Instructor Solution Manual For Principles of Macroeconomics, 9th Edition N. Gregory Mankiw Ronald D.

Instructor Solution Manual For Principles of Macroeconomics, 9th Edition N. Gregory Mankiw Ronald D. Kneebone Kenneth J McKenzie Chapter 1-18

Chapter 1 Ten Principles of Economics SOLUTIONS TO TEXTBOOK PROBLEMS Questions for Review 1.

What is a tradeoff? Give two examples of tradeoffs that you face in your life.

A tradeoff is what you give up in order to get something else. Examples of tradeoffs include time tradeoffs (such as studying one subject over another, or studying at all compared to engaging in social activities), and spending tradeoffs (such as whether to use your last $15 to purchase a pizza or to buy an online study guide for that tough economics course).

2.

What is the opportunity cost of seeing a movie?

The opportunity cost of seeing a movie includes the monetary cost of admission plus the time cost of going to the theatre and attending the show. The time cost depends on what else you might do with that time; if it’s staying home and watching TV, the time cost may be small, but if it’s working an extra three hours at your job, the time cost is the money you could have earned.

3.

Water is necessary for life. Is the marginal benefit of a glass of water large or small?

The marginal benefit of a glass of water depends on your circumstances. If you’ve just run a marathon, or you’ve been walking in the desert sun for three hours, the marginal benefit is very high. But if you’ve been drinking a lot of liquids recently, the marginal benefit is quite low. The point is that even the necessities of life, like water, don’t always have large marginal benefits.

4.

Why should policymakers think about incentives?

Policymakers need to think about incentives so they can understand how people will respond to the policies they put in place. The text’s examples of seat belts and crosswalk countdown signals show that policy actions can have quite unintended consequences. If incentives matter a lot, they may lead to a very different type of policy; for example, some economists have suggested putting knives in steering columns so that people will drive much more carefully! While this suggestion is silly, it highlights the importance of incentives.

5.

Why isn’t trade among countries like a game, with some winners and some losers?

Trade among countries isn’t a game with some losers and some winners because trade can make everyone better off. By allowing specialization, trade between people and trade between countries can improve everyone’s welfare.

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6.

What does the ―invisible hand‖ of the marketplace do?

The ―invisible hand‖ of the marketplace represents the idea that even though individuals and firms are all acting in their own self-interest, prices and the marketplace guide them to do what is good for society as a whole.

7.

Explain the two main causes of market failure and give an example of each.

The two main causes of market failure are externalities and market power. An externality is the impact of one person’s actions on the well-being of a bystander, such as from pollution or the creation of knowledge. Market power refers to the ability of a single person (or small group of people) to unduly influence market prices, such as in a town with only one well or only one cable television company.

8.

Why is productivity important?

Productivity is important because a country’s standard of living depends on its ability to produce goods and services. The greater a country’s productivity (the amount of goods and services produced from each hour of a worker’s time), the greater will be its standard of living.

9.

What is inflation, and what causes it?

Inflation is an increase in the overall level of prices in the economy. Inflation is caused by increases in the quantity of a nation’s money.

10.

How are inflation and unemployment related in the short run?

Inflation and unemployment are negatively related in the short run. Reducing inflation entails costs to society in the form of higher unemployment in the short run.

Problems and Applications 1.

Describe some of the tradeoffs faced by each of the following. a. a family deciding whether to buy a new car b. a member of Parliament deciding how much to spend on national parks c. a company president deciding whether to open a new factory d. a professor deciding how much to prepare for class a.

A family deciding whether to buy a new car faces a tradeoff between the cost of the car and other things they might want to buy. For example, buying the car might mean they must give up going on vacation for the next two years. So the real cost of the car is the family’s opportunity cost in terms of what they must give up.

b.

For a member of Parliament deciding whether to increase spending on national parks, the tradeoff is between parks and other spending items or tax cuts. If more money goes into the park system, that may mean less spending on national defence or on the police force. Or, instead of spending more money on the park system, taxes could be reduced.

c.

When a company president decides whether to open a new factory, the decision is based on whether the new factory will increase the firm’s profits compared to other alternatives. For example, the company could upgrade existing equipment or expand existing factories. The bottom line is: Which method of expanding production will

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d.

2.

increase profit the most?

In deciding how much to prepare for class, a professor faces a tradeoff between the value of improving the quality of the lecture compared to other things she could do with her time, such as working on additional research.

You are trying to decide whether to take a vacation. Most of the costs of the vacation (airfare, hotel, forgone wages) are measured in dollars, but the benefits of the vacation are psychological.

How can you compare the benefits to the costs?

When the benefits of something are psychological, such as going on a vacation, it isn’t easy to compare benefits to costs to determine if it’s worth doing. But there are two ways to think about the benefits. One is to compare the vacation with what you would do in its place. If you didn’t go on vacation, would you buy something like a new set of golf clubs? Then you can decide if you’d rather have the new clubs or the vacation. A second way is to think about how much work you had to do to earn the money to pay for the vacation; then you can decide if the psychological benefits of the vacation are worth the psychological costs incurred to earn the money to pay for the vacation.

3.

You were planning to spend Saturday working at your part-time job, but a friend asks you to go skiing. What is the true cost of going skiing? Now suppose that you had been planning to spend the day studying at the library. What is the cost of going skiing in this case? Explain.

If you are thinking of going skiing instead of working at your part-time job, the cost of skiing includes its monetary and time costs, including the opportunity cost of the wages you are giving up by not working. If the choice is between skiing and going to the library to study, then the cost of skiing is its monetary and time costs, including the cost to you of getting a lower grade in your course.

4.

You win $100 in a hockey pool. You have a choice between spending the money now or putting it away for a year in a bank account that pays 5 percent interest. What is the opportunity cost of spending the $100 now?

If you spend $100 now instead of saving it for a year and earning 5 percent interest, you are giving up the opportunity to spend $105 a year from now. The idea that money has a time value is the basis for the field of finance, the subfield of economics that has to do with prices of financial instruments like stocks and bonds.

5.

The company that you manage has invested $5 million in developing a new product, but the development is not quite finished. At a recent meeting, your salespeople report that the introduction of competing products has reduced the expected sales of your new product to $3 million. If it would cost $1 million to finish development and make the product, should you go ahead and do so? What is the most that you should pay to complete development?

The fact that you’ve already sunk $5 million isn’t relevant to your decision anymore, since that money is gone. What matters now is the chance to earn profits at the margin. If you spend another $1 million and can generate sales of $3 million, you’ll earn $2 million in marginal profit, so you should do so. You’re right to think that the project has lost a total of $3 million ($6 million in costs and only $3 million in revenue), and you shouldn’t have started it. That’s true, but if you don’t spend the additional $1 million, you won’t have any sales and your losses will be $5 million.

So what matters is not the total profit, but the profit you can earn at the margin. In fact, you’d pay up to $3 million to complete development; any more than that and you won’t be increasing profit at the margin.

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6.

7.

The welfare system provides income for people who are very poor, with low incomes and few assets. If a recipient of welfare payments decides to work and earn some money, the amount he or she receives in welfare payments is reduced. a. How does this affect the incentive to work? b. How does this feature of the welfare system represent the tradeoff between equality and efficiency? a.

The provision of welfare payments lowers an individual’s incentive to work by imposing an implicit tax on labour earnings. For example, if an individual who receives $100 in welfare payments loses 50 percent of those payments for each dollar in extra income earned, this is like a tax on labour earnings, which will discourage work.

b.

By targeting welfare payments at low-income people and reducing payments as their earned income increases, the system is addressing equity concerns. However, this comes at the cost of efficiency due to the decrease in work effort discussed in part a.

Your roommate is a better and faster cook than you are, but you can clean more quickly than your roommate can. If your roommate did all of the cooking and you did all of the cleaning, would your chores take you more or less time than if you divided each task evenly? Give a similar example of how specialization and trade can make two countries both better off.

By specializing in each task, you and your roommate can finish the chores more quickly. If you divided each task equally, it would take you more time to cook than it would take your roommate, and it would take him more time to clean than it would take you. By specializing, you reduce the total time spent on chores.

Similarly, countries can specialize and trade, making both better off. For example, suppose it takes Spanish workers less time to make clothes than French workers, and French workers can make wine more efficiently than Spanish workers. Then Spain and France can both benefit if Spanish workers produce all the clothes and French workers produce all the wine, and they exchange some wine for some clothes.

8.

Nations with corrupt police and court systems typically have lower standards of living than nations with less corruption. Why might that be the case?

These activities tend to lessen the efficiency of an economic system, hence reducing the economic productivity of a nation. Lower productivity means lower standards of living.

9.

Explain whether each of the following government activities is motivated by a concern about equity or a concern about efficiency. In the case of efficiency, discuss the type of market failure involved. a. regulating cable TV prices b. providing some poor people with free prescription drugs c. prohibiting smoking in public places d. preventing mergers between major banks e. imposing higher personal income tax rates on people with higher incomes f. instituting laws against driving while intoxicated a. b.

Efficiency: The market failure comes from the market power of a small number of cable TV firms.

Equity

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c. d. e. f.

10.

Discuss each of the following statements from the standpoints of equity and efficiency. a. ―Everyone in society should be guaranteed the best health care possible.‖ b. ―When workers are laid off, they should be able to collect unemployment benefits until they find a new job.‖ a.

b.

11.

Efficiency: An externality arises because secondhand smoke harms nonsmokers in public places.

Efficiency: The market failure comes from the market power that might occur from potential mergers.

Equity Efficiency: An externality exists because of accidents caused by drunk drivers.

If everyone were guaranteed the best health care possible, much more of our nation’s output would be devoted to health care than is now the case. Would that be efficient? If you believe that doctors have market power and restrict health care to keep their incomes high, you might think efficiency would increase by providing more health care.

But more likely, if the government mandated increased spending on health care, the economy would be less efficient because it would give people more health care than they would choose to pay for. From the point of view of equality, if poor people are less likely to have adequate health care, providing more health care would represent an improvement. Each person would have a more equal slice of the economic pie, though the pie would consist of more health care and fewer other goods.

When workers are laid off, equality considerations argue for the unemployment benefits system to provide them with some income until they can find new jobs. After all, no one plans to be laid off, so unemployment benefits are a form of insurance. But there is an efficiency problemwhy work if you can get income for doing nothing? The economy is not operating efficiently if people remain unemployed for a long time, and unemployment benefits encourage unemployment. Thus, there is a tradeoff between equality and efficiency. The more generous unemployment benefits are, the less income is lost by an unemployed person, but the more that person is encouraged to remain unemployed. So greater equality reduces efficiency.

In what ways is your standard of living different from that of your parents or grandparents when they were your age? Why have these changes occurred?

Since average income in Canada has roughly doubled every 35 years, we are likely to have a better standard of living than our parents, and a much better standard of living than our grandparents. This is mainly the result of increased productivity, so that an hour of work produces more goods and services than it used to. Thus, incomes have continuously risen over time, as has the standard of living.

12.

Suppose Canadians decide to save more of their incomes. If banks lend this extra saving to businesses, which use the funds to build new factories, how might this lead to faster growth in productivity? Who do you suppose benefits from the higher productivity? Is society getting a free lunch?

If Canadians save more and it leads to more spending on factories, there will usually be an increase in production and productivity, since the same number of workers will have more equipment to work with. The benefits from higher productivity will go to both the workers, who will get paid more since they're producing more, and the factory owners, who will get a return on their investments. There is no such thing as a free lunch, however, because when people save more, they are giving up spending. They get higher incomes in the future at the cost of buying fewer goods today.

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Chapter 2 Thinking Like an Economist SOLUTIONS TO TEXTBOOK PROBLEMS Questions for Review 1.

In what ways is economics like a science?

Economics is like a science because economists use the scientific method. They devise theories, collect data, and then analyze these data in an attempt to verify or refute their theories about how the world works. Economists use theory and observation like other scientists, but they are limited in their ability to run controlled experiments. Instead, they must rely on natural experiments.

2.

Why do economists make assumptions?

Economists make assumptions to simplify problems without substantially affecting the answer.

Assumptions can make the world easier to understand.

3.

Should an economic model describe reality exactly?

An economic model cannot describe reality exactly because it would be too complicated to understand. A model is a simplification that allows the economist to see what is truly important.

4.

Name a way that your family interacts in the factor market and a way that it interacts in the product market.

There are many possible answers.

5.

Name one economic interaction that isn’t covered by the simplified circular-flow diagram.

There are many possible answers.

6.

Draw and explain a production possibilities frontier for an economy that produces milk and cookies. What happens to this frontier if disease kills half of the economy’s cows?

Figure 3 shows a production possibilities frontier between milk and cookies (PPF1). If a disease kills half of the economy’s cow population, less milk production is possible, so the PPF shifts inward (PPF2). Note that if the economy produces all cookies so that it doesn’t need any cows, then production is unaffected. But if the economy produces any milk at all, then there will be less production possible after the disease hits.

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Figure 3 7.

Use a production possibilities frontier to describe the idea of ―efficiency.‖ The idea of efficiency is that an outcome is efficient if the economy is getting all it can from the scarce resources it has available. In terms of the production possibilities frontier, an efficient point is a point on the frontier, such as point A in Figure 4. A point inside the frontier, such as point B, is inefficient since more of one good could be produced without reducing the production of another good.

Figure 4 8.

What are the two subfields into which economics is divided? Explain what each subfield studies.

The two subfields in economics are microeconomics and macroeconomics. Microeconomics is the study of how households and firms make decisions and how they interact in specific markets.

Macroeconomics is the study of economy-wide phenomena.

9.

What is the difference between a positive and a normative statement? Give an example of each.

Positive statements are descriptive and make a claim about how the world is, while normative

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statements are prescriptive and make a claim about how the world ought to be. Here is an example. Positive: A rapid growth rate of money is the cause of inflation. Normative: The government should keep the growth rate of money low.

10.

Why do economists sometimes offer conflicting advice to policymakers?

One reason that economists may disagree is that they have different views regarding the validity of alternative positive theories about how the world works or the magnitude of incentive effects.

For example, some economists may interpret the evidence regarding the incentive effects of taxes on work effort differently. Another reason that economists may disagree is they have different normative views about what a policy should try to accomplish, most particularly concerning the equity-efficiency tradeoff.

Problems and Applications 1.

Draw a circular-flow diagram. Identify the parts of the model that correspond to the flow of goods and services and the flow of dollars for each of the following activities. a. Selena pays a storekeeper $2 for a litre of milk. b. Stuart earns $15 per hour working at a fast-food restaurant. c. Shanna spends $30 to get a haircut. d. Salma earns $10 000 from her 10 percent ownership of Acme Industrial.

See Figure 5, where the four transactions are shown. a. $2 c. $30

a. $2 c. $30 Markets for Goods and Services

a. litre of milk c. haircut

a. litre of milk c. haircut

Firms

Households

b. one hour of work d. Acme’s capital

b. one hour of work d. Acme’s capital

Markets for Factors of Production b. $15 d. $10 000

b. $15 d. $10 000

Figure 5

2.

Imagine a society that produces military goods and consumer goods, which we’ll call ―guns‖ and ―butter.‖ a. Draw a production possibilities frontier for guns and butter. Explain why it most likely has a bowed-out shape.

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b. Show a point that is impossible for the economy to achieve. Show a point that is feasible but inefficient. c. Imagine that the society has two political parties, called the Hawks (who want a strong military) and the Doves (who want a smaller military). Show a point on your production possibilities frontier that the Hawks might choose and a point the Doves might choose. d. Imagine that an aggressive neighbouring country reduces the size of its military. As a result, both the Hawks and the Doves reduce their desired production of guns by the same amount. Which party would get the bigger ―peace dividend,‖ measured by the increase in butter production? Explain. a.

Figure 6 shows a production possibilities frontier between guns and butter. It is bowed out because when most of the economy’s resources are being used to produce butter, the frontier is steep, and when most of the economy’s resources are being used to produce guns, the frontier is very flat. When the economy is producing a lot of guns, workers and machines best suited to making butter are being used to make guns, so each unit of guns given up yields a large increase in the production of butter. Thus, the production possibilities frontier is flat. When the economy is producing a lot of butter, workers and machines best suited to making guns are being used to make butter, so each unit of guns given up yields a small increase in the production of butter. Thus, the production possibilities frontier is steep.

Figure 6 b.

Point A is impossible for the economy to achieve; it is outside the production possibilities frontier. Point B is feasible but inefficient because it’s inside the production possibilities frontier.

c.

The Hawks might choose a point like H, with many guns and not much butter. The Doves might choose a point like D, with a lot of butter and few guns.

d.

If both Hawks and Doves reduced their desired quantity of guns by the same amount, the Hawks would get a bigger peace dividend because the production possibilities frontier is much flatter at point H than at point D. As a result, the reduction of a given number of guns, starting at point H, leads to a much larger increase in the quantity of

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butter produced than when starting at point D.

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3.

The first principle of economics discussed in Chapter 1 is that people face tradeoffs. Use a production possibilities frontier to illustrate society’s tradeoff between a clean environment and the quantity of industrial output. What do you suppose determines the shape and position of the frontier? Show what happens to the frontier if engineers develop an automobile engine with almost no emissions.

See Figure 7. The shape and position of the frontier depend on how costly it is to maintain a clean environmentthe productivity of the environmental industry. Gains in environmental productivity, such as the development of a no-emission auto engine, lead to shifts of the production possibilities frontier, like the shift from PPF 1 to PPF2 shown in the figure.

Figure 7 4.

Classify the following topics as relating to microeconomics or macroeconomics. a. a family’s decision about how much income to save b. the effect of government regulations on auto emissions c. the impact of higher national saving on economic growth d. a firm’s decision about how many workers to hire e. the relationship between the inflation rate and changes in the quantity of money a.

A family’s decision about how much income to save is microeconomics.

b.

The effect of government regulations on auto emissions is microeconomics.

c.

The impact of higher national saving on economic growth is macroeconomics.

d.

A firm’s decision about how many workers to hire is microeconomics.

e.

The relationship between the inflation rate and changes in the quantity of money is macroeconomics.

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5.

Classify each of the following statements as positive or normative. Explain. a. Society faces a short-run tradeoff between inflation and unemployment. b. A reduction in the rate of growth of money will reduce the rate of inflation. c. The Bank of Canada should reduce the rate of growth of money. d. Society ought to require welfare recipients to look for jobs. e. Lower tax rates encourage more work and more saving.

6.

a.

The statement that society faces a short-run tradeoff between inflation and unemployment is a positive statement. It deals with how the economy is, not how it should be. Since economists have examined data and found that there is a short-run negative relationship between inflation and unemployment, the statement is a fact; thus it is a positive statement.

b.

The statement that a reduction in the rate of growth of money will reduce the rate of inflation is a positive statement. Economists have found that money growth and inflation are very closely related. The statement thus tells how the world is, and so it is a positive statement.

c.

The statement that the Bank of Canada should reduce the rate of growth of money is a normative statement. It states an opinion about something that should be done, not how the world is.

d.

The statement that society ought to require welfare recipients to look for jobs is a normative statement. It doesn’t state a fact about how the world is. Instead, it is a statement of how the world should be and is thus a normative statement.

e.

The statement that lower tax rates encourage more work and more saving is a positive statement. Economists have studied the relationship between tax rates and work, as well as the relationship between tax rates and saving. They have found a negative relationship in both cases. The statement reflects how the world is, and is thus a positive statement.

If you were Prime Minister, would you be more interested in your economic advisers’ positive views or their normative views? Why? As the Prime Minister, you’d be interested in both the positive and normative views of economists, but you’d probably be most interested in their positive views. Economists are on your staff to provide their expertise about how the economy works. They know many facts about the economy and the interaction of different sectors. So you would be most likely to call on them about questions of factpositive analysis. Since you are the Prime Minister, you are the one who has to make the normative statements as to what should be done, with an eye to the political consequences. The normative statements made by economists represent their own views, not necessarily your views or the electorate’s views.

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7.

An economy consists of three workers: Larry, Moe, and Curly. Each works for ten hours per day and can produce two services: mowing lawns and washing cars. In an hour, Larry can either mow one lawn or wash one car, Moe can either mow one lawn or wash two cars, and Curly can either mow two lawns or wash one car. a. Calculate how much of each service is produced under the following circumstances, which we label A, B, C, and D: • All three spend all their time mowing lawns. (A) • All three spend all their time washing cars. (B) • All three spend half their time on each activity. (C) • Larry spends half his time on each activity, while Moe only washes cars and Curly only mows lawns. (D) b. Graph the production possibilities frontier for this economy. Using your answers to part (a), identify points A, B, C, and D on your graph. c. Explain why the production possibilities frontier has the shape it does. d. Are any of the allocations calculated in part (a) inefficient? Explain. a.

The following table gives the outcomes in the four cases. For example, when each uses half their time in each sector, Larry washes 5 cars and mows 5 lawns in 10 hours, etc.

Lawn mowing Car washing b.

A

B

C

D

40 0

0 40

20 20

25 25

The following graph shows the production possibilities frontier based on the numbers in the table.

Figure 8 c.

The upper part is flatter because the opportunity cost of increasing the number of cars from 0 to 25 is less than 1 lawn per car; moving from 0 cars takes advantage of Moe’s better ability to wash cars than to mow lawns. However, when the number of cars exceeds 25, we start losing Curly’s better skill in mowing lawns; therefore, the opportunity cost of an extra car increases above 1 forgone mowed lawn per extra washed car.

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d.

Allocation C is inefficient. Although all workers use all their time, they do not use their specific skills wisely.

Appendix Problems and Applications A1.

Consider the linear demand curve:

Q D = 56 – 4 P

a. Determine the x- and y-intercepts of this demand curve. b. Determine the slope of this demand curve.

A2.

a.

To determine the x -intercept, set P = 0 and solve for Q D , giving Q D = 56; so the x-intercept is 56. To determine the y -intercept, set Q D = 0 and solve for P, giving 0 = 56 – 4P, P = 56/4, P = 14.

b.

The slope is the rise over the run, where ―rise‖ is the y-intercept and ―run‖ is the xintercept. Thus, slope = –14/56 = –1/4.

Using the general functional form for a linear demand curve, Q D = a – bP, and the data in Table 2A.1, a. Determine the values for a and b for Emma when her income is $30 000. b. Determine the x- and y-intercepts of this demand curve. c. Determine the slope of this demand curve. d. Draw it on a diagram along with the demand curves when her income is $40 000 and $50 000, identifying the x- and y-intercepts in each case. a.

At P = 10, Q = 2 and at P = 9, Q = 6. Therefore, 2 = a – 10b 6 = a – 9b Solve simultaneously for a and b: the first equation gives a = 2 + 10b; substitute into the second equation to get 6 = 2 + 10b – 9b, and solve for b = 4; therefore a = 2 + (10)(4) = 42. Thus, Q D = 42 – 4P.

b.

x-intercept = 42, y-intercept = 10.5

c.

slope = –10.5/42 = –1/4

d.

Figure

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Chapter 3 Interdependence and the Gains from Trade SOLUTIONS TO TEXTBOOK PROBLEMS Questions for Review 1.

Under what conditions is the production possibilities frontier linear rather than bowed out?

The production possibilities frontier is linear when the opportunity cost of increasing the production of one good is always the same irrespective of the current level of production. This constant opportunity cost reflects the homogeneity of the factors of production: all workers spend the same amount of time in both activities, and no resources are more suitable for producing one good as compared to the other.

2.

Explain how absolute advantage and comparative advantage differ.

Absolute advantage reflects a comparison of the productivity of one person, firm, or nation to that of another, while comparative advantage is based on the relative opportunity costs of the persons, firms, or nations. While a person, firm, or nation may have an absolute advantage in producing every good, they can’t have a comparative advantage in every good.

3.

Give an example in which one person has an absolute advantage in doing something but another person has a comparative advantage.

Many examples are possible. Suppose, for example, that Roger can prepare a fine meal of hot dogs and macaroni in just 10 minutes, while it takes Anita 20 minutes. And Roger can do all the wash in 3 hours, while it takes Anita 4 hours. Roger has an absolute advantage in both cooking and doing the wash, but Anita has a comparative advantage in doing the wash (the wash takes the same amount of time as 12 meals, while it takes Roger 18 meals’ worth of time).

4.

Is absolute advantage or comparative advantage more important for trade? Explain your reasoning using the example in your answer to question 3.

Comparative advantage is more important for trade than absolute advantage. In the example in question 3, Anita and Roger will complete their chores more quickly if Anita does at least some of the wash and Roger cooks the fine meals for both, because Anita has a comparative advantage in doing the wash, while Roger has a comparative advantage in cooking.

5.

If two parties trade based on comparative advantage and both gain, in what range must the price of the trade lie?

In order for trade to benefit both parties, the price for the trade must lie between the parties’ opportunity costs.

6.

Why do economists tend to oppose policies that restrict trade among nations?

Economists oppose policies that restrict trade among nations because trade allows all countries to achieve greater prosperity by allowing them to receive the gains from comparative advantage.

Restrictions on trade can hurt all countries.

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Problems and Applications 1.

Maria can read 20 pages of economics in an hour. She can also read 50 pages of sociology in an hour. She spends 5 hours per day studying. a. Draw Maria’s production possibilities frontier for reading economics and sociology. b. What is Maria’s opportunity cost of reading 100 pages of sociology? a.

See Figure 2. If Maria spends all 5 hours studying economics, she can read 100 pages, so that is the vertical intercept of the production possibilities frontier. If she spends all 5 hours studying sociology, she can read 250 pages, so that is the horizontal intercept.

The time costs are constant, so the production possibilities frontier is a straight line.

Figure 2 b.

2.

It takes Maria 2 hours to read 100 pages of sociology. In that time, she could read 40 pages of economics. So the opportunity cost of 100 pages of sociology is 40 pages of economics.

Canadian and Japanese workers can each produce 4 cars per year. A Canadian worker can produce 10 tonnes of grain per year, whereas a Japanese worker can produce 5 tonnes of grain per year. To keep things simple, assume that each country has 100 million workers. a. For this situation, construct a table analogous to panel (a) in Figure 3.1. b. Graph the production possibilities frontier of the Canadian and Japanese economies. c. For Canada, what is the opportunity cost of a car? Of grain? For Japan, what is the opportunity cost of a car? Of grain? Put this information in a table analogous to Table 3.1. d. Which country has an absolute advantage in producing cars? In producing grain? e. Which country has a comparative advantage in producing cars? In producing grain? f. Without trade, half of each country’s workers produce cars and half produce grain.

What quantities of cars and grain does each country produce? g. Starting from a position without trade, give an example in which trade makes each country better off.

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a.

Canada Japan b.

Workers needed to make: One car One tonne of grain 1/4 1/10 1/4 1/5

See Figure 3. With 100 million workers and 4 cars per worker, if either economy were devoted completely to cars, it could make 400 million cars. Since a Canadian worker can produce 10 tonnes of grain, if Canada produced only grain it would produce 1000 million tonnes. Since a Japanese worker can produce 5 tonnes of grain, if Japan produced only grain, it would produce 500 million tonnes. These are the intercepts of the production possibilities frontiers shown in the figure. Note that since the tradeoff between cars and grain is constant, the production possibilities frontier is a straight line.

Canada

Grain (millions of tonnes) Figure 3 c.

Since a Canadian worker produces either 4 cars or 10 tonnes of grain, the opportunity cost of 1 car is 2-1/2 (or 2.5) tonnes of grain, which is 10 divided by 4. Since a Japanese worker produces either 4 cars or 5 tonnes of grain, the opportunity cost of 1 car is 1-1/4 (or 1.25) tonnes of grain, which is 5 divided by 4. Similarly, the Canadian opportunity cost of 1 tonne of grain is 2/5 (or 0.4) car (4 divided by 10), and the Japanese opportunity cost of 1 tonne of grain is 4/5 (or 0.8) car (4 divided by 5). This gives the following table:

Canada Japan d.

Opportunity Cost of: 1 car (in terms of tonnes 1 tonne of grain (in terms of grain given up) of cars given up) 2-1/2 or 2.5 2/5 or 0.4 1-1/4 or 1.25 4/5 or 0.8

Neither country has an absolute advantage in producing cars, since they’re equally productive (the same output per worker); Canada has an absolute advantage in producing grain, since it is more productive (greater output per worker).

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3.

e.

Japan has a comparative advantage in producing cars, since it has a lower opportunity cost in terms of grain given up. Canada has a comparative advantage in producing grain, since it has a lower opportunity cost in terms of cars given up.

f.

With half the workers in each country producing each of the goods, Canada would produce 200 million cars (that is, 50 million workers times 4 cars each) and 500 million tonnes of grain (50 million workers times 10 tonnes each). Japan would produce 200 million cars (50 million workers times 4 cars each) and 250 million tonnes of grain (50 million workers times 5 tonnes each).

g.

From any situation with no trade, in which each country is producing some cars and some grain, suppose Canada changed 1 worker from producing cars to producing grain.

That worker would produce 4 fewer cars and 10 additional tonnes of grain. Then suppose Canada offers to trade 7 tonnes of grain to Japan for 4 cars. Canada will do this because it values 4 cars at 10 tonnes of grain, so it will be better off if the trade goes through. Suppose Japan changes 1 worker from producing grain to producing cars. That worker would produce 4 more cars and 5 fewer tonnes of grain. Japan will take the trade because it values 4 cars at 5 tonnes of grain, so it will be better off. With the trade and the change of 1 worker in both Canada and Japan, each country gets the same number of cars as before and both get additional tonnes of grain (3 for Canada and 2 for Japan).

Thus, by trading and changing their production, both countries are better off.

Pat and Kris are roommates. They spend most of their time studying (of course), but they leave some time for their favourite activities: making pizza and brewing root beer. Pat takes 4 hours to brew 5 L of root beer and 2 hours to make a pizza. Kris takes 6 hours to brew 5 L of root beer and 4 hours to make a pizza. a. What is each roommate’s opportunity cost of making a pizza? Who has the absolute advantage in making pizza? Who has the comparative advantage in making pizza? b. If Pat and Kris trade products with each other, who will trade away pizza in exchange for root beer? c. The price of pizza can be expressed in terms of litres of root beer. What is the highest price at which pizza can be traded that would make both roommates better off? What is the lowest price? Explain. a.

Pat’s opportunity cost of making a pizza is 2.5 litres of root beer, since she could brew 2.5 litres in the time (2 hours) it takes her to make a pizza. Pat has an absolute advantage in making pizza since she can make one in 2 hours, while it takes Kris 4 hours. Kris’s opportunity cost of making a pizza is 3-1/3 litres of root beer, since she could brew 3-1/3 litres in the time (4 hours) it takes her to make a pizza. Since Pat’s opportunity cost of making pizza is less than Kris’s, Pat has a comparative advantage in making pizza.

b.

Since Pat has a comparative advantage in making pizza, she will make pizza and exchange it for root beer that Kris makes.

c.

The highest price of pizza in terms of root beer that will make both roommates better off is 3-1/3 litres of root beer. If the price were higher than that, then Kris would prefer making her own pizza (at an opportunity cost of 3-1/3 litres of root beer) rather than trading for pizza that Pat makes. The lowest price of pizza in terms of root beer that will make both roommates better off is 2-1/2 litres of root beer. If the price were lower than that, then Pat would prefer making her own root beer (she can make 2-1/2 litres of root beer instead of making a pizza) rather than trading for root beer that Kris makes.

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4.

Suppose that there are 10 million workers in Canada, and that each of these workers can produce either 2 cars or 30 tonnes of wheat in a year. a. What is the opportunity cost of producing a car in Canada? What is the opportunity cost of producing a tonne of wheat in Canada? Explain the relationship between the opportunity costs of the two goods. b. Draw Canada’s production possibilities frontier. If Canada chooses to consume 10 million cars, how much wheat can it consume without trade? Label this point on the production possibilities frontier. c. Now suppose that the United States offers to buy 10 million cars from Canada in exchange for 20 tonnes of wheat per car. If Canada continues to consume 10 million cars, how much wheat does this deal allow Canada to consume? Label this point on your diagram. Should Canada accept the deal? a.

Since a Canadian worker can make either 2 cars a year or 30 tonnes of wheat, the opportunity cost of a car is 15 tonnes of wheat. Similarly, the opportunity cost of a tonne of wheat is 1/15 of a car. The opportunity costs are the reciprocals of each other.

b.

See Figure 4. If all 10 million workers produce 2 cars each, they produce a total of 20 million cars, which is the vertical intercept of the production possibilities frontier. If all 10 million workers produce 30 tonnes of wheat each, they produce a total of 300 million tonnes, which is the horizontal intercept of the production possibilities frontier. Since the tradeoff between cars and wheat is always the same, the production possibilities frontier is a straight line.

