SOLUTIONS MANUAL For Macroeconomics, 12th Edition David Colander

SOLUTIONS MANUAL For Macroeconomics, 12th Edition by David Solution Manual For Macroeconomics, 12th Edition David Colander Colander Chapter 1-22

CHAPTER 1: ECONOMICS AND ECONOMIC REASONING Questions and Exercises 1.

Coordination refers to how the three central problems facing any economy are solved. Those three problems are what and how much to produce, how to produce, and for whom to produce. Inevitably, individuals desire more than is available regardless of how much they‘re willing to work for what they desire, causing a problem of scarcity.

The concept of scarcity has two elements: our wants and our means of fulfilling those wants. These two elements are interrelated since wants are changeable and are partially determined by society. In addition, the degree of scarcity is constantly changing, depending upon the available means of production and the development of new wants.

Therefore, the author focused on coordination rather than on scarcity to emphasize the subsidiary nature of scarcity to the overall concept of coordination.

Economics is not merely about our wants or the means of fulfilling those wants; it is also about reconciling our wants with reality, where reality consists of decisionmaking mechanisms, social customs, and political realities.

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

Macroeconomic Microeconomic Macroeconomic Microeconomic Microeconomic Microeconomic Microeconomics studies how economic forces influence individual choices such as the pricing policies of firms, households‘ decisions on what to buy, and how markets allocate resources among alternative ends. Macroeconomics studies aggregate relationships such as how household consumption is related to income and how government policies can affect growth.

3.

Answers will differ. Two microeconomic problems are the pricing policies of firms (price-fixing in particular) and the way wages are determined in labor markets. (Why do athletes and celebrities make so much money, anyway?) Two 1

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macroeconomic problems are unemployment and inflation (business cycles and growth are also macroeconomic problems).

4. a. The opportunity cost of attending college is the sacrifice one must make by attending college. It can be estimated by figuring out the benefit of the nextbest alternative. If that alternative is working, one would guess the likely wage that could be earned at a job that does not require a college degree and then multiply by 40 hours for each week in college. The opportunity cost is also what could be done with the money used for tuition and other costs related to attending college. b. The opportunity cost of taking a course could also be estimated using the same technique as in part a if you otherwise would be working during these hours. If you had taken another course instead, the opportunity cost would be the benefit you would have received from taking that other course. c. The opportunity cost of attending yesterday‘s lecture would depend on what you otherwise could have done with that time (sleep, eat lunch with an interesting person, etc.). Although this is no longer a choice to you, past activities do have opportunity costs.

5.

Answers will vary. A correct answer will indicate that the student compared the marginal costs and benefits and chose the activity because the marginal benefit exceeded the marginal cost.

6.

The marginal costs are the additional costs of the additional activity. In this case, the additional activity is driving (200 − 100) miles. The marginal cost is the 10 cents per mile for all miles over 100 plus the additional cost of gas. Therefore, the marginal cost is $10.00  [0.10  (200  100)] plus the cost of gas. The initial payment can be forgotten because it is a sunk cost; it is not part of the marginal costs.

7.

No, since the marginal cost of drug control exceeds the marginal benefit; the government should not spend $4,170 to deter one person from using drugs.

8.

The opportunity cost of buying a $20,000 car is the benefit you would have gained by using that $20,000 for the next-best alternative, which could be spending it on other goods and services or saving it.

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9.

Only the marginal costs and benefits of taking the job are relevant. That means that the sunk cost of the bachelor‘s degree is irrelevant. Therefore, the relevant costs are the opportunity cost of taking the job (forgone earnings from your current job) and other things you could have done with the money you need to pay for business school. The relevant benefit is the increased lifetime earnings of $600,000.

10.

You should spend the $5 million on projects that provide the highest marginal benefit per dollar spent. The opportunity cost of spending the money on one project is the lost benefit that the college would have received by spending it on a different project. Thus, another way to restate the decision rule is to spend the money on the project that minimizes opportunity cost per dollar.

11.

Answers will differ. Two examples of social forces are our unwillingness to charge friends interest and our unwillingness to ―buy‖ friends. These issues are still subject to economic forces; however, there is no market in ―friends‖ or in loans to friends, and so the economic force does not become a market force.

12.

Answers will differ. Two examples of political or legal forces are rent control laws and restrictions on immigration. Both prevent the invisible hand from working. Rent control laws place a price ceiling on rent, causing shortages of apartments, and immigration restrictions cause the number of immigrants seeking entry to exceed the number allowed to enter, which tends to cause wage rates to differ among countries.

13. a. Both parties benefit. The person who gains the kidney benefits if it works when transplanted into his or her body as he or she will no longer have the emotional and financial burden of dialysis. The person selling the kidney gains the $30,000.

Their gains will also have impacts on others (their family, for example). b. Both parties must undergo surgery and face all the attendant risks and costs. The seller faces the potential cost of a future illness or injury harming his or her only remaining kidney, causing the seller to need dialysis. It raises moral issues that could be seen as hurting society because organs change from being inalienable to being a commodity and, hence, is another element that negatively affects the individuals. c. Whether a society should allow this transaction is a question of value judgments and cultural norms. Our society has chosen not to allow such transactions because (among other reasons) those with more money would have increased access to organs and therefore would have advantages over those of limited means. Thus, the poor could be exploited in such transactions.

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14.

An economic model is a framework that places the generalized insights of a theory in a more specific contextual setting. Policymakers need to understand the empirical evidence supporting the theory as well as real-world economic institutions to make policy recommendations.

15.

No. Economic theory proves nothing about what system is best. It simply provides a way to look at systems and indicates what the advantages and disadvantages of various systems will likely be. Normative decisions about what is best can only follow from one‘s value judgments, which are subjective.

16.

A theorem is a proposition that is logically true based on the assumptions of the model, whereas a precept is a policy rule that a particular course of action is preferable. Economists can agree about theorems but disagree about precepts if they have different value judgments regarding the intended goals.

17.

A normative statement reflects ethical judgments about what should be. It reflects values and is subjective. A positive statement refers to a fact or a logical relationship. It is in principle testable or is the result of logic analysis. Positive statements of facts are not subject to debate among individuals. The art of economics refers to issues of judgment on how to achieve the goals determined in normative economics, giving the facts and logical relationships one finds in positive economics. Art of economics statements are subject to debate.

18. a. Positive statement, since it is a statement of logic. b. Normative economics, since it deals with what the goals of the economy should be and is subjective. c. Since this is relating a normative goal to a decision, this could be a statement in the art of economics. It could also be seen as a normative statement if one interprets it as a normative imperative. d. Positive statement, since it is a statement of fact.

Questions from Alternative Perspectives 1.

Austrian Most economists would answer ―yes‖ because they see economic variables such as unemployment as objective measures, which make them available as measures for planning. Most economists see only individual preferences, not social 4

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preferences, as subjective. Austrians believe in a radical subjectivity, uncertainty with respect to time, knowledge, and matters beyond preferences. This eliminates the possibility of using objective economic analysis as the basis for government planning. For an Austrian study on the nature of time and uncertainty for economics, see the work of Mario Rizzo and Gerald O‘Driscoll, Jr.

2.

Religious a. The rational choice model assumes that individuals are one-dimensional, that they know what they want, and that they will do what is in their best interest.

Addictive behavior undermines that assumption, leading to a conflict between passion and reason. b. The conflict suggests that we have to be careful not to apply the economic model in cases in which that conflict is important, such as with behaviors that have addictive elements. When there is a conflict between passion and reason, there may be greater reason for government to limit access to the addictive good or behavior.

3.

Feminist a. Patriarchy is a social institution in which men exercise a disproportionate amount of social power and are in a position to define the roles of women and children.

Because patriarchy affects the way people behave and interact, it is an institution.

Gender affects the labor market because those who are in power will make hiring decisions that perpetuate their position of power. For example, husbands and fathers may make, or heavily influence, the decisions of whether a woman will look for work. b. Some economists might argue that men and women are merely expressing their preferences in job choices, whereas feminist economists might argue that these choices are culturally determined by institutions, or patterns of behavior, such as the patriarchy. It is impossible to separate the market from the institutions within which they are embedded. The free market may not determine the institutions or mores of a society, but it nevertheless operates within those institutions.

4.

Institutionalist a. A free market outcome would provide the flu vaccine to those willing and able to pay the most for it, which probably would not include all of those given priority under the rationing scheme. b. The determination of which option is ―just‖ requires delving into theories of justice. The free market solution best mirrors commutative justice—one based on 5

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efficiency of exchange— and the rationing scheme best mirrors distributive justice—one based on some notion of fairness that favors those with a greater predisposition to illness.

5.

Post-Keynesian a. This answer will differ among students but should include an assessment of the marginal benefits incurred between various institutions. b. Most students probably will answer this question ―no.‖ The standard theory presented in the book is based on the assumption that decision makers have full information about all factors that might influence their decisions: They have substantive knowledge of all possible outcomes of their decision making and the consequences of each decision. Most likely you had limited knowledge of the pros and cons of the schools you were considering when deciding which college to attend. As a result, you probably turned to the advice and norms of a small group of friends, family members, or teachers to help you make a decision. c. Recognizing that you have limited time, knowledge, and ability to compute all the possible outcomes of each economic decision, you probably rely on social norms and rules of thumb to help you make many of your economic decisions. For example, when you go to the grocery store, you may continue to buy Diet Coke even though other diet sodas might provide you with a higher level of satisfaction at a lower price because you are in the habit of buying Diet Coke and uncertain of the exact benefit you will incur from other diet beverages. d. The implication of this behavior is that individuals do not follow the economic decision rule of gaining complete information to optimize their choices but rely on rules of thumb or habit to come up with a satisfactory outcome even though it might not be the most optimizing. This means that economic analysis, which assumes that humans are one-dimensional rational beings who calculate all relevant marginal costs and benefits, is limited.

6.

Radical a. It implies that there is no clear-cut distinction between positive and normative economics and that seemingly positive economics has implicit value judgments hidden within it. b. Economics is value laden. The relevant question about whether the distinction is tenable is whether it is relatively less value-laden than the alternatives. That is an open question.

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Issues to Ponder 1.

Regretting a decision doesn‘t necessarily mean that we did not use the economic decision rule when making that decision. The economic decision rule infers that the individual has perfect information, which is an idealization of the reality of decision-making. At the time the decision was made, we weighed the marginal costs and marginal benefits, undertaking the activity if the marginal benefit exceeded the marginal cost and not undertaking the activity if the marginal cost exceeded the marginal benefit. Many decisions are made without knowledge of the full marginal costs and marginal benefits. Sometimes these marginal costs and marginal benefits are revealed at a later date, making us regret the initial decision.

An example is going out to a restaurant. From recommendations, we form an expectation about the marginal benefit. If that recommendation overstates our actual experience, we will have overestimated the marginal benefit of eating out.

We may regret having spent the money to eat out.

2. a. It depends on the perspectives used to answer the question. From a purely economic perspective, we would conclude that it is reasonable to execute hackers based on cost/benefit analysis. However, since this decision can by no means be simplified to pure economics, we need to take into consideration social, political, and religious factors. Therefore, Landsburg‘s argument should be evaluated in a more holistic context. b. Cost/benefit analysis can be extended to many areas, such as social welfare programs and almost all the policy discussions. (Source: ―Feed the Worms Who Write the Worms to the Worms,‖ http://slate.com/id/2101297/), Slate Magazine, May 26, 2004.)

3.

The Theory of Moral Sentiments emphasizes the importance of morality. The invisible hand directs people‘s selfish desires (tempered by the social and political forces) to the welfare of society but is based on certain presuppositions about the morality of individuals which constrains individuals‘ selfish actions. What Smith is suggesting is that the way individuals calculate marginal cost and marginal benefit must be interpreted within a social context.

4. a. & b.

Parts a and b have no ―right‖ answers. Most people would say ―no‖ to a and ―yes‖ to b. If one were answering this question from the perspective of the economic decision rule alone, one would measure the marginal benefits against the marginal costs of the choice.

c. People tend to believe that children should be afforded greater protection than is afforded to adults and are therefore repelled by the idea of sacrificing a child even 7

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though it would save the lives of other children. Sick people are closer to death, and therefore their lives tend to be valued less. d. Brain imaging suggests that the moral sense behind one‘s answers does not come from rational thought, but instead from emotional, gut responses. This suggests that a kind of moral intuition exists that is quite separate from reason. If that is the case, opportunity costs were not central to the decision. It was a moral, not an economic, decision. Opinions among philosophers and economists differ on this issue.

5. a. It depends. On the basis of cost/benefit analysis, one could figure out cases in which most people would say that they should be dishonest, but cost/benefit analysis is not the final arbiter if you believe that dishonesty is wrong.

Additionally, you should consider the social implications of dishonesty, as your reputation and future interactions may be impacted. b. You can make yourself more believable by developing a reputation for honesty.

Developing such a reputation usually has a cost because it requires you to be honest even when others might be dishonest. To encourage the other person to tell the truth, you could use economic incentives.

6. a. Answers will vary. b. Economic theory says that prices are determined by supply and demand, but businesses often use cost-plus-markup rules, or rules of thumb, to set their prices.

If two firms have different costs of supplying the same item, they probably will set different prices for that item. People might be willing to pay the higher price if the store is closer to where they live or simply to support a smaller, local store. c. Again, answers will vary, but the reasoning is the same as in part b.

7.

It depends on the perspective one takes. It is economically reasonable to legalize organ sales. But from a moral perspective, organ sales may be unethical, and poorer people might feel compelled to sell their organs to support their family, a result that many people would find morally reprehensible. Economics has nothing definitive to say on normative moral issues such as this.

8.

Answers will vary. Here is an example: Banks are economic institutions. They take a cost/benefit approach to deciding to whom to give loans, and they influence decision making by allowing individuals to spend more money than they earn or have as wealth.

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9. a. This is a matter of personal views; there are arguments for and against it. An argument against the practice is that wealthy songwriters would have too much power in promoting their songs. The songs of the songwriters who can afford to share profits will get more play time and become even more famous to the detriment of new entrants into the industry. Arguments for this practice are that it could be used to offset racism as in the example given and, to the extent that new songwriters have the capability of offering such royalty share, promote new kinds of music. b. The royalty payment gave Freed a strong incentive to choose what he considered the best song and to promote that song heavily. The flat payment would have just given him an incentive to play any song and no long-term interest in whether the song succeeded or failed. c. Answers will vary. Here are a few examples: Product placement in movies is legal, as are free newspapers to professors for getting a class to use the newspaper. Direct payments to doctors for prescribing a particular type of drug are illegal, although taking doctors to lunch is not.

10.

Three ways (among many) that dormitory rooms could be rationed are administrative decree, lottery, and a market system. In the first, individual behavior would be forced to fit the will of the administrator. Individuals probably would complain and try to influence the administrator's decision. Because administrative decree is not necessarily an efficient system, some people probably would attempt to trade rooms after the allocation. In the second, individual behavior would be forced to fit the luck of the draw; individuals probably would attempt to trade rooms after the draw. In the final example, individual behavior would have already been subject to economic forces, and thus, there would be no tendency to trade after one has "bought" the room one can afford.

11.

It suggests that policy should be willing to give up more in possible gains to avoid losses than otherwise would be the case. Economic policies should be riskaverse—more committed to maintaining the current standard of living than to risking economic losses by trying to improve it. Another possible policy response would be to offset this tendency by making gains more salient than losses.

12.

A good economist always tries to be objective. However, no one can ever be completely objective. Sometimes the best we can hope for is an awareness of the cultural norms and value judgments that influence our views and decisions.

Additionally, many policy issues (such as organ markets and minimum wage laws) probably should not be approved in a purely objective way since they also have moral and social implications.

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13.

―Letting the data speak‖ means using computer power to find patterns in data. As computational methods have improved exponentially, the patterns that computers find are more robust and useful in finding patterns. So, the reason modern economists are more likely to let the data speak is due to technological change in computational methods.

CHAPTER 2: THE PRODUCTION POSSIBILITY MODEL, TRADE, AND GLOBALIZATION Questions and Exercises 14.

In the figure to the right, wadget production is measured on the vertical axis and widget production is measured on the horizontal axis. If the society becomes more productive in its output of widgets, it can produce more of them, and the end point of the curve on the horizontal axis will move to the right, as shown. If the society is also less productive in its production of wadgets, the end point on the vertical axis will move down, as shown. The result is a new production possibility curve.

15.

If a society became equally more productive in the production of both widgets and wadgets, the production possibility curve would shift out to the right as shown in the accompanying graph.

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16.

Any production possibility curve that shows the principle of rising trade-off must be bowed out. The accompanying grade production possibility curve embodies the principle of rising trade off. The table is presented below. Notice that for each 20-point gain in the History grade the amount of points lost on the Economics grade steadily increases.

History 40 60 80

Economics 100 80 50

17. a. In order to produce one more Peep, JustBorn must give up 3 Mike and Ikes.

Hence, the trade-off for 1 Peep is 3 Mike and Ikes. The trade-off for one Mike and Ike is 1/3 of a peep. d. See the accompanying graph. Opportunity costs are constant.

e. Point A is efficient. Point B is inefficient. Point C is impossible. f. See the accompanying graph.

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18.

The theory of comparative advantage underlies the shape of the production possibility curve. By taking advantage of each person's comparative advantage, higher total output can be reached than if each produced all goods on his or her own, or if each produced goods for which he or she did not have a comparative advantage. As more and more of a good is produced, resources that have less of a comparative advantage are brought into the production of a good, causing the production possibility curve to be bowed outward.

19. a. See the accompanying graph.

g. As the output of food increases, the trade-off (opportunity costs) between food and clothing increases. To illustrate, giving up 4 units of clothing (from 20 to 16) results in a gain of 5 units of food (from 0 to 5), but giving up another 4 units of clothing (from 16 to 12) results in a gain of 4 units of food (from 5 to 9), and this pattern continues. h. If the country gets better at producing food, the production possibility curve shifts out along the food axis only. i. If the country gets equally better at producing food and clothing, the production possibility curve will shift out along both axes by the same proportion.

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20.

There are no gains from trade when neither of two countries has a comparative advantage in either of two goods.

21.

The fact that the production possibility model tells us that trade is good does not mean that in the real world, free trade is the best policy. The production possibility model does not take into account the importance of institutions and government in trade. For example, the model does not take into account externalities associated with some trades, the provision of public goods, or the need for a stable set of institutions or rules. The production possibility model shows maximum total output, but that is not the only societal goal to take into account when formulating policy.

22. a. See the accompanying graph.

j. The United States has a comparative advantage in the production of wheat because it can produce 2 additional tons of wheat for every 1 fewer bolt of cloth while Japan can produce 1 additional ton of wheat for every 2 fewer bolts of cloth. Japan has a comparative advantage in producing cloth. k. The United States should trade wheat to Japan in return for bolts of cloth. One possibility is that the United States produces 1,000 tons of wheat and Japan produces 1,000 bolts of cloth and they divide total production equally. Both get 500 tons of wheat and 500 yards of cloth. Both end up with more of each good.

(Note: Other combinations are possible.) l. See the accompanying graph. Point A is the bundle of goods each country will be able to consume. Because point A is outside the production possibility curve for each country, trade clearly benefits both countries.

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23.

Globalization increases competition by allowing greater specialization and division of labor. Because companies can move operations to countries with a comparative advantage, they can lower production costs and increase competitive pressures. The decreased importance of geographical location increases the size of potential markets, increasing the number of suppliers in each market and thus increasing competition.

24.

The law of one price rules, meaning that U.S. wages can only exceed foreign wages to the degree that U.S. workers are more productive than foreign workers.

The adjustments, therefore, that will need to occur will equalize wage rates. So, either Western nominal wages will grow slowly and foreign nominal wages will grow rapidly and catch up or U.S. exchange rates will decline to equalize wages.

Some combination of the two is most likely. It is possible that there will develop areas of production/services that will allow U.S. wages to remain high.

25.

The law of one price states that wages of workers in one country will not differ significantly from wages of (equal) workers in another institutionally similar country. As the world is globalizing, the law of one price causes firms to hire workers in other countries. Because wages adjusted for productivity differences are lower in other countries, firms choose to use workers in foreign countries. As they do so, wages will be bid up until wages, adjusted for productivity differences, are equal between the two countries.

Questions from Alternative Perspectives 26.

Austrian In a market economy competition, the market process translates individual actions into actions that are good for society. There is no such mechanism for government; government has a monopoly on power, which allows individuals in 4

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government to use that monopoly to achieve their ends, which may not be ―good‖ ends. This monopoly on power makes government less reliable than the market to do good, since the government is not subject to entry and exit as firms are in the market. Also, whether or not every individual voice is taken into account depends on the government system, while the market will always include any individual‘s voice by either their entry or exit.

27.

Religious m. Most people would say that while it might be a component of the goals of society, it is not ―the‖ goal of society. Other goals might include virtues such as kindness and generosity. n. If a country is Christian, maximizing output probably should not be "the" goal of society. o. In a Christian society the paramount goal would be to discern and fulfill the will of God.

28.

Feminist p. Companies definitely think that sex sells products. Just look at the cover of any number of magazines. q. Sex is used in the advertising of numerous products. r. All people are subject to abuse by advertising, but women are more likely to be portrayed as objects instead of people and are therefore at greater risk of exploitation. s. While men and women may both be used in advertising, many times men are shown to be in a dominant position of power, while women are shown in subordinate positions.

29.

Institutionalist t. Back in the 1950s President Eisenhower warned of the military/industrial complex, which maintains all types of military spending on projects so that they continue to generate jobs for those areas. Senators with power on the appropriations committee inevitably have larger defense expenditures in their districts than senators not on the appropriations committee. This high spending on military production results in a trade-off. It means that there is less money to spend on consumer goods, leading to a lower production of consumer goods.

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u. The short-term consequence is a loss in consumer goods. The long-term consequences are potentially much more serious, because in order for the military to justify the expenditures, wars are necessary; thus, the production of military goods over consumer goods can increase the probability of wars. Some argue that the 2003 Iraq war is an example, because Halliburton benefited from it, and the former head of Halliburton, Vice President Cheney, leading the group pushed for U.S. entrance into the war.

30.

Radical v. Yes, not only does technology still have such effects, those effects on our lives seem to be increasing in some areas. While technology has freed us from some arduous jobs, it has also eliminated jobs that gave meaning to people's lives.

Technology is leading to more and more specialization in the methods of production to include more and more computational work. This is making more and more jobs that we used to consider desirable human jobs done by technology.

So the job becomes designing the technology to do the job, not doing the job.

In modern society technology is replacing many human activities that were called work with activities associated with computers. Today computers can design buildings, diagnose medical problems, drive cars, and many more tasks. This is reducing the types of labor that are needed. The type of labor that is needed now is much more involved with software design. Many other types of labor, such as physical labor, or quasi-skilled labor are being replaced. If work were only something to be avoided, this might be without cost and an overall benefit to society. But it misses the broader issue of what the purpose of life it. As Ralph Waldo Emerson said, ―The purpose of life is not to be happy. It is to be useful, to be honorable, to be compassionate, to have it make some difference that you have lived and lived well.‖ All too often economic models miss these broader fundamental cultural issues and miss the point that technological change is making it harder for many to find that purpose. It makes them redundant to society. w. When making policy decisions, society must take into account not only what is produced, but the methods and means of production.

Issues to Ponder 31.

This statement can be true or false depending on the implicit assumptions made in the analysis. It is true given that individuals will eliminate all inefficiencies they see through trading. It might be false if not everyone knows all the benefits and the inefficiencies or does not have the opportunity to correct the inefficiencies, or if the costs of eliminating the inefficiency are too high.

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32.

If achieving a particular distribution of income is one of society‘s goals, a particular production technique that leads to greater output might be considered an inefficient method of production if it also leads to a less desirable distribution of income. Remember, efficiency is achieving a goal as cheaply as possible.

Maximizing output is not the only goal of a society.

33. a. From the numbers alone, one would choose not to work because the opportunity cost of working is giving up an $80,000 increase in lifetime income while the benefit is $32,000 of income now. Although there is a correlation between working time and GPA, we cannot conclude that working an after-school job causes the decrease in GPA. Therefore, one might be able to maintain a decent GPA while working. Moreover, earning money might be the priority for a particular student to reach another goal, such as saving for college that will lead to even greater lifetime earnings. x. It depends on the particular student. Working takes time from study and thus might be a reason for the decrease in GPA. But the situation varies from student to student. In some cases, work experience may complement what is learned in class and can lead to higher grades.

34.

The fact that lawns occupy more land in the United States than any single crop does not mean that the United States is operating inefficiently. Although the cost of enjoying lawns is not included in GDP, lawns are nevertheless produced consumption goods and are included in the production possibility curve for the United States. The high proportion of land devoted to lawns implies that the United States has sufficient food that it can devote a fair amount of land to the production of goods for enjoyment such as lawns.

35.

Following the hint that society‘s production possibility curve reflects more than just technical relationships, we realize that trust is an input to production to the extent that it is necessary for transactions. If everyone could fake honesty, the production possibility curve would shift inward since no one could trust anyone else leading to the disintegration of markets. If some could fake honesty, those few will gain at the expense of others.

36. a. Firms may produce in Germany, because (1) transportation costs to/from the other countries may be very high, so that if these costs are included, it would not be efficient to produce there; (2) there might be tariffs or quotas for imports into Germany that will prevent producing elsewhere; (3) the productivity of German labor may be so much higher that unit labor costs in Germany are the lowest; and (4) historical circumstances may have led to production in Germany and the cost of moving production may exceed potential gains.

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y. There would probably not be a significant movement of workers right away. One would expect some movement from Greece and Italy into Germany, but this is limited by social restrictions such as language, culture and the economic climate in Germany, which currently has high unemployment. Movement in the long run, however, may be substantial. z. I would want to know about the rule of law in Thailand that will govern business practices, the stability of the government, and the infrastructure. All of these will affect the costs of production.

CHAPTER 2 APPENDIX: GRAPHISH: THE LANGUAGE OF GRAPHS

a

37.

See the accompanying graph. d.

c b

38.

See the accompanying graph. aa. The relationship is nonlinear because it is curved, not straight. bb. From 0 to 5, cost declines as quantity rises (inverse relationship). From 5 to 10, cost rises as quantity rises (direct relationship).

8

cc. From 0 to 5, the slope is negative (slopes down). From 5 to 10, the slope is positive (slopes up). dd. The slope between 1 and 2 units is the change in cost (30−20) divided by

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the change in quantity (1 − 2), or −10.

39.

See the accompanying graph.

10 9 8 7 6 5 4 3 2 1

d

b a

c

1

2 3 4

5 6 7

8 9 10

40. a. 1 ee. −3 ff. 1/3 gg. −3/4 hh. 0 41. a. C ii. A and E jj. B and D kk. B is a local maximum; D is a local minimum.

42. a. See line a in the accompanying graph. ll. See line b in the accompanying graph.

2

mm. See line c in the accompanying graph.

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2

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43. a. y = 5x + 1,000 nn. y = 3x + 1,500.

44. a. line graph oo. bar graph pp. pie chart qq. line graph

CHAPTER 3: ECONOMIC INSTITUTIONS Questions and Exercises 45.

In a market economy, fluctuations in prices play a role in coordinating individuals‘ wants. Price is the mechanism through which people‘s desires are coordinated and goods are rationed.

46.

In a centrally planned socialist economy, sometimes called a command economy, economic activity is governed by central planning. These planning boards set society‘s goals and then direct individuals and firms as to how to achieve those goals.

47.

Market economies solve the three problems through markets and the system of rewards and payments. What gets produced is what businesses believe can be sold. How it gets produced is determined by businesses; generally, they choose the method that makes the largest profit. Those who are willing to pay for the goods at the market-determined prices will get them.

48.

Centrally planned socialist economies solve the three problems by using administrative control. Central planners decide what to produce according to what they believe is socially beneficial. In deciding how to produce central planners are guided by what they believe is good for the economy. Central planners decide distribution based on their perception of individuals‘ needs.

49.

Although economics does not provide an answer to normative questions such as this, economics can be used to describe the characteristics of capitalistic and socialistic economic systems, the degree to which each economy relies on markets, and how this reliance has changed over time. Economics can explain 1

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how each system functions and explain how efficient each system is, but economics does not provide an answer to normative questions without imposing normative judgments.

50.

A market economy depends on coordination, and the mechanisms of coordination depend on the people who choose which goods to supply and what to demand.

People supply the labor that makes the economy run. Economic growth, and what is considered a resource depend on technology, and people develop new technologies. Even the institutions that oversee the economy are governed by that economy‘s people. It follows that the economy‘s ultimate strength resides in its people.

51.

Business is dynamic; it involves meeting new problems constantly, recognizing needs, and meeting those needs in a timely fashion. These are precisely the skills of entrepreneurship. Entrepreneurship is the ability to organize and get something done and is an important part of business. Businesses in the United States decide what to produce, how to produce, and for whom to produce, and entrepreneurs solve these dynamic coordination problems.

52.

The three forms of businesses are corporations, partnerships and sole proprietorships. a. In the United States, most small firms are sole proprietorships. b. Corporations account for most sales.

53.

You would most likely choose a sole proprietorship because it‘s easy to start, requires minimal bureaucratic hassle, and is controlled by you, the owner. If you need more money than you have to start this business, you might consider taking on a partner. This would also allow you to share the work and the risk, but you will also have to share the profits and figure out a way to work together successfully.

54.

The state and local government‘s two largest categories of spending are education (approximately 28 percent) and health & welfare (approximately 36 percent), with expenditures on public safety being the third largest (approximately 7 percent).

55.

The six roles of government in a market economy are (1) providing a stable set of institutions and rules, (2) promoting effective and workable competition, (3) correcting for externalities, (4) ensuring economic stability and growth, (5) providing public goods, and (6) adjusting for undesired market results.

2

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56.

Pollution permits require firms to pay the cost of pollution they create. When these permits are tradable, firms that face the lowest cost of reducing pollution will reduce pollution emissions the most and sell their extra rights to firms who face a higher cost of reducing pollution. Permits assign the right to pollute, thereby correcting for the externality.

57.

A merit good is a good that government believes is good for you even if you choose not to buy it. An example might be going to the opera.

A demerit good is a good that government believes is bad for you even if you choose to buy it. An example is alcohol or drugs.

A public good is a good that if supplied to one person must be supplied to all and whose consumption by one does not preclude the consumption by another. An example is national defense.

An externality is the effect of a trade on a person not involved in the trade. An example are the second-hand effects from cigarette smoke.

58.

Economic actions are coordinated by a wide variety of international organizations such as the United Nations, The World Trade Organization (W TO), and the World Bank. (The answer needs to mention only two of these three organizations.)

59.

Countries have developed global and regional organizations whose role is to coordinate trade among countries and reduce trade barriers. The World Trade Organization, European Union and NAFTA are examples of these types of organizations

60.

International organizations are limited in their effectiveness because membership is voluntary, as are any agreements among members. There is no world government to enforce international laws or agreements. What keeps countries somewhat in line is moral tradition.

Questions from Alternative Perspectives Austrian 1. The dangers of government intervention and support of activities is that once intervention begins, it is hard to limit. For example, if the state supports children 3

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the state will want control of those children, which will impinge upon individual’s freedoms.

2. If governments financially support families, they might attempt to limit the number of children that families can have, such as the People’s Republic of China did with the “one child policy.” Alternatively, governments may want more children to increase the size of the military and will limit birth control to achieve these ends, just as Romania did in its socialist period.

61.

Religious He meant that strongly held religious beliefs can lead people to violate the law, because they hold the law of God above the law of the state. There is debate about whether he is correct, but as can be seen with some religious fundamentalists who incorporate violence into their belief system, the state may face serious problems when people rely on religion as their primary guide for action.

62.

Feminist Economists know relatively little about intra-household decision-making and have generally assumed that households have a single joint utility function. In one popular theory, those with power (parents) are assumed to be benevolent while those without power (children) are assumed to be selfish. Widespread spouse and child abuse and evidence of harmful unequal food distribution within families clearly undermine this simple notion of household decision-making.

3. Absolutely. Bargaining is likely to take place among individuals within a household. A child might agree to eat certain foods in exchange for getting a toy, for example.

4. The ability to walk away from the bargain is what gives someone power. Paying the bills also gives power. In families the individual with higher income is likely to have greater bargaining power.

5. Individuals are more likely to act cooperatively within a household because there are additional mechanisms besides money to maintain accountability. However, there may be unspoken competition within a family, such as when children compete for their parents' attention. There is also cooperation elsewhere, such as when employees work together to accomplish a task.

6. It makes sense within the theory of social behavior of groups of various sizes and strengths of relations.

4

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63.

Institutionalist The dilemma is obvious and represents an inherent conflict in a society whose values are greatly influenced by the Judeo-Christian ethic of charity towards all, and the free market ethic, which emphasizes the pursuit of self-interest. In thinking about ethics, there is a difference between intention and result, and in the Theory of Moral Sentiments, Adam Smith argued that all people have an inherent concern about others, but that often in trying to do good, the end result left things worse off. In some cases, he argued that the competitive market was the best way to blend the two goals together. In developing this idea, discussion can be used to delineate concepts of justice and the difficulty of universal application.

64.

Radical To some degree consumers’ desires influence what is produced, but with so much advertising, it is difficult to determine people’s true desires, and whether those desires are being created by businesses. The ability of firms to influence consumers’ behavior is increasing with the development of data science and the large amount of data generated by Internet activity. As firms better understand consumer psychology, they are in a better position to use it to their advantage.

Firms have a strong incentive to develop tastes for the products that they are selling, and they spend lots of money on advertising to shape tastes. But since we don’t know what people’s underlying tastes are, views on this issue can differ, and it is difficult to say which view is correct.

The other group that has some sovereignty is business. If business sovereignty holds, then the analysis based on consumer sovereignty is misleading, and should not necessarily be followed. What this tells us is that economic analysis is much more complicated than an introductory text can provide.

Issues to Ponder Markets have little role in most families. In most families decisions about who gets what are usually made by benevolent parents. Because families are small and social bonds are strong, this benevolence can work. Thus, a socialist organization seems more appropriate to a family and a market-based organization to a large economy where social bonds don‘t hold the social unit together. The propensity to look after the common good is much stronger in a family than in an entire economy.

The benefits of a market-based economy in a family would be to provide incentives to all members of the family to contribute to family production, although this may undermine the social bonds of families.

5

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65. a. The fact that more money is spent on adults than on children in the family does not imply that the children are deprived or that the distribution is unfair. Children and adults have different needs. Adults, for example, eat more.

