost of living. b. The manager needs to offer a nominal salary in New York City such that the real salary in ―Cleveland dollars‖ is at least $80,000. Using the equation from part a: NYCrealCleveland = NYCnominal × (CPICleveland/CPINYC).

Substitute in $80,000 for NYCrealCleveland and solve for NYCnominal. $80,000 = NYCnominal × (100/210).

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Multiplying each side by 210/100 yields $168,000 = NYCnominal.

13. Calculate the PPP-adjusted GDP for each of four countries, using the information found in Table 8P-10. [LO 8.6] Answer: Using the equation in the text for PPP adjustment, we find that: PPP-adjusted GDP = GDPnominal × [1/(100% + purchasing power index)].

Country

GDP

Ona

$10,000

Price-level comparison 6%

Rye

$12,700

−27%

Zolfo

$14,100

−10%

Avon

$23,400

20%

PPP-adjusted GDP =10,000 × [1/(1 + 0.06)] = 10,000 × 1/1.06 = $9,434 =12,700 × [1/(1 – 0.27)] = 12,700 × 1/0.73 = $17,397 =14,100 × [1/(1 – 0.10)] = 14,100 × 1/0.9 = $15,667 =23,400 × [1/(1 + 0.20)] = 23,400 × 1/1.20 = $19,500

CHAPTER 9 UNEMPLOYMENT AND THE LABOR MARKET Solutions to End-of-Chapter Questions and Problems Review Questions 1. During the 1960s societal norms regarding working women were changing, and many women who had been housewives began working outside the home. How would you expect this new norm to change the labor-force participation rate? What about the unemployment rate? [LO 9.1] Answer: Growing opportunities for women to work outside the home increased the laborforce participation rate as women either found jobs or spent time looking for jobs. Determining whether an increase in the number of women in the labor force changes the unemployment rate takes a bit more care. If one assumes there are a fixed number of jobs in the economy, every job taken by a woman (or immigrant or minority or any other group) would take a job away from someone else. Thus, unemployment would rise because more people would be searching for the same number of jobs. However, the assumption that the number of jobs in an economy is fixed is typically incorrect and often referred to as the ―lump of labor fallacy.‖ An increase in the number of women in the workforce tends to lead to an increase in the equilibrium number of jobs, increasing the employment/population ratio 1-137 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

and having little effect on the unemployment rate in the long run. Empirically, the laborforce participation rate averaged 59.2 percent in the 1960's and 66.7 percent in the 1990's.

The employment/population ratio rose from 56.4 percent to 62.9 percent between the two decades. Unemployment was relatively unchanged across this time period, averaging 4.9 percent in the 1960's and 5.8 percent in the 1990's, even though the 1990's number was biased upward by cyclical unemployment caused by a recession in the early part of the decade. In the short run more women entering the labor force might lead to an increase in the unemployment rate, especially if women find they are lacking skills and education. The natural rate of unemployment was in fact higher in the 1970's and 1980's before falling in the 1990's.

2. List at least five types of people who do not have paid jobs but would nevertheless not be considered unemployed. [LO 9.1] Answer: To be unemployed, one needs to not have a job but be actively searching for one.

Anyone without a job but not actively searching would be neither employed nor unemployed.

Examples include students, retirees, many disabled persons, persons institutionalized or incarcerated, homemakers, full-time volunteers, and discouraged workers who do not have a job but have given up looking for work.

3. Compare two countries, one that has unlimited unemployment insurance and one in which workers are eligible for 26 weeks of unemployment insurance. Explain one reason why the country with more unemployment insurance may have a higher equilibrium unemployment rate. [LO 9.2] Answer: Workers in the country with unlimited unemployment benefits have less incentive to search diligently for work since they will receive benefits for an unlimited period of time even if they don’t find work. Thus, they are more likely to remain unemployed than workers in a country with benefits limited to 26 weeks, who have a very strong incentive to find a new job within the 26 weeks before they lose their benefits.

4. Suppose the president of a country comes to you to ask your advice. The country is currently at 8 percent unemployment, and the president wishes to reduce unemployment in the country to 3 percent. As an economist, you determine that the country’s natural rate of unemployment is 5 percent. What advice would you give the president? [LO 9.3] Answer: There are several potential things you could tell the president. First, since the current unemployment rate is 8 percent and the natural rate is 5 percent, the country must be suffering from cyclical unemployment. Anything the president can do to stimulate the economy is likely to reduce the unemployment rate closer to 5 percent. However, the president should also pick a different target. The natural rate of unemployment is "the minimum level of unemployment that is unavoidable in a dynamic economy," and in general, any attempts to reduce unemployment below this number are likely to result in a lot of effort 1-138 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

for little gain. So, economic recovery should bring the unemployment rate down closer to 5 percent, but there is no reason to believe the economy can get all of the way to 3 percent.

There are ways to reduce the natural rate of unemployment (although probably not to 3 percent, at least in the U.S.). The government can provide retraining for those with structural unemployment issues. Lowering unemployment compensation and eliminating the minimum wage are also likely to reduce the natural rate of unemployment.

5. Innovation often requires ―creative destruction,‖ in which the new product or technology makes previous products or technologies obsolete. For example, when the personal computer was invented, typewriters became useless; hence, the personal computer ―destroyed‖ the typewriter. This process of creative destruction often results in structural unemployment because workers who knew how to build and maintain the old products have skills that are no longer in demand. Do you think the government has a role in either limiting how often new products are created or in helping those workers who are displaced because of the new product? [LO 9.3] Answer: Almost certainly the government shouldn’t limit how often new products are introduced. Word processors, for example, have clearly made the economy more efficient and made the world a better place for almost everyone─except typewriter manufacturers and repairers. That being said, there is certainly a case to be made to help out those hurt by technological changes, although for the most part this is more of a normative (that is, subjective or opinion-based) response than a positive or objective one.

6. Suppose the National Bureau of Economic Research (NBER) just came out with a report suggesting that the economy will soon dip into recession. How do you think the levels of frictional, structural, and cyclical unemployment will change as the recession begins? What will happen to the labor-force participation rate? [LO 9.4] Answer: Certainly, the biggest change is that cyclical unemployment will rise. The effects on frictional and structural unemployment are ambiguous. Frictional unemployment may rise as new graduates or other people losing their jobs for normal "course of life" reasons will find it harder to get new jobs. On the other hand, given a bad job market, people may stay in school or their existing job longer, reducing frictional unemployment. Structural unemployment is not likely to change much over the short run, as recessions do little to change the underlying rate of labor market evolution. The labor-force participation rate is likely to fall. Potential workers facing a bad job market are more likely to stay in school, stay at home, or retire early rather than look for a job.

7. What happens to a country’s levels of frictional, structural, and cyclical unemployment, as well as its labor-force participation rate, as a recession drags on for an extended period of time? [LO 9.4] Answer: A recession will increase cyclical unemployment and generally have an ambiguous 1-139 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

effect on frictional and structural unemployment. As a recession drags on, however, workers who have been unemployed for a long period of time begin to see their skills deteriorate and therefore may move from simply cyclically unemployed to structurally unemployed. Thus, a lengthy recession may have bad long-run effects on the labor market, even once the economy has technically recovered from the recession. In a lengthy recession one should definitely expect the labor-force participation rate to fall as workers who have been unable to find work for a long period of time become discouraged and drop out of the labor market.

8. What happens to a country’s levels of frictional, structural, and cyclical unemployment, as well as its labor-force participation rate, as a country begins to recover from a deep recession? [LO 9.4] Answer: As a country recovers from a recession, cyclical unemployment will clearly fall and the labor-force participation rate will rise. The effects on frictional and structural unemployment are somewhat ambiguous; however, there is reason to believe that frictional unemployment may actually rise, counter-balancing a portion of the fall in cyclical unemployment. Better job prospects will draw some people from out of the labor force back in. To the extent that not all of the new job searchers will be able to find work, frictional unemployment may rise. The net effect, however, will be a fall in the total unemployment rate.

9. Give two reasons why it may be rational for a firm to offer wages above the minimum wage.

[LO 9.5] Answer: The old adage is ―you get what you pay for.‖ Paying higher wages is likely to attract higher-quality workers, who will be more productive. Paying higher wages also induces higher effort from employees, since highly paid workers have more to lose if they lose their jobs. Finally, highly paid workers are less likely to leave their jobs, and since recruiting and training employees is expensive, reducing job turnover is valuable to firms.

10. In France, labor laws typically made it very difficult or even illegal for firms to fire workers during economic downturns. How would these laws affect cyclical unemployment as well as frictional and structural unemployment? (Hint: Think about how these laws affect firms’ decisions to hire workers in the first place.) [LO 9.4, 9.5] Answer: Making it difficult to fire employees during economic downturns will reduce cyclical unemployment. That’s the obvious part of the question. These laws, however, make it far riskier to hire workers in the first place, since firms will be unable to fire them in the case of a recession. Since firms are more reluctant to hire in the first place, frictional and structural unemployment is likely to be higher. The net effect on unemployment is ambiguous, but overall, one should expect a higher natural rate of unemployment in France but lower peaks of unemployment during recessions. Laws like this make it very hard to find work in the first place, but also make the jobs that workers do have more secure.

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11. Unemployment is often called a lagging or trailing indicator because unemployment tends to rise sometime after the economy begins to slow down, and unemployment begins to fall again after the economy begins to rebound. In other words, unemployment trails GDP. Why do you think this might be the case? [LO 9.5] Answer: It is expensive and unpleasant for firms to fire or lay off workers. Thus, firms will avoid getting rid of employees at the first sign of an economic downturn and will often wait until a recession is firmly in place before they start getting rid of workers. Thus, the rise in unemployment trails the fall in GDP. Likewise, it is expensive to recruit and train new employees, so firms typically wait until a recovery is well underway before they start hiring again. Again, the fall in unemployment trails the rise in GDP. 12. The traditional goal of a government is to maximize its citizens’ welfare. Given this goal, would you suggest getting rid of unemployment insurance? How would your answer change if the goal of the government is to maximize employment? [LO 9.6] Answer: Obviously this question is a normative one, so there is no one right answer. That being said, most people benefit from having a safety net that protects them from economic variations that are beyond their control. Unemployment insurance helps people just during the time that they need help the most, so it can easily be argued that the unemployment insurance safety net improves citizens’ welfare on average. On the other hand, it is clear that unemployment insurance reduces workers’ incentives to find new jobs when they lose their old ones, which decreases employment. Whether unemployment insurance is a ―good‖ thing clearly depends on what government is trying to maximize.

13. In the United States during regular economic times, the maximum length of time a worker can collect unemployment insurance is 26 weeks. During recessions, however, Congress often increases the length of time in which workers can collect benefits. During the recent financial crisis, workers could collect benefits for up to 99 weeks in some states. Comment on the advantages and disadvantages of this system. [LO 9.6] Answer: With a 26-week limit on unemployment insurance, workers have a strong incentive to search diligently for work since their benefits last only a short period of time. In normal times, this amount of time should be sufficient for a worker to find a new job, so unemployed workers are provided with an adequate safety net while also given appropriate incentives to find work. In a recession, however, there will be more unemployed workers and fewer firms hiring, so 26 weeks may not be sufficient for the typical person to find a new job. Raising the length of time a worker can receive benefits keeps the safety net in place while acknowledging the additional difficulty in finding work in a bad economy. Of course, raising the length of time an unemployed individual is eligible for benefits will generally prolong the amount of time a person stays out of work.

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Problems and Applications 1. For each of the following situations, is Rick Alexander (from the chapter-opening story) counted as employed, unemployed, or not in the labor force by the Bureau of Labor Statistics? [LO 9.1] a. Alexander is self-employed in his old job as a carpenter. b. Alexander moves to Florida and begins looking for work. c. Alexander feels discouraged looking for work and stops applying for jobs. d. Alexander starts looking for work again. e. Alexander starts work at a new job.

Answer: Alexander is employed if he has a job, unemployed if he doesn’t have a job but is actively looking for one, and not in the labor force if he doesn’t have a job but isn’t searching for one. a. Self-employment is a type of job, so Alexander is employed. b. Alexander no longer has a job but is looking for one, so he is unemployed. c. Alexander doesn’t have a job but isn’t looking, so he is neither employed nor unemployed. He is not in the labor force. d. Alexander still doesn’t have a job but is now looking for one, so he is back to being unemployed. e. Alexander finally has a job again, so he is employed.

2. Consider the economy whose data appear in Table 9P-1. [LO 9.1]

a. What is the unemployment rate? b. What is the labor-force participation rate?

Answer: a. Unemployment rate = Unemployed/Labor force = 12,000/65,000 = 0.185, or 18.5%. b. Labor-force participation rate = Labor force/Population = 65,000/140,000 = 0.50, or 50%.

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3. Table 9P-2 uses data for the year 2018, adjusted to be comparable to each other. All population values are in thousands.

a. Fill in the blanks in the table. [LO 9.1] b. In part a, you should have found that the unemployment rates of the three countries differ significantly from one another. Suggest three possible reasons to explain why the countries might have different unemployment rates. [LO 9.3, 9.4] Answer:

a. (1) Labor force = Employed + Unemployed = 67,130 + 1,73 = 68,860.

(2) Unemployment rate = Unemployed/Labor force = 1,730/(67,130 + 1,730) = 2.5%.

(3) Labor-force participation rate = Labor force/Working-age population = 68,860/75,469 = 91.2%.

(4) Employed = Labor force – Unemployed = 30,399 – 2,874 = 27,525.

(5) Unemployment rate = Unemployed/Labor force = 2,874 /30,399 = 9.5.

(6) Labor-force participation rate = Labor force/Working-age population, so Working-age population = Labor force/Labor-force participation rate = 30,399 /0.722 = 42,104.

(7) Labor-force participation rate = Labor force/Working-age population = 43,401/53,484 = 81.1.

(8) Unemployment rate = Unemployed/Labor force, so Unemployed = Unemployment rate × Labor force = 0.051 × 43,401 = 2,213.

(9) Labor force = Employed + Unemployed, so Employed = Labor force – Unemployed = 43,401 – 2,213 = 41,188. b. There are multiple possible reasons for this: • Germany could have a lower natural rate of unemployment than France.

• Germany could be in an expansion and have lower cyclical unemployment.

• France could have higher (and binding) minimum wages.

• Japan could have a more liberalized labor market, leading to lower frictional unemployment.

• France could have more generous unemployment benefits.

4. Assume the equilibrium wage rate is $6. Draw a graph of the labor market to answer the following questions. [LO 9.2] 1-143 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

a. When the government introduces a minimum wage of $5.50, does unemployment increase, decrease, or stay the same compared to unemployment at the equilibrium wage? b. When the government introduces a minimum wage of $6.50, does unemployment increase, decrease, or stay the same compared to unemployment at the equilibrium wage?

Answer:

a. Since the equilibrium wage is above the government-mandated minimum wage, the minimum wage will not be binding. Firms will already be paying above the set minimum wage, and, therefore, the minimum wage will have no effect on the wage paid or the unemployment rate. b. Since the government-mandated minimum wage is above the equilibrium wage, in this case, the minimum wage is binding. The wages paid to workers will rise, but so will unemployment.

5. Assume that the labor demand equation for a fictional country is Ld = 60 − 2w, where w is the wage per hour worked and Ld is the number of workers demanded by firms. Assume also that the labor supply equation for that country is Ls = 0.4(w), where Ls is the number of people willing to work. [LO 9.2, 9.5] a. Find the equilibrium wage and quantity of labor employed. b. At the equilibrium wage, how many people are unemployed? c. How would the number of unemployed change if the supply of workers increased?

Answer: a. Set Ld = Ls. 60 – 2w = 0.4(w).

Add 2w to both sides, leaving 60 = 2.4(w).

Divide both sides by 2.4, leaving 25 = w.

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Plugging 25 into either Ld or Ls, we get the equilibrium quantity of labor employed = 10. b. Since Ld = Ls, there is no unemployment. At the equilibrium wage rate, the labor market exactly clears. c. If the supply of workers increases, then the labor supply curve will shift to the right. As long as the wage is free to quickly adjust, Ld will still exactly equal Ls, so no unemployment will occur. The equilibrium wage will fall and employment will rise. One major cause of unemployment in the real-world economy is that wages do not always quickly adjust to changes in labor supply or demand so that the labor market is not always in perfect equilibrium.

6. Suppose a firm’s labor demand equation is Ld = 60 − 2(w) and the labor supply equation that it faces is Ls = −20 + 3(w), where w is the wage per hour worked, Ld is the number of workers demanded by firms, and Ls is the number of people willing to work. [LO 9.2, 9.5] a. Find the equilibrium wage and quantity of labor employed. b. The workers, thinking that their wages are too low, decide to strike. After tense negotiations, the firm decides to raise the wage by 50 percent. After the wage increase, how many people are unemployed?

Answer: a. Set Ld = Ls. 60 – 2w = −20 + 3w.

Add 2w and 20 to both sides, leaving 80 = 5w.

Divide both sides by 5, leaving 16 = w.

Plugging 16 into either Ld or Ls, we get the equilibrium quantity of labor employed = 28.

Since Ld = Ls, there is no unemployment. At the equilibrium wage rate, the labor market exactly clears. b. Now the wage rate is increased by 50 percent from 16 to 24.

At w = 24, Ld = 60 – 2(24) = 12, and Ls = −20 + 3(24) = 52.

Since the quantity of labor demanded is 12 and the quantity of labor supplied is 52, there is an excess supply or surplus of labor, better known as unemployment, of 40 units.

7. Classify each of the following situations as either frictional, structural, or cyclical unemployment. [LO 9.3, 9.4] a. Maria has started looking for work after taking time off to have a baby. b. Juan left high school without graduating and can’t find any jobs he is qualified for. c. Rohit had a job working on Wall Street but lost his job during the financial crisis. d. Adam has just arrived in a new city and is looking for work. e. Max wants to work as an air steward, but because the airline industry is heavily unionized there are very few jobs available. f. Jada has just lost her job in a web start-up that was affected by a downturn in the economy.

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Answer: Remember, frictional unemployment is unemployment caused by a worker changing his or her location, job, or career. Structural employment occurs due to a mismatch between the skills workers can offer and the skills in demand in the economy. Cyclical unemployment occurs when people become temporarily unemployed due to an economic downturn. a. Frictional unemployment: Returning from work after childbirth is a natural life change. b. Structural unemployment: Juan lacks the skills to engage in productive work. c. Cyclical unemployment: The financial crisis is a temporary economic downturn. d. Frictional unemployment: Changing cities is a natural life change. e. Structural unemployment: Unions alter the demand structure for labor in the airline industry. f. Cyclical unemployment: Her job was lost due to a temporary economic downturn.

8. For each of the following situations, would the unemployment rate increase, decrease, or stay the same? [LO 9.5] a. A company begins paying efficiency wages above the equilibrium wage rate. b. The number of workers covered by union contracts falls. c. The government extends the duration of unemployment insurance.

Answer: a. Efficiency wages raise the wage rate above the equilibrium level, increasing unemployment. b. Unions raise the wage rate above the equilibrium level. A reduction in unions will therefore bring wage rates closer to the equilibrium level, reducing unemployment. c. Increasing the duration of unemployment insurance reduces unemployed workers’ incentives to find work increasing the unemployment rate.

9. Suppose a country has a 26-week limit on the duration that an unemployed person receives unemployment benefits. You collect some data and notice that workers in their 26th week of unemployment benefits somehow manage to find jobs at a much higher rate than other unemployed workers. What would this statistic tell you about the incentives involved with unemployment insurance? [LO 9.6] Answer: The fact that large numbers of people find jobs during the last week of benefits suggests that unemployed workers receiving unemployment checks have an incentive to wait until their benefits run out before seriously looking for work or taking new jobs.

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10. Understanding that unemployment benefits give workers the incentive to not look for work until their benefits run out, suppose an economist suggested that instead of giving workers up to 26 weeks of unemployment benefits that end once the person finds work, a person who loses his or her job would just get a single big check for 26 weeks of benefits, regardless of how long the worker is unemployed. What are the advantages and disadvantages of this idea?

[LO 9.6] Answer: Because unemployed workers would get 26 weeks of benefits regardless of how soon they find new jobs, these workers have an incentive to look for work right away since they don’t lose benefits the moment they find a new job. Thus, the advantage of this idea is that it is likely to reduce unemployment by increasing the incentives to look for work earlier.

The disadvantage of the idea is that it would be costly. All workers would be compensated for a full 26 weeks of unemployment; under the previous 26-week limit, any workers finding jobs before 26 weeks are up don’t receive benefits, thus reducing total unemployment payments.

CHAPTER 10 ECONOMIC GROWTH Solutions to End-of-Chapter Questions and Problems Review Questions 1. Explain why inflation reduces the real value of nominal GDP per capita. [LO 10.1] Answer: Real GDP per capita is the amount of goods and services produced per person.

Nominal GDP per capita is the number of dollars produced per person. Since inflation increases the number of dollars required to purchase goods and services, if a country’s nominal GDP is fixed, inflation will reduce the amount of goods and services that the fixed amount of nominal GDP can purchase.

2. When policy-makers discuss policies that encourage long-run growth in per capita real GDP, they often mention policies aimed at reducing the growth rate in the population. If effective, why might these policies improve long-run growth? Also, what are the potential costs associated with these policies? [LO 10.1] Answer: As can be seen in Equation 10-1, real GDP per capita growth rate = Nominal GDP growth rate – Inflation rate – Population growth rate. If one can keep the nominal GDP growth rate and inflation rate the same while simultaneously reducing the population growth rate, then real GDP per capita growth rate will rise. More intuitively, if one can keep the size of the cake growing at the same rate but reduce the number of people among whom you have 1-147 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

to divide up the cake, everyone will get bigger and bigger slices. There are two primary costs.

First, the policies that reduce population growth may also reduce nominal GDP at the same time. For example, lower population growth will eventually reduce the amount of labor a country can provide or may reduce the rate of technological innovation or capital accumulation. Second, the policies required to reduce population growth may be considered coercive or a violation of human rights. For example, China’s ―one child‖ policy is often criticized on human rights grounds.

3. Does the rule of 70 predict greater increases in the amount of income for richer or poorer countries when both have the same growth rate? Why? [LO 10.1, 10.3] Answer: The rule of 70 predicts that the amount of time it will take a country’s income to double is dependent only on its growth rate, not on its initial level of income. However, the size of the increase certainly depends on its starting point. For example, two countries with a 7% real per capita growth rate will both have their incomes double in 10 years (70/7 = 10). If one country started with a GDP of $1,000/capita and the other started with a GDP of $10,000/capita, the poor country would have experienced an increase in income from $1,000 to $2,000 per person in 10 years, an increase of $1,000 per person. The rich country would have experienced an increase in income from $10,000 to $20,000 per person in 10 years, an increase of $10,000 per person.

4. Explain why many rich countries are able to continuously grow, even though they already have very high levels of physical and human capital. [LO 10.2] Answer: Rich countries with high levels of physical and human capital are able to continuously grow if they can continuously increase any of the components that lead to productivity growth. First, it is possible that even countries with high levels of physical and human capital can continue to accumulate even higher levels of these factors of production.

Second, countries with lots of physical and human capital are well equipped to engage in technological innovation, another component of productivity growth.

5. At a young age, would you rather have a large level of savings or a pool of savings that was increasing at a faster rate? [LO 10.3] Answer: The answer depends on the relative size of the two starting amounts, and on the two growth rates. As a general rule, it is possible that the smaller initial amount of savings growing at a faster rate will end up larger after some long period of time. For example, if you start with $5,000 and the growth rate is 11% per year, then you end up with $114,461.48 after 30 years. If you start with $50,000 (a much larger level) and the growth rate is 2% per year, then you end up with $90,568.08. If the growth rate on the $5,000 is only 9%, then after 30 years you would end up with $66,338.39.

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6. If a country’s labor and capital grow at the same rate, is this likely to have the same impact on the growth rate of output? Why or why not? [LO 10.4] Answer: According to the growth accounting equation, the growth rate of output is equal to the growth rate of labor times labor's share of output plus the growth rate of capital times capital's share of output plus the growth rate of technology. Therefore, the impact of labor growth and capital growth on output growth depends on their respective shares of output. For example, suppose both labor and capital grow at 5%, labor's share of output is 60%, and capital's share of output is 40%. The impact on output of the growth in labor is 0.05 × 0.60 = 0.03, or the 5% growth in labor leads to 3% growth in output. The impact of the growth in capital is 0.05 × 0.40 = 0.02, or the 5% growth in capital leads to 2% growth in output.

7. Measuring the growth in technology directly is almost impossible. How does the growth accounting equation allow economists to calculate an implied growth rate for technology?

[LO 10.4] Answer: According to the growth accounting equation, the growth rate of output is equal to the growth rate of labor times labor's share of output plus the growth rate of capital times capital's share of output plus the growth rate of technology. We can observe or calculate the growth rate of output, the growth rate of labor, the growth rate of capital, labor's share of output, and capital's share of output. Therefore, we can solve for the implied rate of growth in technology. We cannot easily observe or calculate technology directly.

8. Using the growth rates for countries found in Figure 10-3, is there evidence that poorer countries in Africa and Asia are converging to the level of income found in Western Europe?

Why or why not? [LO 10.5] Answer: The map shows that over the past 20 years countries in Africa and Asia have grown faster than countries in Western Europe. This suggests that some level of convergence has taken place.

9. Southern states in the United States are, on average, poorer than northern states. Southern states also have higher growth rates in real GDP per capita, on average, than northern states.

Use these facts to draw a conclusion about whether the theory of convergence is correct.

What other factors should be considered? [LO 10.5] Answer: Convergence theory predicts that different countries or regions will eventually converge to the same growth rate, but not necessarily the same level of income. Countries that start out at a lower income level may grow at a faster rate, but that rate will eventually slow down due to decreasing marginal returns. The level of per capita income in a country is influenced by its savings rate, level of education, and level of technology.

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10. Many believe that technology is very costly to create, but cheap to transfer. For example, think of the personal computer: The technology underpinning the personal computer took a generation of time and a ton of money to create. However, now that the personal computer has been created, it is easy for others to purchase and reap the benefits. Given this insight, what do you believe will be the growth implications for the United States (traditionally more apt to create new technology) and China (traditionally more apt to adopt technologies created elsewhere)? [LO 10.5, 10.6] Answer: Growth should be slower in a country that has to engage in the creation of new technologies and faster in countries that get to deploy technologies that have already been created elsewhere. Thus, China should grow faster than the U.S. The idea of technology transfer is one reason why economists believe that convergence may be likely to occur between rich and poor countries.

11. How might low rates of saving in the United States limit the accumulation of physical capital? [LO 10.6] Answer: If a country must rely primarily on domestic sources of savings in order to provide funds for investment, a low savings rate will result in a low rate of physical capital accumulation. Domestic savings comes from individuals and firms deciding to save more and spend less, or from the government deciding to increase taxes to pay for government investment spending. It is also possible for a country to use the savings of foreigners to pay for physical capital accumulation.

12. Realizing that poor countries must solve many problems at once has shifted donors away from the idea of giving multiple small payments to the idea of a ―Big Push.‖ This Big Push entails giving a very large sum of money that could be used to fix multiple problems at once.

In fact, the amount of money required might be so large that other countries might be the only ones who could afford the donation. What are the trade-offs associated with this idea?

[LO 10.6] Answer: There are tradeoffs faced by both the donor country and the recipient country.

From the donor country's perspective, a large donation to a developing nation could have great humanitarian benefits, including reducing poverty and encouraging sustainable growth in that country. However, this money could have been used for other purposes within the donor country. Here in the United States, it is a frequent source of contention that the U.S. donates "so much" money to other countries instead of rebuilding our own cities. (Of course, we don't actually donate a large portion of our GDP.) So, the tradeoff is between improving the lives and welfare of foreigners with the opportunity cost of the money.

From the recipient's perspective, the benefits of a large donation could be quite dramatic— again, reducing poverty and encouraging sustainable growth. However, receiving a sudden large donation might simultaneously undermine that country's nascent set of institutions.

Corruption, for example, might arise, as local officials try to siphon off some of the incoming 1-150 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

funds. Also, the developing country might begin pushing for policies that it thinks will attract more foreign funds, rather than pushing for policies that are actually in the country's best interests.

13. How is it possible that Switzerland, a landlocked country with almost no natural resources, is one of the richest countries in the world while the Democratic Republic of the Congo, a huge country with vast deposits of many strategically important minerals, is one of the poorest?

[LO 10.2, 10.6, 10.7] Answer: The case of Switzerland vs. the Democratic Republic of the Congo clearly highlights that natural resources are only one component of productivity. All things equal, it is probably better to have more natural resources than less, but when comparing a country with lots of physical capital, human capital, technology, and good governance but few resources (Switzerland) and a country with lots of resources but little human or physical capital, low levels of technology, and a long history of corrupt governance (Democratic Republic of the Congo), we see that natural resources alone generally can’t make up for all of the advantages that the other components of productivity growth bring.

14. Why could a free press be important for economic growth? (Think about the connection between the press and government.) [LO 10.7] Answer: Good governance is an important component of economic growth. A free, independent press serves to promote good government by publicizing government corruption, waste, and fraud. Government officials who run the risk of public exposure are less inclined to engage in behavior detrimental to the economy.

Problems and Applications 1. Fill in the blanks in Table 10P-1. [LO 10.1]

Answer: The equation used in the text to calculate the real GDP per capita growth rate is: Real GDP per capita growth rate = Nominal GDP growth rate – Inflation rate – Population growth rate 1-151 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

2. Equation 10-1 states that the Real GDP per capita growth rate = Nominal GDP per capita growth rate – Inflation rate – Population growth rate. This equation is an approximation of the exact rate of growth of GDP per capita, and so it results in some errors when calculating this rate. However, the simplified equation is both easy to use and results in small error terms when inflation, nominal GDP growth, and population growth are low, and so it is a useful approximation. Table 10P-2 lists a fictional country’s nominal GDP, real GDP, GDP deflator, and population over two years. [LO 10.1]

a. Use your knowledge from Chapter 8, ―The Cost of Living,‖ to verify that the real GDP figures in Table 10P-2 are accurate. b. Calculate this country’s real GDP per capita for both 2015 and 2016. c. Calculate the growth rate in this country’s real GDP per capita between 2015 and 2016. d. Calculate the growth rates in the nominal GDP, GDP deflator, and the population.

Answer: a. Real GDP (2017 dollars) = Nominal GDP × GDP deflator (2017)/GDP deflator (year of nominal GDP).

Real GDP in 2017 = $1,000,000 × 100/100 = $1,000,000.

Real GDP in 2018 = $1,050,000 × 100/103 = $1,019,417. b. Real GDP per capita = Real GDP/Population.

For 2017, real GDP per capita = $1,000,000/1,000 = $1,000.

For 2018, real GDP per capita = $1,019,417/1,005 = $1,014. c. The growth rate between any two numbers = [(New – Old)/Old] × 100.

Real per capita GDP growth = [(1,014 – 1,000)/1,000] × 100 = 1.4%. d. The growth rate between any two numbers = [(New – Old)/Old] × 100.

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Nominal GDP growth = [(1,050,000 – 1,000,000)/1,000,000] × 100 = 5%.

The growth in the GDP deflator = [(103 – 100)/100] × 100 = 3%.

Population growth = [(1,005 – 1,000)/1,000] × 100 = 0.5%.

3. For each growth rate below, use the rule of 70 to calculate (i) how long it will take incomes to double. [LO 10.2] a. 4 percent. b. 7 percent. c. 2.5 percent. d. 10 percent. e. 3 percent.

Answer: To find the time to double, simply take 70 and divide by the growth rate to find the number of years to double.

a. b. c. d. e.

4.0 percent 7.0 percent 2.5 percent 10 percent 3.0 percent

Years for incomes to double 70/4 = 17.5 years 70/7 = 10 years 70/2.5 = 28 years 70/10 = 7 years 70/3 = 23.3 years

4. For each part below, determine whether the following actions will increase or decrease productivity, and name the component of productivity that each affects. [LO 10.2] a. The local government builds a new school. b. Teachers in the new school hold classes for young students. c. A manufacturer installs robots on its assembly line. d. A research team designs a more efficient system of irrigation. e. A soda company discovers a new source of underground water that can be used to make its products. f. A professor writes a new and improved economics textbook. g. A large number of people have less access to health care. h. A worker receives on-the-job training to be a mechanic.

Answer: The factors that influence labor productivity are physical capital, human capital, technology, and natural resources. a. The construction of a new school will increase productivity by increasing physical capital. b. The teaching of classes will increase productivity by increasing human capital. c. Installing robots on an assembly line will increase productivity by increasing physical capital.

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d. The development of a more efficient irrigation system will increase productivity by increasing technology. (Building an irrigation system is investment in physical capital, but taking existing water and capital and making it work better is technology.) e. The discovery of a new source of water increases productivity by increasing natural resources. f. A new and improved textbook improves the quality of teaching and learning and thus will eventually increase human capital. g. Healthier people are more productive, so providing health care increases productivity by increasing human capital. Thus, less access to health care decreases productivity and decreases human capital. h. On-the-job training increases productivity by increasing human capital.

5. Which of the countries shown in Table 10P-3 had the highest level of per capita income in 2015? Which had the highest rate of income growth from 2010 to 2015? Do incomes in these countries appear to be converging? [LO 10.3, 10.5]

Answer: Artinia had the highest level of per capita income in 2018 at $15,854 per person.

Chi had the highest rate of growth in per capita income over the five-year period.

Growth = (New GDP – Old GDP)/Old GDP, and the calculations are shown below for each country.

Convergence is the theory that countries starting at low levels of income will grow at a faster rate than those starting at higher levels. Based on this sample of countries, convergence has not occurred. The two poorest countries in 2013, Boliv and Ghala, also had the lowest levels of GDP per capita growth between 2013 and 2018, so they did not catch up to the richer countries in the sample.

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6. In 2017 the median household income in Louisiana was approximately $43,903 per year, while the income per household in Massachusetts was about $74,167. However, suppose the growth rate of per capita real GDP in Louisiana is higher than in Massachusetts (3 percent versus 2 percent). [LO 10.3, 10.5] a. From the perspective of trying to maximize your income per capita, which state will have higher increases in income over the next few years? b. From the perspective of trying to maximize your income per capita, which state will have higher increases in income in the long run?

Answer: a. The increase in income will be higher in Massachusetts than Louisiana over the next few years. Although Louisiana is growing at a faster rate, its level of income is much lower.

In the first year, Massachusetts will increase income by 2% of $74,167, or $1,483. In the first year, Louisiana will increase income by 3% of $43,903, or $1,317. b. Given Louisiana’s higher rate of income growth, household income in Louisiana should eventually overtake that of Massachusetts if the differences in growth rates persist. For example, by the time 60 years have passed, Louisiana will have a higher income. This can be calculated as $44,903(1.03)60.

7. Will the three countries in Table 10P-4 converge to the same level of economic development given enough time? [LO 10.3, 10.5]

Answer: Yes. Incomes have converged so that they are much more similar in 20 years than they were before. Notice the poorest country is growing the fastest, and the middle country is growing faster than the richest country. This means the bottom two will catch up to, and in fact surpass, the richest country. For example, in 20 years Ansonia will be the richest country.

Country Ansonia

Income per capita $5,000

Real per capita GDP Real GDP per capita in 20 years growth rate 7% 5,000(1.0720) = 19,348 1-155

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Country Trumbull Shelton

Income per capita $7,500 $10,000

Real per capita GDP Real GDP per capita in 20 years growth rate 4.5% 7,500(1.04520) = 18,088 2% 10,000(1.0220) = 14,859

8. Indicate whether each of the following statements is true or false and explain your answer.

[LO 10.4] a. Country A’s labor share is 60 percent, Country B’s labor share is 70 percent, and labor is growing at a rate of 3 percent in both countries. All else the same, Country B has a higher growth rate of output. b. Country A’s labor share is 40 percent, Country B’s labor share is 70 percent, and labor is growing at a rate of 10 percent in country A and 6 percent in country B. All else the same, Country A has a higher growth rate of output. c. Labor is growing at a negative rate in country A and a positive rate in country B, so country B must have a higher growth rate of output. d. Labor and capital are both growing more quickly in Country A than in Country B, so Country A must have a higher growth rate of output.

Answer: According to the growth accounting equation, the growth rate of output is equal to the growth rate of labor times labor's share of output plus the growth rate of capital times capital's share of output plus the growth rate of technology. a. True. The impact on output of the growth in labor in Country A is 0.03 × 0.60 = 0.018, or 1.8%. The impact on output of the growth in labor in Country B is 0.03 × 0.70 = 0.021, or 2.1%. b. False. The impact on output of the growth in labor in Country A is 0.10 × 0.40 = 0.04, or 4%. The impact on output of the growth in labor in Country B is 0.06 × 0.70 = 0.042, or 4.2%. c. False. It depends on how fast capital and technology are growing in each country. In Country A, capital and technology could be growing more quickly and this could offset the effect of the negative growth rate in labor. d. False. It depends on how fast technology is growing in both countries. If Country B has a higher rate of growth in technology, then this can compensate for slower growth in labor and capital.

9. Calculate the implied growth rate of technology in each scenario in Table 10P-5. Assume labor’s share of output is 70 percent and capital’s share of output is 30 percent. [LO 10.4]

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Answer: According to the growth accounting equation, the growth rate of output is equal to the growth rate of labor times labor's share of output plus the growth rate of capital times capital's share of output plus the growth rate of technology. Therefore the growth rate of output minus the contribution by labor minus the contribution by capital is equal to the implied growth rate of technology.

