Solution Manual for Microeconomics: Principles, Applications and Tools Jeffrey Phillips

Solution Manual for Microeconomics: Principles, Applications and Tools Jeffrey Phillips

Microeconomics: Principles, Applications and Tools Tenth Edition

Arthur O’Sullivan Steven M. Sheffrin Stephen J. Perez

Contents Chapter 1 Introduction: What Is Economics?  1 Chapter 2 The Key Principles of Economics  12 Chapter 3 Exchange and Markets  25 Chapter 4 Demand, Supply, and Market Equilibrium  35 Chapter 5 Elasticity: A Measure of Responsiveness  53 Chapter 6 Market Efficiency and Government Intervention  66 Chapter 7 Consumer Choice: Utility Theory and Insights from Neuroscience  82 Chapter 8 Production Technology and Cost  91 Chapter 9 Perfect Competition  102 Chapter 10 Monopoly and Price Discrimination  116 Chapter 11 Market Entry and Monopolistic Competition  127 Chapter 12 Oligopoly and Strategic Behavior  136 Chapter 13 Controlling Market Power: Antitrust and Regulation  150 Chapter 14 Imperfect Information: Adverse Selection and Moral Hazard  159 Chapter 15 Public Goods and Public Choice  171 Chapter 16 External Costs and Environmental Policy  179 Chapter 17 The Labor Market and the Distribution of Income  193 Chapter 18 International Trade and Public Policy  206

1 Introduction: What Is Economics?

Chapter Summary Chapter 1 provides a basic illustration of what economics is and why it is useful. Economics is the study of the choices people, firms, and governments make when resources are scarce.

Economic analysis helps us understand the consequences of these choices. Here are the main points of the chapter:  Most of modern economics is based on positive analysis, which answers the question ―What is?‖ or ―What will be?‖  Economies must answer three questions: What products do we produce? How do we produce the products? Who consumes the products?  Normative analysis answers the question ―What ought to be?‖  To think like an economist, we (a) use assumptions, (b) use the notion of ceteris paribus, (c) think in marginal terms, and (d) assume that rational people respond to incentives.  Macroeconomics helps us understand why economies grow and understand economic fluctuations. Microeconomics helps us understand how markets work.

Learning Objectives: 1.1 What is Economics? List the three key economic questions.

1.2 Economic Analysis and Modern Problems: Discuss the insights from economics for a realworld problem such as congestion.

1.3 The Economic Way of Thinking: List the four elements of the economic way of thinking.

1.4 Employability—Economic Logic on the Job: Explain how studying economics improves a person‘s employment prospects.

1.5 Preview of Coming Attractions—Macroeconomics: List three ways to use macroeconomics.

1.6 Preview of Coming Attractions—Microeconomics: List three ways to use microeconomics.

Approaching the Material The first classes are very important in determining your students‘ attitudes toward economics.

You have to find out their attitude and use real-world examples that help them understand that economics relates to their lives. Stating to the class that economics is ―The study of how scarce resources are allocated to satisfy unlimited wants‖ is accurate but is also one of the reasons why some people still refer to economics as ―the dismal science.‖ Try the following definition of economics instead: ―Economics is the study of how you, your friends, the stores where you shop, and your mayor make choices.‖ Every student in front of you makes choices everyday—what to wear, what to have for breakfast, or whether to sleep in, whether to study or play video games.

Students allocate resources all day long. Time is one resource that everyone can relate to and

everyone has the same amount of. Use what students know to teach them what you want them to know.

Chapter Outline

1.1 What Is Economics?

A. Scarcity: the resources we use to produce goods and services are limited. Economics is the study of choices when there is scarcity.

 Teaching Tip Students have scarce resources they have to allocate. Ask the class who had breakfast this morning. You should have a room full of both breakfasters and those who did not eat. Ask those who did not eat breakfast why not. Someone is sure to say they did not have the time. Explain that we all have the same amount of time (a scarce resource), but we choose to allocate it differently. (i.e., sleep in, workout, study, eat breakfast).

B.

Factors of Production Factors of production: the resources used to produce goods and services, also known as production inputs.

Natural resources: the resources provided by nature and used to produce goods and services.

Labor: the physical and mental effort people use to produce goods and services.

Physical capital: the stock of equipment, machines, structures, and infrastructure that is used to produce goods and services.

Human capital: the knowledge and skills acquired by a worker through education and experience.

Entrepreneurship: the effort used to coordinate the factors of production—natural resources, labor, physical capital, and human capital—to produce and sell products.

C. Positive versus Normative Analysis 1. Positive analysis answers the questions ―What is?‖ or ―What will be?‖ a. For example: What is the effect on poverty of a living wage ordinance? Or, What is the effect on a city‘s costs of a living wage ordinance?

2. Normative analysis answers questions of ―What ought to be?‖ a. For example: Should a city implement a living wage ordinance?

 Teaching Tip Tell the students that Mr. Alumni Bigbucks has donated 50 million dollars to the university. The following question is an example of positive analysis: Should the donation be used to build a new stadium or a state-of-the art library/technology center? The following question is an example of normative analysis: What do they think should be built and why?

D. The Three Key Economic Questions The choices made by individuals, firms, or governments answer three fundamental questions: 1. What goods and services do we produce?

2. How do we produce these goods and services?

3. Who consumes the goods and services that are produced?

 Teaching Tip Now is a good time to introduce the concept of markets indirectly. Consumers decide what is produced and for whom; businesses decide how the products are produced.

E. Economic Models An economic model is a simplified representation of an economic environment, often employing a graph. For example, economists use the model of a market to analyze the effects of public policy on economic outcomes.

1.2 Economic Analysis and Modern Problems Economic analysis can provide insights into real-world problems such as: A. Economic View of Traffic Congestion: problem is solved by paying tolls.

B. Trade-offs from International Trade: there are winners and losers (or trade-offs) associated with specialization and trade.

C. Economic View of Managing the U.S. Economy: governments throughout the world intervene to try and help their economies.

1.3 The Economic Way of Thinking A. Use of Assumptions to Simplify and Facilitate Learning B. Isolate Variables—Ceteris Paribus

A variable is a measure of something that can take on different values. The ceteris paribus is a Latin expression meaning other variables being held fixed. The assumption is that when we consider changes in one variable, we hold all other variables constant.

 Teaching Tip Ask the students to recall doing experiments in high school science (chemistry) classes. Remind them that in order to obtain reliable results, they had to change only one component while holding other components constant.

C. Thinking at the Margin Economists consider small, incremental changes to determine whether or not it is desirable to change the level of economic activity. A small, one-unit change in value is

known as a marginal change. For example, should you eat the fourth piece of pizza if you aren‘t hungry?

D. Rational People Respond to Incentives

 Teaching Tip Self-interest is not the same as selfishness. Ask the students to think about all of the things their parents have done for them over the years. Not selfish but certainly in the parent‘s self-interest.

E. Example: Southern California Addresses Its Congestion Problem The Southern California Council of Governments (SCAG) advocates a congestion tax (or ―decongestion fee‖) that would be paid by drivers who use roads during peak periods. A similar plan was implemented in Stockholm, which experienced a 20 percent decrease in traffic as a result.

 Teaching Tip Ask the students what other pricing schemes London could have used to reduce congestion—free public transportation, alternative work hours, higher parking rates.

 Teaching Tip Almost every college campus in America lacks enough spaces for those who want to park. Discuss the current parking policy at your university. Ask the students to use economic analysis to come up with alternative policies to solve the parking problem (small groups should work well here). The possible solutions should include raising parking fees, restricting parking by types of parkers (no freshman, faculty/staff only), remote parking with free shuttles, altering class schedules, rewards for car pooling, and expanding parking spaces.

Review these key questions and their related Applications:

Question 1: How do people respond to incentives?

APPLICATION 1: INCENTIVES TO INSTALL ROOFTOP SOLAR PANELS The federal government is offering a tax credit for homeowners to install rooftop solar panels to generate electricity. Studies have shown that consumers are very responsive to tax incentives for solar power, especially if they pay a relatively high price for electricity.

Question 2: What is the role of prices in allocating resources?

APPLICATION 2: HOUSING PRICES IN CUBA The Cuban government confiscated most housing in 1960 and did not allow homeowners to sell their property.

As a result, the housing stock deteriorated because there was little incentive to

repair it.

Housing reforms allowed the sale and purchase of homes in Cuba in 2011. These reforms increase incentives and are expected to increase construction of houses.

1.4 Employability: Economic Logic on the Job Economics involves making choices. There are many examples of jobs in the real world where economic analysis can be applied in making decisions.

1.5 Preview of Coming Attractions: Macroeconomics Macroeconomics is the study of the nation‘s economy as a whole; it focuses on the issues of inflation, unemployment, and economic growth.

A. Why Study Macroeconomics?

1. To understand why economies grow 2. To understand economic fluctuations 3. To make informed business decisions

1.6 Preview of Coming Attractions: Microeconomics Microeconomics is the study of the choices made by households, firms, and the government, and how these choices affect the markets for goods and services.

A. Why Study Microeconomics?

4. To understand markets and predict changes 5. To make personal or managerial decisions 6. To evaluate public policies

Additional Applications to Use in Class Question: Does a real estate agent have an incentive to get you the highest price?

ADDITIONAL APPLICATION: FREAKONOMICS Source: Motley Fool audio interview with economist Steven Levitt Interviewed by David Gardner ―Freakonomics‖ Summary: Key Points in the Article This audio clip features an interview with one of the authors of the best-selling book Freakonomics. Economist Steven Levitt answers a host of questions typically not tackled by most economists. One of the questions is related to realtors and agency relationships. In other words, do realtors really work for real estate sellers?

According to Levitt, it is in the best interest of the realtor to convince sellers to take an offer lower than they would receive if the property remained on the market. Since the percentage of the sales price that real estate salespersons receive from selling a house is a very small fraction, a $10,000 increase in sales price might net a real estate professional another $150 commission for a tremendous amount of additional work. Therefore, it is in the real estate salesperson‘s best interest to convince the seller to make the quick sale and take the first reasonable offer. Levitt

points toward evidence that real estate professionals tend to leave their own properties on the market longer and receive 2 percent to 3 percent more in sales price.

Levitt addresses many other issues including market efficiency, horse racing, and drug dealing in this interview. Listen to the clip for Levitt‘s economic explanation of numerous topics.

Analyzing the News Levitt‘s primary contribution is his application of economic thought to a number of topics typically not addressed by economics. As you will hear, economics is truly a social science that can be used to explain quite a bit of human behavior.

Thinking Critically Questions 7. What is ―freakonomics?‖ 8. Why would the illustration of ―realtors‖ and not maximizing sales price for sellers be an economic topic?

9. Are the stock markets efficient according to Levitt?

 Teaching Tip This is a great example of how people‘s incentives are often not the same.

Although the real estate agent works for the seller, their interests regarding holding out for a higher price are not the same.

Question: How does a tightening of discretionary income affect luxury industries?

ADDITIONAL APPLICATION: SPORTSBIZ: GOLF INDUSTRY GETS HIT HARD Sweet, David ―SportsBiz: Golf Industry Gets Hit Hard‖ Posted 12/3/2008 on MSNBC.com Summary: Key Points in the Article Golf courses are not only on hold in the United States, but also many are being converted to other uses. The 1990s saw tremendous expansion in the sport, which is now being reversed as many people forgo the game due to tight budgets. More courses are closing this year than are opening, and openings are the lowest in 20 years.

In addition, many new courses are tied to housing projects that are currently mothballed due to the flagging housing market.

Equipment sales are down as well as rounds played. The one bright spot appears to be China. One course designer formerly in high demand in the United States is now focusing on China’s growing appetite for the game.

Analyzing the News Golf is a game that consumes discretionary income. As more people look for ways to reduce spending either due to job loss or conservation of cash, golf may be one of the first luxuries to

go. It appears that the recession may be impacting all levels of income. You may begin to see a reduction in price as shown in the graph as golf courses attempt to draw customers back to the green. Of course, if the number of golf courses in the United States falls even further, you would see a leftward shift in supply that might help the surviving courses.

Thinking Critically Questions 1. What is causing the leftward shift in demand for golf?

2. How do expectations cause demand shifts?

3. Why is China experiencing a golf boom?

Question: Should people invest in low-cost health insurance?

ADDITIONAL APPLICATION: IS LOW-COST HEALTH INSURANCE WORTH IT? McCormack, Karyn ―Is Low-Cost Health Insurance Worth It?‖ Posted 8/04/2008 on MSNBC.com Businessweek Summary: Key Points in the Article Some of the low-cost health insurance plans currently being pitched on television may not be worth the price. A couple of options limit coverage so that any surgery or hospitalization is capped at less than $1,200. The primary coverage is minor medical instead of major medical.

Critics maintain that policies of this nature do little for the insured since any major medical event would result in thousands of dollars of expenses not paid by the plans. However, representatives at one of the companies said that company representatives will negotiate large bills on behalf of their clients. The company, iCan, maintains that their network pricing clout and negotiation will reduce a typical $50,000 bill to around $10,000 to $12,000.

There are currently 47 million uninsured Americans that may opt for these low-cost mini-medical plans. However, even at the low end price of $160 a month for individuals and $260 a month for families these plans may stress a lot of budgets.

Analyzing the News Access to medical care is a critical issue in the United States.

Does everyone have access to treatment? Probably not equally and many people are forced into bankruptcy every year due to high medical bills. Expect to see continued debate over this issue after the presidential election.

Thinking Critically Questions 1. Why is this issue important?

2. What are some options for the government to debate?

3. What forms of nationalized health care currently exist?

Appendix A Using Graphs and Percentages 1A.1 Using Graphs A. Graphing Single Variables 1. Pie charts 2. Bar graphs 3. Line graphs Students who are not familiar with graphs will need lots of time here. Give them simple data, and let them create their own pie charts and bar graphs.

B. Graphing Two Variables 1. Two variable graphs use both the horizontal and vertical axis.

2. Play ―connect the dots‖ to determine points on the line.

 Teaching Tip Have the students create graphs without numbers. Using concepts they are familiar with (Hours of study, G.P.A.), have them draw the line that shows the general shape of the relationship.

Positive relationship: a relationship in which two variables move in the same direction.

Negative relationship: a relationship in which two variables move in opposite directions.

C. Computing the Slope Slope of the curve is the vertical difference between two points (the rise) divided by the horizontal difference (the run).

 Teaching Tip Most students should be familiar with the concept of slope, but it is worth your time to go step by step for at least a few problems.

D. Moving along the Curve versus Shifting the Curve 1. Variables in the graph versus variables not in the graph 2. Changing variables in the graph—movement along the curve 3. Changing variables not in the graph—movement of the curve Emphasize that the Y-intercept represents variables not in the graph.

E. Graphing Negative Relationships Illustrate the negative relationship between downloads and CDs purchased. Most students should not have a problem with the concept of a negative relationship.

 Teaching Tip

Ask students to come up with three pairs of variables that have a negative relationship.

F. Graphing Nonlinear Relationships Show students what a nonlinear relationship looks like. Unless you have an unusual class, you should avoid using calculus to explain nonlinear relationships. An explanation of how there may not be a constant relationship between variables would be useful.

1A.2 Computing Percentage Changes and Using Equations A. Computing Percentage Changes Use the formulas to show students how to compute percentage change. Several examples may be necessary.

 Teaching Tip Most students are shoppers. Use concepts like ―20 percent off‖ sales to help them understand this concept.

Review this key question and the related application:

Question 3: How do we compute percentage changes?

APPLICATION 3: THE PERILS OF PERCENTAGES This Application explains how in the 1970s the government of Mexico City repainted highway lines to make a four-lane highway into a six-lane highway and then turned it back into a four-lane highway. When reporting on the results of those changes in lanes on the highway, the government incorrectly reported the percentage changes of the effects of redoing the highway because they used the simple approach to computing percentage changes. This shows that percentage calculations can be inaccurate, if you‘re not careful. It‘s important to remember that the midpoint formula accurately records percentage changes.

B. Using Equations to Compute Missing Values Follow the formulas in the book. As this is basic algebra, students should be wellversed, but a few in-class problems should be helpful.

Solutions to End-of-Chapter Exercises Chapter 1 SECTION 1.1: WHAT IS ECONOMICS? 1.1 1.2 1.3 1.4

what, how, Who natural resources, labor, physical capital, human capital, entrepreneurship statement ―a.‖ is TRUE a. normative b. positive c. normative d. normative e. positive

SECTION 1.2: ECONOMIC ANALYSIS AND MODERN PROBLEMS 2.1 2.2 2.3 2.4

b. benefits, prices. workers displaced by international trade. inflation.

SECTION 1.3: THE ECONOMIC WAY OF THINKING 3.1 3.2 3.3 3.4 3.5 3.6

the earth is flat, the roads are flat assumptions, use of ceteris paribus to isolate variables, margin, incentives b.

8 housing repair and maintenance false

Critical Thinking 1.

Hillyland specializes in coffee, and Flatland specializes in rice. Consumers benefit because the price of rice decreases in Hillyland and the price of coffee decreases in Flatland. Rice workers in Hillyland lose their jobs, and so do coffee workers in Flatland. The negative job effects will persist until displaced workers make the transition to the other job.

2.

The decrease in price decreases the incentive for maintenance and repair, so the quality of housing will decrease over time as the owner spends less on maintenance and repair.

Chapter 1 Appendix 1. a.

b. $5.00, hours/month c. $15.00

d. 6 additional hours

2.

$20, $4.00, 10, $60, $80

3.

a.

b. -2.0 movies, CD 4.

a.

Number Deliveries 0 5 10 15 20

of Total Costs 50 90 130 170 210

b. $8.00, delivery c. Drivers‘ wages and the rental cost of the truck. In addition, the other costs of delivery, such as the price of fuel, insurance, and taxes. d. deliveries e. drivers‘ wages, the rental cost of the truck, or the price of fuel 5.

along, shifts

6.

10.0%, -2.0%, 6.0%

7.

112, 54, 23

8.

40% = 20/50, 33% = 20/60

2 The Key Principles of Economics Chapter Summary Chapter 2 introduces the key principles that are central to all economic theory:

    

The principle of opportunity cost states that the opportunity cost of something is what you sacrifice to get it. Opportunity costs in production are generally increasing, and thus, the production possibilities curve is bowed outward.

The marginal principle states that any activity should be increased as long as the marginal benefits of the additional activity exceed the marginal costs.

The principle of voluntary exchange states that a voluntary exchange between two people makes both people better off.

The principle of diminishing returns states that, in the short run, if use of one input is increased while all others are held constant, production will eventually increase at a decreasing rate.

The real-nominal principle states that what matters to people is the real value or purchasing power of money or income, not its face or nominal value.

Learning Objectives: 2.1 The Principle of Opportunity Cost: Apply the principle of opportunity cost.

2.2 The Marginal Principle: Apply the marginal principle.

2.3 The Principle of Voluntary Exchange: Apply the principle of voluntary exchange.

2.4 The Principle of Diminishing Returns: Apply the principle of diminishing returns.

2.5 The Real-Nominal Principle: Apply the real-nominal principle.

Approaching the Material Continue the approach you developed in the first chapter, reaching students where they are. The decision to go to college is a great illustration of opportunity costs because students forgo earnings that they would have received from a full-time job. Apply the concept of diminishing returns to hours studying: If a student studies for five hours, will studying one additional hour really benefit him or her? Most of the students will have had jobs, so use the price of a gallon of gas or a burger per hour worked to explain real wages. Most students will have trouble with the marginal principle, so have plenty of examples ready. A seat on a bus or train that is not full is a good example. An extra passenger in a car for a road trip or another person watching a movie will also work.

Chapter Outline 2.1 The Principle of Opportunity Cost A. Definition

1. The opportunity cost of something is what you sacrifice to get it.

2. What you sacrifice is the next best alternative.

3. For example, if you choose to buy a cup of coffee, you are giving up the money it costs to buy it. What else would you have used the $2.00 for? The opportunity cost of the coffee is the one thing (or next best alternative) that you would buy if not the coffee.

 Teaching Tip Ask the students what they would be doing if they weren‘t in class. Answers will range from sleeping, working, watching TV, studying, etc. You can make the point that the alternatives are infinite and computing the cost of them all is

impossible. However, since they could only be doing one thing (not all of them) if they were not in class, determining the opportunity cost requires only knowing the one thing they would be doing.

B. The Cost of College

1. The classic example of opportunity cost is the costs of going to college. Be sure to illustrate the implicit opportunity cost of forgone income as well as tuition, books, etc.

 Teaching Tip It‘s also helpful to have a discussion about whether room and board should be considered a cost of college. If the person has to pay the same amount for room and board whether he or she goes to college or work, it should not be considered a cost of college.

C. The Cost of Military Spending

D. Opportunity Cost and the Production Possibilities Curve 1.

The production possibilities curve: a curve that shows the possible combinations of products that an economy can produce, given that its productive resources are fully employed and efficiently used.

2.

Discussion of relevant points on the production possibilities graph. a. Points on the curve are efficient and indicate an economy is utilizing all resources. b. Points inside the curve are inefficient and indicate an economy is not utilizing all resources or resources are not used in the least-cost manner. c. Points outside the curve are not feasible given current technologies and resources.

3. Shifts in the Production Possibilities Curve (PPC). Show how points outside the PPC are feasible in the future if it shifts out due to increases in resources or technological innovation. It is also useful to discuss what might make the PPC shift in: a natural disaster, the Y2K bug, etc. a.

Increased resources b.

Technological innovation

 Teaching Tip Use something students are familiar with to construct their first production possibilities curve. Pick two classes, such as Economics and Marketing. Tell them they are going to allocate study time to produce grades in the classes. The choice involves how much study time to allocate for each class. You can start

with an all-or-nothing scenario producing an A|F outcome and make adjustments from there. Once they are comfortable, remind them that everything else was held constant. Ask them what would happen to the curve if the professors were better teachers, if students had better study skills, smaller classes, better textbooks, upgraded computers, or more time to study.

Review this key question and the related application:

Question 1: What is the opportunity cost of running a business?

APPLICATION 1: DON‘T FORGET THE COSTS OF TIME AND INVESTED FUNDS This Application gives an example of developing a software application to explain how we can use the principle of opportunity cost to compute the cost of developing the app. In any business, the total costs are affected by the costs of raw materials, the opportunity costs of funds invested, and the opportunity costs of time. This Application shows that we must include the opportunity cost of funds invested, as well as the opportunity costs of time in computing the true development cost.

2.2 The Marginal Principle A. Definition

1. Marginal benefit is the additional benefit resulting from a small increase in some activity.

2.

Marginal cost is the additional cost resulting from a small increase in some activity.

3. Choose a level of the activity such that marginal benefit of the last unit equals the marginal cost of the last unit.

B. Using the Marginal Principle: Movie Sequels, Renting College Facilities, Automobile Emissions Standards, Driving Speed and Safety

 Teaching Tip There are several easy-to-understand examples of the Marginal Principle in the world of college students. An easy way to start is with examples where the marginal cost is zero: The amount of food consumed at a particular meal in the cafeteria; Internet minutes in the computer lab; cell phone weekend minutes with some plans. Given that the marginal costs are zero, the student‘s decision to consume is based on positive marginal benefits. You can then introduce situations where there are positive marginal costs, such as fast food that needs to be paid for.

Review this key question and the related application:

Question 2: How do people think at the margin?

APPLICATION 2: HOW FAST TO SAIL? This Application explains the factors that go into the decision regarding how fast to sail an ocean cargo ship. We can use the marginal principle to see that the increase in a ship‘s speed depends on the marginal benefit of delivering more cargo compared to the cost of additional fuel. If the marginal benefit (the increase in revenue from delivered cargo) is greater than the marginal cost (the increase in fuel cost), the ship operator will increase the ship‘s speed.

2.3 The Principle of Voluntary Exchange A. The

assumption is that people act in their own selfinterest. A voluntary exchange between two people makes both better off. Markets work because they are based on the principle of voluntary exchange.

 Teaching Tip College students easily understand the principle of voluntary exchange because they are constantly engaged in voluntary exchanges. Work and consumption are two examples from their world. If they are employed, they voluntarily exchange their time and effort for the money they earn. Nobody kidnaps them and forces them to work. Their employer pays them voluntarily as well. Both the student and employer are better off. Any time individuals purchase anything, they exchange money for a product or a service, making both the buyer and the seller better off. Ask students what they purchased yesterday or today: Coffee or soda?

Candy? Newspaper? Why did they purchase it?

B. Exchange and Markets

10. A market is an institution or arrangement that allows buyers and sellers to exchange goods and services.

 Teaching Tip Create a market in the classroom. Do the experiment described in the book or in MyEconLab. C. Online Games and Market Exchange

11. Online games such as EverQuest illustrate how markets and exchange develop on their own because of the desire to trade.

Review this key question and the related application:

Question 3: What is the rationale for specialization and exchange?

APPLICATION 3: RORY MCILROY AND WEED-WHACKING Rory McIlroy is one of the best golfers in the world as well as a skillful weed whacker. He can whack down all the weeds on his property in one hour, making him 20 times more productive than the best gardener. Rory should still hire the less productive gardener because of the lower opportunity cost. If he earns $1,000 per hour playing golf, by paying the gardener only $200 ($10 an hour x 20), he would end up saving $800. This shows how the principles of voluntary exchange and specialization are beneficial.

2.4 The Principle of Diminishing Returns A.

Principle of Diminishing Returns: Suppose that output is produced with two or more inputs, and we increase one input while holding the others constant. Eventually, output will begin to increase at a decreasing rate.

 Teaching Tip Have the students picture the front end of a fast-food franchise, such as McDonald‘s, Burger King, Wendy‘s, or another franchise near you. Ask them what would happen if you kept on adding more and more workers at McDonald‘s. All the equipment is fixed. The number of workers is the variable input. Ask students what would happen to the number of hamburgers served as you increased the number of workers from 1 to 3 to 5 to 50. Eventually, the restaurant would be so crowded that none of the workers would be able to move or serve any hamburgers. (Make sure to point out that this is well beyond the point of diminishing returns.)

B. 1.

Diminishing Returns from Sharing a Production Facility A good example of diminishing returns is when a company tries to add workers to an existing production facility.

Eventually, the facility will become overcrowded, and the additional output resulting from additional workers will fall.

Review this key question and the related application:

Question 4: Do farmers experience diminishing returns?

APPLICATION 4: FERTILIZER AND CROP YIELDS This Application illustrates how the notion of diminishing returns applies to all inputs to the production process. For a farmer, continuously increasing the amount of fertilizer applied to a fixed amount of land eventually reduces the increases in output. The farmer will experience diminishing return because, while even though the amount of fertilizer was not fixed, the other inputs to the production process are fixed.

 Teaching Tip A classroom full of urban or suburban students might not relate very well to this example. You can use watering the lawn instead. An excessive amount of water will not help the lawn grow faster.

2.5 The Real-Nominal Principle A. Definition

1.

What matters to people is the real value or purchasing power of money or income, not its face value.

2.

The nominal value of an amount of money is its face value. The real value is the value of an amount of money in terms of what it can buy.

B. The Design of Public Programs C. The Value of the Minimum Wage When the government publishes statistics about the economy, it takes into account the realnominal principle. For example, the value of ―real wages‖ shows what has happened to the purchasing power of workers over time. The nominal wage shows what has happened to the sum on the worker‘s paycheck, but it cannot show what has happened to purchasing power.

 Teaching Tip Ask the students how many of them would be happy to earn $500,000 per year.

Most will say yes. Then tell them that a case of soda pop costs $100, a CD costs $250, and a new car costs $500,000. Are they still happy? You can now proceed to explain the difference between nominal and real variables.

Review this key question and the related application:

Question 5: How does inflation affect lenders and borrowers?

APPLICATION 5: REPAYING STUDENT LOANS This Application shows how inflation can impact the value of money paid back over time. Using changes in annual salaries, the Application demonstrates the work time it takes someone to pay back the loan under various inflation assumptions.

 Teaching Tip Another way to illustrate this concept is to ask students if they know their parents‘ monthly mortgage payments and when they purchased their homes.

Inflation in home prices affects the amount that people will have to borrow. An older home usually will have a smaller nominal mortgage payment. However, your students‘ parents‘ salaries have presumably risen partly due to inflation.

Therefore, inflation has helped those who have been debtors.

Additional Applications to Use in Class Question: Has fish production reached the point of diminishing returns?

ADDITIONAL APPLICATION: SO LONG SEAFOOD? EXPERTS WARN OF DISASTER MSNBC Staff and News Service Reports ―So Long Seafood? Experts Warn of Disaster‖ Posted on MSNBC.com Financial Times http://www.msnbc.msn.com/id/15532333/ Posted 11/03/2006 Summary: Key Points in the Article According to some experts, overfishing and pollution will virtually wipe out all the world‘s fisheries by the year 2050. A team of economists and ecologists arrived at that conclusion by extrapolating current trends. The team warned that unless fisheries management practices radically change, we were in the ―last century of wild seafood.‖ The team spent four years using controlled experiments and existing data to arrive at their conclusions. However, industry professionals do not appear to share the concerns. The National Fisheries Institute issued a statement that said, ―Fish stocks naturally fluctuate in population,‖ and ―By developing new technologies that capture target species more efficiently and result in less impact on other species or the environment, we are helping to ensure our industry does not adversely affect surrounding ecosystems or damage native species.‖ Seafood consumption is up in the United States, with the average American eating 16.6 pounds of seafood in 2004 versus 15.2 pounds in 2002. Fishing accounts for over $80 billion in revenue worldwide.

Analyzing the News Note that the National Fisheries Institute did not deny declining fish stocks. Instead the organization indicated the decline was part of a natural cycle. Could it be that the increasing global demand for seafood has pushed fishing to the point of diminishing returns?

Thinking Critically Questions 12. It appears that fish harvests are increasing, but overall fish stocks may be declining. What economic principle is exhibited?

13. How can we increase production?

14. At what point would we cease to add fishing boats?

Question: How can people invest in themselves?

ADDITIONAL APPLICATION: ―SHORT ON CASH, SOME PUT A PRICE ON THEMSELVES‖ Aleccia, JoNel Posted 12/5/2008 on MSNBC.com Summary: Key Points in the Article The shrinking economy has had an impact on people’s willingness

to donate plasma, sperm, and fertile eggs. Hair sales are up as well. While the practice of selling most body products is illegal in the United States, there are instances where people are considered ―compensated donors.‖ For example, many plasma centers will pay $20 for donor time and travel. The sudden spike in donor applications begs the question of whether the motives are altruistic or financial.

Donating fertile eggs can be lucrative. One nursing student reported being able to graduate from college debt free due to the $28,000 she received for four cycles of fertile eggs donated since February. Viable sperm donors can earn $600 a month for a cycle of ten donations.

While the practice can earn some cash, only a small fraction of donors makes it through the rigorous medical and life history screens for fertile eggs and sperm. In any case, applications to be donors are up 20 to 30 percent at most clinics with plasma donations up as much as 50 percent in some areas. The uptick appears to be consistent with the recession.

Analyzing the News Since ―price‖ appears fixed for these items you simply see an increase in overall quantity. However, this article begs the question of whether body parts and products should be available for sale instead of merely compensation for time and travel. What do you think?

Thinking Critically Questions 1. What is driving the increase on ―donations‖ for certain body products?

2. How do clinics compensate donors, since it is illegal to buy plasma?

3. Should this practice be outlawed?

Solutions to End-of-Chapter Exercises Chapter 2 SECTION 2.1: THE PRINCIPLE OF OPPORTUNITY COST 1.1 10, 180 1.2 arrow up 1.3 arrow up 1.4 $22,000 1.5 safe drinking water for 5 million people 1.6 outbidding, $1/hectare 1.7 $86,000 per year 1.8 Scientists and engineers will be used to execute the mission, so part of the opportunity cost might be measured in science and engineering education (or any

other non-mission-related scientific productivity) forgone.

1.9 The cost of holding wealth in non-interest-bearing form is higher where the interest rate is higher.

1.10 a. The loan cost me the interest I could have earned by investing the $100. b. The opportunity cost is the current market price, not the historical price. c. The cost of the stadium is $50 million plus the forgone earnings from renting the land or the interest that could be earned on the proceeds from sale of the land (whichever is higher). d. The cost would also include the time difference between alternative methods of commuting.

1.11 a.

b.

c.

6, 10 1.12 current value of the furniture, current rate of return on alternative investment(s).

SECTION 2.2: THE MARGINAL PRINCIPLE 2.1 Yes, the marginal benefit ($300) is less than the marginal cost ($200).

2.2 Yes, the marginal benefit ($135) exceeds the marginal cost ($125).

2.3 Yes, the marginal benefit ($50 million) exceeds the marginal cost ($30 million).

2.4 marginal, marginal 2.5 a. Draw MB and MC curves crossing at 40mph.

b. Shift MB to the right and show an increase in speed.

c. Shift MB to the left and show a decrease in speed.

d. The MC curve should have a kink making it steeper to the right of 35mph. This lowers the speed that he drives.

2.6

a. It made sense if the marginal revenue of $3,100 was greater than the marginal costs. b. cost, less, 3,100

2.7 a. b.

2.8

yes, marginal revenue 2500 > marginal cost 2000 no, marginal revenue 1500< marginal cost 2000

Three officers should be hired, since the marginal benefit of the third officer ($40,000) equals the constant marginal cost of $40,000, but the marginal benefit of the fourth officer would fall below the constant marginal cost.

2.9 a. 26 b. yes

2.10

b.

a.

Pick 5 pints.

Pick 3 pints.

SECTION 2.3: THE PRINCIPLE OF VOLUNTARY EXCHANGE 3.1 False 3.2 $15, $15 3.3 Up arrow 3.4 softer 3.5 a.

No, the cost of forgone surgeries exceeds the benefit of clean drains. b. $1,150 per hour (= ($20 per minute × 60 minutes/hour) – $50 per hour) 3.6 a.

50 fish b.

Assign the tribe’s least productive fishermen to build the boat. The cost of the boat decreases to 20 fish.

3.7 The tree-cutter paid the neighbor to compensate for lost shade.

SECTION 2.4: THE PRINCIPLE OF DIMINISHING RETURNS 4.1 300 4.2 False. Diminishing returns means that output increases at a decreasing rate.

4.3 less than, at least 4.4 inflexible, flexible 4.5 arrow up, arrow down 4.6 This is true, so long as there are no limitations on

availability of resources other than soil.

4.7 a.

Yes, because employment of some resources is inflexible within a week. b.

Possibly not, because employment of all resources used in production of memory chips is likely to be flexible over a period of two years.

4.8 a.

No, because of the principle of diminishing returns. b.

Yes 4.9 2, 154, 48, 11 3, 172, 36, 11 4, 184, 24, 11 5, 190, 12, 11 6, 193, 6, 11 Ted should work five hours, since MB < MC for the sixth hour of work.

SECTION 2.5: THE REAL-NOMINAL PRINCIPLE 5.1 $1 in purchasing power 5.2 negative $20 in purchasing power 5.3 down arrow, 3% 5.4 $65,000 5.5 No 5.6 Inflation, since it lowers the real cost of the debt repayment.

5.7 Number of baskets per week: 4.10, 3.05 So the real value of welfare payments decreased.

5.8 a.

130.488%, 117.287%, 136.497%, 122.469%, 120.753% b.

Wage increases lagged consumer price increase in three of four groups. c.

Real wages fell in every sector except professional services.

5.9 a. —, 5 months $5,000, 4 months $2,000, 10 months b.

Inflation 5.10 a. 55 tunes, $55, 10% b.

55 tunes, 66 dollars, 32% Critical Thinking 1.

One component of opportunity cost is the income foregone while in law school.

2.

The marginal benefit of another hour is the additional revenue. The marginal cost is the additional cost. If the marginal benefit exceeds the marginal cost, it is sensible to remain open for an additional hour.

3.

The opportunity cost of Steph Curry’s cleanup time is the income he could otherwise earn signing autographs or doing commercials.

If his opportunity cost is greater than the hourly groundskeeper wage, it is sensible to hire the groundskeeper.

4.

5.

Grade increases by 48 points for the first hour, 24 points for the second hour, 12 points for the third hour, 6 points for the fourth hour, 3 points for the fifth hour.

As a debtor, you will prefer inflation over the 10-year repayment period.

After the loan is repaid, you are a lender, and will prefer stable prices.

3 Exchange and Markets Chapter Summary The concept of comparative advantage and dividing production to minimize opportunity costs shows why individuals gain through specialization and exchange. Here are the main points of the chapter:  Specialization and exchange form the basis for the existence of markets.  Specialization increases productivity through the division of labor.  A system of international specialization and trade is sensible because nations have different opportunity costs of producing goods. These differences give rise to comparative advantages.  Markets emerge because self-interested people, guided by prices, make decisions about what products to produce, how to produce them, and whom they are produced for.  The government‘s roles in a market economy include establishing the rules for exchange, reducing economic uncertainty, and responding to market failures.

Learning Objectives: 3.1 Comparative Advantage and Exchange: Use opportunity cost to explain the rationale for specialization and trade.

3.2 Markets: Explain how markets allow specialization and trade.

3.3 Market Failure and the Role of Government: List the roles of government in a market economy.

Approaching the Material Continue the approach developed in the first two chapters. Begin the discussion of specialization and exchange on a personal level and then build up to regions and countries. One approach is to ask the students what their lives would be like if they had to do everything themselves—grow food, make clothes, and build their own houses. Teaching is another example of specialization students should be familiar with. As they moved from grammar school to high school to college, the teachers became more specialized and (hopefully) more productive.

Chapter Outline

3.1 Comparative Advantage and Exchange A. Specialization and the Gains from Trade

1.

Numerical Example: 2 individuals (Fred, Kate), 2 goods (fish per day, coconuts per day). Fred can gather 6 fish per day or 2 coconuts per day; Kate can gather 1 fish per day or 1 coconut per day.

Remind students of the following key principle:

KEY PRINCIPLE: THE PRINCIPLE OF OPPORTUNITY COST The opportunity cost of something is what you sacrifice to get it.

2.

We can calculate the opportunity cost of each person’s production: the principle of opportunity cost states that the opportunity cost of something is what you sacrifice to get it. a.

Fred’s opportunity cost of producing 1 fish is 3 coconuts; his opportunity cost of producing 1 coconut is 1/3 of a fish. b.

Kate’s opportunity cost of producing 1 fish is 1 coconut; her opportunity cost of producing 1 coconut is 1 fish.

3.

A comparative advantage is the ability of one person or nation to produce a good at a lower opportunity cost than another person or nation. Fred has a comparative advantage in gathering coconuts because he gives up fewer fish (1/3 < 1) per coconut gathered; Kate has a comparative advantage in gathering fish because she gives up fewer coconuts per fish gathered (1 < 3).

4.

Specialization is beneficial if there are differences in opportunity costs because it increases the production of the group or society. (See Figure 3.1: Most students benefit from ―pictures.‖ Remember, you are teaching the ―video‖ generation.)

 Teaching Tip Ask the class what their parents do for a living. In a normal classroom, several students will have parents with very specialized occupations, such as neonatal nurse, police officer, professor, and so on. Discuss the different training and skills needed for each type of occupation. Ask students what would happen if a police officer and teacher switched jobs for a day, or an accountant and a bartender.

Another approach would be to examine the medical profession over time. Point out to the students how doctors have become more and more specialized, leading to increased productivity and better overall health. In the 1950s, a person was likely to see the same doctor for a broken arm and a suspicious lump in his or her leg. Today, there are orthopedic specialists as well as oncology specialists.

5.

Production and Consumption Possibilities Curves: The production possibilities curve represents the

combinations of goods a country can produce using its own resources.

If, however, the country specializes in the good or goods it can produce most cheaply (with the lowest opportunity cost), it can trade that good on the world market more cheaply than producing it itself. The consumption possibilities curve is a curve showing the combinations of two goods that can be consumed when a nation specializes in the production of one good and trades with another nation.

 Teaching Tip Be sure to mention that if a country specializes in the goods it can produce most cheaply and trades with a country that can produce another more cheaply, the result is increased consumption possibilities for both countries.

B. Comparative Advantage versus Absolute Advantage

An absolute advantage is the ability of one person or nation to produce a product at a lower resource cost than another person or nation. In the fish–coconut example, Fred has an absolute advantage in both goods because he can produce more of each product.

Remind students of the following key principle:

KEY PRINCIPLE: THE PRINCIPLE OF VOLUNTARY EXCHANGE A voluntary exchange between two people makes both people better off.

 Teaching Tip Ask students to consider a law office. You‘re a lawyer who can charge $300 per hour. You pay an executive assistant $20 per hour. You spent many years going to law school and you passed the bar. You can also type 100 words per minute. Your assistant has not quite finished a college degree and can only type 25 words per minute. You have an absolute advantage in word processing. Should you type your own briefs since you‘re a faster typist? Obviously not. You have a comparative advantage in the practice of law. The opportunity cost of you typing 1000 words is 10 minutes. This for you would cost $50 in lost legal service charges. It only costs you $13.33 to have the executive assistant type them.

C. The Division of Labor and Exchange

1. Adam Smith noted three reasons for productivity to increase with specialization, with each worker performing a single production task: repetition, continuity, and innovation.

2. Specialization and exchange result from differences in productivity. Differences in productivity, in turn, result from differences in skills and the benefits associated with the division of labor.

D. Comparative Advantage and International Trade 1. The lessons of comparative advantage and specialization apply to trade between nations. On the one hand, each nation could be self-sufficient and produce all the goods it consumes. On the other hand, each nation could instead specialize in products for which it has a comparative advantage.

2. National governments can intervene in international trade by erecting barriers to trade. An import is a product produced in a foreign country and purchased by residents of the home country. An export is a product produced in the home country and sold in another country E. Outsourcing: When considering outsourcing, there are

three facts that many people overlook: 15. Job losses are normal for a healthy economy.

16. Insourcing from other countries increases the number of jobs in the United States.

17. Cost savings are substantial, leading to more production and more jobs.

 Teaching Tip Compare life 150 years ago to today. The continued division (and subdivision) of labor has led to an increase in productivity (and income) and the lifestyles we enjoy today. Use the production of cars as an example. Each worker has a very specialized job, allowing cars to be produced much faster.

 Teaching Tip Provide the students with a list of countries: France, England, India, Japan, China, Mexico, and Vietnam. Ask them what products come to mind when they think of a particular country. They‘re likely to mention France and wine, England and tea, India and spices, and Japan and cars. Another alternative would be to ask them to check the labels on their clothing for country of manufacture.

They‘re likely to mention China, Vietnam, and Mexico. Either example naturally leads to a discussion of international trade.

 Teaching Tip Ask the students if they have ever called a business‘s 800 number and were connected to another country. To get the idea of insourcing across, ask students to name where car manufacturers such as Honda, Toyota, and BMW build their cars. They may say only Japan and Germany. However, each company has facilities in the United States and employs thousands of people.

Review this key question and the related application:

Question 1: What is the rationale for specialization and trade?

APPLICATION 1: ABSOLUTE ADVANTAGE IN LATVIA

DISADVANAGE

AND

COMPARATIVE

The Application points out that countries benefit by producing the good it has a comparative advantage in and trading with others. Latvia has a comparative advantage in saw timber while the European Community (EC) has a comparative advantage in grain. By specializing and trading, both the EC and Latvia will benefit.

3.2 Markets A market economy is an economy in which people specialize and exchange goods and services in markets.

A. Social and government inventions that make markets work better: 1. Contracts 2. Insurance 3. Patents 4. Accounting rules B. Virtues of Markets 1. Under a market system, the people make the decisions about what to produce, and their decisions are guided by prices. Prices provide signals about the relative scarcity of a product and help an economy respond to scarcity. The decisions made in markets arise from the interactions of millions of people, each motivated by self-interest.

2. Entrepreneurs will enter the market and increase production.

3.

We can see the advantages of a market system by

examining what happened in economies that were once centrally planned, economies in which the government bureaucracy decides how much of each good to produce, how to produce the goods, and who gets them. In the late 1980s and early 1990s, most centrally planned economies began a transition to a market economy.

In the former Soviet Union, state-run shops, plagued by shortages, were replaced by shops run by entrepreneurs. In China, farmers moved away from the inefficient communal system and started selling their own products independently.

C. The Role of Entrepreneurs D. Example of the Emergence of Markets: POW Camps

 Teaching Tip Ask the class what their favorite new store, product, or service is. You will get several varied responses (Target, iPod, manicures). Ask them how they think this new venture came about. This question should lead to a discussion of demand and supply, prices, profits, and entrepreneurship.

Review this key question and the related application:

Question 2: Why do markets develop?

APPLICATION 2: WEATHER-LINKED CROP INSURANCE This Application explains crop insurance for farmers that is related to the weather. If a farmer has this insurance and the weather is bad or unfavorable, he or she would receive an insurance payment to partially offset the loss of revenue. This insurance encourages farmers to take more risk and thereby increases the supply of farm products.

3.3 Market Failure and the Role of Government A. Shortcomings of Markets 1. Market failure may occur when markets are unable to achieve the most efficient outcomes on their own. This occurs in situations with the following characteristics: pollution, public goods, imperfect information, and/or imperfect competition. The role of government is to correct this problem.

 Teaching Tip Any campus example will work here: noise, traffic congestion, cafeteria lines, and large classes. For the first two examples, local governments create laws and structures—police officers stop speeding drivers. Traffic lights control the flow of traffic.

2. The government establishes rules for exchange in markets and uses its police power to enforce the rules. The government’s role is also to reduce economic uncertainty

and provide for people who experience job losses, poor health, or other such circumstances.

B. Government Enforces the Rules of Exchange 18. The government helps to enforce contracts by maintaining a legal system that punishes people who violate contracts.

19. The government requires that producers provide information to consumers about the features of their products, including warnings.

20. The government enforces patent laws to support innovation.

21. The government also supports policies designed to foster competition between firms.

 Teaching Tip Have the students list five laws that impact their lives. They may mention minimum wage, drinking age, and speed limits. Then ask them to think about what would happen if those laws were repealed.

C.

Government Can Reduce Economic Uncertainty Market economies may be uncertain, so governments provide a safety net that provides for citizens who experience bad economic outcomes.

 Teaching Tip Ask the students why they think the university publishes class schedules in advance. What is the benefit to students? How does this reduce uncertainty in their lives?

Review this key question and the related application:

Question 3: What is the role of government in a market economy?

APPLICATION 3: PROPERTY RIGHTS AND URBAN SLUMS One of the roles of government is to enforce property rights. When a person has ownership of a dwelling, this increases their incentive to maintain the property. A program in Peru that granted property titles illustrated this idea by improving the housing conditions of urban households.

Additional Applications to Use in Class Question: What happens to college students when the economy goes sour?

ADDITIONAL APPLICATION: COLLEGES, TRADE SCHOOLS FEEL THE PINCH AS LENDERS QUIT OR RESTRICT SCHOOL LOANS Cooper, Robin K. ―Colleges, Trade Schools Feel the Pinch as Lenders Quit or Restrict School Loans‖ Posted 8/31/2008 on MSNBC.com The Business Review (Albany) Summary: Key Points in the Article The fallout from the subprime mortgage crisis and tougher lending

standards is being felt on many college and trade school campuses. Lenders are pulling out of the student loan business due to lack of profitability. Thirty lenders no longer offer private student loans and 132 lenders have pulled out or reduced lending in various guaranteed federal student loan programs.

Wachovia, Bank of America, and Citigroup Inc. are all moving away from the undergraduate student loan market. The low profitability and lender exodus is due to a number of factors. New federal regulations have made the process too time consuming to be profitable. In addition, the secondary market is nervous about buying securities backed by these loans. The subprime mortgage mess is still fresh on everyone’s mind.

