Chapter 7: Economic Growth, Business Cycles, Unemployment ...people.southwestern.edu/~northrop/Documents/classes/MACR0EC… · Web viewc. It definitely was primarily in the art

Chapter 22: Economic Growth, Business Cycles, Unemployment, and Inflation

Questions for Thought and Review

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

2. U.S. per capita growth rate of 1.5 to 2.0 percent per year is lower than that of Japan (4.8 percent per year) and China (2.4 percent per year), close to Western Europe (2.5 percent per year), and Latin America (1.4 percent per year), and higher than Eastern Europe (1.0 percent per year) and Africa (0.8 percent per year).

3. Real output is a measure of the total goods and services an economy actually produces stated in constant prices. Potential output is a measure of the total goods and services an economy is capable of producing given its resources and institutions.

4. A representative business cycle is shown on the right. Each of the four phases—the peak, downturn, trough, and expansion are clearly labeled.

5. Besides predicting the recessions that did occur, the index has also predicted many recessions that did not occur. So the predictions have not been especially accurate. Predicting recessions is difficult because business cycles have varying durations and intensities. The leading indicators are called indicators and not predictors because they're only rough approximations of what's likely to happen in the future.

6. Reducing unemployment to 1.2 percent in the 1990s is not likely for several reasons. One is that a low inflation rate seems to be incompatible with low unemployment. Another is that the 1990s differ from the World War II period when there was an enormous ideological commitment to the war effort and an acceptance of strong wage and price controls.

7. Structural unemployment results from changes in the economy itself, while cyclical unemployment results from fluctuations in economic activity.

Page 719, Answers to End-of-Chapter Questions

8. Structural unemployment, because it results from changes in the structure of the economy, is best studied in the long-run framework. Cyclical unemployment, which results from fluctuations in economic activity, is best studied in the short-run framework.

9. Some economists argue that the unemployment rate undercounts unemployment because people who have stopped trying to find jobs are considered voluntarily idle and are not counted as unemployed. Others point out that, because of unemployment insurance, people often say they are looking for work when they really aren't, and therefore unemployment is overstated. So there are tendencies both to overestimate and underestimate the problem.

10. Okun's rule of thumb states that a 1 percentage point change in the unemployment rate will cause income to change in the opposite direction by 2 percent. Thus a 2 percentage point rise in unemployment will likely cause income to decrease by 4 percent.

11. Expectations are central to understanding inflation because the relative price increase people want must be tacked onto the inflation they expect. Expectations of inflation play an important role in any ongoing inflation. Expectations can snowball a small inflationary pressure into accelerating inflation.

12. While inflation doesn't make the nation any poorer on average, it does have costs. Its costs include capricious distributional effects, the destruction of the informational value of prices, and the breaking down of the institutional structure within which markets work.

13. Solving inflation often worsens unemployment and slows growth. Similarly, reducing unemployment by stimulating growth tends to increase inflation. So, in the short run, there will likely be a relationship. However, once expectations of inflation are built in, there can be high inflation with high unemployment, so the answer to the question is no.

Problems and Exercises

1. a. The labor force participation rate is the total number of people employed and/or looking for work (or the labor force) as a fraction of the population over 16 years old. In this instance it is 140,910/208,782 X 100 = 67 percent.

b. The unemployment rate is the total number of unemployed as a fraction of the labor force. In this instance it is 5,689/140,910 X 100 = 4 percent.

c. The employment rate is the total number of unemployed as a fraction of the labor force. Since the labor force equals the unemployed plus the employed, we know that in this instance it is (140,910 – 5,689)/140,910 X 100, or 96 percent.

2. a. The index in 2000 is 68/64 X 100 = 106.25.


b. Real output is nominal output/price index X 100 = $300 billion/115 X 100 = $260.9 billion.

c. The change in nominal output = change in real output + change in the price level. Thus, change in nominal output = 5 percent + 2 percent = 7 percent.

d. The change in nominal output = change in real output + change in the price level. Thus inflation = 7 percent – 3 percent = 4 percent.

3. The purpose of life and therefore a desired lifestyle is a complicated issue. To the extent that work provides a sense of self-worth and identity, complete idleness is not desirable. This, however, is a normative question. Unemployment within our culture and set of institutions is a measure of aggregate well-being to the extent that employment provides a sense of well-being and sufficient income to support a desired lifestyle. The Eloi are all unemployed, but if they can support their desired lifestyle with the work of machines, unemployment is not so bad. This example shows that unemployment must be understood within this broader framework-its meaning is specific to a set of institutions and a culture.

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

b. It is impossible to say which is better. Each needs to be judged within the broader system of the economy. This requires far more knowledge than is required for this book.

c. The answer to this question depends upon the distribution of layoffs and hires in each of the economies. If layoffs in Japan were unavoidable and occurred among lower ranking employees, the average tenure of Japanese employees would rise. If instead the elderly were asked to retire, the average tenure would decline. In the U.S., assuming that new hires came from those just entering the labor force, the average tenure in the U.S. would most likely decline.

5. a. 5.3% b. 5% c. $.02 billion d.2.1 e. 5.3%

Web Questions

1. a. According to the White House’s figures, prices rose by 3.2% in the first quarter of 2000, while the unemployment rate, after seasonal adjustment, stood at 4.1% in March 2000.

b. According to the Livingston Survey, prices were forecasted to rise by 2.9% in 2000, while the unemployment rate was to remain steady at 4.2%.

c. Given the recent interest rate increases by the Fed, we would have deduced that prices had risen by more than what was forecasted. However, due to the growth of the economy, we would have expected unemployment to have fallen rather


than risen. However, we should keep in mind that these figures are approximates.