If Canada chooses to consume 10 million cars, it will need 5 million workers devoted to car production. That leaves 5 million workers to produce wheat, who will produce a total of 150 million tonnes (5 million workers times 30 tonnes per worker). This is shown as point A on Figure 4.

c.

If the United States buys 10 million cars from Canada and Canada continues to consume 10 million cars, then Canada will need to produce a total of 20 million cars. So Canada will be producing at the vertical intercept of the production possibilities frontier. But if Canada gets 20 tonnes of wheat per car, it will be able to consume 200 million tonnes of wheat, along with the 10 million cars. This is shown as point B in the figure. Canada should accept the deal because it gets the same number of cars and 50 million more tonnes of wheat.

Wheat (millions of tonnes) Figure 4

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5.

6.

England and Scotland both produce scones and sweaters. Suppose that an English worker can produce 50 scones per hour or 1 sweater per hour. Suppose that a Scottish worker can produce 40 scones per hour or 2 sweaters per hour. a. Which country has the absolute advantage in the production of each good? Which country has the comparative advantage? b. If England and Scotland decide to trade, which commodity will Scotland trade to England? Explain. c. If a Scottish worker could produce only 1 sweater per hour, would Scotland still gain from trade? Would England still gain from trade? Explain. a.

English workers have an absolute advantage over Scottish workers in producing scones, since English workers produce more scones per hour (50 vs. 40). Scottish workers have an absolute advantage over English workers in producing sweaters, since Scottish workers produce more sweaters per hour (2 vs. 1). Comparative advantage runs the same way. English workers, who have an opportunity cost of 1/50 sweater per scone (1 sweater per hour divided by 50 scones per hour), have a comparative advantage in scone production over Scottish workers, who have an opportunity cost of 1/20 sweater per scone (2 sweaters per hour divided by 40 scones per hour). Scottish workers, who have an opportunity cost of 20 scones per sweater (40 scones per hour divided by 2 sweaters per hour), have a comparative advantage in sweater production over English workers, who have an opportunity cost of 50 scones per sweater (50 scones per hour divided by 1 sweater per hour).

b.

If England and Scotland decide to trade, Scotland will produce sweaters and trade them for scones produced in England. A trade with a price between 20 and 50 scones per sweater will benefit both countries, as they’ll be getting the traded good at a lower price than their opportunity cost of producing the good in their own country.

c.

Even if a Scottish worker produced just 1 sweater per hour, the countries would still gain from trade, because Scotland would still have a comparative advantage in producing sweaters. Its opportunity cost for sweaters would be higher than before (40 scones per sweater, instead of 20 scones per sweater before). But there are still gains from trade since England has a higher opportunity cost (50 scones per sweater).

The following table describes the production possibilities of two cities:

Montreal Toronto

Red Sweaters per Worker per Hour

Blue Sweaters per Worker per Hour

3 2

3 1

a. Without trade, what is the price of blue sweaters (in terms of red sweaters) in Montreal?

What is the price in Toronto? b. Which city has an absolute advantage in the production of each colour of sweater? Which city has a comparative advantage in the production of each colour of sweater? c. If the cities trade with each other, which colour of sweater will each export? d. What is the range of prices at which trade can occur? a.

With no trade, the price of 1 blue sweater is 1 red sweater in Montreal since productivity is the same for the two sweaters. The price in Toronto is 2 red sweaters for 1 blue sweater.

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b.

Montreal has an absolute advantage in the production of both colours of sweater, since a worker in Montreal produces more (3 sweaters per hour) than a worker in Toronto (2 red sweaters per hour or 1 blue sweater per hour).

Toronto has a comparative advantage in producing red sweaters, since the opportunity cost of producing red sweaters in Toronto is 1/2 of a blue sweater, while the opportunity cost of producing a red sweater in Montreal is 1 blue sweater. Montreal has a comparative advantage in producing blue sweaters, since the opportunity cost of producing a blue sweater in Montreal is 1 red sweater, while the opportunity cost of producing a blue sweater in Toronto is 2 red sweaters.

7.

c.

If they trade sweaters, Montreal will produce blue sweaters for export, since it has the comparative advantage in blue sweaters, while Toronto produces red sweaters for export, which is Toronto’s comparative advantage.

d.

Trade can occur at any price between 1 and 2 red sweaters per blue sweater. At a price lower than 1 red sweater per blue sweater, Montreal will choose to produce its own red sweaters (at a cost of 1 red sweater per blue sweater) instead of buying them from Toronto. At a price higher than 2 red sweaters per blue sweater, Toronto will choose to produce its own blue sweaters (at a cost of 2 red sweaters per blue sweater) instead of buying them from Montreal.

Are the following statements true or false? Explain in each case. a. ―Two countries can achieve gains from trade even if one of the countries has an absolute advantage in the production of all goods.‖ b. ―Certain very talented people have a comparative advantage in everything they do.‖ c. ―If a certain trade is good for one person, it can’t be good for the other one.‖ d. ―If a certain trade is good for one person, it is always good for the other one.‖ e. ―If trade is good for a country, it must be good for everyone in the country.‖ a.

True; two countries can achieve gains from trade even if one of the countries has an absolute advantage in the production of all goods. All that’s necessary is that each country has a comparative advantage in some good.

b.

False; it is not true that some people have a comparative advantage in everything they do. In fact, no one can have a comparative advantage in everything. Comparative advantage reflects the opportunity cost of one good or activity in terms of another. If you have a comparative advantage in one thing, you must have a comparative disadvantage in the other thing.

c.

False; it is not true that if a trade is good for one person, it can’t be good for the other one. Trades can and do benefit both sidesespecially trades based on comparative advantage. If both sides didn’t benefit, trades would never occur.

d.

True. If a trade were not good for both persons, it wouldn’t take place.

e.

False; trade liberalization may hurt some people in import-competing industries. Trade liberalization may make some people lose their jobs or some business owners see their profits diminished. Overall, though, a country benefits from lower prices and more diversity of imported goods.

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8.

Canada exports oil and pulp and paper to the rest of the world, and it imports computers and clothing from the rest of the world. Do you think this pattern of trade is consistent with the principle of comparative advantage? Why or why not?

Yes, this trade pattern is consistent with comparative advantage because oil and wood are abundant in Canada. This has determined Canadian producers to become more efficient than foreigners in extracting oil and producing pulp and paper, while having less time left for learning how to produce good computers and clothing.

9.

Conrad and Barbara produce food and clothing. In an hour, Conrad can produce 1 unit of food or 1 unit of clothing, while Barbara can produce 2 units of food or 3 units of clothing. They each work 10 hours a day. a. Who has an absolute advantage in producing food? Who has an absolute advantage in producing clothing? Explain. b. Who has a comparative advantage in producing food? Who has a comparative advantage in producing clothing? Explain. c. Draw the production possibilities frontier for the household (that is, Conrad and Barbara together), assuming that each spends the same number of hours each day as the other producing food and clothing. d. Barbara suggests that, instead, she specialize in making clothing. That is, she will do all of the clothing production, unless her time is fully devoted to clothing, and then Conrad will chip in. What does the household production possibilities frontier look like now? e. Conrad suggests that Barbara specialize in producing food. That is, Barbara will do all the food production, unless her time is fully devoted to food, and then Conrad will chip in. What does the household production possibilities frontier look like under Conrad’s proposal? f. Comparing your answers to parts (c), (d), and (e), which allocation of time makes the most sense? Relate your answer to the theory of comparative advantage. a.

Barbara has an absolute advantage in the production of both food and clothing because she can produce more of each in an hour than Conrad can.

b.

Conrad has a comparative advantage in the production of food: his opportunity cost of producing 1 unit of food is 1 unit of clothing, while Barbara’s opportunity cost of producing 1 unit of food is 3/2 = 1.5 units of clothing. By the reversed logic, Barbara has a comparative advantage in the production of clothing.

c.

The two spend equal amounts of time on both activities:

Food

30

15 Clothing 20

40

Figure 5

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d.

Barbara does the clothing: Figure 6 shows both production possibilities frontiers and their combination. As the graph shows, Barbara does all the clothing and some food when they want to do fewer than 30 units of clothing. If they want to produce more than 30 units of clothing, Barbara does only clothing, while Conrad does some food and some clothing. For example, suppose they want to produce 15 units of clothing and food for the remaining time. Barbara will work 5 hours to produce the 15 units of clothing, and 5 hours to produce 5 × 2 = 10 units of food; in the meantime, Conrad will work 10 hours only on food, producing 10 units of food. The result is 15 units of clothing and 10 + 10 = 20 units of food.

Food

30

20

Barbara and Conrad

Barbara d

10 Conrad 10 15

30

Clothing 40

Figure 6 e.

If Barbara does the food and Conrad the clothing, Barbara will produce only food if the desired quantity is less than or equal to 20 units, the maximum Barbara can produce in 10 hours. At 20 units of food, the most clothing that can be produced is how much Conrad can produce in 10 hours, which is 10 units. If they want more than 10 units of clothing, then Barbara should produce correspondingly less food and help Conrad do more clothing. Figure 7 shows this arrangement.

Food

30 Barbara and Conrad 20

Barbara 10 Conrad

10

20 Figure 7

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30

Clothing 40

f.

10.

The most efficient allocation is the one at point d, with Barbara specializing in clothing and Conrad in food. Thus, typically Barbara does all the clothing and some food, while Conrad does only food and occasionally, when not too much food is needed, he does some clothing. This is consistent with the theory of comparative advantage, which predicts that the person having comparative advantage specializes in the production of that good, but the other person can also contribute to the total production.

Suppose that in a year, a Canadian worker can produce 100 shirts or 20 computers, while a Chinese worker can produce 100 shirts or 10 computers. a. Graph the production possibilities curve for the two countries. Suppose that without trade, the workers in each country spend half their time producing each good. Identify this point in your graph. b. If these countries were open to trade, which country would export shirts? Give a specific numerical example and show it on your graph. Which country would benefit from trade? Explain. c. Explain at what price of computers (in terms of shirts) the two countries might trade. d. Suppose that China catches up with Canadian productivity so that a Chinese worker can produce 100 shirts or 20 computers. What pattern of trade would you predict now? How does this advance in Chinese productivity affect the economic well-being of the citizens of the two countries? a.

If the two countries devote half of their time to produce both goods, they produce a total of 100 shirts and 15 computers. This is point A in Figure 8.

Shirts 100

A

Canada China 10 15 20

Computers

Figure 8 b.

China’s cost of producing a computer is 100/10 = 10 shirts. Canada’s cost is 100/20 = 5 shirts. China has a comparative advantage in the production of shirts. Starting at point A’, the initial production and consumption point, if China produces 20 extra shirts and 2 fewer computers, it can buy from Canada up to 4 computers, thus ending up consuming the same number of shirts as before, but up to 2 more computers. Canada would have to produce up to 4 computers to sell to China, which costs it up to 20 shirts.

Thus, China gains some additional computers and Canada some additional shirts. The new consumption points are B’ for China and B’’ for Canada (Figure 9).

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Shirts 100

B’’ B’ 50

A’

China

5

10

Canada

Computers 20

Figure 9

11.

c.

Trade can take place at any price between the costs of production in each country. The cost of a computer in China is 100/10 = 10 shirts; the cost of a computer in Canada is 100/20 = 5 shirts. Thus, any price between 5 and 10 shirts allows for trade.

d.

With increased productivity in the computer sector, the Chinese can now consume the same number of shirts as before and more computers. Therefore, they must be better off. Canadians see now the price of their shirts increasing, so they must be worse off than before. Since the two countries are now identical in terms of productivity, trade based on comparative advantage in the two sectors does not benefit them.

An average worker in Brazil can produce 30 mL of soy milk in 20 minutes and 30 mL of coffee in 60 minutes, while an average worker in Peru can produce 30 mL of soy milk in 50 minutes and 30 mL of coffee in 75 minutes. a. Who has the absolute advantage in coffee? Explain. b. Who has the comparative advantage in coffee? Explain. c. If the two countries specialize and trade with each other, who will import coffee?

Explain. d. Assume that the two countries trade and that the country importing coffee trades 60 mL of soy milk for 30 mL of coffee. Explain why both countries will benefit from this trade. a.

Brazil can produce each of the two commodities in less time than Peru. Brazil has, therefore, an absolute advantage in both commodities.

b.

In Brazil, it takes longer to produce coffee than soy. Thus, the cost of soy should be less than an ounce of coffee. This cost is precisely 20/60 = 1/3 mL of coffee/mL of soy. In Peru, the same price is 50/75 = 2/3 coffee/soy. Since the (opportunity) cost of producing soy is greater in Peru, Brazil has a comparative advantage in soy and Peru in coffee.

c.

Brazil will specialize in the production of soy; therefore, it imports coffee.

d.

The cost of a mL of coffee in Brazil is 3 mL of soy. By importing it at only 2 mL of soy per mL of coffee, Brazil gains 1 mL of soy for each mL of coffee imported. The cost of coffee in Peru is 3/2 = 1.5 mL of soy per mL of coffee. By exporting it at 2 mL of soy per 1 mL

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of coffee, Peru gains 0.5 mL of soy for each mL of coffee exported.

12.

A German worker takes 400 hours to produce a car and 2 hours to produce a case of wine. A French worker takes 600 hours to produce a car and X hours to produce a case of wine. a. For what values of X will gains from trade be possible? Explain. b. For what values of X will Germany export cars and import wine? Explain. a.

Gains from trade will be possible when X does not equal 3. Gains from trade are possible when a comparative advantage exists. The opportunity cost of 1 car in Germany is 200 cases of wine (400 hours/2 hours per case of wine). Likewise, the opportunity cost of 1 case of wine in Germany is 1/200 car. When X = 3, the opportunity cost of 1 car in France is 200 cases of wine (600 hours/3 hours per case of wine). In this instance, neither country has a comparative advantage. At all other values of X, a comparative advantage will exist.

b.

Germany will export cars and import wine for all values of X < 3. For Germany to export cars, it must have the comparative advantage in producing cars, and France must have the comparative advantage in producing wine. This occurs when Germany has a smaller opportunity cost of producing cars than France does. We know the opportunity cost of 1 car in Germany is 200 cases of wine. When X < 3, the opportunity cost of 1 car in France is greater than 200 cases of wine. For example, when X = 2, the opportunity cost of 1 car in France is 300 cases of wine (600 hours/2 hours per case = 300 cases).

Therefore, Germany, having the comparative advantage in cars, will export cars and import wine for all values of X < 3

Chapter 4 The Market Forces of Supply and Demand SOLUTIONS TO TEXTBOOK PROBLEMS Questions for Review 1.

What is a competitive market? Briefly describe one the types of markets other than perfectly competitive markets.

A competitive market is a market in which there are many buyers and many sellers of an identical product so that each has a negligible impact on the market price. Other types of markets include monopoly, in which there is only one seller, markets in which there are a few sellers that do not always compete aggressively, and markets in which there are many sellers, each offering a slightly different product.

2.

What are the demand schedule and the demand curve, and how are they related? Why does the demand curve slope downward?

The demand schedule is a table that shows the relationship between the price of a good and the quantity demanded. The demand curve is the downward sloping line relating price and quantity demanded. The demand schedule and demand curve are related because the demand curve is simply a graph showing the points in the demand schedule.

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The demand curve slopes downward because of the law of demand—other things equal, when the price of a good rises, the quantity demanded of the good falls. People buy less of a good when its price rises, both because they cannot afford to buy as much and because they switch to purchasing other goods.

3.

Does a change in consumers’ tastes lead to a movement along the demand curve or a shift in the demand curve? Does a change in price lead to a movement along the demand curve or a shift in the demand curve?

A change in consumers’ tastes leads to a shift in the demand curve. A change in price leads to a movement along the demand curve.

4.

Popeye’s income declines and, as a result, he buys more spinach. Is spinach an inferior or a normal good? What happens to Popeye’s demand curve for spinach?

Since Popeye buys more spinach when his income falls, spinach is an inferior good for him. Since he buys more spinach but the price of spinach is unchanged, his demand curve for spinach shifts out as a result of the decrease in his income.

5.

What are the supply schedule and the supply curve, and how are they related? Why does the supply curve slope upward?

A supply schedule is a table showing the relationship between the price of a good and the quantity a producer is willing and able to supply. The supply curve is the upward sloping line relating price and quantity supplied. The supply schedule and the supply curve are related because the supply curve is simply a graph showing the points in the supply schedule.

The supply curve slopes upward because when the price is high, suppliers’ profits increase, so they supply more output to the market. The result is the law of supply—other things equal, when the price of a good rises, the quantity supplied of the good also rises.

6.

Does a change in producers’ technology lead to a movement along the supply curve or a shift in the supply curve? Does a change in price lead to a movement along the supply curve or a shift in the supply curve?

A change in producers’ technology leads to a shift in the supply curve. A change in price leads to a movement along the supply curve.

7.

Define the equilibrium of a market. Describe the forces that move a market toward its equilibrium.

The equilibrium of a market is the point at which the quantity demanded is equal to the quantity supplied. If the price is above the equilibrium price, sellers want to sell more than buyers want to buy, so there is a surplus. Sellers try to increase their sales by cutting prices. That continues until they reach the equilibrium price. If the price is below the equilibrium price, buyers want to buy more than sellers want to sell, so there is a shortage. Sellers can raise their price without losing customers. That continues until they reach the equilibrium price.

8.

Beer and pizza are complements because they are often enjoyed together. When the price of beer rises, what happens to the supply, demand, quantity supplied, quantity demanded, and the price in the market for pizza?

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When the price of beer rises, the demand for pizza declines, because beer and pizza are complements and people want to buy less beer. When we say the demand for pizza declines, we mean that the demand curve for pizza shifts to the left as in Figure 1. The supply curve for pizza is not affected. With a shift to the left in the demand curve, the equilibrium price and quantity both decline, as the figure shows. Thus the quantity of pizza supplied and demanded both fall. In sum, supply is unchanged, demand is decreased, quantity supplied declines, quantity demanded declines, and the price falls.

Figure 1 9.

Describe the role of prices in market economies.

Prices play a vital role in market economies because they bring markets into equilibrium. If the price is different from its equilibrium level, quantity supplied and quantity demanded are not equal. The resulting surplus or shortage leads suppliers to adjust the price until equilibrium is restored. Prices serve as signals that guide economic decisions and allocate scarce resources.

Problems and Applications 1.

Explain each of the following statements using supply-and-demand diagrams. a. When a cold snap hits Florida, the price of orange juice rises in supermarkets throughout Canada. b. When the weather turns warm in Quebec every summer, the prices of hotel rooms in Caribbean resorts plummet. c. When a war breaks out in the Middle East, the price of gasoline rises, while the price of a used SUV falls. a.

Cold weather damages the orange crop, reducing the supply of orange juice. This can be seen in Figure 2 as a shift to the left in the supply curve for orange juice. The new equilibrium price is higher than the old equilibrium price.

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Figure 2 b.

People often travel to the Caribbean from Quebec to escape cold weather, so demand for Caribbean hotel rooms is high in the winter. In the summer, fewer people travel to the Caribbean, since northern climes are more pleasant. The result, as shown in Figure 3, is a shift to the left in the demand curve. The equilibrium price of Caribbean hotel rooms is thus lower in the summer than in the winter, as the figure shows.

Figure 3 c.

When a war breaks out in the Middle East, many markets are affected. Since much oil production takes place there, the war disrupts oil supplies, shifting the supply curve for gasoline to the left, as shown in Figure 4. The result is a rise in the equilibrium price of gasoline. With a higher price for gasoline, the cost of operating a gas-guzzling automobile, like an SUV, will increase. As a result, the demand for used SUVs will decline,

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Price of used SUVs

as people in the market for cars will not find SUVs as attractive. In addition, some people who already own SUVs will try to sell them. The result is that the demand curve for used SUVs shifts to the left, while the supply curve shifts to the right, as shown in Figure 5.

The result is a decline in the equilibrium price of used SUVs.

Quantity of used SUVs

Figure 4

Figure 5

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2.

―An increase in the demand for notebooks raises the quantity of notebooks demanded, but not the quantity supplied.‖ Is this statement true or false? Explain.

The statement that ―an increase in the demand for notebooks raises the quantity of notebooks demanded, but not the quantity supplied,‖ in general, is false. As Figure 6 shows, the increase in demand for notebooks results in an increased quantity supplied. The only way the statement would be true is if the supply curve were a vertical line, as shown in Figure 7.

Figure 6

Figure 7 3.

Consider the market for minivans. For each of the events listed below, identify which of the determinants of demand or supply are affected. Also indicate whether demand or supply is increased or decreased. Then show the effect on the price and quantity of minivans. a. People decide to have more children. b. A strike by steelworkers raises steel prices. c. Engineers develop new automated machinery for the production of minivans. d. The price of SUVs rises. e. A stock market crash lowers people’s wealth.

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a.

If people decide to have more children (a change in tastes), they will want larger vehicles for hauling their kids around, so the demand for minivans will increase. Supply won’t be affected. The result is a rise in both price and quantity, as Figure 8 shows.

Figure 8 b.

If a strike by steelworkers raises steel prices, the cost of producing a minivan rises (a rise in input prices), so the supply of minivans decreases. Demand won’t be affected. The result is a rise in the price of minivans and a decline in the quantity, as Figure 9 shows.

Figure 9

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c.

The development of new automated machinery for the production of minivans is an improvement in technology. The reduction in firms’ costs results in an increase in supply.

Demand isn’t affected. The result is a decline in the price of minivans and an increase in the quantity, as Figure 10 shows.

Figure 10 d.

The rise in the price of sport utility vehicles affects minivan demand because sport utility vehicles are substitutes for minivans (that is, there is a rise in the price of a related good). The result is an increase in demand for minivans. Supply is not affected. In equilibrium, the price and quantity of minivans both rise.

e.

The reduction in people’s wealth caused by a stock market crash reduces their income, leading to a reduction in the demand for minivans since minivans are likely a normal good. Supply isn’t affected. As a result, both price and quantity decline, as Figure 11 shows.

Figure 11

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4.

Over the past 40 years, technological advances have reduced the cost of computer chips. How do you think this has affected the market for computers? For computer software? For typewriters?

Technological advances that reduce the cost of producing computer chips represent a decline in an input price for producing a computer. The result is a shift to the right in the supply of computers, as shown in Figure 12. The equilibrium price falls and the equilibrium quantity rises, as the figure shows.

Figure 12 Because computer software is a complement to computers, the lower equilibrium price of computers increases the demand for software. As Figure 13 shows, the result is a rise in both the equilibrium price and quantity of software.

Figure 13

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Because typewriters are substitutes for computers, the lower equilibrium price of computers reduces the demand for typewriters. As Figure 14 shows, the result is a decline in both the equilibrium price and quantity of typewriters.

Figure 14 5.

Using supply-and-demand diagrams, show the effect of the following events on the market for sweatshirts. a. A hurricane in South Carolina damages the cotton crop. b. The price of leather jackets falls. c. All universities require morning calisthenics in appropriate attire. d. New knitting machines are invented. a.

When a hurricane in South Carolina damages the cotton crop, it raises input prices for producing sweatshirts. As a result, the supply of sweatshirts shifts to the left, as shown in Figure 15. The new equilibrium has a higher price and lower quantity of sweatshirts.

Figure 15

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b.

A decline in the price of leather jackets leads more people to buy leather jackets, reducing the demand for sweatshirts. The result, shown in Figure 16, is a decline in both the equilibrium price and quantity of sweatshirts.

Figure 16 c.

The effects of universities requiring students to engage in morning calisthenics in appropriate attire raises the demand for sweatshirts, as shown in Figure 17. The result is an increase in both the equilibrium price and quantity of sweatshirts.

Figure 17

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d.

The invention of new knitting machines increases the supply of sweatshirts. As Figure 18 shows, the result is a reduction in the equilibrium price and an increase in the equilibrium quantity of sweatshirts.

Figure 18 6.

Suppose that in the year 2010, the number of births was temporarily high. How will this baby boom affect the price of baby-sitting services in 2015 and 2025? (Hint: Five-year-olds need babysitters, whereas fifteen-year-olds can be baby-sitters.)

A temporarily high birth rate in the year 2010 leads to opposite effects on the price of babysitting services in the years 2015 and 2025. In the year 2015, there are more 5-year-olds who need sitters, so the demand for babysitting services rises, as shown in Figure 19. The result is a higher price for babysitting services in 2015. However, in the year 2025, the increased number of 15-year-olds shifts the supply of babysitting services to the right, as shown in Figure 20. The result is a decline in the price of babysitting services.

Figure 19

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Figure 20 7.

Ketchup is a complement (as well as a condiment) for hot dogs. If the price of hot dogs rises, what happens to the market for ketchup? For tomatoes? For tomato juice? For orange juice?

Since ketchup is a complement for hot dogs, when the price of hot dogs rises, the quantity demanded of hot dogs falls, thus reducing the demand for ketchup, causing both price and quantity of ketchup to fall. Since the quantity of ketchup falls, the demand for tomatoes by ketchup producers falls, so both price and quantity of tomatoes fall. When the price of tomatoes falls, producers of tomato juice face lower input prices, so the supply curve for tomato juice shifts out, causing the price of tomato juice to fall and the quantity of tomato juice to rise. The fall in the price of tomato juice causes people to substitute tomato juice for orange juice, so the demand for orange juice declines, causing the price and quantity of orange juice to fall. Now you can see clearly why a rise in the price of hot dogs leads to a fall in the price of orange juice!

8.

The market for pizza has the following demand and supply schedules: Price $4 5 6 7 8 9

Quantity Demanded 135 104 81 68 53 39

Quantity Supplied 26 53 81 98 110 121

Graph the demand and supply curves. What is the equilibrium price and quantity in this market?

If the actual price in this market was above the equilibrium price, what would drive the market toward the equilibrium? If the actual price in this market was below the equilibrium price, what would drive the market toward the equilibrium?

Quantity supplied equals quantity demanded at a price of $6 and quantity of 81 pizzas (Figure 21). If price were greater than $6, quantity supplied would exceed quantity demanded, so suppliers would reduce their price to gain sales. If price were less than $6, quantity demanded would exceed quantity supplied, so suppliers could raise their price without losing sales. In both

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cases, the price would continue to adjust until it reached $6, the only price at which there is neither a surplus nor a shortage.

Figure 21 9.

Because bagels and cream cheese are often eaten together, they are complements. a. We observe that both the equilibrium price of cream cheese and the equilibrium quantity of bagels have risen. What could be responsible for this pattern—a fall in the price of flour or a fall in the price of milk? Illustrate and explain your answer. b. Suppose instead that the equilibrium price of cream cheese has risen but the equilibrium quantity of bagels has fallen. What could be responsible for this pattern—a rise in the price of flour or a rise in the price of milk? Illustrate and explain your answer. a.

If the price of flour falls, since flour is an ingredient in bagels, the supply curve for bagels would shift to the right. The result, shown in Figure 22, would be a fall in the price of bagels and a rise in the equilibrium quantity of bagels.

Figure 22 Since cream cheese is a complement to bagels, the fall in the equilibrium price of bagels

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increases the demand for cream cheese, as shown in Figure 23. The result is a rise in both the equilibrium price and quantity of cream cheese. So, a fall in the price of flour indeed raises both the equilibrium price of cream cheese and the equilibrium quantity of bagels.

Figure 23 What happens if the price of milk falls? Since milk is an ingredient in cream cheese, the fall in the price of milk leads to an increase in the supply of cream cheese. This leads to a decrease in the price of cream cheese (see Figure 24), rather than a rise in the price of cream cheese. So a fall in the price of milk could not have been responsible for the pattern observed.

b.

Figure 24 In part (a), we found that a fall in the price of flour led to a rise in the price of cream

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cheese and a rise in the equilibrium quantity of bagels. If the price of flour rose, the opposite would be true: it would lead to a fall in the price of cream cheese and a fall in the equilibrium quantity of bagels. Since the question says the equilibrium price of cream cheese has risen, it could not have been caused by a rise in the price of flour.

What happens if the price of milk rises? From part (a), we found that a fall in the price of milk caused a decline in the price of cream cheese, so a rise in the price of milk would cause a rise in the price of cream cheese. Since bagels and cream cheese are complements, the rise in the price of cream cheese would reduce the demand for bagels, as Figure 25 shows. The result is a decline in the equilibrium quantity of bagels. So a rise in the price of milk does cause both a rise in the price of cream cheese and a decline in the equilibrium quantity of bagels.

Figure 25 10.

Suppose that the price of hockey tickets at your school is determined by market forces. Currently, the demand and supply schedules are as follows: Price $4 8 12 16 20

Quantity Demanded 10 000 8 000 6 000 4 000 2 000

Quantity Supplied 8000 8000 8000 8000 8000

a. Draw the demand and supply curves. What is unusual about this supply curve? Why might this be true? b. What are the equilibrium price and quantity of tickets? c. Your school plans to increase total enrollment next year by 5000 students. The additional students will have the following demand schedule:

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Price $4 8 12 16 20

Quantity Demanded 4 000 3 000 2 000 1 000 0

Now add the old demand schedule and the demand schedule for the new students to calculate the new demand schedule for the entire school. What will be the new equilibrium price and quantity? a.

As Figure 26 shows, the supply curve is vertical. The constant quantity supplied makes sense because the hockey arena has a fixed number of seats no matter what the price.

Figure 26 b.

Quantity supplied equals quantity demanded at a price of $8. The equilibrium quantity is 8000 tickets.

c.

Price $4 8 12 16 20

Quantity Demanded 14 000 11 000 8 000 5 000 2 000

Quantity Supplied 8000 8000 8000 8000 8000

The new equilibrium price will be $12, which equates quantity demanded to quantity supplied. The equilibrium quantity is 8000 tickets.

11.

Consider the markets for film streaming services, TV screens, and tickets to movie theatres. a. For each pair, identify whether they are complements or substitutes:

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• Film streaming and TV screens • Film streaming and movie tickets • TV screens and movie tickets b. Suppose a technological advance reduces the cost of manufacturing TV screens. Draw a diagram to show what happens to the market for TV screens. c. Draw two more diagrams to show how the change in the market for TV screens affects the markets for film streaming and movie tickets.

a.

Film streaming and TV screens are complements, because you need a TV screen to watch a film. Film streaming and movie tickets are substitutes, and TV screens and movie tickets are substitutes as well.

b.

Lower costs of manufacturing TV screens shift the supply curve to the right, which decreases the equilibrium price and increases the quantity demanded and supplied. (See Figure 27)

Figure 27

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c.

The decrease in the price of TV screens increases the demand for film streaming and decreases the demand for movie tickets, as Figure 28 shows. The price and quantity demanded of film streaming will increase. The price and quantity demanded of movie tickets will decrease.

Figure 28

12.

A survey shows an increase in drug use by young people. In the ensuing debate, two hypotheses are proposed: • Reduced police efforts have increased the availability of drugs on the street.

• Cutbacks in educational efforts have decreased awareness of the dangers of drug addiction. a. Use supply-and-demand diagrams to show how each of these hypotheses could lead to an increase in the quantity of drugs consumed. b. How could information on what has happened to the price of drugs help us distinguish between these explanations?

a.

Reduced police efforts would shift the supply curve to the right, while cutbacks in education would shift the demand curve to the right. Both imply higher quantity demanded.

b.

As Figure 29 shows, reduced police efforts will reduce the price of drugs, while cutbacks in education will increase it.

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Figure 29 13.

Consider the following events: Scientists reveal that consumption of oranges decreases the risk of diabetes and, at the same time, farmers use a new fertilizer that makes orange trees more productive. Illustrate and explain what effect these changes have on the equilibrium price and quantity of oranges.

The first event increases the demand for oranges, which increases both the equilibrium price and quantity. In Figure 30, this first change corresponds to a move from point A to B. The second event increases the supply of oranges, which decreases the equilibrium price and increases the equilibrium quantity even further (a move from B to C in Figure 30). Thus, the cumulative effect on price is ambiguous (we cannot tell whether the increase in price is larger than the decrease).

The effect on quantity is, however, unambiguous: the quantity traded in the market is higher.

Figure 30

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Appendix Problems and Applications

A1.

Say that the demand schedule for a good is given by QD = 20 – 2P and the supply schedule is given by QS = –10 + 4P. a. Graph the demand and supply curves, showing the x- and y-intercepts for each. b. Determine the equilibrium price and quantity.

A2.

a.

Supply: x-intercept = –10, y-intercept = 10/4 = 5/2 = 2.5.

Demand: x-intercept = 20, y-intercept = 20/2 = 10.

b.