In addition, student loan consolidations are becoming harder to find. While the government has stepped up limits on Stafford loans to combat the student loan shortage, there are many students that are unable to find money to attend school. However, it appears that most of those students are the ones that have already damaged their credit through previous defaults.

Analyzing the News It will be interesting to see the long-term impact of the lack of student loan availability. Will it reduce college enrollments or impact graduation rates? Do students that have poor credit history tend to graduate college anyway? These are some questions that come to mind that would be interesting to answer. In any case, it’s in the government’s best interest for the population to get educated and have a higher income. You pay more taxes with a higher income and are less likely to need other forms of government assistance.

Thinking Critically Questions 1. Why does the government subsidize student loans?

2. What will likely happen as a result of lenders pulling out of this market?

3. Should the government do anything?

Question: Why is rice suddenly in high demand?

ADDITIONAL APPLICATION: BEHIND THE RUN ON RICE Gogoi, Pallavi ―Behind the Run on Rice‖ Posted 4/28/2008 on MSNBC.com Businessweek Summary: Key Points in the Article The demand for rice is increasing so rapidly that many stores are selling out new stock within hours. Large chains like Costco and Sam’s Club have taken to rationing their rice shipments so that some customers don’t find themselves without the now-prized grain. Ironically, there is not a current shortage of rice.

Bumper crops in Thailand, Vietnam, and India have filled grain bins across the globe.

So, what’s driving the increased demand? Consumers fearing food inflation are the culprit. Many rice exporting countries experiencing civil unrest due to high food prices have imposed export bans or limitations on native grown rice. The result is a shortage of the grain in rice importing countries. As prices responded by moving higher, more consumers began buying up rice and hoarding it for the future.

A global surplus has turned into several regional shortages due to consumer expectations of higher prices. This scenario provides a clear illustration of how some fears can become self-fulfilling prophecies.

Analyzing the News Note that the price of rice has moved substantially higher on the global market due to reduction in global supply, as a result of the export bans and also an increase in consumer demand due to expectations of higher prices. The combination of these two factors is a recipe for higher prices.

Thinking Critically Questions 1. How can expectations impact demand?

2. How can an export ban impact prices?

3. How do higher prices impact consumption?

Solutions to End-of-Chapter Exercises Chapter 3 SECTION 3.1: COMPARATIVE ADVANTAGE AND EXCHANGE 1.1

a. 4 tax returns, ¼ financial statement, 1 tax return, 1 financial statement b. tax returns, financial statements 1.2 No 1.3 comparative advantage 1.4 repetition, continuity, innovation 1.5 returns to the United States to purchase U.S.-produced goods 1.6 arrow down, arrow down 1.7 larger 1.8 2% 1.9 a. Outsourcing the customer-service jobs could mean more production workers could be hired. b. If the cost savings from outsourcing the customer service work to India was more than the cost to hire additional production workers, the firm could possibly hire more than 10 production workers.

1.10 comparative, saw timber 1.11 a.

Terry has a comparative advantage in fishing, and Robin has a comparative advantage in gathering coconuts. b.

Robin could produce 48 coconuts and consume 36 (4 more than when operating selfsufficiently) along with 4 fish, while Terry could produce 6 fish and consume 2 along with 12 coconuts (8 more than when operating self-sufficiently).

1.12 Yes. Fred will have a comparative advantage in fish with an opportunity cost of 1/2 coconut per fish (compared to 2 coconuts per fish for Kate). Kate will have a comparative advantage in coconuts with an opportunity cost of 1/2 fish per coconut (compared to 2 fish per coconut for Fred).

Fred can produce 36 fish and trade 6 fish to Kate for 6 of the 12 coconuts she gathered.

Through specialization and trade, Fred can consume 30 fish and 6 coconuts, while Kate can consume 6 fish and 6 coconuts.

1.13 a. Selma should handle city B and Mark should handle city A.

b.

Yes

1.14 Year 2004 Coffee Corn Soybeans Airplanes Footwear Vehicles Crude Oil

Exports ($ millions) 7 6,128 6,685 24,847 450 64,646 265

Imports ($ millions) 1,868 127 53 11,647 16,505 187,828 135,999

Net Exports ($ millions) –1,861 6,001 6,632 13,200 –16,055 –123,182 –135,734

1.15 Year 2004 Australia China Italy Japan Mexico Netherlands Saudi Arabia Singapore

Exports ($ millions) 14,270.9 34,721.0 10,710.8 54,400.2 110,775.3 24,286.3 5,245.2 19,600.9

Imports ($ millions) 7,544.2 196,699.0 28,088.6 129,594.7 155,843.0 12,604.6 20,923.6 15,305.6

Net Exports ($ millions) 6,726.7 –161,978.0 –17,377.8 –75,194.5 –45,067.7 11,681.7 –15,678.4 4,295.2

SECTION 3.2: MARKETS 2.1 2.2 2.3

contracts, insurance, patents, accounting down arrow false

2.4 weather; produce a surplus for sale 2.5

a. Yes

b. 6, 2, 48, 8, 7 2.6

a. Yes

b. 3 loaves, 120 cigarettes, 8 chocolate bars, 5 chocolate bars

SECTION 3.3: MARKET FAILURE AND THE ROLE OF GOVERNMENT 3.1 3.2 3.3 3.4 3.5 3.6

3.7

cost, benefit cost prices, quantities lower investment in housing a. better off b. The next generation of students will be worse off, because fewer texts of lower quality will be produced. a. $2,000 b. $200 c. $1,100

Critical Thinking 1.

Self-sufficiency is not sensible: A has a comparative advantage in producing Y, while B has a comparative advantage in producing X. Each nation can gain by specializing in the product for which it has a comparative advantage, and trading for the other product.

2.

A price provides information about the relative scarcity of wood. An increase in price causes producers to economize on oak wood by cutting it more carefully to avoid waste. In addition, the producer may decrease its use of oak in favor of other woods such as maple or pine.

3.

The legal system punishes people who violate contracts, encouraging buyers and sellers to negotiate contracts required for transactions.

4 Demand, Supply, and Market Equilibrium Chapter Summary Chapter 4 builds on the material in Chapter 3, ―Exchange and Markets,‖ by introducing the variables that determine demand and supply. Here are the main points of the chapter:  Price changes move quantity demanded or supplied up or down along the related curves.  Changes in the determinants of demand (income, price of related goods, population, tastes, consumer price expectations) or supply (input costs, technology, number of firms, producer price expectations) shift the related curve.  Market equilibrium is achieved when quantity demanded equals quantity supplied at a given price and there is no shortage or surplus.  Shifts in the demand curve or the supply curve change market equilibrium.  Demand shifts cause price and quantity to change in the same direction, while supply shifts cause price and quantity to move in opposite directions. This information allows us to understand real-world price or quantity movements. For example, lower prices



associated with lower quantities must be the result of a demand decrease, not a supply increase.

This model of demand and supply explains how a perfectly competitive market operates.

A perfectly competitive market is a market with so many buyers and sellers that no single buyer or seller can affect the market price.

Learning Objectives: 4.1 The Demand Curve: Describe and explain the law of demand.

4.2 The Supply Curve: Describe and explain the law of supply.

4.3 Market Equilibrium—Bringing Demand and Supply Together: Explain the role of price in reaching a market equilibrium.

4.4 Market Effects of Changes in Demand: Describe the effect of a change in demand on the equilibrium price.

4.5 Market Effects of Changes in Supply: Describe the effect of a change in supply on the equilibrium price.

4.6 Predicting and Explaining Market Changes: Use information on price and quantity to determine what caused a change in price.

Approaching the Material Demand and supply is probably the most important tool of economic analysis. Take your time with this chapter. In fact, you might plan on spending twice as much time on this chapter as any other. Use plenty of examples. Create demand and supply schedules. Most students will relate to demand easier than supply—students have been demanders since they first received an allowance. Create examples where they are the suppliers—offer to buy their pens or to hire them to mow lawns. Use concert tickets or sporting events to illustrate surpluses and shortages and explain price changes. Music is a good way to explain changes in demand. Make sure you explain the difference between quantity changes and changes in demand and supply.

Chapter Outline 4.1 The Demand Curve The demand curve shows the relationship between the price of a good and quantity demanded by an individual consumer, ceteris paribus (holding all else constant). It tells you how much a consumer is willing to buy of a product at any given price. A consumer who is ―willing to buy‖ will give up enough money to purchase a good. Consumers ―want‖ or ―desire‖ many goods but are not necessarily willing to give up money to get them. Demand is defined for a specific time period, such as a day, week, or year. Variables that affect individual consumer decisions: a. The price of the product b. Consumer income c. The price of related (substitute or complementary) goods d. Consumer tastes and advertising e. Consumer expectations about future prices A. The Individual Demand Curve and the Law of Demand 1.

The individual demand curve shows the relationship between the price of the good and the quantity demanded, for example, the amount of a product that consumers are willing and able to buy during a particular time period, holding all other variables constant. To construct a demand curve, we use the data in a demand schedule, which is a table that shows the relationship between the price of a product and the quantity demanded, ceteris paribus.

The individual demand curve is a curve that shows the relationship between the price of a good and quantity demanded by an individual consumer, ceteris paribus.

2.

The law of demand states that there is a negative relationship between price and quantity demanded, ceteris paribus. Thus, the demand curve is negatively sloped.

(See Figure 4.1. Remind students that they have ―known‖ the law of demand since they were ―kids in a candy store.‖) 3.

A change in quantity demanded is a change in the quantity consumers are willing and able to buy when the price changes, represented graphically by a movement along the demand curve.

B. From Individual Demand to Market Demand 1.

The market demand curve shows the relationship between the price of the good and quantity demanded by all

consumers in a market, ceteris paribus.

Factors other than the price of the good that determine individual demand are held constant along the demand curve. In addition, the number of buyers (population) is held constant along the demand curve.

3.

The market demand curve is derived from individual demand curves by adding the quantity that each consumer will buy at a given price. (Use a figure to show how the market demand is determined by literally adding the quantities for the two consumers that make up the market.)

2.

 Teaching Tip An effective way to teach all of the concepts associated with demand is to literally create demand curves in the classroom. Pick three items (pizza, concert tickets, fancy dinners, sporting events, and spring break trips work well). Call out prices at a decreasing rate. Have students raise their hands when they are willing to pay the price you have called out. Record the number of hands. Once a student's hand is up, it stays up. When you have reached zero, stop. You now have the data to illustrate the demand for a particular item in your classroom.

You have a set of prices and quantity demanded and the data points are sitting in front of you! You can now teach the students all of the concepts about demand and quantity demanded, the law of demand, changes in price, changes in income, the price of other goods, and market demand with their responses proving the theory.

Review this key question and the related application:

Question 1: What is the law of demand?

APPLICATION 1: THE LAW OF DEMAND FOR YOUNG SMOKERS This application illustrates the negative relationship between price and quantity demanded. As the price of cigarettes decreases, the quantity demanded of cigarettes increases because people who originally smoked now smoke more and some people start smoking. In the United States, higher cigarette taxes have led to fewer young smokers as well as fewer cigarettes consumed per smoker.

In Canada, a cut in the cigarette tax increased the smoking rate by about 17 percent.

4.2 The Supply Curve A perfectly competitive market is composed of a large number of small firms. What determines how much each firm is willing to supply? Variables that affect seller decisions: a. The price of the product b. The cost of inputs used to produce the product c. The state of production technology d. Producer expectations about future prices e. Taxes or subsidies from the government

Together, these variables determine the quantity supplied, the amount of a product that firms are willing and able to sell.

A. The Individual Supply Curve and the Law of Supply 1. The individual supply curve shows the relationship between the price of the good and the quantity supplied by a single firm, ceteris paribus. To construct a supply curve, we use the data in a supply schedule, which is a table that shows the relationship between the price of a product and the quantity supplied, ceteris paribus.

2.

The law of supply states that there is a positive relationship between price and quantity supplied, ceteris paribus.

3.

Change in quantity supplied is a change in the quantity firms are willing and able to sell when the price changes, represented by movement along the supply curve.

4.

The minimum supply price is the lowest price at which a product will be produced.

B. Why Is the Individual Supply Curve Positively Sloped?

1.

The marginal benefit for a firm is what it gets from selling one more unit of the product (the price).

2.

The marginal cost is the cost of producing one more unit.

3.

The firm should produce up to the point where marginal benefit equals marginal cost.

4.

An increase in price will make it profitable to produce more units.

Remind students of the following key principle:

KEY PRINCIPLE: MARGINAL PRINCIPLE Increase the level of an activity as long as its marginal benefit exceeds its marginal costs. Choose the level at which the marginal benefit equals the marginal cost.

C. From Individual Supply to Market Supply: Show how the market is made up of two suppliers so the market supply at any price is the sum of quantity supplied by each supplier.

1.

The market supply curve shows the relationship between the market price of the good and the quantity supplied by all firms, ceteris paribus. Show that if all firms are the same, the market supply curve is smooth.

2.

To draw the supply curve, we hold all the variables that affect individual supply and the number of firms in the market constant.

 Teaching Tip Use the same approach here that you did for demand. Create supply curves in the classroom. Ask the students if they would be willing to come out to your house to cut grass, shovel snow, rake leaves (depending on the season) for free. Next, offer to pay $10. Keep raising the price until you have all students involved. You

have created a labor supply curve. You can create a second curve by offering to buy their pens at increasing prices. Once again, you have the data set in front of you as you illustrate the various concepts.

D. Why Is the Market Supply Curve Positively Sloped?

1.

The market supply curve is positively sloped both because each individual supply curve is positively sloped and because an increase in price will draw more firms into the market.

Review this key question and the related application: Question 2: What is the law of supply?

APPLICATION 2: LAW OF SUPPLY AND WOOLYMPICS This application illustrates the positive relationship between price and quantity supplied. As the price of wool decreased in the 1990s, the quantity of wool supplied in New Zealand and other exporters decreased. There have been several attempts to revive the wool industry in recent years.

4.3 Market Equilibrium: Bringing Demand and Supply Together When the quantity demanded equals the quantity supplied at the prevailing market price, this is called a market equilibrium.

A. Excess Demand Causes the Price to Rise

1. Excess demand (shortage) is a situation in which, at the prevailing price, the quantity demanded exceeds the quantity supplied. If there is excess demand (shortage), the price will tend to increase, causing the quantity demanded to decrease and the quantity supplied to increase, effectively reducing the excess demand.

B. Excess Supply Causes the Price to Drop 1.

Excess supply (surplus) is a situation in which, at the prevailing price, the quantity supplied exceeds the quantity demanded. If there is excess supply (surplus), the price will tend to decrease, causing the quantity demanded to increase and the quantity supplied to decrease, effectively reducing the excess supply.

Review this key question and the related application: Question 3: What are consequences of a price above the equilibrium price?

APPLICATION 3: SHRINKING WINE LAKES This application explains how the European Union supports the agricultural sectors of its member countries under the Common Agricultural Policy (CAP). The EU guarantees farmers minimum prices for products such as grain, dairy products, and wine. Since the prices are set above the market-equilibrium price, it causes an excess supply of these goods. To support these minimum

prices, the EU purchases any output a farmer cannot sell and stores the excess supply in facilities called ―butter mountains‖ and ―wine lakes‖ by the European press.

4.4 Market Effects of Changes in Demand A. Change in Quantity Demanded versus Change in Demand: A shift of the demand curve caused by a change in a variable other than the price of a product is a change in demand. A change in the price of the good itself causes a change in quantity demanded. (Emphasize a movement of the demand curve by showing how the amount of pizzas demanded is higher even if the price does not change.)

B. Increases in Demand Shift the Demand Curve 1. An increase in income increases demand. a. Normal goods are goods for which an increase in income increases demand. b. Inferior goods are goods for which an increase in income decreases demand.

2. A change in the price of a related good increases demand. a. Substitutes are two goods for which an increase in the price of one good increases the demand for the other good (chicken and pork). b. Complements are two goods for which a decrease in the price of one good increases the demand for the other good (hot dogs and hot dog buns).

3.

An increase in demand causes excess demand at the original price.

4. Excess demand causes the price to increase, and thus the quantity demanded falls along the demand curve and quantity supplied increases along the supply curve, until a new equilibrium is reached (at a higher price and quantity).

C. Decreases in Demand Shift the Demand Curve 1.

A decrease in income decreases demand. a. Normal goods are goods for which a decrease in income decreases demand. b. Inferior goods are goods for which an increase in income decreases demand.

2.

A change in the price of a related good decreases demand. a. If the price of a good falls, the demand for the substitute will decrease. b. If the price of a good rises, the demand for the complementary good will decrease.

3.

A decrease in demand causes excess supply at the original price.

4.

Excess supply causes the price to decrease, and thus the quantity demanded rises along the demand curve, and quantity supplied falls along the supply curve, until a new equilibrium is reached (at a lower price and quantity).

D. A Decrease in Demand Decreases the Equilibrium Price

 Teaching Tip Here is a good place to do the experiment at the end of the chapter. You can supplement it by changing the number of consumers and producers.

Review this key question and the related application:

Question 4: How does a change in demand affect the equilibrium price?

APPLICATION 4: CRAFT BEER AND THE PRICE OF HOPS This application discusses the production of craft beer in the United States in recent years.

Because of the increased popularity of craft beer, there was an increase in demand for hops. As a result, the equilibrium price of hops increased from $3.17 to $5.92 per pound.

4.5 Market Effects of Changes in Supply A. Change in Quantity Supplied versus Change in Supply

(Again, emphasize a movement of the curve versus a movement along the curve.)

1. A shift in the supply curve caused by a change in a variable other than the price of the product causes a change in supply. A change in the price of the good itself causes a change in quantity supplied.

B. Increases in Supply Shift the Supply Curve: Remind students that an increase in supply is a rightward shift of the curve. Increases in supply can be caused by: 1.

A decrease in input costs 2.

An advance in technology 3.

An increase in the number of producers 4.

Expectations of lower future prices 5.

Subsidy (or a decrease in taxes) C. An Increase in Supply Decreases the Equilibrium Price D. Decreases in Supply Shift the Supply Curve: Decreases in supply can be caused by: 1. An increase in input costs 2. A decrease in the number of producers 3. Expectations of higher future prices 4. Increased taxes E. A Decrease in Supply Increases the Equilibrium Price F. Simultaneous Changes in Demand and Supply: 1. A simultaneous increase in demand and supply causes an increase in quantity, but the effect on the price depends on the relative size of the shifts.

2.

A simultaneous decrease in demand and supply causes a decrease in quantity, but the effect on the price depends on the relative size of the shifts.

 Teaching Tip Applications of demand and supply are everywhere. The strategy here is to choose ones that the students can relate to. Use examples from campus, the local economy, and products and services that are familiar to 18–22-year-olds. It is much easier for most students to understand changes in the markets for music or fashion than for chicken and corn!!

Review this key question and the related application: Question 5: How does a change in supply affect the equilibrium price?

APPLICATION 5: THE HARMATTAN AND THE PRICE OF CHOCOLATE The harmattan is a dry, dusty wind in the Sahara Desert. As it sweeps through cocoa plantations in Ghana and the Ivory Coast, it dries the pods and cuts down on yields. This decrease in supply was one reason that the world price of cocoa increased drastically in 2015.

4.6 Predicting and Explaining Market Changes When demand changes and the demand curve shifts, price and quantity change in the same direction. When supply changes and the supply curve shifts, price and quantity change in opposite directions. This information becomes very powerful when determining what caused the price of a good to change.

Review this key question and the related application:

Question 6: What explains a decrease in price?

APPLICATION 6: WHY LOWER DRUG PRICES? This application refutes a statement made by Ted Koppel of Nightline. He argued that the recent decrease in drug prices is due to an increase in the supply of drugs. However, since the quantity of drugs consumed has actually decreased, the correct explanation of lower drug prices is due to a decrease in demand.

Additional Applications to Use in Class Question: How would a bartender know that the price of an exotic drink was too low?

ADDITIONAL APPLICATION: SIP SLOWLY—THESE DRINKS ARE EXPENSIVE William Birdthistle ―Sip Slowly‖ Posted on MSNBC.com Forbes http://www.msnbc.msn.com/id/15135240/ posted 10/06/2006 Summary: Key Points in the Article Beverage consultants and barkeepers note that the newest trend in the business is exotic cocktails.

Not since mixed drinks were invented to disguise the taste of alcohol during prohibition days have mixed drinks proliferated to this extent. However, now the trade is also moving upscale with some new drinks costing thousands of dollars.

The most expensive list is topped by drinks with diamonds and other precious stones used as garnish. One drink blends champagne and vintage cognac poured over a sugar cube. Add a 0.6 carat diamond, and the blend runs $4,350 a drink. Smaller gemstone garnishes cost less.

Drinks without jewelry can still be expensive. The most expensive nongarnished drink is the ―Ritz Side Car‖ served at Bar Hemingway in the Paris Ritz. This drink uses an 1830 vintage cognac of which only a few bottles remain in existence. For the equivalent of $515 a drink, patrons can sample a cognac from the days of Napoleon.

Graphing It Out

Analyzing the News Scarcity drives prices higher. In the case of rare drinks, the fact that supply is so limited causes any increase in demand to push the price higher. Lately an increase in demand for exotic drinks has pushed many truly rare alcohols higher.

Thinking Critically Questions 22. How is the price of a product determined?

23. How would a bartender know that the price of an exotic drink was too low?

24. How would the bartender know that the price of the drink was too high?

Question: Why do people buy guns in a sour economy?

ADDITIONAL APPLICATION: GUN SALES THRIVING IN UNCERTAIN TIMES Kunkle, Fredrick ―Gun Sales Thriving in Uncertain Times‖ Posted 10/26/2008 on MSNBC.com The Washington Post Summary: Key Points in the Article Gun and ammunition sales are up between 10 and 12 percent nationwide for 2008. The increase is notable since gun sales were already up 20 percent during 2007 over the previous year. Most experts point to the housing crisis and fear of civil unrest as driving factors for the 2007 increase.

This year the election and the crippled economy appear to be the primary culprits.

Many gun enthusiasts fear that gun sales will be restricted in some manner if Obama gets elected. Most expect either outright

prohibitions on certain items or extremely high taxes that will make the cost prohibitive. Similar increases in sales occurred during the Clinton administration when several bans were eventually imposed.

So, while Americans limit their purchases of other goods such as furniture and cars, guns appear to be on the shopping list.

Mandatory FBI background checks bear that out. They are up 9 percent over last year.

Analyzing the News The possibility of a very poor economy always creates fear of social unrest. Many people appear to be coping with that uncertainty by purchasing guns in order to protect themselves if times do get bad. In addition, demand may be driven by election uncertainty and fears that the next political administration may enact stricter gun laws.

Thinking Critically Questions 1. Why do people buy guns when the economy is doing poorly?

2. Why would the coming election cause people to purchase more guns?

3. Why has the price not increase much in this market?

Question: How do car dealerships affected by the economy?

ADDITIONAL APPLICATION: AUTO DEALERS FEEL PAIN OF CREDIT CRUNCH Jones, Roland ―Auto Dealers Feel Pain of Credit Crunch‖ Posted 10/03/2008 on MSNBC.com Summary: Key Points in the Article Car showrooms across the country are noticeably vacant. Customer traffic is down about 50 percent over last year, and sales of almost every major brand are down 20 percent. Even the popular brands such as Toyota and Honda are getting hit hard. Sales for 2008 are on tap to be the worst year in a decade.

The National Automobile Dealers Association blames credit underwriters for becoming more reluctant to lend. Some people are unable to get credit at all for the first time in years. Even those receiving loans are paying higher interest rates and have to put more money down.

One consulting firm estimates that 20 percent of the nation’s dealerships will be forced out of business over the credit crunch. The auto industry is lobbying for its own bailout with Congress and hopes to be included in the $700 billion bank package. If not, car sales may continue to plummet.

Analyzing the News The lack of available credit is keeping many potential car buyers home. For those with good credit, interest rates have increased as well as the average amount of the down payments. The impact of the credit crunch will be a leftward shift in the demand for cars. The quantity demanded will decline, and prices should begin to fall as well.

Thinking Critically Questions 1. Why does a tightening of credit hurt car sales?

2. What other sectors might be hurting too?

3. How could the bailout bill help the situation?

Solutions to End-of-Chapter Exercises Chapter 4 SECTION 4.1: THE DEMAND CURVE 1.1 1.2 1.3 1.4 1.5 1.6 1.7

 Consumer income, price of other related goods, consumer expectations about future prices Price of the product, quantity of the product purchased horizontal quantity demanded 17 percent a.

s b. 11,000 1.8 Youth smoking. The tax decreases the price from $6 to $3, and the quantity increases from 100 to 117.

SECTION 4.2: THE SUPPLY CURVE 2.1  2.2 Wages paid to workers, the price of materials used in production, taxes paid by producers 2.3 lowest 2.4 horizontal 2.5 Quantity supplied 2.6 ,  2.7 Marginal cost is less than 10,000 2.8 a

a. Market supply is kinked at P = $24 and Q = 14 million pounds. b. Quantity supplied equals 5 million pounds at a price of 15 cents and 26 million pounds at a price of 30 cents.

2.9 a. , ,  b. higher

2.10 The price decreases from $20 to $14 (30 percent), and the quantity supplied decreases from 100 units to 70 units.

SECTION 4.3: MARKET EQUILIBRIUM: BRINGING DEMAND AND SUPPLY TOGETHER 3.1 3.2 3.3 3.4 3.5 3.6

3.7

3.8

Supply, Demand less, greater , ,  , ,  supply a. c, $150, 200 b. demand, rise c. supply, fall a

b. 100, 1,000 c. 300 A decrease in the minimum price decreases the gap between the quantity supplied and the quantity demanded.

SECTION 4.4: MARKET EFFECTS OF CHANGES IN DEMAND 4.1 4.2

shift of, movement along Circle: quantity of pencils demanded, price of pencils. Cross out: number of consumers, price of pens, consumer income.

4.3 4.4 4.5 4.6 4.7

left, left , ,  (product normal),  ,  increased; hops , 

4.8

, 

4.9

,  (assuming we are looking at the effect of an increase in the price of gasoline)

4.10 The demand curve shifts to the right, increasing the equilibrium price from $6 to $9.

SECTION 4.5: MARKET EFFECTS OF CHANGES IN SUPPLY 5.1 5.2 5.3

shift of, movement along Circle: quantity of pencil supplies, price of pencils. Cross out: price of wood, production technology.  (an increase in cost (shift curve up) and a decrease in supply (shift curve to left));  (a decrease in cost (shift curve down) and an increase in supply (shift curve to right));  (an increase in cost (shift curve up) and a decrease in supply (shift curve to left)).

5.4 5.5 5.6 5.7 5.8 5.9 5.10

,  demand  demand decreases; increases Equilibrium price increases and equilibrium quantity decreases. , 

5.11 , 

5.12 , 

5.13 Equilibrium price decreases and equilibrium quantity increases.

5.14

5.15 The supply curve will shift to the left, increasing the price.

Quantity of Chocolate Ice Cream

SECTION 4.6: PREDICTING AND EXPLAINING MARKET CHANGES 6.1

6.2 6.3 6.4 6.5 6.6

decrease, increase decrease, decrease increase, decrease increase, increase demand, supply decrease, supply increase, demand demand a. Did the quantity of gasoline purchased (or sold) increase or decrease? b. The quantity of gasoline purchased (or sold) increased.

c. The quantity of gasoline purchased (or sold) decreased.

6.7

Since the price increased and the quantity decreased, it must be due to a reduction in supply. This could be for a variety of reasons including an increase in the cost of labor or an increase in the cost of dairy cow feed.

6.8 6.9

Demand increased. Organ transplant operations also increased.

Demand increased.

6.10

6.11 The supply of used newspapers increased.

6.12 Price decreased; quantity increased.

Critical Thinking 1. The increase in price causes movement upward along the market demand curve to a smaller quantity demanded. The decrease in beer drinking will decrease drunk driving, decreasing the number of traffic accidents.

2. The disabling of refrigerators will increase the demand for ice and increase its price. Firms obey the law of supply: an increase in price increases the quantity supplied.

3. There is excess demand, meaning that the price is below the equilibrium price. At the current price, the quantity demanded (on the demand curve) is less than the quantity supplied (on the supply curve).

4. The demand for parking slots increases, shifting the demand curve to the right. The equilibrium price increases.

5. The increase in production cost will shift the supply curve upward and to the left, so the equilibrium price will increase.

6. You need information about the change in quantity. If the quantity increased, the increase in price was caused by an increase in demand. If the quantity decreased, the increase in price was caused by a decrease in supply.

5 Measuring a Nation‘s Production and Income

Chapter Summary Chapter 5 is the first chapter in macroeconomics and introduces many of the basic terms and concepts required to study the economy as a whole. Here are the main points of the chapter:  The circular flow diagram shows how the production of goods and services generates income for households and how households purchase goods and services by firms. The expanded circular flow diagram includes government and the foreign sector.  Gross domestic product (GDP) is the market value of all final goods and services produced in a given year.  GDP consists of four components: consumption, investment, government purchases, and net exports. The GDP deflator is an index that measures how the prices of goods and services included in GDP change over time.  National income is obtained from GDP by adding the net income of U.S. individuals and firms earn from abroad, then subtracting depreciation.  Real GDP is calculated by using constant prices. The Commerce Department now uses methods that take an average using base years from neighboring years.  A recession is commonly defined as a six-month consecutive period of negative growth.

However, in the United States, the National Bureau of Economic Research (NBER) uses a broader definition.  GDP does not include nonmarket transactions, leisure time, the underground economy, or changes to the environment.

Learning Objectives: 5.1 The Flip Sides of Macroeconomic Activity—Production and Income: Explain the circular flow.

5.2 The Production Approach—Measuring a Nation‘s Macroeconomic Activity Using Gross Domestic Product: Identify the components of GDP. 5.3 The Income Approach—Measuring a Nation‘s Macroeconomic Activity Using National Income: Describe the steps from GDP to income.

5.4 A Closer Examination of Nominal and Real GDP: Calculate real and nominal GDP. 5.5 Fluctuations in GDP: List the phases of the business cycle.

5.6 GDP as a Measure of Welfare: Discuss the relationship of GDP to welfare.

Approaching the Material It is easy to lose students with the material in this chapter. Crunching the numbers for GDP net income and personal income numbers can cause students‘ eyes to glaze over. Focus on the visuals. This chapter contains many graphs and figures. Use them. It is much more important for students to understand the how and why of national income accounts rather than the how-to.

Chapter Outline Macroeconomics is the study of the nation‘s economy as a whole; it focuses on the issues of inflation, unemployment, and economic growth. The sustained increase in the average prices of all goods and services is called inflation.

5.1 The Flip Sides of Macroeconomic Activity: Production and Income 1. Macroeconomics studies the economy as a whole.

2. Two basic issues are long-run growth and short-run fluctuations in economic performance.

3. Topics include GDP, unemployment, and inflation.

4. Production and income are two sides of the same macro coin.

 Teaching Tip If the semester does begin with this chapter, a brief reintroduction of what economics is and the basics of economic analysis could be useful to get students thinking like economists again. A graphical review of supply and demand, likewise, is always appropriate. There are two resources to use from this Instructor‘s Manual: The Appendix to Chapter 1, ―Using Graphs and Percentages,‖ and Chapter 4, ―Demand, Supply, and Market Equilibrium.‖ One way to open the semester here is to reinforce what they should know by pointedly asking students to define the subject of economics and explain opportunity cost and marginal analysis.

A.

The Circular Flow of Production and Income 1. The simplified economy contains firms and households.

2. Both interact in product and factor markets.

3. In product markets, firms sell goods and services to households.

4. In factor markets, households sell factors of production to firms.

5. The essence of the simple model in production generates income.

6. The facts of the U.S. economy found in the circular flow model are contained in the National and Income Product Accounts.

 Teaching Tip Point out that the divisive issue of us versus them where ―them‖ refers to corporations, and ―us‖ refers to citizens, is patently false. This is evidenced by the circular flow model as we are dually us and them. At times ―we‖ are sellers in markets, and at other times ―we‖ are buyers. Lastly, as stock ownership in the United States hits 50% of households, ownership of firms themselves broadens.

Encourage students to look at the Circular Flow of Production and Income and either use the PowerPoint figure or draw the figure on the board.

 Teaching Tip Students should see the usefulness of the circular flow model by noting that GDP is measured by three methods: (1) the expenditure method, (2) the production method, and (3) the income method. All three methods should be equal, given the concept of the model; what we buy is what we produce with the income we earn producing.

Review this key question and the related application:

Question 1: How can we use economic analysis to compare the size of a major corporation to the size of a country?

APPLICATION 1: USING VALUE ADDED TO MEASURE THE TRUE SIZE OF WALMART The application points out that the true measure of the size of a corporation is its value added.

Using Walmart to explain the concept, it shows that while Walmart‘s gross sales were $473 billion, its cost of sales was $358 billion, leaving a value added of $115 billion.

5.2 The Production Approach: Measuring a Nation‘s Macroeconomic Activity Using Gross Domestic Product 1. Gross Domestic Product (GDP) is the total market value of all final goods and services produced within an economy in a given year.

2. It is the most common measure of an economy‘s total output.

3. Total market value means the quantities are measured according to their market prices.

4. Intermediate goods are defined as goods used in the production process that are not final goods and services. They are exempted from GDP to avoid double-counting.

5. Due to the use of market prices, GDP will rise even if only prices rise, regardless of whether more was actually produced.

Remind students of the following key principle:

KEY PRINCIPLE: REAL-NOMINAL PRINCIPLE What matters to people is the real value of money or income—its purchasing power—not the face value of money.

6.

Measuring Real versus Nominal GDP Real GDP is a measure of GDP that controls for changes in prices. Nominal GDP is the value of GDP in current dollars. a.

GDP can increase because of an increase in either quantity or the price level. If uncorrected for price changes, nominal GDP is measured. Correcting for price changes produces real GDP. b.

One simple method to correct for price changes is to use the same price level across several years. c.

Using real GDP is superior to nominal GDP when

measuring output. Economic growth is defined as the percentage change in real GDP. 7. Economic growth is defined as sustained increases in the real GDP of an economy over a long period of time.

A. The Components of GDP Using the expenditure approach, GDP is divided into consumption, investment, government purchases, and net exports.

1. Consumption expenditures are purchases of newly produced goods and services by households. a. The three categories of consumption are durables, nondurables, and services.

2.

Private investment expenditures are defined as purchases of newly produced goods and services by firms. a. The three components are: the spending by firms on new plant and equipment, purchases of new residences, and net additions to inventory. b. Gross investment is total new investment expenditures, whereas net investment is gross investment minus depreciation. c. Depreciation is the reduction in the value of capital goods over a one-year period due to physical wear and tear and also to obsolescence; also called capital consumption allowance.

 Teaching Tip Students will need constant reminders in the beginning of the course to think of investment as economists do and as distinct from financial investment of stocks or bonds. The same goes for capital and financial capital.

3.

Government purchases includes purchases of newly produced goods and services by local, state, and federal governments. a. Government purchases exclude transfer payments, defined as payments from governments to individuals that do not correspond to the production of goods and services (unemployment benefits are an example).

4. Net exports a. Import: A good produced in a foreign country and purchased by residents of the home country. For example, the United States buys televisions that are produced in Japan. This is an import for the United States. b. Export: A good produced in the home country and sold in another country c. Net exports are defined as exports minus imports. d. The United States has run a trade deficit for more than the past decade, as imports have outpaced exports. A trade deficit is the excess of imports over exports. A trade surplus is the excess of exports over imports. e. Discuss how our trade accounts have occasionally been balanced; the United States has had a negative balance of trade for much of the past half century.

B. Putting It All Together: The GDP Equation 1. If we set GDP equal to Y, then we can algebraically represent the four components of GDP according to the expenditure approach as Y = C + I + G + NX. 2. This identity is the simplest configuration for remembering the four components of GDP according to the

expenditure approach.

 Teaching Tip The sheer size of the GDP numbers can sometimes trouble students as if they were somewhat surreal. Students also, unfortunately, have trouble in understanding the terms ―trillions‖ versus ―billion‖ or ―million.‖ Consider the average income level of roughly $45,000 and the size of the labor force of approximately 140 million. While these ―wages‖ are only part of the size of the U.S. economy, it does get us over halfway to the total of over $10 trillion.

Review this key question and the related application:

Question 2: How can we distinguish between intermediate goods and final goods and services in the modern digital economy?

APPLICATION 2: INTELLECTUAL PROPERTY IN GDP ACCOUNTS Intellectual property, such as research and development, new works of art, movies, or literary works, are an important part of our economy. In the past, they were not counted directly in GDP. Today, intellectual products are counted as investment expenditures when they are made. This change shows the importance of the evolution of our knowledge-based economy.

5.3 The Income Approach: Measuring a Nation‘s Macroeconomic Activity Using National Income National income is defined as the total income earned by a nation‘s residents both domestically and abroad in the production of goods and services. It is the income that flows to the private sector (read: firms and households).

A. Measuring National Income 1. Two adjustments are made to GDP when measuring national income. a. Gross national product is defined as GDP plus net income earned abroad. i.

Net income earned abroad by U.S. residents is defined as income earned abroad by U.S. citizens and firms minus income earned in the U.S. by foreign firms and residents. Net income is added to GDP to calculate GNP. ii. The difference between GDP and GNP is typically negligible. For example, in the United States, the difference is only 0.2 percent. b. The second adjustment is subtracting depreciation from GNP, thus calculating net national product, NNP. 2.

National income is divided into six broad categories: compensation of employees (wages and benefits), corporate profits, rental income, proprietor’s income (unincorporated firms), net interest, and other items.

3.

For most countries, compensation to employees dominates national income. This is true of the United States where it is approximately two-thirds.

4.

A final income measure is personal income, or the income, including transfer payments, received by

households. Personal disposable income is the personal income that households retain after paying taxes.

B. Measuring National Income through Value Added 1.

An alternative method for measuring national income is to use the value added by each firm in the economy.

2.

Value added is the sum of all income—wages, interest, profits, and rent—generated by an organization. For a firm, we can measure value added by the dollar value of the firm’s sales minus the value of the goods and services purchased from other firms.

3.

The value added for all firms, including firms that produce intermediate goods and basic material, must be included.

 Teaching Tip Although much of the data will be for the United States, most concepts are applicable to other nations. The methods of collection are often different, however, which makes comparisons less clear. National GDP is probably the easiest to compare across nations and the least likely to be ―different‖ in methodology.

C.

An Expanded Circular Flow 1. We can expand the circular flow model by adding the international sector to account for imports and exports and adding the government sector.

 Teaching Tip This is an interesting use of value added. You can show the students that learning what is often considered a boring and/or archaic section of the course can allow them to think critically about what they read in the paper. Here, we see that the difference between value added and sales is important. Walmart‘s true size should not include the size of the companies that produce its intermediate goods, which is included in Walmart‘s sales. We should look at only the contribution of Walmart to the economy. This is better measured by its value added.

Review this key question and the related application:

Question 3: Do increases in gross domestic product necessarily translate into improvements in the welfare of citizens?

APPLICATION 3: THE LINKS BETWEEN SELF-REPORTED HAPPINESS AND GDP This Application notes that despite increases in real per capita income over the past 30 years, people today report that they are less happy than people said they were 30 years ago. However, holding other things constant, people with higher incomes report they are happier than those lower on the income scale. It is the ―other things‖ that matter.

5.4 A Closer Examination of Nominal and Real GDP A.

Measuring Real versus Nominal GDP Calculate real versus nominal GDP for a simple economy that

produces cars and computers. Nominal GDP is simply the sum of the number of computers and cars times their prices.

Real GDP is nominal GDP adjusted for price changes. The adjustment is made by holding prices constant.

B. How to Use the GDP Deflator The GDP deflator is an index that measures how the prices of goods and services included in GDP changes over time.

1.

If we divide the nominal GDP of a year by real GDP for that year and multiply by 100, we calculate the GDP deflator: Nominal GDP GDP Deflator   100 Real GDP 2.

In the base year, real and nominal GDP are the same, and thus, the deflator equals 100. Since in most periods there is some inflation, the GDP deflator in subsequent periods is greater than 100.

3. The chain-weighting method has been used since 1996 by the Commerce Department to measure real GDP. The chainweighted index for calculating changes in prices uses an average of base years from neighboring years to measure real GDP and averages the differences.

5.5 Fluctuations in GDP A. Real GDP does not grow smoothly at a constant rate over time.

B. Growth rates vary, and real GDP even declines during periods called recessions, commonly defined as six consecutive months of declining real GDP. C. The business cycle is composed of peaks, the date at which a recession starts, recessions, troughs, the date at which output stops falling in a recession, and expansions, the period after a trough in the business cycle during which the economy recovers.

D. A recession is more broadly defined by the NBER as a ―significant decline in activity spread across the economy, lasting more than a few months, visible in industrial production, employment, real income, and wholesale-retail trade.‖ E. A depression is the common name for a severe recession.

F. The Great Depression lasted from 1929 to 1933, as GDP declined 33 percent and the unemployment rate hit estimates of 25 percent. This was our last depression, but not the world’s; see Thailand and Argentina and Russia during the past two decades.

 Teaching Tip In December of 1991, the United States was one of the last countries to switch from focusing on GNP to focusing on GDP. Explaining the difference can bring home the important concepts of worker productivity and varying rates of growth.

You can ask students to think about whether GDP or GNP is ―better‖ to capture the size of an economy.

Talk about the issues of multinational corporations and the typical process of how goods are often shipped back and forth across borders. These issues show how the measurement of GDP is not as straightforward as students might initially think.

5.6 GDP as a Measure of Welfare GDP is the broadest measure of output for an economy. It does not perfectly measure a citizen‘s welfare, however, because of what it does not measure.

A. Shortcomings of GDP as a Measure of Welfare 1. Any transactions that do not occur in organized markets, such as illegal gambling, are excluded from GDP. 2. A significant problem with excluding nonmarket transactions is the rapid increase of women entering the workforce. Now many services, such as housework and childcare, once provided within the family, and thus not measured in the past, are transacted in organized markets and thus now are measured. This probably caused GDP growth to be overestimated recently.

3. Leisure time is also excluded but is valued by households. Thus, this value is missed in measuring welfare solely using GDP. 4. Another exclusion involves the underground economy where transactions aren’t reported to authorities, whether these activities are otherwise legal or illegal.

5. The impact on the environment is also ignored in GDP accounting.

Any environmental degradation that is associated with economic growth is ignored by strict GDP calculations. This illustrates why GDP can only be used as a piece of social welfare and not as an allencompassing measure of social welfare.

 Teaching Tip A good discussion topic here is, ―How much does your happiness depend on what you have relative to other people?‖

 Teaching Tip There have been several articles in the popular press over the years that have tried to measure the dollar value of a stay-at-home mom. Using one of the articles, discuss the actual dollar impact on GDP as more women enter the work force and these services now have to be paid for. Based on their own experiences, have the students calculate their own value of a stay-at-home parent.

Additional Applications to Use in Class Question: How do we know if we‘re in a recession?

ADDITIONAL APPLICATION: IS THIS ANOTHER GREAT DEPRESSION? Schoen, John W. "Is This Another Great Depression?"

MSNBC.com Summary: Key Points in the Article A depression is defined as a severe recession. But what constitutes severe? Since the Great Depression of the 1930s, we have had short-lived and relatively shallow downturns in economic activity. But many forecasters and pundits are throwing the term ―depression‖ around this time.

While economic conditions do appear to be dire, they are not yet of the same magnitude as the Great Depression.

GDP fell 27 percent between 1929 and 1933. In the current downturn, we are only down 2.5 to 3 percent. The stock market lost 90 percent of its value in the Great Depression, and we are only down 35 to 40 percent now. One third of all banks failed in the Great Depression. And, while the current bank failures are large, they are numbered in the dozens.

By any metric, we are not in a depression. However, the period leading up to the Great Depression has some similarities that are alarming. A period of prosperity in the 1920s led to asset price bubbles and a faltering banking system. However, the current belief is that we learned from our policy mistakes of the 1930s. The Fed has been aggressive in addressing the liquidity crisis. In addition, the government appears to be near additional massive fiscal stimulus. Only time will tell whether we have better tools today to keep this downturn classified as a recession.

Analyzing the News Where are we on the business cycle? Unfortunately, we won't know until later. Did the aggressive monetary and fiscal stimulus work? I'll let you know in a few years, but until then we will all be speculating. Was it enough? Was it too much? Will it get better or worse? It appears we have not been able to prevent downturns nor predict their magnitude. Economic intervention is still more art than science.

Thinking Critically Questions 1. What is the business cycle?

2. Why are we concerned about this particular decline?

3. What is the point of the fiscal and monetary stimulus?

Question: Can economic data give conflicting signals?

ADDITIONAL APPLICATION: “MADE IN THE USA” STILL MEANS SOMETHING Sirkin, Harold L. MSNBC.com Businessweek Summary: Key Points in the Article The news media paints a dire picture of U.S. manufacturing. We often hear that most goods are now manufactured overseas using cheaper sources of labor and more modern factories. While this may be true for many goods, the United States is still ―the world's leading manufacturer.‖ However, the mix of goods has changed significantly.

Instead of dress shirts, microwave ovens, and boom boxes, we now produce chemicals and aircraft. We have shifted production to high-value fields such as medical technologies where we manufacture more than half of the $175 billion of these products purchased annually worldwide.

The focus on the jobs lost in manufacturing often overshadows the job gains due to visibility. Many of the more common consumer goods such as clothing are now made outside the United States. In contrast, optimists point out that the United States now focuses on high value capital goods, as Ricardo's comparative advantage predicts.

Analyzing the News Much has been written about the United States falling behind in manufacturing. However, it depends on what metric you use to evaluate manufacturing. While we may have lost jobs in this sector, it appears that dollars of products produced has increased significantly. According to this metric, the United States still leads the world in manufacturing.

Thinking Critically Questions 1. Why have we lost some manufacturing jobs?

2. Why does the United States continue to manufacture high-end products?

3. Why would a dollar increase in manufacturing translate to fewer jobs?

Solutions to End-of-Chapter Exercises Chapter 5 SECTION 5.1: THE FLIP SIDES OF MACROECONOMIC ACTIVITY: PRODUCTION AND INCOME 1.1 1.2 1.3 1.4 1.5 1.6

income product b.

False Dollars are spent to purchase goods, and thus, they move in opposite directions during a transaction.

Using the circular flow, we can see that production generates income, so looking at either side can allow us to measure output for the entire economy.

SECTION 5.2: THE PRODUCTION APPROACH: MEASURING A NATION‘S MACROECONOMIC ACTIVITY USING GROSS DOMESTIC PRODUCT 2.1 2.2 2.3 2.4 2.5 2.6

c. b. gross investment exports, imports GDP is higher in Economy A than Economy B, but actual output is equal.

It is not included in GDP because the government is not purchasing a good or service. This is a transfer payment included in the government budget.

2.7 2.8

2.9

Although consumption rises by $50,000, net exports fall by $50,000 because of the increase in imports. The result is that GDP does not change.

Your car has depreciated for several reasons. First, you put on some mileage and there is wear and tear on the car. Second, many people want to buy only new cars because they do not trust buying used cars. Third, in the year since you bought the car, there may be new features available. For all these reasons, the value of your car has fallen—this is depreciation.

It is classified as an intellectual property product which is an investment in the GDP accounts.