2. a. The answers to this question will depend upon the current state of the economy. The graph is shown on the right. The copy of the Economic Report of the President for Spring 2000 did not include quarterly data back to 1989, so we looked on BEA’s web site at www.bea.doc.gov to find it. The peak and trough are marked.

b. The economy is currently in an expansion.c. It has been in an expansion for 36 quarters.d. The last recession was 36 quarters ago in 1990.

Chapter 23: National Income Accounting


1. It depends on whether more foreign businesses and individuals conduct business in the country relative to domestic businesses and individuals. If more foreign businesses and individuals conduct business in the country relative to domestic businesses and individuals, then GNP will be greater than GDP.

2. If you add up all transactions you will include intermediate goods, so the amount will far exceed GDP, which is the measure of final output within a country.

3. A stock concept is the amount of something at a given point in time. A flow concept has a time period associated with it. A stock is the amount of water in a reservoir; a flow is the amount of water that flows over Niagara Falls every hour.

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

5. If the United States introduced universal child care, GDP should increase because some child care provided at home would then become market transactions. The welfare implications of that rise will depend on how society views this change. For example, would the quality and amount of child care increase? Would there be fewer neglected and abused children? Would an increase in the number of well-cared-for children eventually mean lower unemployment, more productive workers, and higher wages?


http://www.bea.doc.gov/

6. NDP is actually preferable to GDP as the expression of a country's domestic output because it takes depreciation into account. Depreciation is a cost of producing goods. However, measuring true depreciation is difficult because asset values fluctuate, and so GDP rather than NDP is generally used in discussions of economic activity.

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

8. Transfer payments are not included in national income, and so nothing directly would happen to it.

9. Personal income differs from national income because it measures the income actually received by households as opposed to the income they earned. Thus unearned income (transfer) is added to personal income, and earned income not received (corporate retained earnings, corporate income taxes, social security taxes) is subtracted from personal income to arrive at national income.

10. The difference between domestic personal income and national personal income is the addition of net foreign factor income to domestic personal income.

11. GDP does not measure happiness nor does it measure economic welfare. GDP measures economic activity. Economists talk about GDP because it is measurable and they need something to talk about. Moreover, GDP figures are used to make comparisons of one country's production with another country's and of one year's production with another year's. Besides, GDP does have some relation to happiness.


1. a. GDP is the sum of the value added by the three firms: 550 + 1850 + 950 = 3350.b. A 10 percent value-added tax would generate (. 10)(3350) = $335 of revenue.c. A 10 percent income tax would generate the same revenue.d. A 10 percent sales tax on final output would generate (.10)(1000 + 2100 + 1000)

= $410 of revenue.

2. a. GDP should fall as non-market transactions increase.b. GDP would not change.c. GDP would rise by the broker's commission.d. GDP would not change.e. GDP would not change.f. GDP would rise.

3. Students can search on the Internet or call the embassies of each country to find this information.


4. GDP = C + I + G + (X - M) = 500 + 185 + 195 + 4 = 884.GNP = GDP + net foreign factor income = 884 + 2 = 886.NNP = GNP - depreciation = 886 - 59 = 827.NDP = GDP - depreciation = 884 - 59 = 825.NI = NNP - indirect business taxes = 827 - 47 = 780.PI = NI + transfers from government - corporate retained earnings (undistributed corporate profits) - corporate income taxes - social security taxes = 780 + 72 - 51 - 64 - 35 = 702DPI = PI - personal income tax = 702 - 91 = 611

5. a. The expenditure approach:GDP = C + I + G + (X - M) = 700 + 500 + 300 + 275 = 1775GNP = C + I + G + (X - M) + net foreign factor income = 700 + 500 + 300 + 275 + (-3) = 1772.The income approach:National income = wages + rents + interest + profits + proprietor's income: 972 + 25 + 150 + 500 = 1,647. GNP = NI + indirect business taxes + depreciation = 1,647 + 100 + 25 = 1772.GDP = GDP - net foreign factor income = 1775.

b. NDP = GDP - depreciation = 1775 - 25 = 1750. NNP = GNP - depreciation = 1772 - 25 = 1747.

National income = wages + rents + interest + profits + proprietor's income: 972 + 25 + 150 + 500 = 1,647.

c. PI = NI + transfers - corporate income taxes - undistributed corporate profits - social security contrib. = 1647 + 0 - 215 - 60 - 0 = 1372.

d. DPI = PI - personal taxes = 1372 - 165 = 1207.

6. a. GDP = C + I + G + (X - M) = 485. GNP = GDP + Net foreign factor income = 488.

NI = Comp. + rent + profits + net interest = 448.NNP = NI + indirect business taxes = 475.

NNP = NDP + net foreign factor income: NDP = 472.b. Depreciation = GDP - NDP = 13.c. GDP = C + I + G + (X - M) = 480.

GNP = GDP + Net foreign factor income = 483. NI = Comp. + rent + profits + net interest = 459.

NNP = NI + indirect business taxes = 486. NNP = NDP + net foreign factor income: NDP = 483. Depreciation = GDP - NDP = -3.

7. a. 1996: 7813; 1997: 8146.2; 1998: 8496.6; 1999: 8848.9.b. Since inflation was positive in every year, nominal GDP growth always exceeded

real GDP growth in each of the last three years.c. It is impossible to say in which year society's welfare increased the most. GDP

measures market activity, not welfare.


