会员注册 | 登录|微信快捷登录 QQ登录 微博登录 |帮助中心 精品学习网 专业在线学习考试资料文档分享平台

曼昆《经济学原理》第五版宏观经济学习题答案(英文

收 藏 此文档一共:300页 本文档一共被下载: 本文档被收藏:

显示该文档阅读器需要flash player的版本为10.0.124或更高!

关 键 词:
经济学原理  
  文库屋所有资源均是用户自行上传分享,仅供网友学习交流,未经上传用户书面授权,请勿作他用。
文档介绍
23 MEASURING A NATION’S INCOME WHAT’S NEW IN THE FIFTH EDITION: There is more clarification on the GDP deflator. The Case Study on “Who Wins at the Olympics?” is now an FYI box. LEARNING O****ECTIVES: By the end of this chapter, students should understand:  why an economy’s total income equals its total expenditure.  how gross domestic product (GDP) is defined and calculated.  the breakdown of GDP into its four ****jor components.  the distinction between real GDP and nominal GDP.  whether GDP is a good measure of economic well-being. CONTEXT AND PURPOSE: Chapter 23 is the first chapter in the ****croeconomic section of the text. It is the first of a two- chapter sequence that introduces students to two vital statistics that economists use to monitor the ****croeconomy—GDP and the consumer price index. Chapter 10 develops how economists measure production and income in the ****croeconomy. The following chapter, Chapter 11, develops how economists measure the level of prices in the ****croeconomy. Taken together, Chapter 10 concentrates on the quantity of output in the ****croeconomy while Chapter 11 concentrates on the price of output in the ****croeconomy. The purpose of this chapter is to provide students with an understanding of the measurement and the use of gross domestic product (GDP). GDP is the single most important measure of the health of the ****croeconomy. Indeed, it is the most widely reported statistic in every developed economy. KEY POINTS:  Because every transaction has a buyer and a seller, the total expenditure in the economy must equal the total income in the economy.  Gross domestic product (GDP) measures an economy’s total expenditure on newly produced goods and services and the total income earned from the production of these goods and services. More precisely, GDP is the ****rket value of all final goods and services produced within a country in a given period of time.  GDP is divided among four components of expenditure: consumption, investment, government purchases, and net exports. Consumption includes spending on goods and services by households, with the exception of purchases of new housing. Investment includes spending on new equipment and structures, including households’ purchases of new housing. Government purchases include spending on goods and services by local, state, and federal governments. Net exports equal the value of goods and services produced domestically and sold abroad (exports) minus the value of goods and services produced abroad and sold domestically (imports).  Nominal GDP uses current prices to value the economy’s production of goods and services. Real GDP uses constant base-year prices to value the economy’s production of goods and services. The GDP deflator―calculated from the ratio of nominal to real GDP―measures the level of prices in the economy.  GDP is a good measure of economic well-being because people prefer higher incomes to lower incomes. But it is not a perfect measure of well-being. For example, GDP excludes the value of leisure and the value of a clean environment. CHAPTER OUTLINE: Regardless of whether microeconomics is taught before ****croeconomics or vice versa, students need to be reminded of the differences between the two areas of study. Begin by defining the two terms and contrasting and comparing their focus. I. Review of the Definitions of Microeconomics and Macroeconomics A. Definition of microeconomics: the study of how households and firms ****ke decisions and how they interact in ****rkets. B.StuDdeefnintsitihoanvoefhmeaarcdroofecGoDnPo****nidcst:hethy earsetugdenyuoinfeelycoinnteormesyte-dwiindeleparhneinngommoerneaabout waghiganrtcelgiutaditsei.npTgrhoiednubfclaatistoiicnopnao,niduntnaetghmgartepgyloaotuyemmineucnsottm,geeatninadcareoncsaostniioosnmthoiavctegrGraDoPwpetrihsio.ad measure of both of one year. You can demonstrate this by using the circular-flow diagram and explaining that production II. ThgeenEecroanteosmiyn’csoImnceo, mwehicahndprEoxvpideensditthuerepurchasing power that generates the de****nd for the products. A. To judge whether or not an economy is doing well, it is useful to look at Gross Domestic Product (GDP). 1. GDP measures the total income of everyone in the economy. 2. GDP measures total expenditure on an economy’s output of goods and services. B. For an economy as a whole, total income must equal total expenditure. 1. If someone pays someone else $100 to mow a lawn, the expenditure on the lawn service ($100) is exactly equal to the income earned from the production of the lawn service ($100). 2. We can also use the circular-flow diagram from Chapter 2 to show why total income and total expenditure must be equal. Figure 1 a. Households buy goods and services from firms; firms use this money to pay for resources purchased from households. b. In the **** economy described by this circular-flow diagram, calculating GDP could be done by adding up the total purchases of households or summing total income earned by households. c. Note that this **** diagram is somewhat unrealistic as it omits saving, taxes, government purchases, and investment purchases by firms. However, because a transaction always has a buyer and a seller, total expenditure in the economy must be equal to total income. III. The Measurement of Gross Domestic Product A. Definition of gross domestic product (GDP): the ****rket value of all final goods and services produced within a country in a given period of time. To put GDP in terms the student ****y understand better, explain to them that GDP represents the amount of money one would need to purchase one year’s worth of the economy’s production of all final goods and services. Have a contest and see which student can come closest in guessing the level of GDP for the United States last year. B. “GDP Is the Market Value . . .” 1. To add together different items, ****rket values are used. 2. Market values are calculated by using ****rket prices. C. “. . . Of All . . .” 1. GDP includes all items produced and sold legally in the economy. 2. The value of housing services is somewhat difficult to measure. a. If housing is rented, the value of the rent is used to measure the value of the housing services. b. For housing that is owned (or mortgaged), the government esti****tes the rental value and uses this figure to value the housing services. 3. GDP does not include illegal goods or services or items that are not sold in ****rkets. a. When you hire someone to mow your lawn, that production is included in GDP. b. If you mow your own lawn, that production is not included in GDP. D. “. . . Final . . .” 1. Intermediate goods are not included in GDP. Make sure that students realize that investment goods (such as structures and vehicles used in production) are not intermediate goods. Investment goods represent products purchased for final use by business firms. 2. The value of intermediate goods is already included as part of the value of the final good. 3. Goods that are placed into inventory are considered to be “final” and included in GDP as a firm’s inventory investment. a. Goods that are sold out of inventory are counted as a decrease in inventory investment. b. The goal is to count the production when the good is finished, which is not necessarily the same time that the product is sold. E. “. . . Goods and Services . . .” 1. GDP includes both tangible goods and intangible services. F. “. . . Produced . . .” 1. Only current production is counted. 2. Used goods that are sold do not count as part of GDP. G. “. . . Within a Country . . .” 1. GDP measures the production that takes place within the geographical boundaries of a particular country. 2. If a Canadian citizen works temporarily in the United States, the value of his output is included in GDP for the United States. If an American owns a factory in Haiti, the value of the production of that factory is not included in U.S. GDP. Students sometimes have trouble understanding that the production of a foreign firm operating in the United States is part of U.S. GDP. Help them ****ke the connection by using the circular-flow diagram. Show them that, even if it is a foreign firm, the firm’s workers are living in the United States and buying clothes, groceries, and other goods in the United States. Thus, the workers in the foreign firm operating in the United States are fueling the domestic economy. H. “. . . in a Given Period of Time.” 1. The usual interval of time used to measure GDP is a quarter (three months). 2. When the government reports GDP, the data are generally reported on an annual basis. 3. In addition, data are generally adjusted for regular seasonal changes (such as Christ****s). I. In addition to summing expenditure, the government also calculates GDP by adding up total income in the economy. 1. The two ways of calculating GDP almost exactly give the same answer. 2. The difference between the two calculations of GDP is called the statistical discrepancy. J. FYI: Other Measures of Income It can be a challenge to teach all of these definitions without putting your students to sleep. Concentrate on the measures that will mean the most to students as the semester progresses. A. Gross National Product (GNP) is the total income earned by a nation’s per****nent residents. 1. GNP includes income that American citizens earn abroad. 2. GNP excludes income that foreigners earn in the United States. B. Net National Product (NNP) is the total income of a nation’s residents (GNP) minus losses from depreciation (wear and tear on an economy’s stock of equipment and structures). C. National income is the total income earned by a nation’s residents in the production of goods and services. 1. National income differs from NNP by excluding indirect business taxes and including business subsi****s. 2. NNP and national income also differ due to “statistical discrepancy.” D. Personal income is the income that households and noncorporate businesses receive. E. Disposable personal income is the income that households and noncorporate businesses have left after taxes and other obligations to the government. IV. The Components of GDP A. GDP (Y ) can be divided into four components: consumption (C ), investment (I ), government purchases (G ), and net exports (NX ). Y = C + I + G + NX Students will ask why GDP is called “Y.” Remind them that in equilibrium GDP expenditures must be equal to income. The “Y ” stands for income because the letter “I ” is used for investment. B. Definition of consumption: spending by households on goods and services, with the exception of purchases of new housing. C. Definition of investment: spending on capital equipment, inventories, and structures, including household purchases of new housing. 1. GDP accounting uses the word “investment” differently from how we use the term in everyday conversation. 2. When a student hears the word “investment,” he or she thinks of financial instruments such as stocks and bonds. 3. In GDP accounting, investment means purchases of investment goods such as capital equipment, inventories, or structures. D. Definition of government purchases: spending on goods and services by local, state, and federal governments. 1. Salaries of government workers are counted as part of the government purchases component of GDP. 2. Transfer payments are not included as part of the government purchases component of GDP. Spend some time in class distinguishing between government purchases and transfer payments. Point out that transfer payments are actually negative taxes representing payments from the government to individuals (with no good or service provided in return) rather than payments from individuals to the government. Define net taxes as the difference between taxes and transfers. E. Definition of net exports: spending on domestically produced goods by foreigners (exports) minus spending on foreign goods by domestic residents (imports). Table 1 F. Case Study: The Components of U.S. GDP 1. Table 1 shows these four components of GDP for 2007. 2. The data for GDP come from the Bureau of Economic Analysis, which is part of the Department of Commerce. Make sure that you point out Table 1. Call attention to the importance of consumption and the negative number in the net exports column. V. Real Versus Nominal GDP A. There are two possible reasons for total spending to rise from one year to the next. 1. The economy ****y be producing a larger output of goods and services. 2. Goods and services could be selling at higher prices. B. When studying GDP over time, economists would like to know if output has changed (not prices). C. Thus, economists measure real GDP by valuing output using a fixed set of prices. D. A Numerical Example Make sure that you do this example or a similar numerical example in class. If you feel comfortable improvising, let the students pick two goods and then ****ke up an example with them. Table 2 1. Two goods are being produced: hot dogs and hamburgers. Year Price of Quantity of Price of Quantity of Hot Dogs Hot Dogs Hamburgers Hamburgers 2008 2009 $1 100 $2 50 2010 $2 150 $3 100 $3 200 $4 150 2. Definition of nominal GDP: the production of goods and services valued at current prices. Nominal GDP for 2008 = ($1 × 100) + ($2 × 50) = $200. Nominal GDP for 2009 = ($2 × 150) + ($3 × 100) = $600. Nominal GDP for 2010 = ($3 × 200) + ($4 × 150) = $1,200. 3. Definition of real GDP: the production of goods and services valued at constant prices. Let’s assume that the base year is 2008. Real GDP for 2008 = ($1 × 100) + ($2 × 50) = $200. Real GDP for 2009 = ($1 × 150) + ($2 × 100) = $350. Real GDP for 2010 = ($1 × 200) + ($2 × 150) = $500. Make sure that it is clear to students how to calculate these numbers so that they can compute nominal GDP and real GDP on their own. E. Because real GDP is unaffected by changes in prices over time, changes in real GDP reflect changes in the amount of goods and services produced. Emphasize that when there is inflation, nominal GDP can increase while real GDP actually declines. Make sure that students understand that real GDP will be used as a proxy for aggregate production throughout the course. ALTERNATIVE CLASSROOM EXAMPLE: The country of ____________ (insert name based on school ****scot such as “Pantherville” or “Owlstown”) produces two goods: footballs and basketballs. Below is a table showing prices and quantities of output for three years: Year Price of Quantity of Price of Quantity of Footballs Footballs Basketballs Basketballs Year 1 Year 2 $10 120 $12 200 Year 3 12 200 15 300 14 180 18 275 Nominal GDP in Year 1 = ($10 × 120) + ($12 × 200) = $3,600 Nominal GDP in Year 2 = ($12 × 200) + ($15 × 300) = $6,900 Nominal GDP in Year 3 = ($14 × 180) + ($18 × 275) = $7,470 Using Year 1 as the Base Year: Real GDP in Year 1 = ($10 × 120) + ($12 × 200) = $3,600 Real GDP in Year 2 = ($10 × 200) + ($12 × 300) = $5,600 Real GDP in Year 3 = ($10 × 180) + ($12 × 275) = $5,100 (Note that nominal GDP rises from Year 2 to Year 3, but real GDP falls.) GDP deflator for Year 1 = ($3,600/$3,600) × 100 = 1 × 100 = 100 GDP deflator for Year 2 = ($6,900/$5,600) × 100 = 1.2321 × 100 = 123.21 GDP deflator for Year 3 = ($7,470/$5,100) × 100 = 1.4****7 × 100 = 146.47 F. The GDP Deflator 1. Definition of GDP deflator: a measure of the price level calculated as the ratio of nominal GDP to real GDP times 100. GDP deflator = Nominal GDP ᄡ 100 Real GDP 2. Example Calculations GDP Deflator for 2008 = ($200 / $200) × 100 = 100. GDP Deflator for 2009 = ($600 / $350) × 100 = 171. GDP Deflator for 2010 = ($1200 / $500) × 100 = 240. Make sure that you point out that nominal GDP and real GDP will be equal in the base year. This implies that the GDP deflator for the base year will always be equal to 100. G. Case Study: Real GDP over Recent History Figure 2 1. Figure 2 shows quarterly data on real GDP for the United States since 1965. 2. We can see that real GDP has increased over time. 3. We can also see that there are times when real GDP declines. These periods are called recessions. VI. Is GDP a Good Measure of Economic Well-Being? Get students involved in a discussion of the merits and problems involved with using GDP as a measure of well-being. Students are often as interested in what is not included in GDP as they are in what is included. Have the students break into s****ll groups and list the things that might be missing if we use GDP as a measure of well-being. Then, have each group report their results and sum****rize them on the board. A. GDP measures both an economy’s total income and its total expenditure on goods and services. B. GDP per person tells us the income and expenditure level of the average person in the economy. C. GDP, however, ****y not be a very good measure of the economic well-being of an individual. 1. GDP omits important factors in the quality of life including leisure, the quality of the environment, and the value of goods produced but not sold in for****l ****rkets. 2. GDP also says nothing about the distribution of income. 3. However, a higher GDP does help us achieve a good life. Nations with larger GDP generally have better education and better health care. D. In the News: The Underground Economy 1. The measurement of GDP misses ****ny transactions that take place in the underground economy. 2. This article compares the underground economies of the United States and several other countries. E. Case Study: International Differences in GDP and the Quality of Life Table 3 1. Table 3 shows real GDP per person, life expectancy, **** literacy rates, and Internet usage for 12 countries. 2. In rich countries, life expectancy is higher and **** literacy and Internet usage rates are also high. 3. In poor countries, people typically live only into their 50s, only about half of the **** population is literate, and Internet usage is very rare. Activity 1—GDP and Well-Being Type: In-class demonstration Topics: Per capita GDP Materials needed: None Time: 15 minutes Class limitations: Works in any size class Purpose This activity examines the usefulness and limits of measures of GDP. Students often have difficulty accepting the use of GDP as a proxy for well-being. Per capita GDP does not directly measure well-being but it is highly correlated with direct measures. Making this correlation explicit helps students understand the emphasis on GDP in ****croeconomics. Instructions Ask students the following questions. Discuss each before moving to the next question. 1. If GDP is a good measure of well-being, why is Switzerland’s GDP so much lower than India’s GDP or China’s GDP? 2. What measures would be better to compare the well-being of different countries? 3. How do you expect these direct measures to correlate with per capita GDP? Common Answers and Points for Discussion 1. GDP itself tells very little; Switzerland’s GDP is much lower than that of India or China, yet Swiss citizens have one of the highest standards of living in the world. The difference, of course, is population. Switzerland is a s****ll country, so its GDP is relatively s****ll, despite its wealth. The appropriate comparison is per capita GDP. A more interesting question is “Is per capita GDP a good measure of well-being?” Or worded another way: “What constitutes well-being?” 2. Well-being can be measured directly in a variety of ways. Students often suggest these: Health care Food Education These are certainly better measures than money income, but they can be difficult to collect and interpret. 3. Although per capita GDP is not a direct measure of well-being, it can be used as a proxy for direct measures. The wealthiest countries have per capita incomes over 10 times higher than the poorest. E. FYI: Who Wins at the Olympics? 1. When the Olympics end, commentators use the number of medals each nation takes as a measure of success. 2. In studying the determinants of success at the Olympics, two economists have found that the level of total GDP ****tters. It does not ****tter if the high total comes from a high level of GDP per person or from a large population. 3. In addition to GDP, two other factors influence the number of medals won. a. The host country usually earns extra medals. b. The former communist countries of Eastern Europe earn more medals than other countries with similar levels of GDP. SOLUTIONS TO TEXT PROBLEMS: Quick Quizzes: 1. Gross domestic product measures two things at once: (1) the total income of everyone in the economy and (2) the total expenditure on the economy’s output of final goods and services. It can measure both of these things at once because all expenditure in the economy ends up as someone’s income. 2. The production of a pound of caviar contributes more to GDP than the production of a pound of hamburger because the contribution to GDP is measured by ****rket value and the price of a pound of caviar is much higher than the price of a pound of hamburger. 3. The four components of expenditure are: (1) consumption; (2) investment; (3) government purchases; and (4) net exports. The largest component is consumption, which accounts for more than two-thirds of total expenditure. 4. Real GDP is the production of goods and services valued at constant prices. Nominal GDP is the production of goods and services valued at current prices. Real GDP is a better measure of economic well-being because changes in real GDP reflect changes in the amount of output being produced. Thus, a rise in real GDP means people have produced more goods and services, but a rise in nominal GDP could occur either because of increased production or because of higher prices. 5. Although GDP is not a perfect measure of well-being, policy****kers should care about it because a larger GDP means that a nation can afford better healthcare, better educational systems, and more of the ****terial necessities of life. Questions for Review: 1. An economy's income must equal its expenditure, because every transaction has a buyer and a seller. Thus, expenditure by buyers must equal income by sellers. 2. The production of a luxury car contributes more to GDP than the production of an economy car because the luxury car has a higher ****rket value. 3. The contribution to GDP is $3, the ****rket value of the bread, which is the final good that is sold. 4. The sale of used records does not affect GDP at all because it involves no current production. 5. 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 sale of American wheat to Russia. (Many other examples are possible.) 6. 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. You cannot determine if a rise in nominal GDP has been caused by increased production or higher prices. 7. Nominal GDP Real GDP GDP Deflator Year 100 X $2 = $200 100 X $2 = $200 ($200/$200) X 100 = 100 2010 200 X $3 = $600 200 X $2 = $400 ($600/$400) X 100 = 150 2011 The percentage change in nominal GDP is (600 − 200)/200 x 100 = 200%. The percentage change in real GDP is (400 − 200)/200 x 100 = 100%. The percentage change in the deflator is (150 − 100)/100 x 100 = 50%. 8. 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 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 ****ke 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. a. Consumption increases because a refrigerator is a good purchased by a household. b. Investment increases because a house is an investment good. c. 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. d. Consumption increases because pizza is a good purchased by a household. e. Government purchases increase because the government spent money to provide a good to the public. f. Consumption increases because the bottle is a good purchased by a household, but net exports decrease because the bottle was imported. g. Investment increases because new structures and equipment were built. 2. With transfer payments, nothing is produced, so there is no contribution to GDP. 3. 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. 4. a. Nominal GDP for each year is found in the following table: Year Nominal GDP 1 P1**** 2 P2**** 3 P3**** b. Real GDP for each year is found in the following table: Year Real GDP 1 P1**** 2 P1**** 3 P1**** c. The GDP deflator for each year is found in the following table: Year GDP deflator 1 100 2 3 (P2/P1)100 (P3/P1)100 d. Real GDP growth from Year 2 to Year 3 equal to [(**** – ****)/****] × 100 percent. e. The inflation rate as measured by the GDP deflator is [(P3 – P2)/P2] × 100 percent. 5. a. Calculating nominal GDP: 2008: ($1 per qt. of milk  100 qts. milk) + ($2 per qt. of honey  50 qts. honey) = $200 2009: ($1 per qt. of milk  200 qts. milk) + ($2 per qt. of honey  100 qts. honey) = $400 2010: ($2 per qt. of milk  200 qts. milk) + ($4 per qt. of honey  100 qts. honey) = $800 Calculating real GDP (base year 2008): 2008: ($1 per qt. of milk  100 qts. milk) + ($2 per qt. of honey  50 qts. honey) = $200 2009: ($1 per qt. of milk  200 qts. milk) + ($2 per qt. of honey  100 qts. honey) = $400 2010: ($1 per qt. of milk  200 qts. milk) + ($2 per qt. of honey  100 qts. honey) = $400 Calculating the GDP deflator: 2008: ($200/$200)  100 = 100 2009: ($400/$400)  100 = 100 2010: ($800/$400)  100 = 200 b. Calculating the percentage change in nominal GDP: Percentage change in nominal GDP in 2009 = [($400 − $200)/$200]  100 = 100%. Percentage change in nominal GDP in 2010 = [($800 − $400)/$400]  100 = 100%. Calculating the percentage change in real GDP: Percentage change in real GDP in 2009 = [($400 − $200)/$200]  100 = 100%. Percentage change in real GDP in 2010 = [($400 − $400)/$400]  100 = 0%. Calculating the percentage change in GDP deflator: Percentage change in the GDP deflator in 2009 = [(100 − 100)/100]  100 = 0%. Percentage change in the GDP deflator in 2010 = [(200 − 100 output levels did not change from 2009 to 2010. This means that the percentage change in real GDP is zero.)/100]  100 = 100%. Prices did not change from 2008 to 2009. Thus, the percentage change in the GDP deflator is zero. Likewise, c. Economic well-being rose more in 2008 than in 2009, since real GDP rose in 2009 but not in 2010. In 2009, real GDP rose but prices did not. In 2010, real GDP did not rise but prices did. 6. Year Nominal GDP GDP Deflator (base (billions) year: 1996) 2000 $9,873 118 1999 $9,269 113 a. The growth rate of nominal GDP is ($9,873 − $9,269)/$9,269  100% = 6.5%. b. The growth rate of the deflator is (118 − 113)/113  100% = 4.4%. c. Real GDP in 1999 (in 1996 dollars) is $9,269/(113/100) = $8,203. d. Real GDP in 2000 (in 1996 dollars) is $9,873/(118/100) = $8,367. e. The growth rate of real GDP is ($8,367 − $8,203)/$8,203  100% = 2.0%. f. The growth rate of nominal GDP is higher than the growth rate of real GDP because of inflation. 7. Many answers are possible. 8. a. GDP is the ****rket value of the final good sold, $180. b. Value added for the farmer: $100. Value added for the miller: $150 – $100 = $50. Value added for the baker: $180 – $150 = $30. c. Together, the value added for the three producers is $100 + $50 + $30 = $180. This is the value of GDP. 9. 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 the United States will differ by more than their comparative economic well-being. 10. a. The increased labor-force participation of women has increased GDP in the United States, because it means more people are working and production has increased. 24b. If our measure of well-being included time spent working in the home and taking leisure, it would not rise as much as GDP, because the rise in women's labor-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 labor-force participation include increased self-esteem and prestige for women in the workforce, especially at ****nagerial 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. 11. a. GDP equals the dollar amount Barry collects, which is $400. b. NNP = GDP – depreciation = $400 − $50 = $350. c. National income = NNP − sales taxes = $350 − $30 = $320. d. Personal income = national income − retained earnings = $320 − $100 = $220. e. Disposable personal income = personal income − personal income tax = $220 − $70 = $150. MEASURING THE COST OF LIVING WHAT’S NEW IN THE FIFTH EDITION: There are no ****jor changes to this chapter. LEARNING O****ECTIVES: By the end of this chapter, students should understand:  how the consumer price index (CPI) is constructed.  why the CPI is an imperfect measure of the cost of living.  how to compare the CPI and the GDP deflator as measures of the overall price level.  how to use a price index to compare dollar figures from different times.  the distinction between real and nominal interest rates. CONTEXT AND PURPOSE: Chapter 24 is the second chapter of a two-chapter sequence that deals with how economists measure output and prices in the ****croeconomy. Chapter 23 addressed how economists measure output. Chapter 24 develops how economists measure the overall price level in the ****croeconomy. The purpose of Chapter 24 is twofold: first, to show students how to generate a price index and, second, to teach them how to employ a price index to compare dollar figures from different points in time and to adjust interest rates for inflation. In addition, students will learn some of the shortcomings of using the consumer price index as a measure of the cost of living. KEY POINTS:  The consumer price index (CPI) shows the cost of a basket of goods and services relative to the cost of the same basket in the base year. The index is used to measure the overall level of prices in the economy. The percentage change in the consumer price index measures the inflation rate.  The consumer price index is an imperfect measure of the cost of living for three reasons. First, it does not take into account consumers’ ability to substitute toward goods that become relatively cheaper over time. Second, it does not take into account increases in the purchasing power of the dollar due to the introduction of new goods. Third, it is distorted by unmeasured changes in the quality of goods and services. Because of these measurement problems, the CPI overstates annual inflation by about one percentage point.  Like the consumer price index, the GDP deflator also measures the overall level of prices in the economy. Although the two price indexes usually move together, there are important differences. The GDP deflator differs from the CPI because it includes goods and services produced rather than goods and services consumed. As a result, imported goods affect the consumer price index but not the GDP deflator. In addition, while the consumer price index uses a fixed basket of goods, the GDP deflator auto****tically changes the group of goods and services over time as the composition of GDP changes.  Dollar figures from different times do not represent a valid comparison of purchasing power. To compare a dollar figure from the past to a dollar figure today, the older figure should be inflated using a price index.  Various laws and private contracts use price indexes to correct for the effects of inflation. The tax laws, however, are only partially indexed for inflation.  A correction for inflation is especially important when looking at data on interest rates. The nominal interest rate is the interest rate usually reported; it is the rate at which the number of dollars in a savings account increases over time. By contrast, the real interest rate takes into account changes in the value of the dollar over time. The real interest rate equals the nominal interest rate minus the rate of inflation. CHAPTER OUTLINE: I. The Consumer Price Index A. Definition of consumer price index (CPI): a measure of the overall cost of the goods and services bought by a typical consumer. B. How the Consumer Price Index Is Calculated Table 1 1. Fix the basket. a. The Bureau of Labor Statistics uses surveys to determine a representative bundle of goods and services purchased by a typical consumer. b. Example: 4 hot dogs and 2 hamburgers. 2. Find the prices. a. Prices for each of the goods and services in the basket must be determined for each time period. b. Example: Year Price of Price of Hot Dogs Hamburgers 2008 2009 $1 $2 2010 $2 $3 $3 $4 3. Compute the basket’s cost. a. By keeping the basket the same, only prices are being allowed to change. This allows us to isolate the effects of price changes over time. ALTERNATIVbE. CELxAaSmSpRleO:OM EXAMPLE: Using the example from Chapter 23:Cost in 2008 = ($1 × 4) + ($2 × 2) = $8. 1. Fix the basket: 3 footballs and 4Cboasstkientb2a0l0ls9. = ($2 × 4) + ($3 × 2) = $14. Cost in 2010 = ($3 × 4) + ($4 × 2) = $20. 2. Find the prices: IotftiesnvhearvyeiamYYepdeaioafrrfrit1caunltt that srPteurcdirceeeanottisf$n1guF0notdhoeetrbssatteallpnssdtahkoewnPitrnoiccmelaaoskfse$Bw1taih2tsehksoeeuttbctaahlleclsuinlasttirouncst.orS’tsuhdeelnpt.s Year 2 time 12 15 Year 3 14 18 3. Compute the Cost of the Basket: Cost in Year 1 = (3 × $10) + (4 × $12) = $78 Cost in Year 2 = (3 × $12) + (4 × $15) = $96 Cost in Year 3 = (3 × $14) + (4 × $18) = $**** 4. Using Year 1 as the base year, compute the index: CPI in Year 1 = ($78/$78) × 100 = 1 × 100 = 100 CPI in Year 2 = ($96/$78) × 100 = 1.2308 × 100 = 123.08 CPI in Year 3 = ($****/$78) × 100 = 1.4615 × 100 = 146.15 5. Compute the inflation rate: Inflation rate for Year 2 = [(123.08 – 100)/100] × 100% = 23.08% Inflation rate for Year 3 = [(146.15 – 123.08)/123.08] × 100% = 18.74% Activity 1— Create a Student Price Index Type: Take-home assignment Topics: Consumer price index Class limitations: Works in any size class Purpose This assignment gives students a practical look at how price indices are measured. It also establishes base prices for calculating inflation rates later in the term. Instructions The students should pick real transaction prices for goods they actually purchase. If the indices will be used to calculate inflation rate, they should save a copy of this assignment in a safe place. They should not use prices from catalogs because such prices will not be subject to much change over the semester. Points for Discussion This assignment ****kes a good introduction to a discussion of ****rket basket selection for price indices. The goods that students usually pick for their ****rket basket account for a relatively s****ll portion of consumer spending compared to housing, medical care, transportation, etc. Ask the students which goods are likely to change price frequently. This can be used to introduce problems with the measurement of the consumer price index. Assignment The consumer price index includes the prices of hundreds of goods purchased by consumers. It is possible to construct ****ny other price indexes. Your mission: Create a personalized student price index. 1. Choose five (or more) different products. — be specific e.g., unleaded gasoline, Budweiser beer 2. Pick a quantity for each product. This will be your ****rket basket. — e.g., 15 gallons gasoline, 12 pack of Budweiser 3. Find the actual price for each product. 4. Calculate the total cost of buying these products. At the end of the semester, have students find the prices for these same five products and recalculate the cost of their ****rket basket. Then, have them calculate their SPI (Student Price Index) and the rate of inflation. 4. Choose a base year and compute the index. a. The base year is the bench****rk against which other years are compared. b. The formula for calculating the price index is: CPI = �cost of basket in current year ��ᄡ 100 � � � cost of basket in base year c. Example (using 2008 as the base year): CPI for 2008 = ($8)/($8) × 100 = 100. CPI for 2009 = ($14)/($8) × 100 = 175. CPI for 2010 = ($20)/($8) × 100 = 250. Point out that the CPI must be equal to 100 in the base year. 5. Compute the inflation rate. a. Definition of inflation rate: the percentage change in the price index from the preceding period. Make sure that you explain that inflation does not mean that the prices of all goods in the economy are rising. Inflation means that prices on average are rising. In fact, the prices of ****ny electronic goods (such as computers and DVD players) have fallen in recent years. b. The formula used to calculate the inflation rate is: inflation rate = �CPI Year 2 - CPI Year 1 � 100% � CPIYear 1 �ᄡ � � c. Example: Inflation Rate for 2009 = (175 – 100)/100 × 100% = 75%. Inflation Rate for 2010 = (250 – 175)/175 × 100% = 43%. Be sure to point out to students that it is possible for the CPI to fall if deflation is present. Point out to students that, even though they have not experienced deflation in their lifetimes, it has occurred during several periods of U.S. history (especially during the Great Depression). C. The Producer Price Index 1. Definition of producer price index (PPI): a measure of the cost of a basket of goods and services bought by firms. 2. Because firms eventually pass on higher costs to consumers in the form of higher prices on products, the producer price index is believed to be useful in predicting changes in the CPI. D. FYI: What Is in the CPI’s Basket? Figure 1 1. Figure 1 shows the ****keup of the ****rket basket used to compute the CPI. 2. The largest category is housing, which ****kes up 43% of a typical consumer’s budget. One way to highlight this is to draw the pie chart on the board without the category names and let the students decide what goes where. Most likely, they will be surprised by the sizes of recreation and medical care. E. In the News: Accounting for Quality Change 1.When considering how price changes affect consumers’ well-being, it is important to measure changes in the quality of goods and services over time. 2.This is an article from the Wall Street Journal that discusses how the Bureau of Labor Statistics takes product improvements into account when computing the CPI. F. Problems in Measuring the Cost of Living 1. Substitution Bias a. When the price of one good changes, consumers often respond by substituting another good in its place. b. The CPI does not allow for this substitution; it is calculated using a fixed basket of goods and services. c. This implies that the CPI overstates the increase in the cost of living over time. 2. Introduction of New Goods a. When a new good is introduced, consumers have a wider variety of goods and services to choose from. b. This ****kes every dollar more valuable, which lowers the cost of ****intaining the same level of economic well-being. c. Because the ****rket basket is not revised often enough, these new goods are left out of the bundle of goods and services included in the basket. 3. Unmeasured Quality Change a. If the quality of a good falls from one year to the next, the value of a dollar falls; if quality rises, the value of the dollar rises. b. Attempts are ****de to correct prices for changes in quality, but it is often difficult to do so because quality is hard to measure. 4. The size of these problems is also difficult to measure. 5. Most stu****s indicate that the CPI overstates the rate of inflation by approxi****tely one percentage point per year. 6. The issue is important because ****ny government transfer programs (such as Social Security) are tied to increases in the CPI. G. The GDP Deflator versus the Consumer Price Index 1. The GDP deflator reflects the prices of all goods produced domestically, while the CPI reflects the prices of all goods bought by consumers. Figure 2 2. The CPI compares the prices of a fixed basket of goods over time, while the GDP deflator compares the prices of the goods currently produced to the prices of the goods produced in the base year. This means that the group of goods and services used to compute the GDP deflator changes auto****tically over time as output changes. 3. Figure 2 shows the inflation rate as measured by both the CPI and the GDP deflator. II. Correcting Economic Variables for the Effects of Inflation A. Dollar Figures from Different Times 1. To change dollar values from one year to the next, we can use this formula: Value in Year 2 dollars = Value in Year 1 dollars ᄡ �Price level in Year 2� ��Price level in Year 1 �� 2. Example: Babe Ruth’s 1931 salary in 2007 dollars: Salary in 2007 dollars = Salary in 1931 dollars × Price level in 2007 Price level in 1931 Salary in 2007 dollars = $80,000 × (207/15.2). Salary in 2007 dollars = $1,089,474. ALTERNATIVE CLASSROOM EXAMPLE: Your father graduated from school and took his first job in 1972, which paid a salary of $7,000. What is this salary worth in 2007 dollars? CPI in 1972 = 41.8 CPI in 2007 = 195 Value in 2007 dollars = 1972 salary × (CPI in 2005/CPI in 1972) Value in 2007 dollars = $7,000 × (207/41.8) = $7,000 × 4.95 = $34,650 3. FYI: Mr. Index Goes to Hollywood a. Reports of box office success are often ****de in terms of the dollar values of ticket sales. b. These ticket sales are then compared with ticket sales of movies in the past. c. However, no correction for changes in the value of a dollar are ****de. Activity 2—You Paid How Much? Type: Take-home assignment Topics: Consumer price index Class limitations: Works in any size class Purpose This assignment gives students a chance to see how much dollar values have changed over time. It also provides them some practice at using the formula to calculate the change in dollar values over time. Instructions Have students ask their parents (or grandparents) how much they paid for their first car and in what year they bought it. (If there are older students in the class, ask them to remember how much they paid for their first car.) Students can then determine how much they would have to pay in current dollars using the consumer price index. B. Indexation 1. Definition of indexation: the auto****tic correction of a dollar amount for the effects of inflation by law or contract. 2. As mentioned above, ****ny government transfer programs use indexation for the benefits. The government also indexes the tax brackets used for federal income tax. 3. There are uses of indexation in the private sector as well. Many labor contracts include cost-of-living allowances (COLAs). C. Real and Nominal Interest Rates Use an example to ****ke the importance of real interest rates clear. Suppose a student has $100 in his savings account earning 3% interest. Ask students what will happen to the purchasing power of that money if prices rise 3% during the year. Then, change the inflation rate to 5% and then 1% and go through the example again. 1. Example: Sally Saver deposits $1,000 into a bank account that pays an annual interest rate of 10%. A year later, she withdraws $1,100. 2. What ****tters to Sally is the purchasing power of her money. a. If there is zero inflation, her purchasing power has risen by 10%. b. If there is 6% inflation, her purchasing power has risen by about 4%. c. If there is 10% inflation, her purchasing power has re****ined the same. d. If there is 12% inflation, her purchasing power has declined by about 2%. e. If there is 2% deflation, her purchasing power has risen by about 12%. 3. Definition of nominal interest rate: the interest rate as usually reported without a correction for the effects of inflation. 4. Definition of real interest rate: the interest rate corrected for the effects of inflation. real interest rate = nominal interest rate - inflation rate 5. Case Study: Interest Rates in the U.S. Economy Figure 3 a. Figure 3 shows real and nominal interest rates from 1965 to the present. b. The nominal interest rate is always greater than the real interest rate in this diagram because there was always inflation during this period. c. Note that in the late 1970s the real interest rate was negative because the inflation rate exceeded the nominal interest rate. SOLUTIONS TO TEXT PROBLEMS: Quick Quizzes 1. The consumer price index measures the overall cost of the goods and services bought by a typical consumer. It is constructed by surveying consumers to determine a basket of goods and services that the typical consumer buys. Prices of these goods and services are used to compute the cost of the basket at different times, and a base year is chosen. To compute the index, we divide the cost of the ****rket basket in the current year by the cost of the ****rket basket in the base year and multiply by 100. 2. Since Henry Ford paid his workers $5 a day in 1914 and the consumer price index was 10 in 1914 and 207 in 2007, then the Ford paycheck was worth $5  207 / 10 = $103.50 a day in 2007 dollars. Questions for Review 1. A 10% increase in the price of chicken has a greater effect on the consumer price index than a 10% increase in the price of caviar because chicken is a bigger part of the average consumer's ****rket basket. 2. The three problems in the consumer price index as a measure of the cost of living are: (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 Navy sub****rine rises, there is no effect on the consumer price index, because Navy sub****rines are not consumer goods. But the GDP price index is affected, because Navy sub****rines are included in GDP as a part of government purchases. 4. Because the overall price level doubled, but the price of the candy bar rose sixfold, the real price (the price adjusted for inflation) of the candy bar tripled. 5. 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. Problems and Applications 1. a. Find the price of each good in each year: Year Cauliflower Broccoli Carrots 2008 $2 $1.50 $0.10 2009 $3 $1.50 $0.20 b. If 2008 is the base year, the ****rket basket used to compute the CPI is 100 heads of cauliflower, 50 bunches of broccoli, and 500 carrots. We must now calculate the cost of the ****rket basket in each year: 2008: (100 x $2) + (50 x $1.50) + (500 x $.10) = $325 2009: (100 x $3) + (50 x $1.50) + (500 x $.20) = $475 Then, using 2008 as the base year, we can compute the CPI in each year: 2008: $325/$325 x 100 = 100 2009: $475/$325 x 100 = 146 c. We can use the CPI to compute the inflation rate for 2009: (146 − 100)/100 x 100% = 46% 2. Many answers are possible. 3. a. The percentage change in the price of tennis balls is (2 – 2)/2 × 100% = 0%. The percentage change in the price of golf balls is (6 – 4)/4 × 100% = 50%. The percentage change in the price of Gatorade is (2 – 1)/1 × 100% = 100%. b. The cost of the ****rket basket in 2009 is ($2 × 100) + ($4 × 100) + ($1 × 200) = $200 + $400 + $200 = $800. The cost of the ****rket basket in 2010 is ($2 × 100) + ($6 × 100) + ($2 × 200) = $200 + $600 + $400 = $1,200. The percentage change in the cost of the ****rket basket from 2009 to 2010 is (1,200 – 800)/800 × 100% = 50%. c. This would lower my esti****tion of the inflation rate because the value of a bottle of Gatorade is now greater than before. The comparison should be ****de on a per-ounce basis. d. More flavors enhance consumers’ well-being. Thus, this would be considered a change in quality and would also lower my esti****te of the inflation rate. 4. a. The cost of the ****rket basket in 2009 is (1 × $40) + (3 × $10) = $40 + $30 = $70. The cost of the ****rket basket in 2010 is (1 × $60) + (3 × $12) = $60 + $36 = $96. Using 2009 as the base year, we can compute the CPI in each year: 2009: $70/$70 x 100 = 100 20109: $96/$70 x 100 = 137.14 We can use the CPI to compute the inflation rate for 2010: (137.14 − 100)/100 x 100% = 37.14% b. Nominal GDP for 2009 = (10 × $40) + (30 × $10) = $400 + $300 = $700. Nominal GDP for 2010 = (12 × $60) + (50 × $12) = $720 + $600 = $1,320. Real GDP for 2009 = (10 × $40) + (30 × $10) = $400 + $300 = $700. Real GDP for 2010 = (12 × $40) + (50 × $10) = $480 + $500 = $980. The GDP deflator for 2009 = (700/700) × 100 = 100. The GDP deflator for 2010 = (1,320/980) × 100 = 134.69. The rate of inflation for 2010 = (134.69 – 100)/100 × 100% = 34.69%. c. No, it is not the same. The rate of inflation calculated by the CPI holds the basket of goods and services constant, while the GDP deflator allows it to change. 5. a. Because the increase in cost was considered a quality improvement, there was no increase registered in the CPI. b. The argument in favor of this is that consumers are getting a better good than before, so the price increase equals the improvement in quality. The problem is that the increased cost might exceed the value of the improvement in air quality, so consumers are worse off. In this case, it would be better for the CPI to at least partially reflect the higher cost. 6. a. introduction of new goods; b. unmeasured quality change; c. substitution bias; d. unmeasured quality change; e. substitution bias 7. a. ($0.75 − $0.15)/$0.15 x 100% = 400%. b. ($14.32 − $3.23)/$3.23 x 100% = 343%. c. In 1970: $0.15/($3.23/60) = 2.8 minutes. In 2000: $0.75/($14.32/60) = 3.1 minutes. d. Workers' purchasing power fell in terms of newspapers. 8. a. If the elderly consume the same ****rket basket as other people, Social Security would provide the elderly with an improvement in their standard of living each year because the CPI overstates inflation and Social Security payments are tied to the CPI. b. Because the elderly consume more health care than younger people do, and because health care costs have risen faster than overall inflation, it is possible that the elderly are worse off. To investigate this, you would need to put together a ****rket basket for the elderly, which would have a higher weight on health care. You would then compare the rise in the cost of the "elderly" basket with that of the general basket for CPI. 9. In deciding how much income to save for retirement, workers should consider the real interest rate, because they care about their purchasing power in the future, not the number of dollars they will have. 10. a. When inflation is higher than was expected, the real interest rate is lower than expected. For example, suppose the ****rket equilibrium has an expected real interest rate of 3% and people expect inflation to be 4%, so the nominal interest rate is 7%. If inflation turns out to be 5%, the real interest rate is 7% minus 5% equals 2%, which is less than the 3% that was expected. b. Because 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. 25c. Homeowners in the 1970s who had fixed-rate mortgages from the 1960s benefited from the unexpected inflation, while the banks that ****de the mortgage loans were harmed. PRODUCTION AND GROWTH WHAT’S NEW IN THE FIFTH EDITION: There are two new In the News boxes on “Measuring Capital” and “Escape from Malthus.” LEARNING O****ECTIVES: By the end of this chapter, students should understand:  how much economic growth differs around the world.  why productivity is the key determinant of a country’s standard of living.  the factors that determine a country’s productivity.  