SECTION 5.3: THE INCOME APPROACH: MEASURING A NATION‘S MACROECONOMIC ACTIVITY USING NATIONAL INCOME 3.1 3.2 3.3 3.4 3.5 3.6

3.7

3.8 3.9

a. a. households GNP We can add up the payments it makes to its factors, including its profit.

GDP is larger than GNP in Australia because the profits that are earned by foreign firms are sent back to their home country. Australia does benefit from the presence of foreign firms because they use hired labor within the country.

Personal income is obtained by adding transfer payments to households to national income (and some other adjustments). Since transfer payments rise during recessions as government programs try to ease the burdens, personal income typically does not fall.

However, the last recession was so severe that even with the transfer payments, personal income still fell.

GNP exceeds GDP because of foreign wage income sent back from abroad.

Value added excludes goods just bought from another firm, which do not really measure a firm‘s size. If we measured total sales in a country, this would include intermediate goods (thereby double-counting) and exceed GDP.

SECTION 5.4: A CLOSER EXAMINATION OF NOMINAL AND REAL GDP 4.1 4.2 4.3 4.4 4.5 4.6 4.7

Real True b.

True a. 24,000, 25,500, 6.25% b. 109.18, 9.18% a. 26,200, 27,840, 6.26% b. 100, 8.40% Prior to 2009, actual prices are lower than 2009 prices, so nominal GDP lies below the line for real GDP. If the base year were 2000, the lines would cross in 2000.

4.8

Date 1991 1992 1993 1994 1995 1996

Nominal Real Growth Growth Inflation Rate Rate Rate 3.00 5.23 5.59 5.63 5.60 4.46

–0.17 3.33 2.67 4.02 2.50 3.70

4.07 2.52 2.29 1.02 2.18 1.91

1997 1998 1999 2000 2001 2002 2003 2004 2005

6.42 5.83 5.60 6.21 4.07 3.11 3.71 6.91 6.47

4.50 4.18 4.45 3.66 0.75 1.60 2.71 4.22 3.53

1.78 1.05 1.23 2.08 2.23 2.02 2.10 2.11 2.78

SECTION 5.5: FLUCTUATIONS IN GDP 5.1 5.2 5.3 5.4 5.5 5.6 5.7

peak False; 11 recessions peak c. one This measure essentially tells you how long it takes to get back to the peak before the recession started and thus is a natural measure of the speed of a recovery.

Based on percent decline in real GDP, the recession starting in July 1981 and December 2007 were the most severe. You might also want to see what happened to unemployment during the recessions to judge their severity.

SECTION 5.6: GDP AS A MEASURE OF WELFARE 6.1 6.2 6.3 6.4 6.5

a.

True 41 percent from Table 5.6. d. a. GDP falls b. GDP does not accurately measure welfare in this case. Government services are evaluated at cost, regardless of the actual production achieved by that cost.

6.6 Measure the loss of the value of trees in each year and treat this as depreciation of capital.

6.7 You would want to compare the value of the extra output produced and then subtract the estimates of environmental damage. The result would be the change in economic welfare.

6.8 While residents in the United States can purchase more goods and services, Europeans have more leisure time. To compare the two regions in terms of true economic welfare, you would have to put some value on the additional leisure time that the Europeans enjoy.

Without doing that you would overestimate economic welfare in the United States.

6.9 Increased real GDP does not reflect the associated increases in workplace stress, traffic congestion, divorce rates, and deterioration in the environment associated with increased real production.

6.10 France has a smaller underground economy as a share of GDP, so its statistics should be more accurate.

Critical Thinking 1. Answer should discuss value added.

2. Answer should be that perhaps yes, as it takes into account income from abroad and subtracts out depreciation (loss of capital).

3. Not clear if people in 1900 or in African countries are less happy, but their material comforts and access to health care and other services are much worse.

6 Unemployment and Inflation Chapter Summary Chapter 6 looks at two key phenomena in macroeconomics: unemployment and inflation.

Combined with real GDP, these three most basic topics of macroeconomics can justifiably be called the ―Macro Big 3.‖ Here are the main points of the chapter:  The unemployed are defined as those individuals without jobs and actively searching for a job. The different types of unemployment include seasonal, frictional, structural, and cyclical.  Different groups of people have different rates of unemployment as do different nations.  Alternative measures for unemployment include categories for people who have been discouraged for a long time as well as those who work part time but would rather work full time.  Unemployment imposes financial and psychological pain on individuals.  The CPI is used to measure price changes across a market basket of consumer goods and services. Percentage changes in the CPI are used to measure inflation. An alternative measure is the GDP deflator, or chain index. Both measures have difficulty accounting for improvements in a good‘s quality.  Both anticipated and unanticipated inflation impose costs on society.

Learning Objectives: 6.1 Examining Unemployment: Define these concepts: the labor force, the labor force participation rate, and the unemployment rate.

6.2 Categories of Unemployment: Distinguish between cyclical, structural, and frictional unemployment.

6.3 The Costs of Unemployment: Describe the costs of unemployment.

6.4 The Consumer Price Index and the Cost of Living: Discuss how the Consumer Price Index is calculated.

6.5 Inflation: Explain the difference between inflation and the price level.

6.6 The Costs of Inflation: Summarize the costs of anticipated and unanticipated inflation.

Approaching the Material Do not be tempted to lose the personal approach. While both inflation and unemployment have several theoretical talking points and mounds and mounds of national data, students will learn more if they can relate to the material. Discuss how price changes impact them: movie tickets, cost of music CDs, and cost of bottled water and soft drinks. Ask them how long they expect to look for a job after graduating from college. Have them develop their own personal basket of goods.

Chapter Outline 6.1 Examining Unemployment 1. Unemployment is directly related to the economic fluctuations studied in Chapter 5.

2. Unemployment rises during bad economic times and falls but does not ever disappear, even during times of improving economic conditions.

3. Unemployment imposes large costs on both the individual and society.

 Teaching Tip This chapter is ripe for the use of government statistics and reports. The Internet has made the monthly employment and inflation reports accessible to all students. Having them download or at least peruse the latest reports will put this chapter in better context for the students, making the text appear more real.

Asking students about their recent job experiences is a good in-class topic.

Students understand that while they may not have trouble finding a job, it is not always the case. Relating a story about the bad old days often helps them to see that available jobs are not a guarantee.

A. How Is Unemployment Defined and Measured?

1. Unemployed are people without work but actively looking.

2. Employed are people who have jobs.

3. Labor force is the total number of workers, including both the employed and the unemployed.

4. The unemployment rate is the percentage of the labor force that is unemployed.

5. Labor force participation rate is the percentage of the population over 16 years of age that is in the labor force.

 Teaching Tip Ask the students in class what type of household they are planning on—double income or a stay-at-home parent. Discuss the advantages and disadvantages.

B. Alternative Measures of Unemployment and Why They Are Important: The alternative measures are important because they illustrate how the measured unemployment rate does not account for people who we intuitively think of as ―unemployed.‖ 1. Household survey a. It is important to understand the difference between being unemployed versus not in the labor force. b. Who is not in the labor force? i. People under 16 ii. Retired people iii. People who do not choose to work for whatever reason (wages too low, child care, etc.)

2. Discouraged workers are workers who left the labor force because they could not find jobs.

3. Marginally attached workers

4. Individuals working part time who wish to work full time can be considered underemployed.

C. Who Are the Unemployed?

1. Different groups suffer differing amounts of unemployment.

2. Adult unemployment rate is lower than the youth unemployment rate.

3. Minorities have higher unemployment rates.

4. Seasonal unemployment is the component of unemployment attributed to seasonal factors.

 Teaching Tip Although this can be a highly charged topic, ask students why they think the rates for some groups, including their own, are so much higher, while the rates for married men and women are so much lower. Ask them if perhaps it is a lack of workplace skills and also flexibility for some who can live at home with mom and dad.

Review this key question and the related application:

Question 1: What factors account for the decline in the labor force participation rate in the last decade?

APPLICATION 1: DECLINING LABOR FORCE PARTICIPATION This Application explains how the labor force participation rate has fallen over the last decade.

There are two primary reasons for this. The first is that because of sluggish economic growth, many individuals probably decided to leave the labor force due to lousy job prospects. In addition, as the baby boomers are aging, increased numbers of them have been retiring.

6.2 Categories of Unemployment A. Types of Unemployment: Cyclical, Frictional, and Structural 1. Cyclical unemployment is the unemployment that occurs during fluctuations in real GDP, including recessions and booms.

2. Frictional unemployment is the unemployment that occurs with the normal workings of the economy, such as workers taking time to search for suitable jobs and firms taking time to search for qualified employees.

3. Structural unemployment is unemployment that occurs when there is a mismatch of skills and jobs.

4. In practice, the difference between frictional and structural is not clear-cut.

B. The Natural Rate of Unemployment 1. Natural rate of unemployment is the level of unemployment at which there is no cyclical unemployment. It consists of only frictional and structural unemployment.

2. Full employment is the level of unemployment that occurs when the unemployment rate is at the natural rate. a. For example, if structural unemployment is 1 percent and frictional unemployment is 2 percent, the natural rate of unemployment is 3 percent. Full employment output is how much is produced when the unemployment rate equals the natural rate of unemployment.

 Teaching Tip The word ―natural‖ appears to connote desirability. In fact, while it is the rate toward which the economy naturally gravitates, a decline in the natural rate over time, as occurred during the 1990s, is a welcomed structural change in the labor market. Talk about the fact that actual unemployment fluctuates around the natural rate, meaning that cyclical unemployment not only can go to zero but can also become negative. The late 1990s is an example of negative cyclical unemployment. What this means is an unsustainable level of hiring: people who won‘t stay employed over the long run.

 Teaching Tip Realize that students often have difficulty with the idea that real GDP can actually go above potential, although temporarily. Push the idea of sustainability of both growth rate and level.

Review this key question and the related application:

Question 2: Do more generous disability insurance payments lead to lower labor force participation rates?

APPLICATION 2: PARTICIPATION

DISABILITY

INSURANCE

AND

LABOR

FORCE

Disabled individuals may receive income through federal programs such as Social Security Disability Insurance (SSDI) and Supplemental Security Income (SSI). A study of Vietnam War veterans who were eligible to receive benefits estimated that their labor force participation rate was reduced by 18 percent. Therefore, there is strong evidence that disability programs can result in large reductions in labor force participation rates.

6.3 The Costs of Unemployment A. Economy is not at potential if actual unemployment > natural rate of unemployment.

B. Waste of resources C. Unemployment insurance is payments unemployed people receive from the government.

D. Financial and nonfinancial costs, e.g., loss of income and stature within a community E. Loss of skills while unemployed F. If unemployment insurance increases, unemployment length increases.

Review this key question and the related application:

Question 3: Are you less upset about being unemployed if unemployment is common in your peer group?

APPLICATION 3: SOCIAL NORMS, UNEMPLOYMENT, AND PERCEIVED HAPPINESS This Application discusses how feelings about becoming unemployed depend on the experiences of those around us. It tells how Economist Andrew E. Clark carefully examined the perceptions and the behavior of the unemployed in Great Britain over a seven-year period. He found, as expected, that people’s perceived well-being declined as they became unemployed and also that employed people become less happy if others around them became unemployed. The conclusion was that becoming unemployed caused less of a decrease in well-being if others were also unemployed.

6.4 The Consumer Price Index and the Cost of Living Remind students of the following key principle:

KEY PRINCIPLE: REAL–NOMINAL PRINCIPLE What matters to people is the real value of money or income—its purchasing power—not the face value of money or income.

1. Consumer Price Index is a price index that measures the cost of a fixed basket of goods chosen to represent the consumption pattern of a typical consumer.

2. CPI in year K = (cost of basket in year K/cost of basket in base year) × 100

 Teaching Tip It‘s worth spending time considering the various items contained in the CPI‘s market basket. Each individual‘s personal basket will vary somewhat from the typical, altering each person‘s actual inflation. More importantly, inflation occurs when the average price rises, not necessarily all prices within the basket. Most of the time, the United States experiences some prices rising, some falling, and some staying unchanged.

 Teaching Tip It‘s important to stress that we are attempting to measure price changes, not solely inflation. This will make the last section easier to comprehend.

A.

The CPI versus the Chain Index for GDP 1. CPI measures consumer goods and services a. Imports included

b. Used goods included 2. GDP Chain Index a. Not a fixed basket, but based on what is produced in a given year. b. All final goods and services produced in the United States only.

 Teaching Tip The differences between the two measures are somewhat overblown since the GDP index uses price data from the CPI to assign prices when calculating GDP. Besides, the two measures tend to track one another. When one is rising, the other tends to rise as well.

B.

Problems in Measuring Changes in Prices 1.

All measured indexes of inflation overstate due to quality improvements.

2.

CPI overstates ―experienced‖ inflation for a few reasons. a. It uses a fixed basket of goods, while consumers substitute away from expensive goods. b. The CPI does not account for quality improvements.

 Teaching Tip Ask students to consider how technological goods have improved during their lifetime. MP3 players, PCs, and cellular phones have all undergone rapid increases in their quality and overall usability. Discuss how much of these improvements alter the good, making it almost a new good. Handling quality changes in the computation of a price index is really just an extension of the process for handling new goods.

3. Overstatement causes true gain for some consumers as measures used for cost-of-living adjustments (COLAs), which are automatic increases in wages or other payments that are tied to the CPI. Review this key question and the related application:

Question 4: How large is the bias in the CPI due to not immediately incorporating new goods?

APPLICATION 4: THE INTRODUCTION OF CELL PHONES AND THE BIAS IN THE CPI This Application is about how cell phones were not introduced to the public until 1983, and it took 15 years, until 1998, before the Bureau of Labor Statistics (BLS) included them in calculating the CPI. Economist Jerry Hausman of MIT estimated the bias in the

CPI caused by the failure to include cell phones in a timely manner. He calculated that because of this delay, the telecommunication component of the price index was biased upward by between 0.8 and 1.9 percent per year. In other words, instead of rising by 1.1 percent per year, telecommunication prices should have been falling by 0.8 percent per year.

6.5 Inflation 1. Inflation rate = the percentage rate of change in the price level.

2. Confusion between inflation rate and price level a. High inflation can exist if prices are low and vice versa.

A. Historical U.S. Inflation Rates 1. 1875–1915 practically no change in price level 2. Increases during and decreases following WWI 3. Since 1940 consistent increases in price level 4. Inflation rates highest 1970–1980: approximately 7 percent 5. Lower 1950–1970: 2.5 percent 6. Lowest 1990–2003: 2.13 percent B. The Perils of Deflation 1. Deflation is negative inflation or falling prices of goods and services.

2. Deflation creates a problem because people cannot repay their debts.

 Teaching Tip The circular flow model is great here. Point out that each person‘s spending is in fact someone‘s income, which in turn is someone‘s spending. Deflationary spirals can actually be harder to fix than inflationary spirals.

3. Devastating as prices fall, incomes fall, and debt is constant in nominal terms but increasing in real terms.

4. Depression had 33 percent decline in prices.

5. Japan recently experienced 1 percent/year decline—still very bad, i.e., debt defaults.

 Teaching Tip Make it clear that there is a difference between inflation, disinflation, and deflation. Also, point out that for most nations of the world, the 20th century is the sole time period with nearly continuous rise in the price level.

6.6 The Costs of Inflation 1. Anticipated inflation is inflation that is expected.

2. Unanticipated inflation is inflation that is not expected.

A. Anticipated Inflation 1. Menu costs are the costs associated with changing prices and printing new price lists when there is inflation.

 Teaching Tip Emphasize how menu costs can actually relate to a much bigger idea than simply changing prices. Relationships matter and any price change could potentially cause damage to relationships between businesses and with their customers.

Firms will often resist changing prices, even in the face of rising costs, in order to protect their relationships.

2. Shoe-leather costs are costs of inflation that arise from trying to reduce holdings of cash.

3. Even fully anticipated inflation is hard for business and the government to keep up with because it requires regular changes in business practices and tax rules.

B. Unanticipated Inflation 1. Arbitrary redistribution of income a.

Borrowers gain b.

Lenders lose 2. Hyperinflation is an inflation rate exceeding 50 percent per month.

Additional Applications to Use in Class Question: Can a recession be gender biased?

ADDITIONAL APPLICATION: THE SLUMP: IT’S A GUY THING Coy, Peter ―The Slump: It‘s a Guy Thing‖ Posted 5/8/2008 on MSNBC.com Businessweek Summary: Key Points in the Article Are there two economies? One for men and one for women? The numbers do indicate some disparities. Over the past six months, American women have gained almost 300,000 jobs, while American men have lost almost 700,000 jobs over that same time span. The difference appears largely due to gender concentrations in certain industries.

The two hardest hit industry sectors are manufacturing and construction, which are male dominated sectors. In contrast, women are concentrated in education and health care sectors, which are doing quite well. Men also appear to have a harder time finding a new job for some reason.

However, in spite of job gains made by women, the pay gap still exists. Over 75 percent of the workers who made over $100,000 last year were men, and the pay gap between men and women actually widened. Some analysts maintain this provides evidence that the newly created jobs taken by women were low paying jobs with little room for advancement such as clerks and home health aides.

Analyzing the News Some industries are male dominated and some are female dominated. Therefore, it makes sense that a recession would adversely impact one gender over another. However, when you look at the female dominated industries of education and health care, it appears women gravitate toward recession proof career choices. Why aren‘t more men doing that?

Thinking Critically Questions 1. Why would education be recession resistant?

2. Why would health care be recession resistant?

3. What other businesses might be somewhat resistant to the

state of the economy?

Question: How can a changing economy—not a declining one—affect layoffs?

ADDITIONAL APPLICATION: AT&T, DUPONT CUTTING THOUSANDS OF JOBS Msnbc.com news services ―AT&T, DuPont Cutting Thousands of Jobs‖ Posted 12/4/2008 on MSNBC.com Summary: Key Points in the Article The recession continues to take a toll on workers. AT&T Inc. and DuPont both announced job cuts. AT&T will reduce its workforce by 12,000 or about 4 percent and DuPont will lay off 2,500. AT&T also plans to decrease its capital budget next year. This is the first time the company will actually see its overall workforce decline since previous layoffs were targeted to positions and coincident with continued hiring company wide.

While part of the reason is a recession-related reduction in sales due to falling consumer spending, a lot is simply due to changes in the industry. The company continues to see a major shift away from landlines and toward the wireless sector. In spite of the declines, AT&T continues to show a profit. In contrast, DuPont‘s layoffs appear to be solely due to declining demand for its products because of drops in homebuilding, automobile sales, and consumer spending.

Analyzing the News As you can see there are two factors at work in AT&T‘s layoffs. One is the recession and that appears to be impacting almost all firms. The other is a structural shift in AT&T‘s business. Cell phones and wireless networks are eliminating the need for landlines and that change is permanent.

Thinking Critically Questions 1. What are the three main types of unemployment?

2. What types of unemployment do we see as a result of the AT&T layoffs and why?

3. Is the economy experiencing any frictional unemployment?

Solutions to End-of-Chapter Exercises Chapter 6 SECTION 6.1 EXAMINING UNEMPLOYMENT 1.1 1.2 1.3 1.4

c.

False d.

It would increase because the numerator in the unemployment rate calculation would increase by a higher percentage than the denominator. Example: Suppose that the unemployed were 1,000 and the labor force was 10,000. Then, the unemployment rate would be 1,000/10,000 = 10%. If the unemployed increased by 100, the new unemployment rate would be 1,100/10,100 =10.89%.

1.5

Measured unemployment falls, so the unemployment rate in this case is an inaccurate indicator of the underlying economic situation and actual production.

1.6 Paul is neither unemployed nor counted as working part time for an economic reason. His decision is fully voluntary.

1.7 The labor force is the sum of the employed and unemployed = 161.11 million. The labor force participation rate is the labor force divided by the population = 161.11/256.78 = 63%.

The unemployment rate is the unemployed/labor force = 6.68/161.41 = 4.1%.

1.8 Robert could possibly retire while it is less likely that Pamela will. If Robert retires and leaves the labor force, the labor force participation rate will decline.

1.9 No, his reasoning is not correct. In this example, the state is reacting to the higher unemployment by increasing unemployment insurance—it is not causing it to occur.

1.10 In June, students leave school and seek work. Some do not find jobs immediately, and the raw unemployment numbers rise.

However, since this happens every year, the BLS will remove this effect through seasonal adjustment.

1.11 Conventional unemployment rate = 8,000,000/ (8,000,000 + 100,000,000) = 7.4% Alternative measure = (8,000,000 + 4,000,000)/ (8,000,000 + 100,000,000 + 4,000,000) = 10.7%.

1.12 Inner-city gang members would be an example of NEETs in the United States.

SECTION 6.2: CATEGORIES OF UNEMPLOYMENT 2.1 2.2 2.3 2.4 2.5

frictional frictional, structural True a.

It could be the case that Spain has experienced a major, severe recession, and Japan has not. Or Spain might normally have a higher natural rate of unemployment. The latter possibility would be more likely if unemployment in Spain over the last decade or so was higher than Japan over the same period.

2.6 Unoccupied apartments might not be the type of apartment that potential renters were seeking, similar to structurally unemployed labor. Additionally, the process of searching for the right apartment takes time and effort, much like frictionally unemployed labor.

2.7 Yes, workers are anticipating the chance of landing a government job and effectively are searching for one. Even though the prospects are low, living standards in the countryside may be much lower.

2.8 With the growth of online news, some journalists working at traditional newspapers might become unemployed. If they can easily find jobs at online news sources, then the unemployment might only be frictional. But if the total number of journalists decreases, it would be structural.

2.9 If those receiving disability and leaving the labor force were unemployed, the unemployment rate would fall. If they were employed, the unemployment rate would rise (since the unemployed would be the same but the labor force would decrease).

SECTION 6.3: THE COSTS OF UNEMPLOYMENT 3.1 3.2 3.3 3.4 3.5

False. From Table 6.1 in the book, 30 percent were unemployed that long.

40 b.

5 There are several reasons why it may be less psychologically painful if your peers are unemployed at the same time. There may be less of a social stigma in being unemployed because it is common. Also, a group of unemployed friends might be able to find ways to amuse themselves with one another.

3.6

Wages at age 40 tend to reflect cumulative prior employment experience, and spells of unemployment reduce this work experience.

SECTION 6.4: THE CONSUMER PRICE INDEX AND THE COST OF LIVING 4.1 4.2 4.3 4.4 4.5 4.6 4.7 4.8 4.9

100 True imported rent The value of $15,000 in 2014 equals $15,000 × (236.7/56.9) = $62,399, so the professor in 2014 has a higher real salary. $8,720 While cost of living in Tokyo may be high, that does not imply that it is rising. It simply means that it rose quickly in the past.

Use the web calculator.

In this case, the additional ―quality‖ of the new phones would be ignored. They may even cost more but are bringing different services to the consumer. Ignoring this would cause an upward bias in the CPI.

SECTION 6.5: INFLATION 5.1 5.2 5.3 5.4 5.5 5.6

20% False b.

(300 − 18)/18 = 15.67 or 1,567.

9.091 percent The elderly consume more housing and medical care and less transportation, education, and food based on the data in the table.

SECTION 6.6: THE COSTS OF INFLATION 6.1 6.2 6.3 6.4 6.5 6.6

6.7

Unanticipated True True 50 Online shopping tends to mitigate the menu costs of inflation.

You are taxed on your dollar gains. Since the price of the stock has doubled to $200, your gain would be $100 ($200 − $100), and you would owe a tax of $15. Ideally, since you did not have a gain in real terms (just nominal), you should not owe any tax.

You would take less money out and make more trips to the ATM. As a result, your shoes would get more wear and your ―shoe-leather‖ costs would increase.

Critical Thinking 1. Teenagers do change jobs more often and often cycle in and out of part-time work. This is somewhat natural and would mean they have higher unemployment rates.

2. An elderly person would have a higher weight of medical care in the CPI, while a family with children would have a higher weight for education. So the same index would not necessarily work for both. This could cause some issues as we compared households over time (as they age and have children).

3. In principle, we can control for changes like this; however, in practice, our measures of controlling for technology are imperfect.

7 The Economy at Full Employment Chapter Summary This chapter studies the economy at full employment. The model developed explains how GDP is produced with the supply of the factors of production—labor and capital. Since capital is fixed at a point in time, the text focuses on fixed capital with full employment labor applied. Labor market equilibrium provides the quantity of labor that, when combined with capital, produces full employment, or potential output. Here are the main points of the chapter:  If capital increases, the demand for labor increases. These increases raise wages and the level of labor employed.  An increase in the supply of labor causes the wage rate to fall, but the level of labor employed increases.  The full-employment model is used to explain taxation issues as well as immigration and economic fluctuations.  Government spending can also be studied using the full-employment model. Crowding out occurs as increased government spending as a percentage of GDP causes the other components to decline as a percentage.

Learning Objectives: 7.1 Wage and Price Flexibility and Full Employment: Identify the key assumption of classical models in macroeconomics.

7.2 The Production Function: Explain the concept of diminishing returns to labor.

7.3 Wages and the Demand and Supply for Labor: Analyze how shifts in demand and supply affect wages and employment.

7.4 Labor Market Equilibrium and Full Employment: Explain how full employment is determined in a classical model.

7.5 Using the Full-Employment Model: Describe how changes in taxes can affect full employment.

7.6 Dividing Output among Competing Demands for GDP at Full Employment: Explain how countries must divide output across different uses.

Approaching the Material Students often find the material in this chapter difficult because they cannot relate to it on a personal level. Make the production examples personal—the ―production‖ of grades in college works well. Make them owners of small businesses and ask them what would happen if business was slow. Would they cut everyone‘s wages or lay people off? How would they react as employees if their company reduced their wages? Later in the chapter, you will discuss technology shocks. Try using the introduction of computers as a positive technology shock and a massive computer virus as a negative technology shock.

Chapter Outline 7.1 Wage and Price Flexibility and Full Employment 25. Classical models are economic models that assume wages and prices adjust freely to changes in demand and supply.

26. Classical model was the dominant model until the Great Depression.

 Teaching Tip Ask students if they‘ve heard of the Great Depression. Speak to them of this experience as having become a cultural touchstone that survives across the generation. Explain the depth and breadth of the Depression and how this was a huge, supposedly short run, deviation away from equilibrium.

27. The classical model is the one we will use to study the economy in the long run. And although Keynes said, ―In the long run, we‘re all dead,‖ it‘s useful to study the economy at full employment. Because, although not instantaneous, wages and prices do eventually adjust.

 Teaching Tip This assumption regarding price and wage flexibility must be made clear at the outset for students to fully understand the chapter‘s material.

28. Issues such as taxation, immigration, and government spending are studied using full-employment models.

A. Understanding Full Employment 29. Economy at full employment does not imply 0 percent unemployment.

30. Cyclical unemployment at 0 percent; frictional and structural > 0 percent.

31. Cyclical unemployment changes with business cycle. Therefore, the long run implies no business cycle.

7.2 The Production Function A. Production function is the relationship between the level of output and the factors of production that are inputs to production. For simplicity, we look at only labor and the stock of capital as factors of production.

B. Stock of capital is total of all machines, equipment, and buildings in an entire economy.

C. Labor is human effort, including both physical and mental effort, used to produce goods and services.

D. Y = F(K, L) 1. Production function is drawn with a fixed level of K because the capital stock does not change instantaneously.

2. K = f(Investment in previous periods); fixed at a point in time.

E. Therefore, labor is the only variable that changes in the figure.

F. However, if the capital stock changes, this shifts the production function.

1. An increase in K will increase Y for all levels of Y => shift the production function up.

Remind students of the following key principle:

KEY PRINCIPLE: PRINCIPLE OF DIMINISHING RETURNS Suppose that output is produced with two or more inputs and that we increase one input while holding the other inputs fixed. Beyond some point—called the point of diminishing returns— output will increase at a decreasing rate.

 Teaching Tip Students often benefit if you provide simple examples of production and the types of capital and labor used in the process. This can include any production process. For example, the local copy store has both copy machines (capital) and workers (labor).

7.3 Wages and the Demand and Supply for Labor 32. Real wage is the wage rate paid to employees adjusted for changes in the price level.

 Teaching Tip Students often have trouble grasping what the real-nominal difference means when applied to something like wages. The best way to show the difference is to introduce annual rates of inflation and changes in nominal wage rates. Show students how in some years the average wage grows more quickly, but other times the average wage is outpaced by inflation. Now make explicit that this means people are losing the ability to purchase goods and services when the latter occurs. Watch for the shock as some now understand the distinction.

33. Labor demand from firms.

34. Labor supply by workers.

a. Substitution effect: With increased wages, opportunity cost of leisure rises, hours worked rises. This implies an upward-sloping labor supply curve. b. Income effect: With increased wages, workers may choose to work less and enjoy more leisure. This implies a downward-sloping labor supply curve.

35. Typically assume Substitution effect > Income effect; labor supply slopes upward.

Remind students of the following key principle:

KEY PRINCIPLE: MARGINAL PRINCIPLE Increase the level of an activity as long as its marginal benefit exceeds its marginal cost. Choose the level at which the marginal benefit equals the marginal cost.

A. Labor Market Equilibrium 36. Quantity of labor demanded equals quantity of labor supplied, determining equilibrium real wage.

B. Changes in Demand and Supply 37. Increase in Ld increases real wage and equilibrium quantity.

38. Increase in Ls decreases real wage but increases equilibrium quantity. a. Increase immigration, increase Ls, pushing down real wage and increasing quantity. b. Current employees dislike immigration because wages fall. c. However, product prices are held down due to lower wages.

Review this key question and the related application:

Question 1: How can changes in the supply of labor affect real wages?

APPLICATION 1: THE BLACK DEATH AND LIVING STANDARDS IN OLD ENGLAND The Application points out that while real wages for laborers in England were nearly the same in 1800 as in 1200, from 1350 to 1550 wages were considerably higher. The simple explanation was the bubonic plague—the Black Death—arrived from Asia in 1348 and caused a long decline in total population through the 1450s. This reduction in labor supply resulted in higher real wages and lower output, consistent with the Malthusian view of demographic changes.

7.4 Labor Market Equilibrium and Full Employment A.

Full-employment output is the level of output that results when the labor market is in equilibrium and the economy is producing at full employment. We show this diagrammatically as equilibrium in the labor market.

B. Equilibrium in the labor market displays W* and L*, equilibrium wage and quantity, respectively. From the production function, we know that potential output is Y* = F(K*, L*).

 Teaching Tip

It‘s good to show the graph of the production function stacked on top of the labor market graph and illustrate how changes in the labor market affect potential output. Stacking the two graphs together gives a good visual representation of the links between what could be considered different topics covered in macroeconomics.

C.

Measuring an Economy’s Output at Full Employment 39. Start with an estimate of unemployment at full employment (cyclical unemployment equal to 0).

40. In 1996, unemployment was 5.6 percent and was close to the natural rate. The labor force equaled 126.7 million. RGDP equaled $7.8 billion, in 1996 dollars. Since unemployment was close to the natural rate, RGDP was close to potential.

7.5 Using the Full-Employment Model A.

Taxes and Potential Output 41. Tax on employers for hiring workers, such as Social Security; increase MC of production due to increased labor cost for employers.

42. Increase MC of production with unchanged MB; less hiring as Ld falls.

43. Decreased Ld causes falling real wage and declining employment levels.

44. Decreased potential output due to the reduced employment.

45. The size of the decline is determined by the slope of the Ls. 46. If Ls is perfectly inelastic, decline in real wage with no change in L*.

 Teaching Tip Ask students whether or not they see working as a choice. This will help them begin understanding the supply curve assumptions. Perhaps working is not a choice, but the intensity and/or hours of work may be a choice.

 Teaching Tip This Application leads into a discussion of how high taxes would have to be to discourage work. Ask the class at what tax rate they would start to work less.

B.

Real Business Cycle Theory 47. Real business cycle theory is the economic theory that emphasizes how shocks to technology can cause fluctuations in economic activity.

48. Changes in technology change full employment and potential output levels because they change labor productivity and hence labor demand.

 Teaching Tip It‘s always good to emphasize divisions within the economics discipline, and the real business cyclists provide a fruitful example for debate. The moral is that no model can explain all facets of our diverse economy.

Review this key question and the related application:

Question 2: What evidence is there that taxes on high-paid soccer stars in Europe affect their location decisions among countries?

APPLICATION 2: DO EUROPEAN SOCCER STARS CHANGE CLUBS TO REDUCE THEIR TAXES? In this Application, a study found that when the rules limiting the number of foreign soccer players on one team were relaxed, the top tax rates did affect the mobility of soccer stars. In addition, players were influenced by the specific tax breaks offered by different countries.

Despite the increase in ―globalization‖ in recent years, tax rates are very different among countries.

Review this key question and the related application:

Question 3: What explains China‘s high savings rates?

APPLICATION 3: GOVERNMENT POLICIES AND SAVINGS RATES China has one of the highest savings rates in the world, at about 47 percent. Households must save a large amount of money because mortgages and old age pensions are not very common. In addition, China‘s one-child policy resulted in more boys being born than girls. Because of this, parents saved more money in order to make their sons more appealing to the smaller number of potential wives. China‘s high savings rate should continue for many years into the future.

7.6 Dividing Output among Competing Demands for GDP at Full Employment A.

International Comparisons 49. Show the large disparity across different nations and the comparative data regarding the division of output across C, I, G, and NX. a. United States has high C, low I, and negative NX. b. France has lower C, higher G, higher I, and small positive NX. c. China has very low C, very low G, and high positive NX. d. Japan and China have very high I.

 Teaching Tip Explore the differences by pointing out that the United States has the highest level of consumption and is the only nation among this group with a trade deficit.

Look at the various levels of government activity relative to each nation‘s GDP. Very simply, if one category takes a larger percentage, the other percentages must fall. Lastly, point out that the table is a snapshot and that these numbers fluctuate a great deal.

B.

Crowding Out in a Closed Economy 50. Crowding out is the reduction in investment (or other components of GDP) caused by an increase in government spending.

51. A closed economy is an economy without international trade.

Remind students of the following key principle:

KEY PRINCIPLE: PRINCIPLE OF OPPORTUNITY COST The opportunity cost of something is what you sacrifice to get it.

52. Use a closed economy model (no trade) to study crowding out. a. Y = C + I + G (in a closed economy) b. Y is fixed in the long run unless there are changes to the labor market and/or technology. c. An increase in G with a fixed Y must be offset by a fall in C + I. C. Crowding Out in an Open Economy 53. An open economy is an economy with international trade. a. Y = C + I + G + NX (in an open economy) 54. In an open economy, with trade, domestic C and I need not be crowded out. Instead, NX could go down.

D. Crowding In Crowding in is the increase of investment (or other component of GDP) caused by a decrease in government spending.

55. A decline in government spending in long run causes other components such as I, C, or NX to increase.

56. The nature of changes in G will determine what components are crowded in/out.

 Teaching Tip Using various government Web sites, gather data on the trade deficit, budget deficit, and investment. Have the students compare interest rates and government deficits. Ask them about the relationships. A good Web site for macroeconomic data is at the St. Louis Fed: http://research.stlouisfed.org/fred2/.

Additional Applications to Use in Class Question: Why are durable goods an indicator of economic growth?

ADDITIONAL APPLICATION: ORDERS PLUNGE

U.S.

DURABLE

GOODS

Anonymous ―U.S. Durable Goods Orders Plunge‖ Posted 11/28/2006 on MSNBC.com FT.com Financial Times Summary: Key Points in the Article Durable goods posted their largest single monthly decline in more than six years during October 2006. New orders fell by 8.3 percent for the month. While the decline was worrisome, the previous two months posted gains that offset the drop. Economists indicated the volatility in durable goods failed to provide good information and that now more attention would fall on home

sales and consumer confidence numbers due later today. The Fed chairman, Ben Bernanke, was also expected to speak, and his comments were widely anticipated.

The breakdown in durable goods numbers failed to provide much hope for some analysts.

Nondefense durable good spending was down 44.5 percent. After excluding aircraft spending, the indicator fell by 5.1 percent. This number is thought to closely mirror overall business spending.

Analyzing the News Business spending on durable goods is seen as a positive sign for economic growth. Businesses don‘t tend to spend money in the face of an economic slowdown. Therefore, this component falling potentially indicates a greater slowdown than expected.

Thinking Critically Questions 1. Why is durable good spending monitored?

2. Why is nondefense spending a more valuable number?

3. Why are Ben Bernanke’s comments so anticipated?

Solutions to End-of-Chapter Exercises Chapter 7 SECTION 7.1: WAGE AND PRICE FLEXIBILITY AND FULL EMPLOYMENT 1.1 1.2 1.3 1.4

classical structural True cyclical

SECTION 7.2: THE PRODUCTION FUNCTION 2.1 2.2 2.3

labor input, output decreases downward

2.4 2.5

downward

2.6

2.7

Yes, this is diminishing returns.

SECTION 7.3: WAGES AND THE DEMAND AND SUPPLY FOR LABOR 3.1 3.2 3.3 3.4 3.5.

supplied right right False. a.

b.

3.6 3.7

The demand for unskilled workers will increase and their wages will rise.

It would reduce wages and increase employment, as the supply curve would shift to the right.

3.8

If an increase in the demand for labor raises wages, the Malthusian argument is that increases in population will shift the supply curve for labor to the right until wages fall back down to subsistence.

3.9. Improved technology will shift the demand curve for labor to the right, raising real wages.

This will eventually lead to a shift in the supply curve to the right, as population increases.

In the long run, population has increased while real wages return to subsistence levels.

SECTION 7.4: LABOR MARKET EQUILIBRIUM AND FULL EMPLOYMENT 4.1

4.2

4.3 4.4 4.5 4.6 4.7

True full employment output All else being equal, the economist who estimated natural unemployment to be lower would estimate a higher value for potential output.

The main cause is that average work hours per year are less in Germany than in the United States. If these were equalized, per capita output levels would be similar.

Potential output increases.

SECTION 7.5: USING THE FULL-EMPLOYMENT MODEL 5.1

5.2 5.3

Demand for labor shifts to the left, wages go down, and employment goes down. steam engine, electric lighting

5.4

5.5

Only top athletes or entertainers would be paying enough tax to make it worthwhile for them to relocate. For middle-class workers, the costs of relocation would exceed the tax savings. a.

b. Wages would fall, while employment and output remain unchanged. Economists say labor bears the full burden of the tax because there is no change in what employers experience; labor input and total expense of hiring (wages + tax) are the same. c. Employment and output fall, while wages remain unchanged. d. More elastic labor supply in Europe than in the United States or Japan would magnify the employment effects of payroll taxes in Europe.

5.6

5.7

Labor supply almost vertical suggests that workers cannot adjust employment in order to avoid payment of the higher payroll tax, leading to increased tax revenue collected by the government.

5.8 No, if there is a negative technology shock, output and real wages will both fall.

5.9 If fewer people sold stocks when the capital gains tax was increased, total revenue could actually fall even though the tax rate was increased.

5.10 This is the same as any negative technological shock. Potential output will fall and wages will fall.

SECTION 7.6: DIVIDING OUTPUT AMONG COMPETING DEMANDS FOR GDP AT FULL EMPLOYMENT 6.1 6.2 6.3 6.4 6.5

6.6 6.7

False open net exports high All of these factors contribute to borrowing which means that individuals do not have to save to make purchases. This reduces savings. In China, there are not extensive mortgage markets, so individuals must save more extensively to buy a house.

Increased spending on swimming pools would crowd out consumption; spending on space exploration could crowd out either investment or consumption spending.

In the 1980s, the savings went to domestic investment including infrastructure. In more recent times, the investment in infrastructure has decreased and the Singapore economy runs a large export surplus, which provides them with substantial financial resources to invest throughout the world.

Critical Thinking 1. Investment spending would increase capital and potential output. However, restricting immigration would lower the skilled labor force and reduce potential output.

2. This would likely force higher saving in the United States and reduce consumption.

3. This could crowd-in investment (by firms) and consumption (by individuals) relating to selfdriving cars. However, if the investment effect was small and consumption increased, it could overall crowd out investment.

8 Why Do Economies Grow?

Chapter Summary In this chapter, we explore the mechanisms of economic growth. Although economists do not have a complete understanding of what leads to growth, they regard increases in capital per worker, technological progress, human capital, and governmental institutions as key factors. In this chapter, we discuss these factors in detail. Here are the main points of the chapter:  Per capita GDP varies greatly throughout the world. Whether poorer countries in the world are converging with richer countries is subject to lively debate.  Economies grow through two basic mechanisms: capital deepening and technological progress. Capital deepening is an increase in capital per worker. Technological progress is an increase in output with no additional increases in inputs.  Ongoing technological progress will lead to sustained economic growth.  A variety of theories attempt to explain the origins of technological progress and determine how we can promote it. These theories include spending on research and development, creative destruction, the scale of the market, induced inventions, and education and the accumulation of knowledge.  Governments can play a key role in designing institutions that promote economic growth.  Investments in human capital are a key component of economic growth.

Learning Objectives: 8.1 Economic Growth Rates: Calculate economic growth rates.

8.2 Capital Deepening: Explain the role of capital in economic growth.

8.3 The Key Role of Technological Progress: Explain the importance of technological progress to economic growth.

8.4 What Causes Technological Progress? Discuss the sources of technological progress.

8.5 A Key Governmental Role—Providing the Correct Incentives and Property Rights: Assess the role of government in assisting economic growth.

Approaching the Material Continuing the theme of making economics personal, focus as much as you can on human capital and its effects on the economy. Students will be able to relate to how investing in themselves— education, training, new skill sets—will increase their ability to be more productive and earn more money. If the students understand this, you can then relate how economies are made up of individuals who become more productive. You can now add in capital goods and technological changes to explain growth.

Chapter Outline Capital Deepening = increases in the stock of capital per worker.

Technological Progress = more efficient ways of organizing economic affairs that allow an economy to increase output without increasing inputs.

Human Capital = the knowledge and skills acquired by a worker through education and experience and used to produce goods and services.

8.1 Economic Growth Rates A. Review 57. GDP measures the total value of final goods and services produced in a country. But it does not adjust for size of a country.

58. Real GDP per capita is the gross domestic product per person adjusted for changes in constant prices. It is the usual measure of living standards across time and between countries.

B. Measuring Economic Growth 59. Growth rates measure percentage rate of change of a variable from one period to another using the following formula:

growth rate 

GDP in year 2  GDP in year 1 GDP in year 1

60. The rule of 70 is a rule of thumb that says output will double in 70/x years, where x is the percentage rate of growth.

 Teaching Tip This is a good point to look at some examples of what this implies. Suppose your income went up by 3 percent a year. This implies your income will double in 23.33 years. But increasing that to 5 percent drops the doubling time to 14 years.

C. Comparing the Growth Rates of Various Countries 61. Comparing GDP across countries is difficult. a. Different currencies b. Different consumption patterns 62. Some economists have accounted for variations in the cost of living in different countries by: a. Collecting vast amounts of data on prices of comparable goods i. Same good ii. Same quality b. Using the prices of all these goods to adjust all prices in other countries to equivalent U.S. prices

D. Are the Poor Catching Up? 63. The very poor countries have extremely low figures.

 Teaching Tip GDP in poor countries may be underestimated because most poor farmers consume their production instead of selling it, and therefore, it is not included in GDP. 64. Growth rates vary quite dramatically across countries.

65. Convergence is the process by which poorer countries close the gap with richer countries in terms of real GDP per capita. Is there convergence, i.e., do poorer countries close the gap by growing faster? a. Evidence in favor of convergence is clear in developed economies. b. For less-developed countries, the picture is less clear. c. All in all, economists find only weak evidence in favor of convergence.

Review this key question and the related application:

Question 1: How may global warming affect economic growth?

APPLICATION 1: GLOBAL WARMING, RICH COUNTRIES, AND POOR COUNTRIES This Application explains how though many people believe that global warming will hurt economic development, research shows that the effects are more complex. Recent research by economists Melissa Dell, Benjamin Jones, and Benjamin Olken provides some useful insights. These include: If global warming can be deferred sufficiently far into the future, poorer countries will have opportunities to develop and perhaps be less subject to global warming trends. However, if global warming occurs relatively soon, then poor countries are likely to be adversely affected.

Review this key question and the related application:

Question 2: How can we persuade very poor people in developing countries to immunize their children?

APPLICATION 2: BEHAVIORAL INCENTIVES IN DEVELOPMENT Two economists describe how they used economic incentives in India to increase immunizations of children. Parents received dal (a common Indian food) and a set of cooking pans after completing the series of shots for their children. The incentives were effective in increasing the success rate for immunizations.

8.2 Capital Deepening One of the most important mechanisms for economic growth is an increase in capital per worker.

A. Recall from last chapter, that an increase in capital increases output even if labor does not change.

66. Additional capital shifts the production function up, increasing output.

67. Additional capital shifts labor demand out, increasing real wages.

68. An economy produces more per worker with more capital.

 Teaching Tip One easily understandable example is four people digging a hole. First, dig with their hands (no capital). Next, add a shovel and see what happens to output per worker. Now add another shovel and so on. This shows explicitly how output per worker rises as you increase capital per worker.

B. Saving and Investment The simple model of capital deepening looks at the relationship between saving (income that is not consumed) and investment.

69. Simple example of capital deepening a. Consider an economy with constant population, full employment, no government, and no foreign sector. b. Output is purchased for consumption or investment, and income is either consumed or saved. i. C + I = C + S ii. S = I c. The stock of capital depends on two factors: gross investment and depreciation.  Kt+1 = Kt + It  Depreciated Capital = Kt + Net investment d. Higher savings, i.e., higher investment, increases the capital stock, i.e., creates capital deepening.

C. How Do Population Growth, Government, and Trade Affect Capital Deepening?

70. Population growth: A larger labor force increases total output. But with a fixed capital stock, output goes up at a decreasing rate as it lowers output per worker.

71. India has the world‘s second largest population. But due to diminishing returns, output per capita in India is very low.

Remind students of the following key principle:

KEY PRINCIPLE: PRINCIPLE OF DIMINISHING RETURNS Suppose that output is produced with two or more inputs and that we increase one input while holding the other inputs fixed. Beyond some point—called the point of diminishing returns— output will increase at a decreasing rate.

 Teaching Tip Discuss the relationship between population and economic growth here—simply producing enough to feed a large population leaves little room for producing capital goods.

72. Government spending and taxation: suppose the government increases taxes to spend more on noninvestment goods and services. a. Higher taxes  lower income  lower private savings  lower investment  less capital deepening b. If the government spent the revenue on investment goods and services  more capital deepening 73. Foreign sector: A trade deficit made up of capital goods increases capital deepening.

74. Capital deepening has limits because of the principle of diminishing returns. a.

With a fixed labor force, an increase in capital increases output at a decreasing rate. b.

Since savings is related to output, savings increases at a decreasing rate. c.

However, if capital depreciates, an increase in the capital stock increases depreciation. See the appendix to this chapter for discussion of Solow growth model and the relationship between gross investment and depreciation. d.

There is a natural point where gross investment is equal to depreciation. K cannot increase above this point; higher savings rates increase investment, but higher capital increases depreciation more.

8.3 The Key Role of Technological Progress A. Technological progress is when an economy operates efficiently by producing more output without using inputs.

75. Invention of the light bulb, thermometer, disposable diapers, etc.

76. New ideas making us more effective

more more

 Teaching Tip A good example of a new idea is electricity. Not just the invention of electricity, but how it allowed factories to be reconfigured due to having the ability to move power around a factory easily.

B.

How do we measure technological progress?