Web Questions

1. The GDP for the last quarter of 1999 was 9,507.9 billion dollars.a. Consumption = $6434.1 billion; Investment = $1675.8 billion; Government

Consumption and Investment = $1688 billion; Net exports = -$290.1 billion.b. The nominal GDP for the last quarter of 1999 was 9,507.9 billion dollars, while

the real GDP for the same quarter was 9,037.2.c. GDP rose by 9.4% in the first quarter of 2000. However, the real GDP rose by

7.3%. Thus, the increase in the aggregate price level was responsible for 2.1% increase in the GDP.

d. The change in consumption contributed the most to the change in GDP. Net exports changed from -278.2 billion dollars to –290.1 billion dollars and thus became more negative.

2. a. The economic contributions of household and volunteer work. b. Crime, depletion of nonrenewable resources, family breakdown and loss of

leisure time. The depletion of nonrenewable resources is the largest of these categories.

c. The GDP has been going up while the GPI has been falling in recent years.

Chapter 24: Growth, Productivity, and the Wealth of Nations

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

b. Answers will vary. Answers will mention the lack of some products such as cars, air-conditioning, dishwashers, TVs, the Internet as well as the need to work longer hours to provide for the goods that did exist. Figure 24-1 supports this.

2. A person living in 1910 is most likely to work more to buy a dozen eggs than the person living in 1990. The reason is that since 1910, the United States income has been rising, on average, by more than the growth in the population. This means that the income per person has gone up since 1910. Thus the person living in the 1990 has a higher income than the person living in 1910 and so is likely to work less to buy the dozen eggs.

3. Specialization and division of labor allow a country to take advantage of its comparative advantage. Thus the individual country can concentrate, (i.e. specialize on the production of goods in which it has a comparative advantage) and trade them with the goods for which they do not have a comparative advantage. Hence free trade will, in general, benefit the participating countries.


4. An increase in savings in the United States can lead to an increase in investment. As investment in the economy increases, total output in the economy will increase and this would raise people’s income. As a result, the standard of living will be higher. But if a politician is to implement policies to encourage savings, it might inhibit aggregate spending in the economy and so income would not increase and so the policy would not be able to meet its objective of raising the standard of living.

5. The three types of capital are: i) physical capital ii) human capital and iii) social capital. Physical capital is the buildings and machines that are available for the production process; human capital is the workers’ skills that are embodied in them through education, experience and on-the-job training i.e. through people’s knowledge. Social Capital is the habitual way of doing things that guides people in how they approach production in the economy.

6. Two ways in which growth through technology differs from growth through the accumulation of physical capital are:

i) Accumulation of physical capital increases output by simply increasing the amount of the capital available for production whereas technology increases output by making the existing capital more efficient and thereby increasing the return per available capital.

ii) Technology can also change the types of goods people buy in an economy by introducing new types of product whereas accumulation of physical capital does not make such a change.

7. The two actions governments can take to promote the development of new technologies are:

i) create patents and protect property rightsii) implement policies to provide funding for research.

8. Thomas Malthus based his prediction that population growth would exceed the growth in goods and services on the law of diminishing marginal productivity of labor. But his prediction did not come true because labor has become more efficient as a result of education and technological progress, which has increased the output per worker.

9. If individuals suddenly needed more food to subsist, the subsistence line would rotate to the left. Population would decrease and output per worker would fall as in shown in the graph below.


10. Positive externalities is the positive effect due to technological change on others not taken into account when the decision to invest in research was taken. Positive externalities occur when a technological gain in one sector of production gives other sectors of production new ideas on how to change what they are doing, which gives other people new ideas. Thus the effect of the technological change is magnified due to the spillover effect.

11. The three ways in which growth can be undesirable are:i) Growth may contribute to increased pollution.ii) Growth gas changes traditional cultures with beautiful handiwork, music

and dance into cultures of modern gadgets.iii) Some argue that the average working hours has increased because of

growth in the economy.

12. Credentialism can lead to the employment of workers who have the necessary degree but do not have the required skills for the job. Thus the average return from the person as a worker would be less and so the production process he or she is involved would become less efficient.

13. To compete with the others, the producer has an incentive to innovate i.e. to invest in technological advance so that he can increase his efficiency and so take a lead among his competitors. But technological innovation is usually associated with a high cost initially and the producer who has advanced his production process cannot afford to impose a high price on his product due to competition in the industry and so he cannot sustain his technological improvement.

14. The answer may vary depending on the students’ perceptions.

15. Communities are willing to give tax relief to new-technology firms located in their community because it would enable them to survive during the initial stages when the start-up costs are very high. If these companies survive, they would be able to


provide employment opportunities to the community members and thereby play a role in increasing the community’s total income and standard of living.


1. Using the rule of 72, we know that it would double in 36 years.

2. Constant returns to scale refers to the relationship between increases in all inputs and output. In this case, only one input rose, so we cannot make any conclusion about returns to scale.

3. Nepal: 65.5 years; Kenya: 42.4 years; Singapore: 10 years; Egypt: 18.5 years.

4. a. -2.7% b. 7.6% c. 1.8% d. 2.8%

5. a. While developing an educational system for a developing country, one might emphasize on technical education especially in high school level. The reason for this is that most students in the underdeveloped countries cannot afford to pursue higher education and stop at the high school level. Therefore, if high schools focus a little more on the technical aspect, then these students would be able to garner some technical knowledge to be efficient in this world of rapid technological change.

b. Because the United States is a rich country, it can afford a more eclectic educational system that teaches less directly relevant aspects of knowledge.