Yes, these percentages probably change with income. The lower the income, the larger the percent of total expenditures spent on children. The reason is that most families want to provide a basic level of needs for their children. Many families feel that luxuries should not be given to children until the children have learned how to work for themselves.

7. Our suspicion is that the allocation would not be significantly different in command economies as compared to capitalist economies. If, however, the average income in command economies were lower, the percentage of total expenditure spent on children might be higher, as described in part b.

66. a. Innovation requires a certain level of freedom of thought and a possibility of profit-making from the innovation. Neither existed in centrally-planned economies. Government planners directed production with income based on need, so workers had neither the freedom nor the incentive to innovate.

Both freedom and the possibility of making profits provide the means and incentives for innovation in capitalist countries.

Schumpeter’s argument was based on the idea that profit-making by innovators was necessary for innovation to occur. As firms become larger, however, the individual ceases to become the direct beneficiary of his or her innovations.

Since his predictions did not materialize, one must believe that firms have either been able to create incentive structures to foster innovation or that some other venue for innovation has arisen. Firms have large research and development departments designed to promote innovation. In addition, individual innovators have been able to raise enough capital to start their own companies to profit directly from their innovations. In the United States there has been enormous growth in the number of such firms. The U.S. government has been a large motivator of innovation through its strong patent and copyright system, as well as providing subsidies for research at universities and support of military innovations, both of which have large spillovers into private industry.

67. a. Such an idea could be expanded to include college courses, but that is unlikely to happen because the quantity of in-person college courses demanded would decline as people substitute toward recorded lectures. Substitution, however, is not perfect since DVDs cannot provide the interaction between student and instructor or among students that exists in the classroom. Social forces would act 6

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against the movement away from college classroom instruction even if the invisible hand pressed action toward it.

Technical problems are virtually nonexistent. Socially, the problems are substantial.

A diminishing role of the university would significantly change its role of providing a focal point for intellectual discussion and discovery, thus changing the nature of education. There would be great social pressures to maintain this role of American colleges. The economic issues are substantial as well. A course could be taught once and used over a period of years. This would reduce the demand for professors and create revenues for certifying agencies that would regulate the distribution and quality of the tapes. If these college-at-home courses became an accepted educational credential, the demand for traditional college education would fall, putting major competitive pressure on traditional colleges.

Even though the program is technically possible and cost efficient, it will not necessarily be a success because social forces will play a major role in limiting the market. Social forces are often strong enough to overcome economic forces.

(Note: Student answers may be more varied now that online college courses have become much more popular during COVID. Platforms like Coursera are now large and trading on the NYSE, so some students may discuss that.)

68.

Answers will vary. There are no ―correct‖ answers; it is more an exercise that asks you to gather information about the limitations on businesses of different types in their communities. You are then asked to make judgments as to whether the limitations were necessary (are you being clear about the goals involved?) and whether the number of limitations is correct. The information is linked to the text‘s material in part d. Part e asks you to learn about business taxes in your community, and part f asks you to gather a sense of business satisfaction.

69.

Consumers decide what goods they want and demonstrate their decisions in their willingness to pay for the goods. Businesses decide what to produce, but their decisions reflect consumer desires. Thus, there is no contradiction. However, some types of advertising, in which businesses attempt to influence consumer behavior, can limit consumer sovereignty.

70.

Individuals might disagree as to the categorization of a good as a merit, demerit or public good or a good that involves an externality. In the case of an externality, they may believe that given sufficient property rights, the externality will be solved most efficiently by the market, not government.

71.

There is market failure only if people do not value operas as much as they should.

This normative statement is valid only if the ―should‖ can be measured against 7

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some absolute truth as to the value of operas, otherwise how would one decide who decides the value of operas? Because it is only through the market that value is revealed, we‘d argue that government intervention in this case will likely lead to government failure—the failure of government to accurately value operas.

With government intervention, the value will likely reflect the preferences of those with political power, not necessarily those of the general population.

72.

People have made decisions based on the rules that were set up, so changing them after the game has been started may be more unfair than continuing to play by the original rules. There is a cost of loss of credibility to changing rules after the game has started. Such decisions must be made based on the marginal cost and benefit of changing the rules.

73.

When making such trade agreements, it is important for countries to realize that trade includes not only economic issues, but cultural and social ones as well.

While free and unregulated trade is generally the most economically beneficial (maximizes consumption possibilities), these economic benefits can be overpowered by the loss of cultural identity as a result of globalization. Taking into consideration such losses is a government‘s responsibility when negotiating trade agreements. These losses must be weighed against the benefits of free trade.

CHAPTER 4: SUPPLY AND DEMAND Questions and Exercises 74.

The law of demand states that quantity demanded falls as price increases; or that quantity demanded rises as price falls. Price is inversely related to quantity demanded because as price rises, consumers substitute other goods whose price has not risen.

75. a.

Price $2 $4 $6 $8 $10 $12 $14 $16

Market Demand 64 56 44 36 28 20 12 8 8

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rr. See the accompanying graph of the table.

ss. At the market price of $4, the total market demand is 56. If the price rises to $10, the total market demand will fall to 28. tt. All of the curves will shift to the right by 50 percent. [(Note: The top part of Javier's demand curve will not shift to the right (an additional 50% of zero is still zero).]

76.

Four shift factors of demand are income, price of other goods, tastes, and expectations. A fifth shift factor is taxes and subsidies to consumers. As income rises, demand increases. As the prices of other substitute goods rise, demand increases. As tastes change to favor a particular good, the demand for that good increases. If people expect the price of a good to fall in the future, demand will fall now. Taxes reduce demand, while subsidies increase it.

77.

A change in the price causes a movement along the demand curve to a new point on the same curve. A shift in the demand curve means that the quantities will be different at all prices; the entire curve shifts.

78.

The law of supply states that quantity supplied rises as price increases or, alternatively, that quantity supplied falls as price decreases. Price is directly 9

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related to quantity supplied because, as price rises, people and firms rearrange their activities to supply more of that good in order to take advantage of the higher price.

79.

Saying that supply increases means that the curve has shifted to the right, which is not the result of a price change. The correct statement is that, normally, as price rises, the quantity supplied increases, other things constant.

80.

A shift in supply is the graphical representation of the effect of anything other than price on supply, and these shift factors shift the entire supply curve. Shift factors of supply include the price of inputs, technological advances, changes in expectations, and taxes and subsidies. As the price of inputs increases, the supply curve shifts to the left. As technological advances are made that reduce the cost of production, the supply curve shifts to the right. If a supplier expects the price of her good to rise, she may decrease supply now to save and sell later. Other expectational effects are also possible. Taxes paid by suppliers shift the supply curve to the left. Subsidies given to producers shift the supply curve to the right.

81.

When adding two supply curves, sum horizontally the two individual supply curves, as in the accompanying diagram. S3 is the market supply curve.

82. a. The market demand and market supply curves are shown in the accompanying graph. uu. Equilibrium price is $40. Equilibrium quantity is 25. vv. At a price of $30, quantity demanded is 35 and quantity supplied is 15. Excess demand is 20. At a price of $60, quantity demanded is 5 and quantity supplied is 45. Excess supply is 40.

10

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83.

In the accompanying graph, the demand curve has shifted to the left, causing a decrease in the market price and the market quantity.

84.

The price of airline tickets rises during the summer months because demand for airline travel increases as more people take vacations. This change in consumer tastes causes a shift of the demand curve to the right.

The equilibrium price increases as does the equilibrium quantity as is shown in the accompanying graph.

85.

Sales volume increases (equilibrium quantity rises) when the government suspends the tax on sales by retailers because the price to demanders falls and hence equilibrium quantity demanded rises. This occurs because the supply curve shifts to the right because suppliers do not have to pay taxes on their sales (cost of production declines).

86.

Increased security measures imposed by government will increase the cost of providing air travel. This will 2

shift the supply curve to the left,

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increase equilibrium price to P1 and decrease equilibrium quantity to Q1 as shown in the accompanying graph. They also might reduce demand (the hassles of the increased security and the additional time it takes to travel), further decreasing equilibrium quantity and offsetting the rise in price, in this case to P2 .

Some students might argue that increased security will increase demand because consumers will feel more comfortable flying (they don't have to worry about terrorists as much). If demand increased, the price would go up even higher and the equilibrium quantity would also increase.

87.

Customers will flock to stores demanding that funky ―economics professor‖ look, creating excess demand (the demand curve shifts right). This excess demand will soon catch the attention of suppliers, and prices will be pushed upward.

Eventually a new equilibrium is reached at an increased price and quantity.

88.

As substitutes for bottled water—clean tap water—decrease, demand for bottled water increases enormously, and there will be upward pressure on prices. Social and political forces will, however, likely work in the opposite direction—against ―profiteering‖ from people‘s misery.

89.

Since the Organization of the Petroleum Exporting Countries (OPEC) is a dominant producer of oil, increasing oil production (not as a result of a price change) will shift the supply of oil out to the right. The price of oil will decline as shown in the accompanying graph.

90.

The results for each part are shown in the accompanying graphs. ww. The bad weather causes a decrease in supply. This is shown by a shift in supply from S0 to S1. Equilibrium price rises from P0 to P1, while equilibrium quantity falls from Q0 to Q1.

2

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xx. The medical report causes a decrease in demand. This is shown by a shift in demand from D0 to D1.

Equilibrium price falls from P0 to P1 and equilibrium quantity falls from Q0 to Q1.

yy. The innovation causes an increase in supply. This is shown as a shift in supply from S0 to S1. Equilibrium price falls from P0 to P1, while equilibrium quantity rises from Q0 to Q1.

zz. The drop in income causes a decrease in demand.

This is shown by a shift in demand from D0 to D1.

Equilibrium price falls from P0 to P1 and equilibrium quantity falls from Q0 to Q1.

91. a. I would expect wheat prices to decline since the supply of wheat is greater than expected. Wheat commodity markets are very competitive, so the initial 30 percent increase in output was already reflected in the current price of wheat. It is only the additional 10 percent increase that will push down the price of wheat. aaa. This is graphically represented by a shift to the right in the supply of wheat, as shown in the accompanying graph. Equilibrium price falls from P0 to P1, while equilibrium quantity rises from Q0 to Q1.

1

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92. a. The cars in Italy are most likely much smaller than those in the United States.

Italians would be likely to want to conserve gasoline and thus demand smaller cars that use less gasoline. bbb. As in (a), Italians will want to conserve gasoline more and thus use public transportation more than Americans use it. ccc. As in (a) and (b), Italians will be more concerned with fuel efficiency in their desire to conserve gasoline since it is relatively more expensive there. ddd. Raising the price of gasoline in the United States to $5 per gallon will decrease the size of cars driven in the U.S., increase the use of public transportation in the U.S., and increase the fuel efficiency of cars purchased in the U.S.

93. a. The tax shifts the supply curve to the left in the market for natural gas exports because it increases the cost of supplying the natural gas to other countries. Therefore, in the market for natural gas exports, equilibrium price rises while equilibrium quantity falls. eee. As it becomes more expensive to sell natural gas to other countries, more natural gas produced in Argentina will be sold in Argentina, causing the domestic price to fall.

94.

It suggests that the price is above the equilibrium price so that the quantity supplied exceeds the quantity demanded, as you can see in the accompanying graph. Including social and political forces in the analysis will provide a counter– pressure to the dynamic forces of supply and demand. The result would be an equilibrium with continual excess supply or excess demand. In this example, there must be a social or political force exerting upward pressure on the price, causing an excess supply of taxis at the airport.

1

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95.

The fallacy of composition is the false assumption that what is true for a part will also be true for the whole. It affects the supply/demand model by drawing our attention to the possibility that supply and demand are interdependent. Feedback effects must be taken into account to make the analysis complete. An understanding of the fallacy of composition is of central relevance to macroeconomics. In the aggregate, whenever firms produce (whenever they supply), they create income (demand for their goods).

96.

The greatest feedback effects are likely to occur in the markets that are the largest.

This is most likely to be true for housing and manufactured-goods markets.

97. a. Because the market for pencils is relatively small, supply/demand analysis would be appropriate without modification. Also, there are no significant political or social forces that would affect the analysis. fff. Because the labor market is very large, supply/demand analysis would not be appropriate without modification. For example, an increase in labor supply will likely lead to greater income and greater demand for goods, which will lead to an increase in quantity of goods produced and therefore an increase in the demand for labor. In this case there are significant feedback effects. ggg. Aggregate markets such as savings and expenditures include feedback (ripple) effects, so supply/demand analysis would not be appropriate without modification. hhh. The tire market is relatively small. Supply/demand analysis would be appropriate without modification.

Questions from Alternative Perspectives 98.

Austrian It is difficult to estimate supply and demand curves without a market. Consumers have an incentive to overstate demand, while suppliers have an incentive to overstate costs. Without the need to pay in a market, it is almost impossible to get individuals to reveal their true preferences. Central planners tried many incentive schemes to get around this problem and never completely succeeded. One thing that did abate this problem was to allow gray markets—semi-legal markets where individuals‘ true supply and demand were revealed. Overall, the socialist experience suggests that central planning for a large country cannot adequately reveal consumers‘ preferences.

99.

Religious 1

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iii. There is some truth to this saying; if people were only selfish, they would lose much that makes them human. jjj. Yes, there is a conflict, although how strong the conflict is a matter of debate.

There are different types of Christianity; some are more in conflict than others.

Where capitalism and Christianity most agree are in their views of human freedom; both see it as central to their ideology. kkk. No probably not, although, again, the answer is debatable. Markets would not work well if people were purely selfless. In many ways if there were more than enough to go around the society would simply not need markets. The market provides efficient ways of allocating scarce resources when individuals are selfish or somewhat selfish.

100. Feminist lll. Women and men have not always been equally free to choose the amount of education they receive. Established in 1833, Oberlin College was the first coeducational college. Over time, women have gained much better access to education, and better access has led to better educational attainment. By the 1880s, 30 percent of all undergraduates in the United States were women. Today, women receive 58 percent of all undergraduate degrees. mmm.

Women did not have the right to vote until 1920. Women today continue to face difficulties in reaching the higher levels of administration in commercial enterprises and studies have shown that they receive less compensation than men who are in similar positions. nnn. To the extent that women are not free to choose, they are not represented in the analysis of supply and demand. The questions that economists consider, and therefore the models economists use, are likely to have been affected by the fact that women have less representation in the field of economics. Thus, if economists base their conclusions on the models alone, they cannot be objective.

101.

Institutionalist You will want to examine the determinants of supply and demand, and the conditions under which they may or may not hold. There is also the problem of interdependency. Discussion of each should include problems of measurement since, ultimately, science requires any and all propositions to be tested. Many of the ideas from which economic analysis is derived are beyond direct systematic measurement. Thus, economic analysis is, in many respects, a belief system: we act as if it were true because we believe it to be true.

102.

Post-Keynesian 2

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ooo. Consumers follow rules of thumb for a variety of reasons, one being to save time. Given that much of our consumption is repetitive (that is, buying the same brand of soda, soap, toothpaste, and so on at the same grocery store), researchers have found that much of our consumption is based on routine habits that give us satisfactory outcomes that may or may not be optimal. ppp. Our decisions to buy goods are usually based on past behavior—habits that have been incorporated in our consumer behavior. This behavior could have come from family, friends or advertisements and may affect our consumption more than the desire to optimize. This analysis allows room for advertisements and social norms—in addition to prices— to influence our consumption rather than price.

This means that economists‘ claims that the market efficiently meets consumer‘s desires is questionable since the market may be creating superficial desires rather than ―true‖ desires. It is, however, extraordinarily difficult to determine what is superficial and what is true.

103.

Radical The hiring decisions of multinational corporations don‘t appear to be very responsive to wages and working conditions, suggesting that few jobs are likely to be lost to better paying wages. In addition, labor demand is not fixed by public policy changes and can be augmented by public spending and tax policies.

Issues to Ponder 104.

It suggests that the job is being rationed, which means that the wage is above the equilibrium wage.

105.

a.

It increased the demand for housing and increased housing prices. The demand curve shifts out, while the supply curve remains constant.

qqq. It decreased the demand for housing and decreased housing prices. The demand curve shifts in while the supply curve remains constant. rrr. The price would increase more in San Francisco.

106.

a.

It would likely raise the value significantly – it was estimated that it would raise it to $50,000 a sheet. Demand shifts to the right as people realize the oddity of the stamp. Supply shifts to the left because of the recall.

sss. It would probably lower the value of the stamps – it was estimated that it would lower the price of the sheet to $100 a sheet. Graphically this would be shown with the supply curve shifting back to the left, resulting in a lower price. The demand curve could remain high, though it might shift back to the left. ttt. They would likely sue to stop the additional sheets from being issued; they did and they lost.

3

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107.

a.

The number of punitive awards would decline because the incentive for plaintiffs to pursue a case declines. The demand curve shifts down by the amount of the tax, lowering the equilibrium price of punitive awards.

uuu. The number of pre-trial settlements would rise because the plaintiff would be willing to accept a lower settlement that is not taxed and the defendant would get to pay a lower punitive award. The tax leads to an increase in the supply of settlements, without affecting the demand for settlements (because the tax is paid by the plaintiff), which accounts for the increase in the quantity of settlements.

108.

A supply/demand analysis that includes only economic forces will likely be incomplete because social and political forces will also impact equilibrium price and quantity. One example is that the prediction that a disaster that leads to loss of electricity will lead to higher prices for flashlights might be wrong if there are laws that prohibit such price gouging during emergencies. Social and political forces must be added to the supply/demand model.

CHAPTER 5: USING SUPPLY AND DEMAND Questions and Exercises 109.

If the equilibrium price and quantity both rose, the simplest cause would be a shift of the demand curve to the right.

110.

If price fell and quantity remained constant, a possible cause would be a shift out to the right of the supply curve and a shift of the demand curve in to the left.

Another possibility would be a shift of the demand curve in to the left with a vertical supply curve. Note that when both curves shift, the effect on either price or quantity depends on the relative size of the shifts.

111.

Computer pricing of roads could end bottlenecks and rush hour congestion by price rationing. Currently at zero price, at certain times, the quantity demanded greatly exceeds the quantity supplied, resulting in congestion. Raising prices, during those times, could eliminate excess demand and reduce the congestion.

This technological change will spread out congestion over wider geographic areas and over the day, as individuals with more flexibility with respect to route and timing, will choose to demand less of the current high demand route at rush hour.

112. a. This would represent a shift in demand to the left assuming the decline in Cookie Monster‘s popularity represents a decline in the popularity of cookies. The 4

price and quantity of cookies would likely fall as shown in the accompanying graph.

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vvv. This is represented by a shift in demand for bread (high in carbohydrates) to the left. Equilibrium price and quantity falls as the graph shows. (Note: this is the same graph as for part a.)

Remember a shift factor of demand is anything other than its price that affects demand. It shifts the entire demand curve. A change in price causes a movement along the demand curve.

113.

a. Both the shift in demand to the right and the shift of supply to the left lead to a higher equilibrium price of oil. The effect on equilibrium quantity is indeterminate. While the shift in demand to the right would lead to a rise in equilibrium quantity, the shift in supply to the left would reduce it. Whether equilibrium quantity rises or falls depends on the relative size of the shifts. The accompanying graph shows a slight decline in equilibrium quantity and a significant increase in equilibrium price.

With an increase in production (supply shifts to the right), equilibrium price will decline and equilibrium quantity will rise as shown in the graph below. Because demand has increased in the meantime, the equilibrium price and quantity will be higher than before the original supply disruption.

2

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114.

a. This represents a shift of the supply curve to the left because the offended decide not to supply organs, increasing the legal price significantly and perhaps reducing the equilibrium quantity to a quantity that is below the amount currently provided at zero cost. This is shown in graph (a) below.

This represents a shift of the supply curve to the right. How responsive quantity supplied is to price affects the slope of the supply curve. If quantity supplied is very responsive to price, the equilibrium price might be quite low and legalizing organ sales would have significant benefits to society. In fact, the authors of the study estimate the equilibrium price of kidneys to be less than $1000. In graph (b) below, S1 is much more responsive to price than S0 .

(b)

(a)

Remember a shift factor of supply is anything other than its price that affects supply. It shifts the entire supply curve. A change in price causes a movement along the supply curve.

115.

The drought in the Midwest causes a decrease in supply, which shifts the supply curve for beef to the left. Equilibrium price rises from $3 to $4 a 2

pound and quantity falls as the accompanying graph shows.

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116.

See the accompanying graph. A price ceiling of PC below equilibrium price will cause a shortage shown by the difference between Q D and QS

117.

As you can see in the accompanying graph, the rent controls create a situation in which demanders are willing to pay much more than the controlled price and much more than the equilibrium price. These payments are sometimes known as key money. In this graph, landlords are willing to supply Qs at the current controlled rent,

PC . Consumers are willing to pay up to PB for the quantity QS . Key money can be an amount up to the difference between PB and PC .

118.

See the accompanying graph. A price floor of PF above equilibrium price will cause a surplus shown by the difference between QS and Q D .

4

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119.

A minimum wage is a price floor as in question 10. A Pmin , above the equilibrium wage will result in the quantity of laborers looking for work to increase to QS and the quantity of employers looking to hire to decrease to Q D . The difference between the two is a measure of the number of unemployed.

120.

a.

A $4 per unit tax on suppliers shifts the supply curve up by $4 shown as a shift in the supply curve from S0 to S1 . Equilibrium price will rise by $4 only if the demand curve is perfectly vertical. In the case of a vertical demand curve, quantity would not change. Otherwise, equilibrium price rises by less than $4 and equilibrium quantity falls as shown in the accompanying graph. In this example, the price increases by less than $4 to P1 and quantity declines to Q1 . The price that suppliers receive falls to P2 .

A $4 per unit tax on consumers shifts the demand curve down by $4 shown as a shift down in the demand curve from D 0 to D1 . Equilibrium price will fall by $4 only if the supply curve is perfectly vertical. In the case of a vertical supply curve, quantity would not change. Otherwise, equilibrium price will fall by less than $4 to P1 and equilibrium quantity falls to Q1 as shown in the accompanying graph.

The price paid by consumers, including the tax, is P2 .

3

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www.

The unit tax on the consumers and suppliers has the same effect on both equilibrium quantity and price. It doesn't matter who pays the tax. Because consumers demand less at every price, substituting other goods whose prices have not risen, the demand curve shifts up by the amount of the tax. The price of the good that suppliers receive rises until quantity supplied equals quantity demanded.

121.

a. The quantity supplied and demanded equal each other when the price is $1.00.

The equilibrium price is $1.00 and the equilibrium quantity is 150 units.

The tax shifts the supply curve up by $0.75 from S0 to S1 . Equilibrium price (the price consumers pay) is $1.50 and equilibrium quantity is 125. Suppliers receive the equilibrium price less the tax, or $0.75.

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xxx. The tax shifts the demand curve down by $0.75 from D 0 to D1 . The equilibrium price (the price suppliers receive) is $0.75 and equilibrium quantity is 125. Consumers pay ($0.75 + $0.75), or $1.50.

yyy. It doesn't matter upon whom the tax is levied. The result is the same. We can see this by considering what happens to demand when customers pay the tax.

Because consumers demand less at every price, substituting other goods whose prices have not risen, the demand curve shifts down by the amount of the tax. The price of the good that suppliers receive falls until quantity supplied equals quantity demanded.

122.

A quota places a quantity restriction on imports. Consumers are willing to pay a higher price for the lower quantity  Q Q  than the equilibrium price without a quota. Therefore, quotas lead to higher import prices as shown in the accompanying graph.

123.

a. As you can see in the graph below, consumers are willing to pay up to $50 for 100 fishing licenses, but pay only $20.

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At $20 per license, demand is 400 and supply 100. There is excess demand of 300. zzz. The maximum a person is willing to pay is $50. aaaa. If Pawnee keeps the number of licenses, it must charge $50. If it eliminates the quantity restriction, it will charge $30 and sell 300.

124.

Public postsecondary education is an example of a third-party payer market because it is heavily subsidized by state government and in most cases, a student‘s parents. Those consuming the good, students, do not pay the entire cost of the education they receive. This likely leads to greater expenditures on postsecondary education than if students had to pay the entire cost of their education.

125.

a. Equilibrium price is $6 and equilibrium quantity is 500.

In third-party-payer markets, the person who demands the good differs from the person paying for the good. Here, with a co-payment of $4 quantity demanded will be 700 units. Sellers require payment of $8 per unit to supply that quantity. bbbb.Total spending in part a is $3, 000  $6  500  . Total spending in part b is

$5, 600  $8  700  .

Questions from Alternative Perspectives 1.

Austrian

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I might decide to hire my friends, or to hire those with whom I like to work—such as those from a preferred ethnic group or gender. Is doing so fair? Fairness is a judgment question and judgments differ. From most people‘s perspective, such methods are not fair. The problem is that wage controls set an equal base wage level but leave open possibilities for other inequalities. Rather than helping the least skilled end of the labor pool it prices them out of the market, increasing their unemployment, and promoting other forms of discrimination. Austrians believe that these market distortions are not good for society and prefer little or no government intervention.

2.

Feminist There are likely a number of reasons why women are paid less than men. Part of the pay gap may be explained by differences in work experience, education, onthe-job training, and work interruptions for women. Economists typically measure discrimination as a residual – that part of the pay gap that remains ―unexplained‖ after accounting for these factors. The second part of the question is a judgment question and judgments differ. A law that requires firms to pay equal wages to those with comparable skills may be difficult to implement. How would the skills be assessed? Others argue that assessment itself would add costs to a firm‘s production and increase product prices. However, if the reason for the pay gap is discrimination, the law can change values and make it more costly to discriminate. Since discrimination necessarily implies that hiring is on the basis of something other than productivity, reducing discrimination may promote efficiency. Feminists generally support such laws.

3.

Institutionalist a. We can see cultural evolution through history; the appendix to Chapter 3 can be used to trace the cultural evolution of the market system. Here it is important to stress that religious values and social relationships had to evolve to accommodate the needs of the new forms of economic organization that emerged. Markets change overnight and increasingly require rapid adaptation by individuals, which can cause shocks to social relationships. One might question the long-term (in)stability caused by market evolution. The outcomes of biological evolution are driven by natural selection: those organisms with traits giving them a competitive edge in the competition for limited energy propagate; others disappear. In this context, the only purpose is to successfully reproduce. Some economists believe that the purpose of cultural evolution is betterment of the human condition for all. b. In the U.S. market, evolution has elevated living standards for everyone relative to those of say 1775. We see access to fresh fruits and vegetables year-round; many diseases have been eliminated; life spans have increased greatly. Yet, we are social beings who are aware of our social position. One may be well fed, but 8

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one may still feel socially destitute because one‘s level of welfare is low relative to one‘s contemporaries. In this sense, market evolution has failed to contribute to betterment.

4.

Religious What is appropriate depends on one's normative judgments, and most normative systems see taking undue advantage of someone in a crisis as wrong. Early economists have examined a concept that they called the "just price," which is the price that should be charged in various situations. There are many interpretations of what the just price should be, but one is that it should be close to the normal market price that would be charged. During emergencies such as floods or hurricanes, most people believe that "price gouging" is inappropriate and there are social pressures and laws against it. That said, there is another view that points out that any restriction on price will prevent some people who really need water and are willing to pay for it, from getting it, since sellers cannot charge the price they are willing to pay. They have no incentive to provide the water to those most willing and able to pay for it.

5.

Radical a. Today‘s rent controls are designed to be less invasive than the ones described in the book, and thus they do not have the strong effects described there. They still have some effects, and the policy question is whether the income redistribution effects they have are sufficiently desirable to warrant the costs of the policies. b. This is a judgment question; economics can tell one about what the costs and benefits of a mechanism are; not about what is an appropriate mechanism. c. This again is a judgment question that requires an integration of normative issues into the analysis. Most mainstream economists would argue that it is better to deal with the underlying income distribution issues, rather than specific ones, and that one must consider the problems of government intervention. Radical economists would argue that, while mainstream economists talk about "underlying issues", they seldom do deal with those problems. If one is going to direct spending toward housing, mainstream economists would prefer using generalized housing vouchers than using administrative means of allocation apartments, since housing vouchers offer individuals more flexibility.

Issues to Ponder 126.

a.

The graph on the left shows the primary market for tickets, assuming that all tickets that will be available for the game are offered by lottery. We know that 9

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there is excess demand because at $130 a seat, 110,000 tickets are demanded and only 10,000 are supplied resulting in an excess demand of 100,000.

The graph on the right represents the scalped ticket market, assuming that only 5,000 of the 10,000 ticket holders and only 50,000 of the 100,000 of those who didn't get tickets are willing to break the law and enter the scalped ticket market.

Assume that sellers will not accept any prices under $2000 and that they will sell for the best price they can get over $200. Given this assumption, no tickets are for sale at $130. At $130 a ticket, there are no tickets available, so excess supply is 50,000. Assuming buyers and sellers do not distinguish among the quality of seats, the market-clearing price is $2,000 per ticket. cccc. If scalping becomes legalized, more people would be willing to sell their tickets because there is no risk of being arrested and fined. Assuming all ticket holders are willing to sell their tickets, the supply of tickets shifts to the right to 10,000, reducing the scalped ticket price of Final-Four tickets to $1,000 a ticket.

127.

a. A weakly enforced anti-scalping law would add an additional cost to those selling scalped tickets and push up the resale cost of tickets to include the expected cost of being caught, which would be fairly small given weak enforcement. In the accompanying graph, this shifts the supply curve from S0 to S1 , raising the equilibrium price slightly from P0 to P1 .

(Note: This assumes that only selling, not buying, is illegal and that public (consumer) attitudes toward scalping are independent of its legal status.)

A strongly enforced anti-scalping law (against suppliers) would push up prices far more as the cost of supply rose and the supply curve shifted to the left. If enforcement were sufficiently strong, a two-tier price system would emerge with a low legal price at P0 and another very high price, P2 .

128.

a. Boards often exist not only to benefit the consumer, but also to benefit existing producers. Often those who are currently certified attempt to limit the number of new certifications so as to limit the supply and raise prices.

Possible changes include eliminating the board of certification, limiting its regulation to only those skills that it addresses directly, or requiring continual recertification so that skills of those already certified reflect the current demand for skills in that market. dddd.A political difficulty with implementing these changes is that a relatively small group of those currently certified will be hurt and will lobby hard for the status quo. Those currently certified may have more ―clout‖ with the board if the board 10

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is comprised of certified hairdressers. The benefits of the changes are also large, but they are spread out over large groups of consumers, with each consumer benefiting very little. Therefore, it will be easier for the small group, whose benefit per individual is large, to organize.

129.

a. The Oregon Health Plan includes a prioritized list of medical services that determine whether a service is covered. The list is based on comparative benefit to those covered as determined by the Health Care Board. Those services that this Board believed had the highest net benefit were ranked highest. Those they believed had a lower net benefit were not covered. The Health Care Board was made up of health professionals whose goal was hoped to be the ―greatest good for the greatest number.‖

Economists should not oppose the Oregon Plan because it involves rationing. The market involves rationing through the price mechanism. Economists might oppose the Oregon Plan because in general they support the market as the least-cost method of providing goods and services to those who actually need it, and because they believe the board‘s rationing is less fair than market rationing.

Economists are open to the argument that the market may not distribute goods and services in the way that society wants, which may require government intervention. eeee. In the market, the interaction of demand and supply determines the equilibrium price and quantity that is bought and sold. Those who are able to pay the equilibrium price are the ones who receive the specified types of health care. The Oregon Plan uses its benefit-ranking system determined by their Board of Professionals, rather than price as the rationing mechanism.

130.

a. Frequent-flyer programs allow companies to lower their effective prices without lowering their reported prices. Companies also use them to get business travelers to choose their airline. Such programs are an example of a third-party-payer system: The business traveler gets the benefit (frequent-flyer miles), while their business pays for the current flight.

Other examples include points that hotels give to travelers, loyalty cards, and bonus checks based on charges that Discover gives those who use its credit card. ffff. Firms likely do not monitor these programs because it would be too costly to do so, and because the benefits of the program are not taxed, which makes them a type of tax-free income for their employees.

131.

a. An import quota will increase the price of imported sugar. The accompanying graph shows how a higher imported sugar price 12

increases the price that domestic producers can charge and

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increases the quantity they can supply to the market. For example, at world price P0 , domestic consumers demand the quantity E−B from importers and quantity B from domestic producers. After a quota represented by quantity D minus C is imposed, the import price is P1 . Domestic consumers demand the quantity D−C from importers and quantity C from domestic producers.

The government could have imposed a tariff on imported sugar. This would also have raised the price of imported sugar. gggg.A minimum required import level of 1.25 million will limit the ability of the United States to support domestic sugar prices. The increase in quantity supplied will put downward pressure on sugar prices.

132.

a. As shown in the accompanying graph, the controlled price  PC  is below equilibrium. At this price the quantity of apartments demanded  Q D  exceeds the quantity of apartments supplied  QS  .

Since there are more apartments demanded than supplied at this price, apartments are hard to find.

Since at the existing quantity supplied, QS , demanders would be willing to pay Pb , there is a strong incentive to make side payments to existing tenants to acquire the apartment. At Pb , more tenants are willing to supply their apartments than at Pc , so a side payment can induce a tenant to give up their apartments. This is one form of rationing. hhhh.Eliminating rent controls would most likely allow the market price of apartments to increase and eliminate side payments. The quantity supplied will rise until it equals the quantity demanded at the market price. The price, quantity combination is  Pe , Q e  in the graph. However, if there are few additional apartments available to be rented (the supply curve is almost vertical), then price will increase dramatically, and quantity supplied will only rise slightly.

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iiii. The political appeal of rent control is that it benefits those who currently rent apartments. Apartment renters who live in rent-controlled apartments are more likely to vote, and this is why it is maintained. There are other possible reasons as well.

133.

a. The government subsidy of mohair provided an enormous incentive for those who were allowed to sell mohair to sell large quantities at lower price than otherwise. The elimination of this subsidy shifted the supply curve to the left (shown below as a shift from Ssubsidy to Sno subsidy , increasing the market price for mohair from P0 to P1 and decreasing the quantity demanded and supplied from

Q 0 to Q1 .

This program was likely kept in existence because not many people knew about it (mohair is a relatively small market), and ranchers had no incentive to broadcast the subsidy. jjjj. A law that requires that suppliers receive $3.60 more than the market price is the same as a tax, but the revenue goes to the supplier. The demand curve would shift to the left (down) to include this tax. The quantity demanded would fall dramatically. Consumers would not support this law because they would have to pay an enormously high price. Suppliers would support this law only if they were guaranteed that they could sell at that high price.

134.