77. Recall the production function: Y = F(K, L) 78. Robert Solow, a Nobel laureate from M.I.T., added a measure of technological progress, A: a. Y = F(K, L, A) 79. Growth accounting is a method to determine the contribution to economic growth from increased capital, labor, and technological progress. a. We observe Y, K, and L over time in most economies. b. How much of the change in Y is due to changes in K and changes in L? Whatever growth is left over must be due to A. This is called growth accounting.

C. Using Growth Accounting 80. Growth accounting can be used to understand different aspects of economic growth.

81. Look at the following applications for examples.

82. Labor productivity is the output produced per hour of work.

Review this key question and the related application:

Question 3: How can we use economic analysis to understand the sources of growth in different countries?

APPLICATION 3: SOURCES OF GROWTH IN CHINA AND INDIA China grew at a rate of 9.3 percent, while India grew at a rate of 5.4 percent. Employment grew at 2 percent per year in both countries so the difference must be attributed to capital deepening and technological progress. In particular, China‘s more rapid growth can be attributed to a more rapid accumulation of physical capital and more rapid technological progress.

Review this key question and the related application:

Question 4: Can we measure the productivity of large infrastructure investments?

APPLICATION 4: HOW IMPORTANT IS INFRASTRUCTURE? Spending on infrastructure, such as roads and bridges, is often recommended today. Investments in the railroads during the late 1800s greatly increased the productivity of farmers. However, some proposed projects are just a way for members of Congress to win votes by helping their constituents.

8.4 What Causes Technological Progress?

A. Research and development funding B. Monopolies that spur innovation: Creative destruction is the view that a firm will try to come up with new products and more efficient ways to produce products to earn monopoly profits.

83. Without the ability to reap the rewards of innovation, a company will not fund research and development.

84. The government grants patents to allow for temporary monopolies for 20 years.

C. The scale of the market: If markets are too small, there are not enough incentives to engage in technological progress.

D. Induced innovations: Many innovations are the result of a need to cut cost.

E. Education, human capital, and the accumulation of knowledge: Increasing the investment in human capital increases the productivity of the labor force.

F. New growth theory: modern theories of growth that try to explain the origins of technological progress.

Review this key question and the related application:

Question 5: How does the growth of very large cities contribute to economic growth?

APPLICATION 5: THE ROLE OF MEGACITIES IN ECONOMIC GROWTH

This Application discusses the important economic impact of large cities in the world. A concentrated population leads to specialization of labor as well as the production and sharing of new ideas. This extra productivity is referred to as ―agglomeration economies.‖ Large cities require a major investment in infrastructure in order to work well.

 Teaching Tip Now might be a good time to revisit production possibility curves, pointing out that poor countries have to devote most of their production capacity to food production, which leaves few resources for anything else. Therefore, they are not producing much capital, and the production possibilities curve does not move out over time.

Review this key question and the related application:

Question 6: Did culture or evolution spark the Industrial Revolution?

APPLICATION 6: CULTURE, EVOLUTION, AND ECONOMIC GROWTH In studying the economic history of England before the industrial revolution, Professor Gregory Clark found that the children of the more affluent were more likely to survive. Over time, they became a larger and larger portion of the population, bringing their social virtues such as thrift and hard work with them. This created a society more likely to embrace changes in science and technology, making the Industrial Revolution more likely.

8.5 A Key Governmental Role: Providing the Correct Incentives and Property Rights A. Governments play a critical role in a market economy by ensuring that contracts are upheld and that property rights are enforced.

B. This allows businesses and individuals to enter into economic transactions.

C. Without this, people are reluctant to trade and the incentive to innovate is muted.

 Teaching Tip World War II is a classic example of how war destroys the capital stock of a country and reduces its productive capacity. Explain to the students how much of the capital stock of Germany and Japan was destroyed during the war. With the help of the United States, huge investments of new capital took place in both countries leading to tremendous rates of economic growth in both countries. A discussion point with the students would be what is going to happen in post-war Iraq.

Review this key question and the related application:

Question 7: Why are clear property rights important for economic growth in developing countries?

APPLICATION 7: LACK OF PROPERTY RIGHTS HINDERS GROWTH IN PERU The Application points out that in many South American cities, the poor live in slums without any clear title to the real estate they occupy. A Peruvian economist, Hernando DeSoto, points out that without clear property rights, people are not willing to make long-term investments. Perhaps more importantly, they are unable to use property to borrow money.

Additional Applications to Use in Class Question: How is direct impact different than total impact?

ADDITIONAL APPLICATION: DEM CONVENTION BOOSTS DENVER MERCHANTS Briggs, Bill ―Dem Convention Boosts Denver Merchants‖ Posted 8/28/2008 on MSNBC.com MSNBC Summary: Key Points in the Article Denver business owners are smiling all the way to the bank after the Democratic National Convention (DNC). While several economists predict large gains from conventions, others point out the local customers are often ―crowded out‖ and negate the convention sales. Previous political convention cities back up the crowding-out theory. Boston, host of the 2004 DNC, posted a $150 million direct impact from the convention. However, subsequent studies indicated the impact was closer to $15 million after factoring in spending declines from locals and regular tourism.

However, Denver points out that Boston‘s mayor asked locals to stay home to relieve congestion, whereas Denver‘s mayor asked locals to come into town and participate. A full house in every restaurant and bar coupled with record sales appears to vindicate Denver‘s strategy. Critics still maintain that time will tell and when the numbers shake out the convention‘s impact will not be the $160 million that Denver‘s promoters promised. Proponents maintain they may be right…it may be even higher.

Analyzing the News More customers mean more unit sales and higher prices. Some businesses such as local hotels actually took the forecasts to heart and more than doubled their room rates. With occupancy at 100 percent, it is easy to see that their revenues and profits increased at least for that week.

Thinking Critically Questions 1. How can hotels increase their room rates and increase profits?

2. What is ―crowding out‖ in this sense?

3. How is direct impact different than total impact?

Question: How can privatizing help some countries?

ADDITIONAL APPLICATION: NATIONAL TREASURE Victor, David G ―National Treasure‖ Posted 4/17/2008 on Newsweek Summary: Key Points in the Article This article uses Mexico‘s state run oil company, Pemex, as a case study into why we should fear continued high prices for oil. Pemex has been, and continues to be, a cash cow for the Mexican government. However, the government‘s short-sighted approach has been to limit exploration and overall investment in Pemex and use the profits for other government interests. The company currently accounts for about 40 percent of Mexican government income.

Now Pemex‘s aging technology and existing oil fields are in decline and are impossible to fix given the political handcuffs the company faces. Managers are hampered by laws that won‘t allow external investors and political parties that have their own short-term interests in mind.

Mexico‘s plight seems ridiculous to most capitalists who understand risk taking and the potential rewards in the oil business, but the country‘s approach is not isolated. Brazil, Kuwait, Venezuela, and other oil-rich countries seem bent on making decisions that hamper the global supply of oil.

With two-thirds of the planet‘s oil controlled by various governments, it doesn‘t appear that supply issues will be resolved any time soon as demand for oil continues to escalate.

Analyzing the News Note that oil prices, like any other commodity, will continue to rise as long as demand increases are not met with increases in supply. And, if the author David Victor is right, supply may decrease as fields and technologies continue to age without additional investment.

Thinking Critically Questions 1. Why are the governments allowing the oil fields to decline?

2. Why do the people in these countries allow these shortsighted approaches to continue?

3. How would privatizing help these countries?

Appendix to Chapter 8: A Model of Capital Deepening The chapter alludes to the relationships between saving, depreciation, and capital deepening. The appendix presents a simple model of capital deepening that shows explicitly the links between saving, depreciation, and capital deepening. The model helps us to understand more fully the critical role that technological progress must play in economic growth. The main points of the appendix are:  Capital deepening, leading to economic growth and increased real wages, will occur as long as total saving exceeds depreciation.  Eventually, the process of capital deepening will come to a halt as depreciation catches up with total saving.  A higher saving rate will promote capital deepening, but eventually, the economic growth comes to an end as the economy reaches the new equilibrium.  Technological progress not only directly raises output, but it also allows capital deepening to occur.

8.1A A Model of Capital Deepening A. Simple model of capital deepening to focus on the relationships between savings, depreciation, and capital deepening developed by Robert Solow.

B. Look at Figure 8A.1 showing the production function. Recall that it exhibits the principle of diminishing returns.

Remind students of the following key principle:

KEY PRINCIPLE: PRINCIPLE OF DIMINISHING RETURNS Suppose that output is produced with two or more inputs and that we increase one input while holding the other inputs fixed. Beyond some point—called the point of diminishing returns— output will increase at a decreasing rate.

C. Assumptions of the Growth Model 85. Savings is a constant proportion of income and without government or a foreign sector, savings equals investment. Thus, investment is a constant proportion of income.

86. Capital depreciates at a constant rate.

D. Finally, look at changes in the stock of capital: 1. Savings (= sY) increases capital 2. Depreciation (= dK) decreases capital 3. So, the change in the stock of capital = sY – dK E. Now look at Figure 8A.3 which shows all of the relevant relationships together.

1. At K0, dK < sY, which means that the capital stock is growing.

2. This is also true at K1.

3. So, K continues growing until K = K*.

4. If K > K*, dK > sY and the capital stock decreases until K = K*.

5. K* is the long-run equilibrium capital stock.

F. Figure 8A.4 shows what happens if the savings rate rises.

1. Higher s leads to an increase in K and thus an increase in Y.

G. What happens with technological progress?

1. Better technology leads to an increase in K and thus an increase in Y. H. Summary of Basic Points of Solow Model (directly from the appendix) 1. Capital deepening, an increase in the stock of capital per worker, will occur as long as total saving exceeds depreciation. As capital deepening occurs, there will be economic growth and increased real wages.

2. Eventually, the process of capital deepening will come to a halt as depreciation catches up with total saving.

3. A higher saving rate will promote capital deepening. If a country saves more, it will have a higher output. But eventually, the process of economic growth through capital deepening alone comes to an end, even though this may take decades to occur.

4. Technological progress not only directly raises output, but also it allows capital deepening to continue.

Solutions to End-of-Chapter Exercises Chapter 8 SECTION 8.1: ECONOMIC GROWTH RATES 1.1 1.2 1.3 1.4 1.5 1.6

per capita real GDP lower False 17.5 This is a Web exercise.

From the data, the figures are Canada 24 percent, China 45 percent, and the United States 19 percent.

1.7 There would in fact be divergence. The rich would be growing faster than the poor and the gap would grow wider and wider in time.

1.8 6 percent 1.9 Yes, poor countries that have large agricultural exports are particularly vulnerable to increases in temperatures. But in 20 years, India is likely to be more developed and relatively less vulnerable to temperature increases.

1.10 The mere fact that someone visited the village could increase vaccination rates. You would want to do a controlled experiment where people would visit different villages, but some would give sweets and others would not.

1.11 The data does support the theory of convergence.

SECTION 8.2: CAPITAL DEEPENING 2.1 2.2 2.3 2.4 2.5 2.6 2.7

d. increase; decrease 180 True c.

It is false because an increase in the supply of capital will increase the demand for labor and raise real wages. It would, however, reduce the return to capital.

Total investment increases.

2.8

Yes, the foreign investors in mining are supplying capital to Australia. This is matched with a trade deficit that puts Australian dollars in foreign hands.

SECTION 8.3: THE KEY ROLE OF TECHNOLOGICAL PROGRESS 3.1 3.2 3.3 3.4 3.5 3.6

3.7 3.8 3.9

technological progress technological progress True True In both of these examples, capital (in the form of computers) are employed. Some of the benefits to consumers would be attributed to the increase in capital.

As discussed in the application, China had a higher rate of technological progress, consistent with higher levels of foreign investment. But if India now opens its markets, its rate of technological progress should increase as well.

These are examples of intangible capital. They are similar to research and development expenditures and are a form of capital.

Reduced transportation costs would be one example.

Employers have increasingly compensated employees in ways for which the employers have a comparative advantage (e.g., provision of group health insurance rather than wages).

Hence, health insurance is not provided ―free‖ to employees.

SECTION 8.4: WHAT CAUSES TECHNOLOGICAL PROGRESS? 4.1 4.2 4.3 4.4 4.5

Adam Smith False d. decrease Shorter patent terms will reduce investment in research and development activities, eventually reducing the supply of new drug products.

4.6 In a large city, there is a bigger market so there is more likely to be specialization. This specialization could lead to more creativity and chefs‘ focus on new and innovative dishes.

4.7 Since gasoline has become more expensive, the payoff for developing a good battery powered car increases and we should see more inventions.

4.8 Mass migration out of agriculture might have temporarily increased the real cost of food, depressing real wages and causing malnutrition and decreased average height.

4.9 At the age of 50, forgone earnings (opportunity costs) are very high and the time to recoup your investment in medical school is limited compared to someone who goes to school in their 20s or 30s.

4.10 The theory faces challenges in explaining East Asian growth as there are no obvious cultural changes that have occurred in recent years.

SECTION 8.5: A KEY GOVERNMENTAL ROLE: PROVIDING THE CORRECT INCENTIVES AND PROPERTY RIGHTS 5.1 5.2 5.3 5.4 5.5 5.6

False d.

False True With less investment in human capital, growth will likely be less.

The reduced supply of educated workers increases the wage paid to educated workers and increases incentives for acquisition of education. The hypothesis can be tested by comparing the change in wages paid to educated workers with rates of emigration by educated workers.

5.7 Increased labor income allows parents to buy food in a market instead of producing it at home, freeing the children from producing food.

Critical Thinking

1.

2.

3.

It would be better to live in Economy A. Economy B has more capital accumulation, so it has more savings. But this means less consumption, so residents of Economy A have higher consumption levels.

These are the agglomeration economies discussed in the text. Larger markets allow more specialization and more face-to-face interaction to generate new ideas.

In the simple model, higher population leads to lower per capita output because of diminishing returns. But with higher population, you may have larger markets (which allow specialization) and more new ideas. Both of these factors lead to higher growth.

Chapter 8 Appendix 1.

2.

3.

4.

saving, depreciation b.

False Destruction of capital in Japan and Germany reduced capital per worker, causing saving to exceed depreciation and capital per worker to increase.

5.

Increased depreciation rate reduces the equilibrium capital stock and the equilibrium level of output.

9 Aggregate Demand and Aggregate Supply Chapter Summary In this chapter, we discuss how sticky prices—or lack of full wage and price flexibility—cause output to be determined by demand in the short run. We develop a model of aggregate demand and supply to help us analyze what is happening or has happened in the economy. Here are the main points of the chapter:  Economists think of GDP as being determined primarily by demand factors in the short run.  The aggregate demand curve depicts the relationship between the price level and total demand for real output in the economy. The aggregate demand curve is downward sloping because of the wealth effect, an interest rate effect, and an international trade effect.  Decreases in taxes, increases in government spending, and increases in the supply of money all increase aggregate demand and shift the aggregate demand curve to the right.

Increases in taxes, decreases in government spending, and decreases in the supply of money all decrease aggregate demand and shift the aggregate demand curve to the left. In general, anything (other than price movements) that increases (decreases) the demand for total goods and services will increase (decrease) aggregate demand.  The total shift in the aggregate demand curve is greater than the initial shift. Their ratio is known as the multiplier.  The aggregate supply curve depicts the relationship between the price level and the level of output firms supply in the economy. Output and prices are determined at the intersection of the aggregate demand and aggregate supply curves.  The long-run aggregate supply curve is vertical because, in the long run, output is determined by the supply of factors of production. The short-run aggregate supply curve is fairly flat because, in the short run, prices are largely fixed and output is determined by demand.  Supply shocks can shift the short-run aggregate supply curve.  The short-run aggregate supply curve shifts in the long run, restoring the economy to the full employment equilibrium.

Learning Objectives: 9.1 Sticky Prices and Their Macroeconomic Consequences: Explain the role sticky wages and prices play in economic fluctuations.

9.2 Understanding Aggregate Demand: List the determinants of aggregate demand.

9.3 Understanding Aggregate Supply: Distinguish between the

9.4

short-run and long-run aggregate supply curves.

From the Short Run to the Long Run: Explain how the shortrun aggregate supply curve shifts over time.

Approaching the Material Many students will find this chapter difficult. Take your time with the material. One good approach is to use individual businesses and consumers to illustrate reactions to changes in prices, taxes, and other macroeconomic measures. You can then point out that when we talk about the economy as a whole, it is simply the aggregation of all these individual businesses and consumers.

 Teaching Tip A good example to use throughout this chapter is a restaurant. In the short run (any given night), the restaurant‘s prices are fixed for meals. So, the number of meals produced depends on how many people come in on a given night. In other words, it is determined by demand. In the long run, the restaurant will change the price of meals to optimally fill the restaurant (produce at potential). If there is a change in the size of the restaurant, the LRAS curve moves.

Chapter Outline 9.1 Sticky Prices and Their Macroeconomic Consequences In the long run, we assume that there is no business cycle.

Therefore, there are no recessions. The Great Depression led economists to investigate how an economy can move away from potential output for long stretches of time.

A. Flexible and Sticky Prices 1. Normally, the price system coordinates what goes on in an economy. a. Who does what? b. What resources to use? c. How much to make? d. From whom to buy?

2. But prices do not adjust immediately; they are sometimes ―sticky.‖ a. Wages adjust slowly. b. Therefore, prices also adjust slowly.

B. How Demand Determines Output in the Short Run 1. Price stickiness requires alternative rules to coordinate economic activity. a. In general, workers and firms let demand determine the level of output in the short run. b. Firms often negotiate long-term contracts (with both suppliers and laborers) that set prices in the short run and allow output to fluctuate.

2. Short-run in macroeconomics is the period of time in which prices do not change or do not change very much.

 Teaching Tip Magazines are a good example of sticky prices. Ask the students what magazines they read on a regular basis. Ask them how often the price changes.

Review this key question and the related application:

Question 1: What does the behavior of prices in consumer markets demonstrate about how quickly prices adjust in the U.S. economy?

APPLICATION 1: MEASURING PRICE STICKINESS IN CONSUMER MARKETS This Application is about how economists have taken a number of different approaches to analyze the behavior of retail prices.

Anil Kashyap of the University of Chicago examined prices in consumer catalogs. He found that prices in consumer catalogs are quite sticky, while others change more frequently.

 Teaching Tip Now is a good time to ask students what it ―costs‖ to change prices.

9.2 Understanding Aggregate Demand A. What Is the Aggregate Demand Curve? The aggregate demand curve is a curve that shows the relationship between the level of prices and the quantity of real GDP demanded.

B. The Components of Aggregate Demand (AD) 1. AD = C + I + G + NX C. Why the Aggregate Demand Curve Slopes Downward 1. The wealth effect is the increase in spending that occurs because the real value of money increases when the price level falls. a. AD is downward sloping because a change in the price level changes the purchasing power of money held by the public.

Remind students of the following key principle:

KEY PRINCIPLE: THE REAL-NOMINAL PRINCIPLE What matters to people is the real value or purchasing power of money or income, not the face value of money or income.

2. The interest rate effect is the decrease in spending that occurs because a rise in prices increases interest rates and hence reduces interest-sensitive spending.

3. The international trade effect is a decrease in spending that occurs because a rise in prices makes domestic goods more expensive relative to foreign goods and hence reduces net exports.

 Teaching Tip It is very important that students understand that the reason for the downward slope of the aggregate demand curve is completely different than the reason for the downward slope of the demand curve for a given good. The one good demand curve slopes down because people substitute away from a good when it becomes more expensive. The aggregate demand curve slopes down because people become less wealthy when the price level rises. Spend extra time explaining this concept.

D. Shifts in the Aggregate Demand Curve 1. Changes in money supply a. Increase M => increase AD 2. Changes in taxes: a. Increase T => decrease AD 3. Changes in government spending: a. Increase G => increase AD 4. Other factors a. Foreign income b. Business and consumer confidence E. How the Multiplier Makes the Shift Bigger 1. An increase in desired spending shifts aggregate demand by more than the increase; the multiplier is the ratio of the total shift in aggregate demand to the initial shift in aggregate demand.

2. Consumption function is the relationship between the level of income and consumer spending (C). a. C = Ca + by b. Autonomous consumption spending (Ca) is the part of consumption spending that does not depend on income. c. Marginal propensity to consume (MPC, b) is the fraction of additional income that is spent, MPC = additional consumption /additional income. d. Marginal propensity to save is the fraction of additional income that is saved.

3. Multiplier = 1/(1 – MPC) a. If MPC = 0.9, Multiplier = 1/(1 – 0.9) = 10.

4. Use the multiplier to see the effect of a change in G. a. Change in G = 400 b. MPC = 0.8 c. Multiplier equals 1/(1 – 0.8) = 5 d. Change in Y = 400 × 5 = 2000 Review this key question and the related application:

Question 2: How can we determine what factors cause recessions?

APPLICATION 2: TWO APPROACHES TO DETERMINING THE CAUSES OF RECESSIONS This Application discusses how economists have used the basic framework of aggregate demand and supply analysis to explain recessions. Recessions can occur either when there is a sharp decrease in aggregate demand—a leftward shift in the aggregate demand curve—or a decrease in aggregate supply—an upward shift in the short-run aggregate supply curve. The two approaches economists have used to study recessions include using economic models or more traditional historical methods. These studies have shown that recessions are caused by many different factors, including both supply and demand shocks.

9.3 Understanding Aggregate Supply A. The aggregate supply curve is a curve that shows the relationship between the level of prices and the quantity of output supplied.

B. The long-run aggregate supply curve is a vertical aggregate supply curve that represents the idea that in the long run, output is determined solely by the factors of production.

1. Full-employment output, yP, depends solely on the supply of factors, capital and labor, and the state of technology.

2. Full-employment output is independent of the price level, and the long-run aggregate supply curve is vertical.

3. Interaction of LRAS and AD a. Long-run aggregate supply  output b. Aggregate demand  price level C. The short-run aggregate supply curve is a relatively flat horizontal supply curve that represents the idea that prices do not change very much in the short run and that firms adjust production to meet demand.

1. In the short run, prices are sticky, and output is determined by aggregate demand.

2. Sticky prices mean a relatively flat aggregate supply.

3. Interaction of SRAS and AD determines output and the price level at any point in time.

4.

Changes in AD mainly result in changes in output in the short run.

5. Over time, the short-run aggregate supply curve can shift a. If there is pressure on wages and prices to fall. b. In the long run, SRAS will shift down to reflect the adjustment of prices.

 Teaching Tip One way to explain the difference between long-run aggregate supply and shortrun aggregate supply is to remind students that output is determined by supply in the long run and by demand in the short run. Go back to the restaurant example and discuss what happens in a restaurant on a given night if more customers show up than expected (more meals are served). However, if this continues, the restaurant will raise prices in response to the increased customers.

 Teaching Tip Now is a good time to review how expectations impact economic activity. As business and consumer expectations change, there is an effect on aggregate demand. In the Application, much of the change in expectations was due to the unpredictability of output.

Review this key question and the related application:

Question 3: Is the U.S. economy still susceptible to oil price increases?

APPLICATION 3: OIL PRICE INCREASES ECONOMY

AND THE CHANGING U.S.

The United States imports a smaller amount of petroleum products today than it did in the past, for a variety of reasons. In addition, it is now a net exporter of these products. As a result, the U.S. economy is less vulnerable to oil supply shocks than it was in the 1970s.

D. Supply shocks are external events that shift the aggregate supply curve.

1. Oil prices rose in 1973 and 1979.

2. Firms had to raise prices to maintain profit levels.

3. The effect is a rise in prices and fall in output.

4.

Stagflation is a decrease in real output with increasing prices.

 Teaching Tip A good way to make this concept real to students is to ask them what percentage of their spending is on gasoline and how gasoline price changes impact the rest of their spending.

 Teaching Tip One way to explain supply shocks is to discuss the impact of an extended period of little or no rain on a farm economy. Fewer crops mean higher prices as well as fewer farm workers employed.

9.4 From the Short Run to the Long Run A. SRAS and AD intersect at y = y0 > yp, there is a boom: Output exceeds potential and unemployment is very low.

B. This will make it hard to hire workers, so wages and prices will rise.

C. As prices rise, the SRAS curve shifts up and short-run output falls until y = yp.

D. This process happens anytime that y > yP. E. The reverse happens if y < yP.

 Teaching Tip A May 2005 article in Businessweek reported the following information from a survey conducted by the National Association for Business Economics: • a ―robust‖ outlook for capital spending • a second consecutive quarterly improvement in employment conditions • an improved outlook for hiring in the next six months

What would you predict would happen to output and prices? What actually happened?

Additional Applications to Use in Class Question: Can a stimulus plan have long-range effects?

ADDITIONAL APPLICATION: DEMS AMONG STIMULUS PLAN SKEPTICS MacGillis, Alec "Dems Among Stimulus Plan Skeptics" MSNBC.com The Washington Post Summary: Key Points in the Article The massive $825 billion stimulus package has many Republicans and Democrats questioning whether it will deliver the jobs as promised. President Obama maintains the plan that will accomplish both short-term stimulus and begin a long-term transformation of the U.S. economy.

However, many critics contend those two goals may be conflicting.

Longer-term ―New Deal‖ like programs, such as high-speed rail and alternative energy spending, are not ―shovel ready.‖ These projects take longer to get the money into circulation, and economic stimulus needs to be immediate. While many applaud the efforts as a beginning, it appears that spending $825 billion in a rapid fashion may be harder to do than ever envisioned.

Analyzing the News The purpose of the stimulus is to shift aggregate demand (AD) to the right. That would increase output and push the economy closer to full employment. However, one fact that bears mentioning is that there will be some type of lag effect. The impact may not be as immediate as lawmakers would like to see. Note also that one possible consequence of this is also an increase in prices.

Thinking Critically Questions 1. Why is it possible the stimulus package might not generate long-term benefits?

2. What types of spending might have a longer-term impact?

3. What will happen when the initial injection is spent?

Question: How would an emissions tax designed to reduce carbon dioxide impact the economy?

APPLICATION: GLOBAL WARMING VERSUS ECONOMIC GROWTH Robert J. Samuelson ―Samuelson: The Dilemma of Global Warming vs. Economic Growth‖ Posted on MSNBC.com Newsweek Summary: Key Points in the Article

The British government released a report conducted by Nicholas Stern, the former chief economist for the World Bank, which paints a dire picture of Earth‘s future. According to Stern, global warming will ultimately result in a global depression with output falling more than 20 percent. Additionally, many of the planet‘s coastal cities will be under water. Stern advocates massive government intervention in order to curb greenhouse gas emissions and prevent the environmental disaster.

Robert Samuelson disagrees with the negative rhetoric and the fact that anything will actually be done about the problem. He maintains that there are no economically feasible and/or politically acceptable ways to cut greenhouse gases. Politicians like to talk about the issue, but none will be willing to take the drastic steps necessary to solve a problem that may not even occur in their lifetimes.

Samuelson also goes on to state that it would require all countries, rich and poor alike, to pledge to reduce emissions and actually follow through on those pledges. History does not indicate that this scenario is likely. Samuelson also maintains the cost is much higher than Stern indicates and that the subsequent economic slowdown associated with curbing emissions might be worse than the unknown impact of global warming.

Graphing It Out

Analyzing the News Note that the imposition of a tax on emissions would shift the AD curve to the left as shown in the graph. A tax reduction would have the opposite impact and increase AD. Thinking Critically Questions 1. How would an emissions tax designed to reduce carbon dioxide emissions impact the economy?

2. What possible economic policy might stimulate the economy while combating the supposed global warming?

3. What are the government factors that would result in an increase in aggregate demand?

Solutions to End-of-Chapter Exercises Chapter 9 SECTION 9.1: STICKY CONSEQUENCES 1.1 1.2 1.3 1.4

1.5 1.6 1.7 1.8

PRICES

AND

THEIR

MACROECONOMIC

custom labor False a. slowly b. quickly c. slowly d. quickly Internet shopping has already altered pricing of almost all goods, but it is unlikely very soon to alter pricing in highly specialized services, such as heart surgery.

When they are under contract, the athletes have sticky wages but they become flexible when they become free agents.

The production of mops involves more long-term labor than does tomatoes. Moreover, weather makes harvests of tomatoes more variable.

High inflation affects the prices of inputs, making output price changes necessary.

SECTION 9.2: UNDERSTANDING AGGREGATE DEMAND 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9

d. wealth right 1/(1-0.6) = 2.5 smaller Shifts to left The marginal propensity to save is 40/200 = 0.2. The marginal propensity to consume is 160/200 = 0.8. Note that both marginal propensities add up to one.

The multiplier increases as the MPS decreases. Therefore, Country B has a higher multiplier.

These actions will all be contractionary and shift the aggregate demand curve to the left.

SECTION 9.3: UNDERSTANDING AGGREGATE SUPPLY 3.1 3.2 3.3 3.4

vertical downward decrease, not change decrease, increase 3.5 It is a decrease in aggregate demand and would shift the aggregate demand curve to the left.

3.6 The key to the answer is to look at what happened to aggregate demand and aggregate supply. If the party in power is correct, then there should be both a decline in output and an increase in prices. If the opposition is correct, then there should be both a decline in output and a decline in prices.

3.7 We now produce more of our own oil and petroleum products so there is a benefit from oil price increases to our producers which can offset the effects of some of the shocks.

3.8 With slower economic growth in China, there is less opportunity for exports to China so aggregate demand in the rest of the world will decline.

3.9 It would have no long-run effect on output.

SECTION 9.4: FROM THE SHORT RUN TO THE LONG RUN 4.1 4.2 4.3 4.4 4.5 4.6

4.7

increase, increase, increase, be unchanged decrease, decrease, decrease, be unchanged Real GDP will be below potential and unemployment exceeds the natural rate. Wages are pushed down, and the aggregate supply curve moves down. below, too high, down, downward It is a supply shock because as it reduces economic efficiency, it will mean higher prices for the same amount of costs.

After aggregate demand increases, the economy is operating beyond full-employment and wages begin to increase. This shifts up the short-run aggregate supply curve. Thus, the initial increase in demand caused the ―cost-push‖ inflation.

It would shift to the right.

Critical Thinking 1.

If you react too quickly, you may just purchase goods without shopping.

Moreover, the Internet sales companies will know this and could put in higher prices.

All these factors suggest that prices may not change that much.

2.

This would lead to an increase in exports and shift the AD curve to the right.

The groups that liked the old policy were domestic consumers of oil because more supply was forced onto domestic markets.

3.

It matters because it determines how long the economy will

be away from full employment. Anything that increases wage flexibility would speed up the adjustment process.

10 Fiscal Policy Chapter Summary Chapter 10 covers how governments can use fiscal policy—changes in taxes and spending that affect the level of real GDP—to stabilize the economy. Here are the main points of the chapter:  Changes in government spending and taxation can, in principle, stabilize the economy.  Stabilizing the economy through the use of fiscal policy is easier in theory than in reality.  Government spending and taxation are tools of fiscal policy.  There are controversies surrounding the federal deficit and ―deficit spending.‖  A review of public views about the role of the federal government beginning with the Great Depression of the 1930s.

Learning Objectives: 10.1 The Role of Fiscal Policy: Explain how fiscal policy works using aggregate demand and aggregate supply.

10.2 The Federal Budget: Identify the main elements of spending and revenue for the U.S. federal government.

10.3 Fiscal Policy in U.S. History: Discuss the key episodes of active fiscal policy in the United States since World War II.

Approaching the Material This is a chapter that works well with the personal approach. The students in the classroom are part of the national economy. They are subject to tax policies and spending programs. Each of the students has either paid income taxes or at least heard people talk about them. Each has paid sales tax. Most colleges and universities receive at least some federal money in the form of scholarships or other means. So, the students should also be aware of government spending in this way.

Chapter Outline 10.1 The Role of Fiscal Policy Fiscal policy can be defined as changes in government taxes and spending that affect the level of GDP. A. Fiscal Policy and Aggregate Demand 1. An increase in government spending or a decrease in taxes

will increase aggregate demand and shift the AD curve to the right.

2. A decrease in government spending or an increase in taxes will decrease aggregate demand and shift the AD curve to the left.

3. Changes in government spending affect aggregate demand directly because it is a direct component of AD (Y = C + I + G + NX).

4. Changing taxes affects aggregate demand indirectly. a. Changing taxes on income causes changes in the level of consumption, one of the four components of aggregate demand. b. Changing taxes on businesses changes their incentives regarding investment spending: another component of aggregate demand.

5. Government policy actions that lead to increases in aggregate demand are called expansionary policies.

6. Government policy actions that lead to decreases in aggregate demand are called contractionary policies.

7. The use of fiscal policy is straightforward with regards to stabilizing the economy through the use of fiscal policy but the implementation of effective policy is much more difficult.

 Teaching Tip It‘s always worthwhile to review the AD/AS model as this is the first application chapter for the model.

B. The Fiscal Multiplier 1. The existence of the multiplier allows for a greater total shift of the AD curve than the initial change.

2. The multiplier works through the impact on household income and thus consumption spending following an initial shock to aggregate demand.

3. The size of the multiplier is dependent on the size of the marginal propensity to consume.

4. Government policies designed to stabilize the economy must take into consideration the impact of the multiplier on their effects.

C. The Limits to Stabilization Policy Stabilization policies are policy actions taken to move the economy closer to full employment or potential output.

1. Both expansionary and contractionary policies are considered stabilization policies.

2. Stabilization policies are designed to bring the economy closer to full employment or potential output.

3. Stabilizing the economy is difficult due to lags or delays in policy actions and the inability of economists to accurately forecast the direction of the economy.

4. Lags complicate the ability of policymakers to properly time their stabilization attempts. a. Properly timed policies dampen business cycle

fluctuations, while ill-timed policies magnify such swings of real GDP around full employment.

5. Lags can be divided into inside and outside lags.

6. Inside lags are the time it takes to formulate a policy. a. One reason for an inside lag is the lag due to identifying and recognizing a problem. b. A second reason for an inside lag is the lag due to politics between members of Congress and the president.

7.

Outside lags are the time it takes for the policy to actually work. a. Consumers and businesses make plans for future spending and investing. b. Changes in government taxes or spending are delayed while consumers and businesses change their plans.

8. Econometric models are used to predict the impact of policy actions as well as their attendant lags.

9. Many forecasting uncertainties make the implementation of properly timed policies very difficult.

 Teaching Tip Get students to see that fiscal policy depends on many things, including having most of the U.S. Senators, Representatives, and the president agreeing on estimates of current GDP levels in relation to full employment, economic forecasts, and the impact of tax/spend changes. Further complications are derived from the other purposes for federal government legislation, such as income redistribution.

Review this key question and the related application:

Question 1: Why are the United States and many other countries facing dramatically increasing costs for their government programs?

APPLICATION 1: INCREASING LIFE EXPECTANCY POPULATIONS SPUR COSTS OF ENTITLEMENT PROGRAMS

AND

AGING

This Application points out that due to increased life expectancies, aging population, and new medical technologies, the percentage of the federal budget that is spent on retirement and health programs is expected to grow dramatically. It has been predicted that spending on health programs will grow from its current 10 percent to 22 percent of total expenditures by 2075.

Possible solutions include raising taxes and/or cutting entitlement programs.

10.2 The Federal Budget

 1. The federal government works on a fiscal year running from Oct. 1 to Sept. 30.

A. Federal Spending Discretionary spending is the spending programs that Congress authorizes on an annual basis.

Entitlement and mandatory spending is the spending that Congress has authorized by prior law, primarily providing support for individuals.

Social Security is a federal government program to provide

retirement support and a host of other benefits.

Medicare is a federal government health program for the elderly.

Medicaid is a federal and state government health program for the poor.

1. Total federal government spending is divided into expenditures and transfer payments with only the former included in GDP. 2. Expenditures are spread among discretionary, entitlements, and mandatory spending.

3. Discretionary spending, broadly divided into defense and nondefense, includes programs authorized by Congress on an annual basis.

4. Entitlements and mandatory spending are the result of prior legislation.

5. Included in entitlements and mandatory spending are Social Security, Medicare, and Medicaid.

6. Means-tested programs are programs where the amount paid is determined by the income of the recipient.

7. Net interest is the interest paid to the public on debt and savings bonds.

 Teaching Tip Students should see that much of current and future government spending (such as Social Security and Medicare) has already been predetermined due to past legislative promises. Furthermore, promises related to Social Security and Medicare will continue to take ever-larger shares of government spending.

B. Federal Revenues 1. The federal government earns its revenues from taxes levied on individuals and corporations. (See Table 10.2 for a breakdown of the sources of federal revenue.)

2. Individual taxes are assessed on income earned by individuals.

3. Social insurance taxes pay for Social Security and Medicare.

4. Corporate income taxes are levied on the income of corporations.

5. Estate, excise, and miscellaneous taxes are the remaining sources of revenues.

 Teaching Tip Note for students that the relationship between individual income and social insurance taxes has evolved greatly, with the latter increasing to near-equality with the former. In the mid-1960s, income taxes were larger by 2:1.

6. Supply-side economics and the Laffer curve. a. Supply-side economics is a school of thought

that

emphasizes the role that taxes play in the supply of output in the economy. b. The Laffer curve shows a relationship between the tax rates and tax revenues that illustrates that high tax rates could lead to lower tax revenues if economic activity is severely discouraged (named after Arthur Laffer). c. Although conceivable, the Laffer curve is not seen as applicable to broad-based income or payroll taxes.

 Teaching Tip Now is a good time to have a discussion about how government tax revenue is a function of how well (or poorly) the economy is performing. This will help illustrate that budget forecasts also depend on the state of the economy.

C. The Federal Deficit and Fiscal Policy 1. The budget deficit is the amount by which government spending exceeds revenues in a given year.

2. A budget surplus is the amount by which government revenues exceed government expenditures in a given year.

D. Automatic Stabilizers 1. Automatic stabilizers are taxes and transfer payments that stabilize GDP without requiring policymakers to take explicit action.

2. If the economy enters a recession, an increased budget deficit acts as an automatic stabilizer.

3. Increased transfer payments and decreased taxes paid by individuals and corporations all act to cushion the impact of the recession.

4. The opposite occurs during expansions, as increased taxes and decreased transfer payments help to dampen economic activity.

E. Are Deficits Bad? 1. Over the course of the business cycle, revenues and spending change, and deficits can occur during recessions.

2. Although this is the right policy, persistent deficits not related to a slowing economy can have long-term negative effects.

3. Future growth is reduced if persistent deficits cause a crowding out of private consumption and investment.

Crowding out is the reduction in a component of GDP that results when government spending is increased or taxes are decreased. It is an example of one of the key principles— opportunity cost.

Remind students of the following key principle:

KEY PRINCIPLE: PRINCIPLE OF OPPORTUNITY COSTS The opportunity cost of something is what you sacrifice to get it.

Review this key question and the related application:

Question 2: How does Congress account for the dynamic effects of its policies?

APPLICATION 2: DYNAMIC SCORING The Joint Tax Committee (JCT) estimates how revenues will change when taxes are changed. In the past, the JCT only considered the microeconomic effects of tax cuts.

Today, by taking the macroeconomic effects into account, it hopes to give more accurate estimates.

This is known as dynamic scoring.

By looking at the dynamic effects, the JCT estimates that President Trump’s tax cuts will not increase the deficit as much.

10.3 Fiscal Policy in U.S. History A. The Depression Era 1.

Fiscal policy was discussed and debated during the 1920s and 1930s.

2.

It is a mistaken belief, however, to associate Depression-era government with modern ideas regarding fiscal policy.

3.

Only during 1931 and 1936 did the government use expansionary fiscal policy, and only then over the objections of Presidents Hoover and Roosevelt.

4.

The impediment to utilizing expansionary policy was the overriding fear regarding budget deficits.

B. The Kennedy Administration  1. Modern fiscal policy truly begins with the Kennedy administration during the 1960s.  2. Unemployment was 6.7 percent when Kennedy took office.  3. Walter Heller, chairman of the president‘s Council of Economic Advisors, recommended tax cuts intended to bring the economy back to full employment, estimated at 4 percent.  4. Tax rates were extremely high, with the top individual rate at 91 percent and the top corporate rate at 52 percent, compared to today‘s sub-40 percent for both.  5. The budget deficit was also only 1 percent of GDP with projections of a reduction following the stimulated growth related to the tax cuts.  6. Enacted in 1964, the Kennedy tax cuts occurred after his assassination.  7. From 1963 to 1966, real GDP growth exceeded 4 percent annually.

C. The Vietnam War Era  1. This era can be marked by the increased military spending attendant with the fighting in Vietnam during 1966–1969.  2. Unemployment fell below 4 percent by the end of this period.  3. Policymakers enacted a 10 percent tax surcharge intended to slow consumption and cool an over-heating economy.  4. This temporary surcharge had less impact on consumption than estimated as consumers rightly saw this as temporary.  5. Consumption behavior is more a function of permanent income than current income.



    

6. Permanent income is an estimate of a household‘s long-run average level of income.  7. Mild tax cuts during the 1970s, following the 1973 recession, had little impact on the economy.

D. The Reagan Administration  1. The large tax cuts in 1981 were not intended to increase aggregate demand as much as they were designed to enhance aggregate supply.  2. Consumption did increase, however, and the economy recovered from its deepest recession(s) since the Depression.  3. The large deficits of the mid-1980s quelled demand for such large fiscal policy initiatives.

E. The Clinton and George W. Bush Administrations  1. An early term stimulus package proposed by President Clinton was defeated.  2. Clinton passed a large tax increase that allowed for balanced budgets and even small surpluses by the end of the 1990s.  3. During the first year of President Bush‘s term, he enacted a large tax cut package.  4. Consumers actually used much of the tax rebate to increase savings, not consumption.  5. Following September 11, 2001, the Bush administration and Congress enacted large spending plans meant to stimulate the economy in light of the terrorist attacks and the concomitant recession.  6. In late spring 2003, President Bush passed a further set of tax cuts meant to stimulate economic activity, in particular investment spending.  7. Large deficits returned by 2003.

F. The Obama and Trump Administrations 1.

In 2008, President Bush and Congress used tax rebates and some investment incentives to deal with a slowing economy.

2.

In 2009, President Obama and Congress enacted the largest stimulus package in U.S. history, which proved to be controversial.

3.

By fiscal year 2011, the deficit was much higher than usual historical levels.

4.

In December 2017, President Donald Trump signed into law a major tax cut for individuals as well as businesses. The Congressional Budget Office predicted that the level of debt held by the public would rise drastically. This could potentially lead to higher inflation.

Review this key question and the related application:

Question 3: Was the fiscal stimulus in 2009 successful?

APPLICATION 3: HOW EFFECTIVE WAS THE 2009 STIMULUS? This application discusses the American Recovery and Reinvestment Act, the largest fiscal stimulus in U.S. history. Many economists believe it had a significant impact on the economy. Economist John Taylor, however, believes it was ineffective. He found little evidence that the temporary tax cuts stimulated consumption but instead were saved. He also found that state and local governments increased spending on transfer programs but reduced their spending on goods and services. There is still disagreement among economists as to the effectiveness of the stimulus package. It is difficult to predict what state and local governments would have done if there hadn’t been a stimulus package.

Additional Applications to Use in Class Question: What would be a ―fair‖ tax system?

ADDITIONAL APPLICATION: MOST AMERICANS FIND TAX SYSTEM UNFAIR Anonymous ―Poll: Most Americans Find Tax System Unfair‖ Posted 4/15/2006 on MSNBC.com The Associated Press Summary: Key Points in the Article Fifty-eight percent of the American public believes the current U.S. income tax system is unfair.

The general consensus is that middle class individuals and small businesses pay too much in taxes and that the wealthy and big businesses pay too little in taxes. The overall opinion remains largely the same as it was two decades ago in spite of numerous changes to the tax code.

The poll results show that most people also believe the poor bear a larger tax burden than they should. All of this information comes at a time when the current Bush administration is attempting to make tax cuts for wealthier individuals, and also businesses, permanent. The bipartisan battle on tax policy will likely continue in the face of growing budget deficits.

Graphing It Out

Analyzing the News It is possible that lowering taxes will increase income and lower the deficit. The Laffer curve shows the proposed relationship between the tax rate expressed as a percentage and the total tax revenues such percentages should generate. Note that tax revenues are maximized at some rate T and begin to fall at higher tax rates. If the Laffer curve is correct, total tax revenues may fall if the tax rate gets too high because high tax rates create disincentive to earn more money. Therefore, as supply-side economists believe, it is possible to make everyone better off with a tax cut.

Thinking Critically Questions  1.

Why does the Bush administration favor tax cuts?  2.

Why are lower taxes such a hot button issue?  3.

How is the debt financed?

Question: How do entitlement programs affect the economy?

ADDITIONAL APPLICATION: OBAMA PLEDGES ENTITLEMENT REFORM Shear, Michael D. ―Obama Pledges Entitlement Reform‖ Posted 1/16/2009 on MSNBC.com The Washington Post Summary: Key Points in the Article President-elect Obama has his work cut out for him. While pressing for passage of the $825 billion economic stimulus package and another $350 billion of the TARP money, he acknowledged the financial challenges ahead. Government entitlement programs threaten to derail the U.S. budget.

Social Security will face a significant financial strain in the next 20 years as waves of baby boomers begin to retire. In fact, beginning in 2011, the system will take in less money than it pays out. However, even more problematic is Medicare because of the skyrocketing cost of health care. Medicare spending will double in the next 20 years and the program will be insolvent in 10 years.

Obama has pledged to host a financial summit almost immediately on entering office to begin to tackle these issues. However, first priority is to get the economy moving again and many now question whether the stimulus package is even large enough to do that.

Analyzing the News Obama faces greater challenges than any president since Franklin Roosevelt, given the current economic forecasts. Some are even predicting a deeper and longer trough than the Great Depression. Time will tell whether Obama has enough tools at his disposal to challenge the economic decline.

Thinking Critically Questions 1. What is the purpose of the fiscal stimulus package?

2. Why is Social Security an issue?

3. Why is Medicare nearly insolvent?

Question: What is the link between GDP and Olympic success?

ADDITIONAL APPLICATION: HIGH GDP WORTH WEIGHT IN GOLD (MEDALS) Briggs, Bill ―High GDP Worth Weight in Gold (Medals)‖ Posted 8/22/2008 on MSNBC.com MSNBC Summary: Key Points in the Article In Olympic terms, economic gold equates to Olympic gold. The 10 largest world economies have snatched up almost 60 percent of the gold medals and more than 50 percent of the overall medals in the Beijing games. According to a recently published study by PricewaterhouseCoopers, this is commonly the case. Countries with more resources tend to invest more money in the Olympics.

While most observers attribute the correlation between GDP and Olympic gold to be a matter of investment priority of the country, others note that it could be that higher GDP countries may have better nutrition and overall health. In any case, many countries have specifically focused significant efforts on grabbing gold this year and in London 2012. As the article notes ―politics and pride are the engines.‖ Obviously a few low GDP countries sneak into the club. Belarus has a GDP of only $82 billion yet they have won 13 medals this year. Jamaica has also done well in spite of ranking 108th in the world in GDP terms and having a population the size of Kansas.

Analyzing the News The article points out that there are anomalies such as Belarus and Jamaica where low GDP countries have won a lot of hardware. In the case of Belarus, they also point out that its success could be due to the fact that it was a former Soviet bloc country where the Olympics were a substantial focus.

Thinking Critically Questions 1. What is GDP? 2. Why is there a correlation between GDP and Olympic medals?