how a country’s policies influence its productivity growth. CONTEXT AND PURPOSE: Chapter 25 is the first chapter in a four-chapter sequence on the production of output in the long run. Chapter 25 addresses the determinants of the level and growth rate of output. We find that capital and labor are among the pri****ry determinants of output. In Chapter 26, we address how saving and investment in capital goods affect the production of output, and in Chapter 27, we learn about some of the tools people and firms use when choosing capital projects in which to invest. In Chapter 28, we address the ****rket for labor. The purpose of Chapter 25 is to examine the long-run determinants of both the level and the growth rate of real GDP per person. Along the way, we will discover the factors that determine the productivity of workers and address what governments might do to improve the productivity of their citizens. KEY POINTS:  Economic prosperity, as measured by GDP per person, varies substantially around the world. The average income in the world’s richest countries is more than ten times that in the world’s poorest countries. Because growth rates of real GDP also vary substantially, the relative positions of countries can change dra****tically over time.  The standard of living in an economy depends on the economy’s ability to produce goods and services. Productivity, in turn, depends on the amounts of physical capital, hu****n capital, natural resources, and technological knowledge available to workers.  Government policies can try to influence the economy’s growth rate in ****ny ways: encouraging saving and investment, encouraging investment from abroad, fostering education, promoting good health, ****intaining property rights and political stability, allowing free trade, and promoting the research and development of new technologies.  The accumulation of capital is subject to diminishing returns: The more capital an economy has, the less additional output the economy gets from an extra unit of capital. As a result, while higher saving leads to higher growth for a period of time, growth eventually slows down as the economy approaches a higher level of capital, productivity, and income. Also because of diminishing returns, the return to capital is especially high in poor countries. Other things being equal, these countries can grow faster because of the catch-up effect.  Population growth has a variety of effects on economic growth. On the one hand, more rapid population growth ****y lower productivity by stretching the supply of natural resources and by reducing the amount of capital available for each worker. On the other hand, a larger population ****y enhance the rate of technological progress because there are more scientists and engineers. CHAPTER OUTLINE: I. Economic Growth Around the World Table 1 A. Table 1 shows data on real GDP per person for 13 countries during different periods of time. 1. The data reveal the fact that living standards vary a great deal between these countries. 2. Growth rates are also reported in the table. Japan has had the largest growth rate over time, 2.76% per year (on average). Use Table 1 to ****ke the point that a one-percentage point change in a country’s growth rate can ****ke a significant difference over several generations. The powerful effects of compounding should be used to underscore the process of economic growth. 3. Because of different growth rates, the ranking of countries by income per person changes over time. a. In the late 19th century, the United Kingdom was the richest country in the world. b. Today, income per person is lower in the United Kingdom than in the United States and Canada (two former colonies of the United Kingdom). B. FYI: Are You Richer Than the Richest American? 1. According to the ****gazine American Heritage, the richest American of all time is John B. Rockefeller, whose wealth today would be the equivalent of $200 billion. 2. Yet, because Rockefeller lived from 1839 to 1937, he did not get the chance to enjoy ****ny of the conveniences we take for granted today such as television and air conditioning. 3. Thus, because of technological advances, the average American today ****y enjoy a “richer” life than the richest American who lived a century ago. C. FYI: A Picture Is Worth a Thousand Statistics 1. This box presents three photos showing a typical family in three countries – the United Kingdom, Mexico, and Mali. Each family was photographed outside their home, together with all of their ****terial possessions. 2. These photos demonstrate the vast difference in the standards of living in these countries. II. Productivity: Its Role and Determinants A. Why Productivity Is So Important 1. Example: Robinson Crusoe a. Because he is stranded alone, he must catch his own fish, grow his own vegetables, and ****ke his own clothes. b. His standard of living depends on his ability to produce goods and services. 2. Definition of productivity: the amount of goods and services a worker produces in each hour of work. 3. Review of Principle #8: A Country’s Standard of Living Depends on Its Ability to Produce Goods and Services. B. How Productivity Is Determined 1. Physical Capital per Worker a. Definition of physical capital: the stock of equipment and structures that are used to produce goods and services. b. Example: Crusoe will catch more fish if he has more fishing poles. 2. Hu****n Capital per Worker a. Definition of hu****n capital: the knowledge and skills that workers acquire through education, training, and experience. b. Example: Crusoe will catch more fish if he has been trained in the best fishing techniques. 3. Natural Resources per Worker a. Definition of natural resources: the inputs into the production of goods and services that are provided by nature, such as land, rivers, and mineral deposits. b. Example: Crusoe will have better luck catching fish if there is a plentiful supply around his island. 4. Technological Knowledge a. Definition of technological knowledge: society’s understanding of the best ways to produce goods and services. b. Example: Crusoe will catch more fish if he has invented a better fishing lure. c. Case Study: Are Natural Resources a Limit to Growth? This section points out that as the population has grown over time, we have discovered ways to lower our use of natural resources. Thus, most economists are not worried about shortages of natural resources. C. FYI: The Production Function 1. A production function describes the relationship between the quantity of inputs used in production and the quantity of output from production. 2. The production function generally is written like this: Y = A F(L, K, H, N) where Y = output, L = quantity of labor, K = quantity of physical capital, H = quantity of hu****n capital, N = quantity of natural resources, A reflects the available production technology, and F () is a function that shows how inputs are combined to produce output. 3. Many production functions have a property called constant returns to scale. a. This property implies that as all inputs are doubled, output will exactly double. b. This implies that the following must be true: xY = A F(xL, xK, xH, xN) where x = 2 if inputs are doubled. c. This also means that if we want to examine output per worker we could set x = 1/L and we would get the following: Y/L = A F(1, K/L, H/L, N/L) This shows that output per worker depends on the amount of physical capital per worker (K /L), the amount of hu****n capital per worker (H /L), and the amount of natural resources per worker (N /L). D. In the News: Measuring Capital 1. The concept of “capital” is sometimes interpreted broadly. 2. This is an article from the Wall Street Journal describing differences in “intangible wealth” across countries. III. Economic Growth and Public Policy Start out by asking students what factors they believe will lead to greater economic growth in the future. A. Saving and Investment 1. Because capital is a produced factor of production, a society can change the amount of capital that it has. 2. However, there is an opportunity cost of doing so; if resources are used to produce capital goods, fewer goods and services are produced for current consumption. B. Diminishing Returns and the Catch-Up Effect 1. Definition of diminishing returns: the property whereby the benefit from an extra unit of an input declines as the quantity of the input increases. Figure 1 a. As the capital stock rises, the extra output produced from an additional unit of capital will fall. b. This can be seen in Figure 1, which shows how the amount of capital per worker determines the amount of output per worker, holding constant all other determinants of output. c. Thus, if workers already have a large amount of capital to work with, giving them an additional unit of capital will not increase their productivity by much. d. In the long run, a higher saving rate leads to a higher level of productivity and income, but not to higher growth rates in these variables. 2. An important implication of diminishing returns is the catch-up effect. a. Definition of catch-up effect: the property whereby countries that start off poor tend to grow more rapidly than countries that start off rich. b. When workers have very little capital to begin with, an additional unit of capital will increase their productivity by a great deal. C. Investment from Abroad 1. Saving by domestic residents is not the only way for a country to invest in new capital. 2. Investment in the country by foreigners can also occur. a. Foreign direct investment occurs when a capital investment is owned and operated by a foreign entity. b. Foreign portfolio investment occurs when a capital investment is financed with foreign money but operated by domestic residents. 3. Some of the benefits of foreign investment flow back to foreign owners. But the economy still experiences an increase in the capital stock, which leads to higher productivity and higher wages. 4. The World Bank is an organization that tries to encourage the flow of investment to poor countries. a. The World Bank obtains funds from developed countries such as the United States and ****kes loans to less-developed countries so that they can invest in roads, sewer systems, schools, and other types of capital. b. The World Bank also offers these countries advice on how best to use these funds. D. Education 1. Investment in hu****n capital also has an opportunity cost. a. When students are in class, they cannot be producing goods and services for consumption. b. In less-developed countries, this opportunity cost is considered to be high; as a result, children often drop out of school at a young age. 2. Because there are positive externalities in education, the effect of lower education on the economic growth rate of a country can be large. 3. Many poor countries also face a “brain drain”—the best educated often leave to go to other countries where they can enjoy a higher standard of living. 4. In the News: Promoting Hu****n Capital a. Hu****n capital is a key to economic growth. b. This is an article that describes how some developing countries now give parents an immediate financial incentive to keep their children in school. E. Health and Nutrition 1. Hu****n capital can also be used to describe another type of investment in people: expenditures that lead to a healthier population. 2. Other things being equal, healthier workers are more productive. 3. Making the right investments in the health of the population is one way for a nation to increase productivity. F. Property Rights and Political Stability 1. Protection of property rights and promotion of political stability are two other important ways that policy****kers can improve economic growth. 2. There is little incentive to produce products if there is no guarantee that they cannot be taken. Contracts must also be enforced. 3. Countries with questionable enforcement of property rights or an unstable political cli****te will also have difficulty in attracting foreign (or even domestic) investment. G. Free Trade 1. Some countries have tried to achieve faster economic growth by avoiding transacting with the rest of the world. 2. However, trade allows a country to specialize in what it does best and thus consume beyond its production possibilities. 3. When a country trades wheat for steel, it is as well off as it would be if it had developed a new technology for turning wheat into steel. 4. The amount a nation trades is determined not only by government policy but also by geography. a. Countries with good, natural seaports find trade easier than countries without this resource. b. Countries with more than 80 percent of their population living within 100 kilometers of a coast have an average GDP per person that is four times as large as countries with 20 percent of their population living near a coast. H. Research and Development 1. The pri****ry reason why living standards have improved over time has been due to large increases in technological knowledge. 2. Knowledge can be considered a public good. 3. The U.S. government promotes the creation of new technological infor****tion by providing research grants and providing tax incentives for firms engaged in research. 4. The patent system also encourages research by granting an inventor the exclusive right to produce the product for a specified number of years. I. Population Growth 1. Stretching Natural Resources a. Tho****s Malthus (an English minister and early economic thinker) argued that an ever-increasing population meant that the world was doomed to live in poverty forever. b. However, he failed to understand that new ideas would be developed to increase the production of food and other goods, including pesticides, fertilizers, mechanized equipment, and new crop varieties. c. In the News: Escape from Malthus –This is an article from the New York Times describing the impact the Industrial Revolution had on England’s economy. 2. Diluting the Capital Stock a. High population growth reduces GDP per worker because rapid growth in the number of workers forces the capital stock to be spread more thinly. b. Countries with a high population growth have large numbers of school-age children, placing a burden on the education system. 3. Some countries have already instituted measures to reduce population growth rates. 4. Policies that foster equal treatment for women should raise economic opportunities for women leading to lower rates of population. 5. Promoting Technological Progress a. Some economists have suggested that population growth has driven technological progress and economic prosperity. b. In a 1993 journal article, economist Michael Kremer provided evidence that increases in population lead to technological progress. Start a class discussion of the trade-offs that are necessary to sustain economic growth. Point out that current consumption must be forgone for higher consumption in the future. Ask students to examine the trade-offs involved with each of the public policies discussed. SOLUTIONS TO TEXT PROBLEMS: Quick Quizzes 1. The approxi****te growth rate of real GDP per person in the United States is 1.83 percent (based on Table 1) from 1870 to 2006. Countries that have had faster growth include Japan, Brazil, Mexico, China, Ger****ny, Canada, and Argentina; countries that have had slower growth include India, United Kingdom, Indonesia, Pakistan, and Bangladesh. 2. The four determinants of a country’s productivity are: (1) physical capital, which is the stock of equipment and structures that are used to produce goods and services; (2) hu****n 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, such as land, rivers, and mineral deposits; and (4) technological knowledge, which is society’s understanding of the best ways to produce goods and services. 3. Ways in which a government policy****ker can try to raise the growth in living standards in a society include: (1) investing more current resources in the production of capital, which has the drawback of reducing the resources used for producing current consumption; (2) encouraging investment from abroad, which has the drawback that some of the benefits of investment flow to foreigners; (3) increasing education, which has an opportunity cost in that students are not engaged in current production; (4) protecting property rights and promoting political stability, for which no drawbacks are obvious; (5) pursuing outward- oriented policies to encourage free trade, which ****y have the drawback of ****king a country more dependent on its trading partners; (6) reducing the rate of population growth, which ****y have the drawbacks of reducing individual **** and lowering the rate of technological progress; and (7) encouraging research and development, which (like investment) ****y have the drawback of reducing current consumption. Questions for Review 1. 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 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, because the level of GDP is a measure of prosperity. 2. The 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) hu****n capital, which consists of 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. A college degree is a form of hu****n capital. The skills learned in earning a college degree increase a worker's productivity. 4. 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 policy****ker 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. A higher rate of saving leads to a higher growth rate temporarily, not per****nently. 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 ****y take several decades. 6. 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 countries to consume more goods and services. 7. The higher the rate of population growth, the lower is the level of GDP per person because there's less capital per person, hence lower productivity. 8. The U.S. government tries to encourage advances in technological knowledge by providing research grants through the National Science Foundation and the National Institute of Health, with tax breaks for firms engaging in research and development, and through the patent system. Problems and Applications 1. The facts that countries import ****ny 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 ****ny goods and services, then trading them for goods and services produced in other countries, a nation ****ximizes its standard of living. 2. a. More investment would lead to faster economic growth in the short run. b. The change would benefit ****ny 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 group would have to reduce their spending for some time so that investment could rise. 3. 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. Education can be considered as both consumption and investment. 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. Government spending on health programs is an investment in hu****n capital. This is truer for spending on health programs for the young rather than those for the elderly. 4. The opportunity cost of investing in capital is the loss of consumption that results from redirecting resources toward investment. Over-investment in capital is possible because of diminishing ****rginal returns. A country can "over-invest" in capital if people would prefer to have higher consumption spending and less future growth. The opportunity cost of investing in hu****n capital is also the loss of consumption that is needed to provide the resources for investment. A country could "over-invest" in hu****n capital if people were too highly educated for the jobs they could getfor example, if the best job a Ph.D. in philosophy could find is ****naging a restaurant. 5. a. When a Ger****n firm opens a factory in South Carolina, it represents foreign direct investment. b. The investment increases U.S. GDP because it increases production in the United States. The effect on U.S. GNP would be s****ller because the owners would get paid a return on their investment that would be part of Ger****n GNP rather than U.S. GNP. 6. a. The United States benefited from the Chinese and Japanese investment because it ****de our capital stock larger, increasing our economic growth. b. It would have been better for the United States to ****ke the investments itself because then it would have received the returns on the investment itself, instead of the returns going to China and Japan. 7. Greater educational opportunities for women could lead to faster economic growth in these developing countries because increased hu****n capital would increase productivity and there would be external effects from greater knowledge in the country. Second, increased educational opportunities for young women ****y lower the population growth rate because such opportunities raise the opportunity cost of having a child. 8. a. Individuals with higher incomes have better access to clean water, medical care, and good nutrition. b. Healthier individuals are likely to be more productive. c. Understanding the direction of causation will help policy****kers place proper emphasis on the programs that will achieve both greater health and higher incomes. 9. a. Political stability could lead to strong economic growth by ****king the country attractive to investors. The increased investment would raise economic growth. b. Strong economic growth could lead to political stability because when people have high incomes they tend to be satisfied with the political system and are less likely to overthrow or change the government. 10. a. If output is rising and the number of workers is declining, then output per worker must be rising. b. Policy****kers should not be concerned as long as output in the ****nufacturing sector is not declining. The reduction in ****nufacturing jobs will allow labor resources to move to other industries, increasing total output in the economy. An increase in productivity of workers (as measured by output per worker) is beneficial to the economy. 26 S****ING, INVESTMENT, AND THE FINANCIAL SYSTEM WHAT’S NEW IN THE FIFTH EDITION: There is added clarification on the budget deficit and how it affects the supply of loanable funds. There is also a new In the News feature: “In Praise of Misers.” LEARNING O****ECTIVES: By the end of this chapter, students should understand:  some of the important financial institutions in the U.S. economy.  how the financial system is related to key ****croeconomic variables.  the model of the supply and de****nd for loanable funds in financial ****rkets.  how to use the loanable-funds model to ****yze various government policies.  how government budget deficits affect the U.S. economy. CONTEXT AND PURPOSE: Chapter 26 is the second chapter in a four-chapter sequence on the production of output in the long run. In Chapter 25, we found that capital and labor are among the pri****ry determinants of output. For this reason, Chapter 26 addresses the ****rket for saving and investment in capital, and Chapter 27 addresses the tools people and firms use when choosing capital projects in which to invest. Chapter 28 will address the ****rket for labor. The purpose of Chapter 26 is to show how saving and investment are coordinated by the loanable funds ****rket. Within the framework of the loanable funds ****rket, we are able to see the effects of taxes and government deficits on saving, investment, the accumulation of capital, and ulti****tely, the growth rate of output. KEY POINTS:  The U.S. financial system is ****de up of ****ny types of financial institutions, such as the bond ****rket, the stock ****rket, banks, and mutual funds. All of these institutions act to direct the resources of households that want to save some of their income into the hands of households and firms who want to borrow.  National income accounting identities reveal some important relationships among ****croeconomic variables. In particular, for a closed economy, national saving must equal investment. Financial institutions are the mechanism through which the economy ****tches one person’s saving with another person’s investment.  The interest rate is determined by the supply and de****nd for loanable funds. The supply of loanable funds comes from households who want to save some of their income and lend it out. The de****nd for loanable funds comes from households and firms who want to borrow for investment. To ****yze how any policy or event affects the interest rate, one must consider how it affects the supply and de****nd for loanable funds.  National saving equals private saving plus public saving. A government budget deficit represents negative public saving and, therefore, reduces national saving and the supply of loanable funds available to finance investment. When a government budget deficit crowds out investment, it reduces the growth of productivity and GDP. CHAPTER OUTLINE: I. Definition of financial system: the group of institutions in the economy that help to ****tch one person’s saving with another person’s investment. II. Financial Institutions in the U.S. Economy A. Financial Markets 1. Definition of financial ****rkets: financial institutions through which savers can directly provide funds to borrowers. 2. The Bond Market a. Definition of bond: a certificate of indebtedness. b. A bond identifies the date of ****turity and the rate of interest that will be paid periodically until the loan ****tures. c. One important characteristic that determines a bond’s value is its term. The term is the length of time until the bond ****tures. All else being equal, long- term bonds pay higher rates of interest than short-term bonds. d. Another important characteristic of a bond is its credit risk, which is the probability that the borrower will fail to pay some of the interest or principal. All else being equal, the more risky a bond is, the higher its interest rate. e. A third important characteristic of a bond is its tax treatment. For example, when state and local governments issue bonds (called municipal bonds), the interest income earned by the holders of these bonds is not taxed by the federal government. This ****kes the bonds more attractive, lowering the interest rate needed to entice people to buy them. 3. The Stock Market a. Definition of stock: a claim to partial ownership in a firm. b. The sale of stock to raise money is called equity finance; the sale of bonds to raise money is called debt finance. c. Stocks are sold on organized stock exchanges (such as the New York Stock Exchange or NASDAQ) and the prices of stocks are determined by supply and de****nd. d. The price of a stock generally reflects the perception of a company’s future profitability. e. A stock index is computed as an average of a group of stock prices. f. FYI: Key Numbers for Stock Watchers describes three key numbers that are reported on the financial pages. B. Financial Intermediaries 1. Definition of financial intermediaries: financial institutions through which savers can indirectly provide funds to borrowers. 2. Banks a. The pri****ry role of banks is to take in deposits from people who want to save and then lend them out to others who want to borrow. b. Banks pay depositors interest on their deposits and charge borrowers a slightly higher rate of interest to cover the costs of running the bank and provide the bank owners with some amount of profit. c. Banks also play another important role in the economy by allowing individuals to use checking deposits as a medium of exchange. 3. Mutual Funds a. Definition of mutual fund: an institution that sells shares to the public and uses the proceeds to buy a portfolio of stocks and bonds. b. The pri****ry advantage of a mutual fund is that it allows individuals with s****ll amounts of money to diversify. c. Mutual funds called “index funds” buy all of the stocks of a given stock index. These funds have generally performed better than funds with active fund ****nagers. This ****y be true because they trade stocks less frequently and they do not have to pay the salaries of fund ****nagers. Activity 1 — Create a Portfolio Type: Take-home assignment Topics: Financial ****rkets Class limitations: Works in any size class Purpose This assignment requires students to use the financial pages of the newspaper to create their own portfolio. Many students are unfamiliar with the basic elements of stock and bond tables. This assignment then asks students to ****yze elements that would affect their portfolio. Instructions Ask the students to do the following assignment. Many possible variations exist. It can be worthwhile to have students reevaluate their portfolio at the end of the semester. 1. Assume you have $100,000 in savings. Create a portfolio of securities worth $100,000. Decide what financial instruments you would like to use, then find their current prices in the newspaper. Calculate your holdings of each security based on current prices. 2. What objectives do you have for this portfolio? Was it chosen to ****ximize short-term gains, long-term stability, or some other objective? 3. Explain how each of the following economic events would affect the value of your portfolio: a. an increase or decrease in interest rates b. a recession c. rapid inflation d. a depreciation of the U.S. dollar Common Answers and Points for Discussion Most students pick a mix of common stocks, mutual funds, and bonds. Some choose familiar, low-risk, but low-yielding bank accounts and certificates of deposit. A few ****y choose more sophisticated financial instruments. This can be used to introduce the trade-off between risk and return and the concept of the risk premium. The impact of ****croeconomic events on financial ****rkets usually interests students. Portfolios heavily invested in cyclical stocks will give low returns in the event of recession. Bonds and cash perform poorly with unanticipated inflation. Foreign-denominated assets ****y give high returns if the dollar depreciates. Interest rate changes can cause large swings in the value of bond-heavy portfolios. C. Summing Up 1. There are ****ny financial institutions in the U.S. economy. 2. These institutions all serve the same goal—moving funds from savers to borrowers. III. Saving and Investment in the National Income Accounts Make sure that you work through all of the algebraic steps here. Students will not understand this ****terial if you skip steps. A. Some Important Identities 1. Remember that GDP can be divided up into four components: consumption, investment, government purchases, and net exports. Y = C + I + G + NX 2. We will assume that we are dealing with a closed economy (an economy that does not engage in international trade or international borrowing and lending). This implies that GDP can now be divided into only three components: Y =C +I +G 3. To isolate investment, we can subtract C and G from both sides: Y -C -G =I 4. The left-hand side of this equation (Y – C – G ) is the total income in the economy after paying for consumption and government purchases. This amount is called national saving. 5. Definition of national saving (saving): the total income in the economy that re****ins after paying for consumption and government purchases. 6. Substituting saving (S) into our identity gives us: S =I 7. This equation tells us that saving equals investment. 8. Let’s go back to our definition of national saving once again: S =Y - C - G 9. We can add taxes (T) and subtract taxes (T): S = (Y - C -T ) + (T - G ) 10. The first part of this equation (Y – T – C ) is called private saving; the second part (T – G ) is called public saving. a. Definition of private saving: the income that households have left after paying for taxes and consumption. b. Definition of public saving: the tax revenue that the government has left after paying for its spending. c. Definition of budget surplus: an excess of tax revenue over government spending. d. Definition of budget deficit: a shortfall of tax revenue from government spending. The important point to ****ke here is that with a government budget deficit, public saving is negative and the public sector is thus “dissaving.” To ****ke up for this shortfall, it must go to the loanable funds ****rket and borrow the money. This will reduce the supply of loanable funds available for investment. 11. The fact that S = I means that (for the economy as a whole) saving must be equal to investment. a. The bond ****rket, the stock ****rket, banks, mutual funds, and other financial ****rkets and institutions stand between the two sides of the S = I equation. b. These ****rkets and institutions take in the nation's saving and direct it to the nation's investment. B. The Meaning of Saving and Investment 1. In ****croeconomics, investment refers to the purchase of new capital, such as equipment or buildings. You will have to keep reminding students what the term “investment” means to ****croeconomists. Outside of the economics profession, most people use the terms “saving” and “investing” interchangeably. 2. If an individual spends less than he earns and uses the rest to buy stocks or mutual funds, economists call this saving. IV. The Market for Loanable Funds A. Definition of ****rket for loanable funds: the ****rket in which those who want to save supply funds and those who want to borrow to invest de****nd funds. B. Supply and De****nd for Loanable Funds Figure 1 1. The supply of loanable funds comes from those who spend less than they earn. The supply can occur directly through the purchase of some stock or bonds or indirectly through a financial intermediary. 2. The de****nd for loanable funds comes from households and firms who wish to borrow funds to ****ke investments. Families generally invest in new homes while firms ****y borrow to purchase new equipment or to build factories. 3. The price of a loan is the interest rate. Students will wonder which interest rate is the price of a loan. Explain to them that interest rates in the economy do vary because of the things discussed earlier (term, risk, and tax treatment), but that these interest rates tend to move together when changes in the loanable funds ****rket occur. Thus, it is appropriate to talk of one interest rate. a. All else equal, as the interest rate rises, the quantity of loanable funds supplied will increase. b. All else equal, as the interest rate rises, the quantity of loanable funds de****nded will fall. Make sure that you spend time discussing why the de****nd for loanable funds is downward sloping and why the supply of loanable funds is upward sloping. It is important for students to understand the relationships among the interest rate, saving, and investment. 4. At equilibrium, the quantity of funds de****nded is equal to the quantity of funds supplied. a. If the interest rate in the ****rket is greater than the equilibrium rate, the quantity of funds de****nded would be s****ller than the quantity of funds supplied. Lenders would compete for borrowers, driving the interest rate down. b. If the interest rate in the ****rket is less than the equilibrium rate, the quantity of funds de****nded would be greater than the quantity of funds supplied. The shortage of loanable funds would encourage lenders to raise the interest rate they charge. It is a good idea to remind students that the supply of loanable funds comes from saving and the de****nd for loanable funds comes from investment by putting “(saving)” next to the supply curve and “(investment)” next to the de****nd curve as shown above. 5. The supply and de****nd for loanable funds depends on the real (rather than nominal) interest rate because the real rate reflects the true return to saving and the true cost of borrowing. When examining the next three sections on different policies, encourage students to follow the three-step process developed in Chapter 4. First, determine which curve is affected. Then, decide which way it shifts to determine the effects on the equilibrium interest rate and quantity of funds. C. Policy 1: Saving Incentives Figure 2 1. Savings rates in the United States are relatively low when compared with other countries such as Japan and Ger****ny. 2. Suppose that the government changes the tax code to encourage greater saving. a. This will cause an increase in saving, shifting the supply of loanable funds to the right. b. The equilibrium interest rate will fall and the equilibrium quantity of funds will rise. 3. Thus, the result of the new tax laws would be a decrease in the equilibrium interest rate and greater saving and investment. 4. In the News: In Praise of Misers a. Increased national saving can provide important economic benefits. b. This is an opinion piece by economist Steven Landsburg defending Ebenezer Scrooge. If you would like, now would be a good time to discuss the debate in Chapter 23 concerning whether the tax laws should be reformed to encourage saving. D. Policy 2: Investment Incentives Figure 3 1. Suppose instead that the government passed a new law lowering taxes for any firm building a new factory or buying a new piece of equipment (through the use of an investment tax credit). a. This will cause an increase in investment, causing the de****nd for loanable funds to shift to the right. b. The equilibrium interest rate will rise, and the equilibrium quantity of funds will increase as well. 2. Thus, the result of the new tax laws would be an increase in the equilibrium interest rate and greater saving and investment. Point out that both Policy 1 (a law to increase saving) and Policy 2 (a law to increase investment) each lead to an increase in both saving and investment. the difference between these two policies lies in their effects on the interest rate. E. Policy 3: Government Budget Deficits and Surpluses Figure 4 1. A budget deficit occurs if the government spends more than it receives in tax revenue. 2. This implies that public saving (T – G) falls, which will lower national saving. a. The supply of loanable funds will shift to the left. b. The equilibrium interest rate will rise, and the equilibrium quantity of funds will decrease. 3. When the interest rate rises, the quantity of funds de****nded for investment purposes falls. 4. Definition of crowding out: a decrease in investment that results from government borrowing. 5. When the government reduces national saving by running a budget deficit, the interest rate rises and investment falls. 6. Government budget surpluses work in the opposite way. The supply of loanable funds increases, the equilibrium interest rate falls, and investment rises. Now might be a good time to move to the section in Chapter 23 concerning the debate on whether or not the government should balance its budget. 7. Case Study: The History of U.S. Government Debt Figure 5 a. Figure 5 shows the debt of the U.S. government expressed as a percentage of GDP. In recent years, government debt has been about 30% to 40% of GDP. b. Throughout history, the pri****ry cause of fluctuations in government debt has been wars. However, the U.S. debt also increased substantially during the 1980s when taxes were cut but government spending was not. c. By the late 1990s, the debt-to-GDP ratio began declining due to budget surpluses. d. The debt-to-GDP ratio began rising again during the first few years of the George W. Bush presidency. The causes have been threefold: tax cuts, a recession, and an increase in government spending for the war on terrorism. SOLUTIONS TO TEXT PROBLEMS: Quick Quizzes 1. A stock is a claim to partial ownership in a firm. A bond is a certificate of indebtedness. They are different in numerous ways: (1) a bond pays interest (a fixed payment determined when the bond is issued), while a stock pays dividends (a share of the firm’s profits that can increase if the firm is more profitable); (2) a bond has a fixed time to ****turity, while a stock never ****tures; and (3) if a company that has issued both stock and bonds goes bankrupt, the bondholders get paid off before the stockholders, so stocks have greater risk and potentially greater return than bonds. Stocks and bonds are similar in that both are financial instruments that are used by companies to raise money for investment, both are traded on exchanges, both entail a degree of risk, and the returns to both are taxed (usually). 2. 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. National saving is equal to the total income in the economy that re****ins after paying for consumption and government purchases. Investment is the purchase of new capital, such as equipment or buildings. These terms are related in two ways: (1) National saving is the sum of public saving and private saving.. (2) In a closed economy, national saving equals investment. 3. If more Americans adopted a “live for today” approach to life, they would spend more and save less. This would shift the supply curve to the left in the ****rket for loanable funds. At the new equilibrium, there would be less saving and investment and a higher interest rate. Questions for Review 1. The financial system's role is to help ****tch one person's saving with another person's investment. Two ****rkets that are part of the financial system are the bond ****rket, through which large corporations, the federal government, or state and local governments borrow, and the stock ****rket, through which corporations sell ownership shares. Two financial intermediaries are banks, which take in deposits and use the deposits to ****ke loans, and mutual funds, which sell shares to the public and use the proceeds to buy a portfolio of financial assets. 2. It is important for people who own stocks and bonds to diversify their holdings because then they will have only a s****ll stake in each asset, which reduces risk. Mutual funds ****ke such diversification easy by allowing a s****ll investor to purchase parts of hundreds of different stocks and bonds. 3. 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. Investment refers to the purchase of new capital, such as equipment or buildings. It is equal to national saving. 5. A change in the tax code that might increase private saving is the expansion of eligibility for special accounts that allow people to shelter some of their saving from taxation. This would increase the supply of loanable funds, lower interest rates, and increase investment. 6. A government budget deficit arises when the government spends more than it receives in tax revenue. Because a government budget deficit reduces national saving, it raises interest rates, reduces private investment, and thus reduces economic growth. Problems and Applications 1. a. The bond of an eastern European government would pay a higher interest rate than the bond of the U.S. government because there would be a greater risk of default. b. A bond that repays the principal in 2025 would pay a higher interest rate than a bond that repays the principal in 2005 because it has a longer term to ****turity, 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 the federal government would pay a higher interest rate than a bond issued by New York State because an investor does not have to pay federal income tax on the bond from New York State. 2. The stock ****rket 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 ****rkets, so people know that they can sell their stock if they want to. 3. 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 4. 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. It also gives employees an additional incentive to work hard, knowing that if the firm does well, they will profit. But from an employee’s point of view, owning stock in the company for which she or he works can be risky. The employee’s wages or salary is already tied to how well the firm performs. If the firm has trouble, the employee could be laid off or have her or his 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 your own company is a very risky proposition. Most employees would be better off diversifyingowning stock or bonds in other companiesso their fortunes would not depend so much on the firm for which they work. 5. To a ****croeconomist, saving occurs when a person’s income exceeds his consumption, while investment occurs when a person or firm purchases new capital, such as a house or business equipment. 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 paycheck to buy stock in AT&T, that is saving because your income of $200 is not being spent on consumption goods. c. When your room****te 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 $1,000 from a bank to buy a car to use in your pizza- delivery business, that is investment because the car is a capital good. 6. Given that Y = 8, T = 1.5, Sprivate = 0.5 = Y −T − C, Spublic = 0.2 = T − G. Because Sprivate = Y − T − C, then rearranging gives C = Y − T − Sprivate = 8 − 1.5 − 0.5 = 6. Because Spublic = T − G, then rearranging gives G = T − Spublic = 1.5 − 0.2 = 1.3. Because S = national saving = Sprivate + Spublic = 0.5 + 0.2 = 0.7. Finally, because I = investment = S, I = 0.7. 7. Private saving is equal to (Y – C – T) = 10,000 – 6,000 – 1,500 = 2,500. Public saving is equal to (T – G) = 1,500 – 1,700 = -200. National saving is equal to (Y – C – G) = 10,000 – 6,000 – 1,700 = 2,300. Investment is equal to saving = 2,300. The equilibrium interest rate is found by setting investment equal to 2,300 and solving for r: 3,300 – 100r = 2,300. 100r = 1,000. r = 10 percent. 8. a. If interest rates increase, the costs of borrowing money to build the factory become higher, so the returns from building the new plant ****y not be sufficient to cover the costs. Thus, higher interest rates ****ke it less likely that Intel will build the new factory. b. Even if Intel uses its own funds to finance the factory, the rise in interest rates still ****tters. 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 ****rket 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 ****rket. If interest rates rise, so that bond ****rket returns rise, Intel is again less likely to invest in the factory. Figure 2 9. 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. b. Because 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 is 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 Figure 4 d. The more elastic the de****nd for loanable funds, the flatter the de****nd curve would be, so the interest rate would rise by less and thus national saving would fall by more, as Figure 4 shows. 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. Thus, 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 was 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. This is the case of Ricardian equivalence. 10. If world savings declines at the same time world investment rises, the supply curve of loanable funds shifts to the left and the de****nd curve shifts to the right. Figure 6 illustrates the result. The world interest rate will rise, while the overall effect on the equilibrium quantity of loanable funds is ambiguousit depends on the relative sizes of the shifts of the two curves and on their elasticities. Figure 5 11. 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 after-tax real interest rate, because 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, because, for example, if Ricardian equivalence holds, the decline in the government budget deficit would be ****tched by an equal decline in private saving, so national saving would not increase at all; and (3) how elastic investment is with respect to the interest rate, because if investment is quite inelastic, neither policy will have much of an impact on investment. 27 THE BASIC TOOLS OF FINANCE WHAT’S NEW IN THE FIFTH EDITION: There is a new In the News box on “Neurofinance.” LEARNING O****ECTIVES: By the end of this chapter, students should understand:  the relationship between present value and future value.  the effects of compound growth.  how risk-averse people reduce the risk they face.  how asset prices are determined. CONTEXT AND PURPOSE: Chapter 27 is the third chapter in a four-chapter sequence on the level and growth of output in the long run. In Chapter 25, we discuss how capital and labor are among the pri****ry determinants of output and growth. In Chapter 26, we addressed how saving and investment in capital goods affect the production of output. In Chapter 28, we will show some of the tools people and firms use when choosing capital projects in which to invest. Because both capital and labor are among the pri****ry determinants of output, Chapter 28 will address the ****rket for labor. The purpose of Chapter 27 is to introduce the students to some tools that people use when they participate in financial ****rkets. We will show how people compare different sums of money at different points in time, how they ****nage risk, and how these concepts combine to help determine the value of a financial asset, such as a share of stock. KEY POINTS:  Because savings can earn interest, a sum of money today is more valuable than the same sum of money in the future. A person can compare sums from different times using the concept of present value. The present value of any future sum is the amount that would be needed today, given prevailing interest rates, to produce that future sum.  Because of diminishing ****rginal utility, most people are risk averse. Risk-averse people can reduce risk by buying insurance, diversifying their holdings, and choosing a portfolio with lower risk and lower return.  The value of an asset equals the present value of the cash flows the owner of the share will receive. For a share of stock, cash flows include the stream of dividends and the final share price. According to the efficient ****rkets hypothesis, financial ****rkets process valuable infor****tion rationally, so a stock price always equals the best esti****te of the value of the underlying business. Some economists question the efficient ****rkets hypothesis, however, and believe that irrational psychological factors also influence asset prices. CHAPTER OUTLINE: I. Definition of finance: the field that stu****s how people ****ke decisions regarding the allocation of resources over time and the handling of risk. A. Many of the basic insights of finance are central to understanding how the economy works. B. The tools of finance help us think through some of the decisions that we must ****ke in our lives. II. Present Value: Measuring the Time Value of Money A. Money today is more valuable than the same amount of money in the future. B. Definition of present value: the amount of money today that would be needed to produce, using prevailing interest rates, a given future amount of money. 1. Example: you put $100 in a bank account today. How much will it be worth in N years? 2. Definition of future value: the amount of money in the future that an amount of money today will yield, given prevailing interest rates. a. Definition of compounding: the accumulation of a sum of money in, say, a bank account where the interest earned re****ins in the account to earn additional interest in the future. b. If we invest $100 at an interest rate of 5% for 10 years, the future value will be (1.05)10 × $100 = $163. c. Example: You expect to receive $200 in N years. What is the present value of $200 that will be paid in N years? i) To compute a present value from a future value, we divide by the factor (1 + r)N. ii) If the interest rate is 5% and the $200 will be received 10 years from now, the present value is $200/(1.05)10 = $123. If r is the interest rate, then an amount $X to be received in N years has a present value of $X/(1+r )N . d. The higher the interest rate, the more you can earn by depositing your money at the bank, so the more attractive having $100 today becomes. e. The concept of present value also helps to explain why investment is inversely related to the interest rate. C. FYI: The Magic of Compounding and the Rule of 70 1. Growth rates that seem s****ll in percentage terms seem large after they are compounded for ****ny years. 