Economics Today A Canadian Perspective Macroeconomics, Canadian Edition, 1st edition Roger LeRoy Mil

Economics Today A Canadian Perspective Macroeconomics, Canadian 1ST Ed By Roger LeRoy Miller

Email: Richard@qwconsultancy.com

Chapter 1

The Nature of Economics 

Answers to Questions for Critical Analysis

AI: DECISION MAKING THROUGH DATA Why do you suppose that economists sometimes disagree about whether to classify as a microeconomic or macroeconomic endeavor the application of big data analytics to massive volumes of information encompassing virtually all of a nation’s industries and interactions among those industries?

Because big data analytics uses such massive volumes of information, which can encompass virtually all a nation’s industries and interactions among those industries, it seems as if the endeavor is a macroeconomic application (large scale). However, in many cases, this big data just represents a small part of the economy, which could be perceived as a microeconomic application (individual scale or sub-scale).

THE INCENTIVES TO ATTEND POST-SECONDARY EDUCATION (P. 7) Sometimes adults tell young people to “get all the education you can get.” Does this mean that you should necessarily obtain an advanced degree?

Under special circumstances, your answer to this Real Application question would be, yes. Those special circumstances would involve being able to obtain an advanced degree at zero cost to you and simultaneously not having any job opportunities as an alternative. Otherwise, you should look at how much more you would expect to earn per year if you complete an advanced degree program compared with what you could have earned working rather than spending more time in a university. Plus, you would have to consider the out-of-pocket costs of pursuing an advanced degree.

ASSESSING WHETHER CHARITABLE DONATIONS REFLECT CARING FOR OTHERS OR FOR ONESELF How might the fact that the Canadian government allows larger tax deductions for some charitable donations than for others, how would this affect Canadian taxpayers’ incentives about how much to donate and to whom they direct their donations?

Canadian taxpayers are likely to donate to charities that will both help others and those in which will make them better off (either through a tax deduction or a charitable gift). If the government allows larger tax deductions for some charitable donations over others, taxpayers are likely to donate more to the charities where they receive a larger benefit (tax deduction).

GETTING DIRECTIONS In what way do small talk and gossip represent the use of simplifying assumptions?

Gossip and small talk usually deal with other persons or situations of interest to the persons engaged in the conversation. Often the people who are talking choose to leave out details which they consider unimportant or information that do not support their position. The interpretation of the situation or the behaviour of the person being talked about will be affected by which details are omitted. .

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition

Economics in Your Life

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GOVERNMENT PROVIDES INCENTIVE PROGRAM FOR ZERO-EMISSION VEHICLES (ZEV).

For Critical Thinking Overall, does it appear that the incentive provided to purchase ZEV arise from the application of centralized command and control, the price system, or a mix of the two? Explain your reasoning.

It appears that the government incentive provided to purchase ZEV is a mix of the two or a mixed economy. The market will determine what and how much ZEVs to produce. The government incentive or consumer subsidy will decrease the ZEV price and make the purchase more attractive to consumers.

Real Application Assume that you decide to buy a ZEV. Should you take advantage of the incentive?

Because the only cost to you, is your time to fill out the government application, you should definitely take advantage of the incentive. Assuming you comply with the government requirements you will benefit paying a lower price for your ZEV.

Issues & Applications

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WHY EDUCATION AND FINANCIAL INDEPENDENCE HELPS TO EXPLAIN WHY WOMEN ARE DELAYING MARRIAGE AND WHY FEWER WOMEN ARE MARRIED For Critical Thinking Why do you think that the prevalence of marriages by women to higher-income-earning partners has remained relatively steady in recent years? (Hint: More higher-income-earning partners have completed more years of education and have more stable employment prospects than those who earn less.)

The argument states that women choose to marry out of self-interest and will marry a partner that will be able to provide financially for the household. If women’s interests and actions do not change, then the prevalence of marriages to higher-income-earning partners should remain relatively steady.

Real Application Currently, a larger percentage of women are obtaining advanced degrees than are men. What are some of the real-world implications of this trend with respect to marriage?

Women with advanced degrees typically do not seek out spouses who have little or no education past high school. One might predict, that there will be a higher percentage of marriages among men and women who have advanced degrees.

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Answers to End-of-Chapter Questions

1-1.

Define economics. Explain briefly how the economic way of thinking—in terms of rational, self-interested people responding to incentives—relates to each of the following situations. a. A student deciding whether to purchase a textbook for a particular class b. Government officials seeking more funding for mass transit through higher taxes c. A municipality taxing hotel guests to obtain funding for a new sports stadium .

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Chapter 1 The Nature of Economics Economics is the study of how individuals allocate limited resources to satisfy unlimited wants. a. Among the factors that a rational, self-interested student will consider are her income, the price of the textbook, her anticipation of how much she is likely to study the textbook, and how much studying the book is likely to affect her grade. b. A rational, self-interested government official will, for example, recognize that higher taxes will raise more funds for mass transit while making more voters, who have limited resources, willing to elect other officials. c. A municipality’s rational, self-interested government will, for instance, consider that higher hotel taxes will produce more funds if as many visitors continue staying at hotels, but that the higher taxes will also discourage some visitors from spending nights at hotels.

1-2.

Some people claim that the “economic way of thinking” does not apply to issues such as health care. Explain how economics does apply to this issue by developing a “model” of an individual’s choices.

This issue involves choice and, therefore, can be approached using the economic way of thinking. In the case of health care, an individual typically has an unlimited desire for good health. The individual has a limited budget and limited time, however. She must allocate her budget across other desirable goods, such as housing and food, and must allocate her time across waiting in a physician’s office, work, leisure, and sleep. Hence, choices must be made in light of limited resources.

1-3.

Does the phrase “unlimited wants and limited resources” apply to both a low-income household and a middle-income household? Can the same phrase be applied to a very high-income household?

Because wants are unlimited, the phrase applies to very high-income households as well as lowand middle-income households. Consider, for instance, a household with a low income and unlimited wants at the beginning of the year. The household’s wants will still remain unlimited if it becomes a high-income household later in the year.

1-4.

In a single sentence, contrast microeconomics and macroeconomics. Next, categorize each of the following issues as a microeconomic issue, a macroeconomic issue, or not an economic issue. a. The national unemployment rate b. The decision of a worker to work overtime or not c. A family’s choice to have a baby d. The rate of growth of the money supply e. The national government’s budget deficit f. A student’s allocation of study time across two subjects

Microeconomics is the study of individual decision making, whereas macroeconomics examines the aggregate behaviour of the entire economy. a. macroeconomics b. microeconomics .

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition c. d. e. f.

1-5.

microeconomics macroeconomics macroeconomics microeconomics

One of your classmates, Sally, is a hardworking student, serious about her classes, and conscientious about her grades. Sally is also involved, however, in volunteer activities and an extracurricular sport. Could Sally be displaying rational behaviour? Based on what you read in this chapter, construct an argument supporting the conclusion that she is.

Sally is displaying rational behaviour if all of these activities are in her self-interest. For example, Sally likely derives intrinsic benefit from volunteer and extracurricular activities and may believe that these activities, along with good grades, improve her prospects of finding a job after she completes her studies. Hence, these activities are in her self-interest even though they reduce some available study time.

1-6.

Recently, a bank was trying to decide what fee to charge for “expedited payments”— payments the bank would transmit with extra speed so that customers could avoid late fees on cable TV bills, electric bills, and the like. To try to determine what fee customers were willing to pay for expedited payments, the bank conducted a survey. It was able to determine that many of the people surveyed already paid fees for expedited payment services that exceeded the maximum fees they said they were willing to pay. How does the bank’s finding relate to economists’ traditional focus on what people do, rather than what they say they will do?

This example illustrates that what people say they will do does not actually correspond to what matters in the economy, which is what they actually do.

1-7.

Explain, in your own words, the rationality assumption, and contrast it with the assumption of bounded rationality proposed by adherents of behavioural economics.

The rationality assumption states that people do not intentionally make choices that leave them worse off. The bounded rationality hypothesis suggests that people are almost, but not completely, rational.

1-8.

Why does the assumption of bounded rationality suggest that people might use rules of thumb to guide their decision making instead of considering every possible choice available to them?

The bounded rationality hypothesis indicates that because people cannot study every possible alternative available to them, they consider only the most obvious apparent choices. They find easy ways of deciding which of these obvious choices to select, and according to the hypothesis, these methods are simple rules of thumb.

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Chapter 1 The Nature of Economics 1-9.

Under what circumstances might people appear to use rules of thumb, as suggested by the assumption of bounded rationality, even though they really are behaving in a manner suggested by the rationality assumption?

Suppose that there is a change in the environment that a person faces, and the person adjusts to this change as predicted by the rationality assumption. If the new environment becomes predictable, then the individual who actually behaves as predicted by the traditional rationality assumption may settle into behaviour that appears to involve repetitive applications of a rule of thumb.

1-10. For each of the following approaches that an economist might follow in examining a decision-making process, identify whether the approach relies on the rationality assumption or on the assumption of bounded rationality. a. To make predictions about how many apps a person will download onto her tablet device, an economist presumes that the individual faces limitations that make it impossible for her to examine every possible choice among relevant apps. b. In evaluating the price that an individual will be willing to pay for a given quantity of a particular type of health-care service, a researcher assumes that the person considers all relevant health-care options in pursuit of his own long-term satisfaction with resulting health outcomes. c. To determine the amount of time that a person will decide to devote to watching online videos each week, an economist makes the assumption that the individual will feel overwhelmed by the sheer volume of videos available online and will respond by using a rule of thumb. a. Bounded rationality b. Rationality assumption c. Bounded rationality 1-11. For each of the following approaches that an economist might follow in examining a decision-making process, identify whether the approach relies on the rationality assumption or on the assumption of bounded rationality. a. An economic study of the number of online searches that individuals conduct before selecting a particular item to purchase online presumes that people are interested only in their own satisfaction, pursue their ultimate objectives, and consider every relevant option. b. An economist seeking to predict the effect that an increase in a state’s sales tax rate will have on consumers’ purchases of goods and services presumes that people are limited in their ability to process information about how the sales-tax-rate increase will influence the after-tax prices those consumers will pay. c. To evaluate the impact of an increase in the range of choices that an individual confronts when deciding among devices for accessing the Internet, an economic researcher makes the assumption that the individual is unable to take into account every new Internet-access option available to her.

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition a. Rationality assumption b. Bounded rationality c. Bounded rationality 1-12. Which of the following predictions appear(s) to follow from a model based on the assumption that rational, self-interested individuals respond to incentives? a. For every ten exam points Myrna must earn in order to pass her economics course and meet her graduation requirements, she will study one additional hour for her economics test next week. b. A coin toss will best predict Leonardo’s decision about whether to purchase an expensive business suit or an inexpensive casual outfit to wear next week when he interviews for a high-paying job he is seeking. c. Celeste, who uses earnings from her regularly scheduled hours of part-time work to pay for her room and board at college, will decide to purchase and download a newly released video this week only if she is able to work two additional hours. a. Yes, because Myrna is acting in her own self-interest by establishing this allocation of her time to studying economics. b. No, because Leonardo is leaving an important decision affecting his self-interest to random chance, potentially leaving him worse off if he fails to obtain employment. c. Yes, because Celeste is basing her choice on a self-interest assessment of expenditures in light of available resources.

1-13. Write a sentence contrasting positive and normative economic analysis.

Positive economic analysis deals with economics models with predictions that are statements of fact, which can be objectively proved or disproved. Normative analysis considers subjective personal or social values concerning the way things ought to be.

1-14. Based on your answer to Problem 1–13, categorize each of the following conclusions as resulting from positive analysis or normative analysis. a. A higher minimum wage will reduce employment opportunities for minimum wage workers. b. Increasing the earnings of minimum wage employees is desirable, and raising the minimum wage is the best way to accomplish this. c. Everyone should enjoy open access to health care at no explicit charge. d. Health-care subsidies will increase the consumption of health care. a. b. c. d.

Positive Normative Normative Positive

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Chapter 1 The Nature of Economics 1-15. Consider the following statements, based on a positive economic analysis that assumes all other things remain constant. For each, list one other thing that could independently change in a way that offsets the outcome stated. a. Increased demand for digital devices will drive up their price. b. Falling gasoline prices will result in additional vacation travel. c. A reduction of income tax rates will result in more people working. a. An increase in the supply of digital devices, perhaps because of the entry of new device manufacturers into the market, pushes their price back down. b. Another factor, such as higher hotel taxes at popular vacation destinations, makes vacation travel more expensive. c. Some other factor, such as a fall in market wages that workers can earn, discourages people from working additional hours.

1-16. Suppose that the government has borrowed $50 billion to expand its total spending on goods and services across the entire economy in an effort to boost by $50 billion the aggregate production by the nation’s firms. Would we apply microeconomic or macroeconomic analysis to analyze this policy action?

This policy action involves billions of dollars in economywide total spending and aggregate production. Because the action involves the economy has a whole, macroeconomic analysis would be applied.

1-17. Suppose that the government has raised by $10 a per-carat tax rate it imposes on diamonds in an effort to influence production of this particular good by each of the firms that produce it and purchases by individual consumers. Would we apply microeconomic or macroeconomic analysis to analyze this policy action?

This policy action involves a tax per unit applied to sales of one specific item produced by a particular set of firms and bought by a particular group of consumers. Because the action involves a small part of the economy, microeconomic analysis would be applied.

1-18. Centralized command and control prevails throughout a certain nation’s economy. What three key economic questions have been addressed in this nation, and what has been the common element of the nation’s answers to those questions?

The three questions are as follows: What and how much will be produced? How will items be produced? For whom will items be produced? In this command-and-control economy, the common element of the nation’s answers to these questions is that the government makes all decisions.

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition 1-19. During her years of college, Dominique discovered that her three favorite subjects were astronomy, chemistry, and political science. She chose to major in astronomy because she had seen data indicating that science majors earn higher-than-average wages and because she liked astronomy better than both chemistry and political science. Upon graduation, however, she learned that average wages in chemistry fields were 20 percent higher than average wages earned by astronomers. Did Dominique’s behaviour violate the rationality assumption?

The rationality assumption states that individuals do not intentionally make decisions that would leave themselves worse off. When Dominique decided on astronomy over chemistry, she sought an enjoyable field of study within the generally higher-pay area of science. Thus, she did not intentionally make herself worse off. Indeed, with her training in astronomy she may still receive earnings higher than average pay in other non-science fields, including political science. She has ended up “less well off” only in the sense that she could have earned even higher wages if she had majored in chemistry and only after the fact—not because she intentionally made a decision that would leave her “worse off.”

1-20. Sebastian is a financial analyst who is convinced that his clients do not always make choices that are consistent with their long-term objectives. He has also determined that his clients do not consider every relevant choice and often fail to act in their own self-interest.

Does Sebastian perceive that his clients’ behaviour necessarily accords with the rationality assumption or the assumption of bounded rationality?

Sebastian perceives that the bounded rationality assumption applies, because he views their behaviour as inconsistent with their long-term goals, their capabilities to evaluate every relevant choice, and their own self-interest.

1-21. Maneesha has completed an analysis of the market for a prescription medication. She concludes that the policymaker should act to prevent an increase in the price of this drug on the grounds that the mainly older consumers of the medication have already spent their lives paying too much for pharmaceuticals. They ought not to have to pay higher prices, Maneesha has concluded, so the government should act to halt any further price increases in this market. Has Maneesha applied positive or normative economic analysis?

Maneesha has predicated her analysis on the basis of what the outcome “should” be, what price is “too much” to pay, and what people “ought not” be obliged to do. Consequently, her analysis is based on value judgments instead of purely descriptive considerations, and as such it is an example of normative economic analysis.

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Chapter 1 The Nature of Economics

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Appendix A: Answers to End-of-Appendix Questions

A-1. Explain which is the independent variable and which is the dependent variable for each of the following examples. a. Once you determine the price of a flash drive at the college bookstore, you will decide how many flash drives to buy. b. You will decide how many credit hours to register for this semester once the university tells you how many work-study hours you will be assigned. c. You anticipate earning a higher grade on your next economics exam because you studied more hours in the weeks preceding the exam. a. Independent: price of a flash drive; Dependent: quantity of flash drives b. Independent: work-study hours; Dependent: credit hours c. Independent: hours of study; Dependent: economics grade A-2. For each of the following items, state whether a direct or an inverse relationship is likely to exist. a. The number of hours you study for an exam and your exam score b. The price of pizza and the quantity purchased c. The number of games the university basketball team won last year and the number of season tickets sold this year a. direct b. inverse c. direct A-3. Review Figure A-4, plot the points on the coordinate axes, and then state whether each of the following paired observations is on, above, or below the x axis and on, to the left of, or to the right of the y axis. a. (–10, 4) b. (20, −2) c. (10, 0) a. above x axis; left of y axis b. below x axis; right of y axis c. on x axis; to right of y axis A-4. State whether each of the following functions specifies a direct or an inverse relationship. a. y = 5x b. y = 10 – 2x c. y = 3 + x d. y = –3x a. b. c. d.

direct (or positive); each 1-unit rise in x induces a 5-unit increase in y. inverse (or negative); each 1-unit rise in x induces a 2-unit decrease in y. direct (or positive); each 1-unit rise in x induces a 1-unit increase in y. inverse (or negative); each 1-unit rise in x induces a 3-unit decline in y. .

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition A-5. Given the function y = 5x, complete the following schedule and plot the curve.

Y −20 −10 0 10 20

x −4 −2 0 2 4

A-6. Given the function y = 8 – 2x, complete the following schedule and plot the curve. y

x

16 12 8 4 0

−4 −2 0 2 4

A-7. Calculate the slope of the function you graphed in Problem A-5.

Each one-unit increase in x yields a 5-unit increase in y, so the slope given by the change in y corresponding to the change in x is equal to 5.

A-8. Calculate the slope of the function you graphed in Problem A-6.

Each one-unit increase in x yields a 2-unit decrease in y, so the slope given by the change in y corresponding to the change in x is equal to −2.

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Chapter 2

Scarcity and the World of Trade-Offs 

Answers to Questions for Critical Analysis

WHY PEOPLE WITH THE HIGHEST HOURLY OPPORTUNITY COST ALLOCATE AS MUCH TIME TO LEISURE AS EVERYONE ELSE Why might a high-income individual perceive a substantial opportunity cost of devoting an available labour hour to a low-income task?

A high-income individual would need to give up a substantial amount (the cost of the time they could have spent working) to devote one hour to a low-income task (like watching TV). Whereas a low-income individual would need to give up less (the cost of the time they could have spent working) to devote one hour to a low-income task).

THE ECONOMIC EXPLANATION FOR SHRINKING AIRLINE RESTROOMS Why do you suppose that some airlines have simply removed a restroom or two from each of their passenger planes?

These airlines have found these additional restrooms have incurred a high opportunity cost. By reducing the number of restrooms, they can add additional rows of seats to the airplane, which can generate additional revenue for the airline (whereas the restrooms generate no revenue).

AI: CITY MANAGEMENT Who ultimately funds the information-gathering and decision-making activities of city governments that big data techniques are helping to guide?

Governments are mainly funded by taxpayer dollars. By using big data techniques for information-gathering and decision-making, city governments are using their scarce resources more efficiently.

CITY BICYCLE LANES ENCOUNTER THE LAW OF INCREASING ADDITIONAL COST Why might we anticipate a bowed shape for the production possibilities curve relating space taken up by a bicycle lane along a street to parking spaces along the street?

Cities will first convert parking spaces that are more suitable for bicycle lanes (those with fewer potholes) at a relatively low cost. As more and more spaces are being converted from parking spaces to bicycle lanes, eventually they will require resources that are not as suitable for bicycle lanes, thus increasing the costs associated with the change.

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Economics in Your Life

EXTREME SPECIALIZATION LEADS ONE PERSON TO PURSUE SMALL-ROCKET LAUNCHES For Critical Thinking As more aerospace firms set up in New Zealand to launch satellites and other payloads beyond the earth’s atmosphere, what is likely to happen to the opportunity cost of larger portions of the airspace above that nation? Explain briefly. .

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition As more aerospace firms set up to launch satellites in New Zealand, the opportunity cost of the portions of airspace would likely rise. The companies will first seek out the areas with the lowest opportunity costs (for example, inhabitable land that is not utilized). As more and more land is being used to launch satellites, however, areas with greater opportunity costs (for example, farmland) will need to be used.

Real Application Assume you are hired as part of the management team for a new aerospace company in New Zealand. It, too, wishes to launch satellites along paths very close to those of Rocket Labs. What would you tell the president of that new company about future opportunity costs?

You would have to point out that the opportunity cost of the airspace that your new company desires to use will definitely rise, and in particular it will rise more quickly, the more satellites Rocket Lab launches.

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Issues & Applications

ARE WE “LOSING” FARMLAND IN CANADA? For Critical Thinking What are some of the alternative uses for farmland? With your understanding of the concept of opportunity cost how do farmers evaluate the decision to sell their farmland? When farmland is converted to some of these alternative uses is it actually “lost”? What factors would help reverse the “loss” of farmland to urbanization?

There are many uses for land. Farmland could also be used for residential, commercial, industrial purposes (e.g. condominiums, business offices, shopping centers, parking lots, golf courses, manufacturing, etc.). The land could also be set aside as parks or wilderness preserves.

When deciding to convert or sell their farmland, farmers evaluate the value of the various alternative uses of their land. The decisions to convert or sell will depend on whether the value from continuing to use the land for farming is less than the next best alternative (e.g. using the land for a golf course).

The conversion of farmland does not necessarily mean it is “lost”. It is possible where converting the land back to farming becomes the next-best alternative.

Factors that could help reverse the “loss” of farmland to urbanization, are things that would increase the land’s value as farmland. This could be driven by factors that would improve the profitability of the farm. For example, higher crop prices, improved crop yields (perhaps through better fertilizer or pesticides), improvements in harvesting techniques/ equipment, etc.

Real Application Assume you are the owner of agricultural land. You discover that someone is willing to lease a section of your land that you set aside for the development of a large storage shed and workshop for $40,000 per year. Of the two options, how do you determine which makes you better off?

You already know that you can lease the land for $40,000 per year. You have to ascertain the costs associated with foregoing the large storage shed and workshop. If, for example, you believed that it would cost $25,000 per year to store your farm equipment elsewhere at a .

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Chapter 2 Scarcity and the World of Trade-Offs neighboring farm, then the opportunity cost of that section of land is $25,000 per year. Your net gain of leasing the land would be $40,000 minus $25,000, or $15,000 per year, and you should lease the land. If the cost to store your farm equipment elsewhere was more than $40,000 per year, however, you should build the storage shed and workshop.

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Answers to End-of-Chapter Questions

2-1. Define opportunity cost. What is your opportunity cost of attending a class at 11:00 A.M.?

How does it differ from your opportunity cost of attending a class at 8:00 A.M.?

The opportunity cost of attending a class at 11:00 A.M. is the next-highest-valued use of that hour of the day. Likewise, the opportunity cost of attending an 8:00 A.M. class is the next-highestvalued use of that particular hour of the day. If you are an early riser, it is arguable that the opportunity cost of the 8:00 A.M. hour is lower because you will already be up at that time, but have fewer choices compared with the 11:00 A.M. hour when shops, recreation centers, and the like are open. If you are a late riser, it may be that the opportunity cost of the 8:00 A.M. hour is higher, because you place a relatively high value on an additional hour of sleep in the morning.

2-2. If you receive a ticket to a concert at no charge, what, if anything, is your opportunity cost of attending the concert? How does your opportunity cost change if miserable weather on the night of the concert requires you to leave much earlier for the concert hall and greatly extends the time it takes to get home afterward?

The opportunity cost of attending the concert is the next-highest-value use of the time spent at the concert. If bad weather extends the amount of time spent on an evening at the concert, then there is an additional opportunity cost in the form of the next-best uses of that additional time.

2-3. You and a friend decide to spend $100 each on concert tickets. Each of you alternatively could have spent the $100 to purchase a textbook, a meal at a highly rated local restaurant, or several Internet movie downloads. As you are on the way to the concert, your friend tells you that if she had not bought the concert ticket, she would have opted for a restaurant meal, and you reply that you otherwise would have downloaded several movies. Identify the relevant opportunity costs for you and your friend of the concert tickets that you purchased. Explain briefly.

The opportunity cost is the cost of the single, next-highest-valued foregone alternative to the $100 spent on the concert ticket, which for your friend was a restaurant meal she otherwise could have purchased and which for you was movie downloads that you otherwise could have bought.

2-4. After the concert discussed in Problem 2-3 is over and you and your friend are traveling home, you discuss how each of you might otherwise have used the four hours devoted to attending the concert. The four hours could have been used to study, to watch a streaming video of a sporting event, or to get some extra sleep. Your friend decides that if she had not spent four hours attending the concert, she would have chosen to study, and you reply that you otherwise would have watched the streaming video. Identify the relevant opportunity costs for you and your friend for allocating your four hours to attending the concert.

Explain briefly. .

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition The opportunity cost is the cost of the single, next-highest-value forgone alternative to the four hours spent attending the concert, which for your friend was time that she otherwise could have devoted to study and for you was time that you otherwise could have spent watching the streaming video of the sporting event.

2-5. Recently, a woman named Mary Krawiec attended an auction in Fredericton, New Brunswick. At the auction, a bank was seeking to sell a foreclosed property: a large Victorian house suffering from years of neglect in a neighborhood in which many properties had been on the market for years yet remained unsold. Her $10 offer was the highest bid in the auction, and she handed over a $10 bill for a title to ownership. Once she acquired the house, however, she became responsible for all taxes on the property and for an overdue water bill of $2,000. In addition, to make the house habitable, she and her husband devoted months of time and unpaid labour to renovating the property. In the process, they incurred explicit expenses totaling $65,000. Why do you suppose that the bank was willing to sell the house to Ms. Krawiec for only $10? (Hint: Contemplate the bank’s expected gain, net of all explicit and opportunity costs, if it had attempted to make the house habitable.)

The bank apparently determined that the net gain that it anticipated receiving from trying to sell the house to someone else, considering the opportunity cost of resources that the bank would have had to devote to renovating the house, was less than $10.

2-6. The following table illustrates the points a student can earn on examinations in economics and biology if the student uses all available hours for study. Plot this student’s production possibilities curve. Does the PPC illustrate the law of increasing additional cost?

Economics 100 90 80 70 60 50 40

Biology 40 60 75 85 93 98 100

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Chapter 2 Scarcity and the World of Trade-Offs Each additional 10 points earned in economics costs a greater number of biology points. For example, the opportunity cost to the student of increasing points earned in economics from 60 to 70 is 8 points forgone in biology, but the opportunity cost of increasing economics points from 90 to 100 rises to 20 points forgone in biology. Thus, the new PPC curve illustrates the law of increasing relative cost.

2-7. Based on the information provided in Problem 2-6, what is the opportunity cost to this student of allocating enough additional study time on economics to move her grade up from a 90 to a 100?

If the student allocates additional study time to economics in order to increase her score from 90 to 100, her biology score declines from 60 to 40, so the opportunity cost of earning 10 additional points in economics is 20 fewer points in biology.

2-8. Consider a change in the table in Problem 2-6. The student’s set of opportunities is now as follows: Does the PPC illustrate the law of increasing additional cost? What is the opportunity cost to this student for the additional amount of study time on economics required to move her grade from 60 to 70? From 90 to 100?

Economics 100 90 80 70 60 50 40

Biology 40 50 60 70 80 90 100

Each additional 10 points earned in economics costs 10 additional points in biology, so this PPC illustrates constant additional opportunity costs. It does not satisfy the law of increasing additional costs. For instance, the opportunity cost to the student of increasing points earned in economics from 60 to 70 is 10 points forgone in biology, and the opportunity cost of increasing economics points from 90 to 100 remains at 10 points forgone in biology.

2-9. Construct a production possibilities curve for a nation facing increasing opportunity costs for producing food and video games. Show how the PPC changes given the following events. a. A new and better fertilizer is invented. b. Immigration occurs, and immigrants’ labour can be employed in both the agricultural sector and the video game sector. c. People invent a new programming language that is much less costly to code and is more memory-efficient. d. A heat wave and drought result in a 10 percent decrease in usable farmland.

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition

Consider the following diagram when answering Problems 2-10, 2-11, and 2-12.

2-10. During a debate on the floor of the House of Commons, Member of Parliament (MP) Creighton states, “Our nation should not devote so many of its fully employed resources to producing capital goods because we already are not producing enough consumption goods for our citizens.” Compared with the other labeled points on the diagram, which one could be consistent with the current production combination choice that MP Creighton believes the nation has made?

Point C

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Chapter 2 Scarcity and the World of Trade-Offs 2-11. In response to MP Creighton’s statement reported in Problem 2-10, MP Long replies, “We must remain at our current production combination if we want to be able to produce more consumption goods in the future.” Of the labeled points on the diagram, which one could depict the future production combination MP Long has in mind?

Point D 2-12. MP Borman interjects the following comment after the statements by MPs Creighton and Long reported in Problems 2-10 and 2-11: “In fact, both of my esteemed colleagues are wrong, because an unacceptably large portion of our nation’s resources is currently unemployed.” Of the labelled points on the diagram, which one is consistent with MP Borman’s position?

Point A 2-13. A nation’s residents can allocate their scarce resources either to producing consumption goods or to producing human capital—that is, providing themselves with training and education. The table below displays the production possibilities for this nation: Units of Production Consumption Units of Combination Goods Human Capital A 0 100 B 10 97 C 20 90 D 30 75 E 40 55 F 50 30 G 60 0 a. Suppose that the nation’s residents currently produce combination A. What is the opportunity cost of increasing production of consumption goods by 10 units? By 60 units? b. Does the law of increasing additional cost hold true for this nation? Why or why not? a. If the nation’s residents increase production of consumption goods from 0 units to 10 units, the opportunity cost is 3 units of human capital forgone. If the nation’s residents increase production of consumption goods from 0 units to 60 units, the opportunity cost is 100 units of human capital. b. Yes, because successive 10-unit increases in production of consumption goods generate larger sacrifices of human capital, equal to 3, 7, 15, 20, 25, and 30.

2-14. Like physical capital, human capital produced in the present can be applied to the production of future goods and services. Consider the table in Problem 2-13, and suppose that the nation’s residents are trying to choose between combination C and combination F. Other things being equal, will the future production possibilities curve for this nation be located farther outward if the nation chooses combination F instead of combination C? Explain. .

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition No, because combination F entails production of less human capital than combination C, so choosing combination F today would result in a smaller output shift in the production possibilities curve than would be experienced if combination C were chosen instead.

2-15. You can wash, fold, and iron a basket of laundry in two hours and prepare a meal in one hour. Your roommate can wash, fold, and iron a basket of laundry in three hours and prepare a meal in one hour. Who has the absolute advantage in laundry, and who has an absolute advantage in meal preparation? Who has the comparative advantage in laundry, and who has a comparative advantage in meal preparation?

Because it takes you less time to do laundry, you have an absolute advantage in laundry. Neither you nor your roommate has an absolute advantage in meal preparation. You require 2 hours to fold a basket of laundry, so your opportunity cost of folding a basket of laundry is 2 meals. Your roommate’s opportunity cost of folding a basket of laundry is 3 meals. Hence, you have a comparative advantage in laundry, and your roommate has a comparative advantage in meal preparation.

2-16. Based on the information in Problem 2-15, should you and your roommate specialize in a particular task? Why? If so, who should specialize in which task? Show how much labour time you save if you choose to “trade” an appropriate task with your roommate as opposed to doing it yourself.

Yes, you and your roommate should specialize in the task in which each of you has a comparative advantage. You should specialize in folding laundry and your roommate in preparing meals. If you fold a basket of laundry, you must forgo the time that it would take to prepare two meals. For your roommate to fold a basket of laundry, the time that it takes to prepare three meals must be given up.

Suppose that you “trade” folding a basket of laundry for preparing 2.5 meals. You gain 0.5 meals, which is equivalent to one-half hour of meal preparation time. Hence, you save one-half hour for every basket of laundry you fold for your roommate in exchange for an hour of meal preparation time.

2-17. Using only the concept of comparative advantage, evaluate this statement: “A professor with a Ph.D. in physics should never mow his or her own lawn, because this would fail to take into account the professor’s comparative advantage.”

It may be that the professor is very proficient at doing yard work relative to teaching and research activities, so in fact the professor may have a comparative advantage in doing yard work.

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Chapter 2 Scarcity and the World of Trade-Offs 2-18. Country A and country B produce the same consumption goods and capital goods and currently have identical production possibilities curves. They also have the same resources at present, and they have access to the same technology. a. At present, does either country have a comparative advantage in producing capital goods? Consumption goods? b. Suppose that country A now chooses to produce more consumption goods, compared with country B. Other things being equal, which country will experience the larger outward shift of its PPC during the next year? a. If the two nations have the same production possibilities, then they face the same opportunity costs of producing consumption goods and capital goods. Thus, at present neither has a comparative advantage in producing either good. b. Because country B produces more capital goods today, it will be able to produce more of both goods in the future. Consequently, country B’s PPC will shift outward by a greater amount next year.

2-19. Suppose that in Figure 2-1, a student currently is allocating her study time in such a way that she is earning a C in mathematics and a C in economics. What is the opportunity cost, measured in terms of the resulting grade change, if this student wishes to reallocate her study time in order to raise her mathematics grade by one letter, from a C to a B? According to the figure, if the student makes the required reallocation of study time to earn a B in mathematics, then she will earn a D in economics. Thus, the student’s opportunity cost of raising her grade by one letter grade, from a C to a B, is a one-letter grade drop in her economics grade, from a C to a D. 2-20. Suppose that in Figure 2-1, a student currently is allocating her study time in such a way that she is earning a C in mathematics and a C in economics. If the student desires to boost her economics grade to an A, how must she alter the number of hours per week that she studies economics? How must she alter the number of hours per week that she studies mathematics?

The student currently is allocating 3 hours per week of study time to mathematics and 3 hours per week of study time to economics. To boost her grade in economics from a C to an A, she must devote all 6 hours of available study time to economics, so she must increase the amount of time she spends studying economics by 3 hours per week. To attain a grade of A in economics, she can devote none of her weekly study hours to mathematics, so she must decrease the amount of time she devotes to studying mathematics by 3 hours per week.

2-21. Suppose that in Figure 2-2, the nation currently is producing combination D in the table and on the graph of the production possibilities curve. What is the opportunity cost of producing 5 million more smartphones and moving to production combination C? To move from combination D to combination C and produce 5 million more smartphones, instead of producing 30 million tablet devices at point D, at point C the nation is capable of producing only 20 million tablets. Thus, in order to move to point C, the nation must give up production of 10 million .

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition tablets (30 million tablets – 20 million tablets = 10 million tablets). The opportunity cost of the additional 5 million smartphones, therefore, is 10 million tablets.

2-22. Suppose that in Figure 2-2, the nation currently is producing combination D in the table and on the graph of the production possibilities curve. What is the opportunity cost of producing 20 million more tablet devices and moving to production combination F? To move from combination D to combination F and produce 20 million more tablet devices at point F, instead of producing 45 million smartphones at point C, at point F the nation is capable of producing only 22.5 million smartphones. Thus, in order to move to point F, the nation must give up production of 17.5 million smartphones (45 million smartphones – 22.5 million smartphones = 17.5 million smartphones). The opportunity cost of the additional 20 million tablets, therefore, is 17.5 million smartphones.

2-23. Suppose that in Figure 2-4, the nation currently has sufficient resources to produce combinations located along only the innermost production possibilities curve. In addition, suppose that the nation’s residents have determined that smartphones function mainly as consumption goods while tablet devices function primarily as capital goods. If the nation produces no additional tablets this year, will the intermediate-shifted PPC resulting from minimal economic growth or the farthest-shifted PPC caused by more significant economic growth be more likely to apply next year?

The nation is said to have determined that tablet devices are capital goods that can be used to produce more items in the future, whereas smartphones are consumption goods that cannot.

Consequently, by producing no additional tablets this year, the nation has chosen to produce no new capital goods. Its economic growth will be minimal, so the intermediate-shifted PPC will result.

2-24. Suppose that in Figure 2-4, the nation with otherwise the same background conditions as in Problem 2-23 currently has sufficient resources to produce combinations located along only the innermost production possibilities curve. If the nation produces no additional smartphones this year, will the intermediate-shifted PPC resulting from minimal economic growth or the farthest-shifted PPC caused by more significant economic growth be more likely to apply next year?

The nation is said to have determined that tablet devices are capital goods that can be used to produce more items in the future, whereas smartphones are consumption goods that cannot.

Consequently, by producing no additional smartphones this year, the nation has chosen to produce as many tablets—that is, capital goods—as feasibly can produce. Its economic growth will be substantial, so the farthest-shifted PPC will result.

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Chapter 3

Demand and Supply 

Answers to Questions for Critical Analysis

THE SOARING RELATIVE PRICE OF RESTAURANT MEALS How might the law of demand help to explain why, in one recent year, the number of prepared lunches sold by Canadian restaurants dropped by more than 100 million units from the previous year? How might you respond in the future to an even higher relative price of restaurant meals?

Clearly, the law of demand is at work for both the total market and for you with respect to restaurant meals. As long as the relative price of prepared meals continues to rise, both other buyers in the market and you will probably respond by purchasing fewer prepared lunches. We are assuming here, obviously, that you are not making a much higher income during the time period in question.

ASSESSING THE QUALITY-ADJUSTED PRICES OF OLD AND NEW CONCERT VIOLINS If a concert violinist perceives that instruments that look very old enhance the experience of ticket-buying crowds, will that violinist be willing to pay more for an older violin?

Yes. To that violinist the quality of the experience is worth the higher price. In this instance, the quality-adjusted price for the older violin would be less than the quality-adjusted price for the newer violin.

WHY PAY-WHAT-YOU-WANT PRICING OFTEN PAYS OFF FOR CHARITABLE ORGANIZATIONS Why do you suppose that available evidence indicates that charitable organizations are more likely to offer “pay-what-you-want” pricing for items produced or obtained at relatively low cost per unit?

Charitable organizations are more likely to offer “pay-what-you-want” pricing for low-cost items because individuals who purchase from charities are likely to pay more than they would otherwise. The difference between the price of the item (low) and the price paid by the altruistic individual (high) can then be used for charity.

IN CHINA, LOWER-PRICED SOLAR ENERGY PUTS A DAMPER ON THE DEMAND FOR COAL What has happened to the position of China’s market demand curve for coal? Explain briefly.

The market demand curve for coal has shifted to the left (a decline in demand). Because the price of a substitute (solar energy) has declined, the demand for coal has also declined. This causes a decrease in the price for coal.

AI: THE GLOBAL TOURISM INDUSTRY Once the predicted position of the demand for tourism services has been determined, would an anticipated increase in the incomes of tourists generate a movement along that curve or a shift in the position of the curve?

An anticipated increase in the incomes of tourists would generate a shift in the demand curve to the right (increase).

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition TECHNOLOGICAL CHANGE BOOSTS SUPPLY IN THE JEWELLERY MARKET In what direction has the supply curve in the global jewellery market shifted? Explain briefly.

The supply curve in the global jewellery market has shifted to the right (increase). With the advances of technology, it is now less costly to produce jewellery, so a larger quantity can be supplied at every price.

A BRITISH VEGETABLE SHORTAGE HAS PREDICTABLE EFFECTS ON VEGETABLE PRICES Once the prices of vegetables stopped rising and reached new market clearing levels, what must have been true of the relationship between quantities demanded and supplied in the affected British vegetable markets?

Once the prices of vegetables stopped rising and reached equilibrium, quantity supplied was equal to quantity demanded. The increase in price reduced the quantity demanded and increased the quantity supplied until they were both equal at the new equilibrium.

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Economics in Your Life

SPACE-CONSTRAINED RESTAURANTS DISCOVER THAT CUSTOMERS CARE ABOUT QUALITYADJUSTED LUNCH PRICES For Critical Thinking Did the decline in the quality-adjusted price of soup-and-sandwich lunches offered by Panera Bread and other soup-and-sandwich restaurant chains generate a rightward shift in the demand curve or a downward movement along that curve? Explain.

The decline in the quality-adjusted price of soup-and-sandwich lunches resulted in a downward movement along the demand curve. Changes in price result in movements along a curve, and changes in other determinants of demand result in shifts of the curve.

Real Application As a future entrepreneur or manager, what lesson can you learn from the actions of this realworld manager?

The full price of purchasing any good or service includes the time necessary to obtain that good or service. Hence, as a future entrepreneur or manager, you will want to consider the time cost of your customers when they purchase an item that you are offering for sale in the marketplace. As an example, assume that you are selling furniture or at-home gym equipment that requires the customer to put what they purchased together themselves. If considerable time is required to put together what you are selling, that implies a relatively higher full price. You might then, through experimentation and research, reduce the number of steps necessary to assemble the furniture or the at-home gym equipment.

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Issues & Applications

WORLD OIL PRICES COLLAPSE Identify one key factor noted in the Issues and Applications that could contribute to an increase in demand for oil.

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Chapter 3 Demand and Supply An effective vaccine is found and employees go back to work and travel bans are lifted, thus increasing the demand for oil.

Identify one factor noted in the Issues and Applications that could impact the supply of oil.

If an alternative, more efficient energy source is discovered, the rate of population growth changes, or agreements are made between top oil-producing countries it could affect the supply of oil.

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Answers to End-of-Chapter Questions

3-1. Suppose that in a recent market period, the following relationship existed between the price of tablet devices and the quantity supplied and quantity demanded: Price

Quantity Demanded

Quantity Supplied

$330

100 million

40 million

$340

90 million

60 million

$350

80 million

80 million

$360

70 million

100 million

$370

60 million

120 million

Graph the supply and demand curves for tablet devices using the information in the table.

What are the equilibrium price and quantity? If the industry price is $340, is there a shortage or surplus of tablet devices? How much is the shortage or surplus?

The equilibrium price is $350 per tablet device, and the equilibrium quantity is 80 million tablet devices. At a price of $340 per tablet device, the quantity of tablet devices demanded is 90 million, and the quantity of tablet devices supplied is 60 million. Hence, there is a shortage of 30 million tablet devices at a price of $340 per tablet. .

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition 3-2. Suppose that in a later market period, the quantities supplied in the table in Problem 3-1 are unchanged. The amount demanded, however, has increased by 30 million at each price.

Construct the resulting demand curve in the illustration you made for Problem 3-1. Is this an increase or a decrease in demand? What are the new equilibrium quantity and the new market price? Give two examples of changes in ceteris paribus conditions that might cause such a change.

D1

If quantity demanded increases by 30 million at each price, then the new equilibrium price is $360 per tablet device, and the new equilibrium quantity is 100 million tablet devices. This is an increase in demand, which could be brought about by a change in any of the ceteris paribus conditions relating to the demand curve. For example, an increase in the demand for tablet devices could arise from either a decrease in the price of a complement, such as apps, or an increase in the price of a substitute, such as laptop computers or sophisticated smartphones.

3-3. Consider the market for cable-based Internet access service, which is a normal good.

Explain whether the following events would cause an increase or a decrease in demand or an increase or a decrease in the quantity demanded. a. Firms providing wireless (an alternative to cable) Internet access services reduce their prices. b. Firms providing cable-based Internet access services reduce their prices. c. There is a decrease in the incomes earned by consumers of cable-based Internet access services. d. Consumers’ tastes shift away from using wireless Internet access in favour of cablebased Internet access services. a. Wireless and cable Internet access services are substitutes, so a reduction in the price of wireless Internet access services causes a decrease in the demand for cable-based Internet access services. b. A decrease in the price of cable-based Internet access services generates an increase in the quantity of these services demanded. .

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Chapter 3 Demand and Supply c. Cable-based Internet access services are a normal good, so a fall in the incomes of consumers reduces the demand for these services. d. If consumers’ tastes shift away from wireless Internet access services in favour of cable-based Internet services, then the demand for the latter services increases.

3-4. In the market for wireless earbuds (a normal good), explain whether the following events would cause an increase or a decrease in demand or an increase or a decrease in the quantity demanded. Also explain what happens to the equilibrium quantity and the market clearing price. a. There is an increase in the price in carrying cases for wireless earbuds. b. There is a decrease in the price of devices used to charge wireless earbuds. c. There is an increase in the number of consumers of wireless earbuds. d. A booming economy increases the income of the typical buyer of wireless earbuds. e. Consumers of wireless earbuds anticipate that the price of this good will decline in the future. a. Carrying cases are complements in the consumption of wireless earbuds, so increases in their prices cause the demand for wireless earbuds to decline. The market clearing price and equilibrium quantity of wireless earbuds both decline. b. Devices used to charge wireless earbuds are a complement in the consumption of wireless earbuds, so a fall in the price of this item generates an increase in the demand for wireless earbuds. The market clearing price and equilibrium quantity of wireless earbuds both increase. c. An increase in the number of consumers of wireless earbuds generates an increase in the demand for this item, which causes both the market clearing price and equilibrium quantity of wireless earbuds to increase. d. As long as wireless earbuds are a normal good, the rise in consumers’ incomes causes the demand for wireless earbuds to increase. This causes both the market clearing price and equilibrium quantity of wireless earbuds to increase. e. Because consumers expect a lower price of wireless earbuds in the future, their current demand for wireless earbuds decreases. The result is a decrease in both the market clearing price and equilibrium quantity of wireless earbuds in the present.