6. a. The borrowing circle probably would not work in the United States, because the strong social forces that exists in Bangladesh that eliminate the need for collateral do not exist in the United States. Perhaps there are some minority groups that do not have the necessary collateral to get loans in the traditional way but whose culture could provide the social forces to make repayment of loans more certain.

b. A possible modification of the program would be to require proof that the “traditional” methods of financing are not open. This would limit the program to those who have few options, but have a good business plan and intention to repay. Another modification would be to require that the business be maintained in the neighborhood where the cosigners live. This would maintain the social forces that ensure repayment.

c. Minorities often face the same problems because they do not have adequate assets for collateral necessary to gain traditional financing. They also may face discrimination by banks and venture capitalists. Nevertheless, they may have good business plans and an intention to repay.

7. a. It exhibits decreasing marginal productivity.b. If the population is at L1, it will grow. The surplus food is shown by Q1 – S1.


c. At L2 population is declining because there is not enough food to go around.d. The intersection of the two curves gives the level of population, L*, at which the

economy is in a steady state. It is a steady state because there is no surplus or shortage—there is just enough to keep people at their subsistence level.

Web Questions

1. This information was found in the World Development Indicators files.a. Students have to subtract the population growth from the average annual growth

in output. Kenya = 0.1 %; Mexico = -0.1% – 1.6; United States = 2.1; Japan = 2.7;

b. Kenya = 3.1%; Mexico = 1.9%; United States = 1.0%; Japan = 0.4;c. Kenya = 19.7% ; Mexico = 23.1% ; United States = ; Japan = 32.3%;

2. This question was answered according to the Index of Economic Freedom, 2000. The ratings for the top two are Hong Kong = 1.3; Singapore = 1.45. The ratings for the bottom two are North Korea = 5.0 and Iraq = 4.90.

a. The top two are countries where there is the greatest absence of government coercion or constraint in the following spheres beyond what is necessary for the citizens’ protection: production, consumption and distribution.

b. Using figures from 1998, the GDP per capita growth rates were as follows: Singapore = 0.4 %; Hong Kong = -7.9% ; North Korea = -6.8% ; Iraq = not available. As can be seen, there does not seem to be a definite relationship between the two factors. Even if one compares these GDP per capita growth rates with the Index of Economic Freedom for 1998, one cannot make any definite conclusions. The relationship between economic freedom and growth may be more visible over longer time comparisons.

3. The term of a patent is 20 years although exceptions can be made for, say pharmaceuticals.

a. Shortening the length of patents means that the new product or the technological innovation will become “common knowledge” soon. As such, it will be available to other sectors of production that might use it or might develop new ideas from it.


b. If the length of the patent if shortened, then there is reduced incentive to spend on R&D and technology since your funds are indirectly being used to provide new technologies to other sectors.

Chapter 25 Aggregate Demand, Aggregate Supply, and Modern Macroeconomics


1. The central difference between activist and laissez-faire economists is their differing views about whether the economy is self-regulating. Laissez-faire economists (Classicals) believe the pricing mechanism will bring the economy to an equilibrium (potential output and full employment) while activist economists (Keynesians) do not share that belief.

2. Classicals felt that if the wage was lowered, the depression would end. They saw unions as preventing the fall in wages, and they saw the government lacking the political will to break up unions.

3. Five factors that shift the AD curve are: changes in foreign income, changes in expectations, changes in exchange rates, changes in the distribution of income, and changes in government aggregate demand policy.

4. Say there is a rise in the price level. That would make the holders of money poorer (the wealth effect). It would also reduce the real money supply, increasing the interest rate (the interest rate effect). Assuming fixed exchange rates, it would also make goods less internationally competitive (the international effect). All these three account for the quantity of aggregate demand decreasing—decreasing spending as the price level rises. These initial increases are then multiplied by the multiplier effect as the initial spending reverberates through the economy.

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

6. If the economy is in short-run equilibrium below potential output, there will be downward pressures on the price level. The aggregate supply curve will shift down and the price level will fall. This will set the wealth, interest rate, and international effects in motion, increasing the quantity of aggregate demand and thereby bringing the economy into long-run equilibrium at potential output.

7. This implies that productivity is increasing significantly. If computers are a large portion of the economy, and wages do not rise by the full amount of the productivity increase, the result will be to lower the AS curve. It can also shift out the potential output curve to the right, increasing equilibrium potential output and lowering the price level.


8. Yes; they would emphasize the inherent value of the program, rather than discussing the program's effect on aggregate demand. This is because programs that increase aggregate demand when the economy is close to potential will ultimately lead to inflation and little increase in real output.

9. As can be seen in the following diagram, a large increase in potential output causes downward pressure on the price level from P0 to P1. As the price level shifts down the output level increases from Y0 to Y1.

10. The simple model abstracts from a number of important issues such as the problem of estimating potential income. Without knowing potential income we cannot know whether expansionary or contractionary policy is called for.


1. a. The AS curve will shift up since wages rise by more than the rise in productivity.b. The AS curve will shift down since productivity rises by more than the rise in

wages.c. The AS curve will shift up since wages rise and productivity declines.d. The AS curve will not shift since the wage increase is exactly offset by a

productivity increase.

2. a. Keynes used models not in a mechanistic way, but in an interpretive way. He was a Marshallian who saw economic models as an engine of analysis, not an end in themselves.

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

c. It definitely was primarily in the art of economics since the above method is the method used in the art of economics.