2. Example: Jerry and Elaine both graduate from college at the age of 22 and take jobs earning $30,000 per year. a. Jerry lives in an economy where incomes grow at 1% per year. b. Elaine lives in an economy where incomes grow at 3% per year. c. Forty years later (when both are 62), Jerry will be earning $45,000 and Elaine will be earning $98,000. 3. The Rule of 70 can help us understand the effects of compounding: Rule of 70: If a variable grows at X % per year,then that variable will double in approxi****tely 70/X years. This is a good time to explain to students how important saving can be while they are young. Show students how the ****gic of compounding can turn a s****ll amount of saving (say, $1,000 per year) into a large amount in 25 or 30 years. III. Managing Risk A. Risk Aversion 1. Most people are risk averse. a. People dislike bad things happening to them. b. In fact, they dislike bad things more than they like comparable good things. Figure 1 c. For a risk-averse person, the pain from losing the $1,000 would exceed the pleasure from winning $1,000. 2. Economists have developed models of risk aversion using the concept of utility, which is a person’s subjective measure of well-being or satisfaction. a. A utility function exhibits the property of diminishing ****rginal utility: the more wealth a person has, the less utility he gets from an additional dollar. b. Because of diminishing ****rginal utility, the utility lost from losing $1,000 is greater than the utility of winning $1,000. B. The Markets for Insurance 1. One way to deal with risk is to purchase insurance. 2. From the standpoint of the economy as a whole, the role of insurance is not to eliminate the risks inherent in life but to spread them around more efficiently. a. Owning insurance does not prevent bad things from happening to you. b. However, the risk is shared among thousands of insurance-company stockholders rather than being borne by you alone. 3. The ****rkets for insurance suffer from two types of problems that impede their ability to spread risk. a. A high-risk person is more likely to apply for insurance than a low-risk person because a high-risk person would benefit more from insurance protection. This is adverse selection. b. After people buy insurance, they have less incentive to be careful about their risky behavior because the insurance company will cover much of the resulting losses. This is moral hazard. 4. FYI: The Peculiarities of Health Insurance a. Three features distinguish health insurance from other kinds of insurance. b. Health insurance often covers routine expenses. c. Health insurance often covers s****ll, random expenses. d. Many people obtain their health insurance through their employer. e. One reason why health insurance has these features is the U.S. tax system, which ****kes employer-provided health insurance exempt from income and payroll taxes. Many economists believe that this leads to excess coverage. C. Diversification of Firm-Specific Risk 1. Practical advice that finance offers to risk-averse people: “Don’t put all your eggs in one basket.” 2. Definition of diversification: the reduction of risk achieved by replacing a single risk with a large number of s****ller unrelated risks. a. A person who buys stock in a company is placing a bet on the future profitability of that company. Figure 2 b. Risk can be reduced by placing a large number of s****ll bets rather than a s****ll number of large ones. 3. Risk can be measured by the standard deviation of a portfolio’s return. a. Standard deviation measures the volatility of a variable. b. The higher the standard deviation of a portfolio’s return, the riskier it is. c. The risk of a stock portfolio falls as the number of stocks increases. 4. It is impossible to eliminate all risk by increasing the number of stocks in the portfolio. a. Definition of firm-specific risk: risk that affects only a single economic actor. b. Definition of ****rket risk: risk that affects all economic actors at once. c. Diversification can eliminate firm-specific risk, but will not affect ****rket risk. D. The Trade-off between Risk and Return 1. Principle #1: People face trade-offs. 2. Risk-averse people are willing to accept the risk inherent in holding stock because they are compensated for doing so. 3. When deciding how to allocate their savings, people have to decide how much risk they are willing to undertake to earn a higher return. Figure 3 4. The choice of a particular combination of risk and return depends on a person’s risk aversion, which reflects a person’s own preferences. IV. Asset Valuation A. The price of a share of stock is determined by supply and de****nd. B. To understand stock prices, we need to understand what determines a person’s willingness to pay for a share of stock. C. Fundamental Analysis 1. Definition of fundamental ****ysis: the study of a company’s accounting statements and future prospects to determine its value. 2. If the price of a share of stock is less than the value, the stock is said to be undervalued. 3. If the price of a share of stock is greater than its value, the stock is said to be overvalued. 4. If the price of a share of stock is equal to its value, the stock is said to be fairly valued. 5. The value of a stock to a shareholder is what he receives from owning it, which includes the present value of dividend payments and the final sale price. a. Both of these are highly related to the firm’s ability to earn profits. b. The firm’s profitability depends on a large number of factors that affect the de****nd for its product and its costs of doing business. 6. There are three ways to rely on fundamental ****ysis to select a stock portfolio. a. Do all of the necessary research yourself. b. Rely on the advice of Wall Street ****ysts. c. Buy a mutual fund. D. The Efficient Markets Hypothesis 1. Definition of the efficient ****rkets hypothesis: the theory according to which asset prices reflect all publicly available infor****tion about the value of an asset. 2. Each company listed on a ****jor stock exchange is followed closely by money ****nagers who monitor news stories and conduct fundamental ****ysis to determine a stock’s value. 3. At the equilibrium ****rket price of a share of stock, the number of shares being offered for sale is exactly equal to the number of shares that people want to buy. a. At the ****rket price, the number of people who think that the stock is overvalued exactly balances the number of people who think it is undervalued. b. As judged by the typical person in the ****rket, all stocks are fairly valued all of the time. 4. Definition of infor****tionally efficient: reflecting all available infor****tion in a rational way. a. Stock prices change when infor****tion changes. b. When the good (bad) news about a company’s prospects becomes public, the value and the price of the stock will rise (fall). 5. Definition of random walk: the path of a variable whose changes are hard to predict. a. Changes in stock prices are impossible to predict from available infor****tion. b. The only thing that can move stock prices is news that changes the ****rket’s perception of the company’s value. c. Because news is unpredictable, changes in stock prices should be unpredictable. 6. Case Study: Random Walks and Index Funds a. Some of the best evidence in favor of the efficient ****rkets hypothesis comes from the perfor****nce of index funds. b. In practice, funds that are actively ****naged by a professional rarely beat index funds and often do worse. E. Market Irrationality 1. The efficient ****rkets hypothesis assumes that people buying and selling stock rationally process all of the infor****tion they have about the stock’s underlying value. 2. There is a long tradition suggesting that fluctuations in stock prices are partly psychological. a. In the 1930s, John Maynard Keynes suggested that asset ****rkets are driven by the “ani****l spirits” of investors. b. In the 1990s, Federal Reserve Chair****n Alan Greenspan questioned whether the stock ****rket boom was due to "irrational exuberance.” 3. The value of a stock depends on the final sale price expected in the future. a. A person ****y be willing to pay more than a stock is worth today if he believes that another person will pay even more in the future. b. Therefore, to evaluate a stock, you have to esti****te not only the value of the business but also what other people ****y believe the business is worth in the future. 4. There is much debate among economists about whether departures from rational pricing are important or rare. a. Believers in ****rket irrationality point out that the stock ****rket often moves in ways that are hard to explain on the basis of news that might alter a rational valuation. b. Believers in the efficient ****rkets hypothesis point out that it is difficult to know the correct, rational valuation of a company so it is hard to tell if any particular valuation is irrational. F. In the News: Neurofinance 1. New research is exploring the linkages between economics, psychology, and brain science. 2. This is an article from the Wall Street Journal describing neuroeconomic stu****s of investment behavior. SOLUTIONS TO TEXT PROBLEMS: Quick Quizzes 1. The present value of $150 to be received in 10 years if the interest rate is 7 percent is $150 / (1.07)10 = $76.25. 2. There are three ways in which a risk-averse person ****y reduce the risk he faces: (1) purchase insurance, (2) diversify his portfolio, or (3) choose safer alternatives by accepting a lower rate of return. 3. No. According to the efficient ****rkets hypothesis, the price of a share of stock should reflect all available infor****tion about its value. Thus, the stocks on this list should perform no better on average than other stocks listed on the stock exchange. Questions for Review 1. If the interest rate is 7%, the present value of $200 to be received in 10 years is $200/(1.07)10 = $101.67. If the interest rate is 7%, the present value of $300 to be received 20 years from now is $300/(1.07)20 = $77.53. 2. Purchasing insurance allows an individual to reduce the level of risk he faces. Two problems that impede the insurance industry from working correctly are adverse selection and moral hazard. Adverse selection occurs because a high-risk person is more likely to apply for insurance than a low-risk person is. Moral hazard occurs because people have less incentive to be careful about their risky behavior after they purchase insurance. 3. Diversification is the reduction of risk achieved by replacing a single risk with a large number of s****ller unrelated risks. A stockholder will get more diversification going from 1 to 10 stocks than from 100 to 120 stocks. 4. Stocks have more risk because their value depends on the future value of the firm. Because of its higher risk, shareholders will de****nd a higher return. There is a positive relationship between risk and return. 5. A stock ****yst will consider the future profitability of a firm when determining the value of the stock. 6. The efficient ****rkets hypothesis suggests that stock prices reflect all available infor****tion. This means that we cannot use current infor****tion to predict future changes in stock prices. One piece of evidence that supports this theory is the fact that ****ny index funds outperform mutual funds that are actively ****naged by a professional portfolio ****nager. 7. Economists who are skeptical of the efficient ****rkets hypothesis believe that fluctuations in stock prices are partly psychological. People ****y in fact be willing to purchase a stock that is overvalued if they believe that someone will be willing to pay even more in the future. This means that the stock price ****y not be a rational valuation of the firm. Problems and Applications 1. The future value of $24 invested for 400 years at an interest rate of 7% is (1.07)400  $24 = $13,600,000,000,000 = $13.6 trillion. 2. a. The present value of $15 million to be received in four years at an interest rate of 11% is $15 million/(1.11)4 = $9.88 million. Because the present value of the payoff is less than the cost, the project should not be undertaken. The present value of $15 million to be received in four years at an interest rate of 10% is $15 million/(1.10)4 = $10.25 million. Because the present value of the payoff is greater than the cost, the project should be undertaken. The present value of $15 million to be received in four years at an interest rate of 9% is $15 million/(1.09)4 = $10.63 million. Because the present value of the payoff is greater than the cost, the project should be undertaken. The present value of $15 million to be received in four years at an interest rate of 8% is $15 million/(1.08)4 = $11.03 million. Because the present value of the payoff is greater than the cost, the project should be undertaken. b. The exact cutoff for the interest rate between profitability and nonprofitability is the interest rate that will equate the present value of receiving $15 million in four years with the current cost of the project ($10 million): $10 = 15 /(1 + x )4 10(1 + x )4 = 15 (1 + x )4 = 1.5 1 + x = (1.5)0.25 1 + x = 1.1067 x = 0.1067 Therefore, an interest rate of 10.67% would be the cutoff between profitability and nonprofitability. 3. The value of the stock is equal to the present value of its dividends and its final sale price. This is equal to $5/1.08 + $5/(1.08)2 + ($5 + $120)/(1.08)3 = $4.63 + $4.29 + $99.23 = $108.15. Since this is lower than the initial selling price of $110, XYZ stock is not a good investment. 4. a. A sick person is more likely to apply for health insurance than a well person is. This is adverse selection. Once a person has health insurance, he ****y be less likely to take good care of himself. This is moral hazard. b. A risky driver is more likely than a safe driver to apply for car insurance. This is adverse selection. Once a driver has insurance, he ****y drive more recklessly. This is adverse selection. 5. a. The insurance would increase the amount that individuals spend on clothing. The amount of clothing purchased would likely be greater than the efficient level, because those ****king the purchase decisions are not paying the entire cost. b. Individuals who desire or need to spend a lot on clothing will be those most likely to buy clothing insurance. c. Clothing insurance will cost more than $2,000. Only those who spend more than average will want to purchase the insurance. The insurance company will have to set the premium such that it covers expected losses and administrative costs. Due to the adverse selection problem, the insurance company will end up providing insurance for those who will spend more than $2,000 per year on clothing. Thus, the premium will have to be greater than $2,000. d. No, this is not a good idea. It leads to overspending on clothing. This issue is very different from health insurance, because purchases of medical care can often be life-or-death decisions. In addition, increases in health lead to higher productivity so total output in the economy can be affected by improvements in health. Last, there ****y be positive externalities associated with some health expenditures (such as vaccinations). 6. To reduce the risk associated with the portfolio, it is better to diversify. This means that the stocks should be of companies from different industries as well as located in different countries. 287. A stock that is very sensitive to economic conditions will have more risk associated with it. Thus, we would expect for that stock to pay a higher return. To get stockholders to be willing to accept the risk, the expected return must be larger than average. 8. Shareholders will likely de****nd a higher return due to the stock’s firm-specific risk. Firm-specific risk is risk that affects only that particular stock. All stocks in the economy are subject to ****rket risk. 9. a. If a room****te is buying stocks in companies that everyone believes will experience big profits in the future, the price-earnings ratio is likely to be high. The price is high because it reflects everyone’s expectations about the firm’s future earnings. The largest disadvantage in buying these stocks is that they are currently overvalued and ****y not pay off in the future. b. Firms with low price-earnings ratios will likely have lower future earnings. The reason why these stocks are cheap is that everyone has lower expectations about the future profitability of these firms. The largest disadvantage to buying this stock is that the ****rket ****y be correct and the firm's stock ****y provide a low return. 10. a. Answers will vary, but ****y include things like infor****tion on new products under development or infor****tion concerning future government regulations that will affect the profitability of the firm. b. The fact that those who trade stocks based on inside infor****tion earn very high rates of return does not violate the efficient ****rkets hypothesis. The efficient ****rket hypothesis suggests that the price of a stock reflects all available infor****tion concerning the future profitability of the firm. Inside infor****tion is not readily available to the public and thus is not reflected in the stock’s price. c. Insider trading is illegal because it gives some buyers or sellers an unfair advantage in the stock ****rket. 11. Answers will vary. UNEMPLOYMENT WHAT’S NEW IN THE FIFTH EDITION: There is a new FYI box on “The Jobs Number” and a new In the News feature on “Unemployment Policy at Home and Abroad.” LEARNING O****ECTIVES: By the end of this chapter, students should understand:  the data used to measure the amount of unemployment.  how unemployment can result from minimum-wage laws.  how unemployment can arise from bargaining between firms and unions.  how unemployment results when firms choose to pay efficiency wages. CONTEXT AND PURPOSE: Chapter 28 is the fourth chapter in a four-chapter sequence on the level and growth of output in the long run. In Chapter 25, we learned that capital and labor are among the pri****ry determinants of output and growth. In Chapter 26, we addressed how saving and investment in capital goods affect the production of output. In Chapter 27, we learned about some of the tools people and firms use when choosing capital projects in which to invest. In Chapter 28, we see how full utilization of our labor resources improves the level of production and our standard of living. The purpose of Chapter 28 is to introduce students to the labor ****rket. We will see how economists measure the perfor****nce of the labor ****rket using unemployment statistics. We will also address a number of sources of unemployment and some policies that the government might use to lower certain types of unemployment. KEY POINTS:  The unemployment rate is the percentage of those who would like to work but do not have jobs. The Bureau of Labor Statistics calculates this statistic monthly based on a survey of thousands of households.  The unemployment rate is an imperfect measure of joblessness. Some people who call themselves unemployed ****y actually not want to work, and some people who would like to work have left the labor force after an unsuccessful search and therefore are not counted as employed.  In the U.S. economy, most people who become unemployed find work within a short period of time. Nonetheless, most unemployment observed at any given time is attributable to the few people who are unemployed for long periods of time.  One reason for unemployment is the time it takes for workers to search for jobs that best suit their tastes and skills. This frictional unemployment is increased as a result of unemployment insurance, a government policy designed to protect workers’ incomes.  A second reason why our economy always has some unemployment is minimum-wage laws. By raising the wage of unskilled and inexperienced workers above the equilibrium level, minimum-wage laws raise the quantity of labor supplied and reduce the quantity de****nded. The resulting surplus of labor represents unemployment.  A third reason for unemployment is the ****rket power of unions. When unions push the wages in unionized industries above the equilibrium level, they create a surplus of labor.  A fourth reason for unemployment is suggested by the theory of efficiency wages. According to this theory, firms find it profitable to pay wages above the equilibrium level. High wages can improve worker health, lower worker turnover, raise worker quality, and increase worker effort. CHAPTER OUTLINE: I. Unemployment can be divided into two categories. A. The economy’s natural rate of unemployment refers to the amount of unemployment that the economy nor****lly experiences. B. Cyclical unemployment refers to the year-to-year fluctuations in unemployment around its natural rate. II. Identifying Unemployment A. How Is Unemployment Measured? 1. The Bureau of Labor Statistics (BLS) surveys 60,000 households every month. 2. The BLS places each **** (age 16 or older) into one of three categories: employed, unemployed, or not in the labor force. Figure 1 Ask students which category they are in. Remind them that to be considered to be unemployed, they must be without a job and looking for work. Many students are not in the labor force, but ****y consider themselves to be unemployed simply because they do not have a job. Explain to students that the unemployment rate is a useful statistic because it answers the following question: Of those in the economy who want to work, what percentage cannot find a job? 3. Definition of labor force: the total number of workers, including both the employed and the unemployed. Labor force = Number of employed + Number of unemployed 4. Definition of unemployment rate: the percentage of the labor force that is unemployed. Unemployment rate = �Number of unemployed ���ᄡ 100% �� Labor force 5. Definition of labor-force participation rate: the percentage of the **** population that is in the labor force. Labor-force participation rate = � Labor force ��ᄡ 100% ��Adult population � 6. Example: data from 2007. In that year, there were 146.0 million employed people and 7.1 million unemployed people. a. Labor Force = 146.0 + 7.1 = 153.1 million. b. Unemployment Rate = (7.1/153.1) × 100% = 4.6%. c. If the **** population was 231.8 million, the labor-force participation rate was: Labor-Force Participation Rate = (153.1/231.8) × 100% = 66.0%. Make sure that students understand how to ****ke these calculations. Make sure that the formula is written on the board and refer to it often. ALTERNATIVE CLASSROOM EXAMPLE: The country of Bada has collected the following infor****tion: Population 240,000 Employed 180,000 Unemployed 30,000 Labor Force = 180,000 + 30,000 = 210,000 Unemployment rate = (30,000/210,000) × 100% = 14.3% Labor-force participation rate = (210,000/240,000) × 100% = 87.5% Table 1 7. Table 1 shows unemployment and labor-force participation rates for various sub- groups of the U.S. population. a. Women ages 20 and older have lower labor-force participation rates than men, but have similar rates of unemployment. b. Blacks ages 20 and older have similar labor-force participation rates to whites, but have higher rates of unemployment. c. Teenagers have lower labor-force participation rates than ****s, but have higher unemployment rates. Figure 2 8. Figure 2 shows the unemployment rate in the United States since 1960. B. Definition of the natural rate of unemployment: the nor****l rate of unemployment around which the unemployment rate fluctuates. C. Definition of cyclical unemployment: the deviation of unemployment from its natural rate. Discuss how the age composition of the labor force and other demographic and social factors can cause the natural rate of unemployment to vary over time. For 2004, economists at the Congressional Budget Office have esti****ted a natural rate of 5.2%. D. Case Study: Labor-Force Participation of Men and Women in the U.S. Economy 1. There has been a dra****tic rise in the labor-force participation rates of women over the past 50 years. Figure 3 2. Figure 3 shows this rise in the labor-force participation rate of women. The figure also shows that the labor-force participation rates for men have actually fallen by a s****ll amount over the same time period. E. In the News: The Rise in Adult Male Joblessness 1. An increasing number of men are neither working nor looking for work. 2. This is an article by economist Alan Krueger that details this trend. F. Does the Unemployment Rate Measure What We Want It To? 1. Measuring the unemployment rate is not as straightforward as it ****y seem. 2. There is a tremendous amount of movement into and out of the labor force. a. Many of the unemployed are new entrants or reentrants looking for work. b. Many unemployment spells end with a person leaving the labor force as opposed to actually finding a job. 3. There ****y be individuals who are calling themselves unemployed to qualify for government assistance, yet they are not trying hard to find work. These individuals are more likely not a part of the true labor force, but they will be counted as unemployed. 4. Definition of discouraged workers: individuals who would like to work but have given up looking for a job. a. These individuals will not be counted as part of the labor force. b. Thus, while they are likely a part of the unemployed, they will not show up in the unemployment statistics. 5. Table 2 presents other measures of labor underutilization calculated by the Bureau of Labor Statistics. Activity 1 — Who Is Unemployed? Type: In-class assignment Topics: Unemployment categories Materials needed: None Time: 5 minutes Class limitations: Works in any size class Purpose This assignment helps familiarize students with labor-force statistics. Instructions Ask the students to classify each of the following individuals in one of the following categories: employed, unemployed, or not in the labor force. 1. Steve worked 40 hours last week in a music supply store. 2. Last week, Elizabeth worked 10 hours as a computer programmer for the National Video Company and attended night classes at the local college. She would prefer a full-time job. 3. Roger lost his job at the R-gone Manufacturing Company. Since then he has been trying to find a job at other local factories. 4. Linda is a home****ker. Last week she was occupied with her nor****l household chores. She neither held a job nor looked for a job. 5. Linda’s father is unable to work. 6. Scott has a Ph.D. He worked full-time but does not like his job as a dishwasher. He has applied for jobs with three companies and five universities. As soon as he gets an offer, he will quit his current job. 7. Mary-Helen has been out of work for a full year. She would take a job if it was offered, but no local companies are hiring. She is not actively searching for work. Common Answers and Points for Discussion Steve, Elizabeth, and Scott are employed. Roger is unemployed. Linda, Linda’s father, and Mary-Helen are not in the labor force. This assignment can also be used to discuss measurement problems such as underemployment (Elizabeth and Scott are examples) and discouraged workers (Mary-Helen provides an example). Table 2 G. How Long Are the Unemployed without Work? 1. Another important variable that policy****kers ****y be concerned with is the duration of unemployment. 2. Most spells of unemployment are short, and most unemployment observed at any given time is long term. H. Why Are There Always Some People Unemployed? 1. In an ideal labor ****rket, wages would adjust so that the quantity of labor supplied and the quantity of labor de****nded would be equal. 2. However, there is always unemployment even when the economy is doing well. The unemployment rate is never zero; it fluctuates around the natural rate. a. Definition of frictional unemployment: unemployment that results because it takes time for workers to search for the jobs that best suit their tastes and skills. b. Definition of structural unemployment: unemployment that results because the number of jobs available in some labor ****rkets is insufficient to provide a job for everyone who wants one. c. Three possible reasons for structural unemployment are minimum-wage laws, unions, and efficiency wages. I. FYI: The Jobs Number 1. When the Bureau of Labor Statistics announces the unemployment rate each month, it also announce the number of jobs the economy gained or lost. 2. This infor****tion comes from a survey of 160,000 business establishments. III. Job Search A. Definition of job search: the process by which workers find appropriate jobs given their tastes and skills. B. Because workers differ from one another in terms of their skills and tastes and jobs differ in their attributes, it is often difficult for workers to ****tch with the appropriate job. C. Why Some Frictional Unemployment Is Inevitable 1. Frictional unemployment often occurs because of a change in the de****nd for labor among different firms. a. When consumers decide to stop buying a good produced by Firm A and instead start buying a good produced by Firm B, some workers at Firm A will likely lose their jobs. b. New jobs will be created at Firm B, but it will take some time to move the displaced workers from Firm A to Firm B. c. The result of this transition is temporary unemployment. d. The same situation can occur across industries and regions as well. 2. This implies that, because the economy is always changing, frictional unemployment is inevitable. Workers in declining industries will find themselves looking for new jobs, and firms in growing industries will be seeking new workers. D. Public Policy and Job Search 1. The faster infor****tion spreads about job openings and worker availability, the more rapidly the economy can ****tch workers and firms. 2. Government programs can help to reduce the amount of frictional unemployment. a. Government-run employment agencies give out infor****tion on job vacancies. b. Public training programs can ease the transition of workers from declining to growing industries and help disadvantaged groups escape poverty. 3. Critics of these programs argue that the private labor ****rket will do a better job of ****tching workers with employers and therefore the government should not be involved in the process of job search. E. Unemployment Insurance 1. Definition of unemployment insurance: a government program that partially protects workers’ incomes when they become unemployed. 2. Because unemployment insurance reduces the hardship of unemployment, it also increases the amount of unemployment that exists. 3. Many stu****s have shown that more generous unemployment insurance benefits lead to reduced job search effort and, as a result, more unemployment. 4. In the News: Unemployment Policy at Home and Abroad a. Traditionally, ****ny European countries have had unemployment insurance programs that are far more generous than that of the United States. b. This is an article from the New York Times that discusses how policy****kers are starting to rethink the generosity of unemployment benefits. IV. Minimum-Wage Laws A. Unemployment can also occur because of minimum-wage laws. Figure 4 B. The minimum wage is a price floor. 1. If the minimum wage is set above the equilibrium wage in the labor ****rket, a surplus of labor will occur. 2. However, this is a binding constraint only when the minimum wage is set above the equilibrium wage. a. Most workers in the economy earn a wage above the minimum wage. b. Minimum-wage laws therefore have the largest affect on workers with low skill and little experience (such as teenagers). C. FYI: Who Earns the Minimum Wage? 1. In 2006, the Department of Labor released a study concerning workers who reported earnings at or below the minimum wage. a. Of all workers paid an hourly rate in the United States, about 2% of men and 3% of women reported wages at or below the minimum wage. b. Minimum-wage workers tend to be young, with about half under the age of 25. c. Minimum-wage workers tend to be less educated. Of those workers ages 16 and over with a high school education, only 2% earned the minimum wage. d. The industry with the highest proportion of workers with reported wages at or below the minimum wage was leisure and hospitality. e. The proportion of workers earning the prevailing minimum wage has trended downward since 1979. D. Anytime a wage is kept above the equilibrium level for any reason, the result is unemployment. 1. Other causes of this situation include unions and efficiency wages. 2. This situation is different from frictional unemployment where the search for the right job is the reason for unemployment. V. Unions and Collective Bargaining A. Definition of union: a worker association that bargains with employers over wages and working conditions. B. Unions play a s****ller role in the U.S. economy today than they did in the past. However, unions continue to be prevalent in ****ny European countries. C. The Economics of Unions 1. Definition of collective bargaining: the process by which unions and firms agree on the terms of employment. 2. Unions try to negotiate for higher wages, better benefits, and better working conditions than the firm would offer if there were no union. 3. Definition of strike: the organized withdrawal of labor from a firm by a union. 4. Economists have found that union workers typically earn 10% to 20% more than similar workers who do not belong to unions. 5. This implies that unions raise the wage above the equilibrium wage, resulting in unemployment. a. Unions are often believed to cause conflict between insiders (who benefit from high union wages) and outsiders (who do not get the union jobs). b. Outsiders will either re****in unemployed or find jobs in firms that are not unionized. c. The supply of workers in nonunion firms will increase, pushing wages at those firms down. D. Are Unions Good or Bad for the Economy? 1. Critics of unions argue that unions are a cartel, which causes inefficiency because fewer workers end up being hired at the higher union wage. 2. Advocates of unions argue that unions are an answer to the problems that occur when a firm has too much power in the labor ****rket (for example, if it is the only ****jor employer in town). In addition, by representing workers’ views, unions help firms provide the right mix of job attributes. VI. The Theory of Efficiency Wages A. Definition of efficiency wages: above-equilibrium wages paid by firms in order to increase worker productivity. B. Efficiency wages raise the wage above the ****rket equilibrium wage, resulting in unemployment. C. There are several reasons why a firm ****y pay efficiency wages. 1. Worker Health a. Better-paid workers can afford to eat better and can afford good medical care. b. This is more applicable in developing countries where inadequate nutrition can be a significant problem. 2. Worker Turnover a. A firm can reduce turnover by paying a wage greater than its workers could receive elsewhere. b. This is especially helpful for firms that face high hiring and training costs. 3. Worker Quality a. Offering higher wages attracts a better pool of applicants. b. This is especially helpful for firms that are not able to perfectly gauge the quality of job applicants. 4. Worker Effort a. Again, if a firm pays a worker more than he or she can receive elsewhere, the worker will be more likely to try to protect his or her job by working harder. b. This is especially helpful for firms that have difficulty monitoring their workers. 5. Case Study: Henry Ford and the Very Generous $5-a-Day Wage a. Henry Ford used a high wage (about twice the going rate) to attract better employees. b. After instituting this higher wage policy, the company’s production costs actually fell due to reduced turnover, absenteeism, and shirking. When discussing the ****terial in this chapter, you ****y find that students want to begin discussing possible policies to deal with unemployment. Keep the focus on institutional responses such as unemployment insurance, job training, and government-sponsored employment agencies. SOLUTIONS TO TEXT PROBLEMS: Quick Quizzes 1. The unemployment rate is measured through a survey of 60,000 households to determine the percentage of the labor force that is unemployed. The unemployment rate overstates the amount of joblessness because some of those who report being unemployed ****y not, in fact, be trying hard to find a job. But the unemployment rate ****y understate the amount of joblessness because discouraged workers are considered not in the labor force even though they are workers without jobs. 2. An increase in the world price of oil increases the amount of frictional unemployment as oil-producing firms increase output and employment, but other firms, such as those in the auto industry, reduce output and employment. The sectoral shift from the auto industry to oil firms causes higher frictional unemployment for a time until workers have shifted from the auto industry to the oil industry. Although no increase in unemployment is really desirable, this type of frictional unemployment is a natural outcome of the reallocation of resources between different sectors. Public policies that might affect the unemployment caused by this change in the price of oil include government-run employment agencies, which can help autoworkers move into the oil industry, job-training programs to help workers adapt to a new industry, and unemployment insurance, which keeps workers from suffering economic hardship while changing from one industry to another. 3. Figure 1 shows the supply curve (S) and the de****nd curve (D) for labor. The wage (W) is above the equilibrium wage (WE). The result is unemployment, equal to the amount by which the quantity of labor supplied (LS) exceeds the quantity of labor de****nded (LD). Figure 1 4. A union in the auto industry raises the wages of workers employed by General Motors and Ford by threatening to strike. To prevent the costs of a strike, the firms generally pay higher wages than they would if there were no union. However, the higher wages reduce employment at General Motors and Ford. The unemployed autoworkers seek jobs elsewhere, reducing wages and increasing employment in the nonunion sector. 5. There are four reasons that firms might find it profitable to pay wages above the level that balances the quantity of labor supplied and the quantity of labor de****nded: (1) to ensure that workers are in good health so they will be more productive; (2) to reduce worker turnover because it is costly to hire new workers; (3) to ****ke workers eager to keep their jobs, thus discouraging them from shirking; and (4) to attract a better pool of workers. Questions for Review 1. The BLS categorizes each **** (16 years of age and older) as either employed, unemployed, or not in the labor force. The labor force consists of the sum of the employed and the unemployed. The unemployment rate is the percentage of the labor force that is unemployed. The labor-force participation rate is the percentage of the total **** population that is in the labor force. 2. Unemployment is typically short term. Most people who become unemployed are able to find new jobs fairly quickly. But some unemployment is attributable to the relatively few workers who are jobless for long periods of time. 3. 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 through public policies that provide infor****tion about job vacancies in order to ****tch 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. 4. Minimum-wage laws are a better explanation for unemployment among teenagers than among college graduates. Teenagers have fewer job-related skills than college graduates do, so their wages are low enough to be affected by the minimum wage. College graduates' wages generally exceed the minimum wage. 5. Unions ****y affect the natural rate of unemployment via the effect on insiders and outsiders. Because unions raise the wage above the equilibrium level, the quantity of labor de****nded declines while the quantity supplied of labor rises, so there is unemployment. Insiders are those who keep their jobs. Outsiders, workers who become unemployed, have two choices: either get a job in a firm that is not unionized, or re****in 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. 6. Advocates of unions claim that unions are good for the economy because they are an antidote to the ****rket power of the firms that hire workers and they are important for helping firms respond efficiently to workers' concerns. 7. 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) the firm can attract higher quality workers; and (4) worker effort is increased. Problems and Applications 1. The labor force consists of the number of employed (145,993,000) plus the number of unemployed (7,381,000), which equals 153,374,000. To find the labor-force participation rate, we need to know the size of the **** population. Adding the labor force (153,374,000) to the number of people not in the labor force (79,436,000) gives the **** population of 232,810,000. The labor-force participation rate is the labor force (153,374,000) divided by the **** population (232,810,000) times 100%, which equals 66%. The unemployment rate is the number of unemployed (7,381,000) divided by the labor force (153,374,000) times 100%, which equals 4.8%. 2. Many answers are possible. 3. Men age 55 and over experienced the greatest decline in labor-force participation. This was because of increased Social Security benefits and retirement income, encouraging retirement at an earlier age. The rise in fe****le labor force participation ****y be the result of changes in social attitudes, labor- saving devices in the home such as dishwashers and microwave ovens, and lower fertility rates. 4. The fact that employment increased 6.8 million while unemployment declined 1.1 million is consistent with growth in the labor force of 5.7 million workers. The labor force constantly increases as the population grows and as labor-force participation increases, so the increase in the number of people employed ****y always exceed the reduction in the number unemployed. 5. a. If an auto company goes bankrupt and its workers immediate begin looking for work, the unemployment rate will rise and the employment-population ratio will fall. b. If some of the unemployed auto workers give up looking for a job, the unemployment rate will fall and the employment-population ratio will re****in the same. c. If numerous students graduate from college and cannot find work, the unemployment rate will rise and the employment-population ratio will re****in unchanged. d. If numerous students graduate from college and immediately begin new jobs, the unemployment rate will fall and the employment-population ratio will rise. e. If a stock ****rket boom induces earlier retirement, the unemployment rate will rise and the employment-population ratio will fall. f. Advances in health care that prolong the life of retirees will not affect the unemployment rate and will lower the employment-population ratio. 6. a. A construction worker who is laid off because of bad weather is likely to experience short-term unemployment, because the worker will be back to work as soon as the weather clears up. b. A ****nufacturing worker who loses her job at a plant in an isolated area is likely to experience long-term unemployment, because there are probably few other employment opportunities in the area. She ****y 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 because his entire industry is shrinking. He will probably need to gain additional training or skills to get a job in a different industry. 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 will probably have only a short spell of unemployment. e. An expert welder with little education who loses her job when the company installs auto****tic welding ****chinery is likely to be without a job for a long time, because she lacks the technological skills to keep up with the latest equipment. To re****in in the welding industry, she ****y need to go back to school and learn the newest techniques. 7. Figure 2 shows a diagram of the labor ****rket with a binding minimum wage. At the initial minimum wage (m1), the quantity of labor supplied L1S is greater than the quantity of labor de****nded L1D, and unemployment is equal to L1S − L1D. An increase in the minimum wage to m2 leads to an increase in the quantity of labor supplied to L2S and a decrease in the quantity of labor de****nded to L2D. As a result, unemployment increases as the minimum wage rises. Figure 2 8. a. Figure 3 illustrates the effect of a union being established in the ****nufacturing labor ****rket. In the figure on the left, the wage rises from w1U to w2U and the quantity of labor de****nded declines from U1 to U2D. Because the wage is higher, the quantity supplied of labor increases to U2S, so there are U2S − U2D unemployed workers in the unionized ****nufacturing sector. b. When those workers who become unemployed in the ****nufacturing sector seek employment in the service labor ****rket, shown in the figure on the right, the supply of labor shifts to the right from S1 to S2. The result is a decline in the wage in the nonunionized service sector from w1N to w2N and an increase in employment in the nonunionized service sector from N1 to N2. Figure 3 9. a. Wages between the two industries would be equal. If not, new workers would choose the industry with the higher wage, pushing the wage in that industry down. b. If the country begins importing autos, the de****nd for domestic auto workers will fall. If the country begins to export aircraft, there would be an increase in the de****nd for workers in the aircraft industry. c. In the short run, wages in the auto industry will fall, while wages in the aircraft industry will rise. Over time, new workers will move into the aircraft industry bringing its wage down until wages are equal across the two industries. d. If the wage does not adjust to its equilibrium level, there would be a shortage of workers in the aircraft industry and a surplus of labor (unemployment) in the auto industry. 10. a. If a firm was not providing such benefits prior to the legislation, the curve showing the de****nd for labor would shift down by exactly $4 at each quantity of labor, because the firm would not be willing to pay as high a wage given the increased cost of the benefits. b. If employees value the benefit by exactly $4 per hour, they would be willing to work the same amount for a wage that's $4 less per hour, so the supply curve of labor shifts down by exactly $4. Figure 4 c. Figure 4 shows the equilibrium in the labor ****rket. Because the de****nd and supply curves of labor both shift down by $4, the equilibrium quantity of labor is unchanged and the wage rate declines by $4. Both employees and employers are just as well off as before. d. If the minimum wage prevents the wage from falling, the result will be increased unemployment, as Figure 5 shows. Initially, the equilibrium quantity of labor is L1 and the equilibrium wage is w1, which is $3 lower than the minimum wage wm. After the law is passed, de****nd falls to D2 and supply rises to S2. Because of the minimum wage, the quantity of labor de****nded (L2D) will be s****ller than the quantity supplied (L2S). Thus, there will be unemployment equal to L2S – L2D. Figure 5 29 Figure 6 e. If the workers do not value the ****ndated benefit at all, the supply curve of labor does not shift down. As a result, the wage rate will decline by less than $4 and the equilibrium quantity of labor will decline, as shown in Figure 6. Employers are worse off, because they now pay a greater total wage plus benefits for fewer workers. Employees are worse off, because they get a lower wage and fewer are employed. THE MONETARY SYSTEM WHAT’S NEW IN THE FIFTH EDITION: There are two new In the News boxes on “Monetary Lessons from Iraq” and “The Financial Crisis of 2008.” LEARNING O****ECTIVES: By the end of this chapter, students should understand:  what money is and what functions money has in the economy.  what the Federal Reserve System is.  how the banking system helps determine the supply of money.  what tools the Federal Reserve uses to alter the supply of money. CONTEXT AND PURPOSE: Chapter 29 is the first chapter in a two-chapter sequence dealing with money and prices in the long run. Chapter 29 describes what money is and develops how the Federal Reserve controls the quantity of money. Because the quantity of money influences the rate of inflation in the long run, the following chapter concentrates on the causes and costs of inflation. The purpose of Chapter 29 is to help students develop an understanding of what money is, what forms money takes, how the banking system helps create money, and how the Federal Reserve controls the quantity of money. An understanding of money is important because the quantity of money affects inflation and interest rates in the long run, and production and employment in the short run. KEY POINTS:  The term money refers to assets that people regularly use to buy goods and services.  Money serves three functions. As a medium of exchange, it provides the item used to ****ke transactions. As a unit of account, it provides the way in which prices and other economic values are recorded. As a store of value, it provides a way of transferring purchasing power from the present to the future.  Commodity money, such as gold, is money that has intrinsic value: It would be valued even if it were not used as money. Fiat money, such as paper dollars, is money without intrinsic value: It would be worthless if it were not used as money.  In the U.S. economy, money takes the form of currency and various types of bank deposits, such as checking accounts.  The Federal Reserve, the central bank of the United States, is responsible for regulating the U.S. monetary system. The Fed chair****n is appointed by the president and confirmed by Congress every four years. The chair****n is the lead member of the Federal Open Market Committee, which meets about every six weeks to consider changes in monetary policy.  The Fed controls the money supply pri****rily through open-****rket operations. The purchase of government bonds increases the money supply, and the sale of government bonds decreases the money supply. The Fed can also expand the money supply by lowering reserve requirements or decreasing the discount rate, and it can contract the money supply by raising reserve requirements or increasing the discount rate.  When banks loan out some of their deposits, they increase the quantity of money in the economy. Because banks influence the money supply in this way, the Fed’s control of the money supply is imperfect.  