Solution Manual for Macroeconomics Principles for a Changing World 5th Edition by Eric Chiang

Solutions Manual to accompany Chiang, Economics, 5e

Chapter 1

Chapter 1 By the Numbers: Assessing your Data Literacy 1.

Based on the list of popular jobs held by economists, what is the median salary of a financial manager?

What is the median salary of a public relations specialist?

Answer: The median salary of a financial manager is approximately $125,000, while the median salary of a public relations specialist is approximately $59,000.

2.

What factors might explain the large difference in median salary between a financial manager and a public relations specialist?

Answer: Financial managers earn more, on average, than public relations specialists because of the demand for and supply of workers in these fields. Although both roles are important to companies, financial managers generally require a high level of math and technical skills to succeed, and therefore companies pay higher salaries to attract the limited number of students who pursue this career. There are also other lucrative careers that financial managers can pursue based on their technical skills, so companies must compete for this talent by paying higher salaries.

3.

Based on the introduction at the top of this page, what types of jobs (other than those listed in the graph) might economists hold?

Answer: Because economics is a broad discipline that teaches practical analytical skills, some economists choose to pursue a career in law, financial consulting, or marketing. Others may pursue a career in government, either running for elected office or working in one of numerous government organizations such as the U.S. Census or the U.S. Labor Department. Teaching is another popular career as economics courses are an important part of high school and college curricula. With an economics degree, the careers one can pursue are very abundant.

Check Your Understanding 1.

What is wrong with the statement ―Economics is everything to do with money‖?

Answer: Economics involves making choices with limited resources. Money is just one type of resource. Time, intellect, and ability are other resources to be considered. Focusing only on money issues ignores the vast array of nonmoney issues in which economics plays an important role.

2.

Does your going to college have anything to do with expanding choices or reducing scarcity? Explain.

Answer: Yes, clearly going to college instead of going immediately to work represents a choice to get additional skills now and enter the labor force later. Even if you are working and going to school, you are choosing between investing in your education versus another activity. You will see the benefits in the future, when your skills command greater resources.

3.

What is the difference between a positive question and a normative question?

Answer: A positive question attempts to study the relationship between two variables in an economy, while a normative question is based on a value judgment. A positive question would ask what is likely to happen when an activity is undertaken, while a normative question would ask whether that activity should or should not be undertaken.

4.

You normally stay at home on Wednesday nights and study. Next Wednesday night, your best friend is having his big 21st birthday party. What is the opportunity cost of going to the party?

Answer: Opportunity cost is the value of what you give up in order to attend the party. Because you would normally be at home studying, the opportunity cost of the party is the benefit (such as a higher homework or exam grade) that you would have gained from studying that night.

5.

What is the incentive to spend four years of one’s life and tens of thousands of dollars to earn a college degree?

Solutions Manual to accompany Chiang, Economics, 5e

Chapter 1

Answer: An incentive encourages individuals to take actions that are in their best self-interest.

Although attending college is both costly and time consuming, the potential rewards from significantly higher lifetime earnings more than offsets what one gives up to attend college.

6.

Why do markets typically lead to an efficient outcome for buyers and sellers?

Answer: Markets allow buyers and sellers to interact in such a way that sellers who wish to sell items can find buyers wishing to buy them. Markets are flexible, meaning that prices adjust until every unit of a good that sellers wish to sell is eventually purchased by a consumer wishing to buy it.

Apply the Concepts 7.

Many companies offer employees health savings accounts (HSAs) instead of traditional health care plans. HSAs provide each employee with money (usually between $500 and $1,000 per year) that can be used for any health care expense but then requires employees to cover a much higher portion of expenses beyond that. Describe an issue of efficiency and an issue of equity that arises from this policy.

Answer: There are many correct answers, but HSAs promote efficiency by giving more control of health care spending to the individual. They are more likely to shop around for better prices, knowing that money is limited. Individuals might also maintain healthier habits to avoid having to pay health care expenses out-of-pocket, which can translate to more efficiency in the workplace. In terms of equity, the fact that everyone in a company receives the same amount of money can be equitable.

However, critics point out that individuals with higher health care costs due to preexisting conditions or have family members covered under the plan will end up paying much more under HSA plans, and therefore such plans are not equitable. Also, if individuals forgo health care services because of the incentive to save money, serious illnesses may go undetected until it’s too late, which makes this system less efficient at allocating health care to those who need it the most.

8.

Stores depend on feedback from their customers as a way to improve their business practices and to market their products. To encourage customers to offer feedback, stores will sometimes offer an incentive, such as a discount on a future purchase or additional reward points in a frequent shopper program. Why do some customers, but not all, take advantage of the incentive to leave feedback? Does the actual shopping experience of the customer affect his or her willingness to do so?

Answer: Mail-in rebates allow individuals to recoup a fixed amount of money if they complete and submit the required paperwork. Submitting documents for a rebate involves opportunity costs in terms of the time required to complete the paperwork as well as monetary costs such as a stamp, envelope, and auto expenses incurred to deposit the check. The value of time varies from person to person.

Therefore, a person with a lower opportunity cost of time (such as a retiree) is more likely to submit rebate requests than someone with a higher opportunity cost of time (such as a bank executive).

9.

The black rhinoceros is extremely endangered. Its horn is considered a powerful aphrodisiac in many Asian countries, and a single horn fetches many thousands of dollars on the black market, creating a great incentive for poachers. Unlike other stories of endangered species, this one might have a simple solution. Conservationists could simply capture as many rhinos as possible and remove their horns, reducing the incentive to poach. Do you think this will help reduce poaching? Why or why not?

Answer: It is probably bound to help somewhat. If only some have horns removed, however, poachers might still kill the rhino to keep from having to track this animal in the future. After all, poachers are concerned with efficiency as well. Thus, the more animals with horns removed, the better the result.

Also, dehorning may make the animals more susceptible to predators. But incentives do matter, and removing the horn on balance may help the effort to save the black rhino. See Charles Wheelan, Naked Economics: Undressing the Dismal Science (New York: W. W. Norton), 2002, Chapter 2.

Solutions Manual to accompany Chiang, Economics, 5e

Chapter 1

10.

Most amusement parks in the United States charge a fixed price for admission, which includes unlimited roller coaster rides for the day. Some people attempt to ride the roller coasters as often as possible in order to maximize the value of their admission. Why is riding a roller coaster at an amusement park over and over to ―get your money’s worth‖ not considered thinking on the margin?

Answer: Attempting to ride the roller coaster as many times as possible allows one to minimize the average cost per ride. However, this does not necessarily maximize one’s satisfaction. After riding a roller coaster several times, one may get bored or even physically sick from riding again. If riding the roller coaster one more time makes a person worse off, then total satisfaction would fall. Therefore, thinking on the margin says that one should continue riding the roller coaster as long as the marginal benefit is greater than the marginal cost.

11.

Because the U.S. government wants to reduce the nation’s reliance on fossil fuels, greater use of solar panels has been encouraged among households and businesses. However, the cost of installing solar panels can be prohibitively expensive for most people. Because people follow incentives, what can the government do to encourage more households and businesses to install solar panels?

Answer: Because the cost of installing solar panels can outweigh the savings in monthly utility bills, even over a long period of time, most households and businesses would rationally choose not to install them. However, those who place a greater value on environmental protection may experience nonmonetary benefits, thereby encouraging installations. If the government wishes to increase solar panel installations, it needs to incentivize households and businesses by increasing monetary benefits relative to costs. It can do so by offering tax credits and deductions for installation expenses. It could also subsidize the installation costs in exchange for a monthly fee equivalent to part of the electricity savings that result. In some states, the utility company will install solar panels for free but charge a monthly fee similar to an electricity bill. In this latter case, there may be no monetary benefit or cost but may be some nonmonetary benefits that encourage greater installations.

12.

Some colleges and universities charge tuition by the credit hour, while others charge tuition by the term, allowing students to take as many classes as they desire. How do these tuition structures affect the incentives students face when deciding how many classes to take? Provide an example of a beneficial effect and an example of a potentially harmful effect resulting from the incentives created with each system. How does marginal analysis affect the incentives with each system?

Answer: If tuition is charged as a fixed rate per term regardless of the number of courses taken, students would have an incentive to take more classes per term. It might encourage students to forgo working and take additional classes to complete their degrees more quickly. A beneficial effect of the fixed rate is that it encourages students to focus on their studies and complete degrees more quickly. A beneficial effect of the per credit system is that it allows working students to complete their degrees part time while holding a job. A potentially harmful effect of the fixed rate system is that students may enroll in more classes than they can handle, resulting in lower grades. Marginal analysis guides students into determining whether it is in their best interest to take an additional class: Under the per credit system, the marginal cost of an additional class is the monetary cost of tuition and the time commitment, while under the fixed tuition system, the marginal cost of tuition is zero, but the time commitment still creates a marginal cost.

In the News 13.

The New York Times reported in an article titled ―What the Top 1% of Earners Majored In‖ that 8.2% of Americans who majored in economics for their undergraduate degree are in the top 1% of salary earners. Only those who majored in pre-med had a higher percentage in the top 1%. What might be some reasons why economics majors have done well in the job market?

Answer: Economics is an analytical subject that prepares students for a very broad range of careers.

Economics majors can find jobs in corporations, banks, and government institutions. Economics is also a popular major for those wishing to pursue a law degree. In sum, economics provides a well-rounded background for many well-paying careers.

Solutions Manual to accompany Chiang, Economics, 5e

14.

Chapter 1

In 2018, Seattle and San Francisco passed laws banning the use of plastic disposable straws because they are harmful to the environment (because plastic does not easily biodegrade) and to marine life (which ingest straws that end up in the ocean). But opponents point out that such bans may result in unintended monetary costs as well as external costs. Describe two potential costs that may arise as a result of these new laws.

Answer: Critics of the plastic straw ban have pointed out a number of unintended costs and consequences that may arise. For example, it may make life more difficult for individuals with disabilities who require straws to consume liquids and liquefied foods. It may also harm certain businesses such as bubble (boba) tea shops that require large straws to effectively consume their products. And for many businesses that choose to replace plastic straws with paper or biodegradable straws, the added cost will reduce profits and/or be passed on to consumers in the form of higher prices. There are many other arguments against the plastic straw ban, highlighting the difficult tradeoffs that occur when debating any new policy.

Solving Problems 15.

Suppose your favorite band is on tour and coming to your area. Tickets are $100, and you take a day off of work for which you could have earned $60. What is your opportunity cost of going to the concert?

Answer: The opportunity cost is the $100 that you could have spent on something else plus the $60 you would have earned by working, for a total of $160.

16.

At your local family fun center, miniature golf is $12 per person for unlimited rounds in a day, while each go-kart session is $8. If you played three rounds of miniature golf and rode the go-karts three times, what was the marginal cost of the third round of miniature golf ? What was the marginal cost of the third go-kart session?

Answer: Miniature golf costs $12 regardless of how many rounds you play; therefore, the third round has a marginal cost of $0 because you already paid the $12 to play the first round. However, the marginal cost of the third round of go-karts is $8 because each session requires an additional payment.

Chapter 2

By the Numbers: Assessing Your Data Literacy 1.

From 1998 to 2017, how many years did exports rise from the previous year? How many years did imports rise from the previous year?

Answer: Not including the first year shown, exports rose 14 times from the previous year, while imports also rose 14 times from the previous year. Note: The change in imports from 2012 to 2013 was nearly zero, so an answer of 15 is also acceptable.

2.

Between which two years did exports increase the most? Imports?

Answer: Exports increased the most between the years 2010 and 2011, but just slightly more than between 2009 and 2010, thus either answer would be acceptable. Imports increased the most between the years 2009 and 2010 immediately following the end of the Great Recession, and increased significantly again between 2010 and 2011.

3.

Recessions occurred in 2001 and 2007‒2009. What was the general trend in trade during these recessions? Why do you think this trend occurs?

Answer: During the past two recessions, both imports and exports fell. This was the case in 2001 and in 2009 toward the end of the last recession. During an economic downturn, consumers and businesses buy fewer goods overall, including imported goods. But when the U.S. economy is in a downturn, other countries also experience slower economic growth, which results in fewer exports as other countries reduce their consumption as well.

Solutions Manual to accompany Chiang, Economics, 5e

Chapter 1

Check Your Understanding 1.

When can an economy increase the production of one good without reducing the output of another?

Answer: When there are unemployed resources and the economy is operating within the production possibilities frontier.

2.

In which of the three basic questions facing any society does technology play the greatest role?

Answer: Technology will be most important in the ―how to produce‖ question.

3.

Explain the important difference between a straight-line PPF and a PPF that is concave to (bowed away from) the origin.

Answer: A straight-line PPF curve has constant opportunity costs, whereas the bowed out (concave to the origin) curve has increasing opportunity costs as the production of one good is increased.

4.

How would unemployment be shown on the PPF? Answer: Any time the economy is operating inside the PPF, some resources will be unemployed; thus, any point inside the PPF represents unemployment.

5.

List three factors that can contribute to an economy’s growth.

Answer: Economies can grow through increases in the quality or quantity of labor, land, capital, and entrepreneurial activity. Increases in resources expand the PPF outward. Improvements in technological progress can increase growth in an economy.

6.

How can a country that does not have an absolute advantage in producing goods still benefit from trade?

Answer: All countries can benefit from trade as long as they specialize in the production of the good in which they have a comparative advantage. All countries have a comparative advantage in producing something because comparative advantage deals with relative abilities rather than absolute abilities.

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Chapter 1

Apply the Concepts 7.

Innovation and technology has allowed for new forms of biodegradable plastics to be created that are less harmful to the environment. How might such inventions impact production efficiency and allocative efficiency (if at all) of industries that use a lot of plastics, such as the construction and automobile industries?

Answer: The production efficiency of industries that use a lot of plastics may not be affected initially if the cost of biodegradable plastics is high and their use is limited. However, over time, such costs tend to fall, allowing firms to achieve production efficiency. Allocative efficiency, however, may be achieved more quickly as more and more consumers become environmentally conscious and demand products that are eco-friendly. By producing products containing biodegradable plastics, companies are producing what societies desire, which improves allocative efficiency.

8.

Describe how a country producing more capital goods rather than consumption goods ends up in the future with a PPF that is farther out than that of a country that produces more consumption goods and fewer capital goods.

Answer: Capital goods are those goods used to produce other goods. Producing more capital goods represents an investment in the economy. This investment leads to the ability of the country to produce more goods and services in the future.

9.

The United States has an absolute advantage in making many goods, such as short-sleeved golf shirts.

Why do Indonesia and Bangladesh make these shirts and export them to the United States?

Answer: Indonesia and Bangladesh, while smaller, have a comparative advantage in the production of shirts, making it profitable for both countries to specialize and ship shirts to the United States.

10.

Why is it that the United States uses heavy street-cleaning machines driven by one person to clean the streets, while China and India use many people with brooms to do the same job?

Answer: Both China and India have huge labor resources relative to available capital; therefore the job is done with a lot of labor and a little capital. The United States has less labor relative to capital; thus, wages are higher, and capital is substituted for labor.

11.

If specialization and trade as discussed in this chapter lead to a win-win situation in which both countries gain, why is there often opposition to trade agreements and globalization?

Answer: While trade is typically beneficial to both countries in the aggregate, individuals and groups within each country lose when their product faces competition from a country with a comparative advantage.

12.

China’s rising middle class has resulted in a surge of luxury food imports such as lobsters from the United States. China’s demand for U.S. lobsters is so great that fishermen in Maine (where most U.S. lobsters are caught) have a tough time filling orders. Explain how China’s increased demand for lobsters affects consumers and producers of lobsters in the United States.

Answer: China’s demand for lobsters creates a lot of opportunities for American fishermen to export to China. If the supply of lobsters does not increase by a similar amount, prices will rise, which would increase the profits of American fishermen. In this case, U.S. producers benefit from trade as exporters. However, the rising prices of lobster will lead to higher prices for U.S. consumers since they are essentially competing with Chinese consumers for the available supply. In this case, U.S. consumers might be worse off from trade.

In the News 13.

In 2017, Hurricane Harvey caused more than $100 billion in damage to homes, businesses, and farms in Texas and Louisiana. The production capacity of this region was subsequently affected for several months. Explain how such a natural disaster can affect a region’s PPF. How might it affect economic growth?

Answer: Many natural disasters are short-term phenomena that do not have noticeable impacts on

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Chapter 1

growth over the long term. In these cases, workers might be temporarily laid off, moving the economy to a point inside (or further inside) of the PPF in the short run. However, major disasters such as Hurricane Harvey, the Japanese earthquake and tsunami of 2011, and Hurricane Katrina of 2005 can result in long-term disruptions in production. In these cases, if the production capacity is reduced, the PPF would shift inward to reflect the reduction in resources available for production. This can subsequently reduce economic growth.

14.

In 2017, a $500 million private-public initiative was announced for the purpose of boosting STEM (science, technology, engineering, and math) education, as the United States continues to fall behind other industrialized nations in student achievement in these fields. How would spending on STEM initiatives today, which leads to higher costs in the near term, pay off in future benefits to the economy?

Answer: Investments in education result in an increase in long-term productivity through a more productive workforce. This is especially the case for STEM education, which is often viewed as critical for maintaining a labor force that is innovative and productive. Spending on STEM initiatives would require increased spending in the near term, which requires a tradeoff of other useful services that this money could be used for. However, in the long term, boosting STEM education allows the United States to maintain competitiveness with other countries, which have continued to increase their investment in education.

Solving Problems 15.

Iceland and Denmark both produce skis and sleds. Iceland can produce 3 skis or 6 sleds using one day of labor, while Denmark can produce 4 skis or 12 sleds using one day of labor. Which country has an absolute advantage in producing skis? Sleds? Which country has a comparative advantage in producing skis? Sleds? Are gains from trade possible between Iceland and Denmark? If yes, which good should each country specialize in producing?

Answer: Denmark has an absolute advantage in the production of both goods. The opportunity cost of producing 1 ski in Iceland is 2 sleds, and in Denmark it is 3 sleds. Therefore, Iceland has a comparative advantage in ski production. The opportunity cost of producing 1 sled in Iceland is 0.5 ski, and in Denmark it is 0.33 ski. Therefore, Denmark has a comparative advantage in producing sleds. Yes, there are gains from trade if each country specializes in the good in which it has a comparative advantage and then trades with one another.

16.

The following table shows the potential output combinations of oranges and jars of prickly pear jelly (from the flower of the prickly pear cactus) for Florida and Arizona. a. Compute the opportunity cost of oranges in Florida in terms of jars of prickly pear jelly. Do the same for prickly pear jelly in terms of oranges. b. Compute the opportunity cost of oranges in Arizona in terms of jars of prickly pear jelly. Do the same for prickly pear jelly in terms of oranges. c. Would it make sense for Florida to specialize in producing oranges and for Arizona to specialize in producing prickly pear jelly and then trade? Why or why not?

Florida Oranges 0 50 100 150 200 250

Prickly Pear Jelly 10 8 6 4 2 0

Arizona Oranges 0 20 40 60 80 100

Prickly Pear Jelly 500 400 300 200 100 0

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Answer: a. Florida’s opportunity cost of oranges: 2/50 = 0.04, or 0.04 jar of prickly pear jelly for each orange.

The opportunity cost of a jar of prickly pear jelly: 50/2 = 25, or 25 oranges must be given up for each jar of prickly pear jelly. b. Arizona’s opportunity cost of oranges: 100/20 = 5, or 5 jars of prickly pear jelly for each orange.

The opportunity cost of a jar of prickly pear jelly: 20/100 = 0.2, or 0.2 orange must be given up for each jar of prickly pear jelly. c. Total combined output for both states will rise to 250 oranges and 500 jars of prickly pear jelly.

This is larger than the sum of any two combinations available to both states. They will be able to share the excess through trade.

Chapter 3 By the Numbers: Assessing Your Data Literacy 1.

Which type(s) of institutions for higher learning increased in percent of total enrollment from 1997 to 2017? Which type(s) decreased? Which type(s) did not change?

Answer: Enrollments at four-year public schools and for-profit schools increased as a percent of the total, Enrollment at two-year schools decreased as a percent of the total, and private non-profit schools were mostly unchanged.

2.

Which type of institution for higher learning has seen the largest nominal increase in enrollment by percent of total from 1997 to 2016? Which has seen the largest relative increase?

Answer: Enrollments at four-year public schools as a percent of the total increased by 3.9% from 1997 to 2017. But, the largest relative increase was in for-profit schools, which more than doubled its percentage over the period.

3.

Explain how fluctuations in the economy might affect enrollment in certain types of institutions for higher learning.

Answer: Schools that cater to working people are most likely to see fluctuating enrollments. Because the economy has been growing over the past decade, enrollments at public two-year schools and for-profit schools as a percentage of total enrollment have fallen.

Check Your Understanding 1.

Product prices give consumers and businesses a lot of information besides just the price. What kinds of information?