Equate supply and demand and solve for P: 20 – 2P = –10 + 4P, 6P = 30, P = 30/6 = 5.

Then Q = 20 – 2(5) = 10.

The demand and supply functions for hockey sticks are given by QD = 286 – 20P QS = 88 + 40P

a. Graph the supply and the demand curves, clearly showing the intercepts and indicating the slopes of the two curves. b. Determine the equilibrium price and quantity of hockey sticks. c. Suppose that both the men’s and the women’s teams win Olympic gold medals, causing an increase in the demand for hockey sticks across the country to QD = 328 – 20P. What impact does this have on the price of hockey sticks and the quantity sold?

a.

The slopes are –1/20 and 1/40, respectively. The horizontal intercepts are found by setting P = 0 in each equation: Q D(P = 0) = 286; Q S(P = 0) = 88. The vertical intercepts are found by calculating the price that makes the two quantities zero: P (Q D = 0) = 286/20 = 14.30; P(Q S = 0) = –88/40 = –2.20. (See Figure 31.)

b.

The equilibrium price is the solution to equation Q D = Q S, 286 – 20P = 88 + 40P, which gives the result P E = 3.30. Using the demand equation, we can determine the equilibrium quantity: Q E = 286 – 20 × 3.3 = 220.

c.

The increase in demand determines a shift to the right of the demand curve so that the new horizontal intercept is 328 instead of 286. The slope of the demand remains the same. The equilibrium price increases to 4, while the equilibrium quantity increases to 248.

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P QS

$14.30

$3.30

QD 88

220

286

QD, QS

−2.20

Figure 31 A3.

Suppose that the demand curve for concert tickets is linear. When the price of a ticket is $5.00, the number of tickets purchased is 1000; when the price of a ticket is $15.00, the number of tickets purchased is 200. Find the slope of the demand curve.

The slope of the demand curve is equal to the change in price over the change in quantity demanded: Slope = (15 – 5)/(200 – 1000) = 10/(–800) = –1/80.

A4.

At a price of $320 per tonne, the quantity supplied of wheat in Canada is 25 million tonnes and the quantity demanded is 26 million tonnes. When the price increases to $340 per tonne, the quantity supplied increases to 27 million tonnes and the quantity demanded decreases to 22 million tonnes. Assume that both the demand and supply curves are linear. a. What is the equation for the demand curve for wheat? b. What is the equation for the supply curve for wheat? c. Using these equations, what is the equilibrium price and quantity of wheat? a.

A demand equation has the general form Q D = a – bP. When two price–quantity pairs are known, one can calculate b = –(Q D1 – Q D0)/(P1 – P0). With the numbers given, b = –(22 – 26)/(340 – 320) = 4/20 = 0.20. The intercept is a = Q D0 + bP0 = 26 + 0.20 × 320 = 90. Thus, the demand equation is Q D = 90 – 0.20P.

b.

A supply equation has the general form Q S = c + dP, where d = (Q S1 – Q S0)/(P1 – P0) = (27 – 25)/(340 – 320) = 2/20=0.10. The horizontal intercept is c = Q S0 – dP0 = 25 – 0.10 x 320 = –7. With c and d calculated, the supply equation is Q S = –7 + 0.10P.

c.

The equilibrium price is determined where Q D = Q S, or 90 – 0.20P = –7+ 0.10P. The solution to this equation is P E = 323.33. Now, using the demand equation, we can determine the equilibrium quantity: Q E = 90 – (0.20)(323.33) = 25.33.

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A5.

Market research has revealed the following information about the market for chocolate bars: The demand schedule can be represented by the equation QD = 1600 – 300P, where QD is the quantity demanded and P is the price. The supply schedule can be represented by the equation QS = 1400 + 700P, where QS is the quantity supplied. a. Calculate the equilibrium price and quantity in the market for chocolate bars. b. Say that in response to a major industry ad campaign, the demand schedule for chocolate bars shifted to the right, as represented by the equation QD = 1800 – 300P. What happens to the equilibrium price and quantity of chocolate bars in this case? c. Returning to the original demand schedule, say that the price of cocoa beans, a major ingredient in the production of chocolate bars, increased because of a drought in subSaharan Africa, a major producer of cocoa, changing the supply schedule to QS = 1100 + 700P. What happens to the equilibrium price and quantity in this case? a.

Equilibrium occurs where quantity demanded is equal to quantity supplied:

QD = QS

1600 – 300P = 1400 + 700P 200 = 1000P P = $0.20

Q D = 1600 – 300(0.20) = 1600 – 60 = 1540 Q S = 1400 + 700(0.20) = 1400 + 140 = 1540 The equilibrium price of a chocolate bar is $0.20 and the equilibrium quantity is 1540 bars. b.

Given the change in demand, equilibrium occurs where quantity demanded is equal to quantity supplied:

QD = QS

1800 – 300P = 1400 + 700P 400 = 1000P P = $0.40

Q D = 1800 – 300(0.40) = 1800 – 120 = 1680 Q S = 1400 + 700(0.40) = 1400 + 280 = 1680 The equilibrium price of a chocolate bar is $0.40 and the equilibrium quantity is 1680 bars. c.

Given the change in supply, equilibrium occurs where quantity demanded is equal to quantity supplied:

QD = QS

1600 – 300P = 1100 + 700P 500 = 1000P P = 500/1000 = $0.50

Q D = 1600 – 300(0.50) = 1600 – 150 = 1450 Q S = 1100 + 700(0.50) = 1100 + 350 = 1450 The equilibrium price of a chocolate bar is $0.50 and the equilibrium quantity is 1450 bars.

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Measuring a Nation’s Income SOLUTIONS TO TEXTBOOK PROBLEMS Questions for Review 1.

Explain why an economy’s income must equal its expenditure.

An economy’s income must equal its expenditure since every transaction has a buyer and a seller. Thus, expenditure by buyers must equal income of sellers.

2.

Which contributes more to GDP—the production of an economy car or the production of a luxury car? Why? The production of a luxury car contributes more to GDP than the production of an economy car because the luxury car has a higher market value.

3.

A farmer sells wheat to a baker for $2. The baker uses the wheat to make bread, which is sold for $3. What is the total contribution of these transactions to GDP? The contribution to GDP is $3, the market value of the bread, which is the final good that is sold.

4.

Many years ago, Peggy paid $500 to put together a record collection. Today, she sold her albums at a garage sale for $100. How does this sale affect current GDP? The sale of used records does not affect GDP at all because it involves no current production.

5.

List the four components of GDP. Give an example of each.

The four components of GDP are consumption, such as the purchase of a music CD; investment, such as the purchase of a computer by a business; government purchases, such as an order for military aircraft; and net exports, such as the difference in the value of sales of Canadian wheat to Russia and the value of Canadians’ purchase of German autos.

6.

Why do economists use real GDP rather than nominal GDP to gauge economic well-being?

Economists use real GDP rather than nominal GDP to gauge economic well-being because real GDP is not affected by changes in prices, so it reflects only changes in the amounts being produced. If nominal GDP rises, you do not know if that is because of increased production and/or higher prices.

7.

In the year 2021, the economy produces 100 loaves of bread that sell for $2 each. In the year 2022, the economy produces 200 loaves of bread that sell for $3 each. Calculate nominal GDP, real GDP, and the GDP deflator for each year. (Use 2021 as the base year.) By what percentage does each of these three statistics rise from one year to the next?

Year

Nominal GDP

Real GDP

GDP Deflator

2021

100 × $2 = $200

100 × $2 = $200

($200/$200) × 100 = 100

2022

200 × $3 = $600

200 × $2 = $400

($600/$400) × 100 = 150

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The percentage change in nominal GDP is (600 – 200)/200 × 100 = 200%. The percentage change in real GDP is (400 – 200)/200 × 100 = 100%. The percentage change in the deflator is (150 – 100)/100 × 100 = 50%.

8.

Why is it desirable for a country to have a large GDP? Give an example of something that would raise GDP and yet be undesirable.

It is desirable for a country to have a large GDP because people could enjoy more goods and services. But GDP is not the only important measure of economic well-being. For example, laws that restrict pollution cause GDP to be lower. If laws against pollution were eliminated, GDP would be higher, but the pollution might make us worse off. Or, for example, an earthquake would raise GDP, as expenditures on cleanup, repair, and rebuilding increase. But an earthquake is an undesirable event that lowers our welfare.

Problems and Applications 1.

What components of GDP (if any) would each of the following transactions affect? Explain. a. A family buys a new refrigerator. b. Aunt Jane buys a new house. c. Ford sells a Thunderbird from its inventory. d. You buy a pizza. e. Quebec repaves Highway 50. f. Your parents buy a bottle of French wine. g. Honda expands its factory in Alliston, Ontario. a. b. c. d. e. f. g.

2.

Consumption increases because a refrigerator is a good purchased by a household.

Investment increases because a house is an investment good.

Consumption increases because a car is a good purchased by a household, but investment decreases because the car in Ford’s inventory had been counted as an investment good until it was sold.

Consumption increases because pizza is a good purchased by a household.

Government purchases increase because the government spent money to provide a good to the public.

Consumption increases because the bottle is a good purchased by a household, but net exports decrease because the bottle was imported.

Investment increases because new structures and equipment were built.

The ―government purchases‖ component of GDP does not include spending on transfer payments such as Employment Insurance. Thinking about the definition of GDP, explain why transfer payments are excluded.

With transfer payments, nothing is produced, so there is no contribution to GDP.

3.

Why do you think households’ purchases of new housing are included in the investment component of GDP rather than the consumption component? Can you think of a reason why households’ purchases of new cars should also be included in investment rather than in consumption? To what other consumption goods might this logic apply?

Purchases of new housing are included in the investment portion of GDP because housing provides services for a long time. For the same reason, purchases of new cars could be thought of as investment, but by convention they are not. The logic could apply to any durable good,

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such as household appliances.

4.

As the chapter states, GDP does not include the value of used goods that are resold. Why would including such transactions make GDP a less informative measure of economic well-being?

If GDP included goods that are resold, it would be counting output of that particular year, plus sales of goods produced in a previous year. It would double-count goods that were sold more than once and would count goods in GDP for several years if they were produced in one year and resold in another.

5.

Below are some data from the land of milk and honey.

Year 2020 2021 2022

Price of Milk $1 1 2

Quantity of Milk (litres) 100 200 200

Price of Honey $2 2 4

Quantity of Honey (litres) 50 100 100

a. Compute nominal GDP, real GDP, and the GDP deflator for each year, using 2020 as the base year. b. Compute the percentage change in nominal GDP, real GDP, and the GDP deflator in 2021 and 2022 from the preceding year. For each year, identify the variable that does not change. Explain in words why your answer makes sense. c. Did economic well-being rise more in 2021 or 2022? Explain. a.

Calculating nominal GDP: 2020: ($1 per L of milk  100 L milk) + ($2 per L of honey  50 L honey) = $200 2021: ($1 per L of milk  200 L milk) + ($2 per L of honey  100 L honey) = $400 2022: ($2 per L of milk  200 L milk) + ($4 per L of honey  100 L honey) = $800 Calculating real GDP (base year 2020): 2020: ($1 per L of milk  100 L milk) + ($2 per L of honey  50 L honey) = $200 2021: ($1 per L of milk  200 L milk) + ($2 per L of honey  100 L honey) = $400 2022: ($1 per L of milk  200 L milk) + ($2 per L of honey  100 L honey) = $400 Calculating the GDP deflator: 2020: ($200/$200)  100 = 100 2021: ($400/$400)  100 = 100 2022: ($800/$400)  100 = 200

b.

Calculating the percentage change in nominal GDP: Percentage change in nominal GDP in 2021 = [($400 – $200)/$200]  100 = 100%.

Percentage change in nominal GDP in 2022 = [($800 – $400)/$400]  100 = 100%.

Calculating the percentage change in real GDP: Percentage change in real GDP in 2021 = [($400 – $200)/$200]  100 = 100%.

Percentage change in real GDP in 2022 = [($400 – $400)/$400]  100 = 0%.

Calculating the percentage change in GDP deflator: Percentage change in the GDP deflator in 2021 = [(100 – 100)/100]  100 = 0%.

Percentage change in the GDP deflator in 2022 = [(200 – 100)/100]  100 = 100%.

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Prices did not change from 2020 to 2021. Thus, the percentage change in the GDP deflator is zero. Likewise, output levels did not change from 2021 to 2022. This means that the percentage change in real GDP is zero. c.

Economic well-being rose more in 2021 than in 2022, since real GDP rose in 2021 but not in 2022. In 2021, real GDP rose and prices did not. In 2022, real GDP did not rise and prices did.

6. Consider an economy that produces only chocolate bars. In year 1, the quantity produced is 3 bars

and the price is $4. In year 2, the quantity produced is 4 bars and the price is $5. In year 3, the quantity produced is 5 bars and the price is $6. Year 1 is the base year. a. What is nominal GDP for each of these three years? b. What is real GDP for each of these years? c. What is the GDP deflator for each of these years? d. What is the percentage growth rate of real GDP from year 2 to year 3? e. What is the inflation rate as measured by the GDP deflator from year 2 to year 3? f. In this one-good economy, how might you have answered parts (d) and (e) without first answering parts (b) and (c)? a. Calculating Nominal GDP: Year 1: (3 bars  $4) = $12 Year 2: (4 bars  $5) = $20 Year 3: (5 bars  $6) = $30 b. Calculating Real GDP: Year 1: (3 bars  $4) = $12 Year 2: (4 bars  $4) = $16 Year 3: (5 bars  $4) = $20 c.

Calculating the GDP deflator: Year 1: $12/$12  100 = 100 Year 2: $20/$16  100 = 125 Year 3: $30/$20  100 = 150

d. The growth rate of real GDP from year 2 to year 3 = (20 – 16)/16  100 = 25% e. The inflation rate from year 2 to year 3 = (150 – 125)/125  100 = 20% f.

To calculate the growth rate of real GDP, we could simply calculate the percentage change in the quantity of bars. To calculate the inflation rate, we could measure the percentage change in the price of bars.

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7.

Consider the following data on Canadian GDP: Year

Nominal GDP (billions)

GDP Deflator (base year 2012)

2018

$2231

108

2019

$2311

110

a. What was the growth rate of nominal GDP between 2018 and 2019? (Note: The growth rate is the percentage change from one period to the next.) b. What was the growth rate of the GDP deflator between 2018 and 2019? c. What was real GDP in 2019 measured in 2012 prices? d. What was real GDP in 2018 measured in 2012 prices? e. What was the growth rate of real GDP between 2018 and 2019? f. Was the growth rate of nominal GDP higher or lower than the growth rate of real GDP? Explain.

8.

a.

The growth rate of nominal GDP between 2018 and 2019 was ($2311 – $2231)/$2231  100 = 3.6%.

b.

The growth rate of the GDP deflator was (110 – 108)/108  100 = 1.9%.

c.

Real GDP in 2019 (in 2012 dollars) was ($2211/110)  100 = $2101.

d.

Real GDP in 2018 (in 2012 dollars) was ($2231/108)  100 = $2066.

e.

The growth rate of real GDP was ($2101 – $2066)/$2066  100 = 1.7%.

f.

The growth rate of nominal GDP was greater than the growth rate of real GDP because the inflation rate was positive.

If prices rise, people’s income from selling goods increases. The growth of real GDP ignores this gain, however. Why, then, do economists prefer real GDP as a measure of economic well-being?

Economists ignore the rise in people’s incomes that is caused by higher prices because although incomes are higher, the prices of the goods and services that people buy are also higher.

Therefore, they will not necessarily be able to purchase more goods and services. For this reason, economists prefer to look at real GDP instead of nominal GDP.

9.

Revised estimates of Canadian GDP are usually released by Statistics Canada near the end of each month. Find a source that reports on the most recent release, or read the news release yourself at www.statcan.gc.ca, the website of Statistics Canada. Discuss the recent changes in real and nominal GDP and in the components of GDP. Many answers are possible.

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10.

Goods and services that are not sold in markets, such as food produced and consumed at home, are generally not included in GDP. Can you think of how this might cause the numbers in the second column of Table 5.5 to be misleading in a comparison of the economic well-being of Canada and India? Explain.

In countries like India, people produce and consume a fair amount of food at home that is not included in GDP. So GDP per person in India and Canada will differ by more than their comparative economic well-being.

11.

The participation of women in the Canadian labour force has risen dramatically since 1970. a. How do you think this rise affected GDP? b. Now imagine a measure of well-being that includes time spent working in the home and taking leisure time. How would the change in this measure of well-being compare to the change in GDP? c. Can you think of other aspects of well-being that are associated with the rise in women’s labour force participation? Would it be practical to construct a measure of well-being that includes these aspects? a.

The increased labour force participation of women has increased GDP in Canada, since it means more people are working and production has increased.

b.

If our measure of well-being included time spent working in the home and taking leisure, it would not rise as much as GDP, since the rise in women’s labour force participation has reduced time spent working in the home and taking leisure.

c.

Other aspects of well-being that are associated with the rise in women’s increased labour force participation include increased self-esteem and prestige for women in the workforce, especially at managerial levels, but decreased quality time spent with children, whose parents have less time to spend with them. Such aspects would be quite difficult to measure.

Chapter 6 Measuring the Cost of Living SOLUTIONS TO TEXTBOOK PROBLEMS Questions for Review 1.

Which do you think has a greater effect on the consumer price index: a 10 percent increase in the price of chicken or a 10 percent increase in the price of caviar? Why? A 10 percent increase in the price of chicken has a greater effect on the consumer price index than a 10 percent increase in the price of caviar because chicken is a bigger part of the average consumer’s market basket.

2.

Describe the three problems that make the consumer price index an imperfect measure of the cost of living.

The three problems in the consumer price index as a measure of the cost of living are:

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(1) substitution bias, which arises because people substitute toward goods that have become relatively less expensive; (2) the introduction of new goods, which are not reflected quickly in the CPI; and (3) unmeasured quality change.

3.

If the price of a military aircraft rises, is the consumer price index or the GDP deflator affected more? Why?

If the price of a military aircraft rises, there is no effect on the consumer price index, since military aircraft are not consumer goods. But the GDP deflator is affected, since military aircraft are included in GDP as a part of government purchases.

4.

Over a long period of time, the price of a candy bar rose from $0.10 to $0.60. Over the same period, the consumer price index rose from 150 to 300. Adjusted for overall inflation, how much did the price of the candy bar change?

Since the overall price level doubled, but the price of the candy bar rose six-fold, the real price (the price adjusted for inflation) of the candy bar tripled.

5.

Explain the meaning of nominal interest rate and real interest rate. How are they related?

The nominal interest rate is the rate of interest paid on a loan in dollar terms. The real interest rate is the rate of interest corrected for inflation. The real interest rate is the nominal interest rate minus the rate of inflation.

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Problems and Applications 1.

Suppose that people consume only three goods, as shown in this table: Tennis Balls

Tennis Racquets

Gatorade

2021 price 2021 quantity

$2 100

$40 10

$1 200

2022 price 2022 quantity

$2 100

$60 10

$2 200

a. What is the percentage change in the price of each of the three goods? What is the percentage change in the overall price level? b. Do tennis racquets become more or less expensive relative to Gatorade? Does the well-being of some people change relative to the well-being of others? Explain. a.

The price of tennis balls increases 0 percent; the price of tennis racquets increases 50 percent [= ($60 – $40)/$40 × 100]; the price of Gatorade increases 100 percent [= ($2 – $1)/$1 × 100].

To find the percentage change in the overall price level, follow these steps: 1)

Determine the fixed basket of goods: 100 balls, 10 racquets, 200 Gatorades

2)

Find the price of each good in each year: Year 2021 2022

b.

2.

Balls $2 $2

Racquets $40 $60

Gatorade $1 $2

3)

Compute the cost of the basket of goods in each year: 2021: (100 × $2) + (10 × $40) + (200 × $1) = $800 2022: (100 × $2) + (10 × $60) + (200 × $2) = $1200

4)

Choose one year as a base year (2021) and compute the CPI in each year: 2021: $800/$800 × 100 = 100 2022: $1200/$800 × 100 = 150

5)

Use the CPI to compute the inflation rate from the previous year: 2022: (150 – 100)/100 × 100 = 50%

Tennis racquets are less expensive relative to Gatorade, since their price rose 50 percent while the price of Gatorade rose 100 percent. The well-being of some people changes relative to the well-being of others. Those who purchase a lot of Gatorade become worse off relative to those who purchase a lot of tennis racquets or tennis balls.

Suppose that the residents of Vegopia spend all of their income on cauliflower, broccoli, and carrots. In 2021, they buy 100 heads of cauliflower for $200, 50 bunches of broccoli for $75, and 500 carrots for $50. In 2022, they buy 75 heads of cauliflower for $225, 80 bunches of broccoli for $120, and 500 carrots for $100. If the base year is 2021, what is the CPI in both years? What is the inflation rate in 2022?

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To find the percentage change in the overall price level, follow these steps: 1)

Determine the fixed basket of goods: 100 heads of cauliflower, 50 bunches of broccoli, 500 carrots.

2)

Find the price of each good in each year: Year 2021 2022

3.

Cauliflower $2 $3

Broccoli $1.50 $1.50

Carrots $0.10 $0.20

3)

Compute the cost of the basket of goods in each year: 2021: (100 × $2) + (50 × $1.50) + (500 × $.10) = $325 2022: (100 × $3) + (50 × $1.50) + (500 × $.20) = $475

4)

Choose one year as a base year (2021) and compute the CPI in each year: 2021: $325/$325 × 100 = 100 2022: $475/$325 × 100 = 146

5)

Use the CPI to compute the inflation rate from the previous year: 2022: (146 – 100)/100 × 100 = 46%

Go to the website of Statistics Canada (www.statcan.gc.ca) and find data on the consumer price index. By how much has the index including all items risen over the past year? For which categories of spending have prices risen the most? The least? Have any categories experienced price declines? Can you explain any of these facts?

Many answers are possible.

4.

A small nation of ten people idolizes the TV show Canadian Idol. All that the ten people produce and consume are karaoke machines and CDs, in the following amounts:

2021 2022

Karaoke Machines Quantity Price 10 $40 12 60

CDs Quantity 30 50

Price $10 12

a. Using a method similar to the consumer price index, compute the percentage change in the overall price level. Use 2021 as the base year, and fix the basket at 1 karaoke machine and 3 CDs. b. Using a method similar to the GDP deflator, compute the percentage change of the overall price level. Also use 2021 as the base year. c. Is the inflation rate in 2022 the same using the two methods? Explain why or why not. a.

The expenditures on the consumption basket in the two years are: 2021: Expenditure = 1 × $40 + 3 × $10 = $70; CPI = 100 2022: Expenditure = 1 × $60 + 3 × $12 = $96; CPI = 96/70 × 100 = 137.1 The inflation rate is 37.1 percent.

b.

2021: GDP = 10 × $40 + 30 × $10 = $700; GDP deflator = 100 2022: Nominal GDP = 12 × $60 + 50 × $12 = $1320; Real GDP = 12 × $40 + 50 × $10 = $980;

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GDP deflator = 1320/980 × 100 = 134.7 Inflation rate = 34.7 percent c.

5.

Which of the problems in the construction of the CPI might be illustrated by each of the following situations? Explain. a. The invention of the iPad b. The introduction of air bags in cars c. Increased personal computer purchases in response to a decline in the price d. More scoops of raisins in each package of Raisin Bran e. Greater use of fuel-efficient cars after gasoline prices increase a. b. c. d. e.

6.

7.

The inflation rates calculated in the two different ways are different because one is based on a consumption basket, while the other is based on the GDP deflator. The weights in which each price enters the two price indexes (CPI and GDP deflator) are different.

introduction of new goods unmeasured quality change substitution bias unmeasured quality change substitution bias

A single copy of the Ottawa Citizen cost $0.10 in 1970 and $0.50 in 1990. The average wage in manufacturing was $3.01 per hour in 1970 and $14.19 in 1990. a. By what percentage did the price of a newspaper rise? b. By what percentage did the wage rise? c. In each year, how many minutes does a worker have to work to earn enough to buy a newspaper? d. Did workers’ purchasing power in terms of newspapers rise or fall? a.

($0.50 – $0.10)/$0.10 × 100% = 400%

b.

($14.19 – $3.01)/$3.01 × 100% = 371%

c.

In 1970: $0.10/($3.01/60) = 2.0 minutes. In 1990: $0.50/($14.19/60) = 2.1 minutes

d.

Workers’ purchasing power fell in terms of newspapers.

The chapter explains that Canada Pension Plan benefits are increased each year in proportion to the increase in the CPI, even though most economists believe that the CPI overstates actual inflation. a. If the elderly consume the same market basket as other people, does the Canada Pension Plan provide the elderly with an improvement in their standard of living each year? Explain. b. In fact, the elderly consume more medicine than younger people, and medicine costs have risen faster than overall inflation. What would you do to determine whether the elderly are actually better off from year to year? a.

If the elderly consume the same market basket as other people, the Canada Pension Plan would provide the elderly with an improvement in their standard of living each year because the CPI overstates inflation and Canada Pension Plan payments are tied to the CPI.

b.

Since the elderly consume more medicines than younger people, and since the cost of

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medicine has risen faster than overall inflation, it is possible that the elderly are worse off. To investigate this, you would need to put together a market basket for the elderly, which would have a higher weight on medicine. You would then compare the rise in the cost of the ―elderly‖ basket with that of the general basket for CPI. 8.

How do you think the basket of goods and services you buy differs from the basket bought by the typical Canadian household? Do you think you face a higher or lower inflation rate than is indicated by the CPI? Why? Many answers are possible. A common answer may be that as students, they spend a greater proportion of their income on tuition and books than the typical household. If the prices of tuition and books have risen faster than average prices, students face a higher inflation rate than the typical household.

9.

Federal government income tax brackets were not indexed until 2000. When inflation pushed up people’s nominal incomes during the 1970s, what do you think happened to real tax revenue?

(Hint: This phenomenon was known as ―bracket creep.‖) When bracket creep occurred, inflation increased people’s nominal incomes, pushing them into higher tax brackets, so they had to pay a higher proportion of their incomes in taxes, even though they were not getting higher real incomes. As a result, real tax revenue rose.

10.

When deciding how much of their income to save for retirement, should workers consider the real or the nominal interest rate that their savings will earn? Explain.

In deciding how much income to save for retirement, workers should consider the real interest rate, since they care about their purchasing power in the future, not the number of dollars they will have.

11.

Suppose that a borrower and a lender agree on the nominal interest rate to be paid on a loan.

Then inflation turns out to be higher than they both expected. a. Is the real interest rate on this loan higher or lower than expected? b. Does the lender gain or lose from this unexpectedly high inflation? Does the borrower gain or lose? c. Inflation during the 1970s was much higher than most people had expected when the decade began. How did this affect homeowners who obtained fixed-rate mortgages during the 1960s? How did it affect the banks that lent the money? a.

When inflation is higher than was expected, the real interest rate is lower than expected.

For example, suppose the market equilibrium has an expected real interest rate of 3 percent and people expect inflation to be 4 percent, so the nominal interest rate is 7 percent. If inflation turns out to be 5 percent, the real interest rate is 7 percent minus 5 percent equals 2 percent, which is less than the 3 percent that was expected.

b.

Since the real interest rate is lower than was expected, the lender loses and the borrower gains. The borrower is repaying the loan with dollars that are worth less than was expected.

c.

Homeowners in the 1970s who had fixed-rate mortgages from the 1960s benefited from the unexpected inflation, while the banks that made the mortgage loans were harmed.

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SOLUTIONS TO TEXTBOOK PROBLEMS Questions for Review 1.

What does the level of a nation’s GDP measure? What does the growth rate of GDP measure?

Would you rather live in a nation with a high level of GDP and a low growth rate, or in a nation with a low level of GDP and a high growth rate?

The level of a nation’s GDP measures both the total income earned in the economy and the total expenditure on the economy’s output of goods and services. The growth rate of GDP measures the percentage change in GDP over a period of time. The level of real GDP is a good gauge of economic prosperity, and the growth of real GDP is a good gauge of economic progress. You would rather live in a nation with a high level of GDP, even though it had a low growth rate, than in a nation with a low level of GDP and a high growth rate, since the level of GDP is a measure of prosperity.

2.

List and describe four determinants of productivity.

Four determinants of productivity are: (1) physical capital, which is the stock of equipment and structures that are used to produce goods and services; (2) human capital, which is the knowledge and skills that workers acquire through education, training, and experience; (3) natural resources, which are inputs into production that are provided by nature; and (4) technological knowledge, which is society’s understanding of the best ways to produce goods and services.

3.

In what way is a university or college degree a form of capital?

A university or college degree is a form of human capital. The skills learned in earning a degree increase a worker’s productivity.

4.

Explain how higher saving leads to a higher standard of living. What might deter a policymaker from trying to raise the rate of saving?

Higher saving means fewer resources are devoted to consumption and more to producing capital goods. The rise in the capital stock leads to rising productivity and more rapid growth in GDP for a while. In the long run, the higher saving rate leads to a higher standard of living. A policymaker might be deterred from trying to raise the rate of saving because doing so requires that people reduce their consumption today and it can take a long time to get to a higher standard of living.

5.

Does a higher rate of saving lead to higher growth temporarily or indefinitely?

A higher rate of saving leads to a higher growth rate temporarily, not permanently. In the short run, increased saving leads to a larger capital stock and faster growth. But as growth continues, diminishing returns to capital mean growth slows down and eventually settles down to its initial rate, though this may take several decades.

6.

Why would removing a trade restriction, such as a tariff, lead to more rapid economic growth?

Removing a trade restriction, such as a tariff, would lead to more rapid economic growth because the removal of the trade restriction acts like an improvement in technology. Free trade allows all

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countries to consume more goods and services.

7.

How does the rate of population growth influence the level of GDP per person?

The higher the rate of population growth, the lower the level of GDP per person because there is less capital per person, and hence lower productivity.

8.

Describe two ways in which the Canadian government tries to encourage advances in technological knowledge.

The Canadian government tries to encourage advances in technological knowledge by providing research grants, with tax breaks for firms engaging in research and development, and through the patent system.

Problems and Applications 1.

Most countries, including Canada, import substantial amounts of goods and services from other countries. Yet this chapter says that a nation can enjoy a high standard of living only if it can produce a large quantity of goods and services itself. Can you reconcile these two facts?

The facts that countries import many goods and services yet must produce a large quantity of goods and services themselves to enjoy a high standard of living are reconciled by noting that there are substantial gains from trade. In order to be able to afford to purchase goods from other countries, an economy must generate income. By producing many goods and services, then trading them for goods and services produced in other countries, a nation maximizes its standard of living.

2.

3.

List the capital inputs necessary to produce each of the following. a. cars b. high-school education c. plane travel d. fruits and vegetables a.

Producing cars requires a factory with machines, robots, and an assembly line, as well as human capital that comes from training workers.

b.

Producing a high-school education requires books and buildings as well as human capital from the teachers.

c.

Producing plane travel requires planes and airports as well as human capital in terms of pilots’ knowledge.

d.

Producing fruits and vegetables requires irrigation systems, harvesting machinery, and trucks to transport the goods to the market, as well as human capital in the form of agricultural knowledge.

Canadian income per person today is many times what it was a century ago. Many other countries have also experienced significant growth over that period. What are some specific ways in which your standard of living differs from that of your great-grandparents?

Today’s standard of living differs from those of our great-grandparents because of improved transportation, communications, entertainment, machinery for household work, and computers,

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among other things.

4.

This chapter discusses how employment has declined relative to output in the farm sector. Can you think of another sector of the economy where the same phenomenon has occurred more recently? Would you consider the change in employment in this sector to represent a success or a failure from the standpoint of society as a whole?

In the manufacturing sector, employment has fallen sharply while output remains about the same percentage of GDP as before. This is good for our economy because it is the result of increased productivity. Many manufactured goods are much cheaper than they used to be.

Of course, those who previously found employment in the manufacturing sector will complain the change has not been good for them personally. This is why good public policy recognizes the need to compensate individuals who suffer losses as a result of productivity gains that benefit the economy as a whole.

5.

Suppose that society decided to reduce consumption and increase investment. a. How would this change affect economic growth? b. What groups in society would benefit from this change? What groups might be hurt?

6.

a.

More investment would lead to faster economic growth in the short run.

b.

The change would benefit many people in society who would have higher incomes as the result of faster economic growth. However, there might be a transition period in which workers and owners in consumption-good industries would get lower incomes, and workers and owners in investment-good industries would get higher incomes. In addition, some would have to reduce their spending for some time so that investment could rise.