The Federal Reserve has in recent years set monetary policy by choosing a target for the federal funds rate, a short-term interest rate at which banks ****ke loans to one another. As the Fed achieves its target, it adjusts the money supply. CHAPTER OUTLINE: This is a good chapter to “win back” the students who were bored with national income accounting. Students are generally interested in learning more about the banking system and the Federal Reserve. The Federal Reserve offers a free, 13-minute video entitled “The Fed Today” that discusses the history and operations of the Fed. I. The Meaning of Money Begin the ****ysis by asking students, “What is money?” Students will likely want to start right in with a discussion of the functions that money serves. Stop them. Ask them instead to describe money. Hold up a dollar bill and a piece of paper cut to the same size. Ask the students which they would prefer and why. A. Definition of money: the set of assets in an economy that people regularly use to buy goods and services from other people. B. The Functions of Money 1. Money serves three functions in our economy. a. Definition of medium of exchange: an item that buyers give to sellers when they want to purchase goods and services. b. Definition of unit of account: the yardstick people use to post prices and record debts. c. Definition of store of value: an item that people can use to transfer purchasing power from the present to the future. 2. Definition of liquidity: the ease with which an asset can be converted into the economy’s medium of exchange. a. Money is the most liquid asset available. b. Other assets (such as stocks, bonds, and real estate) vary in their liquidity. c. When people decide in what forms to hold their wealth, they must balance the liquidity of each possible asset against the asset’s usefulness as a store of value. C. The Kinds of Money 1. Definition of commodity money: money that takes the form of a commodity with intrinsic value. 2. Definition of fiat money: money without intrinsic value that is used as money because of government decree. 3. In the News: Monetary Lessons from Iraq a. After the Gulf War ended in 1991, Iraq had two currencies: its original dinars (referred to as Swiss dinars) and Saddam dinars. b. This is an article from the New York Times describing how the original currency ****intained its value, while the new currency did not. D. Money in the U.S. Economy 1. The quantity of money circulating in the United States is sometimes called the money stock. 2. Included in the measure of the money supply are currency, de****nd deposits, and other monetary assets. a. Definition of currency: the paper bills and coins in the hands of the public. Figure 1 b. Definition of de****nd deposits: balances in bank accounts that depositors can access on de****nd by writing a check. 3. Figure 1 shows the monetary assets included in two important measures of the money supply, M1 and M2. Point out to students that currency only ****kes up about 30% of the value of M1, with the re****ining 70% in the form of checking deposits. Students need to understand that the ****jority of the money in the economy is actually ****de up of account balances rather than stacks of currency in a vault. Make sure that students realize that the assets included in M1 and M2 differ in terms of their liquidity. Also note that there are other measures of the money supply (M3 and L), which include less liquid assets like large time deposits. 4. FYI: Credit Cards, Debit Cards, and Money a. Credit cards are not a form of money; when a person uses a credit card, he or she is simply deferring payment for the item. Students are quite curious about whether credit cards are considered money. You can satisfy their curiosity in part by pointing out that credit cards actually lead to a drop in the quantity of money people need to carry because they allow households to consolidate bills for payment once a month. b. Because using a debit card is like writing a check, the account balances that lie behind debit cards are included in the measures of money. 5. Case Study: Where Is All the Currency? a. If we divide the amount of outstanding currency in the United States by the **** population, we find that the average **** should have approxi****tely $3,134 in currency. b. Of course, most ****s carry a much s****ller amount. c. One explanation is that a great deal of U.S. currency ****y be held in other countries. d. Another explanation is that large amounts of currency ****y be held by criminals because transactions that use currency leave no paper trail. II. The Federal Reserve System A. Definition of Federal Reserve (Fed): the central bank of the United States. B. Definition of central bank: An institution designed to oversee the banking system and regulate the quantity of money in the economy. Activity 1—What Can Be Learned from a Dollar? Type: In-class demonstration Topics: Money, Federal Reserve Materials needed: None Time: 5 minutes Class limitations: Works in any size class Purpose This activity introduces the role of the Federal Reserve in controlling the money supply. Instructions Ask the class to take a dollar bill from wallets (or a $5, $10, $20, or $100). Students without any currency can share with someone who does. Ask the class to read the bill. After a minute, ask them what they have learned. Common Answers and Points for Discussion Most students focus on the statement “This note is legal tender for all debts, public and private.” This statement is the only “backing” U.S. currency has—the note is not convertible into gold or silver. This can be used to introduce the difference between fiat money and commodity money. Someone will usually point to the phrase printed at the top of the face of each bill: “Federal Reserve Note.” Explain the Fed functions as the United States' central bank—controlling the money supply and supplying currency to banks. Infor****tion about the structure of the Federal Reserve can be found in the seal to the left of Washington’s portrait. The writing around the seal says “Federal Reserve Bank of ___________.” If the class is big enough, all 12 Federal Reserve Banks will be represented: Boston, New York, Philadelphia, Richmond, Atlanta, Cleveland, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco. This is a good place to introduce the Federal Reserve Districts, and the Banks’ roles in those regions. These include check clearing, holding commercial bank reserves, supplying currency, lending to commercial banks, and collecting and ****yzing regional economic data. The discussion of the structure of the Fed can be expanded to include the Board of Governors, the Federal Open Market Committee, and the importance of the Chair****n of the Federal Reserve. C. The Fed’s Organization Highlight the Federal Reserve’s independence from the federal government. Students are surprised to find that the Fed is actually a corporation that earns more than enough to finance its operations without being funded by Congress. 1. The Fed was created in 1913 after a series of bank failures. 2. The Fed is run by a Board of Governors with 7 members who serve 14-year terms. a. The Board of Governors has a chair****n who is appointed for a four-year term. b. The current chair****n is Ben Bernanke. 3. The Federal Reserve System is ****de up of 12 regional Federal Reserve Banks located in ****jor cities around the country. Have students pull out dollar bills and read the name of the city of the district bank on the bill. But ****ke sure that they are actually reading off dollar bills and not just guessing the names of large cities. 4. One job performed by the Fed is the regulation of banks to ensure the health of the nation’s banking system. a. The Fed monitors each bank's financial condition and facilitates bank transactions by clearing checks. b. The Fed also ****kes loans to banks when they want (or need) to borrow. 5. The second job of the Fed is to control the quantity of money available in the economy. a. Definition of money supply: the quantity of money available in the economy. b. Definition of monetary policy: the setting of the money supply by policy****kers in the central bank. D. The Federal Open Market Committee 1. The Federal Open Market Committee (FOMC) consists of the 7 members of the Board of Governors and 5 of the 12 regional Federal Reserve District Bank presidents. Introduce students to the idea of open ****rket operations here, but do not be surprised if they do not catch on quickly. You can return to this topic later in the chapter. 2. The pri****ry way in which the Fed increases or decreases the supply of money is through open ****rket operations (which involve the purchase or sale of U.S. government bonds). a. If the Fed wants to increase the supply of money, it creates dollars and uses them to purchase government bonds from the public through the nation's bond ****rkets. b. If the Fed wants to lower the supply of money, it sells government bonds from its portfolio to the public. Money is then taken out of the hands of the public and the supply of money falls. III. Banks and the Money Supply The process of money creation in the banking system is one of the more difficult things to teach at the Principles level. Nearly every aspect of the process will be new to students and nothing is obvious or intuitive. Therefore, it is extremely important that each step in the process is shown through T-accounts so that students can see how the banking system creates money as banks carry out their nor****l functions of accepting deposits and giving out loans. A. The Simple Case of 100-Percent-Reserve Banking 1. Example: Suppose that currency is the only form of money and the total amount of currency is $100. 2. A bank is created as a safe place to store currency; all deposits are kept in the vault until the depositor withdraws them. a. Definition of reserves: deposits that banks have received but have not loaned out. b. Under the example described above, we have 100-percent-reserve banking. Make sure that you explain why bank reserves are an asset from the bank’s perspective, but customer deposits are a liability. 3. The financial position of the bank can be described with a T-account: Assets FIRST NATIONAL BANK Liabilities Reserves $100.00 $100.00 Deposits Students will either catch on to T-accounts immediately or be completely confused. It is a good idea to explain them and then let students work together in s****ll groups of two or three. You can check each group to identify the students who will require individualized attention. 4. The money supply in this economy is unchanged by the creation of a bank. a. Before the bank was created, the money supply consisted of $100 worth of currency. b. Now, with the bank, the money supply consists of $100 worth of deposits. 5. This means that, if banks hold all deposits in reserve, banks do not influence the supply of money. B. Money Creation with Fractional-Reserve Banking 1. Definition of fractional-reserve banking: a banking system in which banks hold only a fraction of deposits as reserves. 2. Definition of reserve ratio: the fraction of deposits that banks hold as reserves. 3. Example: Same as before, but First National decides to set its reserve ratio equal to 10% and lend the re****inder of the deposits. 4. The bank’s T-account would look like this: Assets FIRST NATIONAL BANK Liabilities Reserves $100.00 Loans $10.00 Deposits 90.00 5. When the bank ****kes these loans, the money supply changes. a. Before the bank ****de any loans, the money supply was equal to the $100 worth of deposits. b. Now, after the loans, deposits are still equal to $100, but borrowers now also hold $90 worth of currency from the loans. c. Therefore, when banks hold only a fraction of deposits in reserve, banks create money. 6. Note that, while new money has been created, so has debt. There is no new wealth created by this process. C. The Money Multiplier 1. The creation of money does not stop at this point. 2. Borrowers usually borrow money to purchase something and then the money likely becomes redeposited at a bank. 3. Suppose a person borrowed the $90 to purchase something and the funds then get redeposited in Second National Bank. Here is this bank’s T-account (assuming that it also sets its reserve ratio to 10%): SECOND NATIONAL BANK Assets Liabilities Reserves $9.00 Deposits $90.00 Loans $81.00 4. If the $81 in loans becomes redeposited in another bank, this process will go on and on. 5. Each time the money is deposited and a bank loan is created, more money is created. 6. Definition of money multiplier: the amount of money the banking system generates with each dollar of reserves. money multiplier = 1/reserve ratio 7. In our example, the money supply increased from $100 to $1,000 after the establishment of fractional-reserve banking. ALTERNATIVE CLASSROOM EXAMPLE: Reserve ratio = 12.5% Money multiplier = 1/0.125 = 8 Spend some time showing students how the multiplier changes as reserve requirements change. Make sure that you explain why the multiplier changes when the reserve ratio changes. Students will catch on to the ****th fairly quickly; it is the intuition that is most difficult for them. D. The Fed’s Tools of Monetary Control 1. Definition of open ****rket operations: the purchase and sale of U.S. government bonds by the Fed. a. If the Fed wants to increase the supply of money, it creates dollars and uses them to purchase government bonds from the public in the nation's bond ****rkets. b. If the Fed wants to lower the supply of money, it sells government bonds from its portfolio to the public in the nation's bond ****rkets. Money is then taken out of the hands of the public and the supply of money falls. c. If the sale or purchase of government bonds affects the amount of deposits in the banking system, the effect will be ****de larger by the money multiplier. You ****y wish to use T-accounts to show the effects of an open ****rket purchase or sale. This way, students can see that the effect of an open ****rket operation can be quite large because of the money multiplier. d. Open ****rket operations are easy for the Fed to conduct and are therefore the tool of monetary policy that the Fed uses most often. Activity 2—Money Creation Type: In-class demonstration Topics: The banking system and deposit expansion Materials needed: two volunteers, a paper with “$1,000” written on it Time: 25 minutes Class limitations: Works in any size class Purpose This activity demonstrates the role of the banking system in expanding the money supply. Instructions The two volunteers are bankers. Have each of them draw a balance sheet on the board. BankTwo AmerBankCorp Assets Liabilities Assets Liabilities 0 0 0 0 The rest of the class is the public. They are all eager borrowers and depositors. The instructor is the Federal Reserve. The Federal Reserve sets the reserve requirement at 20% of deposits. The Federal Reserve also conducts open-****rket operations. Use the $1,000 paper to buy a baseball cap from a student. (Explain that the Fed actually buys government bonds from the public because the ****rket for used baseball caps is s****ll.) The capless student now has $1,000 to spend with any other member of the class. This student receives $1,000 and puts it in the bank of his or her choice. The bank now has $1,000 in deposits (a liability) and $1,000 in cash (an asset). The bank needs to keep $200 in reserve (20%) but can loan the other $800. Have the banker tear off 20% of the bill and give the rest to another student. Revise the banks' balance sheets. Now the borrower spends the $800 and the recipient deposits it in a bank. This bank now has $800 in deposits and $800 in cash. Of that, $160 needs to be kept in reserve and $****0 can be lent. Have the banker save 20% of the paper and give the rest to another eager borrower. Revise the banks' balance sheets. Continue this process for a few more iterations. At the end, ask everyone who has money in the bank to stand. The total deposits in the bank will far exceed the initial $1,000 that the Fed put into the economy. Show the final balance sheet for each bank. Points for Discussion Banks are important to the process of money creation. The banking system, as a whole, literally expands the money supply. If the process is carried on far enough, you can derive the money multiplier. 2. Definition of reserve requirements: regulations on the minimum amount of reserves that banks must hold against deposits. a. This can affect the size of the money supply through changes in the money multiplier. b. The Fed rarely uses this tool because of the disruptions in the banking industry that would be caused by frequent alterations of reserve requirements. 3. Definition of discount rate: the interest rate on the loans that the Fed ****kes to banks. a. When a bank cannot meet its reserve requirements, it ****y borrow reserves from the Fed. b. A higher discount rate discourages banks from borrowing from the Fed and likely encourages banks to hold onto larger amounts of reserves. This in turn lowers the money supply. c. A lower discount rate encourages banks to lend their reserves (and borrow from the Fed). This will increase the money supply. d. The Fed also uses discount lending to help financial institutions that are in trouble. 4. In the News: The Financial Crisis of 2008 a. In the wake of a rise in mortgage defaults and home foreclosures, the Fed tried to calm the financial waters. b. This is an article from the Washington Times describing the Fed’s actions in early 2008. E. Problems in Controlling the Money Supply 1. The Fed does not control the amount of money that consumers choose to deposit in banks. a. The more money that households deposit, the more reserves the banks have, and the more money the banking system can create. b. The less money that households deposit, the s****ller the amount of reserves banks have, and the less money the banking system can create. 2. The Fed does not control the amount that bankers choose to lend. a. The amount of money created by the banking system depends on loans being ****de. b. If banks choose to hold onto a greater level of reserves than required by the Fed (called excess reserves), the money supply will fall. 3. Therefore, in a system of fractional-reserve banking, the amount of money in the economy depends in part on the behavior of depositors and bankers. 4. Because the Fed cannot control or perfectly predict this behavior, it cannot perfectly control the money supply. 5. Case Study: Bank Runs and the Money Supply a. Bank runs create a large problem under fractional-reserve banking. b. Because the bank only holds a fraction of its deposits in reserve, it will not have the funds to satisfy all of the withdrawal requests from its depositors. c. Today, deposits are guaranteed through the Federal Depository Insurance Corporation (FDIC). F. The Federal Funds Rate 1. Definition of federal funds rate: the short-term interest rate that banks charge one another for loans. 2. When the federal funds rate rises or falls, other interest rates often move in the same direction. 3. In recent years, the Fed has set a target for the federal funds rate. SOLUTIONS TO TEXT PROBLEMS: Quick Quizzes 1. The three functions of money are: (1) medium of exchange; (2) unit of account; and (3) store of value. Money is a medium of exchange because money is the item people use to purchase goods and services. Money is a unit of account because it is the yardstick people use to post prices and record debts. Money is a store of value because people use it to transfer purchasing power from the present to the future. 2. The pri****ry responsibilities of the Federal Reserve are to regulate banks, to ensure the health of the banking system, and to control the quantity of money that is ****de available in the economy. If the Fed wants to increase the supply of money, it usually does so by creating dollars and using them to purchase government bonds from the public in the nation’s bond ****rkets. 3. Banks create money when they hold a fraction of their deposits in reserve and lend out the re****inder. If the Fed wanted to use all three of its tools to decrease the money supply, it would: (1) sell government bonds from its portfolio in the open ****rket to reduce the number of dollars in circulation; (2) increase reserve requirements to reduce the money created by banks; and (3) increase the discount rate to discourage banks from borrowing reserves from the Fed. Questions for Review 1. 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. 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. De****nd deposits are balances in bank accounts that depositors can access on de****nd simply by writing a check. They should be included in the supply of money because they can be used as a medium of exchange. 4. The Federal Open Market Committee (FOMC) is responsible for setting monetary policy in the United States. The FOMC consists of the 7 members of the Federal Reserve Board of Governors and 5 of the 12 presidents of Federal Reserve Banks. Members of the Board of Governors are appointed by the president of the United States and confirmed by the U.S. Senate. The presidents of the Federal Reserve Banks are chosen by each bank’s board of directors. 5. If the Fed wants to increase the supply of money with open-****rket operations, it purchases U.S. government bonds from the public on the open ****rket. The purchase increases the number of dollars in the hands of the public, thus raising the money supply. 6. Banks do not hold 100% reserves because it is more profitable to use the reserves to ****ke 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 s****ller the fraction of reserves banks hold, the larger the money multiplier, because each dollar of reserves is used to create more money. 7. The discount rate is the interest rate on loans that the Federal Reserve ****kes to banks. If the Fed raises the discount rate, fewer banks will borrow from the Fed, so both banks' reserves and the money supply will be lower. 8. 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. The Fed cannot control the money supply perfectly because: (1) the Fed does not control the amount of money that households choose to hold as deposits in banks; and (2) the Fed does not control the amount that bankers choose to lend. The actions of households and banks affect the money supply in ways the Fed cannot perfectly control or predict. Problems and Applications 1. a. A U.S. penny is money in the U.S. 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 U.S. 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, because they represent short-term loans rather than being an asset like currency. 2. For an asset to be useful as a medium of exchange, it must be widely accepted (so all transactions can be ****de 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 s****ller denominations. For an asset to be useful as a store of value, it must be something that ****intains 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) ****ke good stores of value. 3. Many answers are possible. 4. When your uncle repays a $100 loan from Tenth National Bank (TNB) by writing a check from his TNB checking 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 Liabilities Before: Checking Account $100 Loans $100 After: Checking Account $0 Loans $0 Tenth National Bank Assets Liabilities Before: Loans $100 Deposits $100 After: Loans $0 Deposits $0 By paying off the loan, your uncle simply eliminated the outstanding loan using the assets in his checking account. Your uncle's wealth has not changed; he simply has fewer assets and fewer liabilities. 5. a. Here is BSB's T-account: Beleaguered State Bank Assets Liabilities Reserves $25 million Deposits $250 million Loans $225 million b. When BSB's largest depositor withdraws $10 million in cash and BSB reduces its loans outstanding to ****intain the same reserve ratio, its T-account is now: Beleaguered State Bank Assets Liabilities Reserves $24 million Deposits $240 million Loans $216 million c. Because BSB is cutting back on its loans, other banks will find themselves short of reserves and they ****y also cut back on their loans as well. d. BSB ****y find it difficult to cut back on its loans immediately, because it cannot force people to pay off loans. Instead, it can stop ****king 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 Fed. 6. If you take $100 that you held as currency and put it into the banking system, then the total amount of deposits in the banking system increases by $1,000, because a reserve ratio of 10% means the money multiplier is 1/.10 = 10. Thus, the money supply increases by $900, because deposits increase by $1,000 but currency declines by $100. 7. With a required reserve ratio of 10%, 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 ****ximum increase in the money supply from a $10 million open-****rket purchase is $100 million. The s****llest possible increase is $10 million if all of the money is held by banks as excess reserves. 8. The money supply will expand more if the Fed buys $2,000 worth of bonds. Both deposits will lead to monetary expansion. But the Fed’s deposit is new money. The $2,000 from the cookie jar is already part of the money supply. 9. a. If the required reserve ratio is 5%, then ABC Bank's required reserves are $500,000 x .05 = $25,000. Because the bank’s total reserves are $100,000, it has excess reserves of $75,000. b. With a required reserve ratio of 5%, the money multiplier is 1/.05 = 20. If ABC Bank lends out its excess reserves of $75,000, the money supply will eventually increase by $75,000 x 20 = $1,500,000. 10. a. With a required reserve ratio of 10% and no excess reserves, the money multiplier is 1/.10 = 10. If the Fed sells $1 million of bonds, reserves will decline by $1 million and the money supply will contract by 10 x $1 million = $10 million. b. Banks might wish to hold excess reserves if they need to hold the reserves for their day-to-day operations, such as paying other banks for customers' transactions, ****king change, cashing paychecks, and so on. If banks increase excess reserves such that there is no overall change in the total reserve ratio, then the money multiplier does not change and there is no effect on the money supply. 11. a. With banks holding only required reserves of 10%, the money multiplier is 1/.10 = 10. Because reserves are $100 billion, the money supply is 10 x $100 billion = $1,000 billion. b. If the required reserve ratio is raised to 20%, the money multiplier declines to 1/.20 = 5. With reserves of $100 billion, the money supply would decline to $500 billion, a decline of $500 billion. Reserves would be unchanged. 12. a. To expand the money supply, the Fed should buy bonds. b. With a reserve requirement of 20%, the money multiplier is 1/0.20 = 5. Therefore to expand the money supply by $40 million, the Fed should buy $40 million/5 = $8 million worth of bonds. 13. a. If people hold all money as currency, the quantity of money is $2,000. b. If people hold all money as de****nd deposits at banks with 100% reserves, the quantity of money is $2,000. c. If people have $1,000 in currency and $1,000 in de****nd deposits, the quantity of money is $2,000. 30d. If banks have a reserve ratio of 10%, the money multiplier is 1/.10 = 10. So if people hold all money as de****nd deposits, the quantity of money is 10 x $2,000 = $20,000. e. If people hold equal amounts of currency (C) and de****nd 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 de****nd deposits; and (2) 10 x ($2,000 – C) = D, so that the money multiplier (10) times the number of dollar bills that are not being held by people ($2,000 – C) equals the amount of de****nd deposits (D). Using the first equation in the second gives 10 x ($2,000 – D) = D, or $20,000 – 10D = D, or $20,000 = 11 D, so D = $1,818.18. Then C = $1,818.18. The quantity of money is C + D = $3,636.36. MONEY GROWTH AND INFLATION WHAT’S NEW IN THE FIFTH EDITION: There is a new In the News box on “A Recipe for Economic Disaster.” LEARNING O****ECTIVES: By the end of this chapter, students should understand:  why inflation results from rapid growth in the money supply.  the meaning of the classical dichotomy and monetary neutrality.  why some countries print so much money that they experience hyperinflation.  how the nominal interest rate responds to the inflation rate.  the various costs that inflation imposes on society. CONTEXT AND PURPOSE: Chapter 30 is the second chapter in a two-chapter sequence dealing with money and prices in the long run. Chapter 29 explained what money is and how the Federal Reserve controls the quantity of money. Chapter 30 establishes the relationship between the rate of growth of money and the inflation rate. The purpose of this chapter is to acquaint students with the causes and costs of inflation. Students will find that, in the long run, there is a strong relationship between the growth rate of money and inflation. Students will also find that there are numerous costs to the economy from high inflation, but that there is not a consensus on the importance of these costs when inflation is moderate. KEY POINTS:  The overall level of prices in an economy adjusts to bring money supply and money de****nd into balance. When the central bank increases the supply of money, it causes the price level to rise. Persistent growth in the quantity of money supplied leads to continuing inflation.  The principle of monetary neutrality asserts that changes in the quantity of money influence nominal variables but not real variables. Most economists believe that monetary neutrality approxi****tely describes the behavior of the economy in the long run.  A government can pay for some of its spending simply by printing money. When countries rely heavily on this “inflation tax,” the result is hyperinflation.  One application of the principle of monetary neutrality is the Fisher effect. According to the Fisher effect, when the inflation rate rises, the nominal interest rate rises by the same amount, so that the real interest rate re****ins the same.  Many people think that inflation ****kes them poorer because it raises the cost of what they buy. This view is a fallacy, however, because inflation also raises nominal incomes.  Economists have identified six costs of inflation: 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 nonindexation of the tax code, confusion and inconvenience resulting from a changing unit of account, and arbitrary redistributions of wealth between debtors and creditors. Many of these costs are large during hyperinflation, but the size of these costs for moderate inflation is less clear. CHAPTER OUTLINE: I. The inflation rate is measured as the percentage change in the Consumer Price Index, the GDP deflator, or some other index of the overall price level. A. Over the past 70 years, prices have risen an average of about 4% per year in the United States. 1. There has been substantial variation in the rate of price changes over time. 2. During the 1990s, prices rose at an average rate of 2% per year, while prices rose by 7% per year during the 1970s. B. International data shows an even broader range of inflation experiences. In 2005, inflation was 12% in Russia and 15% in Venezuela. II. The Classical Theory of Inflation Start off the chapter by differentiating between a “once-and-for-all” increase in the average level of prices and a continuous increase in the price level. Also ****ke sure that students realize that inflation means that the average level of prices in the economy is rising rather than the prices of all goods. It is instructive to review the inflation history of the United States. While your students are likely fully aware of inflation, they ****y not realize that, prior to World War II, the United States experienced several periods of deflation. Also point out to the students that the rate of inflation has varied significantly since World War II. A. The Level of Prices and the Value of Money 1. When the price level rises, people have to pay more for the goods and services that they purchase. 2. A rise in the price level also means that the value of money is now lower because each dollar now buys a s****ller quantity of goods and services. 3. If P is the price level, then the quantity of goods and services that can be purchased with $1 is equal to 1/P. B. Money Supply, Money De****nd, and Monetary Equilibrium 1. The value of money is determined by the supply and de****nd for money. 2. For the most part, the supply of money is determined by the Fed. a. This implies that the quantity of money supplied is fixed (until the Fed decides to change it). b. Thus, the supply of money will be vertical (perfectly inelastic). 3. The de****nd for money reflects how much wealth people want to hold in liquid form. a. One variable that is very important in determining the de****nd for money is the price level. b. The higher prices are, the more money that is needed to perform transactions. Figure 1 c. Thus, a higher price level (and a lower value of money) leads to a higher quantity of money de****nded. 4. In the long run, the overall price level adjusts to the level at which the de****nd for money equals the supply of money. a. If the price level is above the equilibrium level, people will want to hold more money than is available and prices will have to decline. b. If the price level is below equilibrium, people will want to hold less money than that available and the price level will rise. 5. We can show the supply and de****nd for money using a graph. a. The left-hand vertical axis is the value of money, measured by 1/P. b. The right-hand vertical axis is the price level (P ). Note that it is inverted—a high value of money means a low price level and vice versa. c. At the equilibrium, the quantity of money de****nded is equal to the quantity of money supplied. C. The Effects of a Monetary Injection 1. Assume that the economy is currently in equilibrium and the Fed suddenly increases the supply of money. 2. The supply of money shifts to the right. Figure 2 3. The equilibrium value of money falls and the price level rises. 4. When an increase in the money supply ****kes dollars more plentiful, the result is an increase in the price level that ****kes each dollar less valuable. 5. Definition of quantity theory of money: a theory asserting that the quantity of money available determines the price level and that the growth rate in the quantity of money available determines the inflation rate. D. A Brief Look at the Adjustment Process 1. The immediate effect of an increase in the money supply is to create an excess supply of money. 2. People try to get rid of this excess supply in a variety of ways. a. They ****y buy goods and services with the excess funds. b. They ****y use these excess funds to ****ke loans to others by buying bonds or depositing the money in a bank account. These loans will then be used to buy goods and services. c. In either case, the increase in the money supply leads to an increase in the de****nd for goods and services. d. Because the supply of goods and services has not changed, the result of an increase in the de****nd for goods and services will be higher prices. E. The Classical Dichotomy and Monetary Neutrality 1. In the 18th century, David Hume and other economists wrote about the relationship between monetary changes and important ****croeconomic variables such as production, employment, real wages, and real interest rates. 2. They suggested that economic variables should be divided into two groups: nominal variables and real variables. a. Definition of nominal variables: variables measured in monetary units. b. Definition of real variables: variables measured in physical units. 3. Definition of classical dichotomy: the theoretical separation of nominal and real variables. 4. Prices in the economy are nominal (because they are quoted in units of money), but relative prices are real (because they are not measured in money terms). 5. Classical ****ysis suggested that different forces influence real and nominal variables. a. Changes in the money supply affect nominal variables but not real variables. b. Definition of monetary neutrality: the proposition that changes in the money supply do not affect real variables. Mankiw’s ****ogy of changing the size of a yard from 36 inches to 18 inches is a useful way to explain the confusion that a change in a unit of measurement (or a unit of account) can cause. F. Velocity and the Quantity Equation 1. Definition of velocity of money: the rate at which money changes hands. 2. To calculate velocity, we divide nominal GDP by the quantity of money. velocity = nominal GDP/money supply 3. If P is the price level (the GDP deflator), Y is real GDP, and M is the quantity of money: velocity = P ᄡ Y M 4. Rearranging, we get the quantity equation: M ᄡV = P ᄡY ALTERNATIVE CLASSROOM EXAMPLE: Suppose that: Real GDP = $5,000 Velocity = 5 Money supply = $2,000 Price level = 2 We can show that: MxV=PxY $2,000 x 5 = 2 x $5,000 $10,000 = $10,000 5. Definition of quantity equation: the equation M × V = P × Y, which relates the quantity of money, the velocity of money, and the dollar value of the economy’s output of goods and services. a. The quantity equation shows that an increase in the quantity of money must be reflected in one of the other three variables. b. Specifically, the price level must rise, output must rise, or velocity must fall. Figure 3 c. Figure 3 shows nominal GDP, the quantity of money (as measured by M2) and the velocity of money for the United States since 1960. It appears that velocity is fairly stable, while GDP and the money supply have grown dra****tically. 6. We can now explain how an increase in the quantity of money affects the price level using the quantity equation. a. The velocity of money is relatively stable over time. b. When the central bank changes the quantity of money (M ), it will proportionately change the nominal value of output (P × Y ). c. The economy’s output of goods and services (Y ) is determined pri****rily by available resources and technology. Because money is neutral, changes in the money supply do not affect output. d. This must mean that P increases proportionately with the change in M. e. Thus, when the central bank increases the money supply rapidly, the result is a high level of inflation. Now would be a good time to discuss the debate in Chapter 23 on whether monetary policy should be ****de by rule or discretion. G. Case Study: Money and Prices during Four Hyperinflations 1. Hyperinflation is generally defined as inflation that exceeds 50% per month. Figure 4 2. Figure 4 shows data from four classic periods of hyperinflation during the 1920s in Austria, Hungary, Ger****ny, and Poland. 3. We can see that, in each graph, the quantity of money and the price level are almost parallel. 4. These episodes illustrate Principle #9: Prices rise when the government prints too much money. H. The Inflation Tax 1. Some countries use money creation to pay for spending instead of using tax revenue. 2. Definition of inflation tax: the revenue the government raises by creating money. 3. The inflation tax is like a tax on everyone who holds money. Point out that an inflation tax is a more subtle form of taxation than the standard forms of taxation (income tax, sales tax, etc.). 4. Almost all hyperinflations follow the same pattern. a. The government has a high level of spending and inadequate tax revenue to pay for its spending. b. The government’s ability to borrow funds is limited. c. As a result, it turns to printing money to pay for its spending. d. The large increases in the money supply lead to large amounts of inflation. e. The hyperinflation ends when the government cuts its spending and eliminates the need to create new money. 5. In The News: A Recipe for Economic Disaster a. There are three steps involved: print a lot of money, try to stop inflation by controlling prices, and watch the laws of economics unfold. b. This is an article about the disastrous economic policies created by Zimbabwe’s president, Robert Mugabe. I. The Fisher Effect 1. Recall that the real interest rate is equal to the nominal interest rate minus the inflation rate. 2. This, of course, means that: nominal interest rate = real interest rate + inflation rate a. The supply and de****nd for loanable funds determines the real interest rate. b. Growth in the money supply determines the inflation rate. ALTERNATIVE CLASSROOM EXAMPLE: Real interest rate = 5% Inflation rate = 2% This means that the nominal interest rate will be 5% + 2% = 7%. If the inflation rate rises to 3%, the nominal interest rate will rise to 5% + 3% = 8%. 3. When the Fed increases the rate of growth of the money supply, the inflation rate increases. This in turn will lead to an increase in the nominal interest rate. 4. Definition of Fisher effect: the one-for-one adjustment of the nominal interest rate to the inflation rate. a. The Fisher effect does not hold in the short run to the extent that inflation is unanticipated. b. If inflation catches borrowers and lenders by surprise, the nominal interest rate will fail to reflect the rise in prices. Figure 5 5. Figure 5 shows the nominal interest rate and the inflation rate in the U.S. economy since 1960. III. The Costs of Inflation A. A Fall in Purchasing Power? The Inflation Fallacy 1. Most individuals believe that the ****jor problem caused by inflation is that inflation lowers the purchasing power of a person’s income. 2. However, as prices rise, so do incomes. Thus, inflation does not in itself reduce the purchasing power of incomes. Point out to students that prices involve both buyers and sellers. This implies that the higher prices paid by consumers are exactly offset by the higher incomes received by the sellers. Also remind students that individuals often get pay increases over time to compensate for increases in the cost of living. B. Shoeleather Costs 1. Because inflation erodes the value of money that you carry in your pocket, you can avoid this drop in value by holding less money. 2. However, holding less money generally means more trips to the bank. 3. Definition of shoeleather costs: the resources wasted when inflation encourages people to reduce their money holdings. 4. This cost can be considerable in countries experiencing hyperinflation. C. Menu Costs 1. Definition of menu costs: the costs of changing prices. 2. During periods of inflation, firms must change their prices more often. D. Relative-Price Variability and the Misallocation of Resources 1. Because prices of most goods change only once in a while (instead of constantly), inflation causes relative prices to vary more than they would otherwise. 2. When inflation distorts relative prices, consumer decisions are distorted and ****rkets are less able to allocate resources to their best use. E. Inflation-Induced Tax Distortions 1. Law****kers fail to take inflation into account when they write tax laws. 2. The nominal values of interest income and capital gains are taxed (not the real values). Students find this section intriguing. Most have not considered the fact that tax laws do not differentiate between nominal and real interest income and capital gains, and they soon realize that this can lead to effects on rates of saving. Work through an example of the after-tax real interest rate under different inflation scenarios as is done in the text. Table 1 a. Table 1 shows a hypothetical example of two individuals, living in two countries earning the same real interest rate, and paying the same tax rate, but one individual lives in a country without inflation and the other lives in a country with 8% inflation. b. The person living in the country with inflation ends up with a s****ller after- tax real interest rate. 3. This implies that higher inflation will tend to discourage saving. 4. A possible solution to this problem would be to index the tax system. ALTERNATIVE CLASSROOM EXAMPLE: Homer and Marge each earn a real interest rate on their savings account of 3%. However, Homer lives in a country with a 1% inflation rate, while Marge lives in a country with a 10% inflation rate. Both countries have a 20% tax on income. Real interest rate Homer Marge Inflation rate 3% 3% Nominal interest rate 1 10 Reduced interest due to 20% tax 4 13 After-tax nominal interest rate 0.8 2.6 After-tax real interest rate 3.2 11.4 2.2 1.4 Note that the after-tax return on saving is lower in Marge’s country than in Homer’s. This means that individuals in Marge’s country will be less likely to save. F. Confusion and Inconvenience 1. Money is the yardstick that we use to measure economic transactions. 2. When inflation occurs, the value of money falls. This alters the yardstick that we use to measure important variables like incomes and profit. G. A Special Cost of Unexpected Inflation: Arbitrary Redistributions of Wealth 1. Example: Sam Student takes out a $20,000 loan at 7% interest (nominal). In 10 years, the loan will come due. After his debt has compounded for 10 years at 7%, Sam will owe the bank $40,000. 2. The real value of this debt will depend on inflation. a. If the economy has a hyperinflation, wages and prices will rise so much that Sam ****y be able to pay the $40,000 out of pocket change. b. If the economy has deflation, Sam will find the $40,000 a greater burden than he i****gined. 3. Because inflation is often hard to predict, it imposes risk on both Sam and the bank that the real value of the debt will differ from that expected when the loan is ****de. 4. Inflation is especially volatile and uncertain when the average rate of inflation is high. H. Case Study: The Wizard of Oz and the Free Silver Debate 1. Most people do not know that the book The Wizard of Oz was written about U.S. monetary policy in the late nineteenth century. 2. From 1880 to ****6, the United States experienced deflation, redistributing wealth from farmers (with outstanding loans) to banks. 3. Because the United States followed the gold standard at this time, one possible solution to the problem was to start to use silver as well. This would increase the supply of money, raising the price level, and reduce the real value of the farmers’ debts. 4. There has been some debate over the interpretation assigned to each character, but it is clear that the story revolves around the monetary policy debate at that time in history. 5. Even though those who wanted to use silver were defeated, the money supply in the United States increased in ****8 when gold was discovered in Alaska and supplies of gold were shipped in from Canada and South Africa. 6. Within 15 years, prices were back up and the farmers were better able to handle their debts. Most students have no idea that The Wizard of Oz was written about this situation. They will enjoy any infor****tion you can give them on this subject. For example, point out to the students that, in the book, Dorothy wore silver slippers, not ruby slippers. Activity 1—The Inflation Fairy Type: In-class demonstration Topics: Inflation Materials needed: None Time: 10 minutes Class limitations: Works in any size class Purpose This activity demonstrates the effects of inflation. Instructions Ask the class to consider the effect of an overnight doubling of prices. Tell them everything doubled in price while they slept. A soft drink that sold for a dollar, now sells for two dollars; a car that sold for $20,000 now sells for $40,000. The price of labor doubled as well, so a job paying $6 an hour now pays $12; a $30,000 annual salary becomes a $60,000 annual salary. The value of all assets doubled as well. Stock prices are twice what they were at yesterday’s closing. A $1,000 bond becomes a $2,000 bond. A $35 balance in a checking account become $70, and so on. Debts have also doubled. The $5 borrowed from a room****te becomes $10. The $3,000 in student loans becomes $6,000. A $75,000 home mortgage becomes a $150,000 mortgage. And even cash balances double. The inflation fairy sneaks in at night and replaces the $10 bill in their wallet with a new $20 bill. The inflation fairy even doubles the coins in their piggy banks. If the prices of everything doubled overnight, what would happen? POINTS FOR DISCUSSION If the prices of everything doubled overnight, what would happen: NOTHING. If all prices adjusted perfectly there would be no real effect. Everyone would have exactly the same purchasing power. They have twice as much money but everything costs twice as much. There have been no relative changes in price. This is a fantastic rate of inflation: 100% daily. Prices would increase over a billion-fold in a month at this rate of price change. Yet, if everything adjusts perfectly there will be no real effect on the economy. The problem, of course, is there is no inflation fairy ensuring that everything adjusts smoothly. Some prices adjust quickly and others do not. Cash balances would not double without the inflation fairy, so people would not be willing to hold cash or accept cash in payment. This would increase transaction costs considerably. If prices do not change at the same rate, there will be winners and losers from inflation. For example, if everything doubled in price overnight except debt, then borrowers would see the real value of their loan payments halved. Borrowers would win and lenders would lose. If the overnight inflation is an ongoing process, everyone would try to borrow, but no one would be willing to lend. Credit ****rkets would collapse. More generally, anyone whose income does not keep up with inflation will lose. Anyone whose costs rise less than inflation will come out ahead. Other problems can be introduced here: bracket creep, increased uncertainty, weakening of price signals, shoeleather costs, menu costs, etc. Much of the problem with inflation is distributional, but there are real consequences as well. Time spent worrying about inflation, or profiting from inflation, is a diversion of resources away from productive activity. SOLUTIONS TO TEXT PROBLEMS: Quick Quizzes 1. When the government of a country increases the growth rate of the money supply from 5 percent per year to 50 percent per year, the average level of prices will start rising very quickly, as predicted by the quantity theory of money. Nominal interest rates will increase dra****tically as well, as predicted by the Fisher effect. The government ****y be increasing the money supply to finance its expenditures. 2. Six costs of inflation are: (1) shoeleather costs; (2) menu costs; (3) relative- price variability and the misallocation of resources; (4) inflation-induced tax distortions; (5) confusion and inconvenience; and (6) arbitrary redistributions of wealth. Shoeleather costs arise because inflation causes people to spend resources going to the bank more often. Menu costs occur when people spend resources changing their posted prices. Relative-price variability occurs because as general prices rise, a fixed dollar price translates into a declining relative price, so the relative prices of goods are constantly changing, causing a misallocation of resources. The combination of inflation and taxation causes distortions in incentives because people are taxed on their nominal capital gains and interest income instead of their real income from these sources. Inflation causes confusion and inconvenience because it reduces money’s ability to function as a unit of account. Unexpected inflation redistributes wealth between borrowers and lenders. Questions for Review 1. An increase in the price level reduces the real value of money because each dollar in your wallet now buys a s****ller quantity of goods and services. 