Answer: Price can be a reflection of quality (albeit imperfectly) and provide businesses with information about levels of demand. Prices provide consumers with relative comparisons between products.

2.

Provide an example of a factor that might increase the demand for frozen slushies. What might decrease the demand for frozen slushies?

Answer: Any of the five determinants of demand can increase or decrease the demand for frozen slushies. For example, warm weather may increase the preferences for frozen drinks, or a decrease in the price of a complement good, such as soft pretzels, may lead to greater demand. A decrease in the price of a substitute, such as ice cream, will decrease demand for frozen slushies, and so will a fall in incomes, assuming that frozen slushies are a normal good. There are many other correct answers.

However, an incorrect answer would be a change in the price of frozen slushies because price causes a change in quantity demanded, not a change in demand.

3.

Assume there is a positive relationship between aging and cholesterol levels. As the world population ages, will the demand for cholesterol drugs increase, decrease, or remain the same? Would this cause a change in demand or a change in quantity demanded?

Answer: Increase; change in demand.

4.

If incomes are rising in an economy, why would we see a decrease in demand for certain goods?

Answer: Although most goods that we buy are normal goods in which demand increases with income,

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some goods are inferior goods, which we buy less of when incomes increase. For example, if one eats fewer fast-food burgers and more gourmet salads as income increases, salads would be a normal good, and the fast-food burger would be an inferior good. Inferior goods vary from person to person.

5.

6.

Explain how an increase in the price of organic onions can affect the supply of organic tomatoes that use the same land to grow. How will this affect the equilibrium price and quantity of organic tomatoes?

Answer: An increase in the price of organic onions is an increase in the price of a related commodity in the market for organic tomatoes. As farmers produce more onions instead of tomatoes, the supply curve of organic tomatoes will shift to the left, resulting in a higher equilibrium price and lower equilibrium quantity.

Suppose the market for tomatoes is in equilibrium and events occur that simultaneously shift both the demand and supply curves to the right. Is it possible to determine how the equilibrium price and/or quantity would change? Explain.

Answer: When both the demand and supply curves shift to the right, the overall equilibrium quantity will increase because both shifts result in a higher quantity. However, it is not possible to determine the overall effect on equilibrium price without additional information on the magnitudes of the changes because an increase in demand pushes prices higher, while an increase in supply pushes prices lower.

Apply the Concepts 7.

Suppose that high temperatures and a lack of rain in Wisconsin causes a shortage of cranberries, leading to a rise in cranberry prices. Explain how this would affect the equilibrium price and quantity for other products that use cranberries, such as cranberry sauce and cranberry juice?

Answer: An increase in the price of cranberries is an increase in the price of resources used to produce cranberry products, which shifts the supply curve to the left. This means that the equilibrium price will increase and the equilibrium quantity will decrease.

8.

Suppose the price of monthly data plans required to access the Internet anywhere using a tablet computer falls in price. How would this affect the market for tablet computers?

Answer: Monthly data plans are a complement to tablets, which require a data plan in order to operate fully. If data plans fall in price, it would encourage more consumers to buy tablets, increasing the demand for tablets and their equilibrium price and quantity.

9.

Using the accompanying figures, answer the following questions: a.

On the Demand panel: • Show an increase in demand and label it D1.

• Show a decrease in demand and label it D2.

• Show an increase in quantity demanded.

• Show a decrease in quantity demanded.

• What causes demand to change?

• What causes quantity demanded to change? b.

On the Supply panel: • Show an increase in supply and label it S1.

• Show a decrease in supply and label it S2.

• Show an increase in quantity supplied.

• Show a decrease in quantity supplied.

• What causes supply to change?

• What causes quantity supplied to change?

Solutions Manual to accompany Chiang, Economics, 5e

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Answer: See the following figure. A change in demand is a shift in the entire demand curve and is caused by a change in one or more of the determinants. In contrast, a change in quantity demanded is a movement along an existing demand curve caused by a change in price. This distinction is important if, for example, you want to distinguish between rising sales due to an expanded advertising program and rising sales due to a sale or a reduction in price. A change in supply shifts the curve and is caused by a change in one or more of the determinants. A change in quantity supplied is caused by a change in price.

10.

Several medical studies have shown that drinking red wine in moderation is good for the heart. How would such a study affect the public’s demand for wine? Would it have an impact on the type of grapes planted in new vineyards?

Answer: The market demand for red wine would increase (shift to the right). More vineyards would plant grape varieties that produce red wines rather than white wines.

11.

Disneyland has an exclusive members-only club called Club 33 where celebrities and wealthy Disney fans dine on fine food. Although annual membership fees are reported to be upwards of $30,000, there is still a 14-year waiting list to join. How would this market for memberships be represented in a supply and demand diagram? In what ways can the shortage be eliminated, especially if Disney controls the price and the supply of memberships?

Answer: A 14-year waiting list to join Club 33 clearly suggests that demand for memberships greatly exceeds supply. Therefore, the current membership price is below the market equilibrium, creating the shortage. However, in this case, the shortage may be intentional in order to create a greater sense of exclusivity for the Club. Still, the shortage suggests that prices can be raised if Disney chooses to do so. Alternatively, Disney could increase the number of memberships for sale, though that might make

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the experience less exclusive.

12.

Over the past decade, cruise ship companies have dramatically increased the number of mega-ships (those that carry 3,000 passengers or more), increasing the supply of cruises. At the same time, the popularity of cruising has increased among consumers, increasing demand. Explain how these two effects can coincide with a decrease in the average price of cruise travel.

Answer: An increase in the supply pushes quantity higher and prices lower, while an increase in demand (due to the rising popularity of cruises) pushes both prices and quantity higher. In order for the average price of cruise travel to decrease, the increase in the supply of cruises must be greater than the increase in the demand.

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In the News 13.

In January 2018, the online ticket market StubHub reported record high average prices for Super Bowl tickets as the Minnesota Vikings advanced through the playoffs and was one game away from playing in the Super Bowl in their home stadium in Minneapolis. However, when the Vikings lost to the Eagles in the last game before the Super Bowl, ticket prices plummeted. Explain why prices for Super Bowl tickets on StubHub reacted in this way after the Vikings lost using demand and supply analysis.

Answer: When the Vikings were close to playing in the Super Bowl, Vikings fans started buying Super Bowl tickets, and ticket holders anticipated a large increase in prices as Vikings fans were excited to see their team play in their own home stadium. An increase in demand and price expectations led to an increase in prices. However, when the Vikings lost, many Vikings fans were no longer interested in attending the Super Bowl. This was partly offset by an increase in demand by Eagles fans, but the decline in demand by Vikings fans was larger. Also, more ticket holders wanted to sell their tickets, leading to an increase in supply. This combination of factors led to a decrease in the equilibrium price of Super Bowl tickets.

14.

In 2014, self-balancing scooters (known as hoverboards) saw a huge spike in sales as their popularity rose and more companies started producing them. In 2015, a safety risk was exposed when it was reported that over 100 incidences of hoverboards catching fire or exploding occurred, causing injuries.

This led to a massive recall of hoverboards as manufacturers had to retool their products and fix existing products. Also, it led to a ban on hoverboards on airlines and in many schools. Explain how these two events affected the equilibrium price and quantity of hoverboards.

Answer: The bad press and the new restrictions on hoverboard usage led to a decrease in demand for hoverboards, which reduced the equilibrium price and quantity as stores had to lower their prices.

Also, manufacturers had to spend money fixing the problem, which led to a decrease in supply, further reducing the quantity of hoverboards for sale but increasing the price. The result of the two events led to a lower quantity of hoverboards sold but an indeterminate effect on prices. Over time, however, hoverboard sales recovered as the public regained confidence about their safety and their popularity resumed.

Solving Problems 15.

A popular tradition when traveling to Hawaii is to receive a lei, a wreath of flowers to welcome guests.

Although a lei can be made of flowers, leaves, nuts, or even candy and money, orchids remain the most popular flower used to create them. Suppose that supply and demand in the orchid lei market in Hawaii are as represented in the table provided: Price ($/unit) 5 10 15 20 25

Quantity Demanded (thousands) 24 20 16 12 8

Quantity Supplied (thousands) 8 12 16 20 24

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Chapter 1

a.

Graph both the supply (S0) and demand (D0) curves. What is the current equilibrium price? Label the equilibrium point a.

b.

Assume that the Hawaiian lei industry increases its use of orchids from Thailand (where they are grown at a lower price), allowing orchid lei supply to increase by 8,000 units at every price.

Illustrate the increase in the supply in your graph. Label the new supply curve (S1). What will the new equilibrium price in the market be? Label that point b.

Now assume that luxury hotels in Hawaii begin cost-cutting measures by no longer presenting guests with a lei upon check-in, reducing orchid lei demand by 8,000 units at every price. Label the new demand curve (D1). What will the new equilibrium price be? Label this new equilibrium point c.

Subsequently assume that severe monsoons and civil unrest in Thailand lead to a reduction in orchid production, reducing supply back to the original curve (S0). What will the new equilibrium price be? Label this new equilibrium point d.

c.

d.

Answer: a. See graph following figure. The current equilibrium price is $15, which occurs at point a.

b. c. d.

An increase in orchid lei supply of 8,000 units at every price will shift the supply curve to the right to point b. The new equilibrium price would be $10.

A decrease in orchid lei demand of 8,000 units at every price will shift the demand curve to the left to point c. The new equilibrium price would be $5.

If the supply curve returns to the original curve, the new equilibrium point would be d, at a new equilibrium price of $10.

Solutions Manual to accompany Chiang, Economics, 5e

16.

Chapter 1

The following figure shows the supply and demand for strawberries. Answer the questions that follow.

a. b. c.

Indicate the equilibrium price and equilibrium quantity.

Suppose sellers try to sell strawberries at $4. How much of a shortage or a surplus of strawberries would result?

Now suppose that the demand for strawberries falls by 10 units at every price. Draw the new demand curve in the figure and estimate what the new equilibrium price and equilibrium quantity would be.

If sellers still try to sell strawberries at $4, would the shortage or the surplus increase or decrease?

d.

Answer: a. The equilibrium price is $3 a pound, and the equilibrium quantity is 30,000 pounds. b. At $4 a pound, quantity demanded is 20,000 pounds, and quantity supplied is 40,000 pounds, creating a surplus of 20,000 pounds. c. If quantity demand falls by 10,000 pounds at every price, the demand curve would shift to the left.

The new equilibrium price would be about $2.50 a pound, and the equilibrium quantity would be about 25,000 pounds.

Chapter 4 By the Numbers: Assessing Your Data Literacy 1.

How much would you earn in one year if you worked 2,000 hours (50 weeks × 40 hours) at the federal minimum wage? How much more would you earn per year if you worked at the minimum wage in Washington?

Answer: Working 2,000 hours per year at the federal minimum wage would generate an annual income of $14,500. Working 2,000 hours in Washington at its minimum wage of $12.00 per hour would generate an annual income of $24,000, or $9,500 more.

Solutions Manual to accompany Chiang, Economics, 5e

Chapter 1

2.

How much must a person earn per hour in order to support a household of three people at the federal poverty guidelines of $21,330 in 2019? In which states would the minimum wage be enough?

Answer: One must work 2,000 hours at $10.67 per hour in order to earn $21,330 to keep a household of three people out of poverty. In 2019, nine states had a minimum wage higher than $10.67 per hour.

These include Washington, California, Massachusetts, New York, Colorado, Arizona, Maine, Vermont, and Oregon.

3.

What factors might explain why states pass minimum wages higher than the federal level? There are many correct answers, including economic and noneconomic reasons.

Answer: There are many possible answers. First, many states with higher minimum wages have a higher cost of living such as California, New York, and Washington. Second, states with higher minimum wages tend to have a legislature and a governor that place a high priority on raising the minimum wage as a policy issue. Third, many believe that a person working full-time in any job should not be forced to live in poverty. Fourth, higher wages motivate people to work harder and be happier, thereby improving productivity.

Check Your Understanding 1.

Describe how consumer surplus and producer surplus are measured.

Answer: Consumer surplus is the difference between an individual’s willingness-to-pay for a product and the price paid. For a market, consumer surplus is measured as the difference between the demand curve and the price. Producer surplus is the difference between the price of a good and a seller’s willingness-to-sell. For a market, producer surplus is measured as the difference between the price and the supply curve.

2.

Using the following graph, show what happens to consumer surplus when a new technology reduces the cost of production.

Answer: When production costs decline, supply increases to S1 in the figure, which increases consumer surplus by the area P1P0ea (the shaded area).

Solutions Manual to accompany Chiang, Economics, 5e

Chapter 1

3.

Explain why deadweight loss can occur with a price below equilibrium even when some consumers benefit from it.

Answer: When a price is below equilibrium, a shortage occurs because suppliers are unwilling to supply all that is demanded at that price. Therefore, consumers who are lucky enough to buy the good at the lower price benefit; however, the reduction in overall output creates a deadweight loss because some mutually beneficial transactions do not take place unless prices rise toward equilibrium.

4.

Why does an effective price ceiling appear below the equilibrium rather than above it?

Answer: A price ceiling is only effective (binding) when it is low enough so that the market price is restricted. Therefore, in order for a price ceiling to be effective, it must be set below the market equilibrium price.

5.

If a price floor is reduced toward equilibrium but not below it, does the surplus and deadweight loss in this market increase or decrease?

Answer: A price floor that is set above the equilibrium price creates a surplus and results in a deadweight loss. As the price floor is reduced, it becomes less restrictive, which means that the surplus of goods falls and the deadweight loss decreases. Once the price floor reaches the equilibrium price, both the surplus and deadweight loss disappear.

6.

Why does the quantity of public college education determined in a free market (without government intervention) represent a market failure?

Answer: The cost of college education is very expensive, and without subsidies, scholarships, or grants to reduce the price paid by students, the market-determined equilibrium quantity would be less than the quantity most people view as desirable for a well-educated society. A market failure occurs because the market does not deliver a socially desirable quantity.

Apply the Concepts 7.

An increasing number of charities have turned to online auctions as a way to raise money by selling unique experiences donated by celebrities (such as a meet-and-greet with a celebrity before a concert or a walk-on role on a television show). Why would the use of auctions lead to a better outcome for the charity as opposed to just setting a fixed price? Explain using the concepts of consumer surplus and producer surplus.

Answer: The use of auctions allows the seller to find the buyer with the highest willingness-to-pay, which increases the producer surplus (and reduces the consumer surplus) from the transaction.

Although the same outcome can occur with a fixed price, the seller would have to guess correctly what this price would be. If the price is set too low, a buyer with a much higher willingness-to-pay would

Solutions Manual to accompany Chiang, Economics, 5e

Chapter 1

reap more consumer surplus.

8.

Luigi’s is the only pizzeria in a small town in northern Alaska. It is constantly busy, but there is never a wait for a table. One of Luigi’s friends suggests that he would earn much more money if he raised his menu prices by 25% because no one would likely open a new pizzeria in the near future. If Luigi follows his friend’s advice, what would happen to consumer and producer surplus and efficiency?

Answer: Raising the price of pizza might cause some customers to not consume pizza, causing some producer surplus to be lost. But for those customers who continue to buy pizza, producer surplus rises and consumer surplus falls due to the higher price. Efficiency is reduced in this market because fewer pizzas are bought and sold. This outcome is common for businesses with market power (little to no competition) because consumers have few alternatives if prices are raised.

9.

Over the past decade, many American candy companies, including The Hershey Company, Brach’s Confections, and Ferrara Candy company, opened factories in Mexico and Canada to produce candy that is then shipped back to the United States for sale. Although lower wages in Mexico might explain part of this move, wages in Canada are comparable to U.S. wages. Explain how U.S. government agricultural policy in the sugar industry may have encouraged these moves.

Answer: The U.S. sugar industry is a small but highly protected industry, one in which price supports facilitate U.S. sugar farmers’ abilities to earn a comfortable living. However, a consequence of these price supports is that the price of sugar in the United States is much higher than in Mexico and Canada.

Because sugar is one of the most important ingredients (inputs) to produce candy, the price support has the effect of shifting the supply curve to the left for U.S.-produced candy, raising its price. By moving production plants to Mexico and Canada, lower-priced sugar can be acquired, allowing the U.S. candy industry to remain competitive against other foreign candy makers.

10.

Government and employer subsidies to reduce the price of health insurance have important benefits to the individual in terms of improved health. In addition, society overall can benefit from higher levels of health care coverage. Provide three examples of external benefits that may result from increased health care coverage.

Answer: Because increased health care coverage leads to more preventive care that keeps the overall population healthier, external benefits are generated. These can include increased productivity for employers as fewer sick days are taken by workers, less effort and stress on family members who take care of the sick, less waiting for major treatments, reduced usage of expensive emergency room visits, and reduced free ridership that could lower insurance premiums.

11.

In cities around the country, the government provides assistance to families with low incomes to rent apartments at prices capped by the U.S. Department of Housing and Urban Development (HUD), essentially setting a price ceiling on apartments. These designated apartments tend to rent quickly, and tenants are less likely to move once they find an apartment. Explain how rent controls affect market prices for non–rent-controlled apartments. How are incentives by landlords affected in terms of maintaining rent-controlled and non–rent-controlled apartments? How would your answer change if the government provided a subsidy payment to landlords to offset the difference between the price ceiling and the market price?

Answer: Rent controls tend to cause shortages of apartments because more people demand than what is available. Because this may affect the supply of non–rent-controlled apartments, market prices for non–rent-controlled apartments may rise, further widening the difference between the price ceiling and market price. If landlords are not subsidized, they have less incentive to maintain the rent-controlled apartments, especially when non–rent-controlled apartments become more profitable.

However, if the government subsidizes rent-controlled apartments (as they do for Section 8 housing approved by HUD), then the rents received by landlords are closer to the market price, reducing the incentives to alter their behavior.

The U.S. Department of Labor reports that of the roughly 155 million people employed, just over half are paid hourly, but less than 5% earn the minimum wage or less; 95% of wage earners earn more. And of those earning the minimum wage or less, 25% are teenagers living at home. If so few people are affected by the minimum wage, why does it often seem to be such a contentious political issue?

Answer: The minimum wage draws attention probably for several reasons. The first is political: One

12.

Solutions Manual to accompany Chiang, Economics, 5e

Chapter 1

party—Democratic—is more inclined toward government intervention in the marketplace, and raising the minimum wage is part of its platform. The Republican Party generally favors freer markets, reacts to intervention with skepticism, and focuses on the unemployment caused by increasing the required wage above equilibrium. Second, $7.25 an hour (the U.S. federal minimum wage in 2013) seems unfairly low to many people, and they focus on this unfairness. Third, there is some evidence that increasing the minimum wage increases other wages as well. Thus, unions and others are in favor of increasing the minimum wage because this will enhance their chances of getting wage increases for their members in the future.

In the News 13.

Over the past few years, several U.S. states have either legalized recreational marijuana or at least decriminalized its use (―Would Legalizing Marijuana Help the Economy?,‖ Debate.org). Proponents argue that legalizing the use of marijuana would help the economy by boosting economic activity and reducing costs. Do you agree? Why or why not? Use the concepts of supply and demand and consumer and producer surplus to support your answer.

Answer: Although the answer may vary, one of the central economic arguments in favor of legalizing marijuana is that permitting the market to freely operate (even for marijuana) allows consumer and producer surplus to be maximized. When restrictions are placed on a market (in this case, a restriction of no legal sales), any efficiency gains must be achieved in the underground market, where risks are higher. This tends to raise prices that consumers pay, raise costs incurred by producers, and produce no government revenue in terms of taxes. Another argument is that increased supply of legal marijuana will drive down prices, making it less profitable for marijuana traffickers, essentially putting them out of business. But not all people support such policies. Some argue that legalizing marijuana may encourage its use, thereby reducing productivity, among other effects.

14.

In 2018, Governor Baker of Massachusetts signed a bill to raise the state’s minimum wage to $15 per hour by 2023 (―Massachusetts Governor Signs Bill Raising Minimum Wage to $15,‖ The Hill, June 29, 2018). Proponents argue that this policy helps the working poor who hold full-time jobs yet are not able to pull their families out of poverty. Meanwhile, opponents argue that the policy would cause harm in the labor market. Provide an example of a situation that would support each side’s argument.

Answer: There are many possible answers based on sound economic arguments. A $15 per hour minimum wage would mean that a person working full-time will earn about $30,000 per year, an annual income that is well above the poverty rate for a family of four. Proponents argue that this will reduce poverty and lessen dependence on federal and state income assistance programs (such as food stamps). In turn, government spending would fall, and government revenues would rise because more taxable income is being earned. Also, proponents argue that crime and depression fall when poverty is reduced, providing external benefits to society. Opponents to the minimum wage argue that this policy raises wages above the labor market equilibrium, which would cause employers to hire fewer workers, raising unemployment in the industry. They also argue that the higher wages will result in higher prices as businesses pass on the higher costs to their customers, causing inflation. Some also argue that raising minimum wages in one industry is unfair to workers in other low-pay industries, such as janitors and grocery store workers.