A. 0.03 – (0.60 × 0.02) – (0.40 × 0.02) = 0.01, or 1% B. 0.042 – (0.60 × 0.03) – (0.40 × 0.03) = 0.012, or 1.2% C. 0.03 – (0.60 × 0.01) – (0.40 × 0.05) = 0.004, or 0.4% D. 0.042 – (0.60 × 0.01) – (0.40 × 0.04) = 0.02, or 2 % 10. For each of the following examples, state whether this activity would likely hinder or promote economic growth, and name a component of productivity each produces or reduces.

[LO 10.2, 10.6] a. Not requiring students to attend school. b. Granting patents on new inventions. c. Building a solid infrastructure system. d. Allowing local rivers and streams to become polluted.

Answer: The factors that influence labor productivity are physical capital, human capital, technology, and natural resources. a. Not requiring students to attend school will hinder growth by reducing the accumulation of human capital. b. Granting patents on new inventions will likely increase growth by encouraging the invention of new technology. c. Building a solid infrastructure system will increase growth by increasing physical capital. d. Allowing local rivers and streams to become polluted will reduce growth by reducing natural resources.

11. Policy-makers in the U.S. government have long tried to write laws that encourage growth in per capita real GDP. These laws typically do one of three things, as listed below. For each of the three points, name a law or government program with that intention. [LO 10.6] 1-157 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

a. They encourage firms to invest more in research and development in order to boost technology. b. They encourage individuals to save more in order to boost the physical capital stock. c. They encourage individuals to invest more in education in order to boost the stock of human capital.

Answer: Obviously there are many possible answers here. A handful of correct answers are presented, but others exist. a. The government grants patents for inventions. Companies get tax credits for R&D costs.

Government agencies like the National Institute of Health and the National Science Foundation directly provide grants for scientific research. b. The government often provides lower tax rates on income earned through savings.

Programs like 401K or IRA retirement savings plans, health savings accounts, and 529 education savings accounts provide incentives for saving for specific purposes. c. Public schools and universities provide education at a subsidized price. The government provides loans such as Perkins or Stafford loans for attending college. The GI Bill provides education subsidies for veterans.

12. Name the type of institution that is responsible for promoting a stable environment for the economy regarding each of the following situations. [LO 10.7] a. Someone steals your car, but is caught. b. You claim that your employer violated the terms of your employment contract.

Answer: a. The police department promotes a stable economy by allowing people to safely buy goods (like cars) without worrying as much about losing the ability to enjoy your purchase. b. The court system promotes a stable economy by allowing contracts to be written and enforced.

CHAPTER 11 AGGREGATE EXPENDITURE Solutions to End-of-Chapter Questions and Problems Review Questions 11. What effect does an increase in current income have on current consumption? What effect does an increase in expected future income have on current consumption? [LO 11.1] 1-158 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Answer: If current income increases, then current consumption will also increase. People are likely to spend part of the extra income on consumption and save the rest. If expected future income increases, then current consumption will increase. People are likely to spend a little bit more of their current income and save a little bit less due to the expectation of higher income in the future.

12. What effect does an increase in the interest rate have on current consumption? What effect does an increase in wealth have on current consumption? [LO 11.1] Answer: If interest rates increase, then it becomes more expensive to borrow. Consumers are likely to spend less on big purchases that require borrowing such as new cars and new houses. Additionally, consumers may be inclined to save a little bit more due to the higher interest earned on saving. If wealth increases, then consumers are likely to spend a little bit more and save a little bit less out of their current income. This is because they have a larger stock of wealth (in the form of financial assets or real estate) that they can draw on for retirement or other expenses, and therefore they feel less of a need to add to that stock of wealth by saving a greater amount of current income.

13. How does a change in expected profitability affect aggregate investment? How does a change in business taxes affect aggregate investment? [LO 11.2] Answer: If firms expect profit to increase in the future, they are likely to increase aggregate investment by choosing to replace or upgrade existing equipment or expand productive capacity. If business taxes increase, then this is likely to decrease aggregate investment. Higher taxes will reduce profitability and therefore make purchases of new equipment and buildings less attractive.

14. How does a change in the interest rate affect aggregate investment? What if firms prefer to pay for investment spending out of retained earnings? Does a change in the interest rate still affect aggregate investment? [LO 11.2] Answer: When firms take out loans to pay for capital improvements, any increase in the interest rate will decrease aggregate investment because it is more costly to borrow. When firms prefer to pay for investment spending out of retained earnings, any increase in the interest rate will decrease aggregate investment. This is because the retained earnings are likely to be accumulated in a bank account that pays interest. Therefore, when the interest rate goes up, the opportunity cost of spending the accumulated funds also goes up, and investment spending is likely to fall.

15. Does the amount of government spending in an economy respond directly to changes in aggregate income, wealth, or interest rates? Does it respond indirectly to changes in these variables? [LO 11.3] 1-159 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Answer: There is no direct relationship between government spending and aggregate income, wealth, or interest rates, meaning a change in one of these variables does not automatically change government spending. The U.S. Congress and the president determine government spending each year as part of the budget process. A change in one of these variables may have an indirect effect on government spending. If changes in income, wealth, or interest rates are linked to a severe recession, then the government may feel compelled to change government spending and enact a specific policy to stimulate economic activity.

16. What are government transfer payments? Are they included as part of the government spending component of GDP? [LO 11.3] Answer: Government transfer payments include payments for unemployment compensation, Social Security benefits, and food assistance. Government transfer payments do not count as part of the government spending component of GDP because they do not directly result in the production of new goods or services. Transfer payments involve the transfer of money from the government to individuals in the economy who are eligible to receive the payment under a specific government policy. The government obtains the funds it needs to make the transfer payments from tax revenue and government borrowing, so technically government transfer payments are transfers of money from one group of people in the economy to another, with the government acting as the middleman. When the individuals receiving the payments spend the income, then there is an impact on GDP. Payments to military personnel or public school teachers count as part of government spending because the government is paying people to provide a new service.

17. What happens to the level of net exports in an economy when income in that economy increases? What happens to the level of net exports in an economy when income in other economies increases? [LO 11.4] Answer: Net exports is equal to the value of exports minus the value of imports. When income in the economy increases, the level of net exports will decrease. With higher levels of income, consumption spending is higher and some of this spending represents imports. Higher import spending reduces net exports. When income in other economies increases, the level of net exports will increase. When foreigners have more income, they spend more, and some of this is on our exports.

18. You read in the paper that the dollar has strengthened in value relative to the euro. How is this change in the exchange rate value of the dollar likely to affect exports to Europe and imports from Europe? [LO 11.4] Answer: If the dollar has strengthened in value, then this is like the exchange rate changing from $1.10 per euro to $1.06 per euro. In this case, people pay fewer dollars for a euro, so the 1-160 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

euro has lost value relative to the dollar, meaning the dollar has gained value relative to the euro. When the dollar becomes stronger in value, this will decrease exports to Europe and increase imports from Europe. When the value of the dollar is stronger, Europeans receive fewer dollars per euro ($1.06 vs. $1.10), so U.S. goods are relatively more expensive. When the dollar is stronger, people in the U.S. can buy euros for fewer dollars, so European goods are relatively cheaper.

19. The investment category of GDP measures three different types of expenditures. What are they? Why is planned investment sometimes different from actual investment? [LO 11.6] Answer: Investment measures spending by firms on new goods and services, and includes spending on new capital, new houses, and inventory accumulation. Purchases of stocks and bonds are a type of financial investment, and this does not count in the investment spending category of GDP. When firms or people purchase stocks, they are converting one type of asset (money) to another type (stock), and this does not count as new production.

Unexpected changes in demand will cause planned investment to differ from actual investment. For example, suppose a firm produces 10 units, plans to sell 8, and plans to put the extra 2 in inventory. If this all happens, then planned investment equals actual investment (the value of the 2 extra units). If they only sell 7, then they will add 3 to inventory and actual investment (the value of the 3 units) is greater than planned investment (the value of the 2 units).

20. What causes a movement along the planned aggregate expenditure curve? What causes the planned aggregate expenditure curve to shift? [LO 11.5] Answer: The planned aggregate expenditure line illustrates the relationship between planned aggregate expenditure (on the vertical axis) and output/income (on the horizontal axis). When income rises, so does expenditure and output, and this leads to an upward movement along the planned expenditure line. Changes in nonincome determinants of aggregate expenditure such as government spending, interest rates, and business optimism cause the planned aggregate expenditure line to shift. For example, if businesses are more optimistic, then they will increase investment spending and this will lead to an increase in planned aggregate expenditure at the given level of output—the PAE line will shift upwards.

21. Which components of aggregate expenditure do not directly depend on current income? [LO 11.6] Answer: Investment: Investment includes spending on new capital, new houses, and inventory accumulation. The determinants of investment are the factors that change the benefits and costs of adding new physical capital—expected profitability, the interest rate, and business taxes.

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based on what they think citizens need.

Consumption: Consumption depends directly on income—when people have more income, they spend more.

Net exports: Net exports depend directly on income because some of the extra consumption spending will be spent on imports.

22. In a Keynesian equilibrium will the economy always be producing at its level of potential output? Why or why not? [LO 11.7] Answer: The economy does not always produce at its level of potential output. Firms do not choose to produce the most they can at a given price. Instead, they produce what they can sell at a given price. When demand is weak and prices do not immediately fall, firms end up producing only what is demanded. Firms will choose to reduce output in response to weak demand to avoid unwanted inventory accumulation.

23. Suppose planned aggregate expenditure is greater than actual aggregate expenditure. In this case, what do you think will happen to output over time? [LO 11.7] Answer: If actual aggregate expenditure is less than planned aggregate expenditure, then actual investment is less than planned investment. In this case, firms must be adding less output to inventory than was planned, meaning they are selling more than they expected. Firms will have an incentive to increase output.

24. Suppose the economy is experiencing a recessionary output gap. What has happened to planned aggregate expenditure? What might have caused this change? [LO 11.8] Answer: If the economy is in a recessionary gap, then the current level of equilibrium output is below potential output. In this case, the planned aggregate expenditure line shifted down due to a change in some nonincome determinant such as an increase in interest rates, a drop in consumer or firm optimism, an increase in taxes, or a decrease in government spending.

25. Suppose that an increase in business confidence increases investment expenditure by one million dollars. How do you expect this increase in investment expenditure to affect equilibrium output? Will equilibrium output increase by exactly one million, more than one million, or less than one million? [LO 11.9] Answer: Equilibrium output will increase by more than one million dollars due to the multiplier effect. A multiplier effect occurs because of an increase in consumer spending that occurs when spending by one person causes others to earn more income and therefore spend more too, increasing the impact on the economy of the initial spending. In this case, when 1-162 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

firms increase spending by one million dollars, this will increase income by one million dollars and cause consumption spending to rise by some amount that depends on the marginal propensity to consume. This process will repeat itself as firms produce more output in response to the extra spending, and this in turn leads to more consumption spending.

26. Define the relationship between the expenditure multiplier and the marginal propensity to consume. If the marginal propensity to consume increases, what happens to the expenditure multiplier? [LO 11.9] Answer: Equilibrium output will increase by more than one million dollars due to the multiplier effect. A multiplier effect occurs because of an increase in consumer spending that occurs when spending by one person causes others to earn more income and therefore spend more too, increasing the impact on the economy of the initial spending. In this case, when firms increase spending by one million dollars, this will increase income by one million dollars and cause consumption spending to rise by some amount that depends on the marginal propensity to consume. This process will repeat itself as firms produce more output in response to the extra spending, and this in turn leads to more consumption spending.

Problems and Applications 1. ―People who earn more income tend to have higher levels of consumption spending, so the value of their marginal propensity to consume must be greater than that of lower income people.‖ Do you think this is a true statement? Why or why not? [LO 11.1] Answer: This statement is false because the marginal propensity to consume is a proportion of additional income spent. The average propensity to consume is the proportion of income spent. The average propensity to consume is likely lower for those with higher incomes.

2. Do you think there is a predictable relationship between the business cycle and aggregate investment spending? Why or why not? [LO 11.2] Answer: When the economy is in a recession, spending on goods and services falls, so firms will reduce production. Because firms are producing less output, they don't need to hire as many workers and this causes unemployment to rise. Rising unemployment leads to a reduction in income. Firms will be less likely to purchase new equipment and expand their productive capacity because planned aggregate expenditure has fallen. During a recession, aggregate investment spending falls. During an expansion, aggregate investment spending rises.

3. ―During a recession more people qualify for unemployment insurance. This will increase the 1-163 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

government spending category of GDP and help reduce the severity of the recession.‖ Do you agree with this statement? Why or why not? [LO 11.3] Answer: Unemployment insurance is a government program that provides cash benefits to eligible workers who have lost their jobs. The purpose of the program is to reduce the severity of recessions. When people lose their jobs during a recession, their income falls and this causes consumption to fall. The cash benefits from the government act as temporary income and this causes consumption to rise. Note the cash benefit is typically not more than 50% of the worker’s lost salary and the benefits can only be collected for 26 weeks during normal times. The cash benefits are government transfer payments and, therefore, they do not count as part of the government spending category.

4. ―When one country in the world falls into a recession, this tends to cause other countries to also fall into a recession.‖ Do you agree with this statement? Why or why not? [LO 11.4] Answer: When a country falls into recession, the levels of output and income will decrease.

Because firms are producing fewer goods, they need fewer workers and unemployment will increase. The reduction in income will reduce consumption spending. People will spend less on domestically produced goods and on imported goods, so imports will fall. When imports fall, net exports will increase because net exports is equal to exports minus imports.

Given imports to the country in recession have fallen, exports from the trade partners will fall. This will reduce the level of production and income in the trade partners’ countries.

When one country in the world fall into a recession, this tends to cause other countries to also fall into a recession, given the importance of global trade.

5. For each of the following shocks, identify what component(s) of planned aggregate expenditure is/are directly affected and in which direction. [LO 11.1, 11.2, 11.3, 11.4] a. Tax rates increase. b. China experiences an economic boom. c. People become more optimistic regarding their future prospects. d. Congress decides to increase funding for education. e. German fashion designs become popular among celebrities Answer: a. When income tax rates increase, disposable income will fall, consumption will fall, and planned aggregate expenditure will fall. b. When China experiences an economic boom, it will buy more goods from other countries. Our net exports will rise. c. When people become more optimistic regarding their future prospects, they are likely to consume more and save less. Consumption will increase. d. When Congress decides to increase funding for education, government spending will 1-164 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

increase. e. When German fashion designs become popular among celebrities, spending on imported clothing will rise. Net exports will decrease.

6. Draw a planned aggregate expenditure curve as described in the chapter. Then show what happens to the planned aggregate expenditure curve in each of the following scenarios. [LO 11.6] a. Government spending increases. b. Business taxes increase. c. Aggregate income decreases.

Answer: Planned aggregate expenditure is equal to the sum of consumption spending, planned investment spending, government spending, and net exports: PAE = C + I + G + NX. a. An increase in government spending will shift the PAE curve upwards. Equilibrium output will increase.

b. An increase in business taxes will reduce planned investment spending and the PAE curve will shift downwards. Equilibrium output will decrease.

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c. A decrease in aggregate income causes a downward movement along the PAE curve and not a shift of the curve. A shift is caused by a change in autonomous expenditure.

7. Draw a planned aggregate expenditure curve for an economy where autonomous expenditure is $500 billion and the marginal propensity to consume is equal to 0.75. [LO 11.6] Answer: If autonomous expenditure is $200 billion, then the planned aggregate expenditure curve intersects the vertical axis at the point (0, 200). The marginal propensity to consume measures the amount by which consumption increases when income (Y) increases. If income increases by 100 and the MPC is 0.50, then consumption will increase by 50. When consumption increases by $50 billion, then so does planned aggregate expenditure. The second point on the curve is (100, 250). The remaining points are (200, 300), (300, 350), (400, 400), and (500, 450).

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8. Which of the following would be classified as an autonomous change to planned aggregate expenditure? [LO 11.5] a. Interest rates in an economy decrease. b. Current income in an economy increases. c. Domestic goods become more expensive relative to foreign goods. d. Congress decides to undertake an infrastructure repair project.

Answer: An autonomous change to planned aggregate expenditure is a change that is independent of current income. Changes in autonomous spending shift the planned aggregate expenditure curve. A decrease in interest rates will increase planned aggregate expenditure. If domestic goods become more expensive relative to foreign goods, then people will prefer to buy imported goods. Planned aggregate expenditure will decrease. If Congress decides to undertake an infrastructure repair project, then government spending will increase and this will cause planned aggregate expenditure to increase.

9. Consider the planned expenditure curve in Figure 11P-1. What is the level of autonomous expenditure in this economy? [LO 11.5, 11.6]

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Answer: Autonomous expenditure is the level of expenditure in the economy when output (Y) is equal to zero because it represents spending independent of income. This is found by looking at the point where the planned aggregate expenditure curve (PAE) intersects the vertical axis. Autonomous expenditure is equal to $100 billion.

10. Consider the data presented in Table 11P-1. [LO 11.7]

a. What is the marginal propensity to consume for households in this economy? b. Based on the assumptions of our aggregate expenditure model, fill in the columns for planned investment, government spending, and net exports. What is this type of expenditure called? c. For each level of actual aggregate expenditure, calculate unplanned inventory investment. d. What is the equilibrium level of aggregate expenditure in this economy? How do you know? e. For each level of actual aggregate expenditure, label the future output tendency as 1-168 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

―increase,‖ ―decrease,‖ or ―same‖ based on what you expect to happen to future output.

What relationship does this categorization have to your answer in part d?

Answer:

a. The marginal propensity to consume measures the amount by which consumption will increase when income increases. The marginal propensity to consume is calculated as the change in consumption divided by the change in income. From the table, observe that as income increases by $50 billion (400 – 350), consumption increases by $20 billion (220 – 200). The MPC is therefore 20/50, or 0.40. b. The aggregate expenditure model assumes that planned investment, government spending, and net exports are fixed at the given amounts. This type of spending is called autonomous spending because it is independent of changes in income. When income changes, we assume planned investment, government spending, and net exports do not change. This assumption is made to make the model easier to understand. c. Planned aggregate expenditure is equal to C + I + G + NX and these values are recorded in the table above. For example, at an income level of Y = 350: C + I + G + NX = 200 + 60 + 90 + 60 = $410 billion.

If people spend $410 billion and production is only $350 billion, then unplanned inventory investment is equal to 350 – 410 = -$60 billion. d. The equilibrium level of aggregate expenditure is Y = $450 billion. At this level of output, Y = C + I + G + NX and unplanned inventory investment is equal to zero. e. Inventory investment measures the change in the stock of inventory. If unplanned inventory investment is negative, then production is less than sales and firms are depleting their stock of inventory. In this case, the tendency will be to increase output.

When unplanned inventory investment is negative, then production is greater than sales and firms will tend to decrease output in upcoming months. f. At the equilibrium level of output, firms have no tendency to change output and unplanned inventory investment is equal to zero.

11. Suppose that an economy is at an aggregate expenditure equilibrium at an output level of $300 billion. [LO 11.7] a. Show this point on a planned versus actual aggregate expenditure graph.

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b. Label a point on the planned aggregate expenditure curve where the economy will decrease its output next year. (To do this, pick a specific level of output that makes sense.) c. Label a point on the planned aggregate expenditure curve where the economy will increase its output next year. (To do this, pick a specific level of output that makes sense.)

Answer:

a. Output is at its equilibrium level if planned aggregate expenditure is equal to actual aggregate expenditure. Graphically, this means the planned aggregate expenditure curve (PAE) intersects the PAE = Y line. Equilibrium output is $300 billion. b. From the PAE curve, planned aggregate expenditure is equal to $250 billion at an output level of $200 billion. Because planned expenditure is greater than actual expenditure, output in the economy will increase in the upcoming year. c. From the PAE curve, planned aggregate expenditure is equal to $350 billion at an output level of $400 billion. Because planned expenditure is less than actual expenditure, output in the economy will decrease in the upcoming year.

12. Consider the data presented in Table 11P-2. [LO 11.7, 11.8]

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a. For each level of actual aggregate expenditure, calculate unplanned inventory investment. b. What is the equilibrium level of aggregate expenditure in this economy? How do you know? c. Suppose that planned investment increases by $50 billion. What is the new equilibrium level of aggregate expenditure in this economy? d. What is the marginal propensity to consume in this economy? e. What is the expenditure multiplier in this economy?

Answer:

The aggregate expenditure model assumes that planned investment, government spending, and net exports are fixed at the given amounts. This type of spending is called autonomous spending because it is independent of changes in income. When income changes, we assume planned investment, government spending, and net exports do not change. This assumption is made to make the model easier to understand. a. Planned aggregate expenditure is equal to C + I + G + NX and these values are recorded in the table above. For example, at an income level of Y = 500: C + I + G + NX = 300 + 150 + 100 + 50 = $600 billion.

If people spend $600 billion and production is only $500 billion, then unplanned inventory investment is equal to 600 – 500 = -$100 billion. b. The equilibrium level of aggregate expenditure is Y = $700 billion. At this level of output, Y = C + I + G + NX and unplanned inventory investment is equal to zero. c. If planned investment spending increases by $50 billion, then the new equilibrium level 1-171 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

of aggregate expenditure is Y = $800 billion. You could redo the numbers in the table to find this new level of equilibrium output, as is shown below. You could also calculate the expenditure multiplier and find the new equilibrium level of aggregate expenditure, as is explained in part f below.

d. The marginal propensity to consume measures the amount by which consumption will increase when income increases. The marginal propensity to consume is calculated as the change in consumption divided by the change in income. From the table, observe that as income increases by 100 (600 – 500), consumption increases by 50 (350 – -300). The MPC is therefore 50/100, or 0.50. e. The expenditure multiplier is calculated as 1/(1 – MPC), or 1/(1 – 0.50) = 2. This means that for every dollar increase in autonomous expenditure, equilibrium output will increase by $2. Note that when planned investment spending increased by $50 billion, equilibrium output increased by $100 billion.

13. Consider the graph in Figure 11P-2, where the full-employment level of output is given by YFE and is the equilibrium level of aggregate expenditure for curve PAE1. [LO 11.8]

a. Which planned aggregate expenditure curve will result in a recessionary output gap?

Label the size of the recessionary output gap on the graph.

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b. Which planned aggregate expenditure curve will result in an inflationary output gap?

Label the size of the inflationary output gap on the graph.

Answer:

a. If planned aggregate expenditure is given by PAE3 in the diagram above, this economy is in a recessionary output gap. In this equilibrium, the economy is producing $200 billion less than its full-employment level of output. The size of the output gap is given by the difference between the current equilibrium level ($300 billion) and the full-employment output level ($500 billion). b. If planned aggregate expenditure is given by PAE2 in the diagram above, this economy is in an inflationary output gap. In this equilibrium, the economy is producing $200 billion more than its full-employment level of output.

14. Consider the graph in Figure 11P-3. [LO 11.9]

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a. What is the expenditure multiplier in this economy? b. What is the marginal propensity to consume in this economy?

Answer: a. The expenditure multiplier measures the change in equilibrium output caused by a change in autonomous expenditure. The change in autonomous expenditure is given by the vertical shift in the PAE curve. For any income level, the vertical distance between the two PAE lines is $150 billion. When the PAE line shifts upwards, equilibrium output increases from $500 billion to $800 billion, an increase of $300 billion. Therefore, the expenditure multiplier is equal to $300 billion/$150 billion, or 2. b. The marginal propensity to consume measures the change in consumption resulting from a change in income. The slope of the PAE curve is the marginal propensity to consume because when income increases, consumption increases and this causes the upward movement along the PAE line, given that all other expenditure is assumed to be autonomous. Looking at PAE1, when income increases from $500 billion to $800 billion, planned aggregate expenditure increases from $500 billion to $650 billion. The marginal propensity to consume equals the change in consumption, $150 billion, divided by the change in income, $300 billion, or 0.50.

15. In each of the following scenarios, describe and calculate the overall effect on aggregate expenditure. [LO 11.9] a. A recent stock market boom has increased household wealth by $20 billion, which increases consumption by $10 billion, and the marginal propensity to consume in the economy is equal to 0.5. b. Rising interest rates reduce domestic consumption by $3 billion and reduce investment by $4 billion, and the marginal propensity to consume in the economy is equal to 0.5.

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a. If household wealth increases by $20 billion and this increases consumption by $10 billion, then the change in autonomous expenditure is $10 billion. If the marginal propensity to consume in the economy is equal to 0.5, then the expenditure multiplier is equal to 1/(1 – 0.5), or 2.0. Therefore, the change in aggregate expenditure is equal to $10 billion × 2.0, or $20 billion. b. If rising interest rates reduce domestic consumption by $3 billion and reduce investment by $4 billion, then the change in autonomous expenditure is -$7 billion. If the marginal propensity to consume in the economy is equal to 0.7, then the expenditure multiplier is equal to 1/(1 – 0.5), or 2.0. Therefore, the change in aggregate expenditure is equal to -$7 billion × 2.0, or -$14 billion.

.

CHAPTER 12 AGGREGATE DEMAND AND AGGREGATE SUPPLY Solutions to End-of-Chapter Questions and Problems Review Questions 14. Identify the four components of aggregate demand. Explain the relationship between aggregate demand and the price level. [LO 12.1] Answer: Aggregate demand is made up of consumption, investment, government spending, and net exports.

There is a negative relationship between aggregate demand and the price level because when the price level rises, planned aggregate expenditure will decrease, causing firms to decrease production of goods and services. A rise in the price level reduces the real value of income and wealth, so consumption falls. When the price level rises, the interest rate also tends to rise, so investment spending will fall because it is more expensive to borrow. When the price level rises, domestic goods are more expensive, so exports, and hence net exports, will fall.

15. The demand curves for individual goods are typically downward-sloping, due both to the substitution effect as well as to the income effect. Why does the substitution effect not affect the aggregate demand curve? [LO 12.1] Answer: The demand curve for an individual good is downward-sloping because an increase in the price of the good will reduce the amount of the good purchased, assuming the prices of all other goods remain the same. When the price of the good rises, other goods 1-175 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

become relatively cheaper and people have an incentive to substitute towards another similar good.

The aggregate demand curve is downward-sloping because an increase in the price level (or the price index) will reduce the real value of income and wealth, and people will reduce the quantity of goods and services purchased. In this case there is no substitution effect because the overall price level is rising, so we are thinking about the effect of a change in overall purchasing power, and not the effect of a change in relative prices that causes people to substitute away from one good and towards another.

16. What is the relationship between the equilibrium level of aggregate expenditure in an economy and the aggregate demand curve? According to the aggregate expenditure equilibrium model, why does the aggregate demand curve slope downward? [LO 12.1] Answer: When the price level rises, the planned aggregate expenditure line shifts downwards because the higher price level reduces the real value of income and wealth so there is less consumption spending. Our exports are also more expensive, so there is less net export spending. The decrease in planned aggregate expenditure causes firms to decrease production of goods and services. This explains why the aggregate demand curve slopes downwards.

17. What effect does rising business optimism and confidence have on the aggregate demand curve? What effect does falling optimism and confidence in business prospects have on the aggregate demand curve? [LO 12.2] Answer: Aggregate demand is the sum of the four spending sectors (consumption, investment, government spending, and net exports). When consumers have more confidence (consumption) and when business optimism rises (investment), the aggregate demand curve will shift to the right, representing an increase in aggregate demand. When consumers have less confidence (consumption) and when business optimism falls (investment), the aggregate demand curve will shift to the left, representing a decrease in aggregate demand.

18. List several events that could cause a ―demand-side‖ recession (i.e., a recession caused by a fall in aggregate demand). [LO 12.2] Answer: Anything that causes C, I, G, or NX to fall will result in a demand side recession.

These things include, but are not limited to: a collapse in wealth due to a stock market or housing market crash, a fall in consumer or business confidence, a fall in government spending, an increase in taxes, an increase in interest rates, or a collapse in foreign demand for a country’s exports.

19. Everything else equal, which will have a larger effect on aggregate demand and GDP: a $100 1-176 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

million reduction in taxes or a $100 million increase in government spending? Is everything else equal in practice? Why or why not? [LO 12.3] Answer: The $100 million increase in government spending will have a larger effect because planned aggregate expenditure will initially rise by the full $100 million. When taxes are cut by $100 million, this will cause disposable income to rise by $100 million and consumption will rise by less than $100 million because the MPC is less than 1. For example, if the MPC is 0.9, then the $100 million tax cut will increase consumption spending (and therefore planned aggregate expenditure) by an initial amount of $90 million.

20. Suppose the economy is in a recession and the president wants to stimulate production and create jobs. To do this, he has decided to increase government spending. Some of his economic advisors are suggesting the marginal propensity to consume (MPC) has a value of 0.9 and others are suggesting the value is 0.8. How will this difference in the value of the MPC affect the president’s decision regarding the dollar amount of the increase in government spending? [LO 12.3] Answer: The expenditure multiplier is equal to 1/(1 - MPC). If the MPC has a value of 0.9, then the expenditure multiplier is equal to 10. If the MPC has a value of 0.8, then the expenditure multiplier is equal to 5. If the president believes the MPC has a value of 0.9, then he will choose to increase government spending by less than the amount he would choose if he believed the MPC had a value of 0.8. With an MPC of 0.9, any given increase in government spending will increase output (GDP) by a factor of 10, as opposed to a factor of 5 with an MPC of 0.8. Therefore, the change in government spending does not need to be as large.

21. Which typically can change faster: the components of aggregate demand or the components of aggregate supply? Explain. [LO 12.4] Answer: Typically, the components of AD can change faster than the components of AS. A person can make a quick decision about whether to buy a new car (C). A business can make a quick decision about whether to build a new plant (I). The government can make a quick decision about whether to spend more money. Increasing the number of workers, the amount of capital, or the level of technology in a country, all of which affect AS, takes a long time to occur. The only component of AS that can change somewhat quickly is price expectations, but even this can be somewhat slow due to wage and price stickiness.

22. Explain the difference between sticky wages and sticky prices. How do these two ideas explain the upward slope of the short-run aggregate supply curve? Why don’t sticky wages or sticky prices affect the long-run aggregate supply curve? [LO 12.4] Answer: Sticky wages are contracts that keep wages fixed between businesses and workers, while sticky prices are contracts that keep prices fixed between businesses and their 1-177 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

suppliers. The SRAS is upward-sloping because as prices of a firm’s products rise, it is willing to supply more if its input costs are not rising at the same time. Thus, in the presence of sticky wages and prices, the SRAS is upward-sloping. Sticky wages and prices don’t affect the LRAS because eventually every contract expires and firms, workers, and consumers renegotiate prices. Thus, prices and wages are only sticky in the short run, not in the long run. In the long run, prices and wages will adjust and output will be equal to potential output, so the LRAS is vertical.

23. List several events that could cause a ―supply-side‖ recession (i.e., a recession caused by a fall in aggregate supply). [LO 12.5] Answer: Anything that reduces L, K, or technology, or increases the prices of inputs can cause a supply side recession. Examples include, but are not limited to, famine, migration, war, large increases in oil or food prices, and significant increases in corporate taxes.

24. In the late 1990s, the United States experienced very high GDP growth, record low unemployment rates, and virtually nonexistent inflation. Based on the conclusions of the AD/AS model, what could explain this combination of good economic results? [LO 12.5, 12.6] Answer: High GDP growth and low unemployment must mean that AD or AS was shifting to the right. However, if AD were shifting right, there should be upward pressure on prices, but instead the late 90s experienced almost no inflation. A shift right in either SRAS or LRAS, on the other hand, would cause output to rise while putting downward pressure on prices. So, the boom of the late 90s must have been the result of a rightward shift in SRAS or LRAS. While lots of things can cause a shift in AS, the most likely culprit in the late 90s was an increase in technology as the Internet spread throughout the economy.

25. Why is long-run economic growth generally positive rather than negative? [LO 12.5] Answer: Long-run changes in output are driven by changes in the LRAS. The primary components of LRAS are L, K, and technology. While all three of these can either rise or fall, at least with technology, this component tends to go only one direction. Once something is discovered or invented, it is rarely forgotten, so technology causes economic output to steadily grow. Of course, it is possible for technology to go backwards. The dark ages represented a long period of time in Europe where, for a variety of reasons, things were forgotten. Thus, economic growth stagnated and potentially even reversed for many centuries. More recently, in Cambodia in the late 1970s, the Khmer Rouge dictatorship actively destroyed the country’s existing modern technology, significantly reducing GDP (as well as resulting in the deaths of roughly 2 million citizens.)

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when consumer confidence falls. [LO 12.6] Answer: When consumer confidence falls, in the short run, aggregate demand will shift to the left, reducing equilibrium GDP and the price level. In the long run, the lower price level resulting from reduced aggregate demand will lower costs, increasing the aggregate supply curve and shifting it to the right.

27. Suppose a country is in the midst of an economic boom and is running large budget surpluses. The president suggests that due to the good economic conditions, the time is ripe for a large tax cut. What are the arguments for and against this position? [LO 12.6, 12.8] Answer: The fact that the country is experiencing a boom should lead one to believe that the economy is at or above its usual long-run equilibrium. The president is suggesting that the country now further stimulate the economy by cutting taxes. This will push AD to the right and increase output even further. However, this higher level of output is above LRAS, so it is not sustainable. SRAS will eventually shift left bringing the economy back to its original level of output but with much higher prices. Cutting taxes in an economic boom can’t produce a long-run increase in output and will only serve to overheat an already booming economy. While the president’s suggestion might sound right, this is actually poor macroeconomic policy.

28. Suppose a country is in the midst of a serious recession, with high unemployment and large government deficits. The president suggests that in times like this the government has the obligation to ―tighten its belt‖ and cut spending, since so many families around the country have to do the same thing. Do you agree with the president? Why or why not? [LO 12.6, 12.8] Answer: The fact that the country is experiencing a recession should lead one to believe that the economy is below its usual long-run equilibrium. The president is suggesting that the country now further restrain the economy by raising taxes and cutting spending. This will push AD to the left and decrease output even further. While the president’s suggestion might sound right, this is actually poor macroeconomic policy.

29. Using the aggregate demand and aggregate supply model, explain the difference between a one-year drought and permanent climate change. What happens to the price level and output in the short run and in the long run for each type of shock? [LO 12.5, 12.6, 12.8] Answer: A one-year drought raises the price of inputs to the production of food, shifting the SRAS to the left, raising prices, and reducing output. However, when crop yields recover during the next growing season, SRAS will shift back to the right to its original position, bringing the economy back to long-run equilibrium. (If producers anticipate a return to normal crop yields before they actually arrive, the SRAS may actually shift back even earlier.) A permanent change in the growing climate that makes producing food harder will 1-179 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

shift LRAS (and SRAS) to the left. Since the LRAS shifts, prices are permanently higher and output is permanently lower.

30. A government official observes that there has been a short-run increase in the price level. Is it possible for her to determine whether this was caused by a demand shock or a supply shock?

Why or why not? [LO 12.9] Answer: This was caused by a positive demand shock or a negative supply shock. A positive demand shock will increase aggregate demand—the aggregate demand curve will shift to the right, causing firms to increase production and the price level. A negative supply shock will decrease short-run aggregate supply; the short-run aggregate supply curve will shift to the left as firms increase prices and production falls.

A negative demand shock would shift the aggregate demand curve to the left and the price level would fall.

A positive supply shock would shift the short-run aggregate supply curve to the right and the price level would fall.

31. A government official observes that there has been a long-run increase in the price level but no change in the level of potential output. Is it possible for her to determine whether this was caused by a demand shock or a supply shock? Why or why not? [LO 12.9] Answer: This was caused by a positive demand shock. A positive demand shock will increase aggregate demand; the aggregate demand curve will shift to the right, causing firms to increase production and the price level. In the long run, the prices of inputs and the wages of workers will increase, causing the short-run aggregate supply curve to shift to the left. The price level will increase further and output will return to potential.

A negative supply shock will decrease short-run aggregate supply; the short-run aggregate supply curve will shift to the left as firms increase prices and production falls. Assuming this is a temporary supply shock, in the long run, the short-run aggregate supply curve will shift back to the right, causing the price level and output to return to their initial long-run levels.

A negative demand shock would shift the aggregate demand curve to the left and the price level would fall. In the long run, the prices of inputs and the wages of workers will decrease, causing the short-run aggregate supply curve to shift to the right. The price level will decrease further and output will return to potential.

A positive supply shock will increase short-run aggregate supply; the short-run aggregate supply curve will shift to the right as firms decrease prices and production rises. Assuming this is a temporary supply shock, in the long run, the short-run aggregate supply curve will shift back to the left, causing the price level and output to return to their initial long-run levels.

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32. Why does the government have a harder time counteracting shifts in AS than in AD? [LO 12.8, 12.10] Answer: The main problem is that leftward shifts in AS both raise prices and reduce output.

Standard policies can only cure one of these two problems at a time. If the government raises spending or cuts taxes, output can be restored, but at the cost of even more upward pressure on prices. If the government cuts spending or raises taxes, prices can be restored to their previous levels, but output falls even further.

33. Whenever AD or AS shifts, putting the economy out of long-run equilibrium, AS has a natural tendency to shift in such a way as to bring the economy back into long-run equilibrium. If the economy always eventually comes back to long-run equilibrium, why would the government ever try to implement policies to bring the economy into equilibrium through government means? [LO 12.10] Answer: There are two reasons. First, when AD shifts the economy experiences a short-run change in output and both a short-run and long-run change in prices. The appropriate government response can eliminate the long-run shift in prices. Second, negative shifts in AS or AD cause a reduction in output and a corresponding increase in unemployment. The natural return to full unemployment may take a long time and government action can speed up the process reducing suffering.

Problems and Applications 1. Is there a negative, positive, or no relationship between the price level and the following components of aggregate demand? [LO 12.1] a. Consumption. b. Investment. c. Government spending. d. Net exports.