3. Why would a country see this as a good investment?

Solutions to End-of-Chapter Exercises Chapter 10 SECTION 10.1: THE ROLE OF FISCAL POLICY 1.1 1.2 1.3 1.4

increase left, decreasing, decreasing –$225 billion outside

1.5

1.6 1.7 1.8 1.9

a. AD shifts rightward, increasing the price level and real output

b. The effectiveness of the policy was frustrated by the apparent dependence of consumption spending on permanent income. The policy did not work.

First, it assumes that workers actually look to see what is in their paycheck. Second, it assumes that they will spend any additional funds and not save them.

Less time would be needed to reach an agreement across party lines, thus, we would expect the inside lag to be shorter in England.

It would be zero, because with no additional spending there would be no economic activity.

It makes it easier as policymakers have more time to make decisions and execute policy.

SECTION 10.2: THE FEDERAL BUDGET 2.1 2.2 2.3 2.4 2.5

2.6 2.7 2.8

2.9

2017 False, it is individual taxes.

Social Security, Medicare, Medicaid, veterans‘ benefits, and agricultural price support programs. income taxes, social insurance taxes a. State tax collections will fall as income falls. b. Many states will be forced to decrease spending or increase tax rates. c. AD shifts leftward.

interest, debt As more organizations become structured as partnerships, there will be less corporate tax collected. This explains in part why revenues from the corporate tax have fallen.

The problem is that the level of entitlements as a fraction of GDP is predicted to rise so high that raising taxes would dramatically increase the tax burden on the economy and impede economic growth.

It made it easier to implement tax cuts as they would show less of a deficit.

SECTION 10.3: FISCAL POLICY IN U.S. HISTORY 3.1 3.2 3.3 3.4 3.5

Kennedy True 1998–2001 Permanent a. No b. Yes c. No 3.6 Fiscal surpluses arose in the late 1990s because of a rapidly growing economy, higher tax rates, and limited government spending. The deficits disappeared after a recession and a series of tax cuts.

3.7 No, in this case, everyone would be effectively saving their tax cut and not spending it.

3.8 A college student would be more likely to spend a tax rebate, while a middle-aged married man would be more likely to save it (at least by using it to repay existing debt). The college student is more likely to be constrained by finances, and the rebate will allow him/her to consume more.

3.9 It mostly means we have deficits—expenditures exceeding revenues.

3.10 Demographically induced growth in entitlement spending outstrips growth in tax revenue from existing payroll tax programs, even allowing for the expiration of existing tax cuts (deemed rather unlikely).

Critical Thinking 1.

A strong case can be made for dynamic scoring for both major tax and expenditure changes as both can have larger effects on the economy. If spending $100 billion leads to $29 billion more in revenues, the true cost of the spending is only $80 billion.

2.

The tax cut put more money in the hands of corporations and they may spend some of it.

This is a demand stimulus. At the same time, if it leads to higher investment spending and more capital formation, then it has supply effects.

3.

Democrats would use more spending policies and Republicans more tax cuts.

11 The Income-Expenditure Model Chapter Summary This chapter explains the logic of Keynesian economics and presents the basic tool for short-run analysis, the income-expenditure model. It shows how the demand for goods and services determines GDP in the short run when prices are fixed. This chapter also discusses the role that government taxes and spending play in determining output. Finally, we show how the level of exports and imports can affect the economy in the short run.

Once the idea is understood that output is determined by demand in the short run, the next step is determining demand. The chapter begins with the simplest income-expenditure model with only consumption and investment (both constants) composing demand. This model illustrates the logic of the income-expenditure model diagram and the use of the 45° line. Once you review this model, it is relatively easy for the students to understand why the economy tends toward the equilibrium level of demand.

Next, we add an income-sensitive consumption function, government expenditures and taxes, and net exports for realism. Using the same techniques to find the short-run equilibrium outcome of the new model, the students can determine the effect of changes in fiscal policy and the effect of the foreign sector on domestic production. Using the income-expenditure model, the students can show that an increase in spending will lead to a larger increase in GDP (multiplier effect). The size of this effect depends on the behavior of individuals and government.

Here are the main points of the chapter:  The level of GDP in the short run is determined by the total demand for goods and services.  Consumption spending consists of two parts: one part independent of income (autonomous consumption) and another part that depends on the level of income.  An increase in spending will typically lead to a larger increase in GDP; this effect is called the multiplier.  In the short run, increases in government spending lead to increases in GDP; increases in taxes lead to decreases in GDP.  Fiscal policies were used aggressively in the 1960s to manage the economy, but concerns about budget deficits limit the use of these policies today.  Higher tax rates reduce fluctuations in GDP caused by shocks to spending.  Increases in exports lead to increases in GDP; increases in imports lead to decreases in GDP. Learning Objectives: 11.1 A Simple Income-Expenditure Model: Discuss the incomeexpenditure model.

11.2 The Consumption Function: Identify the two key components of the consumption function.

11.3 Equilibrium Output and the Consumption Function: Calculate equilibrium income in a simple model.

11.4 Government Spending and Taxation: Explain how government spending and taxes affect equilibrium income.

11.5 Exports and Imports: Discuss the role of exports and imports in determining equilibrium income.

11.6 The Income-Expenditure Model and the Aggregate Demand Curve: Explain how the aggregate demand curve is related to the income-expenditure model.

Approaching the Material Students can relate to this chapter. They are, above all, consumers. You can make concepts that seem abstract, such as the marginal propensity to consume, real. Ask students what they would do with changes in income. If most of your students work part time, ask them what they would do if

their boss gave them a bonus of $200 next week as a reward for a creative idea. Or, ask students what they would do if a relative gave them $1,000 as a reward for doing well in school. Discuss how they determine how much to spend and how much to save. Do they buy imported goods?

Chapter Outline 11.1 A Simple Income-Expenditure Model A. Equilibrium Output 1. The 45° line is essential to understanding the model. a. The key fact to remember regarding the 45° line is that the vertical and horizontal distances measured along the axes are equal.

2. For simplicity, assume: a. No government or foreign sector. b. Consumers demand a fixed amount of goods, C. c. Firms demand a fixed amount of goods, I. d. Planned expenditures is another term for total demand for goods and services and is made up of C and I in the simple model.

3. In the short run, demand determines output. a. Output = Demand b. Output = C + I 4. Equilibrium output is the level of GDP at which planned expenditure equals the amount that is produced. a. where y = C + I b. Equilibrium occurs where the horizontal line representing C + I crosses the 45° line. c. At this point, the vertical axis (Demand = C + I) is equal to the horizontal axis (Output = y). d. Equilibrium is at y*, where the demand line crosses the 45° line.

B. Adjusting to Equilibrium Output 1. Suppose y < y* a. At that level of output, Demand > Output, inventories fall and firms will react by increasing output, that is, y rises.

2. Suppose y > y* a. At that level of output, Demand < Output, inventories rise and firms will react by decreasing output, that is, y falls.

3. Only at y = y* are we at equilibrium.

4. Forecasters look at inventories to project future output.

According to the previous discussion, firms should change inventories in a way that would help predict future movements in GDP.

 Teaching Tip It may be worth the time to review with students the geometric/mathematical reasoning behind the 45° line.

11.2 The Consumption Function A. Consumer Spending and Income. The consumption function is the relationship between consumption spending and the level of income.

1. Economists have found that consumer spending depends on the level of income in the economy. More income results in more consumption.

2. This implies a simple consumption function of the following form: a. C = Ca + b y b. Ca represents autonomous consumption, the part of consumption that does not depend on income. c. b represents the marginal propensity to consume (MPC).

The MPC is the fraction of additional income that is spent. i. MPC < 1. Additional income is either spent or saved. Therefore, MPC + MPS = 1 (MPS is the marginal propensity to save).

B. Changes in the Consumption Function 1. The level of demand for consumption goods is determined by the level of autonomous consumption and the MPC × income.

2. A higher level of autonomous consumption shifts the consumption function up. This can happen for a number of reasons: a. Increase in consumer wealth b. Increase in consumer confidence 3. A change in the MPC will cause the slope of the consumption function to change. a. If a consumer believes an increase in income is permanent, he or she will consume a higher fraction of the increase, that is, MPC rises.

 Teaching Tip Ask the students what expenditures they have planned after they start their postcollege career. This is a good example of a permanent change in their income.

Review this key question and the related application:

Question 1: How does the composition of household wealth affect consumption behavior?

APPLICATION 1: THE WEALTHY HAND-TO-MOUTH AND CONSUMPTION SPENDING Households that have substantial assets, but live day-to-day on what they earn, are known as the ―wealthy hand-to-mouth.‖ This group has a high marginal propensity to consume. A study estimated that about 30 percent of all households live hand-tomouth and about two thirds of them are wealthy.

 Teaching Tip Point out to students that ownership of stock tends to be concentrated in higher income households who are more likely to save.

11.3 Equilibrium Output and the Consumption Function A. With the realistic consumption function, equilibrium output is determined the same as before.

1. Output = Demand = C + I = Ca + b y + I. The only difference from the simple model is that the demand curve is upward sloping. But equilibrium is still where demand crosses the 45° line. At this level of income, y*, total spending equals output.

2. In the appendix, we show that the equilibrium level of income can be found algebraically as: a. Equilibrium Income = (Autonomous Consumption + Investment)/(1 – MPC ) b. y* = (Ca + I) / (1 – b) 3. Given numerical values for Ca, I, and b, we can calculate y* a. C = 100 + 0.6y, I = 40 b. y* = 350 B. Saving and Investment 1. It is also true that at equilibrium S = I. a. y = C + S (income is either spent or saved) b. y = C + I (demand is either consumption or investment) c. C + S = C + I ↔ S = I 2. Savings Function is the relationship between the level of saving and the level of income. a. S = Y – C = Y – (Ca + bY) C. Understanding the Multiplier 1. What is the effect of a change in investment spending (∆I)?

2. ∆I > 0, implies the C + I line moves up by the amount ∆I. 3. From the income-expenditure model, we see y* increases.

4. In fact, ∆y > ∆I. This is called the multiplier effect. a. ∆y/∆I = multiplier > 1 b. Why? i. The multiplier is greater than 1 because an initial increase in demand leads to an increase in income which, in turn, leads to an increase in demand.

5. Suppose ∆I = $10 million and MPC= 0.8: a. Initial ∆y = $10 million because of the added investment demand. b. According to the consumption function, an increase in income of $10 million will lead to an increase in consumption of MPC × ($10 million) = 0.8 × 10 = $8 million. c. Now demand has changed by $10 + $8 million. But, the additional increase in income of $8 million leads to additional consumption of 0.8 × 8 = $6.4 million. d. If we add all the subsequent additions to consumption,

the total increase in GDP = $50 million. Therefore, multiplier = 5.

6. In the appendix, a simple formula is derived: a. Multiplier = 1/(1 – MPC) b. If the MPC goes up, the multiplier also goes up.

Review this key question and the related application:

Question 2: Are multipliers for government spending higher during recessions?

APPLICATION 2: MULTIPLIERS IN GOOD TIMES AND BAD Many believe that fiscal multipliers are bigger during recessions because of slack in the economy. However, economists disagree on whether this is true. Using data from a broad range of countries in the OECD, and looking at periods when government spending increased while the economy had slower or negative growth, the multiplier was calculated to be 2.3, larger than the conventionally calculated multiplier.

11.4 Government Spending and Taxation A. Fiscal Multipliers: To add government spending, taxation, fiscal policy realism to the model and the ability to analyze policy, we include a government sector that spends and taxes.

1. Using government spending or taxation to alter the demand for goods and services (and hence output in the short run) is known as Keynesian fiscal policy.

2. Government spending (G) is a component of total spending. a. Demand = C + I + G b. Increases in G, shift demand up just like increases in I. c. The effect is an increase in y*. d. The effect is exactly the same for G as for I. e. Multiplier for G = 1/(1 – MPC)

 Teaching Tip An effective way to illustrate this is to have the government spend all its money with a construction company that then pays workers, buys materials, etc.

3. Taxes affect disposable personal income. a. Disposable personal income = income – taxes = y – T i. T is net taxes that account for transfers. b. People are able to spend disposable personal income, not total income, altering the consumption function. i. C = Ca + b(y – T) c. An increase in T reduces the amount of income people can consume and hence reduces consumption. i. The change in consumption equals b times the change in T. ii. The demand curve will shift down by b × ∆T. iii. This lowers y*. iv. Tax multiplier = 2b/(1 – b) 4. Balanced budget multiplier a. What if ∆T = ∆G? b. Since the multiplier for G is greater than the

multiplier for T in absolute value, this policy will increase GDP. c. In the appendix, we show the balanced budget multiplier = 1.

B. Using Fiscal Multipliers 1. Suppose GDP is $6,000 billion and MPC= 0.6. a. What if policymakers want to increase GDP by 1 percent or $60 billion? How much do policymakers need to increase G to reach this target? i. The multiplier for G = 1/(1 – 0.6) = 2.5 ii. ∆y/∆G = 2.5 ↔ ∆y/2.5 = ∆G iii. ∆y/2.5 = 60/2.5 = $24 billion = ∆G b. What if policymakers wanted to use tax cuts instead? i. The multiplier for T = –0.6/(1 – 0.6) = 21.5 ii. ∆y/(21.5) = 60/21.5) = –$40 billion = ∆T c. What if policymakers wanted to use a balanced budget approach? i. Balanced budget multiplier = 1 ii. ∆y/1 = 60/1 = $60 billion = ∆T = ∆G

 Teaching Tip This is a good time to explain to the students that while a yearly balanced budget may be good accounting, it can be terrible economics because in the short run there would be no ability to respond to the business cycle.

2. Examples of the Use of Fiscal Policy a. In 1993, President Clinton’s Council of Economic Advisers wrote him a letter saying the government spending multiplier was about 1.5. This implied the effect of a proposed cut in G of $20 billion would be to lower GDP by $30 billion and reduce the growth rate of GDP from 3 percent to 2.5 percent. b. In 1994, the Japanese government presented a fiscal stimulus plan to revive the slumping Japanese economy.

The U.S. government used multiplier analysis to urge the Japanese to take more aggressive actions. c. During the late 1990s, the Chinese economy came under pressure from the economic downturn in Asia and its own attempts to reform and restructure the economy.

The government decided to increase spending on domestic infrastructure including roads, rails, and urban facilities. d. After the September 11, 2001, terrorist attack on the United States, the government increased spending for disaster relief. Additionally, President Bush and Congress instituted additional spending programs to stimulate the economy. e. President Obama’s economic advisors used multiplier analysis to gauge the size of their stimulus package.

Their multipliers ranged between 1 and 2.

3. Important Lessons a. Increases in G increase output. b. Cuts in taxes increase output. c. Policymakers need to account of the multiplier.

 Teaching Tip Form student groups and tell them they are the Council of Economic Advisors.

Give them various macroeconomic situations (e.g., output is $700 million below potential output and the MPC= 0.8) and tell them to come up with fiscal policy advice.

Remind students of the key principle from the chapter:

KEY PRINCIPLE: PRINCIPLE OF OPPORTUNITY COSTS The opportunity cost of something is what you sacrifice to get it.

 Teaching Tip One way you can illustrate Keynes‘ influence is to discuss what role government plays in today‘s economy. An easy way to measure this influence is to talk about what proportion of their paychecks is taken in taxes. This activist government can be traced, in part, back to Keynes.

C. Understanding Automatic Stabilizers 1. The U.S. economy was much more stable following World War II. 2. Taxes and transfers act as an automatic stabilizer and have helped stabilize the U.S. economy.

3. High income  high net taxes  less consumer spending  lower income 4. Low income  low net taxes  more consumer spending  higher income 5. This effect can be shown with the use of an income tax: a. T = t y, where t is the tax rate b. C = Ca + b (1 – t) y i. Now the MPC is adjusted for taxes: MPC= b (1 – t) c. Raising t lowers the MPC and pivots the C + I + G line down, resulting in lower output.

6. Higher taxes also lower the size of the multiplier = 1/(1 – b(1 – t)). a. The economy is less sensitive to shocks with higher taxes.

 Teaching Tip Compare what happens to someone who is laid off today to what would have happened in 1920. Today, a person would be eligible for unemployment insurance and would likely find another comparable job in about 326 months.

In the 1920s, a person would not have any source of income other than the money he or she happened to have saved. An unemployed person in the 1920s

would not have a government source of income and would either have to take any job at all or rely on financial assistance from family members or a charity.

Unemployment insurance was created in the Social Security Act of 1925.

Review this key question and the related application:

Question 3: How does Keynesian economics change our normal ideas of economic scarcity?

APPLICATION 3: THE BROKEN WINDOW FALLACY AND KEYNESIAN ECONOMICS The Application describes Henry Hazlitt‘s ―Broken Windows‖ fallacy in economics. A broken window generates spending through the multiplier effect but is not a benefit for society. His argument also applies to public spending financed by taxes, which will crowd out other production of goods and services. However, according to the Keynesian view, the extra spending will increase output, as long as there is excess capacity in the economy.

11.5 Exports and Imports A. Exports (X) and imports (M) affect GDP by influencing the demand for U.S.-made goods and services.

1. Increase in X increases the demand for U.S. goods 2. Increase in M reduces the demand for U.S. goods.

Marginal propensity to import (m) is the fraction of additional income that is spent on imports.

B. Add exports to desired spending and subtract imports.

1. Assume the level of exports is constant = X 2. Assume the level of imports is sensitive to income; M = m y a. Imports behave similarly to consumption because they are similar goods.

3. Now Demand = C + I + X - M = Ca + I + X + (b - m) y a. See Figure 11.11 for this graph and how equilibrium output is determined. b. An increase in X leads to an increase in equilibrium y. c. An increase in m leads to a decrease in equilibrium y.

Review this key question and the related application:

Question 4: How do countries benefit from growth in their trading partners?

APPLICATION 4: THE LOCOMOTIVE EFFECT: HOW FOREIGN DEMAND AFFECTS A COUNTRY‘S OUTPUT The Application points out that the United States acts as a locomotive, pulling other economies along as it grows. As the size of the United States economy grows, so does its demand for imports, benefiting the economies it imports from.

 Teaching Tip Remind students that one country‘s imports are another country‘s exports. A recent article in Businessweek magazine reported that the projected trade deficit for 2005 was running at $696 billion dollars, up from $617 billion dollars in 2004. The article goes on to say that this growing deficit is more than offset by increases in labor productivity and Americans are still better off. Discuss with students that the trade deficit is not always a bad thing. Consumers are able to purchase goods that they would not be able to otherwise.

11.6 The Income-Expenditure Model and the Aggregate Demand Curve A. Deriving the Aggregate Demand Curve: 1. A decrease in the price level increases the demand for goods and services through the wealth effect. This illustrates the negative relationship between the price level and demand for goods and services found on the aggregate demand curve.

B. Shifts in Aggregate Demand C. Final Reminder 1. All models in this chapter are based on the short run.

2. Policies may have different implications in the long run and the short run. a. In the short run, increases in consumption lead to increases in output. b. In the long run, increases in savings lead to increases in output.

Additional Applications to Use in Class Question: How does inflation impact consumption?

ADDITIONAL APPLICATION: SQUEEZED FROM TWO SIDES

CONSUMERS

BEING

Schoen, John W. ―Consumers Being Squeezed From Two Sides‖ Posted 5/30/2008 on MSNBC.com MSNBC Summary: Key Points in the Article Consumer spending continues to increase slightly in spite of higher prices and a host of economic issues such as falling housing values and unemployment numbers. In fact, personal consumption was up about 1 percent in the first quarter of the year after adjusting for inflation.

While spending is not declining yet, consumers continue to be pessimistic about the future.

Economists blame the decline in consumer confidence on four straight months of job loss data and the fact that incomes have not kept pace with inflation. The median family income is actually about $500 below what it was in 2000. Consumer spending during the past few years was instead fueled by rising home values and tapping into home equity.

Now economists fear that tightening credit and declining home prices will stall consumption.

Couple those two facts with a Fed that may have to raise interest rates to combat inflation and you have a recipe for declining consumption and a full-blown recession.

Analyzing the News When consumption falls, there is a greater change in output due to the multiplier. In this case, you can see that output fell as a result of the drop in consumption and the magnitude is greater than the change in consumption.

Thinking Critically Questions 1. What is autonomous consumption?

2. How does the value of one’s home impact consumption?

3. How does inflation impact consumption?

Appendix: Formulas for Equilibrium Income and the Multiplier Simple Model without Government and the Foreign Sector: Equilibrium Output 1.

Equilibrium output occurs where: a. Output = Demand = C + I 2.

Substitute in y for output and the expression for the consumption function: a. y = (Ca + b y) + I 3.

Collect all terms in y on the left-hand side of the equation: a. y – b y = Ca + I 4. Factor the left-hand side: a. y(1 – b) = Ca + I 5. Divide both sides by (1 – b): a. y* = (Ca + I)/(1 – b) 6.

This procedure can be used to get equilibrium output, no matter what the model. Simply follow steps 1–5 to get the answer.

Simple Model without Government and the Foreign Sector: Multiplier 1.

For an original level of investment I0, equilibrium output is: a. y0 = (Ca + I0)/(1 – b) 2. For a new level of investment at I1, equilibrium output is: a. y1 = (Ca + I1)/(1 – b) 3. The change in output (∆y) is the difference: a. ∆y = y1 – y0 = (Ca + I1)/(1 – b) – (Ca + I0)/(1 – b) b. ∆y = ∆I [1/(1 – b)] 4. The multiplier is the ratio of the change in income to the change in investment spending: a. ∆y/∆I = 1/(1 – b)

Addition of Government Spending, Taxes, and Net Exports 1. The same procedures can be used to find equilibrium output and the multipliers by adding government expenditures, taxes, and net exports to the expression for demand: a. Output = Demand = C + I + G = Ca + b(y – T) + I + G + X – m y 2. This results in: a. equilibrium output = y* = (Ca – bT + I + G + X)/[1 – (b – m)]) b. multiplier for government spending = ∆y/∆G = 1/[1 – (b – m)] c. multiplier for Taxes = ∆y/∆T = – b/[1 – (b – m)] 3.

Balanced budget multiplier = 1

Solutions to End-of-Chapter Exercises Chapter 11 SECTION 11.1: A SIMPLE INCOME-EXPENDITURE MODEL 1.1 1.2 1.3 1.4 1.5 1.6

False True increasing output a. GDP increases b. No, demand might have unexpectedly decreased. a. C + I b. Expenditure falls below the 45° line. c. Expenditures are less than output.

SECTION 11.2: THE CONSUMPTION FUNCTION 2.1 2.2 2.3 2.4 2.5

autonomous consumption downward upward increase In buying a home, the household may have used up all its liquid assets, so no longer has as much of a buffer in the face of stocks.

2.6 While wealth has gone up and this encourages consumption, people near retirement may fear that the stock market may go back down, so they could be cautious and not change their spending very much.

2.7 The wealth effect as described in the text could be thought of as the level of consumption households would ideally desire to undertake given their wealth. However, some households might not have enough current income to increase their consumption. In a rising market they can, so the effect on consumption could be larger when house prices rise.

2.8 Household B because it has less liquid assets and is more likely to have to adjust consumption spending to current income.

SECTION 11.3: EQUILIBRIUM OUTPUT AND THE CONSUMPTION FUNCTION 3.1 3.2 3.3 3.4 3.5 3.6

3.7

750 a. 1000 b. 5 0.6 decrease a. Equilibrium income decreases by $25 billion b. $25 billion, $15 billion decrease a. 300 b. Equilibrium savings must equal investment, and investment was unchanged. c. Output and savings decrease as planned investment decreases. d. Increased saving rates could actually lower output and total savings (if investment were independent of both output and interest rates). a. 800 b. 2.0 c. S = 2200 + 0.5y

d.

e. S = 200 3.8 3.9

Wealth decreased, but income increased. Here, they moved in opposite directions.

The basic reason this argument is unpersuasive is that government spending was increased in response to a falling economy. To measure a multiplier, you need to find a case where the spending increase was not related to the state of the economy. This is often difficult to do.

3.10 With a vertical long-run aggregate supply curve, there is no change in output, so the multiplier would be zero. With the short-run supply curve, output does increase so there is a positive multiplier. If we think of recessions as the short run and full employment as the long run, this explains the intuition.

SECTION 11.4: GOVERNMENT SPENDING AND TAXATION 4.1 4.2 4.3 4.4 4.5

False decrease declined increases a. 20 b. 225 4.6 We see the effects of the public works expenditures on new construction and GDP. But we do not see the negative effects from taxes—current or future—needed to pay for these projects.

4.7 a. Output decreases by roughly the decrease in government spending. b. Yes 4.8 With higher tax rates, there is more automatic stabilization. This may have substituted for active, discretionary policy.

4.9 The students will find that he criticized the treaty primarily for leaving Germany destitute and that he was the engineer of the Bretton Woods fixed exchange rate system after World War II.

SECTION 11.5: EXPORTS AND IMPORTS 5.1 5.2

increase increase

5.3

Output increases

5.4 5.5

False a. European equilibrium output would decrease. b. U.S. equilibrium output would decrease. c. World trade volume decreased significantly.

In an open economy, the MPC adjusted for imports is 0.6, so the multiplier will be 2.5.

Therefore, an increase in investment of 80 would be needed. In a closed economy, the marginal propensity to import is zero, so the MPC is 0.9 and the multiplier is 10. Thus, an increase in investment of 20 would be needed.

The short-run effect is to increase demand and increase GDP through the multiplier.

5.6

5.7

SECTION 11.6: THE INCOME-EXPENDITURE MODEL AND THE AGGREGATE DEMAND CURVE 6.1 6.2 6.3 6.4 6.5 6.6

6.7

decrease, up and to the left aggregate demand This is a shift along the curve. decrease a. $100 billion = (5.0) × ($20 billion) b. $50 billion = (2.5) × ($20 billion) a. Aggregate expenditure decreases, decreasing output.

b. The aggregate demand curve shifts to the left.

If large changes in prices do not have much of an effect on consumption spending, then from Figure 11.14, it will not raise GDP by very much. Thus, large changes in prices will be associated with small changes in GDP along the aggregate demand curve. This means the curve will be steep.

Appendix A. 1 A. 2 A. 3 A. 4

The multiplier is 1.667 = [1 – (0.6 – 0.2)]–1.

Income increases by $2.666 billion = $3.333 billion – $0.667 billion S + T + C = C + I + G; hence, S + T = I + G a.

b. c. d. e. f.

380 2.0 = [1 – (1 – 0.5)]–1 S = 2100 + 0.5 × (y – T) 80 80 + 20 = 50 + 50

Critical Thinking 1.

Probably the best answer is that Friedman agreed with Keynes that the economy could deviate from full employment and we were not in the classical economic world. But Friedman did not believe in active stabilization policies.

2.

Governments often use fiscal policies to fight recessions. So when we see spending changing, it is often in response to events. We have to avoid the problem of reverse causality—for example, fire fighters may go to where the fires are, but they do not cause fires! To measure the effects of fire fighters you need to take this into account. The same is true with fiscal policy.

3.

Growth abroad means that foreign countries will import more from us. That means our exports will increase which will lead to higher demand and higher GDP. This is true in the AD–AS model and not just the Keynesian model.

12

Investment and Financial Markets Chapter Summary This chapter discusses investment spending, interest rates, and financial intermediation. In the last chapter, we made the assumption that investment is simply constant. In fact, investment spending responds to several factors: interest rates, expected future income, and ―animal spirits.‖ To fully understand short-run fluctuations in output, we must understand what makes investment fluctuate.

The chapter explains why investment spending depends inversely on real interest rates. We also examine how financial intermediaries play a crucial role in modern economies in channeling funds from savers to investors, reducing interest rates, and promoting investment. Here are the main points of the chapter:  Investments are actions that incur costs today but provide benefits in the future.  Investment spending is a very volatile component of GDP primarily because investment decisions are made with an eye to the ever-changing future. Keynes thought that much investment activity was irrational and governed by the animal spirits of investors.  Investment spending depends inversely on real interest rates.  Financial intermediaries reduce risk and costs through their expertise and by pooling the funds of savers.

Learning Objectives: 12.1 An Investment—A Plunge into the Unknown: Explain why investment spending is a volatile component of GDP. 12.2 Evaluating the Future: Discuss the concept of present value.

12.3 Understanding Investment Decisions: Describe the role of interest rates in making investment decisions.

12.4 How Financial Intermediaries Facilitate Investment: List the ways that financial intermediation can facilitate investment.

Approaching the Material Investment can be difficult for some students to grasp. They do not run firms and may not have any stocks or bonds. There are two approaches that can be helpful. One is to use their bank accounts as a proxy for investments, and another is to explain to them that buying a house or a car can be viewed as an investment. You can explain the relationship between the rate of return and the level of investment using either one of these concepts.

Chapter Outline 12.1 An Investment: A Plunge into the Unknown A. Payoffs for investment are in the future and thus not known with certainty.

1. Building a factory requires anticipating future demand for a product.

B. Firms and individuals constantly change their estimates of the future.

1. Keynes emphasized the roles of optimism and pessimism in the estimation process. a. These are the ―animal spirits‖ of investors.

2. According to the accelerator theory, current investment spending depends positively on the expected future growth of real GDP. a. But since many people believe that ―If output is growing today, I think it will continue to grow,‖ that makes current investment directly related to current GDP growth.

C. Investment is very volatile relative to GDP because of both animal spirits and the accelerator theory.

1. Investment is highly procyclical, meaning it moves in the same direction as real GDP. D. Different types of investment behave differently.

1. In 1991, both nonresidential structures and producers‘ durable equipment fell.

2. Investment in structures was much slower to recover.

E. Due to the multiplier, changes in investment are very important in understanding business fluctuations.

F. Multiplier-accelerator model is a model in which a downturn in real GDP leads to a sharp fall in investment, which triggers further reductions in GDP through the multiplier.

 Teaching Tip Students need to understand that business investment is very different than personal investment. It can be worth the extra time to be sure.

Review this key question and the related application:

Question 1: How do fluctuations in energy prices affect investment decisions by firms?

APPLICATION 1: ENERGY PRICE UNCERTAINTY REDUCES INVESTMENT SPENDING This Application points out that uncertainty can reduce investment, which in turn can cause GDP to fall. Businesses that are uncertain about oil prices, for example, might hold off on investing in energy-saving equipment.

 Teaching Tip

Ask students how uncertainty about the price of gasoline might affect their decision to buy a car.

12.2. Evaluating the Future A. Understanding Present Value 1. The present value of a dollar amount in the future is the maximum amount a person is willing to pay today to receive that dollar amount in the future.

 Teaching Tip Another way to get at the present value of a dollar amount in the future (say $1,000 in one year) is to ask the students how much would they have to have in the bank right now to make it equal the $1,000 in the future. Most should see that you would need less than $1,000 and the amount depends on the interest rate.

2. Present value of K paid in t years (with an interest rate of i) = K/(1 + i)t.

3. An increase in interest rates causes present value to fall.

4. A decrease in interest rates causes present value to increase.

Remind students of the key principle from the chapter:

KEY PRINCIPLE: PRINCIPLE OF OPPORTUNITY COST The opportunity cost of something is what you sacrifice to get it.

5. Key Points about Present Value a. The present value—the value today—of a given payment in the future is the maximum amount a person is willing to pay today for that payment. b. As the interest rate increases, the opportunity cost of your funds also increases, so the present value of a given payment in the future falls. In other words, you need less money today to get to your future ―money goal.‖ c. As the interest rate decreases, the opportunity cost of your funds also decreases, so the present value of a given payment in the future rises. In other words, you need more money today to get to your money goal.

 Teaching Tip It may be worth your time to do a few present value calculations at various interest rates with your students.

C. Real and Nominal Interest Rates 1. Interest rates are paid when one individual borrows from another. a. Banks borrow from you when you make a deposit in a

bank. b. You borrow from a bank to pay college tuition. c. Governments and companies use bonds to borrow (bond = a promise to pay money in the future).

2. Nominal interest rates are those quoted in the market = the actual rate an individual must pay.

3. Real interest rates are nominal interest rates minus the inflation rate.

Remind students of the key principle from the chapter:

KEY PRINCIPLE: REAL-NOMINAL PRINCIPLE What matter to people is the real value of money or income—the purchasing power—not the face value of money. a. Real rate = Nominal rate – Inflation rate b. Example: a firm borrows $100 at a 10 percent interest rate when inflation is 6 percent. i. The firm must pay back $110. ii. Lender must receive $106 to buy the same goods the $100 would have been able to purchase. iii. There is only a $4 gain to lenders (4 percent interest rate) once inflation is accounted for. iv. People actually use the expected real interest rate, that is, the nominal interest rate minus the expected inflation rate, to make decisions. v. It is difficult to determine real rates of interest because we never know exactly what inflation rates people expect.

 Teaching Tip One way to explain the difference in real and nominal is to use a consumer item (automobiles) that increases in price over a year‘s time. Ask the students if they put the money in the bank instead, would they still be able to buy the item next year? Would they have funds left over?

Review this key question and the related application:

Question 2: What factors explain the relatively low rate of investment spending following the last recession?

APPLICATION 2: EXPLAINING LOW INVESTMENT RATES The United States has always had a smaller amount of investment relative to GDP than many other countries. Two economists determined that the reasons for this are a movement toward intangible assets (which do not count as investment), decreased competition in the economy, and more pressure by shareholders to increase their own earnings. It will be interesting to see if the Trump Tax Bill, which provided tax incentives for investment, will change this trend.

12.3 Understanding Investment Decisions A. Suppose a firm can invest $100 today and receive $104 next year.

1. Should the firm take the investment? It should consider its opportunity cost.

2. Opportunity cost of investment is $100 plus the interest that could be earned if put in the bank. a. If the interest rate = 3%, then opportunity cost =

$103. Since return is $104, do the investment project. b. If the interest rate = 4%, then opportunity cost = $104. Since return is $104, do the investment project because the opportunity cost covers best potential alternative. c. If the interest rate = 6%, then opportunity cost = $106. Because the return is $104, do not do the investment project.

3. Neoclassical theory of investment is a theory of investment that says both real interest rates and taxes are important determinants of investment. a. There are millions of investment projects in the economy with different rates of returns. b. As interest rates fall, more investment projects become profitable (opportunity cost < net return).

4. The investment schedule depicts the negative relationship between interest rates and investment. a. Because investment spending is negatively related to real interest rates, nominal interest rates are not a perfect indicator of the true cost of investing. i. Nominal rate = 10% with inflation = 9% implies the real rate = 1% ii. During the 1970s, homeowners in California followed this logic: 1) They bought homes at interest rates exceeding 10 percent.

2) Because housing prices were also growing by more than 10 percent, the real rate was very low, if not negative.

B. Investment and the Stock Market 1. Price of the stock = present value of future earnings 2. Stock market is closely tied to investment.

3. Investment theories: a. The neo-classical theory of investment gives the real rate and taxes a key role in investment. b. The Q-theory of investment gives a firm’s stock price a key role. High stock price implies a firm should undertake investment.

4. Retained earnings are corporate earnings that are not paid out as dividends.

5. Corporate bonds are bonds sold by a corporation to the public in order to borrow money.

 Teaching Tip Tell the students that they have been promoted to the long-range planning group at General Motors. They have to make a decision on whether or not to build a new plant. Ask them to list all the information they would need to make this decision.

The information includes: expected prices, wages, interest rates, demand for cars, gas prices, etc.

Review this key question and the related application:

Question 3: Should we have done more to assist homeowners with burdensome mortgage debt?

APPLICATION 3: UNDERWATER HOMEOWNERS AND DEBT FORGIVENESS This Application discusses how many U.S. homes are currently ―underwater.‖ The term underwater means that homeowners owe more on their mortgages than their homes are worth. Two economists argue that recovery from the recession was dependent on providing assistance to homeowners who were underwater with their homes.

They found that by not providing enough assistance, this prolonged the recession. Policymakers did try to help homeowners, but these programs became very controversial.

12.4 How Financial Intermediaries Facilitate Investment A. Financial intermediaries are organizations that receive funds from savers and channel them to investors.

1. Households save part of their income, supplying the source of funds for investment.

2. The motivations for savers and investors are different. a. Savers want assets that are: i. Safe ii. Liquid, which means easily convertible into money on short notice iii. Small b. Investors need funds that: i. can be exposed to risk ii. can be kept illiquid for a long period of time iii. are large 3. It would be impossible for each firm to go directly to savers for funds.

4. Financial intermediaries serve to reduce costs, monitor investment, reduce risk, and provide liquidity to facilitate the flow of funds from savers to investors.

5. How do financial intermediaries do this? a. Financial intermediaries collect savings from many households. i. Making many small deposits into fewer large loans ii. Creating small liquid deposits from large illiquid loans b. By pooling many loans, financial intermediaries reduce risk by diversification. i. Financial intermediaries invest in a large number of projects with independent returns.

1) The return of one project is unrelated to the return of another. ii. Each project may earn a large return or go bankrupt. iii. On average, the projects will have a moderate safe return because it is unlikely all projects will fail at the same time; they are independent. iv. Insurance companies work the same way.

1) They write many automobile theft policies with the assumption that not all cars are likely to be stolen at the same time.

2) Is it wise for an insurance company to write earthquake insurance only in the Los Angeles area?

6. Financial intermediation is extremely important to an economy because it makes investment possible.

7. Securitization: The practice of purchasing loans, repackaging them, and selling them to the financial markets became a common phenomenon in the 2000s. a. Mortgages were increasingly securitized and purchased with leveraged money. b. This helped lead to the financial crisis in the late 2000s.

B. When financial intermediaries malfunction

1. During the Great Depression of the 1930s, many banks made loans that were unprofitable. a. Depositors became worried the banks would fail, which triggered bank runs. i. A bank run occurs when panicky investors try to withdraw their funds from a bank they believe may fail when depositors withdrew funds, causing banks to fail. b. No firms could get loans, causing the Depression to be deeper and longer.

2. To prevent bank runs from happening again, the U.S. government began to provide deposit insurance, which is federal government insurance on deposits in banks and savings and loans. a. Deposit insurance may have helped cause the savings and loan crisis. i. S&Ls began having trouble attracting deposits in the 1980s. ii. They promised very high interest rates, necessitating risky investment strategies. iii. Depositors were not worried because they were insured. iv. Predictably, many of the risky projects failed and the taxpayers had to pay the tab.

3. Japan also had many banks lose money in the 1990s. a. The government chose to support the banks with $13 billion to avoid disruption in the financial markets.

4. The decline in housing prices in the late 2000s triggered a severe crisis in the newly developed securitization markets and caused major financial disruptions in the economy. As the housing-generated financial crisis spread, it i. froze banks worldwide. ii. forced financial institutions like Bear Stearns and Lehman Brothers to close. iii. forced governments around the world to attempt to alleviate the crisis.

 Teaching Tip One way to introduce the students to the various types of financial intermediaries is to tell them that a rich uncle has lent them one million dollars but that they cannot spend it for 10 years. What would they do? Why? Review this key question and the related application:

Question 4: What are the key components of the Dodd–Frank legislation?

APPLICATION 4: NEW REGULATONS FOR FINANCIAL STABILITY The Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010 was passed to address the financial crisis of 2007–2008. It

included the creation of the Federal Stability Oversight Council (FSOC) to promote financial stability. The act also put various restrictions and requirements on large banks.

The Consumer Financial Protection Bureau (CFPB) proved to be controversial, with some arguing that it is too independent of Congress.

 Teaching Tip It is probably a good time to discuss the benefits of the federal government maintaining the stability of the banking industry through regulation and supervision. Without this role of the government, the financial intermediaries would not be able to serve their function.

Additional Applications to Use in Class Question: Why do some industries deserve more money?

ADDITIONAL APPLICATION: DETROIT CRASHES THE CONVENTIONS Sasseen, Jane ―Detroit Crashes the Conventions‖ Posted 9/3/2008 on MSNBC.com Businessweek Summary: Key Points in the Article The domestic auto industry is on a quest for capital. ―Detroit‘s Big Three‖ auto manufacturers need money for new plants and to retool old, declining facilities. To that end, they are lobbying hard for the government to fund the $25 billion in government subsidized loans already approved.

The companies maintain they need the subsidies to get preferred rates of about 5 percent or lower.

Detroit‘s lobbyists descended en masse on both political party conventions to plead their case.

The plan was approved by Congress when the new fuel efficiency mandates were passed.

Automakers have until 2020 to produce vehicle fleets that average 35 miles per gallon. In order to meet those deadlines, the companies need fast access to cheap capital. Some estimate that the total retooling costs will run about $100 billion.

The Big Three would like to see Congress loosen the purse strings this fall, while both parties are in the mood to please voters. In any case, many argue the nation‘s auto manufacturing is just as strategic as the financial industry and needs propping up soon.

Analyzing the News Some industries are strategic and should receive subsidies. If we allowed free trade to totally eliminate our domestic automobile production, we would be at the mercy of the countries that produced autos. The U.S. needs to make sure that we always have the ability to produce steel, autos, weapons, and other strategic products.

Thinking Critically Questions 1. Why are some industries considered strategic industries?

2. What other reason would Congress have to make the funds available?

3. Why is the timing critical according to Detroit?

Question: Why is a lack of financial acumen considered to be problematic?

APPLICATION: TEENS LACK FINANCIAL LITERACY Anonymous ―Teens Still Lack Financial Literacy, Survey Finds‖ Posted 4/5/2006 on MSNBC.com The Associated Press

Summary: Key Points in the Article The Federal Reserve released the results of a recent survey about the financial and economic literacy of U.S. high school seniors. This latest survey, the fifth of its kind, showed that high school seniors correctly answered only 52.4 percent of questions. While these results are disappointing, they are a very slight improvement over last year‘s results where seniors answered 52.3 percent of the questions correctly. And both years represent improvement over the 2002 survey results where 50.2 percent of these questions were answered correctly.

Only 14.2 percent of students correctly identified stocks as offering higher growth potential than U.S. savings bonds. A majority of students believe that they would have no liability when a credit card was lost or stolen. Only slightly more than one in five knew that income tax could be assessed on interest income. Another 62 percent incorrectly identified retirement income from a company pension plan as Social Security.

Demographic differences also exist with seniors from higher income households being more financially literate than those from the lowest income groups. White students also scored higher than black and Hispanic students.

Analyzing the News Lack of financial acumen probably contributes further to income disparities. The ―have-nots‖ may never be able to turn into the ―haves‖ if they lack financial knowledge. While many may increase their earning potential through education, many will not retain and grow wealth without financial knowledge.

Thinking Critically Questions 1. Why would demographic differences exist between income groups?

3. Why is this lack of financial acumen considered to be problematic?

4. How could the problem of lack of financial knowledge be remedied?

Question: What happens when ethics enters the market?

ADDITIONAL APPLICATION: BETTING ON DEATH

LIFE

SETTLEMENTS:

Goldstein, Matthew ―Life Settlements: Betting on Death‖ Posted 7/23/2007 on MSNBC.com Businessweek Summary: Key Points in the Article Several well-known investors are betting heavily on death, specifically by buying and selling unwanted life insurance policies. Many elderly own policies but have no living beneficiaries to leave the death benefit to. Astute investors have recognized the value in these unwanted policies and are buying them up.

However, the primary problem is that the market is totally unregulated, and unscrupulous investors are buying and selling policies along with honest investors. Some hedge funds are in the mix and have generated returns of 10 percent a year for three years. Obviously, the policies‘ values depend on the life expectancy of the individual. If the person dies sooner, the investors make more money. If they live longer than expected, the investors‘ returns fall.

Analyzing the News It seems morbid, but there is a market for everything. In this case, the dying benefit by receiving cash now for their death benefit. They can choose current consumption over consumption by their beneficiaries. While the purchasers of these policies do provide a service, they also make more money if someone dies faster because there is a time value associated with any cash flow.

Thinking Critically Questions 1. Why would someone sell their life insurance policy to an investor?

2. Why will the investor make more money if the person dies sooner?

3. What are the ethical issues involved?

Solutions to End-of-Chapter Exercises Chapter 12 SECTION 12.1: AN INVESTMENT: A PLUNGE INTO THE UNKNOWN 1.1 1.2 1.3 1.4 1.5 1.6

1.7 1.8

False, it is smaller than consumption (although more volatile). procyclical John Maynard Keynes False The accelerator refers to the fact that investment depends on the change (or acceleration) in the rate of investment. The multiplier refers to the impact of investment spending on GDP. Durable goods are investment goods. So the same ideas about animal spirits—pessimism and optimism—would apply to consumers as well as firms as they forecast their own incomes into the future.

The data will show a much larger drop in the second period.

A credible oil price floor might increase incentives to invest in energy-saving technologies.

SECTION 12.2: EVALUATING THE FUTURE 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8

181.82 = 200/1.10 190.48 = 200/1.05, 181.41 = 200/(1.05)2 increases fall For given installation cost, the present value of future benefits is larger when interest rates are lower.

Since the firms could earn more by investing the $500,000 at higher interest rates, they would increase the annuity payments.

PV (8%) = $9.82 million; PV (5%) = $12.46 million.

They understood that the present value of $1,000 a year for 10 years was less than $10,000.

Therefore, they wanted to make sure you paid them enough to make the present value of the payments equal to $10,000 – the amount you owed them in a lawsuit.

SECTION 12.3: UNDERSTANDING INVESTMENT DECISIONS 3.1 3.2 3.3 3.4 3.5

7 percent decreases True James Tobin dividends

3.6

3.7 3.8 3.9

While nominal rates were low, homeowners may not have expected any housing price appreciation or perhaps they even expected depreciation—that is, housing prices to fall. In this case, the real mortgage costs would be high.

The firms earn profits from the data-related projects, so their stock prices are high. But since they are investing in intangibles, the link between stock prices and investment weakens.

For given installation cost, the present value of future benefits from the hydroelectric plant will be larger when interest rates are lower.

Stock prices are the present value of future dividends. For any pattern of future dividends, their present value increases as interest rates fall. As corporate earnings rise, it is likely that dividends will also rise.

SECTION 12.4: INVESTMENT 4.1 4.2 4.3 4.4 4.5 4.6

4.7

4.8 4.9

HOW

FINANCIAL

INTERMEDIARIES

FACILITATE

False deposit insurance False, it was passed in 2010. securitization The research shows that households with fewer assets will spend more if debt is forgiven.

See Application 3. a. You would have a 20 percent gain and a 10 percent loss. b. You would have a gain of $200 on your $50 investment, so your percent gain would be 400 percent. You have a loss of $100 on a $50 investment, so a 200 percent loss.

As interest rates rise, an S&L‘s cost of funds might rise above the relatively fixed interest yield on its portfolio of earning assets (mortgage loans.) As home prices in a geographical area fall, the value of a local S&L‘s collateral might fall below the face value of its loan portfolio, exposing the S&L to increased default risk. Institutions such as Fannie Mae and Freddie Mac assemble mortgages originated by individual S&Ls into more widely (geographically) diversified pools of mortgages for purchase by investors, thereby reducing the risk borne by secondary mortgage market investors.

A national program of disaster insurance might be able to more easily pool risks associated with diverse locations. the Secretary of the Treasury, who serves as the Chairperson of the Council; the Chairman of the Board of Governors of the Federal Reserve System; the Comptroller of the Currency (OCC); the Director of the Bureau of Consumer Financial Protection (CFPB); the Chairman of the Securities and Exchange Commission (SEC); the Chairperson of the Federal Deposit Insurance Corporation (FDIC); the Chairperson of the Commodity Futures Trading Commission (CFTC); the Director of the Federal Housing Finance Agency (FHFA); the Chairman of the National Credit Union Administration (NCUA); and an independent member with insurance expertise who is appointed by the President and confirmed by the Senate for a six-year term.