Solutions Manual to accompany Chiang, Economics, 5e

Chapter 1

Solving Problems 15.

Consider the market shown in the following graph.

a. Compute the consumer surplus. b. Compute the producer surplus.

Now assume that government puts a price floor on this product at $20 a unit. c. Compute the new consumer surplus. d. Compute the new producer surplus. e. What group would tend to have their advocates or lobbyists support price floors?

Answer: See original figure for answers a and b. a. Consumer surplus = [($30 − $15) × 6,000]/2 = ($15 × 6,000)/2 = $90,000/2 = $45,000. b. Producer surplus = [($15 − $6) × 6,000]/2 = ($9 × 6,000)/2 = $54,000/2 = $27,000.

See the figure provided for answers c and d.

c. New consumer surplus = [($30 − $20) × 4,000]/2 = ($10 × 4,000)/2 = $40,000/2 = $20,000. d. New producer surplus = ($20 − $12) × 4,000 = $8 × 4,000 = $32,000 plus [($12 − $6) × 4,000]/2 = ($6 × 4,000)/2 = $24,000/2 = $12,000. Thus, total producer surplus = $32,000 + $12,000 = $44,000. e. Producers typically support price floors such as agricultural price supports, whereas labor groups tend to support minimum wage laws.

16.

Suppose the U.S. government places a price ceiling on the sale of gasoline at $3 per gallon, as shown in the following figure.

Solutions Manual to accompany Chiang, Economics, 5e

Chapter 1

a. Would a shortage or surplus result? How large is it? b. Calculate the effects of this policy in terms of the changes in consumer surplus and producer surplus. c. How much deadweight loss is created? d. What would happen if the price ceiling were raised to $6 per gallon?

Answer: a. A price ceiling of $3 would create a shortage of 30 million − 10 million = 20 million gallons. b. Consumer surplus increases for the consumers who purchase the 10 million gallons available for sale but is offset as a result of the reduction in output. Producer surplus falls as a result of the price ceiling. Producers earn $1 less for each of the 10 million gallons sold, in addition to the loss resulting from the reduction in output. c. Deadweight loss is represented by the triangle between quantities 10 million and 20 million and between the $3 and $5 price. This value is 1/2 × (20 million − 10 million) × ($5 − $3) = $10 million. d. If the price ceiling were raised to $6 per gallon, the price ceiling would no longer be binding. The market equilibrium would prevail, and no deadweight loss would be created.

Chapter 5(16)

By the Numbers: Assessing Your Data Literacy 1.

In which years did the size of the economy contract (exhibit negative real GDP growth)?

Answer: The size of the economy contracted in 2008 (0.3%) and in 2009 (2.8%).

2.

Describe what happened to real GDP growth and the unemployment rate during the economic recession of 2007–2009.

Answer: During the recession of 2007 to 2009, real GDP growth dropped significantly while the unemployment rate rose from 4.6% to 9.3%.

3.

Describe how real GDP growth and the unemployment rate changed during the period of recovery and expansion from 2010 to 2018.

Answer: In the recovery and expansion from 2010 to 2018, real GDP growth hovered mostly between 2% and 3%. Meanwhile, the unemployment rate showed consistent improvement throughout the recovery, from an average of 9.6% in 2010 to 3.9% in 2018.

Check Your Understanding

Solutions Manual to accompany Chiang, Economics, 5e

Chapter 1

1.

How are business cycles defined? Describe the four phases of business cycles.

Answer: Business cycles are alternating increases and decreases in economic activity. Business cycles include a peak at the top of the cycle, then a downturn (or recession) as the economy cools off.

Eventually the economy reaches the bottom of the cycle, or the trough, followed by a recovery as business picks up and the economy heads toward another peak.

2.

Explain the a key problem with the way the NBER dates recessions and recoveries?

Answer: A key problem is that the dating of recessions and recoveries is done after the events have already started. Therefore, it describes what has already happened and does not help to predict when future recessions will occur or when they will end.

3.

Describe the circular flow diagram. Why must all income equal spending in the economy?

Answer: The circular flow diagram shows how the product and factor markets interact to produce goods and services and pay the factors of production. Ignoring some of the statistical measurement difficulties, when goods or services are produced and sold, that spending must somehow be split among the factors of production (and payments to): labor (wages), land (rent), capital (interest), and entrepreneurial activity (profits).

4.

Why does GDP accounting include only the final value of goods and services produced? What would be the problem if intermediate products were included?

Answer: GDP accounting adds up only the final value of goods and services to avoid ―double counting.‖ When a car is sold, the final price on the lot includes the sum of the costs of the individual parts, and to count them again would be to count them twice. For example, a $28,000 Toyota Prius has tires that Toyota paid $240 for, plus other parts that add up to, say, $15,000. We would not want to increase GDP by $43,240 ($28,000 + $15,000 + $240) when the car is sold; that $15,240 in parts is already included in the $28,000 retail price.

5.

Explain why GDP can be computed using either the expenditures or income approach.

Answer: All spending in the economy necessarily equals payments to all of the factors of production.

A dollar spent adds up to a dollar in wages, interest, rents, or profits.

Solutions Manual to accompany Chiang, Economics, 5e

6.

Chapter 1

What does GDP per capita measure? Why is it not a precise measure of a typical person’s standard of living in a country?

Answer: GDP per capita measures the total output of an economy divided by its population. Although GDP per capita provides a general indication of the standard of living of a country, it is not a precise measure because it does not take into account differences in income distribution. Therefore, a rich country in terms of GDP per capita can have many poor citizens.

Apply the Concepts 7.

Explain how it is possible for an economy in the recovery phase of the business cycle to have a lower GDP and a higher unemployment rate than when it was in the recession phase of the business cycle.

Answer: An economy in a recovery phase is one that has reached its low point (trough) when GDP has decreased and unemployment has increased. Therefore, in the early part of the recovery phase, an economy might not have had enough time to increase its GDP or reduce its unemployment. In this case, GDP and unemployment may appear worse during the recovery than during the recession.

8.

As a percentage of GDP, government spending tends to increase during recessions and decrease during times of economic expansion. Explain why government spending tends to change depending on the phase of the business cycle and how that affects spending as a percentage of GDP. Answer: During a recession, GDP falls while government spending tends to increase as more people seek government assistance, such as unemployment benefits, Medicaid, and other income assistance programs. The increase in government spending and the decrease in GDP increase government spending as a percent of GDP. The opposite occurs during an expansion of the economy, when GDP rises and fewer people seek government benefits, allowing government spending as a percent of GDP to fall.

9.

Critics of the way GDP is measured argue that it fails to fully account for ―intangibles‖ in knowledge-based goods. For example, the value of books are counted in the year they were produced, but when those books are lent out in a library or resold in the used book market, it does not add to GDP despite the benefits and knowledge that the books provide to readers. What might be some problems associated with trying to include intangibles in GDP? Answer: Including the intangible value of knowledge-based goods such as books may be a good idea in terms of measuring the impact of such goods in our economy, but implementing such a measurement is problematic. First, there is an issue of timing. When should the value of the book be counted—when it was written and produced or when it was read? Also, the value that knowledge contributes to society is very subjective—unlike the price of a book, there is no definitive value from the knowledge gained from the book. These and other reasons explain why intangibles are not included in GDP and why only the price of the book when it was initially sold is counted.

10.

GDP and GNP are two different measures of the overall value of production in an economy. Suppose that a country’s GDP is much greater than its GNP. What does that mean in terms of investment in and out of the country?

Answer: If a country’s GDP is significantly greater than its GNP, this means that the country has many foreign companies producing goods and services within its border compared to its companies producing outside its border. One reason for this may be favorable tax laws that attract foreign companies into a country. For example, Ireland has many multinational corporations operating within its borders, and its GDP is about 25% higher than its GNP.

11.

Among the major spending categories that make up GDP, why is gross private domestic investment (GPDI) much more volatile than personal consumption expenditures over the business cycle? In your response, provide two examples of an investment purchase that may be put on hold during a recession that may explain this volatility.

Answer: GDPI is much more volatile because businesses are less likely to expand their production during recessions. For example, a restaurant chain is less likely to open a new franchise and a factory is less likely to buy new equipment when sales are down. Similarly, individuals are less likely to

Solutions Manual to accompany Chiang, Economics, 5e

Chapter 1

purchase new homes (which also count toward GDPI) when the economy is performing poorly.

Because these items are major expenses (unlike most personal consumption expenditures, which consist of items individuals buy each day), when businesses or potential homeowners delay these purchases until the economy improves, GDPI will decrease significantly during recessions but increase during recoveries and expansions.

12.

Suppose that a new method of calculating GDP allows for reductions in GDP as a result of the severity of environmental degradation in a country. If this method is used, which of the following countries might experience the greatest adjustment to their GDP calculation: India, Germany, or Iceland?

Answer: If the severity of environmental degradation is factored into the calculation of GDP, countries with greater environmental degradation, such as India, would experience a greater adjustment (reduction) in their GDP calculation.

In the News 13.

For much of the last 20 years, China’s GDP has grown around 10% per year but in recent years has fallen to around 6% per year, which is still much higher than the average U.S. growth rate in recent years of about 2% per year. Why would a slowdown in China’s GDP growth be a significant concern to the U.S. macroeconomy? If prices of goods and services fall in China due to slower growth, does this help or hurt U.S. GDP? Explain.

Answer: The U.S. economy depends a lot on the health of other economies. China is an important trading partner, and if China’s economy slows down, Chinese consumers will reduce purchases of all goods, including American exports, which will hurt U.S. GDP. Further, if prices fall in China, imports of Chinese goods will fall in price, encouraging American consumers to buy more imported goods than domestic goods, which will further reduce U.S. GDP.

14.

According to the CIA’s World Factbook, in 2018 the tiny country of Equatorial Guinea had the highest GDP per capita in Africa (over $30,000 per year), even higher than more developed countries, such as Morocco, Egypt, or South Africa. But despite the significant overall income from the sale of its natural resources, Equatorial Guinea has extreme poverty, with half of the population lacking clean drinking water and one of the highest infant mortality rates in the world. How can a country that looks so good on paper (in terms of GDP per capita) be one of the least desirable places to live on the planet for the average citizen?

Answer: Although Equatorial Guinea has a very high GDP per capita, that income is not spread evenly across the population. In fact, the country is one of the most corrupt nations in the world according to the UN Human Development Index. Much of the nation’s wealth is controlled by the ruling elite, while the majority of its citizens are forced to live in poverty. Even worse, the government does not adequately provide for basic needs, such as health care and education, making life very miserable for the majority of its citizens. These sorts of injustices are not reflected in GDP statistics because GDP does not take into account how income is distributed across the population.

Solving Problems 15.

The following table lists gross domestic product (GDP), consumption (C), gross private domestic investment (I), government spending (G), and net exports (X – M ) . Compute each as a percent of GDP for the six years presented.

Year 1965

GDP 719.1

C 443.8

I

X–M 5.6

G 1 1 8 .

2

1 5 1 .

5

C (%)

I (%)

G (%)

X – M (%)

Solutions Manual to accompany Chiang, Economics, 5e

Year 1975

GDP 1,638.3

C 1,034.4

I

X–M 16

G 2 3 0 .

2

1985

4,220.3

2,720.3

Chapter 1

C (%)

I (%)

G (%)

X – M (%)

3 5 7 .

7 879

115.2

7 3 6 .

2 1,369.2 –91.4 1 , 1 4 4 2005 12,455.8 8,742.4 2,057.4 2,372.8 –716.7 2015 18,128.2 12,429.0 3,019.2 3,206.5 –526.5 a. Which category (or categories) has increased as a percent of GDP from 1965 to 2015? Which category (or categories) has decreased? And which category (or categories) has not changed much from 1965 to 2015? b. Which category has been the most volatile in terms of changes in the percent of GDP? c. Ignoring net exports, which component has grown the fastest as a percent of GDP since 1965?

1995

7,397.7

4,975.8

Answer: Year 1965

GDP 719.1

C 443.8

I

X–M 5.6

C (%) 61.72

I (%) 16.44

G (%) 21.07

X – M (%) 0.78

16

63.14

14.05

21.83

0.98

879

–115.2

64.46

17.44

20.83

–2.73

1,369.2

–91.4

67.26

15.46

18.51

–1.24

2,372.8

–716.7

70.19

16.52

19.05

–5.75

G 1 1 8 .

2

1 5 1 .

5 3 5 7 .

7

1975 1, 6 3 8.

3

1, 0 3 4.

4

2 3 0 .

2

4, 2 2 0.

3

2, 7 2 0.

3

7 3 6 .

2

7, 3 9 7.

7 12,455.8

4, 9 7 5.

8

1 , 1 4 4 2,057.4

1985

1995

2005

8,

Solutions Manual to accompany Chiang, Economics, 5e

Year

2015 a.

b. c.

16.

Chapter 1

GDP

C

I

G

X–M

C (%)

I (%)

G (%)

X – M (%)

18,128.2

7 4 2.

4 12,429.0

3,019.2

3,206.5

–526.5

68.56

16.65

17.69

–2.90

Consumption has increased as a percent of GDP, government spending and net exports have decreased as a percent of GDP, and gross private domestic investment has not changed much from 1965 to 2015.

Net exports is the most volatile.

Consumption increased from 61.72% to 68.56%.

Use the following list of GDP components and data (given in millions of $U.S.) to answer the following questions.

Corporate profits 1,300 Gross private domestic investment 2,800 Consumption of nondurable goods 3,100 Exports 1,400 Proprietors’ income 1,000 Net income payments to rest of world 700 Consumption of services 4,300 Net interest 500 Compensation of employees 8,000 Imports 1,900 Rental income 400 Government spending 2,100 Consumption of durable goods 1,300 Capital consumption allowance 1,400 a.

Indicate whether each component is part of the expenditures approach to calculating GDP (put an ―E‖ next to the component) or the income approach to calculating GDP (put an ―I‖ next to the component). b. Compute the GDP using both expenditures and income approaches. What factor explains the difference between these measures? c. Calculate the value of national income. Which category (categories) is (are) not included in national income, but are included in the calculation of GDP using the income approach?

Answer: a. Corporate profits 1,300 __I__ Gross private domestic investment 2,800__E__ Consumption of nondurable goods 3,100__E__ Exports 1,400__E__ Proprietors’ income 1,000__I__ Miscellaneous adjustments 700__I__ Consumption of services 4,300__E__ Net interest 500__I__ Compensation of employees 8,000__I__ Imports 1,900__E__ Rental income 400__I__ Government spending 2,100__E__ Consumption of durable goods 1,300__E__ Capital consumption allowance 1,400__I__ b. GDP using the expenditures approach is consumption (3,100 + 4,300 + 1,300) + gross private domestic investment (2,800) + government spending (2,100) + exports (1,400) – imports (1,900) = 13,100 (or $13.1 billion). GDP using the income approach is compensation of

Solutions Manual to accompany Chiang, Economics, 5e

c.

Chapter 1

employees (8,000) + proprietors’ income (1,000) + corporate profits (1,300) + rental income (400) + net interest (500) + consumption of fixed capital (1,400) + net income payments to rest of world (700) = 13,300 (or $13.3 billion). The difference between the expenditures approach and the income approach is due to a statistical discrepancy of –$200 in the income approach.

Consumption of fixed capital, net income payments to rest of world, and the statistical discrepancy are not included in the measurement of national income. Removing these, national income equals 11,200 (or $11.2 billion).

Chapter 6(17)

By the Numbers: Assessing Your Data Literacy 1.

Excluding Presidents Carter and Trump, under which presidencies did the Misery Index fall (from the first year to the last year of the presidency), and under which presidencies did it rise? Under which presidencies was the average Misery Index highest? Lowest?

Answer: The Misery Index fell during the Reagan, Clinton, and Obama administrations, and rose during both Bush administrations. The Misery Index was highest on average during the Reagan administration (12.2) and lowest during the George W. Bush administration (8.1).

2.

Based on the graph, did the Misery Index increase in the years during the last three recessions in 1990– 1991, 2001, and 2007–2009?

Answer: The Misery Index increased in 1990, 1991, and 2001. However, it fell in 2007, rose in 2008, and fell again in 2009. In sum, the Misery Index did not always rise during recessions.

3.

Explain why the fluctuations in the Misery Index are less volatile than if we were to look at just the unemployment rate or the inflation rate by itself.

Answer: The Misery Index is less volatile than unemployment or inflation by itself because unemployment often (but not always) moves in the opposite direction as inflation. For example, when unemployment rose in 2008 and 2009, inflation was falling, offsetting the rise in the Misery Index. As a result, the Misery Index will not always rise during recessions, but in most cases it does because unemployment has generally changed more than inflation in the past 25 years.

Check Your Understanding 1.

Describe the three common indices used to measure inflation and the focus of each.

Answer: The three measures are the consumer price index (CPI), the producer price index (PPI), and the GDP deflator. The CPI focuses on retail prices to consumers. The PPI reflects prices received by domestic producers at the wholesale level. The GDP deflator is the broadest measure of inflation; it includes all goods and services covered by the national income and product accounts.

2.

Who loses from unanticipated inflation? Who benefits?

Answer: Workers lose temporarily (until adjustments are made over a longer time period) because the goods and services they buy have gone up in price. Creditors lose because inflation has reduced the value of the payments they receive. However, persons with fixed interest rate loans benefit from unanticipated inflation because the real value of the loan payments are lower.

3.

Why is the inflation rate a positive number prices of certain goods, such as computers and televisions, fall dramatically due to technological advancement?

Answer: Because the inflation rate is calculated based on a representative basket of goods, some goods (such as technology goods) may fall in price while others will rise in price. In most years, the overall price of the basket will rise, leading to a positive inflation rate.

4.

What is required for a person to be considered unemployed? How is the unemployment rate computed?

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Answer: To be unemployed, you must not have a job but must be available for work and have been actively seeking work in the previous four weeks. The unemployment rate is the number of unemployed divided by the labor force (the sum of the numbers of employed and unemployed).

5.

6.

Why do teenagers and young people have high unemployment rates?

Answer: Teenagers and young people in general have not had enough time to acquire the kinds of skills that are associated with lower unemployment rates (college education, professional training, or trade skills beyond the apprenticeship period).

Describe the three types of unemployment. What types of government programs would be most effective in combating each type?

Answer: Frictional, structural, and cyclical. A job-matching employment service would reduce search time for the frictionally unemployed. Extensive job training and retraining programs would be most useful for structurally unemployed people. Cyclical unemployment is minimized with good monetary and fiscal policies to reduce the swings in the business cycle.

Apply the Concepts 7.

If you believe that inflation is going to increase significantly over the next few years and you are planning to purchase a new car, would it be advantageous to purchase the car now with a low fixed-interest-rate loan or wait a few years and purchase the car with your savings? Explain.

Answer: If you believe inflation is going to increase significantly, it would be better to buy the car now before the price of all goods, including cars, goes up. Although borrowing money requires you to pay interest, the money you are paying back has less purchasing power, which benefits the borrower.

This assumes that in fact inflation does rise significantly more than the market had expected; otherwise, the bank would factor these expectations into the interest rate.

8.

Suppose you work hard at a job after graduation and after your first year, your effort is rewarded with a 3% raise when the average wage increase in your company is 2%. Then, the government releases its inflation report, which states that inflation is running at 5%. Given this information, did your standard of living improve? Why or why not?

Answer: No, your real income actually fell because your 3% raise is smaller than the 5% average rise in prices. Therefore, the purchasing power of your income (even with the 3% raise) is less than it was last year when the price level was lower.

9.

Suppose Mexico’s population grew by 10% over the past two decades due to increased immigration from Central America while Costa Rica’s population grew by 10% over the same period primarily due to rising life expectancy. Would the population growth have the same effect on the labor force and unemployment rate in each country? Explain.

Answer: If Mexico’s population growth is primarily due to working-age people, this will increase its labor force and the number of people looking for work. If the same population growth in Costa Rica is primarily due to people living longer, the labor force does not rise as much since many older people choose not to work in their retirement. All else equal, Mexico’s unemployment rate will likely increase more than in Costa Rica.

10.

Assume you just lost your job and have decided to take a monthlong break to travel to Europe before looking for a new position. Just as you return home from your trip, you are interviewed by the Department of Labor about your employment status. How would you be classified (employed, unemployed, or not in the labor force)? Explain why.

Answer: Not in the labor force. You were not actively seeking work over the past four weeks.

11.

The Bureau of Labor Statistics categorizes unemployed people into several groups, including job leavers, job losers, and discouraged workers. During a mild recession, which group would tend to increase the most? During a deep recession? During a boom?

Answer: During a mild recession, the number of job losers would probably increase the most, but when the recession is deep, the number of discouraged workers would grow quite fast. In a boom, the number of job leavers would grow as people change jobs with ease.

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12.