Societies choose what share of their resources to devote to consumption and what share to devote to investment. Some of these decisions involve private spending; others involve government spending. a. Describe some forms of private spending that represent consumption, and some forms that represent investment. b. Describe some forms of government spending that represent consumption, and some forms that represent investment. a.

Private consumption spending includes buying food and buying clothes; private investment spending includes people buying houses and firms buying computers. Many other examples are possible.

b.

Government consumption spending includes paying workers to administer government programs; government investment spending includes buying military equipment and building roads. Many other examples are possible.

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7.

What is the opportunity cost of investing in capital? Do you think a country can ―overinvest‖ in capital? What is the opportunity cost of investing in human capital? Do you think a country can ―overinvest‖ in human capital? Explain.

The opportunity cost of investing in capital is the loss of consumption that results from redirecting resources toward investment. Overinvestment in capital is possible because of diminishing marginal returns. A country can ―overinvest‖ in capital if people would prefer to have higher consumption spending and less future growth. The opportunity cost of investing in human capital is also the loss of consumption that is needed to provide the resources for investment. A country could ―overinvest‖ in human capital if people are too highly educated for the jobs they could getfor example, if the best job a PhD in philosophy could find is managing a restaurant.

8.

9.

10.

Suppose that an auto company owned entirely by German citizens opens a new factory in Quebec. a. What sort of foreign investment would this represent? b. What would be the effect of this investment on Canadian GDP? Would the effect on the Canadians be larger or smaller than this? a.

When a German firm opens a factory in Quebec, it represents foreign direct investment.

b.

The investment increases Canadian GDP since it increases production in Canada. The effect on Canadian GNP would be smaller since the owners would get paid a return on their investment that would be part of German GNP rather than Canadian GNP.

In the 1960s, American investors made significant direct and portfolio investments in Canada. At the time, many Canadians were unhappy that this investment was occurring. a. In what way was it better for Canada to receive this American investment than not to receive it? b. In what way would it have been better still for Canadians to have done this investing? a.

Canada benefited from the American investment since it made our capital stock larger, increasing our economic growth.

b.

It would have been better for Canada to make the investments itself since then it would have received the returns on the investment itself, instead of the returns going to the United States.

In the countries of South Asia in 1992, only 56 young women were enrolled in secondary school for every 100 young men. Describe several ways in which greater educational opportunities for young women could lead to faster economic growth in these countries.

Greater educational opportunities for women could lead to faster economic growth in the countries of South Asia because increased human capital would increase productivity and there would be external effects from greater knowledge in the country. Second, increased educational opportunities for young women may lower the population growth rate because such opportunities raise the opportunity cost of having a child.

11.

The International Property Right Index scores countries based on the legal and political environment and how well property rights are protected. Go online and find a recent ranking.

Choose three countries with high scores and three countries with low scores. Then find estimates of GDP per person in each of these six countries. What pattern do you find? Give two possible interpretations of the pattern.

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Country Finland New Zealand Switzerland Bangladesh Chad Haiti

IPR Index 2022 8.173 7.929 7.940 3.577 3.071 2.834

GDP per person (2021, US $) $53 774 $48 317 $92 248 $2497 $697 $1765

Countries ranked more highly with respect to property rights also tend to enjoy much higher levels of GDP per capita. One explanation for this is that the protection of property rights ensures that people who open a new mine or develop a new method of production are able to reap the rewards from their work without fear of having their idea or their property seized.

Without this protection, they will not take the risk. Strong protection of property rights allows them to secure their own prosperity and also create wealth and provide employment opportunities for others. Another explanation is that in countries where property rights are not well protected, the payment of bribes to government officials or others becomes necessary to ensure economic security. This is a waste of resources that could otherwise be used to create wealth and employment.

12.

International data show a positive correlation between income per person and the health of the population. a. Explain how higher income might cause better health outcomes. b. Explain how better health outcomes might cause higher income. c. How might the relative importance of your two hypotheses be relevant for public policy? a. b. c.

13.

Higher income enables a family to maintain a good diet and in this way maintain better health.

Good health means people do not miss work and are more productive. This enables them the opportunity to earn higher incomes.

These two hypotheses support the provision of a social safety net that makes available affordable health care and income support to those with low income. These characteristics of the social safety net are meant to better the lives of citizens and to enable them to more fully participate in the economy.

The great 18th-century economist Adam Smith wrote, ―Little else is requisite to carry a state to the highest degree of opulence from the lowest barbarism but peace, easy taxes, and a tolerable administration of justice: all the rest being brought about by the natural course of things.‖ Explain how each of the three conditions Smith describes would promote economic growth.

A peaceful society, one free from both internal and external strife, is an obvious pre-condition for economic growth as it protects society from the destruction and loss of life that is a consequence of war. By ―easy taxes,‖ Smith meant that taxes should be kept as low as possible given the need to fund the provision of worthwhile public goods. This approach leaves as much income in the hands of those who earn it as possible, thereby rewarding them for their hard work and encouraging them to continue in those endeavours. Finally, by ―a tolerable administration of justice,‖ Smith refers to a system of justice composed of honest police and fair courts. When inevitable disagreements arise between people, economic growth is enhanced if those conflicts can be resolved in an open, transparent, and fair manner. This again encourages people and firms to engage in production without fear of arbitrary decisions by courts.

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14.

How large will Canada’s GDP be in 25 years? The answer depends on what the rate of growth in GDP will be over that 25-year period. A mathematical formula we can use for this calculation is the following: GDP2047 = GDP2022 (1 + g)25

where GDP2047 is the level of GDP in the year 2047, GDP2022 is the level of GDP in the year 2022, and g is the rate of growth in GDP. Assume that GDP in 2022 is $1000 million and assume that the value of g is 0.035 (3.5 percent per year). What will be the value of GDP in 2047? Now suppose that the value of g is 0.040 (4.0 percent per year). What will be the value of GDP in 2047 given this slightly larger rate of growth? What does this result say about the importance of policies that promote even slightly faster rates of growth in GDP? GDP2047 = 1000(1 + 0.035)25 = 1000(1.035)25 = $2363 million GDP2047 = 1000(1 + 0.040)25 = $2666 million The value of GDP in 2047 rises as the annual growth rate increases. Policies to promote even slightly faster growth rates in GDP lead to more employment, productivity, and higher standards of living.

Chapter 8 Saving, Investment, and the Financial System SOLUTIONS TO TEXTBOOK PROBLEMS Questions for Review 1.

What is the role of the financial system? Name and describe two markets that are part of the financial system in our economy. Name and describe two financial intermediaries.

The financial system’s role is to help match one person’s saving with another person’s investment. Two markets that are part of the financial system are the bond market, through which large corporations, the federal government, or provincial and territorial governments borrow, and the stock market, through which corporations sell ownership shares. Two financial intermediaries are banks, which take in deposits and use the deposits to make loans, and mutual funds, which sell shares to the public and use the proceeds to buy a portfolio of financial assets.

2.

Why is it important for people who own stocks and bonds to diversify their holdings? What type of financial intermediary makes diversification easier?

It is important for people who own stocks and bonds to diversify their holdings because then they will have only a small stake in each asset, which reduces risk. Mutual funds make such diversification easy by allowing a small investor to purchase parts of hundreds of different stocks and bonds.

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3.

What is national saving? What is private saving? What is public saving? How are these three variables related?

National saving is the amount of a nation’s income that is not spent on consumption or government purchases. Private saving is the amount of income that households have left after paying their taxes and paying for their consumption. Public saving is the amount of tax revenue that the government has left after paying for its spending. The three variables are related because national saving equals private saving plus public saving.

4.

What is investment? How is it related to national saving?

Investment refers to the purchase of new capital, such as equipment or buildings. It is equal to national saving.

5.

Describe a change in the tax laws that might increase private saving. If this policy were implemented, how would it affect the market for loanable funds?

A change in the tax laws that might increase private saving is the introduction of a consumption tax to replace the income tax. Since a consumption tax would not tax the returns to saving, it would increase the supply of loanable funds, thus lowering interest rates and increasing investment.

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6.

What is a government budget deficit? How does it affect interest rates, investment, and economic growth?

A government budget deficit arises when the government spends more than it receives in tax revenue. Since a government budget deficit reduces national saving, it raises interest rates, reduces private investment, and thus reduces economic growth.

7.

How does government accumulate debt? If the government maintains a budget surplus, what happens to its debt? What if it maintains a budget deficit?

When government (tax) revenue falls short of government expenses, the government runs a deficit. Deficits, like other variables such as GDP, savings, investment, and consumption, are measured every year starting from zero at the beginning of the year. Each year’s deficit increases a government’s accumulated debt. A surplus reduces debt. To summarize, deficit or surplus is an annual variable, while debt is cumulative; it is the result of past deficits and surpluses.

Problems and Applications 1.

2.

For each of the following pairs, which bond would you expect to pay a higher interest rate?

Explain. a. a bond of the Canadian government or a bond of an East European government b. a bond that repays the principal in year 2018 or a bond that repays the principal in year 2028 c. a bond from Coca-Cola or a bond from a software company you run in your garage d. a bond issued by the federal government or a bond issued by Prince Edward Island a.

The bond of an East European government would pay a higher interest rate than the bond of the Canadian government because there would be a greater risk of default.

b.

A bond that repays the principal in 2028 would pay a higher interest rate than a bond that repays the principal in 2018 because it has a longer term to maturity, so there is more risk to the principal.

c.

A bond from a software company you run in your garage would pay a higher interest rate than a bond from Coca-Cola because your software company has more credit risk.

d.

A bond issued by Prince Edward Island would pay a higher interest rate than a bond issued by the federal government because of the somewhat greater credit risk compared to the federal government.

Check a newspaper or the Internet for the stock listings of two companies you know something about (perhaps as a customer). What is the price/earnings ratio for each company? Why do you think they differ? If you were to buy one of these stocks, which would you choose? Why? Many answers are possible. Price/earnings ratios vary. A high price/earnings ratio might indicate either that people expect earnings to rise in the future or that the stock is overvalued. A low price/earnings ratio might indicate either that people expect earnings to fall or that the stock is undervalued.

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3.

Theodore Roosevelt once said, ―There is no moral difference between gambling at cards or in lotteries or on the race track and gambling in the stock market.‖ What social purpose do you think is served by the existence of the stock market?

The stock market does have a social purpose. Firms obtain funds for investment by issuing new stock. People are more likely to buy that stock because there are organized stock markets, so people know that they can sell their stock if they want to.

4.

Declines in stock prices are sometimes viewed as harbingers of future declines in real GDP. Why do you suppose that might be true?

Stock prices are viewed as harbingers of future declines in real GDP because people value stocks based on the expected future profitability of the firm. If stock prices fall, this must mean that investors expect a lower future profitability for the firms. This means that we might expect output in these firms to decline as well.

5.

When the Russian government defaulted on its debt to foreigners in 1998, interest rates rose on bonds issued by many other developing countries. Why do you suppose this happened?

When the Russian government defaulted on its debt, investors perceived a higher chance of default (than they had before) on similar bonds sold by other developing countries. Thus the supply of loanable funds shifted to the left, as shown in Figure 1. The result was an increase in the interest rate.

Figure 1 6.

Many workers hold large amounts of stock issued by the firms for which they work. Why do you suppose companies encourage this behaviour? Why might people not want to hold stock in the company where they work?

Companies encourage their employees to hold stock in the company because it gives the employees the incentive to care about the firm’s profits, not just their own salary. Then, if employees see waste or see areas in which the firm can improve, they will take actions that benefit the company because they know the value of their stock will rise as a result. And it also gives employees an additional incentive to work hard, knowing that if the firm does well, they will profit.

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But from an employee’s point of view, owning stock in the company for which they work can be risky. The employee’s salary or wages are already tied to how well the firm performs. If the firm has trouble, the employee could be laid off or have their salary reduced. If the employee owns stock in the firm, then there is a double whammythe employee is unemployed or gets a lower salary and the value of the stock falls as well. So owning stock in the company where you work is a very risky proposition. Most employees would be better off diversifyingowning stock or bonds in other companiesso their fortunes wouldn’t depend so much on the firm for which they work.

7.

Explain the difference between saving and investment as defined by a macroeconomist. Which of the following situations represent investment? Saving? Explain. a. Your family takes out a mortgage and buys a new house. b. You use your $200 paycheque to buy stock in Bombardier. c. Your roommate earns $100 and deposits it into her account at a bank. d. You borrow $1000 from a bank to buy a car to use in your pizza delivery business.

To a macroeconomist, saving occurs when a person’s income exceeds her or his consumption, while investment occurs when a person or firm purchases new capital, such as a house or business equipment.

8.

a.

When your family takes out a mortgage and buys a new house, that is investment, because it is a purchase of new capital.

b.

When you use your $200 paycheque to buy stock in Bombardier, that is saving, because your income of $200 is not being spent on consumption goods.

c.

When your roommate earns $100 and deposits it in her account at a bank, that is saving, because the money is not spent on consumption goods.

d.

When you borrow $1000 from a bank to buy a car to use in your pizza delivery business, that is investment, because the car is a capital good.

Suppose GDP is $800 billion, taxes are $150 billion, private saving is $50 billion, and public saving is $20 billion. Assuming this economy is closed, calculate consumption, government purchases, national saving, and investment.

Given that Y = 800, T = 150, Sprivate = 50 = Y – T – C, Spublic = 20 = T – G. Since Sprivate = Y – T – C, then rearranging gives C = Y – T – Sprivate = 800 – 150 – 50 = 600.

Since Spublic = T – G, then rearranging gives G = T – Spublic = 150 – 20 = 130.

Since S = national saving = Sprivate + Spublic = 50 + 20 = 70.

Finally, since I = investment = S, I = 70.

9.

Economists in Funlandia, a closed economy, have collected the following information about the economy for a particular year: Y = 10 000 C = 6000 T = 1500 G = 1700 The economists also estimate that the investment function is: I = 3300 – 100r

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where r is the country’s real interest rate, expressed as a percentage. Calculate private saving, public saving, national saving, investment, and the equilibrium real interest rate.

Since Sprivate = Y – T – C, then Sprivate = 10 000 – 1500 – 6000 = 2500.

Since Spublic = T – G, then Spublic = 1500 – 1700 = –200.

Since S = national saving = Sprivate + Spublic = 2500 + (–200) = 2300.

Finally, since I = investment = S, then 3300 – 100r= 2300 so that after rearranging, r = 10.

10.

Suppose that Intel is considering building a new chip-making factory. a. Assuming that Intel needs to borrow money in the bond market, why would an increase in interest rates affect Intel’s decision about whether to build the factory? b. If Intel has enough of its own funds to finance the new factory without borrowing, would an increase in interest rates still affect Intel’s decision about whether to build the factory? Explain. a. b.

11.

If interest rates increase, the costs of borrowing money to build the factory become higher, so the returns from building the new plant may not be sufficient to cover the costs. Thus, higher interest rates make it less likely that Intel will build the new factory.

Even if Intel uses its own funds to finance the factory, the rise in interest rates still matters. There is an opportunity cost on the use of the funds. Instead of investing in the factory, Intel could invest the money in the bond market to earn the higher interest rate available there. Intel will compare its potential returns from building the factory to the potential returns from the bond market. So if interest rates rise so that bond market returns rise, Intel is again less likely to invest in the factory.

Three students have each saved $1000. Each has an investment opportunity in which he or she can invest up to $2000. Here are the rates of return on the students’ investment projects: Harry

5 percent

Ron

8 percent

Hermione

20 percent

a. If borrowing and lending are prohibited, so each student uses only personal saving to finance his or her own investment project, how much will each student have a year later when the project pays its return? b. Now suppose their school opens up a market for loanable funds in which students can borrow and lend among themselves at an interest rate r. What would determine whether a student would choose to be a borrower or lender in this market? c. Among these three students, what would be the quantity of loanable funds supplied and quantity of loanable funds demanded at an interest rate of 7 percent? At 10 percent?

Assume unlimited funds are available to be borrowed at these interest rates. a.

Harry will earn 5 percent on his $1000 in saving. After a year, Harry will have $1050.

Ron will earn 8 percent on his $1000 in saving. After a year, Ron will have $1080.

Hermione will earn 20 percent on her $1000 in saving. After a year, Hermione will have $1200.

b.

Hermione earns the highest rate of return on her investment project (20 percent). She will offer to borrow $1000 from Harry at a rate of just over 8 percent. Since that exceeds the rate of return on the investment project available to him, Harry agrees to lend to

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Hermione. Offering Harry just over 8 percent for his savings is more than Ron is willing to pay because he can earn only 8 percent on the investment project available to him.

Had Hermione only offered to borrow from Harry at 6 percent, Ron would have made a similar offer and competed with Hermione for Harry’s savings. So Hermione is guaranteed to be able to borrow Harry’s savings by offering Harry just over the maximum amount Ron would be willing to offer. She now invests $2000 in the investment project available to her. Harry will be a lender and Hermione will be a borrower. Ron will be neither.

c.

At an interest rate of 7 percent, Harry will lend his $1000 in savings. This is because lending at 7 percent is a better than the 5 percent rate of return available by investing in the investment project available to him. Ron would like to borrow $1000 at 7 percent so he can invest this amount and his own savings at the 8 percent rate of return available by investing in the investment project available to him. Hermione will also wish to borrow $1000 at 7 percent so she can invest this amount and her own savings at the 20 percent rate of return available by investing in the investment project available to her. Both Hermione and Ron borrow $1000 at 7 percent so they can invest in projects that earn Hermione 20 percent and Ron 8 percent, respectively. Harry will lend his $1000 in savings to earn 7 percent.

At an interest rate of 10 percent, only Hermione will wish to borrow money. She will borrow $1000 to invest in the project available to her, a project that earns 20 percent.

Neither Harry nor Ron will borrow at 10 percent because that interest rate exceeds that rate of return available on the projects available to them. Harry will lend his $1000 in savings to earn 10 percent; Ron will also lend his $1000 in savings to earn 10 percent.

12.

Suppose the government borrows $20 billion more next year than this year. a. Use a supply-and-demand diagram to analyze this policy. Does the interest rate rise or fall? b. What happens to investment? To private saving? To public saving? To national saving?

Compare the size of the changes to the $20 billion of extra government borrowing. c. How does the elasticity of supply of loanable funds affect the size of these changes? d. How does the elasticity of demand for loanable funds affect the size of these changes? e. Suppose households believe that greater government borrowing today implies higher taxes to pay off the government debt in the future. What does this belief do to private saving and the supply of loanable funds today? Does it increase or decrease the effects you discussed in parts (a) and (b)?

a. Figure 2 illustrates the effect of the $20 billion increase in government borrowing. Initially, the supply of loanable funds is curve S1, the equilibrium real interest rate is i1, and the quantity of loanable funds is L1. The increase in government borrowing by $20 billion reduces the supply of loanable funds at each interest rate by $20 billion, so the new supply curve, S2, is shown by a shift to the left of S1 by exactly $20 billion. As a result of the shift, the new equilibrium real interest rate is i2. The interest rate has increased as a result of the increase in government borrowing.

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Figure 2 b.

Since the interest rate has increased, investment and national saving decline and private saving increases. The increase in government borrowing reduces public saving. From the figure, you can see that total loanable funds (and thus both investment and national saving) decline by less than $20 billion, while public saving declines by $20 billion and private saving rises by less than $20 billion.

c.

The more elastic the supply of loanable funds, the flatter the supply curve would be, so the interest rate would rise by less and thus national saving would fall by less, as Figure 3 shows.

Figure 3

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d.

The more elastic the demand for loanable funds, the flatter the demand curve would be, so the interest rate would rise by less and thus national saving would fall by more, as Figure 4 shows.

Figure 4

e.

If households believe that greater government borrowing today implies higher taxes to pay off the government debt in the future, then people will save more so they can pay the higher future taxes, so private saving will increase as will the supply of loanable funds. This will offset the reduction in public saving, thus reducing the amount by which the equilibrium quantity of investment and national saving decline, and reducing the amount that the interest rate rises.

If the rise in private saving were exactly equal to the increase in government borrowing, there would be no shift in the national saving curve, so investment, national saving, and the interest rate would all be unchanged.

13.

Over the past ten years, new computer technology has enabled firms to reduce substantially the amount of inventories they hold for each dollar of sales. Illustrate the effect of this change on the market for loanable funds. (Hint: Expenditure on inventories is a type of investment.) What do you think has been the effect on investment in factories and equipment?

Since new computer technology enables firms to reduce inventory investment, the demand curve for loanable funds shifts to the left, as shown in Figure 5. As a result, the equilibrium quantity of loanable funds declines, as does the interest rate. The decline in the interest rate then increases investment in factories and equipment, but overall investment still declines.

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Figure 5 14.

This chapter explains that investment can be increased both by reducing taxes on private saving and by reducing the government budget deficit. a. Why is it difficult to implement both of these policies at the same time? b. What would you need to know about private saving in order to judge which of these two policies would be a more effective way to raise investment? a.

Investment can be increased by reducing taxes on private saving or by reducing the government budget deficit. But reducing taxes on private saving has the effect of increasing the government budget deficit, unless some other taxes are increased or government spending is reduced. So it is difficult to engage in both policies at the same time.

b.

To know which of these policies would be a more effective way to raise investment, you would need to know: (1) what the elasticity of private saving is with respect to the aftertax real interest rate, since that would determine how much private saving would increase if you reduced taxes on saving; (2) how private saving responds to changes in the government budget deficit, since, for example, the decline in the government budget deficit would be matched by an equal decline in private saving (people know they will have to pay higher taxes in the future), so national saving would not increase at all; and (3) how elastic investment is with respect to the interest rate, since if investment is quite inelastic, neither policy will have much of an impact on investment.

Chapter 9 Unemployment and Its Natural Rate SOLUTIONS TO TEXTBOOK PROBLEMS Questions for Review

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1.

What are the three categories into which Statistics Canada divides everyone? How does Statistics Canada compute the labour force, the unemployment rate, and the labour-force participation rate?

Statistics Canada categorizes each adult (15 years of age and older) as either employed, unemployed, or not in the labour force. The labour force consists of the sum of the employed and the unemployed. The unemployment rate is the percentage of the labour force that is unemployed. The labour-force participation rate is the percentage of the total adult population that is in the labour force.

2.

Is unemployment typically short term or long term? Explain.

Unemployment is typically short term. That is to say, most people who experience unemployment do so for a relatively short period of time.

3.

Employment Insurance provides an economic incentive that encourages people to enter the labour force. Explain.

The EI program increases the total income people receive by working. They not only earn a wage while working, but they also become eligible to collect EI benefits should they leave their job.

4.

Why is frictional unemployment inevitable? How might the government reduce the amount of frictional unemployment?

Frictional unemployment is inevitable because the economy is always changing. Some firms are shrinking while others are expanding. Some regions are experiencing faster growth than other regions. Transitions of workers between firms and between regions are accompanied by temporary unemployment.

The government could help to reduce the amount of frictional unemployment by public policies that provide information about job vacancies in order to match workers and jobs more quickly, and through public training programs that help ease the transition of workers from declining to expanding industries and help disadvantaged groups escape poverty.

5.

Are minimum-wage laws a better explanation for structural unemployment among teenagers or among postsecondary graduates? Why? Minimum-wage laws are a better explanation for unemployment among teenagers than among postsecondary graduates. Teenagers have fewer job-related skills than postsecondary graduates do, so their wages are low enough to be affected by the minimum wage. Postsecondary graduates’ wages generally exceed the minimum wage.

6.

How do unions affect the natural rate of unemployment?

Unions may affect the natural rate of unemployment via the effect on insiders and outsiders.

Since unions raise the wage above the equilibrium level, the quantity of labour demanded declines while the quantity supplied of labour rises, so there is unemployment. Insiders are those who keep their jobs. Outsiders, workers who become unemployed, have two choices: get a job in a firm that is not unionized, or remain unemployed and wait for a job to open up in the union sector. As a result, the natural rate of unemployment is higher than it would be without unions.

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7.

What claims do advocates of unions make to argue that unions are good for the economy?

Union advocates claim that unions are good for the economy because they are an antidote to the market power of the firms that hire workers, and they are important for helping firms respond efficiently to workers’ concerns.

8.

Explain four ways in which a firm might increase its profits by raising the wages it pays.

Four reasons why a firm’s profits might increase when it raises wages are: (1) better paid workers are healthier and more productive; (2) worker turnover is reduced; (3) worker effort is increased; and (4) the firm can attract higher quality workers.

Problems and Applications 1.

Statistics Canada announced that in June 2021, of all Canadians aged 15 years and older, 18 789 900 were employed, 1 591 600 were unemployed, and 10 901 800 were not in the labour force. How big was the labour force? What was the labour-force participation rate? What was the unemployment rate?

The labour force consists of the number of employed (18 789 900) plus the number of unemployed (1 591 600), which equals 20 381 500. To find the labour-force participation rate, we need to know the size of the adult population. Adding the labour force (20 381 500) to the number of people not in the labour force (10 901 800) gives the adult population of 31 283 300.

The labour-force participation rate is the labour force (20 381 500) divided by the adult population (31 283 300) times 100, which equals 65.2 percent. The unemployment rate is the number of unemployed (1 591 600) divided by the labour force (20 381 500) times 100, which equals 7.8 percent.

2.

Explain whether each of the following events increases, decreases, or has no effect on the unemployment rate and the labour-force participation rate. a. After a long search, Jon finds a job. b. Tim, a full-time university student, graduates and is immediately employed. c. After an unsuccessful job search, Arya gives up looking and retires. d. Max quits his job to become a stay-at-home parent. e. Sansa has a birthday, becomes an adult, but has no interest in working. f. Jaime has a birthday, becomes an adult, and starts looking for a job. g. Lou dies while enjoying retirement. h. Jorah dies working long hours at the office.

a. b. c. d. e. f. g. h.

3.

The unemployment rate falls; there is no effect on the labour-force participation rate.

The unemployment rate falls; the labour-force participation rate increases.

The unemployment rate increases; the labour-force participation rate falls.

The unemployment rate increases; the labour-force participation rate falls.

The unemployment rate is unchanged; the labour-force participation rate falls.

The unemployment rate is unchanged; the labour-force participation rate is unchanged.

The unemployment rate is unchanged; the labour-force participation rate increases.

The unemployment rate increases; the labour-force participation rate is unchanged.

The labour-force participation rate of women increased sharply between 1976 and 2020.

However, there were different patterns for different age groups, as shown in this table:

1976

All Women 46%

Women 15–24 58%

Women 25–54 52%

Women 55 and Over 18%

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2020

60

62

82

31

Why do you think that women aged 25-54 years experienced a bigger increase in labour-force participation than women of other ages?

Women aged 25-54 years experienced a bigger increase in labour-force participation than women of other ages because more of them have entered the labour force (in part because of social changes), so there are more two-career families. In addition, women have delayed having children until later in life and have reduced the number of children they have, so they are in the labour force for a greater proportion of their lives than was the case previously.

4.

Between 2008 and 2009, total employment in Canada decreased by 277 000 workers, but the number of unemployed workers increased by 400 000. How are these numbers consistent with each other?

The fact that employment decreased by 277 000 while unemployment increased by 400 000 is consistent with an increase in the labour force of 123 000 (= 400 000 – 277 000). The labour force is equal to the number of employed plus the number of unemployed. Since the labour force does not remain constant, the change in unemployment does not have to mirror the change in employment.

5.

Go to the Government of Canada’s website at

http://srv129.services.gc.ca/eiregions/eng/postalcode_search.aspx and enter your postal code.

After clicking on the name of your community you will be told the unemployment rate in your

region, the number of hours of employment you will need to qualify for EI benefits, and the number of weeks you will be eligible to collect EI, depending on your recent employment history.

Now enter a postal code for someone living in an area of the country with a much different unemployment rate from that in your area. How might these differences influence labour market behaviour in one region versus the other?

Many answers are possible.

6.

Are the following workers more likely to experience short-term or long-term unemployment?

Explain. a. a construction worker laid off because of bad weather b. a manufacturing worker who loses her job at a plant in an isolated area c. a stagecoach-industry worker laid off because of competition from railroads d. a short-order cook who loses his job when a new restaurant opens across the street e. an expert welder with little formal education who loses her job when the company installs automatic welding machinery a.

A construction worker who is laid off because of bad weather is likely to experience short-term unemployment, since the worker will be back to work as soon as the weather clears up.

b.

A manufacturing worker who loses her job at a plant in an isolated area is likely to experience long-term unemployment, since there are probably few other employment opportunities in the area. She may need to move somewhere else to find a suitable job, which means she will be out of work for some time.

c.

A worker in the stagecoach industry who was laid off because of the growth of railroads is likely to be unemployed for a long time. The worker will have a lot of trouble finding another job when his entire industry is shrinking. He will probably need to gain additional

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training or skills to get a job in a different industry.

7.

d.

A short-order cook who loses his job when a new restaurant opens is likely to find another job fairly quickly, perhaps even at the new restaurant, and thus he will probably have only a short spell of unemployment.

e.

An expert welder with little formal education who loses her job when the company installs automatic welding machinery is likely to be without a job for a long time, since she lacks the technological skills to keep up with the latest equipment. To remain in the welding industry, she may need to go back to school and learn the newest techniques.

Using a diagram of the labour market, show the effect of an increase in the minimum wage on the wage paid to workers, the number of workers supplied, the number of workers demanded, and the amount of unemployment.

Quantity of Labour

Figure 2 Figure 2 shows a diagram of the labour market with a binding minimum wage. The initial equilibrium with minimum wage m1 has quantity of labour supply L1S greater than the quantity of labour demanded L1D, with unemployment equal to L1S – L1D. An increase in the minimum wage to m2 leads to an increase in the quantity of labour supplied to L2S and a decrease in the quantity of labour demanded to L2D. As a result, unemployment increases as the minimum wage rises.

8.

Do you think that firms in small towns or in cities have more market power in hiring? Do you think that firms generally have more market power in hiring today than 50 years ago, or less?

How do you think this change over time has affected the role of unions in the economy? Explain.

Firms in small towns have more market power in hiring because there are fewer opportunities for workers to find jobs elsewhere. Firms generally have less market power now than they used to, since it is now easier for employees to travel farther to go to work. This change in the market power of firms has reduced the need for unions, since competition from other firms keeps workers’ wages and benefits high and reduces the need for collective bargaining.

9.

Consider an economy with two labour markets, neither of which is unionized. Now suppose a union is established in one market. a. Show the effect of the union on the market in which it is formed. In what sense is the quantity of labour employed in this market an inefficient quantity?

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b. Show the effect of the union on the nonunionized market. What happens to the equilibrium wage in this market? a.

b.

Figure 3 illustrates the effect of a union being established in one labour market. When one labour market is unionized, shown in the figure on the left, the wage rises from w1U to w2U and the quantity of labour demanded declines from U1 to U2D. Since the wage is higher, the quantity supplied of labour increases to U2S, so there are U2S – U2D unemployed workers in the unionized sector. The quantity of labour employed in this market is inefficient, since more workers would like to have jobs at the existing wage.

When those workers who become unemployed in the union sector seek employment in the nonunionized market, shown in the figure on the right, the supply of labour shifts to the right from S1 to S2. The result is a decline in the wage in the nonunionized sector from w1N to w2N and an increase in employment in the nonunionized sector from N1 to N2.

Quantity of Labour

Quantity of Labour

Figure 3

10.

It can be shown that an industry’s demand for labour will become more elastic when the demand for the industry’s product becomes more elastic. Let’s consider the implications of this fact for the Canadian automobile industry and Unifor, the union that represents Canadian autoworkers. a. What happened to the elasticity of demand for Canadian cars when the Japanese developed a strong auto industry? What happened to the elasticity of demand for Canadian autoworkers? Explain. b. As the chapter explains, a union generally faces a tradeoff in deciding how much to raise wages because a larger increase is better for workers who remain employed but also results in a greater reduction in employment. How did the rise in auto imports from Japan affect the wage–employment tradeoff faced by Unifor? c. Do you think the growth of the Japanese auto industry increased or decreased the gap between the competitive wage and the wage negotiated by Unifor? Explain. a.

When the Japanese developed a strong auto industry, Canadian auto demand became more elastic as a result of increased competition. With more elastic demand for autos, the elasticity of demand for Canadian autoworkers increased.

b.

Since the rise in auto imports made the demand for autoworkers more elastic, to maintain a higher-than-competitive wage rate requires a greater reduction in the quantity

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of labour demanded. So the union had to choose between allowing the union wage to decline or facing the loss of many jobs. c.

11.

Given the tradeoff faced by the union, the growth of the Japanese auto industry forced the union wage to move closer to the competitive wage.