2. According to the quantity theory of money, an increase in the quantity of money causes a proportional increase in the price level. 3. 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 nominal 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. 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, instead of taxes, to finance its spending. 5. 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. 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 nonindexation of the tax code, confusion and 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 the United States, none of these costs are very high. Perhaps the most important one is the interaction between inflation and the tax code, which ****y reduce saving and investment even though the inflation rate is low. 7. 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. In this problem, all amounts are shown in billions. a. Nominal GDP = P x Y = $10,000 and Y = real GDP = $5,000, so P = (P x Y )/Y = $10,000/$5,000 = 2. Because M x V = P x Y, then V = (P x Y )/M = $10,000/$500 = 20. b. If M and V are unchanged and Y rises by 5%, then because M x V = P x Y, P must fall by 5%. As a result, nominal GDP is unchanged. c. To keep the price level stable, the Fed must increase the money supply by 5%, ****tching the increase in real GDP. Then, because velocity is unchanged, the price level will be stable. d. If the Fed wants inflation to be 10%, it will need to increase the money supply 15%. Thus M x V will rise 15%, causing P x Y to rise 15%, with a 10% increase in prices and a 5% rise in real GDP. 2. a. If people need to hold less cash, the de****nd for money shifts to the left, because there will be less money de****nded at any price level. b. If the Fed does not respond to this event, the shift to the left of the de****nd 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. Figure 1 c. If the Fed wants to keep the price level stable, it should reduce the money supply from S1 to S2 in Figure 2. This would cause the supply of money to shift to the left by the same amount that the de****nd for money shifted, resulting in no change in the value of money and the price level. Figure 2 3. 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 x V = P x Y ). 4. 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. 5. 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. 6. a. When the price of both goods doubles in a year, inflation is 100%. Let’s set the ****rket basket equal to one unit of each good. The cost of the ****rket basket is initially $4 and becomes $8 in the second year. Thus, the rate of inflation is ($8 − $4)/$4 × 100% = 100%. Because the prices of all goods rise by 100%, the farmers get a 100% increase in their incomes to go along with the 100%increase in prices, so neither is affected by the change in prices. b. If the price of beans rises to $2 and the price of rice rises to $4, then the cost of the ****rket basket in the second year is $6. This means that the inflation rate is ($6 − $4) / $4 × 100% = 50%. Bob is better off because his dollar revenues doubled (increased 100%) while inflation was only 50%. Rita 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%. c. If the price of beans rises to $2 and the price of rice falls to $1.50, then the cost of the ****rket basket in the second year is $3.50. This means that the inflation rate is ($3.5 − $4) / $4 × 100% = -12.5%. Bob is better off because his dollar revenues doubled (increased 100%) while prices overall fell 12.5%. Rita is worse off because inflation was -12.5%, 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%. d. The relative price of rice and beans ****tters more to Bob and Rita 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. 7. The following table shows the relevant calculations: (a) (b) (c) (1) Nominal interest rate 10.0 6.0 4.0 (2) Inflation rate 5.0 2.0 1.0 (3) Before-tax real interest rate 5.0 4.0 3.0 (4) Reduction in nominal interest rate due to 40% tax 4.0 2.4 1.6 (5) After-tax nominal interest rate 6.0 3.6 2.4 (6) After-tax real interest rate 1.0 1.6 1.4 Row (3) is row (1) minus row (2). Row (4) is .40 x row (1). Row (5) is (1 − .40) x 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 lower than the before-tax real interest rate. 8. 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 college president differs from you ****inly in having a higher wage, thus having a higher cost of time. 9. The functions of money are to serve as a medium of exchange, a unit of account, and a store of value. Inflation ****inly affects the ability of money to serve as a store of value, because inflation erodes money's purchasing power, ****king it less attractive as a store of value. Money also is not as useful as a unit of account when there is 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. Sometimes countries even stop using their local currency altogether and use a foreign currency as the medium of exchange as well. 10. a. Unexpectedly high inflation helps the government by providing higher 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 labor 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 that has invested some of its endowment in government bonds because the higher inflation rate means the college is receiving a lower real interest rate than it had planned. (This assumes that the college did not purchase indexed Treasury bonds.) 3111. 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 nonindexation of the tax code, and the confusion and inconvenience resulting from a changing unit of account. 12. 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, ****kes borrowers better off and lenders worse off. b. The statement, "If prices change in a way that leaves the overall price level unchanged, then no one is ****de better or worse off," is false. Changes in relative prices can ****ke 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, "Inflation does not reduce the purchasing power of most workers," is true. Most workers' incomes keep up with inflation reasonably well. OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS WHAT’S NEW IN THE FIFTH EDITION: There are two new In the News features: “Breaking Up the Chain of Production” and “How a Weak Dollar Boosts Exports.” LEARNING O****ECTIVES: By the end of this chapter, students should understand:  how net exports measure the international flow of goods and services.  how net capital outflow measures the international flow of capital.  why net exports must always equal net foreign investment.  how saving, domestic investment, and net capital outflow are related.  the meaning of the nominal exchange rate and the real exchange rate.  purchasing-power parity as a theory of how exchange rates are determined. CONTEXT AND PURPOSE: Chapter 31 is the first chapter in a two-chapter sequence dealing with open-economy ****croeconomics. Chapter 31 develops the basic concepts and vocabulary associated with ****croeconomics in an international setting: net exports, net capital outflow, real and nominal exchange rates, and purchasing-power parity. The next chapter, Chapter 32, builds an open- economy ****croeconomic model that shows how these variables are determined simultaneously. The purpose of Chapter 31 is to develop the basic concepts ****croeconomists use to study open economies. It addresses why a nation’s net exports must equal its net capital outflow. It also addresses the concepts of the real and nominal exchange rate and develops a theory of exchange rate determination known as purchasing-power parity. KEY POINTS:  Net exports are the value of domestic goods and services sold abroad (exports) minus the value of foreign goods and services sold domestically (imports). Net capital outflow is the acquisition of foreign assets by domestic residents (capital outflow) minus the acquisition of domestic assets by foreigners (capital inflow). Because every international transaction involves an exchange of an asset for a good or service, an economy’s net capital outflow always equals its net exports.  An economy’s saving can be used to finance investment at home or buy assets abroad. Thus, national saving equals domestic investment plus net capital outflow.  The nominal exchange rate is the relative price of the currency of two countries, and the real exchange rate is the relative price of the goods and services of two countries. When the nominal exchange rate changes so that each dollar buys more foreign currency, the dollar is said to appreciate or strengthen. When the nominal exchange rate changes so that each dollar buys less foreign currency, the dollar is said to depreciate or weaken.  According to the theory of purchasing-power parity, a dollar (or a unit of any other currency) should be able to buy the same quantity of goods in all countries. This theory implies that the nominal exchange rate between the currencies of two countries should reflect the price levels in those two countries. As a result, countries with relatively high inflation should have depreciating currencies, and countries with relatively low inflation should have appreciating currencies. CHAPTER OUTLINE: I. We will no longer be assuming that the economy is a closed economy. A. Definition of closed economy: an economy that does not interact with other economies in the world. B. Definition of open economy: an economy that interacts freely with other economies around the world. II. The International Flows of Goods and Capital A. The Flow of Goods: Exports, Imports, and Net Exports 1. Definition of exports: goods and services that are produced domestically and sold abroad. 2. Definition of imports: goods and services that are produced abroad and sold domestically. Point out foreign products that students are likely to buy. 3. Definition of net exports: the value of a nation’s exports minus the value of its imports, also called the trade balance. NX = Exports - Imports 4. Definition of trade balance: the value of a nation’s exports minus the value of its imports, also called net exports. 5. Definition of trade surplus: an excess of exports over imports. 6. Definition of trade deficit: an excess of imports over exports. 7. Definition of balanced trade: a situation in which exports equal imports. Point out to students that a trade surplus implies a positive level of net exports, a trade deficit means that net exports are negative, and balanced trade occurs when net exports are equal to zero. While this will likely be obvious to most students, some will benefit if you review this. 8. There are several factors that influence a country’s exports, imports, and net exports: a. The tastes of consumers for domestic and foreign goods. b. The prices of goods at home and abroad. c. The exchange rates at which people can use domestic currency to buy foreign currencies. d. The incomes of consumers at home and abroad. e. The cost of transporting goods from country to country. f. Government policies toward international trade. Figure 1 9. Case Study: The Increasing Openness of the U.S. Economy a. Figure 1 shows the total value of exports and imports (expressed as a percentage of GDP) for the United States since 1950. b. Advances in transportation, telecommunications, and technological progress are some of the reasons why international trade has increased over time. c. Policy****kers around the world have also become more accepting of free trade over time. 10. In the News: Breaking Up the Chain of Production a. Some goods have parts that are ****nufactured in ****ny countries. b. This is an article from the New York Times describing the origin of the 451 parts that ****ke up the Apple iPod. B. The Flow of Financial Resources: Net Capital Outflow 1. Definition of net capital outflow (NCO): the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners. NCO = purchases of foreign assets - purchases of domestic assets by domestic residents by foreigners You will likely have to write this equation several times on the board for students when discussing this chapter and the next. Students can grasp the concept of net exports more easily than they can grasp the concept of net capital outflow. 2. The flow of capital abroad takes two forms. a. Foreign direct investment occurs when a capital investment is owned and operated by a foreign entity. b. Foreign portfolio investment involves an investment that is financed with foreign money but operated by domestic residents. 3. Net capital outflow can be positive or negative. a. When net capital outflow is positive, domestic residents are buying more foreign assets than foreigners are buying domestic assets. Capital is flowing out of the country. b. When net capital outflow is negative, domestic residents are buying fewer foreign assets than foreigners are buying domestic assets. The country is experiencing a capital inflow. 4. There are several factors that influence a country’s net capital outflow: a. The real interest rates being paid on foreign assets. b. The real interest rates being paid on domestic assets. c. The perceived economic and political risks of holding assets abroad. d. The government policies that affect foreign ownership of domestic assets. C. The Equality of Net Exports and Net Capital Outflow 1. Net exports and net capital outflow each measure a type of imbalance in a world ****rket. a. Net exports measure the imbalance between a country’s exports and imports in world ****rkets for goods and services. b. Net capital outflow measures the imbalance between the amount of foreign assets bought by domestic residents and the amount of domestic assets bought by foreigners in world financial ****rkets. 2. For an economy, net exports must be equal to net capital outflow. 3. Example: You are a computer programmer who sells some software to a Japanese consumer for 10,000 yen. a. The sale is an export for the United States so net exports increases. b. There are several things you could do with the 10,000 yen c. You could hold the yen (which is a Japanese asset) or use it to purchase another Japanese asset. Either way, net capital outflow rises. d. Alternatively, you could use the yen to purchase a Japanese good. Thus, imports will rise so the net effect on net exports will be zero. e. One final possibility is that you could exchange the yen for dollars at a bank. This does not change the situation though, because the bank then must use the yen for something. ALTERNATIVE CLASSROOM EXAMPLE: Assume that U.S. residents do not want to buy any foreign assets, but foreign residents want to purchase some stock in a U.S. firm (such as General Motors). How are the foreigners going to get the dollars to purchase the stock? They would do it the same way U.S. residents would purchase the stock—they would have to earn more than they spend. In other words, foreigners must sell the United States more goods and services than they purchase from the United States. This leads to negative net exports for the United States. The extra dollars spent by U.S. residents on foreign-produced goods and services would be used to purchase the stock in General Motors. 4. This example can be generalized to the economy as a whole. a. When a nation is running a trade surplus (NX > 0), it must be using the foreign currency to purchase foreign assets. Thus, capital is flowing out of the country (NCO > 0). b. When a nation is running a trade deficit (NX < 0), it must be financing the net purchase of these goods by selling assets abroad. Thus, capital is flowing into the country (NCO < 0). 5. Every international transaction involves exchange. When a seller country transfers a good or service to a buyer country, the buyer country gives up some asset to pay for the good or service. 6. Thus, the net value of the goods and services sold by a country (net exports) must equal the net value of the assets acquired (net capital outflow). D. Saving, Investment, and Their Relationship to the International Flows 1. Recall that GDP (Y ) is the sum of four components: consumption (C ), investment (I ), government purchases (G ) and net exports (NX ). Y = C + I + G + NX 2. Recall that national saving is equal to the income of the nation after paying for current consumption and government purchases. S =Y -C -G 3. We can rearrange the equation for GDP to get: Y - C - G = I + NX Substituting for the left-hand side, we get: S = I + NX 4. Because net exports and net capital outflow are equal, we can rewrite this as: S = I + NCO 5. This implies that saving is equal to the sum of domestic investment (I ) and net capital outflow (NCO ). 6. When an American citizen saves $1 of his income, that dollar can be used to finance accumulation of domestic capital or it can be used to finance the purchase of capital abroad. 7. Note that, in a closed economy such as the one we assumed earlier, net capital outflow would equal zero and saving would simply be equal to domestic investment. E. Summing Up 1. Table 1 describes three possible outcomes for an open economy: a country with a trade deficit, a country with balanced trade, or a country with a trade surplus. Table 1 2. Case Study: Is the U.S. Trade Deficit a National Problem? Figure 2 a. Panel (a) of Figure 2 shows national saving and domestic investment for the United States as a percentage of GDP since 1960. b. Panel (b) of Figure 2 shows net capital outflow for the United States as a percentage of GDP for the same time period. c. Before 1980, domestic investment and national saving were very close, meaning that net capital outflow was s****ll. d. National saving fell after 1980 (in part due to large government budget deficits) but domestic investment did not change by as much. This led to a dra****tic increase in the size of net capital outflow (in absolute value because it was negative). e. From 1991 to 2000, the capital flow into the United States also increased as investment went from 13.4% to 17.7% of GDP. f. From 2000 to 2006, the capital flow into the United States increased further, reaching a record 5.8% of GDP. g. When national saving falls, either investment will have to fall or net capital outflow will have to fall. h. On the other hand, a trade deficit led by an increase in investment will not pose a large problem for the United States if the increased investment leads to a higher production of goods and services. III. The Prices for International Transactions: Real and Nominal Exchange Rates Students are curious about the currencies of other countries. Bring in a current list of nominal exchange rates between several currencies and the U.S. dollar. Quiz the students to see if they can ****tch up the currencies with the countries where they are used. Encourage students to bring in foreign currencies if they have them. A. Nominal Exchange Rates 1. Definition of nominal exchange rate: the rate at which a person can trade the currency of one country for the currency of another. 2. An exchange rate can be expressed in two ways. a. Example: 80 yen per dollar. b. This can also be written as 1/80 dollar (or 0.0125 dollar) per yen. ALTERNATIVE CLASSROOM EXAMPLE: $1 = 10 pesos 1 peso = $0.10 3. Definition of appreciation: an increase in the value of a currency as measured by the amount of foreign currency it can buy. 4. Definition of depreciation: a decrease in the value of a currency as measured by the amount of foreign currency it can buy. 5. When a currency appreciates, it is said to strengthen; when a currency depreciates, it is said to weaken. 6. When economists study nominal exchange rates, they often use an exchange rate index, which converts the ****ny nominal exchange rates into a single measure. 7. FYI: The Euro a. During the 1990s, ****ny European nations decided to give up their national currencies and use a new common currency called the euro. b. The euro started circulating on January 1, 2002. c. Monetary policy is now set by the European Central Bank (ECB), which controls the supply of euros in the economy. d. Benefits of a common currency include easier trading ability and increased unity. e. However, because there is only one currency, there can be only one monetary policy. Make sure that you emphasize that when the dollar appreciates against a particular currency that currency must depreciate against the dollar. Use an example to illustrate this point. B. Real Exchange Rates 1. Definition of real exchange rate: the rate at which a person can trade the goods and services of one country for the goods and services of another. 2. Example: A bushel of American rice sells for $100 and a bushel of Japanese rice sells for 16,000 yen. The nominal exchange rate is 80 yen per dollar. 3. The real exchange rate depends on the nominal exchange rate and on the prices of goods in the two countries measured in the local currencies. real exchange rate = Nominal exchange rate ᄡ Domestic price Foreign price 4. In our example: real exchange rate = (80 yen per dollar)($100 per bushel of American rice) 16,000 yen per bushel of Japanese rice real exchange rate = 8,000 yen per bushel of American rice 16,000 yen per bushel of Japanese rice real exchange rate = 1/2 bushel of Japanese rice per bushel of American rice ALTERNATIVE CLASSROOM EXAMPLE: Price of Mexican corn = 50 pesos/bushel Price of American corn = $10/bushel Nominal exchange rate: $1 = 10 pesos real exchange rate = (10 pesos per dollar)($10 per bushel of American corn) real exchange rate = 50 pesos per bushel of Mexican corn real exchange rate = 100 pesos per bushel of American corn 50 pesos per bushel of Mexican corn 2 bushels of Mexican corn per bushel of American corn 5. The real exchange rate is a key determinant of how much a country exports and imports. 6. When studying an economy as a whole, ****croeconomists focus on overall prices instead of the prices of individual goods and services. a. Price indexes are used to measure the level of overall prices. b. Assume that P is the price index for the United States, P* is a price index for prices abroad, and e is the nominal exchange rate between the U.S. dollar and foreign currencies. real exchange rate = e ᄡP P* 7. The real exchange rate measures the price of a basket of goods and services available domestically relative to the price of a basket of goods and services available abroad. 8. A depreciation in the U.S. real exchange rate means that U.S. goods have become cheaper relative to foreign goods. U.S. exports will rise, imports will fall, and net exports will increase. 9. Likewise, an appreciation in the U.S. real exchange rate means that U.S. goods have become more expensive relative to foreign goods. U.S. exports will fall, imports will rise, and net exports will decline. C. In the News: How a Weak Dollar Boosts Exports 1. In 2007, the U.S. dollar weakened in foreign exchange ****rkets. 2. This is an article from the Boston Globe describing how the fall in the dollar’s value benefited shoppers from abroad. IV. A First Theory of Exchange-Rate Determination: Purchasing-Power Parity A. Definition of purchasing-power parity: a theory of exchange rates whereby a unit of any given currency should be able to buy the same quantity of goods in all countries. B. The Basic Logic of Purchasing-Power Parity 1. The law of one price suggests that a good must sell for the same price in all locations. a. If a good sold for less in one location than another, a person could ****ke a profit by buying the good in the location where it is cheaper and selling it in the location where it is more expensive. b. The process of taking advantage of differences in prices for the same item in different ****rkets is called arbitrage. c. Note what will happen as people take advantage of the differences in prices. The price in the location where the good is cheaper will rise (because the de****nd is now higher) and the price in the location where the good was more expensive will fall (because the supply is greater). This will continue until the two prices are equal. 2. The same logic should apply to currency. a. A U.S. dollar should buy the same quantity of goods and services in the United States and Japan; a Japanese yen should buy the same quantity of goods and services in the United States and Japan. b. Purchasing-power parity suggests that a unit of all currencies must have the same real value in every country. c. If this was not the case, people would take advantage of the profit-****king opportunity and this arbitrage would then push the real values of the currencies to equality. Activity 1—A Profitable Opportunity Type: In-class assignment Topics: Exchange rates, arbitrage Materials needed: None Time: 20 minutes Class limitations: Works in any size class Purpose This assignment lets the students practice calculating prices with exchange rates and looking for profit opportunities. Instructions Explain the following: Molson’s Beer is produced in Canada and sold in ****ny countries. In the province of Ontario, a six-pack of Molson’s beer sells for $8.75 Canadian. Across the border in Michigan, a six pack of the same beer sells for $5.19 U.S. Suppose that the exchange rate is $0.67 U.S. = $1.00 Canadian. Ask the class to ****ke the following calculations: 1. How much would it cost in U.S. currency to buy the beer in Ontario? 2. How much would it cost in Canadian currency to buy the beer in Michigan? 3. Is there an arbitrage opportunity? 4. If there is an arbitrage opportunity, where would you buy and where would you sell? How much profit could you expect on a six-pack? Common Answers and Points for Discussion 1. How much would it cost in U.S. currency to buy the beer in Ontario? 8.75  0.67 = $5.86 U.S. 2. How much would it cost in Canadian currency to buy the beer in Michigan? 5.19/0.67 = $7.75 Canadian 3. Is there an arbitrage opportunity? Yes. A price differential exits. The beer is more expensive in Canada, cheaper in the United States. 4. If there is an arbitrage opportunity, where would you buy and where would you sell? How much profit could you expect on a six-pack? Buy in Michigan, sell in Ontario. The profit per six-pack would be the difference between the price in Ontario, $5.86, and the price in Michigan, $5.19, which equals $0.67 U.S. (Or, measured in Canadian currency, a profit of $1.00 Canadian.) C. Implications of Purchasing-Power Parity 1. Purchasing-power parity means that the nominal exchange rate between the currencies of two countries will depend on the price levels in those countries. 2. If a dollar buys the same amount of goods and services in the United States (where prices are measured in dollars) as it does in Japan (where prices are measured in yen), then the nominal exchange rate (the number of yen per dollar) must reflect the prices of goods and services in the two countries. 3. Suppose that P is the price of a basket of goods in the United States (measured in dollars), P* is the price of a basket of goods in Japan (measured in yen), and e is the nominal exchange rate (the number of yen each dollar can buy). a. In the United States, the purchasing power of $1 is 1/P. b. In Japan, $1 can be exchanged for e units of yen, which in turn have the purchasing power of e/P*. c. Purchasing-power parity implies that the two must be equal: 1/P = e/P * d. Rearranging, we get: 1 = (eP )/P * Note that the left-hand side is a constant and the right-hand side is the real exchange rate. This implies that if the purchasing power of a dollar is always the same at home and abroad, then the real exchange rate cannot change. e. We can rearrange again to see that: e =P P* This implies that the nominal exchange rate is determined by the ratio of the foreign price level to the domestic price level. Nominal exchange rates will change when price levels change. 4. Because the nominal exchange rate depends on the price levels, it must also depend on the money supply and money de****nd in each country. a. If the central bank increases the supply of money in a country and raises the price level, it also causes the country’s currency to depreciate relative to other currencies in the world. b. When a central bank prints large quantities of money, that money loses value both in terms of the goods and services it can buy and in terms of the amount of other currencies it can buy. 5. Case Study: The Nominal Exchange Rate during a Hyperinflation Figure 3 a. Figure 3 shows the Ger****n money supply, the Ger****n price level, and the nominal exchange rate (measured as U.S. cents per Ger****n ****rk) during Ger****ny's hyperinflation in the early 1920s. b. When the supply of money begins growing, the price level also increases and the Ger****n ****rk depreciates. D. Limitations of Purchasing-Power Parity 1. Exchange rates do not always move to ensure that a dollar has the same real value in all countries all of the time. 2. There are two reasons why the theory of purchasing-power parity does not always hold in practice. a. Many goods are not easily traded (haircuts in Paris versus haircuts in New York). Thus, arbitrage would be too limited to eliminate the difference in prices between the locations. b. Tradable goods are not always perfect substitutes when they are produced in different countries (American cars versus Ger****n cars). There is no opportunity for arbitrage here, because the price difference reflects the different values the consumer places on the two products. 3. Case Study: The Hamburger Standard a. The Economist, an international news ****gazine, occasionally compares the cost of a Big Mac in various countries all around the world. b. Once we have the prices of Big Macs in two countries, we can compute the nominal exchange rate predicted by the theory of purchasing-power parity and compare it with the actual exchange rate. c. In an article from January 2005, it was shown that the exchange rates predicted by the theory were not exactly equal to the actual rates. However, the predicted rates were fairly close to the actual rates. Students who have lived or traveled overseas will often point out that ****ny American products (such as blue jeans) are much more expensive overseas than they are in the United States. Point out to students that this could be the result of trade restrictions or price discrimination. Examine the implications of each. Point out to students that, even with its flaws, purchasing-power parity does tell us about exchange rates. Large and persistent movements in nominal exchange rates typically reflect changes in price level at home and abroad. SOLUTIONS TO TEXT PROBLEMS: Quick Quizzes 1. Net exports are the value of a nation’s exports minus the value of its imports, also called the trade balance. Net capital outflow is the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners. Net exports equal net capital outflow. 2. The nominal exchange rate is the rate at which a person can trade the currency of one country for the currency of another. The real exchange rate is the rate at which a person can trade the goods and services of one country for the goods and services of another. They are related through the expression: real exchange rate equals nominal exchange rate times domestic price divided by foreign price. If the nominal exchange rate goes from 100 to 120 yen per dollar, the dollar has appreciated because a dollar now buys more yen. 3. Because Spain has had high inflation and Japan has had low inflation, the number of Spanish pesetas a person can buy with Japanese yen has increased. Questions for Review 1. 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, because exports from one country to another are ****tched by payments of some asset from the second country to the first. 2. Saving equals domestic investment plus net capital outflow, because 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 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 American car divided by 500,000 yen per Japanese car, which equals two Japanese cars per American car. 4. 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. 5. If the Fed started printing large quantities of U.S. dollars, the U.S. price level would increase, and a dollar would buy fewer Japanese yen. Problems and Applications 1. a. When an American art professor spends the summer touring museums in Europe, he spends money buying foreign goods and services, so U.S. exports are unchanged, imports increase, and net exports decrease. b. When students in Paris flock to see the latest movie from Hollywood, foreigners are buying a U.S. good, so U.S. exports rise, imports are unchanged, and net exports increase. c. When your uncle buys a new Volvo, an American is buying a foreign good, so U.S. exports are unchanged, imports rise, and net exports decline. d. When the student bookstore at Oxford University sells a pair of Levi's 501 jeans, foreigners are buying U.S. goods, so U.S. exports increase, imports are unchanged, and net exports increase. e. When a Canadian citizen shops in northern Vermont to avoid Canadian sales taxes, a foreigner is buying U.S. goods, so U.S. exports increase, imports are unchanged, and net exports increase. 2. a. When an American buys a Sony Walk****n, there is a decrease in net exports. b. When an American buys a share of Sony stock, there is an increase in net capital outflow. c. When the Sony pension fund buys a U.S. Treasury bond, there is a decrease in net capital outflow. d. When a worker at Sony buys some Georgia peaches from an American farmer, there is an increase in net exports. 3. 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 (because 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. 4. Foreign direct investment requires actively ****naging 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 engage in foreign direct investment, while an individual investor is more likely to engage in foreign portfolio investment. 5. a. When an American cellular phone company establishes an office in the Czech Republic, U.S. net capital outflow increases, because the U.S. company ****kes a direct investment in capital in the foreign country. b. When Harrod's of London sells stock to the General Electric pension fund, U.S. net capital outflow increases, because the U.S. company ****kes a portfolio investment in the foreign country. c. When Honda expands its factory in Marysville, Ohio, U.S. net capital outflow declines, because the foreign company ****kes a direct investment in capital in the United States. d. When a Fidelity mutual fund sells its Volkswagen stock to a French investor, U.S. net capital outflow declines (if the French investor pays in U.S. dollars), because the U.S. company is reducing its portfolio investment in a foreign country. 6. If national saving is constant and net capital outflow increases, domestic investment must decrease, because national saving equals domestic investment plus net capital outflow. If domestic investment declines, the country's accumulation of domestic capital declines. 7. a. The newspaper shows nominal exchange rates, because it shows the number of units of one currency that can be exchanged for another currency. b. Many answers are possible. c. If U.S. inflation exceeds Japanese inflation over the next year, you would expect the 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. 8. a. Dutch pension funds holding U.S. government bonds would be happy if the U.S. dollar appreciated. They would then get more Dutch guilders for each dollar they earned on their U.S. investment. In general, if you have an investment in a foreign country, you are better off if that country's currency appreciates. b. U.S. ****nufacturing industries would be unhappy if the U.S. 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 the United States would be unhappy if the U.S. dollar appreciated because they would get fewer U.S. dollars for each Australian dollar, so their vacation will be more expensive. d. An American firm trying to purchase property overseas would be happy if the U.S. dollar appreciated because it would get more units of the foreign currency and could thus buy more property. 9. 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. a. If the U.S. nominal exchange rate is unchanged, but prices rise faster in the United States than abroad, the real exchange rate rises. b. If the U.S. nominal exchange rate is unchanged, but prices rise faster abroad than in the United States, the real exchange rate declines. c. If the U.S. nominal exchange rate declines and prices are unchanged in the United States and abroad, the real exchange rate declines. d. If the U.S. nominal exchange rate declines and prices rise faster abroad than in the United States, the real exchange rate declines. 3210. If purchasing-power parity holds, then 12 pesos per soda divided by $0.75 per soda equals the exchange rate of 16 pesos per dollar. If prices in Mexico doubled, the exchange rate will double to 32 pesos per dollar. 11. a. To ****ke a profit, you would want to buy rice where it is cheap and sell it where it is expensive. Because American rice costs 100 dollars per bushel, and the exchange rate is 80 yen per dollar, American rice costs 100 x 80 equals 8,000 yen per bushel. So American rice at 8,000 yen per bushel is cheaper than Japanese rice at 16,000 yen per bushel. So you could take 8,000 yen, exchange them for 100 dollars, buy a bushel of American rice, then sell it in Japan for 16,000 yen, ****king a profit of 8,000 yen. As people did this, the de****nd for American rice would rise, increasing the price in America, and the supply of Japanese rice would rise, reducing the price in Japan. The process would continue until the prices in the two countries were the same. b. If rice were the only commodity in the world, the real exchange rate between the United States and Japan would start out too low, then rise as people bought rice in America and sold it in Japan, until the real exchange became one in long-run equilibrium. 12. If you take X units of foreign currency per Big Mac divided by 3.41 dollars per Big Mac, you get X/3.06 units of the foreign currency per dollar; that is the predicted exchange rate. a. Indonesia: 15,900/3.41 = 4,663 rupiah/$ Hungary: 600/3.41 = 176 forint/$ Czech Republic: 52.9/3.41 = 15.5 koruna/$ Brazil: 6.9/3.41 = 2.02 real/$ Canada: 3.88/3.41 = 1.14C$/$ b. Under purchasing-power parity, the exchange rate of the Hungarian forint to the Canadian dollar is 600 forints per Big Mac divided by 3.88 Canadian dollars per Big Mac equals 155 forints per Canadian dollar. The actual exchange rate is 180 forints per dollar divided by 1.05 Canadian dollars per dollar equals 171 forints per Canadian dollar. c. The exchange rate predicted by the Big Mac index (155 forints per Canadian dollar) is somewhat close to the actual exchange rate of 171 forints per Canadian dollar. A MACROECONOMIC THEORY OF THE OPEN ECONOMY WHAT’S NEW IN THE FIFTH EDITION: There is an improved explanation of why net capital outflow does not depend on the exchange rate. There is a new Case Study on “Capital Flows from China” and a new In the News feature on “What Causes the U.S. Trade Deficit?” LEARNING O****ECTIVES: By the end of this chapter, students should understand:  how to build a model to explain an open economy’s trade balance and exchange rate.  how to use the model to ****yze the effects of government budget deficits.  how to use the model to ****yze the ****croeconomic effects of trade policies.  how to use the model to ****yze political instability and capital flight. CONTEXT AND PURPOSE: The purpose of Chapter 32 is to establish the interdependence of a number of economic variables in an open economy. In particular, Chapter 32 demonstrates the relationships between the prices and quantities in the ****rket for loanable funds and the prices and quantities in the ****rket for foreign-currency exchange. Using these ****rkets, we can ****yze the impact of a variety of government policies on an economy’s exchange rate and trade balance. KEY POINTS:  Two ****rkets are central to the ****croeconomics of open economies: the ****rket for loanable funds and the ****rket for foreign-currency exchange. In the ****rket for loanable funds, the real interest rate adjusts to balance the supply of loanable funds (from national saving) and the de****nd for loanable funds (from domestic investment and net capital outflow). In the ****rket for foreign-currency exchange, the real exchange rate adjusts to balance the supply of dollars (from net capital outflow) and the de****nd for dollars (for net exports). Because net capital outflow is part of the de****nd for loanable funds and because it provides the supply of dollars for foreign-currency exchange, it is the variable that connects these two ****rkets.  A policy that reduces national saving, such as a government budget deficit, reduces the supply of loanable funds and drives up the interest rate. The higher interest rate reduces net capital outflow, which reduces the supply of dollars in the ****rket for foreign-currency exchange. The dollar appreciates, and net exports fall.  Although restrictive trade policies, such as tariffs or quotas on imports, are sometimes advocated as a way to alter the trade balance, they do not necessarily have that effect. A trade restriction increases net exports for a given exchange rate and, therefore, increases the de****nd for dollars in the ****rket for foreign-currency exchange. As a result, the dollar appreciates in value, ****king domestic goods more expensive relative to foreign goods. This appreciation offsets the initial impact of the trade restriction on net exports.  When investors change their attitudes about holding assets of a country, the ramifications for the country’s economy can be profound. In particular, political instability can lead to capital flight, which tends to increase interest rates and cause the currency to depreciate. CHAPTER OUTLINE: I. Supply and De****nd for Loanable Funds and for Foreign-Currency Exchange A. The Market for Loanable Funds 1. Whenever a nation saves a dollar of income, it can use that dollar to finance the purchase of domestic capital or to finance the purchase of an asset abroad. 2. The supply of loanable funds comes from national saving. 3. The de****nd for loanable funds comes from domestic investment and net capital outflow. a. Because net capital outflow can be positive or negative, it can either add to or subtract from the de****nd for loanable funds that arises from domestic investment. b. When NCO > 0, the country is experiencing a net outflow of capital. When NCO < 0, the country is experiencing a net inflow of capital. 4. The quantity of loanable funds de****nded and the quantity of loanable funds supplied depend on the real interest rate. a. A higher real interest rate encourages people to save and thus raises the quantity of loanable funds supplied. b. A higher interest rate ****kes borrowing to finance capital projects more costly, discouraging investment and reducing the quantity of loanable funds de****nded. c. A higher real interest rate in a country will also lower net capital outflow. All else being equal, a higher domestic interest rate implies that purchases of foreign assets by domestic residents will fall and purchases of domestic assets by foreigners will rise. You ****y need to write the equation for net capital outflow on the board to explain its relationship with the real interest rate. Point out that when the U.S. real interest rate rises, purchases of foreign assets by domestic residents fall and purchases of U.S. assets by foreigners rise. Thus, net capital outflow is inversely related to the real interest rate. 5. The supply and de****nd for loanable funds can be shown graphically. a. The real interest rate is the price of borrowing funds and is therefore on the vertical axis; the quantity of loanable funds is on the horizontal axis. b. The supply of loanable funds is upward sloping because of the positive relationship between the real interest rate and the quantity of loanable funds supplied. c. The de****nd for loanable funds is downward sloping because of the inverse relationship between the real interest rate and the quantity of loanable funds de****nded. Figure 1 Put “saving” in parentheses next to the supply of loanable funds and “I + NCO ” next to the de****nd for loanable funds. Encourage students to do the same. These will serve as reminders of from where the supply and de****nd for loanable funds are derived. 6. The interest rate adjusts to bring the supply and de****nd for loanable funds into balance. a. If the interest rate was below r*, the quantity of loanable funds de****nded would be greater than the quantity of loanable funds supplied. This would lead to upward pressure on the interest rate. b. If the interest rate was above r*, the quantity of loanable funds de****nded would be less than the quantity of loanable funds supplied. This would lead to downward pressure on the interest rate. 7. At the equilibrium interest rate, the amount that people want to save is exactly equal to the desired quantities of domestic investment and net capital outflow. B. The Market for Foreign-Currency Exchange 1. The imbalance between the purchase and sale of capital assets abroad must be equal to the imbalance between exports and imports of goods and services. 2. Net capital outflow represents the quantity of dollars supplied for the purpose of buying assets abroad. 3. Net exports represent the quantity of dollars de****nded for the purpose of buying U.S. net exports of goods and services. 4. The real exchange rate is the price that balances the supply and de****nd in the ****rket for foreign-currency exchange. a. When the U.S. real exchange rate appreciates, U.S. goods become more expensive relative to foreign goods, lowering U.S. exports and raising imports. Thus, an increase in the real exchange rate will reduce the quantity of dollars de****nded. b. The key determinant of net capital outflow is the real interest rate. Thus, as the real exchange rate changes, there will be no change in net capital outflow. Go back to the list of factors that influence net capital outflow (from the previous chapter). Show students that the exchange rate is not there. 5. We can show the ****rket for foreign-currency exchange graphically. a. The real exchange rate is on the vertical axis; the quantity of dollars exchanged is on the horizontal axis. b. The de****nd for dollars will be downward sloping because of the inverse relationship between the real exchange rate and the quantity of dollars de****nded. c. The supply of dollars will be a vertical line because of the fact that changes in the real exchange rate have no influence on the quantity of dollars supplied. Figure 2 Remind students that net exports determine the de****nd for dollars by placing “NX ” in parentheses next to the de****nd curve. Show that net capital outflow determines the supply of dollars by placing “NCO ” in parentheses next to the supply curve. 6. The real exchange rate adjusts to balance the supply and de****nd for dollars. a. If the real exchange rate was lower than real e*, the quantity of dollars de****nded would be greater than the quantity of dollars supplied and there would be upward pressure on the real exchange rate. b. If the real exchange rate was higher than real e*, the quantity of dollars de****nded would be less than the quantity of dollars supplied and there would be downward pressure on the real exchange rate. 7. At the equilibrium real exchange rate, the de****nd for dollars to buy net exports exactly balances the supply of dollars to be exchanged into foreign currency to buy assets abroad. C. FYI: Purchasing-Power Parity as a Special Case 1. Purchasing-power parity suggests that a dollar must buy the same quantity of goods and services in every country. As a result, the real exchange rate is fixed and the nominal exchange rate is determined by the price levels in the two countries. 2. Purchasing-power parity assumes that international trade responds quickly to international price differences. a. If goods were cheaper in one country than another, they would be exported from the country where they are cheaper and imported into the second country where the prices are higher until the price differential disappears. b. Because net exports are so responsive to s****ll changes in the real exchange rate, purchasing-power parity implies that the de****nd for dollars would be horizontal. Thus, purchasing-power parity is simply a special case of the model of the foreign-currency exchange ****rket. c. However, it is more realistic to draw the de****nd curve downward sloping. II. Equilibrium in the Open Economy A. Net Capital Outflow: The Link between the Two Markets 1. In the ****rket for loanable funds, net capital outflow is one of the sources of de****nd. Figure 3 2. In the foreign-currency exchange ****rket, net capital outflow is the source of the supply of dollars. 3. This means that net capital outflow is the variable that links the two ****rkets. 4. The key determinant of net capital outflow is the real interest rate. 5. We can show the relationship between net capital outflow and the real interest rate graphically. a. When the real interest rate is high, owning domestic assets is more attractive and thus, net capital outflow is low. Again, you ****y need to write the equation for net capital outflow on the board to demonstrate the inverse relationship between the real interest rate and net capital outflow. b. This inverse relationship implies that net capital outflow will be downward sloping. c. Note that net capital outflow can be positive or negative. B. Simultaneous Equilibrium in Two Markets Students will be frightened by the next diagram showing the ****rket for loanable funds and the ****rket for foreign-currency exchange, with the diagram of net capital outflow linking the two. Go through it very slowly. You will likely have to repeat the equilibrium Figure 4 process several times before students understand it. 1. The real interest rate is determined in the ****rket for loanable funds. 2. This real interest rate determines the level of net capital outflow. 3. Because net capital outflow must be paid for with foreign currency, the quantity of net capital outflow determines the supply of dollars. 4. The equilibrium real exchange rate brings into balance the quantity of dollars supplied and the quantity of dollars de****nded. 5. Thus, the real interest rate and the real exchange rate adjust simultaneously to balance supply and de****nd in the two ****rkets. As they do so, they determine the levels of national saving, domestic investment, net capital outflow, and net exports. C. FYI: Disentangling Supply and De****nd 1. Sometimes it is a bit arbitrary how we divide things between supply and de****nd. 2. In the ****rket for loanable funds, our model treats net capital outflow as part of the de****nd for loanable funds. a. Investment plus net capital outflow must equal saving (I + NCO = S). b. Thus, we could say instead that investment is equal to saving minus net capital outflow (I = S – NCO). 