Excess supply in U.S. agricultural markets is caused by the government‘s policy of agricultural price supports, or price floors on agricultural products. Political forces prevent the invisible hand from working.

135.

It would likely increase the number since it reduces the cost of having a car that you drive very little.

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136.

The demand for rolling machines went up enormously because loose tobacco became a cheaper substitute for the taxed cigarettes and rolling machines are a complement of loose tobacco; some companies more than quadrupled their sales of loose tobacco and rolling machines.

137.

a. Japan prescribed many more drugs than the U.S. because Japanese doctors had a financial incentive to do so.

It would lead to many more drugs being produced, even if they were not really innovative, as happened when Japan tried this. kkkk.Drug reps would likely provide free samples and other gifts to doctors and have lunches for them where they tout the advantages of their drugs.

138.

a. They would likely fall. In fact, they fell by 13 percent.

They also would likely fall. In fact, they fell by 22 percent. llll. The graphs below show the effect of increasing co-payments. The graph on the left has a co-payment of $15. Consumers demand Q1 and the shaded region shows the medical claim costs. In the accompanying graph on the right, consumers must pay the first $1,500 of medical costs, demonstrated by the lowershaded region. (For simplicity, we assume that consumers end up purchasing 50 units at a cost of $30 per unit.) As you can see, however, the medical cost to the firm (upper shaded area) is much smaller. In addition, the units of medical services demanded are lower, illustrating the answer to the second question – hospital admissions declined.

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APPENDIX: ALGEBRAIC REPRESENTATION OF SUPPLY, DEMAND, AND EQUILIBRIUM 139.

a. The tables are shown below:

Price (Dollars per gallon) 0 1 2 3 4 5 6

Quantity Demanded (Gallons per year)

Quantity supplied (Gallons per year

600 500 400 300 200 100 0

−150 0 150 300 450 600 750

See the accompanying graph. Equilibrium price is 3 and equilibrium quantity is 300. mmmm.

P = 3; Q = 300

140.

a. The following are the demand and supply tables after the hormone is introduced: Quantity Quantity Price Demanded Supplied (dollars per (gallons per (gallons gallon) year) per year) 16

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0.00 1.00 2.00 2.50 3.00 4.00 5.00 6.00

600 500 400 350 300 200 100 0

−25 125 275 350 425 575 725 875

The hormone (a technological advance) shifts the supply curve to the right by 125,000 gallons, The demand curve is unchanged.

17

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The original supply curve is S 0 . The growth hormone shifts the supply curve to S1 (to the right by 125). Equilibrium price falls to $2.50 a gallon, and equilibrium quantity rises to 350 million gallons (point B). nnnn.The demand curve remains the same at QD  600 100 P . The supply curve becomes QS  25  150 P . To solve the two equations, set them equal to one another: 600 − 100P = -25 + 150P and solve for P. Doing so, we get P = 2.5.

Substituting this value for P into either the demand or supply equation gives us equilibrium quantity of 350. oooo.Quantity supplied would be 425 (25  150  3) and quantity demanded would be 300 (600  100  3) . There would be excess supply of 125. The price floor is shown in the accompanying graph.

141.

a. The demand curve is QD  10  P ; the supply curve is QS  2 P  5 . To solve for equilibrium price and quantity, set the two equations equal and solve for P. Substitute P into either to find equilibrium quantity. The solution is P = $5, Q = 5.

The new demand curve is QD  13  P . To solve for equilibrium price and quantity, set the two equations equal and solve for P. Substitute P into either to find equilibrium quantity. The solution is P = $6, Q = 7.

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pppp.The new supply curve is QS  2 P  8 . To solve for equilibrium price and quantity, set the two equations equal and solve for P. Substitute P into either to find equilibrium quantity. The solution is P = $7, Q = 6.

142.

a. A demand curve follows the formula QD  a  bP , where a is the quantity-axis intercept and b is the slope of the curve. A shift in demand is reflected in a change in a. An increase in demand increases a and a decrease in demand reduces a.

A supply curve follows the formula, QS  a  bP , where a is the quantity – axis intercept and b is the slope of the curve. A shift in supply is reflected in a change in a. An increase in supply increases a and a decrease in supply decreases a. qqqq.A movement in supply or demand is reflected in the effect of a change in P on either QS or QD . The equations themselves do not change.

143.

a. P = 4; Q = 6

Since the government set price is above the equilibrium price, it is a price floor. Thus, it would create a surplus. Solving the equations, we see the surplus would be 2 million bushels.

144.

a. The new supply equation is QS  150  150( P  1) where P is the equilibrium price, or QS  300  150 P .

P = 3.60; Q = 240. rrrr. Farmers receive $2.60 per gallon, while demanders pay $3.60 per gallon.

145.

a. The new demand equation is QD  600  100  P  1 where P is the price suppliers receive, or QD  500  100 P .

P = 3.60; Q = 240. ssss. Farmers receive $2.60 per gallon. It doesn‘t matter who pays the tax, the market outcome is the same.

146.

a. The new supply equation is QS  150  150  P  1 where P is the equilibrium price, or QS 150 P .

2

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P = 2.40; Q = 360. tttt. Farmers receive $3.40 per gallon.

147.

Equilibrium price is $2.

a. P = $3.00 is above equilibrium price, so it is a price floor. There is a surplus of 8.

P = $1.50 is below equilibrium price, so it is a price ceiling. There is a shortage of 4. uuuu.P = $2.25 is above equilibrium price, so it is a price floor. There is a surplus of 2. vvvv.P = $2.50 is above equilibrium price, so it is a price floor. There is a surplus of 4.

CHAPTER 6: ECONOMIC GROWTH, BUSINESS CYCLES, AND UNEMPLOYMENT Questions and Exercises 148.

Classical economists felt that if the wage level fell, the Depression would end.

They saw labor unions as preventing the fall in wages, and they believed that the government lacked the political will to break up unions.

149.

Classical economics supported laissez-faire policies because they believed business cycles were temporary glitches which the market would correct.

150.

Keynesian economists are more likely to emphasize the fallacy of composition.

The fallacy of composition is the false assumption that what is true for a part will also be true for the whole. Keynes carefully distinguished the adjustment process for a single market from the adjustment process for the aggregate economy, arguing that the effects differ significantly between the two.

151.

Classical economics grew in importance in the 1970s because Keynesians didn't have a model for inflation, whereas Classicals did.

152.

Structural stagnation is neither a Keynesian nor a Classical theory. It includes elements of both. Structural stagnation occurs in the time period between the long run Classical analysis and the short run Keynesian analysis, so both analyses are needed to model it.

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153.

Potential output is the highest amount of output an economy can sustainably produce and sell using existing production processes and resources. Potential output is not purely a physical measure because unemployed workers do not contribute to potential output, factories may be technologically obsolete, and production must be sustainable to be equal to potential.

154.

Economic growth is measured by changes in total output and changes in output per person.

155.

Growth has slowed in recent years in both Western Europe and the United States.

156.

From 1940 to 1970 the U.S. economy grew at a rate of about 2.5 percent per year, which was lower than Western Europe and Japan but higher than many other countries. In the following decades, U.S. growth was higher than most except for India and China, which have experienced considerable growth. Since 2000 the U.S. economy has been slower than many countries, averaging about 2 percent per year in the first decades of the 2000s.

157.

A representative business cycle is shown in the accompanying graph. Each of the four phases—peak, downturn, trough, and upturn—is clearly labeled.

158.

Structural stagnation is a period of protracted slow growth and high unemployment. Because the expansion of the economy is slow with structural stagnation, the economy does not return to its long-term trend. In contrast, a recession is a short period of declining output followed by an expansionary period that returns the economy to its long-term trend.

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159.

The structural stagnation theory is more pessimistic because it argues that the economy must undergo structural changes before it will return to its long-term growth trend. An example is that with structural stagnation, workers will have to accept lower wages or learn new skills before the economy returns to its potential.

In the conventional business cycle view, the economic recession is short-lived as those who become unemployed will be rehired without having to accept lower wages or learn new skills.

160.

Structural unemployment is unemployment caused by the institutional structure of an economy or by economic restructuring making some skills obsolete, whereas cyclical unemployment is unemployment resulting from fluctuations in economic activity. A fall in structural unemployment requires structural changes; a fall in cyclical unemployment does not.

161.

Structural unemployment, which results from changes in the structure of the economy, is best studied in the long-run framework. Cyclical unemployment goes up and down with the business cycle.

162.

Cyclical unemployment, which results from fluctuations in economic activity, is best studied in the short-run framework. Cyclical unemployment goes up and down with the business cycle. Structural unemployment is caused by the institutional structure of an economy and economic restructuring, and therefore is best studied in the long-run framework.

163.

The unemployment rate is the total number of unemployed as a fraction of the labor force.

Unemployment rate = (Number of unemployed ∕ Labor Force) × 100.

Unemployment rate = (15 ∕ 189) × 100 = 7.9%

164.

Some economists argue that the standard unemployment rate underestimates unemployment because people who have gotten frustrated and stopped trying to find jobs are not counted as unemployed. Also, the standard unemployment rate doesn‘t include people who are underemployed such as people who are working part-time but would like to work full-time. Others point out that, because of unemployment insurance, people often say they are looking for work when they really aren't, and therefore unemployment is overstated. Furthermore, these economists believe that people could find a job if they really wanted to and instead turn down jobs they find unappealing. So, there are tendencies both to overestimate and underestimate the problem.

5

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The official measure of unemployment is based on judgments about who should be counted as unemployed. Keynesians argue that discouraged workers who would like jobs but have left the labor force should be included in the measure of unemployment because there is a lack of decent jobs and affordable transportation. Classicals believe that some of those counted as unemployed are choosing to be unemployed and should not be counted.

165.

You are much more likely to be able to calculate this problem quickly with the use of a calculator, but your grandparents didn't have calculators at their disposal, so they learned to do such calculations by hand. While your grandparents may have been employed in ―calculator‘ jobs, working to solve equations and functions by hand, any teenager today can quickly compute the answer on the calculator programmed into almost all of today‘s phones. The jobs your grandparents once held are now obsolete, performed more efficiently and productively by algorithms.

This example is indicative of a coming change that will likely impact a vast array of job sectors. Positions that once required human know-how will soon be replaced by algorithms and intelligent software. In the future, as the skills required to perform many mid-level professional jobs are instead done by computers and algorithms, more humans will be most needed to act as technicians, completing any work that may have been missed by the computer and monitoring the software. As learning-based software continues to improve, even the programmers that are needed to code algorithms may be replaced by automated systems that perform the job more efficiently. New jobs will be forthcoming, but they will likely be quite different jobs than we currently have.

166.

As the information revolution outpaces human intelligence and replaces most mid-level mental strength jobs with computer algorithms, the nature of the jobs will change. In the future, low- and mid-level, mundane technician jobs will likely be replaced with algorithms. High-level jobs for the super intelligent will exist— designing algorithms that design algorithms, and supplemental jobs cleaning up the issues that are not efficiently done by algorithms will also be available as well many service jobs that are not doable by robots. There will likely be jobs for all, but these jobs will likely require a different education than students currently have.

Questions from Alternative Perspectives 167.

Austrian Austrians believe that the government's attempts to deal with business cycles can often lead to the creation of government programs that cost a lot but have little 6

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benefit. Therefore, when government tries to solve problems, it often creates greater problems.

168.

Institutionalist Institutionalists believe that this proposition is very reasonable. A firms‘ focus on making money and financial issues can leave real issues secondary and can bring about waves of pessimism and optimism. Institutionalists believe that the insight that the production of goods is a normal, daily aspect of life in all societies since the beginning of time was fundamental to Mitchell‘s analysis. Production occurs because it is necessary to reproduce culture. Institutionalists believe that the money economy has perverted this timeless process by giving control to a group that allows culture to reproduce itself only if that group is able to profit from that activity. Thus, during the Great Depression, farmers destroyed their crops while people went hungry; workers were available, yet factories were empty. Business owners did not expect a profit and thus used their power to idle the economy, imperiling the reproduction of culture and threatening democracy itself.

169. Post-Keynesian wwww.

Since the Great Depression, the government has been more active in the economy and has used monetary and fiscal policy to stabilize the economy. PostKeynesians believe that these policies are responsible for the avoidance of severe depressions since that time. xxxx.These policies are definitely Keynesian. yyyy.Post-Keynesians believe that these policies are still relevant today, whereas Classical economists argue that such policies will cause much more serious consequences in the long term.

170. Radical zzzz. This is a judgment question, and judgments differ. Radical economists would agree with Vickrey that unemployment should be very low. aaaaa.

Radical economists believe that unemployment tends to hurt the people who are the weakest and poorest in society and who need the most help. If such policies generate inflation, institutions should be changed to eliminate the inflation through means other than unemployment. bbbbb.

Vickrey supported a plan put forward by Abba Lerner and the author of this textbook. It was called a market anti-inflation plan in which a firm could raise its prices only if it bought the right to do so from another firm that lowered its price by an offsetting amount.

171.

Austrian, Institutionalist, Post-Keynesian, Radical, Feminist, Religious 7

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In natural science, there are controlled experiments which allow one to say when a theory has failed and when it has not. In macroeconomics, controlled experiments are much more difficult to conduct, which means that alternative explanations can be given for why the existing theory failed. For example, it can be argued that the theory was correct, but the execution of the policy was flawed.

When such alternative explanations are possible, it is much more difficult to overthrow a theory.

Issues to Ponder 172.

Deciding what is the purpose of life and therefore what constitutes a desired lifestyle is a complicated issue. To the extent that work provides a sense of selfworth and identity, complete idleness is not desirable. This, however, is a normative question. Unemployment within our culture and set of institutions is a measure of aggregate well-being to the extent that employment provides a sense of well-being and sufficient income to support a desired lifestyle. This example shows that unemployment must be understood within this broader framework; its meaning is specific to a set of institutions and a culture. All else equal, however, reducing the amount of work it takes to produce a given amount of output can generally be seen as a positive change.

173.

Reducing unemployment to 1.2 percent today is not likely for several reasons.

One is that a low inflation rate seems to be incompatible with low unemployment.

Another is that today‘s economy differs from that of the World War II period, when there was an enormous ideological commitment to the war effort and acceptance of strong wage and price controls.

174.

a.

Possible explanations include Japanese cultural emphases on tradition, honor, and loyalty. In Japan, firms are less willing to lay off workers in times of excess supply and workers are less likely to change employers in search of higher compensation. Another explanation is the nature of Japanese production. One could suggest that Japanese production does not rely on a changing base of skills so that the skills of workers always match the skills demanded by a particular firm.

ccccc.

It is impossible to say which is better. Each needs to be judged within the broader context of the national economy. ddddd.

The answer to this question depends on the distribution of layoffs and hires in each of the economies. If layoffs in Japan were unavoidable and occurred among mid- to low-ranking employees, the average tenure of Japanese employees would rise since those who remain have relatively higher tenure. If instead the elderly were asked to retire earlier, the average tenure would decline. In the 8 © MCGRAW HILL LLC. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW HILL LLC.

United States firms would have to lay off fewer workers than usual as a result of the booming economy, and average tenure would rise. In the United States, the newly hired in an expansion would lower overall tenure.

175.

Normal business cycles are demand induced—they occur because demand fluctuates. A COVID-induced recession has both demand and supply elements, which makes it harder to deal with, and can be significantly more inflationary.

CHAPTER 7: MEASURING AND DESCRIBING THE AGGREGATE ECONOMY Questions and Exercises 176.

A stock concept is the amount of something at a given point in time. A flow concept is an amount over a specific time period. For example, a stock concept is the amount of water in a reservoir; a flow concept is the amount of water that flows over Niagara Falls every hour. (Note: the question does not require an example.)

177.

Consumption spending is the largest expenditure category of production for most countries.

178.

Wealth accounts are a balance sheet of an economy‘s stock of assets and liabilities while national income accounts show the flow of income and expenditures in a country. Wealth accounts reflect stock measures and national accounts reflect flow measures.

179.

a.

If more same-sex couples decide to live together because they are allowed to marry, then GDP would fall as non-market transactions increase. In the shortrun, however, GDP would rise due to marriage-related expenditures.

eeeee.

GDP would not change. There is a transfer of assets, not the creation of new market output. Hence GDP does not change.

GDP would rise by the broker‘s commission. While the transfer of assets does not affect GDP, that transfer can be assumed to increase both the seller‘s and buyer‘s welfare since both did it voluntarily. The commission paid by an individual to a broker for services associated with the sale of a house facilitated that increase in welfare and is considered as a market output, increasing GDP.

fffff.

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GDP would not change. There is a transfer of income from taxpayers to recipients. GDP attempts to measure increases in market output.

ggggg.

hhhhh.

GDP would not change. The increase or decrease in the value of the stock market is a change in the value of an asset, but because there is no market output that has increased, GDP has not changed. iiiii. GDP does not change when the person gets the job. GDP rises only when the

person begins to produce a good or provides a service that is sold in the market.

180.

If you add up all transactions in an economy, you will include intermediate goods—so the amount will far exceed both GDP and GNP, which are measures of final output of an economy. You will not arrive at either GDP or GNP.

181.

The aggregate value added at each stage of production is, by definition, precisely equal to the value of final sales and income. Thus, the value-added tax rate should also be 15 percent. (Technical note: This is assuming the value-added tax is income-based rather than consumption-based.)

182.

a.

GDP is the sum of the value added by the three firms $250 + $1,750 + $950 = $2,950.

jjjjj. A 10 percent value-added tax would generate 0.10 × $2,950 = $295 of revenue. kkkkk.

A 10 percent income tax would generate the same $295 of revenue because total income and total value added are the same by definition. lllll. A 10 percent sales tax would generate the same $295 of revenue because final output, total income, and total value added are the same by definition.

183.

Transfer payments are not included in aggregate output so nothing would happen to it.

184.

NDP is preferable to GDP as the expression of a country‘s domestic output because NDP takes depreciation, a relevant cost of producing goods, into account.

However, measuring true depreciation is difficult because asset values fluctuate, and so GDP rather than NDP is generally used in discussions of economic activity.

185.

It depends on whether net foreign factor income is positive or negative. GDP measures output produced in a country, regardless of whether or not it was produced by a citizen or American company. GNP measures output produced by 10

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a citizen or company or a country regardless of where it was produced. If American companies and citizens produce more output outside the United States than non-American companies and non-American citizens produce in the United States, then GNP will be greater than GDP. If not, it will be the opposite.

Remember, GNP = GDP + Net foreign factor income.

186.

GDP = C + I + G + (X − M) = $597 + $162 + $173 + $6 = $938 GNP = GDP + Net foreign factor income = $938 + $3 = $941 NDP = GDP − Depreciation = $938 − $49 = $889

187.

Employee compensation is the largest component of national income for most countries.

188.

a.

The expenditure approach: Aggregate output (GDP) = C + I + G + (X − M) = $700 + $500 + $300 + $269 = $1,769 Aggregate income = Employee compensation + rent + interest + profit: $1,329 + $25 + $150 + $268 = $1,772

mmmmm. Aggregate income is greater than aggregate output. There are a number of complicated accounting decisions involved in the calculations (such as, but not limited to, net foreign factor income) and this makes them close, but not perfectly equal. nnnnn.

GNP = GDP + NFFI = $1,769 + $3 = $1,772

If you are wondering why, in this example, GNP does not equal national income, good for you! You‘re really thinking critically. There are a number of differences between GNP and national income. One is depreciation. National income doesn‘t include depreciation. The figures to compare would be net national product and net national income. But even these figures aren‘t equal because of a host of other differences too complicated to get into in an intro course. ooooo.

189.

NDP = GDP − depreciation = $1,769 − $25 = $1,744

a.

GDP = C + I + G + (X − M) = $397 + $80 + $43 + ($55 − $63) = $512 GNP = GDP + Net foreign factor income = $512 + $3 = $515

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Aggregate income = Employee compensation + Rent + Profit + Interest = $356 + $14 + $96 + $49 = $515 ppppp.

Depreciation = Investment − Net investment = $80 − $72 = 8

qqqqq.

NDP = GDP − Depreciation = $512 − $8 = $504

15.

Profit is the income category that keeps output and income the same. Aggregate output and aggregate income are essentially the same because aggregate output must create an equal amount of aggregate income. The income is either paid to factors of production or is profit.

16.

In an economy that has a trade surplus, domestic production is higher than domestic expenditures because some of the domestic production is for foreign expenditures.

17.

It is difficult to compare GDP over time because prices change. That is, because GDP is measured in prices, a rise in GDP could reflect either a rise in prices or a rise in the amount of goods and services produced. Economists collect data on prices and adjust GDP for those price level increases to calculate real GDP. A rise in real GDP keeps prices constant and therefore reflects an increase in the amount of goods and services produced.

18. a. Real GDP = (Nominal GDP ∕ GDP Deflator) × 100 For Year 1: ($18,000 ∕ 100) × 100 = $18,000 billion.

For Year 2: ($18,540 ∕ 103) × 100 = $18,000 billion.

For Year 3: ($19,467 ∕ 104) × 100 = $18,718 billion.

For Year 4: ($20,246 ∕ 106) × 100 = $19,100 billion. rrrrr. Since inflation was positive in every year, nominal GDP growth exceeded real GDP growth in each of the last three years. You do not have to calculate the growth rate to answer this question, simply recognize that inflation was positive in every year. sssss. It is impossible to say in which year society's welfare increased the most. GDP measures market activity, not welfare.

19.

Real Interest Rate Nominal Interest Rate 6 7 9 14

Inflation 1 5

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15

19

4

Inflation = Nominal interest rate − Real interest rate Nominal interest rate = Real interest rate + Inflation Real interest rate = Nominal interest rate − Inflation 20.

One must be careful when comparing real GDP per capita between countries.

Two reasons are: (1) GDP includes only market activities, and it is likely that many people in Burundi grow their own food and barter—activities that would not be included in measured output. (2) GDP measures activities at the market price and relative prices in Burundi are likely to be lower compared to prices in the United States. Both issues suggest that $800 is an underestimate of output in Burundi.

21. a. To the extent that a larger labor force contributed to higher market production, measured GDP also rose. ttttt. The effect on welfare is uncertain. To the extent that the value of the nonmarket activities women were engaged in before entering the workforce is of equal or greater than the value of the market activities they took on when entering the labor force, welfare may have changed. To the extent the nonmarket activities are less valued, welfare rose. There are other considerations related to women entering the labor force, including greater financial independence, the move toward more equitable decision-making, and greater respect for women as members of society, all of which likely increased welfare.

22. a. Like all measures that focus on different aspects of what is being measured, including GDP, the Genuine Progress Indicator (GPI) is a subjective measure of the economy. What is included in the indicator is a matter of judgment. For example, the GPI adjusts for income distribution with greater inequality lowering the GPI. Someone who believes that income distribution is not a concern would not include it in the measure. uuuuu.

GDP is a subjective measure of economic activity for a variety of reasons. One is that it does not include non-market activities such as unpaid household production, barter exchanges such as when a person exchanges clothing for food, and sales of illegal drugs. All of these activities are a type of production but not included in GDP.

Questions from Alternative Perspectives 23.

Feminist 13

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vvvvv.

While one reason may be that there is no direct measure of non-market activity and therefore must be imputed indirectly, feminist economists believe that the reason is an underlying bias against women that devalues the work that women do – paid and unpaid. It is not impossible to include the value of nonmarket activities in GDP and is done in the case of the services provided by owner-occupied housing. wwwww.

Feminists believe that treating the unpaid work that women do within the home as ―leisure‖ in our national income accounting framework not only devalues women but also works against them when they retire if benefits, such as Social Security, are calculated in part on income earned in a lifetime. xxxxx.

One would have to measure the market value (price) of the services provided by a housespouse.

24.

Religious yyyyy.

Measures of issues that relate to individual welfare, such as amount of crime, amount of pollution, or the stability of family relationships might be included. Some people might include church attendance; others may not. zzzzz.

This is a judgment question; judgments differ. Government expenditures on defense might not be included if the religious ethic is against war.

Conspicuous consumption might also be excluded.

25.

Institutionalist GDP is an institution in the sense that it is a social norm that was created in a specific cultural setting. In other words, what is included and excluded from GDP is based on inherent values that economists at the time had, values that were in turn based on the society the economists lived in. aaaaaa.

An Institutionalist will say GDP accounting shapes thought processes and social values by legitimating some economic contributions (e.g. Tazers, a type of gun) and de-legitimating others (e.g. homemaking). Because one activity is valued by society, we socially ascribe numerical values towards those engaging in the activity and give them social status. The opposite happens for non-valued activities. Furthermore, just because expenditures are rising does not mean social welfare has increased. Many expenditures arise in attempts to reduce undesirable market outcomes. This means scarce resources are used to ameliorate the harmful effects of things that free markets allow to happen. Institutionalists believe that a rising GDP can give the impression that things are getting better even when they are getting worse! bbbbbb.

Individuals who are relatively more concerned with material goods and services benefit since the policy is designed to keep them increasing. Individuals who are relatively more concerned with more spiritual, cultural and moral 14

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philosophical goals are hurt because these goals are given far less focus in the accounting system used. In the 1500s before modern accounting was developed, spiritual goals were given much more focus.

26.

Austrian Austrians believe that government spending is for the most part unproductive and therefore should not be included in GDP. Currently it is included as output valued at cost, and they see it as often worth far less than cost. Also, much of government spending should be included as an intermediate good, not a final good, and it might even be considered to have zero value since there is no market test for its value. Austrians tend to believe that the political processes waste resources since they are not subject to competition and market incentives. At a minimum they would measure the value of government investment as much less than private investment. They would definitely not see it being valued at cost.

27.

Austrian cccccc.

Austrians believe that the collection of statistics can be a private good, not a public good, and can be most efficiently provided by private firms. dddddd.

Austrians believe that government bureaucrats whose job depends on having the data collected are often the largest supporters, as are individuals who want to expand the role of government, since the data are often used to provide justification of government action, even when the quality of the data is often poor.

28.

Radical eeeeee.

This is a judgment question; judgments differ. Most Radical economists believe that the Genuine Progress Indicator would provide a better indicator. ffffff.Radical economists support the Genuine Progress Indicator because it is more inclusive of dimensions that they believe are important for a good society and happy individuals.

Issues to Ponder 29.

You can find consumption as a percent of GDP on the World Bank website.

People share basic needs such as food, clothing and shelter, which suggests lowerincome countries would spend a higher portion of their income on consumption.

The share of income devoted to consumption also depends on cultural value placed on consumption of what could be considered non-essential goods, which may explain other variations among countries.

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30. a. Answers may differ. Five goods we buy frequently are newspapers, soda, gas, shirts, and chicken. gggggg.

The answers you give will depend on goods chosen. The average annual increase for chicken from 1950 to 2022 was 2.3% (40 cents per pound in 1950 and $2 per pound in 2022. hhhhhh.

Over this same time the annual percentage increase in CPI was 3.5%, so the price of chicken was rising more slowly than the CPI.

31.

If the United States introduces universal childcare, GDP should increase because some childcare provided at home would then become a market transaction. The welfare implications of that rise will depend on how society views this change.

For example, would the quality and amount of childcare increase? Would there be fewer neglected and abused children? Would an increase in the number of wellcared-for children eventually mean lower unemployment, more productive workers, and higher wages?

32.

GDP does not measure happiness, nor does it measure economic welfare. GDP measures economic activity. GDP figures are used to make comparisons of one country's production with another country's and of one year's production with another year's.

33.

The Simplicity Movement argues that after some point (after basic needs are met), increased consumption, and therefore increased GDP per capita, reduces welfare.

CHAPTER 8:

THE SHORT-RUN KEYNESIAN POLICY MODEL: DEMAND-SIDE POLICIES

Questions and Exercises 34.

According to Keynesians, the economy could deviate from its potential because if aggregate demand falls for some unexplained reason, firms would respond by decreasing output and laying off workers, which lowers people‘s income. Lower income leads consumers to cut expenditures further, which once again causes firms to decrease production. So the fall in aggregate demand creates a cycle that feeds on itself and can develop into a vicious downward spiral in which output is less than potential. Note that a similar virtuous upward spiral in hiring, income, and expenditure can explain an output level above an economy's potential.

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35.

As prices fall during deflation, profits decline, making entrepreneurs hesitant to start businesses, thus slowing the growth of the economy. Asset values (prices of assets such as houses, stocks, and bonds) also decline, thus reducing the value of collateral to support consumer and producer loans and therefore spending. Both of these effects will lead to lower output.

36.

The paradox of thrift is the notion that an increase in saving can lead to a decrease in expenditures, which can lead to decreasing supply, decreasing output, causing a recession, and lowering total saving. Government has a role in offsetting the cycle of declining expenditures and production.

If the paradox of thrift holds, increasing savings will lower aggregate income and set in motion a cycle of declining expenditures and production. This will reduce income far enough so that once again saving and investment will be in equilibrium, but then the economy will be in an almost permanent recession, with ongoing unemployment. Keynesians believe that in this case the economy will need government's help to prop up aggregate expenditures.

37.

One expects the AD curve to be vertical because when the price level rises, all prices rise together. That is, since wages have risen as much as prices for consumer goods, no relative prices have changed and therefore people‘s decisions to consume should not have changed either.

38. a. A rise in the price level reduces the value of cash people hold. They withdraw more from their banks to regain that value, which reduces the amount banks have to lend. Thus, interest rate rises, which reduces investment expenditures. All of these factors lower aggregate quantity demanded.

iiiiii. Assuming fixed exchange rates, a rise in the price level would make goods less internationally competitive. This would lead to a decrease in net exports, lowering aggregate quantity demanded. jjjjjj. When there is a rise in the price level, the holders of money become poorer so they will buy less, lowering aggregate quantity demanded.

39.

Five factors that shift the AD curve are: (1) changes in foreign income, (2) changes in expectations, (3) changes in exchange rates, (4) changes in the distribution of income, and (5) changes in fiscal and monetary policies. (Note that the multiplier amplifies the effects of these initial shift factors. It is not the initial cause of a shift, so is not included in the list.)

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40.

When the price level falls real GDP increases because of the interest rate, international, and money wealth effects. However, a falling price level could reduce aggregate demand (shift the demand curve to the left) by more than the lower price level increases the quantity of aggregate demand. This is because a lower price level brings with it expectations of falling aggregate demand and lower asset prices.

41. a. The AD curve will be steeper because a change in the price level will be offset by a change in the exchange rate eliminating the international effect on the AD curve.

Note that the exchange rate, the money wealth effect, and international effect all help explain why the aggregate demand curve is not vertical, so any reduction in these three effects would make the aggregate demand curve steeper or closer to a vertical line. kkkkkk.

The AD curve will become steeper if a fall in the price level doesn't make people feel richer since the fall in the price will not cause them to increase their expenditures. This is an example of the money wealth effect not holding true. llllll. The AD curve will be steeper if a fall in the price level creates expectations of a further fall in the price level (it may even be backward bending) since the fall in the price level will cause people to reduce their present expenditures in the hope of getting more for their money in the future. mmmmmm. Assuming that poor people spend a higher percentage of their income than rich people (as suggested by the data), the AD curve will shift to the right.

42.

nnnnnn. effect).

The AD curve will shift to the right by a multiple of 20 (the multiplier

oooooo. effect).

The AD curve will shift to the left by a multiple of 10 (the multiplier

Two factors that shift the SAS curve are changes in productivity and changes in input prices.

43. a. The SAS curve will shift up, with inflation equal to 1 percent since wages rise by more than the rise in productivity. pppppp.

The SAS curve will shift down, with inflation equal to -2 percent (deflation) since productivity rises by more than the rise in wages. qqqqqq.

The SAS curve will shift up, with inflation equal to 2 percent since wages rise and productivity declines.

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rrrrrr.The SAS curve will not shift since the wage increase is exactly offset by a productivity increase.

44.

The LAS curve is vertical because potential output depends on the capacity for production, not the price level. In the long run, output is independent of the price level.

45. a. An increase in the availability of inputs will shift the LAS curve to the right. The SAS curve will not shift initially. The SAS curve will eventually shift down to the intersection of the new LAS and AD curve. ssssss.

A civil war will presumably destroy productive capacity or otherwise halt production and cause a shift in the LAS curve to the left. In the short run, it will also increase the prices of inputs and increase inflationary expectations, shifting the SAS curve up. tttttt. If wages that were fixed become flexible and aggregate demand increases, the SAS curve will shift up as wages rise. The LAS curve does not shift.

46.

If the economy is in short-run equilibrium below potential output, underutilization of inputs will cause input prices to fall, causing the short-run aggregate supply curve to shift down and the price level to fall. This will set the money wealth, interest rate, and international effects in motion, increasing the quantity of aggregate demand and thereby bringing the economy into long-run equilibrium at potential output.

47. a. This implies that productivity is increasing significantly. If computers are a large portion of the economy, and wages do not rise by the full amount of the productivity increase, the result will be to lower the price level and increase output. uuuuuu.

In terms of the AS/AD model, this shifts the SAS curve down. It can also shift out the potential output (LAS) curve to the right, increasing equilibrium potential output and lowering the price level.

48. a

It is likely that the rise in oil prices will shift the SAS curve up and the drop in world income will shift the AD curve in, causing equilibrium income to fall even more below

potential (from point A to point B in the accompanying graph).

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LAS

Price level

vvvvvv.

We might suggest expansionary fiscal and monetary policy to shift the AD curve out (from AD0 to AD2 ) and bring equilibrium output to its potential at point C. We would caution the government about the possible inflationary consequences, but since the economy is significantly below potential, we would argue that it is a risk worth taking.

SAS1 C SAS0

B P1 A

P0

AD2

AD1 AD0 Y0

Y1

Real output

49. a. The slowing of foreign economies will reduce exports, shifting the AD curve to the left by a multiple of the initial decline in exports (from AD0 to AD1 in the accompanying graph). You should recommend that the government increase expenditures by an amount equal to the initial decline in exports. This will shift the AD curve back to its initial position, as shown in graph (a). wwwwww. An economy operating above potential output is shown by point A in graph (b). To keep the inflation from rising (the SAS curve from shifting up), the government should reduce expenditures enough (shifting the AD curve from AD0 to AD1 ) to bring the economy back to long-run equilibrium at potential output, YP , and the price level, P1 , as shown. xxxxxx.

A new technology that increases potential output will shift the L A S curve to the right (from LAS0 to LAS1 ), as shown in graph (c), creating excess capacity and downward pressure on factor prices. If left alone, the price level will fall and real output will rise. If the government wants to keep the price level constant, or if it wants to take advantage of a faster increase in aggregate demand, it can increase expenditures enough to increase output to the new potential (shifting the AD curve from AD0 to AD1 ).