Some workers in the economy are paid a flat salary and some are paid by commission. Which compensation scheme would require more monitoring by supervisors? In which case do firms have an incentive to pay more than the equilibrium level (as in the worker-effort variant of efficiency-wage theory)? What factors do you think determine the type of compensation firms choose?

Workers need to be monitored if they earn a flat salary, but little monitoring is needed under a commission structure. Under a system with flat salaries, the wage needs to exceed the equilibrium wage to encourage greater effort by workers. The wage need not exceed the equilibrium wage under a system with commissions, since workers can choose their level of effort and get paid in proportion to their effort. The factors that determine the type of compensation scheme include the cost of monitoring, the willingness of workers to bear risk under the commission scheme, and the interdependence of tasks.

12.

Structural unemployment is sometimes said to result from a mismatch between the job skills that employers want and the job skills that workers have. To explore this idea, consider an economy with two industries: auto manufacturing and aircraft manufacturing. a. If workers in these two industries require similar amounts of training, and if workers at the beginning of their careers could choose which industry to train for, what would you expect to happen to the wages in these two industries? How long would this process take? Explain. b. Suppose that one day the economy opens itself to international trade and, as a result, starts importing autos and exporting aircraft. What would happen to demand for labour in these two industries? c. Suppose that workers in one industry cannot be quickly retrained for the other. How would these shifts in demand affect equilibrium wages in the long run? d. If for some reason wages fail to adjust to the new equilibrium levels, what would occur? a.

Wages in the two manufacturing industries should eventually become equal. If one industry would consistently pay higher wages, more workers would choose to train for that industry and labour supply would increase, driving down wages in that industry. This adjustment process may take a few years, since training takes time.

b.

The labour demand in the auto industry falls and the labour demand in the aircraft industry rises. Wages rise in the aircraft industry and fall in the auto industry in the short run.

c.

In the long run, more workers would choose to (re)train for the aircraft industry, and wages again equalize.

d.

If wages stay high in the auto industry, they send the wrong signal to new workers, who do not make the right decision to train for the aircraft industry. There is going to be structural unemployment in the auto industry, and it takes longer until workers learn that it is harder to find a job in the auto industry and that they should train for the aircraft industry.

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13.

(This problem is challenging.) Suppose that Parliament passes a law requiring employers to provide employees some benefit (such as dental care) that raises the cost of an employee by $4 per hour. a. What effect does this employer mandate have on the demand for labour? (In answering this and the following questions, be quantitative when you can.) b. If employees place a value on this benefit exactly equal to its cost, what effect does this employer mandate have on the supply of labour? c. If the wage is free to balance supply and demand, how does this law affect the wage and the level of employment? Are employers better or worse off? Are employees better or worse off? d. If a minimum-wage law prevents the wage from balancing supply and demand, how does the employer mandate affect the wage, the level of employment, and the level of unemployment? Are employers better or worse off? Are employees better or worse off? e. Now suppose that workers do not value the mandated benefit at all. How does this alternative assumption change your answers to parts (b), (c), and (d) above? a.

If a firm was not providing such benefits prior to the legislation, the curve showing the demand for labour would shift down by exactly $4 at each quantity of labour, because the firm would not be willing to pay as high a wage given the increased cost of the benefits.

Quantity of Labour

Figure 4

d.

b.

If employees value the benefit by exactly $4 per hour, they would be willing to work the same amount for a wage that is $4 less per hour, so the supply curve of labour shifts down by exactly $4.

c.

Figure 4 shows the equilibrium in the labour market. Since the demand and supply curves of labour both shift down by $4, the equilibrium quantity of labour is unchanged and the wage rate declines by $4. Both employees and employers are just as well off as before.

If the minimum wage prevents the wage from falling, the result will be increased unemployment, as Figure 5 shows. Initially, labour supply is L1S and labour demand is

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L1D, so unemployment is given by L1S – L1D. The downward shift of both the demand and supply curves gives a new equilibrium with labour supply L2S, labour demand L2D, and unemployment L2S – L2D. The wage is unchanged, the level of employment declines, and the level of unemployment rises. Employers are worse off because they hire less labour at a higher wage (including benefits). The workers who become unemployed are worse off because of the policy, while workers who remain employed are better off, since their wages plus benefits have increased.

Quantity of Labour

Figure 5

Quantity of Labour

Figure 6 e.

If the workers do not value the mandated benefit at all, the supply curve of labour does not shift down. As a result, in part (c), the wage rate will decline by less than $4 and the equilibrium quantity of labour will decline, as shown in Figure 6. The new wage, w2, will be less than w1, but greater than w1 – $4. Employers are worse off, since they now pay a greater total wage plus benefits for fewer workers. Employees are worse off, since they get a lower wage and work less.

With a minimum wage in effect, as in part (d), the impact on unemployment is not as bad as when the workers valued the benefits. Looking back at Figure 5, the only difference is that the labour-supply curve does not shift, so the equilibrium quantity of

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labour supplied stays the same at L1S. So the wage stays the same, labour demand declines, labour supply is unchanged, and unemployment rises. As before, employers are worse off since they get less labour at a higher wage plus benefits. Employees are worse off, too, since there is less employment at the same wage.

Chapter 10

The Monetary System SOLUTIONS TO TEXTBOOK PROBLEMS Questions for Review 1.

What distinguishes money from other assets in the economy?

Money is different from other assets in the economy because it is the most liquid asset available.

Other assets vary widely in their liquidity.

2.

What is commodity money? What is fiat money? Which kind do we use?

Commodity money is money with intrinsic value, like gold, which can be used for purposes other than as a medium of exchange. Fiat money is money without intrinsic value; it has no value other than its use as a medium of exchange. Our economy today uses fiat money.

3.

What are demand deposits, and why should they be included in the stock of money?

Demand deposits are balances in bank accounts that depositors can access on demand simply by writing a cheque. They should be included in the stock of money because they can be used as a medium of exchange.

4.

Who is responsible for setting monetary policy in Canada?

The Bank of Canada is responsible for setting monetary policy in Canada.

5.

If the Bank of Canada wants to increase the money supply with open-market operations, what does it do?

If the Bank of Canada wants to increase the supply of money with open-market operations, it purchases Canadian government bonds from the public on the open market. The purchase increases the number of dollars in the hands of the public, thus raising the money supply.

6.

Why don’t banks hold 100 percent reserves? How is the amount of reserves banks hold related to the amount of money the banking system creates?

Banks do not hold 100 percent reserves because it is more profitable to use the reserves to make loans, which earn interest, instead of leaving the money as reserves, which earn no interest. The amount of reserves banks hold is related to the amount of money the banking system creates through the money multiplier. The smaller the fraction of reserves banks hold, the larger the money multiplier, since each dollar of reserves is used to create more money.

7.

What is the overnight rate? What happens to the money supply when the Bank of Canada raises the overnight rate?

The overnight rate is the interest rate on very short-term loans between commercial banks. A

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higher overnight rate discourages borrowing from the Bank of Canada, which reduces the money supply.

8.

What are reserve requirements? What happens to the money supply when a central bank raises reserve requirements?

Reserve requirements are regulations on the minimum amount of reserves that banks must hold against deposits. An increase in reserve requirements raises the reserve ratio, lowers the money multiplier, and decreases the money supply.

9.

Why can’t the Bank of Canada control the money supply perfectly?

The Bank of Canada cannot control the money supply perfectly because: (1) the Bank of Canada does not control the amount of money that households choose to hold as deposits in banks; and (2) the Bank of Canada does not control the amount that commercial bankers choose to lend.

The actions of households and banks affect the money supply in ways the Bank of Canada cannot perfectly control or predict.

Problems and Applications 1.

2.

Which of the following are money in the Canadian economy? Which are not? Explain your answers by discussing each of the three functions of money. a. a Canadian dollar coin b. a Mexican peso c. a Picasso painting d. a plastic credit card a.

A Canadian dollar coin is money in the Canadian economy because it is used as a medium of exchange to buy goods or services, it serves as a unit of account because prices in stores are listed in terms of dollars and cents, and it serves as a store of value for anyone who holds it over time.

b.

A Mexican peso is not money in the Canadian economy because it is not used as a medium of exchange, and prices are not given in terms of pesos, so it is not a unit of account. It could serve as a store of value, though.

c.

A Picasso painting is not money because you cannot exchange it for goods or services, and prices are not given in terms of Picasso paintings. It does, however, serve as a store of value.

d.

A plastic credit card is similar to money but represents deferred payment, rather than immediate payment. So credit cards do not fully represent the medium of exchange function of money, nor are they really stores of value, since they represent short-term loans rather than being an asset like currency.

Explain whether each of the following events increases or decreases the money supply. a. The Bank of Canada buys bonds in open-market operations. b. The Bank of Canada increases the interest rate it pays on reserves. c. Scotiabank repays a loan it had previously taken from the Bank of Canada.

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d. After a rash of pickpocketing, people decide to hold less currency. e. Fearful of bank runs, bankers decide to hold more excess reserves. a. b. c. d. e.

3.

Increases the money supply Decreases the money supply Decreases the money supply Decreases the money supply Decreases the money supply

What characteristics of an asset make it useful as a medium of exchange? As a store of value?

For an asset to be useful as a medium of exchange, it must be widely accepted (so all transactions can be made in terms of it), recognized easily as money (so people can perform transactions easily and quickly), divisible (so people can provide change), and difficult to counterfeit (so people will not print their own money). That is why nearly all countries use paper money with fancy designs for larger denominations and coins for smaller denominations.

For an asset to be useful as a store of value, it must be something that maintains its value over time and something that can be used directly to buy goods and services or sold when money is needed. In addition to currency, financial assets (like stocks and bonds) and physical assets (like real estate and art) make good stores of value.

4.

this

Suppose that someone in Canada discovered an easy way to counterfeit $100 bills. How would development affect the Canadian monetary system? Explain.

If someone in Canada discovered an easy way to counterfeit $100 bills, they could flood the country with counterfeit currency, thus reducing the value of all $100 bills. The result might be a switch to a different type of currency.

5.

Go to the website of the Bank of Canada at www.bankofcanada.ca and find the following information: a. data on the recent history of the overnight rate b. the next fixed announcement date c. the Bank’s latest press release about overnight rates, and why the Bank decided to change, or not change, its target for the overnight rate Many answers are possible.

6.

Your uncle repays a $100 loan from Tenth National Bank by writing a $100 cheque on his TNB chequing account. Use T-accounts to show the effect of this transaction on your uncle and on TNB. Has your uncle’s wealth changed? Explain.

When your uncle repays a $100 loan from Tenth National Bank (TNB) by writing a cheque from his TNB chequing account, the result is a change in the assets and liabilities of both your uncle and TNB, as shown in these T-accounts: Your Uncle Assets Before: Chequing Account After: Chequing Account

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Liabilities $100

Loans

$100

$0

Loans

$0

Tenth National Bank Assets Before: Loans After: Loans

Liabilities $100

Deposits

$100

$0

Deposits

$0

By paying off the loan, your uncle simply eliminated the outstanding loan using the assets in his chequing account. Your uncle’s wealth has not changed; he simply has fewer assets and fewer liabilities.

7.

Beleaguered Provincial Bank (BPB) holds $250 million in deposits and maintains a reserve ratio of 10 percent. a. Show a T-account for BPB. b. Now suppose that BPB’s largest depositor withdraws $10 million in cash from her account. If BPB decides to restore its reserve ratio by reducing the amount of loans outstanding, show its new T-account. c. Explain what effect BPB’s action will have on other banks. d. Why might it be difficult for BPB to take the action described in part (b)? Discuss another way for BPB to return to its original reserve ratio. a.

Here is BPB’s T-account:

Reserves Loans b.

When BPB’s largest depositor withdraws $10 million in cash and BPB reduces its loans outstanding to maintain the same reserve ratio, its T-account is now:

Reserves Loans

8.

Beleaguered Provincial Bank Assets Liabilities $25 million Deposits $250 million $225 million

Beleaguered Provincial Bank Assets Liabilities $24 million Deposits $240 million $216 million

c.

Since BPB is cutting back on its loans, other banks will find themselves short of reserves and they may also cut back on their loans as well.

d.

BPB may find it difficult to cut back on its loans immediately, since it cannot force people to pay off loans. Instead, it can stop making new loans. But for a time, it might find itself with more loans than it wants. It could try to attract additional deposits to get additional reserves, or borrow from another bank or from the Bank of Canada.

You take $100 you had kept under your mattress and deposit it in your bank account. If this $100 stays in the banking system as reserves and if banks hold reserves equal to 10 percent of deposits, by how much does the total amount of deposits in the banking system increase? By how much does the money supply increase?

If you take $100 that you held as currency and put it into the banking system, then the total

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amount of deposits in the banking system increases by $1000, since a reserve ratio of 10 percent means the money multiplier is 1/.10 = 10. Thus, the money supply increases by $900, since deposits increase by $1000 but currency declines by $100.

9.

The Bank of Canada conducts a $10 million open-market purchase of government bonds. If the required reserve ratio is 10 percent, what is the largest possible increase in the money supply that could result? Explain. What is the smallest possible increase? Explain.

With a required reserve ratio of 10 percent, the money multiplier could be as high as 1/.10 = 10, if banks hold no excess reserves and people do not keep some additional currency. So the maximum increase in the money supply from a $10 million open-market purchase is $100 million.

The smallest possible increase is $10 million if all of the money is held by banks as excess reserves.

10.

Suppose that the T-account for First National Bank is as follows:

Reserves Loans

Assets $100 000 400 000

Deposits

Liabilities $500 000

a. If the Bank of Canada requires banks to hold 5 percent of deposits as reserves, how much in excess reserves does First National now hold? b. Assume that all other banks hold only the required amount of reserves. If First National decides to reduce its reserves to only the required amount, by how much would the economy’s money supply increase?

11.

a.

If the required reserve ratio is 5 percent, then First National Bank’s required reserves are $500 000 × .05 = $25 000. Since the bank’s total reserves are $100 000, it has excess reserves of $75 000.

b.

With a required reserve ratio of 5 percent, the money multiplier is 1/.05 = 20. If First National lends out its excess reserves of $75 000, the money supply will eventually increase by $75 000 × 20 = $1 500 000.

Consider a hypothetical economy in which private banks are required to maintain a reserve requirement equal to 10 percent of deposits. Also assume that banks do not hold any excess reserves. a. If the central bank of this economy sells $1 million of government bonds, what is the effect on the economy’s reserves and money supply? b. Now suppose the central bank lowers the reserve requirement to 5 percent, but banks choose to hold another 5 percent of deposits as excess reserves. Why might banks do so? What is the overall change in the money multiplier and the money supply as a result of these actions? a.

The reserves fall by $1 million and the money supply by $10 million, since the money multiplier is 10.

b.

The banks may choose to hold excess reserves when they are uncertain about future economic conditions. The money multiplier is still 10. The money supply decreases by $10 million, the same as before. This example shows that the Bank of Canada has only partial control over the money supply. In times of recession, when banks are reluctant to lend, monetary policy may become ineffective.

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12.

13.

14.

Assume there is a reserve requirement of 20 percent. Also assume that banks do not hold excess reserves and there is no cash held by the public. The Bank of Canada decides that it wants to expand the money supply by $40 million. a. If the Bank of Canada is using open-market operations, will it buy or sell bonds? b. What quantity of bonds does the Bank of Canada need to buy or sell to accomplish the goal? Explain your reasoning. a.

To expand the money supply, the country’s central bank needs to buy bonds.

b.

Since the reserves are 20 percent, the money multiplier is 1/0.2 = 5. In order to obtain an increase in money supply by $40 million, the country’s central bank needs to buy $40/5 = $8 million worth of bonds.

Suppose that the Bank of Canada sells 100 million euros from its foreign exchange reserves, and that the exchange rate is $1.50 Canadian per euro. a. Explain what happens to the Canadian money supply. b. Now suppose that the Bank of Canada does not want the money supply to change.

What would it need to do to sterilize its foreign exchange market operation? a.

The Canadian money supply falls by $150 million (100 million euros × $1.50 Canadian per euro).

b.

The Bank of Canada can use the Canadian dollars acquired from the foreign exchange market to buy Canadian government bonds.

(This problem is challenging.) The economy of Elmendyn contains 2000 $1 bills. a. If people hold all money as currency, what is the quantity of money? b. If people hold all money as demand deposits and banks maintain 100 percent reserves, what is the quantity of money? c. If people hold equal amounts of currency and demand deposits and banks maintain 100 percent reserves, what is the quantity of money? d. If people hold all money as demand deposits and banks maintain a reserve ratio of 10 percent, what is the quantity of money? e. If people hold equal amounts of currency and demand deposits and banks maintain a reserve ratio of 10 percent, what is the quantity of money? a.

If people hold all money as currency, the quantity of money is $2000.

b.

If people hold all money as demand deposits at banks with 100 percent reserves, the quantity of money is $2000.

c.

If people have $1000 in currency and $1000 in demand deposits, the quantity of money is $2000.

d.

If banks have a reserve ratio of 10 percent, the money multiplier is 1/.10 = 10. So if people hold all money as demand deposits, the quantity of money is 10 × $2000 = $20 000.

e.

If people hold equal amounts of currency (C) and demand deposits (D), and the money multiplier for reserves is 10, then two equations must be satisfied: (1) C = D, so that people have equal amounts of currency and demand deposits; and (2) 10 × ($2000 – C) = D, so that the money multiplier (10) times the number of dollar

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bills that are not being held by people ($2000 – C) equals the amount of demand deposits (D). Using the first equation in the second gives 10 × ($2000 – D) = D, or $20 000 – 10 D = D, or $20 000 = 11 D, so D = $1818.18. Then C = $1818.18. The quantity of money is C + D = $3636.36.

Chapter 11 Money Growth and Inflation SOLUTIONS TO TEXTBOOK PROBLEMS Questions for Review 1.

Explain how an increase in the price level affects the real value of money.

An increase in the price level reduces the real value of money because each dollar in your wallet now buys a smaller quantity of goods and services.

2.

According to the quantity theory of money, what is the effect of an increase in the quantity of money?

According to the quantity theory of money, an increase in the quantity of money causes a proportional increase in the price level.

3.

Explain the difference between nominal and real variables, and give two examples of each.

According to the principle of monetary neutrality, which variables are affected by changes in the quantity of money?

Nominal variables are those measured in monetary units, while real variables are those measured in physical units. Examples of nominal variables include the prices of goods, wages, and the dollar value of GDP. Examples of real variables include relative prices (the price of one good in terms of another), real wages, and real GDP. According to the principle of monetary neutrality, only nominal variables are affected by changes in the quantity of money.

4.

In what sense is inflation like a tax? How does thinking about inflation as a tax help explain hyperinflation?

Inflation is like a tax because everyone who holds money loses purchasing power. In a hyperinflation, the government increases the money supply rapidly, which leads to a high rate of inflation. Thus, the government uses the inflation tax, in addition to other types of taxes (such as income tax or sales tax), to finance its spending.

5.

According to the Fisher effect, how does an increase in the inflation rate affect the real interest rate and the nominal interest rate?

According to the Fisher effect, an increase in the inflation rate raises the nominal interest rate by the same amount that the inflation rate increases, with no effect on the real interest rate.

6.

What are the costs of inflation? Which of these costs do you think are most important for the Canadian economy?

The costs of inflation include shoeleather costs associated with reduced money holdings, menu costs associated with more frequent adjustment of prices, increased variability of relative prices, unintended changes in tax liabilities due to non-indexation of the tax laws, confusion and

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inconvenience resulting from a changing unit of account, and arbitrary redistributions of wealth between debtors and creditors. With a low and stable rate of inflation like that in Canada, none of these costs are very high. Perhaps the most important one is the interaction between inflation and the tax laws, which may reduce saving and investment even though the inflation rate is low.

7.

If inflation is less than expected, who benefits—debtors or creditors? Explain.

If inflation is less than expected, creditors benefit and debtors lose. Creditors receive dollar payments from debtors that have a higher real value than was expected.

Problems and Applications 1.

Using the quantity theory of money, suppose that this year’s money supply is $50 billion, nominal GDP is $1 trillion, and real GDP is $500 billion. a. What is the price level? What is the velocity of money? b. Suppose that velocity is constant and the economy’s output of goods and services rises by 5 percent each year. What will happen to nominal GDP and the price level next year if the Bank of Canada keeps the money supply constant? c. What money supply should the Bank of Canada set next year if it wants to keep the price level stable? d. What money supply should the Bank of Canada set next year if it wants inflation of 10 percent? a.

Nominal GDP = P × Y = $1 trillion and Y = real GDP = $500 billion, so P = (P × Y)/Y = $1 trillion/$500 billion = 2.

Since M × V = P × Y, then V = (P × Y)/M = $1 trillion/$50 billion = 20.

2.

b.

If M and V are unchanged and Y rises by 5 percent, then since M × V = P × Y, P must fall by 5 percent. As a result, nominal GDP is unchanged.

c.

To keep the price level stable, the Bank of Canada must increase the money supply by 5 percent, matching the increase in real GDP. Then, since velocity is unchanged, the price level will be stable.

d.

If the Bank of Canada wants inflation to be 10 percent, it will need to increase the money supply by 15 percent. Thus M × V will rise 15 percent, causing P × Y to rise 15 percent, with a 10 percent increase in prices and a 5 percent rise in real GDP.

Suppose that changes in bank regulations expand the availability of credit cards, so that people need to hold less cash. a. How does this event affect the demand for money? b. If the Bank of Canada does not respond to this event, what will happen to the price level? c. If the Bank of Canada wants to keep the price level stable, what should it do? a.

If people need to hold less cash, the demand for money shifts to the left, since there will be less money demanded at any price level.

b.

If the Bank of Canada does not respond to this event, the shift to the left of the demand for money combined with no change in the supply of money leads to a decline in the value of money (1/P), which means the price level rises, as shown in Figure 1.

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Figure 1 c.

If the Bank of Canada wants to keep the price level stable, it should reduce the money supply from S1 to S2, as shown in Figure 2. This would cause the supply of money to shift to the left by the same amount that the demand for money shifted, resulting in no change in the value of money and the price level.

Figure 2 3.

It is often suggested that the Bank of Canada try to achieve zero inflation. If we assume that velocity is constant, does this zero-inflation goal require that the rate of money growth equal zero? If yes, explain why. If no, explain what the rate of money growth should equal.

With constant velocity, reducing the inflation rate to zero would require the money growth rate to equal the growth rate of output, according to the quantity theory of money ( M × V = P × Y).

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4.

The economist John Maynard Keynes wrote in The Economic Consequences of the Peace (1919): ―Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.‖ Justify Lenin’s assertion.

Lenin is right that governments can confiscate the wealth of citizens with inflation. Inflation acts like a tax on people who hold money, by reducing its value. The government can finance its expenditures by printing money and using it to buy things, which results in a higher money supply and inflation. The result is a transfer of wealth from money-holders to the government.

5.

Suppose that a country’s inflation rate increases sharply. What happens to the inflation tax on the holders of money? Why is wealth that is held in savings accounts not subject to a change in the inflation tax? Can you think of any way in which holders of savings accounts are hurt by the increase in the inflation rate?

If a country’s inflation rate increases sharply, the inflation tax on holders of money increases significantly. Wealth in savings accounts is not subject to a change in the inflation tax because the nominal interest rate will increase with the rise in inflation. But holders of savings accounts are hurt by the increase in the inflation rate because they are taxed on their nominal interest income, so their real returns are lower.

6.

Hyperinflations are extremely rare in countries whose central banks are independent of the rest of the government. Why might this be so?

Hyperinflations usually arise when governments try to finance much of their expenditures by printing money. This is unlikely to occur if the central bank (which is responsible for controlling the level of the money supply) is independent of the government.

7.

Let’s consider the effects of inflation in an economy comprising only two people: Bob, a bean farmer, and Bridgitte, a rice farmer. Bob and Bridgitte both always consume equal amounts of rice and beans. In year 2018, the price of beans was $1, and the price of rice was $3. a. Suppose that in 2019 the price of beans was $2 and the price of rice was $6. What was inflation? Was Bob better off, worse off, or unaffected by the changes in prices?

What about Bridgitte? b. Now suppose that in 2019 the price of beans was $2 and the price of rice was $4.

What was inflation? Was Bob better off, worse off, or unaffected by the changes in prices? What about Bridgitte? c. Finally, suppose that in 2019 the price of beans was $2 and the price of rice was $1.50. What was inflation? Was Bob better off, worse off, or unaffected by the changes in prices? What about Bridgitte? d. What matters more to Bob and Bridgitte —the overall inflation rate or the relative price of rice and beans? a.

When the price of both goods doubles in a year, inflation is 100 percent. The total cost of purchasing equal amounts of beans and rice equals the quantity of each good times its price, added together for all goods. That is, if x is the quantity of beans, which also equals the quantity of rice, then the cost of beans and rice for the year is x(PB + PR). In the second year, the cost is x(PB' + PR'), where the ' mark refers to the price in the second year. Then we can define a price index with a value of one in the first year. In the second year, the price index has the value of the cost of goods in the second year divided by the cost of goods in the first year. Thus the price index in the second year is x(PB' + PR')/x(PB + PR) = (PB' + PR')/(PB + PR) = ($2 + $6)/($1 + $3) = $8/$4 = 2. The inflation rate is then (2 – 1)/1 × 100% = 100%. Since the prices of all goods rise by 100

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percent, the farmers get a 100 percent increase in their incomes to go along with the 100 percent increase in prices, so neither is affected by the change in prices.

8.

b.

If the price of beans rises to $2 and the price of rice rises to $4, then the price index in the second year is (PB' + PR')/(PB + PR) = ($2 + $4)/($1 + $3) = $6/$4 = 1.5, so the inflation rate is (1.5 – 1)/1 × 100% = 50%. Bob is better off because his dollar revenues doubled (increased 100 percent) while inflation was only 50 percent. Bridgitte is worse off because inflation was 50 percent, so the prices of the goods she buys rose faster than the price of the goods (rice) she sells, which rose only 33 percent.

c.

If the price of beans rises to $2 and the price of rice falls to $1.50, then the price index in the second year is (PB' + PR')/(PB + PR) = ($2 + $1.50)/($1 + $3) = $3.50/$4 = 0.875, so the inflation rate is (0.875 – 1)/1 × 100% = –12.5%. Bob is better off because his dollar revenues doubled (increased 100 percent) while prices overall fell 12.5 percent.

Bridgitte is worse off because inflation was –12.5 percent, so the prices of the goods she buys didn’t fall as fast as the price of the goods (rice) she sells, which fell 50 percent.

d.

The relative price of rice and beans matters more to Bob and Bridgitte than the overall inflation rate. If the price of the good that a person produces rises more than inflation, he or she will be better off. If the price of the good a person produces rises less than inflation, he or she will be worse off.

If the tax rate is 40 percent, compute the before-tax real interest rate and the after-tax real interest rate in each of the following cases. a. The nominal interest rate is 10 percent and the inflation rate is 5 percent. b. The nominal interest rate is 6 percent and the inflation rate is 2 percent. c. The nominal interest rate is 4 percent and the inflation rate is 1 percent.

The following table shows the relevant calculations:

(1) Nominal interest rate (2) Inflation rate (3) Before-tax real interest rate (4) Reduction in nominal interest rate due to 40% tax (5) After-tax nominal interest rate (6) After-tax real interest rate

(a) 10.0 5.0 5.0 4.0 6.0 1.0

(b) 6.0 2.0 4.0 2.4 3.6 1.6

(c) 4.0 1.0 3.0 1.6 2.4 1.4

Row (3) is row (1) minus row (2). Row (4) is .40 × row (1). Row (5) is (1 – .40) × row (1), which equals row (1) minus row (4). Row (6) is row (5) minus row (2). Note that even though part (a) has the highest before-tax real interest rate, it has the lowest after-tax real interest rate. Note also that the after-tax real interest rate is much less than the before-tax real interest rate.

9.

What are your shoeleather costs of going to the bank? How might you measure these costs in dollars? How do you think the shoeleather costs of the president of your school differ from your own?

The shoeleather costs of going to the bank include the value of your time, gas for your car that is used as you drive to the bank, and the inconvenience of not having more money on hand. These costs could be measured by valuing your time at your wage rate and valuing the gas for your car at its cost. Valuing the inconvenience of being short of cash is harder to measure, but might depend on the value of the shopping opportunities you give up by not having enough money to buy things you want. Your president differs from you mainly in having a higher wage, thus

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having a higher cost of time.

10.

Recall that money serves three functions in the economy. What are those functions? How does inflation affect the ability of money to serve each of these functions?

The functions of money are to serve as a medium of exchange, a unit of account, and a store of value. Inflation mainly affects the ability of money to serve as a store of value, since inflation erodes money’s purchasing power, making it less attractive as a store of value. Money also is not as useful as a unit of account when there’s inflation, because stores have to change prices more often and because people are confused and inconvenienced by the changes in the value of money. In some countries with hyperinflation, stores post prices in terms of a more stable currency, such as the U.S. dollar, even when the local currency is still used as the medium of exchange. And sometimes countries even stop using their local currency altogether, using a foreign currency as the medium of exchange as well.

11.

a. b. c. d.

12.

Suppose that people expect inflation to equal 3 percent, but in fact prices rise by 5 percent.

Describe how this unexpectedly high inflation rate would help or hurt the following: the government a homeowner with a fixed-rate mortgage a union worker in the second year of a labour contract a college or university that has invested some of its endowment in government bonds a.

Unexpectedly high inflation helps the government by providing higher inflation tax revenue and reducing the real value of outstanding government debt.

b.

Unexpectedly high inflation helps a homeowner with a fixed-rate mortgage because he pays a fixed nominal interest rate that was based on expected inflation, and thus pays a lower real interest rate than was expected.

c.

Unexpectedly high inflation hurts a union worker in the second year of a labour contract because the contract probably based the worker’s nominal wage on the expected inflation rate. As a result, the worker receives a lower-than-expected real wage.

d.

Unexpectedly high inflation hurts a college or university that has invested some of its endowment in government bonds because the higher inflation rate means the college or university is receiving a lower real interest rate than it had planned.

Explain one harm associated with unexpected inflation that is not associated with expected inflation. Then explain one harm associated with both expected and unexpected inflation.

The redistribution from creditors to debtors is something that happens when inflation is unexpected, not when it is expected. The problems that occur with both expected and unexpected inflation include shoeleather costs associated with reduced money holdings, menu costs associated with more frequent adjustment of prices, increased variability of relative prices, unintended changes in tax liabilities due to non-indexation of the tax laws, and the confusion and inconvenience resulting from a changing unit of account.

13.

Explain whether the following statements are true, false, or uncertain. a. ―Inflation hurts borrowers and helps lenders, because borrowers must pay a higher rate of interest.‖ b. ―If prices change in a way that leaves the overall price level unchanged, then no one is made better or worse off.‖ c. ―Inflation does not reduce the purchasing power of most workers.‖ Copyright © 2024 Cengage Learning Canada, Inc.

a.

The statement that ―Inflation hurts borrowers and helps lenders, because borrowers must pay a higher rate of interest‖ is false. Higher expected inflation means borrowers pay a higher nominal rate of interest, but it is the same real rate of interest, so borrowers are not worse off and lenders are not better off. Higher unexpected inflation, on the other hand, makes borrowers better off and lenders worse off.

b.

The statement that ―If prices change in a way that leaves the overall price level unchanged, then no one is made better or worse off‖ is false. Changes in relative prices can make some people better off and others worse off, even though the overall price level does not change. See problem 7 for an illustration of this.

c.

The statement that ―Inflation does not reduce the purchasing power of most workers‖ is true. As explained in this chapter, monetary neutrality means that in the long run, inflation has no impact on variables such as employment, production, real wages, or real interest rates. In the long run, then, purchasing power is unaffected by inflation.

Chapter 12 Open-Economy Macroeconomics: Basic Concepts SOLUTIONS TO TEXTBOOK PROBLEMS Questions for Review 1.

Define net exports and net capital outflow. Explain how and why they are related.

The net exports of a country are the value of its exports minus the value of its imports. Net capital outflow refers to the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners. Net exports are equal to net capital outflow by an accounting identity, since exports from one country to another are matched by payments of some asset from the second country to the first.

2.

Explain the relationship among saving, investment, and net capital outflow.

Saving equals domestic investment plus net capital outflow, since any dollar saved can be used to finance accumulation of domestic capital, or it can be used to finance the purchase of capital abroad.

3.

If a car in Japan costs 500 000 yen, a similar car in Canada costs $10 000, and a dollar can buy 100 yen, what are the nominal and real exchange rates?