3-5. Give an example of a complement and a substitute in consumption for each of the following items: a. Bacon b. Tennis racquets c. Coffee d. Automobiles a. Complement: eggs; Substitute: sausage b. Complement: tennis balls; Substitute: racquetball racquets c. Complement: cream; Substitute: tea d. Complement: gasoline; Substitute: city bus

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition 3-6. Listed below are some changes in (shifts in) demand for various items. In each case, the change in demand has been caused by a change in the price of a substitute or of a complement. Explain whether the price of the substitute or complement must have increased or decreased. a. A rise in the demand for a dashboard global-positioning-system device follows a change in the price of automobiles, which are complements. b. A fall in the demand for e-book readers follows a change in the price of e-books, which are complements. c. A rise in the demand for tablet devices follows a change in the price of ultrathin laptop computers, which are substitutes. d. A fall in the demand for physical books follows a change in the price of e-books, which are substitutes. a. Decrease in price of automobiles b. Increase in price of e-books c. Increase in price of ultrathin laptop computers d. Decrease in the price of e-books 3-7. Identify which of the following would generate an increase in the market demand for tablet devices, which are a normal good. a. A decrease in the incomes of consumers of tablet devices b. An increase in the price of ultrathin computers, which are substitutes c. An increase in the price of online apps, which are complements d. An increase in the number of consumers in the market for tablet devices b and d 3-8. Identify which of the following would generate a decrease in the market demand for e-book readers, which are a normal good. a. An increase in the price of downloadable apps utilized to enhance the e-book reading experience, which are complements b. An increase in the number of consumers in the market for e-book readers c. A decrease in the price of tablet devices, which are substitutes d. A reduction in the incomes of consumers of e-book readers a, c, and d 3-9. Consider the following diagram of a market for one-bedroom rental apartments in a college community.

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Chapter 3 Demand and Supply

a. At a rental rate of $1,000 per month, is there an excess quantity supplied, or is there an excess quantity demanded? What is the amount of the excess quantity supplied or demanded? b. If the present rental rate of one-bedroom apartments is $1,000 per month, through what mechanism will the rental rate adjust to the equilibrium rental rate of $800? c. At a rental rate of $600 per month, is there an excess quantity supplied, or is there an excess quantity demanded? What is the amount of the excess quantity supplied or demanded? d. If the present rental rate of one-bedroom apartments is $600 per month, through what mechanism will the rental rate adjust to the equilibrium rental rate of $800? a. At the $1,000 rental rate, the quantity of one-bedroom apartments supplied is 3,500 per month, but the quantity demanded is only 2,000 per month. Thus, there is an excess quantity of one-bedroom apartments supplied equal to 1,500 apartments per month. b. To induce consumers to lease unrented one-bedroom apartments, some landlords will reduce their rental rates. As they do so, the quantity demanded will increase. In addition, some landlords will choose not to offer apartments for rent at lower rates, and the quantity supplied will decrease. At the equilibrium rental rate of $800 per month, there will be no excess quantity supplied. c. At the $600 rental rate, the quantity of one-bedroom apartments demanded is 3,000 per month, but the quantity supplied is only 1,500 per month. Thus, there is an excess quantity of one-bedroom apartments demanded equal to 1,500 apartments per month. d. To induce landlords to make more one-bedroom apartments available for rent, some consumers will offer to pay higher rental rates. As they do so, the quantity supplied will increase. In addition, some consumers will choose not to try to rent apartments at higher rates, and the quantity demanded will decrease. At the equilibrium rental rate of $800 per month, there will be no excess quantity demanded.

3-10. Consider the market for economics textbooks. Explain whether the following events would cause an increase or a decrease in supply or an increase or a decrease in the quantity supplied.

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition a. b. c. d.

The market price of editorial services increases.

The market price of economics textbooks increases.

The number of publishers of economics textbooks increases.

Publishers expect that the market price of economics textbooks will increase next month.

a. The rise in the price of editorial services, a key input in textbook production, causes a decrease in the supply of textbooks. b. An increase in the market price of economics textbooks causes an increase in the quantity of textbooks supplied. c. A rise in the number of textbook publishers increases the supply of textbooks. d. If publishers expect the market price of textbooks will rise next month, the current supply of textbooks will decline.

3-11. Consider the market for smartphones. Explain whether the following events would cause an increase or a decrease in supply or an increase or a decrease in the quantity supplied.

Illustrate each, and show what would happen to the equilibrium quantity and the market clearing price. a. The price of touchscreens used in smartphones declines. b. The price of machinery used to produce smartphones increases. c. The number of manufacturers of smartphones increases. d. There is a decrease in the market demand for smartphones. a. Because touchscreens are an input in the production of smartphones, a decrease in the price of touchscreens causes an increase in the supply of smartphones. The market supply curve shifts to the right, which causes the market price of smartphones to fall and the equilibrium quantity of smartphones to increase. b. Machinery used to produce smartphones is an input in the production of these devices, so an increase in the price of machinery generates a decrease in the supply of smartphones. The market supply curve shifts to the left, which causes the market price of smartphones to rise and the equilibrium quantity of smartphones to decrease. c. An increase in the number of manufacturers of smartphones causes an increase in the supply of smartphones. The market supply curve shifts rightward. The market price of smartphones declines, and the equilibrium quantity of smartphones increases. d. The demand curve for smartphones shifts to the left along the supply curve, so there is a decrease in the quantity supplied. The market price falls, and the equilibrium quantity declines.

3-12. If the price of flash memory chips used in manufacturing smartphones decreases, what will happen in the market for smartphones? How will the equilibrium price and equilibrium quantity of smartphones change?

Because flash memory chips are an input in the production of smartphones, a decrease in the price of flash memory chips generates an increase in the supply of smartphones. The market price of smartphones will decrease, and the equilibrium quantity will increase.

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Chapter 3 Demand and Supply 3-13. Assume that the cost of aluminum used by soft drink companies increases. Which of the following correctly describes the resulting effects in the market for soft drinks distributed in aluminum cans? (More than one statement may be correct.) a. The demand for soft drinks decreases. b. The quantity of soft drinks demanded decreases. c. The supply of soft drinks decreases. d. The quantity of soft drinks supplied decreases.

Aluminum is an input in the production of canned soft drinks, so an increase in the price of aluminum reduces the supply of canned soft drinks (option c). The resulting rise in the market price of canned soft drinks brings about a decrease in the quantity of canned soft drinks demanded (option b). In equilibrium, the quantity of soft drinks supplied decreases (option d) to an amount equal to the quantity demanded. The demand curve does not shift, however, so option b does not apply.

3-14. In Figure 3-2, what are the effects of a price decrease from $4 per wireless earbud to $2 per wireless earbud on the quantities of wireless earbuds demanded by buyer 1 and by buyer 2 individually and combined?

For buyer 1, the price decrease from $4 per wireless earbud to $2 per wireless earbud causes a 20-unit increase in the quantity of wireless earbuds demanded, from 20 to 40. For buyer 2, the price decrease generates a 30-unit increase in the quantity of wireless earbuds demanded, from 20 to 50. Thus, for the two buyers combined, there is a 50-unit increase in the total quantity demanded, from 40 units to 90 units.

3-15. In Figure 3-2, what are the effects of a price increase from $1 per wireless earbud to $3 per wireless earbud on the quantities demanded by buyer 1 and by buyer 2 individually and combined?

For buyer 1, the price increase from $1 per wireless earbud to $3 per wireless earbud causes a 20-unit decrease in the quantity of wireless earbuds demanded, from 50 to 30. For buyer 2, the price increase generates a 20-unit decrease in the quantity of wireless earbuds demanded, from 60 to 40. Thus, for the two buyers combined, there is a 40-unit decrease in the total quantity demanded, from 110 units to 70 units.

3-16. In Figure 3-4, the current position of the demand curve is D1, and the price of a wireless earbud is $3. If there is an increase in the price of tablet devices that are complements to wireless earbuds, will the demand curve shift to D2 or to D3? What is the change in the amount of wireless earbuds demanded?

The increase in the price of tablet devices that are complements to wireless earbuds causes a leftward shift in the demand for wireless earbuds, from D1 to D3. At the price of $3 per wireless earbud, the amount of wireless earbuds demanded decreases by 2 million units, from 6 million units to 4 million units.

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition 3-17. In Figure 3-4, the current position of the demand curve is D1, and the price of a wireless earbud, which is a normal good, is $3. If there is an increase in consumer incomes, will the demand curve shift to D2 or to D3? What is the change in the amount of portable power banks demanded?

The increase in consumer incomes generates a rightward shift in the demand curve, from D1 to D2. At the price of $3 per wireless earbud, the amount of wireless earbuds demanded increases by 4 million units, from 6 million units to 10 million units.

3-18. In Figure 3-7, what are the effects of a price decrease from $5 per wireless earbud to $3 per wireless earbud on the quantities supplied by supplier 1 and by supplier 2 individually and combined?

For supplier 1, the price decrease from $5 per wireless earbud to $3 per wireless earbud causes a 20-unit decrease in the quantity of wireless earbuds supplied, from 55 to 35. For supplier 2, the price decrease generates a 15-unit decrease in the quantity of wireless earbuds supplied, from 35 to 20. Thus, for the two suppliers combined, there is a 35-unit decrease in the total quantity supplied, from 90 to 55.

3-19. In Figure 3-7, what are the effects of a price increase from $2 per wireless earbud to $4 per wireless earbud on the quantities supplied by supplier 1 and by supplier 2 individually and combined?

For supplier 1, the price increase from $2 per wireless earbud to $4 per wireless earbud causes a 15-unit increase in the quantity of wireless earbuds supplied, from 25 to 40. For supplier 2, the price increase generates a 15-unit increase in the quantity of wireless earbuds supplied, from 15 to 30. Thus, for the two suppliers combined, there is a 30-unit decrease in the total quantity supplied, from 40 to 70.

3-20. In Figure 3-9, the current position of the supply curve is S1, and the price of a wireless earbud is $3. If suppliers anticipate a higher price of wireless earbuds in the future, will the supply curve shift to S2 or to S3? What is the change in the amount of wireless earbuds supplied?

The increase in the anticipated future price of wireless earbuds induces suppliers to withhold from the market part of their current supply, which causes a leftward shift in the supply curve for wireless earbuds, from S1 to S3. At the price of $3 per wireless earbud, the amount of wireless earbuds supplied decreases by about 3 million units, from 6 million units to about 3 million units.

3-21. In Figure 3-9, the current position of the supply curve is S1, and the price of a wireless earbud is $3. If the cost of inputs that suppliers use to produce wireless earbuds decreases, will the supply curve shift to S2 or to S3? What is the change in the amount of wireless earbuds supplied?

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Chapter 3 Demand and Supply The decrease in the cost of inputs used to produce wireless earbuds causes a rightward shift in the supply curve for wireless earbuds, from S1 to S2. At the price of $3 per wireless earbud, the amount of wireless earbuds supplied increases by about 3 million units, from 6 million units to about 9 million units.

Appendix B B-1 Suppose that in a recent market period, the following relationship existed between the price of tablet devices and the quantity supplied and quantity demanded. Using the table data below, answer the following questions:

a.

Price

Quantity Demanded

Quantity Supplied

$330

100 million

40 million

$340

90 million

60 million

$350

80 million

80 million

$360

70 million

100 million

$370

60 million

120 million

Calculate the linear demand equation for a tablet device.

Using points (330,100) and (340,90), calculate the slope: (90 − 100) / (340 − 330) = −1, so QD = b − 1P. Calculate the intercept term by using (330,100): 100 = b − 330, so b = 430.

The linear demand equation for a tablet device is QD = 430 − 1P.

b.

Calculate the linear supply for a tablet device.

Using points (330,40) and (340,60), calculate the slope: (60 − 40) / (340 − 330) = 2, so QS = b + 2P. Calculate the intercept term by using (330,40): 40 = b + 2(330), so b = −620.

The linear supply equation for a tablet device is QS = −620 + 2P.

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition c.

Solve for the equilibrium quantity of tablet devices.

Set QD = QS and solve for Pe 430 − 1Pe = −620 + 2Pe −3Pe = −1050 Pe = 350

d.

Solve for the equilibrium price of a tablet device.

QS = −620 + 2(350) Qe = −620 + 700 Qe = 80

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Chapter 4

Extensions of Demand and Supply Analysis 

Answers to Questions for Critical Analysis

AI: TRANSACTION COSTS AND “PRICE STICKINESS” Why can we anticipate that retailers’ use of more machine learning to monitor consumers’ visits to their websites and competitors’ price adjustments could make prices less “sticky” in the future?

Using more machine learning to monitor consumers’ visits and competitors’ price adjustments will lower transaction costs, which will speed up price adjustments (make prices less “sticky”) in the future.

THE EFFECTS OF A SIMULTANEOUS DECREASE IN THE SUPPLY OF AND AN INCREASE IN THE DEMAND FOR VINYL RECORDS If some firms were to exit the market for vinyl records, what would happen to the market clearing price and equilibrium quantity? Explain briefly.

Firms existing the market for vinyl records would create a decrease in supply (a shift to the left).

This will raise the price of vinyl records even higher. The effect on equilibrium quantity can only be determined if we know how much supply decreases relative to the increase in demand (due to changes in tastes and preferences).

CUSTOMERS OF EWATER PREFER PRICE RATIONING OVER FIRST COME, FIRST SERVED AT A ZERO PRICE Why do you think that a number of people in Gambia and Tanzania are willing to pay to use eWater’s dispensers instead of public pumps available at no charge?

The total cost of using public pumps (zero price plus the opportunity cost of the time spent waiting in line) is greater than the total cost of using eWater’s dispensers. This suggests that the opportunity cost of the time spent waiting in line is more than the cost of using eWater’s dispensers.

“99-SEAT THEATERS” IN LOS ANGELES ADAPT TO A MINIMUM WAGE REQUIREMENT A certain percentage of those studying this textbook will attempt to become actors. You know that you need experience to become successful. How could you react to Los Angeles’ higher minimum wage?

Firstly, you could decide not to become a member of Actor’s Equity Association or if you are already a member, you could relinquish your membership. Secondly, you could seek out acting possibilities in cities that are not covered by the $15 minimum wage. Thirdly, you could let it be known at various theaters that you are willing to work as an unpaid volunteer. Consequently, you would have to earn a living at the same time by becoming a waiter or waitress or a salesperson in a retail outlet.

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition EXPERIMENTAL EVIDENCE VERIFIES PREDICTIONS ABOUT THE EFFECTS OF IMPOSING A PRICE FLOOR IN A LABOUR MARKET Why do you suppose economists have found that firms sometimes respond to minimum wage requirements to pay higher explicit dollar wages by reducing fringe benefits such as premiums for health insurance coverage?

Minimum wage requirements will cause firms to face higher costs of employment. To recover these costs, they can reduce other costs they incur, like fringe benefits.

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Economics in Your Life

A MAYOR FAVORS THE MINIMUM WAGE UNTIL CONFRONTING ITS CONSEQUENCES For Critical Thinking Who unambiguously would have been harmed if the city council’s plan had gone into effect?

Any workers at the current minimum wage who would have lost their jobs due to the reduction in existing workforces and workers whose work locations would have relocated due to the increase in minimum wage would have harmed.

Real Application Assume that you are the owner of a fast-food restaurant in a city that is going to increase its minimum wage to, say, $20 per hour. What would be some of the ways you could legally react to such a higher minimum wage?

You could eliminate all or most of the benefits you are now providing to your employees.

These might include subsidized health insurance, paid vacation time, fully paid “personal” days, free-meals while working, etc. You might also explore greater use of tablet devices and mobile apps for ordering without human assistance. And, in the kitchen, you might explore the use of robots.

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Issues & Applications

WHY SHORTAGES OF SOME PHARMACEUTICALS GENERATE HIGHER PRICES FOR OTHER DRUGS For Critical Thinking If the demand for Medication B in panel (b) of Figure 4-8 were to rise significantly to push the market clearing price above a government price ceiling, what events would occur in the market for Medication B? Explain briefly.

Manufacturers would respond by cutting back or even halting production of Medication B until a new period begins with a higher government threshold price set at or above the market clearing price. Quantity supplied at the price ceiling drops below the quantity demanded, causing a shortage.

Real Application At some point in our lives, virtually all of us will become consumers of health care services, including the use of prescribed pharmaceuticals. Faced with a shortage of a prescribed drug, what are some of the ways you could react?

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Chapter 4 Extensions of Demand and Supply Analysis If your medical condition is not serious, you could “wait and see.” That is to say, you could wait to see when the prescribed pharmaceutical would become available. If your medical condition was more critical, you would obviously press your physician into prescribing a replacement drug or a combination of drugs that might result in a similar positive outcome for you. Lastly, you could engage in online research into alternative sources of the prescribed drug in other countries.

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Answers to End-of-Chapter Questions

4-1. In recent years, technological improvements have greatly reduced the costs of producing smartphones, and a number of new firms have entered the smartphone industry. At the same time, prices of substitutes for smartphones, such as various tablet devices, have declined considerably. Construct a supply and demand diagram of the market for smartphones. Illustrate the impacts of these developments, and evaluate the effects on the market price and equilibrium quantity.

The ability to produce smartphones at lower cost and the entry of additional producers shift the supply curve rightward, from S1 to S2. At the same time, reduced prices of substitute devices result in a leftward shift in the demand for smartphones, from D1 to D2. Consequently, the equilibrium price of basic smartphones declines, from P1 to P2. The equilibrium quantity may rise, fall, or, as shown in the diagram, remain unchanged.

Quantity of Smartphones

4-2. Advances in research and development in the pharmaceutical industry have enabled manufacturers to identify potential cures more quickly and therefore at lower cost. At the same time, the aging of our society has increased the demand for new drugs. Construct a supply and demand diagram of the market for pharmaceutical drugs. Illustrate the impacts of these developments, and evaluate the effects on the market price and the equilibrium quantity.

The ability to produce drugs at lower cost leads to an increase in the market supply of drugs, so the supply curve shifts rightward (from S1 to S2). At the same time, the increased demand for drugs by an aging population shifts the market demand curve rightward (from D1 to D2). Thus, .

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition the equilibrium quantity of drugs increases (from Q1 to Q2), but the market clearing price may rise, fall, or remain unchanged (as shown).

4-3. There are simultaneous changes in the demand for and supply of global-positioning-system (GPS) devices, with the consequences being an unambiguous increase in the market clearing price of these devices but no change in the equilibrium quantity. What changes in the demand for and supply of GPS devices could have generated these outcomes? Explain.

An increase in demand for GPS devices and an accompanying reduction in supply of GPS devices could result in an unambiguous increase in the market clearing price but no change in the equilibrium quantity.

4-4. There are simultaneous changes in the demand for and supply of tablet devices, with the consequences being an unambiguous decrease in the equilibrium quantity of these devices but no change in the market clearing price. What changes in the demand for and supply of tablet devices could have generated these outcomes? Explain.

A simultaneous decrease in the demand for tablet devices and accompanying reduction in the supply of tablet devices could result in an unambiguous decrease in the equilibrium quantity of these devices but no change in the market clearing price.

4-5. The following table depicts the quantity demanded and quantity supplied of studio apartments in a small college town.

Monthly Rent $600 $650 $700 $750 $800

Quantity Demanded 3,000 2,500 2,000 1,500 1,000

Quantity Supplied 1,600 1,800 2,000 2,200 2,400

What are the market price and equilibrium quantity of apartments in this town? If this town imposes a rent control of $650 per month, how many studio apartments will be rented?

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Chapter 4 Extensions of Demand and Supply Analysis

The market rental rate is $700 per apartment, and the equilibrium quantity of apartments rented to tenants is 2,000. At a ceiling price of $650 per month, the number of apartments students desire to rent increases to 2,500 apartments. At the ceiling price, the number of apartments that owners are willing to supply decreases to 1,800 apartments. Thus, there is a shortage of 700 apartments at the ceiling price, and only 1,800 are rented at the ceiling price.

4-6. Suppose that the government places a ceiling on the price of a medical drug below the equilibrium price. a. Show why there is a shortage of the medical drug at the new ceiling price. b. Suppose that a black market for the medical drug arises, with pharmaceutical firms secretly selling the drug at higher prices. Illustrate the black market for this medical drug, including the implicit supply schedule, the ceiling price, the black market supply and demand, and the highest feasible black market price. a. At the ceiling price of the medical drug, P1, the quantity of the drug demanded exceeds the quantity of the drug legally supplied by pharmaceuticals firms, so there is a shortage of the drug. b. If a black market develops, then the implicit supply curve is S1, and the black market price will end up between P1 and P2. The highest feasible black market price is P2.

4.7. The table below illustrates the demand and supply schedules for seats on air flights between two cities: Quantity Quantity Price Demanded Supplied $200 2,000 1,200 $300 1,800 1,400 $400 1,600 1,600 $500 1,400 1,800 $600 1,200 2,000 What are the market price and equilibrium quantity in this market? Now suppose that federal authorities limit the number of flights between the two cities to ensure that no more

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition than 1,200 passengers can be flown. Evaluate the effects of this quota if price adjusts.

(Hint: What price per flight are the 1,200 passengers willing to pay?)

The market price is $400, and the equilibrium quantity of seats is 1,600. If airlines cannot sell tickets to more than 1,200 passengers, then passengers are willing to pay $600 per seat.

Normally airlines would be willing to sell each ticket for $200, but they will be able to charge a price as high as $600 for each of the 1,200 tickets they sell. Hence, the quantity of tickets sold declines from 1,600, and the price of a ticket rises from $400 to as high as $600.

4-8. The consequences of decriminalizing illegal drugs have long been debated. Some claim that legalization will lower the price of these drugs and reduce related crime and that more people will use these drugs. Suppose some of these drugs are legalized so that anyone may sell them and use them. Now consider the two claims—that price will fall and quantity demanded will increase. Based on positive economic analysis, are these claims sound?

The fact that drug sellers incur legal penalties if caught means that there is an extra cost of selling drugs over and above those associated with production and distribution of these substances. Legalization would eliminate these costs and cause the market supply curve to shift rightward. This would indeed reduce the market price and increase the equilibrium quantity. To the extent that drug users commit crimes to fund currently high-market prices, drug legalization could indeed reduce the incentive for such criminal activities. At the same time, to the extent that drug use causes a national health problem, increased use of legalized drugs could expand the scope of that problem. Thus, both sides have potentially legitimate points.

4-9. In recent years, the government of Pakistan has established a support price for wheat of about $0.20 per kilogram of wheat. At this price, consumers are willing to purchase 10 billion kilograms of wheat per year, while Pakistani farmers are willing to grow and harvest 18 billion kilograms of wheat per year. The government purchases and stores all surplus wheat. a. What are annual consumer expenditures on the Pakistani wheat crop? b. What are annual government expenditures on the Pakistani wheat crop? c. How much, in total, do Pakistani wheat farmers receive for the wheat they produce? a. Consumers buy 10 billion kilograms at the support price of $0.20 per kilogram and hence spend $2 billion on wheat. b. The amount of surplus wheat at the support price is 8 billion kilograms, so at the $0.20 per kilogram support price, the government must spend $1.6 billion to purchase this surplus wheat. c. Pakistani wheat farmers receive a total of $3.6 billion—the sum of the $2 billion in consumers’ purchases and the $1.6 billion of the government’s purchases—for the wheat they produce at the support price.

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Chapter 4 Extensions of Demand and Supply Analysis 4-10. Consider the information in Problem 4-9 and your answers to that problem. Suppose that the market clearing price of Pakistani wheat in the absence of price supports is equal to $0.10 per kilogram. At this price, the quantity of wheat demanded is 12 billion kilograms.

Under the government wheat price-support program, how much more is spent each year on wheat harvested in Pakistan than otherwise would have been spent in an unregulated market for Pakistani wheat?

In the absence of price supports, consumers would have bought 12 billion kilograms of wheat at the market price of $0.10 per kilogram, thereby spending $1.2 billion. Hence, under the government’s price support program, wheat farmers in Pakistan are receiving $2.4 billion more for wheat than they would have in the absence of the price support.

4-11. Consider the diagram below, which depicts the labour market in a city that has adopted a “living wage law” requiring employers to pay a minimum wage rate of $11 per hour.

Answer the questions that follow.

a. What condition exists in this city’s labour market at the present minimum wage of $11 per hour? How many people are unemployed at this wage? b. A city councilwoman has proposed amending the living wage law. She suggests reducing the minimum wage to $9 per hour. Assuming that the labour demand and supply curves were to remain in their present positions, how many people would be unemployed at a new $9 minimum wage? c. A councilman has offered a counterproposal. In his view, the current minimum wage is too low and should be increased to $12 per hour. Assuming that the labour demand and supply curves remain in their present positions, how many people would be unemployed at a new $12 minimum wage? a. At the present minimum wage of $11 per hour, the quantity of labour supplied is 102,000 workers, and the quantity of labour demanded by firms is 98,000. There is an excess quantity supplied of 4,000 workers, which is the number of people who are unemployed.

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition b. At a minimum wage of $9 per hour, there would be nothing to prevent market forces from pushing the wage rate to the market clearing level of $10 per hour. This $10-perhour wage rate would exceed the legal minimum and hence would prevail. There would be no unemployed workers. c. At a $12-per-hour minimum wage, the quantity of labour supplied would increase to 104,000 workers, and the quantity of labour demanded would decline to 96,000. There would be an excess quantity of labour supplied equal to 8,000 workers, which would then be the number of people unemployed.

4-12. A city has decided to impose rent controls, and it has established a rent ceiling below the previous equilibrium rental rate for offices throughout the city. How will the quantity of offices leased by building owners change?

The reduction in the allowable rental rate, or price of rental offices, reduces the quantity of offices that owners are willing to supply. Hence, the quantity of offices leased to tenants declines.

4-13. In 2019, the government of a nation established a price support for wheat. The government’s support price has been above the equilibrium price each year since, and the government has purchased all wheat over and above the amounts that consumers have bought at the support price. Every year since 2019, there has been an increase in the number of wheat producers in the market. No other factors affecting the market for wheat have changed. Predict what has happened every year since 2019, to each of the following: a. Amount of wheat supplied by wheat producers b. Amount of wheat demanded by all wheat consumers c. Amount of wheat purchased by the government a. The rise in the number of wheat producers causes the market supply curve to shift rightward, so more wheat is supplied at the support price. b. The quantity of wheat demanded at the same support price is unchanged. c. Because quantity demanded is unchanged while quantity supplied has increased, the amount of surplus wheat that the government must purchase has risen.

4-14. The province of Ontario decided to boost its own minimum wage by an additional $1.60 per hour. This pushed the wage rate earned by Ontario teenagers above the equilibrium wage rate in the teen labour market. What is the predicted effect of this action by Ontario’s government on each of the following? a. The quantity of labour supplied by Ontario teenagers b. The quantity of labour demanded by employers of Ontario teenagers c. The number of unemployed Ontario teenagers a. The quantity of labour supplied by Ontario teenagers increases. b. The quantity of labour demanded by employers of Ontario teenagers decreases. c. There is an increase in the excess quantity supplied in the Ontario market for teen labour, so the number of unemployed Ontario teenagers increases.

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Chapter 4 Extensions of Demand and Supply Analysis 4-15. Consider Figure 4-1. The current demand and supply curves are D1 and S1, at which the equilibrium price and quantity are P1 and Q1. If there is a decrease in the price of an item that consumers regard as a substitute for this good, which curve shifts, and in which direction does it shift? What happens to the market clearing price and to the equilibrium quantity?

A decrease in the price of an item that consumers regard as a substitute for this good causes the demand curve for this good to shift leftward, as shown in panel (b) by the leftward shift from D1 to D3.

Consequently, there is a movement from equilibrium point E1 to equilibrium point E3 in panel (b). The market clearing price decreases, from P1 to P3, and the equilibrium quantity decreases, from Q1 to Q3.

4-16. Consider Figure 4-1. The current demand and supply curves are D1 and S1, at which the equilibrium price and quantity are P1 and Q1. If firms adopt a cost-reducing technique for producing this good, which curve shifts, and in which direction does it shift? What happens to the market clearing price and to the equilibrium quantity?

A technological improvement causes the supply curve for this good to shift rightward, as shown in panel (c) by the rightward shift from S1 to S2. Consequently, there is a movement from equilibrium point E1 to equilibrium point E2 in panel (c). The market clearing price decreases, from P1 to P2, and the equilibrium quantity increases, from Q1 to Q2.

4-17. Consider Figure 4-3. Suppose that the government reduces the ceiling price to $500 per unit. Would the shortage at the $500-per-unit ceiling price be greater than at the $600-perunit price ceiling?

The reduction in the ceiling price from $600 per unit to $500 per unit would generate a decrease in the quantity supplied and an increase in the quantity demanded. Consequently, the amount of the excess quantity demanded, or shortage, would increase to an amount exceeding 10,000 units.

4-18. Suppose that in Figure 4-4, the government raises the floor price of milk above the displayed $1.50 per litre floor price, to $1.75 per litre. Will the excess quantity of milk supplied increase or decrease as a consequence?

An increase in the floor price from $1.50 per litre to $1.75 per litre will cause the quantity of milk demanded to fall and the quantity of milk supplied to rise. Hence, the excess quantity of milk supplied will increase.

4-19. Suppose that in Figure 4-4, the government reduces the floor price of milk below the displayed $1.50 per litre floor price, to $1.00 per litre. Will the excess quantity of milk supplied increase or decrease as a consequence?

A decrease in the floor price from $1.50 per to $1.00 per litre will result in in an increase in the quantity of milk demanded, from 27.3 million hectolitres to 31.5 million hectolitres, and a decrease in the quantity of milk supplied, from 49.8 million hectolitres to 31.5 million hectolitres.

Thus, the excess quantity supplied decreases to zero. .

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition 4-20. Suppose that Figure 4-7 applies to the labour market in British Columbia, in which Wm is the minimum wage established by the provincial government, and Qs – Qd therefore is British Columbia’s excess quantity of labour supplied as a result of the wage minimum.

What would happen to British Columbia’s excess quantity of labour supplied if the province were to decide to increase the minimum wagefurther?

If British Columbia were to further increase the minimum wagethan Wm, the quantity of labour demanded would decrease, and the quantity of labour supplied would increase. Thus, the amount of the excess quantity of labour supplied in British Columbia would increase.

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Chapter 5

Market Failures and the Public Sector 

Answers to Questions for Critical Analysis

BAD SMELLS HAVE NEIGHBOURS CRYING FOUL ABOUT AN ALBERTA COMPOST FACILITY Could negative externalities be addressed if compose facilities negotiated payments for the right to pollute air shared with properties owned by residential neighbours? Explain your reasoning.

If people could negotiate prices at which compost facilities would pay explicit fees for the right to pollute air shared with properties owned by residential neighbours, then the negative externalities for the property owners would have been internalized through the fees paid to the property owners.

AI: CONTEMPLATING BIG DATA AS A PUBLIC GOOD Over 2 billion people use Facebook. Consequently, Facebook has access to enormous amounts of Internet usage data. Facebook allowed access to such data as Microsoft, Spotify, and Netflix.

If you are a Facebook user, should you be worried?

Let’s face it: Social media have become ubiquitous. Typically, you pay nothing for access to and use of social media. Those companies that provide social media platforms, however, have to make a profit to survive. Social media platforms earn most of their revenue from selling advertising and their subscribers’ data. Facebook did not provide access to its customers’ Internet use data free of charge to Microsoft, Spotify, and Netflix. Rather, it charged for such access.

Should you be worried? Probably not, unless Facebook starts providing such data to the government, as is done in China today. That is to say, Internet usage data in China is used by government agencies to monitor your “social awareness.” If a citizen of that country does not appear to be “socially correct,” that person might not be able to reserve an airline ticket, as just one example. Remember, you always have the solution of cancelling your social media account.

GOVERNMENT SPONSORSHIP KEEPS LIGHT RAIL SYSTEMS IN OPERATION Why do you suppose that light rail service cutbacks take place when governments reduce their sponsorship funding even if an affected operating authority responds by charging riders slightly higher fares?

The government sponsorship (subsidy) results in higher quantity being produced than would be in a free market. Reducing the subsidy would decrease the amount of services supplied and increasing fares would decrease the amount of services demanded, resulting in rail service cutbacks (both on the supply side and demand side).

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition TO INHIBIT NICOTINE CONSUMPTION, SHOULD GOVERNMENT ASSUME THAT ALL CONSUMERS BEHAVE THE SAME? Why might imposing the same taxes on traditional cigarettes and e-cigarettes fail to generate the same changes in quantity demanded? (Hint: Is someone who is limiting nicotine consumption by exclusively “vaping” likely to cut back as much in response to a tax-induced price increase than someone who regularly smokes traditional cigarettes?)

Motives for using e-cigarettes differ from those affecting consumption of nicotine via traditional cigarettes. Because the motives are different, the taxes may not generate a cut back as much as expected.

GOVERNMENTS CONFRONT HIGHER DEBT REPAYMENT EXPENSES Who ultimately pays the debt repayment expenses owed by the federal government?

Taxpayers ultimately pay the debt repayment expenses in the form of taxes and user charges.

AVERAGE TAX RATES AND CANADIAN INCOME TAX PROGRESSIVITY If you have a chance in the future to invest in a risky, but potentially profitable venture, what is most important to you – your average tax rate or your marginal tax rate? Why? If you are trying to determine your overall after-tax income, your average tax rate allows you to do so easily. If you make $100,000 in a year and your average tax rate is 20 percent, you will be left with $80,000 in after-tax income. In contrast, if you have been offered the chance to place funds in a somewhat risky, but potentially highly profitable venture, then you must examine your marginal tax rate. Suppose you might make an extra $20,000 per year because of your involvement, and you want to know how much of that additional income will go into your pocket. Only by knowing your marginal income tax rate can you make this calculation. You might react differently to this risky, but potentially profitable opportunity if your marginal tax rate is 90 percent rather than 35 percent.

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Economics in Your Life

FAKE “SERVICE PETS” CREATE EXTERNAL COSTS ON AIRLINE FLIGHTS For Critical Thinking Why do you suppose that proposals have surfaced for the U.S. Transportation Department to allow airlines to charge special fees to passengers who wish to board planes accompanied by service pets?

The fees are an attempt to transfer the negative effects (externality) the pets have on other passengers to the owners of the service pets. The resulting increase in price to the passengers with service pets would reduce the quantity of service pets on board.

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Chapter 5 Market Failures and the Public Sector Real Application Airline companies are increasingly changing their rules about which animals they will accept as “service animals.” If by chance you require a service animal to enjoy less stressful airline flights, then the change in rules may affect you. What might be your options if your particular service animal is no longer accepted?

One option is for you to purchase another animal for emotional comfort that remains on the airlines’ accepted list. Another possibility is for you to consider driving or taking a train instead of taking a plane. Yet another action to consider is to reduce the overall amount of travel that you undertake each year.

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Issues & Applications

CANADIANS GET A LESSON IN EXTERNALITIES: LIBERALS PROPOSE A FIVE-FOLD INCREASE IN THE CARBON TAX TO MEET CLIMATE GOALS For Critical Thinking Using a supply and demand graph, show the impact a border adjustment tax would have on the equilibrium price and quantity for a Canadian good. (Hint: treat the foreign produced good as a substitute for the Canadian good).

The border adjustment tax, represents an increase in the price of a substitute good (i.e. the foreign product) for the Canadian good. This will cause the demand for the Canadian good to shift outward. Demand for the Canadian good will increase now that it is priced more attractively relative to the foreign good subject to the border adjustment tax. The shift out of the demand curve will result in a higher equilibrium price and quantity for the Canadian good than before the border adjustment tax was applied.

Real Application It is estimated that the new climate plan will increase the price of gasoline 37.57 cents a litre by 2030. What are the ways this price increase will directly and indirectly impact you? What tradeoffs will you have to make to accommodate this price increase?

The gasoline price increase will directly impact the costs associated with driving your vehicle to school or work, operating recreational vehicles, and operating any other gasoline powered device (e.g. lawnmower, snow blower, etc.). The higher cost of gasoline will also impact the price of any of the good/service that requires gasoline to make or transport them. So you may also be indirectly impacted by having to pay higher shipping costs on goods purchased online, food deliveries, public transportation fees, etc.

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition There are many things you could do to mitigate the higher price of gasoline. For example, you could walk or bike to work instead of drive. You could trade-in your existing vehicle for a more fuel efficient one. You could move closer to your work or school to minimize the travel distance. Note how some of these changes are easier and less expensive than others.

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Answers to End-of-Chapter Questions

5-1. Many people who do not smoke cigars are bothered by the odor of cigar smoke. If private contracting is impossible, will too many or too few cigars be produced and consumed?

Taking all costs into account, is the market price of cigars too high or too low?

In the absence of laws forbidding cigar smoking in public places, people who are bothered by the odor of cigar smoke will experience costs not borne by cigar producers. Because the supply of cigars will not reflect these costs, from society’s perspective the market cigar supply curve will be in a position too far to the right. The market price of cigars will be too low, and too many cigars will be produced and consumed.

5-2. Suppose that repeated application of a pesticide used on orange trees causes harmful contamination of groundwater. The pesticide is applied annually in almost all of the orange groves throughout the world. Most orange growers regard the pesticide as a key input in their production of oranges. a. Use a diagram of the market for the pesticide to illustrate the implications of a failure of orange producers’ costs to reflect the social costs of groundwater contamination. b. Use your diagram from part (a) to explain a government policy that might be effective in achieving the amount of orange production that fully reflects all social costs. a. As shown in the figure, if the social costs associated with ground-water contamination were reflected in the costs incurred by orange producers, the supply schedule would be S2 instead of S1, and the market clearing price of oranges would be higher, at P2 instead of P1.

The equilibrium quantity of oranges produced would be lower, at Q2 instead of Q1.

b. The government could tax the production and sale of pesticide-treated oranges. If it is able set the tax at a level that reflects all social costs, the result is a shift of the supply 46

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Chapter 5 Market Failures and the Public Sector curve upward and to the left to a position, S2, that yields the socially optimal production of oranges using the pesticide.

5-3. Draw a diagram of the market for oranges. Explain how the government policy you discussed in part (b) of Problem 5-2 is likely to affect the market price and equilibrium quantity in the orange market. In what sense do consumers of oranges now “pay” for dealing with the spillover costs of pesticide production?

Imposing the tax on pesticides causes an increase in the price of pesticides, which are an input in the production of oranges. Hence, the supply curve in the orange market shifts leftward. The market price of oranges increases, and the equilibrium quantity of oranges declines. Hence, orange consumers indirectly help to pay for dealing with the spillover costs of pesticide production by paying more for oranges.

5-4. Suppose the Canadian government determines that cigarette smoking creates social costs not reflected in the current market price and equilibrium quantity of cigarettes. A study has recommended that the government can correct for the externality effect of cigarette consumption by paying farmers not to plant tobacco used to manufacture cigarettes. It also recommends raising the funds to make these payments by increasing taxes on cigarettes.

Assuming that the government is correct that cigarette smoking creates external costs, evaluate whether the study’s recommended policies might help correct this negative externality.

If the consumption of cigarettes creates social costs not reflected in the current market price and quantity, then from society’s point of view the supply curve is in a location below and to the right of the optimal position. Paying tobacco farmers not to plant tobacco would reduce the quantity supplied at each price of tobacco, which would shift the supply curve leftward and upward. So, would increasing taxes on cigarettes to raise the funds to pay the farmers. Both of these policy actions, therefore, would be consistent with helping to correct the negative externality.

5-5. A nation’s government has determined that mass transit, such as bus lines, helps alleviate traffic congestion, thereby benefiting both individual auto commuters and companies that desire to move products and factors of production speedily along streets and highways. .

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition Nevertheless, even though several private bus lines are in service, the country’s commuters are failing to take into account the positive externality associated with the use of mass transit. a. Discuss, in the context of demand-supply analysis, the essential implications of commuters’ failure to take into account the positive externality associated with bus ridership. b. Explain a government policy that might be effective in achieving the socially efficient use of bus services. a. As shown in the figure below, if the positive externality associated with bus ridership were considered, the demand schedule would be D' instead of D, and the market price would be higher. The equilibrium quantity of bus rides would be higher.

b. The government could pay commuters a subsidy to ride the bus, thereby shifting the demand curve outward and to the right. This would increase the market price and equilibrium number of bus rides.

5-6. Draw a diagram of this nation’s market for automobiles, which are a substitute for buses.

Explain how the government policy you discussed in part (b) of Problem 5-5 is likely to affect the market price and equilibrium quantity in the country’s auto market. How are auto consumers affected by this policy described in your answer to Problem 5-5?

Although the government subsidy for riding the bus raises the market price of bus rides, it reduces the effective price that consumers actually pay. Bus rides are a substitute for using an automobile for transit, so the demand for automobiles declines. Thus, in this case, automobile owners indirectly benefit, through lower prices, from the government subsidy that promotes bus ridership.

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Chapter 5 Market Failures and the Public Sector

5-7. Consider a nation with a government that does not provide people with property rights for a number of items and that fails to enforce the property rights it does assign for remaining items. Would externalities be more or less common in this nation than in a country such as the Canada? Explain.

If this nation’s government does not provide people with property rights for a number of items and fails to enforce the property rights that it does assign for remaining items, externalities would be more common than in a country such as the Canada. Any two parties to transactions in that nation would know that any third parties who might be subject to spillover effects from their production or consumption activities. Thus, any two parties undertaking such transactions would experience no incentives to reduce or eliminate the transactions’ spillover effects, resulting in widespread externalities.

5-8. Many economists suggest that our nation’s legal system is an example of a public good.

Does the legal system satisfy the key properties of a public good? Explain your reasoning.

Our nation’s legal system subjects every person to the same laws and to identical sets of penalties for violating these laws. Thus, the principle of rival consumption arguably does not apply. The experience of benefits provided by the legal system by one person does not necessarily reduce any other individual’s receipt of benefits. Furthermore, any person who has helped to pay for the legal system benefits from its existence only if the legal system applies to all others who might violate a law and infringe on that person’s property rights, whether or not those violators helped to pay for the legal system beforehand. Taken together, these arguments support the idea that the legal system is a public good.

5-9. Displayed in the diagram below are conditions in the market for residential Internet access in a Canadian province. The government of this province has determined that access to the Internet improves the learning skills of children, which it has concluded is an external benefit of Internet access. The government has also concluded that if these external benefits were to be taken into account, 3 million residences would have Internet access. Suppose that the provincial government’s judgments about the benefits of Internet access are correct and that it wishes to offer a per-unit subsidy just sufficient to increase total Internet access to 3 million residences. What per-unit subsidy should it offer? Use the diagram to explain

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition how providing this subsidy would affect conditions in the province’s market for residential Internet access.

At present, the equilibrium quantity of residences with Internet access is 2 million. To consider the external benefit of Internet access and boost the quantity of residences with access to 3 million, the demand curve would have to shift upward by $20 per month at any given quantity, to D2 from the current position D1. Thus, the government would have to offer a $20-per-month subsidy to raise the quantity of residences with Internet access to 3 million.

5-10. A few years ago, the French government allocated the equivalent of more than $120 million in public funds to Quaero (Latin for “I search”), an Internet search engine analogous to Google or Yahoo. Does an Internet search engine satisfy the key characteristics of a public good? Why or why not? Based on your answer, is a publicly funded Internet search engine a public good or a government-sponsored good?

A public good can be used by more and more people at no additional opportunity cost and without depriving others of any of the services of the good. In addition, it is difficult to design a .

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Chapter 5 Market Failures and the Public Sector collection system for a public good on the basis of how much individuals use it. An Internet search engine satisfies neither property of a public good because access to a search engine can be restricted and the provider of an Internet search engine can require someone to pay to use the search engine. Thus, the French Internet search engine is a government-sponsored good, not a public good.

5-11. A government offers to let a number of students at public schools transfer to private schools under two conditions: It will transmit to private schools the same per-pupil subsidy it provides public schools, and the private schools will be required to admit the students at an out-of-pocket tuition rate below the market tuition rate. Will the economic outcome be the same as the one that would have arisen if the government instead simply provided students with grants to cover the current market tuition rate at the private school? (Hint: Does it matter if schools receive payments directly from the government or from consumers?)

No, the outcome will be different. If the government had simply provided grants to attend private schools at the current market tuition rate, parents and students receiving the grants would have paid a price equal to the market valuation of the last unit of educational services provided.

Granting a subsidy to private schools allows the private schools to charge parents and students a price less than the market price. Private schools thereby will receive a higher-than-market price for the last unit of educational services they provide. Consequently, they will provide a quantity of educational services in excess of the market equilibrium quantity. At this quantity, parents and students place a lower value on the services than the price received by the private schools.

5-12. After a government implements a voucher program, granting funds that families can spend at schools of their choice, numerous students in public schools switch to private schools.

The program’s per-unit subsidy is exactly equal to the external benefit from private educational services. Is anyone likely to lose out nonetheless? If so, who?

Public schools will lose students to private schools. The subsidized prices that public schools receive will also decline. Both of these changes will result in lower revenues for public schools.

5-13. Suppose that the current price of a tablet device is $300 and that people are buying 1 million devices per year. The government decides to begin subsidizing the purchase of new tablet devices. The government believes that the appropriate price is $260 per tablet, so the program offers to send people cash for the difference between $260 and whatever the people pay for each tablet they buy. a. If no consumers change their tablet-buying behaviour, how much will this program cost the taxpayers? b. Will the subsidy cause people to buy more, fewer, or the same number of tablets?

Explain. c. Suppose that people end up buying 1.5 million tablets once the program is in place. If the market price of tablets does not change, how much will this program cost the taxpayers?