3. In the ****rket for foreign-currency exchange, net exports are the source of the de****nd for dollars and net capital outflow is the source of the supply of dollars. a. When a U.S. citizen buys an imported good, we treat it as a decrease in the de****nd for dollars rather than an increase in the supply of dollars. b. When a Japanese citizen buys a U.S. government bond, we treat the transaction as a decline in the supply of dollars rather than an increase in the de****nd for dollars. III. How Policies and Events Affect an Open Economy For the next three applications, use the three-step process developed in Chapter 4. First, determine which of the supply and de****nd curves have been affected. Second, determine in which direction the curves shift, and finally, use the supply and de****nd diagrams to examine how these shifts alter equilibrium in the two ****rkets. A. Government Budget Deficits Figure 5 1. A government budget deficit occurs when the government spending exceeds government revenue. 2. Because a government deficit represents negative public saving, it lowers national saving. This leads to a decline in the supply of loanable funds. 3. The real interest rate rises, leading to a decline in both domestic investment and net capital outflow. 4. Because net capital outflow falls, people need less foreign currency to buy foreign assets, and therefore supply fewer dollars in the ****rket for foreign-currency exchange. 5. The real exchange rate rises, ****king U.S. goods more expensive relative to foreign goods. Exports will fall, imports will rise, and net exports will fall. 6. In an open economy, government budget deficits raise real interest rates, crowd out domestic investment, cause the dollar to appreciate, and push the trade balance toward deficit. 7. Because they are so closely related, the budget deficit and the trade deficit are often called the twin deficits. Note that because ****ny other factors affect the trade deficit, these “twins” are not identical. Now would be a good time to discuss the debate in Chapter 36 concerning whether the federal government should balance the budget. 8. In The News: What causes the U.S. Trade Deficit? a. Saving abroad can lead to a trade deficit at home. b. This is an article from the Washington Post describing the effects of low U.S. saving rates on its trade deficit. B. Trade Policy Figure 6 1. Definition of trade policy: a government policy that directly influences the quantity of goods and services that a country imports or exports. 2. Two common types of trade policies are tariffs (taxes on imported goods) and quotas (limits on the quantity of imported goods). 3. Example: The U.S. government imposes a quota on the number of cars imported from Japan. 4. Note that the quota will have no effect on the ****rket for loanable funds. Thus, the real interest rate will be unaffected. 5. The quota will lower imports and thus increase net exports. Because net exports are the source of de****nd for dollars in the ****rket for foreign-currency exchange, the de****nd for dollars will increase. 6. The real exchange rate will rise, ****king U.S. goods relatively more expensive than foreign goods. Exports will fall, imports will rise, and net exports will fall. 7. In the end, the quota reduces both imports and exports but net exports re****in the same. 8. Trade policies do not affect the trade balance. 9. Recall that NX = NCO. Also remember that S = I + NCO. Rewriting, we get: NCO = S – I. Substituting for NCO, we get: NX = S – I. 10. Because trade policies do not affect national saving or domestic investment, they cannot affect net exports. 11. Trade policies do have effects on specific firms, industries, and countries. But these effects are more microeconomic than ****croeconomic. C. Political Instability and Capital Flight 1. Definition of capital flight: a large and sudden reduction in the de****nd for assets located in a country. 2. Capital flight often occurs because investors feel that the country is unstable, due to either economic or political problems. 3. Example: Investors around the world observe political problems in Mexico and begin selling Mexican assets and buying assets from other countries that are viewed as safe. Figure 7 4. Mexican net capital outflow will rise because investors are selling Mexican assets and purchasing assets from other countries. a. Because net capital outflow determines the supply of pesos, the supply of pesos increases. b. Because net capital outflow is also a part of the de****nd for loanable funds, the de****nd for loanable funds rises. 5. The increased de****nd for loanable funds causes the equilibrium real interest rate to rise. 6. The increased supply of pesos lowers the equilibrium real exchange rate. 7. Thus, capital flight from Mexico increases Mexican interest rates and lowers the value of the Mexican peso in the ****rket for foreign-currency exchange. 8. Capital flight in Mexico will also affect other countries. If the capital flows out of Mexico and into the United States, it has the opposite effect on the U.S. economy. 9. In 1997, several Asian countries experienced capital flight. A similar experience occurred in Russia in 1998 and Argentina in 2002. ALTERNATIVE CLASSROOM EXAMPLE: Suppose that investors feel very confident about the prospects for investment in Brazilian assets. In this case (from the perspective of Brazil): 1. The de****nd for loanable funds will shift left because NCO decreases. 2. The NCO curve will also shift left. 3. The real interest rate in Brazil will fall. 4. The supply of reals (the “real” is the currency of Brazil) will shift left. 5. The real exchange rate will rise. 6. Brazilian net exports will fall. 10. Case Study: Capital Flows from China a. What happens if a country’s government encourages capital to flow to other countries? b. It leads to a weaker currency and a trade surplus. c. In recent years, this has been the case with China as its government has tried to depress its currency. Activity 1—Open Economy Article Type: Take-home assignment Topics: Open-economy ****croeconomics Class limitations: Works in any class Purpose This assignment helps students apply the open-economy ****cro model to world events. Instructions This model is often confusing to students. This assignment has them work through an example of real-world events that relate to international ****croeconomics. Students ****y need some direction in finding appropriate topics such as interest rate changes, changes in net capital outflow, or changes in net exports. Assignment 1. Find an article in a recent newspaper or ****gazine illustrating a change that will affect net capital outflow or net exports. 2. Explain how and why net capital outflow or net exports would shift. 3. Use the three ****rket open-economy model (the ****rket for loanable funds, net capital outflow, and the ****rket for foreign-currency exchange) to ****yze this change. 4. Graph the equilibrium real interest rate, level of net capital outflow, and real exchange rate before the change. Then show how the change will affect these variables. 5. Turn in a copy of the article along with your explanation. SOLUTIONS TO TEXT PROBLEMS: Quick Quizzes 1. The supply of loanable funds comes from national saving. The de****nd for loanable funds comes from domestic investment and net capital outflow. The supply in the ****rket for foreign-currency exchange comes from net capital outflow. The de****nd in the ****rket for foreign-currency exchange comes from net exports. 2. The two ****rkets in the model of the open economy are the ****rket for loanable funds and the ****rket for foreign-currency exchange. These ****rkets determine two relative prices: (1) the ****rket for loanable funds determines the real interest rate and (2) the ****rket for foreign-currency exchange determines the real exchange rate. 3. If Americans decided to spend a s****ller fraction of their incomes, the increase in saving would shift the supply curve for loanable funds to the right, as shown in Figure 1. The decline in the real interest rate increases net capital outflow and shifts the supply of dollars to the right in the ****rket for foreign-currency exchange. The result is a decline in the real exchange rate. Since the real interest rate is lower, domestic investment increases. Since the real exchange rate declines, net exports increase and the trade balance moves toward surplus. Overall, saving and domestic investment increase, the real interest rate and real exchange rate decrease, and the trade balance moves toward surplus. Figure 1 Questions for Review 1. The supply of loanable funds comes from national saving; the de****nd for loanable funds comes from domestic investment and net capital outflow. The supply of dollars in the ****rket for foreign exchange comes from net capital outflow; the de****nd for dollars in the ****rket for foreign exchange comes from net exports. The link between the two ****rkets is net capital outflow. 2. Government budget deficits and trade deficits are sometimes called the twin deficits because a government budget deficit often leads to a trade deficit. The government budget deficit leads to reduced national saving, causing the interest rate to increase, and reducing net capital outflow. The decline in net capital outflow reduces the supply of dollars, raising the real exchange rate. Thus, the trade balance will move toward deficit. 3. If a union of textile workers encourages people to buy only American-****de clothes, imports would be reduced, so net exports would increase for any given real exchange rate. This would cause the de****nd curve in the ****rket for foreign exchange to shift to the right, as shown in Figure 2. 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. Figure 2 4. Capital flight is a large and sudden movement of funds out of a country. Capital flight causes the interest rate to increase and the exchange rate to depreciate. Problems and Applications 1. Japan generally runs a trade surplus because the Japanese savings rate is high relative to Japanese domestic investment. The result is high net capital outflow, which is ****tched by high net exports, resulting in a trade surplus. The other possibilities (high foreign de****nd for Japanese goods, low Japanese de****nd for foreign goods, and structural barriers against imports into Japan) would affect the real exchange rate, but not the trade surplus. 2. a. A reduction in the U.S. government budget deficit would increase national saving, shifting the supply curve of loanable funds to the right in Figure 3. This would reduce the real interest rate in the United States, thus increasing net capital outflow, and reducing the real exchange rate. The real value of the dollar would decline, not increase as the president suggested. However, the trade deficit will decline. Figure 3 b. The increased confidence would lead to a reduction in net capital outflow as shown in Figure 4. The de****nd for loanable funds will fall, along with the real interest rate. The decline in net capital outflow will also reduce the supply of dollars, increasing the real exchange rate. Thus, the trade balance will move toward deficit. Figure 4 3. a. If Congress passes an investment tax credit, it subsidizes domestic investment. The desire to increase domestic investment leads firms to borrow more, increasing the de****nd for loanable funds, as shown in Figure 5. This raises the real interest rate, thus reducing net capital outflow. The decline in net capital outflow reduces the supply of dollars in the ****rket for foreign exchange, raising the real exchange rate. The trade balance also moves toward deficit, because net capital outflow, hence net exports, is lower. The higher real interest rate also increases the quantity of national saving. In sum****ry, saving increases, domestic investment increases, net capital outflow declines, the real interest rate increases, the real exchange rate increases, and the trade balance moves toward deficit. b. A rise in the real exchange rate reduces exports. Figure 5 4. a. A decline in the quality of U.S. goods at a given real exchange rate would reduce net exports, reducing the de****nd for dollars, thus shifting the de****nd curve for dollars to the left in the ****rket for foreign exchange, as shown in Figure 6. b. The shift to the left of the de****nd curve for dollars leads to a decline in the real exchange rate. Because net capital outflow is unchanged, and net exports equals net capital outflow, there is no change in equilibrium in net exports or the trade balance. c. The claim in the popular press is incorrect. A change in the quality of U.S. goods cannot lead to a rise in the trade deficit. The decline in the real exchange rate means that we get fewer foreign goods in exchange for our goods, so our standard of living ****y decline. Figure 6 5. A reduction in restrictions of imports would reduce net exports at any given real exchange rate, thus shifting the de****nd curve for dollars to the left. The shift of the de****nd curve for dollars leads to a decline in the real exchange rate, which increases net exports. Because net capital outflow is unchanged, and net exports equals net capital outflow, there is no change in equilibrium in net exports or the trade balance. But both imports and exports rise, so export industries benefit. 6. a. When the French develop a strong taste for California wines, the de****nd for dollars in the foreign-currency ****rket increases at any given real exchange rate, as shown in Figure 7. b. The result of the increased de****nd for dollars is a rise in the real exchange rate. c. The quantity of net exports is unchanged. Figure 7 7. An export subsidy increases net exports at any given real exchange rate. This causes the de****nd for dollars to shift to the right in the ****rket for foreign exchange, as shown in Figure 8. The effect is a higher real exchange rate, but no change in net exports. So the senator is wrong; an export subsidy will not reduce the trade deficit. Figure 8 8. If the government increases its spending without increasing taxes, public saving will fall (as will national saving). As Figure 9 shows, this will raise the real interest rate, reducing investment. Net capital outflow will fall. The real exchange rate will rise, causing exports to fall and imports to rise, moving the trade balance toward deficit. Figure 9 9. Higher real interest rates in Europe lead to increased U.S. net capital outflow. Higher net capital outflow leads to higher net exports, because in equilibrium net exports equal net capital outflow (NX = NCO ). Figure 10 shows that the increase in net capital outflow leads to a lower real exchange rate, higher real interest rate, and increased net exports. Figure 10 10. a. If the elasticity of U.S. net capital outflow with respect to the real interest rate is very high, the lower real interest rate that occurs because of the increase in private saving will increase net capital outflow a great deal, so U.S. domestic investment will not increase much. b. Because an increase in private saving reduces the real interest rate, inducing an increase in net capital outflow, the real exchange rate will decline. If the elasticity of U.S. exports with respect to the real exchange rate is very low, it will take a large decline in the real exchange rate to increase U.S. net exports by enough to ****tch the increase in net capital outflow. 11. a. If the Japanese decided they no longer wanted to buy U.S. assets, U.S. net capital outflow would increase, increasing the de****nd for loanable funds, as shown in Figure 11. The result is a rise in U.S. interest rates, an increase in the quantity of U.S. saving (because of the higher interest rate), and lower U.S. domestic investment. b. In the ****rket for foreign exchange, the real exchange rate declines and the balance of trade moves toward surplus. Figure 11 12. The flight to safety led to a desire by foreigners to buy U.S. government bonds, resulting in a decline in U.S. net capital outflow, as shown in Figure 12. The decline in net capital outflow also means a decline in the de****nd for loanable funds. As the figure shows, the shift to the left in the de****nd curve results in a decline in the real interest rate in the United States. In addition, the decrease in net capital outflow decreases the supply of dollars in the foreign-exchange ****rket, causing the dollar to appreciate, shown as a rise in the real exchange rate. The lower real interest rate causes national saving to decline, but increases domestic investment. Because net capital outflow is lower, net exports are lower, thus the trade balance moves toward deficit. Figure 12 13. a. When U.S. mutual funds become more interested in investing in Canada, Canadian net capital outflow declines as the U.S. mutual funds ****ke portfolio investments in Canadian stocks and bonds. The de****nd for loanable funds shifts to the left and the net capital outflow curve shifts to the left, as shown in Figure 13. As the figure shows, the real interest rate declines, thus reducing Canada’s private saving, but increasing Canada’s domestic investment. In equilibrium, Canadian net capital outflow declines. b. Because Canada's domestic investment increases, in the long run, Canada's capital stock will increase. c. With a higher capital stock, Canadian workers will be more productive (the value of their ****rginal product will increase) so wages will rise. Thus, Canadian workers will be better off. 33d. The shift of investment into Canada means increased U.S. net capital outflow. As a result, the U.S. real interest rises, leading to less domestic investment, which in the long run reduces the U.S. capital stock, lowers the value of ****rginal product of U.S. workers, and therefore decreases the wages of U.S. workers. The impact on U.S. citizens would be different from the impact on U.S. workers because some U.S. citizens own capital that now earns a higher real interest rate. Figure 13 AGGREGATE DEMAND AND AGGREGATE SUPPLY WHAT’S NEW IN THE FIFTH EDITION: There is a new In the News box on “The 2008 Fiscal Stimulus.” LEARNING O****ECTIVES: By the end of this chapter, students should understand:  three key facts about short-run economic fluctuations.  how the economy in the short run differs from the economy in the long run.  how to use the model of aggregate de****nd and aggregate supply to explain economic fluctuations.  how shifts in either aggregate de****nd or aggregate supply can cause booms and recessions. CONTEXT AND PURPOSE: To this point, our study of ****croeconomic theory has concentrated on the behavior of the economy in the long run. Chapters 33 through 35 now focus on short-run fluctuations in the economy around its long-term trend. Chapter 33 introduces aggregate de****nd and aggregate supply and shows how shifts in these curves can cause recessions. Chapter 34 focuses on how policy****kers use the tools of monetary and fiscal policy to influence aggregate de****nd. Chapter 35 addresses the relationship between inflation and unemployment. The purpose of Chapter 33 is to develop the model economists use to ****yze the economy’s short-run fluctuations—the model of aggregate de****nd and aggregate supply. Students will learn about some of the sources for shifts in the aggregate-de****nd curve and the aggregate-supply curve and how these shifts can cause recessions. This chapter also introduces actions policy****kers might undertake to offset recessions. KEY POINTS:  All societies experience short-run economic fluctuations around long-run trends. These fluctuations are irregular and largely unpredictable. When recessions do occur, real GDP and other measures of income, spending, and production fall, and unemployment rises.  Classical economic theory is based on the assumption that nominal variables such as the money supply and the price level do not influence real variables such as output and employment. Most economists believe that this assumption is accurate in the long run but not in the short run. Economists ****yze short-run economic fluctuations using the model of aggregate de****nd and aggregate supply. According to this model, the output of goods and services and the overall level of prices adjust to balance aggregate de****nd and aggregate supply.  The aggregate-de****nd curve slopes downward for three reasons. The first is the wealth effect: A lower price level raises the real value of households’ money holdings, which stimulates consumer spending. The second is the interest-rate effect: A lower price level reduces the quantity of money households de****nd; as households try to convert money into interest-bearing assets, interest rates fall, which stimulates investment spending. The third is the exchange-rate effect: As a lower price level reduces interest rates, the dollar depreciates in the ****rket for foreign-currency exchange, which stimulates net exports.  Any event or policy that raises consumption, investment, government purchases, or net exports at a given price level increases aggregate de****nd. Any event or policy that reduces consumption, investment, government purchases, or net exports at a given price level decreases aggregate de****nd.  The long-run aggregate-supply curve is vertical. In the long run, the quantity of goods and services supplied depends on the economy’s labor, capital, natural resources, and technology, but not on the overall level of prices.  Three theories have been proposed to explain the upward slope of the short-run aggregate- supply curve. According to the sticky-wage theory, an unexpected fall in the price level temporarily raises real wages, which induces firms to reduce employment and production. According to the sticky-price theory, an unexpected fall in the price level leaves some firms with prices that are temporarily too high, which reduces their sales and causes them to cut back production. According to the misperceptions theory, an unexpected fall in the price level leads suppliers to mistakenly believe that their relative prices have fallen, which induces them to reduce production. All three theories imply that output deviates from its natural rate when the actual price level deviates from the price level that people expected.  Events that alter the economy’s ability to produce output, such as changes in labor, capital, natural resources, or technology, shift the short-run aggregate-supply curve (and ****y shift the long-run aggregate-supply curve as well). In addition, the position of the short-run aggregate- supply curve depends on the expected price level.  One possible cause of economic fluctuations is a shift in aggregate de****nd. When the aggregate-de****nd curve shifts to the left, output and prices fall in the short run. Over time, as a change in the expected price level causes perceptions, wages, and prices to adjust, the short-run aggregate-supply curve shifts to the right. This shift returns the economy to its natural rate of output at a new, lower price level.  A second possible cause of economic fluctuations is a shift in aggregate supply. When the short-run aggregate-supply curve shifts to the left, the short-run effect is falling output and rising prices―a combination called stagflation. Over time, as perceptions, wages, and prices adjust, the short-run aggregate-supply curve shifts back to the right, returning the price level and output back to their original levels. CHAPTER OUTLINE: I. Economic activity fluctuates from year to year. A. Definition of recession: a period of declining real incomes and rising unemployment. B. Definition of depression: a severe recession. II. Three Key Facts about Economic Fluctuations Figure 1 A. Fact 1: Economic Fluctuations Are Irregular and Unpredictable 1. Fluctuations in the economy are often called the business cycle. 2. Economic fluctuations correspond to changes in business conditions. 3. These fluctuations are not at all regular and are almost impossible to predict. 4. Panel (a) of Figure 1 shows real GDP since 1965. The shaded areas represent recessions. B. Fact 2: Most Macroeconomic Quantities Fluctuate Together 1. Real GDP is the variable that is most often used to examine short-run changes in the economy. 2. However, most ****croeconomic variables that measure some type of income, spending, or production fluctuate closely together. 3. Panel (b) of Figure 1 shows how investment spending changes over the business cycle. Note that investment spending falls during recessions just as real GDP does. C. Fact 3: As Output Falls, Unemployment Rises 1. Changes in the economy’s output level will have an effect on the economy’s utilization of its labor force. 2. When firms choose to produce a s****ller amount of goods and services, they lay off workers, which increases the unemployment rate. 3. Panel (c) of Figure 1 shows how the unemployment rate changes over the business cycle. Note that during recessions, unemployment generally rises. Note also that the unemployment rate never approaches zero but instead fluctuates around its natural rate of about 5% or 6%. D. In The News: Offbeat Indicators 1. When the economy goes into a recession, ****ny economic variables are affected. 2. This is an article from USA Today discussing how the volume of trash generated by consumers is related to the health of the economy. III. Explaining Short-Run Economic Fluctuations A. The Assumptions of Classical Economics 1. The classical dichotomy is the separation of variables into real variables and nominal variables. 2. According to classical theory, changes in the money supply only affect nominal variables. B. The Reality of Short-Run Fluctuations 1. Most economists believe that the classical theory describes the world in the long run but not in the short run. 2. Beyond a period of several years, changes in the money supply affect prices and other nominal variables, but do not affect real GDP, unemployment, or other real variables. 3. However, when studying year-to-year fluctuations in the economy, the assumption of monetary neutrality is not appropriate. In the short run, most real and nominal variables are intertwined. C. The Model of Aggregate De****nd and Aggregate Supply Begin by reviewing de****nd, supply, and equilibrium. Make it clear that the microeconomic variables of price and quantity can be aggregated into a price level (either the GDP deflator or the Consumer Price Index) and total output (real GDP). 1. Definition of model of aggregate de****nd and aggregate supply: the model that most economists use to explain short-run fluctuations in economic activity around its long-run trend. 2. We can show this model using a graph. Figure 2 a. The variable on the vertical axis is the average level of prices in the economy, as measured by the CPI or the GDP deflator. b. The variable on the horizontal axis is the economy’s output of goods and services, as measured by real GDP. c. Definition of aggregate-de****nd curve: a curve that shows the quantity of goods and services that households, firms, and the government want to buy at each price level. d. Definition of aggregate-supply curve: a curve that shows the quantity of goods and services that firms choose to produce and sell at each price level. 3. In this model, the price level and the quantity of output adjust to bring aggregate de****nd and aggregate supply into balance. IV. The Aggregate-De****nd Curve A. Why the Aggregate-De****nd Curve Slopes Downward Figure 3 1. Recall that GDP (Y ) is ****de up of four components: consumption (C ), investment (I ), government purchases (G ), and net exports (NX ). Y = C + I + G + NX 2. Each of the four components is a part of aggregate de****nd. a. Government purchases are assumed to be fixed by policy. b. This means that to understand why the aggregate-de****nd curve slopes downward, we must understand how changes in the price level affect consumption, investment, and net exports. You will likely need to remind students of the difference between changes in quantity de****nded (movements along the de****nd curve) and changes in de****nd (shifts in the de****nd curve). Highlight the fact that all three of these effects begin with a decrease (or increase) in the price level and end with an increase (decrease) in aggregate quantity de****nded. Table 1 3. The Price Level and Consumption: The Wealth Effect a. A decrease in the price level raises the real value of money and ****kes consumers feel wealthier, which in turn encourages them to spend more. b. The increase in consumer spending means a larger quantity of goods and services de****nded. 4. The Price Level and Investment: The Interest-Rate Effect a. The lower the price level, the less money households need to buy goods and services. b. When the price level falls, households try to reduce their holdings of money by lending some out (either in financial ****rkets or through financial intermediaries). c. As households try to convert some of their money into interest-bearing assets, the interest rate will drop. d. Lower interest rates encourage borrowing firms to borrow more to invest in new plants and equipment and it encourages households to borrow more to invest in new housing. e. Thus, a lower price level reduces the interest rate, encourages greater spending on investment goods, and therefore increases the quantity of goods and services de****nded. 5. The Price Level and Net Exports: The Exchange-Rate Effect a. A lower price level in the United States lowers the U.S. interest rate. b. American investors will seek higher returns by investing abroad, increasing U.S. net capital outflow. c. The increase in net capital outflow raises the supply of dollars, lowering the real exchange rate. d. U.S. goods become relatively cheaper to foreign goods. Exports rise, imports fall, and net exports increase. e. Therefore, when a fall in the U.S. price level causes U.S. interest rates to fall, the real exchange rate depreciates, and U.S. net exports rise, thereby increasing the quantity of goods and services de****nded. 6. All three of these effects imply that, all else being equal, there is an inverse relationship between the price level and the quantity of goods and services de****nded. Remind students that the aggregate-de****nd curve (like all de****nd curves) is drawn assuming that everything else is held constant. B. Why the Aggregate-De****nd Curve Might Shift Get the students involved in suggesting factors that might shift the aggregate- de****nd curve. Relate changes in aggregate de****nd to changes in consumption, investment, government purchases, and net exports. Show students that, if any of these four components of GDP change (for reasons other than a change in the price level), the aggregate-de****nd curve will shift. 1. Shifts Arising from Changes in Consumption a. If Americans become more concerned with saving for retirement and reduce current consumption, aggregate de****nd will decline. b. If the government cuts taxes, it encourages people to spend more, resulting in an increase in aggregate de****nd. c. In the News: The 2008 Fiscal Stimulus − this article describes the expected impact of the 2008 tax rebate. 2. Shifts Arising from Changes in Investment a. Suppose that the computer industry introduces a faster line of computers and ****ny firms decide to invest in new computer systems. This will lead to an increase in aggregate de****nd. b. If firms become pessimistic about future business conditions, they ****y cut back on investment spending, shifting aggregate de****nd to the left. c. An investment tax credit increases the quantity of investment goods that firms de****nd, which results in an increase in aggregate de****nd. d. An increase in the supply of money lowers the interest rate in the short run. This leads to more investment spending, which causes an increase in aggregate de****nd. 3. Shifts Arising from Changes in Government Purchases a. If Congress decides to reduce purchases of new weapon systems, aggregate de****nd will fall. b. If state governments decide to build more highways, aggregate de****nd will shift to the right. 4. Shifts Arising from Changes in Net Exports a. When Europe experiences a recession, it buys fewer American goods, which lowers net exports at every price level. Aggregate de****nd will shift to the left. b. If the exchange rate of the U.S. dollar increases, U.S. goods become more expensive to foreigners. Net exports fall and aggregate de****nd shifts to the left. V. The Aggregate-Supply Curve A. The relationship between the price level and the quantity of goods and services supplied depends on the time horizon being examined. Figure 4 B. Why the Aggregate-Supply Curve Is Vertical in the Long Run 1. In the long run, an economy’s production of goods and services depends on its supplies of resources along with the available production technology. 2. Because the price level does not affect these determinants of output in the long run, the long-run aggregate-supply curve is vertical. 3. The vertical long-run aggregate-supply curve is a graphical representation of the classical theory. C. Why the Long-Run Aggregate-Supply Curve Might Shift 1. The position of the aggregate-supply curve occurs at an output level sometimes referred to as potential output or full-employment output. 2. Definition of natural rate of output: the production of goods and services that an economy achieves in the long run when employment is at its natural level. 3. This is the level of output that the economy produces when unemployment is at its natural rate. 4. Any change in the economy that alters the natural rate of output shifts the long- run aggregate-supply curve. 5. Shifts Arising from Changes in Labor a. Increases in immigration increase the number of workers available. The long- run aggregate-supply curve would shift to the right. b. Any change in the natural rate of unemployment will alter long-run aggregate supply as well. 5. Shifts Arising from Changes in Capital a. An increase in the economy’s capital stock raises productivity and thus shifts long-run aggregate supply to the right. b. This would also be true if the increase occurred in hu****n capital rather than physical capital. 6. Shifts Arising from Changes in Natural Resources a. A discovery of a new mineral deposit increases long-run aggregate supply. b. A change in weather patterns that ****kes farming more difficult shifts long- run aggregate supply to the left. c. A change in the availability of imported resources (such as oil) can also affect long-run aggregate supply. 7. Shifts Arising from Changes in Technological Knowledge a. The invention of the computer has allowed us to produce more goods and services from any given level of resources. As a result, it has shifted the long- run aggregate-supply curve to the right. b. Opening up international trade has similar effects to inventing new production processes. Therefore, it also shifts the long-run aggregate-supply curve to the right. D. Using Aggregate De****nd and Aggregate Supply to Depict Long-Run Growth and Inflation Figure 5 1. Two important forces that govern the economy in the long run are technological progress and monetary policy. a. Technological progress shifts long-run aggregate supply to the right. b. The Fed increases the money supply over time, which raises aggregate de****nd. 2. The result is growth in output and continuing inflation (increases in the price level). 3. Although the purpose of developing the model of aggregate de****nd and aggregate supply is to describe short-run fluctuations, these short-run fluctuations should be considered deviations from the continuing long-run trends developed here. E. Why the Aggregate-Supply Curve Slopes Upward in the Short Run 1. The Sticky-Wage Theory Table 2 Figure 6 a. Nominal wages are often slow to adjust to changing economic conditions due to long-term contracts between workers and firms along with social norms and notions of fairness that influence wage setting and are slow to change over time. b. Example: Suppose a firm has agreed in advance to pay workers an hourly wage of $20 based on the expectation that the price level will be 100. If the price level is actually 95, the firm receives 5% less for its output than it expected and its labor costs are fixed at $20 per hour. c. Production is now less profitable, so the firm hires fewer workers and reduces the quantity of output supplied. d. Nominal wages are based on expected prices and do not adjust immediately when the actual price level differs from what is expected. This ****kes the short-run aggregate-supply curve upward sloping. 2. The Sticky-Price Theory a. The prices of some goods and services are also sometimes slow to respond to changing economic conditions. This is often blamed on menu costs. b. If the price level falls unexpectedly, and a firm does not change the price of its product quickly, its relative price will rise and this will lead to a loss in sales. c. Thus, when sales decline, firms will produce a lower quantity of goods and services. d. Because not all prices adjust instantly to changing conditions, an unexpected fall in the price level leaves some firms with higher-than-desired prices, which depress sales and cause firms to lower the quantity of goods and services supplied. 3. The Misperceptions Theory a. Changes in the overall price level can temporarily mislead suppliers about what is happening in the ****rkets in which they sell their output. b. As a result of these misperceptions, suppliers respond to changes in the level of prices and thus, the short-run aggregate-supply curve is upward sloping. c. Example: The price level falls unexpectedly. Suppliers mistakenly believe that as the price of their product falls, it is a drop in the relative price of their product. Suppliers ****y then believe that the reward of supplying their product has fallen, and thus they decrease the quantity that they supply. The same misperception ****y happen if workers see a decline in their nominal wage (caused by a fall in the price level). d. Thus, a lower price level causes misperceptions about relative prices, and these misperceptions lead suppliers to respond to the lower price level by decreasing the quantity of goods and services supplied. 4. Note that each of these theories suggest that output deviates from its natural rate when the price level deviates from the price level that people expected. 5. Note also that the effects of the change in the price level will be temporary. Eventually people will adjust their price level expectations and output will return to its natural level; thus, the aggregate-supply curve will be vertical in the long run. 6. Because the sticky-wage theory is the ****st of the three theories, it is the one that is emphasized in the text. F. Summing Up 1. Economists debate which of these theories is correct and it is possible that each contains an element of truth. 2. All three theories suggest that output deviates in the short run from its long-run level when the actual price level deviates from the expected price level. Quantity of Natural rate + a ( Actual price level - Expected price level) output = of output 3. Each of the three theories emphasizes a problem that is likely to be temporary. a. Over time, nominal wages will become unstuck, prices will become unstuck, and misperceptions about relative prices will be corrected. b. In the long run, it is reasonable to assume that wages and prices are flexible and that people are not confused about relative prices. G. Why the Short-Run Aggregate-Supply Curve Might Shift 1. Events that shift the long-run aggregate-supply curve will shift the short-run aggregate-supply curve as well. 2. However, expectations of the price level will affect the position of the short-run aggregate-supply curve even though it has no effect on the long-run aggregate- supply curve. 3. A higher expected price level decreases the quantity of goods and services supplied and shifts the short-run aggregate-supply curve to the left. A lower expected price level increases the quantity of goods and services supplied and shifts the short-run aggregate-supply curve to the right. VI. Two Causes of Economic Fluctuations A. Long-Run Equilibrium Figure 7 1. Long-run equilibrium is found where the aggregate-de****nd curve intersects with the long-run aggregate-supply curve. 2. Output is at its natural rate. 3. Also at this point, perceptions, wages, and prices have all adjusted so that the short-run aggregate-supply curve intersects at this point as well. B. The Effects of a Shift in Aggregate De****nd Figure 8 Table 3 Students will be confused by the graphs showing the adjustment process that occurs when aggregate de****nd shifts. Take the time to walk them through step by step several times, sum****rizing what moves the economy from one point to the next. 1. Example: Pessimism causes household spending and investment to decline. 2. This will cause the aggregate-de****nd curve to shift to the left. 3. In the short run, both output and the price level fall. This drop in output means that the economy is in a recession. 4. In the long run, the economy will move back to the natural rate of output. a. People will correct the misperceptions, sticky wages, and sticky prices that cause the aggregate-supply curve to be upward sloping in the short run. b. The expected price level will fall, shifting the short-run aggregate-supply curve to the right. 5. In the long run, the decrease in aggregate de****nd can be seen solely by the drop in the equilibrium price level. Thus, the long-run effect of a change in aggregate de****nd is a nominal change (in the price level) but not a real change (output is the same). 6. Instead of waiting for the economy to adjust on its own, policy****kers ****y want to eliminate the recession by boosting government spending or increasing the money supply. Either way, these policies could shift the aggregate de****nd curve back to the right. 7. FYI: Monetary Neutrality Revisited a. According to classical theory, changes in the quantity of money affect nominal variables such as the price level, but not real variables such as output. b. If the Fed decreases the money supply, aggregate de****nd shifts to the left. In the short run, output and the price level decline. After expectations, prices, and wages have adjusted, the economy finds itself back on the long- run aggregate-supply curve at the natural rate of output. c. Thus, changes in the money supply have effects on real output in the short run only. 8. Case Study: Two Big Shifts in Aggregate De****nd: The Great Depression and World War II a. Figure 9 shows real GDP for the United States since 1900. Figure 9 b. Two time periods of economic fluctuations can be seen dra****tically in the picture. These are the early 1930s (the Great Depression) and the early 1940s (World War II). c. From 1929 to 1933, GDP fell by 27%. From 1939 to 1944, the economy’s production of goods and services almost doubled. 9. Case Study: The Recession of 2001 a. The United States experienced a recession in 2001 where unemployment rose from 3.9% in December 2000 to 6.3% in June 2003. b. The recession has been attributed to three aggregate de****nd shocks. First, the dot-com bubble in the stock ****rket ended. Second, the terrorist attack in September 2001 led to increased uncertainty. Third, several corporate accounting scandals were revealed. c. The federal government passed tax cuts to improve consumer spending, while the Fed responded by keeping interest rates low. d. By January 2005, the unemployment rate had fallen back to 5.2%. C. The Effects of a Shift in Aggregate Supply Figure 10 1. Example: Firms experience a sudden increase in their costs of production. 2. This will cause the short-run aggregate-supply curve to shift to the left. (Depending on the event, long-run aggregate supply ****y also shift. We will assume that it does not.) 3. In the short run, output will fall and the price level will rise. The economy is experiencing stagflation. 4. Definition of stagflation: a period of falling output and rising prices. Figure 11 5. The result over time ****y be a wage-price spiral. 6. Eventually, the low level of output will put downward pressure on wages. a. Producing goods and services becomes more profitable. b. Short-run aggregate supply shifts to the right until the economy is again producing at the natural rate of output. 7. If policy****kers want to end the stagflation, they can shift the aggregate-de****nd curve. Note that they cannot simultaneously offset the drop in output and the rise in the price level. If they increase aggregate de****nd, the recession will end, but the price level will be per****nently higher. 8. Case Study: Oil and the Economy a. Crude oil is a key input in the production of ****ny goods and services. b. When some event (often political) leads to a rise in the price of crude oil, firms must endure higher costs of production and the short-run aggregate- supply curve shifts to the left. c. In the mid-1970s, OPEC lowered production of oil and the price of crude oil rose substantially. The inflation rate in the United States was pushed to over 10%. Unemployment also grew from 4.9% in 1973 to 8.5% in 1975. d. This occurred again in the late 1970s. Oil prices rose, output fell, and the rate of inflation increased. e. In the late 1980s, OPEC began to lose control over the oil ****rket as members began cheating on the agreement. Oil prices fell, which led to a rightward shift of the short-run aggregate-supply curve. This caused both unemployment and inflation to decline. f. In 2008, world oil prices dra****tically rose leading some observers to fear that the U.S. economy ****y again suffer from stagflation. 9. FYI: The Origins of Aggregate De****nd and Aggregate Supply a. The AD/AS model is a by-product of the Great Depression. b. In 1936, economist John Maynard Keynes published a book that attempted to explain short-run fluctuations. c. Keynes believed that recessions occur because of inadequate de****nd for goods and services. d. Therefore, Keynes advocated policies to increase aggregate de****nd. Activity 1—National Output Article Type: Take-home assignment Topics: Fluctuations in output and the price level Class limitations: Works in any class Purpose This assignment is a good way for students to connect economic theory to actual events. Assignment 1. Find an article in a recent newspaper or ****gazine illustrating a change that will affect national output. 2. Analyze the situation using economic reasoning. 3. Draw an aggregate de****nd and aggregate supply graph to explain this change. Be sure to label your graph and clearly indicate which curve shifts. Explain what happens to national income and to the price level in the short run. 4. Turn in a copy of the article along with your explanation. Points for Discussion This can be a nice way to review the elements of aggregate de****nd (consumption, investment, government spending, and net exports) and the elements of aggregate supply (productive resources, technology). Most changes will only shift one curve. Discussing the long-run impact of these changes can emphasize the differences between AS and AD shifts. Activity 2—The Economics of War Type: In-class assignment Topics: National income, price levels, total spending, resources Materials needed: None Time: 20 minutes Class limitations: Works in any size class Purpose This assignment asks students to examine their beliefs about the impact of war on the economy. It can be used to examine aggregate de****nd shifts and aggregate supply shifts. This assignment can generate lively discussion. Instructions Ask the class to answer the following questions. Give them time to write an answer to a question, then discuss their answers before moving to the next question. 1. Is war good or bad for the economy? 2. What are the opportunity costs of using resources in wars? 3. How would a war affect aggregate supply? 4. Graph the shift in aggregate supply. What happens to output and the price level? 5. How would a war affect aggregate de****nd? 6. Graph the shift in aggregate de****nd. What happens to output and the price level? 7. Is peace good or bad for the economy? SOLUTIONS TO TEXT PROBLEMS: Quick Quizzes 1. Three key facts about economic fluctuations are: (1) economic fluctuations are irregular and unpredictable; (2) most ****croeconomic quantities fluctuate together; and (3) as output falls, unemployment rises. Economic fluctuations are irregular and unpredictable, as you can see by looking at a graph of real GDP over time. Some recessions are close together and others are far apart. There appears to be no recurring pattern. Most ****croeconomic quantities fluctuate together. In recessions, real GDP, consumer spending, investment spending, corporate profits, and other ****croeconomic variables decline or grow much more slowly than during economic expansions. However, the variables fluctuate by different amounts over the business cycle, with investment varying much more than other variables. As output falls, unemployment rises, because when firms want to produce less, they lay off workers, thus causing a rise in unemployment. 