Critical Thinking 1.

If they pay out more dividends over a short period of time, there will be less retained earnings available for investment. The key here is that the question asked about paying dividends over a short period of time.

2.

Since you can earn higher returns on your savings, you will need to save less.

3.

Financial institutions would make fewer loans, so less overall credit would be extended.

13 Money and the Banking System Chapter Summary In this chapter, we first examine the role that money plays in the economy and how economists define ―money.‖ We then take a closer look at banks in their role as financial intermediaries. We see how banks can ―create‖ money through the process of deposit creation. In addition, we learn how the Federal Reserve can control the supply of money through open market purchases and sales and other policies. Here are the main points of the chapter:  Money consists of anything that is regularly used in making exchanges; that is, buying and selling goods and services. In modern economies, it consists primarily of currency and deposits in checking accounts.  Banks are financial intermediaries that earn profits by accepting deposits and making loans. Deposits, which are liabilities of banks, are included in the money supply.  Banks are required by law to hold a fraction of their deposits as reserves, either in cash or in deposits with the Federal Reserve. Total reserves consist of required reserves plus excess reserves.  If there is an increase in reserves in the banking system, the supply of money will expand by a multiple of the initial deposit. This multiple is known as the money multiplier.  The Federal Reserve‘s primary tools for increasing or decreasing the supply of money is by changing the total amount of reserves in the banking system through open market purchases of government bonds (which increase reserves) or open market sales (which decrease reserves).  The Federal Reserve can also change the supply of money by changing reserve requirements or changing the discount rate.  Decisions about monetary policy are made by the Federal Open Market Committee (FOMC), which includes the seven members on the Board of Governors, the president of the New York Federal Reserve Bank, and four of the other eleven regional bank presidents who serve on a rotating basis.

Learning Objectives: 13.1 What Is Money? Identify the components of money in the U.S. economy.

13.2 How Banks Create Money: Explain the process of multiple expansion and contraction of deposits.

13.3 A Banker‘s Bank—The Federal Reserve: Describe the structure of the Federal Reserve.

13.4 What the Federal Reserve Does during a Financial Crisis: Discuss examples of how the Federal Reserve acts during financial crises.

Approaching the Material When it comes to their day-to-day experiences, students are familiar with money and what it does. They are also aware of the banking system. Use this basic knowledge to teach this chapter.

Follow their paycheck as they deposit it in the bank. Discuss how much currency they hold. Ask them how interest rates affect their behavior. For example, do they have a car loan or a student loan? What interest are they paying? Did they shop around for a rate?

Chapter Outline 13.1 What Is Money?

A. Money is any item that is regularly used in economic transactions or exchanges and accepted by buyers and sellers.

1. We trade currency for an ice cream cone.

2. The ice cream owner trades because the currency can be used to pay for other things: a. Costs of production b. Profits to buy other goods 3. Actual transactions usually include the use of checks that instruct a bank to transfer money to another individual.

4. Anything that can be used to buy something is money.

5. Other examples: a. Stones by ancient peoples b. Gold bars c. Cigarettes by prisoners of war

 Teaching Tip Students sometimes argue that credit cards are just like money. Explain to them that credit cards are preapproved loans that charge interest and fees. A loan for one person increases his or her buying power. But the credit card company that makes the loan must borrow the money from someone or something, reducing the purchasing power of someone else. In the end, it all nets out to zero.

6. Medium of exchange is any item that buyers give to sellers when they purchase goods and services.

7. Barter is the exchange of one good or service for another.

8. Double coincidence of wants is the problem in a system of barter that one person may not have what the other desires.

B. Three Properties of Money 1. Money serves as a medium of exchange. a. Without money, all transactions must be via barter (goods for goods). b. Barter is problematic because of the double coincidence of wants. i. If you want a car and have a boat, you must find someone who has a car and wants a boat. ii.

Barter is terribly inefficient.

c. Money solves the double coincidence of wants because it is readily accepted in exchange for goods.

Remind students of the following key principle:

KEY PRINCIPLE: THE PRINCIPLE OF VOLUNTARY EXCHANGE A voluntary exchange between two people makes both people better off.

2. Money serves as unit of account (a standard unit in which prices can be stated and the value of goods and services can be compared). a. Prices are quoted in terms of money, making economic transactions easier.

3. Money serves as a store of value (the property of money that it preserves value until it is used in an exchange). a. Ideally, money will not change value over time, so exchanges don’t have to all happen at the same time. b. Money loses value during times of inflation, making it an imperfect store of value.

4.

Different Types of Monetary Systems a. Commodity money is a monetary system in which the actual money is a commodity, such as gold or silver. b. Gold standard is a monetary system in which gold backs up paper money. c. Fiat money is a monetary system in which money has no intrinsic value but is backed by the government.

 Teaching Tip One way to establish the importance of money is to have students think about how to exchange things without it. Talk about how difficult it would be to get someone that produces all of the things you need in exchange for economics classes (what you produce).

C. Measuring Money in the U.S. Economy 1. There are many ways to perform a transaction, and there are many definitions of money.

2. The difference between the definitions of money is their liquidity, the ease with which an asset can be traded for goods and services.

3. M1 is the sum of currency in the hands of the public, demand deposits, other checkable deposits, and traveler‘s checks. a. Currency held by the public i. This implies each person in the United States, on average, has a very large amount in currency! ii. Much of currency is held abroad in case of emergencies. iii. Many large illegal transactions use currency instead of checks. b. Demand deposits = checking accounts c. Other checkable deposits = those that gain interest d. Traveler’s checks 4. M2 is M1 plus other assets, including deposits in savings and loans accounts and money market mutual funds. a. All of M1 is included. b. Other assets such as money market mutual fund (MMMF) accounts make up the rest.

D. Money is used for transactions. Whether M1 or M2 is a better measure of money is not clear because it is not clear when money is used primarily for transactions or for the purpose of savings.

1. MMMF accounts are paid interest, so people hold them as wealth.

2. You can write checks on your account, so people hold them for transactions.

E. Economists Use Different Definitions Depending on the Specific Purpose at Hand Review this key question and the related application:

Question 1: Why did Greek citizens start holding large amounts of cash in 2015?

APPLICATION 1: CASH AS A SIGN OF TRUST In early 2015, many residents of Greece began withdrawing funds from their banks to keep as cash. They were worried about a major financial catastrophe whereby the country would have to give up the euro and return to its old currency, the drachma.

There was concern that the value of their bank accounts would be significantly less. As a result, people began to withdraw euros from their bank accounts and store them in drawers, safes, and under the proverbial mattress.

13.2 How Banks Create Money A. Banks as Financial Intermediaries 1. Banks bring savers and investors together. a. Banks accept demand deposits (checking accounts). b. To earn income, banks loan part of these deposits to businesses.

B. A bank’s balance sheet: Where the Money Comes from and Where It Goes a. Liabilities are the sources of funds for a bank, including deposits and owners’ equity. b. The bank owes you the value of your checking account. c. Assets are the uses of funds of a bank, including loans and reserves. d. Owners’ equity is the funds provided to a bank by its owners.

2. Firms owe the value of a loan to a bank.

3. Banks also hold some government securities to balance their portfolios.

4. Banks are required to hold a percentage of their demand deposits as reserves with the Federal Reserve (more on this later). a. Reserves are the portion of a bank’s deposits set aside in either vault cash or as deposits at the Federal Reserve. b. The specific fraction of their deposits that banks are required to hold by law is called required reserves.

c. Any additional reserves held above the level of required reserves are called excess reserves.

5. Assets – liabilities = net worth a. Net worth is a source of funds = liability

 Teaching Tip Make sure students (especially if they have never had accounting) understand the difference between an asset and a liability. An asset for an individual or bank is something that is owed to the individual or bank. A liability for an individual or bank is something that is owed by the individual or bank.

C. How Banks Create Money 1. Money supply is M1 = currency + demand deposits a. ∆M1 = ∆C + ∆DD 2. Someone deposits $1,000 in First Bank of Hollywood a. ∆M1 = ∆C + ∆DD = 21,000 + 1,000 = 0 3. Banks make loans to earn income. If required reserve ratio, the ratio of reserves to deposits, is 10 percent, the bank loans out $900.

4. The recipient of loan deposits the $900 in a checking account. a. ∆M1 = ∆C + ∆DD = 0 + 900 = 900 5. The bank loans out $810, which is deposited. a. ∆M1 = ∆C + ∆DD = 0 + 810 D. How the Money Multiplier Works 1. Process continues indefinitely.

2. Total change in money supply = 900 + 810 + 729 + …= $10,000 3. Total ∆M1 = Total ∆C + Total ∆DD a. Total ∆DD = (initial cash deposit)/(required reserve ratio) b. 1/(reserve ratio) is called the money multiplier, which is the ratio of the increase in total checking account deposits to an initial cash deposit, and tells how much demand deposits will grow in response to an initial deposit. c. In 2010, reserve ratio was 3 percent for checkable deposits between $10.7 million and $55.2 million and 10 percent on all checkable deposits exceeding $55.2 million. d. This implies a money multiplier of 10 (since most banks’ deposits exceed $55.2). e. U.S. money multiplier is between 2 and 3 because: i. Banks hold excess reserves. ii. People hold currency.

E. How the Money Multiplier Works in Reverse 1. If initial change in deposits is a withdrawal, the money creation process works in reverse.

2. For a transfer by check, ∆M1 = ∆C + ∆DD a. But, ∆DD = 0 b. Deposit by one individual is equal to the withdrawal by another.

Review this key question and the related application:

Question 2: What is bitcoin and is it really money?

APPLICATION 2: BITCOIN AND CRYPTOCURRENCIES This Application discusses bitcoin, a type of cryptocurrency.

These digital currencies have advantages that include not being dependent on governments and allowing anonymous transactions. A big disadvantage is high volatility in the value of Bitcoin over time. Bitcoins are a medium of exchange, but they do not function as a unit of account or a store of value.

13.3 A Banker‘s Bank: The Federal Reserve A. Created in 1913 to be a banker’s bank, the central bank is an official bank that controls the supply of money in a country.

B. Functions of the Federal Reserve 1. Primary role was to be lender of last resort, the last place, all others having failed, from which banks in an emergency situation can obtain loans.

2. The Federal Reserve has several key functions: a. The Fed supplies currency to the economy. b. The Fed provides a system of check collection and clearing. c. The Fed holds reserves from banks and other depository institutions and regulates banks. d. The Fed conducts monetary policy.

C. The Structure of the Federal Reserve Three distinct subgroups make up the Fed: 1. Federal Reserve Banks are the 12 regional banks that are an official part of the Federal Reserve System: a. The 12 districts each has its own bank. b. They provide monetary policy advice and participate in policy. c. They provide services for banks in their region.

2. The Board of Governors is the seven-person governing body of the Federal Reserve System in Washington, D.C. a. The seven members serve staggered 14-year terms and are appointed by the president and confirmed by the Senate. b. Chairman serves a four-year term.

3. Federal Open Market Committee (FOMC) is the group that decides on monetary policy: It consists of the seven members of the Board of Governors plus five of the 12 regional bank presidents on a rotating basis.

4. Fed must report to Congress on a regular basis regarding monetary policy.

D. The Independence of the Federal Reserve 1. U.S. Fed is relatively independent because the board members are selected for 14year terms.

2. Should a democratic society allow an independent institution to determine monetary policy?

3. More independent central banks have less inflation over long periods of time without any sacrifice in terms of higher unemployment.

13.4 What the Federal Reserve Does During a Financial Crisis Review this key question and the related application:

Question 3: How do policymakers use stress tests to safeguard the financial system?

APPLICATION 3: STRESS TESTS FOR THE FINANCIAL SYSTEM After the financial crisis of 2008, policymakers required major banks to have ―stress tests.‖ These would show if the bank had enough capital or owners‘ equity to survive an adverse change in the economy. The Fed also does its own tests to see if the bank will ―pass.‖ If it does not, the Fed can require the bank to raise additional capital from the markets or prevent it from paying out dividends.

 Teaching Tip 9/11 is a good example to use when discussing the role people‘s confidence has on economic activity. Since people, banks, and business knew the Fed stood ready to maintain the financial system, there was no financial panic.

Review this key question and the related application:

Question 4: How did the Fed successfully respond to the collapse of major financial institutions in 2008?

APPLICATION 4: COPING WITH THE FINANCIAL CHAOS CAUSED BY THE MORTGAGE CRISIS This Application is about how the Fed responded to the collapse of Bear Stearns by directly intervening. The Fed convinced JPMorgan Chase to buy Bear Stearns and then agreed to lend Chase $30 billion to help them with the purchase. Unfortunately, Bear Stearns was only an early symptom of a problem that increased in severity over the coming months. By September and October of 2008, the mortgage crisis had effectively spilled over into the world’s financial markets. Banks and other financial institutions were afraid to lend to one another because they were not sure whether or not their loans would be repaid. The world’s financial markets were freezing up, stock markets were in sharp decline, and panic was growing. As the crisis continued, the Fed continued to develop new programs, such as purchasing the short-term debt of corporations—commercial paper—so that it effectively spread its lender of last resort function beyond financial institutions. It also began a program to extend loans to money market funds, some of which had come under financial pressure, and it started to make purchases of securities backed by mortgages in order to keep funds flowing to the housing sector. Finally, it began to pay interest on deposits held at the Fed, a move designed to induce banks to hold more reserves and increase the Fed’s own ability to make critical loans. Taken together, these were sweeping changes to the Fed’s role in the financial system. The Fed has now abandoned its efforts to support the commercial paper market and money market funds but has maintained the other programs. Only time will tell whether the remaining changes, adopted during a two-month period, will become permanent tools of the Fed or will fade away when the economy evens out.

Additional Applications to Use in Class Question: How can consumers accounts and help the economy?

protect

their

bank

ADDITIONAL APPLICATION: DEPOSITORS, INVESTORS WAIT IT OUT Johnson, Alex ―Depositors, Investors Wait it Out‖ Posted 9/17/2008 on MSNBC.com MSNBC Summary: Key Points in the Article While Wall Street continues to flounder, most investors still feel confident in their local bank.

Government officials and pundits alike feared a run on bank deposits and have been trying to calm the public‘s fears. However, it appears the public is not afraid yet as they continue to leave their money on deposit.

Most investors are protected in the event of bank failure because deposits up to $100,000 are covered by the Federal Deposit Insurance Corporation (FDIC). Retirement accounts are covered

up to $250,000. Also, in spite of the panic, only nine banks have failed recently, compared to the 206 failures in 1988.

So, what should you do? According to experts, make sure that you don‘t have more than the insured amount in any one bank. Split your money that exceeds the $100,000 FDIC limit into separate banks so that it is all covered. Once you‘ve done that, leave it alone, and let the government sort it all out.

Analyzing the News A bank runs by consumers would only worsen the situation as banks would have liquidity problems meeting all the withdrawal demands. Consumers can at least earn some minimal amount on their bank deposits, which is more than you can earn burying it in the backyard in a coffee can. The nation‘s economic health depends on a banking system that functions properly so the government can‘t let it go under.

Thinking Critically Questions 1. Why would there be a ―run‖ on banks?

2. How would that hurt the financial system?

3. What is the FDIC?

Question: How does the speed that money changes hands impact the monetary system?

ADDITIONAL APPLICATION: BANKING TECHNOLOGY IS ALL ABOUT SPEED Lead Story-Dateline: Vanessa Richardson ―Banking Technology Is All About Speed‖ Posted on MSNBC.com MSNBC http://www.msnbc.msn.com/id/15389063/ Posted 10/26/2006 Summary: Key Points in the Article Technology in the financial system has progressed to the point where ATMs and magnetic strip card readers may soon be an artifact of the past. New technologies in contactless credit cards and no-envelope ATMs are being introduced by major banks as the newest time-saving techniques.

Purchase transactions will be completed by simply waving a card with an embedded chip over a receiver.

Currently 30,000 retail establishments from McDonald‘s to local cafes use these contactless cards. According to the experts, ―flashing instead of swiping the card reduces transaction time by 25 percent.‖ While still in the pilot phase, there are millions of users already. However, many small merchants are reluctant to incur the cost of the receivers until customers demand them. In addition to cost concerns, there are also some security concerns. Since the cards use radio frequency identifications, there is some fear that the signal may broadcast too far.

On another front, banks are testing no-envelope ATMs where customers receive an image of the deposited cash or check. The new ATMs are expected to increase consumer confidence and allow them quicker access to deposits.

Analyzing the News Changing the speed of transactions can make a dramatic impact on the economy. Now merchants can complete transactions more rapidly and generate higher volume sales per outlet. This technology should result in greater efficiency assuming the security issues can be resolved.

Thinking Critically Questions 1. How does the speed that money changes hands impact the monetary system?

2. Why do we need to periodically expand the money supply?

3. What is the primary drawback to the new technology?

Solutions to End-of-Chapter Exercises Chapter 13 SECTION 13.1: WHAT IS MONEY? 1.1 1.2 1.3 1.4 1.5 1.6 1.7

barter True True savings accounts False True Introduction of debit cards probably reduced holdings of currency and increased holdings of checking account deposits.

1.8 Unlike traveler’s checks, these cards are typically restricted in their use and not commonly accepted as a medium of exchange. However, they do share some of the features of money.

1.9 This is not really accurate. The reason that the Greeks held cash in euros is because they thought that Greece might exit the system and they would have to hold older Greek currency that would have less value.

1.10 He believed that they just facilitated illegal transactions and tax evasion.

1.11 During all this uncertainty, the U.S. dollar was still seen as safe.

1.12 Bitcoins are a poor store of value because their prices fluctuate too much.

SECTION 13.2: HOW BANKS CREATE MONEY 2.1 reserves 2.2 False 2.3 $80 2.4 False, it is below 1.

2.5 The payment only reduced owners‘ equity immediately.

2.6 Banks can create (deposit) money, while insurance companies cannot.

2.7 M1 decreases, but M2 remains unchanged.

2.8 $10,000 = $2,000/0.20 2.9 It fell sharply around 2008 to a lower level. This is because the Fed began to pay interest on reserves.

2.10 The danger would be that banks would just sit on their reserves and have little incentive to make loans.

SECTION 13.3: A BANKER‘S BANK: THE FEDERAL RESERVE 3.1

lender

3.2 3.3 3.4 3.5 3.6

3.7 3.8 3.9

False FOMC 14 clearing Inclusion of the Treasury Secretary in the FOMC would undercut the political independence of the Fed and increase the likelihood that the Fed would cooperate with the Treasury to lower the cost of financing government budget deficits.

They would move to the West and South from the East and Midwest.

Open market operations are concentrated in New York financial markets by the trading desk at the New York Fed. The benefits of more oversight are democratic accountability—after all, the Fed is a bureaucracy and may not always act in the best interest of all parties. On the other hand, additional Congressional oversight reduces the independence of the Fed.

SECTION 13.4: WHAT THE FEDERAL RESERVE DOES DURING A FINANCIAL CRISIS 4.1 4.2 4.3 4.4

buy or takeover last resort False a. Yes. Reserve holdings that are required cannot be confidently used to meet customer demands for withdrawals. b. The money supply decreased after the increase in reserve requirements.

4.5 Temporarily increase purchases of government securities in the open market and permit increased borrowing of reserves by member banks from the Fed discount window.

4.6 The idea here is that if a bank is too big, its failure would cause so much financial disruption that the government could not let this happen and would bail out the bank. The costs of breaking up a bank depend on whether there are significant cost savings from having larger institutions and whether they would disappear if the bank was forced to reduce its size.

4.7 The Fed will not let a bank pay dividends to its shareholders if it fails a stress test.

4.8 The Fed was concerned with overall financial stability, so it was willing to let the owners not suffer as much as if the firms failed.

Critical Thinking 1. Bitcoins can provide a means for individuals in countries with corrupt governments to move their wealth outside the country. They can also possibly reduce transactions costs in making large exchanges. The downside is that they can be used for illegal purposes and for tax evasion.

2. There certainly will be less check clearing and any other activities that involve processing traditional checks. It may also reduce the need to issue new currency, but we have not seen this yet.

3. The private sector bankers have information about the economy that could be valuable to the Fed. Allowing them to be part of the process may encourage them to provide this information. On the other hand, they may choose presidents to further their own commercial interests as bankers and not for the common good.

14

The Federal Reserve and Monetary Policy Chapter Summary In the last chapter, we discussed how the Federal Reserve can control the money supply. Here, we look at how monetary policy affects the economy in the short run. First, we present a model of the money market. By controlling the money supply, the Fed can change the level of interest rates.

Changes in interest rates will in turn affect investment and output. In an open economy, exchange rates and net exports are also affected by interest rates. This chapter also discusses the limits to conducting successful stabilization policy. Here are the main points of the chapter:  The demand for money depends negatively on the interest rate and positively on the level of prices and GDP.  The Fed can determine the supply of money through open market purchase and sales, changing reserve requirements, or changing the discount rate. Open market operations are the primary tool of the Fed.  The level of interest rates is determined in the money market by the demand and supply for money.  To increase the level of GDP, the Federal Reserve buys bonds on the open market. To decrease the level of GDP, the Federal Reserve sells bonds on the open market.  An increase in the money supply will decrease interest rates, increase investment spending, and increase output. A decrease in the money supply will increase interest rates, decrease investment spending, and decrease output.  In an open economy, a decrease in interest rates will depreciate the local currency and lead to an increase in net exports. Conversely, an increase in interest rates will appreciate the local currency and lead to a decrease in net exports.  Both lags in economic policies and the need to influence market expectations make successful monetary policy extremely difficult in practice.

Learning Objectives: 14.1 The Money Market: Explain the role of demand and supply in the money market.

14.2 How the Federal Reserve Can Change the Money Supply: List the tools that the Fed can use to change short-term interest rates.

14.3 How Interest Rates Are Determined—Combining the Demand and Supply of Money: Demonstrate using supply and demand curves how the Fed can determine short-term interest rates.

14.4 Interest Rates and How They Change Investment and Output (GDP): Describe both the domestic and international channels through which monetary policy can affect real GDP. 14.5 Monetary Policy Challenges for the Fed: Assess the challenges the Fed faces in implementing monetary policy.

Approaching the Material Take your time with this chapter. Many students find this one of the more difficult chapters in principles of macroeconomics. Use plenty of examples. It is useful to discuss the difficulties faced by policymakers when their tools are somewhat limited and their planning horizon is in the future.

Chapter Outline 14.1 The Money Market A. Money market is the market for money in which the amount supplied and the amount demanded meet to determine the nominal interest rate.

B. The Demand for Money 1. A person‘s wealth can be held as stocks, bonds which earn a return, or as money (currency or checking account), which earns no return.

2. Interest rates affect money demand a. Cost of holding money is the foregone return measured by the interest rate.

Remind students of the following key principle:

KEY PRINCIPLE: PRINCIPLE OF OPPORTUNITY COST The opportunity cost of something is what you sacrifice to get it. b. If you are holding wealth as money, it costs you the interest you could earn if you held bonds. c. Rising interest rates lead the public to demand less money (i.e., they will hold more bonds).

 Teaching Tip Piggy banks or cookie jars are good examples of holding wealth in the form of money.

3. The price level and GDP affect money demand a. Why hold money? To perform transactions quickly and easily. The transactions demand for money is the demand for money based on the desire to facilitate transactions.

Remind students of the following key principle:

KEY PRINCIPLE: REAL-NOMINAL PRINCIPLE What matters to people is the real value of money or income—its purchasing power—not the face value of money or income. b. If the dollar value of desired transactions increases, you will need more money. i. An increase in the price level increases the value of desired transactions and money demanded. ii. An increase in GDP is just like an increase in the number of desired transactions and increases money demanded. iii. These are represented by a shift of the money

demand curve Review this key question and the related application:

Question 1: How should the Fed manage its large holdings of financial assets?

APPLICATION 1: WHAT TO DO WITH THE FED‘S BALANCE SHEET? The Fed began to purchase huge amounts of securities beginning in late 2008, a policy known as quantitative easing (QE). The goal was to lower interest rates on bonds and mortgages. During this time, the Fed’s assets increased dramatically. Starting in late 2017, the Fed began to slowly reduce its holdings of assets. It must do this gradually so that interest rates do not rise too rapidly and hurt the economy. This will prove to be a challenge for the Fed in future years.

C. Other Components of Money Demand 1. Liquidity demand for money is the demand for money that represents the needs and desires individuals have to make transactions on short notice without incurring excessive costs a. Illiquid means not easily transferable to money.

2. Speculative demand for money is the demand for money that arises because holding money over short periods is less risky than holding stocks or bonds.

 Teaching Tip Ask the students what they do with their paychecks. Most will keep some as currency and put the rest in the bank. Ask them why. What determines how much?

14.2 How the Federal Reserve Can Change the Money Supply A. Open Market Operations 1. The most frequently used tool of monetary policy.

2. Open market operations are the purchase or sale of U.S. government securities by the Fed. 3. Open market purchases are the Fed’s purchase of government bonds from the private sector. a. This increases reserves in the banking system and increases the money supply.

4. Open market sales are the Fed’s sale of government bonds to the private sector. a. This decreases reserves in the banking system and decreases the money supply.

B. Other Tools of the Fed 1. Changing reserve requirements a. An increase in reserve requirements leads to a decrease in the money supply.

2. Paying interest on reserves

a.

By paying interest, the Fed can affect the willingness of banks to hold reserves.

3. Changing the discount rate a. Discount rate is the interest rate at which banks borrow money from the Fed. i. An increase in the discount rate leads to a decrease in the money supply. b. Federal funds market is the market in which banks borrow and lend reserves to and from one another. c. Federal funds rate is the interest rate on reserves that banks lend each other.

Review this key question and the related application:

Question 2: What is the link between monetary policy and commodity prices?

APPLICATION 2: COMMODITY PRICES AND INTEREST RATES This Application discusses the rise in commodity prices such as oil and food that began in the summer of 2010. Some economists believed that U.S. monetary policy was the cause of this.

However, commodity prices can be affected by other factors as well. Therefore, there is no simple relationship between commodity prices and monetary policy.

4. Repurchase and reverse repurchase Agreements a. The Fed has used this tool since 2013 to temporarily change the level of reserves. b. It temporarily buys or sells Treasury bills to a bank or other securities dealers for a short period of time. c. The Fed has increased its use of repurchase agreements since the financial crisis.

5. Quantitative easing a. Quantitative easing is when the Fed buys long-term Treasury bonds in order to lower long-term interest rates. b. It began doing this in 2010 to stimulate the economy and ended the policy in 2014.

14.3 How Interest Rates Are Determined: Combining the Demand and Supply of Money A. Equilibrium in the Money Market 1. Money demand is downward sloping and is determined by the public.

2. The Fed determines the supply of money, which by assumption, is independent of interest rates. a. It is a vertical curve.

3. Equilibrium occurs where the money supply and demand curves cross, determining the interest rate, r*.

4. The power of the Federal Reserve. a. An open market purchase increases the money supply and decreases interest rates. b. An open market sale decreases the money supply and increases interest rates. c. The Federal Reserve affects interest rates in the short run in order to affect the level of GDP and inflation in the economy.

 Teaching Tip Stress that the interest rate is the price of money, determined the same way as any other price.

B. Interest Rates and Bond Prices 1. Interest rates rise in the economy = bond prices fall a. The two statements are equivalent.

2. A bond entitles the holder to a payment in the future.

3. The price of the bond depends on the payment and the interest rate.

a. Price = Payment/(1 + interest rate) b. If you had $100 today and invested it at 6 percent, it would be worth $106 next year. i. $100 today = $106/(1 + 0.06) c. If interest rates rise, the price of the bond falls. i. To end up with $106 next year, you don’t need to invest as much. d. If interest rates fall, the price of the bond rises. i. To end up with $106 next year, you need to invest more.

4. How open market operations directly affect bond prices a. Since the Fed is buying and selling U.S. government securities (bonds), it is directly affecting the price by changing the demand and/or supply of bonds in the market.

5. Why do ―Fed watchers‖ make so much money? a. If they can provide an inside scoop about the Fed interest rate changes, their employer will have an idea on whether to buy more or sell more bonds.

6. Good news for the economy is bad news for bond prices. a. Good news for the economy = GDP growth. b. GDP growth leads to an increase in money demand and interest rates. c. Higher interest rates are the same as lower bond prices.

Review this key question and the related application:

Question 3: Is it better for decisions about monetary policy to be made by a single individual or by a committee?

APPLICATION 3: THE EFFECTIVENESS OF COMMITTEES This Application is about how Alan Blinder, a former member of the Fed, wondered whether or not committees were a good way to make decisions. He conducted experiments and discovered that not only did committees make the right decision more often, but committees also were faster decision makers than individuals.

14.4 Interest Rates and How They Change Investment and Output (GDP) A. Now we can see how monetary policy affects the economy.

1. There are three ingredients: a. The money market diagram and the level of interest rates, r0 b. An investment function shows the level of investment spending, I0 c. A demand-side (C + I0 + G + NX) model and equilibrium output in the short run, y0 i. Note: changes in interest rates also affect consumption.

1) Spending on consumer durables is really investment goods for the household and will behave just like investment demand.

2. Monetary Policy = Actions taken by the Federal Reserve to influence the level of GDP a. Open market purchase increases the money supply and decreases the interest rates, which leads to an increase in investment and an increase in GDP.

 Teaching Tip Ask the students if they had savings bonds when they were younger. What happened to the money supply when they cashed the bonds in? This is a good way to explain how open market operations impact the money supply. b. Open market sales decrease the money supply and increase the interest rates, which leads to a decrease in investment and a decrease in GDP. c. The Fed can also use reserve requirements and the discount rate to change the money supply.

 Teaching Tip Stress that firms make investments to make profits: the lower the interest rate is, the greater the number of profitable investments.

B. Monetary Policy and International Trade 1. Suppose the Fed lowers interest rates. a. This drives investors to invest some of their funds abroad, causing the value of the dollar to fall. i. Foreign investment requires foreign currency. ii. The demand for U.S. currency falls, lowering its value. b. The exchange rate is the rate at which currencies trade for one another. c. When the value of a currency falls, it is called depreciation. d. The depreciation of the dollar causes U.S. goods to become relatively cheaper on world markets. Why? i. Suppose the exchange rate = 2 euros/1 U.S. dollar. ii. A U.S. machine tool costing $100,000 would cost 200,000 euros. iii. If the U.S. dollar lost value, it would cost fewer euros to get 1 dollar.

1) Exchange rate = 1 euro/1 U.S. dollar 2) The cost of the machine tool is now 100,000 euros.

3) Europeans would want to buy more U.S. goods.

4) U.S. consumers would also buy more U.S. goods because foreign goods would become more expensive. e. When the Fed lowers U.S. interest rates, the value of

the dollar falls (depreciation) and the demand for U.S. goods rises. i.

Net exports rise and GDP rises. f. When the Fed raises U.S. interest rates, the value of the dollar rises. This is called appreciation of a currency. The demand for U.S. goods falls. i.

Net exports fall and GDP falls. g. The international channel makes monetary policy more powerful because net exports move in the same direction as investment and consumption.

 Teaching Tip An effective way to explain these concepts is by using international travel. Many of your students will have traveled abroad. Ask them about currency exchanges and prices of goods in other countries.

14.5 Monetary Policy Challenges for the Fed A. Government has two types of tools to change the level of GDP in the short run.

1. Fiscal policy 2. Monetary policy 3. If GDP is below potential output, expansionary policies (tax cuts, increases in spending, increases in the money supply) raise GDP. 4. If GDP is above full employment, the economy will overheat and inflation will increase. a. To avoid this, the government can use contractionary policy.

5. This is easy. But… a. Lags make decisions harder to make and policies harder to implement. b. We don’t know exactly what is going to happen in the economy.

B. Lags in Monetary Policy 1. Poorly timed policies might be worse than no policy. a. Suppose GDP is too low but will return to full employment in one year. b. Suppose policy takes one year to become effective. c. An expansionary policy will only lead to inflation. i. By the time the policy takes effect, the economy would have been at potential anyway.

The expansionary policy will push the economy above potential.

2. Inside lags are the lags in implementing policy. a. It takes time to recognize a problem. i. Data is only available after a lag and is often conflicting. ii. After the Iraqi invasion of Kuwait in 1990, Fed Chairman Greenspan did not declare a recession until December. iii. We now know the recession started five months

earlier. b. It takes time to take action. i. Monetary policy is much quicker to react when a problem is diagnosed.

3. Outside lags are the lags in the effect of policy. a. The Fed can change interest rates quickly, but it takes time for firms to change their investment decisions. b. Fiscal policy also takes time to take effect. However, the outside lag of fiscal policy is much shorter than that for monetary policy.

C. Influencing Market Expectations: From the Federal Funds Rate to Interest Rates on Long-Term Bonds 1. The Fed controls the Federal Funds rate by changing the demand or supply of reserve through open market operations. a. This is an extremely short-term rate (overnight).

2. Businesses make investment decisions based on long-term rates.

3. Fed needs to affect long-term rates by controlling shortterm rates.

4. How does this happen? a. Long-term rates are a combination of several successive short-term rates.

5. Therefore, the Fed also tries to communicate its intentions about future short-term rates.

6. In recent years, the Fed has used quantitative easing to control expectations about long-term interest rates.

Additional Applications to Use in Class Question: Why the big deal with interest rates?

ADDITIONAL APPLICATION: FED HINTS AT END TO BIG RATE CUTS Guha, Krishna ―Fed Hints at End to Big Rate Cuts‖ Posted 4/8/2008 on Financial Times FT.com Summary: Key Points in the Article The Federal Reserve has aggressively slashed interest rates over the past few months in order to provide liquidity to the troubled financial markets and soften the economic downturn. However, the large cuts of 50 basis points or more at a time may be over. The recently released meeting minutes show that some of the policymakers continue to be concerned about inflation.

The minutes also indicate that the Fed believes that many of our economy‘s underlying issues need to be addressed with more targeted fiscal policy actions. Monetary policy alone is not viewed as capable of solving the entire crisis. Policymakers continue to believe that the dual risks of recession and inflation are ―elevated.‖

In spite of the Fed‘s policy stance toward greater transparency, translating the meetings minutes into a forecast of the next interest rate change is difficult. Some believe the Fed will lower rates 25 basis points while others are betting on a 50 basis point decline.

Analyzing the News Fed interest rate movements are watched very closely by various groups. Investors pay particular attention to interest rates and factor in the anticipated rate movement into their stock valuations.

Therefore, if the interest rate change is different than expected, you will see a lot of investor buying and selling of stocks. If an interest rate cut was less than expected, more investors would sell their stocks at current prices and fewer investors would be willing to purchase at the current price. The combined effect would be to push overall prices lower.

Thinking Critically Questions 1. Why are interest rate expectations important in the financial markets?

2. What is the policy of ―transparency‖ the Fed is currently following?

3. What does transparency have to do with investor expectations?

Solutions to End-of-Chapter Exercises Chapter 14 SECTION 14.1: THE MONEY MARKET 1.1 interest rates 1.2 decrease 1.3 real versus nominal 1.4 transactions 1.5 Payment of interest on money holdings would tend to increase the demand for money.

1.6 Increased demand for money would force the interest-rate-fixing central bank to increase the money supply, thereby forgoing any independent control of the money supply.

1.7 (a) You will naturally hold less currency and make more trips to the ATM to replenish your cash. (b) Since both checking account deposits and currency are part of M1, there may be no effect on the overall demand for money— currency demand will decrease, but your checking account balance could increase by the same amount.

1.8 It would reduce the demand for money and reduce the demand for $100 bills.

SECTION 14.2: HOW THE FEDERAL RESERVE CAN CHANGE THE MONEY SUPPLY 2.1 2.2 2.3

buy reduces federal funds

2.4 2.5

discount At the beginning of 2018, the M1 money multiplier was 0.9. Thus, to increase the money supply by $1 billion it would have to put $1 billion/.95 = $1.052 billion in new reserves into the system.

2.6 Purchasing foreign currency, like any other purchase, will increase the supply of money. Raising reserve requirements will reduce the supply of money. The Chinese government increased reserve requirements to offset the effect of its purchase of U.S. dollars.

2.7 It would raise mortgage rates, that is, interest rates on loans to buy homes.

SECTION 14.3: HOW INTEREST RATES ARE DETERMINED: COMBINING THE DEMAND AND SUPPLY OF MONEY 3.1 3.2 3.3 3.4

positively $100 increase lower

3.5

a. Initial price = $110/1.05 = $104.76. b. New price = $110/1.03 = $106.80 3.6 The investor would sell bonds.

3.7 Interest rates decrease and bond prices increase. See graph to the right.

3.8 There would be a decrease in the speculative demand for money.

However, it would likely affect M2 and not M1, since M1 is primarily used for transaction purposes.

3.9 In principle, the Fed could do this and it could raise the price of stocks. The problem is that the Fed could not easily buy stocks equally and would therefore affect which stocks would rise relative to others.

SECTION 14.4: INTEREST RATES AND HOW THEY CHANGE INVESTMENT AND OUTPUT (GDP) 4.1 4.2 4.3 4.4 4.5 4.6 4.7

lower sale increases, lowers, increases, increase depreciate Refrigerators are a relatively large purchase and more likely to be financed by borrowing.

The effect of changes in exchange rates will tend to be more significant in a small open economy such as the Switzerland, compared to the United States.

They would raise their prices. Since dollars are cheaper on world markets after the depreciation, if they did not raise their nominal prices, then oil would be cheaper for European buyers.

SECTION 14.5: MONETARY POLICY CHALLENGES FOR THE FED 5.1 5.2 5.3 5.4

Inside True the average False

5.5 The lag will become shorter because the international channel, which operates more rapidly, will become more important.

5.6 The stock market can sometimes overreact, leading it to provide ―false‖ signals. In addition, the stock market already reflects market participants‘ expectations of what the Fed might do in the future.

5.7 Since the interest rate on a two-year bond is an average of the rates on today‘s one-year bond and the expected one-year bond rate next year, the market must believe the one-year bond rate next year will rise.

5.8 As Fischer makes clear, they were trying to influence long-term interest rates. And he believes it was successful.

5.9 If the Fed chair is too strong, then the FOMC would operate more like an individual than a group. However, since groups make more effective decisions, this means that U.S. monetary policy may be less effective.

5.10 The rationale for this policy is to make it easier for the public to understand future policy of the Fed. This helps the Fed influence long-term interest rates.

Critical Thinking 1.

These changes would reduce the need to hold currency or checking deposits and reduce M1.

2.

This is an example of good news causing falling asset prices. It is caused by expectations of rising interest rates. This can arise for two reasons. Either the demand for money is expected to increase or the market believes the Fed will contract the supply of money and raise interest rates to prevent the economy from overheating.

3.

This quote does address an important issue. The Fed needs to influence long-term expectations in order to influence long-term interest rates. It can do so through either its announcements or forecasts or sometimes even by buying or selling long-term bonds directly.

15 Modern Macroeconomics: From the Short Run to the Long Run Chapter Summary Thus far in the book, we have discussed how the level of the factors of production determines output and how the price level is determined by aggregate demand in the long run (classical macroeconomics). In the short run (Keynesian macroeconomics), we assume sticky prices, allowing output to be determined by demand.

These two models describe the effect of monetary and fiscal policy over two time horizons. Often we see that policies designed to increase output in the short run (an increase in consumption increases output) will have harmful long-run effects, including reduced savings which lowers per capita output. However, the effects in the intermediate run, the transition from the short to the long run, remains to be explained.

This chapter explains how the economy makes the transition from the short run to the long run. It also highlights why monetary and fiscal policies have different effects in the short run than they do in the long run. Understanding the distinction between the short run and the long run is critical in evaluating economic policy. Here are the main points of the chapter:  When output exceeds full employment, wages and prices rise faster than their past trends.

If output is less than full employment, wages and prices fall relative to past trends.  The price changes that occur when the economy is away from full employment push the economy back toward full employment. Economists disagree on the length that this adjustment process takes, with estimates ranging from two to six years.  Economic policies are most effective when the adjustment process is slow. However, to improve their chances of being reelected, politicians can potentially take advantage of the difference between the short-run effects and the long-run effects of economic policies.  If the economy is operating below full employment, falling wages and prices will reduce money demand and lower interest rates. The fall in interest rates will stimulate investment and lead the economy back to full employment.  The reverse situation occurs when output exceeds full employment. Increases in wages and prices will increase money demand and interest rates. As investment spending falls, the economy returns to full employment.  In the long run, increases in the supply of money are neutral; that is, they do not affect real interest rates, investment, or output.  Increases in government spending will raise real interest rates and crowd out investment in the long run. Decreases in government spending will lower the real interest rates and crowd in investment in the long run.  The adjustment model in this chapter helps us to understand the debate between Keynes and the classical economists.

Learning Objectives: 15.1. Linking the Short Run and the Long Run: Describe the key difference between the short run and long run in macroeconomics.

15.2 How Wage and Price Changes Move the Economy Naturally Back to Full Employment: Demonstrate graphically how the economy can return to full employment.

15.3 The Economics Behind the Adjustment Process: Analyze monetary neutrality and crowding out using graphs.

15.4 Classical Economics in Historical Perspective: Assess how classical economic doctrines relate to modern macroeconomics.

Approaching the Material Most students find this chapter one of the more difficult in macroeconomics. It‘s a good idea to budget extra time. In-class exercises going over the transition from the short run to the long run may prove helpful. Having students derive the many graphs in this chapter should increase their understanding.

Chapter Outline 15.1 Linking the Short Run and the Long Run A. The long run in economics is the period of time in which prices have fully adjusted to any economic changes.

1. Prices are fully flexible.

2. The level of GDP is determined by supply of labor, the stock of capital, and technological progress.

3. The economy operates at full employment.

4. Results a. Increases in government expenditures come at the expense of other uses of output. b. Increases in the supply of money only increase prices, not the level of output. i.

Money is neutral, that is, it does not affect the level of real output in the long run.

B. The short run in economics is the period of time in which prices do not change or do not change very much.

1. Prices are sticky (they don‘t change very much or at all).

2. The total level of demand for goods and services determines the level of GDP. 3. The economy may or may not be at full employment.

4. Results: a. Increases in government expenditures raise total demand and increase output. b. Increases in the supply of money lower interest rates, increase investment, and increase output.

5. How is the short run linked to the long run? a. Through the adjustment of wages and prices.

6. How long is the short run? a. As long as it takes for wages and prices to adjust appreciably.

C. Wages and Prices and Their Adjustment over Time 1. Wages and prices change every day.

2. Sometimes they all move together. a. If output is above potential output, firms will find it difficult to hire workers, and wages will rise. b. This will increase prices. As prices rise, workers want higher wages, and thus prices rise again. c. The reverse happens if output is below potential output and firms can find labor easily, lowering wages. d. This is called a wage–price spiral: The process by which changes in wages and prices cause further changes in wages and prices.

 Teaching Tip Make sure students—especially if they have not had microeconomics— understand why an increase in wages leads to an increase in prices.

Remind students of one of the key principles:

KEY PRINCIPLE: REAL-NOMINAL PRINCIPLE What matters to people is the real value of money or income—its purchasing power—not the face value of money or income.

Review this key question and the related application:

Question 1: Why have some economists revived the idea of ―secular stagnation?‖ APPLICATION 1: SECULAR STAGNATION Secular stagnation is a theory that was developed in the 1930s.

It states that there is not enough aggregate demand to bring the economy to full employment and interest rates will not fall enough. The only solution, in this view, is increased government spending. Lawrence Summers has recently revived this theory. He suggests that increased spending on infrastructure would be very appropriate right now.

15.2 How Wage and Price Changes Move the Economy Naturally Back to Full Employment A. Aggregate Demand and Supply 1. Aggregate demand curve is the curve that shows the relationship between the level of prices and the quantity of GDP demanded.

2. The short-run aggregate supply curve is a relatively flat aggregate supply curve that represents the idea that prices do not change very much in the short run and that firms adjust production to meet demand.

3. The long-run aggregate supply curve is a vertical aggregate supply curve that reflects the idea that, in the long run, output is determined solely by the factors of production (LRAS) is vertical at the full employment level of output.

B. Returning to Full Employment from a Recession 1. Describe the transition to the long-run equilibrium: a. In the short run, y0 and P0 are determined by the intersection of AD and SRAS. b. In the long run, yP and PF are determined by the intersection of AD and LRAS. c. If y0 < yP, wages and prices must fall, and SRAS shifts down over time. d. The downward shift in SRAS continues until y = yP. e. At this point the natural adjustment process stops.

C. Returning to Full Employment from a Boom 1. Describe the transition to the long-run equilibrium: a. If y0 > yP, wages and prices must rise and SRAS shifts up over time. b. The upward shift in SRAS continues until y = yP. c. At this point the natural adjustment process stops.

D. Economic Policy and the Speed of Adjustment 1. Policy choice depends on speed of adjustment.

2. If the economy starts at point a with output too low, the policymaker has two choices. a. Do nothing and let the automatic adjustment process take over and end up at point b. i. Those who believe the adjustment process is slow will say that this creates an undue loss of production. b. Use expansionary policy to shift the AD curve and end up at point c. i. Those who believe the adjustment process is fast will say that this creates an undue increase in prices.

 Teaching Tip This is a great point to illustrate why economists often come to different conclusions as to what is the appropriate policy. It often has to do with making different assumptions. In this case, the key assumption is regarding the speed of the adjustment process.

E. Liquidity trap or Zero Lower Bound is a situation in which nominal interest rates are so low they can no longer fall.

1. In this case, an economy will not recover automatically.

F. Political business cycle is the effects on the economy of using monetary or fiscal policy to stimulate the economy before an election to improve reelection prospects.

1. About a year before an election, a politician will stimulate the economy to lower unemployment in the short run.

2. After getting reelected, the politician can withstand the higher prices and crowding out.

3. The evidence is mixed as to whether this is a real phenomenon.

Review this key question and the related application:

Question 2: What are the links between presidential elections and macroeconomic performance?

APPLICATION 2: EXPECTATIONS

ELECTIONS,

POLITICAL

PARTIES,

AND

VOTER

The historical evidence suggests that Republicans tend to be more concerned with inflation, while Democrats focus on unemployment. The public is aware of this difference, and if they are not sure of the outcome of an election, there will be a contractionary surprise if the Republicans win and an expansionary surprise if Democrats win.

 Teaching Tip Now is a good time to introduce the relationship between politics and economics.

Politics, almost by definition, is a short-run proposition. Politicians must be reelected every two, four, or six years and, therefore, may favor the short run over the long run. In this case, they are much more likely to undertake policies with short-run payoffs and ignore any long-run costs. For example, a politician may be willing to lower taxes to win an election without concern for the possibility of having an increase in the deficit and crowd out investment.

15.3 The Economics Behind the Adjustment Process A. Estimates of the duration of the adjustment process for the U.S. economy range from two to six years.

Remind students of one of the key principles:

KEY PRINCIPLE: REAL-NOMINAL PRINCIPLE What matters to people is the real value of money or income—its purchasing power—not the face value of money or income.

 Teaching Tip Now is a good time to explain how long it takes for the government to implement changes in fiscal or monetary policy.

B. A Closer Look at the Adjustment Process: How do changes in wages and prices restore full employment?

1. The money market determines interest rates.

2. Investment schedule determines the level of investment.

3. As prices change, so does the demand for money. a. Increases in P lead to lower money demand.

4. Suppose P = P0, r = r0, I = I0, y = y0 < yP a. Wages and prices start to fall, money demand falls, interest rates fall, investment increases, quantity of aggregate demanded increases until y = yP. 5. The key to the process is that prices affect money demand, which helps determine interest rates.