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition d. Under the assumption that the program causes people to buy 1.5 million tablets and also causes the market price of tablets to rise to $320, how much will this program cost the taxpayers? a. $40 million b. The effective price of a tablet device to consumers will be lower after the government pays the subsidy, so people will purchase a larger quantity. c. $60 million d. $90 million 5-14. Scans of internal organs using magnetic resonance imaging (MRI) devices are often covered by Medicare. Consider the following table illustrating hypothetical quantities of individual MRI testing procedures demanded and supplied at various prices, and then answer the questions that follow.

Price

Quantity Demanded

Quantity Supplied

$100 $300 $500 $700 $900

100,000 90,000 80,000 70,000 60,000

40,000 60,000 80,000 100,000 120,000

a. In the absence of a government-subsidized coverage, what is the equilibrium price of MRI tests? What is the amount of society’s total spending on MRI tests? b. Suppose that the government establishes a health plan guaranteeing that all qualified participants can purchase MRI tests at an effective price (that is, out-of-pocket cost) to the individual of $100 per test. How many MRI tests will people desire to consume? c. What is the per-unit price that induces producers to provide the number of MRI tests demanded at the government-guaranteed price of $100? What is society’s total spending on MRI tests? d. Under the government’s coverage of MRI tests, what is the per-unit subsidy it provides? What is the total subsidy that the government pays to support MRI testing at its guaranteed price? a. b. c. d.

equilibrium price = $500; society’s total expense = $40 million 100,000 tests producers’ per-unit cost = $700; society’s total expense = $70 million government’s per-unit subsidy= $600; total subsidy = $60 million

5-15. Suppose that, as part of an expansion of its Province Care health system, a provincial government decides to offer a $50 subsidy to all people who, according to their physicians, should have their own blood pressure monitoring devices. Prior to this governmental decision, the market clearing price of blood pressure monitors in this province was $50, and the equilibrium quantity purchased was 20,000 per year. .

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Chapter 5 Market Failures and the Public Sector a. After the government expands its Province Care plan, people in this province desire to purchase 40,000 devices each year. Manufacturers of blood pressure monitors are willing to provide 40,000 devices at a price of $60 per device. What out-of-pocket price does each consumer pay for a blood pressure monitor? b. What is the dollar amount of the increase in total expenditures on blood pressure monitors in this province following the expansion in the Province Care program? c. Following the expansion of the Province Care program, what percentage of total expenditures on blood pressure monitors is paid by the government? What percentage of total expenditures is paid by consumers of these devices? a. $60 – $50 = $10 b. Expenditures after the program expansion are $2.4 million. Before the program expansion, expenditures were $1 million. Hence, the increase in expenditures is $1.4 million. c. At a per-unit subsidy of $50, the share of the per-unit $60 price paid by the government is 5/6, or 83.3 percent. Hence, this is the government’s share of total expenditures on the 40,000 devices that consumers purchase. The consumers of these devices pay $10 of the per-unit $60 price, or 16.67 percent.

5-16. A government agency is contemplating launching an effort to expand the scope of its activities. One rationale for doing so is that another government agency might make the same effort and, if successful, receive larger budget allocations in future years. Another rationale for expanding the agency’s activities is that this will make the jobs of its workers more interesting, which may help the government agency attract better-qualified employees. Nevertheless, the agency will have to convince more than half of the House of Commons and the Senate to approve a formal proposal to expand its activities. In addition, to expand its activities, the agency must have the authority to force private companies it does not currently regulate to be officially licensed by agency personnel. Identify which aspects of this problem are similar to those faced by firms that operate in private markets and which aspects are specific to the public sector.

Seeking to increase budget allocations in future years and to make workers’ jobs more interesting can be consistent with the profit-maximizing objectives of firms in private markets.

Also, the government agency is promoting competition, which is analogous to behaving like a firm in a private market. Achieving these goals via majority rule and regulatory coercion, however, are aspects that are specific to the public sector.

5-17. Suppose that panel (a) of Figure 5-1 applies to Ontario’s steel market. Suppose that steel manufacturers in this province adopt a new, equal-cost technique for producing steel that entails a smaller external cost. In the absence of any government action to correct the negative externality from steel production, would the overallocation of resources to steel production in Ontario be larger or smaller following the adoption of the next steelmanufacturing technique?

The reduced external cost of producing steel would mean that the vertical distance added to the supply curve S1 would be smaller, so that the supply curve considering this external cost would .

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition lie between S1 and S2. Thus, the amount of steel produced that would reflect all external costs would be greater than 100 million tons, which would imply a smaller degree of overallocation of resources to steel production.

5-18. Based on your answer to Question 5-17, if Ontario’s government aims to correct the steel market’s negative externality via an effluent fee, is the appropriate fee higher or lower now that steel producers have adopted the new technique? Why? Because the supply curve does not have to be shifted so far upward and to the left because the external cost of steel production is lower, the appropriate effluent fee to correct the negative externality is now lower.

5-19. Consider panel (b) of Figure 5-1. Assume that a careful study of the likely transmission of influenza in light of a changed population distribution has revealed that the external benefits from inoculations are greater than currently displayed in the graph. In light of this information, is the under allocation of resources to the provision of flu-vaccine inoculations larger or smaller than indicated in panel (b)?

The higher external benefits revealed by the study imply that the true demand curve reflecting these benefits lies to the right of D2. Thus, the amount of flu-vaccine inoculations provided that would reflect all external benefits would be greater than 200 million per year, which would imply a greater degree of under allocation of resources to the provision of inoculations.

5-20. Based on your answer to Question 5-19, if the government aims to correct the positive externality in the inoculation market via a per-unit subsidy to consumers, in the wake of study, is the appropriate per-unit subsidy higher or lower than before?

In light of the study’s revelation of higher external benefits, a higher per-unit subsidy is appropriate. This higher per-unit subsidy would shift the demand curve farther to the right in relation to D2 in order to reflect the increased external benefits of inoculations.

5-21. An online video game has the technical capability for a large number of players to participate, as long as a game administrator works to ensure constant functionality of the game. Adding more players deprives no other participants of the entertainment services provided by the online game. It has been easy, however, to set up a system for excluding participation by anyone who fails to contribute $5 per month to a fund that ensures covering extra expenses generated by that player’s participation. Is this game a public good?

One aspect of the online game that it shares with a public good is the fact that more and more people can participate in teams without depriving other participants of the game’s entertainment services. Nevertheless, the fact that it has been easy to design a collection system to exclude from participation anyone who fails to contribute to assuring provision of the game means that the game is not a public good.

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Chapter 5 Market Failures and the Public Sector 5-22. A senior citizen gets a part-time job at a fast-food restaurant. She earns $8 per hour for each hour she works, and she works exactly 25 hours per week. Thus, her total pretax weekly income is $200. Her total income tax assessment each week is $40. She pays $3 in taxes for the final hour she works each week. a. What is this person’s average tax rate each week? b. What is the marginal tax rate for the last hour she works each week? a. The average tax rate is the total tax of $40 divided by the $200 in income: $40/$200 = 0.2, or 20 percent b. The marginal tax rate for the last hour of work is the change in taxes, $3, divided by the change in income, $8: $3/$8 = 0.375, or 37.5 percent 5-23. For purposes of assessing income taxes, there are three official income levels for workers in a small country: high, medium, and low. For the last hour on the job during a 40-hour workweek, a high-income worker pays a marginal income tax rate of 15 percent, a medium-income worker pays a marginal tax rate of 20 percent, and a low-income worker is assessed a 25 percent marginal income tax rate. Based only on this information, does this nation’s income tax system appear to be progressive, proportional, or regressive?

Because the marginal tax rate increases as workers’ earnings decline, this tax system is regressive.

5-24. Consider the table below when answering the questions that follow. Show your work, and explain briefly.

Christino Jarius Meg Taxes Taxes Taxes Income Paid Income Paid Income Paid $1,000 $200 $1,000 $200 $1,000 $200 $2,000 $300 $2,000 $400 $2,000 $500 $3,000 $400 $3,000 $600 $3,000 $800

a. What is Christino’s marginal tax rate? b. What is Jarius’s marginal tax rate? c. What is Meg’s marginal tax rate? a. Christino’s marginal tax rate is

$300 − 200 $400 − 300 $100 = = = 0.1 , or 10 percent. $2,000 − $1,000 $3,000 − $2,000 $1,000

b. Jarius’s marginal tax rate is

$400 − 200 $600 − 400 $200 = = = 0.2 , or 20 percent. $2,000 − $1,000 $3,000 − $2,000 $1,000

c. Meg’s marginal tax rate is

$500 − 200 $800 − 500 $300 = = = 0.3 , or 30 percent. $2,000 − $1,000 $3,000 − $2,000 $1,000

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition 5-25. Refer to the table in Problem 5-24 when answering the following questions. Show your work, and explain briefly. a. Does Christino experience progressive, proportional, or regressive taxation? b. Does Jarius experience progressive, proportional, or regressive taxation? c. Does Meg experience progressive, proportional, or regressive taxation? a. Christino experiences regressive taxation. This can be seen in one of two ways. First, as his income increases, his average tax rate declines from $200/$1,000 = 0.2 (or 20 percent) to $300/$2,000 = 0.15 (or 15 percent) to $400/$3,000 = 0.133 (or 13.3 percent). Thus, the proportion of income paid as taxes decreases as his income rises.

Second, his marginal tax rate of 10 percent is always less than his average tax rate. b. Jarius experiences proportional taxation. This can be seen in one of two ways. First, as his income increases, his average tax rate remains unaltered at $200/$1,000 = $400/$2,000 = $600/$3,000 = 0.2 (or 20 percent). Thus, the proportion of income paid as taxes remains unchanged as his income rises. Second, his marginal tax rate of 20 percent is always the same as his average tax rate. c. Meg experiences progressive taxation. This can be seen in one of two ways. First, as her income increases, her average tax rate rises from $200/$1,000 = 0.2 (or 20 percent) to $500/$2,000 = 0.25 (or 25 percent) to $800/$3,000 = 0.267 (or 26.7 percent). Thus, the proportion of income paid as taxes increases as her income rises.

Second, her marginal tax rate of 30 percent always exceeds her average tax rate.

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Answers to Questions for Critical Analysis

WHY ARE MORE LAID OFF PERSONS NOT APPLYING FOR EMPLOYMENT INSURANCE BENEFITS? How should you take into account EI benefits when deciding when to accept a job offer?

Clearly, the cost of searching for a new employment situation will be reduced by the amount and length of employment insurance benefits you are eligible to receive. The greater the EI benefits offered and the longer those benefits are made available to you, the lower the cost to you of searching for a better and higher-paying job. (Now, of course, you can look for another job while you are still working.)

TEMPORARY WORK FEEDS EUROPE’S STRUCTURAL UNEMPLOYMENT PROBLEM Why do you suppose older workers might favour the labour laws that have given firms incentives to employ younger workers only on a temporary basis?

Older workers most likely favour these labour laws because they face less competition for jobs they already hold. If it is costly for their employers to lay them off, the employers will be less likely to do so. Also, due to the incentives to hire younger workers on a temporary basis, those workers are unlikely to receive skills training that will help them perform better in their temporary jobs. By not obtaining those skills, the young workers will not become more efficient than the older existing workforce.

ARE PRICES OF NEW HOUSES REALLY ALMOST FOURTEEN TIMES HIGHER THAN 50 YEARS AGO? If claims that media commentators prefer to report the largest possible, attention-grabbing changes in numbers are correct, why might they prefer to report economic data that have not been adjusted for changes in the price level?

When adjusting for changes in the price level, the increase in the price of houses is substantially lower than looking at nominal dollars (those not adjusted for the price level). These nominal changes have a greater impact on headlines and are much more likely to resonate with the populace.

WHY MIGHT SURVEYS FAIL TO REVEAL PEOPLE’S TRUE INFLATION EXPECTATIONS? Why do you think that many observers prefer to gauge the public’s anticipation of inflation by subtracting a measure of the real interest rate from the observed nominal interest rate? (Hint: Recall that by definition, the real interest rate equals the nominal interest rate minus the expected inflation rate.)

Many observers prefer to gauge the public’s anticipation of inflation by subtracting a measure of the real interest rate from the observed nominal interest rate because the polls that ask people about their inflation expectations tend to be biased. People are unable to comprehend all relevant aspects of economic problems, like inflation. For instance, they are likely to gauge their inflation

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition expectations based on prices of a small set of items they consume rather than answer based on changes in the overall price level.

AI: GOOGLE JOB SEARCHES TO PREDICT UNEMPLOYMENT Why do you suppose researchers typically find evidence that values of search indexes for the terms “job centre” and “collect unemployment” are almost as useful as leading indicators as the value of the search index for “jobs”?

People are likely to search for the terms “job centre” and “collect unemployment” when they fear, or know, that they are about to lose their job and are about to join the ranks of the unemployed. Increases in searching for these terms are useful as leading indicators that predict an increase in future unemployment.

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Economics in Your Life

AFTER YEARS OF HIGH TEEN UNEMPLOYMENT RATES, U.S. TEENAGERS ARE FINDING WORK ONCE MORE For Critical Thinking Why do you suppose that the drop in the overall U.S. unemployment rate to its lowest levels in more than 50 years contributed to an increase in the labour force participation rate and a decrease in the teen unemployment rate?

In this instance, the drop in the unemployment rate is likely the result of an increase in the number of jobs that need to be filled. At some point companies will no longer be able to hire skilled workers (those who are older and have been in the labour force a while) and will turn to teen workers to fill these positions, resulting in a decrease in the teen unemployment rate.

As companies look to attract more workers, they will raise wages, which will attract more teen workers to the labour force.

Real Application No one requires teenagers to seek higher education after they graduate from high school. How has the drop in teenage unemployment changed teenagers’ perceived opportunity cost of going to college or university?

In a bad labour market, job opportunities for teenagers and young adults who choose to pursue higher education are relatively low. In a tight labour market, in contrast, perceived job opportunities for young people are greater and probably better paying than in the past. That means that the opportunity cost of seeking higher education rises during periods of low teenage unemployment. For some young adults, the lure of immediate relatively high income may outweigh the desire to seek a degree.

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Issues & Applications

HOW “INFORMAL WORK” COMPLICATES MEASURING UNEMPLOYMENT AND THE LABOUR FORCE For Critical Thinking What would happen to current official measures of the unemployment rate and the labour force participation rate if the informal labour market were to collapse, and people engaged in .

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associated informal work lost their positions? (Hint: Do the official measures take into account those who perform these types of informal work?)

If the informal labour market were to collapse, these people would likely look for formal work (thus increasing the labour force participation rate). If they cannot find formal work, they would be considered unemployed (thus increasing the unemployment rate).

Real Application What are some of the drawbacks to engaging in informal work compared to formal work? Do these drawbacks weigh more heavily on you if you are younger or older? Why? Of course, informal work is a way of avoiding paying provincial and federal income taxes. In contrast, when you work “off the books,” your wages are not counted as “contributions” to the Canada Pension Plan (CPP). That might mean that later on, when you retire, your CPP benefit payments might be less. Additionally, informal employment usually means that you will not be covered by an employer-based health insurance program. Purchasing stand-alone health insurance either as an individual or head of a family is usually much more expensive than the cost of the same coverage offered by an employer. Finally, formal employment usually includes paid vacation and paid sick days, which obviously are not available for informal (nonreported) jobs.

As a young person, many of the “downsides” of informal work are less important. The older a person becomes, the more concerned they are about retirement and health insurance issues.

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Answers to End-of-Chapter Questions

6-1. Suppose you are given the following information: Total population Adult, noninstitutionalized population Unemployment

330.0 million 260.0 million 8.5 million

a. If the labour force participation rate is 65 percent, what is the labour force? b. How many workers are employed? c. What is the unemployment rate? a. Multiplying the fraction of people who participate in the labour force, 0.65, times the adult, noninstitutionalized population of 260.0 million yields a labour force of 169.0 million. b. Subtracting the 8.5 million unemployed from the labour force of 169.0 million yields 160.5 million people who are employed. c. Dividing the 8.5 million unemployed by the 169.0 million in the labour force and multiplying by 100 yields an unemployment rate of about 5.0 percent.

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition 6-2. Suppose you are given the following information: Labour force Nonadult population Employed adults Institutionalized adults Noninstitutionalized adults not in labour force

206.2 million 48.0 million 196.2 million 5.0 million 40.8 million

a. What is the total population? b. How many people are unemployed, and what is the unemployment rate? c. What is the labour force participation rate? a. Summing the labour force of 206.2 million, the 40.8 million adults not in the labour force, the 48.0 million nonadults, and the 5.0 million institutionalized adults yields a population of 300.0 million. b. The number of people unemployed is equal to the labour force of 206.2 million minus the 196.2 million employed adults, or 10.0 million. Dividing the 10.0 million unemployed by the 206.2 million in the labour force and multiplying by 100 yields an unemployment rate of about 4.85 percent. c. Adding the 206.2 million labour force and the 40.8 million adults not in the labour force yields 247.0 noninstitutionalized adults. Hence, the labour force participation rate is equal to 206.2 million divided by 247.0 million times 100, or 83.5 percent.

6-3. Suppose that the noninstitutionalized adult population is 254 million, the number employed is 156 million, and the number unemployed is 8 million. a. What is the unemployment rate? b. Suppose there is a difference of 60 million between the adult population and the combined total of people who are employed and unemployed. How do we classify these 60 million people? Based on these figures, what is the labour force participation rate? a. The labour force equals the number employed plus the number unemployed, or 156 million + 8 million = 164 million. In percentage terms, therefore, the unemployment rate is 100 times 8 million/164 million, or 4.9 percent. b. These 60 million people are not in the labour force. The labour force participation rate is, in percentage terms, 100 times 164 million/224 million, or 73.2 percent.

6-4. During the course of a year, the labour force consists of the same 1,000 people. Employers have chosen not to hire 20 of these people in the face of government regulations making it too costly to employ them. Hence, they remain unemployed throughout the year. At the same time, every month during the year 30 different people become unemployed, and 30 other different people who were unemployed find jobs. a. What is the frictional unemployment rate? b. What is the unemployment rate? c. Suppose that a system of unemployment compensation is established. Each month, 30 new people (not including the 20 that employers have chosen not to employ) continue to become unemployed, but each monthly group of newly unemployed now .

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takes two months to find a job. After this change, what is the frictional unemployment rate? d. After the change discussed in part (c), what is the unemployment rate? a. Thirty people are always unemployed due to job changes each month, so the frictional unemployment rate is (30/1,000) × 100 = 3 percent. b. Twenty people are structurally unemployed, and 30 people are frictionally unemployed.

Hence, 50 people are unemployed, and the total unemployment rate is (50/1000) × 100 = 5 percent. c. Now 60 people are always unemployed due to job changes each month, so 60 people are frictionally unemployed. The frictional unemployment rate is (60/1000) × 100 = 6 percent. d. Twenty people are structurally unemployed, and 60 people are frictionally unemployed. Hence, 80 people are unemployed, and the unemployment rate is (80/1000) × 100 = 8 percent.

6-5. Suppose that a nation has a labour force of 100 people. In January, Amy, Barbara, Carine, and Denise are unemployed. In February, those four find jobs, but Evan, Francesco, George, and Horatio become unemployed. Suppose further that every month, the previous four who were unemployed find jobs and four different people become unemployed.

Throughout the year, however, three people—Ito, Jack, and Kelley—continually remain unemployed because firms facing government regulations view them as too costly to employ. a. What is this nation’s frictional unemployment rate? b. What is its structural unemployment rate? c. What is its unemployment rate? a. Four of the 100 people are always continuously unemployed because they are between jobs, so the frictional unemployment rate is (4/100) × 100 = 4 percent. b. Three of the 100 people are always unemployed as a result of government regulations, so the structural unemployment rate is (3/100) × 100 = 3 percent. c. The unemployment rate is the sum of the frictional and structural rates of unemployment, or 7 percent.

6-6. In a country with a labour force of 200, a different group of 10 people becomes unemployed each month but becomes employed once again a month later. No others outside these groups are unemployed. a. What is this country’s unemployment rate? b. What is the average duration of unemployment? c. Suppose that establishment of a system of unemployment compensation increases to two months the interval that it takes each group of job losers to become employed each month. Nevertheless, a different group of 10 people still becomes unemployed each month. Now what is the average duration of unemployment? d. Following the change discussed in part (c), what is the country’s unemployment rate?

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition a. Ten new people become unemployed each month, so the unemployment rate is (10/200) × 100 = 5 percent. b. one month c. two months d. Now, a total of 20 people are unemployed each month, so the unemployment rate is (20/200) × 100 = 10 percent.

6-7. A nation’s frictional unemployment rate is 1 percent. Its cyclical rate of unemployment is 3 percent, and its structural unemployment rate is 4 percent. What is this nation’s overall rate of unemployment?

The overall unemployment rate is 8 percent.

6-8. In 2019, the cost of a market basket of goods was $2,000. In 2021, the cost of the same market basket of goods was $2,100. Use the price index formula to calculate the price index for 2021 if 2019 is the base year.

The price index for 2021 if 2019 is the base year is ($2,100/$2,000 × 100) = 105.0.

6-9. Suppose that in 2020, a typical Canadian student attending a university bought 10 textbooks at a price of $100 per book and enrolled in 25 credit hours of coursework at a price of $360 per credit hour. In 2021, the typical student continued to purchase 10 textbooks and enroll in 25 credit hours, but the price of a textbook rose to $110 per book, and the tuition price increased to $400 per credit hour. The base year for computing a “student price index” using this information is 2020. What is the value of the student price index in 2020? In 2021? Show your work.

In 2020, the value of the market basket is (10 textbooks × $100) + (25 credit hours × $360) = $1,000 + $9,000 = $10,000. Therefore, the value of the price index is $10,000/$10,000 ×100 = 100.

In 2021, the value of the market basket is (10 textbooks × $110) + (25 credit hours × $400) = $1,100 + $10,000 = $11,100. Therefore, the value of the price index is $11,100/$10,000×100 = 111.

6-10. Between 2020 and 2021 in a particular nation, the value of the Consumer Price Index—for which the base year is 2017—rose by 9.091 percent, to a value of 120 in 2021. What was the value of the price index in 2020?

CPI2021/(1 + % change2020-to-2021) = 120/1.091 = 110.

6-11. Consider the following price indexes: 90 in 2020, 100 in 2021, 110 in 2022, 121 in 2023, and 150 in 2024. Answer the following questions. a. Which year is likely the base year? b. What is the inflation rate from 2021 to 2022? c. What is the inflation rate from 2022 to 2023?

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d. If the cost of a market basket in 2021 is $2,000, what is the cost of the same basket of goods and services in 2020? In 2024? a. b. c. d.

2021 100*(CPI2022 – CPI2021)/CPI2021 = 100*(110-100)/100 = 100* (10/100) = 10 percent 100*(CPI2023 – CPI2022)/CPI2022 = 100*(121-110)/110 = 100*(11/110) = 10 percent (Basket2021/CPI2021)*CPI2020 = ($2,000/100)*90 = 20*90 = $1,800 in 2020 (Basket2021/CPI2021)*CPI2024 = ($2,000/100)*150 = 20*150 = $3,000 in 2024

6-12. The real interest rate is 4 percent, and the nominal interest rate is 6 percent. What is the anticipated rate of inflation?

The anticipated inflation rate is the difference between the 6 percent nominal interest rate and the 4 percent real interest rate, or 2 percent.

6-13. Currently, the price index used to calculate the inflation rate is equal to 90. The general expectation throughout the economy is that next year its value will be 99. The current nominal interest rate is 12 percent. What is the real interest rate?

The expected rate of inflation is equal to 100 × [(99 – 90)/90] = 10 percent. Hence the real interest rate equals the difference between the 12 percent nominal interest rate and the 10 percent anticipated inflation rate, or 2 percent.

6-14. At present, the nominal interest rate is 7 percent and the expected inflation rate is 5 percent. The current year is the base year for the price index used to calculate inflation. a. What is the real interest rate? b. What is the anticipated value of the price index next year? a. The real interest rate is the difference between the 7 percent nominal interest rate and the 5 percent expected inflation rate, or 2 percent. b. 100 × 1.05 = 105.0 6-15. Suppose that in 2022 there is a sudden, unanticipated burst of inflation. Consider the situations faced by the following individuals. Who gains and who loses? a. A homeowner whose wages will keep pace with inflation in 2022 but whose monthly mortgage payments to a savings bank will remain fixed b. An apartment landlord who has guaranteed his tenants that their monthly rent payments during 2022 will be the same as they were during 2021 c. A banker who made an auto loan that the auto buyer will repay at a fixed rate of interest during 2022 d. A retired individual who earns a pension with fixed monthly payments from her past employer during 2022 a. b. c. d.

The homeowner gains; the savings bank loses.

The tenants gain; the landlord loses.

The auto buyer gains; the bank loses.

The employer gains; the pensioner loses. .

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition 6-16. Consider the diagram below. The line represents the economy’s growth trend, and the curve represents the economy’s actual course of business fluctuations. For each part below, provide the letter label from the portion of the curve that corresponds to the associated term. a. Contraction b. Peak c. Trough d. Expansion

a. b. c. d.

V U X S

6-17. Suppose that in Figure 6-3, the number of people employed were to expand by 1 million, and the number of people unemployed were to rise by 0.7 million. What would be the new values of the labour force and of the unemployment rate?

The labour force would equal the sum of the number employed, (18.84 + 1) = 19.84 million, and the number unemployed, (1.17 + 0.7) = 1.87 million, or a total of 21.71 million. The unemployment rate would equal (1.87 million/21.71 million) × 100 = 8.61 percent.

6-18. Suppose that among 15 million unemployed people, 6.9 million are frictionally unemployed, 5.9 million are cyclically unemployed, and 2.2 million are structurally unemployed. What is the natural rate of unemployment if the total labour force is 179.7 million?

The natural unemployment rate includes frictional and structural unemployment but excludes cyclical unemployment, so this rate equals [(6.9 million + 2.2 million) / 179.7 million] × 100 = 5.06 percent.

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Chapter 6

The Macroeconomy: GDP, Unemployment, and Inflation

6-19. Consider Table 6-2, Suppose that the 2022 price of corn were to rise to $8.50 per bushel but that the price of a digital device were to fall to $300. The quantities of the two commodities remain the same, however. How would these changes affect the value of the 2022 price index?

The new cost of the 2022 market basket would be the sum of ($8.50 × 100) = $850 in corn expenditures and ($300 × 2) = $600 in spending on digital devices, or a total of $1,450. The new value of the price index would be ($1,450 / $1,300) × 100 = 111.54.

6-20. The cost of a nation’s market basket in the base year is $1,200, and the current year’s price index equals 125. What is the cost of the market basket in the current year?

We know that price index = (cost of market basket today / cost of market basket in base year) × 100, so 125/100 = cost of market basket today / $1,200. Hence, the cost of the market basket today is equal to 1.25 × $1,200 = $1,500.

6-21. This year’s value of the economy’s price index is 100, and people anticipate that next year’s value will be 103. The current nominal interest rate is 5 percent. What is the real interest rate?

The anticipated future price index, 103, is 3 percent larger than the current price index of 100, so the expected inflation rate is 3 percent. The real interest rate, therefore, equals the nominal interest rate of 5 percent less the 3 percent anticipated inflation rate, which is 2 percent.

6-22. This year is the base year for computing the nation’s price index. The current nominal interest rate is 6 percent, and the real interest rate is 3.5 percent. What is the anticipated value of next year’s price index?

The anticipated inflation rate equals the nominal interest rate minus the real interest rate, or 6 percent – 3.5 percent = 2.5 percent. Because this year is the base year for the price index, this year’s price index has a value of 100. Thus, the anticipated value of next year’s price index is 102.5.

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Chapter 7

Measuring the Economy’s Performance 

Answers to Questions for Critical Analysis

A REDUCED ROLE FOR MANUFACTURING OF PHYSICAL MERCHANDISE AS A SOURCE OF VALUE ADDED IN CANADIAN PRODUCTION How might the reduced role of manufacturing in our economy influence your career choices?

If the most growth is taking place in the service sector, likely there will be more job opportunities and higher pay in that sector. Your career choice will probably not focus on what you could do in the manufacturing sector. You will more likely pursue a career in the service sector. Of course, if you obtain an engineering degree with a specialty in artificial intelligence, you may end up working in the manufacturing sector. You could, as an example, become part of a team that is working on making robots more efficient in the manufacturing of automobiles.

OBSTACLES TO MEASURING AGGREGATE “WELL-BEING” ALONGSIDE GROSS DOMESTIC PRODUCT Why do you think economists who are critical of biometric-based indexes as indicators of aggregate well-being argue that such measures do not necessarily relate to a nation’s overall economic performance?

People can have biometric readings that are influenced by issues other than the overall economic performance of a nation. For example, readings may be biased if an individual had to rush for an appointment or just received bad personal news.

AI: USING NEW INFORMATION ABOUT FLOWS OF GOODS AND SERVICES Why might staffers of the ONS data science campus seek to distinguish between GDP-style versus gross output–style measures of economic activity by carefully accounting for value added at intermediate stages of production? (Hint: Recall that GDP counts only the final market value of items, while gross output double-counts values added at intermediate production stages).

Staffers of the ONS data science campus want to calculate an accurate measure of economic activity. GDP counts only the final market value of items and avoids double counting business spending across all stages in production. GDP is more accurate because it is less likely to change when intermediate businesses are combined.

CORRECTING GDP FOR PRICE INDEX CHANGES, 2007–2019 Based on the information in Table 7-2, how much inflation occurred between 2012 and 2019?

Explain briefly.

Prices increased 9.9 percent between 2012 and 2019. Because the price index in 2012 is 100, that is the base year. The price index in 2019 is 109.9, which is 9.9 higher than the index in 2012, indicating an 9.9 percent increase in prices.

PURCHASING POWER PARITY COMPARISONS OF WORLD INCOMES What is the percentage increase in China’s per capita GDP when one switches from foreign exchange rates to purchasing power parity? .

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Chapter 7 Measuring the Economy’s Performance Using foreign exchange rates, China’s per capita GDP is $8,879, and using purchasing power parity it is $14,344. This represents a 62 percent increase: (14,344 – 8,879)/8,879 = 5,465/ 8,879 = 0.62.



Economics in Your Life

SHOULD REAL GDP BE SUPPLEMENTED OR EVEN REPLACED AS THE PRIMARY MEASURE OF ECONOMIC PERFORMANCE? For Critical Thinking Why might economists experience difficulties in developing objective measures of qualityadjusted prices? (Hint: Do all people identically perceive quality characteristics of a good or service?)

Because people do not identically perceive quality characteristics of a good or service, it would be impossible for economists to create a numerical measure that adjusts for these quality improvements. For example, Sean may think the cameras on the new iPhones are 10 times better than the previous ones, but Amanjeet may think the cameras are only twice as good as the previous ones. How would economists take these discrepancies into account?

Real Application You undoubtedly have downloaded “free” apps on your smartphone, tablet, or laptop. The producers and platforms that offer you these “free” apps eventually must recoup production costs. How do you help them do that?

Many free apps ask you to upgrade to a higher-quality app that is not free but requires you to pay for it. Other apps get paid to allow advertisers to place their ads at various spots within the app when you are using it. Ultimately, nothing is “free” in this world. There has to be a way to recoup, at a minimum, the production costs of “free” items.



Issues & Applications

CHINA’S INCREDIBLY SMOOTH REAL GDP GROWTH Why might officials of China’s government confront different incentives regarding data measurement than private economists interested in predicating the nation’s future economic performance?

Officials of China’s government may be induced to hit certain rates of growth each period.

For example, their budgets for the next quarter may be impacted by the growth rate for the previous period, thus causing them to overstate the actual growth rate of the economy (or at least state a rate near the targeted rate).

Many younger Canadians are learning to speak Chinese and contemplate living and working in China. If you are one of them, why should you be concerned with China’s actual economic rate of growth?

If Chinese officials are indeed exaggerating China’s rate of economic growth, then you might think twice about pursuing a career in that country. To the extent that Chinese officials are masking a less rosy economic landscape, the job opportunities for you might be more limited than you currently believe. .

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition



Answers to End-of-Chapter Questions

7-1. Explain in your own words why the flow of gross domestic product during a given interval must always be equivalent to the flow of gross domestic income within that same period.

As illustrated by the basic circular flow diagram, the flow of the market value of final goods and services produced within a nation’s borders during a given interval—that is, gross domestic product—is what generates the gross domestic income received by the nation’s households during that interval, which they in turn spend in the nation’s product markets. Consequently, the flows of gross domestic product and gross domestic income must be equivalent.

7-2. In the first stage of manufacturing each final unit of a product, a firm purchases a key input at a price of $4 per unit. The firm then pays a wage rate of $3 for the time that labour is exerted, combining an additional $2 of inputs for each final unit of output produced. The firm sells every unit of the product for $10. What is the contribution of each unit of output to GDP in the current year?

The final sale price is used for computing current dollar GDP, so the contribution of each unit to GDP is $10.

7-3. Each year after a regular spring cleaning, Maria spruces up her home a little by retexturing and repainting the walls of one room in her house. In a given year, she spends $25 on magazines to get ideas about wall textures and paint shades, $45 on newly produced texturing materials and tools, $35 on new paint brushes and other painting equipment, and $175 on newly produced paint. Normally, she preps the walls, a service that a professional wall-texturing specialist would charge $200 to do, and applies two coats of paint, a service that a painter would charge $350 to do, on her own. a. When she purchases her usual set of materials and does all the work on her home by herself in a given spring, how much does Maria’s annual spring texturing and painting activity contribute to GDP? b. Suppose that Maria hurt her back this year and is recovering from surgery. Her surgeon has instructed her not to do any texturing work, but he has given her the goahead to paint a room as long as she is cautious. Thus, she buys all the equipment required to both texture and paint a room. She hires someone else to do the texturing work but does the painting herself. How much would her spring painting activity add to GDP? c. As a follow-up to part (b), suppose that as soon as Maria bends down to dip her brush into the paint, she realizes that painting will be too hard on her back after all. She decides to hire someone else to do all the work using the materials she has already purchased. In this case, how much will her spring painting activity contribute to GDP? a. b.

When Maria does all the work herself, only her purchases of the materials in markets (magazines, texturing materials, paint brushes, and paints), which total to $280 per year, count in GDP. She must pay the market price of $200 for the texturing, so her contribution to annual GDP from this project, including the materials, is $480. .

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Chapter 7 Measuring the Economy’s Performance c.

Because Maria now pays for the entire project using market transactions, her total contribution to GDP equals the sum of the $280 material purchases from part (a), $200 for the texturing from part (b), and $350 for the painting, or $830 per year.

7-4. Each year, Johan typically does all his own landscaping and yard work. He spends $200 per year on mulch for his flower beds, $225 per year on flowers and plants, $50 on fertilizer for his lawn, and $245 on gasoline and lawn mower maintenance. The lawn and garden store where he obtains his mulch and fertilizer charges other customers $500 for the service of spreading that much mulch in flower beds and $50 for the service of distributing fertilizer over a yard the size of Johan’s. Paying a professional yard care service to mow his lawn would require an expenditure of $1,200 per year, but in that case, Johan would not have to buy gasoline or maintain his own lawn mower. a. In a normal year, how much does Johan’s landscaping and yard work contribute to GDP? b. Suppose that Johan has developed allergy problems this year and will have to reduce the amount of his yard work. He can wear a mask while running his lawn mower, so he will keep mowing his yard, but he will pay the lawn and garden centre to spread mulch and distribute fertilizer. How much will all the work on Johan’s yard contribute to GDP this year? c. As a follow-up to part (b), at the end of the year, Johan realizes that his allergies are growing worse and he will have to arrange for all his landscaping and yard work to be done by someone else next year. How much will he contribute to GDP next year? a.

b. c.

In a typical year in which Johan buys materials and does all the landscaping work in his yard, his only contribution to GDP from this activity are market purchases of mulch, flowers and plants, fertilizer, and gasoline and lawn mower maintenance.

These annual expenses total to $720 and are included in GDP. When Johan buys materials and continues to mow his lawn but pays the lawn and garden centre a total of $550 to spread mulch and distribute fertilizer, his total contribution to GDP is $1,270 per year.

Next year Johan will buy all materials for $720, pay the lawn and garden centre $550 to distribute mulch and fertilizer, and pay the professional yard care service $1,200, but he will not have to pay $245 for his own gas and lawn mower maintenance. Hence, his contribution to GDP will equal $720 + $550 + $1,200 − $245 = $2,225.

7-5. Consider the following hypothetical data for an economy in 2023 (all amounts are in trillions of dollars): Consumption Non-income-related taxes net of subsidies Depreciation Government spending Imports Gross private domestic investment Exports

.

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14.0 0.8 1.3 4.8 2.7 4.0 2.5

Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition a. b.

Based on the data, what is GDP? NDP? NI? Suppose that in 2024, exports fall to $2.3 trillion, imports rise to $2.85 trillion, and gross private domestic investment falls to $4.25 trillion. What will GDP be in 2024, assuming that other values do not change between 2023 and 2024?

a.

GDP = C + I + G + X = $14 trillion + $4.0 trillion + $4.8 trillion + ($2.5 trillion − $2.7 trillion) = $14 + $4 + $4.8 − $0.2 = $22.6 trillion NDP = GDP − depreciation = $22.6 trillion − $1.3 trillion = $21.3 trillion NI = NDP − non-income-related taxes net of subsidies = $21.3 trillion − $0.8 trillion = $20.5 trillion GDP in 2024 = C + I + G + X = $14 trillion + $4.25 trillion + $4.8 trillion + ($2.3 trillion − $2.85 trillion) = $22.5 trillion

b.

7-6. Look back at Table 7-2, which explains how to calculate real GDP in terms of 2012 constant dollars. Change the base year to 2010. Recalculate the price index, and then recalculate real GDP—that is, express column 4 of Table 7-2 in terms of 2010 dollars instead of 2012 dollars.

Hint: First convert the price index from 2012 base year to 2010 base year by multiplying the old price index with 100 (2012 price index) and dividing by 95.7 (2010 price index).

Year 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

Price Index (base year 2010 = 100) 95.716 99.582 97.283 100.000 103.239 104.493 106.270 108.359 107.419 108.255 110.867 112.957 114.838

Real GDP (millions of dollars per year in constant 2010 dollars) 1,648,277 1,663,996 1,615,217 1,666,048 1,718,399 1,748,631 1,790,020 1,841,000 1,852,969 1,871,078 1,931,234 1,968,761 2,011,905

7-7. Consider the following hypothetical data for an economy in 2023 (in trillions of dollars), and assume that there are no statistical discrepancies, zero net incomes earned abroad, and zero taxes and subsidies for production.

Corporate profits before taxes deducted Proprietorial income Rent Interest Wages Depreciation Consumption .

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3.0 2.0 1.0 0.8 15.2 3.3 16.5

Chapter 7 Measuring the Economy’s Performance Exports Net transfers and interest earnings Nonincome expense items Imports Corporate taxes Social security contributions Government spending

2.0 4.8 5.0 2.8 1.5 2.5 4.3

a. b. c.

What is gross domestic income? GDP? What is gross private domestic investment?

What is personal income?

a.

GDI = wages + rent + interest + proprietorial income + corporate profits before taxes deducted + nonincome expense items = $15.2 trillion + $1.0 trillion + $0.8 trillion + $2.0 trillion + $3.0 trillion + $5.0 trillion = $27.0 trillion GDP = GDI = $27.0 trillion We know that GDP ($27.0 trillion) is the sum of consumption spending ($16.5 trillion), government spending ($4.3 trillion), net exports ($2.0 trillion − $2.8 trillion, or −$0.8 trillion), and gross private domestic investment. Hence, gross private domestic investment must be $7.0 trillion.

Personal income (PI) = GDP – depreciation + net income earned abroad – corporate taxes – social security contributions – taxes on production and imports net of subsidies + net transfers and interest earnings = $27.0 trillion − $3.3 trillion + $0 − $1.5 trillion − $2.5 trillion − $0 + $4.8 trillion = $24.5 trillion

b.

c.

7-8. Which of the following are production activities that are included in GDP? Which are not? a. Mr. King performs the service of painting his own house instead of paying someone else to do it. b. Mr. King paints houses for a living. c. Mrs. King earns income from parents by taking baby photos in her digital photography studio. d. Mrs. King takes digital photos of planets and stars as part of her astronomy hobby. e. E-Trade charges fees to process Internet orders for stock trades. f. Mr. Ho spends $10,000 on shares of stock via an Internet trade order and pays a $10 brokerage fee. g. Mrs. Ho receives an income support payment from the government. h. Ms. Hernandez makes a $300 payment for an Internet-based course on stock trading. i. Mr. Langham sells a used laptop computer to his neighbour. a. b. c. d. e. f.

Not included in GDP Included in GDP Included in GDP Not included in GDP Included in GDP The $10,000 for the shares of stock is not included in GDP, but the $10 fee for brokerage services is included. .

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition g. h. i.

Not included in GDP Included in GDP Not included in GDP

7-9. Explain what happens to contributions to GDP in each of the following situations. a. A woman who makes a living charging for investment advice on her Internet site marries one of her clients, to whom she now provides advice at no charge. b. A man who had washed the windows of his own house every year decides to pay a private company to wash those windows this year. c. A company that had been selling marijuana illegally finally gets around to obtaining a legal provincial operating licence. a. b. c.

Measured GDP declines Measured GDP increases Measured GDP does not change

7-10. Explain what happens to the official measure of GDP in each of the following situations. a. Air quality improves significantly throughout Canada, but there are no effects on aggregate production or on market prices of final goods and services. b. The Canadian government spends considerably less on antipollution efforts this year than it did in recent years. c. The quality of cancer treatments increases, so patients undergo fewer treatments, which hospitals continue to provide at the same price per treatment as before. a. b. c.

No effect on GDP Decline in GDP Decline in GDP

7-11. Which of the following activities of a digital device manufacturer during the current year are included in this year’s measure of GDP? a. The firm makes a chip in June, uses it as a component in a device in August, and sells the device to a customer in November. b. A retail outlet of the firm sells a device completely built during the current year. c. A marketing arm of the company receives fee income during the current year when a buyer of one of its devices elects to use the device manufacturer as her Internet service provider. a. b. c.

The chip is an intermediate good, so its purchase in June is not included in GDP; only the final sale in November is included.

This is a final sale of a good that is included in GDP for the year.

This is a final sale of a service that is included in GDP for the year.

7-12. A number of economists contend that official measures of Canadian gross private investment expenditures are understated. For instance, household spending on education, such as post-secondary tuition expenditures, is counted as consumption. Some economists suggest that these expenditures, which amount to 6 percent of GDP, should be counted as .

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Chapter 7 Measuring the Economy’s Performance investment instead. Based on this 6 percent estimate and the GDP computations detailed in Figure 7-3, how many billions of dollars would shift from consumption to investment if this suggestion were adopted?

Six percent of GDP of $1,820 billion equals 0.06 × $1,820 = $109.2 billion.

7-13. Consider the table below for the economy of a nation whose residents produce five final goods.

Good Shampoo External hard drives Books Milk Candy

2020 Price Quantity $2 15 200 10 40 5 3 10 1 40

2024 Price Quantity $4 20 250 10 50 4 4 3 2 20

Assuming a 2020 base year: a. What is nominal GDP for 2020 and 2024? b. What is real GDP for 2020 and 2024? a.

b.

Nominal GDP for 2020 = ($2 × 15) + ($200 × 10) + ($40 × 5) + ($3 × 10) + ($1 × 40) = $30 + $2,000 + $200 + $30 + $40 = $2,300 Nominal GDP for 2021 = ($4 × 20) + ($250 × 10) + ($50 × 4) + ($4 × 3) + ($2 × 20) = $80 + $2,500 + $200 + $12 + $40 = $2,832 Real GDP for 2020 = nominal GDP for 2020= $2,300 Real GDP for 2024 = GDP for 2024 using 2020 prices = ($2 × 20) + ($200 × 10) + ($40 × 4) + ($3 × 3) + ($1 × 20) = $40 + $2,000 + $160 + $9 + $20 = $2,229

7-14. Consider the following table for the economy of a nation whose residents produce four final goods.

Good Computers Bananas Televisions Cookies

2022 Price Quantity $1,000 10 6 3,000 100 500 1 10,000

2023 Price Quantity $800 15 11 1,000 150 300 2 10,000

Assuming a 2022 base year: a. What is nominal GDP for 2022 and 2023? b. What is real GDP for 2022 and 2023? a.

Nominal GDP for 2022 = ($1,000 × 10) + ($6 × 3,000) + ($100 × 500) + ($1 × 10,000) = $10,000 + $18,000 + $50,000 + $10,000 = $88,000 .

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition

b.

Nominal GDP for 2023 = ($800 × 15) + ($11 × 1,000) + ($150 × 300) + ($2 × 10,000) = $12,000 + $11,000 + $45,000 + $20,000 = $88,000 Real GDP for 2022 is $88,000; for 2023, real GDP is $61,000

7-15. In the table for Problem 8-14, if 2023 is the base year, what is the price index for 2022?

(Round decimal fractions to the nearest tenth) The price index is (2022 nominal GDP/2022 real GDP) × 100 = ($88,000/$136,000) × 100 = 64.7.

7-16. Suppose that early in a year, a tornado hits a town in Ontario and destroys a substantial number of homes. A portion of this stock of housing, which had a market value of $100 million (not including the market value of the land), was uninsured. The owners of the residences spent a total of $5 million during the rest of the year to pay salvage companies to help them save remaining belongings. A small percentage of uninsured owners had sufficient resources to spend a total of $15 million during the year to pay construction companies to rebuild their homes. Some were able to devote their own time, the opportunity cost of which was valued at $3 million, to work on rebuilding their homes.