2. The economy’s behavior in the short run differs from its behavior in the long run because the assumption of monetary neutrality applies only to the long run, not the short run. In the short run, real and nominal variables are highly intertwined. Figure 1 shows the model of aggregate de****nd and aggregate supply. The horizontal axis shows the quantity of output, and the vertical axis shows the price level. Figure 1 3. The aggregate-de****nd curve slopes downward for three reasons. First, when prices fall, the value of dollars in people’s wallets and bank accounts rises, so they are wealthier. As a result, they spend more, thereby increasing the quantity of goods and services de****nded. Second, when prices fall, people need less money to ****ke their purchases, so they lend more out, which reduces the interest rate. The lower interest rate encourages businesses to invest more, increasing the quantity of goods and services de****nded. Third, since lower prices lead to a lower interest rate, some U.S. investors will invest abroad, supplying dollars to the foreign-exchange ****rket, thus causing the dollar to depreciate. The decline in the real exchange rate causes net exports to increase, which increases the quantity of goods and services de****nded. Any event that alters the level of consumption, investment, government purchases, or net exports at a given price level will lead to a shift in aggregate de****nd. An increase in expenditure will shift the aggregate-de****nd curve to the right, while a decline in expenditure will shift the aggregate-de****nd curve to the left. 4. The long-run aggregate-supply curve is vertical because the price level does not affect the long-run determinants of real GDP, which include supplies of labor, capital, natural resources, and the level of available technology. This is just an application of the classical dichotomy and monetary neutrality. There are three reasons the short-run aggregate-supply curve slopes upward. First, the sticky-wage theory suggests that because nominal wages are slow to adjust, a decline in the price level means real wages are higher, so firms hire fewer workers and produce less, causing the quantity of goods and services supplied to decline. Second, the sticky-price theory suggests that the prices of some goods and services are slow to change. If some economic event causes the overall price level to decline, the relative prices of goods whose prices are sticky will rise and the quantity of those goods sold will decline, leading firms to cut back on production. Thus, a lower price level reduces the quantity of goods and services supplied. Third, the misperceptions theory suggests that changes in the overall price level can temporarily mislead suppliers. When the price level falls below the level that was expected, suppliers think that the relative prices of their products have declined, so they produce less. Thus, a lower price level reduces the quantity of goods and services supplied. The long-run and short-run aggregate-supply curves will both shift if the supplies of labor, capital, or natural resources change or if technology changes. A change in the expected price level will shift the short-run aggregate-supply curve but will have no effect on the long-run aggregate-supply curve. Figure 2 5. When a popular presidential candidate is elected, causing people to be more confident about the future, they will spend more, causing the aggregate-de****nd curve to shift to the right, as shown in Figure 2. The economy begins at point A with aggregate-de****nd curve AD1 and short-run aggregate-supply curve AS1. The equilibrium has price level P1 and output level Y1. Increased confidence about the future causes the aggregate-de****nd curve to shift to AD2. The economy moves to point B, with price level P2 and output level Y2. Over time, price expectations adjust and the short-run aggregate-supply curve shifts up to AS2 and the economy moves to equilibrium at point C, with price level P3 and output level Y1. Questions for Review 1. Two ****croeconomic variables that decline when the economy goes into a recession are real GDP and investment spending (****ny other answers are possible). A ****croeconomic variable that rises during a recession is the unemployment rate. 2. Figure 3 shows aggregate de****nd, short-run aggregate supply, and long-run aggregate supply. Figure 3 3. The aggregate-de****nd curve is downward sloping because: (1) a decrease in the price level ****kes consumers feel wealthier, which in turn encourages them to spend more, so there is a larger quantity of goods and services de****nded; (2) a lower price level reduces the interest rate, encouraging greater spending on investment, so there is a larger quantity of goods and services de****nded; (3) a fall in the U.S. price level causes U.S. interest rates to fall, so the real exchange rate depreciates, stimulating U.S. net exports, so there is a larger quantity of goods and services de****nded. 4. 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, labor, 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. Three theories explain why the short-run aggregate-supply curve is upward sloping: (1) the sticky-wage theory, in which a lower price level ****kes 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. The aggregate-de****nd 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 defense spending), or reduced net exports (such as when foreign economies go into recession). Figure 4 traces through the steps of such a shift in aggregate de****nd. The economy begins in equilibrium, with short-run aggregate supply, AS1, intersecting aggregate de****nd, AD1, at point A. When the aggregate-de****nd 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. Figure 4 7. The aggregate-supply curve might shift to the left because of a decline in the economy's capital stock, labor 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 5 traces through the effects of a shift in short-run aggregate supply. The economy starts in equilibrium at point A. The aggregate-supply curve shifts to the left from AS1 to AS2. The new equilibrium is at point B, the intersection of the aggregate-de****nd curve and AS2. As time goes on, perceptions and expectations adjust and the economy returns to long-run equilibrium at point A, because the short-run aggregate-supply curve shifts back to its original position. Figure 5 Problems and Applications Figure 6 1. a. The current state of the economy is shown in Figure 6. The aggregate- de****nd curve and short-run aggregate-supply curve intersect at the same point on the long-run aggregate-supply curve. b. A stock ****rket crash leads to a leftward shift of aggregate de****nd. The equilibrium level of output and the price level will fall. Because 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. 2. a. When the United States experiences a wave of immigration, the labor force increases, so long-run aggregate supply shifts to the right. b. When Congress raises the minimum wage to $10 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 because more output can be produced with the same inputs. d. When a severe hurricane da****ges factories along the East Coast, the capital stock is s****ller, so long-run aggregate supply declines. 3. a. The current state of the economy is shown in Figure 7. The aggregate- de****nd curve and short-run aggregate-supply curve intersect at the same point on the long-run aggregate-supply curve. Figure 7 b. If the central bank increases the money supply, aggregate de****nd shifts to the right (to point B). In the short run, there is an increase in output and the price level. c. Over time, nominal wages, prices, and perceptions will adjust to this new price level. As a result, the short-run aggregate-supply curve will shift to the left. The economy will return to its natural rate of output (point C). d. According to the sticky-wage theory, nominal wages at points A and B are equal. However, nominal wages at point C are higher. e. According to the sticky-wage theory, real wages at point B are lower than real wages at point A. However, real wages at points A and C are equal. f. Yes, this ****ysis is consistent with long-run monetary neutrality. In the long run, an increase in the money supply causes an increase in the nominal wage, but leaves the real wage unchanged. 4. The idea of lengthening the shopping period between Thanksgiving and Christ****s was to increase aggregate de****nd. As Figure 8 shows, this could increase output back to its long-run equilibrium level. Figure 8 5. a. The statement that "the aggregate-de****nd curve slopes downward because it is the horizontal sum of the de****nd curves for individual goods" is false. The aggregate-de****nd curve slopes downward because a fall in the price level raises the overall quantity of goods and services de****nded 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 aggregate-supply curve is vertical because the price level does not affect long-run aggregate supply. 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 aggregate-supply curve shifts to the left" is false. An economy could enter a recession if either the aggregate-de****nd curve or the short-run aggregate- supply curve shifts to the left. 6. 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 labor de****nd 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. The speed of the recovery in each theory depends on how quickly price expectations, wages, and prices adjust. Figure 9 7. If the Fed increases the money supply and people expect a higher price level, the aggregate-de****nd curve shifts to the right and the short-run aggregate-supply curve shifts to the left, as shown in Figure 9. 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). 8. Figure 10 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 policy****kers 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 10 9. a. People will likely expect that the new chair****n will not actively fight inflation so they will expect the price level to rise. b. If people believe that the price level will be higher over the next year, workers will want higher nominal wages. c. Higher labor costs lead to reduced profitability. d. The short-run aggregate-supply curve will shift to the left as shown in Figure 11. Figure 11 e. A decline in short-run aggregate supply leads to reduced output and a higher price level. f. No, this choice was probably not wise. The end result is stagflation, which provides limited choices in terms of policies to remedy the situation. Figure 12 10. a. If households decide to save a larger share of their income, they must spend less on consumer goods, so the aggregate-de****nd curve shifts to the left, as shown in Figure 12. The equilibrium changes from point A to point B, so the price level declines and output declines. b. If Florida orange groves suffer a prolonged period of below-freezing temperatures, the orange harvest will be reduced. This decline in the natural rate of output is represented in Figure 13 by a shift to the left in both the short-run and long-run aggregate-supply curves. The equilibrium changes from point A to point B, so the price level rises and output declines. Figure 13 Figure 14 c. If increased job opportunities cause people to leave the country, the long-run and short-run aggregate-supply curves will shift to the left because there are fewer people producing output. The aggregate-de****nd 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 14 shows. Whether the price level rises or declines depends on the relative sizes of the shifts in the aggregate-de****nd curve and the aggregate-supply curves. 11. a. When the stock ****rket declines sharply, wealth declines, so the aggregate- de****nd curve shifts to the left, as shown in Figure 15. 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 15 Figure 16 b. When the federal government increases spending on national defense, the rise in government purchases shifts the aggregate-de****nd curve to the right, as shown in Figure 16. 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. Figure 17 c. When a technological improvement raises productivity, the long-run and short-run aggregate-supply curves shift to the right, as shown in Figure 17. The economy moves from point A to point B, as output rises and the price level declines. Figure 18 d. When a recession overseas causes foreigners to buy fewer U.S. goods, net exports decline, so the aggregate-de****nd curve shifts to the left, as shown in Figure 18. 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. 12. If the value of the dollar falls in foreign exchange ****rkets, U.S. exports will rise and imports will fall. This will cause the aggregate-de****nd curve to shift to the right (as shown in Figure 19). The price level and output will both rise in the short run. Figure 19 13. a. If firms become optimistic about future business conditions and increase investment, the result is shown in Figure 20. The economy begins at point A with aggregate-de****nd 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-de****nd 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. 34 Figure 20 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 de****nded 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. 14. Economy B would have a more steeply sloped short-run aggregate-supply curve than would Economy A, because only half of the wages in Economy B are “sticky.” A 5% increase in the money supply would have a larger effect on output in Economy A and a larger effect on the price level in Economy B. THE INFLUENCE OF MONETARY AND FISCAL POLICY ON AGGREGATE DEMAND WHAT’S NEW IN THE FIFTH EDITION: There is a new In the News feature on “The FOMC Explains All.” LEARNING O****ECTIVES: By the end of this chapter, students should understand:  the theory of liquidity preference as a short-run theory of the interest rate.  how monetary policy affects interest rates and aggregate de****nd.  how fiscal policy affects interest rates and aggregate de****nd.  the debate over whether policy****kers should try to stabilize the economy. CONTEXT AND PURPOSE: Chapter 34 is the second chapter in a three-chapter sequence that concentrates on short-run fluctuations in the economy around its long-term trend. In Chapter 33, the model of aggregate supply and aggregate de****nd is introduced. In Chapter 34, we see how the government’s monetary and fiscal policies affect aggregate de****nd. In Chapter 35, we will see some of the trade-offs between short-run and long-run objectives when we address the relationship between inflation and unemployment. The purpose of Chapter 34 is to address the short-run effects of monetary and fiscal policies. In Chapter 33, we found that when aggregate de****nd or short-run aggregate supply shifts, it causes fluctuations in output. As a result, policy****kers sometimes try to offset these shifts by shifting aggregate de****nd with monetary and fiscal policy. Chapter 34 addresses the theory behind these policies and some of the shortcomings of stabilization policy. KEY POINTS:  In developing a theory of short-run economic fluctuations, Keynes proposed the theory of liquidity preference to explain the determinants of the interest rate. According to this theory, the interest rate adjusts to balance the supply and de****nd for money.  An increase in the price level raises money de****nd and increases the interest rate that brings the money ****rket into equilibrium. Because the interest rate represents the cost of borrowing, a higher interest rate reduces investment and, thereby, the quantity of goods and services de****nded. The downward-sloping aggregate-de****nd curve expresses this negative relationship between the price level and the quantity de****nded.  Policy****kers can influence aggregate de****nd with monetary policy. An increase in the money supply reduces the equilibrium interest rate for any given price level. Because a lower interest rate stimulates investment spending, the aggregate-de****nd curve shifts to the right. Conversely, a decrease in the money supply raises the equilibrium interest rate for any given price level and shifts the aggregate-de****nd curve to the left.  Policy****kers can also influence aggregate de****nd with fiscal policy. An increase in government purchases or a cut in taxes shifts the aggregate-de****nd curve to the right. A decrease in government purchases or an increase in taxes shifts the aggregate-de****nd curve to the left.  When the government alters spending or taxes, the resulting shift in aggregate de****nd can be larger or s****ller than the fiscal change. The multiplier effect tends to amplify the effects of fiscal policy on aggregate de****nd. The crowding-out effect tends to dampen the effects of fiscal policy on aggregate de****nd.  Because monetary and fiscal policy can influence aggregate de****nd, the government sometimes uses these policy instruments in an attempt to stabilize the economy. Economists disagree about how active the government should be in this effort. According to the advocates of active stabilization policy, changes in attitudes by households and firms shift aggregate de****nd; if the government does not respond, the result is undesirable and unnecessary fluctuations occur in output and employment. According to critics of active stabilization policy, monetary and fiscal policy work with such long lags that attempts at stabilizing the economy often end up being destabilizing. CHAPTER OUTLINE: I. How Monetary Policy Influences Aggregate De****nd Students are very interested in the way in which the Fed changes interest rates. Review what they learned about the Fed and its tools to change the money supply. The effects of monetary policy are easy to show graphically. Begin with money supply, money de****nd, and an equilibrium interest rate. Show how both an increase and a decrease in the money supply affect interest rates. A. The aggregate-de****nd curve is downward sloping for three reasons. 1. The wealth effect. 2. The interest-rate effect. 3. The exchange-rate effect. B. All three effects occur simultaneously, but are not of equal importance. 1. Because a household’s money holdings are a s****ll part of total wealth, the wealth effect is relatively s****ll. 2. Because imports and exports are a s****ll fraction of U.S. GDP, the exchange-rate effect is also fairly s****ll for the U.S. economy. 3. Thus, the most important reason for the downward-sloping aggregate-de****nd curve is the interest-rate effect. C. Definition of theory of liquidity preference: Keynes’s theory that the interest rate adjusts to bring money supply and money de****nd into balance. D. The Theory of Liquidity Preference 1. This theory is an explanation of the supply and de****nd for money and how they relate to the interest rate. Point out that when we discuss the "interest rate" we are discussing both the nominal interest rate and the real interest rate because we are assuming that they will move together. 2. Money Supply Figure 1 a. The money supply in the economy is controlled by the Federal Reserve. b. The Fed can alter the supply of money using open ****rket operations, changes in the discount rate, and changes in reserve requirements. c. Because the Fed can control the size of the money supply directly, the quantity of money supplied does not depend on any other economic variables, including the interest rate. Thus, the supply of money is represented by a vertical supply curve. 3. Money De****nd a. Any asset’s liquidity refers to the ease with which that asset can be converted into a medium of exchange. Thus, money is the most liquid asset in the economy. b. The liquidity of money explains why people choose to hold it instead of other assets that could earn them a higher return. c. However, the return on other assets (the interest rate) is the opportunity cost of holding money. All else being equal, as the interest rate rises, the quantity of money de****nded will fall. Therefore, the de****nd for money will be downward sloping. 4. Equilibrium in the Money Market a. The interest rate adjusts to bring money de****nd and money supply into balance. b. If the interest rate is higher than the equilibrium interest rate, the quantity of money that people want to hold is less than the quantity that the Fed has supplied. Thus, people will try to buy bonds or deposit funds in an interest- bearing account. This increases the funds available for lending, pushing interest rates down. c. If the interest rate is lower than the equilibrium interest rate, the quantity of money that people want to hold is greater than the quantity that the Fed has supplied. Thus, people will try to sell bonds or withdraw funds from an interest-bearing account. This decreases the funds available for lending, pulling interest rates up. E. FYI: Interest Rates in the Long Run and the Short Run 1. In an earlier chapter, we said that the interest rate adjusts to balance the supply and de****nd for loanable funds. 2. In this chapter, we proposed that the interest rate adjusts to balance the supply and de****nd for money. 3.To understand how these two statements can both be true, we must discuss the difference between the short run and the long run. 4. In the long run, the economy’s level of output, the interest rate, and the price level are determined by the following ****nner: a. Output is determined by the levels of resources and technology available. b. For any given level of output, the interest rate adjusts to balance the supply and de****nd for loanable funds. c. Given output and the interest rate, the price level adjusts to balance the supply and de****nd for money. Changes in the supply of money lead to proportionate changes in the price level. 5. In the short run, the economy’s level of output, the interest rate, and the price level are determined by the following ****nner: a. The price level is stuck at some level (based on previously formed expectations) and is unresponsive to changes in economic conditions. b. For any given price level, the interest rate adjusts to balance the supply and de****nd for money. c. The interest rate that balances the money ****rket influences the quantity of goods and services de****nded and thus the level of output. F. The Downward Slope of the Aggregate-De****nd Curve Figure 2 1. When the price level increases, the quantity of money that people need to hold becomes larger. Thus, an increase in the price level leads to an increase in the de****nd for money, shifting the money de****nd curve to the right. 2. For a fixed money supply, the interest rate must rise to balance the supply and de****nd for money. 3. At a higher interest rate, the cost of borrowing and the return on saving both increase. Thus, consumers will choose to spend less and will be less likely to invest in new housing. Firms will be less likely to borrow funds for new equipment or structures. In short, the quantity of goods and services purchased in the economy will fall. 4. This implies that as the price level increases, the quantity of goods and services de****nded falls. This is Keynes’s interest-rate effect. Go through the example above in reverse as well. Make sure that students understand that a decline in the price level will lead to a drop in money de****nd and the interest rate and that this will cause a rise in aggregate quantity de****nded. G. Changes in the Money Supply Figure 3 1. Example: The Fed buys government bonds in open-****rket operations. ALTERNATIVE CLASSROOM EXAMPLE: Suppose the Fed sells government bonds in the open ****rket. The following would occur: 1. The supply of money will decrease, shifting the money supply curve to the left. 2. The equilibrium interest rate will rise, raising the cost of borrowing and the return on saving. 3. Households will lower consumption and firms will lower investment. 4. The quantity of goods and services de****nded will fall at every price level, shifting the aggregate-de****nd curve to the left. 2. This will increase the supply of money, shifting the money supply curve to the right. The equilibrium interest rate will fall. 3. The lower interest rate reduces the cost of borrowing and the return to saving. This encourages households to increase their consumption and desire to invest in new housing. Firms will also increase investment, building new factories and purchasing new equipment. 4. The quantity of goods and services de****nded will rise at every price level, shifting the aggregate-de****nd curve to the right. 5. Thus, a monetary injection by the Fed increases the money supply, leading to a lower interest rate, and a larger quantity of goods and services de****nded. Point out the circumstances under which the Fed is likely to increase the money supply. Then, discuss the circumstances under which the Fed is likely to decrease the money supply. Discuss the short- and long-run effects of each. H. The Role of Interest-Rate Targets in Fed Policy Show students that the Fed can target either the money supply or the interest rate, but not both. 1. In recent years, the Fed has conducted policy by setting a target for the federal funds rate (the interest rate that banks charge one another for short-term loans). a. The target is reevaluated every six weeks when the Federal Open Market Committee meets. b. The Fed has chosen to use this interest rate as a target in part because the money supply is difficult to measure with sufficient precision. 2. Because changes in the money supply lead to changes in interest rates, monetary policy can be described either in terms of the money supply or in terms of the interest rate. Make sure that you point out to students that, while the media describes the actions of the Federal Reserve as “changing interest rates,” they instead could be described as “changing the money supply.” I. In the News: The FOMC Explains Itself 1. Whenever the FOMC ****kes a decision about monetary policy, it releases a statement explaining it. 2. This is a press release from the FOMC regarding its interest rate cut on March 18, 2008. J. Case Study: Why the Fed Watches the Stock Market (and Vice Versa) 1. A booming stock ****rket expands the aggregate de****nd for goods and services. a. When the stock ****rket booms, households become wealthier, and this increased wealth stimulates consumer spending. b. Increases in stock prices ****ke it attractive for firms to issue new shares of stock and this increases investment spending. 2. Because one of the Fed’s goals is to stabilize aggregate de****nd, the Fed ****y respond to a booming stock ****rket by keeping the supply of money lower and raising interest rates. The opposite would hold true if the stock ****rket would fall. 3. Stock ****rket participants also keep an eye on the Fed’s policy plans. When the Fed lowers the money supply, it ****kes stocks less attractive because alternative assets (such as bonds) pay higher interest rates. Also, higher interest rates ****y lower the expected profitability of firms. II. How Fiscal Policy Influences Aggregate De****nd A. Definition of fiscal policy: the setting of the level of government spending and taxation by government policy****kers. B. Changes in Government Purchases 1. When the government changes the level of its purchases, it influences aggregate de****nd directly. An increase in government purchases shifts the aggregate- de****nd curve to the right, while a decrease in government purchases shifts the aggregate-de****nd curve to the left. 2. There are two ****croeconomic effects that cause the size of the shift in the aggregate-de****nd curve to be different from the change in the level of government purchases. They are called the multiplier effect and the crowding-out effect. C. The Multiplier Effect Figure 4 1. Suppose that the government buys a product from a company. a. The immediate impact of the purchase is to raise profits and employment at that firm. b. As a result, owners and workers at this firm will see an increase in income, and will therefore likely increase their own consumption. c. Thus, total spending rises by more than the increase in government purchases. 2. Definition of multiplier effect: the additional shifts in aggregate de****nd that result when expansionary fiscal policy increases income and thereby increases consumer spending. 3. The multiplier effect continues even after the first round. a. When consumers spend part of their additional income, it provides additional income for other consumers. b. These consumers then spend some of this additional income, raising the incomes of yet another group of consumers. 4. A Formula for the Spending Multiplier a. The ****rginal propensity to consume (MPC ) is the fraction of extra income that a household consumes rather than saves. b. Example: The government spends $20 billion on new planes. Assume that MPC = 3/4. c. Incomes will increase by $20 billion, so consumption will rise by MPC × $20 billion. The second increase in consumption will be equal to MPC × (MPC × $20 billion) or MPC 2 × $20 billion. d. To find the total impact on the de****nd for goods and services, we add up all of these effects: Change in government purchases = $20 billion First change in consumption = MPC × $20 billion Second change in consumption = MPC2 × $20 billion Third change in consumption = MPC3 × $20 billion · · · · · · Total Change = (1 + MPC + MPC 2 + MPC 3 + . . .) × $20 billion e. This means that the multiplier can be written as: Multiplier = (1 + MPC + MPC 2 + MPC 3 + . . .). f. Because this expression is an infinite geometric series, it also can be written as: multiplier = 1/(1 - MPC ) g. Note that the size of the multiplier depends on the size of the ****rginal propensity to consume. 5. Other Applications of the Multiplier Effect a. The multiplier effect applies to any event that alters spending on any component of GDP (consumption, investment, government purchases, or net exports). b. Examples include a reduction in net exports due to a recession in another country or a stock ****rket boom that raises consumption. D. The Crowding-Out Effect Figure 5 1. The crowding-out effect works in the opposite direction. 2. Definition of crowding-out effect: the offset in aggregate de****nd that results when expansionary fiscal policy raises the interest rate and thereby reduces investment spending. 3. As we discussed earlier, when the government buys a product from a company, the immediate impact of the purchase is to raise profits and employment at that firm. As a result, owners and workers at this firm will see an increase in income, and will therefore likely increase their own consumption. 4. If consumers want to purchase more goods and services, they will need to increase their holdings of money. This shifts the de****nd for money to the right, pushing up the interest rate. 5. The higher interest rate raises the cost of borrowing and the return to saving. This discourages households from spending their incomes for new consumption or investing in new housing. Firms will also decrease investment, choosing not to build new factories or purchase new equipment. 6. Thus, even though the increase in government purchases shifts the aggregate- de****nd curve to the right, this fall in consumption and investment will pull aggregate de****nd back toward the left. Thus, aggregate de****nd increases by less than the increase in government purchases. 7. Therefore, when the government increases its purchases by $X, the aggregate de****nd for goods and services could rise by more or less than $X, depending on whether the multiplier effect or the crowding-out effect is larger. a. If the multiplier effect is greater than the crowding-out effect, aggregate de****nd will rise by more than $X. b. If the multiplier effect is less than the crowding-out effect, aggregate de****nd will rise by less than $X. E. Changes in Taxes 1. Changes in taxes affect a household’s take-home pay. a. If the government reduces taxes, households will likely spend some of this extra income, shifting the aggregate-de****nd curve to the right. b. If the government raises taxes, household spending will fall, shifting the aggregate-de****nd curve to the left. 2. The size of the shift in the aggregate-de****nd curve will also depend on the sizes of the multiplier and crowding-out effects. a. When the government lowers taxes and consumption increases, earnings and profits rise, which further stimulate consumer spending. This is the multiplier effect. b. Higher incomes lead to greater spending, which means a higher de****nd for money. Interest rates rise and investment spending falls. This is the crowding-out effect. 3. Another important determinant of the size of the shift in aggregate de****nd due to a change in taxes is whether people believe that the tax change is per****nent or temporary. A per****nent tax change will have a larger effect on aggregate de****nd than a temporary one. F. FYI: How Fiscal Policy Might Affect Aggregate Supply 1. Because people respond to incentives, a decrease in tax rates ****y cause individuals to work more, because they get to keep more of what they earn. If this occurs, the aggregate-supply curve would increase (shift to the right). 2. Changes in government purchases ****y also affect supply. If the government increases spending on capital projects or education, the productive ability of the economy is enhanced, shifting aggregate supply to the right. III. Using Policy to Stabilize the Economy If you would like, now would be a good time to cover the debate in Chapter 36 concerning whether or not policy****kers should actively attempt to stabilize the economy. A. The Case for Active Stabilization Policy 1. Example: The government reduces its spending to cut the budget deficit, lowering aggregate de****nd (shifting the curve to the left). a. The Fed can offset this government action by increasing the money supply. b. This would lower interest rates and boost spending, shifting the aggregate- de****nd curve back to the right. 2. Policy instruments are often used in this ****nner to stabilize de****nd. Economic stabilization has been an explicit goal of U.S. policy since the Employment Act of 1946. a. One implication of the Employment Act is that the government should avoid being the cause of economic fluctuations. b. The second implication of the Employment Act is that the government should respond to changes in the private economy in order to stabilize aggregate de****nd. 3. The Employment Act occurred in response to a book by John Maynard Keynes, an economist who emphasized the important role of aggregate de****nd in explaining short-run fluctuations in the economy. 4. Keynes also felt strongly that the government should stimulate aggregate de****nd whenever necessary to keep the economy at full employment. a. Keynes felt that aggregate de****nd responds strongly to pessimism and optimism. When consumers are pessimistic, aggregate de****nd is low, output is low, and unemployment is increased. When consumers are optimistic, aggregate de****nd is high, output is high, and unemployment is lowered. b. It is possible for the government to adjust monetary and fiscal policy in response to optimistic or pessimistic views. This helps stabilize aggregate de****nd, keeping output stable at full employment. 5. Case Study: Keynesians in the White House a. In 1961, President Kennedy pushed for a tax cut to stimulate aggregate de****nd. Several of his economic advisers were followers of Keynes. b. In 2001, President Bush created a tax cut to help the economy recover from the recession that had just begun. B. The Case against Active Stabilization Policy 1. Some economists believe that fiscal and monetary policy tools should only be used to help the economy achieve long-run goals, such as low inflation and rapid economic growth. 2. The pri****ry argument against active policy is that these policy tools ****y affect the economy with a long lag. a. With monetary policy, the change in money supply leads to a change in interest rates. This change in interest rates affects investment spending. However, investment decisions are usually ****de well in advance, so the effects from changes in investment will not likely be felt in the economy very quickly. b. The lag in fiscal policy is generally due to the political process. Changes in spending and taxes must be approved by both the House and the Senate (after going through committees in both houses). 3. By the time these policies take effect, the condition of the economy ****y have changed. This could lead to even larger problems. C. Auto****tic Stabilizers 1. Definition of auto****tic stabilizers: changes in fiscal policy that stimulate aggregate de****nd when the economy goes into a recession without policy****kers having to take any deliberate action. 2. The most important auto****tic stabilizer is the tax system. a. When the economy falls into a recession, incomes and profits fall. b. The personal income tax depends on the level of households’ incomes and the corporate income tax depends on the level of firm profits. c. This implies that the government’s tax revenue falls during a recession. This tax cut stimulates aggregate de****nd and reduces the ****gnitude of this economic downturn. 3. Government spending is also an auto****tic stabilizer. a. More individuals become eligible for transfer payments during a recession. b. These transfer payments provide additional income to recipients, stimulating spending. c. Thus, just like the tax system, our system of transfer payments helps to reduce the size of short-run economic fluctuations. SOLUTIONS TO TEXT PROBLEMS: Quick Quizzes 1. According to the theory of liquidity preference, the interest rate adjusts to balance the supply and de****nd for money. Therefore, a decrease in the money supply will increase the equilibrium interest rate. This decrease in the money supply reduces aggregate de****nd because the higher interest rate causes households to buy fewer houses, reducing the de****nd for residential investment, and causes firms to spend less on new factories and new equipment, reducing business investment. 2. If the government reduces spending on highway construction by $10 billion, the aggregate-de****nd curve shifts to the left because government purchases are lower. The shift to the left of the aggregate-de****nd curve could be more than $10 billion if the multiplier effect outweighs the crowding-out effect, or it could be less than $10 billion if the crowding-out effect outweighs the multiplier effect. 3. If people become pessimistic about the future, they will spend less, causing the aggregate-de****nd curve to shift to the left. If the Fed wants to stabilize aggregate de****nd, it should increase the money supply. The increase in the money supply will cause the interest rate to decline, thus stimulating residential and business investment. The Fed might choose not to do this because by the time the policy action takes effect, the long lag time might mean the economy would have recovered on its own, and the increase in the money supply will cause inflation. Questions for Review 1. The theory of liquidity preference is Keynes's theory of how the interest rate is determined. According to the theory, the aggregate-de****nd curve slopes downward because: (1) a higher price level raises money de****nd; (2) higher money de****nd leads to a higher interest rate; and (3) a higher interest rate reduces the quantity of goods and services de****nded. Thus, the price level has a negative relationship with the quantity of goods and services de****nded. 2. A decrease in the money supply shifts the money-supply curve to the left. The equilibrium interest rate will rise. The higher interest rate reduces consumption and investment, so aggregate de****nd falls. Thus, the aggregate-de****nd curve shifts to the left. 3. If the government spends $3 billion to buy police cars, aggregate de****nd might increase by more than $3 billion because of the multiplier effect on aggregate de****nd. Aggregate de****nd might increase by less than $3 billion because of the crowding-out effect on aggregate de****nd. 4. If pessimism sweeps the country, households reduce consumption spending and firms reduce investment, so aggregate de****nd falls. If the Fed wants to stabilize aggregate de****nd, it must increase the money supply, reducing the interest rate, which will induce households to save less and spend more and will encourage firms to invest more, both of which will increase aggregate de****nd. If the Fed does not increase the money supply, Congress could increase government purchases or reduce taxes to increase aggregate de****nd. 5. Government policies that act as auto****tic stabilizers include the tax system and government spending through the unemployment-benefit system. The tax system acts as an auto****tic 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 auto****tic 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. Problems and Applications 1. a. When the Fed’s bond traders buy bonds in open-****rket operations, the money-supply curve shifts to the right from MS 1 to MS 2, as shown in Figure 1. The result is a decline in the interest rate. Figure 1 Figure 2 b. When an increase in credit card availability reduces the cash people hold, the money-de****nd curve shifts to the left from MD 1 to MD 2, as shown in Figure 2. The result is a decline in the interest rate. c. When the Federal Reserve reduces reserve requirements, the money supply increases, so the money-supply curve shifts to the right from MS 1 to MS 2, as shown in Figure 1. The result is a decline in the interest rate. d. When households decide to hold more money to use for holiday shopping, the money-de****nd curve shifts to the right from MD 1 to MD 2, as shown in Figure 3. The result is a rise in the interest rate. Figure 3 e. When a wave of optimism boosts business investment and expands aggregate de****nd, money de****nd increases from MD 1 to MD 2 in Figure 3. The increase in money de****nd increases the interest rate. Figure 4 2. a. The increase in the money supply will cause the equilibrium interest rate to decline, as shown in Figure 4. Households will increase spending and will invest in more new housing. Firms too will increase investment spending. This will cause the aggregate de****nd curve to shift to the right as shown in Figure 5. Figure 5 b. As shown in Figure 5, the increase in aggregate de****nd will cause an increase in both output and the price level in the short run. c. When the economy ****kes the transition from its short-run equilibrium to its long-run equilibrium, short-run aggregate supply will decline, causing the price level to rise even further. d. The increase in the price level will cause an increase in the de****nd for money, raising the equilibrium interest rate. e. Yes. While output initially rises because of the increase in aggregate de****nd, it will fall once short-run aggregate supply declines. Thus, there is no long- run effect of the increase in the money supply on real output. Figure 6 3. a. When more ATMs are available, money de****nd is reduced and the money- de****nd curve shifts to the left from MD 1 to MD 2, as shown in Figure 6. If the Fed 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- de****nd curve to the right, as consumption and investment increase. b. If the Fed wants to stabilize aggregate de****nd, it should reduce the money supply to MS 2, so the interest rate will re****in at r1 and aggregate de****nd will not change. 4. A tax cut that is per****nent will have a bigger impact on consumer spending and aggregate de****nd. If the tax cut is per****nent, consumers will view it as adding substantially to their financial resources, and they will increase their spending substantially. If the tax cut is temporary, consumers will view it as adding just a little to their financial resources, so they will not increase spending as much. 5. a. The current situation is shown in Figure 7. Figure 7 b. The Fed will want to stimulate aggregate de****nd. Thus, it will need to lower the interest rate by increasing the money supply. This could be achieved if the Fed purchases government bonds from the public. Figure 8 c. As shown in Figure 8, the Fed's purchase of government bonds shifts the supply of money to the right, lowering the interest rate. d. The Fed's purchase of government bonds will increase aggregate de****nd as consumers and firms respond to lower interest rates. Output and the price level will rise as shown in Figure 9. Figure 9 6. a. Legislation allowing banks to pay interest on checking deposits increases the return to money relative to other financial assets, thus increasing money de****nd. b. If the money supply re****ined constant (at MS1), the increase in the de****nd for money would have raised the interest rate, as shown in Figure 10. The rise in the interest rate would have reduced consumption and investment, thus reducing aggregate de****nd and output. c. To ****intain a constant interest rate, the Fed would need to increase the money supply from MS 1 to MS 2. Then aggregate de****nd and output would be unaffected. Figure 10 7. a. If there is no crowding out, then the multiplier equals 1/(1 – MPC ). Because 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. 8. a. The initial effect of the tax reduction of $20 billion is to increase aggregate de****nd by $20 billion x 3/4 (the MPC ) = $15 billion. b. Additional effects follow this initial effect as the added incomes are spent. The second round leads to increased consumption spending of $15 billion x 3/4 = $11.25 billion. The third round gives an increase in consumption of $11.25 billion x 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 x 4 = $60 billion. c. Government purchases have an initial effect of the full $20 billion, because they increase aggregate de****nd directly by that amount. The total effect of an increase in government purchases is thus $20 billion x 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 de****nd 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 de****nd. d. The government could increase taxes by the same amount it increases its purchases. 9. a. If the ****rginal propensity to consume is 0.8, the spending multiplier will be 1/(1-0.8) = 5. Therefore, the government would have to increase spending by $400/5 = $80 billion to close the recessionary gap. b. With an MPC of 0.8, the tax multiplier is (0.8)(1/(1-0.8)) = (0.8)(5) = 4. Therefore, the government would need to cut taxes by $400 billion/4 = $100 billion to close the recessionary gap. c. If the central bank was to hold the money supply constant, my answer would be larger because crowding out would occur. d. They would have to raise both government spending and taxes by $400 billion. The increase in government purchases would result in a boost of $2,000 billion, while the higher taxes would reduce spending by $1,600 billion. This leaves a $400 billion rise in aggregate spending. 10. If government spending increases, aggregate de****nd rises, so money de****nd rises. The increase in money de****nd leads to a rise in the interest rate and thus a decline in aggregate de****nd if the Fed does not respond. But if the Fed ****intains a fixed interest rate, it will increase money supply, so aggregate de****nd will not decline. Thus, the effect on aggregate de****nd from an increase in government spending will be larger if the Fed ****intains a fixed interest rate. 11. 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 de****nd 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 s****ll. Because fiscal policy increases aggregate de****nd, thus increasing money de****nd 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. 12. a. Tax revenue declines when the economy goes into a recession because taxes are closely related to economic activity. In a recession, people's incomes and wages fall, as do firms' profits, so taxes on these things decline. b. Government spending rises when the economy goes into a recession because more people get unemployment-insurance benefits, welfare benefits, and other forms of income support. c. If the government were to operate under a strict balanced-budget rule, it would have to raise tax rates or cut government spending in a recession. Both would reduce aggregate de****nd, ****king the recession more severe. 13. a. If there were a contraction in aggregate de****nd, the Fed would need to increase the money supply to increase aggregate de****nd and stabilize the price level, as shown in Figure 11. By increasing the money supply, the Fed is able to shift the aggregate-de****nd curve back to AD 1 from AD 2. This policy stabilizes output and the price level. Figure 11 35b. If there were an adverse shift in short-run aggregate supply, the Fed would need to decrease the money supply to stabilize the price level, shifting the aggregate-de****nd curve to the left from AD 1 to AD 2, as shown in Figure 12. This worsens the recession caused by the shift in aggregate supply. To stabilize output, the Fed would need to increase the money supply, shifting the aggregate-de****nd curve from AD 1 to AD 3. However, this action would raise the price level. Figure 12 THE SHORT-RUN TRADE- OFF BETWEEN INFLATION AND UNEMPLOYMENT WHAT’S NEW IN THE FIFTH EDITION: There is a new section on the challenges faced by Federal Reserve chair****n Ben Bernanke. There are two new In the News boxes: “Will Stagflation Return?” and “Managing Expectations.” LEARNING O****ECTIVES: By the end of this chapter, students should understand:  why policy****kers face a short-run trade-off between inflation and unemployment.  why the inflation-unemployment trade-off disappears in the long run.  how supply shocks can shift the inflation-unemployment trade-off.  the short-run cost of reducing inflation.  how policy****kers’ credibility might affect the cost of reducing inflation. CONTEXT AND PURPOSE: Chapter 35 is the final chapter in a three-chapter sequence on the economy’s short-run fluctuations around its long-term trend. Chapter 33 introduced aggregate supply and aggregate de****nd. Chapter 34 developed how monetary and fiscal policies affect aggregate de****nd. Both Chapters 33 and 34 addressed the relationship between the price level and output. Chapter 35 will concentrate on a similar relationship between inflation and unemployment. The purpose of Chapter 35 is to trace the history of economists’ thinking about the relationship between inflation and unemployment. Students will see why there is a temporary trade-off between inflation and unemployment, and why there is no per****nent trade-off. This result is an extension of the results produced by the model of aggregate supply and aggregate de****nd where a change in the price level induced by a change in aggregate de****nd temporarily alters output but has no per****nent impact on output. KEY POINTS:  The Phillips curve describes a negative relationship between inflation and unemployment. By expanding aggregate de****nd, policy****kers can choose a point on the Phillips curve with higher inflation and lower unemployment. By contracting aggregate de****nd, policy****kers can choose a point on the Phillips curve with lower inflation and higher unemployment.  The trade-off between inflation and unemployment described by the Phillips curve holds only in the short run. In the long run, expected inflation adjusts to changes in actual inflation, and the short-run Phillips curve shifts. As a result, the long-run Phillips curve is vertical at the natural rate of unemployment.  The short-run Phillips curve also shifts because of shocks to aggregate supply. An adverse supply shock, such as an increase in world oil prices, gives policy****kers a less favorable trade-off between inflation and unemployment. That is, after an adverse supply shock, policy****kers have to accept a higher rate of inflation for any given rate of unemployment, or a higher rate of unemployment for any given rate of inflation.  When the Fed contracts growth in the money supply to reduce inflation, it moves the economy along the short-run Phillips curve, which results in temporarily high unemployment. The cost of disinflation depends on how quickly expectations of inflation fall. Some economists argue that a credible commitment to low inflation can reduce the cost of disinflation by inducing a quick adjustment of expectations. CHAPTER OUTLINE: I. The Phillips Curve A. Origins of the Phillips Curve 1. In 1958, economist A. W. Phillips published an article discussing the negative correlation between inflation rates and unemployment rates in the United Kingdom. 2. American economists Paul Samuelson and Robert Solow showed a similar relationship between inflation and unemployment for the United States two years later. 3. The belief was that low unemployment is related to high aggregate de****nd, and high aggregate de****nd puts upward pressure on prices. Likewise, high unemployment is related to low aggregate de****nd, and low aggregate de****nd pulls price levels down. 4. Definition of Phillips curve: a curve that shows the short-run trade-off between inflation and unemployment. Figure 1 5. Samuelson and Solow believed that the Phillips curve offered policy****kers a menu of possible economic outcomes. Policy****kers could use monetary and fiscal policy to choose any point on the curve. B. Aggregate De****nd, Aggregate Supply, and the Phillips Curve Figure 2 Show how the Phillips curve is derived from the aggregate de****nd/aggregate supply model step by step. This graph is different from all the other graphs that they have drawn in 1m.acTroheecoPnhoilmlipicssc,ubrevceaussheowit sistnhoetcaosmubpipnlayt-iaonnds-doefminafnladtidoinagarnadmu. nemployment that arise in the short run due to shifts in the aggregate-de****nd curve. 