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When the price level falls, people may expect aggregate demand to decline because falling asset prices reduce people‘s wealth.

In addition, falling asset prices might lead to banks calling in loans, which will reduce investment. Both of these shift the aggregate demand curve to the left, offsetting the effect of a falling price level on the quantity of aggregate demand. As the SAS curve begins to shift from SAS0 to SAS1 , the price level falls and the economy begins to move toward point B. But the aggregate demand curve then shifts to the left from AD0 to AD1 as a result of the price level decline. The economy then moves toward point C. Without government intervention this cycle of falling prices and falling aggregate demand can continue indefinitely.

Price level

17.

SAS0 A

P0 SAS1 B

C P1

AD1 Y1

Y0

18.

To design an appropriate fiscal policy, it is important to know the level of potential output because where the economy is relative to that potential tells you whether to implement expansionary or contractionary policy. Conducting fiscal policy without having an estimate of potential output would be like driving without being able to see the road.

19.

The simple model abstracts from a number of important issues such as the problem of estimating potential income. Without knowing potential income, we cannot know whether expansionary or contractionary policy is called for. Also, dynamic price level adjustment feedback effects are ignored. Finally, the model does not take into account the difficulties in implementing fiscal policies and the uncertain effectiveness of those policies.

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AD0

Real output

20.

Countercyclical fiscal policy is difficult to implement because it is difficult to assess the condition of the economy at any one time. Furthermore, it takes a long time to enact new government policies and it is politically difficult to raise taxes when the economy is doing well (or at any time). Oftentimes, politics, not the needs of the economy, guide tax and spending decisions.

Questions from Alternative Perspectives 21.

Austrian yyyyyy.

It could be consistent with the AS/AD model if one sees the SAS and AD curves driven by expectations and agrees that the expectation of government involvement shifted both back to the left. zzzzzz.

Austrians would favor an institutional system that had far less government involvement and left the market to self-correct, whereas the ideas put forward in this book advocate for government intervention when necessary.

22.

Institutionalist aaaaaaa.

When oil production declines, the production possibility curve shifts in, the LAS curve shifts in to the left and the result is an increase in the price level.

An increase in AD will offset the resulting unemployment but cause even more inflation. Declining physical output will make investment in alternative resources more costly (greater opportunity cost in terms of consumption goods). bbbbbbb.

What will happen depends on why oil production declines. If the decline is due to lower demand, then the price will fall and oil producers will be hurt. If the decline is due to a decline in supply, then the price of oil will rise and consumers will be hurt. In either case society may be better off if the decline causes less global warming.

23.

Post Keynesian While Minsky predicted many of the current problems, he did not predict the timing of those problems, which allows people to argue that his theory is not generally applicable but is simply a theory that is right only some of the time. The existing theory is also tied to income of individuals, and to adopt a different theory would likely lead to changes that would undermine the existing income and institutional power structure. Thus, the economics profession, which is supported by the current institutional power structure, continues to teach the current theory in order to protect its income.

24.

Radical 6

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ccccccc.

The graph shown at the right shows the situation where aggregate demand has been reduced. The excess capacity is shown by the gap between the quantity of aggregate demand and the potential output at the price level. If the price level is flexible, there is no problem. A decline in one of the components of aggregate would shift the AD curve to the left, creating excess capacity. ddddddd.

What should be done is a judgment question and judgments differ. Classicals tend to believe that the economy should be left to itself, allowing the price level to fall. Radical economists believe that the easiest and best policy is for the government to increase aggregate demand to restore full employment.

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eeeeeee.

It suggests that the model (positive economics) embodies in it certain biases toward specific policies. For example, the AS/AD model suggests that if the wage and price level were flexible, the problem of unemployment would not exist. fffffff.

While some measure of value judgment is inherent in positive economics, it attempts to be less value laden than normative economics, which is explicitly value laden. So, ideally, positive economics is less value laden.

However, to the degree that values are hidden in the assumptions of positive models, the application of those models may be more value laden since the values are not laid out as they are in normative economics.

Issues to Ponder 25. a. Keynes used models not in a mechanistic way, but in an interpretive way. He was a Marshallian who saw economic models as an engine of analysis, not an end in and of themselves. ggggggg.

It fits in nicely with the ―other things constant‖ assumption since the policy relevance of theory follows only when one has eliminated that assumption and taken into account all the things held at the back of one‘s mind. hhhhhhh.

Keynes‘ interest definitely was primarily in the art of economics since the above method is the method used in the art of economics. Keynes was interested in using well thought out theories and models to develop policies that would help society fulfill its goals.

26.

Yes, the closer the economy is to a high potential output, the more policy makers would emphasize the inherent value of the program rather than discussing the program‘s effect on aggregate demand. This is because programs that increase aggregate demand when the economy is close to potential output will ultimately lead to inflation and little increase in real output.

CHAPTER 8W: THE MULTIPLIER MODEL Questions and Exercises 27.

The multiplier model is more appropriate for large changes in aggregate demand, when the economy tends to be subject to greater feedback effects and is less selfcorrecting.

1

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28.

Since total expenditures are $2,000, induced expenditures are $1,000.

Autonomous expenditures are shown by the y-intercept ($1,000).

29.

The aggregate expenditures curve shifts down by the decline in autonomous expenditures.

30.

If planned expenditures are below actual production, income will decline. Here‘s how: when planned expenditures are below actual production, firms will see that their inventories are building up faster than they‘d like. In response, they decrease production. As production decreases, so does income. Consumption falls by a fraction of the decline in income, leading to a further decline in planned expenditures. This process continues until planned expenditures equal actual production.

31.

At levels of output above equilibrium, inventories are increasing because planned expenditures are below actual production. People are buying less than what is being produced.

32.

The AE curve becomes steeper when the marginal propensity to expend increases.

Equilibrium income rises.

33.

Equilibrium income is [1/ (1  0.4)]  AE = 0.6 × AE = 300 ∕ 0.6 = $500

34.

If the mp e is .8, then the value of the multiplier is 1 ∕ .2, or 5. If autonomous expenditures are $4,200, the equilibrium level of income in the economy is 5 × $4,200 = $21,000. This is demonstrated in the accompanying graph.

2

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35. a. If the mp e is .66, the value of the multiplier is 2.94, or 3. A decrease in autonomous expenditures of $20 will likely result in a decrease in income of $60. iiiiiii. This is demonstrated in the accompanying

graph.

36.

If withdrawals were immediately translated into expenditures, the size of the multiplier would be infinite since leakages from the economy would be zero.

However, autonomous expenditures would no longer exist since the model would have had to assume them away when it assumed no leakages. In short, under these conditions the multiplier model would break down.

37. a. Given that the mpe is 0.8 and autonomous investment has risen by $20, income will increase by $100 (the multiplier is 1 ∕.2, or 5, and 5 × $20 is $100). jjjjjjj. With an mpe of 0.5, the multiplier is now (1 ∕.5), or 2, and so the change in investment causes income to increase by only $40. kkkkkkk.

The decrease in exports and increase in investment cancel each other out so that autonomous expenditures in the aggregate are unchanged. lllllll. See the graphs below. The graph on the left corresponds to (a) and the graph on the right corresponds to (b). The graph to (c) would show the AE curve not moving at all.

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38.

Given that the mpe is 0.6, I 0 = $1,000; G0 = $8,000; C0 = $10,000; and  X 0  M 0  = $1,000, then: mmmmmmm. Y = $10,000 + .6Y + $1,000 + $8,000 + $1,000.

Y − .6Y = $20,000; 0.4Y = $20,000; Y = $50,000.

Thus, the equilibrium level of income in the country is $50,000. nnnnnnn.

If net exports increase by $2,000, income will increase by $5,000 (the multiplier is 2.5, or 1 ∕.4). ooooooo.

If the mp e falls from .6 to .5, the multiplier decreases from 2.5 to 2. The answer to part (a) would now be $40,000; the answer to part (b) would be $4,000

39.

Shocks to aggregate expenditures are any sudden changes in factors that affect C, I, G, X, or M. This includes consumer sentiment, business optimism, foreign income, and government policy. It is possible that people could change their marginal propensities to consume and save, and this could also have an effect on the economy.

40.

If the mp e is .5, then the multiplier is 2. Every $1 increase in autonomous expenditures will raise income by $2. To close a recessionary gap of $200 the government needs to generate $100 of additional autonomous spending. It can accomplish this by increasing government expenditures by $100, or by cutting taxes by $200 (assuming mpc = mp e). The reason the government must cut taxes by $200 is because to increase expenditures by $100, the government must take into account the fact that consumers will not spend the entire amount of the tax cut. Specifically, it must cut taxes by $100 ∕ 0.5, or $200.

41.

Cutting taxes by $100 has a smaller effect on GDP than increasing expenditures by the same amount because people don‘t spend the entire amount of the tax cut—they save some of it, too. The multiplier begins with the increased individual spending resulting from the tax cut, or the mpc times the tax cut.

42. a. This is shown as a shift down of the AE curve from AE0 to AE1 and a decline in real income. ppppppp.

An improvement would be graphically represented by a shift up of the AE curve shown in the graph as the shift from AE1 to AE 2 and a rise in real income.

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43.

Given that income is $50,000, the mpe is .75: qqqqqqq.

The multiplier is 4.0, calculated as [1/ (1  mpe)] . To generate a $2,000 increase in income, increase government spending by $500 or decrease taxes by $667. rrrrrrr.

If the mpe is .67, the multiplier is about 3, which means that to generate a $2,000 increase in income, the government would have to increase spending by $667 or decrease taxes by $1,000. sssssss.

If the mpe is .5, then the multiplier is 2.0, which means that to generate a $2,000 increase in income, the government would have to increase spending by $1,000 or decrease taxes by $2,000.

44. a. If the mp e is .5, the multiplier is 2. Because there is a recessionary gap of $800, the government would have to increase spending by $400 or decrease taxes by $800 to bring the economy back to long-run equilibrium. ttttttt. If the mp e is .8, the multiplier is 5. Because there is an inflationary gap of $1,500, the government would have to decrease spending by $300 or increase taxes by $375 to bring the economy back to long-run equilibrium. uuuuuuu.

If the mpe is .2, the multiplier is 1.25. Because there is an inflationary gap of $1,200, the government should reduce spending by $960 or increase taxes by $4,800. vvvvvvv.

If the mpe is .7, the multiplier is 3.33. Because there is a recessionary gap of $1,500, the government should increase spending by $450 or decrease taxes by $643.

45. a. If the mp e is .5, the multiplier is 2. To eliminate the inflationary gap, the government should undertake a contractionary fiscal policy. Since the economy is $36,000 above potential, we would advise decreasing government spending by $18,000 or increasing taxes by $36,000. wwwwwww. The multiplier now becomes 5, so we would advise decreasing government spending by $7,200 or increasing taxes by $9,000.

46.

A circular flow diagram of the economy that would more accurately describe the multiplier model would include leakages of savings to investment that cause the diagram to pulsate as the economy continually overshoots equilibrium in response to shocks to the economy.

47.

A mechanistic model states the equilibrium independent of where the economy has been or where people want it to be. A mechanistic model is used as a direct 1

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guide for policy prescriptions. An interpretive model is used as a guide that highlights dynamic interdependencies and suggests the possible response of aggregate output to various policy initiatives.

48.

In the multiplier model, the effects are for a continued change in an exogenous variable. If there were only a one-time change, the effects of each successive change would be reduced, bringing the economy back to where it was to begin with. While in the multiplier model the effects of initial change in autonomous spending are magnified by the multiplier, each additional round of effects becomes smaller and smaller. So in the multiplier model, one-time effects will be dampened, which continuous effects will be multiplied as the dampened effects of a continuous set of one time shocks are cumulatively dampened so that the arrive at a steady state flow equilibrium.

49.

In the multiplier-accelerator model, changes in output are accelerated because changes in investment depend on changes in income rather than on the level of income. In this model, when aggregate demand falls, output falls as in the standard multiplier model. But as output falls, unlike in the simple multiplier model, investment also falls since firms can see no reason to invest. This new interconnection accelerates the fall in demand and can possibly make the second shift larger than the first shift. In some cases output can be pushed into a freefall.

50.

If it is true that people base their spending primarily on lifetime income, not yearly income, the marginal propensity to consume out of changes in current income could be very low, approaching zero. In that case, the expenditures function would essentially be a flat line, and the multiplier would be 1. There would be no secondary effects of an initial/par shift in expenditures. This set of arguments is called the permanent income hypothesis.

Questions from Alternative Perspectives 51.

Austrian His work points out that people are not dumb; they figure out ways to make things work on their own, and many times the net result of this self-organization is far better than organization imposed from the top. Austrians believe that when people are treated as intelligent agents, they will act intelligently; when they are treated as dumb, they will still act intelligently, but often their intelligence will be working toward thwarting the plan.

52.

Feminist 2

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From today‘s perspective, this statement seems extremely biased against women, but it was a prevalent view at the time. Feminist economists see work as a human right, not a gender-based privilege. Moreover, they point out that men would have been unlikely to do many of the women‘s jobs at the time.

53.

Institutionalist While each option will cause aggregate expenditures to shift up and thus stimulate GDP in the short-term, each will have different implications for the economy's location on the production possibility curve. Greater access to health care should extend life spans and improve worker productivity. In the long term this should push the production curve outward. An increased military presence in the Middle East will cause a technological bias toward the production of military goods. The military presence will increase oil consumption and accelerate dependence on oil from that region. Development of energy alternatives will cause technological bias away from oil-using technologies. Institutionalists believe that as oil dependence decreases, there should be a move along the curve away from military spending: we won‘t need the troops in the Middle East.

54.

Radical xxxxxxx.

Radical economists believe that these data suggest that the multiplier is very large. yyyyyyy.

Yes, these data suggest that consumption spending was the driving force in the U.S. economic recovery. SucIt was, and that it may not be sustainable because consumers have so much debt.

55.

Post-Keynesian Fazzari‘s findings suggest that spending-side factors are far more important. PostKeynesians believe that this suggests that policies that increase spending will be central to maintaining the economy at a high level of employment.

Issues to Ponder 56.

In 2016, the government budget was in deficit, but because of a sequester, the United States was running a smaller deficit than previously. However, the deficit was expected to rise in the coming years because Congress and the President agreed to stop the sequestering of funds and mandatory spending was expected to rise significantly. This allowed them to pass tax cuts and institute spending increases. Unemployment had fallen below 5 percent but growth was still sluggish, so it is difficult to say precisely where the U.S. economy was in 3

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relationship to its potential output. Arguments can be made on both sides depending on one's view of potential output. So the answer is: It depends.

57.

The effects of this invention on the economy would be manifold and in many ways unpredictable because such major shocks have social, institutional, and political effects, as well as economic effects. The obvious effect is that the demand for the pill would likely be tremendous (after people were sure it was safe), and so production of the pill would gear up to meet the demand. Market structure and pricing decisions will play a big role in determining the effect of the change. Alternative forms of transportation would suffer decreases in demand (cars, mass transit, airplanes, etc.), and levels of production of those goods and services would adjust, as would employment in those industries and related industries. Measured GDP might actually fall.

58.

If there is a delay, it will mean that the initial multiplier effects can be small or non-existent, and then, suddenly, they become large and fast. Uncertain, changing, expectations can add to the ambiguity of the model‘s result.

CHAPTER 8W: APPENDIX A: AN ALEBRAIC PRESENTATION OF THE EXPANDED MULTIPLIER MODEL 59.

To determine precisely how much we would need to decrease taxes we must determine what the multiplier is. Assuming all other marginal propensities are zero, the multiplier is 5. The tax cut would initially affect the economy by only .8 times the tax cut, so to increase output by 400, we would decrease taxes by $100 (.8 100  5  400).

60.

We would recommend increasing expenditures by $80(80  5  400).

61.

This makes the multiplier 3.57, which means that we would increase spending by about $112, or cut taxes by about $140.

62.

This makes the multiplier 2.08, which means that we would increase spending by about $192 or cut taxes by about $213.

63.

Making taxes and imports endogenous reduces the size of the multiplier because they increase the leakages from the expenditure flow. Because of taxes and 4

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imports, increases in income will lead to lower increases in expenditures than otherwise.

64.

This would make the multiplier = 1 ƒ (1 c  ct  m  mt ) . It would be a slightly higher multiplier. (The difference between the two assumptions is whether we are assuming government imports.)

CHAPTER 8W: APPENDIX B: THE MULTIPLIER MODEL AND THE AS/AD MODEL 65. a. As shown in the left-hand graph below, an increase in autonomous expenditures shifts the AE curve up and causes a movement along the AP curve to the right and results in a higher equilibrium income level twice the shift in the AE curve. zzzzzzz.

As shown in the right-hand graph below, an increase in autonomous expenditures shifts the AD curve to the right by twice the increase in autonomous expenditures. Since the price level is fixed, real output increases by twice the rise in autonomous expenditures.

aaaaaaaa.

Since prices are somewhat flexible, the rise in expenditures is split between an upward shift of the AE curve and a rise in prices that causes a downward shift of the AE curve that is smaller than the initial upward shift. The rise in income is less than twice the initial shock. This is shown in the graph to the right. In the AS ∕ AD model, a flexible price means that the shift in the AD curve is split between increases in the price level and increases in real output. Real output rises by less than the multiplier times the increase in autonomous expenditures.

5

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66. a. The AD curve will become steeper. bbbbbbbb. An increase in the size of the multiplier makes the AD curve flatter because the effect of changes in the price level on aggregate demand will be augmented even more by the multiplier. cccccccc.

An increase of $20 in autonomous expenditures has no effect on the slope of the AD curve; the increase only affects the position of the curve. dddddddd. A decline in the price level disrupting the financial market will make the AD curve steeper because it decreases the price-level interest rate effect.

CHAPTER 9: THE CLASSICAL LONG-RUN POLICY MODEL: GROWTH AND SUPPLY-SIDE POLICIES 6

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Questions and Exercises 67.

Economic growth allows everyone in society, on average, to have more. It generates jobs and increases income and therefore consumption. Costs include pollution, resource exhaustion and depletion of natural habitats. (Other answers are possible.)

68.

Using the rule of 72: Nepal: 72 ∕ 1.1 = 65.5 years; Kenya: 72 ∕ 1.7 = 42.4 years; Singapore: 72 ∕ 7.2 = 10 years; Egypt: 72 ∕ 3.9 = 18.5 years.

69.

Through free trade, countries can specialize in the goods in which they have a comparative advantage and trade for those in which they do not. Labor is divided into its best use. This can result in higher productivity and greater economic growth for the involved countries.

70.

A person living in 1910 is most likely to have worked more to buy a dozen eggs than the person living in 2020. The reason is that, since 1910, the United States real income has been rising, on average, by more than the growth in the population. This means that real income per person has gone up since 1910. Thus, the person living in 2020 had a higher real income than the person living in 1910 and so was likely to work less to buy the dozen eggs. Figure 9-2 supports this.

71.

Real growth rate per capita = Real output growth − Population growth. eeeeeeee. Congo: −1.4 − 2.6 = −4.0% ffffffff.

Estonia: 4.3  (0.3)  4.6%

gggggggg. India: 6.2 − 2.1 = 4.1% hhhhhhhh. United States: 2.6 − 0.4 = 2.2% 72.

Informal property rights limit growth by limiting the size of companies (they must stay small to remain below the government‘s radar), by limiting access to business and individual loans when people don‘t have legal collateral, and by limiting incentives for investment.

7

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73.

An increase in saving in the United States means more funds will be available for investment, leading to an increase in investment. As investment in the economy increases, total output in the economy will increase and this would raise people‘s income. Having more investment money available for research and development can also lead to greater technological growth, which will further accelerate income growth. As a result, the standard of living will be higher.

74.

The loanable funds market is shown in the accompanying graph. The supply of loanable funds (savings) is shown by the supply curve while the demand for loanable funds (investment) is shown by the demand curve. While financial markets provide a means of transferring savings into investment, it is the interest rate that equilibrates the two.

75. a. If government increases spending without increasing taxes, the demand for loanable funds will shift to the right as shown in graph a below. The interest rate will rise. Growth is expected to slow as businesses lower their investment expenditures. Note, however, that some of the additional spending by the government could be on things that foster economic growth, which would partly off-set the decrease in growth.

8

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If businesses become more productive, the demand for loanable funds will shift to the right and the interest rate will rise as shown in graph b below. More productive businesses lead to higher growth, but that growth will be limited by the higher interest rate in the loanable funds market. If the effect of the higher interest rate outweighs the increase in productivity, it's possible that growth could slow.

iiiiiiii.

If people save more the supply of loanable funds will shift out to the right, leading to a lower equilibrium interest rate as shown in graph c below. Higher investment will lead to faster growth.

9

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76.

Three types of capital are physical capital, human capital, and social capital.

Physical capital includes the buildings and machines that are available for the production process. Human capital includes the workers‘ skills that are embodied in the worker through education, experience, and on-the-job training (i.e., through people‘s knowledge). Social capital includes the habitual way of doing things that guides people in how they approach production in the economy.

77.

Two ways in which growth through technology differs from growth through the accumulation of physical capital are: (1) Accumulation of physical capital increases output by simply increasing the amount of the capital available for production, whereas technology increases output through improved production processes and capital. (2) Technology can also change the types of goods people buy in an economy by introducing new types of products; accumulation of physical capital does not lead to such a change.

78.

Thomas Malthus based his prediction that population growth would exceed the growth in goods and services on the law of diminishing marginal productivity of labor. Malthus‘ prediction did not come true.

79.

Thomas Malthus‘ prediction did not come true because of technological progress and increases in capital that more than offset the effects of the law diminishing marginal productivity.

80. a. Both theories recognize a role for saving and investment in the growth process.

10

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Classical growth theory focuses on the role of capital while new growth theory focuses on the role of technology.

81. a. An increase in technology increases growth.

Positive externalities increase growth jjjjjjjj.

Uncertain. To the extent that patents provide an incentive to innovate, they increase growth; to the extent that they limit the availability of technology to others who don't own the patent, they limit growth. kkkkkkkk. Learning by doing increases growth. llllllll.

Technological lock-in likely limits growth if the technology that is lockedin is inefficient.

16.

Spillover effects are the impacts that technological advances in one sector have on the technology, production, and output of other sectors. Spillover effects multiply the impact of the initial technological advance, further contributing to economic growth.

17.

Network externalities are when the use of a good by one individual makes that technology more useful to other people. Because of these spillover effects, the effect of the technological change is magnified leading to faster growth.

18.

Since there was no investment, it could not be due to an increase in capital. There are two possibilities. Either there was new technology embedded in the capital purchased to replace depreciated capital (no new net investment) or workers became better at their jobs just by learning—that is, learning by doing.

19.

The answer could be ―yes‖ or ―no.‖ To the extent that the innovation is made freely available there will be greater spillover effects and greater growth. To the extent that the market would provide a greater incentive (greater revenue from a patent than the prize), the policy might lead to fewer innovations and less growth.

Questions from Alternative Perspectives 1.

Austrian No, in absolute terms, the poor have not become poorer.

11

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mmmmmmmm. Based on the growth model, as more capital is collected, one would expect the income of the poor to increase.

Institutionalist Given Americans‘ current habits, it would take many earths to provide those resources.

82.

Post-Keynesian Post-Keynesians believe that such a policy would be consistent with new growth theory, which states that technology is central to growth. nnnnnnnn. Those believing in the Classical theory model would not see industrial policy as so important since the model focuses on capital, not technology.

83.

Radical The arguments could fit in. For example, the book lists formalizing property rights as a "growth policy" but it does not state what the nature of those formalized property rights are. Property rights that protect intellectual property do create income inequality, whereas property rights that recognize the inherent communal nature of intellectual property could allow for much more widely distributed income, without undermining, and possibly increasing, growth. Monetary incentives are often relatively minor in the process of individuals developing new ideas, but the text, and mainstream economics, makes it seem as if monetary incentives are the only incentives. So there seems to be a bias in the presentation that does not recognize that there could be a positive relationship between growth and income equality. oooooooo. Most Radical economists believe that standard economics emphasizes the need for inequality to bring about growth far more than is the case. But ultimately, this is an empirical question upon which economists disagree because the data are not very good. What is surprising is how little empirical study has been devoted to this issue--a fact that Radicals see as a way in which society avoids questioning the presumption that inequality is needed for growth.

84.

Religious Most religiously oriented economists see that property rights are consistent with everything ultimately belonging to God. For religious economists, property rights are temporary; God is eternal. We are stewards of what God has provided. In fact, the Hebrew Bible includes the jubilee year when accumulated property rights are redistributed every 50 years.

Issues to Ponder 12

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a. Answers will vary. Students can do some research about developing countries either at the library or on the Internet to find out about what it is like to live in a developing country.

Answers will vary. The question asks students to compare what it is like to live today compared to 100 years ago. Answers will mention the lack of some products such as air-conditioning, dishwashers, TVs, the Internet as well as the need to work longer hours to provide for the goods that did exist.

85.

The answer to this question is more complicated than comparing increases in relative income. In terms of real income, the poor are doing relatively better than the rich because growth has made everyday goods available to the poor that weren‘t available previously. To the extent that growth has lengthened life expectancy, growth has increased the life expectancy of the poor more than the rich because it has improved the basic diet of the poor more. However, inequality has worsened over the past 30 years, suggesting that most of the recent benefits of growth have gone to the rich.

86.

In the short run, if a politician is to implement a policy to encourage saving, it might inhibit aggregate spending causing income growth to stagnate, so the policy would not be able to meet its objective of raising the standard of living in the short run. Because politicians generally have to act with a mind to short-run concerns in order to win elections, the policy may not be politically viable.

87.

Political structure can be viewed as a type of capital if it contributes to production. The longer a country is a democracy, the stronger and more welldeveloped are the institutions that protect civil liberties and provide secure property and contract rights. These provide the necessary incentives to innovate and produce. A stable political environment also fosters investment in technology because it makes it more likely that the firm will be around in the long term.

(Source: ―Democracy and Growth: A Relationship Revisited,‖ Eastern Economic Journal, Winter 2003.)

CHAPTER 10: THE FINANCIAL SECTOR AND THE ECONOMY Questions and Exercises 88.

Money doesn't have to have any inherent value to function as a medium of exchange. All that's necessary is that everyone believes that other people will 13

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accept it in exchange for their goods. This is the social convention that gives money value.

89.

Money functions as a medium of exchange, a unit of value, and a store of value.

90. a. Money: Funds held in a checking account are considered money. pppppppp. Not money: Foreign currencies are not accepted in exchange for other goods so Brazilian reals do not qualify as money in the United States. qqqqqqqq. Not money: Credit cards are a form of instant loan, but they are not considered money because they create a financial liability for their users, rather than for a bank. rrrrrrrr.

Not money: Only currency held by the public, not currency held by banks, is counted as money. ssssssss.

Money: Currency held by the public (Federal Reserve notes) is considered money. tttttttt.

Not money: Gold is neither highly liquid nor generally accepted in exchange for other goods, so it does not fit the definition of money. uuuuuuuu. Not money: Coupons are only accepted in exchange for a very specific set of goods, and it cannot be used as a reference in valuing other goods, so it is not considered money

91.

Money serves as a unit of account when people compare prices between goods.

92.

Inflation reduces money‘s function as a store of wealth because it reduces how much can be purchased with a given amount of money (lowers money‘s value).

93.

The two components of M 2 that are not components of M1 are smalldenomination time deposits and retail money market funds.

94. a. State and local government bonds are neither included in M1 nor in M 2 . vvvvvvvv.

Checking accounts are included in M1 and must therefore also be

included in M 2 .

14

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wwwwwwww. Small denomination time deposits are included in M 2 but not included in M1 . xxxxxxxx.

Currency is included in M1 and must therefore also be included in M 2 .

yyyyyyyy.

Stocks are neither included in M1 nor in M 2 .

zzzzzzzz.

Corporate bonds are neither included in M1 nor in M 2 .

95. a. Nothing happens to M1 or M 2 as both cash and deposits in savings accounts are included in M1 and M 2 . aaaaaaaaa.

Nothing happens to M1 since neither CDs nor money market mutual

funds are included in M1 . Nothing happens to M 2 as the decrease in the CD and the increase in the money market mutual fund cancel each other out. bbbbbbbbb. Nothing happens to M1 or M 2 as both cash and deposits in savings accounts are included in M1 and M 2 .

96.

Banks earn revenue by lending others money out of deposits given to the bank.

They can do so because at any specific day only a fraction of their deposits are withdrawn, and they hold just a fraction of their total deposits as reserves. So, if everyone tried to withdraw their deposits at the same time, banks would not have enough money on hand to let them do so: this could only be done if all borrowers repaid their loans at the same time. (Note: From Don Leet and Scott Houser, Journal of Economic Education, Fall 2003.)

97.

If individuals hold no cash, the money multiplier is the reciprocal of the reserve requirement. Thus, for the following reserve requirements the money multiplier is found by dividing the requirement percentage into 1: 5 percent: 10 percent: 20 percent: 25 percent: 50 percent: 75 percent: 100 percent:

98.

(1 ∕ 0.05) = 20 (1 ∕ 0.10) = 10 (1 ∕ 0.20) = 5 (1 ∕ 0.25) = 4 (1 ∕ 0.50) = 2 (1 ∕ 0.75) = 1.33 (1 ∕ 1) = 1

If the U.S. government were to raise the reserve requirement to 100 percent, the interest rates banks pay to depositors would decrease and possibly even become 15

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negative (you‘d have to pay to have the bank handle your money), because significant opportunities for profitable loans would be lost, leaving banks with no other way to make revenue.

99. a. The bank can initially lend out $100 –  0.2  100   $80 . ccccccccc.

There is now an additional  $100  $80   $180 in the economy.

ddddddddd. The multiplier is 1 ∕ 0.2 = 5. eeeeeeeee. Jon‘s $100 will ultimately turn into $100 × 5 = $500 of money in the economy.

100.

False. In theory policy makers could be portrayed as if they used the money multiplier to achieve the desired money supply in a limited reserve monetary system In practice, however, because people held cash, which caused the multiplier to fluctuate often unpredictably. So, in practice it was difficult to use since the relationships weren‘t stable. As we will see in the next chapter, today, in the Fed‘s ample reserve system, banks face no reserve requirement, and thus the money multiplier becomes even less useful to control money. This makes the total money supply largely endogenous and the money multiplier relationship a tautology. In short, the money multiplier is the result of a logical process, not the driving force of money creation in actual policy.

101.

Although financial institutions don't produce any tangible real assets, they are nonetheless considered a vital part of the economy because of their central role in transferring savings into investment and in making the real economy more efficient.

102.

The two roles of the financial sector are to facilitate trade and transfer savings back into spending. Flows from the spending stream are channeled into the financial sector as saving when individuals buy financial assets from a person issuing the asset, who has a corresponding financial liability

103. a.

Expanding spending too quickly might create inflation. fffffffff.

Globalization kept inflation low in the period from 2000 to 2007 because foreign firms could sell products at much lower prices than could domestic firms.

104.

a.

Transactions motive 16

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ggggggggg. Precautionary motive hhhhhhhhh. Speculative motive iiiiiiiii.

Transactions motive

105.

If people expect interest rates to rise in the future, they will expect the price of bonds to fall. As a result, they will sell bonds today before the bonds fall in value and increase the amount of money they hold.

106.

Short-term interest rates are determined in the money market.

Questions from Alternative Perspectives 107. Austrian jjjjjjjjj.

Yes, money could be privately supplied. Economists disagree as to whether the government ought to be the monetary authority. Austrians believe that the monetary system works better the less government is involved. kkkkkkkkk. Yes, money has been supplied privately. (See the work of Lawrence White and his former student George Selgin.) People knew its value in the same way they know the value of anything—by the information generated in the market by what people would give them in exchange for the money.

108. Feminist lllllllll.

Since its inception only a very small percentage of the governors have been women. See: www.federalreserve.gov . mmmmmmmmm. Currently, (as of 2022) about all that one can say about the current members is that they are people with a background in economics (there is one lawyer, three women – a historically high number, including the first African American woman).

109.

Institutionalist Two examples include judging the value of someone by the clothes they wear: "Did you see Sue; it looks like she got her clothes at the Salvation Army"; and people‘s discussions about how much money they have made on their houses: "My house has gone up $40,000 in value last year." There are many more.

17

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110. Post-Keynesian nnnnnnnnn. Post-Keynesians believe that the money supply is much more endogenous than is suggested by the textbook presentation. ooooooooo. Post-Keynesians see the money supply being determined by the supply and demand of banks and depositors for financial instruments, which means that when the Fed changes high-powered money, banks and individuals change their actions so that the Fed‘s actions are offset. For example, instead of increasing lending in response to an increase in high-powered money, banks simply increase their excess reserves. Post-Keynesians may believe that the central bank influences the creation of money, but does not determine it, and often has a difficult time influencing it in the way it wants to.

111. Religious ppppppppp. In profit sharing the lender has a stronger stake in the business, and the payment he receives depends on how well the business does. qqqqqqqqq. In an interest paying system, a failed business could be forced to pay back the debt even though the business was not a success. In a profit sharing system, that would not be the case, making it less exploitative.

Issues to Ponder 112.

Money is to the economy as oil is to an engine because money is a financial asset that makes the real economy function smoothly by serving as a medium of exchange, a unit of account, and a store of wealth. Without it, the economy comes to a screeching halt.

113.

To be considered money, the currencies would have to fulfill the functions of money. They only partially fulfill those functions since they have only limited acceptability as a medium of exchange, store of value, and unit of account. Thus, while these monies partially fulfill the functions of money, we would not consider them full monies.

114.

a.

No, because they are hard to move. In this case, pearl shells were used for small transactions.

rrrrrrrrr. prices.

It would lower the value of the stones, causing a general inflation in

sssssssss.

If they could be distinguished, which in this case they could, the new stones would sell at a discount to the older stones, which they did.

18

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ttttttttt.

It depends, in some ways money is a marker of individuals‘ ―gifts to the marketplace.‖ Oftentimes, however, people assume that wealthy individuals got their money at the expense of others.

115.

a.

As more counterfeit money is printed and not identified as counterfeit, the value of money circulated will decline.

uuuuuuuuu. As businesses become suspicious of currency that is circulated, they will favor cashless transactions such as checks or debit cards, and likely offer benefits for using such payment methods. In this case, the volume of cashless transactions will increase. vvvvvvvvv. As counterfeiting increases, the U.S. Treasury will likely spend more to introduce additional security measures. The cost of not doing so will be the loss in the purchasing power of circulating money and the loss to businesses that accept identified counterfeit currency.

APPENDIX: A CLOSER LOOK AT FINANCIAL ASSETS AND LIABILITIES 116.