The remaining people, however, chose to sell their land at its market value and abandon the remains of their houses. What was the combined effect of these transactions on GDP for this year? (Hint: Which transactions took place in the markets for final goods and services?) In what ways, if any, does the effect on GDP reflect a loss in welfare for these individuals?

The market transactions included in GDP would be the $15 million paid to construction companies and the $5 million paid to salvage companies, for a total of $20 million included in real GDP. Any lost market value of existing homes not reclaimed would be a wealth loss not captured in GDP because the wealth loss is in the value of a stock of resources. In addition, the $3 million in time that some devote to the reconstruction of their homes would be nonmarket transactions not included in GDP. Also not included would be the reduction in the general state of happinesswhich is not valued in the marketplacefor all those affected by the tornado.

7-17. Suppose that in 2022, geologists discover large reserves of oil under the tundra in Nunavut.

These new reserves have a market value estimated at $50 billion at current oil prices. Oil companies spend $1 billion to hire workers and move and position equipment to begin exploratory pumping during that same year. In the process of loading some of the oil onto tankers at a port, one company accidentally spills some of the oil into a bay and by the end of the year pays $1 billion to other companies to clean it up. The oil spill kills thousands of birds, seals, and other wildlife. What was the combined effect of these events on GDP for this year? (Hint: Which transactions took place in the markets for final goods and services?) In what ways, if any, does the effect on GDP reflect a loss in national welfare?

The $1 billion expended to pay for employees and equipment and the additional $1 billion paid to clean up the oil spill would be included in GDP, for a total of $2 billion added to GDP in 2022. The rise in oil reserves increases the stock of wealth but is not included in the current flow

.

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Chapter 7 Measuring the Economy’s Performance of newly produced goods and services. In addition, the welfare loss relating to the deaths of wildlife is also not measured in the marketplace and therefore is not included in GDP. 7-18. Consider the diagram below, and answer the following questions.

a. b.

What is the base year? Explain.

Has this country experienced inflation or deflation since the base year? How can you tell?

a.

By definition, nominal GDP equals real GDP in the base year, which is at the crossing point of the two curves, or 2019.

The GDP deflator is equal to nominal GDP divided by real GDP or the ratio of nominal GDP to real GDP. The nominal GDP curve shows a steeper growth path of nominal GDP relative to the shallower growth path of real GDP. This means that the ratio of nominal GDP to real GDP has increased over time, implying that the GDP deflator must be rising. Hence, this country has been experiencing inflation.

b.

7-19. Suppose that in Figure 7-1, the sum total of all the goods and services produced during the relevant period—pairs of shoes, candy bars, digital devices, etc., all summed together—is 500 trillion units. The total dollar value of this flow of output is $20 billion. The total amount of factors of production—labour, land, capital, entrepreneurship, all summed together—is 1 billion units. What is the follow of income—that is, the sum of wages, rents, interest, and profits?

The flow of income during the period equals the dollar value of the flow of output over that interval, or $20 billion.

7-20. In Table 7-1, what is the total dollar amount that is added to the nation’s gross domestic product? Why? Only the $1.00 value added in production of the donut is included in GDP, which sums only the values of final products measured at their market prices. Including only the value added across .

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition all stages of production avoids double counting the contributions of intermediate goods in the production of the final product, the donut.

7-21. Suppose that the consumption spending is $13 billion, gross private domestic investment is $4.5 billion, government spending is $5 billion, and net exports are −$0.5 billion. If interest income is $1 billion, depreciation is $0.5 billion, wages are $12 billion, and rental income is $0.75 billion, what is the net domestic product?

Gross domestic product is the sum of consumption spending, gross private domestic investment, government spending, and net exports, or $13 billion + $4.5 billion + $5 billion − $0.5 billion = $22 billion. Net domestic product is GDP – depreciation, or $22 billion − $0.5 billion = $21.5 billion.

7-22. In Problem 7-21, what is net investment?

Net investment is gross private domestic investment less depreciation, or $4.5 billion − $0.5 billion = $4 billion.

7-23. Consider Figure 7-4. Explain what is special about the year at which the two data plots cross, and why this is so.

The year at which the plots of nominal GDP and real GDP cross, 2012, is the base year. At this crossing point, nominal GDP is equal to real GDP. This fact means that for this year, the flow of goods and services are valued in current-year prices that are the same as base-year prices, which is true only for the base year.

7-24. Take a look at Table 7-3. Provide a possible explanation of why per capita GDP based on purchasing power parity is higher in China and Indonesia than GDP based on foreign exchange rates.

Wages are relatively low in China and Indonesia so that prices of items not traded internationally, such as home repairs, housecleaning services, and restaurant food, are less expensive than otherwise implied by valuing those nations’ GDP levels using exchange rates. This means that the purchasing power of per capita GDP levels are higher than per capita GDP levels calculated using exchange rates.

.

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Chapter 8

Global Economic Growth and Development 

Answers to Questions for Critical Analysis

GROWTH RATES AROUND THE WORLD “The largest change is from zero to one.” Does this statement have anything to do with relative growth rates in poorer versus richer countries?

One would expect that growth rates could be higher in poorer countries because the same absolute increase in real GDP would be a larger percentage of a poorer country’s real GDP than it would of a richer country’s real GDP. LENGTHY, DEEP RECESSIONS AND LONG-RUN ECONOMIC GROWTH Redistributive policies may include additional government-provided benefits to poorer individuals as well as higher taxes on richer individuals. How could such policies affect your future decisions to save and invest?

If you know that you will be “taken care of” by government if your future income falls below a certain level, you might have less of an incentive to save and to invest for your future. If you know that if you “make it big” you will be taxed more heavily, you may have less incentive to work long hours, take risks in new businesses, and invest in other risky ventures. These two personal responses contribute to reduced investment and growth at the macroeconomic level.

IS PATIENCE A VIRTUE FOR ECONOMIC GROWTH? Why should we anticipate that a national population composed mostly of impatient people might be likely to experience a relatively low long-run rate of economic growth?

Impatient people would want to spend their funds today rather than save them. By consuming more, and saving less, there is less investment in capital goods and lower economic growth. In addition, impatient people would be less likely to sacrifice income today to increase their human capital by attending university or seeking out training opportunities, which would lower economic growth.

DO CANADIAN FIRMS THAT OBTAIN PATENTS REALLY ENGAGE IN MORE ACTIVITIES THAT PROMOTE ECONOMIC GROWTH? Why is innovative activity that actually yields higher-valued production required for new inventions to contribute to greater economic growth?

Innovative activity that yields higher-valued production will increase productivity either by reducing costs to produce or by increasing the amount that can be produced using fixed inputs.

This increase in productivity leads to greater economic growth.

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Economics in Your Life

AN OLD INVENTION GENERATES UNFORESEEN MODERN MARKET INNOVATIONS For Critical Thinking How might remote-sensing innovations that enable underwater structural inspections of offshore wind turbines make energy companies more willing to undertake additional investments in windturbine systems?

These remote-sensing innovations reduce the cost and increase the accuracy of inspecting the structure of offshore wind turbines. This means that money that was spent on inspections can be spent elsewhere (which increases productivity by lowering costs), and the increased accuracy leads to less costs in the future.

Real Application Marketing and retailing firms have pursued facial recognition technologies for the past half century. To what extent do these technologies make you better off? To what extent do they make you worse off?

Marketing and retailing firms use facial recognition technologies to determine the effectiveness of their advertising, product placement, and product packaging. The more successful they are in recognizing how you and others respond to marketing programs and to the design of products and packages, the more that products can be designed and advertised in an efficient manner. Presumably this should lead, at least in some situations, to a lower price per constant quality unit of the products and services that you buy. On the negative side, some argue that facial recognition technologies can be used to manipulate your consumer choices, unbeknownst to you. Economists have a difficult time determining whether such manipulation actually occurs.

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Issues & Applications

A COLOUR QUEST DEMONSTRATES WHY INNOVATION IS A FUNDAMENTAL CONTRIBUTOR TO ECONOMIC GROWTH For Critical Thinking Why might rendering shades for products using the smallest feasible set of organic chemicals yield considerable productivity growth for a nation’s economy? (Hint: Contemplate how many items produced by a nation’s firms use different shades of colour.)

Reducing the amount of organic chemicals required to render specific colour shades, reduces costs. Considering how many firms in a nation use (and need to render) different shades of colour, these cost reductions could result in huge increases to productivity. In addition, using a smaller set of chemicals to create different shades of colour will also increase productivity.

These boosts to productivity could lead to increased economic growth.

Real Application What are the two benefits that you, as an individual, receive from companies using minimal inorganic (chemical) resources to create the colours of the products that you buy?

First, because this new technology will result in lower costs, you will able to purchase coloured products—clothes, toys, plastic furniture—at a lower price. Second, you will be .

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subjected to less exposure to potentially dangerous inorganic chemicals such as cobalt, cyanide, and lead.

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Answers to End-of-Chapter Questions

8-1. The graph to the right shows a production possibilities curve for 2023 and two potential production possibilities curves for 2024, denoted 2024A and 2024B. a. Which of the labelled points corresponds to maximum feasible 2023 production that is more likely to be associated with the curve denoted 2024A? b. Which of the labelled points corresponds to maximum feasible 2023 production that is more likely to be associated with the curve denoted 2024B?

a. b.

Y X

8-2. A nation’s capital goods wear out over time, so a portion of its capital goods become unusable every year. Last year, its residents decided to produce no capital goods. It has experienced no growth in its population or in the amounts of other productive resources during the past year. In addition, the nation’s technology and resource productivity have remained unchanged during the past year. Will the nation’s economic growth rate for the current year be negative, zero, or positive?

The nation’s stock of capital goods will shrink because of depreciation, so its rate of economic growth will be negative.

8-3. In the situation described in Problem 8-2, suppose that vocational training during the past year enables the people of this nation to repair all capital goods so that they continue to function as well as new. All other factors are unchanged, however. In light of this single change to the conditions faced in this nation, will the nation’s economic growth rate for the current year be negative, zero, or positive?

The nation will maintain its stock of capital goods at its current level, so its rate of economic growth will be zero.

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition 8-4. Consider the following data. What is the per capita real GDP in each of these countries?

Country A B C

Population (millions) 10 20 5

Real GDP ($ billions) 55 60 70

A. $5,500 per capita B. $3,000 per capita C. $14,000 per capita 8-5. Suppose that during the next 10 years, real GDP triples and population doubles in each of the nations in Problem 8-4. What will per capita real GDP be in each country after 10 years have passed?

A. $8,250 per capita B. $4,500 per capita C. $21,000 per capita 8-6. Consider the following table displaying annual growth rates for nations X, Y, and Z, each of which entered 2020 with real per capita GDP equal to $20,000.

Annual Growth Rate (%) Country 2020 2021 2022 2023 X 7 1 3 4 Y 4 5 7 9 Z 5 5 3 2 a.

b. c.

a. b. c.

Which nation most likely experienced a sizable earthquake in late 2020 that destroyed a significant portion of its stock of capital goods, but was followed by speedy investments in rebuilding the nation’s capital stock? What is this nation’s per capita real GDP at the end of 2023, rounded to the nearest dollar?

Which nation most likely adopted policies in 2020 that encouraged a gradual shift in production from capital goods to consumption goods? What is this nation’s per capita real GDP at the end of 2023, rounded to the nearest dollar?

Which nation most likely adopted policies in 2020 that encouraged a quick shift in production from consumption goods to capital goods? What is this nation’s per capita real GDP at the end of 2023, rounded to the nearest dollar?

X; $23,153 Z; $23,166 Y; $25,472

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8-7. Per capita real GDP grows at a rate of 3 percent in country F and at a rate of 6 percent in country G. Both begin with equal levels of per capita real GDP. Use Table 8-3 to determine how much higher per capita real GDP will be in country G after 20 years. How much higher will real GDP be in country G than in country F after 40 years?

1.77 times higher after 20 years, calculated by dividing the factor 3.20 at a 6 percent rate by the factor 1.81 at a 3 percent rate.

3.16 times higher after 40 years, calculated by dividing the factor 10.30 at a 6 percent rate by the factor 3.26 at a 3 percent rate.

8-8. Since the early 1990s, the average rate of growth of per capita real GDP in Mozambique has been 3 percent per year, as compared with a growth rate of 8 percent in China. Refer to Table 8-3. If a typical resident of each of these nations begins this year with a per capita real GDP of $3,000 per year and past growth rates persist, about how many more dollars’ worth of real GDP per capita would the person in China be earning 10 years from now than the individual in Mozambique?

In China, after 10 years, the per capita real GDP will be ($3,000 × 2.16) = $6,480.

In Mozambique, after 10 years, the per capita real GDP will be ($3,000 × 1.34) = $4,020.

The difference is ($6,480 - $4,020) = $2,460.

8-9. On the basis of the information in Problem 8-8 and reference to Table 8-3, about how many more dollars’ worth of real GDP per capita would the person in China be earning 50 years from now than the individual in Mozambique?

After 50 years, real GDP per capita in China will equal $3,000 × 46.90, or $140,700. Real GDP per capita in Mozambique will equal $3,000 × 4.38, or $13,140. Thus, in China real GDP per capita will be $127,560 higher.

8-10. In 2021, a nation’s population was 10 million. Its nominal GDP was $40 billion, and its price index was 100. In 2022, its population had increased to 12 million, its nominal GDP had risen to $57.6 billion, and its price index had increased to 120. What was this nation’s economic growth rate during the year?

In 2021, the nation’s per capita real GDP = 100 × (nominal GDP / price index) / population = 100 × ($40 billion / 100) / 10 million = $4,000.

In 2022, the nation’s per capita real GDP = 100 × (nominal GDP / price index) / population = 100 × ($57.6 billion / 120) / 12 million = $4,000.

Its rate of economic growth was zero percent.

8-11. Between the start of 2021 and the start of 2022, a country’s economic growth rate was 4 percent. Its population did not change during the year, nor did its price level. What was the rate of increase of the country’s nominal GDP during this one-year interval?

The rate of growth of per capita real GDP equals the rate of growth of real GDP (4 percent) less the rate of population growth (0 percent), which equals 4 percent. .

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition 8-12. In 2021, a nation’s population was 10 million, its real GDP was $1.21 billion, and its price index had a value of 121. By 2022, its population had increased to 12 million, its real GDP had risen to $1.5 billion, and its price index had a value of 125. What was the percentage change in per capita real GDP between 2021 and 2022?

In 2021, the nation’s per capita real GDP = real GDP/population = $1.21 billion/10 million = $121.

In 2022, the nation’s per capita real GDP = real GDP/population = $1.5 billion/12 million = $125.

The percentage change in per capita real GDP = 100 × (per capita real GDP2022 – per capita real GDP2021)/per capita real GDP2021 = 100 × ($125 – $121)/$121 = 3.3 percent.

8-13. A nation’s per capita real GDP was $2,000 in 2020, and the nation’s population was 5 million in that year. Between 2020 and 2021, the inflation rate in this country was 5 percent, and the nation’s annual rate of economic growth was 10 percent. Its population remained unchanged. What was per capita real GDP in 2021? What was the level of real GDP in 2021?

Per capita real GDP in 2021 was 10 percent higher than in 2020, or $2,200. The level of real GDP is $2,200 per person × 5 million people = $11 billion.

8-14. Brazil has a population of about 210 million, with about 150 million over the age of 15. Of these, an estimated 25 percent, or 37.5 million people, are functionally illiterate. The typical literate individual reads only about two nonacademic books per year, which is less than half the number read by the typical literate Canadian or European resident. Answer the following questions solely from the perspective of new growth theory: a. Discuss the implications of Brazil’s literacy and reading rates for its growth prospects in light of the key tenets of new growth theory. b. What types of policies might Brazil implement to improve its growth prospects?

Explain. a. b.

New growth theory emphasizes the importance of human capital as a key facet of economic growth. Brazil’s relatively low literacy rate suggests that it is lagging in human capital development and hence potential for longer-term economic growth.

Policies might include programs narrowly focused on promoting a higher literacy rate and broadly focused on a greater average educational attainment by its residents.

8-15. Based on data in Table 8-1 and the rule of 70, if U.S. per capita real GDP continues to grow at the average rate it has experienced since 1990, about how many years will be required for it to double?

According to the rule of 70, the number of years required for a doubling of U.S. per capita real GDP at the current average growth rate of 1.6 percent will be equal to approximately 44 years.

(70/1.6 = 43.75)

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8-16. Based on data in Table 8-1 and the rule of 70, if India’s per capita real GDP continues to grow at the average rate it has experienced since 1990, about how many years will be required for it to double?

According to the rule of 70, the number of years required for a doubling of India’s per capita real GDP at the current average growth rate of 4.5 percent will be equal to approximately 16 years. (70/4.5 = 15.6.)

8-17. Based on data in Table 8-1 and in Table 8-3, if China's per capita real GDP continues to grow at the average rate it has experienced since 1990, will its per capita real GDP be twice as high as it is today within a decade? Explain your reasoning.

Table 8-1 reports an 8.0 percent average annual growth rate since 1990. Table 8-3 indicates that at an 8 percent annual growth rate, China’s per capita real GDP will double in about nine years.

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Answers to Questions for Critical Analysis

AI: GOVERNMENTS SEEKING GROWTH IN LONG-RUN AGGREGATE SUPPLY Would governmental investments in an “AI infrastructure” likely yield significant additional increases in a nation’s long-run aggregate supply if private firms were to use their own AI technologies independently of this infrastructure? (Hint: If private firms were to employ solely AI technologies that they had developed on their own initiative, could a governmental AI “infrastructure” influence the firms’ production possibilities?)

Yes. Governmental investments in an “AI infrastructure” would increase the technology available to everyone and make the AI technologies created by private firms cheaper to run. This increase in technology and reduction in costs would likely lead to increases in economic growth (rightward shifts of LRAS).

EXPLAINING LOW INFLATION IN THE “EUROZONE” What would happen to the Eurozone price level if the quantity of euros in circulation were to decline while the long-run aggregate supply curve continued to shift rightward? Explain briefly.

The Eurozone price level would decline. A decrease in the money supply causes a decrease in AD (a leftward shift), which reduces the price level. Additionally, the rightward shift in the LRAS curve would also reduce the price level.

EXPLAINING WHY TURKEY’S GROWING ECONOMY EXPERIENCED A BURST OF INFLATION What would have happened to Turkey’s price level if the position of its aggregate demand curve had not changed while long-run aggregate supply increased?

Turkey’s price level would decline due to the rightward shift in the LRAS curve.

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Economics in Your Life

WHY JAPAN’S GOVERNMENT AIMS TO INCREASE LONG-RUN AGGREGATE SUPPLY BY REDUCING PEOPLE’S HOURS AT WORK For Critical Thinking How might a flexible work schedule that totals to the same hourly workweek as a fixed schedule contribute to an increase in the typical employee’s weekly output of goods and services produced?

Employees would be happier with the flexible work schedule and can use the time spent at work actually focusing on work, rather than worrying about other issues (such as childcare), which results in increases in productivity and an increase in the employee’s weekly output of goods and services produced. In addition, employees can use the flexible work schedule to work when they are motivated and not be forced to work at prescribed hours. This would also result in an increase in productivity and an increase in the employee’s weekly output of goods and services produced. .

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Chapter 9 Real GDP and the Price Level in the Long Run Real Application If your boss offered you a flexible work arrangement, including working from home, are there any reasons that you might refuse this flexibility?

Some people do not thrive in a flexible work environment. Rather, they are better off having a regular workweek where they enjoy accountability and consistency. While other people might do well working from home, for example, these workers might find that there are too many distractions at home and be less productive as a result. While it is certainly possible that some individuals become more productive with more flexible work arrangements, others may find that their productivity falls.

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Issues & Applications

HOW A COLD CLIMATE AND ACCESS TO GEOTHERMAL STEAM ARE INCREASING LONG-RUN AGGREGATE SUPPLY IN ICELAND For Critical Thinking New immigrants to Iceland have arrived to fill data-centre positions and have brought with them well-educated spouses and other family members. How might this wave of immigration change Iceland’s resource endowments and thereby influence the position of its long-run aggregate supply curve in the future?

The increase in immigration would increase the population of the country, increase the labour force, and increase labour productivity (via the well-educated spouses). These changes would all result in an increase in economic growth and a rightward shift in the LRAS curve.

Real Application What factors would you have to consider if you were thinking about moving to another country to work?

To be sure, the major determinant of your choice to emigrate to another country would probably have to be how much more annual after-tax income you could earn by so doing. If the differential compared with your current after-tax earnings is sufficiently high, you might seriously consider relocation. You could encounter a language barrier, however. Would you have to become fluent in a foreign language? If so, that involves an investment in your human capital, one that is quite substantial for many individuals. Additionally, you should probably consider climate. Moving to Iceland, for example, might be a shock for someone who lives in Spain or Florida. Finally, there are cultural aspects of working and living in another country that would have to be considered.

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Answers to End-of-Chapter Questions

9-1. Many economists view the natural rate of unemployment as the level observed when real GDP is given by the position of the long-run aggregate supply curve. How can there be positive unemployment in this situation?

The amount of unemployment would be the sum of frictional and structural unemployment.

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition 9-2. Suppose that the long-run aggregate supply curve is positioned at a real GDP level of $22 trillion in base-year dollars, and the long-run equilibrium price level (in index number form) is 115. What is the full-employment level of nominal GDP? Real GDP = 100 × (nominal GDP / price index). So nominal GDP = real GDP × price index / 100 = $25.3 trillion.

9-3. Continuing from Problem 9-2, suppose that the full-employment level of nominal GDP in the following year rises to $25.85 trillion. The long-run equilibrium price level, however, remains unchanged. By how much (in real dollars) has the long-run aggregate supply curve shifted to the right in the following year? By how much, if any, has the aggregate demand curve shifted to the right? (Hint: The equilibrium price level can stay the same only if LRAS and AD shift rightward by the same amount.)

The real value of the new full-employment level of nominal GDP is 100 × (nominal GDP / price index) = 100 × ($25.85 trillion/115) = $22.48 trillion, so the long-run aggregate supply curve has shifted rightward by $0.48 trillion, in base-year dollars.

Because the long-run equilibrium price level is unchanged, the aggregate demand curve has also shifted rightward by $0.48 trillion, in base-year dollars.

9-4. Suppose that the position of a nation’s long-run aggregate supply curve has not changed, but its long-run equilibrium price level has increased. Which of the following factors might account for this event? (Select all that apply.) a. A rise in the value of the domestic currency relative to other world currencies b. An increase in the quantity of money in circulation c. An increase in the labour force participation rate d. A decrease in taxes e. A rise in real incomes of countries that are key trading partners of this nation f. Increased long-run economic growth b, d, and e 9-5. Identify the combined shifts in long-run aggregate supply and aggregate demand that could explain the following simultaneous occurrences. a. An increase in equilibrium real GDP and an increase in the equilibrium price level b. A decrease in equilibrium real GDP with no change in the equilibrium price level c. An increase in equilibrium real GDP with no change in the equilibrium price level d. A decrease in equilibrium real GDP and a decrease in the equilibrium price level a. b. c. d.

A rightward shift of the LRAS curve coupled with a shift in the AD curve farther to the right.

A leftward shift of the LRAS curve coupled with a leftward shift of the AD curve of the same magnitude.

A rightward shift of the LRAS curve coupled with a rightward shift of the AD curve of the same magnitude.

A leftward shift of the LRAS curve coupled with a shift of the AD curve farther to the left. .

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Chapter 9 Real GDP and the Price Level in the Long Run 9-6. Suppose that during the past three years, equilibrium real GDP in a country rose steadily, from $450 billion to $500 billion, but even though the position of its aggregate demand curve remained unchanged, its equilibrium price level steadily declined, from 110 to 103.

What could have accounted for these outcomes, and what is the term for the change in the price level experienced by this country?

The LRAS curve has shifted rightward, and the consequent decline of the equilibrium price level is secular deflation.

9-7. Suppose that during a given year, the quantity of real GDP that can be produced in the long run rises from $21.9 trillion to $22.0 trillion, measured in base-year dollars. During the year, no change occurs in the various factors that influence aggregate demand. What will happen to the long-run equilibrium price level during this particular year?

This change implies a rightward shift of the long-run aggregate supply curve along the unchanged aggregate demand curve, so the long-run equilibrium price level will decline.

9-8. Assume that the position of a nation’s aggregate demand curve has not changed, but the long-run equilibrium price level has declined. Other things being equal, which of the following factors might account for this event? (Select all that apply.) a. An increase in labour productivity b. A decrease in the capital stock c. A decrease in the quantity of money in circulation d. The discovery of new mineral resources used to produce various goods e. A technological improvement a, d, and e 9-9. Suppose that there is a sudden rise in the price level. What will happen to economy-wide planned spending on purchases of goods and services? Why? There are three effects. First, there is a real-balance effect because the rise in the price level reduces real money balances, inducing people to cut back on their spending. In addition, there is an interest rate effect as a higher price level pushes up interest rates, thereby reducing the attractiveness of purchases of autos, houses, and plants and equipment. Finally, there is an open economy effect as home residents respond to the higher price level by reducing purchases of domestically produced goods in favour of foreign-produced goods, while foreign residents cut back on their purchases of home-produced goods. All three effects entail a reduction in purchases of goods and services.

9-10. Assume that the economy is in long-run equilibrium with complete information and that input prices adjust rapidly to changes in the prices of goods and services. If there is a rise in the price level induced by an increase in aggregate demand, what happens to real GDP? If there is full information and rapid adjustment of input prices to the rise in the price level, then firms do not change their production plans. The increase in the price level leads to no change in real GDP. This is an upward movement along the vertical long-run aggregate supply curve. .

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition 9-11. Consider the diagram below when answering the questions that follow. a. Suppose that the current price level is P2. Explain why the price level will decline toward P1. b. Suppose that the current price level is P3. Explain why the price level will rise toward P1.

a. At the price level P2 above the equilibrium price level P1, the total quantity of real goods and services that people plan to consume is less than the total quantity that is consistent with firms’ production plans. One reason is that at the higher-thanequilibrium price level, real money balances are lower, which reduces real wealth and induces lower planned consumption. Another is that interest rates are higher at the higher-than-equilibrium price level, which generates a cutback in consumption spending. Finally, at the higher-than-equilibrium price level P2, people tend to cut back on purchasing domestic goods in favour of foreign-produced goods, and foreign residents reduce purchases of domestic goods. As unsold inventories of output accumulate, the price level drops toward the equilibrium price level P1, which ultimately causes planned consumption to rise toward equality with total production. b. At the price level P3 below the equilibrium price level P1, the total quantity of real goods and services that people plan to consume exceeds the total quantity that is consistent with firms’ production plans. One reason is that at the lower-thanequilibrium price level, real money balances are higher, which raises real wealth and induces higher planned consumption. Another is that interest rates are lower at the lower-than-equilibrium price level, which generates an increase in consumption spending. Finally, at the lower-than-equilibrium price level P3, people tend to raise their purchases of domestic goods and cut back on buying foreign-produced goods, and foreign residents increase purchases of domestic goods. As inventories of output are depleted, the price level begins to rise toward the equilibrium price level P1, which ultimately causes planned consumption to fall toward equality with total production.

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Chapter 9 Real GDP and the Price Level in the Long Run 9-12. Explain whether each of the following events would cause a movement along or a shift in the position of the LRAS curve, other things being equal. In each case, explain the direction of the movement along the curve or shift in its position. a. Last year, businesses invested in new capital equipment, so this year the nation’s capital stock is higher than it was last year. b. There has been an 8 percent increase in the quantity of money in circulation that has shifted the AD curve. c. A hurricane of unprecedented strength has damaged oil rigs, factories, and ports all along the nation’s coast. d. Inflation has occurred during the past year as a result of rightward shifts of the AD curve. a. An increase in the capital stock causes real planned production to rise at any given price level, so the LRAS curve shifts rightward. b. An increase in the quantity of money causes the aggregate demand to shift rightward, which generates a movement upward along the LRAS curve. c. This reduction in the capital stock, which will also lead to higher energy prices, causes real planned production to decline at any given price level, so the LRAS curve shifts leftward. d. When the price level rises, there is a movement of the AD curve upward along the LRAS curve.

9-13. Explain whether each of the following events would cause a movement along or a shift in the AD curve, other things being equal. In each case, explain the direction of the movement along the curve or shift in its position. a. Deflation has occurred during the past year. b. Real GDP levels of all the nation’s major trading partners have declined. c. There has been a decline in the foreign exchange value of the nation’s currency. d. The price level has increased this year. a. When the price level falls, there is a movement downward along the AD curve. b. The decline in foreign real GDP levels reduces incomes of foreign residents, who cut back on their spending on domestic exports. Thus, the domestic AD curve shifts leftward. c. The fall in the foreign exchange value of the nation’s currency makes domesticproduced goods and services less expensive to foreign residents, who increase their spending on domestic exports. Thus, the domestic AD curve shifts rightward. d. An increase in the price level causes a movement upward along the AD curve.

9-14. This year, a nation’s long-run equilibrium real GDP and price level both increased. Which of the following combinations of factors might simultaneously account for both occurrences?

(Select all that apply.) a. An isolated earthquake at the beginning of the year destroyed part of the nation’s capital stock, and the nation’s government significantly reduced its purchases of goods and services.

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition b. There was a technological improvement at the end of the previous year, and the quantity of money in circulation rose significantly during the year. c. Labour productivity increased throughout the year, and consumers significantly increased their total planned purchases of goods and services. d. The capital stock increased somewhat during the year, and the quantity of money in circulation declined considerably. b and c 9-15. Explain how, if at all, each of the following events would affect equilibrium real GDP and the long-run equilibrium price level. a. A reduction in the quantity of money in circulation b. An income tax rebate (the return of previously paid taxes) from the government to households, which they can apply only to purchases of goods and services c. A technological improvement d. A decrease in the value of the home currency in terms of the currencies of other nations a. The aggregate demand curve shifts leftward along the long-run aggregate supply curve; the equilibrium price level falls, and equilibrium real GDP remains unchanged. b. The aggregate demand curve shifts rightward along the long-run aggregate supply curve; the equilibrium price level rises, and equilibrium real GDP remains unchanged. c. The long-run aggregate supply curve shifts rightward along the aggregate demand curve; the equilibrium price level falls, and equilibrium real GDP increases. d. The aggregate demand curve shifts rightward along the long-run aggregate supply curve; the equilibrium price level rises, and equilibrium real GDP remains unchanged.

9-16. For each question, suppose that the economy begins at the long-run equilibrium point A in the diagram. Identify which of the other points on the diagram—points B, C, D, or E— could represent a new long-run equilibrium after the described events take place and move the economy away from point A. a. Significant productivity improvements occur, and the quantity of money in circulation increases. b. No new capital investment takes place, and a fraction of the existing capital stock depreciates and becomes unusable. At the same time, the government imposes a large tax increase on the nation’s households. c. More efficient techniques for producing goods and services are adopted throughout the economy at the same time that the government reduces its spending on goods and services.

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a. B: Productivity improvements cause the LRAS curve to shift rightward, from LRAS1 to LRAS2, and the increase in the quantity of money in circulation causes the AD curve to shift rightward, from AD1 to AD2. b. C: The reduction in the usable portion of the capital stock reduces the economy’s long-run productive capabilities, so the LRAS curve shifts leftward, from LRAS1 to LRAS3. The increase in taxes imposed on households induces them to reduce their expenditures, so the AD curve shifts leftward, from AD1 to AD3. c. E: The technological improvement shifts the LRAS curve rightward, from LRAS1 to LRAS2, and the reduction in government spending shifts the AD curve leftward, from AD1 to AD3.

9-17. In Ciudad Barrios, El Salvador, the latest payments from relatives working in Canada have finally arrived. When the credit unions open for business, up to 150 people are already waiting in line. After receiving the funds their relatives have transmitted to these institutions, customers go off to outdoor markets to stock up on food or clothing or to appliance stores to purchase new refrigerators or televisions. Similar scenes occur throughout the developing world, as each year migrants working in higher-income, developed nations send around $200 billion of their earnings back to their relatives in less developed nations. Evidence indicates that the relatives, such as those in Ciudad Barrios, typically spend nearly all of the funds on current consumption. a. Based on the information supplied, are developing countries’ income inflows transmitted by migrant workers primarily affecting their economies’ long-run aggregate supply curves or aggregate demand curves? b. How are equilibrium price levels in nations that are recipients of large inflows of funds from migrants likely to be affected? Explain your reasoning. a. The income flows are mainly influencing relatives’ consumption, so the main effect is on the aggregate demand curve. b. A rise in aggregate demand will lead to an increase in the equilibrium price level.

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition 9-18. In Figure 9-2, if the economy acquires a larger amount of capital goods in the current year, does a larger or smaller onward shift in the production possibilities curve result?

Does the LRAS curve shift more or less far to the right? Why? The acquisition of a larger amount of capital goods in the current year enables production of more of all types of goods and services in future years. Consequently, the production possibilities curve shifts a farther distance outward, and there is a greater rightward shift of the LRAS curve.

9-19. Consider Figure 9-4, what are the three effects of decreases in the price level, and do these generate upward or downward movements along the economy’s aggregate demand curve?

Decreases in the price level bring about a real-balance effect, because the resulting increases in the real value of money holdings induce people to boost spending. Lower price levels also reduce the interest rate, which gives people an incentive to borrow more and spend more. Finally, lower price levels at home induce people to cut back on spending abroad and to spend more domestically. Taken together, total planned expenditures rise, so there is a downward movement along the AD curve.

9-20. Take a look at panel (a) of Figure 9-6. In the absence of a change in aggregate demand, what effect does economic growth have on the price level over time, other things being equal? Why? Economic growth entails rightward shifts in the position of the long-run aggregate supply curve over time, which generates equilibrium points to the right and lower along the stationary aggregate demand curve. Hence, the price level declines, and secular deflation occurs.

9-21. Take a look at panel (b) of Figure 9-6. If the Bank of Canada seeks to prevent secular deflation from taking place as a consequence of economic growth, how should it change the quantity of money in circulation? How would this policy action prevent secular deflation?

Rightward shifts of the LRAS curve accompanying economic growth would, in the absence of a Bank of Canada policy action, yield new equilibrium points lower down along the aggregate demand curve. Hence, the price level would tend to fall. Appropriate increases in the quantity of money in circulation would shift the AD curve rightward and would keep the price level from falling and thereby prevent secular deflation.

9-22. Consider panel (a) of Figure 9-8. What type of variation in the position of the long-run aggregate supply curve could generate inflation (that is, an increase in the equilibrium, price level)? In a nation that generally experiences economic growth over the long run, would we anticipate that such a change in the position of the long-run aggregate supply curve could explain persistent inflation?

Leftward shifts in the position of the LRAS curve, which might be caused by drops in labour force participation or higher marginal income tax rates, bring about a higher equilibrium price level and, hence, inflation. In an economy that generally experiences economic growth over the .

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Chapter 9 Real GDP and the Price Level in the Long Run long run, such leftward shifts must be short lived and consequently could not explain persistent inflation.

9-23. Take a look at panel (b) of Figure 9-8. What change in the position of the aggregate demand curve could generate inflation (that is, an increase in the equilibrium price level)?

What type of variation in the quantity of money placed into circulation by the Bank of Canada could generate such a change in the position of the aggregate demand curve?

Rightward shifts in the position of the AD curve would generate a higher price level and, hence, inflation. Persistent increases in the quantity of money in circulation by the Bank of Canada could generate such shifts and thereby could explain persistent inflation.

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Answers to Questions for Critical Analysis

AI: AUTOMATED TRADING MAKES AGGREGATE SUPPLY SHOCKS MURKIER Given that a smaller fraction of total energy production is powered by oil-related fuels, do you suppose that oil price changes have become relatively more or less important sources of aggregate supply shocks in recent years?

Because a smaller fraction of total energy production is powered by oil-related fuels, oil price changes are less likely to affect aggregate supply. In years past, oil was a major input into most production processes, so any changes would affect aggregate supply. Now that fewer production processes rely on oil, these prices are less likely to affect aggregate supply as much as they did in the past.

UNCERTAINTY AND AGGREGATE DEMAND SHOCKS Suppose you read that a serious recession is just starting. You do not know what may happen to the market value of your investments. Nor do you know if you will keep your job. What might your response be?

In the face of extreme uncertainty about the future, you might react by dramatically curtailing current and future discretionary spending. For example, you might cancel a planned expensive vacation with your family. You might cancel an order for a new car. You might stop looking for a bigger, more expensive house. You might cut back on the number of meals that your family and you eat out at restaurants. In other words, in the face of economic uncertainty, your immediate response would most likely be to cut back on expenditures.

HOW LONG LASTING ARE THE EFFECTS OF POSITIVE AGGREGATE SUPPLY SHOCKS CAUSED

BY LOWER OIL PRICES? Why does the long-run aggregate supply curve not shift in response to sudden but temporary jumps or drops in global oil prices?

Any temporary changes to the determinates of aggregate supply (like oil price changes), will only affect SRAS. Any permanent changes to the determinates of aggregate supply, on the other hand, will affect both SRAS and LRAS. The past has shown that the energy market changes constantly, so any changes in oil prices are likely to be temporary and only affect SRAS.

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Economics in Your Life

CANADIAN HOUSEHOLD SAVING DECREASES, AND SO DOES PRIVATE INVESTMENT SPENDING For Critical Thinking How could gradual increases in the interest rate contribute to an increase in household saving?

(Hint: Does a nation’s saving function slope upward or downward?)

Individuals are suppliers of funds in the investment market (which determines the interest rate). Like typical supply curves, the nation’s saving function slopes upward. At higher .

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Chapter 10 Classical and Keynesian Macro Analyses interest rates, households have more incentive to forgo current consumption and save (they get a higher rate of return for their savings). At lower interest rates, households have less incentive to forgo current consumption and save (they get a lower rate of return on their savings).

Real Application When you are earning income, you can spend all that you earn after taxes or you can spend only part of it and save more. Under what circumstances would you be inclined to save more and what do you give up by doing so?

There are several reasons for you to consider saving more. One might be in anticipation of buying a “big-ticket” item, such as a house or a car. Another reason to save might be for the expressed purpose of paying for an expensive vacation. More generally, though, you will want to save more to prepare for potential future hardships and have a bigger “nest egg” when you retire.

The opportunity cost of saving more is the amount of pleasure that you would have received had you spent more. In other words, whenever you save, you are forgoing consumption. Consumption always involves expenditures for goods and services that have positive value to you. There is a tradeoff between spending more today and saving less compared with spending less today and saving more.

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Issues & Applications

IS SAY’S LAW RELEVANT TO TODAY’S ECONOMY? For Critical Thinking Could an “overcapacity” or “undercapacity” problem persist if the government were to enact policies that prevented the price level from changing in response? Explain your reasoning.

Yes, government interference affects the dynamics of the free market. For example, let’s say the government sets a minimum price on steel (an industry that currently suffers from an “overcapacity” problem). This government-set minimum price would make it impossible for prices to fall in this industry so that the industry (and the economy) would return to equilibrium. This is exactly Keynes’ point about the inflexibility of wages and prices. Due to government regulations (like the minimum wage), wages will not adjust as quickly downward as they would upward, so the result would not be a quick return to equilibrium.

Real Application Under what circumstances have you probably experienced a situation of “undercapacity”?

During your lifetime, you have probably been interested in a new, highly popular product.

For example, if a shoe manufacturer, such as Nike or Adidas, creates a new model that turns out to be widely popular, you may find that you cannot obtain your size either online or in a retail store. Clearly, the manufacturer faces “undercapacity” for that particular model. If you are really “desperate” to purchase this popular model, you do have the alternative of accessing an online auction site, such as eBay. You will end up paying a higher-than-list price, of course.

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Answers to End-of-Chapter Questions

10-1. Consider a country whose economic structure matches the assumptions of the classical model. After reading a recent best-seller documenting a growing population of lowincome older adults who were ill prepared for retirement, most residents of this country decide to increase their saving at any given interest rate. Explain whether or how this could affect the following: a. The current equilibrium interest rate b. Current equilibrium real GDP c. Current equilibrium employment d. Current equilibrium investment e. Future equilibrium real GDP a. Because saving increases at any given interest rate, the desired saving curve shifts rightward. This causes the equilibrium interest rate to decline. b. There is no effect on current equilibrium real GDP because in the classical model, the vertical long-run aggregate supply curve always applies. c. A change in the saving rate does not directly affect the demand for labour or the supply of labour in the classical model, so equilibrium employment does not change. d. The decrease in the equilibrium interest rate generates a rightward and downward movement along the demand curve for investment. Consequently, desired investment increases. e. The rise in current investment implies greater capital accumulation. Other things being equal, this will imply increased future production and higher equilibrium real GDP in the future.

10-2. Consider a country with an economic structure consistent with the assumptions of the classical model. Suppose that businesses in this nation suddenly anticipate higher future profitability from investments they undertake today. Explain whether or how this could affect the following: a. The current equilibrium interest rate b. Current equilibrium real GDP c. Current equilibrium employment d. Current equilibrium saving e. Future equilibrium real GDP a. Desired investment increases, so the demand curve for investment shifts to the right and the equilibrium interest rate rises. b. There is no effect on current equilibrium real GDP because in the classical model the vertical long-run aggregate supply curve always applies. c. A change in desired investment does not directly affect the demand for labour or the supply of labour in the classical model, so equilibrium employment does not change. d. The increase in the equilibrium interest rate generates a rightward and upward movement along the supply curve of saving. Consequently, equilibrium saving increases.

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Chapter 10 Classical and Keynesian Macro Analyses e. The rise in current investment implies greater capital accumulation. Other things being equal, this will imply increased future production and higher equilibrium real GDP in the future.

10-3. “There is absolutely no distinction between the classical model and the model of long-run equilibrium.” Is this statement true or false? Support your answer.

False. In fact, there is an important distinction. The classical model of short-run real GDP determination applies to an interval short enough that some factors of production, such as capital, are fixed. Nevertheless, the classical model implies that even in the short run the economy’s aggregate supply curve is the same as its long-run aggregate supply curve.

10-4. Suppose that the Keynesian short-run aggregate supply curve is applicable for a nation’s economy. Use appropriate diagrams to assist in answering the following questions: a. What are two events that can cause the nation’s real GDP to increase in the short run? b. What are two events that can cause the nation’s real GDP to increase in the long run? a. A decline in nominal wages is one event. A decrease in the cost of any other important input, such as energy, is another. b. A technological improvement is one event. Greater capital accumulation and increased labour force participation are others.

10-5. What determines how much real GDP responds to changes in the price level along the short-run aggregate supply curve?

The key elements determining the slope of the short-run aggregate supply curve are the speed of adjustment of input prices and the degree of information that people possess within a short-run interval. Thus, the short-run aggregate supply curve is more steeply sloped if input prices adjust more rapidly and people become more fully informed within a short-run interval.

10-6. Suppose there is a temporary but significant increase in oil prices in an economy with an upward-sloping SRAS curve. If policymakers wish to prevent the equilibrium price level from changing in response to the oil price increase, should they increase or decrease the quantity of money in circulation? Why? To prevent a short-run increase in the price level from taking place after the temporary rise in oil prices shifts the SRAS curve leftward, policymakers should decrease the quantity of money in circulation. This will shift the AD curve leftward and prevent the equilibrium price level from rising in the short run.

10-7. As in Problem 10-6, suppose that there is a temporary but significant increase in oil prices in an economy with an upward-sloping SRAS curve. In this case, however, suppose that policymakers wish to prevent equilibrium real GDP from changing in response to the oil price increase. Should they increase or decrease the quantity of money in circulation?

Why?

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition To prevent a short-run decrease in real GDP from taking place after the temporary rise in oil prices shifts the SRAS curve leftward, policymakers should increase the quantity of money in circulation. This will shift the AD curve rightward and prevent equilibrium real GDP from declining in the short run.

10-8. Based on your answers to Problems 10-6 and 10-7, can policymakers stabilize both the price level and real GDP simultaneously in response to a short-lived but sudden rise in oil prices? Explain briefly.

In light of the answers to Problems 10-6 and 10-7, it is not possible for policymakers to stabilize both the price level and real GDP simultaneously in response to a temporary increase in oil prices. Stabilizing the price level requires reducing the quantity of money, but stabilizing real GDP requires increasing the quantity of money.

10-9. If total planned expenditures by Canadian households substantially increased in response to changes in federal tax laws that resulted in a net tax reduction, explain, from a short-run Keynesian perspective, the predicted effects of this event on the equilibrium Canadian price level and equilibrium Canadian real GDP. Be sure to discuss the spending gap that the Keynesian model indicates would result in the short run.

An increase in total planned real expenditures by Canadian households in response to changes in federal tax laws that resulted in a net tax reduction implies a rightward shift in the position of the aggregate demand curve along the short-run aggregate supply curve. The predicted effects are increases in both the equilibrium Canadian price level and equilibrium Canadian real GDP. Keynesian theory indicates that a consequence would be a short-term inflationary gap between expenditures on real GDP in the short run and expenditures on real GDP that would be consistent with long-run equilibrium.

10-10. In the previous decade, a stock market upturn and rising home prices generated a substantial increase in Canadian household wealth that induced most Canadian residents to boost their planned real spending at any given price level. Explain, from a short-run Keynesian perspective, the predicted effects of this event on the equilibrium Canadian price level and equilibrium Canadian real GDP. Be sure to discuss the spending gap that the Keynesian model indicates would result in the short run.

An increase in total planned real expenditures by most Canadian residents at any given price level implies a rightward shift in the position of the aggregate demand curve along the short-run aggregate supply curve. The predicted effects are increases in both the equilibrium Canadian price level and equilibrium Canadian real GDP. Keynesian theory indicates that a consequence would be an inflationary gap between expenditures on real GDP in the short run and expenditures on real GDP that would be consistent with long-run equilibrium.