Answer: a. Negative relationship: An increase in the price level will reduce the real value of income and wealth and, therefore, consumption spending falls. b. Negative relationship: When the price level increases, interest rates also tend to increase, leading to a decrease in investment spending because it is more expensive for firms to borrow. c. No relationship: A change in the price level has no direct effect on government spending. d. Negative relationship: An increase in the price level causes domestic goods to be 1-181 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

relatively more expensive than imports, leading to an increase in import spending and a decrease in net export spending.

2. If the government cuts taxes, what components of aggregate demand are affected? [LO 12.1] Answer: A cut in personal income taxes or sales taxes will increase consumption spending because disposable income will increase. A cut in capital gains taxes or corporate income taxes is likely to increase investment spending because profit will increase. Governments make their decisions about taxing and spending together as part of fiscal policy, and as a general rule are not required to reduce spending just because they reduce taxes. Exports of goods are typically not taxed. Some imported goods are subject to tariffs, but a change in the tariff on a particular good is not likely to be large enough to have a significant impact on imports as a whole.

3. Consider the planned aggregate expenditure lines in Figure 12-1. [LO 12.1]

a. Suppose that the planned aggregate expenditure lines correspond to price levels of 100, 110, and 120. Which line corresponds to which price level? b. Use the information in the expenditure diagram to trace out the aggregate demand curve for this economy.

Answer: Planned aggregate expenditure line PAE1 corresponds to a price level of 80, planned aggregate expenditure line PAE2 corresponds to a price level of 120, and planned aggregate expenditure line PAE3 corresponds to a price level of 160. As the price level rises, the planned aggregate expenditure line shifts downwards due to a reduction in consumption, investment, and net export spending. By plotting the three price level—output pairs (160, $40 billion), (120, $60 billion), and (80, $80 billion)—we trace out the aggregate demand curve.

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4. For each of the following shocks, say whether it is a demand-side shock or a supply-side shock. [LO 12.2, 12.5] a. Consumer confidence falls. b. Government spending increases. c. The price of foreign goods increases. d. The price of oil increases. e. A cyclone destroys manufacturing plants.

Answer: a. Demand-side shock: Consumption spending will fall and the AD curve will shift left. b. Demand-side shock: Government spending is one of the four components of AD, so the AD curve will shift right. c. Demand-side shock: Foreign goods are now relatively more expensive, so imports will fall as people switch to relatively cheaper domestic goods. The AD curve will shift right. d. Supply-side shock: Oil is an input to production, so production cost will rise and the SRAS will shift left. e. Supply-side shock: Manufacturing plants represent capital, a component of LRAS, so LRAS and SRAS will shift left.

5. In the late 1990s, the U.S. experienced a technology boom. In part the boom was due to a revolution in communication technology that resulted in a massive expansion of the Internet; in part the boom was due to households and firms purchasing new computer equipment in 1-183 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

anticipation of Y2K. What two curves of the model would be affected by these events? [LO 12.2, 12.5] Answer: The revolution in technology affects AS because the new technology allows firms to produce more goods and services. LRAS and SRAS will shift to the right, increasing output and decreasing the price level. The purchase of consumer electronics and office equipment in anticipation of Y2K affects AD because both consumption spending and investment spending will increase. An increase in AD will increase output and the price level.

Thus, both factors will increase GDP, but they will have an opposite effect on the price level.

6. Suppose the marginal propensity to consume (MPC) is either 0.55, 0.95, or 0.75. [LO 12.3] a. For each value of the MPC, calculate the expenditure multiplier, or the impact of a onedollar increase in government spending on GDP. b. For each value of the MPC, calculate the impact on GDP of a $250 million increase in government spending. c. Explain the relationship between the MPC and the impact of a change in government spending on GDP. Answer: a. The expenditure multiplier is equal to 1/(1 – MPC).

MPC 0.55 0.95 0.75

Expenditure multiplier 1/(1 – 0.75) = 2.2 1/(1 – 0.95) = 20 1/(1 – 0.75) = 4

b. The impact on GDP (or the change in GDP) = the change in government spending times the expenditure multiplier.

MPC 0.55 0.95 0.75

Impact on GDP 2.2 × $250 = $550 20 × $250 = $5,000 4 × $250 = $1,00

c. The larger the value of the MPC, the larger the expenditure multiplier, and the larger the impact on GDP. This is because people spend a greater portion of any additional income.

7. Suppose the marginal propensity to consume (MPC) is either 0.75, 0.80, or 0.90. [LO 12.3] a. For each value of the MPC, calculate the impact of a one-dollar decrease in taxes on GDP. b. For each value of the MPC, calculate the impact on GDP of a $250 million decrease in taxes. c. Explain the relationship between the MPC and the impact of a change in taxes on GDP. 1-184 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Answer: a. The impact of a one-dollar decrease in taxes is equal to MPC/(1 – MPC).

MPC 0.75 0.80 0.90

Impact of a one-dollar decrease in taxes 0.75/(1 – 0.75) = 3 0.8/(1 – 0.8) = 4 0.9/(1 – 0.9) = 9

b. The impact on GDP (or the change in GDP) = the change in taxes times the impact of a one-dollar change in taxes. Note that when taxes decrease, then GDP will increase.

MPC 0.75 0.80 0.90

Impact on GDP 3 × $250 = $750 4 × $250 = $1,000 9 × $250 = $2,250

c. The larger the value of the MPC, the larger the impact on GDP of a one-dollar change in taxes. This is because people spend a greater portion of any additional income.

8. Say whether the following statements are true or false. [LO 12.4] a. In the long run, prices don’t affect output. b. In the short run, prices may affect output.

Answer: a. True. Long-run equilibrium is determined by the intersection of AD and the LRAS curve.

The LRAS curve is vertical, indicating that prices do not affect output over the long-run but instead are determined by factors of production such as L, K, and technology. b. True. Short-run equilibrium is determined by the intersection of AD and SRAS. Both of these curves show a clear connection between prices and output. On the demand side, prices affect output due to the wealth effect, interest rate effect, and foreign purchases effect. On the supply side, prices affect output due to sticky prices and sticky wages.

9. Say whether the following statements are true or false. [LO 12.4] a. If the prices of all final goods and services are sticky, then the short-run aggregate supply (SRAS) curve is horizontal at the given price level. b. If the prices of inputs and wages are not fixed by contracts, and instead adjust more quickly to demand and supply shocks, then the SRAS curve is more vertical.

Answer: a. This is true. If all prices are sticky, then the price level is fixed, and the SRAS is a horizontal line at the current price level.

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b. This is true. If the prices of inputs and wages adjust more quickly, then the price level will rise and fall more quickly for any given change in output. If prices and wages were perfectly flexible, then output would never deviate from potential because changes in aggregate demand would result in price changes and not output changes.

10. ―Fracking‖ is a relatively new technology that allows drillers to extract significantly larger quantities of natural gas from existing deposits than was previously possible. How is this discovery likely to affect the economy? (Hint: Think about whether this will have a short-run or long-run effect.) [LO 12.5, 12.6] Answer: Higher supplies of natural gas will lead to lower natural gas prices. (In fact, nominal natural gas prices in 2016 were about 75% lower than their peak in 2008.) Natural gas is an input to production. A reduction in its price will cause the short-run and long-run aggregate supply curves to shift to the right, assuming this is a permanent change and not a temporary change. This will increase output and reduce the price level.

11. Throughout the nineteenth and twentieth centuries, the U.S. economy experienced frequent ups and downs, but over the past 200 years, the real GDP in the United States rose from roughly $8.2 billion to over $16.1 trillion, an increase by a factor of nearly 2,000 times. This growth represents a change in which curve? [LO 12.6] Answer: Output can increase temporarily due to shifts in AD, but long-run changes in output can be achieved only by LRAS shifting to the right. Among the obvious explanations for this growth are a large increase in the labor force due to natural growth and immigration; a large increase in capital due to investments by both private industry and the government; and the discovery of a huge number of new technologies during the Industrial Revolution, the age of electricity, and the Information Age.

12. Suppose that a statement by the chair of the Federal Reserve Board about the state of the economy causes a loss of consumer confidence. What will be the long-run impact on the economy if the government allows the economy to adjust without a policy response? [LO 12.7] a. Output will fall below its initial level in the long run and the price level will decline. b. Output will return to its initial level in the long run, but the price level will be lower. c. Output will return to its initial level in the long run, but the price level will be higher. d. Output will rise above its initial level in the long run and the price level will rise.

Answer: b. A loss in consumer confidence is an example of a negative demand shock. The reduction in consumer spending will shift the AD curve to the left, causing production and the price level to fall. In the long run, prices of inputs and wages of workers will fall, leading to a further reduction in the price level. The SRAS curve will shift to the right and production will return to its initial long-run level.

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13. For each of the following situations, use an AD/AS model to describe what happens to price levels and output in the United States in the short run. In each case, assume the economy starts in long- and short-run equilibrium, and describe the appropriate shifts in the AS or AD curves. [LO 12.7, 12.8] a. A stock market crash reduces people’s wealth. b. The spread of democracy around the world increases consumer confidence in the United States. c. The European economy crashes. d. The United States enters into an arms race with China, resulting in a significant increase in military spending. e. A revolution in Iran results in a significant reduction in the world’s supply of oil. f. Terrorist activities temporarily halt the ability of Americans to engage in certain productive activities such as transportation and finance. g. Intel develops a new computer chip that is faster and cheaper than previous chips. h. A summer of perfect weather in the Midwest leads to record harvests of corn, wheat, and soybeans.

Answer: a. A stock market crash reduces wealth and therefore consumption spending, shifting the AD curve to the left. Output falls and the price level falls. b. A rise in consumer confidence increases consumption spending, shifting the AD curve to the right. Output rises and the price level rises. c. A crash in the European economy reduces their consumption spending, and therefore reduces our exports, shifting the AD curve to the left. Output falls and the price level falls. d. An arms race increases government spending, shifting the AD curve to the right. Output rises and the price level rises. e. A reduction in the world's supply of oil increases oil prices and therefore production costs, shifting the AS curve to the left. Output falls and the price level rises. f. If terrorist activities disrupt the transportation of goods and services and financial market activity, there is a temporary reduction in firms' ability to produce goods and services, so the AS curve shifts to the left. Output falls and there is an increase in the price level. g. The new chip is an example of an increase in technology that will increase production, shifting the AS curve to the right. Output rises and the price level will fall. h. The perfect weather is an example of a temporary increase in production. This will shift the AS curve to the right. Output rises and there is a decrease in the price level.

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14. For each of the following scenarios, say whether the shock was a demand-side shock, a supply-side shock, or a combination of both shocks. [LO 12.9] a. The price level and GDP both fell. GDP then increased, but the price level fell even further. b. In the long run, the economy had the same level of output but a higher price level. c. In the short run, the price level increased, but GDP fell. d. In the long run, GDP increased, and the price level fell. e. In the long run, GDP increased, and the price level was constant.

Answer: a. For the price level and GDP to fall, the AD curve must shift to the left. For GDP to then rise with the price level falling further, the SRAS curve must shift to the right. This is an example of a negative demand shock followed by a positive supply shock. b. First, the AD curve must have shifted to the right. Then the SRAS curve shifted to the left to move the economy back to long-run equilibrium at the previous output but a higher price level. This is an example of a combination of both shocks. c. For the price level to rise and GDP to fall in the short run, the SRAS curve must have shifted to the left. This is an example of a supply-side shock. d. If GDP changes in the long run, there must be a shift in LRAS. If the LRAS curve shifts to the right (along with a corresponding change in SRAS), output will rise and the price level will fall. This is an example of a supply-side shock. e. If GDP changes in the long run, there must be a shift in LRAS. As in part d, if the LRAS curve shifts to the right (along with a corresponding change in SRAS), output will rise and the price level will fall. In order to get a long-run increase in output but no change in the price level, AD must shift to the right as well. This is an example of a combination of both shocks.

15. In 2009, during the height of the U.S. financial crisis, real GDP fell 3.5 percent, and the Consumer Price Index fell from 215.3 to 214.9. Was this recession likely caused by a shift in aggregate demand or aggregate supply? [LO 12.9] Answer: The data indicate a decrease in production and a decrease in the price level. This is consistent with the AD curve shifting to the left. Thus, this recession appears to have been caused by a fall in aggregate demand. (A reduction in wealth due to the collapse in housing prices would cause a fall in aggregate demand, for example.)

16. In 1974, GDP fell by 0.6 percent, and inflation increased from 6.2 percent to 11.0 percent.

Was this recession likely caused by a shift in aggregate demand or aggregate supply? [LO 12.9] 1-188 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Answer: The data indicate a decrease in production and an increase in the price level. Thus, this recession appears to be caused by a decrease in aggregate supply. (Oil prices skyrocketed during this time period due to the Arab oil embargo.)

For questions 17–20, use an AD/AS model to answer the following questions. In each case assume the economy starts in long- and short-run equilibrium, and show the appropriate shifts in the AS or AD curves.

17. Suppose a stock market crash reduces people’s wealth. [LO 12.7, 12.8, 12.10] a. Show what happens to price levels and output in the U.S. in the short run. b. Suppose the government takes no action to help the economy. What happens to price levels and output in the long run? c. Suppose, instead, the government decides to take action to help the economy. What action(s) would you recommend? Why? d. If the U.S. government makes the appropriate policy response, what happens to price levels and output in the long run?

Answer: a. A stock market crash reduces the real value of income and wealth, causing a reduction in consumption spending and a shift of the AD curve to the left. Output falls and the price level falls. b. In the long run, input prices and wages of workers will decrease, causing SRAS to shift to the right to move the economy back to long-run equilibrium at the previous level of output but a lower price level. c. Cutting taxes or raising government spending will shift AD back to the right. d. AD shifts back to the right. If exactly the right amount of government help is provided, the economy returns to long-run equilibrium at the same output and price level as before the crash.

18. Suppose the spread of democracy around the world increases consumer confidence in the United States. [LO 12.7, 12.8, 12.10] a. Show what happens to price levels and output in the United States in the short run. b. Suppose the government takes no action to help the economy. What happens to price levels and output in the long run? c. Suppose, instead, the government decides to take action to help the economy. What action(s) would you recommend? Why? d. If the U.S. government makes the appropriate policy response, what happens to price levels and output in the long run?

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Answer: a. A rise in consumer confidence increases consumption spending, shifting the AD curve to the right. Output rises and the price level rises. b. In the long run, input prices and wages of workers will increase, causing SRAS to shift to the left to move the economy back to long-run equilibrium at the previous level of output but a higher price level. c. Raising taxes or cutting government spending will shift AD back to the left. d. AD shifts back to the left. If exactly the right amount of government restraint is provided, the economy returns to long-run equilibrium at the same output and price level as before the confidence boom.

19. Suppose a revolution in Iran results in a significant reduction in the world’s supply of oil.

[LO 12.8, 12.10] a. Show what happens to price levels and out-put in the United States in the short run. b. Suppose the government takes no action to help the economy. What happens to price levels and output in the long run? c. Suppose, instead, the government decides to take action to help the economy. What action(s) would you recommend? Why? d. If the U.S. government makes the appropriate policy response, what happens to price levels and output in the long run?

Answer:

a. A reduction in the world supply of oil will increase oil prices and production cost, shifting the SRAS curve to the left. Output falls and the price level rises.

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b. In the long run, world oil supplies will adjust and return to their previous level. The reduction in oil prices shifts the SRAS curve to the right to move the economy back to long-run equilibrium at the previous level of output and price level. c. Raising taxes or cutting government spending will shift AD to the left, leading to a further drop in output but a reduction in the price level. Cutting taxes or raising government spending will shift AD to the right, leading to a further increase in the price level but an increase in output and, therefore, a reduction in the level of unemployment.

Unlike recessions caused by shifts in AD, government responses to recessions caused by shifts in AS can’t cure all of the problems at the same time. d. AD shifts to the right. This shift will lead to an increase in the price level and output will return to its long-run initial value.

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20. Suppose a summer of perfect weather in the Midwest leads to record harvests of corn, wheat, and soybeans. [LO 12.8, 12.10] a. What happens to price levels and output in the United States in the short run? b. Suppose the government takes no action to help the economy. Show what happens to price levels and output in the long run. c. If the U.S. government reacts to the record harvests by increasing taxes or decreasing spending, what happens to price levels and output in the long run? d. What is the problem associated with the government reacting to the record harvests by increasing taxes or decreasing spending?

Answer:

a. The perfect weather is an example of a temporary increase in production. This will shift the SRAS curve to the right. Output rises and the price level falls. b. In the long run, SRAS will shift back to the left once the perfect weather is over. The price level and output will return to their initial levels. c. If the government reduces spending or increases taxes, then AD shifts to the left. Output will return to its initial level and the price level will be lower. d. An increase in taxes or a decrease in spending will bring output back to long-run equilibrium, but deflationary pressure will increase. The reduction in output will increase unemployment. When the government changes fiscal policy in response to a decrease in aggregate demand, they are able to reduce unemployment and reduce deflationary pressure. Responding to supply shocks is more difficult because the government cannot simultaneously reduce unemployment and deflationary pressure.

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CHAPTER 13 FISCAL POLICY Solutions to End-of-Chapter Questions and Problems Review Questions 1. What is the best fiscal policy for a country suffering from high inflation? [LO 13.1] Answer: Contractionary fiscal policy, which decreases aggregate demand, is the appropriate response. To do this, the government can increase taxes (reducing disposable income, affecting GDP indirectly) or decrease spending (with a direct effect on GDP).

2. If the government wants to reduce GDP by $500 million, should it increase or decrease its spending? Must it increase or decrease spending by exactly $500 million, some amount more than $500 million, or some amount less than $500 million? Would this be expansionary or contractionary fiscal policy? [LO 13.1] Answer: To reduce GDP by $500 million, the government should enact contractionary fiscal policy, which it can do by increasing taxes or—in this case—reducing government spending.

Due to the multiplier effect, it does not need to reduce its spending by the full $500 million, but rather by a smaller amount. The specific amount will be determined by the marginal propensity to consume (MPC)—the higher the MPC, the smaller the required decrease in government spending.

3. President Obama said the following in November 2010 when announcing a two-year pay freeze for civilian federal employees: ―After all, small businesses and families are tightening their belts. Their government should too.‖ What do you think the intended effect of this policy would be, assuming the economy was in a recession at the time? Do you think it was the appropriate response? Why or why not? [LO 13.2] Answer: Paying less to federal employees reduces government spending. The intended effect was likely to reduce the government deficit and the likelihood of crowding out (higher interest rates caused by government borrowing, discouraging other types of spending).

However, a decrease in government spending is contractionary fiscal policy. Reducing government spending will have a negative effect on GDP and income, which is the opposite of the usual remedy for recessionary conditions. Whether you think this is an appropriate response will depend on your opinion about the relative priorities that should be placed on keeping the public debt low versus avoiding especially painful recessions.

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4. If unemployment is high and spending is sluggish, what type of fiscal policy should be enacted? How would this be enacted via taxes? Via government spending? What is the intended effect of this policy on aggregate demand? [LO 13.2] Answer: In response to these recessionary conditions, the government would want to enact expansionary fiscal policy through increasing government spending or decreasing taxes. An increase in government spending would increase the ―G‖ component of aggregate demand directly, whereas a decrease in taxes would affect ―C‖ indirectly by changing disposable income. Successful expansionary fiscal policy would shift the AD curve to the right.

5. ―The problem with democracy,‖ your friend tells you as you debate politics, ―is the time it takes to get approval for every action the government takes. If the president didn’t have to spend so much time arguing back and forth with Congress, policy wouldn’t take so long to affect the economy.‖ Is your friend right or wrong? What would your response be? [LO 13.3] Answer: Assuming a benevolent leader who made choices that were good for the economy, the situation your friend describes would shorten or even eliminate one type of lag in policy implementation: formulation lag. However, two types of lag would still exist. Information lag comes about because it takes time to perceive and correctly identify problems in the economy; implementation lag comes about because once policies are passed, they take time to affect economic variables. Because of these lags, delays would not be eliminated—not to mention the controversies that would swirl around having an all-powerful president!

6. Explain the difference between tax rates and tax revenues, and how each is related to recession and policy enacted to counteract it. Do you expect to see tax rates rise or fall during recession? What about tax revenues? Explain your answer. [LO 13.4] Answer: Tax rates refer to the percentage of income that is taxed. It is the tax rate that is adjusted as part of fiscal policy, and in a recession (or when the government feels that a recession is a pressing threat) it is likely that those rates will be lowered. By doing so, consumers will have more disposable income, and some portion of that will be spent on goods and services, supplying income for their providers and stimulating further spending according to the multiplier effect. Tax revenues, on the other hand, refer to the dollars collected by government in taxes. Tax revenues are an automatic stabilizer; unlike tax rates, they do not require active government policy to change. In a recession, as overall income falls, so do the dollars paid in taxes by households. This increases the money left for spending, acting as a stimulus to the economy that needs no specific government action. This also means that tax revenues are not as susceptible to the information, formulation, and implementation lags that slow down discretionary policy.

7. The government decides to reduce income taxes due to a recession in the economy over the 1-194 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

past nine months. Will the reduction in income taxes boost spending in the economy? Why or why not? [LO 13.5] Answer: A reduction in income taxes will increase disposable income. If people decide to spend a portion of the increase in disposable income, then aggregate demand will increase and GDP will increase. However, the theory of Ricardian equivalence suggests that in some cases, people will choose not to spend any of the increase in disposable income and will instead save the extra income. They will choose to do this because they are forward looking and know that if the government reduces taxes and does not cut spending at the same time, then the government will have to borrow money to pay for the deficit (unless it had been running a surplus). This means that in the future, the government will have to increase taxes to pay off the debt. The evidence on whether Ricardian equivalence holds is mixed—often people spend a portion of any tax cut or rebate, in which case the reduction in taxes will boost spending in the economy.

8. Use the theory of Ricardian equivalence to explain why cutting taxes during a recession may not always be an effective expansionary fiscal policy. [LO 13.5] Answer: A reduction in income taxes will increase disposable income. If people decide to spend a portion of the increase in disposable income, then aggregate demand will increase and GDP will increase. The theory of Ricardian equivalence suggests that in some cases, people will choose not to spend any of the increase in disposable income and will instead save the extra income. They will choose to do this because they are forward looking and know that if the government reduces taxes and does not cut spending at the same time, then the government will have to borrow money to pay for the deficit (unless it had been running a surplus). This means that in the future, the government will have to increase taxes to pay off the debt. The evidence on whether Ricardian equivalence holds is mixed—often people spend a portion of any tax cut or rebate. Cutting taxes is only an effective strategy if people decide to increase spending in response to the tax cut.

9. Why have budget deficits been so high in the United States since 2007? [LO 13.6] Answer: There are several reasons for this, but the most important is recession: In a recession, the government pays more in transfer payments; government spending may increase or taxes may decrease because of expansionary fiscal policy; and since fewer people are employed during recession, overall incomes fall, bringing down tax revenues. All of these add up to perfect conditions for high budget deficits!

10. You hear on the nightly news that the president has vowed to decrease the nation’s debt. ―We’ll have to buckle down and learn to do without, both the government and private citizens,‖ he says. How can a nation lower its debt? How will the government and private citizens be affected? [LO 13.6] Answer: In order to reduce its debt, a nation must run lower deficits (or turn them into 1-195 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

surpluses). This can happen by increasing taxes (bringing in more tax revenue for the government) or decreasing government spending. But there will be costs involved—less government spending means fewer public works and lower transfer payments, and more taxes means less money available for households to spend.

11. A friend of yours looks at the state of the U.S. debt in 2018 and tells you, ―Since the debt is so high, we must be running an incredibly large deficit every year.‖ Is your friend’s analysis valid? Why or why not? [LO 13.7] Answer: The public debt is the sum of all deficits and surpluses run by the government over time. The debt can be high even when the deficit for an individual year is small (or even when the government runs a surplus for this year). Therefore, a high amount of debt does not necessarily imply a deficit in a given year.

12. Is it possible for a nation’s government to run a budget deficit in some years but not have national debt? Explain your answer. [LO 13.7] Answer: The correct answer lies in the distinction between a budget deficit (the excess of government spending over taxes in some year) versus national debt (the total of all budget deficits and surpluses). It is indeed possible for a nation to run a budget deficit in some year without national debt—for example, if the economy started with a surplus at the beginning of the year and the year’s deficit is less than or equal to the national surplus.

13. Explain the differences and similarities among Treasury bills, Treasury notes, and Treasury bonds. [LO 13.8] Answer: Treasury bills mature in less than a year. Treasury notes mature in anywhere from 2 to 10 years. Treasury bonds mature in 30 years. All three offer a known rate of return because they specify the amount for which the security can be sold back to the government upon maturity. Given the rate of return is known, they are all less risky than stocks or mutual funds, whose value changes depending on market activity. None of the securities guarantees a rate of return that exceeds inflation. There is a Treasury inflation-protected security that guarantees a rate of return higher than the rate of inflation.

14. Your friend thinks buying Treasury bills is riskier than leaving money in a savings account.

You disagree. Who is right? [LO 13.8] Answer: You are correct—Treasury bills offer the same level of risk as a savings account.

When you place money into a savings account, you are paid some rate of interest that is in the vast majority of cases a positive rate. Therefore, your money will increase in value over time. When you buy a Treasury bill, you are guaranteed a fixed payment on a particular date (the maturity date). Given you paid an amount that was less than the fixed payment, you will 1-196 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

increase the value of your money over time. In both cases, you end up with a sum of money that is larger than what you started with.

15. Taxpayers are clamoring for their government to be more responsible, and many strongly support a balanced-budget amendment. This would mean the country could no longer spend more than it takes in each year. Discuss the primary advantages and disadvantages of such a law. [LO 13.9] Answer: There are advantages and disadvantages to this type of law, making the decision whether to pass it not nearly as clear-cut as it may originally seem. A balanced-budget amendment will force the government to cut back on its spending, reducing the direct (interest) and indirect (pushing the burden of the debt onto future generations) costs of borrowing to fund public spending increases. However, it will also limit the flexibility of the government in engaging in expansionary fiscal policy. When recession exists or threatens, an increase in government spending can stimulate the overall economy through the multiplier effect. Money spent by the government puts income into the pockets of those it buys from, and some of this money will be spent, resulting in additional increases in GDP. Without the ability to borrow as it likes, the government will be less able to respond to recessionary conditions, and as a result recessions may be more painful and protracted.

16. Is government debt good or bad for the economy and the nation as a whole? Give one argument for each side of the debate. [LO 13.9] Answer: Government debt is good for the economy and nation in that it gives the government the flexibility to respond to economic conditions by changing its spending— specifically, by being able to increase its spending as part of expansionary fiscal policy in response to recessionary conditions. Without the ability to incur debt, the government would be limited to what it collects in taxes, and therefore it might not be able to increase spending as necessary to push GDP back up to its potential level. However, government debt can have negative effects as well. Crowding out can occur when government spending financed by debt increases interest rates, pushing up the cost of borrowing and discouraging spending by businesses and households. Also, debt must be repaid, which implies direct costs (in the form of interest) and indirect costs (pushing the burden of the debt onto future generations, who may suffer in several ways, including increased taxes).

Problems and Applications 1. Is each of the following policies an example of expansionary or contractionary fiscal policy?

Explain your answers in terms of the effect on aggregate demand. [LO 13.1] a. The government slashes funding for the Environmental Protection Agency, without changing any other spending. b. The government raises taxes on households making more than $250,000.

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c. The government decides to fill gaps in Medicare by making it available to more people.

Answer: a. This is contractionary fiscal policy because it involves a reduction in government spending, directly lowering aggregate demand. b. This is contractionary fiscal policy because it increases taxes, indirectly lowering aggregate demand via consumption. c. This is expansionary fiscal policy because it increases government spending, which increases aggregate demand directly.

2. The economy is growing far too quickly, as high aggregate demand is causing inflation. What fiscal policy should be pursued in this instance—expansionary or contractionary? What will be the effect of the appropriate policy on aggregate demand? [LO 13.1] Answer: Contractionary fiscal policy is appropriate in this instance. This policy will slow down spending, reducing aggregate demand and shifting the aggregate demand curve to the left.

3. Assuming that unemployment is high and spending is low, answer the following questions.

[LO 13.2] a. Should the government pursue expansionary or contractionary fiscal policy? b. What will the appropriate policy do to the aggregate demand curve? Will the curve shift to the right or to the left? c. Through which component(s) of aggregate demand (C, I, G, or NX, or some combination of the preceding) will the change occur?

Answer: a. Expansionary fiscal policy (increasing government spending or decreasing taxes) is the appropriate response to these recessionary conditions. b. Expansionary policy will shift the AD curve rightward. c. If government spending is increased, AD will increase directly through its G (government spending) component. If taxes are lowered, AD will increase indirectly through its C (consumption) component—lower taxes will increase disposable (spendable) income, allowing households to spend more.

4. The diagram in Figure 13P-1 shows aggregate demand for New Caprica last year (AD1) and this year (AD2). If you were to advise the president of New Caprica on economic policy, how would you answer the following? [LO 13.2]

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a. How large is current output? How large is potential output? What is the difference, if any, between the two? b. Is New Caprica in a recession or a boom? c. Given your findings, should the president enact expansionary or contractionary fiscal policy, or no policy at all? d. Which direction would the aggregate demand curve shift if the president used contractionary fiscal policy?

Answer: a. Current output is $60 million, found at the intersection of the current aggregate demand curve AD2 and the short-run aggregate supply curve SRAS. Potential output, found where the long-run aggregate supply curve LRAS intersects the aggregate demand curve (note that it doesn’t matter which—any AD curve will intersect the LRAS at potential output), is $80 million. This leaves us with a shortfall of output of $80 million – $60 million = $20 million. b. Since current output is less than potential output, New Caprica is experiencing a recession. c. To correct the recession, the president should enact expansionary fiscal policy. d. Contractionary fiscal policy would reduce spending, shifting the AD curve leftward. This would further increase the shortfall between actual and potential GDP in New Caprica, making the current situation worse rather than better.

5. ―Our fiscal policy was unsuccessful,‖ an economic analyst says, ―due to partisan bickering in Congress that delayed the passing of the appropriate measures and our failure to realize we were headed into recession until it was too late.‖ What type of lags is the analyst describing?

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[LO 13.3] Answer: The analyst is describing an information lag (related to recognizing the current economic situation, in this case, realizing when we are in recession) and a formulation lag (related to deciding on and passing policy through Congress).

6. Assume that the government in some nation intended to respond to low employment via fiscal policy. What type of policy would this require? Assume that this policy ended up having an undesirable outcome. How could this happen in terms of formulation and implementation lags? [LO 13.3] Answer: By the time legislation is decided on and passed (formulation lag) and affects the economy (implementation lag), economic conditions may have changed. The government was trying to respond to recessionary conditions with expansionary policy, which would increase prices and employment in the short run. Apparently, these lags took up enough time that economic conditions changed in the meantime, meaning that inflation became the major threat. Expansionary policy would make that inflation worse by stimulating spending when it should have been lowered, causing prices to rise even higher.

7. Saabira earns $68,000 a year and pays an average tax rate of 15 percent. [LO 13.4] a. Calculate Saabira's disposable income and the amount of tax she pays to the government. b. Suppose a recession hits the economy and Saabira's income falls to $60,000 per year due to the fact that she is earning a smaller annual bonus. If she now pays an average tax rate of 12 percent, what is her disposable income and the amount of tax she pays to the government? c. Calculate how much Saabira's annual salary and disposable income fell by due to the recession. d. Explain how income taxes are an automatic stabilizer in this example.

Answer: a. If Saabira pays an average tax rate of 15%, then she takes home 85% of her salary. Her disposable income is 0.85 × $68,000, or $57,800. She pays 0.15 × $68,000, or $10,200, to the government in taxes. b. If Saabira pays an average tax rate of 12%, then she takes home 88% of her salary. Her disposable income is 0.88 × $60,000, or $52,800. She pays 0.12 × $60,000, or $7,200, to the government in taxes. c. Saabira's annual salary fell by $68,000 – $60,000, or $8,000, and her disposable income fell by $57,800 – $52,800, or $5,000. d. Income taxes are an automatic stabilizer because when Saabira's annual salary fell, her tax rate also fell. This caused her disposable income to fall by a smaller amount than her annual salary.

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8. True or false? If the amount of time a person is eligible for unemployment compensation is reduced from 26 weeks to 4 weeks, people will have an incentive to quickly find a new job.

This occurs because unemployment compensation is an important automatic stabilizer for the economy. [LO 13.4] Answer: True. If a person is only eligible for unemployment compensation for 4 weeks, then he or she will have an increased incentive to quickly find a new job. If people receive unemployment compensation when they lose their jobs, then their spending does not fall by as much as it would if they received no compensation.

9. Consider three countries. The first country runs small budget surpluses each year. The other two countries run large budget deficits each year. In one of the deficit countries the national debt-to-GDP ratio has been steady, whereas in the other deficit country the national debt-toGDP ratio has been rising. Suppose each of these countries decides to reduce income taxes. Is Ricardian equivalence likely to hold in all of these countries? Why or why not? [LO 13.5] Answer: A reduction in income taxes will increase disposable income. If people decide to spend a portion of the increase in disposable income, then aggregate demand will increase and GDP will increase. The theory of Ricardian equivalence suggests that in some cases, people will choose not to spend any of the increase in disposable income and will instead save the extra income. They will choose to do this because they are forward looking and know that if the government reduces taxes and does not cut spending at the same time, then the government will have to borrow money to pay for the deficit, unless it had been running a surplus.

Ricardian equivalence is less likely to hold in the surplus country—since the country had a surplus, the tax cut is potentially sustainable. People are likely to spend the extra income.

Ricardian equivalence is more likely to hold in the country where the debt-to-GDP ratio has been rising. Not only has this country been running deficits, but the debt amount has been rising relative to GDP, indicating that the tax cut will be unsustainable in the future. The government is more likely to have to increase taxes to pay off, or reduce, the debt in the near future. People are more likely to save the extra income to prepare for higher taxes in the future.

10. A country is in the midst of a recession with real GDP estimated to be $2.7 billion below potential GDP. The government’s policy analysts believe the current value of the marginal propensity to consume (MPC) is 0.90. [LO 13.5] a. If the government wants real GDP to equal potential GDP, by how much should it increase government spending? Alternatively, by how much should it reduce taxes? b. Suppose that during the recession people have become less confident and decide they will spend only 50 percent of any additional income. In this case, if the government increases 1-201 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

spending by the amount calculated in part a, will real GDP end up less than, greater than, or equal to potential GDP? By how much? c. With the same decrease in consumer spending described in part b, if the government decreases taxes by the amount calculated in part a, will real GDP end up less than, greater than, or equal to potential GDP? By how much? d. Why is it difficult for the government to predict exactly how a change in spending or taxes will affect GDP? Answer: a. The government wants to increase GDP by $2.7 billion. Given the MPC is equal to 0.90, the expenditure multiplier is equal to 1/(1 – 0.9), or 10. This means that for every onedollar increase in government spending, GDP will increase by $10. Therefore, the necessary change in government spending is $2.7 billion/10, or $0.27 billion.

A decrease in taxes will increase GDP indirectly by increasing disposable income and, therefore, consumption. The impact of a one-dollar decrease in taxes is equal to 0.90/(1 0.90), or 9. This means that for every one-dollar decrease in taxes, GDP will increase by $9. Therefore, the necessary change in taxes is $2.7 billion/9, or $0.30 billion. b. If the MPC is 0.50, then the impact of a one-dollar change in government spending is 1/(1 – 0.50), or 2. If the government increases spending by $0.27 billion, then GDP will increase by $0.54 billion. Therefore, GDP will still be less than potential by $2.7 billion – $0.54 billion, or $2.16 billion. c. If the MPC is 0.50, then the impact of a one-dollar decrease in taxes is 0.50/(1 – 0.50), or 1. If the government decreases taxes by $0.20 billion, then GDP will increase by $0.30 billion. Therefore, GDP will still be less than potential by $2.7 billion – $0.30 billion, or $2.40 billion. d. The value of the MPC depends on the behavior of consumers, and this is difficult to predict. The smaller the value of the MPC, the smaller the impact of a change in government spending or taxes on GDP. In this case, the government overestimated the value of the MPC, so GDP ended up less than potential GDP. 11. If in some year a nation’s budget deficit is $9.49 trillion and government spending is $12.26 trillion, how much must it have earned in tax revenue this year? [LO 13.6] Answer: A nation’s budget deficit is calculated by subtracting government spending from tax revenues. Remember that a deficit implies that the result of this calculation will be a negative number, so we can set up our calculation as follows: -$9.49 trillion = Tax revenues – $12.26 trillion We find that tax revenues must have been $2.77 trillion.

12. ―The government shouldn’t borrow so much,‖ your uncle claims. ―Look at that national debt!

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It’s no different from someone borrowing on credit cards they can’t pay.‖? [LO 13.6] a. Is your uncle right? b. How is government debt spending like someone borrowing on a credit card? c. How is government debt spending different from someone borrowing on a credit card?

Answer: In some ways, your uncle is right. After all, the government is spending more than it brings in when it runs a deficit, and it must borrow to fund the rest, like when someone finances purchases with credit card debt. However, there are two major differences. First, the government has an almost unlimited capacity to borrow by issuing Treasury bonds, which are desirable due to their relatively low risk and decent return. That is certainly a much greater capacity to borrow than any individual has! Second, not all government borrowing is done from other nations. Some of it is intragovernmental borrowing, when the government temporarily uses money from one of its own accounts to pay for another type of spending.

This type of borrowing is more similar to someone temporarily using funds from her savings account to buy groceries rather than purchases on a credit card; it’s not an external lender that must be repaid, but the government’s other account.