 Teaching Tip Ask the students if they would accept a reduction in salary to keep working. This should lead to a discussion of the effectiveness of the labor market and/or how long this process might take.

C. Long-run neutrality of money is an increase in the supply of money that has no effect on real interest rates, investment or output in the long run.

1. Why does monetary policy have different short- and long-run effects? a. Suppose y = yP and the Fed increases the money supply. b. Now y0 > yP. c. In the long run, wages and prices will rise causing the SRAS to shift up until y = yP again.

D. Crowding Out in the Long Run 1. The economy starts at full employment yP with r = rF and I = IF. 2. Suppose G rises to stimulate the economy.

3. In the short run, AD shifts to the right increasing output.

4. But now y0 > yP. 5. In the long run, wages and prices will rise causing the SRAS to shift up until y = yP. 6. At this point, r = r1 > rF and I = I1 < IF. Real investment spending has been reduced in the long run.

7. This is known as crowding out. Increases in government spending will crowd out investment in the long run.

Review this key question and the related application:

Question 3: Will increases in health-care expenditures crowd out consumption or investment spending?

APPLICATION 3: INCREASING HEALTH-CARE EXPENDITURES AND CROWDING OUT This application is about how health-care expenditures were 5.2 percent of GDP in 1950; by 2000, this share had risen to 15.4 percent. As people continue to live longer and older people become a larger share of the population, this number should continue to grow. One estimate has the number growing to 30 percent by mid-century. If this is correct, some other component of GDP must fall. If that component is investment, living standards would decline in the long run. More likely, though, other types of consumption would fall.

15.4 Classical Economics in Historical Perspective A. Say’s Law: Supply creates its own demand.

1. Often associated with classical economics 2. However, if there is too much savings, this could reduce demand and cause a recession.

B. Keynesian and Classical Debates 1. Classical economic models only work if wages and prices are flexible. a. If not, Keynes‘ theories are important.

2. This is the dichotomy that is shown by the short- and long-run models of macroeconomics.

Additional Applications to Use in Class Question: What is the relationship between risk and return?

ADDITIONAL APPLICATION: CALPERS PLANS FIRST INVESTMENTS IN INFRASTRUCTURE Guerrera, Francesco and Anuj Gangahar ―CalPERS Plans First Investments in Infrastructure‖ Posted 9/14/2006 on MSNBC.com The Financial Times Summary: Key Points in the Article The largest public U.S. pension fund, the California Public Employees Retirement System (CalPERS), plans to make direct investments in various commodity infrastructure projects. The move is designed to diversify the giant pension fund‘s $208 billion portfolio into higher risk and hopefully higher return projects. The fund plans to purchase stakes in oil infrastructure projects such as oil depots and other direct investments in commodities like orange groves.

Most pension funds, including CalPERS, have shied away from this type of direct commodity investment due to higher risk. However, the lackluster returns of the stock and bond markets in the recent past have pushed fund managers to adopt new strategies. While still falling short of investing in even higher risk hedge funds, CalPERS‘s investment people cited the tremendous need for capital in the commodity markets as one of the drivers of this change. The commodity sector is expected to need more than $1,600 billion in infrastructure spending in the next 25 years.

Fund managers believe that placing a higher percentage of their money in commodities will also protect the fund against inflation as well as provide even more diversification of invested assets.

Analyzing the News Pension funds are supposed to invest in a prudent manner. It will be interesting to see what percentage of the fund‘s assets is placed in commodity investments. While these higher risk areas have the possibility of higher returns, they also hold the possibility of greater losses. If losses come early, look for CalPERS‘s managers to reverse this strategy. If gains come early, look for CalPERS to be even more aggressive and to potentially overexpose the fund to this sector.

Thinking Critically Questions 1. Why would a pension manager put money in higher risk commodities?

2. Why are commodities considered to be higher risk?

3. Why are commodities expected to be a good long-term investment?

Solutions to End-of-Chapter Exercises Chapter 15 SECTION 15.1: LINKING THE SHORT RUN AND THE LONG RUN 1.1 1.2 1.3 1.4 1.5 1.6

False prices increase, prices, increase, wages False More likely, as the link between price increase and subsequent wage increases would become automatic.

If the actual rate is above the natural rate, wages and prices will fall. They will not change if actual unemployment is at the natural rate.

SECTION 15.2: HOW WAGE AND PRICE CHANGES MOVE THE ECONOMY NATURALLY BACK TO FULL EMPLOYMENT 2.1 2.2 2.3 2.4

upward False False a. In the short run, prices rise, and output falls. Moving to the long run, high unemployment will depress wages, allowing prices to fall and output to increase as the economy returns to full employment. b. The Fed might increase the stock of money. This policy would tend to increase the price level. c. To reverse a decrease in supply (as opposed to a decrease in demand), expansionary monetary policy tends to leave the price level permanently higher.

2.5

a. In the short run with more exports, GDP will increase. b. In the long run, U.S. prices will increase as the economy goes past full employment. If exchange rates do not change, the higher U.S. prices will make U.S. goods more expensive and offset some of the benefits from the open foreign markets.

2.6

The policy-induced increase in aggregate demand might continue to affect the economy even after short-run aggregate supply has increased, creating a short-run equilibrium with output above its capacity level.

2.7

a. This means lower consumption spending. b. These companies naturally invest less in capital goods and since they are so big, the economy also invests less. c. Interest rates cannot fall enough to stimulate demand. d. It takes less money to buy capital goods, so there is not as much spending on them. e. Banks are making fewer loans to allow firms to invest. All these factors reduce aggregate demand.

2.8 They could use contractionary monetary policy (raising interest rates) and offset this with expansionary fiscal policy. The result would be higher interest rates with the economy still at full employment.

2.9 Post-war U.S. unemployment rates appear to be significantly lower during the last two years of presidential four-year terms. The notable exceptions occurred during the Nixon and Reagan administrations, providing a hint of difference (probably not statistically significant) between Republican and Democratic administrations.

SECTION 15.3: UNDERSTANDING THE ECONOMICS OF THE ADJUSTMENT PROCESS 3.1 3.2 3.3 3.4 3.5

increase, increase False True increase a. Aggregate demand temporarily increased.

b. Prices increased, interest rates increased, investment spending decreased, with GDP unchanged.

c. Sales taxes were increased to offset the increased government spending and avoid crowding out. d. Crowding out.

3.6 This is false, because in the long run the Fed cannot affect real interest rates. If this policy is owed, the result will be inflation.

3.7 a. This will increase GDP because of higher labor force participation and more hours of work. b. This should have no effect on growth. c. This should lead to less investment and lower growth. d. It depends on whether spending on new technology comes at the expense of consumption or investment.

3.8 If infrastructure investment makes private investment more profitable, then the latter may not decrease even if interest rates rise. This could mean in an open economy that either consumption or exports fall.

3.9 This would lead to lower interest rates and make a mortgage less expensive.

3.10 Decreased aggregate demand initially decreases real GDP and the price level. With GDP below potential, wages and prices fall, decreasing money demand, which together tend to decrease interest rates, thereby increasing planned investment spending.

SECTION 15.4: CLASSICAL ECONOMICS IN HISTORICAL PERSPECTIVE 4.1 4.2 4.3 4.4 4.5

Patinkin, Modigliani False True classical Friedman believed that the Great Depression began as an ordinary recession that was greatly amplified by the collapse of the financial system, itself a result of incompetent monetary policy.

Critical Thinking 1.

Politicians will adapt to the public. That means both Republican and Democratic candidates will focus less on inflation. To the extent that prior theories of partisan political business cycles relied on Republicans being more sensitive to inflation, this will no longer be as true.

2.

Two possible answers. First, the economy may not really be at full employment and there is more slack in the economy. More people would work if there was more demand.

Second, there could be an artificial or temporary stimulus such as a housing bubble that is keeping the economy at full employment. However, this artificial stimulus cannot last.

3.

Assuming that the infrastructure investment is productive, then if it crowds out consumption it is not a problem. If it crowds out investment it would depend on which type of investment is more productive. In principle, it could also crowd-in private investment.

16 The Dynamics of Inflation and Unemployment Chapter Summary This chapter explores the key role that expectations of inflation play in the economy and how societies deal with inflation. Expectations of inflation affect both interest rates and changes in wages and prices. These expectations depend both on the past history of inflation and expectations about central bank behavior. To reduce inflation, policymakers must increase unemployment above the natural rate. This chapter also looks at the ultimate cause of hyperinflations, excessive monetary growth. Finally, we discuss the costs of unemployment and inflation and why policymakers sometimes deliberately cause recessions to reduce the rate of inflation. Here are the main points of the chapter:  In the long run, higher money growth leads to higher inflation and higher nominal interest rates.  A decrease in the growth rate of money will initially lead to higher real and nominal interest rates. Real rates will eventually return to their prior levels. Nominal rates will be permanently decreased with the decrease in inflation.  The rate of inflation increases when unemployment falls below the natural rate and decreases when unemployment exceeds the natural rate. This relationship is known as the expectations Phillips curve.  How the public forms expectations of inflation and the time frame in which it must form them are important factors in understanding the behavior of inflation and unemployment.  Monetary policymakers need to be cautious in their statements and pronouncements since they can influence expectations of inflation. Conservative central bankers can dampen expectations of inflation.  The quantity equation and the growth version of the quantity equation show the relationship among money, velocity, and nominal income.

 Governments sometimes resort to printing money to finance large portions of their budget deficits. When they do, the result is rapid inflation. Stopping a hyperinflation requires closing the government deficit and ending money creation.

Learning Objectives: 16.1 Money Growth, Inflation, and Interest Rates: Describe how an economy at full employment with inflation differs from one without inflation.

16.2 Understanding the Expectations Phillips Curve—The Relationship between Unemployment and Inflation: Explain the relationship between inflation and unemployment in the short run and long run.

16.3 How the Credibility of a Nation’s Central Bank Affects Inflation: Discuss why increasing the credibility of a central bank can reduce inflation.

16.4 Inflation and the Velocity of Money: Define the velocity of money.

16.5 Hyperinflation: Identify the origins and causes of hyperinflation.

Approaching the Material This is a good chapter to return to the personal approach to teaching economics. Students understand wages and prices from a personal perspective. It is not difficult to move them from nominal to real wages. Remind students that the reason they work is to buy ―stuff.‖ Also, it‘s important to point out the linkages between inflation and unemployment. Policies that affect the labor market will affect wages. Changes in wages in an economy tend to affect prices and hence inflation.

Chapter Outline 16.1 Money Growth, Inflation, and Interest Rates A. Inflation in a Steady State 1. Nominal wages are wages expressed in current dollars.

2. Real wages are nominal or dollar wages adjusted for changes in purchasing power.

3. Money illusion is confusion of real and nominal magnitudes.

4. Expectations of inflation are the belief held by the public about the likely path of inflation in the future.

5. There is no ―magic‖ inflation rate necessary for full employment.

6. Consider an economy at full employment. a. If the Fed increases the money supply at 5 percent a year, then inflation = 5%. i. Nominal prices and wages increase at 5 percent a year.

7. Inflation expectations and interest rates a. Eventually expectations of inflation will be 5 percent, leading to a difference in real and nominal interest rates. i. Expected real rate of interest = Nominal rate of interest – Expectations of inflation ii. In the long run, the real rate of interest is

independent of the money supply. iii. But nominal rates of interest are affected by the money supply.

8. Inflation expectations and money demand a. Money demand will grow 5 percent a year. b. As the dollar value of transactions grows, so does the demand for money.

Remind students of the key principle:

KEY PRINCIPLE: REAL-NOMINAL PRINCIPLE What matters to people is the real value of money or income—its purchasing power—not the face value of money or income.

B. How changes in the growth rate of money affect the steady state. a. What happens if the Fed lowers the growth rate of the money supply to 4 percent? b. Money demand is growing at 5 percent a year, creating an excess demand for money and increasing both real and nominal rates of interest. c. This results in lower investment spending and consumption, leading to lower GDP and higher unemployment. d. In the long run, money is neutral. i. People will come to expect 4 percent inflation, and the real interest rates will return to their previous levels (although the nominal interest rate will remain higher) along with investment, consumption, output, and unemployment. ii. The economy is again at full employment but with a lower inflation rate.

1. U.S. history a. In the late 1970s, the Fed sharply decreased the growth of the money supply. b. By 1981, three-month T-bill rates rose to over 14 percent. c. The economy went into severe recession, with unemployment more than 10 percent. d. By the mid-1980s, the economy was back at full employment with lower interest rates and inflation rates.

2. The long-run effect of monetary policy is on prices only.

In the short run, monetary policy can affect interest rates, investment, output, and unemployment.

 Teaching Tip Now is a good time to introduce students to a historical data set. Have them compare the money supply to GDP over time. (A good source for the data is the Web site for the Federal Reserve Bank of St. Louis.) Ask them if the relationship has been consistent.

Review this key question and the related application:

Question 1: How can data on vacancies and unemployment be used to measure shifts in the natural rate?

APPLICATION 1: SHIFTS IN THE NATURAL RATE OF UNEMPLOYMENT This Application is about how using a variety of job vacancy measures, economist William Dickens found that shifts in the relationship between vacancies and unemployment allowed him to make new estimates of the natural rate. He found that the natural rate was approximately 5 percent in the mid-1960s but then rose in the late 1960s and peaked near 7 percent in the late 1970s and early 1980s. The natural rate began to drift down in the late 1980s and through the 1990s, again reaching the 5 percent level in 2000. It has since remained at this level.

16.2 Understanding the Expectations Phillips Curve: The Relationship between Unemployment and Inflation A. In the United States, inflation increases when economic activity booms and unemployment falls below its natural rate. The reverse is also true: When economic activity slows, unemployment rises above its natural rate.

B. The original Phillips curve, noticed by A.W. Phillips in the late 1950s, explained the relationship between inflation and unemployment without looking at expected inflation.

The relationship between unemployment and inflation, taking into account expectations of inflation, is known as the expectations Phillips curve.

1. Wages and prices can change for two reasons: 2. Business cycle a. During booms (unemployment falling), wages and prices rise. b. During recessions (unemployment rising), wages and prices fall.

3. Inflation expectations a. Expectations for inflation cause wages and prices to rise.

4. If the economy is at full employment, the inflation rate will equal that expected by the public.

5. If U < UN (natural rate of unemployment), inflation will be greater than that expected.

6. If U > UN, inflation will be less than that expected.

7. In the late 1960s, Edmond Phelps and Milton Friedman discovered: a. A sudden rise in inflation is partially unexpected. b. Therefore, nominal wages rise and workers believe their real wages rise (money illusion). c. So output rises, as workers supply more labor. d. Eventually, the increased inflation becomes expected, and workers realize their real wages did not change at all. e. Labor supply goes back to normal, output returns to potential output, and unemployment returns to the natural rate.

C. Are the Public’s Expectations about Inflation Rational?

1. The expectations Phillips curve adjusts for inflationary expectations.

2. Robert Lucas developed rational expectations, the economic theory that analyses how the public forms expectations in such a manner that, on average, they forecast the future correctly.

3. Herbert Simon believed the public used rules-of-thumb to form expectations.

4. Actual expectations appear to be made in both ways.

 Teaching Tip Students sometimes have a difficult time understanding how expectations can influence outcomes. One way to make this understandable is to use sports.

Remind them of when they first learned to play baseball or softball. Until they expected to hit the ball, they had a very difficult making contact. Once they expected to make contact, hitting became much easier. While this is not directly related to the chapter, it does make it clear that expectations matter a great deal.

D. U.S. Inflation and Unemployment in the 1980s 1. The Phillips curve helps describe the pattern of inflation and unemployment for the United States in the late 1970s and 1980s. a. Beginning of 1977 i. Inflation was 6.5 percent. ii. Unemployment more than 7 percent. b. 1980 i. Inflation was 9.4 percent. ii. Unemployment had risen above UN, and the second oil shock increased prices. c. President Carter appointed Paul Volcker, a well-known inflation hawk, as chairman of the Fed. i. Volcker instituted a ―tight money‖ policy, and interest rates shot up. ii. Unemployment rose to over 10 percent (> UN) by 1984. iii. But inflation fell to 2.7 percent, with U at 7 percent by 1986. iv. The recession lowered inflation.

2. Following 1986, unemployment began to fall, and inflation rose a. By 1989, inflation was 4.5 percent.

3. In 1989, the Fed increased unemployment and brought inflation back down to less than 3 percent by 1993.

 Teaching Tip Ask students how interest rates influence their spending. At first, they may say not much, if at all. Remind them about car loans, student loans, and credit cards.

This is relevant once you point out the effect of inflation on nominal interest rates.

E. Shifts in the Natural Rate of Unemployment in the 1990s 1. The U.S. UN fluctuates within a small range.

2. Factors changing the natural rate: a. Demographics b. Institutional changes c. State of the economy d. Changes in growth of labor productivity 3. Europe has seen wide fluctuations in its UN.

 Teaching Tip Ask the students how many times they will switch jobs in their careers. Each time they do, they may temporarily be part of the naturally unemployed.

Review this key question and the related application:

Question 2: How does the Fed use estimates of the natural rate of interest to conduct monetary policy?

APPLICATION 2: ESTIMATING THE NATURAL REAL INTEREST RATE AROUND THE WORLD The natural rate of interest is the real interest rate consistent with full employment after temporary demand and supply shocks have subsided. This interest rate can change due to a variety of things. The Fed tries to determine this interest rate and see how it changes over time.

It has been estimated recently to have fallen from 2–3 percent to virtually 0. This pattern has also occurred in other major countries, suggesting that global factors are responsible for the decrease.

16.3 How the Credibility of a Nation‘s Central Bank Affects Inflation A. Central bankers can influence inflation expectations and hence actual behavior.

1. Workers want higher nominal wages if they expect inflation. a. Large unions negotiating wages for workers may negotiate a high nominal wage. b. Other unions will follow along. c. Prices will eventually rise (without any change in the money supply). d. Fed’s dilemma i. Increased wages shift the SRAS up to AS1. ii. With AD at AD0 the economy will go into recession.

1) Prices would eventually fall to their original level.

iii. Or the Fed can increase the MS to shift AD to AD1 to avoid the recession.

1) Now prices stay at the higher level. e. If the union believes the Fed will not raise AD, they do not want to trigger a recession by negotiating for higher wages. f. If the union believes the Fed will raise AD, they do want to negotiate for higher wages.

2. A central bank’s credibility in the fight against inflation will affect its ability to avoid inflation. a. Credibility allows for low inflation without experiencing extra unemployment. b. Appoint a Chairman who HATES inflation.

3. New Zealand ensured the credibility of its central bank by writing a law in 1989. a. The only goal of the central bank is maintaining stable prices. b. It requires inflation to be between 0 percent and 2 percent a year.

4. True independence of the central bank from the rest of the government might increase credibility. a. The relationship between independence and inflation appears to be a negative one. b. Germany and Switzerland have the most independent central banks and the lowest inflation rate.

5. How do people form expectations regarding the Fed? a. According to Rational Expectations theory, developed

by Robert Lucas in the 1970s, they form expectations such that, on average, they correctly anticipate the future.

 Teaching Tip Ask the students what would happen if all the commuters expected a traffic jam during rush hour tomorrow and left early for work. Their expectations would be fulfilled.

Review this key question and the related application:

Question 3: Why do hyperinflations end suddenly?

APPLICATION 3: THE ENDS OF HYPERINFLATIONS This Application is about a study of four major hyperinflations.

Thomas Sargent observed that they all ended quickly with the creation of a central bank and a change in the way that governments were financed. He suggested that hyperinflations were caused by fiscal policy that was financed by money creation and not taxes.

16.4 Inflation and the Velocity of Money A. Velocity of money is the rate at which money turns over during the year. It is calculated as nominal GDP divided by the money supply.

1. V = P × y/M 2. It is the number of times the money supply has to turn over during a given year to purchase nominal GDP. 3. High velocity implies individuals do not hold money very long.

4. Low velocity implies individuals hold on to money for long periods of time.

B. The above equation can be rewritten to give the quantity equation, which is the equation that links money, velocity, prices, and real output.

1. Money Supply × Velocity = Nominal GDP (the price level × real GDP) 2. M × V = P × y

C. The quantity equation links the money supply and velocity to nominal GDP. 1. If V is predictable, the money supply can be used to predict nominal GDP. 2. But V does vary over time a. Note that in the United States between 1959 and 2001, V for M2 varied between 1.4 and 2.0.

D. The growth version of the quantity equation is an equation that links the growth rates of money, velocity, prices, and real output.

1. Growth rate of M + Growth rate of V = Growth rate of P + Growth rate of y a. %∆M + %∆V = %∆P + %∆y i. If %∆M = 10, %∆V = 0, and %∆y = 3, inflation (%∆P) = 7 2. As long as %∆V and %∆y do not change much over time, %∆M = %∆P

16.5 Hyperinflation A. Hyperinflation is an inflation rate exceeding 50 percent per month.

1. Hyperinflations are extremely disruptive to an economy. a. From November 1943 to November 1944, Greece had inflation of 365 percent per month. i. Prices rose by a factor of 4.65 every month. After a year, a dollar would be worth 1 millionth of one cent! b. In Russia from December 1921 to January 1924, prices rose 57 percent a month. c. In Hungary from August 1945 to July 1946, prices rose 19,800 percent a month 2. During hyperinflations, the velocity of money rises because people do not want to hold an asset losing value.

3. Table 16.3 shows hyperinflations in the 1980s. a. Bolivia, in 1985, had prices rise 11,749 percent a year. b. Argentina, in 1989, had prices rise 3,079 percent a year. c. Nicaragua, in 1988, had prices rise 10,205 percent a year.

4. Money does not serve as a good medium of exchange during hyperinflations because it is hard to determine prices.

B. How Budget Deficits Lead to Hyperinflations 1. Are all hyperinflations caused by excessive money growth?

2. A government can only have higher expenditures than revenue if it runs a deficit.

3. A deficit can be covered in two ways: Government deficit = New borrowing from the public + New money created 4. A country, such as Hungary after World War II, with a devastated economy must run a large deficit. a. But no one will loan a rebuilding country any money. b. A country unable to borrow from the public must create new money.

5. Hyperinflations always occur in countries with large

deficits, that cannot borrow, and which are forced to print new money.

6. Seignorage is revenue raised from money creation.

7. What causes the large deficits? a. Large state-run firms (Argentina, Ukraine) b. Wartime rebuilding 8. To stop hyperinflations, a country must eliminate the government deficit.

9. Monetarists are economists who emphasize the role that the supply of money plays in determining nominal income and inflation.

 Teaching Tip Ask students to discuss what would happen if money became worthless. How would people exchange goods and services?

Additional Applications to Use in Class Question: Who benefits the most from deflation?

ADDITIONAL APPLICATION: FALLING PRICES RAISE WORRIES ABOUT DEFLATION Schoen, John W. ―Falling Prices Raise Worries about Deflation‖ Posted 11/21/2008 on MSNBC.com Summary: Key Points in the Article In addition to the price of fuel falling, consumers are seeing price declines in clothing, transportation, and housing. While these declines are causing many consumers to breathe a sigh of relief, it is causing some concern for policymakers. Deflation can be a problem for a couple of reasons. Number one is the fact that deflation can cause businesses to resist investment now while waiting for prices to bottom out.

Many consumers do the same as the article points out, ―Why shell out $1,200 for a flat-panel TV today when you can get it for $800 six months from now?‖ This type of consumer behavior can keep the economy spiraling downward for years since consumption is the largest component of the economy. In addition to falling consumption, deflation also increases the real value of debt since the money you are paying loans with is now worth more.

While most economists fear deflation, they also believe it is unlikely given the level of fiscal policy stimulus currently being debated and the loose monetary policy of the Fed. While the Fed doesn‘t have much room to lower interest rates further, the fiscal policy stimulus potential is unlimited.

Analyzing the News Assuming a long-run constant aggregate supply (AS) that is constant, you can see where a decline in aggregate demand (AD) will result in falling prices. Falling prices can be a boon to the economy and stimulate buying. However, they can also have the opposite effect and cause

consumers to postpone purchases in the anticipation of cheaper goods if they just wait a little longer.

Thinking Critically Questions 1. What is deflation?

2. How can deflation be beneficial?

3. How can deflation be harmful?

Question: What can governments do to stimulate growth?

ADDITIONAL APPLICATION: UPCOMING WAVE OF LAYOFFS WON’T DISCRIMINATE Herbst, Moira ―Upcoming Wave of Layoffs Won‘t Discriminate‖ Posted 10/22/2008 on MSNBC.com Businessweek Summary: Key Points in the Article The current economic slowdown is expected to impact almost all sectors of the economy.

Manufacturing, financial services, technology, and retail are all either losing jobs or predicted to lose jobs. Companies from Silicon Valley to New York City are announcing layoffs and workforce reductions.

September‘s unemployment rate of 6.1 percent was unchanged from the previous month, but most economists expect some deterioration in the near future. Consumer spending, the engine that drives the bulk of the economy, is slowing drastically as people look for ways to cut back. Home sales are down, consumer electronics sales are suffering, and people are spending less on soft drinks.

There are a few industries that should weather the economic storm. Health care and energy jobs appear to be safe for now. However, experts agree that these industries may not be immune to the downturn if the government is not successful in restoring confidence in the financial markets.

Analyzing the News Recessions and job loss go hand in hand. However, the government has several tools it can employ to restart the growth. One of the tools may be a round of Keynesian spending on infrastructure needs to put people to work. People spend money when they have a secure job and spend less when they don‘t.

Thinking Critically Questions 1. What is Keynesian stimulus?

2. In what areas could the government spend money in a productive manner?

3. How could health care be impacted negatively during a recession?

Solutions to End-of-Chapter Exercises Chapter 16 SECTION 16.1: MONEY GROWTH, INFLATION, AND INTEREST RATES 1.1 1.2 1.3 1.4 1.5

False lower rise; fall money illusion By increasing the money supply rapidly enough and creating expectations of inflation, real rates could be negative while nominal rates are near zero. Recall that the expected real rate equals the nominal rate minus the expected inflation rate.

1.6

1.7

1.8

Money neutrality says that real variables, such as the natural rate of unemployment, are independent of nominal variables. The long-run inflation rate is essentially a nominal variable.

In the first case, (1 – 0.4) × (10%) = 6%, the after-tax nominal cost, and expected inflation is 5 percent, so the expected after-tax real cost of funds is 1 percent. In the second case, (1 – 0.30) × (8%) = 5.6%, the after-tax nominal return, and expected inflation is 6 percent, so the expected after-tax real return is –0.4 percent.

Both examples illustrate that what matters to people is the real value of money, not the nominal value.

SECTION 16.2: UNDERSTANDING THE EXPECTATIONS PHILLIPS CURVE: THE RELATIONSHIP BETWEEN UNEMPLOYMENT AND INFLATION 2.1 2.2 2.3 2.4 2.5 2.6

2.7 2.8

above False, it was Robert E. Lucas, Jr. increase increased According to the graph, the highest was 6.3 in the late 1990s. Recently, the estimated rate is around 4.6. The difference is 1.7 percentage points.

Yes, this could be an example of hysteresis. People who left the labor force during the recession simply did not return. Another explanation could be the continuing retirement of baby boomers.

According to Dicken‘s theory (see Application 1), a higher ratio of vacancies to unemployment will raise the natural rate of unemployment.

The natural rate of interest would rise as less investment spending would be needed to bring the economy to full employment.

SECTION 16.3: HOW THE CREDIBILITY OF A NATION‘S CENTRAL BANK AFFECTS INFLATION 3.1 3.2 3.3 3.4 3.5

3.6

3.7

to the left, increase, decrease the price level independence True, see Figure 16.3.

The financial markets reacted negatively to Blinder‘s comments because the markets perceived that those comments suggested Blinder might be soft on inflation. A conservative central banker would typically not even mention that lower unemployment could increase inflation because such a comment might leave the impression that he or she would not be aggressive in combating inflation. Central bank credibility is based upon the consistency of the message across different pronouncements and actions. A single suggestion of inconsistency could potentially destroy the credibility of the central bank.

Yes, this would be consistent. Higher interest rates in the short run would slow the economy down and could bring down inflation. With lower inflation in the long run, nominal rates would be lower.

Gold prices can change for other reasons. For example, they could rise and fall with political turmoil or be affected by trends in mining. Thus, they provide only very imperfect protection from inflation because they have other risks.

SECTION 16.4: INFLATION AND THE VELOCITY OF MONEY 4.1 4.2 4.3 4.4 4.5

nominal the price level rate of price inflation 3 percent Velocity would rise, since velocity is defined as nominal GDP divided by the money stock and the money stock is smaller.

4.6

4.7

There are several reasons. First, the Fed uses the federal funds rate today and not the stock of money because of constant changes in money demand. Second, the velocity of money varies too much to be a useful measure for monetary policy. Thus, market participants do not pay attention to velocity.

Velocity of turnover for both M1 and M2 has increased, with M1 velocity increasing more than M2 velocity.

M1, January M2, January NGDP, Annual M1 velocity M2 velocity (Billion $s, NSA)

1960 143.3 301.5 526.4 3.67 1.75

2000 1,126.8 4,676.9 9,817.0 8.71 2.10

SECTION 16.5: HYPERINFLATION 5.1 5.2 5.3 5.4 5.5 5.6 5.7

money increase 50 the money stock Having an independent central bank is one way to help ensure that government spending is paid for by taxes and not by selling bonds that are purchased by the central bank.

Money became virtually worthless as inflation became rampant. No one would accept money any more. Barter became just as efficient in those situations.

The government raises funds by printing money, so it is a tax. However, it is a very destructive tax.

Critical Thinking 1.

He meant that tight monetary policy would lead to lower inflation and lower nominal interest rates and the reverse for easy monetary policy. The real rate of interest would not be affected by monetary policy.

2.

This is a real challenge for central banks. They can say they will increase inflation by printing money, but the financial markets might not believe them because historically central banks have been averse to letting inflation increase.

It would require a long public discussion to change expectations.

3.

The way the United States could see a hyperinflation is that we had large and persistent fiscal deficits and had trouble selling government bonds to foreign governments.

Then the only recourse would be to print money to finance the deficits.

Hopefully, the United States would raise taxes or cut spending before that point.

17

Macroeconomic Policy Debates Chapter Summary The topics in this chapter differ from many traditionally covered in an economics textbook.

Usually, you learn factual things like: ―A rise in interest rates reduces investment spending.‖ In this chapter, you look at questions that depend on your views and the facts like: ―Should we balance the federal budget?‖ These types of questions not only require a strong understanding of how the economy works but also require the student to make a judgment regarding priorities.

First, the chapter looks at the pros and cons of balancing the federal government‘s budget. The chapter outlines costs of deficits as well as the benefits of using fiscal policy to stabilize the economy. Next, the chapter addresses the question of a zero inflation rate target. Here, the students need to understand the costs and benefits of inflation. But, it is also necessary to determine the costs of reducing inflation to zero as well as the benefits. Finally, the chapter addresses the question of using tax policy solely to enhance growth. Here are the main points of the chapter:  A deficit is the amount by which the government's current expenditures exceed its revenues. The government debt is the sum of all past yearly deficits.  Deficits can be financed either by borrowing or through money creation. Money creation leads to inflation.  Deficits can be good for the country. Automatic stabilizers and expansionary fiscal policy both work through the creation of deficits.  The national debt involves two burdens: The national debt can reduce the amount of capital in an economy, leading to lower levels of income in the future; it can also result in higher taxes that future generations will have to pay.  A number of developed countries have recently changed their monetary policy to emphasize targeting the inflation rate instead of a range for the inflation rate.  While targeting inflation can increase the credibility of a central bank, it does limit the tools left for active stabilization policy.  A consumption tax would increase the incentives for private savings. However, it is not clear that total savings would necessarily increase, and there would be concerns about the fairness of this form of taxation.

Learning Objectives: 17.1 Should We Balance the Federal Budget?: List the benefits and the costs for a country of running a deficit.

17.2. Should the Fed Target Both Inflation and Employment?: Summarize the arguments in favor of having dual targets.

17.3. Should We Tax Consumption Rather than Income?: Describe the key differences between income and consumption taxes.

Approaching the Material This is a great chapter to help students understand that macroeconomics has some very real insights into everyday life. The questions debated in this chapter are all over the news. Have the students bring in several articles covering both sides of the debates. Explain how politics and economics interact.

Chapter Outline 17.1 Should We Balance the Federal Budget?

1. Government expenditures can be defined as spending on goods and services plus transfer payments.

2. Surplus is the amount by which government revenues exceed government expenditures in a given year. Deficit is the amount by which government expenditures exceed government revenue in a given year.

3. Government debt is the total of all past government deficits.

A. The Budget in Recent Decades 1. In the 1980s and early 1990s, the federal government ran large deficits.

2. In fiscal year 1998, the U.S. government ran a surplus for the first time in 30 years. a. This lowers the debt-to-GDP ratio. b. Options for the surplus i. Reduce the debt ii. Decrease spending and/or raise taxes to increase the surplus iii. Increase spending iv. Decrease taxes 3. In recent years, the federal government has run continuous budget deficits.

B. Five Debates about Deficits 1. Do deficits lead to inflation? a. Deficits can be financed in two ways. i. New money ii. New borrowing b. In the United States, the Treasury Department issues government bonds to cover a deficit. i. If the Fed buys the bond, it raises the money supply and lowers the level of debt outstanding. Monetizing the deficit is the name given to purchases by the central bank of newly issued government bonds. c. If a country cannot borrow money, it is forced to monetize the deficit causing inflation that could lead to hyperinflation.

2. Is government debt a burden on future generations? a. Two burdens of the debt i. Large debts can reduce the capital stock, reducing economic growth.

1) Deficits absorb some savings that would otherwise be invested in capital = crowding out.

Remind students of the following key principle:

KEY PRINCIPLE: PRINCIPLE OF OPPORTUNITY COST The opportunity cost of something is what you sacrifice to get it. ii. Large debt requires increased tax payments in the future to service (pay the interest on) the debt.

1) Interest payments are neutral if all debt is distributed uniformly and held

by U.S. citizens.

 Teaching Tip Be sure students understand that the government being in debt is not the same as an individual or business. The government can always issue new debt to cover the old debt. iii. Ricardian equivalence is the proposition that it does not matter whether government expenditure is financed by taxes or debt.

1) Consumption does not change because people will foresee the increase in future taxes and increase current savings to pay for it. iv. Generational accounting says we should look more closely at how government policy affects other generations.

3. How do deficits affect the size of governments? a. Because taxes are more visible to the public than deficits, politicians can increase spending more easily with deficits than with taxes. b. But states have budget restrictions, and their spending has grown faster than the federal government. c. Since budget restrictions make it difficult for politicians to increase spending, proponents of smaller government may wish to cut taxes to increase deficits and further restrict spending.

4. Can deficits be good for an economy? a. Yes. Deficits can stimulate economic activity as needed during economic downturns. b. Automatic stabilizers—fluctuations in taxes and spending that automatically occur—tend to reduce the fluctuations in an economy. c. Deficits also help to smooth out taxes, reducing the cost of taxes to society.

 Teaching Tip It‘s a good idea to explore ideas with your students about Social Security. Ask them what they think should happen to the system if the current system is not sustainable. Some ideas are encouraging private savings to supplement Social Security, encouraging later retirement, increase taxes, reduce benefits, etc. Ask them what they think is the right idea and what is fair.

5. Would a Balanced Budget Amendment Really Work? a. In 1995, Congress almost passed a balanced budget amendment to the constitution. b. Budget amendments require Congress to propose a budget that is balanced with ―escape clauses‖ allowing for emergencies. c. Proponents i. Prevent deficits during peacetime ii. Costs of deficits will be reduced d. Opponents i. Not enough flexibility to deal with recessions ii. Constitution not right mechanism to make complex budget rules iii. Spending would be taken ―off budget‖—not counted as part of the normal budget e. Increase nonfunded mandates i. If the federal government requires state governments to do something without funding it, it will take that activity off the federal budget.

 Teaching Tip Ask students what they would be willing to go into debt for (car, house, or medical care). Compare that to the reasons the government operates at a deficit during economic downturns (the Great Depression). Ask if it‘s appropriate for a government to borrow to build a new road, dam, or bridge. Is the strategy the same?

Review this key question and the related application:

Question 1: Why did the early U.S. federal government take over the debts of the 13 colonies?

APPLICATION 1: CREATING THE U.S. FEDERAL FISCAL SYSTEM THROUGH DEBT POLICY The United States centralized power in the federal government when it enacted its Constitution in 1789. As a result, the federal government became the sole power to raise revenue through tariffs but also assumed the debts of the state governments. Thomas Sargent states that later, in the 1840s, the federal government did not bail out the states when they had fiscal difficulties because it did not want to enhance its power and control over them. This has defined the fiscal structure of the United States as having a strong central government as well as independent states.

17.2 Should the Fed Target Both Inflation and Employment?

A. Fed‘s Role in Stabilizing the Economy 1. The Fed can use monetary policy.

2. Congress passed the Employment Act of 1946 and Humphrey–Hawkins legislation in 1978 to promote full employment and price stability.

B. Two Debates about Targeting 1. Should the Fed focus on only inflation? a. Some economists believe the Fed should only target price stability because in the long run, monetary policy only affects the price level. i. Increased credibility ii. Free from political pressure to reduce unemployment b. Others see a value in using monetary policy to stabilize the economy. c. A recent approach is price-level targeting where the Fed would target the price level.

Review this key question and the related application:

Question 2: Should the Fed adopt a higher or more flexible inflation target?

APPLICATION 2: DO WE NEED TO CHANGE OUR INFLATION TARGETS? The Fed historically has chosen an inflation target of two percent. There has been recent discussion about whether it should raise the target above two percent, with some economists supporting the idea and others opposing it. The consensus seems to be in favor of a two percent inflation target on average, with flexibility to raise it when necessary.

2. If There Were an Inflation Target, Who Would Set It? a. Government or central bank? i. If set by the government, it could be political. ii. In the United Kingdom, target is set by the elected government. iii. In New Zealand, the target is negotiated between the head of the central bank and the finance minister.

 Teaching Tip Ask students how technology has lowered the costs of inflation—menu costs, shoe-leather costs. For example, menu costs are lower due to everything being priced with bar codes and simply needing to change the price in the computer.

17.3 Should We Tax Consumption Rather than Income?

1. Taxes influence savings that contribute to economic growth.

2. In the United States, we tax interest earned on savings, lowering the savings rate.

3. Consumption taxes are taxes based on the consumption, not the income, of individuals.

A. Two Debates about Consumption Taxation 1. Will consumption taxes lead to more savings? a. Reducing taxes on savings provides a direct incentive to increase savings—the substitution effect. b. Reducing taxes on savings increases wealth, lowering the incentive to save—the income effect. c. Evidence is not conclusive as to the overall effect of taxes on savings.

2. Are consumption taxes fair? a. Basis of consumption tax: Individuals should be taxed on what they take from the economy—consumption. b. But the wealthy will likely benefit the most from exempting savings from taxes. i. Capital gains are profits investors earn when they sell stocks, bonds, real estate, or other assets. c. Are there other means to increase savings? i. As taxes on saving have an ambiguous effect, try something else. ii. Reduce government deficit to increase total savings.

Review this key question and the related application:

Question 3: Can the United States adopt a European-style value-added tax?

APPLICATION 3: IS A VAT IN OUR FUTURE? This Application is about how virtually all developed countries and many developing countries have a value-added tax, commonly known as a VAT. The United States is a prominent exception. In

order for the United States to adopt the VAT system, there are still some problems to be worked out with it.

Additional Applications to Use in Class Question: How can we prevent a Great Depression?

ADDITIONAL APPLICATION: THE ECONOMIC OUTLOOK Hubbard, R. Glenn, and Anthony P. O‘Brien ―The Economic Outlook‖ Posted 10/09/2008 on Webcast Pearson Prentice Hall Summary: Key Points in the Article This presentation and subsequent interview with Hubbard and O‘Brien addressed a number of the problems plaguing our economy. Some of their observations on how our economy got into this situation were that monetary policy was too accommodative in the 2003–2005 time period and that our system had gotten too leveraged using derivative securities.

In spite of the current credit crisis, both experts appeared optimistic. Neither felt that we would suffer economic woes similar to the Great Depression. They expressed the belief that the Fed has learned that inaction was not appropriate and acted decisively this time. However, the action may have been needed sooner although it will take time to see the impact.

Both men indicated that the $700 billion bailout was likely necessary to instill confidence in the capital markets and this crisis created an opportunity to discuss the importance of an active secondary market for financial instruments. The injection also frees up credit for everyone at every level and highlights the importance of our financial system.

Hubbard and O‘Brien did make some suggestions about the crisis. They believe the Treasury should be clear about how to deal with failed financial institutions. We should also continue to increase capital in financial institutions and potentially stabilize the housing market by encouraging wholesale refinancing of these troubled loans at lower rates.

Analyzing the News Hubbard and O‘Brien provided some great insight into the current economic crisis. Fully functioning financial markets are the backbone of any economy. While both men expect to experience a recession they also believe that it will not approach the magnitude of the Great Depression, given the massive government intervention.

Thinking Critically Questions 1. Why do we need the public to have faith in the financial system?

2. What part of the bailout attempted to address restoring public faith in the safety of their deposits?

3. What do we mean when we say that monetary policy was too accommodative?

Solutions to End-of-Chapter Exercises Chapter 17 SECTION 17.1: SHOULD WE BALANCE THE FEDERAL BUDGET?

1.1 1.2 1.3 1.4 1.5

1.6

1.7

1.8

1.9

increase True monetizing war a. For Belgium: Deficit/GDP = 0.062 and Debt/GDP = 1.055. The Deficit/GDP ratio for the United States is currently about 0.026; Debt/GDP = 0.66. The Debt/GDP ratio in the United States was greater than 1.00 only during World War II and immediately thereafter. b. Interest payments are 552.5 francs, creating a deficit from a surplus.

In this example, with a $100 million debt and a 2 percent interest rate, interest payments would be $2 million per year. As long as there is a primary deficit, this will add to that net spending so the government will be spending more than it is receiving in taxes every year.

Hence, the debt will grow over time. In order to stop the debt from growing, you would need a primary surplus of $2 million to offset the interest payments.

In favor: The federal government could (as it did during the founding of the Constitution) assume the debts of some of the states in order to make the United States a more fiscally sound country overall. If California defaulted, that would hurt other states and even the federal government, making it more difficult to borrow. Against: By bailing out the states, it would make them less responsible for the future. That is what the federal governments thought in the 1840s. a. The theory of tax smoothing implies you should raise taxes now, accumulate surplus, and use the surplus to avoid raising taxes even more in the future. b. Under this scenario, Congress will just spend the surplus and not save it, so tax smoothing is not appropriate.

Unless elderly people care about their children and grandchildren, they may consume the tax cut and not save to pay off the future debt. Young people who will be earning more in the future may feel they need to increase their consumption to smooth it over time, so they may also consume the tax cut. In both cases, Ricardian Equivalence would not hold.

SECTION 17.2: SHOULD THE FED TARGET BOTH INFLATION AND EMPLOYMENT? 2.1 2.2 2.3 2.4 2.5

credible U.K. False, it was John Taylor.

False a.

b. Core inflation is more sensitive to aggregate demand (as opposed to supply), which might be more subject to Fed control through monetary policy. Also, targeting core inflation would keep the Fed from responding to supply shocks.

2.6

With a higher average inflation rate, interest rates will on average be higher. This will allow the Fed more room to reduce interest rates if the economy does not perform well.

2.7

Nominal interest rates cannot easily fall below zero. So, to fall 5.1 percentage points on average, nominal rates need to be at least that high. With a real rate of 1–2 percent, this means that inflation must be around 4 percent or so to generate sufficiently high nominal interest rates.

Gold might be a good early warning sign for inflation, so targeting gold might help the Fed offset future inflation. But gold can move up and down for many other reasons, such as national security fears. Adjusting monetary policy to gold could make monetary policy erratic and not responsive to either inflation or employment.

2.8

SECTION 17.3: SHOULD WE TAX CONSUMPTION RATHER THAN INCOME? 3.1 3.2 3.3

$14 value-added False 3.4 two 3.5 a. Your initial cost is $1,000, and you receive $2,000 net of tax after seven years. Using the rule of 70, your money has doubled in seven years, so you earned a 70/7 = 10 percent rate of return. b. The Roth IRA delivers the same result. c. If tax rates are scheduled to rise, you do better with a Roth IRA. You can see this by assuming rates rise to 100 percent in seven years. Then with a traditional IRA you earn nothing—the government takes it all—but with a Roth IRA you still have $2,000.

3.6 No, this is just a transfer of existing funds from one account to another. The parents did not save by reducing their consumption.

3.7 The VAT is a consumption tax and so is a sales tax. States might feel the federal government is encroaching on their fiscal territory.

Critical Thinking 1. There are a number of reasons. First, if economic growth is higher than anticipated or health care costs rise more slowly, the problem will be put off further into the future.

Second, politicians and most people prefer to procrastinate rather than face tough consequences immediately. Third, these are just projections and could change in the future.

2. These might be informative for financial market participants because they signal where interest rates might go in the future. This will help the market decide on the interest rates and prices of long-term bonds and securities. The Congress will want to know to understand the direction that the FOMC members think they will be taking monetary policy in the next several years. The ordinary public probably does not pay much attention to what FOMC members say, but they might notice current changes in interest rates.

3. Since the elderly will tend to be low savers and high consumers, they would be hurt by a move toward a value-added tax. This might be considered unfair. However, if the deficit arises because of high health care costs spent primarily on the elderly, then this might be considered a

fair trade-off.

18 International Trade and Public Policy Chapter Summary This chapter discusses the benefits of specialization and trade. It also explores the trade-offs associated with protectionist policies. The basic conflict is often between us as consumers and us as workers. Here are the main points of the chapter:  Specialization and trade between nations as determined by comparative advantage will benefit both countries. Therefore, free trade is not a zero-sum game, and nations should not become self-sufficient autarkies.  Any restrictions on trade, whether in the form of a ban, quotas, or VERs, raise the domestic price, helping domestic producers and harming domestic consumers. Retaliation leaves a country‘s exporters vulnerable if that nation restricts another‘s exports.  A tariff restricts trade and raises revenue for the government.  A quota restricts trade and raises revenue for importers.  Nations have reduced trade restrictions through multilateral agreements under the auspices of the GATT.  The WTO was created to enforce GATT. Nations have also formed smaller, regional free-trade zones such as NAFTA, the EU, and APEC.  Antidumping laws and the threats of lawsuits often act to limit trade.

Learning Objectives: 18.1 Benefits from Specialization and Trade: Explain carefully the terms comparative advantage and terms of trade.

18.2 Protectionist Policies: List the common protectionist policies.

18.3 What Are the Rationales for Protectionist Policies? Describe the rationales that have been offered for protectionist policies.

18.4 A Brief History of International Tariff and Trade Agreements: Summarize the history of international trade agreements.

18.5 Recent Policy Debates and Trade Agreements: Analyze one recent controversy in trade policy.

Approaching the Material

Students can understand this concept much easier if you make it personal. Set up a few trades in class. If both partners agree to the transaction, both are better off. Ask them what kind of cars they drive, stereos they own, and computers they use.

Chapter Outline This chapter applies many of the concepts from earlier chapters to the discussion of international trade. The title alludes to the context of this discussion in the forum of public policy and debate.