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


b. The AD curve will become steeper if a fall in the price level doesn't make people feel richer since the fall in the price will not cause them to increase their expenditures. This is an example of the wealth effect not working.

c. The AD curve will be steeper if a fall in the price level creates expectations of a further fall in the price level (it may even be backward bending) since the fall in the price level will cause people to shift expenditures further out into the future.

d. Assuming poor people consume more than rich people, the AD curve will shift to the right.

e. The AD curve will shift to the right by a multiple of 20. f. The AD curve will shift to the left by a multiple of 10.

4. a. An increase in the availability of inputs will shift the potential output curve to the right.

b. A civil war will presumably destroy productive capacity or otherwise halt production and cause a shift in the potential output curve to the left.

c. To the degree that the rise in oil prices results in an overall rise in the price level, this will shift the AS curve up. Otherwise, other relative prices will decline to offset the rise in oil prices and the AS curve will not shift at all.

d. If wages become flexible and were previously fixed and aggregate demand increases, the AS curve will shift up as wages rise.

5. a We would suggest that the rise in oil prices will shift the AS curve up and the drop in world income will shift the AD curve in, causing equilibrium income to fall even more below potential (to point B in the graph below).

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

c. A real business cycle economists would say that the actual level of the economy is the best estimate of its potential income. He would suggest that the policy


would be inflationary because it is not affecting the real supply-side issues. If the economy were left on its own, the AS curve will shift down below AS0 until output reached its potential

Web Questions

1. The CPI has been rising. Since there is inflationary pressure in the economy, we would conclude that the economy is in the intermediate range. We would therefore support tighter monetary policy.

2. a.

Year GDP Price Level1989 6,591.8 83.31990 6,707.9 86.51991 6,676.4 89.71992 6,880.0 91.4 1993 7,062.6 94.01994 7,347.7 96.01995 7,543.8 98.11996 7,813.2 1001997 8,144.8 101.91998 8,495.7 103.11999 8,848.2 104.6

b. See the graph on the right of the table.c. Since the curve involves shifts in both the AS curve and AD curves, all we can

say is that these are points of equilibrium given certain assumptions. It is neither an AD nor an AS curve. In order to draw one or the other simplifying assumptions must be made regarding what is held constant.

3. Even though the economy is still growing consumer confidence has been falling lately suggesting that the AD curve may start to shift to the left. If this happens, output will decline as shown in the graph below. We have drawn it so that output declines to potential, but if the economy falls below potential, the AS curve will shift down, bringing equilibrium output back up at a lower price level.



Chapter 26: The Multiplier Model


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

2. Inventories are building up at levels of output above equilibrium because at levels above equilibrium, planned expenditures are below actual production. People are not buying all that is produced.

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

4. The AE curve becomes steeper when the marginal propensity to consume increases. Equilibrium income rises.

5. If savings were immediately translated into investment, the size of the multiplier would be infinite since leakages from the economy would be zero. However, autonomous expenditures would no longer exist. In short, under these conditions the multiplier model would break down.

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

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

8. The circular flow diagram of the economy that would more accurately describe the multiplier model would include leakages of savings to investment that cause


the diagram to pulsate as the economy continually overshoots equilibrium in response to shocks to the economy.

9. A mechanistic model states the equilibrium independent of where the economy has been or of what people wanted. A mechanistic model is used as a direct guide for policy prescriptions. An interpretive model is used as a guide that highlights dynamic interdependencies that is suggestive of the direction of the response of aggregate output to various policy initiatives.

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


1. If the mpc is .8, then the value of the multiplier is (1/.2) or 5. If autonomous expenditures are $4,200, the equilibrium level of income in the economy is 5 x 4200 = $21,000. This isdemonstrated in the graph on the right.

2. a. If the mpc is .66, the value of the multiplier is 3. A decrease in autonomous expenditures of $20 will likely result in a decrease in income of $60. This is demonstrated in the graph below.

3. Given the mpc is 0.8 and autonomous investment has risen by 20,a. Income will increase by 100 (the multiplier is 1/.2 or 5, and 5 X 20 is 100).b. The multiplier is now only 2 (1/.5), and so the change in investment causes

income to change by 40.


c. The decrease in exports and increase in investment cancel each other out so that autonomous expenditures in the aggregate are unchanged.

d. See the graphs below. The graph on the left corresponds to (a) and the graph on the right corresponds to (b). The graph to (c) would show the AE curve not moving at all.

4. Given that the mpc is .6, I = 1000, G = 8000, C = 10,000 and (X - M) = 1000,a. Y = 10,000 +.6Y + 1000 + 8000 + 1000.

Y - .6Y = 20,000; 0.4Y = 20,000; Y = 50,000. Thus the level of income in the country is $50,000 (note that Examland seems to be on a U.S. dollar currency standard).

b. If net exports increase by $2000 income will increase by $5000 (the multiplier is 2.5 or 1/.4).

c. According to Okun's law, a 1 percentage-point change in unemployment will cause a 2 percent change in income in the opposite direction. Thus if income has increased by $5000, which is a 10 percent increase, then unemployment should drop by 5 percentage points.

d. If the mpc falls from 0.6 to 0.5, the multiplier decreases from 2.5 to 2. The answer for part a would now be $40,000, the answer for part b would be $4000, and the answer to part c is that unemployment should rise by 4 percentage points.