Students gain a financial asset and the government incurs a financial liability.

117.

It is a financial asset because it has value due to an offsetting liability of the Federal Reserve Bank.

118.

No. In economic terminology he is saving. Investing is the act of spending the money on real investment goods in economic terminology.

119.

No, she is not correct. While a loan is a loan, that loan is a financial asset to the one issuing the loan because it has value just as a bond does.

120.

$2.50

121.

$0.50

122.

At a 6% interest rate, $2,000 five years from now is worth $1,500 today, so take the $2,000 five years from now (assuming you don't really need the money right 19

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away). At a 10% interest rate, the $2,000 five years from now is worth about $1,241, so take the $1,400 today.

123.

a.

Market rates are likely to be above 10 percent because the price of the bond is below face value.

wwwwwwwww.Its yield is 12.24 percent. xxxxxxxxx. Its price would rise.

124.

As interest rates rise, one would have to save less money today to get $100 in ten years, so the present value falls.

125.

Substituting into the present value formula PV = $1,060 ∕ 1.1, we find that the bond is worth $964 now.

126.

Using the annuity table, we find that a dollar a year for 40 years with a 6 percent interest rate is worth $15.05 now. Thus $100 would be worth $1,505.

127.

Using the present-value table A10-1, we see that at a 3 percent interest rate, the value today of $1 paid 30 years from now is $0.41, so $200 in 30 years would be worth $82 now.

128.

Since we're not sure how long your expected lifetime is, we can use the annuity rule which says that the present value of an annuity is the flow of income divided by the interest rate, which in this case would be $200/.09 = $2,222.22. You should be willing to pay no more than $2,222.22 for that annuity. The amount you are willing to pay does depend on your expectations about future changes in the interest rate and about your own life expectancy; if you expected the interest rate to decline in the future, you would be willing to pay more than $2,222.22, whereas if you expect to live for only a few more years, you would be willing to pay less.

129.

If the interest rate is still 9 percent, the value of a lump sum of $20,000 in 10 years can be calculated using the present-value table in Table A10-1. You should be willing to pay $20,000 × 0.42, or about $8,400 for this offer.

130.

To find the present value of a perpetuity of $100 per year, use the annuity rule, which says that the present value is equal to the amount of the cash flow divided 20

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by the interest rate. Thus, the present value will be: $1,000 if the interest rate is 10 percent; $2,000 if the interest rate is 5 percent; $500 if the interest rate is 20 percent. yyyyyyyyy. Using the same interest rates, the future values of $100 are: $110 in one year and $121 in two years at 10 percent; $105 in one year and $110.25 in two years at 5 percent; and $120 in one year and $144 in two years at 20 percent zzzzzzzzz. Using the rule of 72, your money will double in: about 7.2 years at 10 percent, about 14.4 years at 5 percent, and about 3.6 years at 20 percent.

131.

a.

Agree and disagree. Technically, a rise in stock prices does not imply a richer economy. If, however, the rise in stock prices reflects underlying real economic improvement such as finding the cure for cancer or a technological advance, society will be richer not because of the rise in stock prices, but because of the underlying cause of their rise.

aaaaaaaaaa. Disagree. If both the real and financial assets are worth $1 million, then they have the same value as long as they are valued at market prices. Just as financial assets bear a risk of no repayment, real assets bear a risk of a fluctuation in prices. bbbbbbbbbb. Disagree. Financial assets facilitate trades that could not otherwise have taken place and thus have enormous value to society. cccccccccc. Disagree. The value of an asset depends not only on the quantity but also on its price per unit. The price of land per acre in Japan exceeds that in the United States by so much that the total value of land in Japan also exceeds that in the United States. dddddddddd. Disagree. The stock market valuation depends on the supply and demand for existing stocks. There is, however, a relationship between relative growth in GDP and the rise in stock prices to the extent that growth in stock prices and GDP growth both reflect economic well-being in a country. Also, many of the companies are multinational companies, and where the company is based may not reflect where its value added is generated.

CHAPTER 11: MONETARY POLICY Questions and Exercises 132.

Contractionary monetary policy shifts the aggregate demand curve to the left. In the 21

short run, this will reduce output and reduce the price

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level. The long-run effect depends on where the economy is relative to potential output. In the graph shown, the contractionary monetary policy brings the economy back to its potential (from point A to point B).

Price level

LAS

SAS

P0

A

P1

B

AD0 AD1 Y1

Y0

Real output

2

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133.

a.

In the short run, when the economy is significantly below potential, the shift of the AD curve to the right from AD0 to AD1 will increase both real output and the price level. Because the economy is below potential, there are no cost pressures to shift the SAS curve up. Output rises from Y0 to Y1 and the price level rises from P0 to P1 as shown in graph (a) below.

eeeeeeeeee.

When the economy is significantly above potential, the effect of the shift of the AD curve to the right is entirely borne by the price level, not real output. The AD curve shifts to the right from AD0 to AD1 . In the short run, the price output rises to Y1 and the price level rises to P1 (point B). In the long run, the rise in cost pressures shifts the SAS curve up from SAS0 to SAS1 . Real

Price level

output falls to potential, LAS at Y2 , and the price level rises even further to P2 (point C).

Price level

LAS

SAS1

LAS P2

C

SAS

SAS0

P1

P1

P0

P0

B A

AD1

AD1

AD0 Y0

Y1

AD0 Y2

Real output

Y0

Y1

Real output

134.

It is neither completely private nor completely public. The Fed is a semiautonomous agency of the federal government. Although it is owned by member banks, its officials are appointed by government. It is a creation of Congress, but has much more independence than most public agencies.

135.

There are few regional Fed banks in the western part of the United States because in 1913, when the Fed was established, the West and South were less populated and less important economically than the rest of the country. As these regions grew, the original structure remained because no one wanted to go through the political wrangling that restructuring would bring about.

136.

The six explicit functions of the Fed are: 1) conducting monetary policy; 2) supervising financial institutions; 3) serving as a lender of last resort; 4) providing 1

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banking services to the U.S. government; 5) issuing coin and currency; and 6) providing financial services to commercial banks.

137.

The Fed buys and sells bonds to increase and decrease the amount of reserves banks have on hand. When the Fed buys bonds, banks have more reserves and then are able to lend more. As they lend more, the money supply increases.

138.

The money multiplier is 1 ∕ r. When the Fed eliminated the reserve requirement, the money multiplier increased and, without other Fed action, the supply of money also increases.

139.

If the Fed raises the interest rate paid on reserves, banks will hold more reserves, leading to a decline in the money supply. If the Fed lowers the interest paid on reserves, banks will hold less reserves, leading to an increase in the money supply.

140.

An economy is in a liquidity trap when banks do not lend increases in reserves added by the Fed, instead choosing to keep them as excess.

141.

Banks can also borrow reserves from the Fed at the discount window. The rate banks pay to borrow reserves from the Fed is called the discount rate.

142.

The Federal funds rate is the interest rate that banks charge one another for Fed funds or reserves.

You would expect it to fall since the Fed‘s actions of buying bonds would increase the money supply by making more reserves available to banks and the greater economy.

143.

144.

Because the current money multiplier is 5 (1 ∕ 0.2), the Fed would buy $600,000 ($3,000,000 ∕ 5) worth of bonds, increasing the monetary base by that $600,000 and the money supply by five times that or $3 million.

145.

a.

The money multiplier would be 1.

ffffffffff. The money supply would decrease enormously.

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gggggggggg.

This could be offset by the Federal government buying up Treasury bills, directly increasing the money supply, or by the Federal government making loans to individuals and businesses.

146.

a.

The money multiplier is 1 ∕ r. If this is equal to 2, then the current reserve requirement is 50 percent. Given that the money supply is currently $5,000, banks have $2,500 in reserves. For this amount of reserves to support a money supply of $5,250, the money multiplier has to be 2.1 ($5,250 ∕ $2,500), which means the reserve requirement must be lowered to .48 percent (2.1 = 0.48).

hhhhhhhhhh.

Lowering the discount rate will encourage banks to borrow. This will increase the amount of reserves in the system so that the money supply increases. If the Fed wishes to increase the money supply by $250, and the multiplier is 2, reserves must be increased by $125. If banks will borrow an additional $10 for every point the discount rate is lowered, the Fed should lower the rate by 12.5 percentage points. In reality, given the typical value of the discount rate, the Fed would not be able to lower the rate this much. Remember, monetary policy is not mechanistic. These are simply hypothetical exercises. iiiiiiiiii. To increase the money supply by using open market operations, the Fed should buy bonds, thus increasing the level of reserves in the banking system. To achieve an increase of $250 (if the multiplier is 2) the Fed should buy $125 ($250 ∕ 2) worth of bonds.

147.

To increase income by $240, investment should increase by $60 (the expenditures multiplier is 4). Increasing investment by $60 requires decreasing the interest rate by 1 percentage point (investment increases by $60 for every 1 percentage point drop in interest). To change the interest rate by 1 percentage point requires a change of $5 in the money supply (each change of $5 in the money supply changes the interest rate by 1 percent). Since the money multiplier is 5, the monetary base should increase by $1. Thus, the recommended policy is an open market purchase that would increase the monetary base by $1.

148.

In an ample reserve monetary policy system, the Fed controls the short-term interest rate primarily by changing the interest rate paid to banks on reserves held at the Fed.

149.

Conventional monetary policy directly influences short-term interest rates, pushing them up and down. When the Fed raises interest rates on reserves, it pushes up short-term interest rates as shown by arrow a and a rotation of the yield curve from Yield Curve 1 to Yield Curve 2. With balance sheet policy, the Fed changes its holdings of long-term assets, which will push long-term rates up and 3

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down. When the Fed sells long-term assets, it pushes up long-term interest rates as shown by arrow b and a rotation of the yield curve from Yield Curve 1 to Yield Curve 3.

150.

The yield curve is likely to become inverted when the Fed is implementing contractionary policy because it is pushing up short-term interest rates, but not long-term interest rates, thus leading to a possible inverted yield curve.

151.

With ample reserve monetary policy, the Fed will change the interest paid on reserves to direct the economy–lowering the rate when it wants to expand the economy and raising the rate when it wants to slow the economy. With limited reserve monetary policy, the Fed has other tools at its disposal, such as injecting or withdrawing reserves directly into the system.

152.

Quantitative tightening requires the Fed to buy long-term assets, which will push the price of those assets down and the long-term interest rate up.

153.

The Taylor rule [2 percent + Current inflation + 1 ∕ 2(Current inflation − Inflation target) + 1 ∕ 2(percent output deviates from potential output)] suggests that the Fed will target a Fed funds rate of 5.5 percent  2  3  .5 1  .5  0   .

154.

The Taylor rule is that the Fed funds target is 2 percent + Current inflation + 1 ∕ 2(Current inflation − inflation target) + 1 ∕ 2(percent output deviates from potential output).

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jjjjjjjjjj.

Fed funds rate target will be 2.5 percent  2  2  .5  1  .5  2   .

kkkkkkkkkk. llllllllll.

155.

Fed funds rate target will be 8.5 percent  2  4  .5  2   .5  3  .

Fed funds rate target will be 5.5 percent  2  4  .5 1  .5  2   .

Expectations definitely matter to policy makers, because expectations will alter people‘s responses to policy actions. If the Fed follows expansionary monetary policy to spur the economy, and the result is raised expectations of inflation, the Fed might end up with higher, not lower, long-term interest rates.

156. Real interest rate mmmmmmmmmm. nnnnnnnnnn. oooooooooo. pppppppppp.

Nominal interest rate 6 −2 2 3

Expected inflation 10 4 5 7 8 6 4 1

Real interest rate = Nominal interest rate − Expected inflation

157.

A monetary regime is a predetermined statement about what policies will be followed in various situations. It ties the hands of policy makers and is meant to change the way people form their expectations. A policy is a one-time action that does not require a particular course of future actions.

158.

An inflation target policy might make the Fed pursue a contractionary monetary policy when only temporary factors raise inflation, whereas it might have been better to wait until the temporary factors disappeared instead of slowing the economy.

With transparency, the Fed tells the people what it is doing and then the people see that in fact, the Fed does what it says it will. This adds credibility to Fed policy.

159.

Questions from Alternative Perspectives 160.

Austrian His argument was that financial institutions can create an almost infinite number of effective substitutes for money, which undermines the ability of the Fed to control the economy with monetary policy.

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161. Feminist qqqqqqqqqq.

Some feminists would argue that an almost exclusive focus on men in prominent quotations perpetuates male bias in the economics profession. It ignores the contributions of women economists and political economists such as Mary Wollstonecraft, Charlotte Perkins Gilman, Joan Robinson, Marianne Ferber, Barbara Bergmann, and Heidi Hartmann among many more. rrrrrrrrrr. This is a judgment question and judgments differ. Most feminists believe that we should be concerned.

162. Institutionalist ssssssssss. When interest rates are very low, it is unlikely that they will go any lower, which makes people worried about holding long-term bonds, since the value of a fixed interest rate bond falls when interest rates rise, and they want to avoid that capital loss. Thus, they prefer to hold money even though it pays no interest. tttttttttt. One possibility is to change the nature of money, making it lose value.

There were such proposals put forward during the Great Depression. Another possibility would be for monetary policy to be directed to foreign exchange, and not on local bonds. By lowering the price of the country‘s currency, such a policy could stimulate the economy.

163.

Post-Keynesian If it were accepted that money were non-neutral, then there would be less focus on using monetary policy only to fight inflation and more consideration of using monetary policy to expand the economy.

164. Radical uuuuuuuuuu.

This is a judgment question and judgments differ. Radical economists believe that the Fed‘s conduct of monetary policy helps the rich bondholders more than it helps the poor. vvvvvvvvvv.

This is a judgment question and judgments differ. Radical economists believe that the Fed should serve the interests of the entire society, with special focus on low-income individuals.

Issues to Ponder 165.

If we consider the example of an open market sale by the Fed, the initial transaction or "splash" would be the Fed sells a bond, and in exchange a person writes a check to the Fed, which the Fed presents to the person's bank for payment. The bank now must adjust to this change, and the "ripples" will show up 6

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on its balance sheet. Paying cash to the Fed means that the bank's reserves are too low, and the bank must figure out a way to meet its reserve requirement. It may call in loans to do so, but that in turn could mean that someone paid the loan from a checking account, which has further balance sheet implications. Now that the bank wants to make fewer loans, it will increase its interest rates, which will discourage investment and have further ripple effects on the economy.

166.

When the Fed takes money out of the economy, banks are in violation of Fed regulations and have no choice but to contract their loans in order to meet their reserve requirements. When the Fed puts money into the economy, banks have excess reserves, but there is no regulation that they are violating because they are covering required reserves. Although they may have a financial incentive to make loans, they are not required to do so. Similarly, consumers are not required to borrow. Since banks are not required to make loans, and thus will not necessarily reduce interest rates, the saying ―You can lead a horse to water, but you can‘t make it drink‖ is relevant.

167.

Treasury bills pay interest; cash does not.

168.

As you can see from Figure 11-6, the Fed does not always follow the Taylor Rule.

This was particularly true after 2008. The policy principles embedded in the Taylor rule are sound. It is reasonable that the Fed raises its federal funds target rate when inflation increases and lowers it as the output gap increases. Following such rules can add credibility to monetary policy. But, if the economy experiences extraordinary shocks, as with 2008 financial crisis and the 2020 pandemic, following the Taylor Rule makes less sense since the situation can change quickly in significant ways. The Taylor Rule is best seen as a reasonable heuristic, not as a rigid rule.

CHAPTER 12: FINANCIAL CRISES, REGULATION, AND THE CRYTO CHALLENGE Questions and Exercises 169.

The Fed's role as lender of last resort is important because if credit dries up, the entire real economy can come to a halt. The Fed can meet this shortage of shortterm credit with loans and monetary policy if no one else will.

170.

Because financial institutions could not sell their assets quickly enough at non-fire sale prices, they could not cover their short-run liabilities, leading to illiquidity.

This caused the stock market to decline significantly and reduced firms' ability to 7

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borrow for their short-term needs. The inability to sell their assets was the cause of the illiquidity.

171.

Extrapolative expectations are expectations that a trend will accelerate. The market may experience an initial shock that causes prices to rise. In an asset price bubble, though, the initial rise in prices leads people to expect further price increases. Thus, people buy goods and assets, causing aggregate demand to shift out to the right, which leads prices to rise even further, fulfilling expectations so that people expect even more price increases. Thus, a rise in prices leads to expectations of a further rise in prices and to a rise in demand at the current price, which leads to another rise in prices and then to expectations of a further rise in prices and so on. Eventually, asset prices will no longer reflect their real value.

172.

Your initial personal investment is $20 and you borrowed the remaining $180 (.9 × $200). At 10 percent interest, you had to repay the original $180 plus $18 interest for a total of $198. The value of the stock rose to $240, which is an increase of $40 (.2 × 200). You will earn $22 ($40 – 18) on an investment of $20, which makes your rate of return 110 percent (22 ÷ 20 × 100).

173.

The Fed followed a much more expansionary policy because there was no sign of inflation, making policy makers estimate a much greater value for potential output than its actual value.

174.

In the standard AS/AD model, financial bubbles play no role in determining potential output because asset price inflation (a financial bubble), is not included in the model. In the standard model, one looks at only goods price inflation to determine whether an economy has exceeded potential output.

175.

The efficient market hypothesis is that all financial decisions are made by rational people and are based on all relevant information that accurately reflects the value of assets today and in the future. The implication is that government does not need to regulate financial markets because people will recognize when the price of assets does not reflect their true value. That is, financial bubbles will not form.

176.

The moral hazard problem is a problem that arises when people‘s actions do not reflect the full cost that will result. With deposit insurance, people can put their money into a bank that offers high interest rates, even though the bank made excessively risky loans, without a risk of losing their money.

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177.

Three reasons the Glass-Steagall Act became less and less effective include: (1) new financial institutions and instruments were invented to circumvent the Act (2) regulations covered fewer financial instruments, and (3) as the collective memory of the reasons for the regulations faded, political pressure to reduce regulations rose.

178.

Large financial institutions are considered too-big-to-fail because these institutions are essential to the workings of the economy; if they fail the entire economy fails. Too-big-to-fail creates the moral hazard problem.

179.

Our future currency is not likely to be a cryptocurrency, though it is likely to be digital. The reason is that cryptocurrencies use decentralized blockchain accounting systems which are more costly and slower than centralized accounting systems, especially when flows are highly regulated as they are with major currency flows. So, our future currency is likely to be digital but not crypto.

180.

Decentralized accounting currencies are not safer than centralized accounting systems. Decentralized currencies such as crypto, in theory, are more transparent than centralized digital accounting currencies since all transactions are listed on the web, but they are harder to actually trace. In practice, crypto transactions are extremely hard to trace since it takes a highly trained specialist to actually trace a transaction. With a centralized digital transaction, the bank keeps a record of transactions for you. That is why criminals and ransomware are based in crypto.

For normal transactions, it is much cheaper and safer for the average user to use non-crypto digital currencies.

181.

There‘s no simple answer. Gold-based money didn‘t keep banks from inflating their currencies or keep the government from issuing too many bank notes in relation to the amount of gold backing those notes. Crypto-based money face the same risks, and even though the base crypto asset may be limited, the assets tied to that asset will not be, which means that both can allow monetary inflation. The safety depends on the institutional structure developed around a monetary asset.

That structure has to be transparent; it needs to include significant checks and balances, and requires limits on rent-seeking seignorage. Without the accompanying institutions, any monetary base will fail to prevent inflationary pressures.

182.

Crypto assets should be thought of as highly speculative assets designed to enrich creators of the asset. Noncreators or neophyte investors should expect, on average, to lose on such investments. If you have money to spare and like to gamble that are not in your favor, go ahead and invest in crypto assets.

9

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Questions from Alternative Perspectives 183.

Austrian The gold standard can be seen as a type of precommitment policy in which the amount of money is set by the amount of gold. While the idea behind the proposal may be sound, and the experience of the past decade suggests that precommitment is needed, it also suggests that people usually find a way around any rule and use the precommitment to their advantage.

184.

Post-Keynesian Minsky‘s theory is based on a view of the economy that involves people being collectively irrational and financial markets not working well. It suggests that regulation of those markets is necessary. Since people in financial markets were making enormous amounts of money, they did not want it regulated, and thus were not inclined to accept a theory that questioned whether the markets were serving a useful purpose.

185.

Post-Keynesian If the economy is nonergodic, the future is truly unknown to everyone, and there can be no single efficient result. There is true uncertainty that creates risk that cannot be hedged against. This undermines the efficient market hypothesis and increases the possibilities for financial bubbles, but also makes it harder to specify whether a change in asset prices is a financial bubble or a change in the structural model. Overall, it makes policy much more difficult to conduct.

186.

Post-Keynesian If Greece makes its bonds legal payment for taxes, many of its taxes will be paid in those bonds rather than with cash, as long as the value of those bonds is below the face value because of default risk. This proposal would essentially monetize those bonds, which would be the equivalent of increasing the money supply.

Since Greece does not have an independent money supply, but is part of the Eurozone, it is unlikely that the European Central Bank will agree to such a policy.

187.

Radical The question whether there is what might be called regulatory capture where the people determining regulations come from the same groups that are being 10

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regulated, is legitimate. In these cases, the regulations are more likely to benefit, or be lenient on, those being regulated. The problem is that regulation requires enormous institutional knowledge and the people who have that institutional knowledge are people in the financial sector.

Issues to Ponder 188.

The answer to such questions is normative. If considering the direct effects on the economy, paying the bondholders would probably take precedence because not doing so would raise interest rates and potentially reduce credit availability in the economy. Not paying employees their pensions would lower their consumption, since they would have to save more to ensure enough for retirement; in the end, this would lower output and raise unemployment.

189.

The answer to this question depends on the specifics of the crisis as well as what view one takes regarding the state of the current economy. If one subscribes to the standard AS/AD model, the answer is to respond in the way the Fed and government are doing today and add credit to the economy (expansionary monetary policy). If one subscribes to the structural stagnation hypothesis, the answer would be to add credit to the economy to avoid a complete collapse, but once the crisis is averted, reverse that action so that structural adjustments necessary for financial health are made.

190.

While the fact that people cannot consistently make money in the market is consistent with the efficient market hypothesis, it is not the only explanation. In order to profit from an investment when the market is far from its ―correct‖ value, people must have access to sufficient funds to take advantage of significant temporary deviations. Such access to sufficient funds does not exist, which means that the investor could go broke before the market returns to its more reasonable level.

191.

If the bailout is needed to keep the economy alive, it is possible that economists will worry more about the short-run problems, because there will be no economy left if you don‘t implement a bailout. After the bailout, regulations can then be put in place to address the moral hazard problem.

192.

This question has more than one right answer, but raises issues related to the moral hazard problem.

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193.

The most recent financial crisis was in part caused by deregulation because deregulation meant that there were fewer and fewer regulations that would help to keep banks and financial institutions from making decisions that would put the financial market at risk of default. The changing institutional structure contributed to deregulation because institutional changes were undermining the goals of the existing regulation to begin with. Technological changes in the financial industry undermined the old regulatory structures, requiring the removal of some regulations, but instituting new ones that addressed potential problems of the new financial environment became necessary. The problem was that the new regulations were not up to the task. Regulation of an evolving system requires constant changes in the regulations.

CHAPTER 13: DEFICITS AND DEBT Questions and Exercises 194.

It follows from the long-run framework because in this framework, deficits are warranted only when government investment is more productive than private investment. When it isn‘t, surpluses are good because they provide additional saving for an economy. The long-run framework directs one to avoid deficits; in the short-run framework, deficits are useful if the economy is significantly below potential.

195.

It depends. Your cash flow budget is in deficit since your expenditures exceed your income. However, if you consider your tuition expense an investment in your future and include it as your capital budget instead of your current account (cash) budget, then your current account budget will have a surplus.

196.

The completed table is shown below:

Year 1 Year 2 Year 3 Year 4 Year 5

Revenue s $182 $216 $227 $219 $240

Expenditure s $174 $278 $216 $226 $222

Debt $583 $645 $634 $641 $623

Note that a budget deficit adds to the debt, while a budget surplus reduces the accumulated debt.

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197.

The two ways the government can finance a deficit is by selling bonds or by printing money.

198.

Actual deficit = Structural deficit + Cyclical deficit Cyclical deficit = Actual deficit − Structural deficit Cyclical deficit = $300 − $100 billion = $200 billion.

199.

Assuming expenditures do not change with income, tax revenues are $50 billion ($250 billion × 20%) dollars higher than they would be if the economy were at its potential. In other words, the cyclical surplus is $50 billion because tax revenues are $50 billion higher as the economy is operating above potential. The structural deficit equals actual deficit minus cyclical deficit. Since we have a cyclical surplus we add, not subtract, this amount to the actual deficit. So, the structural deficit is $150 billion ($100 billion + $50 billion).

200.

a.

The cyclical deficit must be zero since it is defined as zero at potential output.

wwwwwwwwww. The structural deficit is $200 billion; because there is no cyclical deficit, the entire deficit must be structural. xxxxxxxxxx.

Now, $60 billion of the deficit is cyclical (.3 × $200), and $140 billion is structural: (Actual deficit − Cyclical deficit = $200 − $60). yyyyyyyyyy.

Now there is a cyclical surplus of $30 billion (.3 × $100). The structural deficit is $230 billion (Actual deficit  Cyclical deficit = $200  $30 .

Note, there is a cyclical surplus in this case zzzzzzzzzz.

The structural deficit is likely of more concern to policy makers because standard monetary and fiscal policies cannot change the structural deficit.

201.

The real deficit is calculated as the nominal deficit less the product of the inflation rate and the total debt. Therefore,

aaaaaaaaaaa.

The real budget has a surplus of $80 billion. ($220 billion  (.10  3 trillion) = ($80) billion ($80 billion surplus)) bbbbbbbbbbb.

The real deficit is $30 billion [$50 billion  ((.02 × $1 trillion) = $30 billion deficit].

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ccccccccccc.

The real deficit is $50 billion [$30 billion  ( .04  $500 billion)  $50 billion deficit]. ddddddddddd.

The real budget has a surplus of $160 billion ($100 billion surplus + $60 billion (.03 × $2 trillion) = $160 billion surplus).

202.

Given that the nominal deficit is $480 billion, the inflation rate is 18 percent, and the debt is $2 trillion, the real deficit is calculated as the difference between the nominal deficit and the product of the inflation rate and the total debt, or $480 billion (.18)($2 trillion) = ($120) billion. There is a real deficit of $120 billion.

203.

It would not differ; expected inflation does not enter into the determination of the real deficit, only actual inflation does.

204.

a.

Debt service payments are equal to the interest rate times nominal debt (0.04 × $280 billion) = $11.2 billion.

eeeeeeeeeee.

[Revenue − expenditures = $190 billion − ($11.2 billion + $180 billion) = −$1.2 billion.] Expenditures include debt service payments and government expenditures. The nominal deficit is $1.2 billion. fffffffffff. The budget has a real surplus of $4.4 billion. [Real deficit = nominal deficit − (inflation × debt) = $1.2 billion − (0.02 × $280 billion) = $4.4 billion (a surplus).

205.

Three ways individual debt differs from government debt include: (1) government is ongoing and therefore never needs to pay back the debt, (2) government can pay off the debt by creating money, and (3) much of the government debt is internal debt owed to its own citizens and agencies.

206.

No. Financing internal debt causes redistribution, because interest payments are paid to citizens of the country who own the bonds that finance the debt; it does not make the society poorer.

207.

a.

Since the real deficit is rising at a faster rate than real growth in the economy, the deficit-to-GDP ratio is rising. The country can continue to afford such deficits only as long as it can sell the bonds.

ggggggggggg.

At some point the debt-to-GDP ratio will become so large that creditors will begin to doubt the country's ability to repay the debt. Then, selling bonds will become more difficult and eventually impossible.

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208.

The more debt that is external (held by individuals and governments outside a country), the more a potential debt crisis will impact global markets. This may create global financial instability, as more markets would be affected by a default.

209.

Debt service is an important measure of whether debt is a problem because interest payments are the result of past expenditures and are not additional productive expenditures. They are the burden of the debt. If the debt service is large and is hurting the government‘s ability to fund today‘s expenditures, that debt could be considered a problem.

210.

A debt that is too high may lead bondholders to require a risk premium on bonds.

Interest rates will rise, which will raise interest payments, leading to higher deficits further increasing the debt, which increases the risk of default. Interest rates will rise again, and the process repeats itself.

211.

If the Fed buys up bonds, it may lead to inflation, which will lead to higher interest payments and perhaps a greater risk of default. This will likely raise interest rates further, thus raising the debt even further. A vicious cycle begins, which might lead to a U.S. default.

Questions from Alternative Perspectives 212.

Austrian Austrians believe that our lack of knowledge of the right policy is a severe limit to useful monetary and fiscal policy. But even if we could determine the correct policy, the political process will seriously hinder the government‘s ability to implement the right policy.

213. Institutionalist hhhhhhhhhhh.

Low-income groups have the highest marginal propensity to consume. iiiiiiiiiii. To achieve the greatest demand stimulus from a given tax cut, the cut should go to the poor, but this rarely happens. jjjjjjjjjjj. Tax cuts will increase the debt, which will benefit the rich who hold most of the debt and therefore receive most of the interest payments on the debt. kkkkkkkkkkk.

The pattern seen by some Institutionalists is that the rich get the vast majority of the benefits from tax cuts.

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214. Post-Keynesian lllllllllll. Trump‘s argument for the tax cut was a long-run supply-side argument.

When the economy fell into a recession, he started using short-run demand-side arguments to support the tax cut. Most Post-Keynesians feel that the effect of a tax cut is primarily through its effects on demand, although in the longer run there may be some supply-side effects. mmmmmmmmmmm.

From a Post-Keynesian point of view, President Biden should not worry about the deficit and should focus on using aggregate demand policy to achieve full employment.

215. Feminist nnnnnnnnnnn.

A program that provides a ―baby bonus‖—a payment for each child that a woman has would be a policy with a gender effect. ooooooooooo.

A tax on large sporting events, such as basketball, would affect men more than women (more men watch basketball than women) and thus would not be gender neutral. ppppppppppp.

Feminists believe that such effects are important to consider because if one does not, then women are likely to be shortchanged by the government.

Issues to Ponder 216.

A structural deficit would exist even if the economy were at its potential level of income, which would be at full employment, or at where the unemployment rate is equal to the target rate of unemployment. If an economist believed that the target rate of unemployment was 4 percent instead of 6 percent, then the difference between the economy‘s current state and the potential income level would be larger, leading to a greater cyclical deficit and therefore a smaller structural deficit. Thus, Mr. A would say the structural deficit is $20 billion and Ms. B would say it is $40 billion.

217.

Debt is defined as accumulated deficits and is also a summary measure of a country's financial situation. Debt must be viewed in relation to a country's assets, but, like income and revenues, assets and debts are subject to varying definitions.

There's no unique answer to how assets and debts should be valued, and there are different types of debt. It is also important to examine the debt-to-GDP ratio, rather than debt alone.

218.

To make the deficit look as small as possible, we would do the following: 16

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qqqqqqqqqqq.

Enter government pensions when they become payable, not on an accrual basis. rrrrrrrrrrr. Treat the sale of land as current income rather than spreading it out with the sale of an asset. sssssssssss.

Include Social Security taxes as current revenue, because at this time, revenue from Social Security exceeds payment. ttttttttttt. Count prepayment of taxes as current income instead of reserves for future taxes. uuuuuuuuuuu.

Count expenditures on F-52 bombers as capital expenditures. Do not include their depreciation in the government accounts.

219.

Deficits and surpluses are only summary measures of the economy. A government can undertake significant future obligations and therefore get itself into trouble even if it is not running a deficit.

CHAPTER 14: THE FISCAL POLICY DILEMMA Questions and Exercises 220.

a.

No effect. According to the Ricardian equivalence theorem, paying for an increase in spending by increasing taxes in the future will not affect the economy.

In order to pay tax increases, people will decrease their consumption by the same amount that spending increases.

vvvvvvvvvvv.

No effect. According to the Ricardian equivalence theorem, deficit spending (issuing bonds) has no effect on the interest rate, because people will increase their savings (to pay future taxes to repay the bonds) sufficiently enough to offset the increase in the deficit. wwwwwwwwwww.

The implication is that government ought to follow a policy of sound finance. That is, always balancing the budget regardless of the state of the economy.

221.

According to the Ricardian equivalence theorem, people increase their savings in anticipation of a future increase in taxes to pay for that deficit. The aggregate demand curve does not shift at all because the increase in government spending is exactly offset by a decline in private spending.

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222.

Sound finance does not depend on the Ricardian equivalence theorem because sound finance is based on political grounds. Those who held the sound finance belief tended to be suspicious of the government.

223.

Functional finance is the theoretical proposition that government should make spending and taxing decisions on the basis of their effect on the economy, rather than concern itself with balancing the budget.

224.

a.

According to sound finance theory, there is no room for activist fiscal policy, because government cannot be trusted to implement the right policies.

xxxxxxxxxxx.

According to the functional finance theory, there is room for activist fiscal policy. The economy is subject to fluctuations in output and if it is believed that fiscal policy will smooth out those fluctuations, it should be used to do so.

225.

Functional finance is difficult to implement because (1) financing the deficit often has offsetting effects such as those caused by crowding out, (2) the government often doesn't know the current state of the economy, (3), the government often does not know the economy‘s potential income level, (4) the government has limited flexibility in changing spending and taxes, (5) the size of the government debt matters to the economy, and (6) fiscal policy can negatively affect other government goals.

226.

When the government runs a budget deficit, it must sell bonds to finance that deficit. To get people to buy and hold more bonds, the government must pay a higher interest rate. Higher interest rates make it more expensive for businesses and consumers to borrow, so they reduce their spending.

227.

If interest rates have no effect on investment, there would be no crowding out.

Crowding out occurs when the government‘s sale of bonds to finance expansionary fiscal policy causes interest rates to rise, choking off private investment.

228.

a.

With full crowding out, the AD curve shifts back to its original position and fiscal policy has no effect on the economy as shown in graph (a) below. The economy moves from point A to point B due to expansionary policy and shifts back to A because of full crowding out.

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yyyyyyyyyyy.

With partial crowding out, the AD curve shifts back partway to the left, but not back to its original position, and fiscal policy has less of an effect on the economy compared to if there were no crowding out. This is in graph (b) below as a movement from Point A to point B to point C.

zzzzzzzzzzz.