In the beginning of a recovery after a recession, employment begins to rise, and the news media report these data on job growth. What effect would such a report have on the labor market? How would the report affect the unemployment rate?

Answer: When news of job growth is reported, workers who had given up looking for work during the recession are likely to reenter the workforce, which increases the size of the labor force. If the number of new jobs does not keep up with the growth of the labor force, the unemployment rate can actually rise despite the job growth.

In the News 13.

A debate that regularly occurs in Congress concerns raising the debt ceiling, allowing the U.S. government to continue paying its obligations. A few years ago, one politician proposed that instead of raising the debt ceiling, the U.S. Treasury should just mint a trillion-dollar coin and use it to ―pay off ‖ the federal deficit. If such a coin were to be minted, what would be its potential effects on inflation? Is this a risk-free way of paying off a fiscal deficit? Why or why not?

Answer: Minting a trillion-dollar coin is simply a way of printing money to pay off debts, a process called monetizing the debt. If the coin is not circulated, the immediate effects on inflation would not be significant. However, all money is neutral in the long run. This means that by increasing the amount of money in an economy (even if it is not actually circulated), pressures on prices will rise in the long run, potentially causing significant inflation, especially with that amount of money being added. Therefore, the deficit is paid for through an inflation tax, which means consumers pay more for goods and services as a result of the higher price level. The effects on inflation can be removed if the use of the coin is temporary, for example, if new debt is issued to buy back the coin and the coin is subsequently destroyed.

14.

Many hotel chains are automating the check-in process by allowing guests to use their phones to download a scannable code that can be used to unlock their rooms, allowing one to bypass the front desk altogether upon arrival. How will this technological change affect employment in the hotel industry? What type of unemployment might this create? If the hotel industry continues to expand rapidly, what type of jobs could these workers transition to?

Answer: Automation is occurring in many industries, including the hotel industry. Automating the check-in process at hotels will decrease the number of front-desk workers needed, assuming that the total number of hotels remains the same. If so, structural unemployment will occur as front-desk workers seek other positions. But if the hotel industry continues to grow, employment may still increase despite having fewer staff members per hotel as long as the number of hotels increases sufficiently. Also, hotels are increasingly offering more services, such as concierge and business services, both of which require staff members with similar skills as front-desk workers.

Solving Problems 15.

Suppose the country of Snowland uses the following market basket of goods to determine its consumer price index, with Year 1 being the base year with a CPI of 100. Nominal GDP is also provided Market Basket Items Loaf of bread Movie ticket Gallon of gasoline Scented candle Nominal GDP

a. b. c. d.

Year 1

Year 2

Year 3

Year 4

$2.50 $8.00 $3.50 $12.00 $5 billion

$2.80 $8.80 $4.20 $13.20 $5.6 billion

$3.00 $9.20 $4.00 $14.00 $6.1 billion

$3.10 $9.50 $3.60 $14.30 $6.5 billion

Calculate the CPI in Snowland for each year, using Year 1 as the base year with CPI = 100.

Calculate the rate of inflation (based on CPI) in Year 2, Year 3, and Year 4.

Using the CPI, calculate the real GDP in each of the four years.

Between Year 1 and Year 4, what proportion of the total increase in nominal GDP was due to

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inflation?

Answer: a. The cost of the basket in the base year (Year 1) is $25.00. The cost increased to $29.00 in Year 2, $30.20 in Year 3, and $30.50 in Year 4. CPI = ($25/$25) × 100 = 100 in Year 1, ($29/$25) × 100 = 116 in Year 2, ($30.20/$25) × 100 = 120.8 in Year 3, and ($30.50/$25) × 100 = 122.0 in Year 4. b. The rate of inflation in Year 2 is [(116/100) × 100] – 100 = 16%, [(120.8/116) × 100] – 100 = 4.1% in Year 3, and [(122.0/120.8) × 100] – 100 = 1% in Year 4. c. Real GDP in Year 1 is $5 billion × (100/100) = $5 billion, $5.6 billion × (100/116) = $4.83 billion in Year 2, $6.1 billion × (100/120.8) = $5.05 billion in Year 3, and $6.5 billion × (100/122) = $5.33 billion in Year 4. d. Although nominal GDP increased by 30%, prices increased by 22% over this period. Therefore, inflation represented 22/30 = 73% of the rise in nominal GDP. 16.

The town of Villageton has 500 residents, of which 300 are employed, 30 are not working but actively seeking work, 80 are children in school, 40 are retirees, 30 are full-time college students, and 20 are institutionalized. a. Calculate the unemployment rate in Villageton. b. Suppose that 10 of the 30 college students graduate and enter the labor force actively seeking work, but only 5 find a job. How does this change the unemployment rate in Villageton?

Answer: a. The unemployment rate is 30/(300 + 30) = 1/11 = 9.1%. b. The labor force increases from 330 to 340, and the number of unemployed persons increases from 30 to 35. The new unemployment rate is 35/340 = 10.3%.

Chapter 7(18)

By the Numbers: Assessing Your Data Literacy 1.

Which country in the scatter spot has the highest average life expectancy? Which country has the lowest average life expectancy? What is the difference in GDP per capita between these two countries?

Answer: Japan had the highest life expectancy at 85.5 years, and Chad had the lowest life expectancy at 57.5 years. Japan’s GDP per capita was $42,900 compared to Chad’s $2,300. Japan’s GDP per capita was $40,600 higher, or over 18 times greater.

2.

What trend does the graph show? Why is this not surprising?

Answer: The graph shows a positive correlation between GDP per capita and average life expectancy.

This is not surprising because as GDP per capita increases, countries are able to provide better health care and a more comfortable life, leading to longer lives.

3.

Does any country appear as an outlier (either low GDP per capita with high average life expectancy, or vice versa)? If not, go to the data source named above to find a country that would be an outlier.

Answer: Among the countries in the table, there are not any significant outliers, though there are a few countries that deviate from the trend. For example, Costa Rica had a very high average life expectancy relative to its GDP per capita. Meanwhile, the United States had a lower average life expectancy compared to several other countries with lower GDP per capita. A search using the CIA World Factbook reveals other outliers. For example, Albania had a relatively low GDP per capita of $12,500 but a high average life expectancy of 78.6, while Equatorial Guinea had a relatively high GDP per capita of $37,400 but a relatively low average life expectancy of 65 .

Check Your Understanding 1.

Although abundant natural resources can be a blessing to a country, are they necessary to ensure economic growth and a prosperous economy?

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Answer: Natural resources are helpful but not necessary to have a vibrant and prosperous economy.

Japan and Singapore are clear examples of countries without any significant resources that have high standards of living. These countries do have large numbers of well-educated productive people who have contributed to growth.

2.

If a country’s GDP grows by 10% per year, why isn’t the number of years it takes to double the GDP simply 100%/10% = 10 years?

Answer: Economic growth benefits from the effects of compounding. When GDP grows by 10% per year, each year’s increase builds upon the higher level from the previous year. The Rule of 70 is used to approximate the number of years for a value to double, taking into account the effect of compounding. At a 10% annual growth rate, the number of years for GDP to double is 70%/10% = 7 years.

3.

What are some ways in which countries can improve labor productivity?

Answer: Through training, education, greater capital, and technology.

4.

In what ways do governments help to build technology and ideas?

Answer: By supporting colleges and universities and students directly with loans and grants, through research centers, by providing grants to individuals and companies, and by protecting and enforcing property rights (including intellectual property, such as inventions and ideas).

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5.

Why is investment in human capital good for both individuals and fostering economic growth for the economy as a whole?

Answer: Investment in human capital such as education increases the standard of living for individuals as they become more productive and earn more throughout their working lives. For the economy as a whole, there are positive spillovers from more productive workers. Also, higher levels of education mean more workers are more able to use and create improving technologies.

6.

Why is a stable financial system crucial for economic growth?

Answer: When a country’s financial sector is subject to frequent crises or the currency is subject to wide fluctuations in value, businesses and consumers find their normal activities interrupted. This leads to economic uncertainty and reduces investment in productive activities. Lower investment and other poor economic decisions made because of financial uncertainties reduce a country’s overall growth rate.

Apply the Concepts 7.

If developing countries such as Vietnam and Ethiopia have growth rates more than double that of the United States or countries in Europe, why do they remain considerably poorer?

Answer: A nation’s wealth is developed over a long period of sustained growth. Because developed nations such as the United States and Europe have had steady growth rates for nearly a century, these countries have accumulated much greater wealth than countries that have undergone devastating wars or significant government change in recent decades. Vietnam and Ethiopia are growing fast but are starting from a much smaller level of GDP.

8.

What role might foreign investment play in helping developing nations improve their growth rate and increase income levels?

Answer: Foreign investment can help to jump-start an economy. Areas where the population is poor can benefit from the jobs and income that foreign investment provides. As income grows, other firms develop to provide services and goods to the employees of these foreign firms—now with higher incomes. But for many countries, this is a balancing act to ensure that foreign companies add to economic growth and development without exploiting natural resources or creating environmental problems. The goal is to see that these firms leave a permanent increase in economic growth and prosperity.

9.

Higher levels of savings and investment lead to greater rates of economic growth. What can government do to encourage more savings and investment?

Answer: Saving can be encouraged by making more savings not subject to taxation. The 401(k) accounts used for private pensions in the United States are an example. Focusing taxation more on consumption (sales taxes) than on income will encourage saving. Investment can be encouraged by tax policy as well. Using investment tax credits that are an offset to tax liabilities reduces the cost of investing, resulting in more. Also, investment by government in basic research can often result in more research by private companies to turn these basic discoveries into potential products. For example, the Human Genome Project started by the U.S. government has led to significant research and development by the drug industry into new treatments and drugs.

10.

Per capita income (or output) is the general measure used to compare the standards of living between countries. If a country’s population growth is higher than its economic growth, what happens to per capita income? What are some of the limitations to using per capita income as a measure to compare the well-being of different countries?

Answer: If population growth exceeds economic growth, per capita income will decline—more people to spread the slower-growing pie. Per capita income is a reasonable measure to compare countries but is not perfect. Economic freedoms also add to the quality of life, and governments provide different levels of services (holding per capita income the same), and these add to standards of living. Peter T. Bauer suggested that the birth of a cow adds to per capita GDP, but the birth of a child subtracts from it; something here is not quite right.

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11.

Energy independence has been a goal for many decades. But only in the past decade has the increased focus on renewable energy sources, such as solar, wind, and water, taken on greater significance. How does achieving energy independence contribute to labor productivity and economic growth?

Answer: Achieving energy independence, either by the development of renewable fuels or by reducing energy consumption, leads to job growth and reduces costs of production. Reduced reliance on foreign energy sources shifts jobs to domestic industries, while increased energy efficiency improves the productivity of labor in nearly all industries. The combination of increased job growth and greater labor productivity contributes to economic growth.

12.

When government policymakers debate how to manage a tight budget, they often choose to cut lofty programs such as space exploration, supersonic flights, and reforming the air traffic control system.

How might this lead to a tradeoff between short-run and long-run growth?

Answer: In order to achieve long-run growth, countries must find ways to expand their productive capacity, which means making investments that may not pay off until well into the future. For example, investing in a more efficient air traffic system will streamline air travel and improve long-run productivity but requires sacrificing some short-run objectives. By cutting these investments, however, countries might limit their growth in future years. Countries like China and the United Arab Emirates, however, continue to invest heavily in lofty long-term projects that may allow these countries to achieve higher growth in the future.

In the News 13.

In 2016, the United Kingdom voted to leave the European Union in a decision referred to as Brexit. By doing so, policies such as the open movement of capital and labor along with free trade may be restricted. Subsequently, the United Kingdom’s growth rate has slowed. What are some reasons why Brexit may have contributed to the slowing of the United Kingdom’s economy?

Answer: Economists generally agree that free trade and the movement of capital and labor contribute to economic growth. By leaving the European Union, the United Kingdom faces new restrictions on trade and factor mobility that may reduce productivity. Businesses around the world have expressed concerns about Brexit, resulting in investments being moved to other countries that are still in the European Union. Also, rising uncertainty about the United Kingdom’s future following Brexit has hampered business confidence, reducing economic activity in the country and further slowing its economy.

14.

Finland consistently ranks very high in global rankings of educational achievement in science and math. This was a result of a transformation in Finland’s public education system to one that focuses on small class sizes and highly trained teachers for primary and secondary education, which is considered a highly prestigious profession. At the college level, many countries fully subsidize college tuition, and in Saudi Arabia, the King Abdullah Scholarship Program offers to send its citizens to study at many of the world’s prestigious universities for free. Explain how government investment in education could pay for itself in the long run.

Answer: Many studies have showed a strong relationship between educational achievement and economic growth. Therefore, government spending on education can lead to a higher growth rate over time, which would boost GDP and also increase the tax base, allowing for greater revenues that would fund future investments in education. Therefore, investment in education could pay for itself through the economic growth that it generates.

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Solving Problems 15.

In 2018, U.S. GDP was approximately $20 trillion, while India’s GDP was approximately $2.5 trillion. However, India is growing faster than the United States. a.

If the U.S. economy grows at 3% per year, in what year will U.S. GDP double to $40 trillion?

(Hint: Use the Rule of 70 to approximate the number of years needed for GDP to double.) b. If India’s economy grows at 7% per year, in what year will its GDP double to $5 trillion? In what year would India’s economy increase 16-fold to $40 trillion? c. If each country’s growth rate continues at the same rate, in what year would each country’s GDP reach $80 trillion?

Answer: a. Using the Rule of 70, U.S. GDP will double every 23 years. Therefore, U.S. GDP will double in the year 2041. b. Using the Rule of 70, India’s GDP will double every 10 years. India’s GDP will increase to $5 trillion in 2028, double again to $10 trillion in 2038, double again to $20 trillion in 2048, and double again to $40 trillion in 2058. c. U.S. GDP will increase to $80 trillion in the year (2041 + 23) = 2064. India’s GDP will increase to $80 trillion in the year (2058 + 10) = 2068.

Suppose a new colony is created on the moon with the following production function: Output = A  (L + K + H + N). If L, K, H, and N each equal 5 and technology (A) equals 3, how much output would this new colony produce?

Answer: Plugging the numbers into the production function, output = 3  (5 + 5 + 5 + 5) = 3  20 = 60.

Chapter 8(19) 16.

By the Numbers: Assessing Your Data Literacy 1.

In which year did government spending, as a percentage of GDP, reach its highest point? In which year was it at its lowest point?

Answer: Government spending as a percentage of GDP was highest in 2009 (24.4%), and was lowest in 2000 and 2001 (17.6%).

2.

Describe the trend in the chart during times of economic prosperity (such as from 1985 to 1990 and from 1993 to 2000). Describe the trend during economic recessions (indicated by the shaded bars).

Answer: The graph shows a decline in government spending as a percentage of GDP during times of economic prosperity, and a rise in government spending as a percentage of GDP during economic recessions.

3.

Explain why the relationship described in question 2 generally exists.

Answer: During times of economic prosperity, GDP rises, which makes any fixed amount of spending as a percentage of GDP fall. Moreover, fewer people claim government benefits during times of economic prosperity, reducing nominal government spending as well. The opposite occurs during economic recessions: more people depend on government benefits and GDP falls, both of which will raise spending as a percentage of GDP.

Check Your Understanding 1.

Describe the important difference between the average propensity to consume (APC) and the marginal propensity to consume (MPC).

Answer: The APC is how much an individual consumes out of total income (C/Y), whereas the MPC is the change in consumption associated with a change in income (ΔC/ΔY).

2.

What are the factors that cause consumption to change at any given level of income?

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Answer: The factors that cause consumption to change at any given level of income include wealth, price or income expectations, household debt, and taxes.

3.

If an economy’s spending multiplier is equal to 4, what is its MPC and MPS? Answer: An economy’s spending multiplier is equal to 1/(1 – MPC). Therefore, if the multiplier is equal to 4, the MPC is equal to 0.75, and the MPS is equal to 0.25.

4.

What does the paradox of thrift suggest would happen to output, income, and long-run savings if people increased their MPS in preparation for a recession?

Answer: The paradox of thrift argues that when people increase their savings rate, this would reduce economic activity in the economy due to the multiplier effect. As a result, output would fall, leading to lower income, which then leads to a lower amount of savings.

5.

Explain why a $100 reduction in taxes does not have the same impact on output and employment as a $100 increase in government spending.

Answer: When taxes are reduced by $100, this is essentially the same as income rising by $100. Some of this increase in income is spent (consumed), and some is saved. Thus, the initial impact of the tax reduction is muted by the portion that is saved, reducing the ultimate impact on the economy.

6.

How do injections and withdrawals into an economy affect its income and output?

Answer: Injections include investments, government spending, and exports, which boost aggregate expenditures by the initial injection magnified by the multiplier, leading to higher income and output.

Withdrawals include savings, taxes, and imports (purchases of foreign goods instead of domestic goods), which reduce aggregate expenditures, leading to lower income and output.

Apply the Concepts 7.

If the economy has an MPC equal to 0.80 and is currently $800 million below its full employment income, will a $150 million increase in investment spending bring the economy to its macroeconomic equilibrium, all else equal?

Answer: If MPC is 0.80, the economy’s multiplier is equal to 5. Therefore, a $150 million increase in investment spending would generate a $750 million increase in aggregate expenditures, which is not enough to bring the economy to macroeconomic equilibrium.

8.

Other than reductions in interest rates that increase the level of investment by businesses, what factors would result in higher investment?

Answer: Factors that lead to greater investment include an improvement in business expectations regarding the economy and improvements in technology that stimulate innovations in new products.

9.

The simple aggregate expenditures model discussed in this chapter concluded that one form of spending was just as good as any other; increases in all types of spending lead to equal increases in income. Is there any reason to suspect that private investment might be better for the economy than government spending?

Answer: Private investment typically leads to future increases in productive capacity and often to increases in productivity. Both of these may improve our standards of living in the future. Government spending on education, infrastructure, and research and development has the capacity to do the same.

But some government spending is more like consumption and has little impact on the future. As we will see in later chapters, if government spending is too high, it can ―crowd out‖ private investment, potentially reducing our rate of economic growth.

10.

How would a country correct an inflationary gap using changes in government spending? How would it address a recessionary gap?

Answer: If a country is currently experiencing an inflationary gap, its level of aggregate expenditures exceeds the level needed to achieve macroeconomic equilibrium. The government can reduce government spending by an amount equal to the inflationary gap divided by the multiplier to achieve equilibrium. To address a recessionary gap, the government would increase government spending by

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an amount equal to the gap divided by the multiplier.

11.

How does the economy today differ from that of the Great Depression, the economy Keynes used as the basis for the macroeconomic model discussed in this chapter?

Answer: Unemployment during the Depression peaked at 25%, whereas in 2013 unemployment was around 7%. Today we have many programs that help poor and unemployed people, such as welfare, unemployment compensation, and Medicaid; these were virtually nonexistent in the 1930s. Thanks to Keynes, our understanding of macroeconomics is better today. Also, during the 1930s we did not have a systematic process of data collection on the economy; therefore, policymakers often made decisions based on anecdotes.

12.

In modern politics, the word ―Keynesian‖ often is synonymous with ―big government‖ spending. Does this characterization accurately reflect the role of government in spurring economic activity? How would a tax cut be characterized today versus in Keynes’s time?

Answer: Keynes saw a role for an active government in smoothing out fluctuations in the economy by enacting policies to promote consumption and investment during economic downturns. This role of government is not limited to government spending. Tax cuts also promote spending by giving more money to consumers to spend and to firms to invest. However, in today’s highly politicized society, the word ―Keynesian‖ is more often associated with government spending than with tax cuts.

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In the News 13.

The U.S. tax cuts that went into effect in 2018 reduced the corporate tax rate and individual income tax rates. Tax analysts have determined that while most American taxpayers benefit from the policy, a large portion of the tax cuts is aimed at higher-income households. Explain how the effects of this tax policy might differ, if at all, if more of the tax cuts are aimed at lower-income households based on the multiplier effect.

Answer: Because those with higher incomes generally save a higher percentage of their income, MPC tends to be greater on average among those with lower incomes. This means that the multiplier would be greater when tax cuts are aimed at those with lower incomes because they are more likely to spend their tax savings.

14.

A proposal that has significant support among policymakers regardless of political party is the need to modernize the nation’s infrastructure, such as reinforcing thousands of bridges deemed structurally deficient and modernizing airports. Explain why such policies might not be as effective when the economy is experiencing an expansion than when it is in a recession.

Answer: Increasing government spending during expansions would likely push output beyond the full employment level. This would lead to higher labor costs and prices, which can adversely affect businesses as well as individuals. Government spending is more effective during times of economic recession, when increased spending can help bring an economy back to full employment.

Solving Problems 15.

Using the following aggregate expenditures table, answer the questions that follow.

Income (Y), in $ 2,200 2,300 2,400 2,500 2,600 2,700 2,800 2,900 3,000 a. b. c. d. e.