If a dollar can buy 100 yen, the nominal exchange rate is 100 yen per dollar. The real exchange rate equals the nominal exchange rate times the domestic price divided by the foreign price, which equals 100 yen per dollar times $10 000 per Canadian car divided by 500 000 yen per Japanese car, which equals two Japanese cars per Canadian car.

4.

Describe the economic logic behind the theory of purchasing-power parity.

The economic logic behind the theory of purchasing-power parity is that a good must sell for the same price in all locations. Otherwise, people would profit by engaging in arbitrage.

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5.

If the Bank of Canada started printing large quantities of Canadian dollars, what would happen to the number of Japanese yen a dollar could buy?

If the Bank of Canada started printing large quantities of Canadian dollars, the Canadian price level would increase, and a dollar would buy fewer Japanese yen.

6.

Describe the economic logic behind the theory of interest rate parity.

Interest rate parity, a theory which suggests that the real interest rate in Canada should adjust to equal the real interest rate in the rest of the world, is based on the same concept as the law of one price and purchasing-power parity. People take advantage of the differences in real interest rates until the differentials disappear.

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Problems and Applications 1.

2.

3.

How would the following transactions affect Canada’s exports, imports, and net exports? a. A Canadian art professor spends the summer touring museums in Europe. b. Students in Paris flock to the latest concert by Canadian artist Drake. c. Your uncle buys a new Volvo. d. The student bookstore at Oxford University sells a pair of Bauer hockey skates. e. A Canadian citizen shops at a store in northern Vermont to avoid Canadian sales taxes. a.

When a Canadian art professor spends the summer touring museums in Europe he spends money buying foreign goods and services, so Canadian exports are unchanged, imports increase, and net exports decrease.

b.

When students in Paris flock to see the latest Diana Krall concert, foreigners are buying a Canadian good, so Canadian exports rise, imports are unchanged, and net exports increase.

c.

When your uncle buys a new Volvo, a Canadian is buying a foreign good, so Canadian exports are unchanged, imports rise, and net exports decline.

d.

When the student bookstore at Oxford University sells a pair of Bauer hockey skates, foreigners are buying Canadian goods, so Canadian exports increase, imports are unchanged, and net exports increase.

e.

When a Canadian shops in northern Vermont to avoid Canadian sales taxes, Canadian exports are unchanged, imports increase, and net exports decrease.

International trade in each of the following products has increased over time. Suggest some reasons why this might be so. a. wheat b. banking services c. computer software d. automobiles a.

Wheat is traded more internationally than in the past because shipping costs have declined, as have trade restrictions.

b.

Banking services are traded more internationally than in the past because communications costs have declined, as have trade restrictions.

c.

Computer software is traded more internationally than in the past because the computer industry has grown and the software is easier to transport (since it can now be downloaded electronically).

d.

Automobiles are traded more internationally than in the past because transportation costs have declined, as have tariffs and quotas.

Describe the difference between foreign direct investment and foreign portfolio investment. Who is more likely to engage in foreign direct investment—a corporation or an individual investor?

Who is more likely to engage in foreign portfolio investment?

Foreign direct investment requires actively managing an investment, for example, by opening a retail store in a foreign country. Foreign portfolio investment is passive, for example, buying corporate stock in a retail chain in a foreign country. As a result, a corporation is more likely to

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engage in foreign direct investment, while an individual investor is more likely to engage in foreign portfolio investment.

4.

5.

How would the following transactions affect Canada’s net capital outflow? Also, state whether each involves direct investment or portfolio investment. a. A Canadian cellular phone company establishes an office in the Czech Republic. b. Harrod’s of London sells shares to the Ontario Teachers’ Pension Plan. c. Honda expands its factory in Alliston, Ontario. d. A Bank of Montreal mutual fund sells its Volkswagen shares to a French investor. a.

When a Canadian cellular phone company establishes an office in the Czech Republic, Canadian net capital outflow increases because the Canadian company makes a direct investment in capital in the foreign country.

b.

When Harrod’s of London sells shares to the Ontario Teacher’s Pension Plan, Canadian net capital outflow increases because the Canadian company makes a portfolio investment in the foreign country.

c.

When Honda expands its factory in Alliston, Ontario, Canadian net capital outflow declines because the foreign company makes a direct investment in capital in Canada.

d.

When a Bank of Montreal mutual fund sells its Volkswagen shares to a French investor, Canadian net capital outflow declines (if the French investor pays in Canadian dollars) because the Canadian company is reducing its portfolio investment in a foreign country.

Holding national saving constant, does an increase in net capital outflow increase, decrease, or have no effect on a country’s accumulation of domestic capital?

If national saving is constant and net capital outflow increases, domestic investment must decrease, since national saving equals domestic investment plus net capital outflow. If domestic investment declines, the country’s accumulation of domestic capital declines.

6.

7.

The business section of most major news sources contains a table showing Canadian exchange rates. Find such a table and use it to answer the following questions. a. Does this table show nominal or real exchange rates? Explain. b. What are the exchange rates between the United States and Canada and between Canada and Japan? Calculate the exchange rate between the United States and Japan. c. If Canadian inflation exceeds Japanese inflation over the next year, would you expect the Canadian dollar to appreciate or depreciate relative to the Japanese yen? a.

The news source shows nominal exchange rates, since it shows the number of units of one currency that can be exchanged for another currency.

b.

Many answers are possible.

c.

If Canadian inflation exceeds Japanese inflation over the next year, you would expect the Canadian dollar to depreciate relative to the Japanese yen because a dollar would decline in value (in terms of the goods and services it can buy) more than the yen would.

Would each of the following groups be happy or unhappy if the Canadian dollar appreciated?

Explain. a. Dutch pension funds holding Canadian government bonds b. Canadian manufacturing industries Copyright © 2024 Cengage Learning Canada, Inc.

c. Australian tourists planning a trip to Canada d. A Canadian firm trying to purchase property overseas

8.

a.

Dutch pension funds holding Canadian government bonds would be happy if the Canadian dollar appreciated. They would then get more Dutch guilders for each dollar they earned on their Canadian investment. In general, if you have an investment in a foreign country, you are better off if that country’s currency appreciates.

b.

Canadian manufacturing industries would be unhappy if the Canadian dollar appreciated because their prices would be higher in terms of foreign currencies, which will reduce their sales.

c.

Australian tourists planning a trip to Canada would be unhappy if the Canadian dollar appreciated because they would get fewer Canadian dollars for each Australian dollar, so their vacation will be more expensive.

d.

A Canadian firm trying to purchase property overseas would be happy if the Canadian dollar appreciated because it would get more units of the foreign currency and could thus buy more property.

What is happening to Canada’s real exchange rate in each of the following situations? Explain. a. Canada’s nominal exchange rate is unchanged, but prices rise faster in Canada than abroad. b. Canada’s nominal exchange rate is unchanged, but prices rise faster abroad than in Canada. c. Canada’s nominal exchange rate declines, and prices are unchanged in Canada and abroad. d. Canada’s nominal exchange rate declines, and prices rise faster abroad than in Canada.

All the parts of this question can be answered by keeping in mind the definition of the real exchange rate. The real exchange rate equals the nominal exchange rate times the domestic price level divided by the foreign price level.

9.

a.

If Canada’s nominal exchange rate is unchanged, but prices rise faster in Canada than abroad, the real exchange rate rises.

b.

If Canada’s nominal exchange rate is unchanged, but prices rise faster abroad than in Canada, the real exchange rate declines.

c.

If Canada’s nominal exchange rate declines, and prices are unchanged in Canada and abroad, the real exchange rate declines.

d.

If Canada’s nominal exchange rate declines, and prices rise faster abroad than in Canada, the real exchange rate declines.

List three goods for which the law of one price is likely to hold, and three goods for which it is not. Justify your choices.

Three goods for which the law of one price is likely to hold are farm goods like wheat, which are nearly identical no matter where they are produced; technological goods like computer software, which have low shipping costs because they are light; and clothing, which also has low shipping costs. Three goods for which the law of one price is not likely to hold are real estate, because

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you can’t move land or buildings from one country to another; goods that are mainly consumed in one country and so are not traded, like frog legs in France; and services like haircuts, which cannot be arbitraged even if the price is very different in different countries.

10.

A can of pop costs $0.75 in Canada and 12 pesos in Mexico. What would the peso–dollar exchange rate be if purchasing-power parity holds? If a monetary expansion caused all prices in Mexico to double, so that the price of pop rose to 24 pesos, what would happen to the peso– dollar exchange rate?

If purchasing-power parity holds, then 12 pesos per pop divided by $0.75 per pop equals the exchange rate of 16 pesos per dollar. If prices in Mexico doubled, the exchange rate will double to 32 pesos per dollar.

11.

per

12.

Assume that Canadian wheat sells for $100 per bushel, Argentinian wheat sells for 1600 pesos bushel, and the nominal exchange rate is 4 pesos per dollar. a. Explain how you could make a profit from this situation. What would be your profit per bushel of wheat? If other people exploit the same opportunity, what would happen to the price of wheat in Russia and the price of wheat in Canada? b. Suppose that wheat is the only commodity in the world. What would happen to the real exchange rate between Canada and Russia? a.

To make a profit, you would want to buy wheat where it is cheap and sell it where it is expensive. Since Canadian wheat costs 100 dollars per bushel, and the exchange rate is 4 pesos per dollar, Canadian wheat costs 100 × 4 equals 400 pesos per bushel. So, Canadian wheat at 400 pesos per bushel is cheaper than Russian wheat at 1600 pesos per bushel. So you could take 400 pesos, exchange them for 100 dollars, buy a bushel of Canadian wheat, and then sell it for 1600 pesos, making a profit of 1200 pesos. As people did this, the demand for Canadian wheat would rise, increasing the price in Canada, and the supply of Russian wheat would rise, reducing the price in Russia. The process would continue until the prices in the two countries were the same.

b.

If wheat were the only commodity in the world, the real exchange rate between Canada and Russia would start out too low, and then rise as people bought wheat in Canada and sold it in Russia, until the real exchange rate became one in long-run equilibrium.

A case study in the chapter analyzed purchasing-power parity for several countries using the price of Big Macs. Here are data for a few more countries: Country Indonesia Hungary Czech Republic Thailand China

Price of a Big Mac 34 000 rupiah 900 forint 79 koruna 128 baht 22.4 yuan

Predicted Exchange Rate ___ rupiah/$US ___ forint/$US ___ koruna/$US ___ baht/$US ___ yuan/$US

Actual Exchange Rate 14 518 rupiah/$US 306 forint/$US 21.80 koruna/$US 32.81 baht/$US 6.48 yuan/$US

a. For each country, compute the predicted exchange rate of the local currency per U.S. dollar. (Recall that the U.S. price of a Big Mac was $5.65.) How well does the theory of purchasing-power parity explain exchange rates? b. According to purchasing-power parity, what is the predicted exchange rate between the Hungarian forint and the Chinese yuan? What is the actual exchange rate?

If you take X units of foreign currency per Big Mac divided by US$5.28 per Big Mac, you get

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X/5.28 units of the foreign currency per U.S. dollar; that’s the predicted exchange rate. a.

Indonesia Hungary Czech Republic Thailand China

6 017.7 159.3 15.8 22.7 4.0

The theory does not do a great job of explaining exchange rates. It gets the broad magnitude correct, but there are significant differences between theory and actual. b.

The predicted exchange rate is 39.8 florint/yuan. The actual exchange rate is 47.2 florint/yuan.

Chapter 13 A Macroeconomic Theory of the Small Open Economy SOLUTIONS TO TEXTBOOK PROBLEMS Questions for Review 1.

Describe supply and demand in the market for loanable funds and the market for foreigncurrency exchange. How are these markets linked?

The supply of loanable funds comes from national saving; the demand for loanable funds comes from domestic investment and net capital outflow. The supply of dollars in the market for foreign exchange comes from net capital outflow; the demand for dollars in the market for foreign exchange comes from net exports. The link between the two markets is net capital outflow.

2.

How would a fall in U.S. interest rates affect Canadian investment, saving, and net capital outflow, and the Canadian real exchange rate?

Since the United States is a large open economy, a fall in its interest rate decreases the world interest rate. For Canada, this causes a fall in its NCO, an increase in its real exchange rate, and a fall in its net exports. Canadian investment would increase and savings would fall.

3.

Suppose that a textile workers’ union encourages people to buy only Canadian-made clothes.

What would this policy do to the trade balance and the real exchange rate? What is the impact on the textile industry? What is the impact on the auto industry?

If a union of textile workers encourages people to buy only Canadian-made clothes, imports would be reduced, so net exports would increase for any given real exchange rate. This would cause the demand curve in the market for foreign exchange to shift to the right, as shown in Figure 1. The result is a rise in the real exchange rate, but no effect on the trade balance. The textile industry would import less, but other industries, such as the auto industry, would import more because of the higher real exchange rate.

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Real Exchange Rate

Real Interest Rate

NCO

NCO r*

Supply of loanable funds

E2

E1 Demand for loanable funds

NX

Quantity of Loanable Funds

NX’

Quantity of Dollars

Figure 1

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4.

What is capital flight? When a country experiences capital flight, what is the effect on its interest rate and the value of the currency?

Capital flight is a large and sudden movement of funds out of a country. Capital flight causes the interest rate to increase and the currency to depreciate.

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Problems and Applications 1.

Japan generally runs a significant trade surplus. Do you think this is most related to high foreign demand for Japanese goods, low Japanese demand for foreign goods, a high Japanese saving rate relative to Japanese investment, or structural barriers against imports into Japan? Explain your answer.

Japan generally runs a trade surplus because the Japanese saving rate is high relative to Japanese domestic investment. The result is high net capital outflow, which is matched by high net exports, resulting in a trade surplus. The other possibilities (high foreign demand for Japanese goods, low Japanese demand for foreign goods, and structural barriers against imports into Japan) would affect the real exchange rate, but not the trade surplus.

2.

How would an increase in foreigners’ incomes affect Canada’s net exports curve? How would this affect the value of the dollar in the market for foreign-currency exchange?

As foreigners’ incomes rise, they demand more goods and services, causing Canada’s net exports to rise. The demand for the Canadian dollar rises causing the value of the Canadian dollar to appreciate.

3.

Suppose that Parliament passes an investment tax credit, which subsidizes domestic investment.

How does this policy affect national saving, domestic investment, net capital outflow, the interest rate, the exchange rate, and the trade balance?

If Parliament passes an investment tax credit, it subsidizes domestic investment. The desire to increase domestic investment leads firms to borrow more, increasing the demand for loanable funds, as shown in Figure 2. This increases national saving and reduces net capital outflow. The decline in net capital outflow reduces the supply of dollars in the market for foreign exchange, raising the real exchange rate. Net exports also decline. In summary, the interest rate remains at the world rate, domestic investment increases, net capital outflow declines, the real exchange rate increases, and net exports decrease.

Figure 2

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4.

Economists generally favour reductions in trade restrictions. Many policymakers, however, insist that any lowering of Canadian import restrictions must be accompanied by reductions in other countries’ import quotas on Canadian exports. Only in this way, these policymakers believe, can Canadian exporters benefit from a lowering of Canadian import quotas. Explain how a reduction in import restrictions will benefit exporters even if other countries do not follow Canada’s example and reduce their import quotas on Canadian exports.

A reduction in import restrictions causes net exports to fall. As a result, the demand for the Canadian dollar falls, causing the value of the Canadian dollar to fall and the real exchange rate to fall. This increases net exports, offsetting the direct impact of import restrictions.

5.

In fiscal year 2009–10, the Government of Canada incurred a budget deficit of $56 billion, an increase of about $50 billion from the year before. a. What effect should we expect this increase in the government’s deficit to have had on Canada’s net exports? b. If large deficits were to persist for many years, what would we expect would happen to levels of foreign investment in Canada?

6.

a.

An increase in Canada’s government deficit reduces national saving. The supply of loanable funds in Figure 13.5 shifts to the left, reducing net capital outflow at the world interest rate. In panel (b) of the same figure, a lower net capital outflow is represented by the shift of the supply of dollars curve to the left. The dollar appreciates and net exports decrease.

b.

If the deficit were to persist for many years, the government would have to increase taxes to pay back the debt that will accumulate from year-by-year deficits. If foreign investors lost confidence in the government’s ability to repay the debt, then capital outflow may take place, interest rates might increase, and investment and economic growth may slow down.

Economists often lament the low level of national saving. Low saving impedes capital growth, productivity, and living standards. For this reason, economists tend to favour policies designed to increase saving. Suppose that all Canadians choose to increase their saving. What would be the effect of increased saving on the value of the dollar and on net exports?

Increased savings causes the supply of loanable funds to rise, causing the real interest rate to fall. This would have the effect of causing the dollar to depreciate and net exports to rise.

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7.

Changes in government deficits are closely related to changes in net exports. In particular, increases in government deficits lead to reductions in net exports, while reductions in government deficits lead to increases in net exports. Use a two-panel diagram to explain this important relationship.

A reduction in the government deficit leads to an increase in national savings, which causes the supply of loanable funds to rise. As a result, NCO increases, the real exchange rate falls, and net exports rise.

Real Interest Rate

Real Exchange Rate

S1

*

r

S2

NCO2

NCO1

NCO2

NX E1 E2

I1 Quantity of Loanable Funds

Quantity of Dollars

Figure 3 8.

9.

Suppose the French suddenly develop a strong taste for British Columbia wines. Answer the following questions in words and using a diagram: a. What happens to the demand for dollars in the market for foreign-currency exchange? b. What happens to the value of dollars in the market for foreign-currency exchange? c. What happens to the quantity of net exports? a.

When the French develop a strong taste for British Columbia wines, the demand for Canadian dollars in the foreign-currency market increases at any given real exchange rate.

b.

The result of the increased demand for dollars is a rise in the real exchange rate.

c.

The quantity of net exports is unchanged.

A Member of Parliament (MP) renounces her past support for protectionism: ―Canada’s trade deficit must be reduced, but import quotas only annoy our trading partners. If we subsidize Canadian exports instead, we can reduce the trade deficit by increasing our competitiveness.‖ Using a two-panel diagram similar to that in Figure 13.3, show the effect of an export subsidy on net exports and the real exchange rate. Do you agree with the MP? An export subsidy increases net exports at any given real exchange rate. This causes the demand for dollars to shift to the right in the market for foreign exchange. The effect is a higher real exchange rate, but no change in net exports. So the Member of Parliament is wrong; an export subsidy will not reduce the trade deficit.

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10.

Suppose that the federal government increases the tax on corporate profits. Such a tax has the effect of reducing domestic investment. What effect would this tax increase have on Canada’s real exchange rate and net exports?

A tax on corporate profits reduces domestic investment and the demand for loanable funds, and net capital outflow rises causing the value of the dollar to fall and net exports to rise.

11.

Suppose that the world interest rate rises. a. If the elasticity of national saving in relation to the world interest rate is very high, will this rise in the world interest rate have a large or small effect on Canada’s net capital outflow? b. If the elasticity of Canada’s exports in relation to the real exchange rate is very low, will this rise in the world interest rate have a large or small effect on Canada’s real exchange rate?

12.

a.

If the elasticity of national saving with respect to the world interest rate is very high, the higher world interest rate will increase net capital outflow and cause the Canadian dollar to depreciate. So, higher interest rates will have a large effect on Canada’s net capital outflow.

b.

An increase in the world interest rate induces an increase in net capital outflow and the real exchange rate declines. If the elasticity of Canada’s exports with respect to the real exchange rate is very low, it will have little effect on Canada’s real exchange rate.

Suppose that Europeans suddenly become very interested in investing in Canada. a. What happens to Canadian net capital outflow? b. What effect does this have on Canadian private saving and Canadian domestic investment? c. What is the long-run effect on the Canadian capital stock?

a.

When the Europeans develop a strong interest in investing in Canada, there is a reduction in net capital outflow.

b.

An increase in capital inflows causes a demand for Canadian dollars in the foreigncurrency market, which leads to an appreciation of the value of the dollar. It would result in a decrease in the demand for loanable funds causing the real interest rate to decline, reducing Canada’s private saving but increasing Canada’s domestic investment.

c.

It will increase Canada’s capital stock, since Canada’s domestic investment rises.

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13.

During the 1960s, a commonly held concern among Canadians was that Americans were ―buying Canada.‖ This concern stemmed from the fact that Canada’s net capital outflow during the 1960s was consistently negative. As a result, foreigners, particularly Americans, were buying more Canadian assets than Canadians were buying foreign assets. Because many of these assets were firms operating in Canada, Canadians were concerned that eventually all of Canada would be owned by Americans. In response to this concern, the federal government of the time passed legislation limiting the amount that foreigners could invest in certain sectors of the economy.

How do you think this legislation affected investment in Canada? What do you think happened to Canada’s real exchange rate and net exports as a result?

When the amount of foreign investment in Canada is limited by legislation, the investment curve shifts to the left, while the world interest rate does not change. As a result, Canada’s net capital outflow increases. In the foreign exchange diagram, the increase in NCO shifts the supply of Canadian dollars to the right, increasing net exports and decreasing the exchange rate. In conclusion, the dollar depreciates and Canadian net exports increase as a result of the capital inflow restriction policy.

14.

Figure 13.4 shows the effect of an increase in the world interest rate on a small open economy with perfect capital mobility. In the figure, we assumed that net capital outflow (NCO) was positive. For most of the past 40 years, however, Canada’s NCO has been negative. Redraw the two panels of Figure 13.4, but this time assume that NCO is negative at the world interest rate.

Now suppose that the world interest rate increases. What happens to national saving (S)? What happens to domestic investment (I)? What happens to NCO and the real exchange rate? Does the conclusion we reached in our discussion of Figure 13.4—that an increase in world interest rates causes the Canadian dollar to depreciate and net exports to increase—still hold?

An increase in the world interest rate increases NCO from, say –$40 to –$20 billion. The result is the depreciation of the dollar and an increase in net exports. In the market for loanable funds, the higher interest rate increases national savings and decreases investment. The increase in net capital outflow reduces the real exchange rate. (See Figure 4)

Real Exchange Rate

Real Interest Rate

NCO1

Supply of loanable funds

NCO2

E1

r2* r1*

NCO2

Demand for loanable funds

E2 NX

NCO1 −$40

Quantity of Loanable Funds

−$20

Quantity of Dollars (in billions)

Figure 4: The effects of an increase in the world interest rate when NCO is negative

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Aggregate Demand and Aggregate Supply SOLUTIONS TO TEXTBOOK PROBLEMS Questions for Review 1.

Name two macroeconomic variables that decline when the economy goes into a recession. Name one macroeconomic variable that rises during a recession.

Two macroeconomic variables that decline when the economy goes into a recession are real GDP and investment spending (many other answers are possible). A macroeconomic variable that rises during a recession is the unemployment rate.

2.

Draw a diagram with aggregate demand, short-run aggregate supply, and long-run aggregate supply. Be careful to label the axes correctly.

Figure 1 shows aggregate demand, short-run aggregate supply, and long-run aggregate supply.

Figure 1 3.

List and explain the three reasons why the aggregate-demand curve is downward sloping.

The aggregate-demand curve is downward sloping because: (1) a decrease in the price level makes consumers feel wealthier, which in turn encourages them to spend more, so there is a larger quantity of goods and services demanded; (2) a lower price level reduces the interest rate, encouraging greater spending on investment, so there is a larger quantity of goods and services demanded; (3) a fall in the Canadian price level causes Canadian interest rates to fall, so the real exchange rate depreciates, stimulating Canadian net exports, so there is a larger quantity of goods and services demanded.

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4.

Explain why the long-run aggregate-supply curve is vertical.

The long-run aggregate supply curve is vertical because in the long run, an economy’s supply of goods and services depends on its supplies of capital, labour, and natural resources, and on the available production technology used to turn these resources into goods and services. The price level does not affect these long-run determinants of real GDP.

5.

List and explain the three theories for why the short-run aggregate-supply curve is upward sloping.

Three theories explain why the short-run aggregate-supply curve is upward sloping: (1) the sticky-wage theory, in which a lower price level makes employment and production less profitable because wages do not adjust immediately to the price level, so firms reduce the quantity of goods and services supplied; (2) the sticky-price theory, in which an unexpected fall in the price level leaves some firms with higher-than-desired prices because not all prices adjust instantly to changing conditions, which depresses sales and induces firms to reduce the quantity of goods and services they produce; and (3) the misperceptions theory, in which a lower price level causes misperceptions about relative prices, and these misperceptions induce suppliers to respond to the lower price level by decreasing the quantity of goods and services supplied.

6.

What might shift the aggregate-demand curve to the left? Use the model of aggregate demand and aggregate supply to trace through the effects of such a shift.

The aggregate-demand curve might shift to the left when something (other than a rise in the price level) causes a reduction in consumption spending (such as a desire for increased saving), a reduction in investment spending (such as increased taxes on the returns to investment), decreased government spending (such as a cutback in defence spending), or reduced net exports (such as when foreign economies go into recession, so our exports fall).

Figure 2 traces through the steps of such a shift in aggregate demand. The economy begins in equilibrium, with short-run aggregate supply, AS1, intersecting aggregate demand, AD1, at point A. When the aggregate-demand curve shifts to the left to AD2, the economy moves from point A to point B, reducing the price level and the quantity of output. Over time, people adjust their perceptions, wages, and prices, shifting the short-run aggregate-supply curve down to AS2, and moving the economy from point B to point C, which is back on the long-run aggregate supply curve and has a lower price level.

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Figure 2 7.

What might shift the aggregate-supply curve to the left? Use the model of aggregate demand and aggregate supply to trace through the effects of such a shift.

The aggregate-supply curve might shift to the left because of a decline in the economy’s capital stock, labour supply, or productivity, or an increase in the natural rate of unemployment, all of which shift both the long-run and short-run aggregate supply curves to the left. An increase in the expected price level shifts just the short-run aggregate-supply curve (not the long-run aggregate-supply curve) to the left.

Figure 3 traces through the effects of such a shift. The economy starts in equilibrium at point A. The aggregate-supply curve then shifts to the left from AS1 to AS2. The new equilibrium is at point B, the intersection of the aggregate-demand curve and AS2. As time goes on, the economy returns to long-run equilibrium at point A, as the short-run aggregate supply curve shifts back to its original position.

Figure 3

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Problems and Applications

1.

Why do you think that investment is more variable over the business cycle than consumer spending? Which category of consumer spending do you think would be most volatile: durable goods (such as furniture and car purchases), nondurable goods (such as food and clothing), or services (such as haircuts and dental care)? Why?

Investment is more variable than consumer spending over the business cycle because firms can curtail investment spending more easily than households can curtail consumption spending. In recessions, firms know they will not be able to sell as many goods, so they want to produce less and therefore they put off buying capital (they do not expand factories or buy new equipment).

Much of consumer spending is on necessities, like food, which cannot decline as much in recessions. So, investment spending is more variable over the business cycle than consumer spending. For similar reasons, durable goods spending is the most volatile sector of consumer spending. Durable goods, such as furniture and car purchases, are more volatile over the business cycle than nondurable goods, such as food and clothing, or services, such as haircuts and medical care, for the same reason. People put off buying durable goods and just make do with older cars and furniture when economic times are bad.

2.

Suppose that the economy is in a long-run equilibrium. a. Use a diagram to illustrate the state of the economy. Be sure to show aggregate demand, short-run aggregate supply, and long-run aggregate supply. b. Now suppose that a stock market crash causes aggregate demand to fall. Use your diagram to show what happens to output and the price level in the short run. What happens to the unemployment rate? c. Use the sticky-wage theory of aggregate supply to explain what will happen to output and the price level in the long run (assuming there is no change in policy). What role does the expected price level play in this adjustment? Be sure to illustrate your analysis in a graph.

a.

The current state of the economy is shown in Figure 4. The aggregate-demand curve and short-run aggregate-supply curve intersect at a point on the long-run aggregate supply curve.

b.

A stock market crash leads to a leftward shift of aggregate demand. The equilibrium level of output and the price level will fall. Since the quantity of output is less than the natural rate of output, the unemployment rate will rise above the natural rate of unemployment.

c.

If nominal wages are unchanged as the price level falls, firms will be forced to cut back on employment and production. Over time, as expectations adjust, the short-run aggregate supply curve will shift to the right, moving the economy back to the natural rate of output. In the long run, neither output nor the price level will change.

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Figure 4 3.

4.

Explain whether each of the following events will increase, decrease, or have no effect on longrun aggregate supply. a. Canada experiences a wave of immigration. b. Provincial and territorial governments raise the minimum wage to $15 per hour. c. Intel invents a new and more powerful computer chip. d. A severe hurricane damages factories along the east coast. a.

When Canada experiences a wave of immigration, the labour force increases, so long-run aggregate supply increases as there are more people who can produce output.

b.

When provincial and territorial governments raise the minimum wage to $15 per hour, the natural rate of unemployment rises, so the long-run aggregate-supply curve shifts to the left.

c.

When Intel invents a new and more powerful computer chip, productivity increases, so long-run aggregate supply increases as more output can be produced with the same inputs.

d.

When a severe hurricane damages factories along the east coast, the capital stock is smaller, so long-run aggregate supply declines.

Suppose an economy is in long-run equilibrium. a. Use the model of aggregate demand and aggregate supply to illustrate the initial equilibrium (call it point A). Be sure to include both short-run and long-run aggregate supply. b. The central bank raises the money supply by 5 percent. Use your diagram to show what happens to output and the price level as the economy moves from the initial to the new short-run equilibrium (call it point B). c. Now show the new long-run equilibrium (call it point C). What causes the economy to move from point B to point C?

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d. According to the sticky-wage theory of aggregate supply, how do nominal wages at point A compare to nominal wages at point B? How do nominal wages at point A compare to nominal wages at point C? e. According to the sticky-wage theory of aggregate supply, how do real wages at point A compare to real wages at point B? How do real wages at point A compare to real wages at point C? f. Judging by the impact of the money supply on nominal and real wages, is this analysis consistent with the proposition that money has real effects in the short run but is neutral in the long run? a.

A

b.

 B

AD1

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c.

The economy moves from point B to point C gradually, as people adjust upward their expectations about the price level. Higher expected price levels induce workers to ask for higher wages, which shifts the short-run aggregate supply curve to the left.

AS1

C

 AD1

5.

d.

According to the sticky-wage theory of the short-run aggregate supply curve, output is higher at point B than at point A because wages have not adjusted. Since the price level is higher at point C, the nominal wage at point C must be higher.

e.

The nominal wage at points A and B are the same, but since the price level is higher at point B, the real wage is lower. Point C is on the long-run aggregate supply curve, as is point A, so the real wage must be the same at the two points.

f.

Judging by the impact of the money supply on nominal and real wages, this analysis is consistent with the proposition that money has real effects in the short run but is neutral in the long run.

Explain why the following statements are false. a. ―The aggregate-demand curve slopes downward because it is the horizontal sum of the demand curves for individual goods.‖ b. ―The long-run aggregate-supply curve is vertical because economic forces do not affect long-run aggregate supply.‖ c. ―If firms adjusted their prices every day, then the short-run aggregate-supply curve would be horizontal.‖ d. ―Whenever the economy enters a recession, its long-run aggregate-supply curve shifts to the left.‖ a.

The statement that ―the aggregate-demand curve slopes downward because it is the horizontal sum of the demand curves for individual goods‖ is false. The aggregatedemand curve slopes downward because a fall in the price level raises the overall quantity of goods and services demanded through the wealth effect, the interest-rate effect, and the exchange-rate effect.

b.

The statement that ―the long-run aggregate-supply curve is vertical because economic forces do not affect long-run aggregate supply‖ is false. Economic forces of various kinds (such as population and productivity) do affect long-run aggregate supply. The long-run

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aggregate-supply curve is vertical because the price level does not affect long-run aggregate supply.

6.

c.

The statement that ―if firms adjusted their prices every day, then the short-run aggregate-supply curve would be horizontal‖ is false. If firms adjusted prices quickly and if sticky prices were the only possible cause for the upward slope of the short-run aggregate supply curve, then the short-run aggregate-supply curve would be vertical, not horizontal. The short-run aggregate supply curve would be horizontal only if prices were completely fixed.

d.

The statement that ―whenever the economy enters a recession, its long-run aggregatesupply curve shifts to the left‖ is false. An economy could enter a recession if the aggregate-demand curve or the short-run aggregate-supply curve shift to the left.

For each of the three theories for the upward slope of the short-run aggregate-supply curve, carefully explain the following. a. how the economy recovers from a recession and returns to its long-run equilibrium without any policy intervention b. what determines the speed of that recovery a.

According to the sticky-wage theory, the economy is in a recession because the price level has declined so that real wages are too high; thus labour demand is too low. Over time, as nominal wages are adjusted so that real wages decline, the economy returns to full employment.