With full crowding out, the AD curve shifts back to its original position and fiscal policy has no effect on the economy. If private investment is more productive, however, in the long run, the L A S curve shifts in to the left (from LAS0 to LAS1 ), which causes the SAS curve to shift up (from SAS0 to SAS1 ), and the economy ends up at a lower level of output and a higher price level as shown in graph (c) below. The economy moves from Point A to point B to point C. 19 © MCGRAW HILL LLC. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW HILL LLC.

229.

a.

Increasing taxes shifts the aggregate demand curve in to the left, decreasing real output and the price level, shown below in graph (a) as a movement from point A to point B.

aaaaaaaaaaaa.

The increase in taxes will require government to finance a lower budget deficit, which will lower interest rates. As interest rates fall, investment rises. The decrease in the deficit shifts the AD curve to the left from AD0 to AD1 (the economy moves from point A to point B). If there were partial crowding out, 20 © MCGRAW HILL LLC. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW HILL LLC.

the AD curve would shift back to the right, in this case from AD1 to AD 2 , and the economy moves to point C. Partial crowding slightly offsets the effect of higher taxes on the price level and real output. Since the rise in investment offsets the decline in the deficit, one might call this crowding in; this is crowding out in reverse.

bbbbbbbbbbbb. If there is complete crowding out, the rise in investment will completely offset the contractionary effect of the tax increase on the economy.

The tax increase will have no effect on either the price level or real output. As shown in the graph below, the tax increase moves the economy from point A to point B. The increase in private investment shifts the AD curve back to the right, moving the economy back to point A.

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11.

According to the chapter, a 1 percentage point difference in one‘s estimate of the target rate of unemployment is equal to a 2 percentage point difference in the estimate of potential output. In this case, in a $9 trillion economy, a 0.9 percentage point difference in the estimate of the target rate would be associated with a 1.8 percentage point difference in potential income. So, .018 × $9 trillion = $162 billion.

12.

The budget process begins a year and a half before the budget is implemented, making it difficult to know what type of fiscal policy will be needed by that time.

In addition, many budget decisions are made for political reasons (few politicians would vote for a tax increase in an election year even if such an increase were needed). Finally, nearly two-thirds of the budget is mandated by federal programs and cannot be easily changed.

13.

Increasing government spending shifts aggregate demand out to the right and thereby increases income and reduces unemployment (shown as a movement from point A to point B). This makes people better off in the short run and more likely to vote for the incumbent president. The exception would be if the economy is already above potential income and there is a significant inflation threat.

14.

Increasing taxes shifts the aggregate demand curve in to the left, decreasing income, increasing unemployment, and making people less likely to vote for those in office. The maxim holds because people tend to have short memories. In the graph, this is shown as a leftward shift in the AD curve, moving the economy from point A to point B.

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15.

The assumption that the size of the debt doesn't matter has been called into question more fervently than ever because of the debt problems faced by Greece, which almost faced bankruptcy in 2011. It had to be bailed out by the European Union and the IMF, making it clear that having major debts is unsustainable. The United States hasn‘t had to face the possible difficulties of a burdensome debt yet, but if it doesn't deal with its rising debt soon, it might face similar difficulties as Greece.

16.

State balanced budget requirements are procyclical because during downturns, tax revenue generally falls, making it necessary for state governments to raise tax rates and cut expenditures in order to maintain a balanced budget. Such actions slow the economy even further. The opposite is true during expansions: tax revenues rise so that states accumulate surpluses. They likely cut tax rates and increase expenditures, contributing to a greater expansion.

17.

Automatic stabilizers reduce taxes and raise expenditures during contractions without additional government action. In an expansion, automatic stabilizers raise taxes and decrease expenditures. They therefore act to offset shifts in the economy, giving them their "stabilizing" quality.

18.

One problem with automatic stabilizers is that when an economy starts to climb out of a recession, automatic stabilizers will slow the recovery process for the same exact reasons they slowed the contractionary process when the recession first started. Note that as income finally increases, automatic stabilizers increase 23

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government taxes and decrease government spending, which will act to slow the recovery.

Questions from Alternative Perspectives 19.

Austrian Austrians believe that individuals know what is in their best interest and that savings should be neither encouraged nor discouraged by government. The level of savings will be in part determined by the available opportunities for investment, so sometimes high levels of savings are appropriate, and other times low levels of savings are appropriate.

20.

Post-Keynesian cccccccccccc.

In the standard argument, the unemployment was caused by a fall in aggregate demand moving the economy to point B in the graph, creating a gap between potential and actual output. If the price level fell to where the AD curve intersected the unchanging LAS curve, the economy would return to full employment at point C.

dddddddddddd. The standard model assumes that as demand falls, the LAS curve will not move. Post Keynesians see the LAS curve as something of an illusion; when demand falls, supply falls with it, which means that a fall in the price level will not solve the problem. They also see the AD curve as highly inelastic— almost vertical, so it is not clear that there is any fall in the price level that will achieve equilibrium.

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21.

Institutionalist These voter initiatives are generally financed by out-of-state anti-taxation groups.

Of course, reduced taxation translates into less government involvement, and only government has the power to constrain the free market. It is reasonable to conclude that these groups want to replace government control with control by business.

22.

Radical eeeeeeeeeeee.

Radical economists believe that it would take a firm commitment by government to maintain full employment, and the willingness to design income policies that would limit any inflationary pressures in a fair way. ffffffffffff. A full employment regime would give workers much more power and reduce the power of employers and other capitalists, requiring them to pay higher wages and accept lower profits. gggggggggggg. Within today‘s political environment, it is highly unlikely that any true full employment regime is possible. Radical economists believe that true full employment does not exist because it is not in the interest of those in power.

23.

Religious hhhhhhhhhhhh. Society is deeply divided about the weights that should be given to various goals, which is one of the reasons why policy is so difficult to carry out. iiiiiiiiiiii. Religious economists believe that religious beliefs should play a central role in establishing those values, and that society currently does not give enough weight to religious values.

Issues to Ponder 24. a. In 1995, the unemployment rate fell below the target rate of 6 percent without generating inflationary pressures. He was probably changing his estimates to reflect that reality. jjjjjjjjjjjj. It would shift the LAS curve to the right. Eventually, the price level will fall and output will rise as shown in the graph below. In the accompanying graph, the LAS curve shifts from LAS0 to LAS1 Since potential is now greater than actual output, the SAS curve shifts down from SAS0 to SAS1 . The economy moves from point A to point B. The price level falls and real output rises.

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kkkkkkkkkkkk. As previously argued in an earlier chapter, a 0.5 percentage point decline in the target unemployment rate would imply a rise in potential income of 1 percent, or $73 billion.

25. a. President Clinton's policy does not fit well with the multiplier model because with that model, the two goals are inconsistent with one another in the short run. To increase output and employment using expansionary fiscal tools requires an increase in the deficit. llllllllllll. His policy might have had the desired effect if a reduction in government expenditures caused the interest rate to fall so much and affected expectations positively to such a degree, that investment and consumption expenditures rose sufficiently to more than offset the decline in government spending. mmmmmmmmmmmm. The reduction in the deficit shifts the AD curve to the left from AD0 to AD1 , from point A to point B in the graph, but the increase in investment expenditures, resulting from the reduction in interest rates, shifts the AD curve to the right by so much (from AD1 to AD 2 ) that, on net, output rises.

The economy moves to point C.

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nnnnnnnnnnnn. I would look at interest rates and investment expenditures to see if the explanation is correct.

26. a. In the standard AS/AD model, a tax cut will shift the AD curve to the right, leading to an increase in the price level and real output. This is shown in graph (a) below, as a shift in the AD curve from AD0 to AD1 . The economy moves from point A to point B.

oooooooooooo.

Senator Stable‘s views fit this model well.

pppppppppppp. If Senator Growth is correct, the tax cut will shift the LAS curve to the right, (shown in graph (b) below) a shift from LAS0 to LAS1 . If the economy had previously been in long-run equilibrium, the economy will now be below potential, and there will be pressures for factor prices to decline. Assuming 27 © MCGRAW HILL LLC. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW HILL LLC.

nothing else happens in the meantime, the SAS curve will shift down from SAS0 to SAS1 , leading to a lower price level and higher real output. The effect on the economy is shown as a movement from point A to point B.

qqqqqqqqqqqq.

In the short run, Senator Stable is likely to be correct.

rrrrrrrrrrrr. The tax cut will require government to finance a higher budget deficit.

This would lead to higher interest rates and lower investment. If there is complete crowding out, the decline in investment will completely offset the expansionary effect of the tax cut. In this case, the tax cut will have no effect on either the price level or real output. So, with significant crowding out, both would likely be wrong.

CHAPTER 15: JOBS AND UNEMPLOYMENT Questions and Exercises 27.

The duration of unemployment rose during the 2008/09 recession. The likely cause of this extended duration was that people were unable to find comparable jobs, at comparable pay, to the ones that they had lost, and others couldn‘t find work.

28.

The rise in the duration of unemployment suggests that recent recessions, and subsequent slow expansions, are different from previous business cycles. It is possible that the cause is structural problems in the economy. That would suggest that structural unemployment in the economy has risen. The recent COVID pandemic and the government response to it, has made interpreting the data difficult. Overall unemployment has fallen significantly, but inflation has risen.

28

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29.

Okun‘s rule of thumb states that a 1 percentage point rise in the unemployment rate will be associated with a 2 percent fall in output from its trend and vice versa.

Therefore, a 2 percent rise in unemployment is associated with a 4 percent fall in output from its trend.

30.

Cyclical unemployment is the result of temporary declines in economic output and can be addressed with expansionary policy, whereas structural unemployment requires structural changes in an economy. ssssssssssss.

Cyclical.

tttttttttttt. Structural. uuuuuuuuuuuu.

Structural.

vvvvvvvvvvvv.

Structural.

31.

The reservation wage is the wage a person requires before accepting a job. The higher a person's reservation wage is, the more jobs that person will reject, and the higher structural unemployment will become.

32.

Five reasons that the target rate of unemployment has fluctuated are that (1) the population has become younger, (2) more women have entered the workforce, (3) unemployment benefits and welfare have been implemented, (4) automation and other technological advancements, and (5) globalization.

33.

The concept of unemployment is normative because some people view employment as an individual responsibility —if a person cannot find a job that is already available, he or she can create one, such as dog walking. Others believe it is a social responsibility —society owes a person a respectable job at a decent wage.

34.

A person who believes unemployment is an individual's responsibility will believe the current measure of unemployment overstates true unemployment. At any time in the economy, there are jobs that are left unfilled. People who really want a job will accept a job at any pay just to have a job. People who hold an extreme form of the individual responsibility view believe that all unemployment is voluntary.

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35.

Not necessarily, although it could. It depends on the degree to which college courses improve student‘s ability to think and perform in the workplace.

However, some degrees act strictly as a credential, allowing students to get the job, but not actually influence how productively that job is done. Views differ on this question.

36.

Any jobs program will impose some cost to society. One cost that any program incurs is administering the program. To the extent that people choose the program rather than an open position, the lost output is another cost. Other costs depend upon the program. A job-training program, for example, requires office space, equipment, and people to teach those enrolled. The jobs program suggested in the chapter imposes a cost of wage payments to those enrolled and administration costs.

37.

The jobs proposal provides a safety net to those people who really want to work and cannot find a job in the private sector —those most in need of a job. The existing programs, such as unemployment compensation, benefit those people who have lost a job that they held for a minimum period of time and cannot find a new one. Even if they are not applying for jobs, they believe pay too little or offer work that is "beneath them," people can still collect unemployment compensation.

People who either don't have a job or haven't held one for a long enough period of time are excluded from the program.

38.

The guaranteed-jobs program would be more expensive if it provided jobs useful to society for two reasons. (1) More people would participate because participants would gain skills that would help them get a private-sector job, making the jobs more appealing. (2) These guaranteed-jobs would replace private-sector jobs, either raising private-sector wages and costs of production or lowering privatesector output. To the extent that the government can produce goods as efficiently as the private sector, some of the costs associated with (2) will be offset.

39.

Limiting eligibility reduces the cost of the program. Students are a target for exclusion because they generally are looking for temporary, part-time employment. The jobs program is meant to replace jobs for people who are looking for long-term employment.

Questions from Alternative Perspectives 40.

Radical 30

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wwwwwwwwwwww.

The answer depends on normative judgments and cannot be answered based on positive economic analysis alone. I would tend to favor as low an unemployment rate as possible, as long as it is consistent with sustainable economic growth. My focus, given my normative views, would be on jobs for the least well off, not for the middle class, and definitely not for the rich. xxxxxxxxxxxx. Achieving a low unemployment is desirable for the reasons that Vickrey states, but that rate has to be achievable and not lead to other problems such as inflation or asset bubbles that make it unsustainable. How we define unemployment depends on reservation wages, and normative judgments need to be made about what are appropriate reservation wages. yyyyyyyyyyyy. Some version of the guaranteed jobs program suggested in the text is the best solution. Others may disagree, but as the text says, they should come up with a viable, sustainable alternative that society would be willing to implement.

41.

Feminist Women tend to have greater burdens within the household, which means that they often have limitations on when and where they can work. Because the guaranteed jobs program outlined in the text requires full-time work and does not address the costs of replacing home production (such as caring for below school-age children), it seems to be biased against women and others who have faced these limitations. If it were changed to allow more flexibility, it would be less biased.

42.

Post-Keynesian zzzzzzzzzzzz.

This is a normative question that has no answer based on positive economic analysis alone. My own view is that the income distribution resulting from globalization within the United States is far from fair, but then neither is the global distribution of income. aaaaaaaaaaaaa. As I stated above, I do not consider the global distribution of income fair. By raising incomes of people in countries currently earning a low wage, globalization makes it fairer. This creates a tension—in some ways globalization helps achieve what I believe is a fairer income distribution across countries, but in other ways, it hurts income distribution within some countries.

43.

Religious Yes, I believe it would. If the level of savings influences the level of output, which influences the level of consumption and investment, the paradox of thrift is 31

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possible, and saving could actually decrease consumption, rather than increase it.

So yes, it does suggest different views about how to address the unemployment problem. Ideas based on natural liberty would see little role for government in addressing unemployment, since they do not see savings as potentially decreasing output; Keynes, on the other hand, would see a potentially significant role, since he does see savings as potentially decreasing output. Economic analysis does not say either of these views is right or wrong.

Issues to Ponder 44.

The answer to this question will depend on the student. Not having any income is a significant incentive to find or create a job. Presumably someone who is taking a college-level economics course has some skills that would make them employable at some job, even if it is mopping college classroom floors. There are numerous ways to create a job. One way is to offer computer help for pay to those who need it in the community.

45.

This is a matter of judgment about government and individual responsibility, and judgments differ. Some argue that society owes everyone a job who wants one, and that the lack of decent jobs and affordable transportation to get to the jobs that do exist is unfair and a violation of rights. In that case, one would say that government owes everyone a job. Others argue that individuals are responsible for finding their own job, and that it is not for government to find a job for them. I tend to believe the first position is right, assuming the job is a minimum job, as described in the text. Other views can differ, and economic reasoning will not determine which view is right.

46.

What a government can do to lower structural unemployment is up to debate. One idea is to retrain workers for new jobs in industries that have a low unemployment rate. The government jobs program described in the text is another program government can undertake to lower structural unemployment.

47.

The nature of the guaranteed jobs program for many people will be too focused work. One can morally believe that society owes individuals an income regardless of whether they work or not.

48.

By reducing the "work requirement,‖ the program could be made more appropriate for such political views. Increasing the eligibility of the program might also make the program more acceptable to liberals. Both changes would likely significantly raise the cost of the program. Libertarians might view the providing of jobs by government as morally inappropriate and not be willing to 32

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accept it under any circumstances. Some might find it more morally acceptable if the jobs were made more onerous.

CHAPTER 16: INFLATION, DEFLATION, AND MACRO POLICY Questions and Exercises 49.

Asset price inflation occurs when the prices of assets rise by more than their ―real‖ value. Asset inflation matters for two reasons: (1) it can indicate whether an economy has exceeded its potential output, assuming goods inflation is held down by globalization and (2) it can lead to asset deflation, which will hurt the economy.

50.

False. While inflation does not make society richer or poorer, there are costs. The chapter mentions three: (1) there is a loss of informational value of prices, (2) some faith in the government and its ability to control money as a unit of account is lost, and (3) income is redistributed from those who do not, or cannot, raise their prices to those who do.

51.

Three costs of inflation that economists focus on are informational costs, distributional costs, and institutional costs.

52.

Small amounts of inflation allow nominal prices to rise, which ―tricks‖ workers, and those who sell goods and services, into thinking they are better off. As long as borrowers and lenders enter into fixed contracts and inflation is not expected, small amounts of inflation also reduce the cost of borrowing and spur investment—promoting economic growth. This policy would be ineffective if people built these expectations into their decisions.

Since the financial crisis of 2008, and the introduction of unconventional monetary policy, the view of an inflation target being an upper bound has changed. Inflation targets are no longer seen as an upper bound, but as a rate of inflation to aim for, not a target to stay under. So, if the inflation target is 2 percent, and inflation is 1 percent, policy makers don't congratulate themselves; they look for ways to increase inflation. Inflation's ability to allow people to maintain illusions is the explanation for many of the benefits of inflation, and this is why some of the costs of inflation are discounted, or even totally offset.

Inflation allows us to keep illusions that we are better off than we really are. Such illusions "grease the system."

33

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If people had seen the price increase as a one-time event and accepted the decrease in their real income that it implied, it would not generate ongoing inflation. But if the increase became built into expectations, it would have led to other price increases and result in accelerating inflation.

53.

When nominal interest rates get low, expansionary monetary policy is limited by a zero lower bound—the nominal interest rate cannot fall significantly below zero, because if it does, people will just hold cash. Inflation operates as a type of tax on cash holdings, and thus allows the real interest rate to differ from the nominal interest rate. With inflation, central banks can push the real interest rate below zero, even though the nominal interest rate is zero or above.

Because the real interest rate equals the nominal interest rate minus inflation, inflation provides a way around the zero lower bound. While the nominal interest rate cannot fall below zero, the real interest rate can, as long as inflation is greater than the nominal interest rate. For example, with 2 percent inflation and a zero percent interest rate, the real interest rate is -2 percent. The higher the level of inflation, the lower the real interest rate is relative to the nominal interest rate.

Inflation allows policy makers to achieve negative interest rates, which allows monetary policy to be more expansive than it otherwise could be. It is a way around the zero lower bound.

54.

A placebo effect works through an individual's mind, not through normal medicinal methods. Because people think it will have an effect, it does, and what is essentially an illusion becomes the reality. Unconventional monetary policy involves using a money illusion to affect the economy, and thus can be thought of as a type of placebo effect. Inflation, and the accompanying illusion, give people the idea of being better off, and thereby can actually make them better off.

Goods inflation also keeps the economy away from asset deflation. Since assets often serve as collateral for loans, significant asset deflation can throw an economy into a financial crisis, as occurred in 2008 when the prices of housing assets fell substantially. Inflation pushes up the value of assets, giving society the illusion that it is richer, which encourages people to invest and start new businesses. As they do, the illusion creates a growing economy, and what started as an illusion becomes a reality. It works a bit like a placebo effect in medicine.

The illusion of taking a medicine—even one that has no clinical benefit—helps cure the patient.

Unconventional monetary policy emphasizes that the benefits of low inflation should receive more focus. Because (low) inflation greases the wheels of the economy, provides beneficial placebo effects, and allows for banks to get around the zero lower bound, it is generally thought of as useful to some extent.

34

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55.

Lenders lose out in an unexpected inflation because they are paid a fixed nominal interest rate. When inflation increases, their real interest rate decreases, because the nominal rate is constant, and inflation has increased: real interest rate is equal to the nominal rate minus inflation. That is, they are paid back in dollars that are worth less.

56.

Because (low) inflation greases the wheels of the economy, provides beneficial placebo effects, and allows for banks to get around the zero lower bound, it is to some extent thought of as useful.

57.

Asset price inflation redistributes wealth from more cautious to less cautious individuals. An example is investors. Cautious investors purchase less risky stocks whose prices are not likely to rise as much as more risky stocks in an asset price inflation. These less risky investors will earn a lower return on their investment, as long as the asset price inflation does not turn into asset price deflation. Another example is borrowers. Risky borrowers borrow at low interest rates and receive high returns when the asset they bought rises in value. These risky borrowers gain during asset price inflation.

58.

Policy makers have changed their focus to avoiding low inflation rates, because when inflation rates have been very low, the central bank‘s ability to stimulate the economy by lowering interest rates is compromised.

An alternative explanation is that when asset deflation hits, it hits suddenly and hard, as the United States saw in 2008. Once an asset deflation occurs, firms will find that they can no longer borrow, and that they have to pay off past debts.

Some firms are likely to go bankrupt since they don‘t have the assets to cover their liabilities. If they are forced to close, their employees will lose their jobs.

Because deflation undermines the financial health of firms, it can quickly turn into a financial crisis that brings the economy to a standstill. At that point, the government finds it necessary to step in and prop up asset prices, as it did in 2008, to prevent a collapse of the entire economy. So most economists see asset deflation as something to be strongly avoided.

59.

A zero lower bound is important because it is a limit on how far interest rates can fall. With interest rates below zero, people will shift to holding cash. This lower limit constrains the ability of the central bank to stimulate the economy with interest rates.

An alternative explanation is that with conventional monetary policy, policy makers face a zero-interest rate lower bound—a limit on how much interest rates can fall. With unconventional monetary policy, they do not. Because the real 35

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interest rate equals the nominal interest rate minus inflation, inflation provides a way around the zero lower bound. While the nominal interest rate cannot fall below zero, the real interest rate can, as long as inflation is greater than the nominal interest rate. For example, with 2 percent inflation and a zero-interest rate, the real interest rate is -2 percent. The higher the level of inflation, the lower the real interest rate relative to the nominal interest rate. Inflation allows policy makers to achieve negative interest rates, which allows monetary policy to be more expansive than it otherwise could be.

Since the financial crisis of 2008, and the introduction of unconventional monetary policy, that view about an inflation target as being an upper bound for inflation has changed. Inflation targets are no longer seen as an upper bound, but as a rate of inflation to aim for, not a target to stay under. So, if the inflation target is 2 percent, and inflation is 1 percent, policy makers don't congratulate themselves; they look for ways to increase inflation.

60.

Both adaptive and extrapolative expectations are based on past experience.

61.

Inflation would be 2 percent; inflation = wage increases − productivity growth (5 − 3).

62.

The three assumptions that turn the equation of exchange into the quantity theory of money are that (1) velocity of money is constant, (2) real income is independent of the money supply, and (3) the direction of causation is from money to prices.

63.

Inflation will rise to 10 percent. Inflation and the money supply have a direct relationship.

64. a. Real output is $1,200. Use the equation, MV = PQ(600 × 6 = 3Q, so Q = 3, 600/3) . bbbbbbbbbbbbb. Nominal output is $3,600. Nominal output is P  Q(3  $1, 200) ccccccccccccc. If the money supply rises 20 percent (from 600 to 720), the price level will rise 20 percent (from 3 to 3.6). Real output is independent of the money supply, so it would remain unchanged. Nominal output would be $4,320 (3.6 × $1,200). ddddddddddddd. If the government established price controls, either shortages would result if the economy were perfectly competitive, or real output would rise if the economy had monopolistic elements. Within the quantity theory framework, 36 © MCGRAW HILL LLC. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW HILL LLC.

an increase in the money supply, that was not allowed to have an impact on the price level, would have to be accompanied by either a decrease in the velocity of money or an increase in the quantity of goods sold (real output) if that were possible. If that is not possible, shortages would exist that would not be captured by the quantity theory.

The quantity theory of money is problematic because (1) the relationship between the money supply and inflation does not always hold and (2) the velocity of money is not constant.

66.

The short-run Phillips curve is illustrated in the accompanying graph. The shortrun curve shows the trade-off between inflation and unemployment when expectations of inflation are constant. Inflation and unemployment have an inverse relationship.

Inflation

65.

Unemployment rate

67.

The long-run Phillips curve is shown in the accompanying graph below as the vertical curve. The long-run curve shows the lack of a trade-off, as long as expectations of inflation equal actual inflation. There is no relationship between inflation and unemployment.

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68.

No. If inflation changes, but expectations of inflation do not, the economy will stay on the same short-run Phillips curve. The economy will not be on the longrun Phillips curve.

69. a. The economy is at point A on the short-run and long-run Phillips curves on the accompanying graph. eeeeeeeeeeeee. The answer to this question depends on the state of the economy and the concerns of the electorate. If the electorate wants lower unemployment, I would recommend increasing the money supply, moving the economy to a point such as B in the accompanying graph. The problem would be that inflation would rise. If inflation were the concern, I would recommend reducing the money supply, moving the economy to a point such as C in the accompanying graph. The problem with this policy is that unemployment would rise. fffffffffffff.

The short-run consequences are explained in answers to parts a and b. In the case of expansionary monetary policy, inflation expectations will rise, which will shift the short-run Phillips curve up until prices and expectations of inflation are equal. This will occur at an inflation rate greater than 5%, such as point D. Unemployment will return to its target rate. In the case of contractionary monetary policy, inflation expectations will fall, which will shift the short-run Phillips curve down until prices and expectations of inflation are equal, which will be an inflation rate less than 5%, such as point E. Unemployment will return to its target rate.

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Inflation

Long-run Phillips curve

D B

A

5%

PC (Pe >5%)

C

PC (Pe = 5%)

E

PC (Pe < 5%)

Unemployment rate

5%

70. a. An increase in productivity shifts the long-run aggregate supply curve to the right as shown below on the left in graph (a). This allows policy makers to increase aggregate demand (perhaps through expansionary policy, which would keep interest rates low, as desired) without increasing the price level. In this example, the economy moves from point A to point B.

Price level

ggggggggggggg. An increase in productivity shifts the long-run Phillips curve to the left, because it allows a lower unemployment rate at every rate of inflation. This is shown below in graph (b). Because unemployment is higher than its target, inflation and expectations of inflation fall, shifting the short-run Phillips curve down. The economy moves from its initial position, point A to point B.

LAS0

LAS1

SAS0 SAS1 P1 P0

B A

AD1 AD0 Y0

Y1

Real output

6.

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Inflation

LRPC1 LRPC0

A

i0 i1

B

PC0 PC1 U1

U0

Unemployment rate

7.

Questions from Alternative Perspectives 71.

Austrian hhhhhhhhhhhhh. Many Austrians believe that if the government kept a very low profile, and did not undertake the large amount of spending that it does because of political pressures, that there would be far less inflation than there is. For Austrians, government is not the solution; government is the problem. iiiiiiiiiiiii. Governments might not stop inflation because of political pressure.

72.

Religious jjjjjjjjjjjjj. There is no objective ―just‖ weight; it is a subjective ―just‖ weight that is backing money. Most religiously oriented economists would hold that gold is not what gives money its value, but rather shared trust does, and that shared trust in humanity comes from God. kkkkkkkkkkkkk. Inflation can be seen as an injustice because it changes the value of the measure that people made plans around. How much of an injustice in part depends on the expectations the people held. If they expected the inflation, then the inflation doesn‘t change the value they expected, and therefore is not an injustice. lllllllllllll. The injustice of inflation is born by those who experience, but did not adjust for or expect, inflation.

73.

Institutionalist mmmmmmmmmmmmm. If you graph this you will see that there are several business cycle oscillations where sophisticated statistical analysis is not needed to see the role of oil in the macroeconomy. For instance, the oil embargo of 1973 and the Iranian Revolution and oil shock of 1979 both caused inflation and 40

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unemployment. The expansion in 1983 was partly driven by declining oil prices; similarly, the expansion in the 1990s was partly driven by declining oil prices. nnnnnnnnnnnnn. In the AS/AD model, the oil shock shifts the SAS curve up, increasing prices and reducing output in the short run, creating a recession if nominal demand does not increase. This is shown as a movement from point A to point B in the accompanying graph.

Price level

ooooooooooooo. If one uses expansionary fiscal policy, one can prevent the recession, but only at the cost of more inflation. Expansionary policy will shift the AD curve to the right, and the economy will move from point B to point C in the accompanying graph. The conclusion one can draw from this is that there are difficult tradeoffs in macro policy.

LAS

SAS1

SAS0

C

P2 P1

B

P0

A

AD1 AD0 Y1

74.

Y0

Real output

Post-Keynesian ppppppppppppp. This is a judgment question and judgments differ. Post-Keynesians believe that the cause of inflation is deeply integrated with the price-setting institutions. qqqqqqqqqqqqq. Post-Keynesians recommend the use of income policies involving tax and market incentives to fight inflation. They believe that such policies are likely to distribute the costs of fighting inflation more fairly. rrrrrrrrrrrrr.

If one believes that inflation is caused by excess demand, then income policies make far less sense. The answer to inflation is to reduce demand.

75.

Radical sssssssssssss.

The Radical view emphasizes social conflict between different classes of people; the textbook view downplays that social conflict. The 41

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differences in views are primarily ones of emphasis, rather than totally different views. ttttttttttttt. This is a judgment question and judgments differ.

Issues to Ponder 76. a. Stopping inflation tends to transfer money from debtors to creditors. Creditors are generally rich and are made wealthier when inflation falls, so they continued to golf. Debtors, faced with a decrease in their wealth, must cut back on discretionary expenditures, of which golf is one. uuuuuuuuuuuuu. Since the exchange rate was fixed, any differential in inflation rates between the two countries could not be offset by a change in the exchange rate. The fact that goods in dollar equivalent pesos in Argentina were higher than in NYC suggests that the Argentinean inflation rate remained greater than that of the U.S., and the high prices of goods were serving as an anchor on the economy. vvvvvvvvvvvvv. When there‘s inflation (with interest rates falling behind inflation), people look for real assets to buy to protect their wealth. This increases the demand for goods relative to services, increasing their price. When the inflation is stopped, the opposite occurs. wwwwwwwwwwwww. One reason why luxury auto dealers were shutting down was the same as the argument given in (a). A second reason is equivalent to that given in (c). A third reason is that wealthy Argentineans who would most likely purchase such a car, also probably had foreign bank accounts denominated in dollars. The car in dollars was cheaper, because the peso was overvalued at the fixed exchange rate. The demand for luxury cars fell as Argentineans substituted dollar-denominated luxury cars for peso-denominated cars.

77.

The advantage of indexing grades is that it provides a benchmark with which to measure a student‘s performance relative to the rest of his or her class. It would distinguish between an A received in a difficult class, in which many did not receive As, and an A earned in an easy class in which As were plentiful. It allows for comparisons across different schools with different grading standards.

However, it also does not account for the self-selection of intelligent students into upper-level classes, where all may be deserving of As, and that of less intelligent (or at least less diligent) students into ‗slacker classes,‘ where no one deserves an A. It might result in professors making distinctions among students whose abilities are virtually the same, just to achieve a given distribution of grades.

78.

It depends. With short-run, long-run, and shifting curves, just about any 42

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combination of inflation and unemployment rates can fit some Phillips curve. So, yes, the short-run Phillips curve is a figment of economists' imaginations. But then again, aren't all models simply structures imposed on reality, and doesn't reality only get interpreted through imaginary imposed structures? If so, to suggest that the Phillips curve is "nothing but a figment" is incorrect. Reality is itself a figment of imagination. (If you follow this answer, you might consider shifting to a philosophy major.)

79. a. He would likely be a quantity theorist, since quantity theorists see inflation most related to long-term growth, as low inflation means that the informational job of prices is working better, and more investment is taking place. xxxxxxxxxxxxx. Inflation can affect household decisions in a number of ways. It can add uncertainty about the future, leading households to save more and make fewer major purchases. Alternatively, it could lead them to temporarily supply more labor than they would otherwise (if they perceive the inflation as an increase in their wages, but not in the prices of goods), causing a temporary spurt in growth, and then a fall in growth once they recognize their mistake.

CHAPTER 17: COMPARATIVE ADVANTAGE, EXCHANGE RATES AND GLOBALIZATION Questions and Exercises 80.

A country does better exporting a good for which it has a comparative advantage and importing goods for which other countries have comparative advantages.

81.

There is a basis for trade because Wadgetland can produce wadgets at a lower opportunity cost than Widgetland. Wadgetland gives up 1/ 4 of a widget for every wadget it makes, while Widgetland gives up 1 widget for every wadget it makes.

So Widgetland has a lower opportunity cost of producing widgets. They give up 1 wadget while Wadgetland gives up 4 wadgets to make a widget. Wadgetland has a comparative advantage in producing wadgets and Widgetland has a comparative advantage in producing widgets.

If each specializes in their respective comparative advantage, Wadgetland ought to produce 720 wadgets and 0 widgets and Widgetland ought to produce 240 widgets and 0 wadgets.

With this production combination, a possible deal in which each can consume more than before is for Widgetland to trade 120 widgets for 240 wadgets. It could then consume 120 widgets and 240 wadgets, doubling the amount of wadgets they 43

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are now able to consume. Wadgetland would then consume 480 wadgets and 120 widgets, doubling the amount of widgets they were previously able to consume.

Both countries will be better off than before.

82. a. Iowa has a comparative advantage in bushels of corn (gives up 1/ 3 bushels of wheat for every bushel of corn). Nebraska has a comparative advantage in wheat (gives up 1/ 3 bushels of corn for every bushel of wheat). It would be recommended that Iowa produce 180 bushels of corn [120  (3  20)] and 0 bushels of wheat and Nebraska produce 0 bushels of corn and 180 bushels of wheat [120  (3  20)] .

With this combination, Nebraska can trade 120 bushels of wheat for 60 bushels of corn. With this trade, Nebraska will end up with 120 bushels of corn and 60 bushels of wheat and Iowa will end up with 60 bushels of corn and 120 bushels of wheat. Nebraska ends up with 20 more bushels of corn and Iowa ends up with 20 more bushels of wheat than required by the question. Thus, each can achieve at least the consumption combination required by the question. The excess must go somewhere, and part b tells us where—the trader. yyyyyyyyyyyyy.The states together produce 180 million bushels of both corn and wheat but consume 160 million bushels of each leaving the trader 20 million bushels of corn and 20 million bushels of wheat.

83. a. The countries must realize that the only way to get to the new consumption combinations is if they specialize and then trade. Machineland has the comparative advantage in machines and should specialize in them and trade them for food from Farmland. Doing so, Machineland produces 200 machines and Farmland produces 200 units of food. They can then end up at points B and D with a one-to-one trade with Machineland trading 50 machines for 50 units of food. zzzzzzzzzzzzz. At points A and C, the total production of machines is 110 and the total production of food is 170. By specialization, the total production of each would increase to 200, so production of machines increases by 90 and production of food increases by 30. aaaaaaaaaaaaaa. There is no set amount that a trader should receive, but the trader's share should compensate him and still allow for the two nations to gain from trade. Eventually, the above-normal returns will be competed away. bbbbbbbbbbbbbb. If costs fell as production rose, the argument for specialization is even stronger. The recommendation doesn‘t change, but the economic case behind it becomes stronger.