Consumption (C), in $ 2,320 2,380 2,440 2,500 2,560 2,620 2,680 2,740 2,800

Saving (S), in $ −120 −80 −40 0 40 80 120 160 200

Compute the APC when income equals $2,300 and the APS when income equals $2,800.

Compute the MPC and MPS. What does the simple Keynesian multiplier equal?

If investment spending is equal to $120, what will be equilibrium income?

Using the following graph, show saving, investment, and equilibrium income.

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a. b. c. d. e.

16.

Chapter 1

Answer: When Y = 2,300, APC = 1.035. When Y = 2,800, APS = 0.043.

MPC = 0.6; MPS = 0.4. k = 1/(1 − MPC) = 1/MPS = 1/0.4 = 2.5.

Y = 2,800.

See the following figure.

Use the figure to answer the following questions.

a. b.

What are the MPC, the MPS, and the multiplier?

If the economy is currently in equilibrium at point a and full employment income is $4,000, how much in additional expenditures is needed to move this economy to full employment? What is this level of spending called? c. Assume the economy is currently in equilibrium at point a and full employment income is $4,000.

How much of a tax decrease would be required to move the economy to full employment?

Answer: a. The MPC is 0.6 (300/500), the MPS is 0.4 (200/500), and the multiplier is 2.5 (1/0.4). b. The multiplier is equal to 2.5, and income must grow by $1,000; therefore, an aggregate expenditure increase of $400 is required ($400  2.5 = $1,000). This is the recessionary gap. c. To close the GDP gap of $1,000, an increase in aggregate spending of $400 is needed because the multiplier is 2.5. Because only 0.6 (the MPC) of the tax reduction will be multiplied, we will need to reduce taxes by more than $400. Therefore, the question boils down to what tax reduction times 0.6 equals $400. The algebra is 400 = x (0.6) 400/0.6 = x x = $667 Therefore, a $667 tax reduction will close the GDP gap of $1,000.

Chapter 9(20)

Solutions Manual to accompany Chiang, Economics, 5e

Chapter 1

By the Numbers: Assessing Your Data Literacy 1.

What is the average homeownership rate of the top five states? What is the average homeownership rates of the bottom five states?

Answer: The average homeownership rate of the five top states is 74.7% and the average homeownership rates of the five bottom states is 57.7%.

2.

What is the difference in the homeownership rate between the state with the highest rate of homeownership and the state with the lowest homeownership rate?

Answer: The difference in homeownership rate between the top state (Maine) and the lowest (New York) is 76.1% – 52.3% = 23.8%.

3.

What factors might explain the large difference in homeownership rates between states?

Answer: An important factor in determining homeownership is affordability, which depends on average incomes as well as the average price of homes and the interest rate to finance a home. The five states with the highest homeownership rates have large rural populations where home prices are inexpensive. The exception may be Michigan which has several large urban areas including Detroit; however, significant population decline in Detroit over the past several decades caused home prices to plummet. The states with the lowest homeownership rates have large urban populations where home prices are significantly higher and where many residents live in rented apartments and homes. Also, residents in urban areas tend to move more often than those who live in rural areas, making homeownership more practical in areas where people tend to stay put for longer periods.

Check Your Understanding 1.

Describe the impact of rising interest rates on consumer spending.

Answer: Higher interest rates mean that the cost of borrowing rises. Some consumers will decide not to purchase items normally purchased on credit; therefore, consumer spending falls.

2.

When the economy is operating at full employment, why is an increase in aggregate demand not helpful to the economy?

Answer: When the economy is operating at full employment, an increase in aggregate demand just translates into higher prices (inflation). Temporarily, the economy might expand beyond full-employment output, but it quickly moves back to the long-run aggregate supply curve and back to full employment, but now the price level is even higher.

3.

Why is a supply shock (such as sudden rising prices for energy, food, or raw materials), doubly disruptive and harmful to the economy?

Answer: A leftward shift in the short-run aggregate supply curve causes two problems for policymakers: increased unemployment (lower output) and a higher price level (inflation). Reducing unemployment by increasing aggregate demand will cause more inflation. Bringing the price level back to its original state would require aggregate demand to be reduced, increasing unemployment even more.

4.

Explain why the aggregate supply curve is positively sloped during the short run and vertical in the long run.

Answer: During a depression, the unemployment rate is high, and the economy has significant slack; therefore, output can be increased with no effect on prices. In normal short-run circumstances, employment is below full employment, and increasing output may require overtime (hiring and training of people takes time and adds to costs), causing prices to rise somewhat, resulting in an increase in the price level along with rising output. But in the long run, the economy is at full employment; therefore, an increase in aggregate demand results only in a rising price level.

Explain how imports and exports affect aggregate demand.

5.

Solutions Manual to accompany Chiang, Economics, 5e

Chapter 1

Answer: Imports are purchases of foreign goods by American consumers, while exports are purchases of American goods by foreign consumers. Therefore, exports will increase aggregate demand, while imports will reduce aggregate demand. An increase in net exports, which are exports less imports, increases aggregate demand.

6.

Provide and explain some factors that will shift the long-run aggregate supply curve.

Answer: A shift in the long-run aggregate supply curve will occur when the productive capacity of an economy changes. Factors include changes in the amount of available capital, changes in the skill level of workers, and changes in technology.

Apply the Concepts 7.

There is little doubt that artificial intelligence and automation have changed the economy. Machines are performing manual tasks at a faster and more consistent pace and are becoming better at replacing humans, even in service-oriented jobs, such as customer support. Show the impact of these innovations in production on the economy using an aggregate demand and supply framework.

Answer: Artificial intelligence and automation have led to a lower cost of production by reducing input costs, most notably labor wages, as machines perform the work that humans used to do but at a faster pace. This innovation shifts the short-run aggregate supply curve to the right and results in greater aggregate output at each price level. If the innovations increase the productive capacity of the economy, then long-run aggregate supply will increase as well.

8.

Unemployment can be caused by a reduction in aggregate demand or short-run aggregate supply. Both changes are represented by a leftward shift of the curves. Does it matter whether the shift occurs in aggregate demand or short-run aggregate supply? Use the aggregate demand/aggregate supply framework to support your answer.

Answer: If aggregate demand declines, the price level falls (or inflation pressures are reduced). If short-run aggregate supply declines, the price level rises. Less inflation is better than more inflation.

9.

Why is cost-push inflation a more difficult problem for policymakers than demand-pull inflation?

Answer: To solve demand-pull inflation, policymakers can just reduce aggregate demand, and the economy will return to full employment at the old price level. With cost-push inflation, output falls, and the price level and unemployment rise; therefore, increasing aggregate demand to bring the economy back to full employment results in an even higher price level. Reducing aggregate demand makes unemployment worse.

10.

Why is consumer confidence very important in determining the equilibrium level of output and employment?

Answer: Because consumer spending is roughly 70% of total spending, a small drop in consumer spending results in a large change in equilibrium output and income. Consumer confidence is one important factor driving consumer spending.

11.

As the Japanese yen appreciated in value during the 1980s and 1990s, more Japanese auto companies built manufacturing plants in other parts of Asia and in the United States. What impact did this have on net exports for the United States? Why did Japanese automakers build plants in the United States?

Were the reasons similar to the reasons that American firms build plants (or establish offshore production) in China and other parts of Asia?

Answer: Japanese investment in the United States increased investment spending and reduced imports of Japanese cars, increasing net exports. The rising value of the yen made production in Japan relatively expensive; producing in the United States made them more competitive. Also, shipping cars within the United States is much less expensive than shipping cars from Japan, further increasing competitiveness. Yes, both situations represent firms seeking production costs that keep them competitive.

12.

Some advocates have suggested that the United States should move to a universal health care plan paid

Solutions Manual to accompany Chiang, Economics, 5e

Chapter 1

for at the federal level, like Medicare, which would be funded out of general tax revenues. Such a plan, it is argued, would guarantee quality health care to all. Ignoring all the controversy surrounding such a plan, how would the introduction of universal health care paid for from tax revenues impact short-run aggregate supply? On long-run aggregate supply?

Answer: It could affect aggregate supply on at least two levels. First, with all workers covered, workers might become healthier and more productive, increasing aggregate supply. Many companies today have ―wellness‖ programs that provide incentives (money and other rewards) to employees to eat right, exercise, and generally take better care of their health. These programs reduce sick days and health costs and lead to more productive employees. Second, removing the responsibility of health care costs from private firms would reduce costs to businesses and increase aggregate supply (this is the equivalent of lower resource costs).

In the News 13.

The U.S. economy has significantly expanded since recovering from the severe effects of the 2007– 2009 recession. In 2019 the unemployment rate was under 4%, below the natural rate of unemployment. Given that the economy was at or beyond full employment, describe the effects of the multiplier when the federal government continued to increase government spending and reduce taxes to boost aggregate demand.

Answer: When the economy is at or beyond its potential output, the short-run aggregate supply curve becomes very steep, indicating that further increases to aggregate demand is not likely to significantly raise output because input prices and wages would react quickly and result in a higher price level.

Therefore, the actual multiplier is likely to be much smaller than if the economy was producing below its potential output. Still, government spending and tax cuts are very popular with politicians who see this strategy as a way to promote their accomplishments and to win elections, even as the national debt continues to rise to record levels.

14.

In 2018 the United States and China entered into a trade dispute that led both countries to impose import tariffs on each other’s goods. Economists have concluded that the tariffs contributed to slower economic growth for both countries, though the effects were greater in China. Using aggregate demand and supply analysis, explain how a trade dispute can lead to a slowing of aggregate output in both countries.

Answer: Exports are included in a country’s measure of aggregate demand and therefore are an important part of a country’s aggregate output. When the United States placed tariffs on Chinese imports, its goal was to protect domestic manufacturers, which in theory could lead to higher aggregate output. However, China retaliated by placing its own tariffs on imports of U.S. goods, leading to a decline in certain U.S. industries, such as agriculture and industrial equipment. Because the United States imports a much larger volume of goods from China than it exports, the tariff war seemed to have a greater effect on China’s economy. But because China’s growth rate is higher than in the United States, it has an ability to withstand some economic turbulence without entering into a recession.

Solutions Manual to accompany Chiang, Economics, 5e

Chapter 1

Solving Problems 15.

In the following figure, the economy is initially in equilibrium at full employment at point e. Assume that consumption falls by 100, leading to a shift in aggregate demand from AD0 to AD1.

a. What is the new short-run macroeconomic equilibrium price and output? b. How large is the spending multiplier if there were no changes to the aggregate price level? c. How large is the spending multiplier if the aggregate price level adjusts to the new equilibrium?

Answer: a. The short-run equilibrium will be at point a where Q = $2,600. b. Aggregate demand fell by 100, and the gap in GDP is 300; therefore, the simple multiplier is equal to 3. Remember, when AD declines by x and the economy has a lot of slack, the change in equilibrium income, e − b, divided by the change in aggregate demand is the multiplier. c. When the AD curve shifted left, the aggregate price level fell, which reduced the decrease in output from 300 to 200. Therefore, the spending multiplier is 2, because the decline of consumption of 100 led to a decrease in output of 200.

16.

Use the following table and grid to answer the following questions. a. On the grid, graph the aggregate demand and short-run aggregate supply curves (label them AD0 and SRAS0). What are the equilibrium output and the aggregate price level? b. Assume aggregate demand grows by 200 at each price level. Graph the new aggregate demand curve and label it AD1. What are the new equilibrium output and the aggregate price level? c. If full employment output is 600, is the economy experiencing recessionary or inflationary pressures? d. By how much does the SRAS curve need to shift in order for the economy to return to full employment output at 600? What would be the new equilibrium price?

Aggregate Price Level 150 125 100 75 50

Output (short-run aggregate supply) 1,000 800 600 400 200

Output (aggregate demand) 200 400 600 800 1,000

Solutions Manual to accompany Chiang, Economics, 5e

Chapter 1

Answer: a. Q = 600, P = 100. b. Q = 700, P = 112.5. c. If full employment output is 600, the economy is experiencing inflationary pressure. d. The SRAS curve needs to shift left by 200 at every price in order for the economy to return to long-run equilibrium at an output of 600. The aggregate price level at full employment would be 125.

Chapter 10(21)

By the Numbers: Assessing Your Data Literacy 1.

How does the amount of revenue collected from individual income taxes compare to corporate income taxes? Which one produces more government revenue, and how much more than the other?

Answer: The government collects much more revenue from individuals than corporations. In 2018, the government collected over $1.6 trillion in individual income taxes compared to only around $200 billion in corporate income taxes, or about 8 times more.

2.

Social Security, Medicare, Medicaid, and Income Security Programs are all programs aimed at ensuring senior citizens and low income households a minimum level of well-being. How much in total was spent on these four categories? How much more is this amount compared to that spent on national defense?

Answer: Spending on these four categories amounted to around $2.5 trillion in 2018, which was about 4 times greater than the amount spent ($621 billion) on national defense.

Solutions Manual to accompany Chiang, Economics, 5e

3.

Chapter 1

In 2018, did the government have a fiscal surplus or a fiscal deficit? What was the magnitude of this surplus or deficit?

Answer: In 2018, the government spent more than it collected in taxes, and had a fiscal deficit of $779 billion.

Check Your Understanding 1.

What is the main difference between discretionary spending and mandatory spending?

Answer: Discretionary spending is approved by Congress each year through the appropriations process, while mandatory spending is authorized by a law. While discretionary spending can change with each budget proposal, changes to mandatory spending require a change to the corresponding law.

2.

Explain why increasing government purchases of goods and services is expansionary fiscal policy.

Would increasing taxes or reducing transfer payments be contractionary or expansionary? Why? Answer: Increasing government purchases of goods and services is expansionary fiscal policy.

Buying goods from businesses increases aggregate demand, leading to greater sales by firms, which will use these funds to purchase other goods, pay factors, or invest in new production capacity.

Combined with a multiplier effect, income and employment will expand. Raising taxes or reducing transfer payments is contractionary because the government is reducing private income, which will lead to reduced consumption.

3.

Explain why changes in tax rates affect both aggregate demand and aggregate supply.

Answer: On the demand side, tax rate changes affect consumer income, which affects consumer spending and, thus, aggregate demand. Tax rate changes also affect the supply side by altering incentives of labor to work; higher tax rates discourage work effort, while lower tax rates encourage work effort because take-home pay is higher. Further, tax rates affect investment levels and the incentive to invest.

4.

What is one benefit to businesses when the government budget is in surplus?

Answer: One big benefit to businesses is that the government may be retiring (buying) debt; therefore, the government’s efforts to increase bond prices drives interest rates down, making investment prospects more attractive to businesses. Notice that this is essentially the opposite of crowding out.

5.

How might interest paid on the national debt lead to greater income inequality?

Answer: The argument is that it is mostly high-income (or wealthy) individuals who own Treasury bonds, and they receive the interest, further skewing the income distribution in favor of high-income people, adding to income inequality. In addition, if the debt were lower, more money currently paying interest on the debt could be used to support low-income families, reducing income inequality.

What factors determine whether the national debt is a cause for immediate concern?

Answer: Although the nominal size of the national debt is a major factor in a country’s ability to finance its debt, the average interest rate on the debt is also a significant factor. Other factors include the size of the annual deficit or surplus. For example, a country that has a large national debt but is experiencing budget surpluses faces a better trajectory. Also, a higher growth rate makes financing the national debt less burdensome.

6.

Apply the Concepts 7.

One argument against using fiscal policies to smooth fluctuations in the business cycle is that their long lags may end up causing more harm than good. Provide an example that would support this argument and one that would not.

Answer: If an economy is already recovering from a recession, implementing an expansionary fiscal policy may lead to inflationary pressures once the policy finally takes full effect, which may create unintended consequences. However, not using fiscal policy at all when the economy is in a recession or is overheating may cause the negative effects to last a long time, causing significant harm to

Solutions Manual to accompany Chiang, Economics, 5e

Chapter 1

individuals and businesses.

8.

What are some major reasons why mandatory spending in the United States is increasing as a share of the federal budget?

Answer: Mandatory spending includes major programs such as Social Security, Medicare, and interest on the national debt. As the number of individuals reaching the qualification age for Social Security and Medicare rises (for example, due to an increase of seniors from the baby-boomer generation), the government needs to support many more millions of individuals. Also, as people live longer, this will further increase government spending on these programs. More recently, the rise in interest rates has increased the amount of interest paid on the national debt (which itself has increased). Each of these factors has led to mandatory spending increasing as a share of the overall federal budget.

9.

Our current personal income tax system is progressive: Income tax rates rise with rising incomes and are lower for low-income individuals. Some policymakers favor a ―flat tax‖ as a replacement for our modestly progressive income tax system. Most exemptions and deductions would be eliminated, and a single low tax rate would be applied to personal income. How would such a change in the tax laws alter the automatic stabilization characteristics of the personal income tax?

Answer: Yes, it would reduce the robustness of the personal income tax as an automatic stabilizer.

Under a progressive tax system, a decline in income leads to a greater-than-proportionate decline in tax liability, putting more income in the hands of households. A flat tax is a proportionate tax; therefore, the decline in tax payments and the increase in disposable income would be less. Taxes would still be an automatic stabilizer, but their impact would be less.

10.

In a speech before the Economic Club of New York in 1962, President Kennedy argued that ―it is a paradoxical truth that taxes are too high today and tax revenues are too low—and the soundest way to raise revenues in the long run is to cut rates now.‖ Is President Kennedy’s argument consistent with supply-side economics? Why or why not?

Answer: In general, President Kennedy’s statement is consistent with the arguments of supply-siders who feel that a reduction in tax rates will yield higher revenues, depending on where tax rates are on the Laffer curve. When President Kennedy made his address, marginal tax rates were as high as 70%.

As of 2013, the top marginal rate was 39.6%; it is less clear that rate reductions will lead to higher long-run revenues.

11.

A balanced budget amendment to the Constitution requiring Congress to balance the budget every year is introduced in Congress every so often. What sort of problems would the passage of such an amendment introduce for policymakers and the economy? What would be the benefit of the passage of such an amendment?

Answer: An annually balanced budget would eliminate the automatic stabilization aspect of the federal budget. When the economy enters a recession, the budget normally moves toward a deficit as transfer payments increase and tax collections decline. With a balanced budget amendment, spending would have to be cut back or taxes raised, causing the recession to be deeper. However, the benefit of such an amendment is that it forces fiscal discipline, preventing politicians from using excessive government spending that can lead to an unsustainable debt.

12.

Suppose the economy (gross domestic product) is growing faster than the growth of the national debt held by the public (both domestic and foreign). How does this affect the ability of the government to manage the national debt? What arguments can you make to rebut the common assertion that the national debt is bankrupting the country?

Answer: If GDP grows faster than the growth of the national debt, the burden of that debt on the annual budget becomes smaller as long as interest rates are low. However, when interest rates climb, the real cost of paying added interest each year is that it subtracts from money that could have been spent on other programs or projects. Arguments against the assertion that the national debt is bankrupting the country include the following: (1) Not all debt is held by the public—a sizable portion of the debt is held by other government agencies; (2) of the debt held by the public, about half of that is held domestically; therefore, the tax payments to pay the interest on that debt goes to other Americans; and (3) if the economy is growing faster than the debt is growing, then the debt as a

Solutions Manual to accompany Chiang, Economics, 5e

Chapter 1

percent of GDP is declining. To the extent that GDP reflects the ability of the country to pay its debt, our position is becoming better, even if the absolute size of the debt is large.

In the News 13.

From 2016 to 2019, interest rates on 30-year Treasury bonds rose from around 2.1% to 3.4%. What are the long-term implications of this change in financing the national debt and in managing the annual federal budget?

Answer: Higher interest rates on 30-year Treasury bonds lock in the rate in which the government must pay for financing its debt. For example, when interest rates were over 10% in the 1980s, the government had to pay these high interest rates on bonds issued in the 1980s until the 2010s even as interest rates on new bonds had fallen significantly over that period. Because interest rates have risen in recent years, the government will need to pay more to finance its debt. Fortunately, even the higher rate remains relatively low by historical standards, which means the government will likely continue to use a relatively small portion of its annual budget to pay interest on the national debt. However, this can change if the debt continues to rise or if interest rates increase further.

14.

Several years ago, Italy and Spain began to include the estimated output of informal activities (such as the drug trade, prostitution, and other illicit activities) as part of its GDP without actually legalizing these activities. If these activities remain illegal and the government does not collect tax revenues, why would it matter if these activities are counted in official GDP measures?

Answer: Although Italy and Spain do not plan to legalize these illegal activities, they still represent economic activity that occurs in their countries. By including the estimated value of these activities in GDP, it allows official measurements such as the debt-to-GDP ratio to improve. Still, the burden of the debt in these countries has not changed; the only change is how the magnitude of the debt is perceived.

Solving Problems 15.