5. a. A likely culprit was a decline in investment spending, partly due to increased bank regulation and Federal Resolution Trust Corporation scrutiny of loans in the wake of the failed S&Ls and liquidity problems of commercial banks in the late 1980s and early 1990s. This was commonly known as the credit crunch, where lower interest rates failed to increase investment spending in the early 1990s. This is shown as a shift down of the AE curve from AE0 to AE1 and a decline in real income.

b. An improvement would be graphically represented by a shift up of the AE curve shown in the graph as the shift from AE1 to AE2 and a rise in real income. The improvement occurred most likely as a result of expectations of an improving economy and further reductions in interest rates increasing consumption and


investment expenditures. Government expenditures did not change much in this period and probably did not contribute to the economic improvement.

c. President Bush would have had to increase government expenditures significantly to stop the slowdown, but given the political atmosphere regarding the high deficit, and debt, it is unlikely he could have done so.

d. President Clinton faced the same political imperatives to decrease the size of the deficit, so he implemented some policies designed to affect potential output (the supply side). He lowered some taxes, calling them supply enhancing tax cuts, changed the composition of government spending calling them supply-enhancing changes, and raised other taxes (discounting their effects on the economy).

Web Questions

1. a. Consumer confidence slipped in April 2000, after having already declined in March 2000. It is now at 136.9 (1985=100) down from 137.1 in March.

b. Falling consumer confidence means that consumption expenditures, and hence aggregate demand will fall. The multiplier model says that the decline in national output will be greater than the fall in aggregate demand.

c. Business confidence rose slightly to 52 in the final quarter of 1999, up from 51 in the previous quarter. (A reading of more than 50 reflects more positive than negative responses).

d. They do not match. We would therefore expect inventories to increase in the coming months since consumption expenditures will fall.

2. a. Manufacturers’ and trade inventories in March 2000 were up 0.3% (±0.1%) from February 2000. Total durable goods were up 0.3 percent (±0.2%) from February while total nondurable goods increased 0.4 percent (±0.1%) from February.

b. Rising inventories means that consumer expenditures, and therefore aggregate demand is declining. The multiplier model tells us that the change in national income will be greater than the change in aggregate demand. We would therefore expect the economy to slow down.

Appendix A: An Algebraic Presentation of the Expanded Multiplier Model

1. We would suggest a decrease in taxes. To determine precisely how much we would need to determine what the multiplier is. Assuming all other marginal propensities are zero, the multiplier is 5. The tax cut would initially affect the economy by only .8 times the tax cut, so to increase output by 400, we would decrease taxes by 100. (.8 X 100 X 5 = 400).

2. We would recommend increasing expenditures by 80.

3. This makes the multiplier 3.57. This means that we would increase expenditures by about 112, or cut taxes by about 140.


4. This makes the multiplier 2.08. This means that we would increase expenditures by about 192 or cut taxes by about 240.

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

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

Appendix B: The Multiplier Model and the AS/AD Model

1. a. As shown in the left-hand graph below, an increase in autonomous expenditures shifts the AE curve up and causes a movement along the AP curve to the right and results in a higher equilibrium income level twice the shift in the AE curve.

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

c. Since prices are somewhat flexible, the rise in expenditures is split between a rise in prices causing a downward shift of the AE curve that is smaller than the initial upward shift. The rise in income is less than twice the initial shock. This is shown in the graph below on the left.

In the AS/AD model, a flexible price means that the shift in the AD curve is split between increases in the price level and increases in real output. Real output rises by less than the multiplier times the increase in autonomous expenditures.

2. a. The AD curve will become steeper.b. An increase in the size of the multiplier does not affect the slope of the AD curve;

It only increases the size of the shifts in the AD curve in response to a shift in autonomous expenditures.

c. An increase of $20 in autonomous expenditures has no effect on the slope of the AD curve; it only affects its position.


d. A decline in the price level disrupting the financial market will make the AD curve steeper because it eliminates the price level interest rate effect.

Chapter 27: Demand Management Policy


1. Franklin D. Roosevelt's statement was made during the Depression of the 1930s, which was partly caused by people getting scared and cutting back their spending. The multiplier then took over and turned that decrease into a much larger decrease. To get the multiplier working in reverse, and so countershock the economy, the government would have had to get people to spend more than they wanted to; hence Roosevelt's attempt to calm people's fears and to encourage them to spend.

2. In early 2000, the government budget was in surplus and the state of fiscal policy was contractionary. This policy made sense because many believed the economy was beyond its potential income and the biggest threat was inflation. Because of strong consumption and investment spending, most economists felt that a contractionary fiscal policy was appropriate. (This answer may change as the economy progresses through the 2000s.)

3. If the mpc is .5, the multiplier is 2. Every one-dollar increase in autonomous expenditures will raise income by two dollars. To close a recessionary gap of $200 the government needs to generate $100 of additional autonomous spending. It can accomplish this by increasing government expenditures by $100.

4. If the economy has a recessionary gap, the following trade policies can be adopted:i) an export-led growth policy in which the country lobbies to remove other

countries’ restrictions on its exports.ii) Allowing its currency to depreciate which means that the exchange rate of

its currency relative to other currency should fall.


5. Cutting taxes by $100 has a smaller effect on GDP than increasing expenditures by the same amount because people don’t spend the entire amount of the tax cut. The multiplier begins with the increased individual spending resulting from the tax cut, or the mpc times the tax cut.

6. To offset a cut in taxes, the U.S. government should implement a policy that reduces net exports by the mpc times the tax cut such as instituting new or higher tariffs.

7. Countercyclical fiscal policy is difficult to implement because politically it is difficult to raise taxes when the economy is doing well (or at any time). Politics, not the needs of the economy guide tax and spending decisions.

8. If interest rates have no effect on investment, there would be no crowding out. Crowding out occurs when the government's sale of bonds to finance expansionary fiscal policy causes interest rates to rise, choking off private investment.