10-11. For each question that follows, suppose that the economy begins at point A. Identify which of the other points on the diagram—point B, C, D, or E—could represent a new short-run equilibrium after the described events take place and move the economy away from point A. Briefly explain your answers. .

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Chapter 10 Classical and Keynesian Macro Analyses

a. Most workers in this nation’s economy are union members, and unions have successfully negotiated large wage boosts. At the same time, economic conditions suddenly worsen abroad, reducing real GDP and disposable income in other nations of the world. b. A major hurricane has caused short-term halts in production at many firms and created major bottlenecks in the distribution of goods and services that had been produced prior to the storm. At the same time, the nation’s central bank has significantly pushed up the rate of growth of the nation’s money supply. c. A strengthening of the value of this nation’s currency in terms of other countries’ currencies affects both the SRAS curve and the AD curve. a. E: The union wage boost causes the SRAS curve to shift leftward, from SRAS1 to SRAS3. The reduction in incomes abroad causes import spending in this nation to fall, which induces a leftward shift in the AD curve, from AD1 to AD3. b. B: The short-term reduction in production capabilities causes the SRAS curve to shift leftward, from SRAS1 to SRAS3, and the increase in money supply growth generates a rightward shift in the AD curve, from AD1 to AD2. c. C: The strengthening of the value of this nation’s currency reduces the prices of imported inputs that domestic firms use to produce goods and services, which causes the SRAS curve to shift rightward, from SRAS1 to SRAS2. At the same time, currency strengthening raises the prices of exports and reduces the prices of imports, so net export spending declines, thereby inducing a leftward shift in the AD curve, from AD1 to AD3.

10-12. Consider an open economy in which the aggregate supply curve slopes upward in the short run. Firms in this nation do not import raw materials or any other productive inputs from abroad, but foreign residents purchase many of the nation’s goods and services.

What is the most likely short-run effect on this nation’s economy if there is a significant downturn in economic activity in other nations around the world? .

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Domestic producers purchase few imported inputs, so the effect on the short-run aggregate supply curve will be minimal. Because foreign residents are key consumers of domestically produced goods, however, the fall in foreign incomes will depress aggregate demand. The equilibrium price level will decline, and equilibrium real GDP will decrease.

10-13. In Figure 10-2, if planned saving were less than planned investment, what would be true of the interest rate in relation to its equilibrium value? How would the interest rate adjust?

Desired saving is below desired investment if the interest rate is below its equilibrium value.

Businesses that wish to undertake investment in excess of the amount of saving must offer a higher interest rate to induce an increase in household saving. As the interest rate rises, planned saving will rise, and planned investment will fall. Ultimately, the two are equalized at a 5 percent interest rate.

10-14. Consider Figure 10-3. Will all people who desire to work be employed if the current wage rate is $28 per hour? How many people will be employed and unemployed at this wage rate?

At the $28-per-hour wage rate, the quantity of labour demanded by firms is 24 million, so 24 million people are employed. The quantity of labour supplied by people who wish to work at this wage rate is 26 million. Consequently, 2 million people will be unemployed at the hourly wage rate of $28.

10-15. Take a look at Figure 10-4. If the Bank of Canada increases the quantity of money in circulation sufficiently to generate a rightward shift in the aggregate demand curve by $0.5 trillion, will actual equilibrium real GDP rise by this amount in the classical model?

Explain.

The $0.5 trillion amount of the rightward shift in the aggregate demand curve is equal to an additional amount of planned spending following the increase in the money supply at the initial equilibrium price level of 110. In the classical model, however, wages and prices adjust rapidly.

As a consequence, the equilibrium price level rises to 120, and equilibrium real GDP remains at $4 trillion.

10-16. Consider Figure 10-9. Suppose that businesses in this nation initially had been exporting significant amounts of domestically produced goods and services abroad. Assume that other nations of the world have experienced a sudden decline in economic conditions.

What happens to the nation’s aggregate demand curve? In the short run, will the nation experience an inflationary gap or a recessionary gap? Explain.

The decline in economic conditions abroad causes foreign residents to reduce their purchases of domestically produced exports, so total planned expenditures in this nation decrease.

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Chapter 10 Classical and Keynesian Macro Analyses Consequently, the aggregate demand curve shifts leftward along the short-run aggregate supply curve, and in the short run, equilibrium real GDP falls below its long-run equilibrium level. A recessionary gap results.

10-17. Consider Figure 10-10. Suppose that the real interest rate suddenly declines for reasons that have nothing to do with the value of the price level. What happens to the nation’s aggregate demand curve? In the short run, will the nation experience an inflationary gap or a recessionary gap? Explain.

The decline in the real interest rate induces the nation’s businesses and consumers to increase their total planned expenditures. As a consequence, the aggregate demand curve shifts rightward along the short-run aggregate supply curve, and in the short run, equilibrium real GDP rises above its long-run equilibrium level. An inflationary gap results.

10-18. Take a look at Figure 10-11. If this country’s government decides to enact short-term barriers to international trade and substantial regulations of domestic businesses, what happens to the short-run equilibrium price level, and why? Is this an example of demandpull or cost-push inflation? Explain.

Erecting near-term barriers to international trade and toughened domestic business regulations causes the short-run aggregate supply curve to shift leftward, which pushes up the equilibrium price level in the short run. This government action pushed up businesses’ costs and generated a reduction of short-run aggregate supply that pushed up the price level, so this is an example of cost-push inflation.

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Consumption, Real GDP, and the Multiplier 

Answers to Questions for Critical Analysis

USING LOTTERY PRIZES TO INDUCE LOW-INCOME PEOPLE IN THE UNITED STATES TO SAVE MORE OF THEIR DISPOSABLE INCOMES Why do you suppose the researchers found that offering low-income people accounts with more frequent automatic saving deductions from their real incomes also raised their real saving?

By deducting smaller amounts more frequently, people are less likely to notice the change in the amount they can spend. It’s like buying a refrigerator at full price now or paying for it over time with small monthly payments. Lower-income individuals, who tend to save less, have a smaller savings built up and are less likely to be able to pay a higher price now. However, they can use a small portion of their income for a payment plan (or automatic saving) with a smaller impact on their current spending.

AI: “NOWCAST” EQUILIBRIUM REAL GDP AND ITS COMPONENTS Under what circumstances in your future might more accurate business forecasting be beneficial for you?

If you eventually end up owning a small business, more accurate forecasting of a coming recession might prevent you from hiring too many new employees. If the recession actually happens, and you were unable to predict it in advance, you might have to fire idle workers. In the meantime, you will have wasted resources training them for your particular business.

If you end up working in a large corporation, you might find yourself working in the human resources section. If you are privy to more accurate predictions of a coming “boom” in the economy, you could argue that hiring decisions should take less time so that your company can acquire required personnel with the right skills.

COMPARING THE RELATIVE CONTRIBUTIONS OF GOVERNMENT-GENERATED MULTIPLIER EFFECTS ON REAL GDP Why might government expenditures have a significant effect on real GDP? Because real consumption spending is such a large portion of Canadian planned expenditures, any determinants that will increase consumption spending will have a greater impact on real GDP. For example, if the government decides to decrease tax rates and increase benefit payments to individuals, this will induce individuals to spend more. This spending turns into income for other individuals (who make up a large part of the economy), who in turn spend more.

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Economics in Your Life

BASED ON SAVING TRENDS, CANADIANS WILL HAVE TO ADJUST THEIR RETIREMENT GOALS OR INCREASE SAVINGS For Critical Thinking Why might the choices that Canadians are making help to explain why the observed fraction of additional aggregate real Canadian disposable income allocated to saving has decreased?

Currently, the older population (baby boomers) in Canada make up a large portion of the total population. If that portion of the population has decreased their rate of saving, this will also decrease the rate of saving for Canada as a whole.

Real Application If the prospect of your having to work well into your 70s makes you uncomfortable, how can you avoid experiencing that situation? Alternatively, what are the positive aspects of your life if you do continue working into your 70s?

There are several ways that you can reduce the probability that you will be forced to work well into your 70s. The first one, of course, is to make a high annual income while you are younger. That may involve working harder, working longer hours, and choosing an occupation that offers a higher-than-average salary. Of course, one way you can enter such occupations is by acquiring more human capital—more schooling and more training.

Another way to reduce the probability of having to work into your 70s is to reduce your consumption each year and therefore save more. Saving a greater portion of your annual income, and potentially earning interest on your accumulated savings, may afford you the opportunity to retire earlier.

Now, all that said, you might find that there are benefits to working into your 70s. You might find satisfaction in your job and will want it to continue working after a normal retirement age. You might discover that being retired is boring. You might find that if you keep working into your 70s (and beyond!) you will remain more physically fit and mentally sharp. It is not uncommon for people who enjoy their jobs to continue working past the age of 70, even when they have sufficient accumulated savings to retire comfortably.

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Issues & Applications

WHY CHANGES IN PLANNED INVESTMENT SPENDING RECEIVES SO MUCH ATTENTION FROM ECONOMISTS For Critical Thinking How do you suppose that a reduction in business tax rates can caused the planned investment function to shift upward?

A reduction in business tax rates represents lower costs to businesses, meaning they can spend more on everything, including investment.

Real Application Assume that at some point in your life, you are running your own business. What are some of the types of planned investment that you might contemplate?

There are several types of business investment that you may plan to pursue. You could contemplate a planned investment in an expansion of your current headquarters, warehouse .

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You could also invest in more advanced artificial intelligence (AI) technologies. That is to say, you might be planning an investment in AI software (or software upgrades) that will render your current staff more productive.

You might contemplate an investment in a better electronic infrastructure that links all of your employees together, regardless of where they are physically working, and is more secure.

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Answers to End-of-Chapter Questions

11-1. Classify each of the following as either a stock or a flow. a. Myung Park earns $850 per week. b. Time Warner purchases $100 million in new telecommunications equipment this month. c. Sally Schmidt has $1,000 in a savings account at a credit union. d. XYZ, Inc., produces 200 units of output per week. e. Giorgio Giannelli owns three private jets. f. Apple’s production declines by 750 digital devices per month. g. Russia owes $25 billion to the International Monetary Fund. a. b. c. d. e. f. g.

Flow Flow Stock Flow Stock Flow Stock

11-2. Consider the table below when answering the following questions. For this hypothetical economy, the marginal propensity to save is constant at all levels of real GDP, and investment spending is autonomous. There is no government.

Real GDP $ 2,000 4,000 6,000 8,000 10,000 12,000

Consumption $2,200 4,000 ______ ______ ______ ______

Saving $______ ______ ______ ______ ______ ______

Investment $400 ______ ______ ______ ______ ______

a. Complete the table. What is the marginal propensity to save? What is the marginal propensity to consume? b. Draw a graph of the consumption function. Then add the investment function to obtain C + I.

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Chapter 11 Consumption, Real GDP, and the Multiplier c. Under the graph of C + I, draw another graph showing the saving and investment curves. Note that the C + I curve crosses the 45-degree reference line in the upper graph at the same level of real GDP where the saving and investment curves cross in the lower graph. (If not, redraw your graphs.) What is this level of real GDP? d. What is the numerical value of the multiplier? e. What is equilibrium real GDP without investment? What is the multiplier effect from the inclusion of investment? f. What is the average propensity to consume at equilibrium real GDP? g. If autonomous investment declines from $400 to $200, what happens to equilibrium real GDP? a. The completed table follows (all amounts in dollars): Real GDP

Consumption

Saving

Investment

$ 2,000 4,000 6,000 8,000 10,000 12,000

$ 2,200 4,000 5,800 7,600 9,400 11,200

$ –200 0 200 400 600 800

$ 400 400 400 400 400 400

MPS = change in saving/change in real GDP = 200/2,000 = 0.1 MPC = change in consumption/change in real GDP = 1,800/2,000 = 0.9 b. The graph appears below. c. Yes. Equilibrium real GDP on both graphs equals $8,000.

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d. The multiplier is 1/(1 – MPC) = 1/(1 − 0.9) = 1/0.1 = 10. e. Without investment, equilibrium real GDP is $4,000. With investment, it is $8,000. The multiplier effect of including the $400 in investment is equal to $400 × 10, or $4,000. f. At the equilibrium income level of $8,000, the average propensity to consume is $7,600/$8,000 = 0.95. g. If autonomous investment declines from $400 to $200, then equilibrium real GDP falls by $200 × 10, or $2,000. The new level of equilibrium real GDP, therefore, is $6,000.

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Chapter 11 Consumption, Real GDP, and the Multiplier 11-3. Consider the table below when answering the following questions. For this economy, the marginal propensity to consume is constant at all levels of real GDP, and investment spending is autonomous. Equilibrium real GDP is equal to $8,000. There is no government.

Real GDP $ 2,000 4,000 6,000 8,000 10,000 12,000

Consumption $ 2,000 3,600 5,200 6,800 8,400 10,000

Saving ______ ______ ______ ______ ______ ______

Investment ______ ______ ______ ______ ______ ______

a. Complete the table. What is the marginal propensity to consume? What is the marginal propensity to save? b. Draw a graph of the consumption function. Then add the investment function to obtain C + I. c. Under the graph of C + I, draw another graph showing the saving and investment curves. Does the C + I curve cross the 45-degree reference line in the upper graph at the same level of real GDP where the saving and investment curves cross in the lower graph, at the equilibrium real GDP of $8,000? (If not, redraw your graphs.) d. What is the average propensity to save at equilibrium real GDP? e. If autonomous consumption were to rise by $100, what would happen to equilibrium real GDP? a. The completed table follows (all amounts in dollars): Real GDP $ 2,000 4,000 6,000 8,000 10,000 12,000

Consumption $ 2,000 3,600 5,200 6,800 8,400 10,000

Saving $0 400 800 1,200 1,600 2,000

Investment $ 1,200 1,200 1,200 1,200 1,200 1,200

Between each row, the change in consumption spending is $1,600 (for instance, between the last two rows, it is $10,000 − $8,400 = $1,600), and the change in real GDP is $2,000 (for instance, between the last two rows, it is $12,000 −$10,000 = $2,000), so MPC = 1,600/2,000 = 0.8.

Between each row, the change in saving is $400 (for instance, between the last two rows, it is $2,000 −$1,600 = $400), and the change in income is $2,000, so MPS = 400/2,000 = 0.2. b. The graph appears below. c. Equilibrium real GDP on both graphs equals $8,000.

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d. APS = saving/real GDP = $1,200/$8,000 = 0.15. e. The multiplier is 1/(1 − MPC) = 1/(1 − 0.8) = 1/0.2 = 5. Thus, if autonomous consumption were to rise by $100, then equilibrium real GDP would increase by $100 × 5, or $500.

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Chapter 11 Consumption, Real GDP, and the Multiplier 11-4. Calculate the multiplier for the following cases. a. MPS = 0.25 b. MPC = 5/6 c. MPS = 0.125 d. MPC = 6/7 a. b. c. d.

Multiplier = 1/MPS = 1/0.25 = 4 Multiplier = 1/(1 − MPC) = 1/(1− 5/6) = 1/(1/6) = 6 Multiplier = 1/MPS = 1/0.125 = 8 Multiplier = 1/(1 − MPC) = 1/(1− 6/7) = 1/(1/7) = 7

11-5. Given each of the following values for the multiplier, calculate both the MPC and the MPS. a. 20 b. 10 c. 8 d. 5 a. The multiplier is 1/MPS = 20, so MPS = 1/20 = 0.05. We know that MPS = 1 − MPC = 0.05, which implies that MPC = 0.95. b. The multiplier is 1/MPS = 10, so MPS = 1/10 = 0.10. We know that MPS = 1 − MPC = 0.10, which implies that MPC = 0.90. c. The multiplier is 1/MPS = 8, so MPS = 1/8 = 0.125. We know that MPS = 1 − MPC = 0.125, which implies that MPC = 0.875. d. The multiplier is 1/MPS = 5, so MPS = 1/5 = 0.20. We know that MPS = 1 − MPC = 0.20, which implies that MPC = 0.80.

11-6. The marginal propensity to consume is equal to 0.80. An increase in household wealth causes autonomous consumption to rise by $10 billion. By how much will equilibrium real GDP increase at the current price level, other things, including other forms of autonomous spending, being equal?

If the MPC = 0.8, then the MPS = 0.2 and the multiplier is 1/MPS = 1/0.2 = 5. Therefore, an equilibrium real GDP will increase by the multiplier × change in income = 5 × $10 billion = $50 billion.

11-7. Assume that the multiplier in a country is equal to 4 and that autonomous real consumption spending is $1 trillion. If current real GDP is $22 trillion, what is the current value of real consumption spending?

The multiplier is 1/(1 − MPC) = 4, so 1 – MPC = 0.25, which implies that MPC = 0.75. Thus, when real GDP equals $22 trillion, real consumption spending is $1 trillion + (0.75 × $22 trillion) = $1 trillion + $16.5 trillion = $17.5 trillion.

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition 11-8. The multiplier in a country is equal to 5, and households pay no taxes. At the current equilibrium real GDP of $14 trillion, total real consumption spending by households is $12 trillion. What is real autonomous consumption in this country?

The multiplier is 1/(1 – MPC) = 5, so 1 – MPC = 0.2, which implies that MPC = 0.8.

Consumption of $12 trillion is equal to autonomous consumption + (0.8 × $14 trillion), or autonomous consumption plus $11.2 trillion. Thus, autonomous consumption is $12 trillion – $11.2 trillion = $0.8 trillion.

11-9. At an initial point on the aggregate demand curve, the price level is 125 and real GDP is $22 trillion. When the price level falls to a value of 120, total autonomous expenditures increase by $250 billion so that the C + I + G + X curve shifts upward by $250 billion.

The marginal propensity to consume is 0.75. What is the level of real GDP at the new point on the aggregate demand curve?

The multiplier is 1/(1 − MPC) = 1/(1 − 0.75) = 4, so the increase in equilibrium real GDP is $250 billion × 4 = $1 trillion, and the level of real GDP at the new point on the aggregate demand curve is $23 trillion.

11-10. At an initial point on the aggregate demand curve, the price level is 100 and real GDP is $22 trillion. After the price level rises to 110, however, there is an upward movement along the aggregate demand curve and real GDP declines to $14 trillion. If total planned spending declined by $200 billion in response to the increase in the price level, what is the marginal propensity to consume in this economy?

The change in real GDP equals the multiplier times the change in real planned spending, or in this case –$8 trillion = multiplier × –$200 billion (or –$0.2 trillion). Therefore, the multiplier is equal to –$8 trillion/–$0.2 trillion = 40. The MPS = 1/multiplier = 1/40 = 0.025, so the MPC = 1 – MPS = 1 – 0.025 = 0.975.

11-11. In an economy in which the multiplier has a value of 3, the price level has decreased from 115 to 110. As a consequence, there has been a movement along the aggregate demand curve from $22 trillion in real GDP to $22.9 trillion in real GDP. a. What is the marginal propensity to save? b. What was the amount of the change in planned expenditures generated by the decline in the price level? a. The MPS is equal to 1/multiplier = 1/3. b. The change in real GDP equals the multiplier times the change in real planned spending, or in this case $0.9 trillion = 3 × change in real planned spending.

Therefore, the change in real planned spending = $0.9 trillion/3 = $0.3 trillion.

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Chapter 11 Consumption, Real GDP, and the Multiplier 11-12. Consider the following diagram, which applies to a nation with no government spending, taxes, or net exports. Use the information in the diagram to answer the following questions, and explain your answers.

a. What is the marginal propensity to save? b. What is the present level of planned investment spending for the present period? c. What is the equilibrium level of real GDP for the present period? d. What is the equilibrium level of saving for the present period? e. If planned investment spending for the present period increases by $25 billion, what will be the resulting change in equilibrium real GDP? What will be the new equilibrium level of real GDP if other things, including the price level, remain unchanged? a. The MPC is equal to the slope of the consumption function. (See Appendix A for a discussion of the slope of a line.) This slope is the “rise,” $3.5 trillion – $0.5 trillion = $3.0 trillion, divided by the corresponding “run,” $4.0 trillion. This is ¾, or 0.75.

The MPS equals 1 – MPC = 1 – ¾ = ¼, or 0.25. b. Planned real investment (I) is the difference between total planned real expenditures (C + I) and planned consumption (C) at each level of real GDP per year, or $0.5 trillion. c. Equilibrium real GDP per year is $4.0 trillion, which is at the point at which the C + I curve crosses the 45-degree reference line. d. Because there are no taxes, equilibrium real saving equals equilibrium real GDP ($4.0 trillion) minus equilibrium planned consumption spending ($3.5 trillion) or $0.5 trillion. Hence real planned investment equals real saving at the equilibrium level of real GDP. e. The multiplier equals 1/MPS, or 1/(¼) = 4. Hence, a $25 billion increase in planned investment will generate an increase in equilibrium real GDP of $100 billion, or $0.1 trillion. Equilibrium real GDP will increase from $4.0 trillion to $4.1 trillion.

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition 11-13. Consider movements from points F to K in both panels of Figure 11-1. Use the resulting changes in planned real consumption and saving corresponding to the change in real disposable income to calculate the marginal propensities to consume and to save.

The change in real disposable income between points F and K is $120,000 −$60,000 = $60,000.

In Figure 11-1, the value of planned real consumption spending at point K is half the distance between $120,000 and $96,000, or $12,000 less than $120,000, which is $108,000. Hence, the change in planned real consumption spending between point F and point K in the upper diagram is $108,000 −$60,000 = $48,000, so the marginal propensity to consume is $48,000/$60,000 = 4/5 = 0.8.

The change in saving in the lower diagram is $12,000 −$0 = $12,000, so the marginal propensity to save is $12,000/$60,000 = 1/5 = 0.2.

11-14. Take a look at Figure 11-5. If current real GDP for this nation’s economy is $1.8 trillion per year, what are the values of planned real investment and actual real investment? What is the amount of the unplanned inventory change, and why does this fact imply that real GDP must change? To what new level will real GDP adjust?

At a real GDP level of $1.8 trillion, planned investment is $0.38 trillion. Actual investment, however, equals planned and actual saving of $0.34 trillion. Thus, there is an unplanned reduction in business inventories equal to $0.34 trillion −$0.38 trillion = −$0.04 trillion.

Businesses will respond by increasing production, so real GDP rises to $2.0 trillion, at which planned investment equals planned saving.

11-15. Consider Table 11-2. What is the average propensity to consume at the equilibrium level of real GDP? What is the average propensity to save?

At the equilibrium real GDP of $2.2 trillion, real disposable income is $1.86 trillion, and planned real consumption is $14.8 trillion. Thus, APC = planned real consumption/real disposable income = $1.48 trillion/$1.76 trillion = 0.796. The average propensity to save is APS = 1 – APC = 1 – 0.796 = 0.204 or, alternatively, APS = planned real saving/real disposable income = $0.38 trillion/$1.86 trillion = 0.204.

11-16. Take a look at Table 11-2 and consider the changes in planned real consumption and saving associated with an increase in real GDP from $1.80 trillion to $1.90 trillion to calculate the marginal propensity to consume.

A rise in real GDP from $1.80 trillion to $1.90 trillion induces an increase in real disposable income from $1.46 trillion to $1.56 trillion = $1.0 trillion and in planned real consumption from $1.16 trillion −$1.24 trillion = $0.8 trillion. Hence, the marginal propensity to consume (MPC) = change in planned real consumption/change in real disposable income = $0.8 trillion/$1.0 trillion = 0.8.

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Chapter 11 Consumption, Real GDP, and the Multiplier 11-17. Consider the current equilibrium real GDP level of $2.20 trillion displayed in Table 11-2.

Based on your answer to Problem 11-6, if real government spending were to decrease by $0.10 trillion, what would be the resulting change in real GDP? What would be the new equilibrium level of real GDP? Verify that at the new level of government spending, this new equilibrium real GDP equals C + I + G + X. The multiplier equals 1/(1 – MPC) = 1/(1 – 0.8) = 1/0.2 = 5, so a $0.10 trillion decrease in government spending would cause real GDP to decrease by $0.10 trillion × 5 = $0.5 trillion.

The new equilibrium real GDP, therefore, would be $2.2 trillion − $0.5 trillion = $1.7 trillion, at which (given that G is now equal to $0.44 trillion − $0.10 trillion = $0.34 trillion) C + I + G + X = $1.08 trillion + $0.38 trillion + $0.34 trillion − $0.10 trillion = $1.70 trillion.

11-18. Consider Figure 11-7, which applies to an economy in which the marginal propensity to consume is 0.8. Why does a $0.01 trillion increase in planned real investment spending cause the aggregate demand curve to shift rightward by exactly $0.05 trillion at the initial equilibrium price level of 110?

At the initial equilibrium price level of 110, total planned real spending rises by the $0.01 trillion increase in planned real investment spending times the multiplier, which is equal to 1/(1 – MPC) = 1/(1 – 0.8) = 1/0.2 = 5. Hence, the AD curve must shift rightward by the amount of the increase in total planned real spending at this price level, which therefore equals $0.05 trillion.

11-19. Following the rightward shift in the aggregate demand curve generated by the $0.01 trillion rise in real planned investment spending in Problem 11-18, why does the actual equilibrium level of real GDP increase by only $0.03 trillion instead of $0.05 trillion?

The rightward shift in the AD curve generates an upward movement along the SRAS curve. In the short run, the equilibrium price level increases from the initial value of 110 to a higher value of 115. People must spend some of the increase in real disposable income on paying higher prices. Consequently, the real value of goods and services that they actually purchase drops below $2.25 trillion, to $2.23 trillion.

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Chapter 12 Fiscal Policy 

Answers to Questions for Critical Analysis

TRYING TO REDUCE GOVERNMENT DEFICITS BY “BEHAVIOURALLY NUDGING” BUSINESSES INTO PAYING TAXES If behavioural nudges were to generate a significant increase in a nation’s aggregate tax collections, what would be the ultimate effects on the equilibrium price level and on equilibrium real GDP? The behavioural nudges would affect spending and the economy in two ways. First, the increase in taxes paid by businesses will likely reduce investment spending (as the firm is induced to pay more in taxes, they have fewer funds to invest). This will decrease AD, lowering real GDP and the price level. On the other hand, the increase in tax revenues collected by the government could change expectations of future tax payments (the Ricardian equivalence theorem). If offset by an increase in government spending or a decrease in tax rates, this could increase AD, raising real GDP and the price level. The ultimate effect on real GDP and the price level will depend on the relative sizes of these changes.

DO PRIVATE–PUBLIC INFRASTRUCTURE PROJECTS GENERATE SMALLER CROWDING-OUT EFFECTS? Why might government construction of a single sports stadium designed for multiple types of sporting events generate a larger private expenditure offset than partial government support for smaller stadiums for specific sporting events?

If the government constructs a single sports stadium for multiple types of sporting events, it reduces the spending by private firms on the same types of facilities (a direct expenditure offset) and there is no impact on real GDP. However, when the government provides partial support to private firms for smaller stadiums, private firms will still spend on investment (in pursuit of higher profits) and the offset of the government spending will be minimized.

AI: REDUCING POLICY TIME LAGS Even if the use of big data enables government officials to better monitor their own budgets, why might they still experience time lags in deciding on and implementing appropriate discretionary policy actions? (Hint: Does just one policymaker always make fiscal policy changes?)

The use of big data will reduce the recognition time lag (the time it takes to gather information about the state of the economy), but not the action time lag (the time it takes to decide on and implement policy) nor the effect time lag (the time it takes for the policy to take effect). The action time lag can be quite significant because it requires parliamentary approval and policymakers do not always agree on the best course of action.

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Economics in Your Life

THE ITALIAN GOVERNMENT CONTEMPLATES A “FLAT TAX” – FOR HIGH-INCOME PEOPLE WILLING TO MOVE TO ITALY For Critical Thinking About how many thousands of people (to the nearest thousand) would have to agree to move to Italy and pay its lump-sum tax to generate $1 billion of additional annual tax collections for the Italian government? Explain briefly.

To generate $1 billion of additional annual tax collections, nearly 8,000 high-income people ($1 billion/$123,000 = 8,130) would have to move to Italy and take advantage of the flat tax.

Real Application In what ways might you react if you faced Italy’s high average tax rate of 43 percent?

First, you could opt to work fewer hours, thereby engaging in more leisure activities. Second, you might seek out additional (or alterative) employment opportunities that involve “off the books” payments. For example, if you are a plumber, you might suggest to your clients that they could pay for part of your services in cash and in exchange you could offer a discount.

Finally, you might consider retiring earlier than otherwise planned because it might seem better for you to choose a life of 100 percent leisure activities.

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Issues & Applications

ASSESSING OVERALL EFFECTS OF DISCRETIONARY CANADIAN FISCAL POLICY ACTIONS ON AGGREGATE DEMAND For Critical Thinking Given the size of the recessionary gap caused by COVID-19 in 2020, were the changes in aggregate demand consistent with discretionary fiscal policy aimed at reducing this gap?

The government increased spending by over 1 percent of GDP, which seemed to result in a net increase in aggregate demand. This net increase in aggregate demand increased real GDP to help eliminate the recessionary gap.

Real Application When the federal government engages in expansionary fiscal policy, how might you become the beneficiary of that policy?

Expansionary fiscal policy can involve decreases in federal marginal tax rates and/or increases in government spending. If your marginal federal income tax rate falls, you are obviously a beneficiary in the sense that your after-tax, spendable income will go up.

If the expansionary fiscal policy involves increases in government spending, you might become a beneficiary. If, for example, the government spends more on infrastructure projects, such as subsidized new housing or road construction, and you are working in those sectors, there will be an increased demand for your services. You might get pay raises or increased benefits from your employer. Alternatively, you might consume a good or service that is paid for with increased government spending. You may, for example, enjoy a local park or public basketball court that was funded by a much larger government spending package. .

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Answers to End-of-Chapter Questions

12-1. Suppose that the government decides that the nation’s economic performance is weakening and that the government should “do something” about the situation. They make no tax changes but do enact new laws increasing government spending on a variety of programs. a. Prior to the government action, careful studies by government economists indicated that the Keynesian multiplier effect of a rise in government expenditures on equilibrium real GDP per year is equal to 3. In the 12 months since the increase in government spending, however, it has become clear that the actual ultimate effect on real GDP will be less than half that amount. What factors might account for this? b. Another year and a half elapses following passage of the government spending boost.

The government has undertaken no additional policy actions, nor have there been any other events of significance. Nevertheless, by the end of the second year, real GDP has returned to its original level, and the price level has increased sharply. Provide a possible explanation for this outcome. a. A key factor that could help explain why the actual effect may have turned out to be lower is the crowding-out effect. Also, some government spending may have entailed direct expenditure offsets that reduced private expenditures on a dollar-for-dollar basis. In addition, indirect crowding out may have occurred. Because the government did not change taxes, it probably sold bonds to finance its increased expenditures, and this action likely pushed up interest rates, thereby discouraging private investment.

Furthermore, the increase in government spending likely pushed up aggregate demand, which may have caused a short-run increase in the price level. This, in turn, may have induced foreign residents to reduce their expenditures on Canadian goods.

It also could have reduced real money holdings sufficiently to discourage consumers from spending as much as before. On net, therefore, real GDP rose in the short run but not by the full amount predicted by the basic multiplier effect. b. In the long run, as the increased spending raised aggregate demand, wages and other input prices likely increased in proportion to the resulting increase in the price level.

Thus, in the long run, the aggregate supply schedule was vertical, and the increase in government spending induced only a rise in the price level.

12-2. Suppose that the government enacts a significant tax cut with the expectation that this action will stimulate aggregate demand and push up real GDP in the short run. In fact, however, neither real GDP nor the price level changes significantly as a result of the tax cut. What might account for this outcome?

There are two possible explanations. One is that to continue spending at the same pace even after cutting taxes, the government had to borrow to finance the resulting deficit. Consequently, market interest rates rose, thereby causing a crowding-out effect: an offsetting fall in private spending. Another potential explanation is that people behaved in a way predicted by the Ricardian equivalence theorem. That is, they realized that the tax reduction today would entail a future tax increase to repay debt that the government incurred. Thus, people saved the amount of the tax reduction instead of spending it, so that aggregate demand did not change. .

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Chapter 12 Fiscal Policy 12-3. Explain how time lags in discretionary fiscal policymaking could thwart the efforts of the government to stabilize real GDP in the face of an economic downturn.

Is it possible that these time lags could actually cause discretionary fiscal policy to destabilize real GDP? Because of the recognition time lag entailed in gathering information about the economy, policymakers may be slow to respond to a downturn in real GDP. Parliamentary approval of policy actions to address the downturn may be delayed; hence, an action time lag may also arise.

Finally, there is an effect time lag because policy actions take time to exert their full effects on the economy. If these lags are sufficiently long, it is possible that by the time a policy to address a downturn has begun to have its effects, real GDP may already be rising. If so, the policy action may push real GDP up faster than intended, thereby making real GDP less stable.

12-4. Determine whether each of the following is an example of a situation in which a direct expenditure offset to fiscal policy occurs. a. In an effort to help rejuvenate the nation’s railroad system, a new government agency buys unused track, locomotives, and passenger and freight cars, many of which private companies would otherwise have purchased and put into regular use. b. The government increases its expenditures without raising taxes. To cover the resulting budget deficit, it borrows more funds from the private sector, thereby pushing up the market interest rate and discouraging private planned investment spending. c. The government finances the construction of a classical music museum that otherwise would never have received private funding.

Situation a is an example of a direct expenditure offset because the government purchases exactly offset private purchases that otherwise would have taken place. Situation b is an example of indirect crowding out, and in situation c no direct expenditure offset occurs.

12-5. Determine whether each of the following is an example of a situation in which there is indirect crowding out resulting from an expansionary fiscal policy action. a. The government provides a subsidy to help keep an existing firm operating, even though a group of investors otherwise would have provided a cash infusion that would have kept the company in business. b. The government reduces its taxes without decreasing its expenditures. To cover the resulting budget deficit, it borrows more funds from the private sector, thereby pushing up the market interest rate and discouraging private planned investment spending. c. Government expenditures fund construction of a high-rise office building on a plot of land where a private company otherwise would have constructed an essentially identical building.

Situation b is an example of indirect crowding out because the reduction in private expenditures takes place indirectly in response to a change in the interest rate. In contrast, situations a and c are examples of direct expenditure offsets.

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition 12-6. The Canadian government is in the midst of spending more than $1 billion on seven buildings containing more than 100,000 square feet of space to be used for study of infectious diseases. Prior to the government’s decision to construct these buildings, a few universities had been planning to build essentially the same facilities using privately obtained funds. After construction on the government buildings began, however, the universities dropped their plans. Evaluate whether the government’s $1 billion expenditure is likely to push Canadian real GDP above the level it would have reached in the absence of the government’s construction spree.

There is a direct expenditure offset, so the government’s $1 billion expenditure will not alter real GDP relative to the level it would have reached if the universities had otherwise expended $1 billion to construct the buildings.

12-7. Determine whether each of the following is an example of a discretionary fiscal policy action. a. A recession occurs, and government-funded unemployment compensation is paid to laid-off workers. b. The government decides to fund a new jobs program designed to put unemployed workers to work. c. The Bank of Canada decides to reduce the quantity of money in circulation in an effort to slow inflation. d. The government decides to authorize an emergency release of funds for spending programs intended to head off economic crises.

Situation b is an example of a discretionary fiscal policy action because this is a discretionary action by the government. So is situation d because the government uses discretionary authority.

Situation c is an example of monetary policy, not fiscal policy, and situation a is an example of an automatic stabilizer.

12-8. Determine whether each of the following is an example of an automatic fiscal stabilizer. a. A federal agency must extend loans to businesses whenever an economic downturn begins. b. As the economy heats up, the resulting increase in equilibrium real GDP per year immediately results in higher income tax payments, which dampen consumption spending somewhat. c. As the economy starts to recover from a severe recession and more people go back to work, government-funded unemployment compensation payments begin to decline. d. To stem an overheated economy, the government authorizes emergency impoundment of funds that were previously authorized for spending on government programs.

Situation a is an example of an automatic fiscal stabilizer because the government’s loans occur automatically. So are situations b, because tax payments automatically change with variations in real GDP, and c, because unemployment payments change automatically. Situation d, however, is an example of a discretionary use of available economic policymaking powers.

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Chapter 12 Fiscal Policy 12-9. Consider the diagram below, in which the current short-run equilibrium is at point A, and answer the questions that follow.

a. What type of gap exists at point A? b. If the marginal propensity to save equals 0.20, what change in government spending financed by borrowing from the private sector that shifts the aggregate demand curve by a significant horizontal distance could eliminate the gap identified in part (a)?

Explain. a. There is a recessionary gap, because at point A equilibrium real GDP of $22.5 trillion is below the long-run level of $23.0 trillion. b. The spending increase must shift the AD curve rightward by $1 trillion, or by the multiplier, which is 1/0.20 = 5, times the increase in spending. Government spending must rise by $200 billion, or $0.2 trillion.

12-10. Consider the diagram below, in which the current short-run equilibrium is at point A, and answer the questions that follow. a. What type of gap exists at point A? b. If the marginal propensity to consume equals 0.75, what change in government spending financed by borrowing from the private sector that shifts the aggregate demand curve by a sufficient horizontal distance could eliminate the gap identified in part (a)? Explain.

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a. There is an inflationary gap, because at point A equilibrium real GDP of $22.8 trillion is above the long-run level of $22.0 trillion. b. The spending decrease must shift the AD curve leftward by $1.6 trillion, or by the multiplier, which is 1/(1 – 0.75) = 1/0.25 = 4, times the decrease in spending.

Government spending must decline by $400 billion, or $0.4 trillion.

12-11. Currently, a government’s budget is balanced. The marginal propensity to consume is 0.80. The government has determined that each additional $10 billion it borrows to finance a budget deficit pushes up the market interest rate by 0.1 percentage point. It has also determined that every 0.1 percentage point change in the market interest rate generates a change in planned investment expenditures equal to $2 billion. Finally, the government knows that to close a recessionary gap and take into account the resulting change in the price level, it must generate a net rightward shift in the aggregate demand curve equal to $200 billion. Assuming that there are no direct expenditure offsets to fiscal policy, how much should the government increase its expenditures? (Hint: How much private investment spending will each $10 billion increase in government spending crowd out?)

Because the MPC is 0.80, the multiplier equals 1/(1 − MPC) = 1/(1 – 0.8) = 1/0.2 = 5.

Recall that the aggregate demand curve is derived by shifting the C + I + G + X curve, which means that shifting the AD curve a particular distance rightward requires an appropriate upward shift of the C + I + G + X curve. Net of indirect crowding out, therefore, total autonomous expenditures must rise by $40 billion to shift the aggregate demand curve rightward by $200 billion. If the government raises its spending by $50 billion, the market interest rate rises by 0.5 percentage point and thereby causes planned investment spending to fall by $10 billion, which results in a net rise in total autonomous expenditures equal to $40 billion.

Consequently, to accomplish its objective the government should increase its spending by $50 billion.

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Chapter 12 Fiscal Policy 12-12. A government is currently operating with an annual budget deficit of $40 billion. The government has determined that every $10 billion reduction in the amount it borrows each year would reduce the market interest rate by 0.1 percentage point. Furthermore, it has determined that every 0.1 percentage point change in the market interest rate generates a change in planned investment expenditures in the opposite direction equal to $5 billion. The marginal propensity to consume is 0.75. Finally, the government knows that to eliminate an inflationary gap and take into account the resulting change in the price level, it must generate a net leftward shift in the aggregate demand curve equal to $40 billion. Assuming that there are no direct expenditure offsets to fiscal policy, how much should the government increase taxes? (Hint: How much new private investment spending is induced by each $10 billion decrease in government spending?)

Because the MPC is 0.75, the multiplier equals 1/(1 − MPC) = 1/(1 – 0.75) = 1/0.25 = 4. Recall that the aggregate demand curve is derived by shifting the C + I + G + X curve, which means that shifting the AD curve a particular distance rightward requires an appropriate upward shift of the C + I + G + X curve. Net of indirect effects on planned investment spending, therefore, total autonomous expenditures must increase by $10 billion to shift the aggregate demand curve rightward by $40 billion. If the government increases lump-sum taxes by $20 billion, it will borrow $20 billion less in the market, the market interest rate falls by 0.2 percentage points and thereby causes planned investment spending to increase by $10 billion, which results in a net increase in total autonomous expenditures equal to $10 billion. Consequently, to accomplish its objective the government should increase lump-sum taxes by $20 billion.

12-13. Assume that the Ricardian equivalence theorem is not relevant. Explain why an income tax rate cut should affect short-run equilibrium real GDP. A cut in the tax rate should induce a rise in consumption that leads to a short-run increase in equilibrium real GDP. 12-14. Suppose that the government enacts a lump-sum tax cut of $750 billion. The marginal propensity to consume is equal to 0.75. Assuming that Ricardian equivalence holds true, what is the effect on equilibrium real GDP? On saving?

Under Ricardian equivalence, equilibrium real GDP does not change and saving increases.

People save the entire $750 billion, which they recognize they will have to repay, along with interest, at a future date.

12-15. The federal government issued one-time tax rebates—cheques returning a small portion of taxes previously paid—to millions of Canadian residents, and Canadian real disposable income temporarily jumped by nearly $500 billion. Household real consumption spending did not increase in response to the short-lived increase in real disposable income. Explain how the logic of the permanent income hypothesis might help to account for this apparent non-relationship between real consumption and real disposable income.

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition According to the logic of the permanent income hypothesis, these small, one-time payments did not raise people’s average lifetime disposable incomes. Instead of using the funds to increase their consumption spending, people applied them toward paying down outstanding debts or to their savings. Hence, consumption spending did not rise in response to the temporary increase in real disposable income.

12-16. It is late 2023, and the Canadian economy is showing signs of slipping into a potentially deep recession. Government policymakers are searching for income tax policy changes that will bring about a significant and lasting boost to real consumption spending.

According to the logic of the permanent income hypothesis, should the proposed income tax policy changes involve tax increases or tax reductions, and should the policy changes be short lived or long lasting?

The permanent income hypothesis suggests that a long-lived tax reduction would be more likely to boost real consumption spending.

12-17. Recall that the Keynesian spending multiplier equals 1/(1 – MPC). Suppose that in panel (a) of Figure 12-1, the government determined that the amount by which the AD curve had to be shifted directly rightward from point E 1 was equal to $100 billion. If the government decided that a $20 billion increase in real government spending was required to generate this shift, what must be the value of the MPC? The government must have determined that the multiplier is equal to the change in real GDP induced by higher government spending at an unchanged price level divided by the increase in government spending, or $100 billion/$20 billion = 5. The value of MPC that yields this value for the multiplier is 0.8. That is, 1/(1 – MPC) = 1/(1 – 0.8) = 1/0.2 = 1/(1/5) = 5.

12-18. Recall that the Keynesian spending multiplier equals 1/(1 – MPC). Suppose that in panel (b) of Figure 12-1, the government knows that the MPC is equal to 0.75 and that the amount of the horizontal distance that the AD curve had to be shifted directly leftward from point E1 was equal to $100 billion. What is the reduction in real government spending required to have generated this shift?

The multiplier equals 1/(1 – MPC) = 1/(1 – 0.75) = 1/0.25 = 1/(1/4) = 4. Therefore, the necessary decrease in real government spending must have been equal to −$100 billion/4 = −$25 billion.

12-19. Recall that the Keynesian spending multiplier equals 1/(1 – MPC). Suppose that in Figure 12-4, the MPC is equal to 0.9. In addition, the amount of the horizontal leftward shift from AD2 to AD3 caused by a crowding-out effect on planned investment spending was $0.5 trillion, or $500 billion. How much investment spending was crowded out?

The multiplier equals 1/(1 – MPC) = 1/(1 – 0.9) = 1/0.1 = 1/(1/10)= 10. Therefore, the amount of investment crowded out to have generated the $500 billion decrease in economy-wide total planned expenditures must have been equal to $500 billion/10 = $50 billion.

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Chapter 12 Fiscal Policy 12-20. Every 1 percentage point increase in the marginal income tax rate induces some workers to supply less labour, which cuts real GDP by $0.2 trillion. At the same time, each 1 percentage point increase in the marginal income tax rate causes spendable income to drop, which induces some workers to supply labour that yields $0.1 trillion more in real GDP. Is the net outcome consistent with the supply-side view? Why? The first $0.2 trillion drop in real GDP results from a reduced opportunity cost of leisure. In contrast, the second $0.1 trillion rise in real GDP results from the fact that the drop in spendable income shifts the demand curve for leisure inward to the left. The fact that the net outcome is a $0.1 trillion fall in real GDP (+$0.1 trillion −$0.2 trillion = −$0.1 trillion) is consistent with the supply-side theory.

12-21. A government has found that two months elapse before it can identify a problem to address with a policy action. It has found that one month is required to determine the appropriate policy action. Finally, it has concluded that the total time required between the initial presence of the problem and the effects of a policy action to be realized is 12 months. What is the remaining policy time lag and its duration?

The first policy time lag is the recognition time lag of two months, and the second is the action time lag of one month. The remaining policy time lag is the effect time lag. The duration of all three lags, from the initial presence of the problem to effects of a policy action, equals 12 months. Hence, the duration of the effect time lag is 12 months – 2 months – 1 month = 9 months.

12-22. In Figure 12-6, explain why a budget deficit naturally tends to arise at a real GDP level such as Y2 to the left of Yf. When real GDP declines, so do the government’s real tax revenues. At the same time, a decrease in real GDP generates more government payments of benefits in the form of unemployment compensation and income transfer payments. Consequently, at a sufficiently low level of real GDP such as Y2, the sum of benefits paid out will exceed tax revenues, and a budget deficit results.