According to the sticky-price theory, the economy is in a recession because not all prices adjust quickly. Over time, firms are able to adjust their prices more fully, and the economy returns to the long-run aggregate-supply curve.

According to the misperceptions theory, the economy is in a recession when the price level is below what was expected. Over time, as people observe the lower price level, their expectations adjust, and the economy returns to the long-run aggregate-supply curve.

b.

7.

The speed of the recovery in each theory depends on how quickly price expectations, wages, and prices adjust.

Suppose the Bank of Canada expands the money supply, but because the public expects this action, it simultaneously raises the public’s expectation of the price level. What will happen to output and the price level in the short run? Compare this result to the outcome if the Bank of Canada expanded the money supply but the public didn’t change its expectation of the price level.

If the Bank of Canada increases the money supply and people expect a higher price level, the aggregate-demand curve shifts to the right and the short-run aggregate-supply curve shifts to the left, as shown in Figure 5. The economy moves from point A to point B, with no change in output and a rise in the price level (to P2). If the public does not change its expectation of the price level, the short-run aggregate-supply curve does not shift, the economy ends up at point C, and output increases along with the price level (to P3).

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Figure 5

8.

Suppose that the economy is currently in a recession. If policymakers take no action, how will the economy evolve over time? Explain in words and using an aggregate-demand/aggregate-supply diagram.

Figure 6 depicts an economy in a recession. The short-run aggregate supply curve is AS1 and the economy is at equilibrium at point A, which is to the left of the long-run aggregate-supply curve.

If policymakers take no action, the economy will return to the long-run aggregate-supply curve over time as the short-run aggregate-supply curve shifts to the right to AS2. The economy’s new equilibrium is at point B.

Figure 6

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9.

Suppose workers and firms suddenly believe that inflation will be quite high over the coming year. Suppose also that the economy begins in long-run equilibrium, and the aggregate-demand curve does not shift. a. What happens to nominal wages? What happens to real wages? b. Using an aggregate-demand/aggregate-supply diagram, show the effect of the change in expectations on both the short-run and long-run levels of prices and output. c. Were the expectations of high inflation accurate? Explain. a.

If people believe that inflation will be high over the next year, workers will want higher nominal wages. If the price level does not rise as much as wages do, real wages will increase, so firms will not hire as many workers.

b.

Figure 7 shows the economy starting out at point A on short-run aggregate-supply curve AS1. With higher nominal wages, the short-run aggregate-supply curve will shift to the left to AS2. The new equilibrium is at point B, with output less than long-run aggregate supply. In the short run, the price level rises and output falls. In the long run, the economy will return to point A, as the decline in output eventually leads to a decline in the price level and the short-run aggregate-supply curve returns to AS1.

Figure 7 c.

10.

In the short-run, expectations of higher inflation were somewhat accurate, as the price level is higher at point B than at point A (however, the price level at point B is not as high as was expected). But inflation expectations were wrong in the long run.

For each of the following events, explain the effect, if any, on the position of the short- and longrun aggregate-supply curves and the aggregate-demand curve. a. In the summer of 2003, a single cow in Alberta was found to suffer from BSE, or mad cow disease. As a consequence, many countries stopped importing Canadian beef and Canadian ranchers found that, at any price, they could sell much less beef than they could previously. b. Over the past decade, prospectors have discovered diamonds in Canada. The development of these diamond mines has progressed to the point that today Canada produces roughly 10 percent of the world’s diamonds.

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c. Ongoing crises in the Middle East and the high price of oil have encouraged firms to significantly expand plants for the extraction of oil from the oil sands region of Alberta. d. In 2003, an outbreak of severe acute respiratory syndrome (SARS) in the Toronto region resulted in a significant reduction in the number of tourists visiting Canada.

11.

a.

The aggregate-demand curve has shifted leftward.

b.

The capacity to produce diamonds has increased over the years, which has caused the long-run and short-run aggregate-supply curve to shift rightward.

c.

The long-run and short-run aggregate supply have shifted rightward.

d.

It depends on which market one is considering—the demand for tourist attractions, flights, restaurants, hotels, etc. The aggregate demand for all of these is reduced and the aggregate-demand curve has shifted leftward.

Explain whether each of the following events shifts the short-run aggregate-supply curve, the aggregate-demand curve, both, or neither. For each event that does shift a curve, use a diagram to illustrate the effect on the economy. a. Households decide to save a larger share of their income. b. Okanagan peach orchards suffer a prolonged period of below-freezing temperatures. c. Increased job opportunities overseas cause many people to leave Canada. a.

If households decide to save a larger share of their income, they must spend less on consumer goods, so the aggregate-demand curve shifts to the left, as shown in Figure 8.

The equilibrium changes from point A to point B, so the price level declines and output declines.

Figure 8

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b.

If Okanagan peach orchards suffer a prolonged period of below-freezing temperatures, the orange harvest will be reduced. This is represented in Figure 9 by a shift to the left in the short-run aggregate-supply curve. The equilibrium changes from point A to point B, so the price level rises and output declines.

Figure 9 c.

If increased job opportunities cause people to leave Canada, the short-run aggregatesupply curve will shift to the left because there are fewer people producing output. The aggregate-demand curve will shift to the left because there are fewer people consuming goods and services. The result is a decline in the quantity of output, as Figure 10 shows.

Whether the price level rises or declines depends on the size of the shifts in the aggregate-demand curve and the short-run aggregate-supply curve.

Figure 10

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12.

For each of the following events, explain the short-run and long-run effects on output and the price level, assuming policymakers take no action. a. The stock market declines sharply, reducing consumers’ wealth. b. The federal government increases spending on national defence. c. A technological improvement raises productivity. d. A recession overseas causes foreigners to buy fewer Canadian goods.

a.

When the stock market declines sharply, wealth declines, so the aggregate-demand curve shifts to the left, as shown in Figure 11. In the short run, the economy moves from point A to point B, as output declines and the price level declines. In the long run, the short-run aggregate-supply curve shifts to the right to restore equilibrium at point C, with unchanged output and a lower price level compared to point A.

Figure 11

b.

When the federal government increases spending on national defence, the rise in government purchases shifts the aggregate-demand curve to the right, as shown in Figure 12. In the short run, the economy moves from point A to point B, as output and the price level rise. In the long run, the short-run aggregate-supply curve shifts to the left to restore equilibrium at point C, with unchanged output and a higher price level compared to point A.

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Figure 12

c.

When a technological improvement raises productivity, the long-run and short-run aggregate-supply curves shift to the right, as shown in Figure 13. The economy moves from point A to point B, as output rises and the price level declines.

Figure 13

d.

When a recession overseas causes foreigners to buy fewer Canadian goods, net exports decline, so the aggregate-demand curve shifts to the left, as shown in Figure 14. In the short run, the economy moves from point A to point B, as output declines and the price level declines. In the long run, the short-run aggregate-supply curve shifts to the right to

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restore equilibrium at point C, with unchanged output and a lower price level compared to point A.

Figure 14

13.

Suppose that firms become very optimistic about future business conditions and invest heavily in new capital equipment. a. Use an aggregate-demand/aggregate-supply diagram to show the short-run effect of this optimism on the economy. Label the new levels of prices and real output. Explain in words why the aggregate quantity of output supplied changes. b. Now use the diagram from part (a) to show the new long-run equilibrium of the economy. (For now, assume there is no change in the long-run aggregate-supply curve.) Explain in words why the aggregate quantity of output demanded changes between the short run and the long run. c. How might the investment boom affect the long-run aggregate-supply curve? Explain.

a.

If firms become optimistic about future business conditions and invest a lot, the result is shown in Figure 15. The economy begins at point A with aggregate-demand curve AD1 and short-run aggregate-supply curve AS1. The equilibrium has price level P1 and output level Y1. Increased optimism leads to greater investment, so the aggregate-demand curve shifts to AD2. Now the economy is at point B, with price level P2 and output level Y2. The aggregate quantity of output supplied rises because the price level has risen and people have misperceptions about the price level, wages are sticky, or prices are sticky, all of which cause output supplied to increase.

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Figure 15

14.

b.

Over time, as the misperceptions of the price level disappear, wages adjust, or prices adjust, the short-run aggregate-supply curve shifts up to AS2 and the economy gets to equilibrium at point C, with price level P3 and output level Y1. The quantity of output demanded declines as the price level rises.

c.

The investment boom might increase the long-run aggregate-supply curve because higher investment today means a larger capital stock in the future, thus higher productivity and output.

In Economy A, all workers agree in advance on the nominal wages that their employers will pay them. In Economy B, half of all workers have these nominal wage contracts, while the other half have indexed employment contracts, so their wages rise and fall automatically with the price level. According to the sticky-wage theory of aggregate supply, which economy has a more steeply sloped short-run aggregate-supply curve? In which economy would a 5 percent increase in the money supply have a larger impact on output? In which economy would it have a larger impact on the price level? Explain.

An increase in the price level will cause a substantial increase in output when all wages are slow to adjust; the stickier the wages, the flatter the SRAS curve. Thus, Economy A has a flatter (more elastic) SRAS curve than Economy B. A 5 percent increase in money supply, which shifts the AD curve outward, will increase output more in Economy A than in Economy B because, as just explained, Economy A has a flatter SRAS curve. On the contrary, in Economy B, prices change more than in Economy A when the AD curve shifts because the SRAS curve is steeper in Economy B.

Chapter 15 The Influence of Monetary Policy on Aggregate Demand

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SOLUTIONS TO TEXTBOOK PROBLEMS Questions for Review 1.

What is the theory of liquidity preference? How does it help explain the downward slope of the aggregate-demand curve?

The theory of liquidity preference is Keynes’s theory of how the interest rate is determined.

According to the theory, the aggregate-demand curve slopes downward because (1) a higher price level raises money demand; (2) higher money demand leads to a higher interest rate; and (3) a higher interest rate reduces the quantity of goods and services demanded. Thus the price level has a negative relationship with the quantity of goods and services demanded.

2.

Use the theory of liquidity preference to explain how a decrease in the money supply affects the aggregate-demand curve. Consider the effects in both a closed economy and a small open economy with a flexible exchange rate.

In a closed economy, a decrease in the money supply shifts the money-supply curve to the left.

The money-supply curve now intersects the money-demand curve at a higher interest rate. The higher interest rate reduces consumption and investment, so aggregate demand falls. Thus, the aggregate-demand curve shifts to the left. In a small open economy, a decrease in the money supply causes the money-supply curve to shift to the left, leading to a higher interest rate, which causes the exchange rate to appreciate. Net exports fall and the aggregate-demand curve shifts further to the left than it otherwise would in a closed economy.

3.

Suppose that survey measures of business confidence indicate that a wave of pessimism about Canada’s economic prospects is sweeping the country. As a consequence, firms announce their intention to delay new spending on plants and equipment. If policymakers do nothing and if the Bank of Canada maintains a flexible exchange rate, what will happen to aggregate demand?

If pessimism sweeps the country, households reduce consumption spending and firms reduce investment, so aggregate demand falls. If the Bank of Canada maintains a flexible exchange rate, these changes will tend to cause the interest rate in Canada to fall below the world interest rate.

Canadian financial assets will be less attractive than those available for purchase elsewhere in the world. This results in sales of Canadian financial assets in favour of foreign financial assets. In the foreign exchange market, the value of the Canadian dollar will fall because the switch from Canadian to foreign financial assets requires a corresponding sale of Canadian dollars purchase of foreign currencies. That fall in the value of the Canadian dollar makes Canadian-produced goods and services less expensive relative of foreign-produced goods and services. As a result, Canadian exports increase and imports fall. The result is an increase in Canadian net exports that completely offsets the fall in consumption and investment expenditures caused by the wave of pessimism. The end result is that if policymakers do nothing and the Bank of Canada maintains a flexible exchange rate, there will be no change in aggregate demand.

Problems and Applications 1.

Explain how each of the following developments would affect the supply of money, the demand for money, and the interest rate. For each case, show what happens in a closed economy and in a small open economy. Illustrate your answers with diagrams. a. The Bank of Canada’s bond traders buy bonds in open-market operations.

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b. An increase in credit card availability reduces the cash people hold. c. Households decide to hold more money to use for holiday shopping. d. A wave of optimism boosts business investment and expands aggregate demand. e. An increase in oil prices shifts the short-run aggregate-supply curve to the left.

a.

When the Bank of Canada’s bond traders buy bonds in open-market operations, the money-supply curve shifts to the right from MS1 to MS2, as shown in Figure 1. The result is a decline in the interest rate. In a closed economy, the reduction in the interest rate raises the quantity of goods and services demanded at a given price level, which shifts the aggregate demand curve to the right and causes the demand for money to rise. In a small open economy, assuming r1 is the world interest rate, the reduction in the interest rate causes Canadian assets to become unattractive to foreigners, which causes the exchange rate to fall and net exports to rise. This causes the aggregate-demand curve to shift and the money-demand curve to shift further to the right. This causes the domestic interest rate to rise and again equal the world interest rate. Output rises by more than it would have in a closed economy.

Figure 1

Figure 2

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b.

In a closed economy, when an increase in credit card availability reduces the cash people hold, the money-demand curve shifts to the left from MD1 to MD2, as shown in Figure 2.

The result is a decline in the interest rate. In a small open economy, the reduction in the interest rate causes the value of domestic currency to fall, which causes net exports and aggregate demand to rise. This causes money demand to increase, which causes the interest rate to rise until the Canadian interest rate once again equals the world interest rate.

c.

In a closed economy, when households decide to hold more money to use for holiday shopping, the money-demand curve shifts to the right from MD1 to MD2, as shown in Figure 3. The result is a rise in the interest rate. In a small open economy, assuming r1 is the world interest rate, an increase in the interest rate causes the exchange rate to appreciate and net exports to fall. The reduction in aggregate demand causes a reduction in money demand to where the Canadian interest rate once again equals the world interest rate.

Figure 3

2.

d.

In a closed economy, when a wave of optimism boosts business investment and expands aggregate demand, money demand increases from MD1 to MD2 in Figure 3. The increase in money demand increases the interest rate. In a small open economy, the increase in interest rates has the same effect as in part (c).

e.

In a closed economy, when an increase in oil prices shifts the short-run aggregate-supply curve to the left, the increased price level increases money demand. The money-demand curve shifts to the right from MD1 to MD2, as shown in Figure 3. The result is a rise in the interest rate. In a small open economy, the increase in interest rates has the same effect as in part (c).

Suppose banks install automated teller machines on every block and, by making cash readily available, reduce the amount of money people want to hold. a. Assume the Bank of Canada does not change the money supply. According to the theory of liquidity preference, what happens to the interest rate? What happens to aggregate demand? Assume a closed economy. b. If the Bank of Canada wants to stabilize aggregate demand, how should it respond?

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a.

When more ATMs are available, money demand is reduced and the money-demand curve shifts to the left from MD1 to MD2, as shown in Figure 4. If the Bank of Canada does not change the money supply, which is at MS1, the interest rate will decline from r1 to r2. The decline in the interest rate shifts the aggregate demand curve to the right, as consumption and investment increase.

Figure 4 b.

3.

If the Bank of Canada wants to stabilize aggregate demand, it should reduce the money supply to MS2, so the interest rate will remain at r1 and aggregate demand will not change.

This chapter explains that with a flexible exchange rate, expansionary monetary policy reduces the interest rate and thus stimulates demand for investment goods. Explain how such a policy also stimulates the demand for net exports.

The demand for net exports is stimulated by expansionary monetary policy through the exchange-rate effect. The decline in the interest rate increases net capital outflow and causes the exchange rate to depreciate, thus increasing net exports.

4.

Suppose the Bank of Canada contracts the money supply in an effort to reduce aggregate demand by a particular amount, say $10 billion. If Canada was a closed economy, would the amount by which the Bank of Canada would need to reduce the supply of money to accomplish this goal be greater or smaller than the amount it would need to reduce the supply of money if Canada was a small open economy with a flexible exchange rate?

The Bank of Canada would have to reduce the money supply by a greater amount in a closed economy than under a small open economy with a flexible exchange rate. For an initial increase in interest rates, output decreases by more in a small open economy than it would in a closed economy because of the exchange-rate effect reducing net exports and causing aggregate demand to shift further to the left.

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5.

Suppose that the world interest rate rises. What happens to the position of the aggregatedemand curve in Canada? Assume that the Bank of Canada allows the exchange rate to be flexible. How does your answer change if you assume that the Bank of Canada maintains a fixed exchange rate? Illustrate your answer with diagrams.

The increase in the world interest rate above the interest rate currently observed in Canada will make Canadian financial assets appear less attractive. Canadian financial assets will be sold by foreigners. With a flexible exchange rate, this sale of Canadian financial assets causes the value of the Canadian dollar to fall. This in turn causes Canada’s net exports to increase, causing an increase in the demand for money. These adjustments continue until the interest rate observed in Canada rises to equal the world interest rate. The rise in net exports means that the aggregatedemand curve shifts to the right.

Under a fixed exchange rate, the sale of Canadian financial assets by private individuals requires that the Bank of Canada intervene in the foreign exchange market to purchase those same Canadian dollars, and in this way prevent the exchange rate from changing. The Bank’s purchase of dollars means the domestic money supply falls. The fall in the domestic money supply continues until the interest rate observed in Canada rises to equal the world interest rate.

6.

An increase in the interest rate discourages private firms from making new investments in factories. How does the sensitivity of investment to changes in the interest rate affect the amount by which monetary policy influences aggregate-demand?

Monetary policy operates by changing the interest rate so as to make investment opportunities more attractive for firms to pursue. If investment is very sensitive to changes in the interest rate, then monetary policy is very effective at influencing aggregate-demand. If investment is not very sensitive to changes in the interest rate, then monetary policy will have little influence on investment decisions and so have very little influence on aggregate-demand.

7.

Suppose that U.S. income rises. As a result, Canada’s exports to the United States increase. What happens to the position of the aggregate-demand curve in Canada? Assume that the Bank of Canada allows the exchange rate to be flexible. How does your answer change if you assume that the Bank of Canada maintains a fixed exchange rate? Illustrate your answer with a diagram showing money demand and money supply.

An increase in U.S. incomes causes Canada’s net exports to rise. This shifts the AD curve to the right. However, as a secondary effect, the demand for money and the Canadian interest rate rise.

If the exchange rate is flexible, the Canadian dollar appreciates and net exports fall. This results in the aggregate demand curve gradually shifting back to the left, thereby decreasing money demand until the Canadian interest rate again equals the world interest rate, as shown in Figure 5.

If the exchange rate is fixed, the Bank of Canada would need to raise the money supply to prevent the appreciation of the Canadian dollar. This would lower the Canadian interest rate until it again equals the world interest rate r*, as shown in Figure 6.

To summarize, under a flexible exchange rate, an increase in U.S. incomes causes the following to occur: Canadian aggregate demand increases, but the increase is reduced through the appreciation of the dollar. Under a fixed exchange rate, the initial increase in AD is enhanced by an expansionary monetary policy aimed to prevent the appreciation of the dollar.

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Real Interest Rate

S

M

r1 r* D

M

M 1

D

Quantity of Money

Figure 5 Real Interest Rate

S

S

M1 M2

r1 r* D

D

M 2

M 1 Quantity of Money

Figure 6 8.

Suppose that the Bank of Canada decides to expand the money supply. a. Why would it be counterproductive for the Bank of Canada to fix the value of the exchange rate? b. What is the effect of this policy on the interest rate in the long run? How do you know? a.

Expanding the money supply lowers the interest rate, causing a depreciation of the exchange rate, an increase in net exports, and an increase in aggregate demand. To prevent changes in the value of the exchange rate, the Bank of Canada can sell foreign currencies and purchase Canadian dollars. This results in a reduction in the money supply and higher interest rates, which reduces consumption, investment, and aggregate demand.

b.

In the long run, lower interest rates have a positive effect on the economy. Due to the long lag time in which monetary policy affects the economy, the full benefits are experienced over a long time period. But even this is uncertain because changes in the economy can happen unexpectedly, which may force policymakers to alter monetary policy.

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9.

Suppose Canada imposes high tariffs on Japanese automobiles. The intention is to make autos produced in Japan so expensive for Canadians to buy that they choose instead to purchase autos constructed in Canada. Advocates of the policy contend this will create new employment in Canada. Assuming the Bank of Canada maintains a flexible exchange rate, will this trade policy prove effective?

The high tariff will reduce imports of Japanese automobiles and so cause an increase in aggregate-demand. However, if the Bank of Canada maintains a flexible exchange rate, the increase in aggregate-demand will also cause the interest rate in Canada to rise above the world interest rate. This results in increased purchases of Canadian financial assets. In the foreign exchange market, the value of the Canadian dollar will rise because the switch to Canadian from foreign financial assets requires a corresponding purchase of Canadian dollars in the foreign exchange market. That rise in the value of the Canadian dollar makes Canadian-produced goods and services more expensive relative of foreign-produced goods and services. As a result, Canadian exports decrease and imports rise. The result is a fall in Canadian net exports that completely offsets the fall in net exports induced by the tariff on Japanese automobiles. If the Bank of Canada maintains a flexible exchange rate, there will be no change in aggregate demand as a result of the tariff.

10.

Suppose the United States, Canada’s largest trading partner, imposes tariffs on Canadian products. This has the effect of making Canadian goods more expensive in the United States.

Explain how such a trade policy would affect the aggregate-demand curve in Canada under each of the following conditions. a. The Bank of Canada has adopted a flexible exchange rate. b. The Bank of Canada has adopted a fixed exchange rate. a. The U.S. tariffs will reduce Canadian exports and so cause a fall in aggregate-demand. The fall in aggregate-demand will cause the interest rate in Canada to fall below the world interest rate. This will cause Canadian financial assets to be sold in favour of foreign financial assets. In the foreign exchange market, this will put downward pressure on the value of the Canadian dollar. If the Bank of Canada maintains a flexible exchange rate, the fall in the value of the Canadian dollar causes Canadian produced goods and services to become less expensive for foreigners to purchase. The fall in the value of the Canadian dollar offsets the effects of the U.S. tariff, leaving Canada’s net exports and aggregate-demand unchanged. b. The U.S. tariffs will reduce Canadian exports and so cause a fall in aggregate-demand. The fall in aggregate-demand will cause the interest rate in Canada to fall below the world interest rate. This will cause Canadian financial assets to be sold in favour of foreign financial assets. In the foreign exchange market, this will put downward pressure on the value of the Canadian dollar. If the Bank of Canada maintains a fixed exchange rate, it must intervene to offset this downward pressure on the value of the Canadian dollar. It does so by purchasing Canadian dollars in the foreign exchange market. This action maintains the value of the Canadian dollar. The result is that the U.S. tariff causes a permanent fall in Canadian net exports and aggregate demand.

Chapter 16 The Influence of Fiscal Policy on Aggregate Demand SOLUTIONS TO TEXTBOOK PROBLEMS

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Questions for Review

1.

The government spends $3 billion to buy police cars. Explain why aggregate demand might increase by more than $3 billion. Explain why aggregate demand might increase by less than $3 billion. Under what conditions might aggregate demand not change at all?

If the government spends $3 billion to buy police cars, aggregate demand might increase by more than $3 billion because of the multiplier effect on aggregate demand. Aggregate demand might increase by less than $3 billion because of the investment crowding-out effect on aggregate demand. Aggregate demand will not change in an open economy with a flexible exchange rate because of the crowding-out effect on net exports. An increase in government spending causes the interest rate to rise, making Canadian assets attractive to foreigners. This causes the exchange rate to appreciate, exports to fall, the demand for money to fall, and aggregate demand to return to its original level of output.

2.

Suppose that a new financial instrument reduces liquidity preference and so causes the demand for money to fall. If policymakers do nothing, and assuming a flexible exchange rate, what will happen to aggregate demand?

The fall in the demand for money causes the domestic interest rate to fall below the world interest rate. This makes domestic financial assets less attractive to hold, and so they are sold in favour of foreign financial assets. In the foreign exchange market, this results in a fall in the value of the domestic currency. This fall makes domestic goods and services cheaper for foreigners to purchase, resulting in an increase in net exports and aggregate-demand. This increases the demand for money until the domestic interest rate again equals the world interest rate. In the end, there is no change in aggregate-demand.

3.

Give an example of a government policy that acts as an automatic stabilizer. Explain why this policy has this effect.

Government policies that act as automatic stabilizers include the tax system and government spending through the unemployment-benefit system. The tax system acts as an automatic stabilizer because when incomes are high, people pay more in taxes, so they cannot spend as much. When incomes are low, so are taxes; thus people can spend more. The result is that spending is partly stabilized. Government spending through the unemployment-benefit system acts as an automatic stabilizer because in recessions, the government transfers money to the unemployed so their incomes do not fall as much, and thus their spending will not fall as much.

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Problems and Applications 1.

2.

3.

Suppose economists observe that in a closed economy an increase in government spending of $10 billion raises the total demand for goods and services by $30 billion. a. If these economists ignore the possibility of crowding out of investment, what would they estimate the marginal propensity to consume (MPC) to be? b. Now suppose the economists allow for crowding out. Would their new estimate of the MPC be larger or smaller than their initial one? a.

If there is no crowding out, then the multiplier equals 1/(1 – MPC). Since the multiplier is 3, then MPC = 2/3.

b.

If there is crowding out, then the MPC would be larger than 2/3. An MPC that is larger than 2/3 would lead to a larger multiplier than 3, which is then reduced down to 3 by the crowding-out effect.

Suppose the government of a closed economy reduces taxes by $20 billion, that there is no crowding out of investment, and that the marginal propensity to consume is 3/4. a. What is the initial effect of the tax reduction on aggregate demand? b. What additional effects follow this initial effect? What is the total effect of the tax cut on aggregate demand? c. How does the total effect of this $20 billion tax cut compare with the total effect of a $20 billion increase in government purchases? Why? a.

The initial effect of the tax reduction of $20 billion is to increase aggregate demand by $20 billion × 3/4 (the MPC) = $15 billion.

b.

Additional effects follow this initial effect as the added incomes get spent. The second round leads to increased consumption spending of $15 billion × 3/4 = $11.25 billion. The third round gives an increase in consumption of $11.25 billion × 3/4 = $8.44 billion. The effects continue indefinitely. Adding them all up gives a total effect that depends on the multiplier. With an MPC of 3/4, the multiplier is 1/(1 – 3/4) = 4. So the total effect is $15 billion × 4 = $60 billion.

c.

Government purchases have an initial effect of the full $20 billion, since they increase aggregate demand directly by that amount. The total effect of an increase in government purchases is thus $20 billion × 4 = $80 billion. So government purchases lead to a bigger effect on output than a tax cut does. The difference arises because government purchases affect aggregate demand by the full amount, but a tax cut is partly saved by consumers, and therefore does not lead to as much of an increase in aggregate demand.

Suppose government spending increases in a closed economy. Would the effect on aggregate demand be larger (a) if the Bank of Canada took no action in response or (b) if the Bank was committed to maintaining a fixed interest rate? Explain.

If government spending increases, aggregate demand rises, so money demand rises. The increase in money demand leads to a rise in the interest rate and thus a decline in aggregate demand if the Bank of Canada does not respond. But if the Bank of Canada maintains a fixed interest rate, it will increase money supply, so aggregate demand will not decline. Thus, the effect on aggregate demand from an increase in government spending will be larger if the Bank of Canada maintains a fixed interest rate.

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4.

5.

In which of the following circumstances is expansionary fiscal policy more likely to lead to a short-run increase in investment? Explain. a. when the investment accelerator is large, or when it is small b. when the interest sensitivity of investment is large, or when it is small c. when the marginal propensity to import is small, or when it is large a.

Expansionary fiscal policy is more likely to lead to a short-run increase in investment if the investment accelerator is large. A large investment accelerator means that the increase in output caused by expansionary fiscal policy will induce a large increase in investment. Without a large accelerator, investment might decline because the increase in aggregate demand will raise the interest rate.

b.

Expansionary fiscal policy is more likely to lead to a short-run increase in investment if the interest sensitivity of investment is small. Since fiscal policy increases aggregate demand, thus increasing money demand and the interest rate, the greater the sensitivity of investment to the interest rate, the greater the decline in investment will be, which will offset the positive accelerator effect.

c.

Expansionary fiscal policy is more likely to lead to a short-run increase in investment if the marginal propensity to import is small. A small marginal propensity to import means a large multiplier effect. A larger marginal propensity to import means that for every increase in spending, the smaller the amount by which spending on Canadian-produced goods and services increases.

An increase in the interest rate discourages private firms from making new investments in factories. How does the sensitivity of investment to changes in the interest rate affect the size of the fiscal policy multiplier?

Fiscal policy influences aggregate-demand directly by changing government expenditures or by changing tax rates to cause households and firms to change their consumption and investment spending. Fiscal policy is made less effective to the extent it causes a change in the interest rate.

For example, an increase in government expenditures intended to increase aggregate-demand will increase the demand for money and so increase the interest rate. If investment is highly sensitive to a change in the interest rate, this fiscal policy will, by increasing the interest rate, ―crowd-out‖ investment spending, making it less effective in its ability to influence aggregatedemand. If, on the other hand, investment is not very sensitive to a change in the interest rate, the crowding-out effect will be small and so this fiscal policy will be more effective than otherwise.

6.

For various reasons, fiscal policy changes automatically when output and employment fluctuate. a. Explain why tax revenue changes when the economy goes into a recession. b. Explain why government spending changes when the economy goes into a recession. c. If the government was to operate under a strict balanced-budget rule, what would it have to do in a recession? Would that make the recession more or less severe? a. A recession is associated with falling employment and people working fewer hours. This means people’s incomes fall. Because the amount of tax one pays is a positive function of income, the government collects less in tax revenue during a recession. Corporation profits also fall in a recession, causing the amount of taxes they pay to fall as well. Finally, with lower incomes, households spend less and so the government collects less revenue from sources such as the GST/HST and commodity taxes on gasoline, liquor, and tobacco.

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b. The fact that a recession is associated with falling employment means that the use of government support programs such as Employment Insurance (EI) and social assistance increases. As a result, government spending automatically increases during a recession. c.

7.

In a recession, government revenues fall and government spending increases. If prior to the recession the government maintained a balanced budget, it will now see its budget move into deficit. If it applied a strict balanced-budget rule, it would need to increase tax rates to recover lost revenue and/or reduce spending in order to offset the increased spending on EI and social assistance. By these actions, the government could maintain a balanced budget, but these actions would also remove the benefits provided to households and firms in the form of lower tax payments and income supports in the form of EI and social assistance payments. The recession would be made more severe by these actions.

In the mid-1990s many Canadian governments carried large amounts of debt. To reduce their debts, many of these governments reduced their spending. During this period the Bank of Canada maintained a flexible exchange rate. When the spending cuts were announced some commentators suggested that the spending cuts would drag the economy into recession. Explain why you would have agreed or disagreed with those commentators.

I would disagree with the commentators. The fall in aggregate-demand resulting from cuts to government spending caused money demand to fall and so caused the domestic interest rate to fall below the world interest rate. This in turn causes a fall in the value of the Canadian dollar and so an increase in net exports. The aggregate-demand curve must return to its position prior to the cuts to government spending to cause the domestic interest rate to again equal the world interest rate. The spending cuts have no effect on aggregate demand so long as the Bank of Canada maintains a flexible exchange rate.

8.

At the writing of this edition, many Canadian governments were increasing their levels of spending. What is your prediction of the effect this policy will have on the value of the Canadian dollar? What will this do to the price Canadians pay for imported goods? What will happen to Canadian exports?

Increased levels of government spending increase aggregate demand and so the demand for money. This pushes the Canadian interest rate above the interest rate observed in the rest of the world and so makes Canadian financial assets attractive to purchase. The purchase of Canadian financial assets requires an increase in demand for Canadian currency and this pushes up the value of the Canadian dollar. A higher value of the dollar makes Canadian goods and services more expensive for foreigners to purchase, causing Canada’s exports to fall. The higher value of the dollar also makes foreign goods cheaper for Canadians to purchase, causing imports to rise.

9.

Consider a closed economy described by the following equations: Y=C+I+G C = 100 + 0.75(Y – T) I = 500 – 50r G = 125 T = 100 where Y is GDP, C is consumption, I is investment, G is government expenditures, T is taxes, and r is the interest rate. If the economy were at full employment (that is, at its natural level), GDP would be 2000. a. Explain the meaning of each of these equations. b. What is the marginal propensity to consume in this economy?