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

10. Increasing government spending shifts out aggregate demand and thereby increases income. This makes people better off in the short run and more likely to vote for them. The exception would be if the economy is beyond potential income and there is a significant inflation threat.

11. Increasing taxes shifts the aggregate demand curve in decreasing income and making people less likely to vote for them. Luckily, for politicians, people tend to have short memories.

12. Even though unemployment was high, most economists felt that the cause of the unemployment was structural, and that the economies were at their potential incomes. Thus, deficits would only be inflationary.


1. a. If the mpc is .8, the multiplier is 5. Every one-dollar increase in autonomous expenditures will raise income by five dollars. To close a recessionary gap of $400 the government needs to generate $80 of additional autonomous spending. It can accomplish this by increasing government expenditures by $80.

b. If the government wishes to achieve the same end by changing taxes, it should decrease taxes by $100. This will generate $80 of additional autonomous


spending. Again, with a multiplier of 5, this will cause a $400 increase in aggregate income.

c. If there is a marginal tax rate of 0.2 (instead of taxes being exogenous), the multiplier is [1/(1 - c + (c ( t))] or [1/(1 - .8 + (.8)(.2))], which is equal to 2.77. With regard to your answers to parts a and b, the government must generate added expenditures of $144.40 to close the recessionary gap, either through an increase in government spending of that amount (part a) or a decrease in taxes of $180.50 (part b).

d. With a marginal propensity to import of .2 the multiplier changes to [1/(1 - c + ct + m)] or [1/(1 - .8 +.16 +.2)] which is equal to [1/.56] or 1.79. With this multiplier, to close a recessionary gap of $400 the government would have to generate $224 in new expenditures, either through an increase in government spending of that amount or a cut in taxes of $280.

e. The graph on the left below shows the shift in the AE curve resulting from an increase in government expenditures of $80 or a reduction of taxes of $100 when the mpc is .8. The graph on the right shows the shift in the AE curve necessary to close the recessionary gap when the marginal tax rate is .2. Notice that the slope of the AE curve is smaller (.64). The AE curve must shift up by more to achieve the same increase in output. Finally, the AE curve for part d has an even smaller slope (.44) shown below the first two graphs. Here the AE curve must shift up by even more.

2. Given that income is $50,000, the mpc is .75:a. To reduce unemployment by 2 percentage points (again, by Okun's rule of thumb)

requires a 4 percent increase in income, which in this case is $2000. The


multiplier is 4.0, calculated as [1/(1 - mpc)]. To generate a $2000 increase in income, increase government spending by $500.

b. If the mpc is .66, the multiplier is 2.94, which means that to generate a $2000 increase in income, government spending would have to increase by $680.27.

c. If the mpc is 0.5, then the multiplier is 2.0, which means that to generate a $2000 increase in income, government spending would have to increase by $1,000.

3. a. In 1995 the unemployment rate fell below the target rate of 6% without generating inflationary pressures. He was probably changing his estimates to reflect that reality.

b. It would shift the potential output curve out.c. Using Okun's rule of thumb that for every 1 percentage point rise in the

unemployment rate, income falls by 2%, a 0.5 percentage point decline in the target unemployment rate would imply a rise in potential income of 1%, or $73 billion.

4. a. President Clinton's policy does not fit well with the multiplier model because with that model the two goals are inconsistent with one another in the short run. To increase output and employment using stimulative fiscal tools requires an increase in the deficit.

b. His policy might have the desired effect if a reduction in government expenditures to reduce the deficit reduces the interest rate so much and affects expectations positively to such a degree that their effect on investment and consumption expenditures offsets the decline in government spending.

c. The reduction in the deficit shifts the AD curve to the left, but the increase in investment expenditures resulting from the reduction in interest rates shifts the AD curve to the right by so much that, on net, output rises as shown in the graph below.

d. I would look at interest rates and investment expenditures to see if the explanation is correct.

5. a. To eliminate the inflationary gap, the government should undertake a contractionary fiscal policy. Since the economy is $36 thousand above potential, we would advise decreasing government spending by $18 thousand.


b. Using Okun’s rule of thumb since income falls by 6%, we would expect unemployment to rise by 3 percentage points to 8%.

c. The multiplier now becomes 5, so we would advise decreasing spending by $7.2 thousand. We would not change our answer to b.

Web Questions

1. a. The four key economic targets are: low inflation, low level of unemployment, high and stable level of economic growth, and external balance between imports and exports.

b. The main policy tools are: Income tax (rates and allowances): This is the key variable of the fiscal policy and can be used to alter consumer expenditures. VAT and other indirect taxes: This indirect tax works like the income tax and can be used to alter expenditures. It is also an important source of government revenue.Government expenditure: This is also a part of the fiscal policy. It includes expenditures on things like defense and highways etc. Interest rate: This is a part of the government’s monetary policy and can be used to control variables like the inflation rate.

c. Assuming that the economy is in equilibrium below the potential output, if income taxes are increased, the resulting fall in aggregate demand will lead to a fall in output at the same level of prices. Thus there will be lower economic growth, greater unemployment, but no change in the inflation rate. The model also predicts imports to decrease.

d. Assuming that the economy is in equilibrium below potential output, the model predicts that the increase in government spending will lead to greater output and hence greater economic growth. There will also be less unemployment and more imports though the inflation rate would remain the same.