Suppose a small economy has two income tax rates: 15% for all income up to $50,000 and 30% for any income earned above $50,000. Suppose that prior to the recession, the economy had five workers earning the following salaries: Amy $20,000 Betty $40,000 Charlie $60,000 Dimitry $80,000 Evelyn $100,000 a. Calculate the total amount of taxes paid by the five workers. What percent of total income does this represent? b. Now assume that a recession causes each of the five salaries to fall by 25%. Given the lower salaries, what would be the total amount of taxes paid by the five workers? What percent of total income does this represent? c. Explain how this progressive tax structure acts as an automatic stabilizer.

Answer: a. Before the recession, Amy’s tax bill would be $3,000, Betty’s $6,000, Charlie’s $10,500 ($7,500 + $3,000), Dimitry’s $16,500 ($7,500 + $9,000), and Evelyn’s $22,500 ($7,500 + $15,000), for a total of $58,500 in taxes. This equals $58,500 ÷ $300,000 = 19.5% in taxes. b. After the recession, Amy’s tax bill falls to $2,250, Betty’s $4,500, Charlie’s $6,750, Dimitry’s $10,500 ($7,500 + $3,000), and Evelyn’s $15,000 ($7,500 + $7,500), for a total of $39,000 in taxes. This equals $39,000 ÷ $225,000 = 17.3% in taxes. c. A progressive tax structure reduces the percentage of income collected in taxes when incomes fall, reducing the burden caused by the reduction in income.

16.

Suppose an economy has a GDP of $40 billion and a national debt of $20 billion, and the average interest rate on this debt is currently 3%.

Solutions Manual to accompany Chiang, Economics, 5e

Chapter 1

Calculate the annual interest payments on the debt. What percentage of this economy’s GDP is spent on interest payments on its debt? b. Suppose that next year one of two events occurs: (1) GDP and interest rates stay the same, but the economy adds $4 billion to its national debt, or (2) GDP and the national debt stay the same, but the average interest rate on the debt increases to 4%. Which of the two events would result in a larger portion of the economy’s GDP going toward interest payments on the national debt?

Answer: a. The economy is currently spending $600 million (3% × $20 billion) in interest payments, which is equal to 1.5% of its GDP ($600 million ÷ $40 billion). b. Event (1) would cause interest payments to increase to $720 million (3% × $24 billion), which is equal to 1.8% of its GDP ($720 million ÷ $40 billion). Event (2) would cause interest payments to increase to $800 million (4% × $20 billion), which is equal to 2% of its GDP ($800 million ÷ $40 billion). An increase in the interest rate from 3% to 4% causes a greater interest rate burden from the debt than an increase in the actual debt by $4 billion. a.

Chapter 11(22)

By the Numbers: Assessing Your Data Literacy 1.

How many of the ten largest banks in the world are based in China, and what are the combined value of assets of these banks? How many are based in the United States, and what are the combined value of assets?

Answer: China had five of the world’s ten largest banks in 2018, with a combined asset value of nearly $16 trillion. The United States had two of the world’s ten largest banks, with a combined asset value of $4.8 trillion.

2.

What factors might explain why China’s banks are so much larger than U.S. banks?

Answer: Several reasons explain why China’s banks are so large. First, most major banks in China are government-owned, and therefore China has fewer banks than the United States but are subsequently much larger. Second, Chinese citizens save much more of their incomes (almost 40% on average) than Americans (who save only 5% on average). And third, China’s high growth rate has increased incomes and the total amount saved, contributing to the size of bank assets.

3.

Return to the web site and select an earlier year (such as 2010). Were Chinese banks dominant back then? Which countries’ banks appeared in the top 10?

Answer: Answers will vary based on the year selected. In 2010, only one Chinese bank was in the top 10 (and it was actually 10th). The other banks in the top 10 were in France, Germany, Japan, the United Kingdom, and the United States.

Check Your Understanding 1.

Describe the three functions of money.

Answer: Money serves as a medium of exchange, a unit of account, and a store of value.

2.

What is a barter economy? Explain why such an approach is difficult for a modern economy.

Answer: A barter economy is one in which participants directly trade goods and services with one another. Barter requires a double coincidence of wants: You have to find someone who produces what you want and wants what you have to trade. Barter networks could exist, but the number of prices soon becomes unmanageable. Modern economies are too complex with too many goods—barter would prevent the attainment of a modern economy.

3.

What is the difference between a pension plan and a defined-contribution plan, such as a 401(k) account?

Answer: A pension is a monthly payment paid to a retired worker for the remainder of his or her life.

Solutions Manual to accompany Chiang, Economics, 5e

Chapter 1

The amount of the monthly payment depends on the number of years one works at the company along with other factors, such as the amount of one’s salary upon retirement. Fixed contribution plans, such as a 401(k) account, allow employees to contribute pretax dollars that are then partially matched by their employers. Contributions into these accounts are invested in a variety of financial assets. Upon turning 59.5 years old, account holders can begin withdrawing funds. However, unlike pensions, which continue to pay until one dies, 401(k) balances can eventually be used up.

4.

What gives money value if there is no gold or silver backing the currency?

Answer: Our money is fiat money—nothing but what it will buy is backing the currency. We all have faith that the government will not debase the currency by printing too much. Recall what the impact of hyperinflation is and how it devastates existing financial assets.

5.

What happens to savings if the real interest rate goes up? What happens to the demand for borrowing?

Answer: When real interest rates rise, we would expect to see people save more because the reward for saving has risen. Borrowing now costs more; thus, we would expect to see that decline.

What are some similarities and differences between cryptocurrency and U.S. dollars that are stored on a popular phone app?

Answer: Both cryptocurrency and U.S. dollars are a form of money that can be used to make purchases and function as a unit of account and store of value. An important difference between the two currencies is that cryptocurrency is not regulated by any country’s central bank and may be riskier to hold because there are fewer protections to insure against loss. Also, the value of cryptocurrency has fluctuated more than the value of the U.S. dollar. Finally, more places of business accept phone app payments in U.S. dollars than in cryptocurrency, making the latter more difficult to use as a medium of exchange.

6.

Apply the Concepts 7.

List the following assets from most liquid to least liquid: a house (real estate); cash; a one-carat diamond; a savings account deposits; 100 shares of Google stock; a Harley-Davidson motorcycle; a checking account; your old leather jacket.

Answer: Remember that liquidity is determined by how quickly, easily, and reliably assets can be converted into cash. The degree of liquidity of the last three items on the list will depend on supply and demand, but real estate transactions nearly always involve a lot of time and transactions costs (real estate agent fees).

• cash • checking account • savings account • 100 shares of Google • one-carat diamond • Harley-Davidson motorcycle • your old leather jacket • house (real estate)

8.

At many game centers (such as Dave & Buster's), it is common for kids to play carnival-type games to win prize tickets, which are then redeemed for a variety of prizes based on the number of tickets earned. In what ways do these prize tickets illustrate the three functions of money?

Answer: In many ways, prize tickets illustrate the three functions of money, albeit in a very limited setting (that of the game center, which accepts them). It serves as a medium of exchange within the store, allowing kids to exchange tickets for prizes. It serves as a unit of account, because each prize requires a specific number of tickets. And it serves as a store of value in that kids can save up tickets over multiple visits to redeem for larger prizes.

9.

During an economic expansion when businesses are increasing their investment spending and individuals are more willing to increase their consumption, what happens to the demand and supply of loanable funds? What is the effect on real interest rates?

Solutions Manual to accompany Chiang, Economics, 5e

Chapter 1

Answer: When the economy is strong, businesses increase their investments by borrowing money, increasing the demand for loanable funds. Meanwhile, consumers increase their consumption by reducing the amount they save, which decreases the supply of loanable funds. The combination of increasing demand and decreasing supply in the market for loanable funds pushes the real interest rate higher.

10.

Most individuals with average wealth choose to save their money using a financial intermediary such as a bank or a mutual fund. However, individuals with greater wealth are more likely to invest in individual stocks or directly in new or existing businesses. Explain why persons of different wealth are likely to show differences in how they save and how financial intermediaries play a role.

Answer: The role of financial intermediaries is to reduce information and transaction costs between savers and borrowers and to diversify assets to reduce risk. For individuals with small or medium-sized savings, a badly selected investment can wipe out one’s entire savings. Therefore, these individuals are more likely to choose less risky assets, such as a mutual fund. Wealthier individuals, however, tend to have more resources to research other investment opportunities that may be riskier but offer a greater potential return on investment. And if one investment fails, it’s likely to be just one of many investments made; in other words, persons with more savings are better able to diversify their assets, including some in riskier investments.

11.

Why would it be better to put $1,000 each year into a retirement account than to wait ten years and put in $10,000 all at once? How much of a difference would it make in the long run?

Answer: Putting $1,000 into a retirement account each year allows money to grow immediately. And with the power of compounding, money deposited in early years will grow significantly over the period. Suppose that the average annual return is 10%. If one puts $10,000 all at once at the end of the ten-year period, the retirement account would be worth $10,000 (the deposit did not have any time to grow). If, instead, $1,000 is deposited each year for ten years, the total value at the end of ten years would be $15,937 (many retirement calculators are available online that allow for easy calculation).

12.

If the stock market and bond market are substitutes for one another, what is expected to happen to bond prices if the stock market increases sharply and investors move more money from bonds into stocks? If this occurs, what will happen to interest rates on bonds?

Answer: If more money is invested in stocks, demand for bonds will fall, pushing bond prices lower.

Because bond prices are inversely related to interest rates, a decrease in bond prices will lead to an increase in interest rates.

In the News 13.

One of the proposals put forth by economists to address the future expected shortfall in Social Security funding is to raise the minimum age when one can begin collecting benefits from 62 to 65. The rationale is that as people live longer, the benefits being collected exceed the amounts contributed during one’s working years, which is unsustainable. If such a proposal becomes law, how would this affect the incentives to work and save? How would this impact the market for loanable funds?

Answer: By raising the minimum age when one can begin collecting Social Security benefits, individuals must save more to cover the reduction in benefits or work more years to prevent using up one’s savings too soon. In either case, the supply of savings will increase as individuals prepare for the reduction in benefits. This will increase the supply of loanable funds and push real interest rates lower, all else equal.

14.

In late 2018, SpaceX CEO Gwynne Shotwell announced the company’s goal of sending people to the Moon by 2023 and to Mars within a decade. This announcement was tied to another round of investment funding from which the company hoped to raise $500 million from investors and to borrow $250 million from banks. How does investing in SpaceX compare to other investments (such as buying stocks or bonds in well-known companies) in terms of risk? What would be the expected return on investment?

Answer: Investing in SpaceX is potentially very profitable if the company is successful in its efforts at sending people to the Moon and Mars. Even if it doesn’t actually reach the Moon or Mars, the

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technology it develops for its spacecraft and rockets could be profitable in itself. However, the company could also fail to achieve these lofty objectives, which could cause it to go bankrupt.

Therefore, investing in SpaceX is likely to entail greater risk compared to other investments and would require a higher expected return on investment.

Solving Problems 15.

Suppose a small country has the following monies in circulation: Cash/currency: $5 million Checkable deposits: $14 million Small-denomination time deposits: $15 million Savings deposits: $20 million Money market deposit accounts: $25 million Calculate the value of M1 and M2 for this country.

Answer: M1 is the sum of cash/currency, demand deposits, and other checkable deposits, which is $5 million + $8 million + $6 million = $19 million. M2 is the sum of M1, small-denomination time deposits, savings deposits, and money market deposit accounts, which is $19 million + $15 million + $20 million + $25 million = $79 million.

16.

The yield for a perpetuity bond is determined by the simple formula

Yield 

Annual Interest Payment Price of Bond

a. b.

Calculate the yield on a $1,000 perpetuity bond that pays $40 a year forever to the bondholder.

Suppose that actions taken by the Fed cause interest rates in the economy to fall by 2%. How will this affect the price of the bond that still pays $40 a year in interest? c. Now suppose that one purchases a new $1,000 perpetuity bond at the lower interest rate. What will the annual interest payment be equal to? d. If interest rates were to rise back to the original level determines in part (a), how will that affect the price of the new bond purchased in part (c)?

Answer: a. The yield would equal $40  $1,000 = $4%. b. If a bond that pays $40 per year represents a 2% return, then the price of the bond would increase to $2,000. c. At an interest rate of 2%, interest payments on a $1,000 bond would be $20. d. If a bond that pays $20 per year represents a 4% return, then the price of the bond would decrease to $500.

Chapter 12(23)

By the Numbers: Assessing Your Data Literacy 1.

By approximately how much (in dollars and in percentage) did the U.S. monetary base increase from 2007 to 2014?

Answer: In 2007, the U.S. monetary base was around $800 billion and in 2014 it had increased to around $4 trillion. This is an increase of approximately $3.2 trillion or 400%.

2.

By approximately how much (in dollars and in percentage) did the U.S. monetary base decrease from 2014 to 2018?

Answer: From 2014 to 2018 the U.S. monetary base decreased from around $4 trillion to around $3.4 trillion, a decrease of approximately $600 billion or 15%.

3.

Why did the U.S. monetary base continue to increase even after the recession ended in 2009?

Answer: From 2007 to 2009, the U.S. economy was in a severe recession and financial crisis. Banks

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were on the verge of bankruptcy due to individuals and companies being unable to repay their loans.

As a result, the Federal Reserve took extraordinary measures to prevent the collapse of the banking system by dramatically increasing bank reserves long after the recession had ended. Although the economy was slowly recovering since 2009, the Fed continued to buy up toxic assets from commercial banks and pumping money into the banking system in a process called quantitative easing. This process continued until 2014 when the Fed began reducing the monetary base.

Check Your Understanding 1.

Describe the role required reserves play in determining how much money the banking system creates.

Answer: Because required reserves make the banking system a ―fractional reserve‖ system, banks can lend only excess reserves (those in excess of required). When these loans are deposited back into the banking system, they create further excess reserves and loans, and so on. Theoretically, banks can create up to a multiple of 1 ÷ reserve requirement (the money multiplier) of new money based on the initial deposit.

2.

Why are checking account deposits considered a liability to the bank?

Answer: Checking accounts or demand deposits are liabilities to banks because depositors have loaned this money to the bank until they write checks and ―demand‖ this money be paid to someone else.

3.

How do leakages reduce the money multiplier from its potential?

Answer: Leakages occur when banks hold excess reserves or when individuals or businesses hold cash, both of which reduce the amount of loans that can be made to borrowers. When fewer loans are made, less money is being created in the banking system, and therefore the money multiplier is lower.

4.

What is the most common tool used by the Federal Reserve to conduct monetary policy, and how does it affect interest rates?

Answer: The most common tool used by the Fed is open market operations, which are the buying and selling of government securities to influence interest rates (specifically, the federal funds rate). When the Fed buys securities, bond prices increase and interest rates fall, and vice versa.

5.

For what type of borrowing do the federal funds rate and the discount rate apply? Which rate is used in more transactions in the United States?

Answer: The federal funds rate is used when banks borrow reserves overnight from another bank to meet the minimum reserve requirement. The discount rate is used when banks borrow reserves directly from the Fed. The federal funds rate is used much more than the discount rate because banks are often reluctant to borrow from the Fed because of the stigma that comes with doing so.

Why are monetary policy lags generally shorter than fiscal policy lags?

Answer: Monetary policy is conducted by the Fed, an independent body that is not influenced by political pressures. Therefore, monetary policy decisions made by the Fed are often quicker than fiscal policy decisions, which require the cooperation between Congress and the president.

6.

Apply the Concepts 7.

The U.S. government produces billions of dollars in banknotes and coins for use in everyday transactions. Explain why issuing currency alone does not represent money creation.

Answer: Currency represents just one part of the money supply. Most money transactions in the economy are conducted electronically, and therefore the money supply increases when other components, such as checking accounts and demand deposits, are increased through the lending and borrowing of money.

8.

During an economic expansion, banks tend to increase their willingness to lend. How does this trend influence the actual money multiplier?

Answer: When banks are more willing to lend, the amount held in reserves falls. Therefore, the

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reserve ratio is smaller, resulting in a larger money multiplier. As a result, each dollar injected into the banking system has a much more powerful effect on the economy.

9.

The Federal Deposit Insurance Corporation (FDIC) insures individual bank accounts up to $250,000.

Does the existence of this insurance eliminate the need for reserve requirements? Does it essentially prevent ―runs‖ on banks?

Answer: No. Reserves are required to prevent banks from becoming too extended financially and maintain that cushion to prevent the bank from not meeting its obligations. More or less, the FDIC has provided sufficient security that runs on the bank by depositors have been prevented.

10.

If the Fed announces that it has no plans to raise the federal fund rate in the following year, how might this announcement affect the actions of individuals and businesses, and what impact might this have on the economy?

Answer: By announcing that interest rates will remain unchanged, individuals and businesses will adjust their expectations. This may lead to increased consumption and investment over the following year if interest rates were originally expected to rise. But if the economy is facing inflationary pressures, keeping interest rates steady may increase the risk of an overheated economy and cause long-term inflation. Of course, the Fed does not have to adhere to its commitment should economic conditions call for immediate action.

11.

Alan Greenspan, a former chairman of the Fed, noted that ―the Federal Reserve has to be independent in its actions and as an institution, because if Federal Reserve independence is in any way compromised, it undercuts our capability of protecting the value of the currency in society.‖ What is so important about protecting the value of the currency? How does Fed independence help?

Answer: Inflation depreciates the currency’s value, and extreme inflation (hyperinflation) renders the currency worthless, creating a whole host of problems for society, including stifling growth and forcing people to turn to barter. By keeping political pressure to continually expand the money supply away from the Federal Reserve, its decisions will reflect a more balanced approach to the economy.

12.

The reserve requirement sets the required percentage of deposits that must be held by the bank in cash or on deposit at the regional Federal Reserve Bank. Many banks have widespread branches and ATMs. How would the existence of branches and ATMs affect the level of excess reserves (above those required) that banks hold, and how would it affect the actual money multiplier?

Answer: ATMs and branches require a lot of vault cash to maintain and might be expected to result in banks holding greater excess reserves. Thus, the actual money multiplier would be lower.

In the News 13.

Eric Keetch offered an interesting anecdote in the Financial Times: In a sleepy European holiday resort town in a depressed economy and therefore no visitors, there is great excitement when a wealthy Russian guest appears in the local hotel reception, announces that he intends to stay for an extended period and places a €100 note on the counter as surety while he demands to be shown the available rooms.

While he is being shown the room, the hotelier takes the €100 note round to his butcher, who is pressing for payment.

The butcher in turn pays his wholesaler who, in turn, pays his farmer supplier.

The farmer takes the note round to his favorite “good time girl” to whom he owes €100 for services rendered. She, in turn, rushes round to the hotel to settle her bill for rooms provided on credit.

In the meantime, the Russian returns to the lobby, announces that no rooms are satisfactory, takes back his €100 note and leaves, never to be seen again.

No new money has been introduced into the local economy, but everyone’s debts have been settled.

What’s going on here? In the end, no new money was introduced into the town, but all debts were paid.

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How do you explain what has happened? Did local GDP increase as a result of all debts being paid? Is the money multiplier infinite?

Answer: This is an interesting puzzle that can be answered by considering what would have happened if each party—the hotelier, butcher, wholesaler, farmer, and ―good time girl‖—went to his or her creditor and said, ―Assume I just paid you,‖ and all accepted the statement as payment. The outcome would have been the same. In effect, it is as if each used credit to barter for each other’s good or service in the circle. Had it not been the equivalent of a barter circle, the hotelier would have had needed to come up with €100 of his own at the end. No new local GDP was created in this process; it rose when the original goods and services were performed on credit.

14.

Increased skepticism about the role of the Federal Reserve as well as the spread of misinformation (e.g., that increasing the money supply devalues the dollar and amounts to counterfeiting) have led some politicians to propose that the Federal Reserve be abolished. If this happens, monetary policy would essentially cease to exist, as the money supply would no longer be flexible. This was the case about 50 years ago when the money supply was still tied to the amount of gold in reserves. Given your knowledge of the role of the Fed, what are some risks to the economy if the Fed is abolished?

Answer: If the Fed were abolished, the country would no longer have a lender of last resort. This means that if there were ever a run on a bank (i.e., many depositors wanting their money back at the same time), there would be no central bank to provide emergency lending through the discount window. Also, the Fed manages the circulation of currency and coins, which may create problems in day-to-day transactions. But most importantly, the Fed influences the money supply (and interest rates) through open market operations. Without the Fed, the government would need to rely solely on fiscal policy, which is a much more arduous process. Without monetary policy, the economy risks experiencing more significant fluctuations in the business cycle.

Solving Problems 15.

Assume that First Purity Bank begins with the balance sheet below and is fully loaned-up. Answer the questions that follow.

First Purity Bank Assets Liabilities Reserves +$700,000 Deposits +$2,000,000 Loans +$1,300,000 a. b.

What is the reserve requirement?