2. The greater the aggregate de****nd for goods and services, the greater the economy’s output and the higher the price level. Greater output means lower unemployment. Whatever the previous year’s price level happens to be, the higher the price level in the current year, the higher the rate of inflation. 3. Example: The price level is 100 (measured by the Consumer Price Index) in the year 2020. There are two possible changes in the economy for the year 2021: a low level of aggregate de****nd or a high level of aggregate de****nd. a. If the economy experiences a low level of aggregate de****nd, we would be at a short-run equilibrium like point A. This point also corresponds with point A on the Phillips curve. Note that when aggregate de****nd is low, the inflation rate is relatively low and the unemployment rate is relatively high. b. If the economy experiences a high level of aggregate de****nd, we would be at a short-run equilibrium like point B. This point also corresponds with point B on the Phillips curve. Note that when aggregate de****nd is high, the inflation rate is relatively high and the unemployment rate is relatively low. 4. Because monetary and fiscal policies both shift the aggregate-de****nd curve, these policies can move the economy along the Phillips curve. a. Increases in the money supply, increases in government spending, or decreases in taxes all increase aggregate de****nd and move the economy to a point on the Phillips curve with lower unemployment and higher inflation. b. Decreases in the money supply, decreases in government spending, or increases in taxes all lower aggregate de****nd and move the economy to a point on the Phillips curve with higher unemployment and lower inflation. II. Shifts in the Phillips Curve: The Role of Expectations A. The Long-Run Phillips Curve Figure 3 1. In 1968, economist Milton Fried****n argued that monetary policy is only able to choose a combination of unemployment and inflation for a short period of time. At the same time, economist Edmund Phelps wrote a paper suggesting the same thing. 2. In the long run, monetary growth has no real effects. This implies that it cannot affect the factors that determine the economy’s long-run unemployment rate. 3. Thus, in the long run, we would not expect there to be a relationship between unemployment and inflation. This must mean that, in the long run, the Phillips curve is vertical. Figure 4 4. The vertical Phillips curve occurs because, in the long run, the aggregate supply curve is vertical as well. Thus, increases in aggregate de****nd lead only to changes in the price level and have no effect on the economy’s level of output. Thus, in the long run, unemployment will not change when aggregate de****nd changes, but inflation will. 5. The long-run aggregate-supply curve occurs at the economy’s natural rate of output. This means that the long-run Phillips curve occurs at the natural rate of unemployment. You ****y want to review what is meant by the “natural rate” of unemployment. B. The Meaning of “Natural” 1. Fried****n and Phelps considered the natural rate of unemployment to be the rate toward which the economy gravitates in the long run. 2. The natural rate of unemployment ****y not be the socially desirable rate of unemployment. 3. The natural rate of unemployment ****y change over time. C. Reconciling Theory and Evidence 1. The conclusion of Fried****n and Phelps that there is no long-run trade-off between inflation and unemployment was based on theory, while the correlation between inflation and unemployment found by Phillips, Samuelson, and Solow was based on actual evidence. 2. Fried****n and Phelps believed that an inverse relationship between inflation and unemployment exists in the short run. 3. The long-run aggregate-supply curve is vertical, indicating that the price level does not influence output in the long run. 4. But, the short-run aggregate-supply curve is upward sloping because of misperceptions about relative prices, sticky wages, and sticky prices. These perceptions, wages, and prices adjust over time, so that the positive relationship between the price level and the quantity of goods and services supplied occurs only in the short run. 5. This same logic applies to the Phillips curve. The trade-off between inflation and unemployment holds only in the short run. 6. The expected level of inflation is an important factor in understanding the difference between the long-run and the short-run Phillips curves. Expected inflation measures how much people expect the overall price level to change. 7. The expected rate of inflation is one variable that determines the position of the short-run aggregate-supply curve. This is true because the expected price level affects the perceptions of relative prices that people form and the wages and prices that they set. 8. In the short run, expectations are somewhat fixed. Thus, when the Fed increases the money supply, aggregate de****nd increases along the upward sloping short- run aggregate-supply curve. Output grows (unemployment falls) and the price level rises (inflation increases). 9. Eventually, however, people will respond by changing their expectations of the price level. Specifically, they will begin expecting a higher rate of inflation. D. The Short-Run Phillips Curve 1. We can relate the actual unemployment rate to the natural rate of unemployment, the actual inflation rate, and the expected inflation rate using the following equation: unemp. rate = natural rate - a (actual inflation - expected inflation) a. Because expected inflation is already given in the short run, higher actual inflation leads to lower unemployment. b. How much unemployment changes in response to a change in inflation is determined by the variable a, which is related to the slope of the short-run aggregate-supply curve. Be sure to discuss why actual inflation always equals expected inflation along the long- run Phillips curve. Figure 5 2. If policy****kers want to take advantage of the short-run trade-off between unemployment and inflation, it ****y lead to negative consequences. a. Suppose the economy is at point A and policy****kers wish to lower the unemployment rate. Expansionary monetary policy or fiscal policy is used to shift aggregate de****nd to the right. The economy moves to point B, with a lower unemployment rate and a higher rate of inflation. b. Over time, people get used to this new level of inflation and raise their expectations of inflation. This leads to an upward shift of the short-run Phillips curve. The economy ends up at point C, with a higher inflation rate than at point A, but the same level of unemployment. E. The Natural Experiment for the Natural-Rate Hypothesis 1. Definition of the natural-rate hypothesis: the claim that unemployment eventually returns to its nor****l, or natural rate, regardless of the rate of inflation. Figure 6 2. Figure 6 shows the unemployment and inflation rates from 1961 to 1968. It is easy to see the inverse relationship between these two variables. 3. Beginning in the late 1960s, the government followed policies that increased aggregate de****nd. a. Government spending rose because of the Vietnam War. b. The Fed increased the money supply to try to keep interest rates down. 4. As a result of these policies, the inflation rate re****ined fairly high. However, even though inflation re****ined high, unemployment did not re****in low. Figure 7 a. Figure 7 shows the unemployment and inflation rates from 1961 to 1973. The **** inverse relationship between these two variables began to disappear around 1970. b. Inflation expectations adjusted to the higher rate of inflation and the unemployment rate returned to its natural rate of around 5% to 6%. III. Shifts in the Phillips Curve: The Role of Supply Shocks A. In 1974, OPEC increased the price of oil sharply. This increased the cost of producing ****ny goods and services and therefore resulted in higher prices. Figure 8 1. Definition of supply shock: an event that directly alters firms’ costs and prices, shifting the economy’s aggregate-supply curve and thus the Phillips curve. 2. Graphically, we could represent this supply shock as a shift in the short-run aggregate-supply curve to the left. 3. The decrease in equilibrium output and the increase in the price level left the economy with stagflation. B. Given this turn of events, policy****kers are left with a less favorable short-run trade- off between unemployment and inflation. 1. If they increase aggregate de****nd to fight unemployment, they will raise inflation further. 2. If they lower aggregate de****nd to fight inflation, they will raise unemployment further. C. This less favorable trade-off between unemployment and inflation can be shown by a shift of the short-run Phillips curve. The shift ****y be per****nent or temporary, depending on how people adjust their expectations of inflation. Figure 9 D. During the 1970s, the Fed decided to accommodate the supply shock by increasing the supply of money. This increased the level of expected inflation. Figure 9 shows inflation and unemployment in the United States during the late 1970s and early 1980s. E. In The News: Will Stagflation Return? 1. In 2008, economist Allan Meltzer worried that the Fed was repeating the mistakes of the 1970s. 2. This is an op-ed written by Meltzer for the Wall Street Journal. IV. The Cost of Reducing Inflation A. The Sacrifice Ratio Figure 10 1. To reduce the inflation rate, the Fed must follow contractionary monetary policy. a. When the Fed slows the rate of growth of the money supply, aggregate de****nd falls. b. This reduces the level of output in the economy, increasing unemployment. c. The economy moves from point A along the short-run Phillips curve to point B, which has a lower inflation rate but a higher unemployment rate. d. Over time, people begin to adjust their inflation expectations downward and the short-run Phillips curve shifts. The economy moves from point B to point C, where inflation is lower and the unemployment rate is back to its natural rate. 2. Therefore, to reduce inflation, the economy must suffer through a period of high unemployment and low output. 3. Definition of sacrifice ratio: the number of percentage points of annual output lost in the process of reducing inflation by one percentage point. 4. A typical esti****te of the sacrifice ratio is five. This implies that for each percentage point inflation is decreased, output falls by 5%. B. Rational Expectations and the Possibility of Costless Disinflation 1. Definition of rational expectations: the theory according to which people opti****lly use all the infor****tion they have, including infor****tion about government policies, when forecasting the future. 2. Proponents of rational expectations believe that when government policies change, people alter their expectations about inflation. 3. Therefore, if the government ****kes a credible commitment to a policy of low inflation, people would be rational enough to lower their expectations of inflation immediately. This implies that the short-run Phillips curve would shift quickly without any extended period of high unemployment. If you would like, now would be a good time to discuss the debate in Chapter 36 concerning whether the central bank should aim for zero inflation. C. The Volcker Disinflation Figure 11 1. Figure 11 shows the inflation and unemployment rates that occurred while Paul Volcker worked at reducing the level of inflation during the 1980s. 2. As inflation fell, unemployment rose. In fact, the United States experienced its deepest recession since the Great Depression. 3. Some economists have offered this as proof that the idea of a costless disinflation suggested by rational-expectations theorists is not possible. However, there are two reasons why we might not want to reject the rational-expectations theory so quickly. a. The cost (in terms of lost output) of the Volcker disinflation was not as large as ****ny economists had predicted. b. While Volcker promised that he would fight inflation, ****ny people did not believe him. Few people thought that inflation would fall as quickly as it did; this likely kept the short-run Phillips curve from shifting quickly. D. The Greenspan Era Figure 12 1. Figure 12 shows the inflation and unemployment rate from 1984 to 1999, called the Greenspan era because Alan Greenspan became the chair****n of the Federal Reserve in 1987. 2. In 1986, OPEC’s agreement with its members broke down and oil prices fell. The result of this favorable supply shock was a drop in both inflation and unemployment. 3. The rest of the 1990s witnessed a period of economic prosperity. Inflation gradually dropped, approaching zero by the end of the decade. Unemployment also reached a low level, leading ****ny people to believe that the natural rate of unemployment has fallen. 4. The economy ran into problems in 2001 due to the end of the dot-com stock ****rket bubble, the 9-11 terrorist attacks, and corporate accounting scandals that reduced aggregate de****nd. Unemployment rose as the economy experienced its first recession in a decade. 5. But a combination of expansionary monetary and fiscal policies helped end the downturn, and by early 2005, the unemployment rate was close to the esti****ted natural rate. 6. In 2005, President Bush nominated Ben Bernanke as the Fed chair****n. E. Bernanke’s Challenges 1. In his first couple of years as Fed chair****n, Bernanke faced some significant economic challenges. a. One challenge arose from problems in the housing and financial ****rkets. b. Commodity prices around the world began rising dra****tically. F. In The News: Managing Expectations 1. To keep a more favorable short-run tradeoff between inflation and unemployment, central bankers try to dampen worries of inflation. 2. This is an article from the Wall Street Journal that describes how ****ysts gauge inflation expectations. SOLUTIONS TO TEXT PROBLEMS: Quick Quizzes 1. The Phillips curve is shown in Figure 1. Figure 1 To see how policy can move the economy from a point with high inflation to a point with low inflation, suppose the economy begins at point A in Figure 2. If policy is used to reduce aggregate de****nd (such as a decrease in the money supply or a decrease in government purchases), the aggregate-de****nd curve shifts from AD1 to AD2, and the economy moves from point A to point B with lower inflation, a reduction in real GDP, and an increase in the unemployment rate. Figure 2 2. Figure 3 shows the short-run Phillips curve and the long-run Phillips curve. The curves are different because in the long run, monetary policy has no effect on unemployment, which tends toward its natural rate. However, in the short run, monetary policy can affect the unemployment rate. An increase in the growth rate of money raises actual inflation above expected inflation, causing firms to produce more since the short-run aggregate supply curve is positively sloped, which reduces unemployment temporarily. Figure 3 3. Examples of favorable shocks to aggregate supply include improved productivity and a decline in oil prices. Either shock shifts the aggregate-supply curve to the right, increasing output and reducing the price level, moving the economy from point A to point B in Figure 4. As a result, the Phillips curve shifts to the left, as the figure shows. Figure 4 4. The sacrifice ratio is the number of percentage points of annual output lost in the process of reducing inflation by 1 percentage point. The credibility of the Fed’s commitment to reduce inflation might affect the sacrifice ratio because it affects the speed at which expectations of inflation adjust. If the Fed’s commitment to reduce inflation is credible, people will reduce their expectations of inflation quickly, the short-run Phillips curve will shift downward, and the cost of reducing inflation will be low in terms of lost output. But if the Fed is not credible, people will not reduce their expectations of inflation quickly, and the cost of reducing inflation will be high in terms of lost output. Questions for Review Figure 5 1. Figure 5 shows the short-run trade-off between inflation and unemployment. The Fed 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 6 2. Figure 6 shows the long-run trade-off between inflation and unemployment. In the long run, there is no trade-off, 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. 3. 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 labor-****rket conditions. 4. 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. When the Fed decides to reduce inflation, the economy moves down along the short-run Phillips curve, as shown in Figure 7. 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 Fed's action was credible, so that expectations would adjust more rapidly. Figure 7 Problems and Applications 1. Figure 8 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%. Points B and C are on SRPC2 because both have expected inflation of 5%. Figure 8 2. a. A rise in the natural rate of unemployment shifts the long-run Phillips curve to the right and the short-run Phillips curve up, as shown in Figure 9. The economy is initially on LRPC1 and SRPC1 at an inflation rate of 3%, 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 re****ining equal to 3%. Figure 9 b. A decline in the price of imported oil shifts the short-run Phillips curve down, as shown in Figure 10, from SRPC1 to SRPC2. For any given unemployment rate, the inflation rate is lower, because oil is such a significant aspect of production costs in the economy. Figure 10 c. A rise in government spending represents an increase in aggregate de****nd, so it moves the economy along the short-run Phillips curve, as shown in Figure 11. The economy moves from point A to point B, with a decline in the unemployment rate and an increase in the inflation rate. Figure 11 d. A decline in expected inflation causes the short-run Phillips curve to shift down, as shown in Figure 12. The lower rate of expected inflation shifts the short-run Phillips curve from SRPC1 to SRPC2. Figure 12 Figure 13 3. a. Figure 13 shows how a reduction in consumer spending causes a recession in both an aggregate-supply/aggregate-de****nd 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 de****nd, shifting the aggregate-de****nd curve to the left from AD1 to AD2. The economy initially re****ins on the short-run aggregate-supply curve SRAS1, so the new equilibrium occurs at point B. The movement of the aggregate-de****nd 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 aggregate-supply/aggregate-de****nd diagram corresponds to the lower inflation rate in the Phillips-curve diagram. The lower level of output in the aggregate-supply/aggregate-de****nd 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. Figure 14 4. a. Figure 14 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 de****nd, moving the economy to point B in the figure. The unemployment rate rises and the inflation rate declines. If the Fed undertakes expansionary monetary policy, it can increase aggregate de****nd, offsetting the pessimism and returning the economy to point A, with the initial inflation rate and unemployment rate. c. Figure 15 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 SRPC 1 to SRPC 2. The economy moves from point A to point C, with a higher inflation rate and higher unemployment rate. If the Fed 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 Fed 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 policy****kers a less favorable trade-off between inflation and unemployment. Figure 15 5. Economists who believe that expectations adjust quickly in response to changes in policy would be more likely to favor using contractionary policy to reduce inflation than economists with the opposite views. If expectations adjust quickly, the costs of reducing inflation (in terms of lost output) will be relatively s****ll. Thus, Milton would be more in favor of following a policy to reduce inflation than would James. Figure 16 6. If the Fed acts on its belief that the natural rate of unemployment is 4%, when the natural rate is in fact 5%, the result will be a spiraling up of the inflation rate, as shown in Figure 16. Starting from a point on the long-run Phillips curve, with an unemployment rate of 5%, the Fed will believe that the economy is in a recession, because the unemployment rate is greater than its esti****te of the natural rate. Therefore, the Fed will increase the money supply, moving the economy along the short-run Phillips curve SRPC1. The inflation rate will rise and the unemployment rate will fall to 4%. As the inflation rate rises over time, expectations of inflation will rise, and the short-run Phillips curve will shift up to SRPC2. This process will continue, and the inflation rate will spiral upwards. The Fed ****y eventually realize that its esti****te of the natural rate of unemployment is wrong by examining the rising trend in the inflation rate. Figure 17 7. a. Figure 17 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 trade-off between inflation and unemployment, as shifts in aggregate de****nd still move the economy along the short-run Phillips curve. 8. a. If wage contracts have short durations, a recession induced by contractionary monetary policy will be less severe, because 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 Fed'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 downwards. 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. 369. 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 the costs of disinflation are higher. 10. a. As shown in the left diagram of Figure 18, equilibrium output and employment will fall. However, the effects on the price level and inflation rate will be ambiguous. The fall in aggregate de****nd puts downward pressure on prices, while the decline in short-run aggregate supply pushes prices up. The diagram on the right side of Figure 18 assumes that the inflation rate rises. b. The Fed would have to use expansionary monetary policy to keep output and employment at their natural rates. Aggregate de****nd would shift back to AD1. c. The Fed ****y not want to pursue this action because it will lead to a rise in the inflation rate as shown by point C. 11. If policy****kers 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 esti****tes of the natural rate downward), they need to look at other variables. Because 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, policy****kers 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 ****croeconomic variables, including the components of GDP and interest rates, to try to disentangle shifts in aggregate supply from shifts in aggregate de****nd, which (when combined with infor****tion about inflation) can help them determine the appropriate stance for monetary policy. FIVE DEBATES OVER MACROECONOMIC POLICY WHAT’S NEW IN THE FIFTH EDITION: A new explanation is provided on why s****ll amounts of inflation ****y be beneficial for the economy. There are two new In the News boxes on “Inflation Targeting” and “Dealing with Deficits.” LEARNING O****ECTIVES: By the end of this chapter, students should understand:  the debate concerning whether policy****kers should try to stabilize the economy.  the debate concerning whether monetary policy should be ****de by rule rather than by discretion.  the debate concerning whether the central bank should aim for zero inflation.  the debate concerning whether the government should balance its budget.  the debate concerning whether the tax laws should be reformed to encourage saving. CONTEXT AND PURPOSE: Chapter 36 is the final chapter in the text. It addresses five unresolved issues in ****croeconomics, each of which is central to current political debates. The chapter can be stu****d all at once, or portions of the chapter can be stu****d in conjunction with prior chapters that deal with the related ****terial. The purpose of Chapter 36 is to provide both sides of five leading debates over ****croeconomic policy. It employs infor****tion and tools that students have accumulated in their study of this text. This chapter ****y help students take a position on the issues addressed or, at least, it ****y help them understand the reasoning of others who have taken a position. KEY POINTS:  Advocates of active monetary and fiscal policy view the economy as inherently unstable and believe that policy can ****nage aggregate de****nd in order to offset the inherent instability. Critics of active monetary and fiscal policy emphasize that policy affects the economy with a lag and that our ability to forecast future economic conditions is poor. As a result, attempts to stabilize the economy can end up being destabilizing.  Advocates of rules for monetary policy argue that discretionary policy can suffer from incompetence, abuse of power, and time inconsistency. Critics of rules for monetary policy argue that discretionary policy is more flexible in responding to changing economic circumstances.  Advocates of a zero-inflation target emphasize that inflation has ****ny costs and few, if any benefits. Moreover, the cost of eliminating inflation—depressed output and employment―is only temporary. Even this cost can be reduced if the central bank announces a credible plan to reduce inflation, thereby directly lowering expectations of inflation. Critics of a zero-inflation target claim that moderate inflation imposes only s****ll costs on society, whereas the recession necessary to reduce the inflation is quite costly. The critics also point out several ways in which moderate inflation ****y be helpful to an economy.  Advocates of a balanced government budget argue that budget deficits impose a burden on future generations by raising their taxes and lowering their incomes. Critics of a balanced government budget argue that the deficit is only one s****ll piece of fiscal policy. Single- minded concern about the budget deficit can obscure the ****ny ways in which policy, including various spending programs, affect different generations.  Advocates of tax incentives for saving point out that our society discourages saving in ****ny ways, such as by heavily taxing capital income and by reducing benefits for those who have accumulated wealth. They endorse reforming the tax laws to encourage saving, perhaps by switching from an income tax to a consumption tax. Critics of tax incentives for saving argue that ****ny proposed changes to stimulate saving would pri****rily benefit the wealthy, who do not need a tax break. They also argue that such changes might have only a s****ll effect on private saving. Raising public saving by increasing the government’s budget surplus would provide a more direct and equitable way to increase national saving. CHAPTER OUTLINE: Provide supporting facts and figures for each side of the debates. Emphasize that there are no clear right or wrong answers. Do not forget to mention the political dimensions involved with these debates. At the heart of these debates is that there is a great deal of wealth and power at stake, and these considerations often are more important than the consensus of economists. Instead of lecturing, divide the students into groups and have them present the debates discussed in the chapter. Ask them to provide facts and figures to support their positions. I. Should Monetary and Fiscal Policy****kers Try to Stabilize the Economy? A. Pro: Policy****kers Should Try to Stabilize the Economy 1. When households and firms feel pessimistic, aggregate de****nd falls. This causes output to fall and unemployment to rise. 2. There is no reason for the economy to suffer through a recession when policy****kers can reduce the severity of economic fluctuations. 3. Thus, policy****kers should take an active role in leading the economy to stability. 4. When aggregate de****nd is inadequate to ensure full employment, policy****kers should act to boost spending in the economy. When aggregate de****nd is excessive and there is a risk of inflation, policy****kers should act to lower spending. 5. Such policy actions put ****croeconomic theory to its best use by leading to a more stable economy. B. Con: Policy****kers Should Not Try to Stabilize the Economy 1. There are substantial difficulties associated with running fiscal and monetary policy. One of the most important problems to remember is the time lag that often occurs with policy. 2. Economic conditions change over time. Thus, policy effects that occur with a lag ****y hit the economy at the wrong time, leading to a more unstable economy. 3. Therefore, policy****kers should refrain from intervening and be content with “doing no harm.” II. Should Monetary Policy Be Made by Rule Rather than by Discretion? A. Pro: Monetary Policy Should Be Made by Rule 1. Discretionary monetary policy leads to two problems. a. It does not limit incompetence and abuse of power. For example, a central banker ****y choose to create a political business cycle to help out a particular candidate. b. It ****y lead to a greater amount of inflation than is desirable. Policy****kers often renege on the actions that they promise. If individuals do not believe that the central bank will follow a low inflation policy, the short-run Phillips curve will shift, resulting in a less favorable trade-off between inflation and unemployment. 2. One way to avoid these problems is to force the central bank to follow a monetary rule. This rule could be flexible enough to allow for some infor****tion on the state of the economy. B. Con: Monetary Policy Should Not Be Made by Rule 1. Discretionary monetary policy allows flexibility. This gives the Fed the ability to react to unforeseen situations quickly. 2. It is also unclear that Fed central bankers use policy to help political candidates. Often, the policy used is one that actually lowers the candidate’s popularity (such as during the Carter administration). 3. The Fed can gain the confidence of people by following through on its promises. If it promises to fight inflation and then runs policies that keep the growth of the money supply low, there is no reason why inflation expectations would be high. Thus, the economy can achieve low inflation without a policy rule. (This has been shown to be the case in the United States in the 1990s.) 4. It would also be very difficult to specify a precise rule. C. In The News: Inflation Targeting 1. Many central banks around the world have adopted explicit targets for inflation. 2. This is an article from The Financial Times arguing that the Fed should follow suit. III. Should the Central Bank Aim for Zero Inflation? A. Pro: The Central Bank Should Aim for Zero Inflation 1. Inflation confers no benefits on society, but it poses real costs. a. Shoeleather costs b. Menu costs c. Increased variability of relative prices d. Tax distortions e. Confusion and inconvenience f. Arbitrary redistributions of wealth 2. Reducing inflation usually is associated with higher unemployment in the short run. However, once individuals see that policy****kers are trying to lower inflation, inflation expectations will fall, and the short-run Phillips curve will shift down. The economy will move back to the natural rate of unemployment at a lower inflation rate. 3. Therefore, reducing inflation is a policy with temporary costs and per****nent benefits. 4. It is not clear that a case could be ****de for any other level of inflation. Price stability only occurs if the inflation rate is zero. B. Con: The Central Bank Should Not Aim for Zero Inflation 1. The benefits of zero inflation are s****ll relative to the costs. Esti****tes of the sacrifice ratio suggest that lowering inflation by one percentage point lowers output in the economy by 5%. These costs are borne by the workers with the lowest level of skills and experience who lose their jobs. 2. There is no evidence that the costs of inflation are large. Also, policy****kers ****y be able to lower the costs of inflation (by changing tax laws, for example) without actually lowering the inflation rate. 3. Although, in the long run, the economy will move back to the natural rate of unemployment, there is no certainty that this will occur quickly. It ****y take time for the central bank to gain the trust of the people. 4. Moreover, recessions have per****nent effects. Investment falls, lowering the future capital stock. When workers become unemployed, they lose valuable job skills. 5. A s****ll amount of inflation ****y actually benefit the economy. IV. Should the Government Balance Its Budget? A. Pro: The Government Should Balance Its Budget 1. Future generations of taxpayers will be burdened by the federal government’s debt. This will lower the standard of living for these future generations. 2. Budget deficits cause crowding out. Reduced national saving raises interest rates and lowers investment. A lower capital stock reduces productivity and thus leads to a s****ller amount of economic growth than would have occurred in the absence of this budget deficit. 3. While it is sometimes justifiable to run budget deficits (such as in times of war or recession), recent budget deficits are not easily justified. It appears that Congress simply found it easier to borrow to pay for its spending instead of raising taxes. B. Con: The Government Should Not Balance Its Budget 1. The problems caused by the government debt are overstated. The future generation’s burden of debt is relatively s****ll when compared with their lifetime incomes. 2. It is important that any change in government spending is examined for external effects. If education spending is cut, for example, this will likely lead to lower economic growth in the future. This will certainly not ****ke future generations better off. 3. To some extent, parents who leave a bequest to their children can offset the effects of the budget deficits on future generations. C. In the News: Dealing with Deficits 1. The federal government’s budget deficit re****ins a focus of debate among policy****kers. 2. This is an article from The Wall Street Journal describing the important issues involved in the determination of the federal budget. V. Should the Tax Laws Be Reformed to Encourage Saving? A. Pro: The Tax Laws Should Be Reformed to Encourage Saving 1. The greater the amount of saving in an economy, the more funds there are available for investment. This increases productivity, raising the nation’s standard of living. 2. Because people respond to incentives, changing the tax laws to ****ke saving more attractive will raise the amount of funds saved. Current laws tax the return on saving fairly heavily. Some forms of capital income (such as corporate profits) are taxed twice: first at the corporate level and then at the stockholder level. Large bequests are also taxed, limiting the amount of incentive parents have to save for their children. 3. Tax laws are not the only government policy that discourage saving. Transfer programs such as welfare and Medicaid are reduced for those who have saved past income. College financial aid policies also are a function of income and wealth, penalizing those who have saved. 4. There are various ways to change the tax laws to encourage saving. a. Expand the ability of households to use tax-advantaged savings accounts such as Individual Retirement Accounts. b. Replace the current income tax system with a tax on consumption. B. Con: The Tax Laws Should Not Be Reformed to Encourage Saving 1. Increasing saving is not the only goal of tax policy. Policy****kers are interested in using tax policy to redistribute income, ****king sure that the burden of taxation falls on those who can most afford it. Any tax change that encourages saving will favor high-income households as they are more likely to be saving in the first place. 2. Changes in tax rates have conflicting substitution and income effects. 3. Saving can be increased in other ways. For example, governments could lower budget deficits (or increase budget surpluses) to raise public saving. 4. Lowering the tax on capital income lowers the revenue of the government. This ****y increase the budget deficit, lower public saving, and push national saving down as well. SOLUTIONS TO TEXT PROBLEMS: Quick Quizzes 1. Monetary and fiscal policies work with a lag. Monetary policy works with a lag because it affects spending for residential and business investment, but spending plans for such investment are often set in advance. Thus, it takes time for changes in monetary policy, working through interest rates, to affect investment. Fiscal policy works with a lag because of the long political process that governs changes in spending and taxes. These lags ****tter for the choice between active and passive policy because if the lags are long, policy must be set today for conditions far in the future, about which we can only guess. Since economic conditions ****y change between the time a policy is implemented and when it takes effect, policy changes ****y be destabilizing. Thus, long lags suggest a policy that is passive rather than active. 2. There are ****ny possible rules for monetary policy. One example is a rule that sets money growth at 3 percent per year. This rule might be better than discretionary policy because it prevents a political business cycle and the time inconsistency problem. It might be worse than discretionary policy because it would tie the Fed’s hands when there are shocks to the economy. For example, in response to a stock-****rket crash, the rule would prevent the Fed from easing monetary policy, even if it saw the economy slipping into recession. 3. The benefits of reducing inflation to zero include: (1) reducing shoeleather costs; (2) reducing menu costs; (3) reducing the variability of relative prices; (4) preventing unintended changes in tax liabilities due to nonindexation of the tax code; (5) eliminating the confusion and inconvenience resulting from a changing unit of account; and (6) preventing arbitrary redistribution of wealth associated with dollar-denominated debts. These benefits are all per****nent. The costs of reducing inflation to zero are the high unemployment and low output needed to reduce inflation. According to the natural rate hypothesis, these costs are temporary. 4. Reducing the budget deficit ****kes future generations better off because with lower debt, future taxes will be lower. In addition, lower debt will reduce real interest rates, causing investment to increase, leading to a larger stock of capital in the future, which means higher future labor productivity and higher real wages. A fiscal policy that might improve the lives of future generations even more than reducing the budget deficit is increased spending on education, which will also increase incomes in the future. 5. Our society discourages saving in a number of ways: (1) taxing the return on interest income; (2) taxing some forms of capital twice; (3) taxing bequests; (4) having means tests for welfare and Medicaid; and (5) granting financial aid as a function of wealth. The drawback of eliminating these disincentives is that, in ****ny cases, doing so would reduce the tax burden on wealthy taxpayers. The lost revenue to the government could require raising other taxes, which might increase the tax burden on the poor. Questions for Review 1. The lags in the effect of monetary and fiscal policy on aggregate de****nd are caused by the fact that ****ny households and firms set their spending plans in advance, so it takes time for changes in interest rates or taxes to alter the aggregate de****nd for goods and services. In addition, the effects of fiscal policy are slowed by the political process. As a result, it is more difficult to engage in activist stabilization policy, because the economy will not respond immediately to policy changes. 2. 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 rules rather than discretion. 3. Credibility might affect the cost of reducing inflation because it influences how quickly the short-run Phillips curve adjusts. If the Fed 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 down quickly, and the cost of disinflation will be high. 4. Some economists are against a target of zero inflation because they believe the costs of reaching zero inflation are large and the benefits are s****ll. 5. 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, so future workers have lower incomes. 6. 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, because balancing the budget would force the government to increase taxes and cut spending, ****king the downturn even worse. 7. 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. The government debt will be s****ller, so future generations will pay less in taxes. But they will also be less educated, so they will have less hu****n capital and thus have lower incomes. Future generations might be worse off in this case. 8. 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. As long as the government debt grows slower than the economy's income, government deficits can continue forever. 9. Income from capital is taxed twice in the case of dividends on corporate stock. The income is taxed once by the corporate income tax and a second time by the individual income tax on dividend income. 10. Examples, other than tax policy, of how our society discourages saving include: (1) the fact that some government benefits, such as welfare and Medicaid, are means-tested, implying that 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 a s****ller amount of financial aid. 11. Tax incentives to raise saving ****y have the adverse effect of raising the government budget deficit, which reduces public saving. Thus, national saving ****y not increase even though private saving rises. Problems and Applications 1. a. Figure 1 illustrates the short-run effect of a fall in aggregate de****nd. The economy starts at point A on aggregate-de****nd curve AD1 and short-run aggregate-supply curve SRAS1. The decline in aggregate de****nd shifts the aggregate-de****nd 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. 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 SRAS2. The economy ends up at point C, with a lower price level, but with output back at Y1. However, this process ****y take years to complete. c. If policy****kers are passive, the economy restores itself, but very slowly. If policy****kers shift aggregate de****nd to the right, they can get the economy back to long-run equilibrium much more quickly. However, due to lags and imperfect infor****tion, a policy to increase aggregate de****nd ****y be destabilizing. Figure 1 2. It is difficult for policy****kers to choose the appropriate strength of their actions because of lags between when policy is changed and when it affects aggregate de****nd, as well as the difficulty in forecasting the economy's future condition. It is also difficult to anticipate how sensitive consumers and firms will be to the changes in policy. 3. a. If money de****nd rises, the interest rate increases for a given money supply, as shown in Figure 2. The rise in the interest rate from r1 to r2 reduces consumption and investment spending, shifting the aggregate-de****nd curve to the left from AD1 to AD2. The result is a decline in output from Y1 to Y2 and a reduction of the price level from P1 to P2. Figure 2 Figure 3 b. If the Fed's rule responded to the unemployment rate, then the effects in part a would be modified, as shown in Figure 3. After output declines to Y2 as in part a, which causes a rise in the unemployment rate, the Fed increases the money supply to from MS1 to MS2, thus reducing the interest rate from r2 to r3. This stimulates consumption and investment spending, so the aggregate-de****nd curve shifts from AD2 to AD3. The result is a rise in output from Y2 to Y3. c. Having an element of feedback in the Fed's rule, as in part b, helps to stabilize the economy. If shocks to aggregate de****nd can be anticipated, as in the case of changes in fiscal policy, then it would help if the Fed's rule responded to predicted unemployment instead of current unemployment, especially given the lags in the effects of policy. For example, suppose the government announced a cut in spending to occur in a year. Then forecasts of the economy would show rising unemployment in the future because of the reduction in aggregate de****nd. If the Fed's rule could respond to those forecasts, the money supply could increase today, so that interest rates would decline today, causing spending in the future to increase, offsetting the contractionary fiscal policy. 4. a. The logic behind this rule has three elements. First, the 2% +  term means that in long-run equilibrium when y = y* and  = *, the real interest rate is 2%, because 2% is the difference between the nominal interest rate (r ) and the inflation rate (). Second, when the term y − y* is positive, that would mean that aggregate de****nd and short-run aggregate supply intersect to the right of long-run aggregate supply, so the Fed should tighten monetary policy (raising r ) to shift the aggregate-de****nd curve left. If y − y* is negative, that would mean that aggregate de****nd and short-run aggregate supply intersect to the left of long- run aggregate supply, so the Fed should ease monetary policy (reducing r ) to shift the aggregate-de****nd curve right. Third, when the term  − * is positive, the inflation rate exceeds the Fed’s goal, so it needs to tighten monetary policy (raising r ) to move down the short-run Phillips curve to reduce inflation. When  − * is negative, the inflation rate is below the Fed’s goal, so it needs to ease monetary policy (reducing r ) to move up the short-run Phillips curve to increase inflation. b. With actual values used in the rule, the rule is backward looking, which is a potential problem because policy works with lagsthus, the policy could be destabilizing. Using forecasts in the rule ****kes more sense because it avoids the lag problem, but forecasts ****y not be good enough for basing policy. 5. a. If investors believe that capital taxes will re****in 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 ****de 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 policy****kers because the government's incentives change over time. In both cases, the policy****ker has an incentive to tell people one thing, then to do another once people have ****de an economic decision. For example, in the case of monetary policy, policy****kers could announce an intention to lower inflation (so firms and workers will enter labor contracts with lower nominal wages), and policy****kers could increase inflation to reduce real wages and stimulate the economy. 6. Issues about whether the costs of inflation are large or s****ll are positive statements, as is the question about the size of the costs of reducing inflation. But the question of whether the Fed should reduce inflation to zero is a nor****tive question. 7. The benefits of reducing inflation are per****nent and the costs are temporary. Figure 4 illustrates this. The economy starts at point A. To reduce inflation, the Fed 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, because the short-run Phillips curve eventually shifts down to SRPC2, and the economy ends up at point B. Because 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 per****nent. The costs of increasing inflation are per****nent and the benefits are temporary for similar reasons. Again, suppose the economy starts at point A. To increase inflation, the Fed 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, because the short-run Phillips curve eventually shifts up to SRPC3, and the economy ends up at point C. Because 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 per****nent. Figure 4 8. If the budget deficit is 12% of GDP and nominal GDP is rising 5% 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 = 12/5, because at that point, a deficit that is 12% of GDP with GDP growing 5% ****intains the debt/income ratio at exactly 12/5. To be sustainable, debt and GDP must grow at the same rate, 5% each year. If the deficit is 12% of GDP, which is growing 5% each year, the ratio of debt to GDP must be 12/5, so that the deficit can be both 12% of GDP and ****intain 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. 9. a. An increase in the budget deficit redistributes income from young to old, because future generations will have to pay higher taxes and will have a lower capital stock. b. More generous subsi****s for education loans redistribute income from old to young, because future generations benefit from having higher hu****n capital. c. Greater investments in highways and bridges redistribute income from old to young, because future generations benefit from having a higher level of public capital than otherwise. d. An increase in Social Security benefits redistributes income from young to old, because current workers fund the benefits of those retired. 10. In a recession, the government can use a budget deficit to increase aggregate de****nd, thus boosting income and output. But in the long run, budget deficits raise interest rates, reducing investment, thus leading to a lower capital stock and reduced future income. An ideal fiscal policy would be one that allows budget deficits in the short run to combat recessions, but requires that the budget be balanced over time so that it does not have a detrimental effect on future income. 11. The fundamental trade-off that society faces if it chooses to save more is that it will have to reduce its consumption. Thus, society can consume less today and save more if it wants higher future income and consumption. The choice is really one of consumption today versus consumption in the future. The government can increase national saving by revising tax laws or by reducing its budget deficit. 12. a. A reduction in the tax rate on income from saving would most directly benefit wealthy people who have a greater amount of capital income. The rise in the tax rate on workers would harm individuals whose incomes come ****inly from labor earnings. b. The increased incentive to save would reduce the interest rate, thus increasing investment, so the capital stock would be larger. As capital per worker rises, productivity would increase, as well as the real wage paid to workers. c. Thus, in the long run, everyone, not just the wealthy, can benefit from reducing the tax rate on income from savings. However, these benefits would be reduced by the level of taxes paid on earnings.
关于本文
本文标题:曼昆《经济学原理》第五版宏观经济学习题答案(英文 链接地址:http://www.topstudy.com.cn/jiaoyu/tiku/84.html
上一篇:宏观经济学课后习题答案
下一篇:曼昆宏观经济学第六版答案

当前资源信息

高级会员

爱学习共有文档721 篇

编号:WENKUWU84

类型: 精品题库

格式: doc

大小: 6.31 MB

上传时间:2018-01-27

相关搜索

关于我们-联系我们-网站声明-文档下载-网站公告-版权申诉-网站客服

文库屋  www.wenkuwu.com (精品学习网 专业在线学习考试资料文档分享平台)

本站部分文档来自互联网收集和整理和网友分享,如果有侵犯了您的版权,请及时联系我们.
© www.topstudy.com.cn 2016-2012 精品学习网 版权所有 并保留所有权  ICP备案号:  粤ICP备14083021号-8              

收起
展开