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84. a. The production possibility curves are shown in the accompanying graph. cccccccccccccc. Busytown has a comparative advantage in producing cars and Lazyasiwannabe has a comparative advantage in gourmet meals. dddddddddddddd. Busytown should produce 60,000 cars and Lazyasiwannabe should produce 50,000 meals.

Lazyasiwannabe then offers Busytown 22,000 meals for 24,000 cars.

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Lazyasiwannabe ends up with 28,000 meals (50,000 − 22,000) and 24,000 cars. If it had produced 24,000 cars on its own, it would have had only 24,000 meals.

Busytown ends up with 36,000 cars. If it had produced 22,000 meals on its own, it would be left with only 33,600 cars (60,000 − 26,400).

85.

Traders get bigger gains from trade in newly opened markets where strong competition among traders has yet to develop. The more competition that exists in international trade, the more the traders will compete with one another and will offer to arrange the trade for less and less. With more competition, gains to traders will be reduced, leaving more gains for citizens of the countries involved in the trade.

86.

Smaller countries tend to get more of the gains from trade because more opportunities are opened up for them. This is true only under the condition that competition among traders prevails.

87.

International traders in small countries often have little competition and so keep larger shares of the gains from trade for themselves; hence, the people of the small country may not get the gains from trade.

88. a. No. Both countries‘ opportunity cost of producing pickles is 2 (they must give up 2 olives to get 1 pickle). Neither has a comparative advantage, so there is no basis for trade. eeeeeeeeeeeeee. If per-unit cost of producing pickles and olives falls as more of each is produced, it definitely pays for both countries to specialize in either olives or pickles since doing so would lower total costs. Which country should specialize in which good is an open question since neither has a comparative advantage and we do not know how much per-unit costs fall for each‘s production.

89.

Four reasons are: (1) Economists can identify both the costs and benefits of trade.

Laypeople often do not recognize that the decline in product prices is the result of trade, while they can readily identify that lost jobs are the costs. (2) Economists know that comparative advantage implies that each country is better at producing at least one good. Laypeople worry that since wages are lower in China, it has a comparative advantage in all goods and the U.S. will lose all its jobs. Economists admit that because the U.S. has a trade deficit, the U.S. will face difficult economic forces to restore a more nearly equal division of comparative advantage. (3) Economists recognize that trade occurs in more sectors than manufacturing. They see the comparative advantage that the U.S. has in trading services. Laypeople tend to see trade as trade in manufactured goods only. (4) Economists' models do not take into account the effect of trade on the distribution 1

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of income. A change in a country's comparative advantage will affect the distribution of income. Laypeople do take this into account.

90.

False. According to the theory of comparative advantage, if one country has a comparative advantage in one good, the other country must have a comparative advantage in another good.

91.

While the loss of a comparative advantage in the manufacturing sector might have hurt the United States‘ economy in some ways, it has freed resources for the sectors in which the United States does have a comparative advantage. Today that comparative advantage is facilitating international trade. This change creates a demand for U.S. advertising, management, and distribution of goods. This creates jobs and income in those sectors.

92.

Outsourcing has reduced the demand for manufactured jobs, reducing employment and income in that industry. Manufacturing supported the middle class for a number of years. Globalization has also created demand for technology, finance, and trade, which all require specialized skills, and ultimately pay higher salaries. Because globalization increases the market for their skills, income in these sectors has increased enormously. The overall result is a greater disparity in income.

93.

Any three of the following ten would be correct: (1) Skills of the U.S. labor force, (2) U.S. governmental institutions, (3) U.S. physical and technological infrastructure, (4) English as the international language of business, (5) wealth from past production, (6) U.S. natural resources, (7) cachet, (8) inertia, (9) U.S. intellectual property rights, and (10) relatively open immigration policy.

94.

Inherent comparative advantages are those that are based on factors that are relatively unchangeable, while transferable comparative advantages are those based on factors that can change relatively easily.

95.

A country would prefer to have an inherent comparative advantage because it would not lose that comparative advantage or face the adjustment costs that accompany the change of comparative advantages.

96.

The depreciation of a currency means that it takes fewer foreign currency units to buy one domestic currency unit. In the case of the United States and China where the dollar depreciates, the price of U.S. exports to China declines and the price of 2

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U.S. imports from China increases as more U.S. dollars would be needed to buy a Chinese import.

97.

Domestic production is shown by Q 0 . Domestic consumption is Q1 . The difference, Q1  Q0 , represents imports. ffffffffffffff. The United States would like to raise world supply since it would increase domestic production and reduce imports.

Price

gggggggggggggg. This might happen in a variety of ways. The United States could gain a comparative advantage in the good by increasing productivity, relative U.S. wages could fall, or the U.S. dollar could depreciate.

S

SW

PW

D

Q0

98.

Q1

Quantity

The resource curse would worsen the distribution because it would cause an appreciation in the value of the currency, lowering the world price level, making the trade position for tradable goods worse. That is, a country‘s exports would cost more, and imports would cost less. The resource sector benefits because by definition, foreign countries demand the resource. Tradable goods sectors tend to employ a large number of workers as compared to natural resource sectors.

Resource sectors tend to have fewer employees, concentrating the rise of income among a few, as compared to other tradable goods sectors.

Questions from Alternative Perspectives 99.

Austrian An Austrian would tend to agree with this statement because they believe that people tend to know what is good for them much better than government does.

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100.

Religious This is a judgment question in which answers will differ. A religiously oriented economist is more likely to give weight to such issues--maintaining cultural identity--than is a mainstream economist.

101. Post-Keynesian hhhhhhhhhhhhhh. Outsourcing tends to undermine the bargaining power of U.S. workers and increase the bargaining power of U.S. employers. iiiiiiiiiiiiii. It will likely lead to lower U.S. wages than otherwise would have been the case. jjjjjjjjjjjjjj. Since lawyers need to be certified by state boards, they do not face as much competition from outsourcing, so outsourcing will not tend to lower lawyers‘ wages. kkkkkkkkkkkkkk. Yes, given that lawyers tend to have more influence in government, they would likely institute policies to limit outsourcing law services that have the potential to be outsourced.

102. Radical llllllllllllll. This is a judgment call, but an argument could be made that since there are economies to scale in the production of cloth and the production of cloth has linkages to other important industries (for example, chemical and machine making) that are key to an initiating industrial revolution that are missing in the production of wine, Ricardo‘s advice was self-serving for England. mmmmmmmmmmmmmm. specialize in wine making.

103.

No, I probably would have advised them not to

Austrian and Post-Keynesian Smith‘s is a moral claim that is difficult to support or dispute. It depends on sensibilities of people. Most people‘s sensibilities would be similar to Smith‘s.

Individuals care about others, especially the poor. Not only do they say this, but they also demonstrate it by politically supporting programs that assist the poor and provide basic needs for people. But those programs have not been very successful at reducing income inequality, and the distribution of income is becoming less equal in the United States due in part to the adjustments caused by a decline in the comparative advantage for manufactured goods in the United States. Lower-income workers in the tradable sectors are seeing their income fall, while others at the top of the trading pyramid are gaining enormously.

Whether this increase in inequality undermines Smith‘s claim that all people care about the poor is unclear. Society today is much richer than it was in Smith‘s 4

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time, and there are many different judgments about whether low-income individuals in U.S. society should be classified as poor and miserable. Some would argue yes, they should be classified as such, and the fact that we haven‘t done anything to stop the increase in inequality shows that people don‘t care about society. Others would argue no, low-income individuals in the United States do not meet Smith‘s conception of ―poor and miserable‖ and thus the fact that income inequality is increasing should not be of concern, nor does it demonstrate that society doesn‘t care about the poor. They believe that the best way to help society is to allow market trade to ―lift all boats.‖ Programs designed specifically to help the poor will likely backfire, and not help the poor, but instead help those who design the programs. Smith also made this argument when he explained why most proposed government programs ―ought never to be adopted, till after having been long and carefully examined, not only with the most scrupulous, but with the most suspicious attention.‖ The problem is that the proposals to help the poor ―come… from an order of men, whose interest is never exactly the same with that of the public, who generally have an interest to deceive and even oppress the public, and who accordingly have, upon many occasions, both deceived and oppressed it.‖

Issues to Ponder 104.

Outsourcing to China and India today differs from outsourcing in the past in two ways: (1) the potential size of outsourcing is much larger today (those countries have combined population of about 3 billion) and (2) China and India are able to compete on a larger number of production levels than in the past (China and India have adopted more technological advances).

105.

The law of one price states that the price of equivalent goods will cost the same across countries. Reasons why the law of one price might not hold include different social institutions, laws, and transportation costs. Another reason is that while two products might be equivalent, consumers might not perceive them as equivalent. American goods currently have cache in some countries that will keep their prices higher than "equivalent" goods in other countries.

106.

The normal textbook presentation might not include the international trader because it complicates the model. How much of the gains go to the trader depends on the cost of facilitating the trade, the competition among traders, and the bargaining power of the country relative to the trader. There is no simple model to reflect these complications. Including the trader in the model recognizes that traders are a necessary component of trading. This allows one to acknowledge the comparative advantage the United States currently has in facilitating trade.

Including traders provides a more comprehensive view of how the benefits of trade are distributed.

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107.

a. zero.

Since the trade would be balanced, the price of the certificates would be

nnnnnnnnnnnnnn. In order to import, the price would be very high. oooooooooooooo. Since the United States has a trade deficit with China. Chinese companies that wanted to export to the United States would pay a high price to American exports for the license to do so. In China, the price of certificates to export would be highly positive, which means that the price of certificates to import would be highly negative. Exporters would have to pay importers to import. pppppppppppppp. Such a law would make exchange rate fluctuations less likely because it would equalize the current account balance.

108.

The subgroup of workers that would likely be most helped are low-wage manufacturing workers in tradable sectors. They would have their industries supported in order to encourage exports, and they would face fewer imports. The subgroup of workers that would likely be most hurt are the international traders who would have to give up some of their gains from importing to create offsetting exports.

CHAPTER 18: INTERNATIONAL TRADE POLICY Questions and Exercises 109.

Because U.S. trade is a relatively small percent of total output, trade is less important to the United States compared to other countries. Considering all goods and services produced, U.S. producers face less competition, this suggests that trade policies are less important.

110.

The two greatest U.S. trading partners are Canada and Mexico. Trade with China and India is rising rapidly. (The Pacific Rim and the European Union are collections of, not single, countries.)

111.

Tariffs and quotas have similar effects on limiting trade. A quota restricts the quantity of imports. A tariff results in the same quantity of imports by raising the world price by the amount of the tariff. The resulting domestic price and quantity are the same in both cases. Domestic producers face less competition in both. The difference is who gets the revenue from the resulting increase in the price of imports. With a tariff, the domestic government gets the revenue, shown by the shaded region. With a quota, the revenues accrue to the foreign producers.

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112.

Both voluntary restraint agreements and tariffs increase the price of the imported good paid by consumers and reduce total quantity demanded. The two, however, impact the government and foreign firms differently. In the case of the tariff, the domestic government collects tax revenue. In the case of voluntary restraint agreement, foreign firms receive higher prices for the products they sell and the government receives no tax revenue.

113.

a.

The gains to domestic producers are shown in the accompanying graph.

Domestic producers now produce B at Pt instead of A at Pw . Domestic producers gain additional revenue shown by areas FHKG and ABKE.

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qqqqqqqqqqqqqq. The revenue to the government is the quantity supplied by foreign producers, BC, multiplied by the tariff. This is shown in the accompanying graph as HIJK. rrrrrrrrrrrrrr. The cost to domestic producers to produce additional units is shown by area ABKHE. ssssssssssssss. The gain to domestic producers is greater than the cost to domestic producers by area FHEG because the cost of producing the additional output is less than the revenue gained from the additional output, specifically, area GEHF.

114.

a.

It might be good or bad for the United States government. To the extent that it produced tariff revenue, it was good. To the extent that it strained U.S – German relations, the trade war was bad.

tttttttttttttt. A tariff by Germany on the U.S. produced chickens would lead to higher chicken prices in Germany since the supply of imported chicken would shift up by the amount of the tariff, increasing their price. German producers would also sell their chickens at the higher price because they face less competition. German consumers would be hurt by the tariff. uuuuuuuuuuuuuu. U.S. chicken producers would be hurt because the quantity of chickens demanded falls and they have to pay a tariff on those chickens that they do sell to Germans. The net price they receive is lower.

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vvvvvvvvvvvvvv. U.S. light-truck producers would gain because light trucks imported from Germany would rise in price and be less competitive. U.S. producers of light trucks could raise their prices. wwwwwwwwwwwwww. Economists, in general, do not support any trade restrictions because they reduce world output and raise prices.

115.

a.

With the quota, the quantity of clothes sold was fixed. Suppliers charged the price (P0 ) consumers were willing to pay for that quantity. With the removal of the quota, as the accompanying graph demonstrates, equilibrium quantity rose (to Q1 ) and equilibrium price fell (to P1 ).

xxxxxxxxxxxxxx. Consumers benefited because they were able to buy a greater quantity at a lower price.

This is represented by an increase in consumer surplus shown by the shaded region in the accompanying graph. yyyyyyyyyyyyyy. The short-run effect of the removal of the quota is that profits declined because the equilibrium price declined (this assumes demand is inelastic in the short run). Revenue falls when supply increases and demand is inelastic). If economies of scale lower average total costs by more than the decline in equilibrium price, in the long run profits might increase with the removal of the quotas.

116. Countries restrict trade for many reasons. Any three of the following are correct answers: a. Unequal internal distribution of the gains from trade. b. Companies that feel they are not getting a good deal from trades will lobby government to restrict trade. c. Countries want to make threats of trade restrictions for the purpose of negotiating credible. d. Learning by doing and economies of scale may reduce the cost of producing a domestic good, making those goods more competitive in the future. This may be particularly true for infant industries. e. Sales of goods to foreign goods may threaten national security. f. Countries may want to use trade restrictions as an international political tool.

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g. Governments earn revenue from the tariffs that can be used to support government spending.

117.

A country would have trade adjustment assistance programs in an effort to facilitate free trade by compensating domestic producers who lose as a result of reductions in trade restrictions. They are difficult to implement because losses from free trade become exaggerated and magnified—often causing the costs of the assistance programs to outweigh the gains.

118.

A credible threat of trade restrictions would lead to lower trade restrictions because the other bargainer's belief that a country would implant trade restrictions gives the country the upper hand in strategic bargaining and enables the country to extract larger gains from trade. These gains could be lower trade restrictions.

119.

Economies of scale refer to the situation in which costs per unit of output fall as output increases. If per unit costs fall sufficiently, the country that increases the production of that good may gain a comparative advantage in that good. Trade restrictions would reduce competition, allowing domestic firms to sell and produce more goods and realize the economies of scale.

120.

From a global perspective, free trade increases total output. International trade provides competition for domestic companies, which forces domestic companies to remain competitive and efficient. By fostering international cooperation, international trade makes war less likely which is a significant contribution to national security.

121.

The WTO is the World Trade Organization. It generally supports multilateral free trade policies.

Questions from Alternative Perspectives 122.

Austrian It depends. In some ways it is true; a tariff protects the income of people who produce goods protected by the tariff. As such, the tariff transfers income from others to that group. In other ways it is more complicated. Government is also a way that people deal with collective problems that have to be solved collectively.

This can involve implicit social contracts among people in a society to compete, and a tariff can also be seen as a way of maintaining a social contract to take into account new issues.

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123.

Radical The view that liberty is the only solution to problems of human relationships does not deal with the fact that one person‘s liberty often infringes on the liberty of another person. Where that infringement occurs, liberty does not, in turn, provide an answer, even if one has a great deal of belief in it.

124.

Religious When there is trade there is a blending of economies that creates better understanding among cultures and mutual dependence. A greater understanding and mutual dependence can reduce the chances of war. But trade also introduces new areas of contention among countries, which can lead to conflict.

125.

Post-Keynesian The group that has been most helped by free trade are international traders and those associated with them. International traders have become wealthy by engaging in trade. The group that has been most hurt by trade are low-skilled laborers. Economists side with the traders.

126. Radical zzzzzzzzzzzzzz. Some radical economists would argue that they did not follow that strategy because they were protecting their infant industries. aaaaaaaaaaaaaaa. Some radical economists would argue that it suggests that economists‘ calls for free trade might be self-serving for developed economies because free trade allows them greater access to the markets of developing economies.

Issues to Ponder 127.

128.

While trade may increase output and income, trade will change the culture of that country. The impact is considerably larger for developing countries with unique and rich cultural practices and production. It often takes the form of exporting the dominant country's culture and goods. a.

Three assumptions are that the good is tradable, that transportation costs are minimal, and that taxes between the two countries do not differ significantly.

bbbbbbbbbbbbbbb.

To the degree that production facilities and labor can move easily, the law of one price should hold for labor, too. Given the wage differentials that exist among countries with seemingly equivalent productivity, it 5

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seems that these conditions do not hold for labor. Barriers such as language and family ties likely explain this observation. ccccccccccccccc. Since capital is more mobile than labor, the law of one price should have a greater tendency to hold for capital. Financial capital is a great example. Interest rates among countries tend to reach an equilibrium much faster than wages.

129.

An equitable method might be to tax those who gain from the trade liberalization and give the proceeds to those who are hurt by it.

ddddddddddddddd.

Assuming the original distribution is equitable, and the government is not trying to change income distribution, this method is equitable because the combined policies make everyone better off. eeeeeeeeeeeeeee. The political problems with implementation include: (1) Everyone will try to exaggerate the amount they are hurt and understate the amount they are helped. Thus, actually finding a tax that accomplishes the goal will be difficult.

(2) Once the taxes and subsidies are in place, they may not be removed after the adjustment of displaced workers is complete. Losers will be overcompensated, and gainers will be taxed too much. (3) Those who have big gains (big business) may have more political power and may be able to prevent the implementation of this policy.

130.

With a price floor, there is a loss of consumer surplus, higher prices and lower quantities.

131.

There is no ―right‖ answer to this question. To the extent that the chemicals present a health problem, the government may want to restrict tomatoes imported from Mexico. Doing so, however, will raise the price of tomatoes for American consumers. Domestic producers will lobby for such restrictions because they will be able to sell more tomatoes at higher prices.

132.

a.

Yes, if the deductions in lost taxes exceed the amount collected. This is indeed the case. Congressional tax experts have estimated that the deductions exceed the amount that corporations pay in taxes by over $6 billion a year.

fffffffffffffff. The natural suggestion would be to eliminate the tax, including the accompanying deductions from corporate taxable income. This would have the added benefit of eliminating the administrative costs associated with the tax.

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ggggggggggggggg.

It is likely that the companies want the tax because they benefit from it—in other words, because the tax results in lower taxable corporate income, it is an implicit subsidy, and they will lobby strongly to keep it. The government may keep the tax because it wants to encourage exports.

133.

a.

Economists opposed the tariff because it creates deadweight loss as shown by the shaded region in the accompanying graph and hurts the welfare of the whole society.

hhhhhhhhhhhhhhh.

The tariff shifts the supply curve of imports up, which increases equilibrium price to P1 and lowers equilibrium quantity to Q1 as shown in the accompanying graph. iiiiiiiiiiiiiii. The tariff would help the economy by increasing the price of imported goods, making domestic goods relatively more competitive and allowing domestic producers to raise their prices if they chose to do so. It would also provide revenue for government that it could spend on consumption or investment, further stimulating the domestic economy. jjjjjjjjjjjjjjj. The macroeconomy would be worsened because a retaliatory tariff reduces the trade between countries, which hurts both of them. The countries do not benefit from the full extent of their comparative advantages.

Price

S1 S0 tariff

P1

P0

D0

Q1

Q0

Quantity

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134.

The answer, in part, will depend on what advice is being given. Most economists would argue that some trade restrictions might benefit a country, but almost no country can limit its restrictions to the beneficial ones. Trade restrictions are addictive; most economists would not recommend them, even in a recession.

CHAPTER 19: INTERNATIONAL FINANCIAL POLICY Questions and Exercises 135.

If a country is running a balance of trade deficit, the amount of goods it is exporting is less than the amount of goods it is importing. However, this is only one part of the current account, which is the part of the balance of payments that lists all short-term flows of payments. A deficit in merchandise could be offset by a surplus in other areas of the account, such as services.

136.

When someone sends 100 British pounds to a friend in the United States, the transaction will show up as a positive value in the component of the current account called net transfers, a section which includes foreign aid, gifts, and other payments to individuals not exchanged for goods or services. It will also appear as a negative value on the financial and capital account as a receipt of foreign currency, just like the purchase of a British stock or bond would. Note that as expected, the current account entry balances against the capital account entry, because the balance of payments follows double-entry accounting rules.

137.

In the short run, a current account deficit, necessarily balanced by a financial and capital account surplus, is nice, because the country is consuming more than it is producing, which gives society immediate pleasure.

138.

In the long run, financial and capital account deficits, necessarily offset by current account surpluses, are nice, because the country is building up holdings of foreign assets, which will provide a future stream of income.

139.

a.

Exports of merchandise are part of the current account.

kkkkkkkkkkkkkkk.

Imports of services are part of the current account.

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lllllllllllllll. Net transfers, which include foreign aid, gifts, and other payments to individuals, not exchanged for goods or services are part of the current account. mmmmmmmmmmmmmmm.

Foreign profits for an American company are a type of holdover from past trade and services imbalances and are therefore part of the current account. nnnnnnnnnnnnnnn.

The financial and capital account measures the flow of payments between countries for both financial assets and ownership rights to real estate such as a new plant for the Ford Motor Company.

140.

a.

An American tourist traveling abroad will supply U.S. dollars in the foreign exchange market.

ooooooooooooooo.

A foreign exchange trader (regardless of nationality) who believes that the dollar exchange rate will fall, will sell and therefore supply the dollar to avoid a loss. ppppppppppppppp.

A foreign exchange trader (regardless of nationality) who believes that the dollar exchange rate will fall, will sell and therefore supply the dollar to avoid a loss. qqqqqqqqqqqqqqq.

A foreign tourist visiting the U.S. will demand U.S. dollars in the foreign exchange market. rrrrrrrrrrrrrrr.

A foreign national wanting to protect their wealth from expropriation will demand U.S. dollars in the foreign exchange market. sssssssssssssss. A foreign national wanting to invest in the U.S. will demand U.S. dollars in the foreign exchange market.

141.

They will sell that currency. If the country wants to keep the value of its currency from falling, it will have to buy its currency using official reserves. Once the government runs out of reserves, it may be forced to devalue the currency, making the speculators‘ predictions self-fulfilling.

142.

a.

A rise in the US price level means foreign goods will be relatively more expensive. British demand for foreign currencies will tend to decrease, and foreign demand for pounds will tend to increase. Thus, the supply of pounds shifts inward from S1 to S0 , and the demand for the pound shifts outward from D 0 to D1 .

The exchange rate value of the pound rises from P2 to P1 , as shown in graph (a) below.

2

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8. ttttttttttttttt. A reduction in U.S. tariffs would tend to shift the demand for pounds to the right from D0 to D1 , as Americans would buy more imports from the U.K. The exchange rate value of the pound rises from P0 to P1 , as shown in graph (b) below.

9. uuuuuuuuuuuuuuu.

A boom in the U.K. economy means an increase in its income, causing an increased demand for imports and an increase in the demand for the foreign currency to buy those imports, thus resulting in an increase in the supply of pounds. (This may also set off an expectations effect.) Thus, the supply of pounds shifts outward from S0 to S1 . If demand is at D 0 , the exchange rate value of the pound falls from P0 to P1 , as shown in graph (c) below.

3

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10. vvvvvvvvvvvvvvv.

If interest rates in the U.S. rise, there will be an increased demand for U.S. assets and decreased demand for U.K. assets, so the demand for pounds will decrease from D1 to D0 , and the supply of pounds will increase from S1 to S0 , as British investors sell their pounds to buy foreign assets. The exchange rate value of the pound falls from P1 to P0 , as shown in graph d below.

(d)

143.

a.

This is an enormous change. In order to bring it about, the Never-Never Land government would have to run an enormously expansionary monetary policy, reducing the real interest rate, possibly to negative amounts, and probably generating significant inflation. As far as trade policies are concerned, the government could eliminate all tariffs, or even subsidize imports, causing imports 4

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to rise and other countries‘ currencies to appreciate relative to the neverback. Of course, since there‘s already a large trade deficit, this may not be a viable option.

5

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wwwwwwwwwwwwwww.

Holders of neverbacks will demand foreign currencies, (increase in supply of neverbacks) because the return on neverback assets has declined (interest rates have fallen). This is shown as a rightward shift in the supply of neverbacks.

Likewise, potential foreign investors will demand fewer neverbacks for the same reason. This is shown as a leftward shift in the demand for neverbacks. The effect is to reduce the exchange rate value of the neverback to $10 per neverback. A reduction in tariffs increases the demand for foreign goods, which shifts the supply of the currency to the right, also contributing to a decline in its value.

144.

The schematics are shown in the text.

145.

If Japan ran expansionary monetary policy, the U.S. trade deficit would fall, and the value of the U.S. dollar would rise. Japanese expansionary monetary policy would lead to higher income and prices in Japan. Both would lead to higher imports for Japan, and therefore, a lower U.S. trade deficit. Expansionary monetary policy would also reduce interest rates, along with the aforementioned increase in demand for imports. Both such consequences lower the exchange rate value of the yen (increase the value of the U.S. dollar).

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146.

Japan‘s contractionary fiscal policy would have an ambiguous effect on the value of the U.S. dollar, because the effect via the interest rate and income paths oppose one another, and the effect through the price level is a long-run effect.

147.

The effect of expansionary fiscal policy on the exchange rate is ambiguous, while contractionary monetary policy is known to increase exchange rates. The net effect will depend on which influence is stronger.

148.

If a country's actual exchange rate is 25 to the dollar and purchasing power parity says it is 20 to the dollar, people in the country can buy fewer goods at the actual exchange rate than what the purchasing power parity ratio would suggest they could buy if the parity exchange rate were the actual rate. This means the currency is undervalued, and that people are better off than a comparison at actual rates might suggest.

149.

When a foreign country‘s purchasing power parity exchange rate is less than the market exchange rate, the prices of goods in that country tend to be relatively cheaper than at home. This tends to make traveling there less expensive.

150.

The real exchange rate remains constant, since the change in the price level offsets the change in the exchange rate.

(Percentage change in real exchange rate = Percentage change in nominal exchange rate + (domestic inflation  foreign inflation) Change in the real exchange rate = 2 + (6  4) = 0.

151.

Forcing governments to make adjustments to meet their international problems is a disadvantage, because the country will have to give up its domestic fiscal and monetary policies to pursue the fixed exchange rate. For example, if the government faced a recession, it would not be able to lower interest rates and maintain the fixed change rate thereby stimulating the economy. However, it can also be an advantage, because fixed change rates create exchange rate stability and credibility in the country's currency.

152.

Both fixed and flexible exchange rate systems have advantages and disadvantages. While fixed exchange rates provide international monetary stability and force governments to make adjustments to meet their international problems, they have some disadvantages as well: they can become unfixed, 6

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creating enormous instability. Such instability can hurt the domestic economy, for example, by creating uncertainty with regard to import and export prices and therefore firm costs and revenue. Forcing governments to make adjustments to meet their international problems can be a disadvantage as well as an advantage.

Flexible rates provide for orderly incremental adjustment of exchange rates, thereby encouraging trade. They also allow governments to be flexible in conducting domestic monetary and fiscal policies.

Given the pluses and minuses of both systems, most policy makers have opted for a policy in between the two, partially-flexible exchange rates.

153.

a.

If foreigners start believing that there is an increased risk of default by the U.S., they will require a higher premium to buy U.S. bonds. That is, they will offer a lower price to buy them (demand for U.S. bonds will shift to the left). As this happens, bond prices will fall and interest rates, which move in the opposite direction from bond prices, will rise. The value of the dollar will fall as a result of the lower demand for bonds (foreigners will not be purchasing as many dollars).

That is, the demand for dollars will also decline, lowering the value of the dollar.

xxxxxxxxxxxxxxx.

Higher interest rates increase the cost of borrowing. This hurts in the short run by reducing aggregate spending and crowding out private investment, a source of long-term growth for the U.S. economy. A lower value of the dollar may increase the competitiveness of U.S. goods in the global economy, but it also makes imports to the United States more expensive, which, in addition to hurting individuals, may hurt businesses that use imports as intermediate goods in their production processes.

154.

The United States would want to hold up the value of the dollar to help prevent the surge in import prices that would result from the fall in exchange rates and to keep foreigners from buying our assets cheaply. Other countries would want a higher value of the dollar in order to keep their goods competitive with U.S. goods.

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155.

a.

This suggests that it was running a financial and capital account deficit, since the two largely offset each other.

yyyyyyyyyyyyyyy.

If the private balance of payments was in surplus, China must have a fixed or partially-flexible exchange rate regime, because the central bank was selling its currency.

Price of yuan in dollars

zzzzzzzzzzzzzzz. It had to be selling its currency to equalize the balance of payments. In the accompanying graph, the Chinese central bank had to be supplying ( QD  QS ) yuan.

Supply

P

Demand

QS

QD

Quantity of yuan

8

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aaaaaaaaaaaaaaaa. The value of the yuan would likely rise. That is, it would take more dollars to buy a yuan, or alternatively, each yuan would be worth more dollars.

156.

Four advantages are that it: (1) eliminates the cost of exchanging currencies, (2) facilitates price comparisons, (3) creates a larger market, and (4) increases the demand for the currency as a store of wealth.

157.

Three disadvantages of a common currency are: (1) loss of national identity, (2) increased economic ties among member countries, and (3) loss of independent monetary policy for member countries.

158.

The future of international finance is likely to be digital, but not crypto because of costs. Digital currencies are much cheaper than non-digital currencies so they will predominate. But those digital currencies will not be crypto because true crypto currencies use a decentralized blockchain technology and a centralized digital currency has much lower costs.

159.

The lack of competition has kept the cost of using digital currencies in international monetary transfers much higher than costs, which has slowed the advance of digital currencies.

Questions from Alternative Perspectives 160. Austrian bbbbbbbbbbbbbbbb.

Having all currencies on a gold standard would eliminate currency risk and promote more trade among nations. cccccccccccccccc. The cost of such a policy would be limiting countries' ability to conduct domestic monetary policy. Most Austrians would see that as a good thing, because they believe that discretionary monetary policy often does more harm than good.

161. Religious dddddddddddddddd.

Jesus would argue for an exchange rate that valued earthly things low and eternal wealth high. eeeeeeeeeeeeeeee. I would suspect that wealthy people would value earthly things higher relative to eternal things, compared to Jesus; in other words, the wealthy believe the exchange rate value for earthly things to be high. ffffffffffffffff.

I suspect that the perceived value of earthly things falls as one gets older. (The exchange rate value for earthly things falls.)

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162. Feminist gggggggggggggggg.

There is no good reason. It is probably historical happenstance rooted in sexism or discrimination. hhhhhhhhhhhhhhhh.

One reason it has remained that way is that the traders are self-perpetuating; they hire people like themselves. iiiiiiiiiiiiiiii.

Yes. One of the reasons trading rooms have remained primarily male is that the conversation is permeated with male locker room humor, making it extremely unpleasant for women and socially sensitive individuals. The opposite is also likely--that the language is coarse specifically because there are so few women. In other words, the language would probably change if more traders were women. jjjjjjjjjjjjjjjj.

163.

This answer will be individual specific.

Post-Keynesian His argument is that the pressures for change are so strong, that once people start expecting a major change in the price of a currency, a small tax will not stop them from buying in a financial crisis. The tax would slow capital flows in normal times when there is no need to slow them, but it would not stop capital flows in crises when there is a need to slow them.

164. Radical kkkkkkkkkkkkkkkk.

This is a judgment question and judgments differ. Radical economists are especially wary of financial liberalization. They identify financial liberalization as the chief cause of the financial crisis of East Asia, as well as the current world economic crisis. But so too is Nobel-prize-winning economist, Joseph Stiglitz, who is a former chief economist at the World Bank and head of the Clinton Council of Economic Advisers. llllllllllllllll.

This, too, is a judgment question and judgments differ. As stated above in a, radical economists are very wary of financial liberalization.

Issues to Ponder 165.

In the early 1980s, the U.S. government was pursuing tight monetary policy and expansionary fiscal policy. The high interest rate resulted in a strong dollar.

However, expansionary fiscal policy failed to stimulate domestic demand as export demand fell sharply due to the high dollar. This, accompanied by the high interest rate that had cut investment, drove the economy into a recession with twin deficits, but a strong dollar.

2

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166.

He was advocating significant trade restrictions. These trade restrictions would have likely provoked retaliation by our trading partners, hurting international cooperation and the world economy.

167.

No. It is extremely difficult to affect exchange rates. Since we don‘t know what the correct exchange rates are, it is probably best not to try to significantly change the exchange rates determined by the market. If one is going to change exchange rates, one must change one‘s domestic monetary and fiscal policies.

168.

We would use a combination of purchasing power parity, current exchange rates, and estimates by foreign exchange traders to determine the long-run exchange rate of the neverback. This combination approach can be justified only by the ―that‘s all we have to go on‖ defense. Since no one really knows what the longrun equilibrium exchange rate is, and since that exchange rate can be significantly influenced by other countries‘ policies, the result we arrive at could well be wrong.

169.

He will likely prefer fixed exchange rates. They provide an anchor, which restricts government temptation to use expansionary monetary policy and promotes price stability.

170.

a.

Three assumptions of the law of one price are: (1) there are zero transportation costs, (2) the goods are tradable, and (3) there are no barriers to trade. (There are many others.)

mmmmmmmmmmmmmmmm. For the law of one price to apply directly, labor would have to be completely mobile and of identical efficiency and ability in all countries. Thus, it does not apply directly. However, assuming capital is flexible, there will be significant indirect pressure toward an equalization of wage rates. nnnnnnnnnnnnnnnn.

Since capital is more mobile than labor, we would expect that the law of one price would hold more for capital than for labor.

171.

A common currency would tie these countries together much more closely, create a larger common market, and make price comparisons among Canada, the United States, and Mexico easier. However, it would be politically difficult since each country would have to give up its own currency, which is a source of national identity. Since the U.S. dollar would likely predominate, this would be especially problematic for Canada and Mexico. These countries would also have to give up their independent monetary policy. Since the economic conditions in the three 3

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countries can and do differ substantially, doing so would likely be unacceptable for Canada and Mexico.