13. Econo Nation started 2015 with no national budget debt or surplus. By the end of 2015, it had a budget surplus of $304 million; in 2016, it had a budget deficit of $452 million; in 2017 it had a budget surplus of $109 million. The amount of its budget deficit or surplus in 2018 is unknown. If at the end of 2018 Econo Nation's national debt totaled $50 million, did it run a deficit or surplus in 2018? How much? [LO 13.7] Answer: National debt is the total of all deficits and surpluses over time. If the result is negative, the nation has debt; if it is positive, the nation is running an overall surplus. Therefore, in our calculations, we must take care to make deficit and debt figures negative and surplus figures positive. We can set up our equation in the format National debt = (Sum of surpluses and deficits), using X as the amount of deficit or surplus for 2016: –$50 million = $304 million surplus – $452 million deficit + $109 million surplus + X (Note that we have subtracted the $452 million deficit because that’s the same as adding – $452 million.) Now we just solve for X, being careful about positive and negative values: –$50 million = –$39 million + X X therefore equals –$11 million. Since the figure is negative, it’s a budget deficit, so we can say that in 2016, Econo Nation ran a deficit of $11 million.

14. ―Though the national debt has increased, don’t worry,‖ the president says in a televised speech. ―We will not have to pay these funds back to bond buyers.‖ How is this possible?

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Answer: If the government has funded its spending via borrowing, but not from issuing bonds, it must have engaged in intragovernmental debt, in which the government borrows money from one of its own funds. The funds will have to be repaid, but this will be the government paying itself back (putting the borrowed money back into the fund from which it came), as opposed to paying bond buyers.

15. You buy a Treasury note for $950. Every 6 months you receive a payment of $40. [LO 13.8] a. What is the annual rate of return? b. What would be the annual rate of return if the payment was instead $30? c. What would be the annual rate of return if the payment was instead $45?

Answer: a. If you receive $40 every six months, then you receive $80 for the whole year. The annual rate of return is $80/$950 = 0.084, or 8.4%. b. If you receive $30 every six months, then you receive $60 for the whole year. The annual rate of return is $60/$950 = 0.063, or 6.3%. c. If you receive $45 every six months, then you receive $90 for the whole year. The annual rate of return is $90/$950 = 0.095, or 9.5%.

16. Your friend believes buying Treasury bills or Treasury notes will offer protection against rising inflation in comparison to buying stocks or mutual funds, because the rate of return on the Treasury bills and notes is known at the time of purchase. Do you agree? Why or why not? [LO 13.8] Answer: There is no protection against rising inflation unless you buy a bond where the rate of return is guaranteed as a specific percentage plus the rate of inflation. In this case, the rate of return varies with the inflation rate. Although the rate of return on the Treasury bill or note is known at the time or purchase, it can still end up higher or lower than the rate of inflation.

This is true for stocks and mutual funds also.

17. Which of the following are examples of the negative effects associated with government debt? [LO 13.9] a. Increased interest rates. b. Increased taxes or lower spending in the future. c. Increased investment in the economy.

Answer: Increased interest rates and increased taxes or lower spending in the future are possible negative effects associated with government debt. Interest rates may increase if crowding-out occurs, in which government spending financed by debt pushes up interest rates by competing with other types of spending for a fixed amount of loanable funds.

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Government debt must also be repaid, which will entail increasing taxes or lowering spending in the future, reducing the government’s ability to respond to recessionary threats with expansionary fiscal policy. Increased investment in the economy is not a correct answer because increases in investment are generally good, not bad, for the economy, especially when recession is the most pressing threat. Additionally, if crowding-out occurs we expect to see decreases in investment as opposed to increases.

18. If the government could borrow as much as it liked with a 0 percent interest rate, would the government debt be cost-free? Explain your answer. [LO 13.9] Answer: If the interest rate were 0 percent, there would be no direct costs of debt. However, there would still be indirect costs. These would include higher interest rates (even at a 0 percent interest rate, when the government borrows, this reduces public savings and lowers the supply of loanable funds, increasing the real interest rate). These higher interest rates can discourage investment and the types of consumption that require borrowing, so that slower economic growth is another indirect cost of this debt.

CHAPTER 14 THE BASICS OF FINANCE Solutions to End-of-Chapter Questions and Problems Review Questions 1. In financial markets, who are the sellers? Who are the buyers? [LO 14.1] Answer: The sellers in financial markets are people or organizations that have accumulated savings and are willing to let others use it. In return, the sellers have an opportunity to earn interest. Sellers are individuals, businesses, and government entities that are willing to forgo spending right now and choose, instead, to save money in return for repayment in the future.

The buyers in financial markets are people or organizations that have a need to spend on something now but don’t have sufficient funds. Examples of buyers are college students needing funds for college; families buying new houses or cars or paying college tuition; businesses building new facilities, starting new ventures, or expanding facilities; and the government when it needs to finance public spending.

2. Identify the two types of information asymmetry defined in the chapter. What is the difference between them? [LO 14.1] Answer: Adverse selection refers to a state that occurs when buyers and sellers have different information about the quality of a good or the riskiness of a situation, and this 1-205 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

asymmetric information results in failure to complete transactions that would have been possible if both sides had the same information.

Moral hazard refers to the tendency for people to behave in a riskier way or to renege on contracts when they do not face the full consequences of their actions. It’s an asymmetric information problem that arises once a transaction takes place.

3. Explain how a country with poorly developed financial markets might have a hard time sustaining economic growth. [LO 14.2] Answer: A well-developed financial system helps transfer savings to those who want to engage in economic investment. Without such a system in place, savers will not find a safe place to put their funds and will miss out on the opportunity to earn some interest, and economic investors will not be able to get the funds they need to expand businesses, take on new projects, add to inventories, etc. Therefore, we would expect a country with a poor financial system to grow more slowly than one with a good financial system.

4. Is it savings or investment when Collins Inc. uses the proceeds from issuing bonds to purchase equipment needed to start a new product line? If Daisy buys some of the Collins Inc. bonds, is her purchase savings or investment? [LO 14.3] Answer: It is investment when Collins, Inc. uses the proceeds from issuing bonds to purchase equipment needed to start a new product line. Collins can buy new buildings, machinery, or other assets used to produce with the proceeds from this bond issue. It is savings if Daisy buys some of the Collins, Inc. bonds. Daisy’s funds not used for consumption of goods and services can be used to purchase securities such as the bonds (or stock in Collins or other companies). These purchases would allow Daisy to put those dollars somewhere safe and earn an acceptable rate of interest.

5. When the real interest rate increases, what happens to the quantity of loanable funds supplied? What happens to the quantity of loanable funds demanded? [LO 14.3] Answer: The (saving) supply curve in the loanable funds model is upward-sloping, so an increase in the real interest rate will increase the quantity of funds supplied as we move up along the (saving) supply curve. The (investment) demand curve in the loanable funds model is downward-sloping, so an increase in the interest rate will decrease the quantity of funds demanded as we move up along the (investment) demand curve.

6. Why might a government want to encourage saving among its citizens? If the government enacts a successful policy aimed at encouraging saving, what would be the likely effect on the interest rate and the quantity of investment? [LO 14.4]

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Answer: The savings-investment identity shows that the amount of investment in an economy depends on the amount of saving, so efforts to encourage saving translate into efforts to increase investment and therefore economic growth. Policy that successfully encourages saving would increase the supply of loanable funds, decreasing the real interest rate and pushing up the equilibrium quantity of investment, all else equal.

7. The government of a small country has enacted new regulations that make it more difficult to obtain a loan from a bank. How does this affect savings, investment, and the interest rate in the country? [LO 14.4] Answer: If it becomes more difficult to obtain a loan, the demand for funds (investment demand) will decrease and shift to the left. This will reduce the equilibrium interest rate and reduce the quantity of funds saved (a downward movement along the supply of saving curve).

8. Using the concept of default, explain why the interest rate on credit card debt is higher than the interest rate on a mortgage. [LO 14.5] Answer: A default happens when a borrower fails to pay back a loan according to the agreed-upon terms. If lenders think that a particular borrower might default, they will demand a higher interest rate to make it worth taking that risk. People are less likely to default on their mortgages because if they do then they will lose their house to the bank.

When people default on credit card debt, it is difficult for the credit card company to get the money back from the people and they have no asset they can seize as an alternative to payment. Therefore, credit card companies charge higher interest rates to balance against any cases of default.

9. Your friend claims that there is no such thing as a risk-free interest rate because all loans are risky. Do you agree? Why or why not? [LO 14.5] Answer: The risk-free rate is usually approximated by interest rates on U.S. government debt because the U.S. government is considered extremely unlikely to default. All other borrowers must pay higher rates to compensate lenders for the higher possibility that they will default.

10. Is the stock exchange an example of a financial intermediary? Why or why not? [LO 14.6] Answer: Various institutions act as financial intermediaries—they channel funds from people who have them to people who want them. A bank is this kind of intermediary. A different kind of intermediary is a stock exchange, which matches people wanting to buy ownership shares of companies with people wanting to sell those shares.

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11. In a famous bet known as the Simon-Ehrlich wager, Paul Ehrlich bet that over the course of 10 years, the prices of five commodities would be higher than they were at the start of the decade; Julian Simon believed the price of these goods would be lower. The loser had to pay the difference of the price from the starting point. What type of financial asset does this wager resemble? Why? [LO 14.7] Answer: This resembles the type of derivative known as a futures contract, in which financial investors essentially bet that the future price of a commodity will be higher than its current price.

12. What is securitization? How did it contribute to the recent housing-market crisis? [LO 14.7] Answer: Securitization refers to combining several loans or other financial assets into a bundle and then selling that bundle in whole or in parts to financial investors. The idea behind securitization is to reduce risk—after all, the chance of 1,000 borrowers all defaulting on their mortgages is much less than the chance of a single borrower defaulting. However, during the recent housing market crisis lenders relied too much on securitization to diversify their financial investments, resulting in over-lending to borrowers who weren’t able to keep up on their loans.

13. How do economists generally define a bank? What kind of bank exemplifies this definition?

Does an investment bank meet this definition? [LO 14.8] Answer: The economic definition of a bank is an entity that takes deposits and makes loans.

A commercial bank exemplifies this definition, but an investment bank does not. It neither takes deposits nor makes loans; instead, it underwrites securities and it buys and sells those securities, while providing a wide range of advice to firms.

14. What is an index fund, and why would a financial investor consider buying one? [LO 14.8] Answer: An index fund mirrors the performance of securities in a financial index such as the S&P 500. They are low-cost (requiring little active management and few transactions compared to other financial investment options), and some have high returns, making them attractive to financial investors.

15. Which is likely to have more risk, a government bond from a developing country or one from France? Which should have a higher return? [LO 14.9] Answer: The government bond from a developing country will have more risk, at least in part because the chance of default (not receiving interest or principal) is higher in a nation with lower GDP and growth. Also, we probably don’t know as much about the developing country as we do France, which has a long-established history of low default and other types 1-208 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

of risk. Since risk and return tend to rise together, all else equal we would expect a higher return from the bond from a developing nation. But remember that all else is not equal in the real world. We can say with a good amount of certainty that the bond from the developing nation will pay a higher interest rate, but whether that will suffice to result in an overall higher return remains to be seen.

16. Define diversification and comment on how successful it is at managing market risk and idiosyncratic risk. [LO 14.9] Answer: Diversification refers to putting one’s savings into a variety of financial investments—different maturities, different industries, different risk profiles, and so on. The idea is to avoid ―putting all your eggs in one basket,‖ with a view to minimizing risk on the premise that, while one security may not pay off, it is less likely that we will experience default or other problems with many securities at once. Diversification is therefore a good way of handling idiosyncratic, or firm-specific, risk. It does not, however, do as good of a job at handling market wide risk, which affects the entire market or economy.

17. During the 1990s, securities related to technology and other dot-com firms experienced skyrocketing market prices, but around 2000 the market crashed. Was that crash an example that supports or offers evidence against the efficient-market hypothesis? [LO 14.10] Answer: The answer here depends on how you look at it. The efficient market hypothesis states that all relevant information will be built into securities prices, so that no one can ―beat the market.‖ We can argue that this example supports the efficient markets hypothesis in that the high demand for and perceived good chances of high returns from these ―dot com‖ securities were incorporated into their prices, and then when sentiments changed, the prices quickly fell to incorporate this. But others use this example to argue against the hypothesis, suggesting that bubbles such as this one could be the result of herding (going along with the crowd – everyone else buys tech stocks, so you do too) or paying too much attention to recent events (seeing how well tech stocks are doing clouds memories of the fact that what goes up in markets must eventually go down).

18. Describe the difference between fundamental analysis and technical analysis. Which, if any, does the efficient-market hypothesis suggest financial investors engage in? [LO 14.10] Answer: Fundamental analysis refers to finding out as much information as possible about the firms or governments that issue securities. It might include research on economic growth, industrial performance, or anything that helps investors better understand risk and return.

Technical analysis bases predictions for future security performance on past performance.

The efficient-market hypothesis would support neither—it implies that all relevant market information will already be built into prices, and financial investors would be better off picking securities at random rather than incurring the time, money, and opportunity costs of either type of analysis.

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19. Does the level of taxation in a closed economy have an impact on national savings? Explain.

[LO 14.11] Answer: Public savings is defined as taxes minus government spending, so if taxes increase and government spending does not change, then public savings will increase. Private savings is defined as income minus taxes minus consumption, so an increase in taxes will reduce private savings. National savings is defined as public savings plus private savings, and is also defined as income minus consumption minus government spending. National savings will not change as long as income, consumption, and government spending remain the same. If individuals reduce their consumption when their taxes increase, then national savings will increase.

20. Explain how a persistent government budget deficit can hurt a closed economy’s ability to engage in economic investment. [LO 14.11] Answer: In a closed economy, national savings is equal to investment. When the government runs a budget deficit—in other words, when it spends more than it brings in via taxes— public savings is negative. This will lower national savings for any given level of private savings, and because national savings will be lower, so will investment. This can cause a nation to grow more slowly than it otherwise would because the capital stock is growing more slowly. Additionally, when the government is running a budget deficit, then it must borrow funds to pay for the extra spending. In a closed economy, the government will borrow from the private sector and this will result in fewer funds being available for firms to borrow. As a result, investment spending is lower.

Problems and Applications 1. For each scenario, indicate whether it is an example of moral hazard or adverse selection. [LO 14.1] a. You decide to buy a new car instead of a used car because you are worried about the quality of the used car. b. You sell your condominium because you fear there will be a large special assessment next year. There has been no official notice of an upcoming assessment. c. The owner of a company has just secured a new line of credit from the bank. He decides to change his business plan and open a second office in a foreign country. d. A firm that has purchased a large insurance policy becomes careless about setting the security alarm. e. A number of households find themselves owing more on their mortgages than their houses are currently worth. Some of them decide to abandon the house and walk away. f. The owners of a company suspect there will be more competition from foreign producers in upcoming years. They have just issued new shares of stock in their company.

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Answer: Moral hazard refers to a situation where people behave in risky ways or renege on contracts. People who have insurance tend to be less risk averse. A business owner changes his plan to one that is more risky after he secures a loan. Owners of homes who owe more than the house is worth decide to walk away from their contractual obligation. In each of these cases, the individual changes his behavior after entering into a contractual relationship.

Adverse selection refers to a situation where buyers and sellers have different information about the quality of a good, or riskiness of a situation. As a result, some transactions do not take place, or the price the good sells for might not be reflective of the missing information. People are often reluctant to buy used cars because they lack reliable information about the quality of the car. A condo owner may sell in anticipation of future negative events. If these events are not public knowledge, then the condo owner may receive a price that is higher than it should be. The stock may be overvalued because the buyers are unaware of the impending competition from foreign producers. a. Adverse selection b. Adverse selection c. Moral hazard d. Moral hazard e. Moral hazard f. Adverse selection

2. The chapter discusses three main functions of a banking system. Classify each of the following by the function it best represents. [LO 14.2] a. Wyatt can get cash out of the ATM at any time of day or night. b. Instead of lending all her savings out to one borrower, Xander’s bank makes the money in her savings account available to a variety of firms, with different characteristics and risk profiles, wishing to invest. c. When Yao’s car suddenly breaks down, she can quickly withdraw funds from her savings account to pay the mechanic and rent a car. d. Zirwat can get start-up funds for her new hair salon from a bank, instead of having to find people in her neighborhood willing to lend their extra money.

Answer: a. Wyatt’s bank provides liquidity through the ATM, allowing Wyatt to access his money quickly and without (much, if any) cost so that he can spend when and on what he likes. b. Xander’s bank assists with diversification. It allows her savings to be loaned to several different borrowers so that the chance of all of them defaulting is much smaller than the chance of just one loan to a single borrower going unpaid. Without banks, default by one borrower would leave Barbara with nothing. c. Yao can get money in this situation quickly and at minimum cost because her bank provides liquidity. Therefore, she can keep his savings in a safe place and earn interest when he doesn’t need the money, but quickly acquire and use it when she does.

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d. Zirwat’s bank acts as an intermediary between savers and borrowers—in this case, allowing Zirwat to borrow the funds she needs all at once instead of inquiring about and receiving small loans from many individuals with savings to spare.

3. After graduating, you take an unusual job: consulting with the queen of a small, newly populated island in the middle of the sea. You’ve provided advice to her on matters related to government and the economy, and while she has taken your advice most of the time, she has so far turned down your suggestion to have a banking system. She claims that banks will make the economy more complicated and do little to make the lives of her subjects easier.

Over the past several months, though, the queen has discussed with you several issues that have arisen in the newly formed economy. For each of the three quotes from the queen below, refer to one of the three functions of banks discussed in this chapter to explain how a banking system could help with the issue described. [LO 14.2] a. ―When my subjects have money left over after spending, they want to keep it somewhere safe and earn some interest on it. But that’s hard for most of them because they have no way of finding out who wants to borrow and whether it would be a good idea to lend to them.‖ b. ―My subjects are lucky that we have very little crime, so they can safely keep their extra money inside their houses and take only what cash they need for a day’s spending.

However, many of them have complained that if an emergency occurs when they’re all the way on the other side of the island, they can’t access their funds.‖ c. ―Some of my subjects who are in the know about good borrowers have been making loans and earning interest. But lately there have been a couple of borrowers who defaulted on loans, and when they did, the lenders were totally out of luck. All that money just disappeared! And those bad experiences have made other potential lenders afraid, so that now borrowing and lending have dried up almost completely. If only there were some easy way for them to divide their savings among several different borrowers, they might feel safe enough to start lending again!‖ Answer: Each of these problems could indeed be solved by introducing a banking system into the kingdom. The function of banks that would best address each issue is listed below, with a brief explanation. a. This situation could be remedied by banks acting as an intermediary between borrowers (firms that want to invest) and lenders (savers with funds left over after consumption).

Banks can take on the task of locating and assessing potential borrowers for the funds deposited by savers. b. Liquidity, the ability to access funds quickly and without excessive cost, is what’s missing here that banks could provide. If an unforeseen emergency arises, the kingdom’s inhabitants won’t need to go all the way back home to retrieve their money (and they won’t have to worry about what happens if crime on the island increases and savings are no longer safe left unguarded inside homes).

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c. The function of banks called diversification could assist with this issue. It’s true that when funds are loaned to only one borrower, the lender loses everything in the case of that borrower’s default, and as the queen described even those who aren’t personally affected by a particular default may eventually start to fear making loans. By relying on banks to lend out small portions of an individual’s savings to many borrowers with different risk profiles and characteristics, the chance of all of those borrowers defaulting is much less than the chance of any single one of them not being able to pay.

4. Categorize each of the following as a type of savings or investment in the economic sense.

[LO 14.3] a. You buy 100 shares of Apple Computer stock. b. You place part of your income in a mutual fund. c. A delivery service buys 1,000 new trucks. d. You put $1,000 in a certificate of deposit by giving money to the bank in exchange for a set amount of return.

Answer: Savings is the portion of income that is not immediately spent on consumption of goods and services. Funds that are saved can be placed into a savings account or can be used to buy stock or other financial assets. Economists use the word investment, or, more properly, investment spending, to refer to spending on productive inputs, such as factories or machinery, by firms. a. Savings b. Savings c. Investment d. Savings

5. Use the following words to fill in the blanks in the statements below about the market for loanable funds. Choose from: demanded, supplied; left, right; higher, lower. [LO 14.4] a. A change that makes people want to save less will shift the quantity of loanable funds ________ to the ________. The resulting new equilibrium in the market for loanable funds would be a ________ interest rate and a ________ quantity of funds saved and invested. b. A change that makes people want to save more will shift the quantity of loanable funds ________ to the ________. The resulting new equilibrium in the market for loanable funds would be a ________ interest rate and a ________ quantity of funds saved and invested. c. A change that makes people want to invest more will shift the quantity of loanable funds ________ to the ________. The resulting new equilibrium in the market for loanable funds would be a ________ interest rate and a ________ quantity of funds saved and invested. d. A change that makes people want to invest less will shift the quantity of loanable funds ________ to the ________. The resulting new equilibrium in the market for loanable funds would be a ________ interest rate and a ________ quantity of funds saved and invested.

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Answer: Saving is the portion of income that is not immediately spent on consumption of goods and services. Funds that are saved are supplied to the loanable funds market.

Investment refers to spending by firms on productive inputs and this creates a demand for loanable funds by firms that need to borrow to pay for the investment spending. a. A change that makes people want to save less will shift the quantity of loanable funds supplied to the left. The resulting new equilibrium in the market for loanable funds would be a higher interest rate and a lower quantity of funds saved and invested. b. A change that makes people want to save more will shift the quantity of loanable funds supplied to the right. The resulting new equilibrium in the market for loanable funds would be a lower interest rate and a higher quantity of funds saved and invested. c. A change that makes firms want to invest more will shift the quantity of loanable funds demanded to the right. The resulting new equilibrium in the market for loanable funds would be a higher interest rate and a higher quantity of funds saved and invested. d. A change that makes firms want to invest less will shift the quantity of loanable funds demanded to the left. The resulting new equilibrium in the market for loanable funds would be a lower interest rate and a lower quantity of funds saved and invested. A change that makes people want to save less will shift the quantity of loanable funds supplied to the left. The resulting new equilibrium in the market for loanable funds would be a higher interest rate and a lower quantity of funds saved and invested.

6. Consider the market for loanable funds. Graphically illustrate the impact on the equilibrium interest rate and the equilibrium quantity of funds saved and invested in each of the following scenarios. [LO 14.3, 14.4] a. Due to slow growth in the economy, fewer workers are receiving pay increases and more workers are losing their jobs. b. The government decides to reduce the number of weeks a person is eligible for unemployment compensation. c. Numerous firms remain concerned about growth prospects in the economy. d. The government decides to reduce income tax rates, and this reduction leads to an increase in the size of the budget deficit.

Answer: a. In this case, workers are not confident about the economy so they will elect to save more. The supply of saving curve shifts to the right, the equilibrium interest rate falls, and the quantity of funds saved and invested increases.

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b. Workers will decide to save more so they have funds to use in the event they lose their jobs. The supply of saving curve shifts to the right, the equilibrium interest rate falls, and the quantity of funds saved and invested increases.

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c. If firms are not confident about the economy, then they are reluctant to invest in new capital. The demand for funds (investment) curve shifts to the left, the equilibrium interest rate falls, and the quantity of funds saved and invested decreases.

d. If the government reduces taxes and this increases the deficit, then they need to borrow more funds. The demand for funds (investment) curve shifts to the right, the equilibrium interest rate rises, and the quantity of funds saved and borrowed rises. Note in this case that because the interest rate is higher, investment spending will be lower.

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7. You go to the bank and purchase a $1,000 certificate of deposit (CD). [LO 14.5] a. Who is doing the borrowing? Who is doing the lending? b. Which is higher, the interest rate paid on the 6-month CD or the 2-year CD? Why? Answer: When you purchase a CD, you are lending your money to the bank. The bank is borrowing the right to use your money for a period of time, and in return they pay you interest.

The interest rate on the 2-year CD will be higher because the opportunity cost is higher—you are giving up the right to have that money back for a longer period of time so you prefer to be compensated at a higher rate. Both CDs are equally risky (or not) because you will get your money back in both cases with a predetermined interest rate.

8. What does the risk premium measure? During a recession, what is likely to happen to the risk premium? [LO 14.5] Answer: The difference between the risk-free rate and the interest rate a particular investor has to pay is called the credit spread or risk premium.

During a recession, there is a higher risk of default because economic activity has slowed down. Therefore, investors will demand a higher interest rate in order to compensate for the higher risk of default.

9. You have a sum of funds sitting in a savings account earning a modest interest rate of 3 percent.

A good friend wants to borrow half of this sum, and he has agreed to pay you an interest rate of 5 percent. Should you lend your friend the money? Why or why not? [LO 14.6] Answer: In general, we assume the goal of saving is to earn interest and allow for higher levels of consumption at some future date. Lending to a friend is risky because there is no guarantee your friend will be able to pay the loan back in a timely manner. You should only lend to the friend if you think the extra 2% interest will compensate you for the extra risk.

10. In your spare time, you help out with a magazine for high schoolers that focuses on current events related to economics and politics. While the magazine aims to be readable and entertaining, it also wants to use terminology correctly. Knowing that you’ve taken an economics class, the editor turns to you to look over a paragraph in a story focusing on the roles of saving and investment after the recent crisis in the housing market. Go through the following paragraph and correct any errors in economic vocabulary, including an explanation for the editor about why the original was incorrect. [LO 14.3, 14.6] ―When Americans invest by buying securities such as stocks and bonds or putting money in a bank, they provide funds for firms wishing to engage in diversification by buying assets used to produce goods and services. Households with extra money left over after buying things 1-217 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

they want or need consume by purchasing securities or putting their funds in savings accounts, and banks help transfer those funds to firms. By matching and working with these borrowers and lenders, banks act as a source of liquidity.‖ Answer: When Americans (a.) save by buying securities such as stocks and bonds or putting money in a bank, they provide funds for firms wishing to engage in (b.) investment by buying assets used to produce goods and services. Households with extra money left over after buying things they want or need purchase securities or put their funds in savings accounts. Banks help transfer those funds to firms. By matching and working with these borrowers and lenders, banks act as (c.) an intermediary. (a) Although it’s common to refer to buying stocks and bonds as ―investment‖ in everyday speech, economists instead call it ―saving.‖ (b) Investment is the term for firms buying productive assets such as buildings and machines used to produce goods and services. Diversification, on the other hand, refers to the method by which savers lend funds to several investors, on the premise that several borrowers with different characteristics are much less likely to default at the same time, compared to a single borrower. (c) Banks provide liquidity when they make funds easily and cheaply available to their depositors, but that is not what’s described here. This portion of the article describes banks acting as an intermediary between savers with extra funds available to lend and borrowers like firms that want to invest in productive assets like buildings and machinery.

11. In each of following examples, name the financial product being described. [LO 14.7] a. A family borrows money to pay for a house. b. A new tech start-up offers investors the ability to purchase a small part of the company to raise needed capital. c. The U.S. government offers to pay investors a 3 percent return rate next year if they finance its debt today.

Answer: Equity is ownership in a company, and the most common form of such ownership is stock. As partial owners, stockholders are entitled to receive a portion of a company’s profits, in the form of dividends, in proportion to the size of their ownership. A mortgage is a loan agreements between a lender and a borrower in which the lender lends money to the borrower in exchange for a promise to repay the amount loaned. A bond is a loan that has been standardized into a more easily tradable and liquid asset. a. Mortgage. b. Stock. c. Bond.

12. Evaluate each of the following statements and say whether it describes a loan, a bond, and/or a stock. [LO 14.7] a. It implies ownership in the issuing firm.

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b. c. d. e.

Small businesses use these to raise funds for investment.

This is also known as equity financing.

We can think of this as a more liquid version of a loan.

It pays some form of interest, and principal is paid at maturity.

Answer: Equity is ownership in a company, and the most common form of such ownership is stock. As partial owners, stockholders are entitled to receive a portion of a company’s profits, in the form of dividends, in proportion to the size of their ownership. The most basic type of debt is a loan. Loans are an agreement between a lender and a borrower in which the lender lends money to the borrower in exchange for a promise to repay the amount loaned. A bond is a loan that has been standardized into a more easily tradable and liquid asset. The holder of the bond is paid interest periodically, and then the face value is repaid at the maturity date. a. Stock. b. Loan. c. Stock. d. Bond. e. Bond.

13. Match each of the following players in the financial system with the financial product(s) they are most associated with. [LO 14.8] a. Commercial banks. b. Savers. c. Investment banks.

i. Stocks. ii. Bonds. iii. Loans.

Answer: a. iii. Loans. b. i. Stocks and ii. Bonds. c. i. Stocks and ii. Bonds

14. Rank the following actors in financial markets by the level of liquidity they are providing.

[LO 14.8] a. Entrepreneurs offering equity in their businesses. b. The Federal Reserve offering banks the chance to borrow short-term money through the discount window. c. Investment banks offering shares in mutual funds, which penalize you if you withdraw your money within 30 days. d. A bank offering you a no-minimum reserve requirement checking account.

Answer: From most liquid to least liquid: d. Checking account balances are among the most liquid assets in our economy.

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b. Banks are borrowing reserves here, which are very safe and liquid, though less so than actual money as in d. This also increases liquidity available to bank customers. c. Because of the penalty for early withdrawal, mutual funds are not as liquid as checking accounts or bank reserves. a. Because the businesses are new and therefore there is little information about them available, equity is the least liquid of all options given. It may be difficult to turn the shares of this firm into cash.

15. Rank the following assets based on their expected return. Then repeat the exercise, this time ranking the assets based on their expected risk. [LO 14.9] a. Real estate. b. Commodities. c. U.S. equities (stocks). d. Cash. e. U.S. fixed-income bonds.

Answer: Cash is very low risk and provides an expected low return. Although assets like equities and real estate provide a relatively higher return, they are less risky when compared to commodities (such as gold, silver, or oil). In general, there is a direct relationship between expected risk and expected return.

16. Evaluate whether the following statements are true or false. [LO 14.9] a. Risk is measured by looking at the expected value (average) of an asset’s returns over time. b. Market risk can be minimized with a well-diversified portfolio. c. Idiosyncratic risk is unique to a particular asset, rather than to the market as a whole. d. A portfolio of well-diversified assets will often be less risky for the same level of return when compared to an individual asset.

Answer: a. In financial markets, the simplest way to measure risk is to look at the standard deviation of an asset’s return over time. b. Market risk, or systemic risk, refers to any risk that is broadly shared by the entire market or economy. Because all businesses will face the consequences of rising prices, market risk is hard to eliminate via diversification.

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c. Idiosyncratic risks are unique to a particular company or asset—for example, the risk that a particular company will make a bad business decision, causing the value of its stock to fall. Idiosyncratic risks are the easiest to lower or even eliminate via diversification. d. A portfolio—a collection or group of many different assets—will often have a higher return for a given level of risk than any individual asset could offer (or, in other words, will be less risky for the same level of return as any individual asset).

17. ―Listen,‖ your buddy says. ―Have you ever noticed that you can get the same type and size of tire for $30 cheaper in the next county over? I’ve got a way to make profits for years—we’ll buy the tires where they’re cheaper and bring them back here to sell.‖ What is the term for the transaction your friend wants to make? Would the efficient-market hypothesis predict it will be as profitable as he says? Explain. [LO 14.10] Answer: Your friend is describing arbitrage, where commodities are bought at a lower price in one location and then resold at a higher price elsewhere. The efficient markets hypothesis would not have much faith in the long-term profitability of such a plan. The hypothesis implies that all market information will be built into prices very quickly—including the information your friend has that tires are cheaper in one county than in the next. Soon others will enter the tire-reselling business to take advantage of the difference in prices, and profits will disappear.

18. In each of the following examples say whether the market is behaving within the principles of the efficient-market hypothesis. [LO 14.10] a. The day after unrest in the Middle East, the source of supply for much of the world’s oil, the price of oil falls. b. Investors find very few opportunities for arbitrage in the foreign exchange market. c. The Dow Jones Industrial Average, a major stock market index, changes in value by 5 percent for an entire week, even though very little economic news is released.

Answer: a. No. We would expect the expected decrease in the supply of oil to push oil prices upward, not downward. b. Yes. The efficient market hypothesis predicts that all arbitrage opportunities will quickly dry up as market information is fully reflected in securities prices. c. No. The efficient markets hypothesis says that changes in securities prices should be reflecting news about markets and securities.

19. In 2018, U.S. government spending was $3.90 trillion, tax revenue was $4.50 trillion, GDP was $14.02 trillion, and total consumer spending was $10.75 trillion. If the economy has no 1-221 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

exports or imports, what was the national savings in 2018? How much was public savings?

How much was private savings? [LO 14.11] Answer: Three equations will help us find these answers: Public savings = Taxes – Government spending Private savings = Income – Taxes – Consumer spending National savings = Public savings + Private savings Here, government spending is $3.90 trillion, taxes are $4.50 trillion, GDP (income) is $14.02 trillion, and consumption (consumer spending) is $10.75 trillion. We can therefore plug in these numbers as follows: Public savings = $4.50 trillion – $3.90 trillion = $0.60 trillion Private savings = $14.02 trillion – $4.50 trillion – $10.75 trillion = –$1.20 trillion National savings is therefore public savings of $0.60 trillion plus private savings of –$1.20 trillion = –$0.60 trillion.

20. A country’s government has been running a deficit for the past few years. Suppose this country decides to increase its government spending. [LO 14.4, 14.11] a. Compare the impact of the increase in government spending in a closed economy and an open economy. b. Are you more likely to observe crowding out in a closed economy or an open economy?

Explain.

Answer: In a closed economy, an increase in government spending will increase the demand for loanable funds. All else the same, this will increase the equilibrium interest rate.

In an open economy, an increase in government spending will increase the demand for loanable funds. All else the same, this will increase the equilibrium interest rate. As a result of this change in the interest rate, capital inflow can be expected to increase and this will cause the supply of loanable funds curve to shift to the right.

Considering your answers to the above questions, crowding out is more likely to be observed in a closed economy because investment spending will be lower.

Crowding out occurs when an increase in government spending leads to an increase in the demand for loanable funds, and an increase in the equilibrium interest rate. The increase in the interest rate will cause investment spending to fall, or, in other words, the higher interest rate crowds out investment. In an open economy, the increase in capital inflow will push the interest rate back down towards its original level, and this will cause investment spending to fall by a smaller amount in an open economy.

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21. Consider the U.S. market for loanable funds in a closed-economy model. Answer the following questions about each scenario. [LO 14.4, 14.11] a. The government starts offering a national savings bond to increase private savings, which pays a higher return than many other options available on the market. Which way will the supply of loanable-funds curve shift? Will the interest rate increase or decrease? Will there be more or less borrowing? b. Suppose the economy is now open. Due to rapid economic expansion in China, the Chinese government decides to invest in U.S. Treasury notes with some of its surplus.

Which way will the supply curve shift? c. A new computer software program is introduced into the market, which offers businesses that purchase it promising returns on their investment. Which curve will shift? Which way will it shift? d. The government reduces the capital gains tax, which taxes earnings on assets in the stock market. Which curve will shift? Which way will it shift?

Answer: a. A relatively low-risk, high-return bond will encourage savings, shifting the supply curve to the right. This will lower the equilibrium interest rate and increase the amount of borrowing. b. The supply curve will shift to the right due to this net capital inflow. c. Investment is represented by the demand curve in the loanable funds model, and it will shift rightward as expectations about higher returns encourage more investment at any given interest rate. d. This will encourage more saving via stocks, increasing the overall level of national savings, all else equal. This will shift the supply curve of loanable funds rightward.

CHAPTER 15 MONEY AND THE MONETARY SYSTEM Solutions to End-of-Chapter Questions and Problems Review Questions 1. Describe how money contributes to economic activity and allows for a more complex society than barter does. [LO 15.1] Answer: In an economy without money, goods and services are traded directly via barter.

But barter is inefficient because each time you want to make a trade you have to find a partner who has something you want and wants what you have to offer. Money acts as a medium of exchange (meaning we can trade it for goods and services), a unit of account 1-223 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

(meaning we can use it to measure relative value), and a store of value (meaning that we can use it to store up purchasing power over time and spend it when and on what we like).

2. Explain how cigarettes fulfilled the three functions of money in the POW camps during World War II. [LO 15.1] Answer: They acted as a medium of exchange in that the cigarettes could be exchanged for staple foods, chocolate, or anything else the POWs might have and offer for trade. They acted as a store of value in that prisoners could save up many cigarettes and trade them in for large purchases (although cigarettes can go stale, they keep for a relatively long time). And they acted as a unit of account in allowing relative values to be read from prices—it’s easy to see that if a tin of potted meat sells for 10 cigarettes and a magazine sells for 20 cigarettes, the magazine is valued roughly twice as highly as the tin of meat.

3. Throughout time, metals such as gold have been popular choices for money across various societies. Explain why this might be, using our criteria for what makes good money. [LO 15.2] Answer: Gold has made for good money because of its stability of value and convenience.

Gold’s value is relatively stable because the supply of gold is fairly constant over time, although using gold doesn’t offer the control a fiat money like the dollar in the United States does, where the supply can be carefully controlled by the central bank. When and where gold has been used as money, it has been widely accepted, at least in part because it can be used both as a commodity (such as jewelry) and as money. Also, gold can easily be melted down into smaller parts and is fairly portable, adding to its convenience.

4. On the Yap Islands in the middle of the Pacific Ocean, giant stone wheels, weighing as much as a small car, were used as currency. What were some of the likely problems with this currency? [LO 15.2] Answer: The giant stone wheels may have had stable values (and been widely accepted), but they lacked one of the main criteria that determine whether something makes good money: convenience. The size and weight of the wheels would hurt the money’s portability—not to mention the question of making change! After a while, it is likely that these portability issues would start to hurt the stone wheels’ wide acceptance, and the money would likely give way to another.