 Teaching Tip It is important to establish that free trade is vital and leads to gains for all nations that participate. It is also important to stress that while every nation as a whole will ―win‖ as a result of free trade, there will be losers in the form of lost jobs. Try to get students to see that the public policy conundrum is due to the gains being spread across all consumers and firms, while the losses are typically concentrated within a sector or region of the economy. This allows for protectionism as the loss is concentrated and the gains are diffused.

 Teaching Tip Students should understand the phrase of ―zero-sum‖ game as it is often used in free-trade debates. Ask them to think of a sport or competitive game of their choice. Now get them to put the concept of ―zero-sum‖ in the context of their game or sport. Now bring the discussion back to free trade and the idea that if trade is free, both sides must be made better off or else the exchange would not have taken place.

18.1 Benefits from Specialization and Trade The first section begins with a restatement of specialization and exchange from Chapter 3. The example used is for two countries named Shirtland and Chipland, respectively.

Remind students of the following key principle:

KEY PRINCIPLE: PRINCIPLE OF OPPORTUNITY COST The opportunity cost of something is what you sacrifice to get it.

 Teaching Tip Refresh students‘ memories regarding self-sufficiency and the gains available from specialization and exchange. Remind them that very few of us produce food, clothing, or shelter for ourselves and yet these are the necessities of life.

We specialize because there are gains to doing so. Now extend the discussion beyond our borders.

A. The production possibilities curve

is a curve that shows the possible combinations of products that an economy can produce, given that its productive resources are fully employed and efficiently used.

 Teaching Tip Reaffirm the concept of opportunity cost, and that since we‘re using straight-line PPCs, the opportunity cost is constant, not increasing.

 Teaching Tip Stress the fact that although each nation starts out being self-sufficient, or ―autarkic,‖ if they choose to trade, both have their PPCs shift to the right. This means that each nation now has a better set of consumption choices.

 Teaching Tip The book makes clear (and you should continue to stress it) that even in this simplified example of shirts and chips, there will be losers and winners.

B. Comparative Advantage and the Terms of Trade

1. Comparative advantage is the ability of one person or nation to produce a good at a lower opportunity cost than another person or nation.

2. Absolute advantage is the ability of one person or nation to produce a product at a lower resource cost than another person or nation.

3. Terms of trade is the rate at which units of one product can be exchanged for units of another product. a. The slope of the production possibilities curves determines the opportunity cost, and the nation with the lower opportunity cost has the comparative advantage.

The terms of trade are set such that each nation benefits by specializing in the good for which they have the comparative advantage in producing. In the example in the text, Shirtland is willing to pay three shirts for each chip and Chipland is willing to accept one shirt for each chip. Splitting the difference allows Shirtland to pay two shirts and allows Chipland to receive two shirts; each nation is made better off by specialization and exchange. Graphically, the increase in each nation‘s welfare is shown by looking at the consumption possibilities curves for each country, which are to the right of their PPCs. b. As Shirtland specializes in producing shirts, more workers are needed to produce the greater level of shirts, but fewer workers are needed to produce chips.

Similarly, in Chipland, fewer workers are needed to produce shirts, but more are needed to produce the greater quantity of chips. Therefore, there is an overall benefit for the country, although workers in the industry that is eliminated in each country incur a steep cost.

 Teaching Tip Remind students that this PPC approach to trade is a simplification or abstraction from reality. Get them to think of the complexities of the real world with the myriad of goods and services any nation produces: wheat, dishes, clothing, shoes, computers, candles, dishes, and toys.

 Teaching Tip Specialization does not end with the production of a good or service. Point out the fact that the Dutch have been at the center of the wholesale trade in flowers for centuries. They are not especially better at growing flowers nor are they the ultimate destination for the flowers that find their way from around the globe to

its markets daily. Rather, the Dutch have specialized in the auctioning of the flowers.

C. The consumption possibilities curve is a curve showing the

combinations of two goods that can be consumed when a nation specializes in a particular good and trades with another nation.

 Teaching Tip It‘s helpful to note for the students that the PPC is the consumption possibilities curve under autarky.

Suppose that the countries decide to trade one chip for two shirts. Both countries can then consume on their higher consumption possibilities curves. Since the CPC lies higher everywhere (except at the intercept) than the PPC, countries can choose to consume more of one or both goods than they did in autarky.

D. How Free Trade Affects Employment 1.

With trade, both countries will tend to specialize in the good in which they have a comparative advantage. This expands the export sector and contracts the import sector.

2. Free trade is not necessarily beneficial for everyone; it depends on how difficult it is for workers to switch sectors. Some displaced workers may be worse off, but those who find jobs in the expanding sectors will be better off.

 Teaching Tip Point out that unemployment may rise at first as trade becomes freer. In the book‘s example, shirt makers in Chipland won‘t necessarily have the skills needed to produce chips while chip producers in Shirtland won‘t necessarily have the skills to produce shirts.

18.2 Protectionist Policies There are four methods by which governments attempt to restrict free trade. These include outright bans on imports, import quotas, voluntary export restraints, and tariffs.

A. Import Bans 1.

Import bans can be examined using the previous example with Chipland’s shirt producers. Without the ban, the market price of $12 is below the minimum needed to induce domestic producers, and imports fill the entire supply of 80 shirts per day. An outright ban excludes foreign imports, so the market is supplied entirely by the higher-cost domestic producers. This higher cost is shown with the domestic supply curve located to the left of the free-trade supply curve. With the ban, the price rises to

$23, and the market shrinks to 60 shirts per day.

B. Quotas and Voluntary Export Restraints

1. An import quota is a government-imposed limit on the quantity of a good that can be imported. With import quotas, the quantity of imports is limited rather than being banned outright. Import quotas are currently illegal in much of the world, so the book compares quotas with voluntary export restraints, which is a scheme under which an exporting country voluntarily decreases its exports. The ―voluntary‖ part may be debatable because a country usually agrees to limit its exports to avoid a ban or tariff.

However, the analysis and graphical results are the same as a quota. The domestic price rises, the quantity exchanged shrinks, and the domestic industry supplies some of the market. In the book‘s example, the price of shirts under the VER is $20 with domestic firms supplying 22 of the 66 shirt daily total. Import licenses are rights issued by a government to import goods.

 Teaching Tip Get students to see that foreign producers may actually want the VER imposed since they get to sell their shirts at a higher price, although they sell fewer shirts.

Often foreign shirt makers would be diverse, and some might have better government contacts, allowing them to be the favored producers under the VER. 2.

The losers of quotas are undeniably consumers who pay higher prices for shirts, and as a result, consumers buy fewer shirts. This situation contrasts with the fact that some foreign producers and their employees benefit if they get to sell their shirts, and domestic shirt producers are likewise winners. Importers also gain with the ability to buy at the lower foreign price and sell at the higher domestic price. The evidence is compelling; after VERs were imposed on Japanese cars in 1984, the average price of Japanese cars was $1,300 higher, which in turn allowed domestic car prices to be higher by about $660.

3. Tariffs A tariff is a tax on imported goods. The results of a tariff are the same as with a quota or a VER. The tariff shifts the supply curve to the left, causing the price in the domestic market to rise and reducing the quantity exchanged. The negative impact is evidenced by the potential gains that could arise if worldwide tariffs were decreased by 50 percent. It is estimated that worldwide food expense would decline by $100 billion if restrictions on agricultural products were similarly reduced.

 Teaching Tip All restrictions cause the domestic price to differentiate from the world market price. The wedge forces the domestic price to be above the world price. If there is a difference between the two prices, that difference has to go somewhere. With tariffs, the government gets the money instead of importers and foreign producers. Students should see that consumers pay the wedge.

Review this key question and the related application:

Question 1: Do tariffs (taxes) on imported goods hurt the poor disproportionately?

APPLICATION 1: THE IMPACT OF TARIFFS ON THE POOR Economists have found that the impact of tariffs in the United States fall most heavily on the poor. Tariffs are generally higher on labor-intensive goods from less-developed countries. These goods tend to be lower priced and thus more likely to be purchased by the poor.

C. Responses to Protectionist Policies

1.

Retaliation usually results from the imposition of any restriction. Protected industries grow (but at an inefficient rate) at the expense of the restricted industry.

As both nations ramp up their mutual retaliation, a trade war results. Examples abound, including the Smoot–Hawley tariff of 1930 where U.S. tariffs were raised to an average level of 59 percent, and the retaliation that followed deepened the Great Depression.

2.

Not only does trade shrink, smuggling becomes more profitable and, hence, more prevalent. Today, the threat of mutually assured destruction, through escalation of trade barriers, often keeps nations from imposing tariffs, or at least lessens their duration.

 Teaching Tip One question to ask is why quotas are illegal while tariffs are still widely used.

Follow the money and see who gets the excess when there is a tariff.

18.3 What Are the Rationales for Protectionist Policies?

Three reasons may be seen as the rationale for government imposition of protectionist policies. It could be to protect domestic workers, to nurture infant domestic industries, or to help established domestic industries gain monopoly power worldwide.

A. To Shield Workers from Foreign Competition 1. The first rationale is the result of mismatched skills between the industries that gain jobs and the industries which suffer losses with specialization and trade. Those who suffer the job losses don‘t necessarily have the skills needed to fill the newly created jobs. The power tends to rest within the declining industries due to the concentration of the job losses versus the diffused gains of lower prices if free trade was allowed to flourish.

B. To Nurture Infant Industries until They Mature 1.

The second rationale is protecting infant industries, industries that are at an early stage of development.

This rationale appears to make more sense than shielding workers from competition. Due to learning by doing, defined as the knowledge and skills workers gain during production that increase productivity and lower cost, an infant industry could become competitive eventually if at first it was protected from foreign competition. The

2.

tariff could then be seen as temporary.

The evidence, however, points to two disquieting facts. The first is that industries rarely ever become competitive, and the second is that governments rarely ever give up potential tax revenue, particularly given the mistaken public perception of tariffs as taxes on foreigners.

 Teaching Tip A similar example to the failure of protectionist policies can be found in tree planting. Imagine planting young trees that have narrow trunks. One method of assuring their survival while their trunks develop is to stake them and use wiring to hold them up. Once the tree has developed, the stakes and wiring are removed.

It seems flawless until it‘s discovered that trees thus supported actually are less tough later and more prone to being blown over.

C. To

Help Domestic Firms Establish Monopolies in World Markets The third rationale for protectionist policies is to help industries, such as airplane manufacturing, that require large economies of scale. A government could subsidize production, thus allowing the domestic industry to expand and be more competitive. Here, the difficulty is that subsidizing could allow a firm to produce when it experiences losses, leaving domestic taxpayers on the hook.

The example in the book is that of the Concorde supersonic jet.

Review this key question and the related application:

Question 2: What have been the local effects of Chinese imports?

APPLICATION 2: CHINESE IMPORTS AND LOCAL ECONOMIES The Application examines the effect of Chinese imports on local communities. Two economists found that some communities were more heavily impacted, depending on the mix of products produced locally. The communities that were more exposed to imports had larger increases in workers receiving government benefits, such as unemployment insurance or food stamps. The study found that the burden of adjustment to imports varies by region.

18.4 A Brief History of International Tariff and Trade Agreements A. The text recounts recent tariff levels in an historic context. Recent tariff levels in the United States (around 5 percent and near other developed nations’ levels) are much less than historic levels. The reduction overtime since the Smoot–Hawley levels of nearly 60 percent is a result of several international trade agreements.

B. General Agreement on Tariffs and Trade (GATT) is an international agreement established in 1947 that has lowered trade barriers between the United States and other nations. Over time, GATT has been expanded to include 146 nations. GATT continues through successive rounds, the last of which was completed in 1994: the Uruguay round. The World Trade Organization (WTO) is an organization established in 1995 that oversees GATT and other international trade agreements, resolves trade disputes, and holds forums for further rounds of trade negotiations.

The latest GATT round, the 2001 Doha round, is concentrating on agricultural protection among other issues where developed countries are pitted against less-developed nations.

C. Regional free-trading blocs include NAFTA, the EU, APEC, and DR-CAFTA. While these do encourage free trade within the blocs, the potential fear is that inter-bloc trade could be negatively impacted.

 Teaching Tip It would be helpful to point out that developed countries might protect the agricultural industries for both cultural reasons and security reasons. A country might be unwise to allow a major portion of its food supply to be imported.

18.5 Recent Policy Debates and Trade Agreements Three issues are discussed regarding free trade. These include questions regarding dumping, the environmental impact of trade laws, and the impact on income inequality resulting from trade.

A. Are Foreign Producers Dumping Their Products?

1. Dumping is defined as a situation in which the price a firm charges in a foreign market is lower than either the price it charges in its home markets or the production costs. Although illegal, many cases alleging dumping are

brought each year including Hong Kong VCRs sold in Europe, Chinese bicycles sold in the United States, and U.S. beef sold in Mexico.

Review this key question and the related application:

Question 3: Can technological advances in another country hurt the United States?

APPLICATION 3: SHOULD WE CARE IF ANOTHER COUNTRY ADOPTS OUR LATEST TECHNOLOGY? When China gains access to U.S. technology, it can hurt the U.S. by eliminating its comparative advantage in producing high-tech goods. If this happens, there is no reason for the two countries to trade. Therefore, technology transfer is now a sensitive issue in U.S.–China relations.

2.

The reasons for dumping include price discrimination, which is the process under which a firm divides consumers into two or more groups and charges a different price for each group buying the same product, and predatory pricing, which is a pricing scheme under which a firm decreases the price to drive rival firms out of business and increases the price when rival firms leave the market. The cases were brought mainly by the developed world until the 1990s. Now over half the cases are brought by the developing world. The threat of the lawsuit, even if the suit is frivolous, is enough to limit imports and act as a protective measure.

B. Do Trade Laws Inhibit Environmental Protection?

1.

Environmental protection is among those choices typically made at the national level. As free trade continues to expand, issues regarding the level of environmental protection chosen become a bargaining tool in trade agreements.

Review this key question and the related application:

Question 4: How has the worldwide trade in automobile parts affected the U.S. auto industry?

APPLICATION 4: HOW AMERICAN ARE AMERICAN CARS? There were record exports of U.S. automobiles in 2014. American cars in the past several years have increasing amounts of foreign parts. For example, the parts for the Ford Fiesta that are from the United States have gone down from 90 percent to 55 percent in a five-year period. Cars are now more competitively priced for consumers. U.S. parts manufacturers have been negatively affected, however, and are facing global pressure (like many others) as a result of globalization.

C. Do Outsourcing and Trade Cause Inequality?

1.

Outsourcing involves firms producing components of their goods and services in other countries.

2.

Free trade causes some degree of income inequality, but the quantity is difficult to measure.

This exemplifies a potential role for the government assisting

workers to attain the educational and training skills necessary to get high-wage jobs.

D. Why Do People Protest Free Trade?

1.

There are several reasons that people protest free trade. a.

A country cannot dictate the production methods of another country, even if it harms the environment. b.

Free trade can contribute to income inequality although lower prices for goods consumed partially offset this effect.

2.

The reasons for protesting free trade are probably driven by a sense of loss of sovereignty and control.

Increased specialization is the need, but this comes at the risk of becoming dependent on others, including other nations, for some of the basics of life. In the end, however, the gains of freer trade far outweigh the costs.

 Teaching Tip Students need to understand that free trade really is just an extension of the previous discussions regarding economic growth through technological change and specialization. We can only continue to grow if we continue to specialize across peoples and nations.

Additional Applications to Use in Class Question: What are the impacts of subsidies?

ADDITIONAL SUBSIDIES

APPLICATION:

THE

TROUBLE

WITH

Zakaria, Fareed "The Trouble with Subsidies" MSNBC.com Newsweek Summary: Key Points in the Article The current global meltdown is creating a protectionist environment. In fact, World Bank estimates indicate that 66 new trade restriction measures have been implemented or proposed by various countries since the economic crisis started. While many of these are outright tariffs, such as Russia‘s increased tariff on used cars, others are massive subsidies to domestic producers.

For example, look at the U.S. subsidies to financial institutions, automakers, and farmers. Every one of these actions is designed to create domestic jobs but will likely backfire. One study estimates that if the ―buy American‖ provisions in the stimulus package result in the best case increase in production for domestic steel, it will create 1000 new jobs. However, at the same time, if our export partners retaliate and our steel exports decline by only 1 percent it will cost the United States 65,000 jobs. The math just doesn't add up. Gaining 1000 jobs at the expense of 65,000 is hardly net job creation.

Will countries retaliate? Of course they will and the 66 new trade restrictions are part of that retaliation. Unfortunately, the trade wars will have the impact of being longer lasting than the

recession would have been and much more costly. The current wave of government bailouts are merely subsidies to inefficient companies that will likely result in a downward protectionist spiral and a lower standard of living for everyone.

Analyzing the News Free trade encourages nations to focus their efforts on production of goods and services that they are best suited to produce. These nations can then engage in trade with other nations to acquire other goods and services produced cheaper elsewhere. The end result should be an expansion in the production possibilities curve with a higher standard of living for all the nations that participate. The shifting PPC illustrates the gains from trade.

Thinking Critically Questions 1. What are subsidies?

2. What are tariffs?

3. Why has the global recession encouraged protectionism such as tariffs and subsidies?

Question: What really constitutes “fair trade?”

ADDITIONAL APPLICATION: IS FAIR TRADE BECOMING “FAIR TRADE LITE?” Gogoi, Pallavi ―Is Fair Trade Becoming ‗Fair Trade Lite‘?‖ Posted 6/19/2008 on MSNBC.com Businessweek Summary: Key Points in the Article TransFair, a U.S.-based organization that certifies products as fair trade, is coming under fire for its relationship with the giant retailer Walmart. Walmart began offering ―fair trade‖ coffees earlier this year. The label means the products come from small farmers who receive a fair price for their output.

Since coffee tends to be grown by small farmers, the point of contention stems from other ―fair trade‖-certified products that are sold by Sam‘s Club, a subsidiary of Walmart. Bananas, tea, sugar, and cut flowers all have the ―fair trade‖ label from TransFair but are produced by large plantations. Critics maintain this practice is ―fair trade lite‖ since it continues the practice established in colonial times of plantation owners exploiting the poor and underprivileged.

TransFair‘s CEO, Paul Rice, maintains otherwise. For a plantation to receive fair trade certification, it must allow workers to unionize, have strong worker safety measures in place, and a portion of the fair trade product premium must be used for worker social and business development projects. Some workers have benefited from free child care and free health care from the program. While the goals are admirable, critics still wonder about how all this will be monitored. Are these mechanisms really in place or just on paper?

Analyzing the News A decline in the number of local gas stations is equivalent to a reduction in local supply. The end result could be TransFair appears to be trying to create a better life for impoverished workers in other countries. However, like many large corporations, the organization is often criticized for its actions overseas. While the system may not be ideal, a good litmus test for social responsibility is

whether or not the system is improving someone‘s situation. The critics don‘t appear to be improving anyone‘s standard of living.

Thinking Critically Questions 1. How does free trade benefit everyone?

2. How does this case illustrate that point?

3. Why would anyone criticize this ―fair trade‖ certification of large plantations?

Question: What factors drive consumer patriotism?

ADDITIONAL APPLICATION: “POCKETBOOK PATRIOTISM”

THE

RESURGENCE

OF

Linn, Allison ―The Resurgence of ‗Pocketbook Patriotism‘‖ Posted 5/19/2008 on MSNBC.com Summary: Key Points in the Article Toy recalls and food product recalls of imported goods have caused many Americans to reflect on their consumption patterns. Other consumers are concerned about labor issues abroad and job loss in the United States. The result is a consumption backlash of sorts where buyers spend more search time looking for U.S.-made products.

Clothing is particularly hard to find with U.S. labels since 97 percent of clothing is imported.

However, diehard ―patriotic‖ buyers have established Web sites that list American-made products and make it easier to find U.S. goods. For some consumers, it simply means buying less. If they can‘t find it, they reevaluate whether they need it.

Critics maintain that these consumers focus on minor issues since the bulk of our imports are petroleum. These critics point out that the best way to buy fewer dollars of foreign goods is to stay home. Every gallon of gas burned increases the trade deficit. In the meantime, consumers are casting dollar votes for the products they want to support.

Analyzing the News While this group is a small part of the U.S. economy, there does indeed appear to be a backlash against the rampant consumption here in the United States. As gas prices continue to escalate, more of these consumers might decide to buy less. In some cases, it will be out of necessity.

Thinking Critically Questions 1. What are ―dollar votes?‖ 2. How does a weaker U.S. dollar impact imported products?

3. What are some of the reasons consumers are buying fewer imported goods?

Solutions to End-of-Chapter Exercises Chapter 18 SECTION 18.1: BENEFITS FROM SPECIALIZATION AND TRADE 1.1

opportunity

1.2 1.3 1.4 1.5

exchanged worse off True a. In B, TVs cost 1/2 computer and computers cost 2 TVs. In C, TVs cost 1/4 computer and computers cost 4 TVs. B has a comparative advantage in computers, and C has a comparative advantage in TVs. b.

1.6

a. 55 pairs of shoes per computer would be the terms of trade. b. The net benefit would be 45 pairs of shoes per computer (for each). a.

1.7

b. Chairland: 18 chairs and 9 tables; Tableland: 20 chairs and 20 tables c. Tableland has a comparative advantage in table production, while Chairland has a comparative advantage in chair production. d. 1.5 chairs/table would be the terms of trade.

e.

f.

1.8

Chairland could consume 15 chairs and 14 tables; Tableland could consume 21 chairs and 26 tables.

Country A was enjoying gains from trade with Country B, but once Country B has the same technology there is no longer the opportunity for trade. So, Country A loses the benefits from trade and is made worse off.

SECTION 18.2: PROTECTIONIST POLICIES 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8

domestic demand, domestic supply below, above False, you raise money with a tariff (not a quota). retaliatory a. $11 per shirt b. Remove the ban, or replace it with a tariff.

Any firms that use steel as an input in production would object as prices of steel in the domestic market would rise.

High tariffs on apparel increased the cost of apparel, which represents a larger share of the budgets of poor consumers than of the rich.

The government will collect exactly the same amount of revenue. Tariffs are more common, however, than auctions of import licenses.

SECTION 18.3: WHAT ARE THE RATIONALES FOR PROTECTIONIST POLICIES? 3.1 3.2 3.3 3.4 3.5

3.6

3.7

infant learning monopoly False; this was Latin American countries.

After 10 years, one would expect that the learning period had ended. However, you could imagine a scenario where the technology in the industry suddenly changed radically, and the industry needs time to learn the new methods.

The firms may benefit if they capture some of the subsidies. Consumers could gain if some of the subsidies lead to lower prices and prevent monopoly. However, they may lose from having two inefficient producers. Taxpayers will typically lose as the countries fail to capture any monopoly profits from the subsidies.

If it rains more slowly, the drains will work. If imports increase slowly, normal turnover in the labor markets may be able to handle the workers displaced by trade. But when it pours

3.8

or when imports suddenly surge, the normal operations of the economy may not be sufficient to handle the volume of workers displaced.

The main lesson is that we should take advantage of our natural endowments and adjust our production accordingly to best meet our needs. We should not simply protect businesses.

SECTION 18.4: A BRIEF HISTORY OF INTERNATIONAL TARIFF AND TRADE AGREEMENTS 4.1 4.2 4.3 4.4 4.5

Doha WTO Canada 1.6 Using this data, tariff rates for the Philippines fell from 22.4 to 3.4 percent. For France, tariff rates fell from 3.6 to 1.6 percent.

4.6 Wage inequality is likely to increase within the original EU countries.

4.7 The U.S. trade representative believes that this violates the trade rules of the WTO and is an unfair trade practice.

SECTION 18.5: RECENT POLICY DEBATES AND TRADE AGREEMENTS 5.1 5.2 5.3 5.4 5.5 5.6

5.7 5.8

5.9

dumping False increase predatory The private industry action would probably be permitted by the WTO, but the government import ban would be disallowed by the WTO as discriminatory against foreign producers.

Generally, Blinder thinks that all nonpersonal services are mobile and without education, and the United States is vulnerable. His model is computer programming or technical services online. Bhagwati emphasizes that the United States has strong comparative advantage in accounting services, information systems, and would benefit from additional trade.

The producers would like it as it leads to higher prices. But if higher prices reduce demand, then sellers and installers would be hurt through lower quantities.

The U.S. believes that the Chinese government highly subsidizes its industries, so it is not a market economy. They want to impose dumping duties and find the use of third-party countries to be useful tools. China resists this and believes dumping duties would be lower if other countries did not use these third country comparisons.

Consumers like it because it lowers prices; automobile firms use foreign parts so they can produce less expensive cars and reach larger markets; domestic parts manufacturers do not like it because they face global competition.

Critical Thinking 1. Yes, since comparative advantage is just relative productivity, a country can create a comparative advantage by finding ways to become more productive in that sector.

Research and development or ―reverse engineering‖ imported goods to discover their technologies can help create comparative advantages.

2. Why not give these workers regular unemployment benefits? One reason is that, this program may be beneficial that it might reduce the political pressures against free trade and reduce the demand for protective tariffs.

3. The pro case is, we want to reduce pollution and not let low cost producers elsewhere gain an unfair advantage by not taking sufficient environmental precautions in production. On the con side, the United States is a wealthier country and we can afford higher pollution standards.

Many developing

countries may prefer to make some other trade-offs between income and the environment.

19 The World of International Finance Chapter Summary This chapter explains market determination of exchange rates based on the desire of economic agents to purchase goods and assets in other countries. Supply and demand for currencies are shifted primarily by changes in national price levels and interest rates, causing currencies to appreciate or depreciate relative to each other.

The real exchange rate reflects relative price levels in the two countries and, thus, relative purchasing power; if purchasing power parity holds, equivalent goods will cost the same amount in each country when converted to a common currency. However, due to the existence of nontraded goods and other factors in the real world, purchasing power parity is not common.

A country‘s balance of payments reflects flows of goods and service and capital assets. The current account is the sum of net exports, net income from investments abroad, and net transfer payments. The capital account measures transactions in existing assets. Under a floating exchange rate system, the balance of payments must sum to zero.

Countries may choose to have fixed or flexible exchange rate regimes; after World War II, much of the world used the Bretton Woods system, under which countries pegged their exchange rates to the value of the dollar. However, fixed-rate systems require participating nations to follow similar economic policies; in the early 1970s, most developed countries moved to a flexible rate system. Flexible rate systems have performed fairly well, and world trade has increased rapidly, but financial crises still occur in part due to the speed of capital movements. Here are the main points of the chapter:  Exchange rates are currently determined in foreign exchange markets by supply and demand.  The real exchange rate—the market exchange rate adjusted for prices—is the relative price of a country‘s goods and services on world markets.  The current account, financial account, and the capital account are related as follows:  The current account is equal to net exports plus net income from existing investments abroad and net transfers from abroad.  The financial account is the value of a country’s sales of assets minus purchases of assets.  The capital account is the net value of a country’s capital transfers and the purchase and sale

 

of nonproduced, not-financial assets.  The sum of the current account, plus the financial account, plus the capital account is zero.

Governments can attempt to change the value of currencies by buying or selling currencies in the foreign exchange market. Purchasing a currency will raise its value; selling a currency will decrease its value.

A system of fixed exchange rates can provide a better environment for business but requires that countries keep their inflation rates and interest rates within narrow limits.

Learning Objectives: 19.1 How Exchange Rates Are Determined? Discuss how the price of foreign exchange is determined by demand and supply.

19.2 Real Exchange Rates and Purchasing Power Parity: Distinguish between the nominal exchange rate and the real exchange rate.

19.3 The Current Account, the Financial Account, and the Capital Account: Explain how the current account, financial account, and capital account are all related to one another.

19.4 Fixed and Flexible Exchange Rates: List the benefits and costs of a system of fixed exchange rates compared to a system of flexible exchange rates.

19.5 Managing Financial Crises: Discuss how international crisis can emerge.

Approaching the Material Students can get lost in the accounting in this chapter. Make sure they do not lose sight of the big picture. Trade is not a difficult topic for most students to understand as long as they do not get lost in the details. Be sure to make it clear to them how the foreign exchange market works and why exchange rates change.

Chapter Outline 19.1 How Exchange Rates Are Determined?

A.

What Are Exchange Rates?

The exchange rate is defined as the price at which currencies trade for one another in the market.

87. An increase in the value of a currency relative to the currency of another nation is called an appreciation of a currency.

88. A decrease in the value of a currency relative to the currency of another nation is called a depreciation of a currency.

89. The euro is the common currency in Europe.

B. How Demand and Supply Determine Exchange Rates 90. The exchange rate (euros per dollar) is the price of a dollar in terms of euros. The demand curve for a currency (e.g., the dollar in terms of euros) is downward sloping; at lower exchange rates (fewer euros per dollar), more dollars will be demanded (in exchange for euros) because United States goods and assets will be less expensive for European buyers.

91. The supply curve is upward sloping; at higher exchange rates, United States citizens will be willing to exchange more dollars for euros.

92. The exchange rate is determined where the supply of dollars equals the demand for dollars.

 Teaching Tip It‘s important to explain to the students that this is a market for currency. The demand and supply of currency to this market is not all of the currency in circulation, only the amount made available to conduct transactions across borders.

 Teaching Tip It‘s important to make it clear to the students what makes up the supply and demand for dollars in the market. Demand is for dollars, so it must be people who don‘t have dollars (Europeans who hold euros) and want them. Why do they want them? To buy things with prices denominated in dollars (U.S. goods and assets). Supply is the supply of dollars by people who have them (Americans with dollars). Why do they supply them? To buy things with prices denominated in euros (European goods and assets). Remind them of this continually.

C.

Changes in Demand or Supply 1. Factors that shift the demand for dollars a.

A change in U.S. interest rates (increasing U.S. interest rates cause an increase in the demand for dollars) b.

A change in U.S. price levels (falling U.S. price levels relative to other countries will cause an increase in the demand for dollars) c.

Increases in demand for the U.S. dollar will cause the dollar to appreciate against the euro.

2. Factors that shift the supply of dollars a.

A change in European interest rates (increasing European interest rates, while U.S. interest rates stay the same, will cause an increase in the supply of dollars) b.

A change in European prices (falling European prices will cause an increase in the supply of dollars) c.

Increases in the supply of dollars will cause the dollar to depreciate against the euro.

 Teaching Tip One key to students‘ understanding exchange rates is make them understand they are dealing with relative prices and that the same forces that determine market prices—supply and demand—determine exchange rates.

19.2 Real Exchange Rates and Purchasing Power Parity Remind students of the following key principle:

KEY PRINCIPLE: REAL-NOMINAL PRINCIPLE What matters to people is the real value of money or income—its purchasing power—not the face value of money or income.

A. The real exchange rate is defined as the price of U.S. goods and services relative to foreign goods and services expressed in a common currency.

1.

Real Exchange Rate = (exchange rate) (United States price level)/(German price level) 2.

Real exchange rate takes into account changes in prices over time. a.

Suppose country A has inflation of 20 percent. b. Country B has no inflation. c.

Suppose country A’s currency depreciates by 20 percent. d.

Real exchange rate does not change.

3.

The multilateral real exchange rate is based on an average of real exchange rates with all United States trading partners (see Figure 19.4). Real exchange rates are important because changes in real exchange rates change a country’s exports and imports.

Review this key question and the related application:

Question 1: How can the price of a Big Mac in Norway shed light on the Norway-U.S. exchange rate?

APPLICATION 1: BIG MACS IN NORWAY The Economist magazine has used the price of a Big Mac throughout the world to see if different currency values are too high or low compared to the law of one price. In January 2018, a Big Mac was cheap in Mexico but very expensive in Norway. Relative to the exchange rate implied by the law of one price, the Norwegian kroner was more expensive than predicted because it is a major exporter of oil.

B.

Purchasing Power Parity 93. Law of one price is the theory that goods easily tradable across countries should sell at the same price expressed in a common currency.

94. The theory of purchasing power parity is a theory of exchange rates whereby a unit of any given currency should be able to buy the same quantity of goods in all countries.

95. In reality, there are substantial deviations from purchasing power parity. A major reason for this is that there are many nontraded goods that influence national price levels but not exchange rates. However, purchasing power parity can be a useful

guide to determining appropriate exchange rates after a hyperinflation or other disruption.

 Teaching Tip Now is a good time to review factors of production and discuss which are mobile and should have the same price (capital and labor), and which are not (land) and therefore have varied prices. Ask them what they think about workers and mobility.

19.3 The Current Account, the Financial Account, and the Capital Account A.

Balance of payments is a system of accounts that measures transactions of goods, services, income, and financial assets between domestic households, businesses, governments, and residents of the rest of the world during a specific time period.

B.

Rules for Calculating the Current, Financial, and Capital Accounts 96. The current account is the sum of net exports (exports minus imports) plus income received from abroad plus net transfer payments from abroad. A positive balance is a current account surplus; a negative balance is a current account deficit.

97. The financial account is the value of a country‘s net sales (sales minus purchases) of assets.

98. The capital account is the value of capital transfer and transaction in nonproduced, non-financial assets in the international accounts. A purchase of a foreign asset is a negative (debit) item in the capital account; the purchase of a domestic asset by a foreign resident is a positive (credit) item in the capital account.

 Teaching Tip A helpful way to remember this is to tell the students to follow the money. If a U.S. asset is sold to a foreign resident, the asset flows out, and money flows into the United States. This is a positive item in the capital account (the money flows in). The other side of this is that it makes money available for U.S. residents to buy foreign goods. An import is a debit to the current account because the money flows out.

4.

The current account plus the capital account must sum to zero.

5.

The United States has had a current account deficit in every year since 1982; this implies a financial account + capital account surplus. Thus, the net international investment position, the domestic holdings of foreign assets minus foreign holdings of domestic assets, has fallen every year. The net international investment position is now negative, and thus the United States is often called a debtor nation.

 Teaching Tip

Be sure to drive home to the students why they look at the financial accounts.

Students can get caught up in the accounting and miss the ―forest for the trees.‖ It‘s helpful to understand how assets are flowing into and out of a country and what is driving those flows.

Review this key question and the related application:

Question 2: How does accounting for investments made in tax havens help explain some puzzles in international finance?

APPLICATION 2: TAX HAVENS AND GLOBAL IMBALANCES There are two puzzles with regard to international financial statistics. First, there appears to be more investment income paid than received each year. In addition, the developing countries are creditors who lend to developed countries like the U.S. An economist at the London School of Economics has solved these puzzles. He found that more than 8 percent of global wealth is held in tax havens that go unrecorded. Complicated laws are used to hold these funds. By taking account of these assets, Europe is a net creditor and the U.S. international position is not negative, as suggested by the data.

19.4 Fixed and Flexible Exchange Rates

A.

99. If a country‘s currency appreciates, imports become cheaper domestically, and exports become more expensive overseas. Thus, net exports will decrease.

100.

If a country‘s currency depreciates, imports become more expensive domestically, and exports become cheaper overseas. Thus, net exports will increase.

Fixing the Exchange Rate 101.

If countries do not want their exchange rate to change (since, for example, an increase in import prices can be inflationary), they can attempt to stop the change through foreign exchange market intervention, which is the sale (or purchase) of currencies by the government to influence the market exchange rate.

102.

To increase the value of a currency, the government must increase the demand for it; to decrease the value of a currency, the government must increase the supply of it. a.

Example: The European and United States governments wish the dollar to trade for 0.8 euros.

However, the equilibrium market rate is currently 0.6 euros/dollar. Either government can intervene by selling euros in exchange for dollars, and the euro will depreciate (dollar will appreciate). b.

If the equilibrium market rate is currently above 0.8 euros/dollar, either government can intervene by selling dollars in exchange for euros, and the euro will appreciate (dollar will depreciate). c.

Governments stockpile foreign currencies to use for intervention; if a government does not have any of the desired currency to sell, it must either try to borrow or try to persuade the other government to do something.

 Teaching Tip

Remind students that fixing exchange rates is not much different than fixing any other price and that the results may be problematic.

B.

Fixed versus Flexible Exchange Rates Flexible exchange rate system is a currency system in which exchange rates are determined by free markets.

2.

Under fixed exchange rate systems, a system in which governments peg exchange rates to prevent their currencies from fluctuating, countries try to keep the value of their currencies constant against one another.

Typically, one country stands in the center, and all others fix or peg their rates to that central country.

Governments intervene to keep rates constant. a.

If there is a balance of payments deficit under a fixed exchange rate system, the supply of a country’s currency exceeds the demand for the currency at the current exchange rate. The government must sell foreign currency and buy its own currency. b.

If there is an excess demand for the country’s currency at the fixed rate, there is a balance of payments surplus. Under a fixed exchange rate system, the government must buy foreign currency and sell its own currency. c. Persistent imbalances usually require a change in the fixed rate. An increase in the exchange rate to which a currency is pegged under a fixed exchange rate system is called a revaluation; a decrease in the exchange rate to which a currency is pegged under a fixed exchange rate system is called a devaluation.

C. The U.S. Experience with Fixed and Flexible Exchange Rates After World War II, the world adopted the Bretton Woods system, a fixed-rate system in which all countries pegged their currencies against the U.S. dollar. This system lasted until the early 1970s, when the world went to a flexible-rate system, in which rates are primarily determined by market supply and demand.

1. While fixed-rate systems facilitate trade, they require countries to pursue similar macroeconomic policies. For example, if the dollar/deutschmark rate is fixed, but the United States’ inflation rate exceeds the German inflation rate, a U.S. balance of payments deficit would arise at the existing rate (which would worsen if the situation continued), requiring intervention by either the U.S. or German government.

2. In the late 1960s, U.S. inflation exceeded inflation throughout much of the world. The dollar was devalued, but trade deficits continued. Attempting to maintain fixed rates against the dollar required other countries to sell their own currencies and buy dollars, increasing their money supplies and essentially importing inflation from the United States. Eventually, the system was abandoned.

1.

D.

Exchange Rate Systems Today Today, most major currencies are flexible; others are fixed. The European Union (with the exception of the United Kingdom) has adopted a single currency, the euro. Other countries have tied their currency’s rates to the dollar or to the yen. Overall, the system has worked fairly well, as demonstrated by the rapid increase in world trade and the relative stability of the system in the face of major supply shocks and other economic disruptions.

 Teaching Tip Flexible exchange rates allow the system of foreign exchange to be more efficient because of the efficiency of markets. It‘s important to discuss the advantages of exchange rate regime.

Review the key question from the chapter opener and its related Application:

Question 3: What are the fundamental causes of economic difficulties for some countries using the euro?

APPLICATION 3: PROBLEMS WITHIN THE EURO BLOC This application explains the current problems with the euro. The vision of a single currency with agreements on fiscal rules among countries proved to be naïve. With a collapse of the housing boom and a worldwide recession in 2007, the governments of many countries could not easily repay their debts. The resulting options included either financial transfers from countries like Germany or sharp cutbacks in budgets and prolonged unemployment.

19.5 Managing Financial Crises A.

The Mexican Peso Problem During the late 1980s and early 1990s, Mexico fixed its exchange rate to the dollar. However, the apparent stability of Mexico and the openness of Mexican markets caused a large inflow of foreign investment, driving up the demand for Mexican goods and increasing the price level.

The price rise caused an increase in Mexico’s real exchange rate and a trade deficit. But continued capital inflow kept there from being a balance of payments deficit, so no intervention was required. However, political instabilities made foreign investors nervous; capital outflow began, but the government took no steps to lower the trade deficit. A devaluation of the peso began to be expected, and even more investors sold pesos. The Mexican government bought pesos in an attempt to support its value but eventually ran out of dollars and could not continue to do this. They were forced to devalue the peso against the dollar. This caused the burden of Mexican debt to increase because both the government and the private sector had borrowed billions of dollars. Mexico faced bankruptcy and economic collapse. To prevent this, the United States and international financial

institutions arranged for the Mexican government to borrow dollars (with extended repayment terms) and avoided disaster.

B. The Asian Crisis In the early 1990s, several Asian countries opened their capital markets to foreign investors and borrowed extensively from abroad. Many investments turned out to be bad, and in Thailand and South Korea, many companies began to lose money. Both domestic and world investors became pessimistic and began to pull funds out of these and other Asian countries. This forced the devaluation of many currencies, which in turn raised the debt burden in those countries. The IMF took various measures that were largely ineffective; the countries that recovered most rapidly were those that used fiscal policies.

 Teaching Tip It‘s a good time to remind students that one of the main reasons that monetary systems work is because people believe in them. Once people lose their faith, disaster may follow.

Review this key question and the related application:

Question 4: What are the causes of financial collapses that occur throughout the globe?

APPLICATION 4: THE ARGENTINE FINANCIAL CRISIS Argentina thought it had solved its financial problems by pegging its currency to the U.S. dollar.

Unfortunately, they were wrong. An appreciating U.S. dollar caused Argentina to run trade deficits.

Additionally, the Argentinean government could not control spending and had to borrow in dollardenominated loans. Brazil‘s devaluation eventually forced Argentina to default on its international debt and freeze bank accounts and a depression ensued.

Additional Applications to Use in Class Question: How does the weakening U.S. dollar make U.S. companies more attractive to foreign investors?

ADDITIONAL APPLICATION: AMERICA FOR SALE Steverman, Ben ―America for Sale‖ Posted 7/25/2008 on Business Week Businessweek.com Summary: Key Points in the Article Foreign buyers are taking advantage of a weak U.S. dollar to snap up U.S. assets. In 2007, nearly $300 billion worth of U.S. firms were purchased by foreign entities. The pace has slowed slightly for 2008 due to a weak global economy but should still exceed $150 billion. Compare those numbers to the paltry $49.6 billion worth of foreign acquisition deals in 2003.

The weak U.S. dollar is seen as the primary driver with many companies using their stronger currency to buy hard assets in the same manner that tourists with strong currencies come on U.S. shopping sprees. Some experts maintain that a weak dollar alone will not create a deal but instead speed up planned acquisitions. Other drivers appear to be easier access to capital outside the United States.

Most of the foreign investors are coming from Canada and developed Europe. However, recently several Asian investors have joined in the bargain hunting. Most of the interest appears to be high-growth businesses and many believe the trend will continue unless the upcoming presidential election curbs the flow.

Analyzing the News As long as the U.S. dollar continues to fall it will make goods (including companies) denominated in U.S. dollars cheaper to the rest of the world. If the companies generate most of their revenue in dollars, it will not work in favor of the acquirers when they are buying cash flows. However, many indicated that asset acquisition was the primary reason to acquire a U.S. firm. Since many U.S. firms have substantial operations in other countries, these companies will become even more attractive to foreign investors.

Thinking Critically Questions 1. Why are U.S. firms cheaper now to a European investor?

2. What are some of the reasons the dollar is falling versus other currencies?

3. Why do foreigners have better access to credit right now?

Question: Why is reform critical to growth?

ADDITIONAL APPLICATION: INDIA’S ECONOMY HITS THE WALL Kripalani, Manjeet ―India‘s Economy Hits the Wall‖ Posted 7/01/2008 on MSNBC.com Businessweek Summary: Key Points in the Article India‘s economic growth is being tested by lack of economic reform. Annual growth is expected to slow from 9 percent to around 7 percent. The stock market has fallen by 40 percent, and inflation hovers above 11 percent. Many fear that the country will lose its ability to float investment grade debt.

Analysts and experts blame part of the country‘s economic woes on high oil prices and the subprime mortgage crisis drying up international investment funds. However, at least a portion of the blame is falling on the government and the lack of any economic reform. The government continues to subsidize diesel fuel and waive loans to farmers in spite of declining tax receipts.

India experts maintain plans to build 30 Special Economic Zones should be expedited instead of mothballed. In addition, the legal system needs shored up with more judges and the government‘s plans to build 1,500 more universities needs to be implemented. However, most agree these bold plans will remain unimplemented unless next year‘s national elections usher in new visionary leaders.

Analyzing the News India has an opportunity to invest in itself or be stagnant. Unfortunately, for most of us, politicians often follow the principle of maximizing their own personal utility instead of making decisions that benefit nations.

Thinking Critically Questions 1. Why are universities needed in India?

2. What about the legal system?

3. Why is India’s ability to sell investment grade debt critical to economic development?

Solutions to End-of-Chapter Exercises Chapter 19 SECTION 19.1: HOW EXCHANGE RATES ARE DETERMINED 1.1 1.2 1.3 1.4 1.5

appreciates depreciates depreciates depreciate a.

b.

c.

1.6

The U.S. dollar appreciated, tending to increase the U.S. trade deficit.

1.7 The dollar will appreciate against the euro.

SECTION 19.2: REAL EXCHANGE RATES AND PURCHASING POWER PARITY 2.1 2.2 2.3 2.4 2.5

increase or appreciate increase False purchasing power parity a. 14.9 percent b. 1980: 2.208; 1990: 2.236 c. Real exchange rate changed by 0.028, or 1.27 percent. d. Most of the change in a. above was the nominal, not real, exchange rate.

2.6 a. 1.046 euros/$ would equalize the costs of a latte. b. The euro was ―too high‖ in early 2004 relative to the dollar.

2.7 Using the Web site, we find that the ruble price of a Big Mac is 130, the current exchange rate is 56.75, and the purchasing power exchange rate is 24.62. The ruble is undervalued relative to the dollar.

2.8 We would not expect purchasing power parity to hold because the law of one price does not hold for nontraded goods.

We would expect the price of Big Macs to be higher in the long run in countries with higher GNPs.

SECTION 19.3: THE CURRENT ACCOUNT, THE FINANCIAL ACCOUNT, AND THE CAPITAL ACCOUNT 3.1 3.2 3.3 3.4 3.5 3.6 3.7

surplus/positive zero debtor deficit, surplus The capital account is positive by $100 billion (–100 + 200). Since the sum of the capital and current account is zero, the current account will be –$100.

For the U.S. and Japan, these are pension funds. China has accumulated funds by running large current account surpluses. The other countries are rich in oil and natural resources.

The commonly used international financial data does not take into account holdings of securities in tax havens. These assets are not included and thus underestimate the asset holdings of residents of Europe.

SECTION 19.4: FIXED AND FLEXIBLE EXCHANGE RATES 4.1 4.2 4.3 4.4 4.5 4.6

sells deficit False, the United States had too high an inflation rate relative to Germany.

False 9.5% (= 14.7% × 5.2%) is the implied depreciation in the lira.

Countries might adopt dollarization for several reasons. First, they may not feel they are sophisticated enough to manage their own currency and central bank. This may be true of very small countries. Second, they may have a history of inflation and this is a way to prevent inflation from emerging again. Finally, if a substantially high fraction of their trade is with the country whose currency they adopt, this might be efficient.

4.7 To manipulate a currency means taking action to lower its value in the market. This will require active intervention by a government in the foreign exchange market.

4.8 With less labor mobility, there has to be more adjustments in wages and prices in each country. This is very difficult and means the adjustment process after economic disturbances will be difficult.

SECTION 19.5: MANAGING FINANCIAL CRISES 5.1 5.2 5.3 5.4 5.5 5.6

fell increase True deficit They believe that the lessons learned in dealing with debt crises in developing countries also apply to developed countries as well.

Two basic reasons. First, borrowers might require it because they fear the country‘s currency would depreciate. Second, it might appear to be cheaper.

Critical Thinking 1.

Firms that import materials for production and consumers as a whole who will pay higher prices.

2.

It is generally believed that the U.S. earns higher returns on its foreign investment than do foreigners on U.S. financial investment. As long as this return differential is large enough, it could offset the fact that we have more liabilities than assets (net debtor).

3.

Suppose China imports material for its manufacturing from other countries but sells its finished goods to the United States. It will then have a trade deficit with those countries and a trade surplus with the United States.