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Appendix E: Answers to End-of-Appendix Questions

E-1. Assume that equilibrium real GDP is $22.2 trillion and full-employment equilibrium (FE) is $22.55 trillion. The marginal propensity to save is 1/7. Answer the questions using the data in the following graph.

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a. b. c. a. b.

c.

What is the marginal propensity to consume?

By how much must new investment or government spending increase to achieve full employment if taxes are unchanged?

By how much must government cut personal taxes to attain full-employment equilibrium if its spending is unchanged?

The marginal propensity to consume is equal to 1 – MPS, or 6/7.

The required increase in equilibrium real GDP is $0.35 trillion, or $350 billion. The multiplier equals 1/(1 − MPC) = 1/MPS = 1/(1/7) = 7. Hence, investment or government spending must increase by $50 billion to bring about a $350 billion increase in equilibrium real GDP. The multiplier relevant for a tax change equals −MPC/(1 − MPC) = −MPC/MPS = −(6/7)/(1/7) = −6. Thus, the government would have to cut taxes by $58.33 billion to induce a rise in equilibrium real GDP equal to $350 billion.

E-2. Assume that MPC = 4/5 when answering the following questions. a. If government expenditures rise by $2 billion, by how much will the aggregate expenditure curve shift upward? By how much will equilibrium real GDP per year change? b. If taxes increase by $2 billion, by how much will the aggregate expenditure curve shift downward? By how much will equilibrium real GDP per year change? a. b.

The aggregate C + I + G + X curve shifts up by $2 billion. The multiplier equals 1/(1 − MPC) = 1/(1 − 4/5) = 1/(1/5) = 5. Hence, equilibrium real GDP increases by $2 billion × 5, or $10 billion.

A tax increase of $2 billion reduces disposable income by $2 billion and hence reduces consumption by an amount equal to the MPC times this decline in disposable income, or 0.8 × $2 billion = $1.6 billion. Consequently, the C + I + G + X curve shifts downward by $1.6 billion. As discussed in part (a), the multiplier is 5, so equilibrium real GDP declines by $1.6 billion multiplied by 5, or by $8 billion.

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Chapter 12 Fiscal Policy E-3. Assume that MPC = 4/5 when answering the following questions. a. If government expenditures rise by $1 billion, by how much will the aggregate expenditure curve shift upward? b. If taxes rise by $1 billion, by how much will the aggregate expenditure curve shift downward? c. If both taxes and government expenditures rise by $1 billion, by how much will the aggregate expenditure curve shift? What will happen to the equilibrium level of real GDP? d. How does your response to the second question in part (c) change if MPC = 3/4? If MPC = 1/2? a. b.

c.

d.

The C + I + G + X curve shifts up by $1 billion. The multiplier equals 1/(1 − MPC) = 1/(1 − 4/5) = 1/(1/5) = 5. Thus, equilibrium real GDP increases by $1 billion × 5, or $5 billion.

A tax increase of $1 billion reduces disposable income by $1 billion and hence reduces consumption by an amount equal to the MPC times this decline in disposable income, or by 0.8 × $1 billion = $0.8 billion. Hence, the C + I + G + X curve shifts downward by $0.8 billion. As discussed in part (a), the multiplier is 5, so equilibrium real GDP declines by $0.8 billion multiplied by 5, or by $4 billion.

As noted in part (a), the C + I + G + X curve shifts upward by $1 billion as a result of the increase in government spending, but as discussed in part (b), it shifts back downward by $0.8 billion as a consequence of the increase in taxes. The net amount of the shift is an upward shift equal to $0.2 billion. As discussed in part (a), the multiplier is 5, so equilibrium real GDP rises by $0.2 billion multiplied by 5, or by $1 billion (the amount of government spending).

With an MPC of ¾ the multiplier equals 1/(1 − MPC) = 1/(1 − 3/4) = 1/(1/4) = 4. The C + I + G + X curve shifts upward by $1 billion due to the $1 billion increase in government spending. It shifts back downward by 0.75 × $1 billion = $0.75 billion due to the tax increase. The net upward shift of the C + I + G + X curve, therefore, is $1 billion −$0.75 billion = $0.25 billion. The resulting increase in equilibrium real GDP equals $0.25 billion × 4 = $1 billion, so the answer is the same as in part (c).

With an MPC of ½, the multiplier equals 1/(1 − MPC) = 1/(1 – 1/2) = 1/(1/2) = 2.

The C + I + G + X curve shifts upward by $1 billion due to the $1 billion increase in government spending. It shifts back downward by 0.50 × $1 billion = $0.50 billion due to the tax increase. The net upward shift of the C + I + G +X curve, therefore, is $1 billion −$0.50 billion = $0.50 billion. The resulting increase in equilibrium real GDP equals $0.50 billion × 2 = $1 billion, so the answer is the same as in part (c).

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Chapter 13

Deficit Spending and the Public Debt 

Answers to Questions for Critical Analysis

COULD CANADIAN TAXPAYERS GAIN FROM THE TREASURY BOARD BORROWING OVER LONGER STRETCHES OF TIME? Assume that you have some savings that you wish to place in Canadian bonds. You have the choice of buying a 1-year bond or a 50-year bond. What are the benefits and risks if you choose a 1-year bond? A 50-year bond?

Typically, the interest rate that you can earn on a one-year government bond is low relative to the interest rate that you can earn on a longer-term bond. Thus, you will receive less interest each year. In contrast, as long as you hold the bond to its maturity for one year, you do not risk any change in the market value of the principal that you will receive at the end of a year.

The opposite would be true with the 50-year bond. You would most likely receive a higher yearly yield on such a long-term bond compared to that for a one-year bond, but you would probably not wait 50 years to “cash in” your 50-year bond. Therefore, you will be exposed to the risk of a reduction in the market value of the bond when you decide to sell it. This would occur if, during the period you are receiving interest on that 50-year bond, interest rates in the economy rose higher than that bond’s yield. In the bond marketplace, when you went to sell the bond, buyers would only agree to a price of the bond such that the actual yield on the bond would be equal to competitive yields in the marketplace for bonds. (Now, to be fair, if interest rates in the economy went down, you would be able to sell the 50-year bond for more than you paid for it.

You would benefit from having held that bond for many years.)

ONE WAY TO GENERATE LOWER GOVERNMENT DEFICITS MIGHT BE TO BETTER INFORM PEOPLE ABOUT THE DEBT Why does generating a shrinkage of the current government deficit fail to bring about a corresponding shrinkage in the current magnitude of the net public debt? (Hint: Recall that the current net public debt has accumulated as a consequence of past deficits.)

The net public debt increases as a result of any deficits, large or small. Large deficits will increase the net public debt by a larger amount, while small deficits will still increase the net public debt but by a smaller amount. A balanced budget, on the other hand, would have no impact on the net public debt. The only way to shrink the net public debt is through a government surplus. If the government receives in revenues more than it spends, it can use the extra to pay back loans and reduce the net public debt.

CUTTING GOVERNMENT SPENDING AND TRIMMING THE FEDERAL DEFICIT Why is the net amount trimmed from the annual federal deficit likely to be smaller than the amount of fraudulent payments and duplicative spending eliminated via application of AI techniques? (Hint: Can the federal government employ AI methods at zero cost?)

The net amount trimmed from the annual federal budget deficit is likely to be smaller than the amount of fraudulent payments and duplicative spending found because taxpayer-funded resources are required to put the AI methods into place and to analyze the results of those .

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition methods. The actual amount trimmed would be the total of the fraudulent payments and duplicative spending minus the cost of the new AI methods.

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Economics in Your Life

GOVERNMENT-PENSION EXPENDITURES APPEAR TO HAVE BECOME NONCONTROLLABLE IN BRAZIL For Critical Thinking What do you suppose has happened to Brazil’s net public debt in recent years? Explain your reasoning.

Brazil’s net public debt has increased dramatically. Budget deficits increase the public debt, and the larger annual budget deficits have increased Brazil’s net public debt by a larger and larger amount.

Real Application Suppose that you take a job with a municipal, provincial, or federal government. You are told that you can retire at age 50. Assume further that no such generous pension plan exists in the private sector. How would you determine whether to stay in the public sector or to move into the private sector?

Clearly, to be induced to move into the private sector from the public sector the privatesector job opportunities would have to be considerably more lucrative than what you are currently earning in the public sector. After all, you would somehow have to make up for the retirement funds that you would start receiving at age 50 in the public sector. Also, assuming that you could still receive your public-sector retirement funds after age 50, even if you went to work in another job, you would benefit from a higher standard of living after age 50 than most people working in the private sector.

In other words, generous public-sector pension plans induce more individuals to want to work in the public sector.

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Issues & Applications

THE WORLD IS AWASH IN GOVERNMENT DEBT For Critical Thinking Why would either a particularly low rate of return on bond-financed global public spending or significant crowding out of private investment expenditures by such public spending yield lower global economic growth? (Hint: What exactly is purchased by private investment spending?)

Private investment spending is used to purchase capital that will help induce future economic growth (shift the production possibilities curve outward). If government spending increases the interest rate and crowds out private investment, the amount of capital produced will decline as will the potential future economic growth.

Real Application Imagine that your outstanding debt is growing faster than your actual and expected income per year. What are the implications of this situation for you personally?

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Chapter 13 Deficit Spending and the Public Debt Presumably, the growing debt that you owe is not being offered to you at a zero interest rate.

That means that, with a growing outstanding debt, you are going to find yourself paying a larger and larger percentage of your after-tax yearly income in interest payments for that rising debt. Eventually, these interest payments may become so large that you will no longer have enough funds during the year to pay for adequate food, housing, and clothing. At that point, you might have to declare bankruptcy.

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Answers to End-of-Chapter Questions

13-1. In 2023, government spending is $5.0 trillion, and taxes collected are $4.1 trillion. What is the federal government deficit in that year? $0.9 trillion 13-2. The estimates of federal budget receipts, federal budget spending, and GDP are shown below, all expressed in billions of dollars. Calculate the implied estimates of the federal budget deficit as a percentage of GDP for each year.

Year 2023 2024 2025 2026

Federal Budget Receipts 4,132.0 4,305.2 4.447.3 4,603.0

Federal Budget Spending 5,008.8 5,199.1 5,407.1 5,644.9

GDP 24,925.2 25,947.1 27,010.9 28,145.4

2023: The projected deficit is $876.8 billion, or 3.52 percent of GDP. 2024: The projected deficit is $893.0 billion, or 3.45 percent of GDP. 2025: The projected deficit is $959.8 billion, or 3.55 percent of GDP 2026: The projected deficit is $1,041.0 billion, or 3.70 percent of GDP. 13-3. It may be argued that the effects of a higher public debt are the same as the effects of a higher deficit. Why? A higher deficit creates a higher public debt.

13-4. What happens to the net public debt if the federal government operates next year with the following: a. A budget deficit? b. A balanced budget? c. A budget surplus? a. Higher net public debt b. Unchanged net public debt c. Lower net public debt .

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition 13-5. What is the relationship between the gross public debt and the net public debt?

The net public debt is obtained by subtracting all financial assets held by the government from the gross public debt.

13-6. Explain how each of the following will affect the net public debt, other things being equal. a. Previously, the government operated with a balanced budget, but recently there has been a sudden increase in federal tax collections. b. The government had been operating with a very small annual budget deficit until three hurricanes hit the Atlantic coast, and now government spending has risen substantially. c. The gross federal debt and financial assets held by the government increase by the same amount. a. The government will operate with a budget surplus during the present year, which will cause the net public debt to decrease. b. The net public debt, which had been rising slowly as a result of previously small annual deficits, will now rise more rapidly due to a sharply higher deficit this year. c. The net public debt remains unchanged.

13-7. Explain in your own words why there is likely to be a relationship between federal budget deficits and Canadian international trade deficits.

When foreign dollar holders hold more domestic government bonds issued to finance higher domestic government budget deficits, they purchase fewer domestic exports, so the domestic trade deficit rises, other things being equal.

13-8. Suppose that the share of Canadian. GDP going to domestic consumption remains constant. Initially, the federal government was operating with a balanced budget, but this year it has increased its spending well above its collections of taxes and other sources of revenues. To fund its deficit spending, the government has issued bonds. So far, very few foreign residents have shown any interest in purchasing the bonds. a. What must happen to induce foreign residents to buy the bonds? b. If foreign residents desire to purchase the bonds, what is the most important source of dollars to buy them? a. Other things being equal, foreign dollar holders can be induced to hold more Canadian government bonds used to finance domestic government deficits only if the interest rate paid on Canadian government bonds rises. b. Immediately, the main source of dollars are the dollars that foreign residents otherwise would use to purchase exports.

13-9. Suppose that the economy is experiencing the short-run equilibrium position depicted at point A in the diagram below. Then the government raises its spending and thereby runs a budget deficit in an effort to boost equilibrium real GDP to its long-run equilibrium level of $22 trillion (in base-year dollars). Explain the effects of an increase in the government deficit on equilibrium real GDP and the equilibrium price level. In addition, given that .

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Chapter 13 Deficit Spending and the Public Debt many taxes and government benefits vary with real GDP, discuss what change we might expect to see in the budget deficit as a result of the effects on equilibrium real GDP.

As shown in the diagram below, the increase in government spending and/or tax reduction that creates the budget deficit also causes the aggregate demand curve to shift rightward, from AD to AD2. Real GDP rises to its long-run equilibrium level of $22 trillion at point B. The equilibrium price level increases to a value of 130 at this point. As real GDP rises, the government’s tax collections increase and payouts of income transfer payments fall, both of which will help ultimately reduce the deficit.

B

AD2

13-10. Suppose that the economy is experiencing the short-run equilibrium position depicted at point B in the diagram below. Explain the short-run effects of an increase in the government deficit on equilibrium real GDP and the equilibrium price level. What will be the long-run effects?

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As shown in the diagram below, the increase in government spending and/or tax reduction that creates the budget deficit also causes the aggregate demand curve to shift rightward, from AD to AD2. With unchanged short-run aggregate supply, a new short-run equilibrium is reached at point C. The equilibrium price level rises to a value such as 130, and equilibrium real GDP increases to a level such as $25 trillion per year. Ultimately, however, upward adjustments in wages and other input prices will induce a leftward shift in the SRAS curve to SRAS2, resulting in a new long-run equilibrium at point D. In the long run, the price level will rise further, to a value such as 133, and real GDP will return to $22.5 trillion.

SRAS2 D

133

C

130

AD2

25

13-11. To eliminate the deficit (and halt the growth of the net public debt), a politician suggests that “we should tax the rich.” The politician makes a simple arithmetic calculation in which he applies a higher tax rate to the total income reported by “the rich” in a previous year. He says that the government could thereby solve the deficit problem by taxing “the rich.” What is the major fallacy in such a claim?

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Chapter 13 Deficit Spending and the Public Debt “The rich” are likely to respond to higher tax rates by reducing their activities that generate taxable income, so actual tax collections from “the rich” will not turn out to be as high as the politician suggests.

13-12. Refer back to Problem 13-11. If the politician defines “the rich” as people with annual taxable incomes exceeding $1 million per year, what is another difficulty with the politician’s reasoning, given that “the rich” rarely earn a combined taxable income exceeding $1 trillion, yet the federal deficit has regularly exceeded $1 trillion in recent years?

Even confiscating the total taxable income typically earned each year by “the rich” would not be sufficient to pay off the deficit. Raising income tax rates for “the rich” is an alternative to confiscation, and this action would only slightly reduce the deficit.

13-13. Say that in each of the past few years the federal government has regularly borrowed funds to pay for at least one-third of expenditures that tax revenues were insufficient to cover. Now the federal government decides to increase expenditures for transfers to people. What does this fact imply about how the government is paying for most of its discretionary expenditures?

These data indicate that tax revenues have been able to cover only about two-thirds—about 67 percent—of federal expenditures. Because more than 60 percent of all federal expenditures are transfers to people, this implies that the federal government has been borrowing to pay for most discretionary spending.

13-14. A fraction of the funds borrowed by the federal government between 2008 and 2015 were used to fund public investments in a number of solar power companies that produced little output and halted operations. These concerns provided no repayments to the government. In what sense might this fraction of deficit spending arguably have imposed a “burden” on future generations?

This spending of borrowed funds failed to contribute to future increases in real GDP, so future generations will have to be taxed at least at a slightly higher rate than otherwise would have been required.

13-15. The long-run effect of higher government budget deficits on the equilibrium annual flow of real GDP is zero. Who, therefore, benefits in the long run from higher government deficits?

Those who benefit in the long run from higher budget deficits are those who receive the larger share of the annual flow of real GDP to government-provided goods and services—that is, those to whom these goods and services are redistributed.

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Chapter 14

Money, Banking, and Money Creation 

Answers to Questions for Critical Analysis

WHAT ONCE WAS OLD MONEY IS NOW “NEW” MONEY IN ZIMBABWE In principle, what functions of money can goats, cattle, and other livestock perform? Explain your reasoning.

Livestock can be used to satisfy all four functions of money. Because the government will accept livestock as a means of payment for government services, it functions as a medium of exchange.

In addition, because livestock is now accepted, the government most likely has created a price system for each government service; that is, how many heads of livestock it would take to purchase certain services (unit of accounting). Livestock can also function as a store of value, if you consider that livestock can be butchered and frozen and kept for a later time. Because the government will accept livestock as payment for debts, it also functions as a standard of deferred payment.

CURRENCY REMAINS ENTRENCHED AS A KEY COMPONENT OF NATIONAL MONEY SUPPLIES Can you think of any reasons why people might prefer to use currency for certain transactions instead of deposit transfers that leave electronic records at depository institutions?

In general, currency is easier to use than deposit transfers. You do not need any information from the seller and you don’t have to provide any information as the buyer. If you were to purchase something illegally or pay for something “under the table,” then cash would be the preferred method because there is no record of the transaction for law enforcement or tax purposes, so it’s like the transaction never took place.

AI: AI IN THE BANKING INDUSTRY Why do you think banks find that having access to more data about potential borrowers improves the likelihood of repayments? (Hint: Recall the asymmetric information problems that banks face as lenders.)

If a bank has access to more data about potential borrowers, the amount of information available to both sides of the loan is more even. The borrower (customer) knows about the bank’s practices and the ability to lend funds, and the bank knows about the assets of the borrower, the borrower’s activities, and the borrower’s ability to repay the loan. By reducing the loans made to high-risk individuals, the bank can improve the likelihood of loan repayments.

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Economics in Your Life

CONTINGENCY PLANNING FOR A CENTRAL BANK DIGITAL CURRENCY For Critical Thinking Central banks pay no interest on paper currency, but in principle how could a central bank easily pay annual interest to holders of its digital currency?

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Chapter 14 Money, Banking, and Money Creation Because a digital currency would enable the central bank to track all exchanges people make and to know at any point in time who holds the digital currency, the central bank could easily credit any interest payments by adding those payments to the holder’s balance of digital cash.

Real Application If the Bank of Canada simultaneously issued physical currency and digital currency, would you benefit in any way from opting to use the digital currency?

There are certainly disadvantages with using physical currency. You have to worry about theft. You can also misplace cash and forget where you put it. And you have to physically go to a banking institution or an ATM to obtain more cash.

Digital currency issued by the Bank of Canada could be available on your computer, tablet, or smartphone. You could therefore have ready access to it to pay for groceries plus all other transactions, small or large.

The major downside of digital currency issued by the Bank of Canada is that all of your transactions, whether by debit card, credit card, or digital currency, would be recorded.

Currently, most of your transactions undertaken with paper currency are not recorded. There may be privacy reasons why you would prefer, therefore, to continue to use physical currency.

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Issues & Applications

THE CANADIAN GOVERNMENT LAUNCHES CONSULTATIONS ON OPEN BANKING For Critical Thinking Does open banking create new prudential risks to financial institutions?

One of the benefits of open banking is that it allows depositors to have greater ease of access to their accounts in depository institutions. Also, consumers would not only have the ability to move money between financial institutions, but they would have the ability to transfer all their accounts between financial institutions. Thus, one belief is that this transferability could cause a bank run.

Real Application How will consumers and businesses benefit from open banking?

Open banking offers many possibilities to improve financial services and the customer experience, ranging from more straightforward uses like account aggregation and facilitating client identification to a host of creative products and services to solve customer needs like switching providers and moving accounts. Currently, when a consumer wants to purchase a home they have to provide a physical or electronic copy of their T4 slip(s), pay stub(s), unregistered savings, chequing and investment accounts, registered accounts (RRSPs, TFSAs), and any other assets they may own along with a credit score check. In addition, they may have to submit a detailed spreadsheet of their monthly expenses so that the financial institution can establish a savings pattern. With open banking consumers can give permission to the financial institution to access all this information without having to provide physical or electronic copies.

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Answers to End-of-Chapter Questions

14-1. Until 1946, residents of the island of Yap used large doughnut-shaped stones as financial assets. Although prices of goods and services were not quoted in terms of the stones, the stones were often used in exchange for particularly large purchases, such as livestock.

To make the transaction, several individuals would insert a large stick through a stone’s centre and carry it to its new owner. A stone was difficult for any one person to steal, so an owner typically would lean it against the side of their home as a sign to others of accumulated purchasing power that would hold value for later use in exchange. Loans would often be repaid using the stones. Which of the functions of money did the stones perform?

Medium of exchange; store of value; standard of deferred payment 14-2. During the late 1970s, prices quoted in terms of the Israeli currency, the shekel, rose so fast that grocery stores listed their prices in terms of the U.S. dollar and provided customers with dollar–shekel conversion tables that they updated daily. Although people continued to buy goods and services and make loans using shekels, many Israeli citizens converted shekels to dollars to avoid a reduction in their wealth due to inflation. In what way did the U.S. dollar function as money in Israel during this period?

Unit of accounting; store of value 14-3. During the 1945–1946 Hungarian hyperinflation, when the rate of inflation reached 41.9 quadrillion percent per month, the Hungarian government discovered that the real value of its tax receipts was falling dramatically. To keep real tax revenues more stable, it created a good called a “tax pengö,” in which all bank deposits were denominated for purposes of taxation. Nevertheless, payments for goods and services were made only in terms of the regular Hungarian currency, whose value tended to fall rapidly even though the value of a tax pengö remained stable. Prices were also quoted only in terms of the regular currency.

Lenders, however, began denominating loan payments in terms of tax pengös. In what ways did the tax pengö function as money in Hungary in 1945 and 1946?

Store of value; standard of deferred payment 14-4. Considering the following data (expressed in billions of Canadian dollars), calculate Ml++, M2, M2+ and M2++.

Currency outside banks Personal nonchequable deposits in chartered banks only Personal fixed-term deposits at chartered banks only Personal chequable deposits at chartered banks only Nonpersonal fixed-term deposits Foreign currency deposits Nonbank deposits Chequable deposits at chartered banks and near-banks Money market mutual funds (MMMFs) .

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100 400 390 410 350 450 500 1,300 30

Chapter 14 Money, Banking, and Money Creation Nonchequable deposits at chartered banks and near-banks Nonpersonal demand and notice deposits at chartered banks only Non-money market mutual funds Canada Savings Bonds and other retail instruments

500 900 1,300 1

M1++ equals currency outside banks plus chequable deposits held at chartered banks and nearbanks plus nonchequable deposits held at chartered banks and near-banks, or $100 billion + $1,300 billion + $500 billion = $1,900 billion.

M2 equals currency outside banks plus personal deposits (including fixed term) at banks plus nonpersonal demand and notice deposits (excluding fixed term) at banks, or $100 billion + ($410 billion + $400 billion + $390 billion) + $900 billion = $2,200 billion.

M2+ equals M2 plus nonbank deposits plus MMMF, or $2,200 billion + $500 billion + $30 billion = $2,730 billion M2++ equals M2+ plus Canada Savings Bonds and other retail instruments plus non-money market mutual funds, or $2,730 + $1 billion + $1,300 billion = $4,031 billion 14-5. Considering the following data (expressed in billions of Canadian dollars), calculate Ml++, M2, M2+ and M2++.

Currency outside banks Non-money market mutual funds Canada Savings Bonds and other retail instruments Nonpersonal chequable deposits at chartered banks only Nonpersonal nonchequable deposits at chartered banks only Personal nonchequable deposits in chartered banks only Personal fixed-term deposits at chartered banks only Personal chequable deposits at chartered banks only Nonpersonal fixed-term deposits Foreign currency deposits Nonbank deposits Chequable deposits at chartered banks and near-banks Money market mutual funds (MMMFs) Nonchequable deposits at chartered banks and near-banks

150 1,300 2 1,200 150 600 585 615 525 675 750 1,950 45 750

M1++ equals currency outside banks plus chequable deposits held at chartered banks and near-banks plus nonchequable deposits held at chartered banks and near-banks, or $150 billion + $1,950 billion + $750 billion = $2,850 billion M2 equals currency outside banks plus personal deposits (including fixed term) at banks plus nonpersonal demand and notice deposits (excluding fixed term) at banks, or $150 billion + ($615 billion + $600 billion + $585 billion) + ($1,200 billion + $150 billion) = $3,300 billion.

M2+ equals M2 plus nonbank deposits plus MMMF, or $3,300 billion + $750 billion + $45 billion = $4,095 billion M2++ equals M2+ plus Canada Savings Bonds and other retail instruments plus non-money market mutual funds, or $4,095 + $2 billion + $1,300 billion = $5,397 billion

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition 14-6. Identify whether each of the following amounts is counted in Ml++, M2, M2+, and/or M2++, or none of the options. a. $50 billion in Canadian Savings Bonds b. $15 billion in personal fixed-term deposits c. $5 billion deposits in nonbanks d. $20 billion in Treasury bills held by mutual funds (MMMFs) a. b. c. d.

M2++ M2, M2+, M2++ M2+, M2++ M2+, M2++

14-7. Identify whether each of the following items is counted in Ml++, M2, M2+ and/or M2++, or neither. a. A $1,000 balance in a chequable deposit at a chartered bank b. A $100,000 personal time deposit in Scotiabank c. A $10,000 fixed-term deposit an elderly widow holds at Caisse Desjardins de Québec d. A $50 cheque issued by an insurance company annuity e. A $50,000 savings deposit in a near-bank a. b. c. d. e.

M1++ M2, M2+, M2++ M2+, M2++ M2+, M2++ M1++, M2+, M2++

14-8. Match each of the rationales for financial intermediation listed below with at least one of the following financial intermediaries: insurance company, pension fund, chartered bank.

Explain your choices. a. Adverse selection b. Moral hazard c. Lower management costs generated by larger scale In principle, each institution can match with each rationale; your explanations are the most important aspect of your answers. a. Insurance companies limit adverse selection by screening applicants for policies. b. Chartered banks limit moral hazard by monitoring borrowers after loans have been made. c. Pension funds reduce management costs by pooling the funds of many future pensioners.

14-9. Identify whether each of the following events poses an adverse selection problem or a moral hazard problem in financial markets. a. A manager of a savings and loan association responds to reports of a likely increase in deposit insurance coverage. She directs loan officers to extend mortgage loans to less creditworthy borrowers. .

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Chapter 14 Money, Banking, and Money Creation b. A loan applicant does not mention that a legal judgment in his divorce case will require him to make alimony payments to his ex-wife. c. An individual who was recently approved for a loan to start a new business decides to use some of the funds to take a Hawaiian vacation. a. moral hazard problem b. adverse selection problem c. moral hazard problem 14-10. In what sense is currency a liability of the Bank of Canada?

In an extreme case in which the Canadian government were to close down the Bank of Canada, it would have to compensate holders of Bank of Canada’s currency for the face value of those notes.

14-11. Draw an empty bank balance sheet with the heading “Assets” on the left and the heading “Liabilities” on the right. Then place the following items on the proper side of the balance sheet: a. Loans to a private company b. Borrowings from Bank of Canada c. Deposits with Bank of Canada d. Canada Treasury bills e. Vault cash f. Chequable deposits a. b. c. d. e. f.

asset liability asset asset asset liability

14-12. Draw an empty bank balance sheet with the heading “Assets” on the left and the heading “Liabilities” on the right. Then place the following items on the proper side of the balance sheet. a. Borrowings from another bank in the interbank loans market b. Deposits this bank holds in an account with another private bank c. Government bonds d. Small-denomination time deposits e. Mortgage loans to household customers f. Money market deposit accounts

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition a. b. c. d. e. f.

liability asset asset liability asset liability

14-13. Consider the following balance sheet for a Canadian chartered bank. Calculate the desired and excess reserves if r = 4%, 5%, 7%, and 10%.

Assets Reserves Desired Excess Loans Securities Total Assets

($000s) 45,000 215,000 50,000 310,000

Liabilities Deposits Advances from Bank of Canada Borrowings Capital

($000s) 220,000 0 35,000 55,000

Total Liabilities

310,000

If r = 4%, then desired = $220,000 × 0.04 = $8,800, excess = $45,000 – $8,800 = $36,200 If r = 5%, then desired = $220,000 × 0.05 = $11,000, excess = $45,000 – $11,000 = $34,000 If r = 7%, then desired = $220,000 × 0.07 = $15,400, excess = $45,000 – $15,400 = $29,600 If r = 10%, then desired = $220,000 × 0.1 = $22,000, excess = $45,000 – $22,000 = $23,000 14-14. Consider the following balance sheet for a Canadian chartered bank. Calculate the amount of loans it could make if $1,000,000 is deposited into the bank.

Assets Reserves Desired Excess Loans Securities Total Assets

($000s) 45,000 13,200 215,000 50,000 310,000

Liabilities

Deposits Advances from Bank of Canada Borrowings Capital

($000s) 220,000 0 35,000 55,000

Total Liabilities

310,000

r = $13,200/$220,000 = 0.06 or 6%, desired = $221,000 × 0.06 = $13,260, excess = $46,000 – $13,260 = $32,740

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Chapter 14 Money, Banking, and Money Creation 14-15. Consider the following balance sheet for a Canadian chartered bank, calculate the amount of loans it could make if $1,000,000 is deposited into the bank.

Assets Reserves Desired Excess Loans Securities Total Assets

($000s) 45,000 17,600 215,000 50,000 310,000

Liabilities Deposits Advances from Bank of Canada Borrowings Capital

($000s) 220,000 0 35,000 55,000

Total Liabilities

310,000

r = $17,600/$220,000 = 0.08 or 8%, desired = $221,000 × 0.08 = $17,680, excess = $46,000 – $17,680 = $28,320 14-16. The desired reserve ratio is 4, 5, 7, and 11 percent. What is the value of the potential money multiplier in each scenario?

The maximum potential money multiplier is 1/desired reserve ratio. Hence, the money multiplier in each scenario is 1/0.04 = 25, 1/0.05 = 20, 1/0.07 = 14.29, and 1/0.11 = 9.09.

14-17. The Royal Bank receives $10,000 in new deposits. The desired reserve ratio is 15 percent. Assuming that no currency leakage occurs, how much in new loans can the Royal Bank can create due to this new deposit?

The Royal Bank will hold 15 percent of the $10,000, or $1,500, as desired reserves. Thus, the bank will lend out $8,500.

14-18. Suppose that the value of the potential money multiplier is equal to 4. What is the desired reserve ratio?

Potential money multiplier = 1/desired reserve ratio, so the desired reserve ratio = 1/potential money multiplier = 1/4 = 25 percent (or 0.25).

14-19. Consider a world in which there is no currency and depository institutions issue only chequable deposits. The desired reserve ratio is 20 percent. Scotiabank receives $1,000 in new deposits. What ultimately happens to the money supply in the banking system?

The money supply increases by the potential money multiplier × excess reserves = (1/desired reserve ratio) × $800 = (1/.20) × $800 = 5 × $800 = $4,000.

14-20. Assume a 1 percent desired reserve ratio and no currency leakages. What is the potential money multiplier? How will total deposits in the banking system ultimately change if the Royal Bank receives $5,000 in new deposits?

The maximum potential money multiplier is 1/0.01 = 100, so total deposits in the banking system will increase by $5,000 × 100 = $500,000. .

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition 14-21. Consider Figure 14-1, which focuses on liquidity. How might limited acceptability of old masters paintings in exchange and difficulties in predicting the values of these paintings from year to year help to explain their relatively low liquidity? How might these characteristics affect the likelihood that these assets could function as forms of money?

While some who like paintings might accept old masters paintings in exchange, others who do not would be less willing, hence their relatively low levels of liquidity and limited usefulness as a medium of exchange. Difficulties in predicting the paintings’ value would make the paintings uncertain stores of purchasing power and thereby also reduce their liquidity and usefulness as forms of money.

14-22. Does Figure 14-3 depict direct finance or indirect finance? Explain. How could the figure be revised to illustrate the alternative form of finance?

The figure depicts indirect finance, a process through which ultimate lenders channel funds to ultimate borrowers indirectly through financial intermediaries such as those listed in the middle stage of the figure. Direct finance could be depicted by eliminating that middle stage—that is, by leaving financial intermediaries out of the process.

14-23. Consider Figure 14-4. Explain how Jill Jones’s debit card transaction affects the assets and liabilities of Scotiabank and the Royal Bank. Why does this transaction leave unchanged the total quantity of deposits in the banking system and, consequently, the money supply?

The $200 transfer out of Jill Jones’ Royal Bank deposit account causes Royal Bank’s liabilities to decline by $200, which requires the bank’s assets to decrease by the same amount.

Simultaneously, the transfer into Canadian Tire’s deposit account with Scotiabank causes Scotiabank’s liabilities and assets to rise by $200. Total deposits change by +$200 −$200 = $0, so total deposits and the money supply are unaffected.

14-24. If desired reserve ratio is 10 percent and a chartered bank loses $10,000 from its deposits due to withdrawals, what will be the ultimate contraction in money supply in the country?

Money supply in the country will decrease by the decrease in excess reserves times the money multiplier. Since excess reserves decrease by $9,000, the money supply will decrease by $9,000 × 10 (money multiplier) = $90,000.

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Chapter 15

Bank of Canada and Monetary Policy 

Answers to Questions for Critical Analysis

AI: REDUCING OR REPLACING THE STAFFS OF CENTRAL BANKS Do you agree or disagree that Canada could adopt AI tools and replace Bank of Canada advisory staff with digital equipment and AI apps?

By replacing Bank of Canada officials, who could make mistakes, with digital equipment and AI apps, the potential for errors and emotional decision making potentially is reduced.

ZIMBABWE SWITCHES TO USING THE U.S. DOLLAR AS ITS MONEY—FOR A WHILE Imagine a situation in which the rate of inflation in Canada increased to 25 percent per year.

How would you react?

Obviously, you would not want to leave too many of your funds in transactions accounts, such as your chequing account, at banking institutions that offer low or zero interest rates. You would instead probably want to purchase assets whose nominal values would rise with the rate of inflation, such as real estate, gold, silver, and stocks.

Initially, if you could obtain loans, such as for buying a house, at interest rates well below 25 percent per year, you would probably wish to do so.

Negotiations for future salary and wage increases would be something that you would have to engage in, too. If your wages or salaries did not rise by at least the rate of inflation, your real income would fall.

DO CENTRAL BANK POLICYMAKERS SHAPE GLOBAL EVENTS OR, LIKE MANY OTHER PEOPLE, REACT TO THEM? Do you suppose that people who currently have positions as central bank officials respond to economic events any more speedily or with any more scientific precision than people now in business who previously worked as central bank policymakers?

No, current central bank officials can respond to events neither more speedily nor with any more precision than current businesspeople who previously worked as policymakers, because both have experience that makes them just as quick to make decisions and just as effective in those decisions.

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Economics in Your Life

A CENTRAL BANK TAKES INFLATION CONTROL TO AN ENTIRELY DIFFERENT LEVEL For Critical Thinking Why do you suppose that critics of Bank Indonesia’s Regional Inflation Control Team argue that it could much more effectively decrease the overall inflation rate by further reducing growth of the nation’s money supply?

According to the quantity theory of money, a change in the money supply leads to an equal change in the price level (holding the velocity of money and real GDP constant). Following .

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition this theory, fewer resources would be required to decrease the rate of growth of the nation’s money supply (to reduce the price level) than it would for the Regional Inflation Control Team to determine the exact reason behind an increase in price for one commodity, which in many cases could be a legitimate increase due to determinants of supply and demand (like increased incomes or changes in preferences).

REAL APPLICATION Suppose that you become an advisor to the Bank of Canada. You notice that the prices of running shoes, snowboards, BMX bicycles, and streaming services are rising much faster than the prices of other goods and services. Would you tell the Bank of Canada to launch an investigation into these rising individual prices to bring down the overall rate of inflation? Why or why not?

Presumably, you would know the difference between changes in the price level and changes in relative prices. Relative prices change frequently because of changes in supply and demand conditions for each good or service. It would not do much good to examine the reasons for the relative price changes in running shoes, snowboards, BMX bicycles, and streaming services. At the same time that those relative prices are going up, it is possible that other relative prices were falling.

If you were in charge of explaining why the rate of inflation was going up, you certainly could simply blame that phenomenon on the increase in the price of every good or service that experienced such an increase in price. But that would be equivalent to your explaining inflation by saying that inflation occurs because of an increase in many prices in the economy. That is not an explanation, that is the definition of inflation.

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Issues & Applications

HOW MONETARY POLICY WORKS: THE TRANSMISSION OF MONETARY POLICY IN CANADA For Critical Thinking If there were a recessionary gap how would consumers’ and business’ expectations change about future interest rates? How would the Bank of Canada use monetary policy?

Typically consumers and businesses would expect inflation to fall and subsequently interest rates to fall as well. The Bank of Canada would conduct expansionary monetary policy to reduce the gap and also align interest rates with that of the market.

Real Application Did monetary policy achieve its inflation target goal during and after the COVID-19 pandemic?

In 2020 inflation was 0.62 percent, slightly lower than the lower limit of the inflation target goal. In 2021 inflation is expected to return to approximately 2 percent.

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Answers to End-of-Chapter Questions

15-1. You learned in an earlier chapter that if there is an inflationary gap in the short run, then in the long run a new equilibrium arises when input prices and expectations adjust upward, causing the short-run aggregate supply curve to shift upward and to the left and pushing equilibrium real GDP per year back to its long-run value. In this chapter, however, you .

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Chapter 15 Bank of Canada and Monetary Policy learned that the Bank of Canada can eliminate an inflationary gap in the short run by undertaking a policy action that reduces aggregate demand. a. Propose one monetary policy action that could eliminate an inflationary gap in the short run. b. In what way might society gain if the Bank of Canada implements the policy you have proposed instead of simply permitting long-run adjustments to take place? a. One possible policy action would be an open market sale of securities, which would reduce the money supply and shift the aggregate demand curve leftward. Another would be to increase the overnight interest rate, which would shift the aggregate demand curve leftward and eliminate the inflationary gap. b. In principle, the Bank of Canada’s action would reduce inflation more quickly.

15-2. You learned in an earlier chapter that if a recessionary gap occurs in the short run, then in the long run a new equilibrium arises when input prices and expectations adjust downward, causing the short-run aggregate supply curve to shift downward and to the right and pushing equilibrium real GDP per year back to its long-run value. In this chapter, however, you learned that the Bank of Canada can eliminate a recessionary gap in the short run by undertaking a policy action that increases aggregate demand. a. Propose one monetary policy action that could eliminate the recessionary gap in the short run. b. In what way might society gain if the Bank of Canada implements the policy you have proposed instead of simply permitting long-run adjustments to take place? a. One possible policy action would be an open market purchase of securities, which would increase the money supply and shift the aggregate demand curve rightward.

Another would be to reduce the policy rate or advances to chartered banks. b. In principle, the Bank of Canada’s action would push real GDP per year back up more quickly.

15-3. Suppose the Bank of Canada buys $100,000 in bonds from Bank 1, and Bank 1 and all other banks have no excess reserves prior to this purchase. a. What type of policy is this? b. What assets of the Bank of Canada change and by how much? c. What liabilities of the Bank of Canada change and by how much? d. What assets of Bank 1 change and by how much? e. What liabilities of Bank 1 change and by how much? f. If the desired reserve ratio for Bank 1 and all other banks is 10 percent, what is the maximum new loan Bank 1 can create? g. What assets and liabilities of Bank 1 will change when it approves this new loan? h. What is the maximum change in the money supply the entire chartered banking system can create due to the Bank of Canada’s purchase of the bonds? a. It is an expansionary monetary policy because it will increase money supply and lower the interest rate. b. The Bank of Canada’s securities asset will increase by $100,000. .

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition c. The Bank of Canada’s reserves (deposits of Payments Canada members) liability will increase by $100,000. d. Bank 1’s reserves asset will increase and its securities asset will decrease by $100,000. e. No liabilities of Bank 1 will change. f. Bank 1’s desired reserves will not increase as there has been no change in Bank 1’s deposits and its excess reserves will increase by $100,000. Therefore, Bank 1 can grant a new loan up to $100,000. g. When Bank 1 approves a $100,000 loan, its loan asset will increase by $100,000 and its deposit liability will increase by $100,000. h. Chartered banking system can change money supply equal to excess reserves times the money multiplier: $100,000 × 10 = $1,000,000.

15-4. Suppose the Bank of Canada increases its policy rate. a. What type of policy is this? b. What happens to investment? c. What happens to aggregate demand? d. What happens to GDP and inflation? a. b. c. d.

It is contractionary monetary policy.

Investment will decrease.

Aggregate demand will decrease.

GDP will decrease and inflation will decrease.

15-5. Suppose the Bank of Canada advances a $10,000,000 loan to Bank 1, and Bank 1 and all other banks have no excess reserves prior to this loan. a. What type of policy is this? b. What asset of the Bank of Canada changes? c. What liability of the Bank of Canada changes? d. What asset of Bank 1 changes? e. What liability of Bank 1 changes? f. What is the maximum new loan Bank 1 can give if the desired reserve ratio of Bank 1 and all other banks is 5 percent? g. What asset and liability of Bank 1 will change because of this new loan? h. What is the maximum new money the banking system can create in the economy due to the Bank of Canada’s loan to Bank 1? a. It is expansionary monetary policy. b. The Bank of Canada’s advances to Payments Canada members asset will increase by $10,000,000. c. The Bank of Canada’s deposits of Payments Canada members (reserves) liability will increase by $10,000,000. d. Bank 1’s reserves asset will increase by $10,000,000.

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Chapter 15 Bank of Canada and Monetary Policy e. Bank 1’s advances from the Bank of Canada (borrowing) liability will increase by $10,000,000. f. Bank 1’s desired reserves will not increase as there was no change in Bank 1’s deposits, and its excess reserves will increase by $10,000,000. Therefore, Bank 1 can grant a new loan up to $10,000,000. g. When Bank 1 approves a $10,000,000 loan, its loans asset will increase by $10,000,000 and its deposits liability will increase by $10,000,000. h. The chartered banking system can change the money supply equal to excess reserves times the money multiplier; that is, $10,000,000 × 20 = $200,000,000.

15-6. Suppose the Bank of Canada redeposits $100,000 in Bank 1’s account and Bank 1 and all other banks have no excess reserves prior to this redeposit. a. What type of policy is this? b. What assets of the Bank of Canada change and by how much? c. What liabilities of the Bank of Canada change and by how much? d. What assets of Bank 1 change and by how much? e. What liabilities of Bank 1 change and by how much? f. If the desired reserve ratio for Bank 1 and all other banks is 10 percent, what is the maximum new loan Bank 1 can create? g. What assets and liabilities of Bank 1 will change when it approves this new loan? h. What is the maximum change in the money supply the entire chartered banking system can create due to the Bank of Canada’s redeposits? a. It is an expansionary monetary policy because it will increase the money supply and lower the interest rate. b. No assets at the Bank of Canada will change. c. The Bank of Canada’s reserves (deposits of Payments Canada members) liability will increase by $100,000 and government deposits liability will decrease by $100,000. d. Bank 1’s reserves asset will increase by $100,000. e. Bank 1’s government deposits liability will increase by $100,000. f. Bank 1’s desired reserves will increase by $10,000 (10 percent of $100,000 new deposits) and its excess reserves will increase by $90,000. Therefore, Bank 1 can grant a new loan up to $90,000. g. When Bank 1 approves a $90,000 loan, its loans asset will increase by $90,000 and its deposits liability will increase by $90,000. h. The chartered banking system can change the money supply equal to excess reserves times the money multiplier; that is, $90,000 × 10 = $900,000.

15-7. The Bank of Canada implements a monetary policy and buys $2 billion worth of securities from chartered banks. Assume that the desired reserve ratio is 10 percent.

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition Initial Balance Sheet of the Bank of Canada ($ billions) Assets Liabilities Securities 350 Chartered banks’ deposits Advances to chartered 50 Government of Canada deposits banks Notes in circulation

70 60 270

Initial Consolidated Balance Sheet of the Chartered Banks ($ billions) Assets Liabilities Reserves 70 Deposits Securities 240 Advances from the Bank of Canada Loans 746 Capital

700 170 186

a. What balance sheet asset changes will occur for the Bank of Canada? b. What balance sheet liability changes will occur for the Bank of Canada? c. What are the initial changes to the chartered banks’ balance sheet assets (before the multiplier process begins)? d. What are the initial changes to the chartered banks’ balance sheet liabilities (before the multiplier process begins)? e. Due the initial security purchase, what is the maximum amount of money the chartered banking system can create? f. What changes occur to the consolidated balance sheet of the chartered banks as a result of the maximum amount of money they created?

a. The Bank of Canada’s securities will increase by $2 billion to $352 billion. b. The Bank of Canada’s chartered banks’ deposits will increase by $2 billion to $72 billion. c. The chartered banks’ reserves asset will increase to $72 billion and securities asset will decrease to $238 billion. d. The chartered banks’ liabilities will not change. e. The maximum money that can be created by the chartered banking system is excess reserves times the money multiplier; that is, $2 billion × 10 = $20 billion. f. The chartered banks’ loans and deposits will increase by $20 billion. New loans will be $766 billion and new deposits will be $720 billion.