5. Explain why keeping a reserve ratio of zero could be a very bad idea. [LO 15.3] Answer: A reserve ratio of 0 would mean that the bank keeps 0 percent of customer deposits on hand for withdrawals. While it’s true that the amount of money withdrawn in a given day is less than 100 percent of deposits (meaning that a reserve ratio of 1 would be a bad idea 1-224 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

too), the amount is no doubt higher than 0 percent! The bank would quickly find itself unable to meet its customers’ liquidity needs and would not be in business long.

6. If banks keep 100 percent of deposits on hand as reserves, what would this imply about the reserve requirement and the multiplier? What would it imply about banks’ ability to create new money? [LO 15.3] Answer: If banks keep 100 percent of deposits on hand, the reserve requirement ratio and the multiplier would be 1, and banks would not be able to create new money. Banks create new money by making loans, and if they were required by law to keep 100 percent of deposits on hand, there would be no dollars to lend and therefore no ability to change the money supply.

7. Explain the role of base money and the money multiplier in the Federal Reserve System’s enactment of monetary policy. [LO 15.4] Answer: Base money (also called hard money) consists of currency in circulation and reserves held by banks at the Federal Reserve. The money multiplier determines the effect on the overall money supply of changes in base money. The Federal Reserve conducts monetary policy by changing the amount of base money in the economy, typically by conducting openmarket operations. Although the Federal Reserve can change the required reserve ratio in order to change the value of the money multiplier and therefore the level of the money supply, it does not in practice conduct monetary policy in this way. For example, during a recession, the Fed is likely to conduct expansionary monetary policy—it will purchase government bonds to increase base money and the money supply in order to stimulate spending in the economy. The increase in base money (reserves) will reduce interest rates and at lower interest rates banks will make more loans. The increase in loans will increase the money supply, and as the loan money is spent this will increase output in the economy.

8. Give an example where depositors changing the way they hold assets could increase the M1 measure of the money supply while leaving M2 unchanged. [LO 15.4] Answer: It’s important to remember in answering this question that M1 is part of M2.

Therefore, one way M1 could increase while leaving M2 unchanged would be if depositors moved assets from savings to checking. This would reduce the savings component of M2 but increase the M1 component (since M1 is made up of cash, demand deposits, and traveler’s checks) by the same amount. Therefore, M1 would rise and M2 would remain unchanged.

9. What is one key way in which the mission of the Federal Reserve differs from the mission of the European Central Bank? [LO 15.5] Answer: The Federal Reserve System (the central bank of the United States) has a dual mandate: full employment and stable prices. The European Central Bank, on the other hand, focuses only on price stability.

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10. What do we mean when we say that the Federal Reserve System is politically independent, and how might this independence be a good thing for the U.S. economy? [LO 15.5] Answer: The Federal Reserve System is independent in that the members of the Board of Governors serve long terms and are not elected by popular vote. This frees them from the need to appease voters and allows them to undertake measures that would not be popular; also, it allows politicians to leave necessary monetary policy to the Federal Reserve and may increase the public’s faith in the central bank knowing that economic experts, not just popular politicians, are making difficult policy decisions.

11. Explain why using changes in reserve requirements to conduct monetary policy is generally not a good idea for the United States. [LO 15.6] Answer: The major disadvantage of using changes in reserve requirements to conduct monetary policy is that they are too powerful. A small percentage change in the reserve requirement results in a massive change in reserves, making this tool of monetary policy inappropriate for day-to-day maintenance. Also, frequently changing or unpredictable reserve requirements make it difficult for bank managers to plan for the future and manage funds as they like.

12. Which tool of monetary policy is used most frequently by the Federal Reserve System?

What makes this tool the best choice in most circumstances? [LO 15.6] Answer: Open-market operations (the buying and selling of government bonds to and from banks) are the primary way the Federal Reserve System enacts monetary policy.

Open-market operations are conducted on a daily basis, which allows policy to change direction or magnitude without it looking like the Federal Reserve has made a mistake, enhancing the Fed’s credibility. Open-market operations don’t inconvenience bank managers the way that changing reserve requirements does, and they don’t require banks to take loans from the Fed as changing the discount rate for policy does. Given open market operations can be conducted daily, this policy option provides greater flexibility to the Fed when deciding what type of policy change should be made.

13. Are there any differences in the effects of fiscal policy versus monetary policy on aggregate demand in the short-run aggregate demand and supply model? [LO 15.7] Answer: Both fiscal and monetary policy will shift the aggregate demand curve: rightward for expansionary policy and leftward for contractionary policy. Just as with fiscal policy, a rightward shift of the AD curve from expansionary monetary policy will increase prices and output in the short run, and a leftward shift from contractionary policy will reduce prices and output. One important difference between monetary and fiscal policy has to do with the lag 1-226 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

between implementing policy and the shift of the AD curve. Monetary policy tends to have shorter lags because it does not require such a broad consensus from so many people to be enacted, nor are the members of the Board of Governors popularly elected. Therefore, they need not consider voters in the same way that Congress and the president do. This means the effects on prices and output from monetary policy may be felt more quickly than those from fiscal policy.

However, there is also a greater chance that the change in monetary policy will not affect the economy at all whereas a change in fiscal policy will always have some impact. If government spending rises or tax rates fall then aggregate demand will increase. If the Federal Reserve pursues expansionary monetary policy and takes action to lower interest rates, aggregate demand will only increase if businesses and people decide to take out loans, such that the extra spending will increase output. It is possible that interest rates can fall and people and businesses can decide not to increase borrowing in which case expansionary monetary policy is not very effective.

14. Describe the slope of the money supply curve in the liquidity-preference model. Are the assumptions behind the supply curve realistic? [LO 15.7] Answer: In the liquidity-preference model, the supply curve is vertical, reflecting the assumption that the Federal Reserve completely controls the supply of money. In reality, its control is nowhere near that complete or direct. The Federal Reserve directly controls the amount of base money in the economy. The exact level of the money supply then depends on the amount of loans the banking system elects to make.

15. Under the liquidity-preference model, how would the slope of the money demand curve affect the power of a central bank to conduct monetary policy? [LO 15.8] Answer: The slope of the money demand curve reflects the relationship between the nominal interest rate and the quantity of money demanded. Because the demand curve slopes downward, we know that this relationship is inverse; when the interest rate rises, the quantity demanded falls, and vice versa. However, the slope of the curve will indicate the strength of this relationship. A very flat money demand curve would mean that when the central bank conducts expansionary monetary policy by shifting the supply of money curve to the right, there will only be a small decrease in the interest rate. If the money demand curve is steeper, the same type of policy will result in a much larger decrease in the interest rate. All else the same, monetary policy is more effective when the money demand curve is steeper because the change in the interest rate will be larger. It is the change in the interest rate that leads to changes in borrowing and spending and therefore output.

16. Use the liquidity-preference model to explain how the Federal Reserve can react to the threat of exceedingly high inflation via monetary policy. Be sure to include the intended effect on the interest rate and quantity of money. [LO 15.8] 1-227 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Answer: When inflation is the major threat, the Fed can pursue contractionary monetary policy. It is likely to sell government bonds in order to reduce base money and therefore the supply of money. The money supply curve will shift to the left and the interest rate will rise.

This action will shift the AD curve to the left, reducing output and the price level. The AD curve will shift to the left if people and businesses decide to take out fewer loans due to the higher interest rates. If loans fall, then there is less spending and output will fall.

Problems and Applications 1. Determine whether each of the following would fulfill the three functions of money. If the item does not fulfill all three, name at least one function of money that it violates. [LO 15.1] a. Salt. b. The barter system. c. Baseball cards.

Answer: a. Salt could fulfill the medium of exchange function as long as people were willing to accept it in exchange for goods and services. It could be a good unit of account as long as people agreed on the prices in terms of salt that goods and services would sell for.

And it could also be a good store of value because salt keeps for a long time. If there aren’t major changes in the supply of salt that cause the purchasing power of a given unit of salt to vary a great deal over time, salt could be an acceptable form of money. b. The barter system does not fulfill all three functions of money. There are problems with the medium of exchange function, because not everyone will accept what we offer in return for the goods and services they offer. Goods and services traded directly under the barter system may not keep their worth, making them a poor store of value as well. If people agreed on the ratios via which one good or service would trade for another, the unit of account function could be satisfactorily fulfilled, but as a whole the barter system is not money and does not fulfill its functions. c. Baseball cards could fulfill the medium of exchange function if everyone agreed to accept them for goods and services, but this may be a difficult agreement to secure!

Baseball cards can keep fairly well over time, as long as they are protected from acidic conditions and moisture, so from this point of view they could act as a good store of value; however, the baseball card market is volatile, meaning the cards may not keep a roughly constant level of purchasing power over time (not fulfilling the store of value function). Moreover, rapidly changing prices make them a poor tool for gauging relative values (not fulfilling the unit of account function).

2. Imagine you own a lawn-mowing business. Identify the main function of money exhibited in each situation below. [LO 15.1] a. You swipe your debit card to purchase gasoline for your lawn mower.

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b. c. d. e.

You stuff your earnings from mowing lawns into a piggy bank.

You pay your friend Cornelius $5 to help you mow lawns.

You calculate your net earnings for the year on your tax return.

You determine how much value your new lawn mower has added to your business.

Answer: When money is exchanged for a good or service, it is being used as a medium of exchange. When we calculate values in dollar terms, we are using money as a unit of account. When we save dollars for a later use, we are using money as a store of value. a. Medium of exchange. b. Store of value. c. Medium of exchange. d. Unit of account. e. Unit of account.

3. From 2004 to 2009 the country of Zimbabwe underwent hyperinflation, in which prices rise rapidly. The government began printing bills as large as 100 billion Zimbabwe dollars.

Explain how this situation would have affected the characteristics of good money discussed in this chapter. [LO 15.2] Answer: Hyperinflation affects all three characteristics of good money. It makes the value of money unstable, which will eventually lower its acceptability (put yourself in the shoes of a seller: would you take money for the goods and services you sell if its value is decreasing rapidly?). When money is not commonly accepted, and using it means keeping up with constant changes in value, it is no longer convenient.

4. Suppose you live in a country perfect for growing tulips and governed by King Balthazar, who proposes that you use the tulips for your currency. After all, says Balthazar, they are widely accepted in the community, they’ve been valuable for years, and they are highly portable. If you were Balthazar’s economic advisor, would you recommend using the tulips?

If yes, list the traits of good money they satisfy. If no, list the trait(s) of good money they do not satisfy. [LO 15.2] Answer: Using an item for money is a good choice if the item has stability of value and is convenient to carry and exchange. Using tulips as money is not likely to be a good choice.

Frequent changes in the demand for and supply of tulips will occur if they are being used as money, which will result in their value not being stable. The fact that tulips are perishable, must be carefully handled, and must be stored within a small range of temperatures will make them an inconvenient choice.

5. You decide to take $500 out of your piggy bank at home and place it in the bank. If the 1-229 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

reserve requirement is 5 percent, how much can your $500 increase the amount of money in the economy? [LO 15.3] Answer: When you deposit the $500 into your bank, 5% of your deposit ($25) must be held on reserve and the rest ($475) can be lent out. When people take out loans and use the loan money to purchase goods and services, and the loan money is then redeposited into the banking system by the sellers of the goods and services, we have a multiplier process. Here the money multiplier equals 1/0.05 = 20, so your $500 can ultimately increase the money supply by $475 × 20 = $9,500. Note the increase in the money supply is $9,500 and not $10,000 because the $500 cash was part of the original money supply. When $500 cash is deposited into the bank, it can lead to the creation of $10,000 of deposits, but the amount of new money is only $9,500.

6. Assume that $1 million is deposited in a bank with a reserve requirement of 15 percent. What is the money supply as a result? What would change if the government decides to raise the reserve requirement to 30 percent? [LO 15.3] Answer: Here the money multiplier equals 1/0.15 = about 6.67, so your $1 million deposit will lead to the creation of $1 million × 6.67 = about $6.67 million of deposits in the banking system. The $6.67 million can be divided into $1 million, which was your initial deposit, plus $5.67 million, representing the creation of new money (the increase in the money supply) resulting from loans and the money creation process.

If the reserve requirement is increased to 30 percent, the new money multiplier will be 1/0.30 = 3.33, and a $1 million deposit will result in a money supply of $3.33 million ($1 million is the original deposit and $2.33 million is the new money created through the money multiplier process).

7. Say whether each of the following are types of M1 or M2, or both. [LO 15.4] a. Checkable deposits. b. Dollar bills. c. Money in your checking account. d. Money in your savings account. e. Certificates of deposit under $100,000. f. Traveler’s checks.

Answer: M1 includes hard money (currency) plus checkable deposits (which are not exactly cash but are readily accessible for most people). M2 includes everything in M1 as well as other items such as savings accounts and CDs (certificates of deposit) that are generally harder to access immediately and so slightly less liquid than other forms of money. a. M1 and M2. b. M1 and M2. c. M1 and M2.

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d. M2. e. M2. f. M1 and M2.

8. Which of the following statements are true regarding the differences between M1 and M2?

Check all that apply. [LO 15.4] a. M1 includes cash and reserves, whereas M2 does not. b. M2 represents a broader measure of the money supply compared to M1. c. Numerically, M1 is larger than M2. d. All items in M1 are more liquid than all items in M2. e. M2 includes savings deposits, whereas M1 does not. f. Checking account balances are part of M2 but not M1.

Answer: b, d, and e. M1 includes cash (hard money) plus checking account balances (demand deposits, which are not exactly cash but are readily accessible for most people).

M2 is broader still. M2 includes everything in M1 plus savings accounts and other financial instruments where money is locked away for a specified period of time. Because these forms of savings can’t be accessed quickly without penalty fees, they are slightly less liquid than other forms of money. (Certificates of deposit are an example of a lessliquid form of money.)

9. The following quotation comes from remarks given by Ben Bernanke, former chairman of the Federal Reserve: ―The substantial ongoing slack in the labor market and the relatively slow pace of improvement remain important reasons that the Commit-tee continues to maintain a highly accommodative monetary policy.‖ The Federal Reserve has a dual mandate. Which mandate does the quote refer to? [LO 15.5] Answer: The dual mandate refers to the Federal Reserve's twin goals of price stability and full employment. This quote is focusing on full employment (note its references to the labor market).

10. Look back to the POW camps described at the beginning of this chapter. Who played the role of the central bank? [LO 15.5] Answer: The central bank decides the money supply, so since it was the Red Cross that decided how many cigarettes were in circulation, the Red Cross would be the central bank.

11. Which tool of monetary policy is most likely being described by each of the following statements? [LO 15.6] a. It’s the major way the Federal Reserve System enacts monetary policy. b. This tool is good for emergency situations that require major, large-scale action. c. This tool goes through the Federal Reserve’s role as lender of last resort.

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d. This tool is best for everyday monetary policy. e. A major disadvantage of this tool is that it requires that banks want to borrow from the Fed. f. Even if they aren’t interested in buying, selling, or borrowing from the Fed, changes in this tool may inconvenience bank managers.

Answer: a. Open-market operations. b. Changing the reserve requirement. c. Discount window policy. d. Open-market operations. e. Discount window policy. f. Changing the reserve requirement.

12. Name the monetary policy tool being used in each of the following examples. [LO 15.6] a. The central bank buys government securities from banks. b. The central bank raises the cost of borrowing money. c. The central bank changes the amount of money banks must hold from their depositors.

Answer: a. This is an example of open-market operations. b. This is changing the discount rate, the interest rate charged when banks borrow from the Federal Reserve System via the discount window. c. This refers to a change in reserve requirements.

13. The economy is in recession and the Federal Reserve wants to increase the money supply.

Should it increase or decrease the following? [LO 15.6] a. Reserve requirements. b. The discount rate. c. Purchases of bonds in the open market.

Answer: a. The Federal Reserve should decrease reserve requirements to allow banks to create more money by making loans. When the reserve requirement falls, banks will have more excess reserves and these excess reserves can be used to make loans. b. The Fed should lower the discount rate to make it easier for banks to take loans from the Federal Reserve system; this will increase the credit available to others in the economy and hopefully increase spending.

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c. The Fed should increase its purchases of bonds in the open market because when it does, it increases reserves in the banking system, and ultimately credit available from banks to households and firms.

14. Using Figure 15P-1, answer the following questions. [LO 15.7]

a. Is this economy in recession, just right, or overheating? b. What is the correct monetary policy in this situation—expansionary or contractionary? c. What is the effect on prices of that policy—will they increase or decrease?

Answer: a. Output is above potential, so the economy is overheating. b. Contractionary monetary policy will cool down spending and stave off inflation. c. Prices will decrease. When the Federal Reserve pursues contractionary monetary policy, it will sell some of its government bonds in an open-market sale. This will decrease reserves in the banking system and interest rates will rise. The increase in interest rates will reduce spending and the aggregate demand curve will shift to the left.

15. What would happen to each of these components of the liquidity-preference model if the Federal Reserve decides to raise the reserve requirement? [LO 15.8] a. Money supply. b. Interest rates. c. Quantity of money in the economy. d. Money demand curve.

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a. Requiring banks to hold more money as reserves will hurt their ability to create new money, shifting the money supply curve leftward. b. The decrease in the supply of money will push interest rates upward, all else equal. c. The equilibrium quantity of money will fall, all else equal. d. There will be a leftward movement up along the money demand curve as the decrease in the money supply pushes interest rates upward.

16. For each of the following situations, identify whether the Federal Reserve is likely to pursue an expansionary or a contractionary monetary policy. [LO 15.8] a. The unemployment rate is at 0.5 percent. b. The economy is experiencing record growth in GDP. c. The unemployment rate is at 15 percent. d. Inflation has reached 10 percent, a recent high. e. A hurricane recently demolished a major city, causing a major recession.

Answer: a. Since the Fed’s goal is not 0% unemployment, the economy is likely producing more than potential output, in which case the Fed would engage in contractionary policy to slow down the growth in spending and stave off inflation. b. The Federal Reserve would likely engage in contractionary policy to ward off excessive inflation. c. The Fed would likely engage in expansionary policy to stimulate spending and therefore employment. d. The Fed would likely engage in contractionary policy to bring down inflation. e. The Fed would want to engage in expansionary policy to increase spending—particularly economic investment—and create jobs.

CHAPTER 16 INFLATION Solutions to End-of-Chapter Questions and Problems Review Questions 1. What is the difference between the Consumer Price Index and the inflation rate? [LO 16.1] 1-234 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Answer: The Consumer Price Index (CPI) is a number that measures the cost of a market basket of goods and services in a given year relative to the cost of the same market basket of goods and services in the base year. For example, if the basket of goods cost $80 in the base year and $120 in 2018, the CPI in 2018 would have a value of ($120/$80) × 100, or 150. This means prices are 50% higher in 2018 than in the base year. The inflation rate measures the percentage change in the CPI from year to year. If the CPI in 2018 was 150 and in 2019 it was 155, then the inflation rate is equal to (155 – 150)/150 × 100 or 3.33%.

2. What is the difference between core inflation and headline inflation? Why do economists calculate both types of inflation? [LO 16.1] Answer: Headline inflation is a measure of inflation that includes all of the goods and services that the average consumer buys. Economists calculate headline inflation to measure changes in the overall price level. Core inflation is a measure of inflation that excludes energy and food from the basket of goods and services purchased by the average consumer. The reason to calculate core inflation is that changes in price levels due to goods with volatile prices might simply reflect shocks to individual product markets rather than any sort of economy wide inflation. In 2018, the price of gasoline dropped 10 percent, while core inflation rose by 2.4 percent.

3. Your uncle comes to you with an investment idea. He tells you that the nominal GDP of Paradisia quadrupled over the past year and suggests that you invest there. Unemployment is at 20 percent, and inflation over the last year was 500 percent. Do you think it’s a good idea to invest? Draw on the neutrality theory of money to explain why or why not. [LO 16.2] Answer: Although nominal GDP has quadrupled (risen by 400%), this does not mean the value of real GDP has increased. Nominal GDP is measured by multiplying current prices times current output, so the growth rate of nominal GDP is equal to the growth rate of prices + the growth rate of output. Therefore, the growth rate of real output is equal to the growth rate of nominal output minus the inflation rate, or -100%. Given the decline in real GDP and the high unemployment rate, Paradisia is not a good place to invest. The neutrality of money defines the idea that, in the long run, changes in the money supply affect nominal variables, such as prices and wages, but do not affect real outcomes in the economy.

4. Why might we want to measure GDP in dollar terms? In output terms? How does the neutrality of money relate to your answer? [LO 16.2] Answer: GDP is intended to measure production. Calculating GDP in dollar terms is a convenient way to add up the many different goods and services produced in the economy. However, nominal GDP will increase anytime there is inflation—even when the economy is not producing any more goods and services than before. By measuring GDP in real (output) terms, we can focus on growth and actual production. Neutrality of money describes the idea that nominal variables such as prices do not affect real variables such as 1-235 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

output.

5. Suppose a country’s currency is a gold coin. One day, speculators find a large gold mine, which doubles the supply of gold coins in the economy. What will happen to output in the short run? What about price levels? What will happen to output in the long run? What about price levels? [LO 16.3] Answer: Although the process by which the supply of money has increased is different from when the Fed increases the money supply, the effect is the same. The increase in the supply of gold coins (money) will result in lower interest rates, which encourages borrowing and pushes up the consumption and investment components of aggregate demand. Therefore, in the short run, both output and the price level will rise due to a rightward shift of the aggregate demand curve. In the long run, the increase in the demand for labor and other inputs will increase the costs of production. Firms will increase prices, shifting the short-run aggregate supply curve to the left. The price level ends up at a higher level, while output goes back to its long-run level.

6. Explain how some analysts might use the short-run and long-run effects on the aggregate demand–aggregate supply model to argue that monetary policy can’t affect employment in the long run. [LO 16.3] Answer: In the short run, expansionary monetary policy shifts the aggregate demand curve rightward, increasing the price level and output. Over time the increase in output will have increased the demand for labor and inputs, and this will increase the costs of production. In response to higher costs of production, firms will increase prices and this will shift short-run aggregate supply to the left. The economy will end up going back to its same level of output with a higher price level. This assumes the economy is at potential output to start with. If the economy is not initially at potential output, monetary policy may have long-term effects on output and employment.

7. Why might the velocity of money increase around the holidays? If the Federal Reserve wants to avoid inflation in those times, what should it do? [LO 33.4] Answer: During the holidays, people increase their spending, which may mean that each dollar of income is spent more times. This is an increase in velocity. To see how inflation could result, consider the quantity equation: MV = PY. If velocity increases while the money supply M and real output Y are constant, inflation will indeed occur. But if the Federal Reserve responds by lowering the money supply, the economy could avoid inflation.

8. Use the quantity theory of money to explain how expansionary monetary policy can be inflationary. [LO 33.4] 1-236 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Answer: The quantity theory of money (MV = PY) can written in growth rate terms: % Change in M + % Change in V = % Change in P + % Change in Y. If we assume that velocity and real output Y are unchanging (in other words, their percentage change is zero), then any change in the money supply M must be matched by an equal change in the price level P.

9. Imagine you own an ice cream store in New York City. Write a brief note to your senators explaining two ways in which unpredictable inflation hurts your business. [LO 33.5] Answer: When inflation is unpredictable, it is harder for the business to make plans. The business may set its plan under one set of assumptions about prices, and then have to change its plan if there are unpredictable changes in prices. When inflation is higher than expected, this will reduce the real value of savings. When inflation is lower than expected, the real interest rate will rise and firms will have to make higher real interest payments. Shoe leather costs and menu costs occur with predictable inflation.

10. Is inflation harmful only when it’s unexpected? If yes, why? If no, name two costs that occur with even predictable inflation. [LO 33.5] Answer: Inflation is harmful even when predictable. Costs involve menu costs (from changing prices on websites, supply sheets, or literal menus), shoe leather costs (related to switching assets from those that pay interest—since predictable inflation is captured in the nominal interest rate—to those that are liquid when we want to spend), and bracket creep, (when increases in nominal but not real income result in being taxed more when our incomes haven’t risen in terms of purchasing power at all).

11. Your senators now claim that lowering prices would be good for everyone— ―Who doesn’t like lower prices, after all?‖ They tell you they plan to lobby for deflation. Explain why falling prices could lead to a bad situation. [LO 33.6] Answer: Deflation is a very bad idea for an economy. It makes debt harder to pay back because loans are made in nominal terms, yet borrowers will have to give up increasing shares of their real income when they pay them back. This will hurt households’ ability to consume. While deflation increases the value of savings in real terms, consumption will remain depressed because people will expect prices to keep on falling and therefore won’t want to spend until they come down even more. The economy would find itself in a deflationary trap in which low investment and consumption would lead to even more low investment and consumption. Deflation is definitely not the answer!

12. When does inflation become hyperinflation? What causes hyperinflation? [LO 33.6] 1-237 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Answer: Hyperinflation occurs when there is an extremely long-lasting and painful increase in the price level. When inflation spirals out of control, it often renders the currency completely useless because people have to hold larger and larger amounts of money to pay for goods and services. Hyperinflation is caused by the printing of too much money or sometimes by expectations that prices will continue to rise. If people expect prices to rise, they demand higher wages, and this then causes firms to increase prices. This can lead to a nasty cycle of rising wages followed by rising prices. When the government prints too much money, and there is no change in velocity or real output, the increase in the money supply is matched by an increase in the price level, as stated by the quantity theory of money.

13. What could have happened to prices and inflation in the wake of the years during and after 2007–2009 recession if the government and Federal Reserve had not intervened in the economy? How would this have affected the economy? [LO 33.7] Answer: If the government and Federal Reserve had not intervened, the reductions in consumption and investment would have continued, pushing the aggregate demand curve so far left that we may have seen deflation in addition to below potential output in the short run. Deflation can be hard to eliminate once it becomes established due to people being unwilling to borrow money and increase spending.

14. Are deflation and disinflation the same thing? Why or why not? [LO 33.7] Answer: No. Deflation is a decrease in overall prices and is very unhealthy for a nation.

Disinflation is a decrease in the rate of inflation (a decrease in the rate of increase of overall prices) and can be quite healthy for a nation, especially when it’s the result of contractionary policy meant to cool down the economy.

15. Would you expect nominal interest rates to be higher in countries that have higher target inflation rates? Why or why not? [LO 33.8] Answer: The nominal interest rate will be higher in countries that have higher target inflation rates. Given the target inflation rate is higher, actual inflation rates are likely to be higher as well. Higher inflation rates lead to higher nominal interest rates in order to maintain a reasonable real interest rate. The real interest rate is equal to the nominal interest rate minus the inflation rate, so higher inflation rates will reduce the real interest rate, all else the same.

As a result, nominal interest rates will rise.

16. Your friend claims that a target inflation rate of zero is a good policy because this will keep prices stable. You claim a positive target inflation rate is preferred because the country will be able to better avoid a liquidity trap. Who is right? [LO 33.8] 1-238 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Answer: A target inflation rate of 2–3% reduces the risk of deflation. If the inflation rate tends to hover around zero percent, and the central bank miscalculates by making monetary policy too contractionary, the result would be deflation, and this can have serious impacts on the economy. If the target inflation rate is 2–3%, then nominal interest rates will be above that level, meaning the Federal Reserve has some room to reduce interest rates before hitting the zero lower bound. A target inflation rate of 2–3% makes it easier for firms to adjust real wages. If prices are stable, reducing the real wage requires employers to reduce the nominal wage; workers may respond to a 1 percent reduction in their nominal pay by reducing their work effort.

17. In the 1960s, policy based on the simple short-run Phillips curve worked better than similar attempts in the 1970s. How might better information availability have contributed to this result? [LO 33.9] Answer: Inflation expectations play a key role in the long-run relationship between unemployment and inflation. We expect inflation to continue at its current level, so after a while output stops responding to inflation changes. The result is output going back to its previous level in the long run while inflation stays high. Essentially, policymakers were using the 1960s Phillips curve to make predictions, but by the 1970s the curve had shifted.

18. When we have a negative output gap, what is the proper monetary policy response in the short run? What are its intended effects on interest rates and employment? [LO 33.9] Answer: When we have a negative output gap, we are producing below our potential output, so expansionary monetary policy would be the best response to bring actual GDP closer to potential levels. The intent would be to lower interest rates to boost borrowing and spending and increase production and therefore employment.

19. Explain the effect contractionary monetary policy will have on the output gap, inflation, and unemployment if unemployment is currently at the non-accelerating inflation rate of unemployment. [LO 33.10] Answer: Contractionary policy will reduce the output gap by decreasing spending and lowering employment. This will result in an increase in the unemployment rate, and inflation will decrease.

20. Compare and contrast the effect of increased unemployment on inflation in the short and long run. [LO 33.10] Answer: In the short run, increased unemployment is associated with decreases in inflation, as captured in the original form of the Phillips curve, but over the long run this relationship tends to disappear as inflation expectations adjust.

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Problems and Applications 1. Two series of hypothetical price index values used to calculate headline and core inflation for 2014 through 2018 are found in Table 33P-1. [LO 33.1] a. Calculate the annual inflation rate for each series. b. Which series represents core inflation and which represents headline inflation? c. How do you know? Is there inflation or deflation in each year?

Answer: a. The annual inflation rate is calculated as (current series value – previous year's series value)/previous year's series value, multiplied by 100 to convert from decimal to percentage form. For example, in 2015 for series 1: (137.22 – 134)/134 = 0.0240 × 100 = 2.40%, or 2.4% rounded to the nearest tenth.

Year 2014 2015 2016 2017 2018

Series 1 134 137.22 141.26 146.24 148.81

Annual Inflation Rate n/a 2.4% 2.9% 3.5% 1.8%

Series 2 125 127.56 129.68 132.72 135.79

Annual Inflation Rate n/a 2.1% 1.7% 2.3% 2.3%

b and c. Core inflation removes food and energy prices because these prices are very volatile. Core inflation provides better information about "true" inflation because it removes the impact of short-run shocks to food and energy prices. Series 2 is likely to represent core inflation because the change in the inflation rate is smaller from year to year.

2. Determine whether each of the following events is likely to cause deflation, disinflation, no change in the price level, or inflation. [LO 33.1] a. A bubble in the biomedical industry just burst. b. A new technology is introduced into the economy, sparking an economic boom. c. The Federal Reserve conducts contractionary monetary policy. d. The Federal Reserve is successful at meeting its dual mandate of full employment and price stability.

Answer: a. A bubble that bursts in the biomedical industry will lead to a reduction in investment spending. This is most likely to lead to disinflation (a falling inflation rate) and not deflation (a negative inflation rate). Prices in the industry were likely to have been rising at a relatively high rate given the bubble, so the bursting of the bubble will slow the rate of price increase.

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b. An economic boom will increase spending and output and lead to inflation. c. Contractionary monetary policy will slow growth in the economy and lead to disinflation (a falling inflation rate). d. When the economy is fully employed and prices are stable, there is no change in the inflation rate.

3. Which of the following can be affected by the money supply in the long run? [LO 33.2] a. Nominal GDP. b. Real GDP. c. Inflation. d. Unemployment.

Answer: a and c. In the long run, the money supply can affect only nominal, not real, variables. The money supply affects nominal GDP in the short run, nominal GDP in the long run, real GDP in the short run, inflation in the short run, inflation in the long run, and unemployment in the short run.

4. The average individual in a country earns an annual salary of $62,000, of which $24,800 is spent on housing, $11,160 on food, $11,160 on transportation, and $14,880 on other goods and services. Suppose the government in this country mandates that all salaries and the prices of all goods and services be reduced by 40 percent. [LO 33.2] a. How much does the average individual now earn? b. How much does the average individual now spend on housing, food, transportation, and other goods and services? c. What happened to the average individual's real salary?

Answer: a. The individual's salary is now only 60% of its previous value, or $37,200. b. All prices and expenditures are now only 60% of their previous level: $14,880 is spent on housing, $6,696 is spent on food, $6,696 is spent on transportation, and $8,928 is spent on other goods and services. c. The real salary has not changed. If the nominal salary and all prices change by the same percentage, then the real salary does not change. In reality it is not possible for the government to mandate a 40% decrease in all prices and salaries, but hypothetically if they did then in real terms there would be no impact.

5. To increase the self-esteem of dieters everywhere, powerful fashion designers lobby 1-241 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Congress to redefine ―five pounds‖ as ―one pound.‖ Under this system, what would have previously been five pounds of bananas will now be one pound of bananas and a 500-pound gorilla would now weigh only 100 pounds. [LO 33.3] a. How much would someone who originally weighed 180 pounds now weigh as a result of this redefinition? b. Has there been a nominal change in the person’s weight? A real change? c. How is this story similar to contractionary monetary policy via a decrease in the money supply in the long run? (Hint: Congress essentially shrunk the ―pounds supply‖ by redefining the word.)

Answer: a. Someone who originally weighed 180 pounds would now weigh 180/5 = 36 pounds. b. There has been a nominal change (in the number of pounds), but not a real change in the person’s weight. c. This is similar to a decrease in the money supply done through contractionary monetary policy because the ―supply‖ of pounds has decreased. Really, it’s not so different from what countries with overheating inflation do when they redefine prices downward.

Through prices (or here, pounds) change, the amount of output doesn’t, which means in the long run we end up with lower prices but no change in output or employment, just as the weight watchers in our example now weigh less in numbers but have no change in body shape or health level that would be experienced if they had really lost weight.

6. ―Monetary policy is incredible,‖ your friend says. ―Just a little manipulation of the money supply and interest rates, and we end up at just the right price level and amount of output.‖ Is your friend overstating the Fed’s control over price levels and output? Why or why not [LO 33.3] Answer: Your friend is overstating the effectiveness of monetary policy for several reasons. In the short run, the Fed can shift the aggregate demand curve via monetary policy. For example, with expansionary monetary policy, the Fed can shift the AD curve rightward by lowering interest rates and thereby pushing up consumption and investment, causing an increase in the price level and real output. When the economy is in recession, this can be an effective policy in terms of putting people back to work. During an expansion, the Fed can use contractionary monetary policy to reduce aggregate demand and prevent an increase in the price level. However, in either case, the effectiveness of monetary policy depends upon how responsive households and firms are to the lower/higher interest rates. Additionally, it is difficult for the Fed to know exactly how much it needs to change interest rates to return the economy to potential output. Finally, sometimes the economy ends up in a liquidity trap where interest rates cannot go any lower but the economy is still in a recession.

7. Your dormitory Griffingate has appointed you central banker of its economy, which deals in 1-242 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

the currency of wizcoins. Assume that the velocity of wizcoins in Griffingate is constant at 10,000 transactions per year. Right now real GDP is 1,000 wizcoins, and there are 2,000 wizcoins in existence. [LO 33.4] a. What will be the value of each of the variables that make up the quantity equation—M, V, and P? b. Now indicate how the other variables will respond to each of the following scenarios, taking each case separately and assuming that velocity remains constant. (i) Real GDP: You increase the money supply to 4,000, and prices increase twofold. (ii) Price level: Start with the initial values. Real GDP drops to 500 wizcoins, and the money supply remains constant. (iii) Real GDP: Start with the initial values. Prices increase threefold because of a sudden scarcity of soda, and you decide to keep the supply of wizcoins constant. (iv) Real GDP: Start with the initial values. You increase the money supply to 5,000 wizcoins, and prices rise by 350 percent.

Answer: a. The money supply (M) is 2,000; velocity (V) is constant at 10,000. We can solve for price level (P) using the other variables: MV = PY, so 2,000 × 10,000 = P × 1,000. After solving for P, we find it is 20,000. b. (i) Real GDP: 1,000 wizcoins. You increase the money supply to 4,000 wizcoins and prices increase twofold. M is now 4,000 wizcoins instead of 2,000 wizcoins (it’s doubled), and prices have doubled as well, from 20,000 to 40,000. Velocity is constant, so we want to solve for our new level of real output Y: MV = PY, so 4,000 × 10,000 = 40,000 × Y. So Y is unchanged at 1,000 wizcoins. Could we have solved this another way? One way would be to use the quantity equation in its percentage-change form: Percentage change in M + Percentage change in V = Percentage change in P + Percentage change in Y. Plug in our changes in percentage form: 100 percent increase in M + No change in V = 100 percent increase in P + Percentage change in Y. We can see that there is no change in real GDP using this formula as well. (ii) Price level: 40,000 wizcoins. Start with the initial values. Real GDP drops to 500 wizcoins and the money supply remains constant. Y is now 500 wizcoins instead of 1,000 wizcoins, and the money supply and velocity are constant. Let’s find out what must happen to the price level P. We’ll use our old values for M and V and the new value for Y, then solve for P using the quantity equation. MV = PY, so 2,000 × 10,000 = P × 500.

Inflation has occurred, as P = 40,000, double its initial value of 20,000. (iii) Real GDP: 333 wizcoins. Start with the initial values. Prices increase threefold because of a sudden scarcity of soda, and you decide to keep the supply of wizcoins constant. We are now solving for the effect on Y using the quantity equation: MV = PY. Plug in our known values (2,000 money supply, 10,000 velocity) and our new value (prices are now 300 percent of 20,000 = 60,000): 2,000 × 10,000 = 60,000 × Y. Y equals about 333 wizcoins. We can see that this huge increase in prices, everything else held constant, caused a major decrease in real output, from 1,000 wizcoins to 333 wizcoins.

It’s a third of its original size!

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(iv) Real GDP: 714 wizcoins. Start with the initial values. You increase the money supply to 5,000 wizcoins and prices rise by 350 percent. First, let’s calculate the change in prices using wizcoin terms: 350 percent of 20,000 = 70,000 wizcoins. So the money supply (M) has risen to 5,000 and prices are now at 70,000. Still assuming velocity is constant at 10,000, we can solve for the new real GDP: MV = PY, so 5,000 × 10,000 = 70,000 × Y. Y now equals about 714 wizcoins, a reduction from its original value of 1,000 wizcoins.