172.

A rising price level would replace the income effect usually associated with expansionary monetary policy. However, since rising prices and rising income both push the exchange rate down, the overall effect as presented in the chapter will not change.

173.

Holding the exchange rate above the equilibrium market exchange rate will make a country's exports more expensive and its imports cheaper than they otherwise would have been. It will also require the country to finance the excess supply of its currency using official reserves or borrowing. Such a policy can temporarily allow the government to avoid making the contractionary macro adjustments that otherwise would be necessary to bring the economy into equilibrium. However, when the government runs out of reserves (or if investors think the government is running out of reserves), the ―fixed‖ exchange rate will become unfixed and drop precipitously.

CHAPTER 20: MACRO POLICY IN A GLOBAL SETTING Questions and Exercises 174.

Whether it's better to have a high or low exchange rate depends on domestic and international goals. A high exchange rate for the dollar makes foreign currencies cheaper, lowering the price of imports; this benefits domestic consumers, but it places competitive pressure on domestic firms. A high exchange rate also tends to widen the trade deficit. On the contrary, a low exchange rate makes imports more expensive, hurting domestic consumers and putting inflationary pressure on the economy. But it can cause a trade surplus. There are pros and cons to both high and low exchange rates.

175.

Having a trade deficit means a country is consuming more than it is producing, which can be good. But a deficit also means that a country will have to finance its consumption by selling assets, on which interest or profit will have to be paid to foreigners in the future. A trade surplus will reverse the flow of capital, which will provide the domestic economy future interest and profits. However, current consumption is sacrificed. There are pros and cons to both trade deficits and trade surpluses.

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176.

A country can‘t target both interest rates and exchange rates because targeting an exchange rate requires changing monetary policy to maintain that target. Since monetary policy affects interest rates, the country must give up this goal.

177.

If China and Japan ran expansionary monetary policy, it would increase domestic aggregate demand and therefore raise Chinese and Japanese imports of U.S. goods. As a result, such action would decrease the U.S. trade deficit, as U.S. exports to China and Japan increase.

178.

A contractionary fiscal policy by Japan and China would decrease domestic income and decrease demand for U.S. imports. Therefore, such action would increase the U.S. trade deficit, as U.S. exports to Japan and China fall.

179.

Increased money → increased income → increased imports → increased trade deficit.

180.

a.

An increase in the trade deficit is probably due to expansionary fiscal or monetary policy. Such expansionary policy would increase inflation, which would reduce competitiveness; the increased income associated with such policy would increase imports and increase the trade deficit.

oooooooooooooooo.

Fiscal policy. If interest rates have risen steadily, along with a rise in the exchange rate, it is likely fiscal policy. Expansionary monetary policy reduces interest rates. pppppppppppppppp.

Yes, the internationalization of debt would increase capital flows into the country, which, in order for the balance of payments to be equal, would require a trade deficit.

181.

a.

You should suggest that the IMF require contractionary measures for both monetary and fiscal policy to ease the trade deficit. I would, however, suggest a relatively more contractionary fiscal policy, so that the exchange rate would also fall while inflation falls, boosting exports.

qqqqqqqqqqqqqqqq.

Such action would tend to slow inflation, after an initial burst due to the effect of a fall in the exchange rate on domestic inflation (caused by higher import prices). The policy would hinder growth and push the economy into a (hopefully short-lived) recession.

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rrrrrrrrrrrrrrrr. The country‘s government would not be happy about the proposal, because its adoption might lead to a deep recession, which is politically unpopular.

182.

The first advice I would give would be to explain that at most, I can talk about tendencies, rather than achieving goals. Not all goals are simultaneously achievable. That advice given; I would provide the following recommendations:

ssssssssssssssss. Suggest a contractionary fiscal policy, which lowers inflation and the interest rate directly, thus reducing the trade deficit by lowering income. Such action will also increase the capital inflow, which will tend to allow an increase in the trade deficit. Expansionary monetary policy would reduce the interest rate, but it would also spur inflation. tttttttttttttttt. These goals are difficult to achieve simultaneously. One could use a combination of monetary and fiscal policies. Expansionary monetary policy would lower the trade surplus and lower interest rates, but it would cause upward pressure on prices. To offset this, contractionary fiscal policy could be used, but that would also result in increasing the trade surplus and raising interest rates. uuuuuuuuuuuuuuuu.

An expansionary monetary policy will reduce interest rates and reduce unemployment too, but it will increase the trade deficit. Expansionary fiscal policy will also reduce unemployment, but it increases interest rates and raises the trade deficit. vvvvvvvvvvvvvvvv.

This combination of goals is difficult to achieve.

Expansionary fiscal policy will tend to reduce unemployment and increase interest rates, but it will also tend to increase the trade deficit. Contractionary monetary policy will offset the undesired effect on the trade deficit, but it will also offset the desired effects on unemployment and the interest rate.

183.

The answer to this question hinges on what is meant by "justified." If that means that the United States is complaining about the actual negative consequences it experiences because of this policy, such as a higher trade deficit and possibly an artificially high value for the dollar, one can say the complaint is justified. If the argument centers on fairness, the issue is clearly complicated by the question of whether a nation should put its goals ahead of, or secondary to, international goals. However, the United States does benefit from Japan‘s and China‘s exportdriven policies in the form of cheaper imported goods.

184.

a.

If the recession was caused by a fall in domestic expenditures, we would expect that its trade balance was moving toward a surplus as imports lagged. If, however, the recession was caused by a fall in exports, we would expect that its trade balance was moving toward a deficit.

6

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wwwwwwwwwwwwwwww.

The G-8 countries were trying to get Japan to boost its economy by increasing aggregate expenditures with either expansionary monetary or fiscal policy.

185.

a.

If the aforementioned figures are correct, one would expect less stabilization, because economic conditions in one country will have a greater impact on the economies of other countries. When one country‘s income falls, foreign incomes will likely fall too. This will lead to falling exports for the first country, which will further decrease income. From here, the cycle continues.

xxxxxxxxxxxxxxxx.

This convergence of growth rates would increase the possibility of a global recession, especially whenever one country goes into a recession. yyyyyyyyyyyyyyyy.

Answers on this can differ; an expected answer is that one will need coordinated, counter-cyclical policy (expansionary fiscal policy or monetary policy), organized through the G-8, World Bank, or some other international organization.

186.

To finance its debt, the domestic government has to sell more bonds. Because foreigners also demand these bonds (demand is greater), the government doesn‘t have to pay as high interest rates as it would if only U.S. investors demanded government bonds. Thus, the interest rate doesn‘t rise as much, and crowding out is reduced.

There‘s another way to avoid the crowding out that results from financing the deficit: Foreigners could buy the debt at the existing interest rate. This is called internationalizing the debt, and that is what happened to the U.S. economy in recent years.

187.

One cost of internationalizing the debt is that interest and profits on sold assets must be paid to foreigners. Also, future consumption must be reduced to pay that amount. Furthermore, foreign governments and individuals can potentially gain economic leverage over U.S. national institutions.

188.

a.

Currency stabilization is limited through direct purchases, because a country must use official reserves (also known as foreign reserves) to purchase its currency. Eventually it will run out of reserves.

zzzzzzzzzzzzzzzz. A country‘s other options are to use monetary and fiscal policy or trade policy.

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189.

There is strong political pressure to manage exchange rates, because exchange rates affect investors, firms, and consumers in an economy. Investors prefer an exchange rate that they can predict and that is not subject to wild fluctuations, because it reduces the risk of their investment. Firms prefer a predictable exchange rate so that they can estimate future production costs (to the extent that inputs are purchased from abroad). Consumers prefer that the government keeps the value of the exchange rate high, in order to allow for cheaply imported consumer goods, but domestic firms prefer a low value of the exchange rate to limit foreign competition. All of these interest groups place pressure on government to manage the exchange rate.

190.

a.

After WWII, the United States had a strong competitive position and a trade surplus, even though the value of the dollar was high. Thus, contractionary policy was not needed.

aaaaaaaaaaaaaaaaa.

In the 1970s, foreign individuals and countries had an enormous demand for U.S. assets, which allowed the U.S. to import more than it exported and maintain a trade deficit. Again, contractionary policy was not needed. bbbbbbbbbbbbbbbbb.

The trade deficit is presenting a challenge today because it means U.S. firms are not competitive, and workers in the tradable sector are losing their jobs. To restore its competitiveness, the United States will have to endure structural changes: reducing the value of the dollar, dropping domestic wages, and/or increasing U.S. productivity. During these structural changes, economic growth will be lower than its long-term rate. If one believes the problems are not structural, policy makers will have to run contractionary monetary and fiscal policy, which will slow the economy.

191.

If the U.S. economy were to collapse, U.S. imports would decline, depressing growth in other world economies. Thus, we can expect foreign governments to step in to support the dollar and slow its fall, if the private demand for U.S. assets decreases.

Questions from Alternative Perspectives 192.

Austrian Governments in developing countries tend to be even more problematic and be even more representative of special interests than those in developed countries, which makes an activist monetary and fiscal policy of even more dubious value.

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193. Religious ccccccccccccccccc.

This is a judgment question and judgments differ. Some religiously oriented economists are very concerned about the trade deficit and the position that the U.S. government might be in in the future. ddddddddddddddddd.

The Bible does not explicitly prohibit borrowing—that is, living beyond one‘s means. It does, however, require anyone who borrows to repay that debt. The implication for a trade deficit is that if a country runs a trade deficit now, it must intentionally plan a way to run a trade surplus later. eeeeeeeeeeeeeeeee.

An argument can be made that the U.S. international debt is going to undermine the position of the United States in the world, a consequence in line with the warnings of the Deuteronomy.

194. Institutionalist fffffffffffffffff. Private savings, government savings, and international savings (which is the inverse of the trade deficit), must sum to zero. ggggggggggggggggg.

As indicated by the figures, the international capital inflows were financing both the U.S. private borrowing and the U.S. government borrowing. hhhhhhhhhhhhhhhhh.

As theorized by the text, the international capital inflows reduced the degree of crowding out that would otherwise have occurred.

195. Post-Keynesian iiiiiiiiiiiiiiiii. This is a judgment question and judgments differ. Most PostKeynesians agree with the first position—that the international trade deficit reflects a structural imbalance in the U.S. economy and will cause serious problems in the future. jjjjjjjjjjjjjjjjj. This is a judgment question and judgments differ. Many economists agree that the shortfall has allowed Americans to consume beyond their means over the past 30 years. Many Post-Keynesians are concerned about whether the international borrowing can continue, and the likely shortage in demand that will exist if it does not will have disastrous consequences.

196.

Radical If the friend is correct, the empirical studies cast doubt on the convergence hypothesis and on the argument that one should support globalization to achieve greater income equality.

9

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Issues to Ponder 197.

This question requires student research. Assuming the dollar has recently fallen in value, this makes U.S. exports cheaper to the foreigners, but it may signal weaker investor confidence in the U.S. economy. This may mean foreign investors are pulling out of U.S. assets, which will also lead to lower stock prices and perhaps higher interest rates. A weaker dollar also means imports are more expensive, which puts upward pressure on domestic inflation and makes traveling in foreign countries more expensive. Whether the dollar should be stronger or weaker depends on who you are. Manufacturers whose sales depend on exports want a lower exchange rate. Investors likely want a higher exchange rate.

198.

This question requires student research. At the time that this was written, the U.S. trade deficit was higher than historical values, even though it fell after the 20082009 recession. It is unclear whether we should want to lower the U.S. trade deficit. As long as the United States can borrow or sell assets, it can have a trade deficit. On the other hand, the more the United States borrows, the more U.S. assets foreigners own. Eventually, the United States will have to run a trade surplus.

199.

If the financial and capital account were balanced, and remained balanced, the exchange rate for a country that gained a comparative advantage in most goods would rise, because the demand for its currency would rise. Foreigners would want to buy more goods from this country, because it produces goods at a lower cost (and therefore lower prices) than can other countries. Another way to look at it is that exports would exceed imports, creating a trade surplus; this would not be offset by a financial and capital account deficit, so there would be excess demand for the currency. This excess demand would lead to a higher exchange rate.

CHAPTER 21: STRUCTURAL STAGNATION, GLOBALIZATION, AND THE POST-COVID BLUES Questions and Exercises 200.

In a normal downturn, an economy is expected to recover quickly and return to its potential output and long-term growth trend. In a structural stagnation, however, the economy does not expand sufficiently after the recession to return to its longterm growth trend. Structural changes, which take a long time, are needed in order to get the economy back on track.

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201.

The underlying growth trend determines how quickly an economy can grow without creating accelerating inflation. For policy makers, if an economy is growing more slowly than its long-term trend, they can run expansionary policies to grow the economy. If it is growing above its trend, policy makers will run contractionary policies to avoid inflation. The growth trend serves as a benchmark.

202.

a.

Economic output declined by $0.80 (0.04  20) , so the output in Year 2 will be 19.2 (20  0.8) .

kkkkkkkkkkkkkkkkk.

The economy needs to grow by 10.4 percent between Years 2 and 3 in order to return to trend. To calculate the percent change needed, first calculate what potential output will be in Year 3: 21.2 (20  1.03  1.03) . The difference between potential output in Year 3 and economic output in Year 2 (21.2  19.20) , divided by output in Year 2, times 100, is the percent growth necessary to return to potential by Year 3. Growth needs to be 10.4 percent (2 / 19.2  100) . lllllllllllllllll. The expansion needed (10.4 percent) to return to trend is more than two times the percent decline during the recession (4 percent). mmmmmmmmmmmmmmmmm.The difference is accounted for by the fact that during both the recession and the expansion, potential output was growing. The expansion must make up for not just lost output due to the recession, but it also must make up for the rise in potential output.

203.

The secular stagnation theory states that advanced countries will eventually stop growing, because investment opportunities will eventually be met. This slows the growth of aggregate demand, hindering economic growth and eventually stopping the growth completely. Structural stagnation argues that for advanced economies, globalization has caused several structural problems that have slowed growth.

Once the structural problems have been addressed, the economy will return to its long-term growth trend. By that time, however, the economy's share of world output will have declined.

204.

The economy begins with a world aggregate supply curve of WAS0 (at the world price level of PW0 ), resulting in a trade deficit of Y0  Y1 . Globally constrained potential output is the most domestic producers can sell-- Y1 ; this is also potential output (LAS0 ) . If the currency falls in value (depreciates), foreign goods will become more expensive, shifting the WAS curve up to WAS1 (at the world price level of PW1 ). While total expenditures fall to Y2 , because the price level has risen, domestic goods have become more competitive and firms can now sell Y3 , which 11

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is the new globally constrained potential output (LAS1 ) . A depreciation of a currency, for an economy with a trade deficit, raises potential output.

205.

The economy begins with a world aggregate supply curve of WAS0 (at the world price level of PW0 ), resulting in a trade deficit of Y0  Y1 . Domestic producers can sell no more than Y1 , which represents globally constrained potential output.

Falling production costs shift the SAS curve down from SAS0 to SAS1 , making domestic goods more competitive. Domestic producers can now sell Y2 , which represents the new, higher, globally constrained potential output. Lower production costs shift potential output to the right (increase), in this case from LAS0 to LAS1 .

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206.

If a country does not run a trade deficit, the world supply curve intersects at the same location that the LAS, SAS and AD curves intersect—that is, at domestic equilibrium.

207.

Globalization masks inflation by putting a ceiling on the price of domestic goods, as shown in the graph below. Domestic producers cannot charge prices higher than world prices. In the example shown in the graph, if there were no global competition, the economy would be operating above potential (the SAS and AD curves intersect to the right of the LAS curve, for example at point A), and there would be pressure for the price to rise. However, with globalization and a world price level that is lower than the domestic price level, there is no pressure for the price level to rise. Excess aggregate demand is met by foreign production. This doesn't mean price pressures do not exist. Increases in aggregate demand might be 13

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channeled into asset inflation, which is not reported in standard measures of inflation.

208.

COVID reduces the anti-inflationary aspects of globalization, and thereby reverts the globalized AS/AD model to the standard AS/AD model in which large increases in aggregate demand cause inflation.

209.

The structural problems resulting from the financial crisis—housing overhang, a reduction in perceived wealth, and the need to unwind expansionary policies in a way that limits contractionary pressures—all make policy more difficult to implement, because policy makers cannot rely on the standard use of expansionary monetary and fiscal policies. Instead, each problem must be addressed with specific programs. The overhang requires government policies that will help eliminate the excess supply of housing. The decline in perceived wealth requires policies that will raise asset prices, and the risk of unwinding fiscal and monetary policy too quickly will require policymakers to be careful when reversing previous fiscal and monetary plans.

210.

False. Even though jobs in the non-tradable sector do not face direct foreign competition, the health of the non-tradable sector depends on the employment and income of the tradable sector. As incomes in the tradable sector decline, those working in that sector will have less income to spend in the non-tradable sector.

This reduces demand for non-tradable goods, which will lower production and raise unemployment in the non-tradable sector. In addition, there will be downward pressure on wages in the non-tradable sector, as unemployed workers in the tradable sector look for jobs in the non-tradable sector.

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211.

Globalization has made the distribution of income more unequal by lowering income for the low-skilled workers in the tradable sector. Workers in the nontradable sector also face lower income. In contrast, globalization has raised income for international traders. Because facilitating trade takes fewer people, the income gain has gone to a small number of people. The declining incomes of many and the rising incomes of few has led to further income inequality.

212.

False. Globalization should not be restricted, because while it may cause shortterm costs, there are long-term benefits to globalization. Specifically, trade increases specialization, which lowers costs and stimulates technological development. Specialization and technological development raise the trend growth rate, which translates into higher production and consumption. The structural problems reflect short-term issues that can be resolved over time. Once they are resolved, the economy will again grow at its long-term growth rate.

213.

False. Globalization is an ongoing process in which countries gain and lose comparative advantages, depending upon technology, social institutions, natural resources and other factors. For example, in the coming years, developing countries will continue to move up the value-added chain, providing competition for a greater array of goods for the United States.

214.

Policies to deal with the long-run structural problems of globalization include (1) decreasing the exchange rate value of the dollar, (2) instituting policies that will pressure workers to lower their reservation wages, (3) raising tariffs to increase the cost of imported goods, and (4) implementing policies that increase U.S. worker productivity, such as job-training programs.

215.

a.

The WAS curve shifts up, shown in the graph as a rise in the W AS curve from WAS0 to WAS1 . The trade deficit falls from Y0  Y2 to Y3  Y1 .

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Price level

nnnnnnnnnnnnnnnnn.

The SAS curve shifts down, shown in the graph as fall in the SAS curve from SAS0 to SAS1 . The trade deficit falls from Y0  Y2 to Y0  Y1 .

SAS0 SAS1

WAS

AD Y2

Y1

Y0

Real output

ooooooooooooooooo.

The WAS curve shifts down, shown as decline in the W AS curve from WAS0 to WAS1 . The trade deficit rises from Y0  Y1 to Y3  Y2 .

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Price level

SAS

WAS0 WAS1

AD Y2

Y1

Y0

Y3

Real output

ppppppppppppppppp.

The answer is the same as for part a. The WAS curve shifts up, shown as a rise in the W AS curve from WAS0 to WAS1 . The trade deficit falls from Y0  Y2 to Y3  Y1 .

216.

Politicians do not like to propose policies that have clear downsides, and the solutions to structural problems are likely to hurt the average American in the short-run. Therefore, one will see that most politicians prefer to avoid talking about the structural problems, and rather, they act as if the current economic slowdown will recover with standard monetary and fiscal policies.

217.

No, COVID does not reduce the structural stagnation problem. It makes the problem worse by adding an inflation problem onto the structural stagnation problem.

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Questions from Alternative Perspectives 218.

Radical Structural stagnation resulted from the costs of globalization, which involved transferring many jobs and activities out of the United States to low-cost countries. This increased the income of the rich international traders and decreased the income of those in low-tech manufacturing, hurting the poor. Had the adjustment costs of globalization been paid up front, globalization would have occurred much more slowly and involved less transfer of income from the poor to the rich.

219.

Post-Keynesian Since a government that can print money can have the central bank buy the bonds with newly-printed money, which pays no interest, technically, it can sell as many bonds as it wants. This means that its deficit can always be financed. In the PostKeynesian view, as long as there is no serious inflation problem, it makes sense to expand the deficit to reduce unemployment.

220.

Institutionalist Globalization involved enormous adjustment costs that were disproportionately borne by the poor in the United States. Had foreign countries been required to have fair labor practices and pay a living wage, globalization would have been slower, and the adjustment costs would have been less drastic. So, there still would have been problems, but they would have been reduced.

221.

Religious In a recession, output falls only by about 3 to 5%; in a rich society, if the fall in income were equally divided among residents, it would hardly be noticeable. The recession would be like living at an income level that one did a couple of years earlier. For most people in an affluent society, a decline of that magnitude would not involve a significant material hardship, however, it may present a material hardship for the lowest income earners. They would have to learn to live with less. In fact, for rich societies, where wants significantly exceed true needs, it might make sense for many people to live on less than they currently have. Doing so would help them recognize their spiritual nature and reorder their priorities.

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222.

Austrian The bubble that led up to the U.S. structural stagnation was in large part caused by an increase in the money supply and the amount of credit. If there had been an effective limit on the increases in the money supply, the bubble would have been far less likely to have developed, and hence, structural stagnation would have been less likely to happen. Having the money supply tied to gold might make it less likely to increase, and it would help to prevent such bubbles.

Issues to Ponder 223.

This is a normative question about which opinions differ. Because people in the United States tend to value their own well-being over the well-being of others-particularly those more unlike themselves, such as people living in China and India-- those who answer the question honestly are likely to discount the improved living standards in China and India. There is a strong argument on equity grounds, however, to weigh the gains for China and India heavily, because their average incomes are considerably less than average incomes in the United States.

224.

Because potential output, and therefore trend growth, cannot be measured directly, there is no one way to decide who is right about what the trend growth rate is. One method is to see at what level of income inflation begins to accelerate (this happens when the economy exceeds potential when world prices are equal to or higher than the domestic price level). Another method is to calculate the relationship between the unemployment rate and income, looking at current unemployment to estimate how far the economy is from potential.

225.

Policymakers have a difficult time coming to a compromise, because both options have significant downsides. Tax increases are unpopular and will lower disposable income and aggregate demand, decreasing output. This would slow the economy even further. Entitlement cuts would be politically unpopular among older voters, those who benefit from large entitlement programs such as Social Security and Medicare. The cuts would also reduce aggregate demand and slow the economy.

226.

It is difficult to say how much of a safety net could be provided. It depends on how many people would be eligible and what programs would be offered. The safety net could include job-training programs, income support, and a better educational system. To begin the discussion with some back-of-the-envelope calculations, that suggest that there are 15 million unemployed, the program would have to spend $200,000 on each of them over the period. This example 19

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points out that if the spending can be targeted at those who most need it, it can be much more effective. (Appendix A to this chapter provides further foundation for a classroom conversation on this topic.)

CHAPTER 22: MACRO POLICIES IN DEVELOPING COUNTRIES Questions and Exercises 227.

Economic statistics do not take into account the quality of life; notably, they exclude the culture and local, social institutions that provide pleasure to individuals in the society.

228.

Comparing incomes using exchange rates is a simple conversion of a domestic income into foreign income using current exchange rates. The purchasing power parity method adjusts income in a way that equalizes the cost of purchasing a similar basket of goods among countries.

229.

Using the purchasing power parity method, rather than current exchange rates, reduces the disparity of income among countries. When viewed on a level playing field, it becomes apparent that exchange rates exacerbate income differences.

230.

Development refers to an increase in productive capacity and output brought about by a change in underlying institutions; growth refers to an increase in output brought about by an increase in inputs. Developing economies are changing their production functions, while growing economies are increasing inputs and production with a given production function.

231.

Three ways in which institutions differ in developing countries are: (1) basic market institutions with well-defined property rights do not, in many cases, exist; (2) there is often a dual nature to the economy; and (3) fiscal structures, with which to adequately implement fiscal policy, often do not exist.

232.

An economist might favor activist policies in developed countries and laissezfaire policies in developing countries, because the policies one favors depend on the desire and the ability of government to work for and achieve the goals of its policies. Different views of government can lead to different views of policy.

Since many economists have a serious concern about the political structure in developing countries, but less concern about it in developed countries, they can 20

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favor laissez-faire policies for developing countries and activist policies for developed countries.

233.

The dual economy refers to the existence of a traditional, less developed (often barter-based) economy and a second, internationally oriented, modern market sector that is highly developed.

234.

A regime change is a change in the entire structure within which the government and economy interact, often brought about by a new leader or ruling party.

Whereas a policy change is a change in one aspect of government action.

235.

An inflation tax is the transfer of wealth from the holders of IOUs denominated in the unit of account, such as cash or bonds, to the issuers of those IOUs. This occurs when there is inflation (cash) or when inflationary expectations are not fully adjusted (bonds).

236.

Governments act to maintain their positions in power, and often feel that in order to do so, they have no choice but to print more money. At the same time, central banks in developing countries often do not enjoy full independence and thus cannot resist political pressures (and may not want to, since they also desire to keep the government in power). For those making the decisions, the short-term benefits of the ―inflation solution,‖ keeping regimes in power, outweigh the costs of any long-term hyperinflation.

237.

Conditionality is the making of loans that are subject to conditions by the IMF. Often, countries will ask the IMF for loans to cover balance of payments deficits, and the IMF will in turn place conditions on those loans that often include running a balance of payments surplus.

238.

Limited investment and poor use of available funding makes economic growth difficult in developing countries. Corruption limits investment and growth because knowing that payments of graft must be made prevents many people from undertaking actions that might lead to growth. Also, tax revenues are often diverted to those in power, instead of going into legitimate productive investment.

The same is sometimes true of foreign aid.

239.

Investment and savings are low in developing countries because income is low, and poor people don‘t have a whole lot left over to save. The rich often keep their savings abroad due to the fear of political instability. As for the middle class, 21

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which is usually small in developing countries, the underdeveloped financial sector leaves them with few opportunities to invest their savings.

240.

Even though developing countries may be unstable and offer a risky environment for investing, if a country has a motivated, cheap work force, a relatively stable government supportive of business, loose regulations, and sufficient infrastructure investment, multinational companies will have a strong motivation to invest in the country. The aforementioned qualities allow for large profit margins for foreign companies.

241.

When education doesn't match the needs of the society, the degrees become more important than the knowledge learned. This credentialism may result in jobs being done by people who might look qualified on paper, when in reality, they do not have the skills. Those who do not have the credentials, but do have the skills, might be underutilized resources.

242.

Many of the good, foreign students sent to a U.S. college don‘t return home.

Those that do go home take jobs as government officials, expecting high salaries and material comforts far beyond what their society can afford. Instead of becoming the dynamic entrepreneurs of growth, they become impediments to growth.

Questions from Alternative Perspectives 243. Religious qqqqqqqqqqqqqqqqq.

Based on the Bible, many religiously oriented economists believe that governments of developed countries should provide more development aid than they are currently providing. rrrrrrrrrrrrrrrrr. The Bible does not provide a single theological perspective about the conditionality of debt forgiveness. The book of Leviticus in the Hebrew Scriptures introduces the concept of the Year of the Jubilee as an ethical norm for God‘s chosen people: every 49 years, all debt is forgiven. The purpose, however, is to level inequalities that may have resulted from political oppression. Other passages, however, suggest that repenting is required to receive God‘s forgiveness on the Day of Judgment. The New Testament is similarly ambiguous. Some passages such as Matt. 22 suggest that ethical behavior, presumably including asking for forgiveness for past wrongs, is required to enter the kingdom of God. But depending on one‘s view of Jesus‘ death and resurrection and redemption, one could argue that it is Jesus‘ death that redeems all sinners. It is Jesus who takes on our sins. Repenting is an expression of living into that reality.

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244. Institutionalist sssssssssssssssss. Often, the finger is pointed at the developing nations themselves.

Many Institutionalists believe that it is often more complicated and that policies in developed countries (such as agriculture subsidies) play a large role in keeping poorer countries from developing. ttttttttttttttttt. The direct consequences of failed development are experienced by the people in the country. However, when economies are incapable of supporting a population, civil discord, rebellion, warfare, and terrorism can be the result; these can be problematic for the entire world. uuuuuuuuuuuuuuuuu.

The more one believes that the cause and consequence of a lack of development goes beyond the country itself, the stronger the argument for aid.

245. Feminist vvvvvvvvvvvvvvvvv.

Women are likely given credit because they often are the harder workers and have stronger social bonds. Another likely reason is that women have had a subordinate role in Bangladeshi society, and one of the goals of the program was to redress that unfairness. wwwwwwwwwwwwwwwww. It suggests that policies aimed at educating women and promoting gender equality can be useful in bringing about development.

246. Religious xxxxxxxxxxxxxxxxx.

Loans place someone in someone else‘s debt and can prevent people from having hope for development, making them an instrument of oppression. yyyyyyyyyyyyyyyyy.

Loans that are used to positively transform a society, and which generate revenues to pay back the loans, can be an instrument of development. By the paying of profit allowed by Sharia law, rather than interest, which is paid only when the development works, one can limit the oppressive aspects of loans. zzzzzzzzzzzzzzzzz.

The conditions for micro loans, such as those from Grameen Bank, ―are to participate in equity capital and grant loans for productive projects and enterprises besides providing financial assistance to member countries in other forms for economic and social development.‖ By participating in equity capital, the loans are less likely to be oppressive and more likely to be made for productive investments. Such loans remain within Islamic law.

247.

Radical 23

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aaaaaaaaaaaaaaaaaa.

This is a judgment question and judgments differ. Radical economists are very skeptical of free trade and financial liberalization policies.

They favor policies that provide more democratic controls over capital flows and economic development, such as taxes on the rapid turnover of capital, capital controls, requirements for local content for multinational production, and minimum labor standards. That is not to say that they are not skeptical of national control, because government policy in the developing world often works in favor of the ruling elite. bbbbbbbbbbbbbbbbbb. This is a judgment question and judgments differ. Radical economists are very skeptical of free trade and financial liberalization policies.

However, they are also skeptical of national control, because such policies often work in favor of the ruling elite.

Issues to Ponder 248.

Answers will differ. Students can use the list in the text for some examples of the kinds of things they would have to give up, as well as examples of some of the things they would have to do.

249.

You can‘t just judge an economy; you must judge the entire culture. Some developing countries have cultures that, in some people‘s view, are preferable to ours.

250.

Suicide rates are lower in developing countries because there is little ambiguity and few questions about the meaning of life. Americans could learn a great deal from an experience of living in a developing country, especially Americans who do not truly appreciate what they have. But learning this lesson would require hardship; the fact that suicide rates are lower in developing countries does not mean that life in developing countries is easier or happier. Thus, it would be an oversimplification to say that Americans would be better off living in such a country.

251.

This exercise asks you to spend a day living like someone in a developing country and then read this chapter and contemplate the degree to which someone in such a situation can pull himself or herself up by the bootstraps. Doing so will likely give them a better sense of what it means to ―pull oneself up by one‘s own bootstraps.‖

252.

This exercise has students interview a foreign student in their school or class about the obstacles to economic development.

24

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253.

a.

I agree with this statement because of the differing importance of institutions. A detailed knowledge of a country‘s institutions and culture is necessary to make prescriptions for development. I disagree with this statement to the degree that the lessons learned from a general theory say that development requires stable political structures and economic conditions, as well as savings that can be invested in various projects. The solutions are specific to the countries but fall within a general framework.

cccccccccccccccccc.

This argument is made for developing countries because culture and traditional institutions play a larger role in the growth of these economies.

254.

This is a student research question. The information for a, b and c is easily found on the internet. The answer for d involves opinion, but it should reflect the discussion in the text.

255.

Governments in developing countries often seem more arbitrary and oppressive than governments in developed countries because of their lack of stable, welldeveloped fiscal, financial, and political institutions. Furthermore, they must meet the demands of their citizens simply to stay in power, and there are few checks or balances that encourage accountability for governmental actions. The uncertainty inherent in this kind of situation leads to changing policies and rules, which often seem arbitrary. The need to maintain power in the absence of accountability constraints can lead to ―oppressive‖ policies.

256.

An investor thinking of making an investment in a developing country would be concerned about the country‘s political stability and its economic condition (inflation, etc.). The existing amount of debt may also be a matter of concern, as would the need to pay bribes just to get a business started.

257.

Overpopulation can be an obstacle to development. Whether a country should control the size and the makeup of its population is a matter of considerable debate. Individuals differ substantially in their assessment of the morality of these programs, but even if one believes that population control is an appropriate government concern, it does not seem that such programs will be successful, by themselves, in limiting population growth.

258.

The UN could encourage the development of microcredit banks, like the Grameen Bank, which provide a low-cost alternative to moneylenders. There are also significant social and cultural limitations in many areas that limit women entrepreneurs; these should be challenged and changed, allowing women easy 25

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access to business opportunities. Also, the lack of day-care centers for full-time mothers is problematic.

259.

a.

I would want to emphasize those skills that have the highest per-dollar return—those that would lead to development. These would probably be the basic reading, writing, and problem-solving skills that fit the indigenous culture; technological and computer training should also be considered.

dddddddddddddddddd. This differs from the ideal educational system in the United States, because U.S. cultural practices and economic problems are different. Thus, in the United States, the focus would be on more abstract analysis and becoming generally educated and cultured, while in developing countries, the focus would be on agricultural science and basic skills. eeeeeeeeeeeeeeeeee.

How much of the U.S. education system involves credentialism is a matter of debate, both about what are the relevant skills and how much credentialism exists. One argument is that many college courses are not relevant to jobs available. The response to this is that even indirectly related courses increase one's abstract thinking skills and general knowledge of U.S. society and institutions. In answering this question, one would need to determine how much individuals would be willing to pay for courses that do not result in a credential compared to how much they would pay for courses that do result in a credential.

260.

The right education is a necessary component of any successful development strategy. The wrong education is an enormous burden. Developing countries tend to have too much of the wrong education and too little of the right education.

However, when students from such countries study abroad, they receive an education that is not culturally relevant for their home country. This leaves them with a hard choice at the end of their education, and many choose not to return home, resulting in a brain drain.

261.

a.

If one cannot get a title to land, one cannot borrow on it, and thus cannot finance buying it or start a new business. Both can slow, and even stop, development.

ffffffffffffffffff. Without titles, public utilities do not know whom to bill for services; this will keep public services from developing.

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