15-8. Suppose the economy is currently in long-run equilibrium. Explain the short-and long-run adjustments that will take place in an aggregate demand–aggregate supply diagram if the Bank of Canada expands the quantity of money in circulation.

The short-run effect is an upward movement along the short-run aggregate supply curve generated by an increase in aggregate demand. The equilibrium price level rises, and equilibrium real GDP increases. In the long run, input prices rise and people anticipate a higher price level, which causes the short-run aggregate supply curve to shift upward and to the left.

The equilibrium price level rises once more, and equilibrium real GDP falls back to its long-run equilibrium level.

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Chapter 15 Bank of Canada and Monetary Policy 15-9. Explain why the net export effect of a contractionary monetary policy reinforces the impact that monetary policy has on equilibrium real GDP per year in the short run.

Because a contractionary monetary policy causes interest rates to increase, financial capital begins to flow into Canada. This causes the demand for dollars to rise, which pushes up the international value of the dollar and makes Canadian exports more expensive to foreign residents. They cut back on their purchases of Canadian products, which tends to reduce AD and Canadian real GDP. 15-10. Suppose that, initially, the Canadian economy was in an aggregate demand–aggregate supply equilibrium at point A along the aggregate demand curve AD in the diagram.

Now, however, the value of the Canadian dollar suddenly appreciates relative to foreign currencies. This appreciation happens to have no measurable effects on either the shortrun or the long-run aggregate supply curve in Canada. It does, however, influence Canadian aggregate demand.

a. Explain in your own words how the dollar appreciation will affect net export expenditures in Canada. b. Of the alternative aggregate demand curves depicted in the figure—AD1 versus AD2—which could represent the aggregate demand effect of the Canadian dollar’s appreciation? What effects does the appreciation have on real GDP and the price level? c. What policy action might the Bank of Canada take to prevent the dollar’s appreciation from affecting equilibrium real GDP in the short run? a. The dollar appreciation will raise the prices of Canadian goods and services from the perspective of foreign residents, so they will reduce their spending on Canadian exports. It will reduce the prices of foreign goods and services from the perspective of Canadian residents, so they will increase their spending on foreign imports. Thus, net export expenditures will decline.

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition b. The fall in net export expenditures will bring about a decrease in Canadian aggregate demand, so the aggregate demand curve AD2 will apply to this situation. In the short run, the equilibrium price level will fall from 118 to 116, and equilibrium real GDP, measured in base-year dollars, will fall from $2.20 trillion to $2.15 trillion. c. The Bank of Canada could engage in a policy action, such as open market purchases, that increase aggregate demand to its original level.

15-11. Suppose that the quantity of money in circulation is fixed but the income velocity of money doubles. If real GDP remains at its long-run potential level, what happens to the equilibrium price level?

The price level doubles. Because MsV = PY, V has doubled, and Ms and Y are unchanged, P must double as well.

15-12. Suppose that following adjustment to the events in Problem 15-11, the Bank of Canada cuts the money supply in half. How does the price level compare with its value before the income velocity and the money supply changed?

The price level remains at its original value. Because MsV = PY, V has doubled, and Y is unchanged, cutting Ms in half leaves P unchanged.

15-13. Consider the following data: The money supply is $1 trillion, the price level equals 2, and real GDP is $5 trillion in base-year dollars. What is the income velocity of money?

MsV = PY, so V = PY/Ms = (2 × $5 trillion)/$1 trillion = 10.

15-14. Consider the data in Problem 15-13. Suppose the money supply increases by $100 billion and real GDP and the income velocity remain unchanged. a. According to the quantity theory of money and prices, what is the new equilibrium price level after full adjustment to the increase in the money supply? b. What is the percentage increase in the money supply? c. What is the percentage change in the price level? d. How do the percentage changes in the money supply and price level compare? a. b. c. d.

MsV = PY, so P = MsV/Y = ($1.1 trillion × 10)/$5 trillion = 2.2. $100 billion/$1 trillion = 0.1, or 10 percent 0.2/2 = 0.1, or 10 percent Both the money supply and the price level increased by 10 percent.

15-15. Assuming that the Bank of Canada determines that inflation is the most significant problem in the economy and that it wishes to employ all of its policy instruments, what should the Bank of Canada do with its policy tools?

The Bank of Canada could do the following: open market sales, less loans to chartered banks, drawdowns, and increase the policy interest rate.

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Chapter 15 Bank of Canada and Monetary Policy 15-16. Suppose that the Bank of Canada implements each of the policy changes you described in Problem 15-15. Explain how the net export effect resulting from these monetary policy actions will reinforce the effects that operate through interest rate changes.

Any one of these contractionary actions will tend to raise interest rates, which in turn will induce international inflows of financial capital. This pushes up the value of the dollar and makes Canadian goods less attractive abroad. As a consequence, real planned total expenditures on Canadian goods decline even further.

15-17. During three intervals between 2008 and 2015, the Federal Reserve engaged in policy actions involving expanding its assets that it termed “quantitative easing.” Total reserves in the banking system increased during each interval. Hence, the Federal Reserve’s liabilities to banks increased, and at the same time its assets rose as it purchased more assets—many of which were securities with private market values that had dropped considerably. The money multiplier declined, so the net increase in the money supply was negligible. Indeed, during a portion of the overall period, the money supply actually declined before rising near its previous value. Evaluate whether the Fed’s “quantitative easing” was a monetary policy or credit policy action.

The money supply did not change, so this did not actually constitute a monetary policy action.

Instead, the Fed only expanded its reserves and, hence, its liabilities, which corresponded to the increase in the Fed’s holdings of privately issued assets. Consequently, the Fed’s “quantitative easing” was primarily a credit policy action.

15-18. Consider the two panels of Figure 15-3. Suppose that the Bank of Canada wants to implement a monetary policy action aimed at pushing down the rate of interest prevailing in the economy. Use the appropriate panel of the figure to assist in explaining whether the Bank of Canada should buy or sell existing bonds.

The appropriate panel of the figure is panel (b), in which the Bank of Canada buys bonds.

This action reduces the supply of existing bonds in the private marketplace. After this purchase, at the initial bond price P1, an excess quantity demanded of bonds exists, so the bond price must rise to P3.

15-19. Take a look at the two panels of Figure 15-3, and also consider Figure 15-2. Suppose that the Bank of Canada wants to implement a monetary policy aimed at inducing individuals and businesses to demand a smaller quantity of money. Use the appropriate panel of Figure 15-2 to assist in explaining whether the Bank of Canada should buy or sell bonds.

Figure 15-2 indicates that the interest rate must rise to induce a lower quantity of money demanded. Generating a higher interest rate requires a lower price of bonds, so panel (a) of Figure 15-3 is appropriate. When the Bank of Canada sells bonds, the supply of existing bonds in the private marketplace rises. At the initial bond price P1, an excess quantity supplied of bonds exists, so the bond price must fall to P2.

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition 15-20. Take a look at Figure 15-4. Discuss a policy action that the Bank of Canada could undertake to bring about the increase in aggregate demand displayed in this figure.

To generate an increase in aggregate demand, the Bank of Canada would have to induce a rise in the price of bonds and a corresponding reduction in the interest rate, which would be associated with an increase in the quantity of money in circulation. To boost the price of bonds, the Bank of Canada would buy existing bonds, which would reduce the supply of these bonds in the private marketplace.

15-21. Consider Figure 15-5. Discuss a policy action that the Bank of Canada could undertake to generate the decrease in aggregate demand displayed in this figure.

To bring about a decrease in aggregate demand, the Bank of Canada would have to generate a fall in the price of bonds and a related increase in the interest rate, which would be associated with a decrease in the quantity of money in circulation. To lower the price of bonds, the Bank of Canada would sell existing bonds, which would raise the supply of these bonds in the private marketplace.

15-22. Take a look at Figure 15-7. Suppose that a multiple reduction in real GDP is the final outcome that the Bank of Canada desires in the last box in the figure. Explain the required directions of effects—that is, increases or decreases—that must occur in the preceding boxes in the figure in order to yield this desired decrease in real GDP. The required change in monetary policy would be an open market sale. This initial policy action would bring about a reduction in excess reserves, a multiple reduction in the money supply, an increase in the interest rate (and corresponding decrease in bond prices), and a decrease in investment. The decline in investment would induce the Bank of Canada’s desired multiple reduction in real GDP. 15-23. Consider Figure 15-8. Discuss a specific monetary policy action that the Bank of Canada could implement to induce the effects traced out by this figure.

An open market purchase would generate an increase in excess reserves, a multiple increase in the money supply, a decrease in the interest rate (and related increase in bond prices), and an increase in investment. The rise in investment would bring about the increase in aggregate demand and short-run increase in equilibrium real GDP.

Appendix F: Answers to End-of-Appendix Questions F-1.

Suppose that each 0.1 percentage point decrease in the equilibrium interest rate induces a $10 billion increase in real planned investment spending by businesses. In addition, the investment multiplier is equal to 5, and the money multiplier is equal to 4. Furthermore, every $20 billion increase in the money supply brings about a 0.1 percentage point reduction in the equilibrium interest rate. Use this information to answer the following questions under the assumption that all other things are equal. a. How much must real planned investment increase if the Bank of Canada desires to bring about a $100 billion increase in equilibrium real GDP? .

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Chapter 15 Bank of Canada and Monetary Policy b. c. a. b.

c.

F-2.

Because the investment multiplier equals 5, a $20 billion increase in planned investment will generate a five-fold increase in equilibrium real GDP, or a rise of $100 billion.

A 0.2 percentage point decrease in the equilibrium interest rate is required to bring about a $20 billion increase in planned investment. Thus, because every $20 billion rise in the money supply pushes the interest rate down by 0.1 percentage points, a $40 billion ($20 billion × 2) increase in the money supply is necessary.

The money multiplier is 4, so a $10 billion increase in reserves generated by an open market purchase is required to boost the money supply by 4 × $10 billion = $40 billion.

Suppose that each 0.1 percentage point increase in the equilibrium interest rate induces a $5 billion decrease in real planned investment spending by businesses. In addition, the investment multiplier is equal to 4, and the money multiplier is equal to 3. Furthermore, every $9 billion decrease in the money supply brings about a 0.1 percentage point increase in the equilibrium interest rate. Use this information to answer the following questions under the assumption that all other things are equal. a. How much must real planned investment decrease if the Bank of Canada desires to bring about an $80 billion decrease in equilibrium real GDP? b. How much must the money supply change for the Bank of Canada to induce the change in real planned investment calculated in part (a)? c. What dollar amount of open market operations must the Bank of Canada undertake to bring about the money supply change calculated in part (b)? a. b.

c.

F-3.

How much must the money supply change for the Bank of Canada to induce the change in real planned investment calculated in part (a)?

What dollar amount of open market operations must the Bank of Canada undertake to bring about the money supply change calculated in part (b)?

Because the investment multiplier equals 4, a $20 billion decrease in planned investment will generate a four-fold decrease in equilibrium real GDP, or a decline of $80 billion.

A 0.4 percentage point increase in the equilibrium interest rate is required to bring about a $20 billion decrease in planned investment. Thus, because every $9 billion reduction in the money supply pushes the interest rate down by 0.1 percentage points, a $36 billion ($9 billion × 4) decrease in the money supply is necessary.

The money multiplier is 3, so a $12 billion decrease in reserves generated by an open market sale is required to reduce the money supply by 3 × $12 billion = $36 billion.

Assume that the following conditions exist: a. All banks are fully loaned up—there are no excess reserves, and desired excess reserves are always zero. b. The money multiplier is 3. c. The planned investment schedule is such that at a 6 percent rate of interest, investment is $1,200 billion; at 5 percent, investment is $1,225 billion. d. The investment multiplier is 3. .

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition e. f.

The initial equilibrium level of real GDP is $18 trillion.

The equilibrium rate of interest is 6 percent.

Now the Bank of Canada engages in expansionary monetary policy. It buys $1 billion worth of bonds, which increases the money supply, which in turn lowers the market rate of interest by 1 percentage point. Determine how much the money supply must have increased, and then trace out the numerical consequences of the associated reduction in interest rates on all the other variables mentioned.

Through its purchase of $1 billion in bonds, the Bank of Canada increased reserves by $1 billion. This ultimately caused a $3 billion increase in the money supply after full multiple expansion. The 1 percentage point drop in the interest rate, from 6 percent to 5 percent, caused investment to rise by $25 billion, from $1,200 billion to $1,225 billion. An investment multiplier of 3 indicates that equilibrium real GDP rose by $75 billion, to $18,075 billion, or $18.075 trillion.

F-4.

Assume that the following conditions exist: a. All banks are fully loaned up—there are no excess reserves, and desired excess reserves are always zero. b. The money multiplier is 4. c. The planned investment schedule is such that at a 4 percent rate of interest, investment is $1,400 billion. At 5 percent, investment is $1,380 billion. d. The investment multiplier is 5. e. The initial equilibrium level of real GDP is $19 trillion. f. The equilibrium rate of interest is 4 percent.

Now the Bank of Canada engages in contractionary monetary policy. It sells $2 billion worth of bonds, which reduces the money supply, which in turn raises the market rate of interest by 1 percentage point. Determine how much the money supply must have decreased, and then trace out the numerical consequences of the associated increase in interest rates on all the other variables mentioned.

Through its sale of $2 billion in bonds, the Bank of Canada reduced reserves by $2 billion. This ultimately caused an $8 billion decrease in the money supply after full multiple contraction. The 1 percentage point rise in the interest, from 4 percent to 5 percent, caused investment to fall by $20 billion, from $1,400 billion to $1,380 billion. An investment multiplier of 5 indicates that equilibrium real GDP fell by $100 billion from $19,000 billion to $18,900 billion.

F-5.

The Bank of Canada has set money supply (Ms) at $2 trillion. The total demand for money, Md, and total demand for gross private domestic investment, I, are given. The Canadian economy is in equilibrium in the Keynesian range of the SRAS curve at $1.40 trillion (without I ), and the expenditure multiplier is 1.5.

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Chapter 15 Bank of Canada and Monetary Policy

a. What is the equilibrium interest rate? b. How much gross private domestic investment would there be? c. If gross private domestic investment were added to the economy, what would be the new equilibrium GDP? d. Suppose the Bank of Canada has determined that full employment GDP is $2.3 trillion.

What type of gap is Canada experiencing? e. Calculate the new level of gross private domestic investment that would cause Canada’s GDP to change to $2.3 trillion. f. Determine the new interest rate that will achieve this level of gross private domestic investment. g. In order to change the interest rate, determine the Bank of Canada’s new level of money supply in the economy. a. b. c. d. e. f. g.

F-6.

4 percent $0.4 trillion $2.0 trillion Recessionary gap $0.6 trillion 3.5 percent $2.5 trillion The Bank of Canada has set money supply (Ms) at $4.5 trillion. The total demand for money, Md, and total demand for gross private domestic investment, I, are given. The Canadian economy is in equilibrium in the Keynesian range of the SRAS curve at $2.20 trillion (without I ), and the expenditure multiplier is 2.0.

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition a. What is the equilibrium interest rate? b. How much gross private domestic investment would there be? c. If gross private domestic investment were added to the economy, what would be the new equilibrium GDP? d. Suppose the Bank of Canada has determined that full employment GDP is $3.2 trillion.

What type of gap is Canada experiencing? e. Calculate the new level of gross private domestic investment that would cause Canada’s GDP to change to $3.2 trillion. f. Determine the new interest rate that will achieve this level of gross private domestic investment. g. In order to change the interest rate, determine the Bank of Canada’s new level of money supply in the economy. a. b. c. d. e. f. g.

1.5 percent $1.4 trillion $4.0 trillion Inflationary gap $1.0 trillion 2.5 percent $3.5 trillion

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Chapter 16

Stabilization in an Integrated World Economy 

Answers to Questions for Critical Analysis

AI: APPLYING AI MAY YIELD RESULTS THAT CENTRAL BANKS DO NOT DESIRE Why is it important to evaluate past performances of policymakers by taking into account only information that was available to them at the time they made their decisions? Explain briefly.

Hindsight is 20-20. After time has passed, all the issues that led to or exacerbated a problem become clear. At the time a decision needs to be made, however, not all these issues are known.

Therefore, to correctly evaluate the past performance of policymakers, you must assess them using the facts they had available to them at the time.

WHAT HAPPENS WHEN THE GOVERNMENT REQUIRES PRICES TO END WITH ZEROS Assume that a law is passed in Canada requiring all posted retail prices to end in a zero (0).

How would your economic life change?

Just like the penny, nickels would likely gradually be eliminated, because you would no longer use them.

Restaurant menu prices, online retail prices, and so on would, to be sure, either be rounded down or rounded up. While you might think that all prices would be rounded up, that would imply that, previously, every retailer was setting its retail prices at less than profit-maximizing prices. It is more likely that some prices would be rounded up and others down.

If you were in the business world, however, you would still negotiate the prices of your company’s inputs, such as raw materials and even labour, down to the last penny. The law would only affect posted retail sales.

SEPARATING TEMPORARY INFLATION VARIATIONS FROM A POLICY-RELEVANT TREND IN INFLATION DYNAMICS Why do you think instability in a relationship that policymakers try to use as a guidepost complicates the policymakers’ efforts to formulate appropriate policy actions? Explain briefly.

If the relationship used by policymakers is not stable, then it is difficult for them to tell if they should perform a particular policy action. The instability could be the result of a new relationship or it could be the result of external factors. Regardless, they would be unable to tell if the relationship still holds and if their policy changes would have the anticipated impact.

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Economics in Your Life

WILL THE BANK OF CANADA FOLLOW THE FED’S MOVE TO “AVERAGE INFLATION TARGETING”?

For Critical Thinking How might the theory of the short-run Phillips curve be applied to motivate the Bank of Canada to try to achieve a particular inflation target in order to attain a desired rate of unemployment?

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition The short-run Phillips curve states that inflation and unemployment are inversely related.

Therefore, if the Bank of Canada wants to target a desired rate of unemployment below the natural unemployment rate, the rate of inflation would need to be a specific, positive targeted value.

Real Application If the Bank of Canada succeeds in raising the rate of inflation, are you necessarily worse off?

Why or why not?

Of course, if there is increased inflation, you will have to pay higher prices on average. But at the other end of this equation, those selling you goods and services at higher prices will receive higher payments. Clearly, then, even if you believe that you are worse off because of higher prices, the economy as a whole will not necessarily be worse off, because producers and sellers are the recipients of those higher prices. You may very well see your annual income rise with inflation. (Admittedly, your own annual income might rise by more or less than the rate of inflation.)

Also, as we have pointed out previously, if you have a fixed-interest mortgage or any other loan and there is an unanticipated increase in the rate of inflation, the real interest rate that you will pay on that loan will fall. You will be better off.

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Issues & Applications

THE BREAKDOWN OF THE CANADIAN RELATIONSHIP BETWEEN INFLATION AND UNEMPLOYMENT For Critical Thinking If the interpretation offered by proponents of passive (nondiscretionary) policymaking is correct, then if the unemployment rate were to rise during the next few years, would you expect the inflation rate to change in response? If so, would the inflation rate rise or fall?

Proponents of passive (nondiscretionary) policymaking suggest there is no relationship between inflation and the unemployment rate, so any changes in the inflation rate would have nothing to do with the increase in unemployment.

Real Application Assume that you have become part of the staff of the Bank of Canada. Why might you be more likely to support active (discretionary) policymaking?

Self-interest. There would be a greater demand for your skills and services if the policymaking team at the Bank of Canada supported discretionary policymaking. Obviously, if there were a trend toward passive-only policymaking, there would be less demand for economists, statisticians, and others at the Bank of Canada. Indeed, if passive (nondiscretionary) policymaking were taken to its ultimate end, the Bank would have precious little demand for research staffers.

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Answers to End-of-Chapter Questions

16-1. Suppose that the government altered the computation of the unemployment rate by including people in the military as part of the labour force. a. How would this affect the measured unemployment rate? .

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Chapter 16 Stabilization in an Integrated World Economy b. How would such a change affect estimates of the natural rate of unemployment? c. If this computational change were made, would it in any way affect the logic of the short-run and long-run Phillips curve analysis and its implications for policymaking?

Why might the government wish to make such a change? a. The actual unemployment rate, which equals the number of people unemployed divided by the labour force, would decline because the labour force would rise while the number of people unemployed would remain unchanged. b. Natural unemployment rate estimates would also be lower. c. The logic of the short- and long-run Phillips curves would not be altered. The government might wish to make this change if it feels that those in the military “hold jobs” and therefore should be counted as employed within the Canadian economy.

16-2. The natural rate of unemployment depends on factors that affect the behaviour of both workers and firms. Make a list of possible factors affecting workers and firms that you believe are likely to influence the natural rate of unemployment.

For both workers and firms, these include access to information and the degree of competition in product markets. For firms, the extent of government taxation and regulation are important factors affecting their willingness to hire workers and, consequently, the natural rate of unemployment. For workers, training and skills are crucial factors that affect the natural unemployment rate.

16-3. Suppose that more unemployed people who are classified as part of frictional unemployment decide to stop looking for work and start their own businesses instead.

What is likely to happen to each of the following, other things being equal? a. The natural unemployment rate b. The economy’s Phillips curve a. The measured unemployment rate when all adjustments have occurred will now always be lower than before, so the natural unemployment rate will be smaller. b. The Phillips curve will shift inward, because the unemployment rate will decline at any given inflation rate.

16-4. Suppose that people who previously held jobs become cyclically unemployed at the same time the inflation rate declines. Would the result be a movement along or a shift of the short-run Phillips curve? Explain your reasoning.

Because the unemployment rate has increased as a consequence of a short-run cyclical adjustment in conjunction with a decline in the inflation rate, there would be a movement downward and rightward along the short-run Phillips curve.

16-5. Suppose that people who previously held jobs become structurally unemployed due to the establishment of new government regulations during a period in which the inflation rate remains unchanged. Would the result be a movement along or a shift of the short-run Phillips curve? Explain your reasoning. .

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition Because the unemployment rate has increased as a consequence of a rise in structural unemployment while the inflation rate has remained unchanged, the short-run Phillips curve will tend to shift rightward together with a rightward shift in the long-run Phillips curve as the natural rate of unemployment increases.

16-6. Suppose that the greater availability of online job placement services generates a reduction in frictional unemployment during an interval in which the inflation rate remains unchanged. Would the result be a movement along or a shift of the short-run Phillips curve? Explain your reasoning.

Because the unemployment rate has decreased as a consequence of a reduction in frictional unemployment while the inflation rate has remained unchanged, the short-run Phillips curve will tend to shift leftward together with a leftward shift in the long-run Phillips curve as the natural rate of unemployment decreases.

16-7. Consider a situation in which Bank of Canada conducts monetary policy much more erratically than in past years. The consequence is that the quantity of money in circulation varies in a much more unsystematic and, hence, hard-to-predict manner. According to the policy irrelevance proposition, is it more or less likely that the Bank of Canada’s policy actions will cause real GDP to change in the short run? Explain.

Because monetary policy is now harder for people to predict, the unsystematic variations in the quantity of money in circulation will tend to be more likely to generate changes in equilibrium real GDP. Inflation expectations will not change and the short-run aggregate supply curve will remain in position as the aggregate demand curve shifts.

16-8. People called “Bank of Canada watchers” earn their living by trying to forecast what policies the Bank of Canada will implement within the next few weeks and months.

Suppose that Bank of Canada watchers discover that the current group of Bank of Canada’s officials is following systematic and predictable policies intended to reduce the unemployment rate. The Bank of Canada watchers then sell this information to firms, unions, and others in the private sector. If pure competition prevails, prices and wages are flexible, and people form rational expectations, are the Bank of Canada’s policies enacted after the information sale likely to have their intended effects on the unemployment rate?

No, because then workers and firms will speedily adjust nominal wages and other input prices when the price level changes in response to the Bank of Canada’s policy actions. As a result, real GDP will not change, so the actual unemployment rate will remain unaltered.

16-9. Suppose that economists were able to use Canadian economic data to demonstrate that the rational expectations hypothesis is true. Would this be sufficient to support the policy irrelevance proposition?

No. It could still be true that wages and other prices of factors of production adjust sluggishly to changes in the price level. Then a rise in aggregate demand that boosts the price level brings

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Chapter 16 Stabilization in an Integrated World Economy about an upward movement along the short-run aggregate supply curve, causing equilibrium real GDP to rise.

16-10. Both the traditional Keynesian theory discussed in a previous chapter and the new Keynesian theory considered in this chapter indicate that the short-run aggregate supply curve is horizontal. a. In terms of their short-run implications for the price level and real GDP, is there any difference between the two approaches? b. In terms of their long-run implications for the price level and real GDP, is there any difference between the two approaches? a. The traditional Keynesian approach and the sticky-price new Keynesian approaches have the same short-run implications: If aggregate demand increases (or decreases), the equilibrium price level remains unchanged in the short run. The largest possible rise (or fall) in equilibrium real GDP takes place, given by a movement along the horizontal aggregate supply curve. b. The long-run implications of the two approaches differ. The traditional Keynesian approach emphasizes only the short run and fails to contemplate how long-run adjustment will take place. In contrast, the new Keynesian approach suggests that in the long run, firms seeking higher profits will choose to incur menu costs and raise (reduce) their prices in response to increases (decreases) in aggregate demand. As a consequence, equilibrium real GDP eventually returns to a long-run equilibrium level.

16-11. Consider the diagram, which is drawn under the assumption that the new Keynesian sticky-price theory of aggregate supply applies. Assume that at present, the economy is in long-run equilibrium at point A. Answer the following questions.

a. Suppose that there is a sudden increase in desired investment expenditures. Which of the alternative aggregate demand curves—AD2 or AD3—will apply after this event occurs? Other things being equal, what will happen to the equilibrium price level and to equilibrium real GDP in the short run? Explain.

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition b. Other things being equal, after the event and adjustments discussed in part (a) have taken place, what will happen to the equilibrium price level and to equilibrium real GDP in the long run? Explain. a. An increase in desired investment spending induces an increase in aggregate demand, so AD3 applies. The price level is unchanged in the short run, and equilibrium real GDP rises from $2.20 trillion at point A to $2.25 trillion at point C. b. Over time, firms perceive that they can increase their profits by adjusting prices upward in response to the increase in aggregate demand. Thus, firms eventually will incur the menu costs required to make these price adjustments. As they do so, the aggregate supply curve will shift upward, from SRAS to SRAS2, as shown in the diagram below. Real GDP will return to its original level of $2.20 trillion, in baseyear dollars. The price level will increase to a level above 119, such as 124.

16-12. Normally, when aggregate demand increases, firms find it more profitable to raise prices than to leave prices unchanged. The idea behind the small menu cost explanation for price stickiness is that firms will leave their prices unchanged if their profit gain from adjusting prices is less than the menu costs they would incur if they change prices. If firms anticipate that a rise in demand is likely to last for a long time, does this make them more or less likely to adjust their prices when they face small menu costs? (Hint: Profits are a flow that firms earn from week to week and month to month, but small menu costs are a one-time expense.)

Increasing the price of a product in response to a long-lasting increase in demand will yield higher profits for several periods. The value of this stream of future profits is more likely to be sufficiently large to outweigh a small, one-time menu cost. In this situation, it is more likely that firms will raise their prices.

16-13. The policy relevance of new Keynesian inflation dynamics based on the theory of small menu costs and sticky prices depends on the exploitability of the implied relationship between inflation and real GDP. Explain in your own words why the average time between price adjustments by firms is a crucial determinant of whether policymakers can actively exploit this relationship to try to stabilize real GDP. .

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Chapter 16 Stabilization in an Integrated World Economy If the average time between price adjustments by firms is significant, then the short-run aggregate supply curve could be regarded as horizontal, as hypothesized by the new Keynesian theorists. As a consequence, there would be a short-run tradeoff between inflation and real GDP that policymakers potentially could exploit.

16-14. Consider Figure 16-2. Explain whether the cyclical unemployment rate is positive, zero, or negative at point E2, after the shift in the aggregate demand curve from AD1 to AD2. In addition, explain whether the cyclical unemployment rate is positive, zero, or negative at point E3, following the shift in the short-run aggregate supply curve from SRAS1 to SRAS2.

At point E2, actual real GDP exceeds the long-run real GDP level, so the actual unemployment rate is less than the natural rate of unemployment, and cyclical unemployment is negative. At point E3, actual real GDP equals the long-run real GDP level, so the actual unemployment rate equals the natural rate of unemployment, and cyclical unemployment is zero.

16-15. Take a look at Figure 16-3. Explain whether the cyclical unemployment rate is positive, zero, or negative at point E2, after the shift in the aggregate demand curve from AD1 to AD2. In addition, explain whether the cyclical unemployment rate is positive, zero, or negative at point E3, following the shift in the short-run aggregate supply curve from SRAS1 to SRAS2.

At point E2, actual real GDP is less than the long-run real GDP level, so the actual unemployment rate is greater than the natural rate of unemployment, and cyclical unemployment is positive. At point E3, actual real GDP equals the long-run real GDP level, so the actual unemployment rate equals the natural rate of unemployment, and cyclical unemployment is zero.

16-16. Consider panel (b) of Figure 16-4, and suppose that the economy initially operates at point A, at which the inflation rate is 0 percent and the unemployment rate is 5 percent, which is the natural rate of unemployment. Then the inflation rate decreases to -1 percent. Does additional cyclical, frictional, or structural unemployment account for the resulting rise in the unemployment rate at point C? Explain briefly.

The fall in the inflation rate to –1 percent corresponds to a short-run reduction in real GDP below the long-run real GDP level, which is why the unemployment rate increases. The natural unemployment rate equals the sum of structural and frictional unemployment rates, so the increase in the actual unemployment rate above the natural rate corresponds to additional cyclical unemployment.

16-17. Take a look at panel (b) of Figure 16-4, and suppose that the economy initially operates at point A, at which the inflation rate is 0 percent and the unemployment rate is 5 percent, which is the natural rate of unemployment. Then the inflation rate increases to 3 percent.

Does reduced cyclical, frictional, or structural unemployment account for the resulting decrease in the unemployment rate at point B? Explain briefly.

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition The rise in the inflation rate to 3 percent corresponds to a short-run increase in real GDP above the long-run real GDP level, which is why the unemployment rate decreases. The natural unemployment rate equals the sum of structural and frictional unemployment rates, so the decrease in the actual unemployment rate below the natural rate arises because of a reduction in cyclical unemployment.

16-18. Consider Figure 16-5, and suppose that the economy initially operates at point A, at which the inflation rate is 0 percent and the unemployment rate is 5 percent, which is the natural rate of unemployment. In the long run, will an increase in the inflation rate to 3 percent result in the economy operating at point B or at point F1? Explain your reasoning.

In the long run, expectations will adjust to reflect the actual inflation. People will recognize that higher nominal wages have not resulted in higher real wages, so higher nominal wages that accompany the inflation will not entice those people out of unemployment. Thus, the unemployment rate will remain at 5 percent at point F1 following an outward shift of the Phillips curve.

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Chapter 17

Policies and Prospects for Global Economic Growth 

Answers to Questions for Critical Analysis

AI: DEVELOPING NATIONS COULD FACE BIG PROBLEMS How might inefficiencies that weaken the delivery of education to residents of some developing nations also delay reaping gains from applications of big data techniques in businesses and governments?

Inefficiencies in delivering education to residents of developing nations will limit the amount of education, or human capital, they receive. This limited increase in human capital will limit the amount of gains they receive from applications of big data techniques, which could limit the amount of potential economic growth.

COULD REGULATORY COMPETITION REDUCE GOVERNMENT CORRUPTION THAT UNDERMINES ECONOMIC GROWTH? If implementation of these researchers’ proposal reduced bribery of government officials, why might we anticipate the result to be a diminishment of dead capital problems that hinder economic growth?

The reduction of bribery leads to lower costs of entry into a particular market. By lowering the costs of entry, more people can compete for capital resources. Through this competition, the price of capital resources would more accurately reflect their potential benefits (most efficient uses), and owners of this capital will attempt to make the best use of this capital to earn the maximum rewards.

BACKING UP MICROLENDERS THAT PROVIDE LOANS TO DEVELOPING NATIONS’ RESIDENTS AFTER NATURAL DISASTERS Someday, you may be a victim of a natural disaster, such as a hurricane or a flood. Why will you not be seeking the help of a “microlender” in this time of financial need?

For the most part, you will probably have purchased insurance to cover any losses from a natural disaster. If you own a house, most likely you will also have a mortgage. The mortgage lender will have required you to pay for homeowners’ insurance that covers losses from natural disasters.

If you still require financial assistance, there will probably be one or more local, provincial, or federal agencies to which you can apply for that assistance.

Additionally, there will probably be numerous private lending institutions to which you can make an application for a short-term loan to “tide you over.” The more solid your employment situation, the easier it would be to obtain such a short-term loan.

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Economics in Your Life

JAPAN’S DEAD CAPITAL PROBLEM For Critical Thinking What likely motivates many people to abandon lands that they informally inherit from departed relations?

For these people, the cost of legally owning the land (the taxes owed plus the amount to legally establish formal ownership) far outweigh the benefits that the land can provide (in terms of creating goods and services or the income received from selling the land).

Real Application At some point in your life, you might purchase real property—vacant land or land with a house or a condo. Why will you not be worried about the question of who has title to this real property once you purchase it?

In Canada we have a well-functioning real property recording system. Virtually every square metre of land and the structures built on that land are owned by either a person, a trust, a business, a local government, a provincial government, or the federal government. Local governments maintain excellent records that can quickly identify the owner of any piece or parcel of real property. Such is not the situation in many other countries.

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Issues & Applications

A POSITIVE EFFECT OF THE GLOBAL ECONOMIC GROWTH SHIFT: A LOWER WORLD POVERTY RATE For Critical Thinking How could increased economic freedom have enabled the increased global population to have produced more real GDP per capita?

Increased economic freedom means more clearly defined property rights and the ability to exchange goods and services with little government intervention. By clearly defining property rights to capital, owners can more efficiently use the capital to increase real GDP or sell it to those who would use it productively. In addition, less government intervention lowers costs of entry into the marketplace, which can increase real GDP. If these increases in real GDP are greater than the increase in population, per capita real GDP will rise.

Real Application You might be a younger person working in a popular city, such as Toronto or Vancouver. You might believe that, although you are not living in poverty, you have trouble making ends meet.

You might, for example, have to share an apartment or a rented house with several roommates.

What options do you have to improve your standard of living?

First, consider the reasons why you might be sharing an apartment or a house with others.

The cost of housing is relatively high in popular cities such as Toronto and Vancouver.

Normally, supply and demand analysis suggests that there would be a higher quantity of houses supplied. Not so in those cities, however. Restrictive zoning laws prevent more housing units from being built.

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Chapter 17 Policies and Prospects for Global Economic Growth So, getting back to your dilemma. You can improve your economic lot in life by considering a move to a city that has less expensive housing. You might, for example, move to Halifax or Edmonton or Winnipeg, which offer lower costs of living. You could alternatively move outside of the city, to the suburbs, and find a job that allows you to telecommute all or most days of the week. You could also consider increasing your human capital by obtaining more skills either through online courses or going back to school for an advanced degree. With more human capital, you are likely to earn a higher annual wage.

Finally, you could do a study of income tax rates in other provinces and cities to determine where you might move to obtain a higher real (after-tax) standard of living (corrected for the true cost of living in that other city or province).

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Answers to End-of-Chapter Questions

17-1. A country’s real GDP is growing at an annual rate of 3.1 percent, and the current rate of growth of per capita real GDP is 0.3 percent per year. What is the population growth rate in this nation?

Population growth rate = real GDP growth rate − rate of growth of per capita real GDP = 3.1 percent − 0.3 percent = 2.8 percent 17-2. The annual rate of growth of real GDP in a developing nation is 0.3 percent. Initially, the country’s population was stable from year to year. Recently, however, a significant increase in the nation’s birthrate has raised the annual rate of population growth to 0.5 percent. a. What was the rate of growth of per capita real GDP before the increase in population growth? b. If the rate of growth of real GDP remains unchanged, what is the new rate of growth of per capita real GDP following the increase in the birthrate? a. Rate of growth of per capita real GDP = rate of growth of real GDP – rate of growth of population = 0.3 percent – 0 = 0.3 percent b. Rate of growth of per capita real GDP = rate of growth of real GDP – rate of growth of population = 0.3 percent – 0.5 percent = – 0.2 percent 17-3. A developing country has determined that each additional $1 billion of net investment in capital goods adds 0.01 percentage points to its long-run average annual rate of growth of per capita real GDP. a. Domestic entrepreneurs recently began to seek official approval to open a range of businesses employing capital resources valued at $20 billion. If the entrepreneurs undertake these investments, by what fraction of a percentage point will the nation’s long-run average annual rate of growth of per capita real GDP increase, other things being equal? b. After weeks of effort trying to complete the first of 15 stages of bureaucratic red tape necessary to obtain authorization to start their businesses, a number of entrepreneurs decide to drop their investment plans completely, and the amount of official investment that actually takes place turns out to be $10 billion. Other things being equal, by what fraction of a percentage point will this decision reduce the nation’s .

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition long-run average annual rate of growth of per capita real GDP from what it would have been if investment had been $20 billion? a. 20 × 0.01 percent = 0.2 percent b. 10 × 0.01 percent = 0.1 percent 17-4. Consider the estimates that the World Bank has assembled for the following nations:

Country Angola Bosnia-Herzegovina Morocco Togo Uruguay

Legal Steps Required to Start a Business 14 12 11 14 10

Days Required to Start a Business 146 59 36 63 27

Cost of Starting a Business as a Percentage of Per Capita GDP 838% 52% 19% 281% 47%

Rank the nations in order, starting with the one you would expect to have the highest rate of economic growth, other things being equal. Explain your reasoning.

Morocco or Uruguay, then Bosnia-Herzegovina, Togo, and Angola. The cost of starting a business is higher in Uruguay than in Morocco, but starting a business in Uruguay requires fewer legal steps. One of these two nations is likely to experience higher growth, other things being equal, than the others (where the cost of starting a business, the number of days required to start a business, and the legal steps required to start a business are much higher).

17-5. Suppose that every $500 billion of dead capital reduces the average rate of growth in worldwide per capita real GDP by 0.1 percentage points. If there is $10 trillion in dead capital in the world, by how many percentage points does the existence of dead capital reduce average worldwide growth of per capita real GDP? $10 trillion/$0.5 trillion × 0.1 percent = 2 percentage points 17-6. Assume that each $1 billion in net capital investment generates 0.3 percentage points of the average percentage rate of growth of per capita real GDP, given the nation’s labour resources. Firms have been investing exactly $6 billion in capital goods each year, so the annual average rate of growth of per capita real GDP has been 1.8 percent. Now a government that fails to consistently adhere to the rule of law has come to power, and firms must pay $100 million in bribes to gain official approval for every $1 billion in investment in capital goods. In response, companies cut back their total investment spending to $4 billion per year. If other things are equal and companies maintain this rate of investment, what will be the nation’s new average annual rate of growth of per capita real GDP? $4 billion × 0.3 = 1.2 percent .

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Chapter 17 Policies and Prospects for Global Economic Growth 17-7. During the past year, several large banks extended $200 million in loans to the government and several firms in a developing nation. International investors also purchased $150 million in bonds and $350 million in stocks issued by domestic firms.

Of the stocks that foreign investors purchased, $100 million were shares that amounted to less than a 10 percent interest in domestic firms. This was the first year this nation had ever permitted inflows of funds from abroad. a. Based on the investment category definitions discussed in this chapter, what was the amount of portfolio investment in this nation during the past year? b. What was the amount of foreign direct investment in this nation during the past year? a. Portfolio investment is equal to $150 million in bonds plus $100 million in stocks representing ownership of less than 10 percent, or $250 million. (Bank loans are neither portfolio investment nor foreign direct investment.) b. Foreign direct investment is equal to $250 million in stocks representing an ownership share of at least 10 percent. (Bank loans are neither portfolio investment nor foreign direct investment.)

17-8. Last year, $100 million in outstanding bank loans to a developing nation’s government were not renewed, and the developing nation’s government paid off $50 million in maturing government bonds that had been held by foreign residents. During that year, however, a new group of banks participated in a $125 million loan to help finance a major government construction project in the capital city. Domestic firms also issued $50 million in bonds and $75 million in stocks to foreign investors. All of the stocks issued gave the foreign investors more than 10 percent shares of the domestic firms. a. What was gross foreign investment in this nation last year? b. What was net foreign investment in this nation last year? a. $0, because net issues of bonds amounted to $50 million in bonds issued by domestic firms minus $50 million in bonds retired by the government, or $0. (Bank loans are neither portfolio investment nor foreign direct investment.) b. $75 million in stocks representing at least a 10 percent ownership share. (Bank loans are neither portfolio investment nor direct foreign investment.)

17-9. Identify which of the following situations currently faced by international investors are examples of adverse selection and which are examples of moral hazard. a. Among the governments of several developing countries that are attempting to issue new bonds this year, it is certain that a few will fail to collect taxes to repay the bonds when they mature. It is difficult, however, for investors considering buying government bonds to predict which governments will experience this problem. b. Foreign investors are contemplating purchasing stock in a company that, unknown to them, may have failed to properly establish legal ownership over a crucial capital resource. c. Companies in a less developed nation have already issued bonds to finance the purchase of new capital goods. After receiving the funds from the bond issue, however, the company’s managers pay themselves large bonuses instead.

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition d. When the government of a developing nation received a bank loan three years ago, it ultimately repaid the loan but had to reschedule its payments after officials misused the funds for unworthy projects. Now the government, which still has many of the same officials, is trying to raise funds by issuing bonds to foreign investors, who must decide whether or not to purchase them. a. b. c. d.

adverse selection adverse selection moral hazard adverse selection

17-10. Identify which of the following situations currently faced by the World Bank or the International Monetary Fund are examples of adverse selection and which are examples of moral hazard. a. The World Bank has extended loans to the government of a developing country to finance construction of a canal with a certain future flow of earnings. Now, however, the government has decided to redirect those funds to build a casino that may or may not generate sufficient profits to allow the government to repay the loan. b. The IMF is considering extending loans to several nations that failed to fully repay loans they received from the IMF during the past decade but now claim to be better credit risks. Currently, the IMF is not sure in advance which of these nations are unlikely to fully repay new loans. c. The IMF recently extended a loan to a government directed by democratically elected officials that would permit the nation to adjust to an abrupt reduction in private flows of funds from abroad. A coup has just occurred, however, in response to newly discovered corruption within the government’s elected leadership. The new military dictator has announced tentative plans to disburse some of the funds in equal shares to all citizens. a. moral hazard b. adverse selection c. moral hazard 17-11. For each of the following situations, explain which of the policy issues discussed in this chapter relates to the stance the institution has taken. a. The World Bank offers to make a loan to a company in an impoverished nation at a lower interest rate than the company had been about to agree to pay to borrow the same amount from a group of private banks. b. The World Bank makes a loan to a company in a developing nation that has not yet received formal approval to operate there, even though the government approval process typically takes 15 months. c. The IMF extends a loan to a developing nation’s government, with no preconditions, to enable the government to make already overdue payments on a loan it had previously received from the World Bank.

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Chapter 17 Policies and Prospects for Global Economic Growth a. The company had already qualified for funding at a market interest rate, so the World Bank is interfering with functioning private markets for credit. In addition, by extending credit to the company at a below-market rate, the World Bank provides an incentive for the company to borrow additional funds for less efficient investment. b. In this situation, the World Bank effectively is tying up funds in dead capital. There is an associated opportunity cost because the funds could instead be allocated to another investment that would yield more immediate returns. c. In this case, the IMF contributes to a moral hazard problem because the government has every incentive not to make reforms that will enable it to repay this and future loans it may receive.

17-12. For each of the following situations, explain which of the policy issues discussed in this chapter relates to the stance the institution has taken. a. The IMF extends a long-term loan to a nation’s government to help it maintain publicly supported production of goods and services that the government otherwise would have turned over to private companies. b. The World Bank makes a loan to companies in an impoverished nation in which government officials typically demand bribes equal to 50 percent of companies’ profits before allowing them to engage in any new investment projects. c. The IMF offers to make a loan to banks in a country in which the government’s rulers commonly require banks to extend credit to finance high-risk investment projects headed by the rulers’ friends and relatives. a. In this situation, the IMF is making loans that otherwise would already have been forthcoming in the private market, so these funds otherwise could have been made to promote growth in a nation in which private credit would not have been forthcoming. b. This is a situation in which World Bank loans are unlikely to promote economic growth as a consequence of the high level of corruption in this nation. c. In this case, the IMF faces a significant adverse selection problem because most who desire to borrow will be poor credit risks.

17-13. Answer the following questions concerning proposals to reform long-term development lending programs currently offered by the IMF and World Bank. a. Why might the World Bank face moral hazard problems if it were to offer to provide funds to governments that promise to allocate the funds to major institutional reforms aimed at enhancing economic growth? b. How does the IMF face an adverse selection problem if it is considering making loans to governments in which the ruling parties have already shown predispositions to try to “buy” votes by creating expensive public programs in advance of elections? How might following an announced rule in which the IMF cuts off future loans to governments that engage in such activities reduce this problem and promote increased economic growth in nations that do receive IMF loans? a. There is an incentive for at least some governments to fail to follow through with reforms, even if those governments might have had good intentions when they applied for World Bank loans. .