If the bank receives a new deposit of $1 million and the bank wants to remain fully loaned-up, how much of this new deposit will the bank loan out? c. When the new deposit to First Purity Bank works itself through the entire banking system (assume all banks keep fully loaned-up), by how much will total deposits, total loans, and total reserves increase? d. What is the money multiplier in this case?

Answer: a. The reserve requirement is equal to 35% ($700,000/$2,000,000). b. The bank must keep 35% ($350,000) in reserves; therefore, the bank will loan out $650,000. c. Total deposits will increase by $2,860,000, total loans will increase by $1,860,000, and total reserves will increase by $1,000,000. d. The potential money multiplier is 1 ÷ Reserve Requirement = 1/0.35 = 2.86.

16.

Suppose that the leakage-adjusted money multiplier can be calculated using a simple modification of our money multiplier formula: 1/(Reserve Requirement + Excess Reserves + Cash Holding), where each component in the denominator is expressed as a percentage.

Suppose that the reserve requirement is 25%, but banks on average hold an additional 10% of their deposits as excess reserves. Further, assume that individuals and businesses choose to hold 15% of

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their borrowed funds in cash. Compare the potential money multiplier with the leakage-adjusted money multiplier. Does the existence of leakages make a significant impact on the ability to conduct monetary policy? Explain why or why not.

Answer: Without the leakages, the potential money multiplier would be 1/Reserve Requirement, or 1/0.25 = 4. However, with the leakages, the leakage-adjusted money multiplier would be 1/(0.25 + 0.10 + 0.15) = 1/0.5 = 2. Therefore, the existence of leakages reduces the multiplier from 4 to 2, which significantly reduces the effectiveness of monetary policy.

Chapter 13(24)

By the Numbers: Assessing Your Data Literacy 1.

Which interest rate tends to change most in tandem with changes in the federal funds rate? Which one is least in tandem with the federal funds rate?

Answer: The prime rate moved most closely in tandem with the fed funds rate, followed closely by the discount rate. The 30-year mortgage rate moved least in tandem with the federal funds rate, though it still followed the general pattern of the other interest rates.

2.

Describe the trend in interest rates as the economy went into the 2007–2009 recession and the trend in interest rates as the economy expanded from 2015 to 2019.

Answer: When the economy went into a recession in late 2007, interest rates started falling and reached record lows very quickly due to aggressive actions by the Fed. The mortgage rate fell more slowly but eventually reached record low rates as well. It took many years for the economy to recover, but once the economic expansion became strong after 2015, interest rates started to rise as the Fed became more concerned with inflation. All four interest rates subsequently increased from 2015 to 2019.

3.

Explain why interest rates would follow the trends described in question 2.

Answer: When an economy enters a recession, the Fed responds with expansionary monetary policy which pushes the federal funds rate lower. Because the discount and prime rates are closely tied to the federal funds rate, those fall quickly as well. Mortgage rates are affected by additional factors, notably demand and supply for housing, and therefore do not respond as quickly as the other rates. However, mortgage rates were the first to pick back up when the housing market (and the economy in general) started to recover. In late 2015 the Fed began using contractionary monetary policy to raise interest rates to prevent inflation from rising due to the stronger economy. This had the effect of pushing all interest rates higher. Mortgage rates also continued to increase as demand for homes increased due to rising incomes.

Check Your Understanding 1.

Why is it important for the Federal Reserve Board to be independent of the executive branch of the federal government?

Answer: If the Fed were not independent, it would be subject to more political pressure. Independence permits the Fed to focus on fighting inflation, along with appropriate concerns about employment and output. Countries where the central bank is not independent tend to have higher long-run inflation rates.

2.

When the interest rate falls, why do people desire higher money balances?

Answer: One reason is that the opportunity cost of holding money is the interest rate; when it falls, people are willing (and want) to hold higher money balances.

3.

Describe how open market operations alter the supply of money.

Answer: The Fed either buys or sells government securities. When the government sells securities, individual buyers or banks use checks or cash to buy those bonds. As a result, the money supply

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immediately shrinks, as do bank reserves. This leads to a further contraction in the money supply. To entice buyers to purchase the bonds, the Fed may receive a lower price (the supply of bonds has now increased), and these lower prices mean that interest rates rise. The opposite is true when the Fed buys bonds.

4.

What does the equation of exchange, M  V = P  Q, help to explain?

Answer: The equation of exchange helps to explain the long-run relationship between the money supply (M) and the price level (P). In the long run, velocity (V) is a function of institutions and technology, and the economy hovers around full employment output (Q). As a result, V and Q are fixed; therefore, changes in M lead directly to changes in P.

5.

How is the impact of expansionary monetary policy different when the economy is considerably below full employment compared to when it is at full employment?

Answer: When the economy is considerably below full employment, increases in the money supply will lead primarily to increases in output and income, with some rise in the price level. But at full employment, increases in the money supply lead primarily to increases in the price level.

6.

How do sticky wages and prices make monetary policy effective in the short run?

Answer: When wages and prices are sticky, changes in the money supply will have a short-term effect on aggregate output. For example, if the Fed increases the money supply, aggregate demand increases, and people feel they have more money and will consume more, pushing aggregate output higher. This effect can help push an economy toward full employment more quickly during a recession.

Apply the Concepts 7.

Suppose a rise in consumer confidence causes aggregate demand to increase, resulting in a short-run equilibrium that is above full employment output. What type of monetary policy might the Fed use to reduce inflationary pressures and to bring the economy back to full employment?

Answer: If the economy is operating above full employment output, upward pressure on prices will occur. To prevent inflation from rising, the Fed can use contractionary monetary policy to cool the economy. By reducing the money supply, interest rates would rise. Higher interest rates mean that consumers borrow less money for purchases, businesses reduce their investments, government spends more on financing debt, and net exports would likely fall. Each of these effects reduces aggregate output and the price level. The Fed would maintain this policy until long-run equilibrium is restored.

8.

It seems that each time the Fed raises interest rates, the stock market has an awful few days. Why do higher interest rates have such an impact on the stock market?

Answer: Higher interest rates might affect the stock market for at least two reasons. First, higher rates make bonds a more attractive investment. Second, high rates mean that the Fed is trying in some way to restrain the economy. This often means slower growth and lower corporate profits.

9.

If the Fed persistently uses expansionary monetary policy to keep interest rates very low, what are some of the risks that may occur?

Answer: If the Fed uses expansionary monetary policy during a recession, very little risk would occur.

However, during an economic expansion when contractionary monetary policy is the appropriate action, continuing to use expansionary monetary policy would lead the economy to overheat and potentially cause rising inflation that would reduce the purchasing power of money. Moreover, by keeping rates excessively low during an expansion, the Fed will have little ability to further reduce interest rates when the economy eventually enters into a recession, thereby risking a prolonged recession.

10.

When NASA scientists were operating the Mars rovers to make them drive across the Martian landscape and collect and analyze rocks and crevices, the scientists complained that the 20-minute delay between when they issued a command and when the rovers responded made their job more challenging. Isn’t this somewhat similar to what monetary policymakers face? How is it different?

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Answer: Yes, it is very similar. The Fed makes policy based on where the economy is today and where they think it is going, but their policy changes take a long time to have an impact. They differ in that Fed policymakers have a more complex environment in which to make policy. Not only must the Fed worry about what consumers and businesses in the United States will do, but they must also be concerned with international impacts and changes as well.

11.

Suppose another spike in energy prices causes a negative supply shock. What type of monetary policy should the Fed use if the goal is to maintain price stability in the economy? What are the consequences of doing so?

Answer: A negative supply shock causes the SRAS curve to shift left, raising the aggregate price level and reducing aggregate output. If the Fed wishes to maintain price stability, it would use contractionary monetary policy to shift the AD curve to the left, thereby pushing the price level back down. The consequence of doing so is the further reduction of aggregate output, which could lead to a recession if output remains depressed for a long period of time.

12.

Explain how the housing bubble at the beginning of the 21st century led to the Taylor rule target exceeding the actual federal funds rate. How might the severity of the Great Recession been reduced had the federal funds rate been adjusted?

Answer: The housing bubble caused prices of housing and related goods to rise, contributing to higher inflation. Two of the four components in the Taylor rule equation are positively influenced by inflation. Also, increased aggregate demand from the housing bubble contributed to a positive output gap, which further increased the Taylor rule estimate. If the Fed had increased the federal funds rate, mortgage rates would likely have increased, which would have tempered some of the demand for housing and the subsequent crash that led to the recession.

In the News 13.

In 2019 President Trump nominated individuals to fill vacancies in the Federal Reserve’s Board of Governors who have been critical of the Fed in the past, even questioning its existence during the height of the quantitative easing years. How might bringing in nominees with strong political views about the Fed play a role in the type of monetary policy decisions that result?

Answer: The Fed’s Board of Governors has historically been an independent, nonpartisan group of economists who understand the role of monetary policy in smoothing out fluctuations in the business cycle. Members of the Fed’s Board of Governors generally focus on keeping inflation low, regardless of the potential consequences their policies may have on economic growth. When members to the Board of Governors are not politically neutral, they may use monetary policy to spur short-run economic growth at the risk of higher long-term inflation. For example, when the economy is overheating, the appropriate policy is to use contractionary monetary policy, but a politically motivated member may be hesitant to do so if it slows economic growth in the short term.

14.

When Greece faced a debt crisis in 2017, it was forced to adopt austerity measures that reduced wages of government workers as well as benefits enjoyed by much of the population. By cutting government spending, particularly investments in public projects, Greece managed to achieve a budget surplus in 2017 and 2018 as well as maintain positive economic growth. However, some worried that such austerity measures would push Greece back into a recession in the near future. Explain how this might occur.

Answer: In order to reduce its government debt, Greece was forced to make dramatic cuts to government spending, including its pension program and investment in public infrastructure projects.

Many worried that such cuts would reduce aggregate demand and cause another recession to develop sooner than if such spending cuts were not forced to occur.

Solving Problems 15.

Suppose a major earthquake disrupts production in many industries, causing SRAS0 to shift to SRAS1

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as in the following figure. What happens to the aggregate price level and aggregate output in this economy? If the government’s objective is to return aggregate output back to full employment as quickly as possible using monetary policy, what policy would it use? Show the effect of the government’s action in the figure. How does it affect the aggregate price level?

Answer: When SRAS0 shifts to SRAS1, the aggregate price level increases from 50 to 55 and the aggregate output falls from 500 to 400. If the government uses expansionary monetary policy (e.g., increasing the money supply to reduce interest rates) to increase aggregate output, the aggregate demand curve would increase from AD0 to AD1. Although aggregate output returns to full employment, the aggregate price level rises further from 55 to 60.

16.

In 2015 U.S. inflation was 1.2%, and output was 0.6% below its long-run potential. In 2019, an expanding U.S. economy caused inflation to increase to 1.6%, and output was 0.4% above its long-run potential. a. If the inflation target is 2%, what was the federal funds target in 2015 using the Taylor rule?

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b.

If the actual federal funds rate was 0.75% in 2016, did the Taylor rule estimate the target accurately? c. Again assuming an inflation target of 2%, what was the federal funds target in 2019 using the Taylor rule? d. If the actual federal funds rate was 2.5% in 2019, did the Taylor rule do a better job predicting interest rates compared to 2016? Explain your answer.

Answer: a. Using the Taylor rule, the federal funds target rate is 2 + 1.2 + (‒0.4) + (‒0.3) = 2.5%. b. The actual federal funds rate was well below the target based on the Taylor rule, suggesting that the Fed was being cautious in raising interest rates after a very long and slow economic recovery. c. Using the Taylor rule, the federal funds target rate is 2 + 1.6 + (‒0.2) + (0.2) = 3.6%. d. The actual federal funds rate remains below the target based on the Taylor rule, but it is much closer. The Fed has been more aggressive in raising interest rates in 2017 and 2018 to keep inflationary pressures from rising.

Chapter 14(25)

By the Numbers: Assessing Your Data Literacy 1.

What was the lowest level of the Index of Consumer Sentiment during the depth of the 2007–2009 recession? In what year did that occur?

Answer: The Index of Consumer Sentiment fell to its lowest point of around 56 in 2008.

2.

In which year did the Index of Consumer Sentiment reach its peak prior to the 2007–2009 recession?

Has consumer confidence returned to that level since the 2007–2009 recession?

Answer: Prior to the 2007–2009 recession, the Index of Consumer Sentiment reached its peak of around 96 in 2005. In recent years, the Index of Consumer Sentiment has reached even higher levels.

For example, in 2017 it reached a level of 98.

3.

How closely does the Index of Consumer Sentiment follow the trend of other measures of the macroeconomy (such as real GDP) over the business cycle?

Answer: In general, the Index of Consumer Sentiment follows the trend of other measures of the health of the overall economy. Although GDP did not fall nearly as much as the Index of Consumer Sentiment, the direction of the changes is similar. Other economic measures, such as stock indexes, would more closely resemble the graph for consumer sentiment because consumers and businesses respond to their perceptions of the economy by altering their investment and financial planning.

Check Your Understanding 1.

Why does the Phillips curve become very steep when unemployment is low and rather shallow when unemployment is high?

Answer: When the economy has a lot of slack, say, when unemployment exceeds 6%, the economy can expand with little pressure on prices. However, when the economy approaches full employment (when unemployment gets below 4%), labor and other markets tighten, and any further expansion is met by rapidly rising prices.

2.

Explain why the long-run Phillips curve makes it difficult (if not impossible) for policymakers to increase output and employment beyond full employment in the long run.

Answer: The vertical long-run Phillips curve (LRPC) means that expanding aggregate demand to move the economy to higher levels of employment when the economy is at full employment will result in a higher level of inflation.

3.

Explain why inflation accelerates if policymakers use monetary and fiscal policy to keep unemployment below the natural rate.

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Answer: Expansionary monetary and fiscal policy designed to keep the economy below the natural rate of unemployment leads to a higher rate of inflation (on the original Phillips curve). This higher rate of inflation raises inflationary expectations, shifting the Phillips curve to the right and worsening the inflation–unemployment tradeoff. Now, keeping the economy below the natural rate requires more expansionary policy, raising inflation even further, and thus the cycle repeats itself.

4.

Explain why rational expectations does not mean that all individuals act rationally and are always correct.

Answer: No. Rational expectations imply that economic actors take into account all available information and put that information into a reasonable economic model. Economic actors are not always right, but there are no systematic biases in their errors.

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5.

Would policymakers prefer a Phillips curve with a steep or a shallow slope? Why? Answer: A steep slope would mean that small reductions in the unemployment rate lead to large changes in inflation rates. The opposite is true for a shallow slope curve. Thus, policymakers would prefer a shallow slope curve—low unemployment rates would be associated with lower inflation rates.

6.

How does a negative supply shock (a huge natural disaster or significant energy price spike) affect the short-run Phillips curve? How does it affect the long-run Phillips curve?

Answer: It would shift out and to the right. Now, higher unemployment rates are temporarily associated with higher inflation rates. There would be no impact on the long-run Phillips curve.

Apply the Concepts 7.

Why would policymakers want to drive unemployment below the natural rate, given that inflation will result?

Answer: Politicians, some policymakers, and some academics see unemployment as a bigger problem than moderate inflation. For politicians, a low unemployment rate makes reelection easier. Further, there are different views on how low unemployment can be pushed before inflation becomes a problem.

8.

Why are inflationary expectations so important for policymakers to keep under control? When a supply shock such as an oil price spike occurs, does it matter how fast policymakers attempt to bring the economy back to full employment? Explain.

Answer: High inflationary expectations shift the Phillips curve rightward, worsening the tradeoff between inflation and unemployment for policymakers. High inflationary expectations make their job of reducing inflation harder. The speed at which policymakers increase aggregate demand to return the economy to full employment could affect inflationary expectations. For this reason, policymakers typically try a slower growth path back to full employment to keep inflationary expectations muted.

9.

Describe a few government policies that could have prevented the financial crisis in 2007.

Answer: In terms of monetary policy, the Fed could have raised interest rates more aggressively to reduce the demand for homes that led to the bubble. Also, the government could have clamped down on imprudent lending practices by banks that led to a large number of defaults and foreclosures.

Regulations could have been placed on bond ratings agencies to ensure that they follow appropriate standards when accounting for risk in the ratings they give to bonds.

10.

Explain how the credibility of policymakers’ (Congress and the Fed) commitment to keeping inflation low affects inflationary expectations when the economy is beset by a supply shock.

Answer: Probably. Today, even with energy prices rising, inflationary expectations are low because individuals and businesses have confidence in the Fed’s commitment to low inflation targets. This low level of inflationary expectations probably makes their job easier.

11.

Explain why those who favor the rational expectations approach to modeling the economy do not favor discretionary policymaking.

Answer: Those who believe that the world is best modeled with rational expectations see policymaking as ineffective. If the economy consists of individuals and businesses that are governed by rational expectations, when policymakers decided to implement some policy, people and business react in ways that are counterproductive and render policy ineffective.

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Chapter 1

Explain how the rise of automation in many industries can lead to both job gains and job losses in the overall economy.

Answer: Automation involves the use of capital to replace labor, so generally it is viewed as harming the number of jobs available for workers. But automation also creates new jobs, especially high-skilled jobs that pay higher wages than the jobs it replaced. Skilled workers are needed to build and maintain the robots and other equipment used in automation. Software programmers are needed to ensure that automation works efficiently, while Internet security experts are needed to ensure that malware and other dangers to a highly automated production process are mitigated.

In the News 13.

Over the last 25 years, the Fed has increased its transparency by providing more detailed policy announcements after its meetings. In response, investors have reacted more quickly in response to the announcements. Does greater transparency provide more or less support to the conclusions of the rational expectations model? Explain how greater transparency might cause monetary policy to become less effective.

Answer: The rational expectations model assumes that individuals respond immediately to available information, thereby eliminating short-run changes to output. When greater information is available by way of increased transparency, this provides more support to the rational expectations model. The irony is that by being more transparent, the Fed may be causing its policies to be less effective if the conclusions of the rational expectations theory hold. However, many other factors exist that might offset this effect, including the existence of efficiency wages and imperfect information in other aspects of the economy.

14.

About every year, Congress is tasked with increasing the debt ceiling that allows the government to continue borrowing. In past decades, such legislation would pass easily because it was authorizing the payment of expenses already incurred. However, in recent years, congressional leaders took the drastic approach to oppose raising the debt ceiling as a way to reign in government spending. If these leaders were successful in preventing the debt ceiling from being raised, what would be some benefits and costs of this action?

Answer: The benefit of opposing an increase in the debt ceiling is that it would force an immediate reduction in government spending. Therefore, such a policy would make spending cuts a necessary rather than a proposed fiscal policy action. However, the costs of not raising the debt ceiling can be substantial. First, the debt ceiling is raised to pay for government spending already incurred. Opposing it would be similar to asking a credit card company to lower the credit limit after one has already charged up the card. Second, it would likely lead to a drop in confidence in U.S. assets, which would raise their interest rates. Higher interest rates mean payments on the debt rise, making it even harder to stay within the ceiling. Finally, much of government spending is mandatory rather than discretionary.

Therefore, unless the law changes on popular programs such as Social Security and Medicare, the government does not have much flexibility to cut significant amounts of spending in the short run.

Solving Problems 15.

The Phillips curve of the 1960s showed a negative relationship between the inflation rate and unemployment. Use the following data on inflation and unemployment to plot a Phillips curve from 2014 to 2018. Does the same relationship between inflation and unemployment hold in 2014–2018 as it did in the 1960s?

Solutions Manual to accompany Chiang, Economics, 5e

Year 2014 2015 2016 2017 2018

Inflation Rate 1.6 0.1 1.3 2.1 2.4

Chapter 1

Unemployment Rate 6.2 5.3 4.9 4.4 3.9

Answer: See the following graph. Although both inflation and unemployment fell from 2014 to 2015, a negative relationship between inflation and unemployment is found from 2015 to 2018. The tradeoff between inflation and unemployment seen in the Phillips curve holds in these latter years.

16.

During the recession from December 2007 to June 2009, the U.S. economy lost a total of 7,163,000 jobs. How many jobs were lost per month, on average? Suppose that a healthy economy generates an average of 200,000 jobs per month. At this rate, how long would it take the economy to gain back the number of jobs it had lost? According to data from the Bureau of Labor Statistics, the U.S. economy gained 5,485,000 jobs from June 2009 to June 2013. What was the average number of jobs per month created during the first four years of recovery? Given your answers to the previous two questions, what does this suggest about the pace of economic recovery after the 2007–2009 recession?

Answer: The U.S. economy lost 397,944 jobs per month, on average, during the 2007–2009 recession. If the economy gains 200,000 jobs per month, it would take roughly 36 months (7,163,000/200,000) to gain back the jobs it had lost. In fact, the U.S. economy was gaining only 114,270 jobs, on average, during the first four years of recovery. This suggests that the pace of economic recovery was very slow after the recession.