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c. Suppose the central bank’s policy is to adjust the money supply to maintain the interest rate at 4 percent, so r = 4. Solve for GDP. How does it compare to the fullemployment level? d. Assuming no change in monetary policy, what change in government purchases would restore full employment? e. Assuming no change in fiscal policy, what change in the interest rate would restore full employment? a. The first equation is an identity. It defines GDP (Y) to be the sum of consumption expenditures (C), investment expenditures (I), and government expenditures (G). The second equation is the consumption function. It describes consumption expenditures ( C) to be positively related to after-tax income (Y – T). It also indicates that even if after-tax income is zero, households will still spend on consumption. The third equation is the investment function. It indicates that investment expenditures ( I) are negatively related to the interest rate (r). It also indicates that if the interest rate is zero, firms will spend 500 on investment. The fourth equation indicates that regardless of the level of GDP, the government spends 125. The final equation indicates that regardless of the level of GDP, the government collects 100 in taxes. b. The marginal propensity to consume (MPC) is 0.75. c.

Substituting values into the equations solves for Y = 1800. This means that the economy is below the full employment level of output where Y = 2000.

d. To move GDP to the full employment level would require increasing GDP by 200. The fiscal policy multiplier in this model is equal to 1/(1 – MPC) = 4. Increasing government expenditures (G) by 50 (from 125 to 175) would cause output to rise to 2000. This can be confirmed by setting the value of G to 175 and re-solve for the value of Y, as was done in part c. e. Substitute Y = 2000 into the five equations and solve for r. The answer is r = 3. The interest rate would need to fall from 4 percent to 3 percent.

Chapter 17 The Short-Run Tradeoff between Inflation and Unemployment SOLUTIONS TO TEXTBOOK PROBLEMS Questions for Review 1.

Draw the short-run tradeoff between inflation and unemployment. How might the Bank of Canada move the economy from one point on this curve to another?

Figure 1 shows the short-run tradeoff between inflation and unemployment. The Bank of Canada can move from one point on this curve to another by changing the money supply. An increase in the money supply reduces the unemployment rate and increases the inflation rate, while a decrease in the money supply increases the unemployment rate and decreases the inflation rate (Figure 2).

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Figure 1

2.

Figure 2

Draw the long-run tradeoff between inflation and unemployment. Explain how the short-run and long-run tradeoffs are related.

Figure 2 shows the long-run tradeoff between inflation and unemployment. In the long run, there is no tradeoff as the economy must return to the natural rate of unemployment on the long-run Phillips curve. In the short run, the economy can move along a short-run Phillips curve, like SRPC1 shown in the figure. But over time (as inflation expectations adjust), the short-run Phillips curve will shift to return the economy to the long-run Phillips curve, for example, shifting from SRPC1 to SRPC2.

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3.

What’s so natural about the natural rate of unemployment? Why might the natural rate of unemployment differ across countries?

The natural rate of unemployment is natural because it is beyond the influence of monetary policy. The rate of unemployment will move to its natural rate in the long run, regardless of the inflation rate.

The natural rate of unemployment might differ across countries because countries have varying degrees of union power, minimum-wage laws, collective-bargaining laws, unemployment insurance, job-training programs, and other factors that influence labour-market conditions.

4.

Suppose a drought destroys farm crops and drives up the price of food. What is the effect on the short-run tradeoff between inflation and unemployment?

If a drought destroys farm crops and drives up the price of food, the short-run aggregate-supply curve shifts up, as does the short-run Phillips curve, because the costs of production have increased. The higher short-run Phillips curve means the inflation rate will be higher for any given unemployment rate.

5.

Suppose the Bank of Canada decides to reduce inflation. Use the Phillips curve to show the shortrun and long-run effects of this policy. How might the short-run costs be reduced?

When the Bank of Canada decides to reduce inflation, the economy moves down along the shortrun Phillips curve, as shown in Figure 3. Beginning at point A on short-run Phillips curve SRPC1, the economy moves down to point B as inflation declines. Once people’s expectations adjust to the lower rate of inflation, the short-run Phillips curve shifts to SRPC2, and the economy moves to point C. The short-run costs of disinflation, which arise because the unemployment rate is temporarily above its natural rate, could be reduced if the Bank of Canada’s action was credible, so that expectations would adjust more rapidly.

Figure 3

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6.

If the slope of the short-run Phillips curve increases, what happens to the size of the sacrifice ratio?

As the slope of the short-run Phillips curve increases, the sacrifice ratio grows smaller.

Problems and Applications 1.

Suppose the natural rate of unemployment is 6 percent. On one graph, draw two Phillips curves that can be used to describe the four situations listed here. Label the point that shows the position of the economy in each case. a. Actual inflation is 5 percent and expected inflation is 3 percent. b. Actual inflation is 3 percent and expected inflation is 5 percent. c. Actual inflation is 5 percent and expected inflation is 5 percent. d. Actual inflation is 3 percent and expected inflation is 3 percent.

Figure 4 shows two different short-run Phillips curves depicting these four points. Points a and d are on SRPC1 because both have expected inflation of 3 percent. Points b and c are on SRPC2 because both have expected inflation of 5 percent.

Figure 4 2.

Figure 5

Illustrate the effects of the following developments on both the short-run and long-run Phillips curves. Give the economic reasoning underlying your answers. a. a rise in the natural rate of unemployment b. a decline in the price of imported oil c. a rise in government spending d. a decline in expected inflation a.

A rise in the natural rate of unemployment shifts the long-run Phillips curve to the right, as shown in Figure 6. The economy is initially on LRPC1 and SRPC1 at an inflation rate of 3 percent, which is also the expected rate of inflation. The increase in the natural rate of unemployment shifts the long-run Phillips curve to LRPC2 and the short-run Phillips curve to SRPC2, with the expected rate of inflation remaining equal to 3 percent.

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b.

A decline in the price of imported oil shifts the short-run Phillips curve down, as shown in Figure 6, from SRPC1 to SRPC2. For any given unemployment rate, the inflation rate is lower, since oil is such a significant aspect of production costs in the economy.

Figure 6

Figure 7

c.

A rise in government spending represents an increase in aggregate demand, so it moves the economy along the short-run Phillips curve, as shown in Figure 7. The economy moves from point A to point B, with a decline in the unemployment rate and an increase in the inflation rate.

d.

A decline in expected inflation causes the short-run Phillips curve to shift down, as shown in Figure 8. The lower rate of expected inflation shifts the short-run Phillips curve from SRPC1 to SRPC2.

Figure 8

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3.

Suppose that a fall in consumer spending causes a recession. a. Illustrate the changes in the economy using both an aggregate-supply/aggregatedemand diagram and a Phillips curve diagram. What happens to inflation and unemployment in the short run? b. Now suppose that over time, expected inflation changes in the same direction that actual inflation changes. What happens to the position of the short-run Phillips curve?

After the recession is over, does the economy face a better or worse set of inflation– unemployment combinations?

Figure 9 a.

Figure 9 shows how a reduction in consumer spending causes a recession in both an aggregate-supply/aggregate-demand diagram and a Phillips-curve diagram. In both diagrams, the economy begins at full employment at point A. The decline in consumer spending reduces aggregate demand, shifting the aggregate-demand curve to the left from AD1 to AD2. The economy initially remains on the short-run aggregate-supply curve AS1, so the new equilibrium occurs at point B. The movement of the aggregate-demand curve along the short-run aggregate-supply curve leads to a movement along short-run Phillips curve SRPC1, from point A to point B. The lower price level in the aggregatesupply/aggregate-demand diagram corresponds to the lower inflation rate in the Phillips curve diagram. The lower level of output in the aggregate-supply/aggregate-demand diagram corresponds to the higher unemployment rate in the Phillips-curve diagram.

b.

As expected, inflation falls over time, the short-run aggregate-supply curve shifts down from AS1 to AS2, and the short-run Phillips curve shifts down from SRPC1 to SRPC2. In both diagrams, the economy eventually gets to point C, which is back on the long-run aggregate-supply curve and long-run Phillips curve. After the recession is over, the economy faces a better set of inflation-unemployment combinations.

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4.

Suppose the economy is in a long-run equilibrium. a. Draw the economy’s short-run and long-run Phillips curves. b. Suppose a wave of business pessimism reduces aggregate demand. Show the effect of this shock on your diagram from part (a). If the Bank of Canada undertakes expansionary monetary policy, can it return the economy to its original inflation rate and original unemployment rate? c. Now suppose the economy is back in long-run equilibrium, and then the price of imported oil rises. Show the effect of this shock with a new diagram like that in part (a). If the Bank of Canada undertakes expansionary monetary policy, can it return the economy to its original inflation rate and original unemployment rate? If the Bank of Canada undertakes contractionary monetary policy, can it return the economy to its original inflation rate and original unemployment rate? Explain why this situation differs from that in part (b). a.

Figure 10 shows the economy in long-run equilibrium at point a, which is on both the long-run and short-run Phillips curves.

b.

A wave of business pessimism reduces aggregate demand, moving the economy to point b in the figure. The unemployment rate rises and the inflation rate declines. If the Bank of Canada undertakes expansionary monetary policy, it can increase aggregate demand, offsetting the pessimism and returning the economy to point a, with the initial inflation rate and unemployment rate.

Figure 10 c.

Figure 11

Figure 11 shows the effects on the economy if the price of imported oil rises. The higher price of imported oil shifts the short-run Phillips curve up from SRPC1 to SRPC2. The economy moves from point a to point c, with a higher inflation rate and higher unemployment rate. Now if the Bank of Canada engages in expansionary monetary policy, it can return the economy to its original unemployment rate at point d, but the inflation rate will be higher. If the Bank of Canada engages in contractionary monetary policy, it can return the economy to its original inflation rate at point e, but the unemployment rate will be higher. This situation differs from that in part (b) because in part (b), the economy stayed on the same short-run Phillips curve, but in part (c), the economy moved to a higher short-run Phillips curve, which gives policymakers a less favourable tradeoff between inflation and unemployment.

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5.

Suppose the Bank of Canada believed that the natural rate of unemployment was 6 percent when the actual natural rate was 5.5 percent. If the Bank of Canada based its policy decisions on its belief, what would happen to the economy?

If the Bank of Canada acts on its belief that the natural rate of unemployment is 6 percent, when the natural rate is in fact 5.5 percent, the result will be a spiralling down of the inflation rate, as shown in Figure 12. Starting from a point on the long-run Phillips curve, with an unemployment rate of 5.5 percent, the Bank of Canada will think that the economy is overheating, since the unemployment rate is below what it thinks is the natural rate. So the Bank of Canada will contract the money supply, moving the economy along the short-run Phillips curve SRPC1. The inflation rate will decline and the unemployment rate will rise to 6 percent. As the inflation rate declines, people’s expectations of inflation will eventually decline, and the short-run Phillips curve will shift to the left to SRPC2. This process will continue, and the inflation rate will spiral downward.

Figure 12

6.

The price of oil fell sharply in 1986, again in 1998, and again in 2015. a. Show the impact of such a change in both the aggregate-demand/aggregate-supply diagram and in the Phillips curve diagram. What happens to inflation and unemployment in the short run? b. Do the effects of this event mean there is no short-run tradeoff between inflation and unemployment? Why or why not? a.

Figure 13 shows the effects of a fall in the price of oil. The short-run aggregate-supply curve shifts to the right, reducing the price level and increasing the quantity of output.

The short-run Phillips curve shifts to the left. In both diagrams, the economy moves from point A to point B. In equilibrium, both the inflation rate and the unemployment rate decline.

b.

The effects of this event do not mean there is no short-run tradeoff between inflation and unemployment, as shifts in aggregate demand still move the economy along the short-run Phillips curve.

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Figure 13 7.

8.

Suppose the Bank of Canada announced that it would pursue contractionary monetary policy in order to reduce the inflation rate. Would the following conditions make the ensuing recession more or less severe? Explain. a. Wage contracts have short durations. b. There is little confidence in the Bank of Canada’s determination to reduce inflation. c. Expectations of inflation adjust quickly to actual inflation. a.

If wage contracts have short durations, a recession induced by contractionary monetary policy will be less severe, since wage contracts can be adjusted more rapidly to reflect the lower inflation rate. This will allow a more rapid movement of the short-run aggregate-supply curve and short-run Phillips curve to restore the economy to long-run equilibrium.

b.

If there is little confidence in the Bank of Canada’s determination to reduce inflation, a recession induced by contractionary monetary policy will be more severe. It will take longer for people’s inflation expectations to adjust downward.

c.

If expectations of inflation adjust quickly to actual inflation, a recession induced by contractionary monetary policy will be less severe. In this case, people’s expectations adjust quickly, so the short-run Phillips curve shifts quickly to restore the economy to long-run equilibrium at the natural rate of unemployment.

Some economists believe that the short-run Phillips curve is relatively steep and shifts quickly in response to changes in the economy. Would these economists be more or less likely to favour contractionary policy in order to reduce inflation than economists who had the opposite views?

Economists who believe the short-run Phillips curve is relatively steep and shifts quickly in response to changes in the economy would be more likely to favour using contractionary policy to reduce inflation than economists with the opposite views. If the short-run Phillips curve is relatively steep, then the unemployment rate does not rise much because of contractionary policy. And if the short-run Phillips curve shifts quickly in response to changes in the economy,

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then the economy will not be off of the long-run Phillips curve for long in response to contractionary monetary policy. Thus, the costs of disinflation will be very small.

9.

Imagine an economy in which all wages are set in three-year contracts. In this world, the Bank of Canada announces a disinflationary change in monetary policy to begin immediately. Everyone in the economy believes the Bank of Canada’s announcement. Would this disinflation be costless?

Why or why not? What might the Bank of Canada do to reduce the cost of disinflation?

If the Bank of Canada announces a disinflation, but nominal wages have been set in three-year contracts, then the lower rate of inflation will mean real wages are too high until the contracts can be renegotiated in three years. As a result, firms will not hire as much labour and the unemployment rate will exceed the natural rate, so the disinflation would be costly. To reduce the cost of disinflation, the Bank of Canada could announce that it would reduce inflation three years from now, so contracts could be adjusted. Alternatively, the Bank of Canada could reduce inflation very slowly, so real wages wouldn’t be too high for long, and the costs of disinflation would be lower.

10.

Given the unpopularity of inflation, why don’t elected leaders always support efforts to reduce inflation? Economists believe that countries can reduce the cost of disinflation by letting their central banks make decisions about monetary policy without interference from politicians. Why might this be so?

Even though inflation is unpopular, elected leaders do not always support efforts to reduce inflation because of the short-run costs associated with disinflation. In particular, as disinflation occurs, the unemployment rate rises, and when unemployment is high, people tend not to vote for incumbent politicians, blaming them for the bad state of the economy. Thus, politicians tend not to support disinflation.

Economists believe that countries with independent central banks can reduce the cost of disinflation because in those countries, politicians cannot interfere with central banks’ disinflation efforts. People will believe the central bank when it announces a disinflation because they know politicians cannot stop the disinflation. In countries with central banks that are not independent, people know that politicians who are worried they will not be reelected could stop a disinflation.

As a result, the credibility of the central bank is lower and thus the costs of disinflation are higher.

11.

Suppose the governor of the Bank of Canada accepts the theory of the short-run Phillips curve and the natural-rate hypothesis and wants to keep unemployment close to its natural rate.

Unfortunately, because the natural rate of unemployment can change over time, the governor is unsure about the value of the natural rate. What macroeconomic variables do you think the governor should look at when conducting monetary policy?

If policymakers are uncertain about the value of the natural rate of unemployment (as was clearly the case in the 1990s, when economists were continually revising their estimates of the natural rate downward), they need to look at other variables. Since there is a correspondence through the Phillips curve between inflation and unemployment, when unemployment is close to its natural rate, inflation should not change. Thus, policymakers can look at data on the inflation rate to judge how close unemployment is to its natural rate. In addition, they can look at other macroeconomic variables, including the components of GDP and interest rates, to try to disentangle shifts in aggregate supply from shifts in aggregate demand, which (when combined with information about inflation) can help them determine the appropriate stance for monetary policy.

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The short-run Phillips curve can be represented by the following equation:

We have learned that expected inflation is well ―anchored‖ at the Bank of Canada’s target of 2 percent. Our best guess for the current value of the natural rate of unemployment is 7 percent.

Finally, assume the value of variable a is 0.5. a. Using the numerical values provided, sketch a diagram showing the long-run and the short-run Phillips curves. b. If the unemployment rate is equal to the natural rate of unemployment, what is the actual rate of inflation? c. What is the slope of the short-run Phillips curve you have sketched? Describe in words what the measure of slope represents. d. Assuming that expected inflation and the value of the natural rate of unemployment are unaffected, to what level would the Bank of Canada need to increase the actual rate of inflation to lower the unemployment rate by 1 percentage point? a.

We need to find two points that determine the short-run Phillips curve. One could be inflation = 0, for which the unemployment rate = 7 – 0.5 × (0 – 2) = 8 (Figure 14); the other is inflation = 2, which gives unemployment rate = 7 – 0.5(2 – 2) = 7. The long-run Phillips curve is vertical at unemployment = 7.

Inflation Rate

12.

Long-run Phillips curve

A

2

Short-run Phillips curve

7

Unemployment Rate

8 Figure 14

b.

When unemployment = 7, the actual rate of inflation can be determined from the equation 7 = 7 – 0.5 × (inflation – 2), with the solution inflation = 2. This is point A in the above graph.

c.

The slope of the short-run Phillips curve shows by how much the inflation rate should be increased in order to obtain a decrease in unemployment by 1 percent: slope = change in inflation divided by the corresponding change in unemployment. In our case, when inflation increases by 1 percentage point, unemployment decreases by 0.5 percentage points. Thus, slope = 1/(–0.5) = –2.

d.

Since the slope of the short-run Phillips curve is –2, to obtain a decrease in unemployment by 1 percent, the Bank of Canada should increase the inflation rate by 2 percentage points.

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Chapter 18 Five Debates over Macroeconomic Policy SOLUTIONS TO TEXTBOOK PROBLEMS Questions for Review 1.

What causes the lags in the effect of monetary and fiscal policy on aggregate demand? What are the implications of these lags for the debate over active versus passive policy?

The lags in the effect of monetary and fiscal policy on aggregate demand are caused by many things. For example, the fact that many households and firms set their spending plans in advance means that it takes time for changes in interest rates to alter the aggregate demand for goods and services. As a result, it is more difficult to engage in activist monetary stabilization policy, because the economy will not respond immediately to policy changes. On the fiscal side, changes in tax rates and spending programs require debate in parliament, and once changes are decided upon, their effects on the economy are not immediate. In either case, the economic boom or bust that the monetary or fiscal policy is intended to address may have resolved itself before the change in policy has had its affect. These lags suggest activist policies should be pursued only in cases when the economic boom or bust is expected to be large and prolonged.

2.

What might motivate a central banker to cause a political business cycle? What does the possibility of a political business cycle imply for the debate over whether monetary policy should be conducted by an independent central bank?

A central banker might be motivated to cause a political business cycle by trying to influence the outcome of elections. A central banker who is sympathetic to the incumbent knows that if the economy is doing well at election time, the incumbent is likely to be reelected. So the central banker could stimulate the economy before the election. To prevent this, it might be desirable to have monetary policy set by an independent central bank.

3.

Explain how credibility might affect the cost of reducing inflation.

Credibility might affect the cost of reducing inflation because it influences how quickly the shortrun Phillips curve adjusts. If the Bank of Canada announces a credible plan to reduce inflation, the short-run Phillips curve will shift down quickly and the cost of disinflation will be low. But if the plan is not credible, people will not adjust their expectations of inflation, the short-run Phillips curve will not shift, and the cost of disinflation will be high.

4.

Why are some economists against a target of zero inflation?

Some economists are against a target of zero inflation because they believe the costs of reaching zero inflation are large and the benefits are small.

5.

Explain two ways in which a government budget deficit hurts a future worker.

Two ways in which a government budget deficit hurts a future worker are (1) taxes on future workers are higher to pay off the government debt, and (2) because of crowding out, budget deficits lead to a reduction in the economy’s capital stock, and so future workers have lower incomes.

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6.

What are two situations in which most economists view a budget deficit as justifiable?

Two situations in which a budget deficit is justifiable are (1) in wartime, so tax rates will not have to be increased so much that they lead to large deadweight losses; and (2) during a temporary downturn in economic activity, during which balancing the budget would force the government to increase taxes and cut spending, making the downturn even worse.

7.

Give an example of how the government might hurt young generations, even while reducing the government debt they inherit.

An example of how the government might hurt young generations while reducing the government debt they inherit occurs if the government reduces spending on education. Then the government debt will be smaller, so future generations will pay less in taxes. But they will also be less educated, so they will have less human capital and thus have lower incomes. So future generations might be worse off in this case.

8.

Some economists say that the government can continue running a budget deficit forever. How is that possible?

The government can run a budget deficit forever because population and productivity continuously increase. Thus the economy’s capacity to pay off its debt grows over time. So as long as the government debt grows slower than the economy’s income, government deficits can continue forever.

9.

Some income from capital is taxed twice. Explain.

Income from capital is taxed twice in the case of dividends on corporate stock. The income is taxed once by corporate income tax and a second time by the individual income tax on dividend income.

10.

Give an example, other than tax policy, of how our society discourages saving.

Examples, other than tax policy, of how our society discourages saving include (1) the fact that some government benefits, such as Old Age Security pension payments, are means-tested, so people who save get reduced benefits; and (2) the fact that colleges and universities grant financial aid inversely to the wealth of students and their families, so people who save get less financial aid.

11.

What adverse effect might be caused by tax incentives to raise saving?

Tax incentives to raise saving may have the adverse effect of raising the government budget deficit, which reduces public saving. Thus national saving may not increase even though private saving rises.

Problems and Applications 1.

The chapter suggests that the economy, like the human body, has ―natural restorative powers.‖ a. Illustrate the short-run effect of a fall in aggregate demand using an aggregatedemand/aggregate-supply diagram. What happens to total output, income, and employment?

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b. If the government does not use stabilization policy, what happens to the economy over time? Illustrate this on your diagram. Does this adjustment generally occur in a matter of months or a matter of years? c. Do you think the ―natural restorative powers‖ of the economy mean that policymakers should be passive in response to the business cycle? a.

Figure 1 illustrates the short-run effect of a fall in aggregate demand. The economy starts at point A on aggregate-demand curve AD1 and short-run aggregate-supply curve AS1. The decline in aggregate demand shifts the aggregate-demand curve from AD1 to AD2 and the economy moves to point B. Total output falls from Y1 to Y2, so income and employment fall as well.

Figure 1

2.

b.

With no policy changes, the economy restores itself gradually over time. The recession induces declines in wages, so the cost of production declines, and the short-run aggregate-supply curve shifts down to AS2. The economy ends up at point C, with a lower price level, but with output back at Y1. However, this process may take years to complete.

c.

If policymakers are passive, the economy restores itself, but very slowly. If policymakers shift aggregate demand to the right, they can get the economy back to long-run equilibrium much more quickly. However, due to lags and imperfect information, a policy to increase aggregate demand may be destabilizing.

In Chapter 16, we learned that the multiplier effect associated with a change in government purchases could be expressed as 1/(1 – MPC + MPI), where MPC is the marginal propensity to consume and MPI is the marginal propensity to import. If MPC = 0.90 and MPI = 0.10, then we can use this formula to calculate that the multiplier effect associated with a change in government purchases is equal to 5. A problem with which fiscal policymakers must deal is the fact they are not absolutely certain what the true magnitudes of the MPC and MPI are. Suppose these values were actually 0.95 and 0.05, respectively. How would this affect the size of the multiplier effect? How does uncertainty about the size of the values of MPC and MPI affect your position on the debate over whether policymakers should try to stabilize the economy?

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The multiplier will increase to 10. Certainly, it adds another element of uncertainty along with the long lag times associated with implementing appropriate fiscal and monetary policies.

3.

4.

In earlier chapters, we learned about automatic stabilizers in the tax system and government spending programs. a. Provide an example of an automatic stabilizer that works via the tax system in Canada and another of an automatic stabilizer that works via a government spending program. b. How does the existence of automatic stabilizers affect your position on the debate over whether policymakers should try to stabilize the economy? a.

The progressive personal income tax system in Canada acts as an automatic stabilizer. As incomes are reduced in times of recession, the taxes collected by the federal government are more than proportionally reduced, thereby dampening the negative influences of the economic downturn on households. The Employment Insurance program also acts as an automatic stabilizer by providing temporary relief to those workers unemployed by the downturn.

b.

Both programs cause budgetary deficits during the downturn. This is hopefully offset by stronger revenue growth and less demands on government spending during expansionary phases of the business cycle, which will lead to budget surpluses. The existence of automatic stabilizers means there is less need for discretionary monetary or fiscal policies. Discretionary monetary and fiscal policies can be reserved for cases of very large economic fluctuations that are not sufficiently muted by automatic stabilizers.

The problem of time inconsistency applies to fiscal policy as well as to monetary policy. Suppose the government announced a reduction in taxes on income from capital investments, like new factories. a. If investors believed that capital taxes would remain low, how would the government’s action affect the level of investment? b. After investors have responded to the announced tax reduction, does the government have an incentive to renege on its policy? Explain. c. Given your answer to part (b), would investors believe the government’s announcement? What can the government do to increase the credibility of announced policy changes? d. Explain why this situation is similar to the time-inconsistency problem faced by monetary policymakers. a.

If investors believe that capital taxes will remain low, then a reduction in capital taxes leads to increased investment.

b.

After the increase in investment has occurred, the government has an incentive to renege on its policy because it can get more tax revenue by increasing taxes on the higher income from the larger capital stock.

c.

Given the government’s obvious incentive to renege on its promise, firms will be reluctant to increase investment when the government reduces tax rates. The government can increase the credibility of its tax change by somehow committing to low future tax rates. For example, it could write a law that guarantees low future tax rates for all capital income from investments made within the next year, or write a law penalizing itself if it raises future taxes.

d.

This situation is similar to the time-inconsistency problem facing monetary policymakers

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because the government’s incentives change over time. In both cases, the policymaker has an incentive to tell people one thing, then to do another once people have made an economic decision. For example, in the case of monetary policy, policymakers could announce an intention to lower inflation, so firms and workers will enter into labour contracts with lower nominal wages, then the policymakers could increase inflation to reduce real wages and stimulate the economy.

5.

Chapter 2 explains the difference between positive analysis and normative analysis. In the debate about whether the central bank should aim for zero inflation, which areas of disagreement involve positive statements and which involve normative judgments?

Issues about whether the costs of inflation are large or small are positive statements, as is the question about the size of the costs of reducing inflation. But the question of whether the Bank of Canada should reduce inflation to zero is a normative question.

6.

Why are the benefits of reducing inflation permanent and the costs temporary? Why are the costs of increasing inflation permanent and the benefits temporary? Use Phillips curve diagrams in your answer.

The benefits of reducing inflation are permanent and the costs are temporary. Figure 2 illustrates this. The economy starts at point A. To reduce inflation, the Bank of Canada uses contractionary policy to move the economy down the short-run Phillips curve SRPC1. Inflation declines and unemployment rises, so there are costs to reducing inflation. But the costs are only temporary, since the short-run Phillips curve eventually shifts down to SRPC2, and the economy ends up at point B. Since inflation is lower at point B than at point A, and point B is on the long-run Phillips curve, the benefits of reducing inflation are permanent.

Figure 2 The costs of increasing inflation are permanent and the benefits are temporary for similar reasons. Again, suppose the economy starts at point A. To increase inflation, the Bank of Canada uses expansionary policy to move the economy up the short-run Phillips curve SRPC1. Inflation rises and unemployment declines, so there are benefits to increasing inflation. But the benefits are only temporary, since the short-run Phillips curve eventually shifts up to SRPC3, and the

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economy ends up at point C. Since inflation is higher at point C than at point A, and point C is on the long-run Phillips curve, the costs of increasing inflation are permanent.

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7.

Suppose the federal government cuts taxes and increases spending, raising the budget deficit to 12 percent of GDP. If nominal GDP is rising 7 percent per year, are such budget deficits sustainable forever? Explain. If budget deficits of this size are maintained for 20 years, what is likely to happen to your taxes and your children’s taxes in the future? Can you do something today to offset this future effect?

If the budget deficit is 12 percent of GDP and nominal GDP is rising 7 percent each year, the ratio of government debt to GDP will rise until it hits a fairly high level. (That level turns out to be debt/income = 12/7, because at that point, a deficit that is 12 percent of GDP with GDP growing 7 percent maintains the debt/income ratio at exactly 12/7. To be sustainable, debt and GDP must grow at the same rate, 7 percent each year. If the deficit is 12 percent of GDP, which is growing 7 percent each year, the ratio of debt to GDP must be 12/7, so that the deficit can be both 12 percent of GDP and maintain a constant ratio of debt to GDP.) Such a high debt level is likely to require a big tax increase on future generations. To keep future generations from having to pay such high taxes, you could increase your savings today and leave a bequest to them.

8.

9.

Explain how each of the following policies redistributes income across generations. Is the redistribution from young to old, or from old to young? a. an increase in the budget deficit b. more generous subsidies for education loans c. greater investments in highways and bridges d. indexation of Old Age Security benefits to inflation a.

An increase in the budget deficit redistributes income from young to old, since future generations will have to pay higher taxes and will have a lower capital stock.

b.

More generous subsidies for education loans redistribute income from old to young, since future generations benefit from having higher human capital.

c.

Greater investments in highways and bridges redistribute income from old to young, since future generations benefit from having a higher level of public capital than otherwise.

d.

The indexation of Old Age Security benefits to inflation prevents income from being unintentionally redistributed from old to young, since older people get unchanged real benefits with indexation, but their benefits would decline over time without indexation.

Surveys suggest that most people are opposed to budget deficits, but these same people elected representatives who in the 1970s and 1980s passed budgets with significant deficits. Why might the opposition to budget deficits be stronger in principle than in practice?

People’s opposition to budget deficits may be stronger in principle than in practice because people want the budget deficit to be lower, but they also don’t want to cut government spending or to pay increased taxes.

10.

In 1991, the federal government simultaneously reduced the income tax rate and introduced the Goods and Services Tax (GST). Explain why economists applauded this switch from taxing incomes to taxing spending.

Taxing incomes means everyone pays income tax, while taxing consumption means that households only pay tax on the basis of their spending. Therefore, income that is saved is exempt from consumption taxation. It provides an incentive for consumers to save rather than spend.

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11.

The following table presents data taken from Finance Canada’s Economic and Fiscal Update, November 2003. It shows borrowing in the market for loanable funds by Canadian governments and Canadian businesses in fiscal years 1992–93 and 2001–02.

Government Business

1992–93

2001–02

(billions of dollars)

(billions of dollars)

+$45.1 +$22.0

–$10.3 +$59.1

Change –$55.4 +$37.1

Source: The Economic and Fiscal Update, http://www.fin.gc.ca/ec2003/ec03e.pdf, Department of Finance Canada, 2003. Contains information licensed under the Open Government Licence—Canada.

In the earlier period, Canadian governments were running large deficits. As a result, they borrowed $45.1 billion in capital markets. In the later period, Canadian governments were realizing budget surpluses and as a result provided $10.3 billion in funds to capital markets. The table shows how the change in government borrowing enabled the private sector greater access to loanable funds. How do you think this change in government policy affected interest rates?

How do you think this change affected the ability of Canadian businesses to expand and create new employment?

Interest rates were reduced causing the cost of borrowing for the private sector to fall and encouraging more private sector borrowing, investment activity, and employment creation.

12.

The following table presents data taken from Finance Canada’s Economic and Fiscal Update, November 2003. It shows federal government spending, after removing spending on interest payments on the debt, in fiscal years 1992–93 and 2001–02. The spending measured here is on health care, defence, pensions, Employment Insurance, and other goods and services.

Federal government program spending

1992–93

2001–02

(percentage of GDP)

(percentage of GDP)

16.8%

11.3%

Change

–5.5%

Source: The Economic and Fiscal Update, http://www.fin.gc.ca/ec2003/ec03e.pdf. Department of Finance Canada, 2003.

In the earlier period, the federal government spent an amount equal to 16.8 percent of GDP on such programs. In the later period, federal spending on these programs amounted to only 11.3 percent of GDP. How do you think this change in government spending policy affected Canadians receiving health care, pensions, and Employment Insurance?

During times of economic expansion, the level of economic output may rise faster than the level of federal government program spending, causing the proportion of spending to GDP to be smaller. The effects on Canadians receiving the benefits of such spending are difficult to assess based on this information alone. For instance, if the population of Canada has increased by more than the increase in government spending, then Canadians see government spending per person decreasing. In addition, the decrease in the proportion of GDP spent by the government does not say whether spending has increased or decreased in real terms.

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