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition b. National governments most interested in obtaining funds to “buy” votes will be among those most interested in obtaining IMF loans (adverse selection).

The proposed IMF rule could help reduce the number of nations whose governments seek to obtain funds to try to “buy” votes.

17-14. Consider Table 17-1. Based on the basic arithmetic of economic growth, what were the average annual rates of real GDP growth since 1990 for those nations experiencing positive rates of annual growth of per capita real GDP? Average annual rate of real GDP growth = rate of growth of per capita real GDP + rate of growth of population Canada: 2.7 percent + 1.06 percent = 3.76 percent Chile: 3.7 percent + 1.1 percent = 4.8 percent China: 8.2 percent + 0.7 percent = 8.9 percent Egypt: 2.5 percent + 1.6 percent = 4.1 percent Haiti: 0.4 percent + 1.5 percent = 1.9 percent Indonesia: 3.6 percent + 1.4 percent = 5.0 percent Malaysia: 3.8 percent + 2.0 percent = 5.8 percent United States: 1.5 percent + 0.9 percent = 2.4 percent 17-15. Take a look at Table 17-1. Based on the basic arithmetic of economic growth, what were the average annual rates of real GDP growth since 1990 for those nations experiencing negative rates of annual growth of per capita real GDP? Average annual rate of real GDP growth = rate of growth of per capita real GDP+ rate of growth of population Congo Democratic Republic: −1.9 percent + 2.8 percent = +0.9 percent Liberia: −0.5 percent + 3.0 percent = +2.5 percent Madagascar: −1.0 percent + 2.9 percent = +1.9 percent Togo: −0.1 percent + 2.5 percent = +2.4 percent 17-16. Consider Figure 17-1. Average rates of population growth have been higher over the entire period covered by the figure in nearly all emerging and developing nations than in advanced nations. What does this tell us about a comparison of the average rate of growth of real GDP since 2000 in emerging and developing nations compared with advanced nations?

The average rate of real GDP growth equals the average growth of per capita real GDP plus average population growth. Because emerging and developing nations have had both higher average growth of per capita real GDP and higher average population growth than in advanced nations since 2000, the average growth of real GDP has been significantly higher in the former than in the latter.

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Chapter 17 Policies and Prospects for Global Economic Growth 17-17. Take a look at Figure 17-1, and read the related text that discusses the exact values of the average growth rates displayed in the figure. Over the entire interval since 2000, which group of countries has experienced a higher rate of economic growth: emerging and developing nations or advanced nations?

The average rate of economic growth for each group equals the sum of the annual growth rates for each year since 2000 divided by the number of years. The number of years is the same for each group. Because the annual growth rate was higher for emerging and developing nations in each and every year, the sum of growth rates for this group unambiguously is a larger total than for advanced nations. Consequently, the average annual growth rate was higher for the former group than for the latter group.

17-18. Suppose that a foreign resident is contemplating buying 5 percent of the shares of a company based in a developing nation but is experiencing difficulty determining whether the firm is riskier than others in that country. What type of investment is this foreign resident considering, and what type of asymmetric information problem are they experiencing?

Because the investment would involve purchasing less than 10 percent of the firm’s shares, this would be a portfolio investment. The foreign resident is having trouble determining higher-risk firms in advance of the investment, so this asymmetric information problem is an adverse selection problem.

17-19. Suppose that a foreign resident has bought 20 percent of the shares of a company based in a developing nation but is experiencing difficulty determine whether the firm has responded to this purchase by engaging in risker behavior. What type of investment has this foreign resident undertaken, and what type of asymmetric information problem are they experiencing?

Because the investment has entailed purchasing more than 10 percent of the firm’s shares, it involves foreign direct investment. The foreign resident is having trouble determining higher-risk firms in following the investment, so this asymmetric information problem is a moral hazard problem.

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Chapter 18

Comparative Advantage and the Open Economy 

Answers to Questions for Critical Analysis

AI: RESHAPING INTERNATIONAL TRADE FLOWS Suppose that the application of AI technologies to production of a large array of goods and services causes some items that currently are not traded internationally to become exported and imported for the first time. Do you think total global gains from international trade would increase or decrease as a result? Explain your reasoning.

The total global gains from international trade would increase as the AI technologies would allow trade to occur where no trade occurred before. This would be like the example of going from a world with no trade to a world with trade. Each nation specializes in producing the goods and services for which they have a comparative advantage (lower opportunity cost) and trades with other countries for goods in which they have a comparative advantage. The result is greater global production, which makes each country better off (that is, they can consume more than they were able to consume before trade).

GAINS FROM AGRICULTURAL SPECIALIZATION AND TRADE CONQUER DISTANCE Why do you suppose that prairie farmers in Canada experience gains from trade by growing and exporting canola to such far-distant nations as China, the European Union, Japan, and the United Arab Emirates?

The land in the prairies is better suited for growing canola due to the soil, climate, and weather conditions. This gives prairie farmers a comparative advantage in canola production, making it possible for them to specialize and trade with other nations, such as China, the European Union, Japan, and the United Arab Emirates.

SHIPPING CONTAINERS AND INTERNATIONAL TRADE Why do you suppose the standardization of the dimensions of shipping containers played a crucial role in enabling shippers to reduce their expenses?

Knowing the sizes of standard shipping containers makes it easier and faster to load cargo onto the ship; the shipping containers fit into the cargo bays without unnecessary rearrangement. This standardization enabled shippers to substitute capital for labour, which reduced costs and sped up loading times. This mean the shippers spent less time loading ships and more time transporting cargo.

IDENTIFYING WHO LOSES OUT AS A CONSEQUENCE OF ASIAN TARIFFS ON RICE IMPORTS Who do you suppose arguably stands to lose the most when governments of Canada and European nations impose tariffs on imports of key dietary foodstuffs such as wheat and corn?

The consumers of wheat and corn stand to lose the most, especially those who need to purchase wheat and corn for sustenance and already spend a large portion of their incomes on food.

Imposing tariffs raises the price of the good, which impacts those who purchase the good (consumers).

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Chapter 18 Comparative Advantage and the Open Economy



Economics in Your Life

CANADA’S COMPARATIVE ADVANTAGE IN ICE WINE PRODUCTION AND THE PANDEMIC For Critical Thinking Although Canada’s methods for producing ice wine heavily uses machinery, why might being able to specialize and export ice wine induce Canadian producers using those methods to hire more workers overall?

Firms that use machines require workers to look after and oversee the machines. They also require workers to ensure the machines are running smoothly and efficiently and to manage the use of those machines.

Real Application Assume that your family owns and operates a small vineyard that produces ice wine. Assume further that you have just been named manager and the COVID-19 pandemic continues. Instead of waiting for the pandemic to end, how could you increase sales?

Your marketing should stress that your enterprise is family owned and operated and that the grapes are picked with the utmost care. You may want to directly sell to the countries where the tourists who purchase your ice wine in the duty free stores come from.



Issues & Applications

WHAT DO COUNTRIES GAIN FROM INVOLVEMENT IN REGIONAL TRADE AGREEMENTS? For Critical Thinking How might making rules of origin overly detailed and complex have a trade-reducing effect?

If the rules of origin for a regional trade agreement are overly detailed and complex, member nations must spend time and money understanding the rules and ensuring that they and other nations abide by them. This time and money can be better spent analyzing production techniques to produce goods more efficiently or producing goods. In addition, many potential members may not want to participate in the regional trade agreement if the rules are too detailed and complex, thus reducing the overall gains from trade.

Real Application Under what personal circumstances would you support and vote for federal and provincial politicians who are in favour of increasing the number of regional trade agreements?

You would first have to determine what industry you are in and if it would be covered by a new regional trade agreement. If the answer is yes, then you would have to assess whether the new regional trade agreement would or would not increase competition in that industry. If it would increase competition, then you might, at least in the short run, become worse off.

Therefore, you would likely not support politicians who are in favour of this particular new regional trade agreement.

In contrast, if the new regional trade agreement blocked imports that compete against your industry’s products, you would likely be in favour of this new regional trade agreement.

Moreover, if a proposed regional agreement opens up new foreign markets for your products, then you also would support such an agreement.

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition



Answers to End-of-Chapter Questions

18-1. To answer the questions below, consider the following table for the neighbouring nations of Northland and West Coast. The table lists maximum feasible hourly rates of production of pastries if no sandwiches are produced and maximum feasible hourly rates of production of sandwiches if no pastries are produced. Assume that the opportunity costs of producing these goods are constant in both nations.

Product Pastries (per hour) Sandwiches (per hour)

Northland 50,000 25,000

West Coast 100,000 200,000

a. What is the opportunity cost of producing pastries in Northland? Of producing sandwiches in Northland? b. What is the opportunity cost of producing pastries in West Coast? Of producing sandwiches in West Coast? a. The opportunity cost of pastries in Northland is 0.5 sandwiches per pastry. The opportunity cost of sandwiches in Northland is 2 pastries per sandwich. b. The opportunity cost of pastries in West Coast is 2 sandwiches per pastry. The opportunity cost of sandwiches in West Coast is 0.5 pastries per sandwich.

18-2. Based on your answers to Problem 18-1, which nation has a comparative advantage in producing pastries? Which nation has a comparative advantage in producing sandwiches?

Northland has a comparative advantage in pastry production, and West Coast has a comparative advantage in producing sandwiches.

18-3. Suppose that the two nations in Problems 18-1 and 18-2 choose to specialize in producing the goods for which they have a comparative advantage. They agree to trade at a rate of exchange of 1 pastry for 1 sandwich. At this rate of exchange, what are the maximum possible numbers of pastries and sandwiches they could agree to trade?

If Northland specializes in producing pastries, the maximum number of pastries it can produce and trade to West Coast is 50,000 pastries. Hence, the maximum number of units of each good that the two countries can trade at a rate of exchange of 1 pastry for 1 sandwich is 50,000.

18-4. Residents of the nation of Border Kingdom can forgo production of 8K televisions and use all available resources to produce 300 bottles of high-quality wine per hour. Alternatively, they can forgo producing wine and instead produce 60 8K TVs per hour. In the neighbouring country of Coastal Realm, residents can forgo production of 8K TVs and use all resources to produce 150 bottles of high-quality wine per hour, or they can forgo wine production and produce 50 8K TVs per hour. In both nations, the opportunity costs of producing the two goods are constant. a. What is the opportunity cost of producing 8K TVs in Border Kingdom? Of producing bottles of wine in Border Kingdom? .

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Chapter 18 Comparative Advantage and the Open Economy b. What is the opportunity cost of producing 8K TVs in Coastal Realm? Of producing bottles of wine in Coastal Realm? a. The opportunity cost of 8K TVs in Border Kingdom equals 300 bottles of wine/60 8K TVs, or 5 bottles of wine per 8K TV. The opportunity cost of a bottle of wine in Border Kingdom equals 60 8K TVs/300 bottles of wine, or 0.20 8K TVs per bottle of wine. b. The opportunity cost of 8K TVs in Coastal Realm equals 150 bottles of wine/50 8K TVs, or 3 bottles of wine per 8K TV. The opportunity cost of a bottle of wine in Coastal Realm equals 50 8K TVs/150 bottles of wine, or 0.33 8K TVs per bottle of wine.

18-5. Based on your answers to Problem 18-4, which nation has a comparative advantage in producing 8K TVs? Which nation has a comparative advantage in producing bottles of wine?

Coastal Realm has a comparative advantage in producing 8K TVs, and Border Kingdom has a comparative advantage in wine production.

18-6. Suppose that the two nations in Problem 18-4 decide to specialize in producing the good for which they have a comparative advantage and to engage in trade. Would residents of both nations find a rate of exchange of 4 bottles of wine for 1 8K TV potentially agreeable? Why or why not?

Residents of Border Kingdom will be willing to trade bottles of wine for 8K TVs produced in Coastal Realm as long as the rate of exchange is less than its own opportunity cost of producing 8K TVs, which is 5 bottles of wine per 8K TV. Thus, Border Kingdom residents will accept a rate of exchange of 4 bottles of wine for 1 8K TV. Residents of Coastal Realm will be willing to trade 8K TVs for bottles of wine produced in Border Kingdom as long as the rate of exchange is less than its own opportunity cost of producing wine, which is 0.33 8K TVs per bottle of wine. Thus, Border Kingdom residents will accept a rate of exchange of 0.25 8K TVs for 1 bottle of wine.

Thus, both countries will accept a rate of exchange of 4 bottles of wine for 1 8K TV. To answer Problems 18-7 and 18-8, refer to the following table, which shows possible combinations of hourly outputs of portable power banks and flash memory drives in South Shore and neighbouring East Isle, in which opportunity costs of producing both products are constant.

South Shore Portable Power Banks Flash Drives 75 0 60 30 45 60 30 90 15 120 0 150

East Isle Portable Power Banks Flash Drives 100 0 80 10 60 20 40 30 20 40 0 50

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition 18-7. Consider the table and answer the questions that follow. a. What is the opportunity cost of producing portable power banks in South Shore? Of producing flash memory drives in South Shore? b. What is the opportunity cost of producing portable power banks in East Isle? Of producing flash memory drives in East Isle? c. Which nation has a comparative advantage in producing portable power banks? Which nation has a comparative advantage in producing flash memory drives? a. For South Shore, each 15-unit increase in portable power bank production, such as from 0 to 15 portable power banks, requires a corresponding 30-unit reduction in flash-drive production, such as a decrease from 120 to 150 flash drives. Hence, the opportunity cost of portable power banks in South Shore equals 30 flash drives/15 portable power banks, or 2 flash drives per portable power bank. Alternatively, each 30-unit increase in flash-drive production, such as from 0 to 30 flash drives, requires a 15-unit decrease in portable power banks production, such as from 75 to 60 portable power banks. Thus, the opportunity cost of flash drives in South Shore equals 15 portable power banks/30 flash drives, or 0.5 portable power banks per flash drive. b. For East Isle, each 20-unit increase in portable power bank production, such as from 0 to 20 portable power banks, requires a corresponding 10-unit reduction in flashdrive production, such as a decrease from 50 to 40 flash drives. Hence, the opportunity cost of portable power banks in East Isle equals 10 flash drives/20 portable power banks, or 0.5 flash drives per portable power bank. Alternatively, each 10-unit increase in flash-drive production, such as from 0 to 10 flash drives, requires a 20-unit decrease in portable power banks production, such as from 100 to 80 portable power banks. Thus, the opportunity cost of flash drives in South Shore equals 20 portable power banks/10 flash drives, or 2 portable power banks per flash drive. c. Residents of South Shore have a comparative advantage in producing flash drives, and residents of East Isle have a comparative advantage in producing portable power banks.

18-8. Refer to your answers to Problem 18-7 when answering the following questions. a. Which one of the following rates of exchange of portable power banks for flash memory drives will be acceptable to both nations: (i) 3 portable power banks for 1 flash drive; (ii) 1 portable power bank for 1 flash drive; or (iii) 1 flash drive for 2.5 portable power banks? Explain. b. Suppose that each nation produces only the good for which it has a comparative advantage and agrees to the rate of exchange you identified in part (a). Prior to trade, South Shore residents produced and consumed 30 portable power banks per hour and 90 flash drives per hour, and East Isle residents produced and consumed 40 portable power banks per hour and 30 flash drives per hour. Now, South Shore residents export the same quantity of their specialty good to East Isle that East Isle residents consumed prior to engaging in international trade. How many units of East Isle’s specialty good does South Shore import from East Isle? c. What is South Shore’s hourly consumption of portable power banks and flash drives after the nation specializes and trades with East Isle? What is East Isle’s hourly

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Chapter 18 Comparative Advantage and the Open Economy consumption of portable power banks and flash drives after the nation specializes and trades with South Shore? d. What consumption gains from trade are experienced by South Shore and East Isle? a. A rate of exchange of 3 portable power banks for 1 flash drive is higher than South Shore’s opportunity cost of producing portable power banks, so its residents will not accept this rate of exchange. A rate of exchange of 2.5 portable power banks for 1 flash drive is higher than East Isle’s opportunity cost of producing flash drives, so its residents will not accept this rate of exchange. The rate of exchange of 1 portable power bank for 1 flash drive is lower than the opportunity cost of producing flash drives in East Isle, and the rate of exchange of 1 flash drive for 1 portable power bank is lower than the opportunity cost of producing portable power banks in South Shore.

Thus, residents of both nations will find this rate of exchange acceptable. b. South Shore’s specialty good for export is flash drives. Residents of East Isle previously were producing and consuming 30 flash drives per hour domestically. Now, if residents of South Shore export this quantity of flash drives at an exchange rate of 1 flash drive for 1 portable power bank, residents of South Shore import 30 portable power banks from East Isle. c. Residents of South Shore specialize in producing flash drives and hence produce 150 flash drives per hour. They export 30 of these to East Isle in trade for 30 portable power banks. Thus, South Shore residents consume 120 flash drives and 30 portable power banks. Residents of East Isle specialize in producing portable power banks and hence produce 100 portable power banks. They export 30 portable power banks to South Shore in exchange for 30 flash drives. Consequently, they consume 70 portable power banks and 30 flash drives. d. For residents of South Shore, the gain from trade is 30 flash drives per hour, and for residents of East Isle, the gain from trade is 30 portable power banks per hour.

18-9. The following table describes the hypothetical PPC (product possibility curves) for furniture and machinery in Canada and Mexico (both in millions of tonnes per year).

Before trade, Canada produces at point C and Mexico at point D. After trade, 20 million tonnes of machinery is traded for 100 million tonnes of furniture.

Canada

A

B

C

D

E

F

Machinery

0

16

32

48

64

80

Furniture

40

32

24

16

8

0

Mexico

A

B

B

D

E

F

Machinery

0

3

6

9

12

15

Furniture

240

192

144

96

48

0

a. What is the opportunity cost of machinery in Canada? b. What is the opportunity cost of machinery in Mexico? .

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition c. d. e. f. g. h.

What is the opportunity cost of furniture in Canada?

What is the opportunity cost of furniture in Mexico?

Which country has a comparative advantage in producing machinery and why?

Which country has a comparative advantage in producing furniture and why?

What are the gains from specialization and trade for each nation?

If trade takes place between Canada and Mexico, what happens to the price of machinery in Canada? i. If trade takes place between Canada and Mexico, what happens to the price of furniture in Canada? j. If trade takes place between Canada and Mexico, who gains and who loses in the Canadian machinery market? k. If trade takes place between Canada and Mexico, who gains and who loses in the Canadian furniture market? a. b. c. d. e.

Opportunity cost of 1 tonne of machinery is 0.5 tonnes of furniture in Canada.

Opportunity cost of 1 tonne of machinery is 16 tonnes of furniture in Mexico.

Opportunity cost of 1 tonne of furniture is 2 tonnes of machinery in Canada.

Opportunity cost of 1 tonne of furniture is 0.063 tonnes of machinery in Mexico.

Canada has a comparative advantage in producing machinery since it has a lower opportunity cost to produce machinery as compared to Mexico. Therefore, Canada should specialize in and export machinery. f. Mexico has a comparative advantage in producing furniture since it has a lower opportunity cost to produce furniture as compared to Canada. Therefore, Mexico should specialize in and export furniture. g. As we can see from the last column in the following table, Canada gains 28 units of machinery and 76 units of furniture. Mexico gains 11 units of machinery and 44 units of furniture after trade.

Country/Product

Canada machinery furniture Mexico machinery furniture

(1) (2) Without With Specialization Specialization

(3) Trade Exports (–) Imports (+)

(4) = (2) + (3) After Trade

(5) = (4) – (1) Gains from Trade

32 24

80 0

–20 +100

60 100

+28 +76

9 96

0 240

+20 –100

20 140

+11 +44

h. The price of machinery increases in Canada as exports of machinery from Canada will lead to a higher price of machinery. i. The price of furniture decreases in Canada as imports of furniture into Canada will lead to a lower price of furniture. .

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Chapter 18 Comparative Advantage and the Open Economy j. In Canada’s machinery market, producers of machinery will gain due to higher output and the higher price of machinery while consumers will lose due to the higher price. k. In Canada’s furniture market, producers of furniture will lose because of zero output while consumers will gain because of the lower price.

18-10. The following graphs describe the hypothetical PPC (product possibility curves) for the production of potassic fertilizer and paint per year in Canada and the United States.

After specialization, 320 million litres of paint is traded for 80 million tonnes of potassic fertilizer.

a. b. c. d. e. f. g. h.

What is the opportunity cost of fertilizer in Canada?

What is the opportunity cost of fertilizer in the United States?

What is the opportunity cost of paint in Canada?

What is the opportunity cost of paint in the United States?

Which country has a comparative advantage in producing fertilizer and why?

Which country has a comparative advantage in producing paint and why?

What are the gains from specialization and trade for each nation?

If trade takes place between Canada and United States, what happens to the price of fertilizer in Canada? i. If trade takes place between Canada and United States, what happens to the price of paint in Canada? j. If trade takes place between Canada and United States, who gains and who loses in the Canadian fertilizer market? k. If trade takes place between Canada and United States, who gains and who loses in the Canadian paint market? a. b. c. d.

Opportunity cost of 1 tonne of fertilizer is 0.5 litres of paint in Canada.

Opportunity cost of 1 tonne of fertilizer is 10 litres of paint in the United States.

Opportunity cost of 1 litre of paint is 2 tonnes of fertilizer in Canada.

Opportunity cost of 1 litre of paint is 0.10 tonnes of fertilizer in the United States.

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition e. Canada has a comparative advantage in producing fertilizer since it has a lower opportunity cost to produce fertilizer as compared to the United States. Therefore, Canada should specialize in and export fertilizer. f. The United States has a comparative advantage in producing paint since it has a lower opportunity cost to produce paint as compared to Canada. Therefore, the United States should specialize in and export paint. g. As we can see from the last column in the following table, Canada gains 160 million tonnes of fertilizer and 200 million litres of paint. The United States gains 20 million tonnes of fertilizer and 200 million litres of paint after trade.

Country/Product

Canada fertilizer paint United States fertilizer paint

(1) (2) (3) (4) = (2) + Without With Trade (3) Specialization Specialization Exports (–) After Imports (+) Trade

(5) = (4) – (1) Gains from Trade

160 120

400 0

−80 +320

320 320

+160 +200

60 480

0 1000

+80 –320

80 680

+20 +200

h. The price of fertilizer increases in Canada as exports of fertilizer from Canada will lead to a higher price of fertilizer. i. The price of paint decreases in Canada as imports of paint into Canada will lead to a lower price of paint. j. In Canada’s fertilizer market, producers of fertilizer will gain because of higher output and a higher price of fertilizer while consumers will lose because of the higher price. k. In Canada’s paint market, producers of paint will lose because of zero output while consumers will gain because of the lower price.

18-11. Critics of the USMCA suggest that much of the increase in exports from Mexico to Canada now involves goods that Mexico otherwise would have exported to other nations. Mexican firms choose to export the goods to Canada, the critics argue, solely because the items receive preferential treatment under USMCA tariff rules. What term describes what these critics are claiming is occurring with regard to Canada–Mexico trade as a result of the USMCA? Explain your reasoning.

The critics are suggesting that Mexican exporters are shifting exports that would have gone to other nations to Canada, a nation within the USMCA, which would constitute trade diversion.

18-12. Some critics of the USMCA suggest that firms outside the USMCA sometimes shift unassembled inputs to Mexico, assemble the inputs into final goods there, and then export the final product to Canada to take advantage of USMCA trade preferences. .

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Chapter 18 Comparative Advantage and the Open Economy What term describes what these critics are claiming is occurring with regard to Canada–Mexico trade as a result of the USMCA? Explain your reasoning.

The critics are suggesting that some non-USMCA exporters are shifting production to Mexico solely to benefit from USMCA trade preferences granted to Mexican imports into Canada, which would constitute trade deflection.

18-13. How could multilateral trade agreements established for all nations through the World Trade Organization help to prevent both trade diversion and trade deflection that can occur under regional trade agreements, thereby promoting more overall international trade?

Diversion and deflection occur when nations within or outside a particular regional trade bloc try to benefit from preferences that only exist within the bloc. As long as the WTO agreements involve all nations equally, no diversion or deflection could occur.

18-14. Consider the data in Table 18-1. Would Canadian residents gain from trade of Canadian tablets for Indian apps if the rate of exchange of tablet devices for digital apps happened to be 3 tablets per app?

The opportunity cost of apps in Canada is 225 tablets/90 apps, or 2.5 tablets per app. Without trade, therefore, Canadian residents already can obtain an app by giving up home production and consumption of 2.5 tablets. Hence, Canadian residents will not gain from trade at a rate of exchange of 3 tablets per app, because then they would have to give up more tablets to obtain apps.

18-15. Take a look at the data in Table 18-1. Would Indian residents gain from trade of Indian apps for Canadian tablets if the rate of exchange of tablet devices for digital apps happened to be 0.75 tablets per app?

The opportunity cost of tablets in India is 50 tablets/100 apps, or 0.5 tablet per app. Without trade, therefore, Indian residents can obtain only 0.5 tablets for each app they produce. At a rate of exchange of 0.75 tablets per app, however, Indian residents can obtain an additional 0.25 tablets for each app that they export to Canada. Hence, Indian residents would gain from trade.

18-16. Take a look at Figure 18-3. What is the effect on foreign textile importers’ total revenues of the imposition of the quota that generates a movement from point E1 to point E2?

Prior to imposition of the quota, at point E1, the total revenues of foreign textile importers were $1.00 per yard of textiles times 900 million yards, or $900 million. After imposition of the quota, at point E2, total revenues are $1.50 per yard times 800 million yards, or $1,200 million. Hence, imposition of the quota has caused total revenues of foreign textile importers to increase by $300 million.

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition 18-17. Consider Figure 18-3. What is the effect on Canadian textile consumers’ total expenditures of the imposition of the quota that generates a movement from point E1 to point E2?

Prior to imposition of the quota, at point E1, the total expenditures of Canadian textile consumers were $1.00 per yard of textiles times 900 million yards, or $900 million. After imposition of the quota, at point E2, total expenditures are $1.50 per yard times 800 million yards, or $1,200 million. Hence, imposition of the quota has caused total expenditures of Canadian textile consumers to increase by $300 million.

18-18. Take a look at panel (a) of Figure 18-4. On a per-unit basis, how much of the $50-perunit tariff on imported tablet devices is paid by Canadian consumers? On a per-unit basis, how much of the $50-per-unit tariff is paid by Chinese tablet-producing firms?

The market equilibrium price of imported tablets rises from $200 per tablet to $225 per tablet, so the price paid by Canadian consumers increases by $25 per unit. Consequently, Canadian consumers pay $25 of the $50-per-unit tariff on each tablet they purchase. Chinese tablet-producing firms pay the remaining $25 of the tariff on each unit they sell in Canada.

18-19. Based on your answer to Problem 18-18, what are the total tariff revenues of the Canadian government? What percentage do Canadian consumers ultimately pay because of a higher price generated by the tariff?

Panel (a) of Figure 18-4 shows that once the $50-per-unit tariff is in place, Canadian consumers buy 8 million tablet devices per period, so each period the Canadian government collects tariff revenues of $50 × 8 million, or $400 million. The amount of these revenues contributed by Canadian consumers is $25 × 8 million, or $200 million, so Canadian consumers pay 50 percent of the tariff.

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Chapter 19

Exchange Rates and the Balance of Payments 

Answers to Questions for Critical Analysis

THE NON-U.S. DERIVED DEMAND FOR AND SUPPLY OF U.S. DOLLARS How might the fact that 30 to 60 percent of other nations’ holdings of various bonds and other financial assets are denominated in dollars also contribute to non-U.S. derived demand for and supply of U.S. dollars? (Hint: Another source of the derived demand for and supply of U.S. dollars involves dollar-denominated assets outside the United States.)

In order to buy bonds and financial assets denominated in dollars, foreign residents must demand dollars and supply foreign currency. Therefore, the demand for U.S. dollars is also derived from the demand for dollar-denominated assets outside the United States.

AFRICAN GOVERNMENTS WITH DOLLAR-DENOMINATED DEBTS CONFRONT FOREIGN EXCHANGE DEPRECIATIONS Who ultimately has to finance the higher payments that the African governments must make to obtain dollars to pay foreign holders of their public debts? (Hint: Who always provides the funds that governments spend?)

Taxpayers finance the higher payments because taxpayers provide the funds that governments spend.

AI: FOREIGN EXCHANGE MARKETS INVOLVING REALLY BIG DATA How can individuals or firms holding large quantities of multiple currencies be exposed to foreign exchange risks even if they are not actively trading currencies in foreign exchange markets from day to day?

If individuals or firms hold large quantities of multiple currencies, any change in the price of those currencies includes some foreign exchange risk. For example, let’s say I have 1 million euros that I purchased at $1 per euro. If tomorrow the price of the euro depreciates to $0.50 per euro, I have basically lost half of my wealth just by holding euros.

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Economics in Your Life

THE HONG KONG MONETARY AUTHORITY ACTS TO KEEP ITS CURRENCY’S EXCHANGE RATE FIXED For Critical Thinking Why does the HKMA’s capability of keeping the exchange rate fixed as demand for Hong Kong dollars drops depend on having a sufficient number of U.S. dollars in reserves to continue buying Hong Kong dollars?

When the demand for Hong Kong dollars drops, the exchange rate of the Hong Kong dollar (relative to the U.S. dollar) falls. The HKMA must decrease the supply of Hong Kong dollars to raise the exchange rate to its original level. To decrease the supply, they must buy up

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition Hong Kong dollars in the foreign exchange market using U.S. dollars, so they require a sufficient number of U.S. dollars in reserves.

Real Application Let’s say that you are going to take a month’s trip to a Latin American country that has a relatively stable economy. Are you better off exchanging your dollars for that nation’s currency as soon as you know that you are going to make the trip, or should you wait to buy that foreign currency just before you leave Canada?

Interestingly, if you believe in efficient markets, it really does not matter when you purchase that nation’s currency with your Canadian dollars. Why? Because in an efficient market, all relevant information is included in the current price of any asset, including a foreign currency. For you to think that you will have a better sense of when to buy a foreign currency means that you believe you are better at predicting the value of this asset than the computer programs and millions of individuals who are involved in the foreign exchange market. After all, if you could predict better than the experts about the future value of a particular foreign currency, you could become a billionaire quite rapidly.

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Issues & Applications

HOW CHANGING A FIXED EXCHANGE RATE TO TRY TO ABSORB SHOCKS EVENTUALLY CAN CAUSE SHOCKS For Critical Thinking What do you suppose happened to Venezuelan import spending following the massive bolivar devaluation? Explain your reasoning.

After the massive bolivar devaluation, the prices of foreign goods skyrocketed. This large increase in prices caused fewer purchases of foreign goods, so import spending declined drastically.

Real Application Assume that you have been hired as an economist for the Venezuelan government. What recommendations might you make to improve that country’s situation?

You could argue in favour of simply eliminating the local currency in favour of using U.S. dollars. Some small countries, including neighbouring Ecuador, have done this in the past.

Alternatively, you could recommend that the country’s central bank dramatically reduce its rate of growth of the money supply in circulation.

In addition, you could recommend that government-owned natural resources be sold to private companies to promote investment and re-establish profitable production in these industries.

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Answers to End-of-Chapter Questions

19-1. Suppose that during a recent year for Canada, merchandise imports were $2 trillion, net secondary income was –$0.2 trillion, service exports were $0.2 trillion, service imports were $0.1 trillion, net primary income was –$0.3 trillion, the capital account balance was $0, and merchandise exports were $1.4 trillion. a. What was the merchandise trade deficit? .

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Chapter 19 Exchange Rates and the Balance of Payments b. What was the balance on goods and services? c. What was the current account balance? a. The merchandise trade deficit was equal to $1.4 trillion in merchandise exports minus $2 trillion in merchandise imports, or –$0.6 trillion. b. Net service exports were equal to $0.2 trillion in service exports minus $0.1 trillion in service imports, or +0.1 trillion. Adding this net service flow to the merchandise trade deficit of –$0.6 trillion yields the balance on goods and services, which was –$0.5 trillion. c. Adding the net primary income of –$0.3 trillion and net secondary income of –$0.2 trillion to the –$0.5 trillion balance on goods and services yields the current account balance, which was –$1.0 trillion.

19-2. Suppose that during a recent year for Canada, the current account balance was –$0.5 trillion, and financial outflows were $0.1 trillion. a. What was the balance in the financial account during the year? b. What were Canada’s financial inflows during the year? a. The sum of the current account balance of –$0.5 trillion and the financial account balance must always equal 0, so the financial account balance must have been +0.5 trillion. b. Canada’s financial inflows were equal to the difference between the financial account balance of +$0.5 trillion and financial outflows of $0.1 trillion, or +0.6 trillion.

19-3. Over the course of a year, a nation tracked its foreign transactions and arrived at the following amounts: Merchandise exports Service exports Net secondary income Net change in domestic liabilities abroad (financial outflows) Net change in foreign assets at home (financial inflows) Merchandise imports Net primary income Service imports

500 75 20 −215 300 600 −10 50

What is this nation’s merchandise and services balance, current account balance, and financial account balance?

The trade balance is merchandise exports minus merchandise imports, which equals 500 – 600 = –100, or a deficit of 100.

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition Adding service exports of 75 and net secondary income of 20 and subtracting net primary income of 10 and service imports of 50 yields –100 + 75 + 20 – 10 – 50 = −75, or a current account balance of −75.

The financial account balance equals the difference between financial inflows and financial outflows, or 300 – 215 = +$85, or a financial account surplus of 85.

19-4. Suppose that during a recent year, a nation has the following transactions related to its balance of payments: Merchandise exports Merchandise imports Service exports Service imports Net Capital account Net Primary income Net Secondary income Net Direct foreign investment Net portfolio investment Net Other investment Official Reserves

600 650 250 300 1 30 −10 35 25 15 ?

Calculate the following for this nation: a. Merchandise account balance b. Service account balance c. Balance of merchandise and services d. Current plus capital account balance e. Financial account balance without official reserves f. Balance of payments without official reserves g. Did the nation’s official foreign reserves increase or decrease? a. Merchandise account balance = (merchandise exports – merchandise imports) = 600 – 650 = –50 (a deficit) b. Service account balance = (service exports – service imports) = 250 – 300 = –50 (a deficit) c. Balance of merchandise and services = merchandise account balance + service account balance = –50 – 50 = –100 (a deficit) d. Current plus capital account balance = balance of merchandise and services + net primary income + net secondary income + net capital account = –100 + 30 – 10 + 1 = –79 (a deficit) e. Financial account balance = net direct foreign investment + net portfolio investment + net other investment = 35 + 25 + 15 = 75 (a surplus) f. Balance of payments = current account balance + financial account balance = –79 + 75 = –4 (a deficit) .

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Chapter 19 Exchange Rates and the Balance of Payments g. The nation’s official reserves will decrease because the nation’s government will sell foreign reserves and purchase domestic currency from the private sector.

19-5. Identify whether each of the following items creates a surplus item or a deficit item in the current account of the Canadian balance of payments. a. A central European company sells products to a Canadian hobby-store chain. b. Japanese residents pay a Canadian travel company to arrange hotel stays, ground transportation, and tours of various Canadian cities. c. A Mexican company pays a Canadian accounting firm to audit its income statements. d. Canada’s churches and mosques send relief aid to Pakistan following a major earthquake in that nation. e. A Canadian microprocessor manufacturer purchases raw materials from an American firm. a. b. c. d. e.

deficit surplus surplus deficit deficit

19-6. Explain how the following events would affect the market for the Mexican peso, assuming a floating exchange rate. a. Improvements in Mexican production technology yield superior guitars, and many musicians around the world buy these guitars. b. Perceptions of political instability surrounding regular elections in Mexico make international investors nervous about future business prospects in Mexico. a. The increase in demand for Mexican-made guitars increases the demand for Mexican pesos, and the peso appreciates. b. International investors will remove some of their financial capital from Mexico. The increase in the supply of pesos in the foreign exchange market will cause the peso to depreciate.

19-7. Explain how the following events would affect the market for South Africa’s currency, the rand, assuming a floating exchange rate. a. A rise in Canadian inflation causes many Canadian residents to buy gold, which is a major South African export good, as a hedge against inflation. b. Major discoveries of the highest-quality diamonds ever found occur in Russia and Central Asia, causing a significant decline in purchases of South African diamonds. a. The demand for the rand increases, so the dollar/rand exchange rate rises. Because more dollars must be given in exchange for the rand, the dollar depreciates and the rand appreciates. b. The demand for the rand would decrease, so the dollar/rand exchange rate falls.

Because fewer dollars must be given in exchange for the rand, the dollar appreciates and the rand depreciates. .

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition 19-8. Suppose the following two events take place in the market for China’s currency, the yuan: Canadian parents are more willing than before to buy action figures and other Chinese toy exports, and China’s government tightens restrictions on the amount of Canadian dollardenominated financial assets that Chinese residents may legally purchase. What happens to the dollar price of the yuan? Does the yuan appreciate or depreciate relative to the dollar?

The increased willingness of Canadian parents to buy Chinese toy exports causes the demand for Chinese yuan to increase. At the same time, the tightened restrictions on Canadian dollardenominated financial assets that Chinese residents can hold cause the supply of yuan to decrease. The combined rightward shift in the yuan demand curve and leftward shift of the yuan supply curve generate an increase in the equilibrium dollar/yuan exchange rate, so the yuan appreciates.

19-9. On Wednesday, the exchange rate between the Japanese yen and the Canadian dollar was $0.010 per yen. On Thursday, it was $0.009. Did the dollar appreciate or depreciate against the yen? By how much, expressed as a percentage change?

Because fewer Canadian dollars are required to purchase each yen, the dollar has appreciated.

The percentage appreciation was 100 times (0.009 – 0.010)/0.010, or 10 percent.

19-10. On Wednesday, the exchange rate between the euro and the U.S. dollar was $1.12 per euro, and the exchange rate between the Canadian dollar and the U.S. dollar was U.S. $0.76 per Canadian dollar. What is the exchange rate between the Canadian dollar and the euro?

The Canadian dollar/euro exchange rate is found by dividing the U.S. dollar/euro exchange rate by the U.S. dollar/Canadian dollar exchange rate, or (1.12 $US/euro)/(0.76 $US/$C) = 1.47 $C/euro, or 1.47 Canadian dollars per euro.

19-11. Suppose that signs of an improvement in the Japanese economy leads international investors to resume lending to the Japanese government and businesses. How would this event affect the market for the yen? How should the central bank, the Bank of Japan, respond to this event if it wants to keep the value of the yen unchanged?

Increased foreign lending to Japan causes an increase in the demand for the yen, and the yen appreciates. The Bank of Japan should buy foreign currencies in exchange for the yen. This will increase the supply of the yen, which pushes the equilibrium exchange rate toward its original level.

19-12. Briefly explain the differences between a flexible exchange rate system and a fixed exchange rate system.

A flexible exchange rate system allows the exchange value of a currency to be determined freely in the foreign exchange market with no intervention by the government. A fixed exchange rate

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Chapter 19 Exchange Rates and the Balance of Payments pegs the value of the currency, and the authorities responsible for the value of the currency intervene in foreign exchange markets to maintain this value.

19-13. Suppose that under a gold standard, the U.S. dollar is pegged to gold at a rate of $35 per ounce and the pound sterling is pegged to gold at a rate of £17.50 per ounce. Explain how the gold standard constitutes an exchange rate arrangement between the dollar and the pound. What is the exchange rate between the U.S. dollar and the pound sterling?

When the U.S. dollar is pegged to gold at a rate of $35 and the pound at a rate of £17.50, the dollar/pound exchange rate equals $35/17.50 = 2 ($/£).

19-14. Suppose that under the Bretton Woods system the dollar is pegged to gold at a rate of $35 per ounce and the pound sterling is pegged to the dollar at a rate of $2 = £1. If the dollar is devalued against gold and the pegged rate is changed to $40 per ounce, what does this imply for the exchange value of the pound in terms of dollars?

When the dollar is pegged to gold at a rate of $35 and the pound is pegged to the dollar at $2 = £1, an implicit value between gold and the pound is established at £17.50 = 1 ounce of gold.

If the dollar falls in value relative to gold, yet the pound is still valued to the dollar at $2 = £1, the pound will become undervalued relative to gold. The exchange rate between the dollar and the pound will have to be adjusted to 2.29 $/£.

19-15. Suppose that the People’s Bank of China wishes to peg the rate of exchange of its currency, the yuan, in terms of the U.S. dollar. In each of the following situations, should it add to or subtract from its dollar foreign exchange reserves? Why? a. U.S. parents worrying about safety begin buying fewer Chinese-made toys for their children. b. U.S. interest rates rise relative to interest rates in China, so Chinese residents seek to purchase additional U.S. financial assets. c. Chinese furniture manufacturers produce high-quality early American–style furniture and successfully export large quantities of the furniture to the United States. a. The demand for the yuan will decrease, which would cause the equilibrium dollar/yuan exchange rate to begin to decline. To prevent a yuan depreciation from occurring, the Bank of China can purchase yuan with dollars, thereby raising the demand for yuan to its previous level at the original exchange rate. Hence, the Bank of China should reduce its dollar reserves. b. To purchase more U.S. financial assets, Chinese residents must obtain more dollars, so they will increase the quantity of yuan supplied at each exchange rate. This would cause the equilibrium dollar/yuan exchange rate to begin to decline. To prevent a yuan depreciation from occurring, the Bank of China can purchase yuan with dollars, thereby causing the demand for yuan to increase sufficiently to push the equilibrium exchange rate back to its original level. Thus, the Bank of China should reduce its dollar reserves.

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Solutions Manual for Roger LeRoy Miller • Economics Today, 1st Canadian Edition c. U.S. residents increase the quantity of yuan demanded at any given exchange rate in order to purchase Chinese furniture, so the demand for yuan increases. This would tend to cause the equilibrium dollar/yuan exchange rate to rise, resulting in a yuan appreciation. To keep this from happening, the Bank of China can purchase dollars with yuan, thereby increasing the supply of yuan and pushing the equilibrium exchange rate back down. Consequently, the Bank of China should increase its dollar reserves.

19-16. At point E in Figure 19-4, how many dollars per year are traded for the equilibrium quantity of pounds?

The total expenditure of dollars for pounds in the foreign exchange market equals the dollar price per pound, $1.50 per pound, multiplied by the quantity of pounds traded per year, 30 billion pounds, or $45 billion per year.

19-17. Take a look at Figure 19-5. Suppose that in response to a significant rise in interest in Jane Austen’s life and works millions of Canadian residents suddenly purchase Britishpublished books by and about the famous author and travel to Britain to visit Jane Austen’s former home. What will happen to the equilibrium dollar price of the pound, and why? Does the dollar appreciate or depreciate in relation to the pound?

The millions of Canadian residents have to obtain British pounds to purchase the Britishpublished books and pay for their tours of Austen’s former home in Britain. Thus, the quantity of pounds demanded increases at each possible exchange rate, meaning that the demand curve for pounds shifts rightward. The equilibrium exchange rate rises, so more dollars must be exchanged for pounds. The dollar has depreciated.

19-18. Consider Figure 19-5. Suppose that the real interest rate in Britain increase relative to the Canadian real interest rate. What will happen to the equilibrium dollar price of the pound, and why? Does the dollar appreciate or depreciate in relation to the pound?

International investors now seek higher returns available from obtaining financial assets in Britain. Consequently, the quantity of pounds demanded increases at any given exchange rate, meaning that the demand curve for pounds shifts rightward. The equilibrium exchange rate increases, which means that more dollars must be exchanged for pounds. The dollar has depreciated.

19-19. Take a look at Figure 19-6. Suppose that the preferences of most British residents alter toward purchasing more Canadian goods. What will happen to the equilibrium dollar price of the pound, and why? Does the dollar appreciate or depreciate in relation to the pound?

To purchase additional Canadian goods, the British residents must obtain more dollars, so the quantity of pounds supplied in exchange for dollars increases at each possible exchange rate.

Consequently, the supply curve in the figure shifts rightward, and the equilibrium dollar price of the pound decreases. The dollar appreciates. .

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Chapter 19 Exchange Rates and the Balance of Payments 19-20. Consider Figure 19-6. A sudden increase in economic and political instability throughout Europe and Asia has caused Canada to appear to British residents to be relatively more economically and politically stable than was previously the case. What will happen to the equilibrium dollar price of the pound, and why? Does the dollar appreciate or depreciate in relation to the pound?

Because Canada now appears to be more economically and politically stable relative to Europe and Asia, more British residents will want to put their savings into Canadian assets instead of their own domestic assets. As a result, the supply curve in the figure shifts rightward, and the equilibrium dollar price of the pound decreases. The dollar appreciates.

19-21. Suppose the initially in Figure 19-8, the market for Bahrain’s currency, the dinar, is in equilibrium at point E1. Now, however, an increase in the U.S. real interest rate has occurred even as real interest rates in Bahrain and elsewhere in the world either have declined or have remained unchanged. What must Bahrain’s central bank do, and why, if it wishes to maintain a fixed exchange rate?

Bahrain’s residents seek to earn higher returns on U.S. assets and thereby sell more dinars for dollars at any given exchange rate. The supply curve shifts rightward, which otherwise would yield point E2. To prevent the exchange rate from falling, Bahrain’s central bank buys more dinars at any exchange rate and shifts the demand curve rightward. Point E3 results, and the exchange rate remains unchanged.

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