Chapter 16(27)

Solutions Manual to accompany Chiang, Economics, 5e

Chapter 1

By the Numbers: Assessing Your Data Literacy 1.

Over which two periods did the U.S. dollar appreciate in value? By approximately what percentage did the U.S. Dollar Index increase in each period?

Answer: The U.S. dollar appreciated from 1995 to 2002 and again from 2014 to 2019. In the first period, the U.S. Dollar Index increased from 92 to 128, an increase of about 39%. In the second period, the U.S. Dollar Index increased from 102 to 128, an increase of about 25%.

2.

By approximately what percentage did the U.S. Dollar Index decrease from its peak in 2002 to its low point in 2008?

Answer: From 2002 to 2008, the U.S. Dollar Index fell from 128 to 97, a decrease of almost 25%.

3.

How does economic growth explain why the U.S. dollar appreciated from 2014 to 2019?

Answer: After the U.S. economy recovered from the 2007–2009 recession and started to expand, interest rates started rising, which led to an increase in demand for U.S. bonds. Also, the U.S. economy was performing relatively better than other developed economies, which further encouraged investment in the United States and led to higher demand for dollar-denominated assets. Demand for U.S. bonds and assets leads to a greater demand for the U.S. dollar, causing it to appreciate.

Check Your Understanding 1.

Describe the balance of trade. What factors contribute to our trade deficit?

Answer: The balance of trade is the difference between exports and imports (X − M). As noted in an earlier chapter, the U.S. budget deficit is contributing to the trade deficit, and the trade deficit is affected by the low savings rate of U.S. consumers. The demand in this country for imports exceeds world demand for our exports.

2.

If the price of one euro changes from U.S.$1.10 to U.S.$1.20, does the value of the euro appreciate or depreciate against the dollar? Does the value of the U.S. dollar appreciate or depreciate against the euro?

Answer: When the price of one euro increases from U.S.$1.10 to U.S.$1.20, it requires more dollars to exchange for a euro. Therefore, the euro becomes more valuable. This means that the euro has appreciated against the U.S. dollar or, equivalently, that the U.S. dollar has depreciated against the euro.

3.

What is the important difference between the current account and the financial account, given that the sum of the two values must equal 0?

Answer: The current account measures payments for exports and imports of goods and services, incomes, and transfers of money in and out of the country. The capital account summarizes the flows of funds in and out of domestic and foreign assets, such as plants and equipment, ownership of companies, and so on.

4.

If the euro appreciates by 30%, what will happen to imports of Mercedes-Benz automobiles in the United States?

Answer: An appreciating euro means that the dollar buys fewer euros, and European goods will now cost roughly 30% more in the United States. Thus, fewer Mercedes-Benz cars will be ordered, and imports of the vehicles will decline.

5.

Describe the difference between fixed and flexible exchange rates.

Answer: Under a fixed exchange rate system, governments alter their macroeconomic policies to maintain the exchange rate at a set level. Countries that adopt a flexible exchange rate system let exchange rate markets adjust the exchange rate to their macroeconomic policies.

Describe the difference between the nominal and real exchange rates. What does rising inflation do to

6.

Solutions Manual to accompany Chiang, Economics, 5e

Chapter 1

a country’s real exchange rate?

Answer: The nominal exchange rate is the price of one country’s currency for another. The real exchange rate takes the price levels of both countries into account; it is the nominal rate times the ratio of the price levels of the two countries. High inflation in one country means that the real exchange rate is higher because prices abroad become relatively cheaper; this puts downward pressure on that country’s currency (it will likely depreciate).

Apply the Concepts 7.

Assume that global warming and especially high temperatures in Northern California have rendered it impossible for wine grapes in the Napa Valley (and all over California) to grow properly. Unable to get California wines, demand jumps dramatically for Australian wines. How would this affect the Australian dollar? Is this good for other Australian exports?

Answer: As wholesalers and other wine merchants need Australian dollars to purchase wine, the demand for Australian dollars grows in the foreign exchange market, causing the Australian dollar to appreciate. This is a dual-edged sword, however, as other Australian export products are now higher priced, making them a little less competitive in world markets.

8.

If the European economies begin having a serious bout of stagflation—high rates of both unemployment and inflation—will this affect the value of the dollar? Explain.

Answer: Relative to the euro, the dollar should become stronger as the exchange rate for the euro drops. This would probably not affect the exchange rate between the dollar and the yen or other non-European currencies.

9.

If a country prefers to use fiscal policy to smooth fluctuations in its business cycle, would a fixed or flexible exchange rate system be more conducive to this objective? Explain.

Answer: Fiscal policy is enhanced when a country fixes its currency to another currency. For example, if a country wishes to expand aggregate output, it could increase government spending, which shifts aggregate demand to the right. Moreover, expansionary fiscal policy leads to higher interest rates, which attract capital into the country, leading to a larger increase in output. This occurs because the fixed exchange rate system prevents the currency from appreciating when interest rates rise, which would negatively affect net exports.

10.

Mexican migrant workers in the United States often send money (known as remittances) to Mexico to support their families. In 2018, these remittances surpassed $30 billion. How are these transfers recorded in the balance of payments accounts?

Answer: Remittances are counted as a transfer of money from the United States to another country, in this case Mexico. Because money is leaving the United States, net transfers decrease, which means the U.S. current account worsens. The opposite is true for Mexico. The money coming into Mexico improves its current account.

11.

If it costs 300 U.S. dollars to purchase an iPad in the United States and 400 Australian dollars to purchase one in Sydney, then according to purchasing power parity, the exchange rate between the Australian dollar and the U.S. dollar should be 4:3. Why might purchasing power parity be different from the exchange rate?

Answer: Trade barriers and import taxes can play a role. The level of competition can also be important. If a company has a monopoly in one country and competition prevails in the other, relative prices will differ.

12.

When the dollar gets stronger against the major foreign currencies, does the price of French wine rise or fall in the United States? Would this be a good time to travel to Australia? What happens to U.S. exports?

Answer: The dollar appreciates; therefore, French wine will be cheaper, as the dollar now buys more euros. Yes, it would be a good time to go to Australia when the Australian dollar is weak relative to the U.S. dollar. Exports in the United States will fall as U.S. goods become more expensive in world markets.

In the News

Solutions Manual to accompany Chiang, Economics, 5e

Chapter 1

13.

From 2014 to 2018, the annual number of tourists visiting Iceland more than doubled, attracted by its natural beauty, which includes hot springs, volcanoes, waterfalls, glaciers, and a chance of spotting the aurora borealis. How does this tourism boom affect the foreign exchange market for Icelandic krona, all else equal? How does it affect Iceland’s current account?

Answer: An increase in tourists to Iceland will increase the demand for Icelandic krona, causing the krona to appreciate against other currencies, all else equal. Tourism counts as a service export in Iceland’s current account. Therefore, Iceland’s current account will improve.

14.

The recent loosening of travel restrictions by the U.S. government for travel to Cuba has led to a large increase in American tourists. However, when tourists exchange U.S. dollars for Cuban pesos, the Cuban government charges a 10% tax. This tax is not levied on any other foreign currency being exchanged for Cuban pesos. What could American tourists do to avoid the 10% tax on foreign exchange transactions (keeping in mind that U.S.-issued credit and debit cards are difficult to use in Cuba)? What are the costs of trying to avoid this tax?

Answer: Because the 10% tax is levied only when exchanging U.S. dollars, one could first exchange U.S. dollars for another currency, such as Canadian dollars, prior to arriving to Cuba. Then, one can exchange the Canadian dollars for Cuban pesos without incurring the 10% tax. However, exchanging U.S. dollars for Canadian dollars will generally incur a transaction fee. If the transaction fee is very high, it may not be worth the effort to avoid the 10% tax.

Solving Problems 15.

Assume that the following exchange rates prevail: (U.S. $ Equivalent) Brazil (real) 0.2545 Canada (dollar) 0.7492 Mexico (peso) 0.0531 New Zealand (dollar) 0.6697 How many Mexican pesos does it take to buy 1 New Zealand dollar? If you had 20 U.S. dollars, could you take a ferry ride in Canada if it costs 25 Canadian dollars? If someone gave you a 100 Brazilian real note to settle a 500 Mexican peso bet, would it be enough?

Answer: To convert 1 New Zealand dollar into pesos, divide 0.6697 by 0.0531, which equals 12.61. It takes 12.61 Mexican pesos to buy 1 New Zealand dollar. A ferry ride that costs 25 Canadian dollars would equal 25 × 0.7492 = U.S.$18.73. Therefore, 20 U.S. dollars is enough to pay for the ferry ride.

A 100 Brazilian real note is worth 100 × 0.2545 = U.S.$25.45. A 500 Mexican peso bet is equal to 500 × 0.0531 = U.S.$26.55. Therefore, a 100 Brazilian real note is not enough to settle a 500 Mexican peso bet.

16.

Suppose that you are given an opportunity to work in Tokyo over the summer as an English tutor, and you are provided with all living expenses and a 500,000-yen cash stipend that you plan to save and bring home. If the exchange rate is 120 yen per U.S. dollar, how much would your stipend be worth in dollars if you exchanged your money right away? Suppose you predict that the exchange rate will change in the next few months to 110 yen per U.S. dollar. Would you receive more dollars if you exchanged the yen now or later? Show your calculations.

Answer: If you exchanged 500,000 yen at a rate of 120 yen per dollar, you would receive $4,167 (500,000 ÷ 120 = 4,167). If you believe the exchange rate will change to 110 yen per dollar, you are predicting that the value of the yen will appreciate, or be worth more in terms of dollars. Therefore, you should wait. If the exchange rate did change to 110 yen per dollar, 500,000 yen would be worth $4,545 (500,000 ÷ 110 = $4,545).

Chapter 16 macro, 15 micro, 26 econ

By the Numbers: Assessing Your Data Literacy

Solutions Manual to accompany Chiang, Economics, 5e

Chapter 1

1.

In what year (from 1998 to 2018) was the U.S. trade deficit the smallest? Largest?

Answer: The U.S. trade deficit was the smallest in 1998 ($166 billion trade deficit) and the largest in 2006 ($761 billion trade deficit).

2.

In terms of dollars, between which two years did the trade balance improve the most? Between which two years did the trade balance worsen the most?

Answer: The trade balance improved the most between 2008 and 2009 when the trade deficit fell from $709 billion to $384 billion (a decrease of $325 billion). The trade balance worsened the most between 2003 and 2004 when the trade deficit increased from $494 billion to $610 billion (an increase of $116 billion). Note: From 2009 to 2010, the trade deficit increased from $384 billion to $495 billion (an increase of $111 billion), so this would be an acceptable answer based on the graph.

3.

The last two recessions occurred in 2001 and 2007–2009 (shaded vertical bars). What was the general trend in the trade balance during these recessions? Why do you think this trend occurs?

Answer: The trend is the trade balance improves during recessions. These trends exist because when the economy is strong, consumers buy more goods and services, including imported goods, which causes trade deficits to rise. The opposite is true when the economy is weak and consumers reduce their spending.

Check Your Understanding 1.

What is the difference between absolute and comparative advantage? Why would Stephen Curry, who is better than you at both basketball and mowing grass, still hire you to mow his lawn?

Answer: Absolute advantage is being able to produce more using the same amount of resources, while comparative advantage is able to produce at a lower opportunity cost. Stephen Curry may have an absolute advantage in both activities, but he is far better in basketball, which means every lawn that he mows incurs a very high opportunity cost (a lost afternoon of practice). Although you cannot mow as fast as Stephen Curry, your opportunity cost is considerably lower, which means you have a comparative advantage in mowing lawns.

2.

If the United States has a comparative advantage in the production of strawberries compared to Iceland, how might trade affect the prices of strawberries in the two countries?

Answer: If the United States has a comparative advantage in strawberry production relative to Iceland, this means that the pretrade price of strawberries is lower in the United States than in Iceland. With trade, strawberry prices would rise in the United States (due to greater overall demand from exports), while strawberry prices would fall in Iceland (due to greater supply from impo rts).

3.

Who are the beneficiaries from a large U.S. tariff on French and German wine? Who are the losers?

Answer: The U.S. government, California, and Australian (and other nations’) wine companies would clearly benefit, and consumers of wine would lose. French and German wine companies also would clearly lose.

4.

Why does a quota generate a larger loss to the importing country than a tariff that restricts imports to the same quantity?

Answer: A quota generates a larger loss to the importing country because the government does not collect tariff revenues on imports. This equivalent amount is instead kept by the exporting country through the higher prices as a result of the quota.

Solutions Manual to accompany Chiang, Economics, 5e

Chapter 1

5.

What is the difference between an infant industry and a key industry? Why do producers in both industries desire protection against foreign imports?

Answer: An infant industry is one that is relatively new in a country and has not generated the cost efficiencies to compete against established foreign companies. A key industry is any industry that produces goods deemed vital to national defense. Both types of industries seek protection against foreign imports in order to protect the many jobs that depend on the existence of the industry.

6.

How could free trade between the United States and China lead to more jobs in the United States?

Answer: Although the United States has made progress increasing exports to China, barriers to trade make it hard for American companies to sell their goods to China. Free trade between the two nations would greatly expand American exports, leading to many more jobs in the United States for export industries such as cars, airplanes, and machinery. However, increased imports from China may offset some of the growth in jobs, but the overall effect on jobs is likely to be positive given the vast untapped consumer markets in China that have a great appetite for American-made products.

Apply the Concepts 7.

Some American politicians claim that China’s trade policies are unfair to the United States and that a large tax (tariffs) should be placed on Chinese imports to protect American workers and industries.

Why might such a policy sound better than it actually is in practice? What are the dangers of imposing large taxes on Chinese imports?

Answer: Those who support large taxes on Chinese imports often fail to recognize two important effects of such a policy. First, the taxes would be paid primarily by American consumers, who would pay more for consumer goods. Second, China would likely react by retaliating with higher taxes on American exports such as airplanes, cars, movies, and agricultural products, potentially leading to a trade war. Millions of American workers who depend on Chinese consumers buying American products could be adversely affected.

8.

Expanding trade in general benefits both countries, or they would not willingly engage in trade. But we also know that consumers and society often gain while particular industries or workers lose. Since society and consumers gain, why don’t the many gainers compensate the few losers for their loss?

Answer: A recognition of this problem of many people gaining at the expense of a few workers prompted the federal government to provide trade assistance to those industries harmed by trade agreements. For workers, this assistance involves helping with retraining expenses.

9.

Some activist groups are calling for ―fair trade laws‖ by which other countries would be required to meet or approach our environmental standards and provide wage and working conditions approaching those of developed nations in order to be able to trade with us. Is this just another form of rent seeking by industries and unions for protection from overseas competition?

Answer: Although this is not the stated goal, it would be the impact if many foreign firms or countries were required to meet our environmental and labor laws and wage rates. Many countries are not at the stage of development at which they can afford to mimic U.S. infrastructure. Worker productivity in many countries is not high enough to support high wages or the tax rates necessary for the level of government services provided in the United States.

10.

Why is there free trade between states in the United States but not necessarily between countries?

Answer: The states of the United States generally have the same objectives and goals, whereas countries often have very different cultures, goals, and objectives. This is one of the difficulties the European Union is having in developing common rules to, in effect, structure itself in a similar way to the United States.

Solutions Manual to accompany Chiang, Economics, 5e

Chapter 1

11.

Remittances from developed countries amount to over $325 billion each year. Most of these funds are sent by foreign workers and migrants to their home countries. Is this similar to the gains from trade discussed in this chapter, or are these workers just taking jobs that workers in developed countries would be paid more to do in the absence of the migrants?

Answer: It is very much like the gains from trade examples discussed in the chapter. Developing nations send workers who produce output in developed countries, and the developing world gets some income (remittances) in return. We benefit and they benefit. Quite possibly, the migrants to developed nations may reduce wages for some jobs that domestic workers in these countries might do if the pay were higher; therefore, some domestic workers may suffer a loss as consumers reap the benefits.

12.

Suppose Brazil developed a secret process that effectively quadrupled its output of coffee from its coffee plantations. This secret process enabled it to significantly undercut the prices of U.S. domestic producers. Would domestic producers receive a sympathetic ear to calls for protection from Brazil’s lower-cost coffee? How is this case different from that of protection against cheap foreign labor?

Answer: Given that Brazil’s secret process is not cheap labor, domestic producers would probably not get much of a hearing (they would be encouraged to develop their own secret process). This is very much like the domestic auto industry going to Washington for help in 2006 and being politely rebuffed. There really isn’t any real difference; comparative advantage is comparative advantage.

In the News 13.

Migrant workers obtain temporary work permits to do jobs that most American workers avoid (such as picking fruit at the minimum wage), allowing U.S. farms to compete against low-cost imports.

However, critics claim that if farm wages increase, these jobs can be filled by American workers.

Given these viewpoints, is there a connection between restricting migrant workers and restricting international trade? Are the effects similar?

Answer: Migrant workers provide U.S. companies with lower-cost inputs (labor), reducing the cost of production. If wages were to increase as a result of restricting migrant workers, prices of goods would rise. Similarly, if international trade were restricted, prices of goods would rise. Whenever immigration (migrant workers) or trade is limited, consumers pay more for goods.

14.

Since before the Civil War, Hawaii had been a major producer and exporter of sugarcane. About the time Hawaii became a U.S. state in 1959, the sugar industry had already started its decline, and in 2016, the last sugar plantation in Hawaii closed. Explain how the sugar industry in Hawaii was affected by reductions in tariffs, world competition, and the opportunity costs of production relative to other states. Why does sugar continue to be produced in Florida and Louisiana but not in Hawaii?

Answer: The sugar industry has been in quick decline in Hawaii due to several factors. First, although U.S. sugar tariffs still protect American sugar producers, these tariffs had declined over the past few decades, making foreign competition, especially from countries such as Brazil, more prevalent. Also, the tourism industry in Hawaii, fueled by a greater number and lower cost of direct flights, has pushed land prices very high, increasing the opportunity cost of sugar plantations. Numerous landowners sold their plantations to condo developers for many millions of dollars. Although Florida and Louisiana are also tourist destinations, these states have much more land where sugar plantations do not compete with tourism.

Solutions Manual to accompany Chiang, Economics, 5e

Chapter 1

Solving Problems 15.

The following figure shows the production possibilities frontiers (PPFs) for Italy and India for their domestic production of olives and tea. Without trade, assume that each is consuming olives and tea at point a.

a.

b.

If Italy and India were to consider specialization and trade, in what commodity would each specialize? What is India's opportunity cost for tea? For olives? What is Italy's opportunity cost for tea? For olives?

Assume the two countries agree to specialize entirely in one product (the one in which each country has a comparative advantage) and agree to split the total output between them. Complete the table provided. Are both countries better off after trade?

Country and Product Before Specialization After Specialization After Trade Italy Olives 6 million tons ___________________ ____________ Tea 10 million tons ___________________ ____________ India Olives 2 million tons ___________________ ____________ Tea 30 million tons ___________________ ____________ Answer: a. India in tea, Italy in olives. India’s opportunity cost for 1 million tons of olives is 15 million tons of tea. Italy’s opportunity cost for olives is 1.7 million tons of tea for 1 million tons of olives.

Italy’s opportunity cost for olives is lower; therefore, it will specialize in olive production. India’s opportunity cost for 1 million tons of tea is 1/15 million (or 0.066 million) tons of olives. Italy’s opportunity cost for tea is 0.6 million tons of olives. India’s opportunity cost for tea is lower; therefore, it will specialize in tea production. b. See the following table. Yes, they both are better off, as shown in the last column.

Country and Product Italy Olives Tea India Olives Tea

Before Specialization 6 million tons 10 million tons 2 million tons 30 million tons

After Specialization 12 million tons 0 0 60 million tons

After Trade 6 million tons 30 million tons 6 million tons 30 million tons

Solutions Manual to accompany Chiang, Economics, 5e

16.

Chapter 1

The following figure shows the annual domestic demand and supply for 64-GB flash drives.

a.

Assume that the worldwide price of these 64-GB flash drives is $10. What percent of sales in the United States is imported? b. Assume the U.S. government puts a $5 tariff per unit on imports. How many 64-GB flash drives would be imported into the United States? c. Given the tariff in question b, how much revenue would the government collect from this tariff? d. Given the tariff in question b, how much more revenue would domestic companies receive?

Answer: a. At $10, unit total sales will be 16 million, with imports equal to the difference between 16 million total sales and domestic supply of 4 million units, therefore imports will be 12 million and as a percent of U.S. sales are equal to 12/16 = 75%. b. 4 million; at a price of $15 ($10 + $5 tariff), total sales are 12 million and domestic supply is 8 million units. c. Imports are 4 million times $5 a unit; therefore, the total revenue from the tariff is $20 million. d. When the price was $10, domestic sales revenue was $10  4 million units = $40 million. With the $5 tariff, sales revenue is $15  8 million units = $120 million; therefore, revenues have increased by $80 million. No wonder domestic industries like tariffs on foreign products.