Therefore, we can say that this increase in the money supply combined with high inflation caused a reduction in real output.

8. Express the following relationships using the equation for the quantity theory of money.

[LO 33.4] a. The money supply is given by nominal GDP divided by the velocity of money. b. The relationship of the money supply to the price level is the same as the relationship between real GDP and velocity. (Hint: Start by dividing the money supply by the price level.) c. Real GDP is given by the flow of money divided by the price level. d. The price level of an economy can be found by dividing the product of the money supply and its velocity by real GDP. Answer: a. M = PY/V. b. M/P = Y/V. c. Y = MV/P. d. P = MV/Y.

9. Identify whether the following individuals will be affected by bracket creep next year given the rates of taxation and levels of inflation found in Table 33P-2. [LO 33.5]

a. b. c. d.

Gabriela makes $9,500, and inflation is at 5 percent.

Cooper makes $160,000, and inflation is at a record high of 20 percent.

Shawna makes $140,000, and inflation is at 8 percent.

Samuel makes $45,000, and inflation is at 6 percent.

1-244

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e. Marguerite makes $96,000, and inflation is at 6 percent.

Answer: a. If Gabriela’s $9,500 income grows by 5 percent due to inflation, she will make 1.05 × $9,500 = $9,975. She will stay in her current tax bracket. However, more inflation than that could mean trouble. b. Cooper is already at the highest marginal tax rate. He won’t change brackets as a result of inflation. c. If Shawna’s $140,000 income grows by the inflation rate of 8 percent, she’ll end up with 1.08 × $140,000 = $151,200. Bracket creep has occurred, as this change in her nominal income has caused him to enter a higher tax bracket. d. Samuel is not likely to be a victim of bracket creep; if his current income of $45,000 grows by the inflation rate of 6 percent, he’ll have 1.06 × $45,000 = $47,700, not the $50,001 required to pay a marginal tax rate of 20%. e. Marguerite is likely to fall victim to bracket creep. If her income increases by the inflation rate of 6 percent, she’ll have income of 1.06 × $96,000 = $101,760. Her marginal tax rate will rise from 20 to 23 percent.

10. Cookie Monster has decided to channel his love of cookies into a new business, ―Me Want Cookies Inc.,‖ a new partnership he has formed with Miss Piggy. They are considering different countries in which to start their venture and would like to rank the countries based on the inflationary environment. They decide to give a country 10 ―menu-cost‖ points for each percent of actual inflation in the last year, since inflation will cause their menu costs to increase. They also dislike unstable inflation, so they will give a country 20 ―uncertainty‖ points for each percent difference in the actual inflation rate when compared to the projected inflation rate. Countries with the least total points will receive the highest rankings. Complete Table 33P-3 for Cookie Monster. [LO 33.5]

Answer:

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KermiKopia

Projected inflation (%) 2

Actual inflation (%) 4

Gonzoland

4

5

Elmostan

7

8

Oscaria

10

13

Bertico

14

14

Country

Uncertainty points (4 – 2) × 20 = 40 (5 – 4) × 20 = 20 (8 – 7) × 20 = 20 (13 –10) × 20 = 60 (14 –14) × 20 = 0

Menu-cost points 4 × 10 = 40

Total points

Rank

40 + 40 = 80

2

5 × 10 = 50

20 + 50 = 70

1

8 × 10 = 80

20 + 80 = 100

3

13 × 10 = 130

60 + 130 = 190

5

14 × 10 = 140

0 + 140 = 140

4

11. Jack recently took out a loan from Diane at an interest rate of 6 percent. Diane expected this year’s inflation rate to be 3 percent and the real interest rate to be 3 percent. The loan is due at the end of this year. Complete Table 33P-4, showing the real interest rate for each possible inflation rate. For each situation, determine whether the unexpected inflation level benefits Jack or Diane. [LO 33.5]

Answer: The expected real interest rate on the loan is 6 percent – 3 percent = 3 percent. If the actual real interest rate is above 3 percent, Diane benefits. Otherwise, Jack benefits.

This year’s actual inflation rate (%) 1 2 -1 -3

Actual real interest rate (%)

Who benefits?

6–1=5 6–2=1 6 – (-1) = 7 6 – (–3) = 9

Diane Diane Diane Diane

12. Assume the prices shown in Table 33P-5 are the prices of Big Macs in 2030, 2031, and 2033, 1-246 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

and that changes in the price of Big Macs tend to closely keep up with inflation. For each of the four instances, determine the following. [LO 33.6, 33.7]

a. The percentage changes in price levels between each consecutive year. b. Whether the economy was experiencing inflation, deflation, disinflation, or hyperinflation over each period. (Assume that inflation above 100 percent constitutes hyperinflation.)

Answer: a. From 2030 to 2031, the price level changed by (1.02 – 1.00)/1.00 = 2 percent; in other words, it had inflation of 2 percent. From 2031 to 2032, the inflation rate was (1.03 – 1.02)/1.02 = 0.98%. b. From 2030 to 2031, prices fell from 1.00 to 0.99. Therefore, there was deflation at a rate of (0.99 – 1.00)/1.00 = 1%. From 2031 to 2032, there was further deflation at a rate of (0.97 – 0.99)/0.99 = 2.02%. c. From 2030 to 2031, there was hyperinflation, as price levels increased by a whopping (0.05 – 0.01)/0.01 = 400%. Hyperinflation continued as we moved from 2031 to 2032, at a rate of (1.00 – 0.05)/0.05 = 1,900%. d. From 2030 to 2031, there was inflation at a rate of (1.10 – 1.00)/1.00 = 10 percent.; Disinflation occurred between 2031 and 2032 as the inflation rate fell to (1.15 – 1.10)/1.10 = 4.54%.

13. Assuming that inflation above 100 percent is hyperinflation, categorize each of the inflation rates in Table 33P-6 as deflation, disinflation, inflation, or hyperinflation as we move from one year to the next. [LO 33.7] Answer: Year 1900 1901 1902

Inflation rate (%) 90 80 120

Description Inflation Disinflation Hyperinflation

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Year 1903 1904

Inflation rate (%) 40 -2

Description Disinflation Deflation

14. Suppose you live in Frigidia, a country near the North Pole that is experiencing hyperinflation. You work for a U.S. company that pays you a monthly income of $100 U.S. Today, you can exchange those dollars for frigids, the currency of Frigidia, at a rate of 1,000 frigids/dollar. You pay a monthly heating bill that costs $10 U.S. Instead of paying the heating bill, you could simply burn Frigidia notes (which you can obtain in one-frigid denominations) at a rate of 1 million per month to supply heating. What would the exchange rate between frigids and U.S. dollars have to be for you to decide to burn bills instead of paying for heating? What level of inflation does this represent, assuming the real exchange rate remains the same? [LO 33.7] Answer: The current exchange rate is 1,000 frigids = $1. That means that our heating bill costs $10 × 1,000 frigids = 10,000 frigids. And, of course, the other option—burning the frigids—would cost 1,000,000 frigids. What exchange rate between dollars and frigids would make us indifferent to paying the bill or burning the currency? It would be the exchange rate that would make $10 equivalent to 1,000,000 frigids. If dollars traded at a rate of 1,000,000/10 = 100,000 frigids to one dollar, we would be indifferent between burning the currency or paying the bill. And if that exchange rate went up anymore, we’d be better off burning the currency.

This would represent a level of hyperinflation of (1,000,000 – 10,000)/10,000 = 9,900 percent!

15. ―The problem wasn’t having the wrong idea about interest rates,‖ a sheepish central bank official says at a conference, ―but rather not having the right idea about inflation rates.‖ What does the official mean? How does the inflation rate affect the central bank’s interest rate target, and how can a wrong prediction about inflation make monetary policy go awry? [LO 33.7] Answer: A central bank like the Federal Reserve generally targets a level of inflation that is positive but small—instead of going for zero growth in prices, they allow some to happen.

The reasons for this are mostly policy-related; by keeping a small positive target there is room for rates to fall, and if inflation is slightly different from expectations interest rates are less likely to hit zero. Real interest rates are what affect the economy through loanable funds, as discussed in previous chapters. But the Fed is targeting nominal interest rates, which include two components: real interest, and expected inflation. If their guess about inflation isn’t correct, they won’t achieve the real interest rate they hoped to get to by pushing the economy toward its nominal target rate.

16. In which scenario is monetary policy likely to be more effective? Explain. [LO 33.8] 1-248 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Scenario A—The inflation rate in the country has hovered close to zero for the last three years.

Scenario B—The inflation rate in the country has averaged 3 percent for the last three years.

Answer: Monetary policy is more effective if the inflation rate in the country has averaged 3 percent for the last three years because nominal interest rates will be higher so the Federal Reserve will not have to worry about hitting the zero lower bound. Keeping the inflation rate at a modest positive level gives the central bank some leeway to make mistakes, without running the risk of tipping the country into a deflationary spiral. If the inflation rate is close to zero, then nominal interest rates will be very low so the central bank will not have much room to lower the interest rate in order to stimulate spending (expansionary policy is not likely to be effective).

If the inflation rate is close to zero, the real interest rate is not necessarily lower—this will depend on where the nominal rate is relative to the inflation rate. When the inflation rate is higher, the nominal interest rate tends to be higher so that lenders will still earn a positive real rate of return.

17. Consider a country that has experienced a decline in labor demand that results in a 2 percent reduction in the equilibrium real wage. [LO 33.8] a. If the inflation rate in the country has been at zero percent, what has to happen to the nominal wage to restore labor market equilibrium? b. If the inflation rate in the country has been at 4 percent, what has to happen to the nominal wage to restore labor market equilibrium? c. Do you think workers and employers would prefer to have a zero percent inflation rate or a 4 percent inflation rate in this case? Explain.

Answer: The real wage is equal to the nominal wage divided by the price level, so percentage change in real wage = percentage change in nominal wage – inflation rate. a. -2% = percentage change in nominal wage – zero percent, so nominal wages will fall by 2%. b. -2% = percentage change in nominal wage – 4%, so nominal wages will rise by 2%. c. All else the same, workers prefer higher nominal wages. Psychologically they are likely to be happier with a 2% increase in nominal wages and 4% inflation as opposed to a 2% reduction in nominal wages and 0% inflation. In both cases the change in the real wage is the same, but workers are likely to feel happier with rising nominal wages because some of them will fail to distinguish between the nominal wage and the real wage.

Employers also prefer higher nominal wages because employee effort is likely to be greater, given some of them have failed to distinguish between real and nominal wages. Employers 1-249 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

are paying higher nominal wages, but if the inflation rate is 4%, then prices are rising faster than nominal wages, so employers are happy.

18. Determine whether the Federal Reserve would pursue contractionary monetary policy, expansionary monetary policy, or no change in policy in each of the following situations.

[LO 33.9] a. Inflation is 10 percent, above its average of 3 percent in the last several years. b. The output gap is positive. c. Unemployment is at a record high. d. The economy is experiencing full employment. e. The economy is on the brink of deflation. f. A new technology causes output to surge.

Answer: a. Contractionary monetary policy. b. Contractionary monetary policy. c. Expansionary monetary policy. d. No change in policy. e. Expansionary monetary policy. f. No change, or prepare for contractionary policy to bring down inflation.

19. Answer each of the following questions assuming the economy is experiencing a positive output gap. [LO 33.9] a. Is inflation decreasing, increasing, or stable? b. Is actual output greater than or less than potential output? c. Is unemployment rising or falling? d. Is the Federal Reserve more likely to pursue expansionary or contractionary monetary policy? e. Is the economy likely experiencing an expansion or contraction?

Answer: When the economy is experiencing a positive output gap, actual output is greater than potential output, and the economy is experiencing expansion. With nearly everyone employed (and working overtime), hiring new workers can be very expensive. Workers can eventually command higher salaries to switch jobs, since employers have to compete for them. Likewise, companies are competing to buy up machines, factories, or other inputs to meet soaring demand for their products, leading to a rise in those prices as well (i.e. increasing inflation). To curb inflation, the Federal Reserve will pursue contractionary monetary policy to slow the expanding economy.

20. Answer each of the following questions assuming the economy is experiencing a negative output gap. [LO 33.9] a. Is inflation decreasing, increasing, or stable? b. Is actual output greater than or less than potential output?

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c. Is unemployment rising or falling? d. Is the Federal Reserve more likely to pursue expansionary or contractionary monetary policy? e. Is the economy likely experiencing an expansion or contraction?

Answer: When the economy is experiencing a negative output gap, actual output is greater than potential output, and the economy is experiencing contraction. There are a lot of resources—either factories or workers—not being fully used. Workers are unemployed, and factories are sitting idle, waiting for work. In other words, the economy is experiencing recessionary conditions. During recessionary periods, low rates of inflation occur in part because there is so little demand for money. The Federal Reserve can fix this problem in the short-run by engaging in expansionary monetary policy.

21. Assume the Phillips curve is given by the simple equation U = –I + 15. The non-accelerating rate of unemployment is 8 percent. If inflation changes to 14 percent, what will be the unemployment rate in the short run? What will it be in the long run? [LO 33.10] Answer: We want to calculate the short-run unemployment rate when the inflation rate (I) is 14 percent. We can do so using the formula given: U = -I + 15. We plug in 14 for I and get U = –14 + 15 = 1 percent; that will be the short-run unemployment rate.

In the long run, though, unemployment will return to the NAIRU rate of 8 percent.

22. Using what you know about the Phillips curve, determine whether the following quantities will increase, decrease, or remain the same. [LO 33.10] a. Unemployment in the short run after an increase in inflation. b. Unemployment in the long run after an increase in inflation. c. Inflation in the short run after a decrease in unemployment. d. Inflation in the long run after a decrease in unemployment.

Answer: a. Decrease—this is an upward movement along the short-run Phillips curve. b. Remain the same—unemployment in the long run always returns to the natural rate. c. Increase—this is an upward movement along the short-run Phillips curve. d. Remain the same—in the long run, the inflation rate and the unemployment rate are independent. A structural change that reduces the natural rate of unemployment will not impact the inflation rate in the long run.

CHAPTER 17 FINANCIAL CRISIS 1-251 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Solutions to End-of-Chapter Questions and Problems Review Questions 1. Your best friend comes to you for financial investment advice. She is wondering whether she should invest in (a) a sector of the economy that has been performing extremely well in the last five years relative to historical levels or (b) one that has been performing extremely poorly in the last five years relative to historical levels. What would you advise? How might irrational expectations affect your recommendations? [LO 17.1] Answer: You might advise your friend to invest in the sector that’s been performing poorly on the assumption that what goes down must eventually go back up, or you might advise her to invest in the sector that’s been performing well on the assumption that what’s done well will continue to do well. Either way, irrational expectations can affect your answer via the recency effect, in which investors pay too much attention to recent events and not enough attention to the big picture.

2. What is leverage, and how can it make an asset pricing bubble worse? [LO 17.1] Answer: Leverage refers to using borrowed money to engage in economic investment. In an asset price bubble, irrational exuberance can keep pushing prices higher. These higher prices make it easier for a firm to borrow and therefore to invest via borrowing. However, if the increases in prices are truly caused by a bubble, leverage can worsen the situation by encouraging too much investment, which can go badly if firms cannot repay the loans they’ve made.

3. What causes a stock market bubble to form? [LO 17.2] Answer: A stock market bubble forms when stock prices become inflated beyond the point where anyone can explain precisely why the stocks should be so valuable. This tends to happen because the people who buy the stocks develop irrational expectations regarding what will happen to the stock prices in the future. Usually investors are irrationally optimistic in these cases and assume the asset's price will continue to rise.

4. History suggests that all stock market bubbles will eventually pop and cause severe financial loss for many of those who purchased stock. Given this history, do you think that stock market bubbles will continue to occur? Why or why not? [LO 17.2] Answer: Stock market bubbles are likely to continue to occur despite the fact that the bubble always bursts, causing stock prices to fall back to normal levels. Bubbles occur because people have irrational expectations and assume prices will continue to increase. Investors may know the bubble will eventually burst, but they may irrationally assume they can purchase the stock at a low price and then sell before the bubble bursts.

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5. Explain why it’s possible for tranching to make investing in a mortgage-backed security more risky than investing in a single subprime loan. [LO 17.3] Answer: Tranching is dividing a large loan into several smaller parts with different characteristics in terms of risk and return; it allows loans to be made that would not have been made otherwise due to borrower uncreditworthiness, but it may result in overextension of credit (loans may be made to borrowers who are simply uncreditworthy). When this occurs, a mortgage-backed security can actually be riskier than a single subprime loan, despite the fact that tranching was created to reduce risk.

6. Explain how a mortgage-backed security can increase loan availability to those with little credit or bad credit. [LO 17.3] Answer: When a bank makes a traditional loan, it takes on the risk of that loan; if the borrower defaults, the bank will suffer significantly. Mortgage-backed securities bundle many mortgages together, with the idea that while one or a few home borrowers may default on their mortgages, the chance of all of them doing so is much less. Spreading out risk in this fashion can make banks more willing to provide credit to those it would not otherwise lend to, increasing loan availability to those with little or bad credit—though, as seen throughout the chapter, sometimes this can go too far.

7. Explain the role that leverage played in the recent housing bubble. [LO 17.4] Answer: Leverage came into the recent housing bubble in the form of ―flipping‖ houses.

With the easy availability of credit, many people bought houses and made minor cosmetic adjustments, counting on prices in the housing market to continue rising so these houses could be quickly resold for a higher price. The resulting increase in demand for houses pushed up housing prices even more, causing more strain on the bubble that would eventually pop.

8. How did government policies and asymmetric information problems make the recent housing bubble worse? [LO 17.4] Answer: The government played a role in the recent housing bubble by promoting loans to low-income individuals, some of which were probably not creditworthy. On the monetary side, the Federal Reserve kept interest rates quite low, encouraging more borrowing to buy houses and for business growth. Investment banks bought loans assuming that commercial banks did their due diligence in researching borrowers and learning as much about them and their likelihood of repayment as possible, but many of those banks were more focused on the fees they could get from making loans than on the kind of information that would imply whether the loan would be repaid in full.

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9. Many subprime borrowers entered into ―adjustable-rate mortgages‖ with low teaser rates.

These mortgages allowed borrowers to pay a low interest rate for the first two years on their mortgage, before the rate jumped to market levels. But the loan documents sometimes made it difficult for borrowers to understand that the rate would increase. Explain why this practice could lead to a bubble in housing prices. [LO 17.5] Answer: Anytime borrowers don’t understand what they’re agreeing to, they run the risk of taking on loans they won’t be able to pay back, and this was definitely the case during the recent housing bubble. If borrowers don’t understand when interest rates on their loans will rise, or how this will affect their required payments, they may take on too much debt and not be able to make payments when the rate change occurs.

10. How did the recent housing crisis affect the aggregate demand curve? [LO 17.5] Answer: The aggregate demand curve shifted leftward mostly because of decreases in investment and consumption spending. Investment spending fell as credit became less available, and the types of consumption that require borrowing were similarly affected.

Moreover, households felt less wealthy than before as the value of their homes decreased, further depressing spending. Their need to make payments on loans pushed consumption down even further by reducing the amount of money households could spend on goods and services.

11. Imagine what would have happened if the Federal Reserve was not in place to act as a lender of last resort during the financial crisis. Absent government involvement, what would be the likely effect on aggregate supply? Why? What would be the likely effect on aggregate demand? Why? [LO 17.6] Answer: The Fed’s ―lender of last resort‖ function means that it stands ready to provide loans to banks that need liquidity. If the Fed didn’t fulfill this function, it would not buy up bad assets or provide reserves to banks that needed them, further decreasing the availability of credit. So aggregate demand would likely decrease even further as borrowing to invest becomes less possible. Eventually, lack of investment would also reduce aggregate supply, as businesses wouldn’t be able to invest in new technology and productive assets, which would hurt their ability to produce goods and services. Therefore, both AD and AS would shift leftward by a larger amount during a financial crisis if the Fed did not act as a lender of last resort.

12. As the Federal Reserve responded to the recent housing crisis, how did this affect its balance sheet? Can you think of what caused the balance sheet’s size to change so much? [LO 17.6] 1-254 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Answer: As a result of monetary policy actions taken to fight the effects of the housing crash, the Fed’s balance sheet more than doubled in size in just a few months. During this time, the Fed was not only buying U.S. Treasury securities (as it normally does to conduct open market operations), but it was also buying up large quantities of mortgage-backed securities and other financial assets in order to provide liquidity to the financial market.

13. What is the ―zero lower bound‖ that must be considered in monetary policy, and how can it cause problems in enacting such policy? [LO 17.7] Answer: The ―zero lower bound‖ refers to interest rates hitting zero—after all, if interest rates are already at zero, how can the Federal Reserve enact expansionary monetary policy by lowering them? Hitting the lower bound can cripple monetary policy, as was the case in Japan over the 1990s.

14. What is quantitative easing, and when might it be used? [LO 17.7] Answer: Quantitative easing occurs when a nation’s central bank targets monetary policy directly at the money supply instead of attempting to affect it indirectly via interest rates (the usual method). This can be effective when the government is at or near the zero lower bound on interest rates and cannot take them further downward; it was used with some success after the housing market bubble burst in2007. Quantitative easing involves the purchase of longterm government bonds or other financial assets by the Federal Reserve, as opposed to its more typical policy of purchasing short-term government securities.

Problems and Applications 1. Determine whether or not each of the following is an example of irrational expectations.

[LO 17.1] a. The price of Amazon’s stock rises after tech blogs reveal that the company plans to release a new tablet, rumored to be competitive with Apple’s iPad. b. The CEO of a new start-up producing applications for tablets is quoted as proclaiming a new era of media, in which thirst for content will rise indefinitely as information becomes more and more convenient for people to digest. An economics blog continues the discussion a year later, discussing returns to investment that have never before been contemplated. Stock prices for media companies are consistently outperforming historical levels by 50 percent and seem to be on a permanent rise. c. After an unusually cool summer, investors in Papa’s Cool Pops decide to sell, believing demand for frozen treats will never reach historic levels again because of the weather. d. The Justice Department reveals allegations against the CEO of a food and beverage company, alleging misconduct within the company. A trial could cost the company millions of dollars. The stock price falls by 5 percent by the day’s end.

Answer: Irrational expectations lead people to make decisions that are not optimal because they fail to adequately use all available information. There is a basic human tendency to 1-255 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

overvalue recent experience when trying to predict the future, and this leads people to make irrational decisions. Irrational expectations are often based on overly optimistic projections for the future, leading to stock market or housing market bubbles. a. This would not be an example of irrational expectations unless investors are reacting too much to the recent event in buying Amazon stock. b. This is an example of the recency effect, in which investors react too much to recent events. Also, it’s irrational to assume that media companies will continue to outperform historical levels by such a large amount. c. This is irrational due to relying too much on recent data rather than looking at the bigger picture. It will get warm, and people will want popsicles again! d. This is probably not an example of irrational expectations, as the market is reacting in a logical fashion to factors that will decrease the desirability of the firm’s securities.

2. Ike, an investor, is considering opening a margin account and investing $1,000 in Mike’s mutual fund. The terms of the account require that he pay back the amount he borrowed on the margin by the end of the year with 10 percent interest. Ike is trying to decide what level of margin he wants. For example, if he chooses an account at the level of 50 percent, the bank will let him borrow and invest an additional $500, or 50 percent of his original $1,000.

Complete Table 17P-1 by filling in Ike’s account value at the end of the year, given varying levels of the margin account and mutual fund performance. Assume that Mike’s mutual fund will return 40 percent per year in a stellar market and 5 percent per year in a fair market, and that in a terrible market, it will lose 30 percent. [LO 17.1]

Answer: Margin account level No margin 60%

Account value in a stellar market $1,000 × 1.40 = $1,400 [$1,000 + (0.60 × $1,000)] × 1.40 = $2,240

Account value in a fair market $1,000 × 1.05 = $1,050 [$1,000 + (0.60 × $1000)] × 1.05 = $1,680

Account value in a terrible market $1,000 × (1 – 0.30) = $700 [$1,000 + (0.60 × $1,000)] × (1 – 0.30) = $1,120

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Margin account level 100%

150%

200%

Account value in a stellar market [$1,000 + (1 × $1,000)] × 1.40 = $2,800 [$1,000 + (1.50 × $1,000)] × 1.40 = $3,500 [$1,000 + (2 × $1,000)] × 1.40 =$4,200

Account value in a fair market [$1,000 + (1 × $1,000)] × 1.05 = $2,100 [$1,000 + (1.50 × $1,000)] × 1.05 = $2,625 [$1,000 + (2 × $1,000)] × 1.05 =$3,150

Account value in a terrible market [$1,000 + (1 × $1,000)] × (1 – 0.30) = $1,400 [$1,000 + (1.50 × $1,000)] × (1 – 0.30) = $1,750 [$1,000 + (2 × $1,000)] × (1 – 0.30) =$2,100

3. Consider a stock whose value increases across an 8-year period as shown in Table 17P-2.

[LO 17.2]

a. Calculate the percentage change in the value of the stock from year to year. b. Calculate the percentage change in the value of the stock across the entire 8-year period. c. Do you think this qualifies as a bubble? Why or why not?

Answer: a. Percentage change is calculated as (new value – old value)/old value, all times 100 Year 1 2 3 4 5 6 7

Stock Value $70.00 $76.00 $82.00 $90.00 $100.00 $187.02 $330.00

Percentage Change n/a (76 – 70)/70 × 100 = 8.6% (82 – 76)/676 × 100 = 7.9% (90 – 82)/82 × 100 = 9.8% (100.00 – 90)/90 × 100 = 11.1% (187.02 – 100)/100 × 100 = 87.0% (330 – 187.02)/187.02 × 100 = 76.5% 1-257

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8

(570 – 330)/330 × 100 = 72.7%

$570.00

b. (570 – 70)/70 × 100 = 714.3%. c. A bubble involves trade in an asset whose price has risen unsustainably far above historically justified levels. From year 1 to year 5, the percentage change in the price was (100 – 70)/70 × 100 = 42.9%. From year 5 to year 8, the percentage change in the price was (570 – 100)/100 × 100 = 470%. The increase in the stock value is likely to be classified as a bubble because the annual growth rate in the last few years (years 6–8) is much greater than the annual growth rate in the first few years (years 1–5). There would have to be some special circumstance that caused the large increase in the growth rate to be justified as opposed to irrational.

4. Assume that a subprime mortgage involves a loan of $1,000 and is to be paid back in full with 30 percent interest after one year. [LO 17.3] a. Sometimes borrowers will not be able to pay off the entire mortgage or may default entirely. Calculate the final amount of money an investor earns under the payback rates shown in Table 17P-3. (Note that a rate of 130 percent means that the whole loan is paid off, plus the additional 30 percent of interest.)

b. Assume investors are unwilling to invest in these loans unless the expected rate of return is 10 percent. Calculate the expected rate of return for this loan by adding up all of the products of the final value and the probability that that value will occur. Will investors want to invest in this loan?

Answer: a.

Amount Paid (%) 130 110 100 50 0

Final Value ($) 1,300 1,100 1,000 500 0

Probability 0.6 0.1 0.1 0.1 0.1 Total expected value

Expected Value ($) 780 110 100 50 0 1,040

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b. This represents a 4% return (since we gained $40, and $40/$1,000 = 4 percent), which falls far short of the 10% required by investors. They will not be interested in buying these loans.

5. A single bank is considering two options: First, it can make a $200,000 mortgage loan for a customer with a 10 percent probability of default, or, second, it can buy a $200,000 security representing a bundle of 100 mortgage loans, which break down as shown in Table 17P-4.

You can calculate the weighted risk for each firm category by multiplying the percentage of loans represented (for example, the first tier includes 40 loans, which is 40/100 = 40% of the total) times the probability of default on loans of that category. Do so for each type of loan, then add together the weighted risks to come up with an overall expected default risk for this financial investment. If the bank is willing to take on only projects for which the default risk is 6 percent or less, which option(s) should it choose? [LO 17.3]

Answer: Number of loans 40 25 15 20

Probability of default (%) 3.0 11.0 1.5 5.0

Weighted risk 40% × 3% = 1.2% 25% × 11% = 2.75% 15% × 1.5% = 0.225% 20% × 5% = 1%

Add together the weighted risks to calculate a measure of expected default risk for the security: 1.2% + 2.75% + 0.225% + 1% = 5.175%. If the bank is only willing to take only loans with a 6% chance or less of default, it will clearly prefer the bundle of mortgages in the security.

6. Table 17P-5 shows hypothetical levels of average household debt and debt service payments in two years, 2015 and 2013. At what annual interest rate would consumers have had to borrow for the debt-service payments in 2018 to equal the debt-service payments in 2015, despite the increase in household debt? Assume households are paying only interest on their debt and not part of the principal. [LO 17.4]

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Answer: Here, in 2015 annual debt service payments were $700/$40,000 = 1.75 percent of total debt. If we want to keep our payments at $700 with our 2018 debt of $70,000, we’ll need to borrow at an interest rate of $700/$70,000 = 1 percent.

7. Imagine that your personal finances are summarized by the account balances shown in Table 17P-6. Assume also that your decision to save is a function of your income and net worth. More specifically, assume that your savings each year will be equal to: 0.2I – NW, where ―I‖ is your income and ―NW‖ is your net worth. [LO 17.4]

a. If your income is $60,000, how much will you save this year? b. Assume the value of your house decreases by 20 percent. What is your net worth now?

How much will you save?

Answer: a. When your income is $60,000, you will need to first calculate your net worth, which is the difference between assets and liabilities. Your net worth is currently $125,000 in assets – $120,000 in liabilities = $5,000. From here, you can calculate the amount you’ll save as follows: 0.2($60,000) – $5,000 = $7,000. b. If the value of your house goes down by 20 percent, it will decrease to $100,000 (its original value) times (1 – 0.20 = 0.80) = $80,000. This is a reduction in assets of $20,000.

Your assets will now total $125,000 – $20,000 = $105,000 and your liabilities will still be $120,000, for a net worth of $105,000 – $120,000 = –$15,000. Plug this amount into your savings equation, being careful about the negative net worth: 0.2($60,000) – (– $15,000) = $27,000.

8. Table 17P-7 gives information on income and debt for a small nation for the years 2015

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through 2018. The nation had average household debt of $34,000 at the end of 2014. Use this information to fill in the blanks. [LO 17.4]

Answer:

Year

Household income ($)

Financial obligations ($)

2015

35,000

4,200

2016

38,000

4,100

2017

41,000

5,100

2018

45,200

6,100

Financial obligations as % of income $4,200/$35,000 = 12.00% $4,200/$38,000 = 10.79% $5,100/$41,000 = 12.44% $6,100/$45,200 = 13.50%

Household debt ($) $34,000 + $4,200 = $38,200 $38,200 + $4,100 = $42,300 $42,300 + $5,100 = $47,400 $47,400 + $6,100 = $53,500

Debt as % of income $38,200/$35,000 = 109.14% $42,300/$38,000 = 111.32% $47,400/$41,000 = 115.61% $53,500/$45,250 = 118.36%

9. If the rate currently payable on 10-year Treasury bonds is 4.8 percent and the risk spread is 3 percent, what is the average rate on other forms of commercial lending? [LO 17.5] Answer: The risk spread is equal to the difference between the rate paid on commercial lending and that paid on long-term Treasuries; in other words: Risk spread = Rate on commercial lending – Rate on 10-year Treasury bonds Since we know the risk spread is 3 percent and the rate on 10-year Treasuries is 4.8 percent, we can plug these into the equation and solve for the rate on commercial lending: 3% = X% – 4.8%. The average rate on commercial lending must be 7.8 percent.

10. Which of the following policies were used in response to the latest financial crisis? Of those used, which are examples of monetary policy? Of fiscal policy? [LO 17.6] a. Aggressive controlling of inflation by raising interest rates. b. Providing short-term financing directly to small businesses to jump-start investment. c. Bailing out banks that have large amounts of risky mortgage-backed securities. d. Purchasing long-term bonds to increase the money supply. e. Raising the Social Security eligibility age by five years to encourage people to work.

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Answer: a. Not used: Interest rates were instead lowered to control unemployment. b. Not used: Financing was provided to banks but not to small businesses. c. Used: The TARP program is an example of fiscal policy. d. Used: This describes expansionary monetary policy via open market operations. e. Not used.

11. Table 17P-8 shows the balance sheet of a bank in millions of dollars. [LO 17.6]

a. What is the bank’s net worth? b. Assume housing prices increase and defaults on subprime mortgages rise, causing the bank’s assets in subprime mortgages to decrease from $500 million to $350 million.

What are total assets now? What is the bank’s new net worth? c. How far would the value of subprime mortgages have to fall to cause the bank to be insolvent (that is, for liabilities to be greater than assets)?

Answer: a. Net worth = Total assets – Total liabilities, so it’s equal to $4,700 million – $4,500 million = $200 million. b. This $150 million decrease in subprime mortgages would cause a $150 million decrease in total assets, to $4,700 million – $150 million = $4,550 million. Net worth would now be $4,550 million – $4,500 million = $50 million. c. We can calculate this by figuring out the amount of subprime loans where total assets and total liabilities would be equal—any greater decrease in subprime loans would cause insolvency. Total liabilities are currently $4,500 million, so we would have to have total assets less than $4,500 million to be insolvent. Starting with our original values, that would require anything more than a $200 million decrease in total assets (since $4,700 million - $4,500 million = $200 million). Therefore, if our subprime loans fell by anything more than $200 million from their original levels, the bank would be insolvent.

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12. Japan’s economic situation throughout its Lost Decade and beyond can be explained in terms of problems with monetary policy via interest rates. Explain what happened. Identify what Japan’s central bank should have done. [LO 17.7] Answer: The problems in Japan occurred because its monetary policy hit the zero lower bound of interest rates, making it impossible to further lower them to stimulate the economy.

Suggestions might include letting some of its biggest banks fail and shifting focus to the money supply. Quantitative easing could target increases in the money supply directly, rather than through interest rates, and might represent a way out of the persistent monetary policy interest rate problems in Japan.

13. Consider an economy with $12 billion in base money and a multiplier of 3. The money supply is currently $12 billion × 3 = $36 billion. Now let’s say that the amount of base money rises by 50 percent, to $18 billion. How must the multiplier change for the money supply to remain unaffected by this change in base money? [LO 17.7] Answer: In this problem base money × multiplier = money supply, so now $18 billion × new multiplier = $36 billion. Therefore, the new multiplier = $36 billion/$18 billion, or 2.

CHAPTER 18 OPEN-MARKET MACROECONOMICS Solutions to End-of-Chapter Questions and Problems Review Questions 1. What happens to the U.S. balance of trade as oil prices rise? [LO 18.1] Answer: The U.S. is a large net importer of oil. In fact, about one-third of our usual trade deficit is net oil imports. If oil prices rise faster than the quantity demanded of oil falls due to its higher price (in other words, if oil is inelastically demanded), then an increase in oil prices will cause an increase in the dollar value of imported oil. The U.S. balance of trade will fall.

2. Suppose a presidential candidate criticizes his opponent by saying his opponent’s economic policies have made the dollar weaker and cost U.S factory workers their jobs. What would be your response? [LO 18.1]

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Answer: This presidential candidate is making no sense. A weak dollar makes our factory exports cheaper for foreigners to buy and makes imports that compete with our domestic factories more expensive. Thus, a weak dollar helps factory workers keep their jobs.

3. Why would a company want to make a direct investment in countries where the company’s home currency has higher purchasing power? [LO 18.2] Answer: If a company’s home currency has a higher purchasing power in a foreign country, that company should be able to purchase labor, land, and factory equipment more cheaply in the foreign country than at home. Thus it makes sense to expand the company’s operations into the foreign country utilizing direct investment.

4. Part of the North American Free Trade Agreement (NAFTA) opened the Mexican stock market to U.S. and Canadian investors for the first time. How would this affect direct and portfolio foreign investment in Mexico? [LO 18.2] Answer: Direct investment is when a foreign company or investor ―directly‖ builds a new factory or store. Portfolio investment is when a foreign investor purchases financial assets in a country. This provision of NAFTA probably wouldn’t have any effect on direct investment, but portfolio investment would rise as foreign investors have an increased ability to purchase Mexican financial assets through the Mexican stock market.

5. If many factories that once made goods in the United States move to Mexico, what must also happen in order to correct the balance of payments in the United States? [LO 18.3] Answer: NCO = NX. If U.S. companies are moving factories to Mexico, they are engaging in direct foreign investment, which increases NCO. To balance this out, net exports (NX) must also increase at the same time.

6. Critics of NAFTA argued that opening our borders to free trade with Mexico would result in U.S. firms moving all of their factories to Mexico and the United States running large trade deficits with Mexico. Comment on the concerns of these critics using your knowledge of international trade and net capital flows. [LO 18.3] Answer: This criticism should not be a concern. If domestic firms increase their direct investment in Mexico, NCO rises—meaning that net exports must also rise to keep the economy in equilibrium. The U.S. would be running trade surpluses, not trade deficits. If the U.S. begins running large trade deficits with Mexico, NCO must fall in order to keep the economy in equilibrium. Thus, under this scenario Mexican firms and individuals would be investing in the U.S. Either one of the critics’ fears may come true, but they both can’t be true at the same time.

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7. Rating agencies rate countries on the perceived riskiness of investing in their economies.

Standard and Poor’s, one of the main rating agencies, downgraded the credit rating for U.S. Treasury bonds in 2011. According to this chapter, what impact should the downgrading have had on net capital outflows and interest rates? Why? [LO 18.4] Answer: If the U.S. is now perceived as riskier, fewer investors will be willing to invest in the U.S. NCO will rise, shifting the I + NCO curve to the right. The equilibrium interest rate will rise.

8. The interest rate on 10-year U.S. Treasury bonds just before Standard and Poor’s downgraded the U.S. credit rating was 2.47 percent. One year later, the interest rate on these bonds had fallen to 1.60 percent. How can one explain this result that seems to contradict the findings of this chapter? [LO 18.4] Answer: There are two potential explanations here. First, we could have had a violation of the ―all other things equal‖ or ceteris paribus condition. For example, while a downgrade of U.S. debt alone would shift I + NCO right, if Standard and Poor’s simultaneously downgraded many other foreign countries by even more, the net effect might be a leftward shift of NCO + I. Alternatively, a large fall in the demand for investment funds in the U.S. would shift I + NCO left, counteracting the initial rightward shift in I + NCO. Finally, a large increase in savings would shift S right, which, if large enough, could more than counteract the rightward shift in NCO + I. The second explanation might be that no one put any faith in Standard and Poor’s judgment about the risk of U.S. debt and simply ignored its downgrade.

This might be a reasonable explanation considering S&P had rated mortgage-backed securities with its highest possible grade only months before the housing meltdown made many of these financial instruments worthless.

9. List three policies that a government could engage in that would reduce interest rates. (Hint: Look back to Figures 18-6 through 18-8.) [LO 18.5] Answer: The government either needs to shift the I + NCO curve left or shift the savings curve (S) right. They can shift S right by encouraging savings (e.g., subsidizing savings through IRA or 401(k) plans or lowering tax rates on interest, dividends, or capital gains) or discouraging consumption (e.g., raising consumption taxes). The government can also directly increase S itself by reducing budget deficits or increasing budget surpluses. It can shift I + NCO left by discouraging investment (which would lower interest rates but be bad for long-term growth) or by engaging in plans that decrease NCO by convincing domestic savers to keep their savings in the country or encouraging foreign investors to bring money to the country (e.g., engaging in actions that make investors feel safe at home, reducing barriers for foreigners to invest, or raising barriers for domestic citizens to invest abroad).

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10. A country doubles its rate of saving. How is this likely to affect the equilibrium interest rate and net capital outflow? What is the impact on the trade balance? [LO 18.5] Answer: This is likely to decrease the equilibrium interest rate as the supply of saving curve shifts to the right. This will increase net capital outflow as people seek higher rates of return in other countries. The value of the country's currency will decrease under a floating exchange rate system because the demand for the local currency will decline. The trade balance (exports – imports) will increase because the decrease in the value of the country's currency will increase exports and decrease imports.

11. Suppose the exchange rate value of the dollar depreciates. Who wins and who loses? [LO 18.6] Answer: When the dollar depreciates, our goods become relatively cheaper so this will benefit people who travel to our country, firms that export our goods, and people who want to buy our assets. Anyone who wants to buy foreign goods will not benefit, such as domestic residents who want to travel to foreign countries and domestic residents who want to buy imported goods or financial assets from other countries.

12. Suppose the exchange rate was 104 yen per dollar in 2017 and 110 yen per dollar in 2018.

Did the dollar appreciate or depreciate? What about the yen? [LO 18.6] Answer: Because you must now pay more yen in exchange for one dollar, the dollar has increased (appreciated) in value and the yen has decreased (depreciated) in value.

13. Identify the main reasons why people convert one currency into another currency. [LO 18.7] Answer: People convert currency to buy goods and services from another country. They also sometimes engage in speculation and buy currency if they think it will increase in value. Foreign investors need to convert their home currency into the local currency to engage in direct foreign investment or portfolio investment.

14. During a recession the central bank lowers interest rates. How does this affect the exchange rate and net exports? [LO 18.7] Answer: During a recession, the central bank lowers interest rates. Under a floating exchange rate system, the value of the currency will depreciate because capital outflow will increase as people move their wealth to other countries where interest rates are relatively higher. Net exports (exports - imports) will increase because when the currency decreases in value, exports become relatively cheaper and imports become relatively more expensive.

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15. A country has a fixed exchange rate. If world interest rates rise, what will the country have to do to maintain its fixed exchange rate? Has the fixed exchange rate become relatively more undervalued or overvalued? [LO 18.8] Answer: If world interest rates rise, the country will have to buy domestic currency and sell foreign currency to maintain the fixed exchange rate because there will be more capital outflow. The fixed exchange rate has become relatively more undervalued.

16. Suppose that in response to a severe recession, a country with an overvalued currency and a fixed exchange rate moves to a floating exchange rate system. Who are the winners and losers in this move? [LO 18.8] Answer: Because the currency was previously fixed and overvalued, the move to a floating exchange rate will cause the exchange rate to depreciate. Exporters and firms that compete against imports (as well as these firms’ workers) are the winners as their products now become cheaper and more competitive against foreign goods.

17. A country operates under a flexible exchange rate system. When the central bank lowers the interest rate during a recession, how does this affect investment and net exports, and ultimately aggregate demand? What if the exchange rate was fixed instead? [LO 18.9] Answer: When the central bank lowers the interest rate during a recession, investment spending will increase because it is cheaper for firms to borrow, the exchange rate value of the currency will decrease because there is more capital outflow, and net exports will increase because of the change in the exchange rate. The aggregate demand curve will shift to the right because spending is higher. If the exchange rate was fixed instead, then the central bank would not be able to use monetary policy to change the interest rate because any change in the interest rate would move the exchange rate away from its fixed value.

18. What are the advantages to fixing the exchange rate at an undervalued level? What are the disadvantages? [LO 18.9] Answer: Fixing the exchange rate at an undervalued level will increase exports and decrease imports. This will be an advantage to those who exports goods and a disadvantage to those who import goods.

19. Discuss what would happen to the real exchange rate between the U.S. and Australia if oil prices fell, which dramatically reduced the cost of transporting goods [LO 18.10] Answer: If transportation costs between Australia and the U.S. fall, we should expect the real exchange rate between the two countries to converge to 1. When the U.S. dollar price is converted to Australian dollars using the nominal exchange rate, this value should equal the 1-267 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Australian dollar price.

20. Is it ever possible for a country’s nominal exchange rate to be depreciating while its real exchange rate is appreciating? Explain. [LO 18.10] Answer: Yes, it is possible for a country’s nominal exchange rate to be depreciating while its real exchange rate is appreciating. EXr = EX × (Ph /Pf). If the nominal exchange rate is depreciating this means EX is falling. EXr could still be rising as long as (Ph /Pf) is rising faster than EX is falling.

21. Foreign investors in a country become worried about the stability of the government due to its rising debt level. What do you expect to happen to the interest rate and the exchange rate value of the country’s currency, assuming the country has a floating exchange rate? [LO 18.11] Answer: Under a floating exchange rate, we would expect the interest rate in the country to increase due to capital outflow, and the exchange rate value of the currency will decrease in value (depreciate) due to an increase in the supply of the country's currency and an increase in the demand for the foreign currency.

22. Foreign investors in a country become worried about the stability of the government due to its rising debt level. How might the IMF help avert a financial crisis in this country? [LO 18.11] Answer: If foreign investors are worried about a country's ability to repay its debts, then they will be reluctant to make more loans to the country, and they may wish to remove funds from this country. This can cause a financial crisis if the country is unable to repay foreign investors. The IMF can step in and act as a lender of last resort. Additionally, the IMF may require the country to reduce its budget deficit and pursue contractionary monetary policy in order to reduce inflation.

Problems and Applications 1. Suppose total U.S. exports in the month of June were $123.1 billion and total imports from foreign countries were $192.2 billion. What was the balance of trade? [LO 18.1] Answer: Balance of trade = Exports – Imports = $123.1billion – $192.2 billion = –$69.1 billion.

2. Suppose a country has total GDP (Y) = $10 trillion, consumption = $8 trillion, government 1-268 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

spending = $2 trillion, investment = $3 trillion, and taxes = $1.6 trillion. What is the level of net exports or balance of trade? What is the level of public savings? What is the level of private savings? What is the level of net capital outflow? [LO 18.1, 18.3] Answer: a. Net exports: Y = C + I + G + NX, so 10 = 8 + 3 + 2 + NX. Thus, NX = 10 – 8 – 3 – 2 = – $3 trillion. b. Public savings = T – G = 1.6 – 2 = –$0.4 trillion. c. Private savings = Y – C – T = 10 – 8 – 1.6 = $0.4 trillion. d. Net capital outflow = NX = –$3 trillion.

Net capital outflow = Total savings – I = (Public savings + Private savings) – I = –0.4 + 0.4 – 3 = –$3 trillion.

3. Assume that U.S. investors purchased $50 billion in foreign assets, and foreigners purchased $100 billion in U.S. financial assets such as stocks and Treasury bills. In addition, U.S. businesses invested $150 billion in foreign factories and operations, while foreign companies invested $100 billion in U.S. factories and operations. What was the net capital outflow for the United States? [LO 18.2] Answer: Total U.S. foreign investment = $50 billion (portfolio investment) + $150 billion (direct investment) = $200 billion.

Total foreign investment in U.S. = $100 billion (portfolio investment) + $100 billion (direct investment) = $200 billion.

Net capital outflow = Total U.S. investment abroad – Total foreign investment in U.S. = $200 billion – $200 billion = $0.

4. Define each of the following as direct or portfolio foreign investment. [LO 18.2] a. Nike (a U.S. company) builds new factories in Cambodia. b. A U.S. hedge fund purchases 30 percent of the shares of a Brazilian paper manufacturer. c. Mercedes-Benz (a German company) builds a new manufacturing plant in Alabama. d. Intel (a U.S. company) sets up a new call center in India. e. A British chocolate maker buys a smaller U.S. rival. f. Hilton Hotels (a U.S. company) builds a new resort in Hawaii.

Answer: a. This is direct investment since Nike is building a new factory. b. This is portfolio investment since the hedge fund is buying financial assets. c. This is direct investment on the part of Germany into the United States. d. This is direct investment since Intel is building physical capital in a foreign country.

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e. This is portfolio investment since the British firm is only buying existing assets and not building anything new. f. This is not foreign investment of any type since Hawaii is part of the United States. If, instead, Hilton was building a new resort in, say, Cabo St. Lucas, Mexico, this would be direct investment.

5. Tom is stuck with his friends on an island that uses coconuts for currency, but they recently discovered Wilson’s Island nearby. Tom’s Island agrees to make only one transaction with Wilson’s Island: It sells a fishing boat to Wilson’s for 15 coconuts. Answer the following questions, assuming that yearly consumption on Tom’s Island equals 500 coconuts and domestic investments in huts and farm equipment equals 150 coconuts. [LO 18.3] a. What are net exports for Tom’s Island? b. What is the total national savings for Tom’s Island? c. Suppose Tom’s Island imports a volleyball net from Wilson’s Island for 5 coconuts.

What is the total national savings now? d. Now Tom purchases 1 coconut tree on Wilson Island at a cost of 10 coconuts. What is the balance of payments? (Hint: A coconut tree produces coconuts like a factory produces goods.)

Answer: a. Net exports = Exports – Imports = 15 – 0 = 15 coconuts. b. Net capital outflow = Total savings – I, and Net exports = Net capital outflow, so 15 = Total savings – 150, so total savings = 165 coconuts. c. Net exports = Exports – Imports = 15 – 5 = 10. Net capital outflow = Total savings – I, and Net exports = Net capital outflow, so 10 = Total savings – 150, so total savings = 160 coconuts. d. Balance of payments = Net exports = Net capital outflows. Net exports = 15 – 5 = 10. Net capital outflow = 10 coconuts (the cost of the foreign investment into Wilson’s - note the purchase of the tree is like a foreign investment because it will return coconuts each year).

6. Over the last five years, Portlandia’s average income has risen and caused the supply curve of loanable funds to increase and shift right. [LO 18.4, 18.5] a. Would the domestic interest rate have increased or decreased? b. Given the change in the interest rate, would General Motors (GM) be more or less likely to open a car manufacturing plant in the country? c. If Portlandia hits a recession and interest rates fall, which way must the demand curve for loanable funds have shifted?

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a. The savings curve will have shifted to the right, lowering interest rates. b. At the lower interest rate, firms are more likely to engage in investment spending, such as building a new car manufacturing plant. This can be seen on the graph as an increase in the equilibrium quantity of funds demanded (a downward movement along the I + NCO curve). c. Assuming the savings curve has remained constant, in order for interest rates to fall, demand must have shifted to the left. This is typical in most recessions. Firms and households hold off on making large investment decisions due to uncertainty about the future, low profits, or poor sales, so investment typically falls during recessions. The effect of recessions on the savings curve is more ambiguous. A recession reduces incomes, which should reduce savings, but recessions also cause uncertainty about the future, which may cause savers to engage in additional precautionary savings.

7. Describe what happens to the supply and/or demand curves for U.S. dollars under the following scenarios. In each scenario, does the U.S. exchange rate appreciate or depreciate, and what happens to the U.S. balance of trade? [LO 18.6, 18.7] a. A drought in Russia destroys the wheat crop, resulting in increased purchases of wheat from the US b. Bollywood movies become extremely popular in the United States, increasing demand for foreign movies. c. The U.S. government forces all government offices to purchase American-made computer products, instead of importing them.

Answer: a. Because foreigners want to purchase U.S. goods, the demand for U.S. dollars increases, appreciating the dollar. Because foreigners now have an increased desire to purchase American goods at any given exchange rate, the net exports curve will shift to the right.

Depending on the relative size of the two shifts, the U.S. balance of trade can either rise or fall. The appreciation of the dollar will reduce net exports and the increased desire to buy American wheat will increase net exports. b. Because Americans want to purchase foreign goods, they will get rid of U.S. dollars, increasing the supply of U.S. dollars. This shifts the supply of dollars curve to the right, depreciating the dollar. Because Americans now have an increased desire to purchase foreign goods at any given exchange rate, the net exports curve will shift to the left.

Depending on the relative size of the two shifts, the U.S. balance of trade can either rise or fall. The depreciation of the dollar will increase net exports and the preference for foreign goods will decrease net exports. c. Because Americans want to purchase domestic goods, they will hold on to U.S. dollars, decreasing the supply of U.S. dollars. This shifts the supply of dollars curve to the left, appreciating the dollar. Because Americans now have an increased desire to purchase domestic goods at any given exchange rate, the net exports curve will shift to the right.

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Depending on the relative size of the two shifts, the U.S. balance of trade can either rise or fall. The appreciation of the dollar will reduce net exports and the preference for American goods will increase net exports.

8. Suppose there is major unrest in the labor market in the United States, making European investors nervous about investing in the United States. [LO 18.6, 18.7] a. Draw the supply and demand curves for U.S. dollars, and show the appropriate shift(s) in supply and demand for U.S. dollars associated with the labor unrest. b. Did the value of the U.S. dollar depreciate or appreciate?

Answer: a. Because foreigners will not want to invest in the United States, demand for U.S. dollars decreases. This shifts the demand curve to the left.

b. Because the demand curve shifted to the left, the dollar depreciated.

9. A government has been running budget deficits for many years and decides to balance its budget. Explain how each of the following are affected under a floating exchange-rate regime. [LO 18.5, 18.6, 18.7] a. The interest rate. b. The exchange rate. c. The trade balance.

Answer: To balance its budget, the government must reduce spending and/or increase taxes. This will increase public saving and shift the saving curve to the right. a. The interest rate will fall because the government is borrowing less so saving is higher.

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b. When interest rates fall, domestic financial assets are less attractive so people may prefer to move their funds to other economies with higher interest rates. Net capital outflow will increase and the exchange rate value of the domestic currency will decrease as people reduce their demand for the local currency. c. Because the currency has depreciated, net exports will rise.

10. Suppose the new CEO for Apple Inc. decides to produce all the company’s products in the United States instead of China. [LO 18.7] a. Which way will the supply for U.S. dollars shift? b. Which way will the demand for U.S. dollars shift? c. Does the value of the U.S. dollar depreciate or appreciate?

Answer: a. Because Americans want to purchase domestic goods instead of foreign goods, they will hang on to U.S. dollars, decreasing the supply of U.S. dollars. b. Because foreigners now want to purchase American goods, they will demand more U.S. dollars, increasing the demand for U.S. dollars. c. From part a, supply decreases, shifting the supply curve to the left. From part b, demand increases, shifting the demand curve to the right. Both of these shifts serve to appreciate the dollar.

11. Suppose that in the United States last season’s hot holiday gift was the iPad (which is made primarily in China), while this season’s big gift is media content for the iPad (which is made in the United States). Determine whether there will be an increase, decrease, or no change for each of the following variables compared to last year. [LO 18.6, 18.7] a. Supply and demand for dollars. b. Exchange rate between the United States and China. c. Net exports for the United States. d. Net capital outflows for the United States.

Answer: a. The supply of U.S. dollars will fall as Americans hang on to dollars in order to purchase domestic iPad content instead of foreign iPad hardware. The demand for U.S. dollars will remain unchanged, as we don’t know anything about foreigners’ relative interest in the iPad hardware versus iPad content. b. The supply of U.S. dollars decreases, shifting the supply curve to the left. This results in an appreciation of the dollar.

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c. Because Americans now have an increased desire to purchase domestic goods at any given exchange rate, the net exports curve will shift to the right. Depending on the relative size of the shift here in part c and the shift in part b, the U.S. balance of trade or net exports can either rise or fall.

d. Because net exports must equal net capital outflows, the effect on net capital outflows will be the same as the effect on net exports. As noted in part c, depending on the relative size of the shift in part c and the shift in part b, the U.S. net capital outflows can either rise or fall.

12. In March 2009 the Canadian dollar was worth $0.78 U.S. dollars. In April 2011 the Canadian dollar was worth $1.06 U.S. dollars. What effect would this increase have on the trade balance between the United States and Canada? Why? [LO 18.6] Answer: Ceteris paribus, the Canadian dollar can now purchase more American goods than it did before ($1.06 vs. $0.78), so Canadians will increase their purchases of U.S. goods.

Similarly, the U.S. dollar can now purchase fewer Canadian goods than before. Since Canadian imports rise and Canadian exports fall, the Canadian trade balance falls and the U.S. trade balance rises.

13. Hiro has $10,000 to invest in the foreign exchange market. He’s interested in trading U.S. dollars (USD) for euros (EUR) and Japanese yen (JPY). Using Table 35P-1, determine the arbitrage profit/loss Hiro will make in each of the following scenarios. (Note: Any value less than $10 should be considered zero.) [LO 18.6]

a. USD  EUR  JPY  USD. b. USD  JPY  EUR  USD. c. Now look up the current exchange rates among any three currencies. Show that there are no arbitrage opportunities for the three currencies you chose.

Answer: a. $10,000 purchases 0.7823 × $10,000 = 7,823 euros.

7,823 euros purchases 103.796 × 7,823 = 811,996 yen.

811,996 yen purchases 0.01232 × 811,996 = $10,004.

This indicates an arbitrage gain of $4, but in reality this is an artifact of a rounding error.

This market essentially shows no arbitrage opportunities.

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b. $10,000 purchases 81.200 × $10,000 = 812,000 yen.

812,000 yen purchases 0.00963 × 812,000 = 7,820 euros.

7,820 euros purchases 1.2783 × 7,820 = $9,996.

This indicates an arbitrage loss of $4, but in reality this is an artifact of a rounding error.

This market essentially shows no arbitrage opportunities. c. Obviously, the exact answer here will depend on the student’s choices. Typing ―exchange rates‖ into Google will bring up current exchange rates for almost any pair of currencies.

Aside from rounding error, the student will not be able to find any significant arbitrage opportunities.

14. Some politicians argue for imposing trade restrictions in the hope that doing so will reduce the trade deficit of the United States. Assuming the United States has a floating exchange rate, answer the following questions regarding the impact of the trade restrictions. [LO 18.7] a. What is the impact in the foreign exchange market for dollars? b. What is the impact in the market for foreign currency (euros, yen, etc.)? c. What happens to the exchange rate of the dollar? d. What happens to net exports?

Answer: a. The imposition of trade barriers decreases the supply of dollars, as people in the U.S. need more dollars and less foreign currency because they will be purchasing more domestic goods. The supply of dollars curve shifts left, causing an appreciation of the exchange rate. b. The demand for foreign currency will decrease because fewer goods are imported and the value of the foreign currency will become weaker. c. A decrease in demand for foreign currency depreciates the foreign currency. The decrease in supply of domestic currency appreciates the U.S. dollar. d. The trade barriers decrease imports which increase net exports. However, the appreciation of the dollar will make U.S. goods relatively more expensive to foreigners, so U.S. exports and therefore net exports will decrease. The net effect on net exports depends on which change is larger.

15. Suppose the U.S. economy slips into a recession. In response, the Federal Reserve cuts the federal funds rate in order to avoid unemployment. Consider what happens to the following under a floating exchange-rate regime. [LO 18.8] a. Domestic investment. b. Capital inflow.

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c. d. e. f.

Capital outflow.

Exchange rate.

Net exports.

Aggregate demand.

Answer: a. Domestic investment will rise since more companies would be willing to build new factories or stores with the lower interest rates. b. Capital inflow will decrease since the return to investment in the U.S. is now lower, leading foreigners to move financial assets out of the U.S. This decreases the demand for U.S. dollars. c. Capital outflow will increase since the return to investment in the U.S. is now lower, leading Americans to move their financial assets abroad. This increases the supply of U.S. dollars. d. Since the demand for U.S. dollars decreases and the supply of U.S. dollars increases, the exchange rate falls. e. Since the dollar depreciates, U.S. exports will be more competitive and domestic goods will be more competitive against imports. Net exports rise. f. Net exports are one of the components of aggregate demand. Since net exports rise, aggregate demand will also rise.

16. Reevaluate the previous problem assuming the U.S. economy follows a fixed exchange-rate regime. [LO 18.8, 18.9] Answer: The answer for all of the parts is ―there is no effect.‖ The reason for this is that when the Federal Reserve cuts interest rates by selling bonds, this causes capital outflows to increase and capital inflows to fall, putting downward pressure on the exchange rate. In order to prop up the exchange rate to its fixed level, the Federal Reserve will have to buy bonds and increase the interest rate. Thus, the interest rate ends up back where it started, and there is no change in any of the economic variables.

17. A country that has been operating under a fixed exchange-rate regime falls into recession. All attempts at using fiscal policy to lift the economy out of recession have failed. [LO 18.9] a. Can monetary policy be effective in this case? Why or why not? b. Should the country allow the exchange rate to float? Why or why not?

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a. If the central bank was to use monetary policy to help lift the economy out of the recession, it would want to increase the money supply and decrease interest rates in the economy. This change in interest rates would cause an increase in net capital outflow as people seek higher rates of return elsewhere. The value of the domestic currency would decrease as people increase the supply of domestic currency. b. To maintain the fixed exchange rate, the central bank would have to buy domestic currency. Under a fixed exchange-rate regime, the central bank cannot use monetary policy to influence economic activity because it needs to buy/sell domestic currency to maintain the fixed exchange rate. The central bank needs to decide which goal is more important—the fixed exchange rate or the state of the domestic economy.

18. In Windsor, Ontario, a Big Mac from McDonald’s costs C$4.17 (Canadian dollars), and across the border in Detroit it costs $3.56 in U.S. dollars. [LO 18.10] a. Suppose the nominal U.S. exchange rate with Canada is US$0.70 per Canadian dollar.

Does the purchasing power parity hold between the two countries? b. What is the purchasing power parity exchange rate for the United States?

Answer: a. Purchasing power parity between the two countries does not hold. If purchasing power parity holds, a Big Mac should cost the same in each country after accounting for the exchange rate. But if the exchange rate is $0.70 (US/C), the Canadian Big Mac costs C$4.17 × 0.70 (US/C) = US$2.92 in Canada, which is less than the $3.56 actual cost of the Big Mac in the U.S. b. If purchasing power parity holds, a Big Mac should cost the same in each country after accounting for the exchange rate. So, we need to find EX (expressed in terms of $ per C$) such that EX × C$4.17 = $3.56. Dividing both sides by C$4.17 gives us EX = 0.854 dollar per Canadian dollar.

19. Suppose the current U.S.−UK exchange rate is 0.64 pound (the pound is the UK currency) per dollar, and the aggregate price level is 175 for the United States and 138 for the UK. What is the real exchange rate? What does this real exchange rate mean in terms of the relative purchasing power of the dollar and the pound? [LO 18.10] Answer: The real exchange rate = nominal exchange rate × (domestic price level/foreign price level), so real exchange rate = 0.64 × (175/138) = 0.812. This real exchange rate means that the U.S. dollar buys 0.812 times as much ―stuff‖ in the UK as it would in the U.S.

20. Imagine there are only two trading nations in the world. For each of the following scenarios,

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determine whether goods in one country will become more attractive relative to goods in the other country given their inflation rates and a shift in the nominal exchange rates. [LO 18.10] a. Inflation is 8 percent in the UK and 4 percent in Germany, but the UK pound−euro exchange rate remains the same. b. Inflation is 3 percent in the U.S. and 7 percent in Japan, but the exchange rate for the United States. dollars to Japanese yen increases from 70 to 80 Japanese yen. c. Inflation is 10 percent in the United States. and 6 percent in Mexico, and the price of the Mexican peso rises from US$0.08 to US$0.15.

Answer: a. Because prices are going up faster in the UK than in Germany but the German currency is not appreciating, German goods will become relatively cheaper in the UK and British goods will become relatively more expensive in Germany. b. Due to inflation, the nominal costs of goods made in Japan are becoming more costly compared to those made in the U.S. at a rate of 4 percent = 7 percent (Japanese inflation) – 3 percent (U.S. inflation). The Japanese currency is becoming cheaper, however, at a rate of 14 percent = (70 – 80)/70. Thus, Japanese goods will become relatively cheaper compared to U.S. goods. Using an example, imagine a good that currently costs $1.00 in the U.S. and 70 yen in Japan. At an exchange rate of 70 yen/$, the two goods are the same price in each country. Now assume inflation of 3 percent and 7 percent, respectively. The U.S. item now costs $1.03 ($1.00 × 1.03) and the Japanese item now costs 74.9 yen (70 yen × 1.07). When converted to U.S. dollars using the new exchange rate of 80 yen per dollar, the Japanese item costs 74.9 yen/80 = $0.936, so it has become cheaper. c. In this case, due to inflation, the nominal costs of goods made in the U.S. are becoming more costly compared to those made in Mexico at a rate of 4 percent = 10 percent (U.S. inflation) – 6 percent (Mexican inflation). The Mexican currency is becoming more expensive, however, at a rate of 88 percent = (0.15 – 0.08)/0.08. Thus, U.S. goods will become relatively cheaper compared to Mexican goods. Using an example, imagine a good that currently costs $1.00 in the U.S. and 12.5 pesos in Mexico. At an exchange rate of 0.08 pesos/$, the two goods are the same price in each country. Now assume inflation of 10 percent and 6 percent, respectively. The U.S. item now costs $1.10 ($1.00 × 1.10) and the Mexican item now costs 13.25 pesos (12.5 pesos × 1.06). When converted to U.S. dollars using the new exchange rate of 0.15 dollar per peso, the Mexican item costs 13.25 × 0.15 = $1.9875, so it has become more expensive.

21. Over several years, foreign investors poured billions of dollars into a country due to its favorable growth prospects. They have now become concerned about the return on their investments because growth in the country is stagnating. As a result they are pulling their money out. Will this country be better able to withstand the financial crisis if it has a fixed or a floating exchange rate? Explain. [LO 18.11] 1-278 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Answer: Under a floating exchange-rate system, the country's currency will depreciate and interest rates in the country will increase. As a result of these changes, net exports will increase and consumption and investment spending will decrease.

Under a fixed exchange-rate system, the country's currency will not change in value and interest rates in the country will not change because the central bank will need to buy domestic currency and sell foreign currency to maintain the fixed exchange rate. As a result of these changes, net exports will not change and consumption and investment spending will not change.

Under the floating exchange-rate system, the value of GDP is likely to decrease due to higher interest rates unless the change in net exports is significant. Under a fixed exchange-rate regime, the central bank may exhaust its supply of foreign currency because it must buy domestic currency in exchange for foreign currency demanded by people as they pull their funds out of the country.

CHAPTER 19 DEVELOPMENT ECONOMICS

Solutions to End-of-Chapter Questions and Problems Review Questions 1. Are capabilities and utility the same thing? If so, why do economists use two different terms for the same concept? If not, explain the difference, both in terms of their definitions and when each is best used in economic analysis. [LO 19.1] Answer: No, capabilities and utility are not the same thing. Utility is satisfaction; in previous chapters, we’ve discussed how individuals seek to maximize utility subject to the constraint of their scarce resources (income). Capabilities, on the other hand, are possibilities—what people can do. Utility is best used for analysis on an individual level, while capabilities are best used for analysis on a societal level.

2. Determine whether each of the following is true or false. [LO 19.1] a. The chance to see a musical is an example of a capability. b. The freedom to practice religion is not a capability because it is not directly related to economic development. c. Economists will make the same conclusions and recommendations using the utilitymaximization approach as they will using the capabilities approach. d. The capabilities approach works better for analyzing what’s best for society, while the utility-maximization approach works better for analyzing what’s best for an individual.

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Answer: a. True. This capability relates to people being able to engage with their culture. b. False. Capabilities do not have to be directly related to economic development. c. False. The capabilities approach takes a broader view. What may maximize one person’s utility may not maximize capabilities for society as a whole. d. True. The utility-maximization approach attempts to find what will give an individual as much satisfaction as possible, given constraints. The capabilities approach focuses instead on what will maximize capabilities in a broad sense for society as a whole, considering things as disparate as engagement in culture, self-expression, health, and human capital.

3. Are economic growth and economic development the same? Why or why not? [LO 19.2] Answer: Economic growth and economic development are not the same. Economic growth refers to increases in output or income (GDP), while economic development refers to increases in capabilities—what those in an economy can do, including living a relatively long and healthy life, receiving education, expressing themselves relatively freely, engaging in their culture, and so on.

4. Does economic growth lead to development? Or does the causation run the other way, with economic development leading to growth? Explain. [LO 19.2] Answer: Economic growth (increases in GDP) does not necessarily lead to economic development. A nation’s GDP can rise while capabilities—to live a long and relatively healthy life, to receive education, to engage in culture, and so on—remain unchanged or even decline. However, more evidence exists that economic development leads to economic growth. Property rights, strong institutions, and increases in human capital can increase investment and productivity, leading to increases in GDP.

5. How can health and education work together to spur economic development? What does this imply about the best way to spend aid funds with the goal of increasing educational attainment in a developing nation? [LO 19.3] Answer: Education increases human capital, which tends to increase economic development.

But that leaves the question of how to increase the level of education in a given nation—do we buy books, supplement teachers’ salaries, or do something else? Some studies indicate that a more indirect approach focusing on the relationship between health and education may be a good choice. Providing medication, such as deworming pills or quinine (which fights malaria), is likely to increase overall health levels of students, which may result in fewer missed school days, a greater ability to concentrate in class, and better learning outcomes.

6. Explain how better health care in a developing nation, such as increasing the number of 1-280 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

immunized children, can have economic effects beyond fewer sick kids. [LO 19.3] Answer: A child who has been immunized and therefore isn’t sick can attend school more frequently, be more attentive in class, and learn more, all else equal. This can increase human capital, push up productivity, and lead to more economic growth. But even children or adults who don’t receive the vaccine can benefit. More vaccinated children can lead to a positive externality—if more kids get vaccinated, not only will they not get sick, but they won’t spread illness to other children and adults. As we discussed in the chapter on externalities, because the positive effects of vaccinations extend beyond those who actually get the vaccines, this is a case where government intervention in the form of providing or subsidizing vaccines could be useful.

7. ―I’m thinking about writing a paper for class on development economics,‖ your friend tells you over lunch. ―I’m going to focus on important institutions like government bodies and economic agencies.‖ Is your friend using the term institutions correctly? Why or why not?

[LO 19.4] Answer: No. In development economics, the term institutions refers to the rules and customs that describe what is and isn’t acceptable in a society. The government bodies and economic agencies your friend is describing are referred to as organizations in development economics.

8. How can capital be considered ―dead,‖ and what do we mean by making this capital ―alive?‖ [LO 19.4] Answer: Capital is considered ―dead‖ when it doesn’t have a legally enforceable title providing proof of ownership. Such assets could be used as collateral to get loans and therefore spur economic development via investment, but without a title lenders will be unwilling to make these loans. This capital can become ―alive‖ if property rights are wellestablished and enforced by a strong titling and court system. Although the evidence is somewhat mixed, ―dead‖ capital contributes less to economic development than does capital that’s ―alive.‖

9. International trade is associated with economic growth and development—open economies tend to grow faster than closed economies, all else equal. Given this information, should a nation seeking to grow and develop faster use the method of import substitution or export-led growth? How would each of these two methods affect GDP through its net exports component? [LO 19.5] Answer: Export-led growth is accomplished by subsidizing exports and giving tax breaks to producers of goods to be sold to other nations. This will increase net exports by increasing 1-281 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

exports (remember, net exports = exports – imports). Import substitution, on the other hand, discourages imports with methods such as tariffs. It can also increase net exports, but by decreasing imports instead of increasing exports. Though both methods can increase GDP through its net exports component, export-led growth keeps the economy more open in terms of international trade and, given what we’re told in the question, would be the better choice.

10. Determine whether each of the following is an example of import substitution, export-led growth, or clustering. [LO 19.5] a. The government gives a $50 million grant to a leading university to work with car manufacturers and to research new ways to produce more fuel-efficient vehicles. b. The government gives $50 million to a domestic car company to subsidize its shipping costs to other countries. c. The government enacts a tariff on all cars imported from abroad.

Answer: a. Clustering. b. Export-led growth. c. Import substitution.

11. How can emigration help the home economy in terms of income? Are the benefits of migration on income limited to those who actually migrate? Why or why not? (LO 19.6) Answer: Emigration can boost a nation’s income when those that migrate send remittances back home. But the positive effects of migration aren’t limited to those who actually migrate.

Many emigrants return home with new ideas and skills gained abroad, which can be passed on to workers in their home economy and may boost productivity and income.

12. How does emigration affect wages and income in the migrant’s country of origin? In the country the migrant immigrates to? (LO 19.6) Answer: Emigration increases wages and income in the home nation in two ways. First, having some workers leave the domestic labor market to seek work elsewhere reduces the home country’s supply of labor, pushing up wages and increasing income, all else equal.

Remittances (money sent home by emigrants) increases income further. It’s a common fear that immigration will cause decreases in wages and income in the destination country.

Although there is some evidence that wages may decrease for domestic low-skilled workers who can be replaced by immigrants willing to take lower pay, evidence is more mixed than many think. If immigrants take jobs that domestic workers don’t want—and there is evidence that this is frequently the case—wages for domestic workers won’t decrease, and the additional production from these immigrants can boost national income in the destination country as well.

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13. Say that the United States is considering giving direct aid to a nation run by a dictator known for his lavish lifestyle while the nation’s citizens suffer through a terrible famine. What might be a problem with giving aid to this nation? Name at least one way to fix the problem. (LO 19.7) Answer: The problem with giving aid to this nation is that the dictator might simply keep the funds given, as in the case described in the text where ―peacekeeping funds‖ in Sierra Leone were embezzled by generals to buy television sets and hunting rifles. Beyond this, there will be little incentive for the dictator to make real economic improvements because that would cause aid, and therefore his lavish lifestyle, to be reduced or eliminated entirely. Luckily, several approaches can address this problem, including monitoring the use of the donated funds and setting specific, measurable goals for economic development in the recipient nation, on the condition that if information isn’t given as requested or goals aren’t met that aid will stop. Also, efforts to improve the nation’s government, such as making receipt of funds contingent on economic and governmental changes and providing assistance in making those changes, will increase the chance of real increases in economic development in the nation over the long run.

14. What are goods-in-kind donations, and how can they hurt the economies they’re meant to help? (LO 19.7) Answer: Goods-in-kind donations are transfers of goods to nations in which we want to improve economic growth and development. They can be free donations or sold at a low price. Even with the best of intentions, goods-in-kind donations can hurt the economies we’re trying to help. Influxes of goods from other countries can hurt domestic manufacturers of those goods, and sometimes we send goods the nation doesn’t need or want. Additionally, even donated goods require shipping costs, which can be substantial and can take up funds that could be better spent in other ways.

15. How does impact investment differ from traditional foreign aid and traditional financial investment? [LO 19.8] Answer: When people donate money to private charities that provide medical supplies to poor countries, this is an example of foreign aid. When people invest money in firms to generate financial and social return, this is an example of impact investment. When people invest money in stocks and bonds to receive a financial return, this is an example of financial investment.

16. Explain briefly how you could set up an RCT to evaluate whether providing free breakfasts to elementary-school students helps them learn. (LO 19.9) Answer: One initial consideration would be how to define and evaluate ―learning‖ in this case. If you decide to use written tests, you’ll want to be reasonably sure test results are 1-283 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

correlated with learning in some meaningful way. Then you’d want to create two groups matched in important factors—demographics, family income, school attendance, hours spent studying, previous grades and test results, and so forth—and randomly assign equal numbers of students to each group. You’ll provide free breakfast to the treatment group and not provide it to the control group. Remember that random placement of students in either group is key to the success of an RCT. Finally, administer and score the tests, then compare the results across the two groups. If you find that the group receiving free breakfast receives higher scores, this isn’t a perfect indicator that the provision of breakfast leads to better learning, but it does lend significant support to the conclusion that it does.

17. List three shortcomings of using an RCT to evaluate the success of a given economic program. (LO 19.9) Answer: There are several possible answers, but these come from the text: (1) You may not be able to replicate the findings in other nations with different cultures and institutions. (2) An RCT is not appropriate to assess the effectiveness of all types of policies, such as a change in monetary policy. (3) An RCT doesn’t give information on why some programs are successful and others aren’t, even if it gives a good indication of whether a program is successful or not.

Problems and Applications 1. In a small town in the midwestern United States lives a drug dealer and manufacturer who supplies the illegal, addictive drug crystal meth. The drug dealer insists that making and selling the drug is what gives him the most satisfaction among any possible use of his time and resources. Using the utility-maximization approach, should he be allowed to continue supplying the drug? What about with the capabilities approach? Explain your answer. [LO 19.1] Answer: The utility-maximization approach would indicate that if this activity truly gives the drug dealer the most satisfaction among all other alternatives, he should do it. But the capabilities approach looks beyond the dealer to what’s good for the society around him.

Because drug addiction is correlated with increases in violent crime, theft of property, negative effects on children, restriction of freedom if users are arrested and serve jail time, and other things that hurt the capabilities of the larger society, the capabilities approach would come to the opposite conclusion.

2. Professor Bucks and Professor Liber are having a debate about the role of economic growth in contributing to economic development. Professor Bucks contends that economic growth is the only thing to consider in development, as people’s utility is directly related to their income. Professor Liber agrees that income is directly related to development, but says that there are other things to consider. Given what we’ve learned in this chapter, pick the option that is most correct according to the capabilities approach. [LO 19.1] 1-284 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

a. Professor Bucks is correct because increases in income are the only way to measure economic development. b. Professor Bucks is correct because capabilities always increase when income does. c. Professor Liber is correct because income is unrelated to capabilities, which are the most important factor in development. d. Professor Liber is correct because income is related to development, but it is not the only contributor to capabilities.

Answer: d. Professor Liber is correct because income is related to development, but it is not the only contributor to capabilities. While income and development are positively correlated, we must consider many other factors that contribute to a society’s capabilities.

3. Table 19P-1 shows the levels and annual growth rates of economic indicators for two countries, Nationavia and Countrystan. Assume these growth rates will remain constant for the foresee-able future. Use these data to determine whether each of the following statements is true, false, or indeterminable. [LO 19.2] a. The theory of income convergence (that national incomes in poor countries will ―catch up‖ to those in wealthier countries) holds for Nationavia and Countrystan. b. Countrystan has higher levels of human capital than Nationavia. c. Inequality is greater in Nationavia. d. In 10 years, it’s likely that Countrystan will have higher levels of human capital than Nationavia.

Answer: a. False. For the incomes in the two nations to converge, the wealthier nation (Nationavia, 1-285 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

with its GDP per capita of $50,000) should experience relatively slower growth in income, and the poorer nation (Countrystan, with its GDP per capita of $30,000) should experience relatively faster growth in income to catch up. But Countrystan’s growth rate of GDP per capita is 3.0%, which is less than Nationavia’s growth rate of 3.1%. b. False. We can assess human capital by looking at average years of education per person.

In Countrystan, that’s 5 years, while in Nationavia it’s 15 years. With the data we have, there is no indicator that Countrystan has higher levels of human capital than does Nationavia—in fact, the opposite is implied. c. Indeterminable. We have information on GDP per capita, which gives us an idea of how much income the ―average‖ person in each nation has, but there is no information about how that income is actually distributed. d. False. Education per person is growing in Countrystan at a rate of 8 percent and is currently at 5 years, compared to Nationavia’s 15 years. To have higher levels of human capital in 10 years, Countrystan’s education per capita would have to more than triple to exceed Nationavia’s 15 years over that time period. An easy way to see why this is not likely is to use the Rule of 70, which tells us the time it takes for some variable to double (in this case, for Countrystan’s 5 years of education per capita to double to 10 years of education per capita). We take 70 divided by the growth rate in percentage form: 70/8 = 8.75. Since it would take 8.75 years at this growth rate for Countrystan’s education per capita to double to 10 years, reaching 15 years in a decade is impossible if the growth rate doesn’t change.

4. In Nation A, GDP per capita is $21,000 and is growing annually at a rate of 1.4 percent. The average citizen in Nation A lives for 51 years, and this figure is growing at 6 percent per year. Additionally, the average person in Nation A has 9 years of education, growing annually at 5.1 percent, and 60 percent of Nation A’s population is currently literate, growing at a rate of 2 percent. In Nation B, GDP per capita is $40,000 and is growing annually at a rate of 0.8 percent. The average citizen in Nation B lives for 68 years, and this value is growing at 2 percent per year. The average person in Nation B has 10.5 years of education, increasing 2 percent annually, while 78 percent of its population is literate, a figure growing at 0.5 percent annually. Which nation is experiencing more economic growth? Which is wealthier? Which currently has more capabilities for its citizens? And which is experiencing more economic development? [LO 19.2] Answer: Nation A is experiencing more economic growth because the growth rate of its GDP per capita of 1.4% exceeds that of Nation B (0.8%).

Nation B is wealthier, with GDP per capita of $40,000 versus Nation A’s GDP per capita of $21,000, which may provide evidence of convergence since the lower-income nation is experiencing faster growth than the higher-income nation, which may allow it to ―catch up.‖

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Nation B has more capabilities—its citizens on average are likely to have more education, a longer lifespan, and are more literate. We find this by looking at the average levels of each of these variables. But to find which nation is experiencing more economic development, we turn our attention to growth rates in these variables.

Nation B also has more economic wealth overall as reflected in the higher level of GDP per capita. But Nation A is experiencing more economic development or growth, as its growth rates for literacy, education, and life expectancy are higher than those for Nation B. In other words, Nation B is more developed, while Nation A is developing more.

5. Imagine that you are the leader of a low-income nation. You have identified lack of access to health care as a major contributor to your nation’s low income, and the United States has offered to help by providing funds to build more health clinics. Will this solve the problem?

Why or why not? If it won’t, what’s one alternative to using these foreign aid dollars to build clinics? [LO 36.3] Answer: Building health clinics will not necessarily solve the problem. Home remedies and untrained non-medical professionals may continue to be more appealing to your citizens because they’re cheaper than clinics and because the non-medical professionals may spend more time with or act more concerned about their patients. This last portion may be especially true because many times doctors in health clinics have too many patients and receive the same salary no matter how many they treat or what quality of care they give. A better use for these funds might be to provide national health insurance so that citizens can seek care at a variety of medical facilities for no or low cost. It is harder to address the issue of the quality of providers in medical clinics, but one possibility might involve attaching providers’ compensation to quality reviews, time spent with the patient, or some other measure, as opposed to paying them a flat salary.

6. While listening to the radio on the way to school, you hear a politician from a small, lowincome nation say the following: ―Over the last five years, there has been a 10 percent increase in the number of children attending school full time. We can expect to see these children grow up to be more productive workers because their human capital has increased.‖ Is the politician’s statement true, false, or somewhere in between? Explain your answer. [LO 19.3] Answer: The statement is somewhere in between true and false. It’s true that more children in his nation are attending school, and years of schooling do contribute to human capital, but that’s not the whole story. Having more years of education means little if that education doesn’t result in better learning outcomes—increased literacy, better math skills, and so on.

And if this increase in student attendance hasn’t been accompanied by increases in necessary factors like classroom space, textbooks, and teachers to accommodate these new students, more education may not mean more learning or more productive workers. The quantity of education has increased in this nation, but we know nothing about its quality.

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7. Classify each of the following as an institution or organization. [LO 19.4] a. The United States Agency for International Development, a U.S. government agency that channels aid abroad. b. The United Nations Development Program. c. The UN Declaration of Human Rights, an agreement among members of the United Nations regarding the rights of individuals. d. The United Nations. e. The Sarbanes-Oxley Act (SOX), which established rules for how publicly traded firms must report information in their financial documents.

Answer: Institutions are the humanly devised constraints that shape human interactions, also thought of as the rules of the game. Organizations are government bodies (such as senates and ministries of education), development agencies (such as the World Bank), and international groups (such as the United Nations). a. Organization b. Organization. c. Institution. d. Organization. e. Institution.

8. A given nation has a good titling system, but theft of productive equipment is rampant, with few consequences for those who steal. What is the term development economists use for what’s lacking in this economy? What effect will this lack likely have on economic growth and economic development? Give one way to improve the situation. [LO 19.4] Answer: The nation doesn’t have strong rule of law if people can steal productive assets and go unpunished or under-punished. A nation without strong rule of law will experience slower economic growth and development, all else equal. Titling doesn’t contribute to growth and development if, even if you can show you legally own something, no one will defend your right to keep it and use it. There are many possible ways to improve the situation, including more or better police, less political corruption, and a better legal system.

9. The small, landlocked nation of Wheatleyton is just starting to develop an agricultural sector.

Firms in this sector appeal to the government to temporarily limit imports of agricultural goods from other nations with more experience and larger scale, resulting in import prices so low domestic firms can’t compete. What is this desired policy called? What problems are associated with it, and how can we reduce them? [LO 19.5] Answer: Firms in the infant industry are requesting a policy of import substitution.

Import substitution is associated with problems such as rent-seeking behavior that attempts to get politicians to keep competition away. It’s also likely to be extended long past its original temporary status; after all, protected firms are likely to lobby to keep these benefits.

Perhaps the best way to reduce these problems is not to use import substitution at all, instead 1-288 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

utilizing a program of export-led growth, which will provide tax breaks and subsidies on exports instead of limiting imports.

10. The small nation of Movieheim wants to develop a film industry. It is considering two options for doing so: Option A: Reimburse relocation expenses for firms and give tax breaks to acting schools, film studios, digital artists, etc., to encourage them to work together and share ideas.

Option B: Make the purchase and exhibition of foreign films illegal for the next 10 years.

What would development economists call each of these options? Which is more likely to encourage long-term economic development, and why? [LO 19.5] Answer: Option A is describing a cluster; Option B is describing import substitution.

The first option is more likely to encourage long-term economic development because having related firms located close to each other and offering tax breaks to those firms to encourage collaboration tends to make the industry stronger. The second option of import substitution limits capabilities. Though the government intends to have the program last for only ten years, such programs tend to get extended via heavy lobbying by the protected firms, as these firms engage in rent-seeking behavior. For these reasons, Option A is the better choice, all else equal.

11. Consider separately each of the following hypothetical scenarios about South Africa and answer the included questions. Assume in each case that medical school has an 80 percent success rate—in other words, 80 percent of people who attend medical school graduate and become doctors. [LO 19.6] a. No doctors are allowed to emigrate, and the number of people going to medical school is given by D = 100,000 × I, where I is an index relating the income of doctors to those in other professions. If I = 4, how many students will go to medical school? How many more doctors will there be in South Africa? b. The United States decides to offer visas for any doctors from South Africa. Additionally, I in the above equation changes to 10. Assume that 30 percent of doctors educated in South Africa immigrate to the United States. How many students will go to medical school? How many will become doctors? How many of those doctors will practice in South Africa, and how many will practice in the United States? c. The United States decides to limit the number of doctors from South Africa who can obtain visas to no more than 10 percent of those graduating from medical school. Assume that I remains at 10. How many students will go to medical school? How many will become doctors? How many of those doctors will practice in South Africa, and how many will practice in the United States?

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Answer: a. Here I = 4, so the number of students going to medical school will be D = 100,000 × 4 = 400,000. Of those, 80% will graduate, so there will be a total of 0.8 x 400,000 = 320,000 new doctors. b. Now I = 10, so the number of students going to medical school will be D = 100,000 × 10 = 1,000,000. Of those, 80% will graduate, so there will be a total of 0.8 × 1,000,000 = 800,000 new doctors. 30 percent of these (0.3 × 800,000 = 240,000) will immigrate and practice in the United States, and the remaining 70 percent (0.7 × 800,000 = 560,000, or 800,000 – 240,000 = 560,000) will practice in South Africa. c. I remains at 10, so 1,000,000 will attend medical school and 800,000 new doctors will be created, as in part (b). 10 percent of these (0.1 × 800,000 = 80,000) will immigrate and practice in the United States, and the remaining 90 percent (0.9 × 800,000 = 720,000, or 800,000 – 80,000 = 720,000) will practice in South Africa.

12. Table 19P-2 shows the size of hypothetical various flows to developing countries in 2017 and 2018 in billions of dollars. [LO 19.7] a. Rank each of the flows in 2018 as a percentage of ODA (official development assistance) in 2017, from highest to lowest. b. Rank each of the flows in terms of their growth rates from 2017 to 2018, from highest to lowest.

Answer: a. We can calculate these figures with the following equation:

Financial Flow

Percentage of 2017nODA

Official development assistance Foreign direct investment Remittances

119/128 × 100 = 92.97% 573/128 × 100 = 447.66% 324/128 × 100 = 253.13%

Rank (1 = highest) 3 1 2

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b. We’ll calculate the growth rate for a given flow using a simple percentage change formula:

Financial flow

Growth rate

Official development assistance

[(119 – 128)/128] × 100 = – 7.03% [(573 – 510)/510] × 100 = 12.35% [(324 – 307)/307] × 100 = 5.54%

Foreign direct investment Remittances

Rank (1 = highest) 3 1 2

13. The following equation provides an alternative calculation to determine a developing country’s financing gap: FG = (A × g) – ID. In this equation, FG is the financing gap; A is a variable that captures the country’s starting income together with its ability to turn investment into growth (expressed in dollars); g is the targeted growth rate; and ID is the amount of domestic investment currently in the economy. Assume that A = $50,000,000,000, g = 0.08, and ID = $500,000,000, and answer the questions that follow.

[LO 19.7] a. What is the size of the financing gap? b. Assume that the population of the United States is 300 million. How much would each U.S. citizen have to pay to fill the financing gap? c. What percentage of GDP per capita in the United States does your answer from (b) represent if GDP per capita is currently $45,000? Now assume that the United States decides to donate the amount of the financing gap to the developing country as aid. Assume also that there are administrative and competitive costs associated with receiving aid.

Specifically, 23 cents of every dollar spent on aid will go to administrative costs. Also, for every dollar received from abroad intended to be used for investment, 50 cents will be used for noninvestment purposes. d. Calculate the real increase in investment dollars the aid from the United States will provide in the recipient country. e. Calculate the new financing gap by subtracting the above from the financing gap you calculated in part (a).

Answer: a. We can calculate the financing gap by plugging the given values into our formula: FG = (A × g) – ID FG = $50,000,000,000 × 0.08 - $500,000,000 = $3,500,000,000. b. To put the financing gap in per-person terms, just divide the gap by the U.S. population: $3,500,000,000 / 300,000,000 = $11.67.

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c. Divide the amount from part (b) above by GDP per capita, then multiply by 100 to express it as a percent: Percentage of GDP per capita = $11.67 / $45,000 × 100 = 0.026%. d. We’re told that of every $1, $0.23 + $0.50 = $0.73 doesn’t go to investment in the recipient country. That means that only 27 percent (1 – 0.73 = 0.27 = 27 percent) of the money donated will increase investment in that country. Therefore, our donation will result in only 0.27 × $3,500,000,000 = $945,000,000 more investment there. e. To find the new financing gap, subtract the value you calculated in part (d) from the original financing gap calculated in part (a): $3,500,000,000 – $945,000,000 = $2,555,000,000.

14. The president of an organization specializing in foreign investment says the following at a shareholder meeting: ―Our one-year program was a failure. We were hoping for a 6 percent return on our investment, but we got only 3 percent.‖ Use the idea of impact investing to provide an alternative argument that the program was not a failure. [LO 19.8] Answer: In traditional financial investment, success or failure is assessed by looking at returns in a narrow sense—by this standard, the 3 percent return when the organization was hoping for 6 percent represents a failure. But impact investing takes a broader view, looking at the longer term, considering social improvements as well as financial gains, and so forth.

From this point of view, the 3 percent return may be considered a success if it was accompanied by other positive social changes.

15. Table 19P-3 displays the results of a study on how to improve vaccination rates in a developing nation. The baseline numbers represent the rates of vaccination at the beginning of the study, while the endline numbers represent the rates of vaccination at the study’s conclusion. Answer the following questions. [LO 19.9]

a. Which campaign(s) had a positive effect on vaccination rates in comparison to the control group?

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b. Which campaign had the largest positive effect on vaccination rates in comparison to the control group? c. Which campaign(s) had a negative effect on vaccination rates in comparison to the control group? d. Which campaign(s) had no effect on vaccination rates in comparison to the control group?

Answer: First, calculate the change in the vaccination rate for each group for each campaign.

To do so, take the endline rate minus the baseline rate.

Campaign Lectures Free provision Subsidy Newspaper announcements

Change in vaccination rate, control group 8% – 5% = 3% 8% – 5% = 3% 8% – 5% = 3% 8% – 5% = 3%

Change in vaccination rate, treatment group 5% – 6% = –1% 8% – 4% = 4% 10% – 5% = 5% 7% – 7% = 0%

a. Free provision and the subsidy had a positive effect on vaccination rates in the amount of 4% and 5%, respectively. b. The subsidy had the largest positive effect at 5%. c. Lectures had a negative effect on vaccination rates at –1%. d. Newspaper announcements had no effect on vaccination rates (a 0% change).

16. Table 19P-4 displays the results of a study on how to improve vaccination rates in a developing nation. The baseline numbers represent the rates of vaccination at the beginning of the study, and the endline numbers represent the rates of vaccination at the study’s conclusion. Rank the campaigns in order from most effective to least effective. Then refer to Table 19-P5, which shows the cost per person of each campaign. Combining information from the two tables, rank the campaigns that resulted in an increase in vaccinations from high to low in terms of cost effectiveness (based on treatment effect alone). [LO 19.9]

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Answer: To find out which campaigns are most effective, subtract the baseline figures from the endline figures for each group and each campaign.

Campaign Lectures Free provision Subsidy Newspaper announcements

Change in vaccination rate, control group 6% – 4% = 2% 6% – 4% = 2% 6% – 4% = 2% 6% – 4% = 2%

Change in vaccination rate, treatment group 9% – 6% = 3% 8% – 7% = 1% 9% – 5% = 4% 2% – 3% = –1%

Rank (1 = most effective) 2 3 1 4

In order from most successful (biggest percentage change) to least successful, we can rank the campaigns as follows: the subsidy, lectures, free provision, and newspaper announcements. To find out which programs are most cost-effective, the quickest way is to divide the percentage change in vaccinations for the treatment group calculated in the above table by the cost per person of each campaign given in Table 19-P5 (don’t worry about converting the percentages to decimal format—for example, on the first, simply take 3 divided by 10). We leave out the newspaper announcements, since they resulted in a decrease in vaccinations. Note that the highest-ranked campaigns are those with the lowest cost per percentage gain in vaccinations.

Campaign Lectures Free provision Subsidy

Change in vaccination rate/cost per person 3%/$10 = $0.30 1%/$20 = $0.05 4%/$15 = $0.27

Rank (1 = most cost effective) 3 1 2

APPENDIX A MATH ESSENTIALS: UNDERSTANDING GRAPHS AND SLOPE 1-294 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Problems and Applications 1. Create four quadrants using x- and y-axes. Use your graph to plot the following points. [LO A.1] a. (1,4) b. (-2,1) c. (-3, -3) d. (3, -2) Answer: Each point is an (x,y) coordinate. For example, for point a, we move up to a positive 1 on the horizontal, or x, axis, and then move up to positive 4 on the vertical, or y, axis.

2. Create four quadrants using x- and y-axes. Use your graph to plot the following points. [LO A.1] a. (0,4) b. (0, -2) c. (1,0) d. (-3, 0) Answer: Each point is an (x,y) coordinate. For example, for point a, we stay on 0 on the horizontal, or x, axis and then move up to positive 4 on the vertical, or y, axis.

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3. Use the curve labeled ―Demand‖ in Figure AP-1 to create a table (schedule) that shows Price in one column and Quantity in another. What is the slope of the curve labeled ―Demand‖?

[LO A.2]

Answer: Price $40 30 20 10 0

Quantity Demanded 0 20 40 60 80

The slope of the curve is rise over the run, or the change in the price divided by the change in quantity: (-40/80) = -0.5.

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4. Use the curve labeled ―Demand‖ in Figure AP-2 to create a table (schedule) that shows Price in one column and Quantity in another. What is the slope of the curve labeled ―Demand‖?

[LO A.2]

Answer: Price $70 50 30 10 0

Quantity Demanded 0 10 20 30 35

The slope of the curve is the rise over the run, or the change in the price divided by the change in the quantity: (−70/35) = −2.

5. Use the information about price and quantity in Table AP-1 to create a graph, with Price on the y-axis and Quantity on the x-axis. Label the resulting curve ―Demand‖. What is the slope of that curve? [LO A.2]

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Answer: The slope of the line is the rise over the run, or the change in the price divided by the change in the quantity: (-12/120) = -0.1.

6. Use the information about price and quantity in Table AP-2 to create a graph, with Price on the y-axis and Quantity on the x-axis. Label the resulting curve ―Demand‖. What is the slope of that curve? [LO A.2]

Answer: The slope of the curve is the rise over the run, or the change in the price divided by the change in the quantity: (-25/5) = -5.

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7. Use the curve labeled ―Supply‖ in Figure AP-3 to create a table (schedule) that shows Price in one column and Quantity in another. What is the slope of the curve labeled ―Supply‖?

[LO A.2]

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Answer: The slope of the curve labeled ―Supply‖ is the rise over the run, or the change in the price divided by the change in the quantity: (30/10) = 3.

Price $0 30 60 90 120 150

Quantity Demanded 0 10 20 30 40 50

8. Use the curve labeled ―Supply‖ in Figure AP-4 to create a table (schedule) that shows Price in one column and Quantity in another. What is the slope of the curve labeled ―Supply‖?

[LO A.2]

Answer: The slope of the curve is the rise over the run, or the change in the price divided by the change in the quantity: (40/160) = 0.25.

Price $0 10 20 30 40

Quantity Supplied 0 40 80 120 160

9. Use the information about price and quantity in Table AP-3 to create a graph, with Price on the y-axis and Quantity on the x-axis. Label the resulting curve ―Supply‖. What is the slope of that curve? [LO A.2] 1-300 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Answer: The slope of the curve is the rise over the run, or the change in the price divided by the change in the quantity: (125/25) = 5.

10. Use the information about price and quantity in Table AP-4 to create a graph, with Price on the y-axis and Quantity on the x-axis. Label the resulting curve ―Supply‖. What is the slope of that curve? [LO A.2]

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Answer: The slope of the curve is the rise over the run, or the change in the price divided by the change in the quantity: (48/12) = 4.

11. What is the direction of slope indicated by the following examples? [LO A.3] a. As price of rice increases, consumers want less of it. b. As the temperature increases, the amount of people who use the town pool also increases. c. As farmers use more fertilizer, their output of tomatoes increases.

Answer: a. As price of rice increases, consumers want less of it. The direction of the slope is negative. b. As the temperature increases, the amount of people who use the town pool also increases.

The direction of the slope is positive. c. As farmers use more fertilizer, their output of tomatoes increases. The direction of the slope is positive.

When the slope of a line is positive, we know that y increases as x increases, and y decreases as x decreases. If a line leans upward, then its slope is positive. When the slope of a line is negative, we know that y decreases as x increases, and y increases as x decreases. If a line leans downward, then its slope is negative.

As the price of rice increases, consumers want less of it. The direction of the slope is negative. As the temperature increases, the amount of people who use the town pool also increases. The direction of the slope is positive. As farmers use more fertilizer, their output of tomatoes increases. The direction of the slope is positive.

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12. Rank the following equations by the steepness of their slope from lowest to highest. [LO A.3] a. y = -3x + 9 b. y = 4x + 2 c. y = -0.5x + 4 Answer: The slope of the curve is the rise over the run or the change in the price divided by the change in the quantity. The steepness rank is determined by the absolute value of the slope. a. Slope is -3

Rank is 2.

b. Slope is +4

Rank is 3.

c. Slope is -0.5 Rank is 1.

APPENDIX B MATH ESSENTIALS: WORKING WITH LINEAR EQUATIONS Problems and Applications 1. Use the demand curve in Figure BP-1 to derive a demand equation. [LO B.1]

Answer: First, use the endpoints to calculate the slope. The slope is the rise over the run, or the change in the y, or price, direction (120 – 0), divided by the change in the x, or quantity, direction (0 – 40). The slope is 120/-40 or -3.

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To find the y-intercept, look at the graph and determine where the line intersects the y-axis.

This occurs at $120, so the y-intercept is 120. The equation is then: P = 120 – 3Q. 2. Use the demand schedule in Table BP-1 to derive a demand equation. [LO B.1]

Answer: The y-intercept occurs where quantity demanded = 0, or 80. The slope is the change in price (10) divided by the change in quantity demanded (-40), which is (-10/40) or -0.25.

The equation is P = 80 – 0.25Q.

3. Use the supply curve in Figure BP-2 to derive a supply equation. [LO B.1]

Answer: The y-intercept occurs where the line crosses the y-axis, which in this case is 0. The slope is the rise over the run, or the change in price (2) divided by the change in quantity (40), which is (2/40) or 0.05. The equation is P = 0.05Q.

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4. Use the supply schedule in Table BP-2 to derive a supply equation. [ [LO B.1]

Answer: The y-intercept occurs where quantity supplied = 0, or 100. The slope is the change in price (100) divided by the change in quantity supplied (25), which is (100/25) or 4. The equation is P = 100 + 4Q.

5. Graph the equation P = 2Q + 3. Is this the supply curve or demand curve? [LO B.1] Answer: This line slopes upward, so it is a supply curve. The slope is the rise over the run or the change in price (13 – 3) divided by the change in quantity (5 – 0). This curve has a slope of (10/5) or 2.

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6. Graph the equation P = -8Q + 10. Is this the supply curve or demand curve? [LO B.1] Answer: This line slopes downward, so it is a demand curve. The slope is the rise over the run or the change in price (10 - 0) divided by the change in quantity (0 – 1.25), which is (10/1.25) or -8.

7. Rearrange the equation Q = 5 – 0.25P and sketch the graph. Is this a supply curve or a demand curve? [LO B.1] Answer: Start with Q = 5 – 0.25P. Subtract 5 from both sides: Q – 5 = - 0.25P. Divide both sides by - 0.25: -4Q + 20 = P. Re-arrange: P = 20 - 4Q. This is a downward-sloping demand curve.

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8. Rearrange the equation Q = 0.2P and sketch the graph. Is this a supply curve or a demand curve? [LO B.1] Answer: Start with Q = 0.2P. Divide both sides by 0.2: 5Q = P. Re-arrange: P = 5Q. This is an upward-sloping line, so it is a supply curve.

9. The entrance fee at your local amusement park is $20 for the day. The entrance fee includes all rides except roller coasters. Roller coasters cost an extra $2 per ride. [LO B.2] 1-307 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

a. Write an equation that represents how much money you will spend on rides as a function of the number of rides you on: S = total spending on rides; Q = the quantity of roller coasters rides. b. What is your total spend on rides if you ride 4 roller coasters? c. Draw a graph of the relationship between total spending on rides and the number of roller coaster rides. d. Redraw the graph from part (c) to show what changes if the entrance fee increases to $25. e. Rewrite the equation from part (a) to incorporate the increased entrance fee of $25. f. After the entrance fee increases to $25, what is your total spending on rides if you ride 4 roller coasters?

Answer: a. The y-intercept is 20, which is the cost of the entrance fee when no roller coasters are ridden. Every additional roller coaster ride costs $2. So, the equation of the line is S = 20 + 2Q. b. If you ride 4 roller coasters, you will pay $20 for entry plus $2 × 4 for the four rides. The total is $28. c. See the correct graph below (Initial Spending). The line should start at a price of $20 and a quantity of 0 roller coaster rides and end at a price of $40 and a quantity of 10 roller coaster rides.

d. See the correct graph above (New Spending). If the entrance fee increases to $25, the line will shift up by $5, but will be parallel to the original line. It will start at $25 and 0 roller coaster rides and end at $45 and 10 roller coaster rides.

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e. Since the entrance fee is all that has changed, only the y-intercept changes in the equation. The new equation is S = 25 + 2Q. f. If you ride 4 roller coasters, you will pay $25 for entry plus $2 × 4 for the four rides. The total is $33.

10. Use the following two equations: [LO B.3] (1) P = 12 – 2Q (2) P = 3 +Q a. Find the equilibrium price and quantity. b. Graph the demand and supply equations. Illustrate the equilibrium point.

Answer: a. Setting the equations equal to each other: 12 – 2Q = 3+ Q. Solving for Q: 9 = 3Q, or Q = 3. Substituting into either equation: P = 12 – 2(3) = $6.

The x-intercept for the demand line occurs where P = 0. So, 0 = 12 – 2Q. Solving, -12 = -2Q, so the x-intercept is Q = 6.

The y-intercept for the demand line occurs where Q = 0. So, the y-intercept is P = 120.

The y-intercept for the supply line occurs where Q = 0. So, the y-intercept is P = 3.

The endpoint for the supply line is determined where Q = 6. So when Q = 6, P = 3 + 6 or $9.

11. With reference to Table BP-3: [LO B.3] 1-309 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

a. Use the information from the table to create the demand and supply equations. b. Use your demand and supply equations to solve for equilibrium. c. Graph supply and demand curves. Illustrate the equilibrium point.

Answer: a. The y-intercept of the demand equation occurs where the quantity demanded is 0 at 120.

The slope of the demand equation is the change in P (20) divided by the change in quantity demand (-2) or -10. The demand equation is P = 120 – 10Q. The y-intercept of the supply equation occurs where the quantity supplied is 0 at 0. The slope of the supply equation is the change in P (20) divided by the change in quantity supplied (4) or 5. The supply equation is P = 5Q. b. Setting the equations equal to each other: 120 – 10Q = 5Q. Solving for Q: 120 = 15Q Q = 8. Substituting into either equation: P = 120 – 10(8) = $40. c. The x-intercept for the demand line occurs where P = 0. So, 0 = 120 – 10Q. Solving: -120 = -10Q, so the x-intercept is Q = 12.

The y-intercept for the demand line occurs where Q = 0. So, the y-intercept is P = 120.

The y-intercept for the supply line occurs where Q = 0. So, the y-intercept is P = 0.

The endpoint for the supply line is determined where Q = 24. So, when Q = 24, P = $120.

This is also shown in the table.

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APPENDIX C MATH ESSENTIALS: CALCULATING PERCENTAGE CHANGE, SLOPE, AND ELASTICITY Problems and Applications 1. Calculate the percentage change in each of the following examples: [LO C.1] a. 8 to 12. b. 18 to 14. c. 130 to 120. d. 95 to 105.

Answer: Using the mid-point method, percentage change in X = (X2 – X1) / [(X2 + X1)/2] × 100 a. 8 to 12: (12 – 8) / [(12 + 8)/2] × 100 = 4/10 × 100 = 40% b. 18 to 14: (14 – 18) / [(14 + 18)/2] × 100 = -4/16 × 100 = 25% c. 130 to 120: (120 – 130) / [(120 + 130)/2] × 100 = -104/125 × 100 = -8% 1-311 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

d. 95 to 105: (105 – 95) / [(105 + 95)/2] × 100 = 10/10 × 100 = 10%

2.

Find the percentage change in price in each of the following examples using the mid-point method. [LO C.1] a. The price of a $4.50 sandwich increases to $5.50. b. The sale discounts the price of a sofa from $750 to $500.

Answer: Using the mid-point method, percentage change in X = (X2 – X1) / [(X2 + X1)/2] × 100 a. $4.50 to $5.50: (5.50 – 4.50) / [(5.50 + 4.50)/2] × 100 = 1/5 × 100 = 20% b. $750 to $500: (7.50 – 5.00) / [(7.50 + 5.00)/2] × 100 = -250/625 × 100 = -40%

3. Use the demand curve in CP-1 to answer the following questions. Use the mid-point method in your calculations. [LO C.2]

a. What is the price elasticity of demand for a price change from $0 to $20? b. What is the price elasticity of demand for a price change from $20 to $40? c. What is the price elasticity of demand for a price change from $40 to $60?

Answer: Price elasticity of demand = % change in quantity demanded/ % change in price.

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Price elasticity of demand = a. From $0 to $20:

b. From $20 to $40:

c. From $40 to $60:

4. Use the demand schedule in Table CP-1 to answer the following questions. Use the midpoint method in your calculations. [LO C.2]

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a. What is the price elasticity of demand for a price change from $4 to $8? b. What is the price elasticity of demand for a price change from $8 to $16? c. What is the price elasticity of demand for a price change from $20 to $24?

Answer: Price elasticity of demand = % Change in QD/% Change in Price

Price elasticity of demand = a. The price elasticity of demand for a price change from $4 to $8:

b. The price elasticity of demand for a price change from $8 to $16:

c. The price elasticity of demand for a price change from $20 to $24: 1-314 © 2021 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

5. Use the demand schedule in Table CP-2 to answer the following questions. Use the midpoint method when calculating elasticity. [LO C.2]

a. What is the price elasticity of demand for a price change from $2 to $3? What is the slope of the demand curve for a price change from $2 to $3? b. What is the price elasticity of demand for a price change from $3 to $5? What is the slope of the demand curve for a price change from $3 to $5? c. What is the price elasticity of demand for a price change from $6 to $7? What is the slope of the demand curve for a price change from $6 to $7?

Answer: Price elasticity of demand = % Change in QD/% Change in Price

Price elasticity of demand =

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Slope =

a. The price elasticity of demand for a price change from $2 to $3:

The slope of the demand curve for a price change from $2 to $3 is m = ($3 – $2) / (35 – 42) = -0.14. b. The price elasticity of demand for a price change from $3 to $5:

The slope of the demand curve for a price change from $3 to $5 is m = ($5 – $3) / (21 – 35) = -0.14. c. The price elasticity of demand for a price change from $6 to $7:

The slope of the demand curve for a price change from $6 to $7 is m = ($7 – $6) / (7 – 14) = -0.14.

APPENDIX D MATH ESSENTIALS: THE AREA UNDER A LINEAR CURVE

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Problems and Applications 1. Use the graph in Figure DP-1 to answer the following questions. [LO D.1]

a. What is the amount of consumer surplus? b. What is the amount of producer surplus? c. What is the amount of total surplus?

Answer: a. Consumer surplus is found by taking the area of the triangle above the market price and below the demand curve. In this instance, the amount of consumer surplus is 1/2(90 – 45) × 60 = $1,350. b. Measuring producer surplus is found by taking the area of the triangle below the market price and above the supply curve. In this instance, the amount of producer surplus is 1/2(45 × 60) = $1,350. c. Total surplus is the sum of consumer and producer surplus. In this instance, the amount of total surplus is $2,700.

2. Use these two supply and demand equations to answer the following questions. [LO D.1] a. What is the equilibrium price? What is the equilibrium quantity? b. Draw a graph of supply and demand and illustrate the equilibrium. c. What is the amount of consumer surplus? d. What is the amount of producer surplus? e. What is the amount of total surplus?

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Answer: a. To find the equilibrium quantity, set demand equal to supply and solve for Q: 50 – 4Q = 2 + 2Q, so Q = 8. The equilibrium quantity is 8. To find the equilibrium price, put Q into either equation and solve for P: 50 – 4(8) = $18. The equilibrium price is $18. b.

c. Consumer surplus is found by taking the area of the triangle above the market price and below the demand curve. The amount of consumer surplus is 1/2(50 – 18) × 8 = $128. d. Measuring producer surplus is found by taking the area of the triangle below the market price and above the supply curve. The amount of producer surplus is 1/2(18 – 2) × 8 = $64. e. Total surplus is the sum of consumer and producer surplus. The amount of total surplus is $128 + $64 = $192.

APPENDIX E MATH ESSENTIALS: ALGEBRA AND AGGREGATE EXPENDITURE Problems and Applications 1.

Consider the following components of the aggregate expenditure equilibrium model: C = 0.6(Y – 200) + 150 Iplanned = 175 G = 200 NX = 50 1-318

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Assume all model parameters are in billions of dollars. [LO G.1, LO G.2] a. What is the marginal propensity to consume in this economy? b. What is the level of taxes in this economy? (You can assume that the functional forms above are consistent with those described earlier.) c. What is the equilibrium level of aggregate expenditure in this economy?

Now suppose that planned investment decreases by $25 billion. d. Find the overall change in equilibrium aggregate expenditure that results from this initial change by finding the new level of equilibrium aggregate expenditure and comparing this new level to the initial level. e. Again, find the overall change in equilibrium aggregate expenditure that results from this initial change, but this time use the changes formulation of the equilibrium aggregate expenditure expression directly.

Answer: a. The consumption function C = 0.6 (Y – 200) + 150 indicates consumption is $150 billion plus an amount that depends on disposable income. Disposable income is defined as income minus taxes, or Y – 200 in this case. The 0.6 is the marginal propensity to consume, indicating people spend 60% of their disposable income, and save the remaining 40%. b. Taxes are equal to $200 billion, given disposable income is Y – 200. c. The equilibrium level of aggregate expenditure is found by equating planned expenditure and actual expenditure, such that planned aggregate expenditure (PAE) is equal to output (Y).

In other words, this means firms will want to produce a level of output equal to the total amount of spending in the economy. We know PAE = C + Iplanned + G + NX so: PAE = 0.6 (Y – 200) + 150 + 175 + 200 + 50 = 0.6 (Y – 200) + 575 = 0.6Y + 455.

Now set PAE = Y so we have 0.6Y + 455 = Y. Rearrange terms to solve for Y = $1,137.5 billion. d. Planned investment is now equal to 150 and planned expenditure is PAE = 0.6Y + 430.

The equilibrium level of aggregate expenditure is Y = $1,075 billion. e. The equilibrium level of aggregate expenditure declined from $1,137.5 billion to $1,075 billion, so the change was equal to $62.5 billion. The expenditure multiplier is equal to 1/(1 – b) where b is the marginal propensity to consume, so we get 1/(1 – 0.6) or 2.5. Notice we can multiply the change in investment (-$25 billion) by the expenditure multiplier (2.5) to get the change in equilibrium output (-$62.5 billion).

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