2. a. The process starts off by the formulation of the President’s budget for a fiscal year. The budget documents are then prepared and transmitted to the Congress. The Congress after reviewing this budget develops its own budget and accepts the expenditure and revenue bills. The agency managers then execute the budget in the fiscal year after which information for the actual spending and receipts becomes available.

b. It takes about two years. For example, for Fiscal Year 2001 (begins October 1, 2000) the President formulated the budget between February-December 1999, and the data on the expenditures and receipts became available in October-November 2001.

c. The President and the Congress have to decide upon the discretionary spending, which accounts for one-third of all federal spending. The remaining two-thirds of all federal spending, called mandatory spending, is authorized by permanent laws.

Chapter 28: Politics, Surpluses Deficits and Debt



1. It follows from the long-run framework. The long-run framework directs one to avoid deficits; in the short-run framework deficits are useful if the economy is significantly below potential.

2. Two ways the government can finance a deficit is by selling bonds or by printing money.

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

4. There are technical aspects of the deficit that must be understood in order to undertake a meaningful discussion of the problems deficits and debts pose for society. Since a deficit is defined as a shortfall of revenues compared to expenditures, these technical aspects include what you define as revenue and what you define as expenditure.

5. Given that the nominal deficit is $300 billion, the inflation rate is 20 percent, and the debt is $2 trillion, the real deficit is calculated as the difference between the nominal deficit and the product of the inflation rate and the total debt, or 300 billion - (.20 )( 2 trillion) = (-100) billion. There is a real surplus of $100 billion.

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

7. The structural deficit is greater than the actual deficit because the economy is above its potential. Assuming expenditures do not change with income, tax revenues are $50 billion dollars higher than they would be if the economy were at its potential, so the structural deficit is $150 billion. The passive surplus is $50 billion because tax revenues are $50 billion higher because the economy is operating above potential. The structural and the passive deficit add up to the actual deficit.

8. A structural deficit would exist even if the economy were at its potential level of income, which would be at full employment, or where the unemployment rate were equal to the normal rate of unemployment. If an economist believed that the normal rate of unemployment was 4 percent instead of 6 percent, then the portion of the deficit considered to be structural would be smaller. Thus, it is Mr. A who should also say that the structural deficit is $20 billion.

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


There's no unique answer to how assets and debts should be valued, and there are different types of debt.

10. Three ways individual debt can differ from government debt are: 1) government is ongoing, and never needs to pay it back; 2) government can pay off the debt by creating money; and 3) much of the government debt is internal debt.

11. No. Financing internal debt causes redistribution; it does not make the society poorer.

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

13. Debt service is a good measure of whether debt is a problem because interest payments do not result in additional productive expenditures. Interest payments are the result of past expenditures.

14. The Budget Enforcement Act changed the politics of spending and taxing. It forced Congress to figure out how they would pay for a program at the same time it instituted the program.

15. Because of the baby boom in the late 1990s there were many people working and relatively few collecting Social Security. This caused a surplus in the Social Security Trust Fund. Since that Trust Fund is part of the government budget, the Social Security system is a primary reason for the surplus.

16. Two real solutions are increasing the retirement age and cutting benefits when baby boomers retire.

17. It depends. Clearly, there is some tendency for deficit to raise the interest rate, thereby decreasing investment and hence future growth. However, to the degree that the government spending is itself productive, not having the deficit could also decrease future growth. The ultimate effect depends on the relative size of the two effects

Problem and Exercises

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

a. Real deficit = 220 billion - (.10 X 3 trillion) = (-80) billionb. 50 billion - (.02 X 1 trillion) = 30 billionc. 30 billion - (-.04 X 500 billion) = 50 billiond. $100 billion surplus + $60 billion = $160 billion surplus.

2. a. Debt service payments are 0.06 times $360 billion = $21.6 billion.


b. The nominal deficit is 160 - ($21.6 + 145) = $6.6 billion.c. The real deficit equals the nominal deficit ($6.6 billion) less .03 X $360 = $4.2

billion surplus.

3. Since the real deficit is rising at a faster rate than real growth in the economy, the deficit/GDP ratio is rising. It can only continue to do so as long as it can sell the bonds, but at some point the deficit/debt ratio will become so large that creditors will begin to doubt the country's ability to repay the debt. Then, selling bonds will become more difficult and eventually impossible.

4. To make the deficit look as small as possible, we would do the following:a. Enter government pensions when they become payable, not on an accrual basis.b. Treat the sale of land as current income rather than spreading it out with the sale

of an asset.c. Include Social Security taxes as a current revenue because at this time revenue

from Social Security exceeds payment.d. Count prepayment of taxes as current income instead of reserves for future taxes.e. Count expenditures on F-52 bombers as capital expenditures and introduce

another cost item of depreciation and allow the F-52 to depreciate as little as possible.

Web Questions

1. a. The system is designed so that there is a direct link between how much a worker pays into the system and how much he gets back as benefits. Secondly, the social security program is a way of providing economic security through retirement, disability and survivor insurance packages.

b. We would be eligible for reduced benefits if we retire early at the age of 62. However, we will get full-retirement benefits if we retire at the age of 65. These benefits replace about 40% of one’s pre-retirement income.

c. The following are some of the options available: raising the retirement age, levying social security taxes on all incomes, creating individual saving accounts for workers to supplement social security benefits, and investing social security reserves in the stock market.

2. a. The U.S. first had debt in 1790 when it assumed the Revolutionary War debts of the Continental Congress.

b. The actual debt at the end of 1997 was $5,369,707 million. This was more than previous year’s debt of $5,181,934 million. The estimate for 2000 is $5,915,719 million.

c. The U.S. government through the Treasury department does so by selling new bonds, and refinancing old ones. Printing money would lead to inflation.

Chapter 29: Money, Banking, and the Financial Sector



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

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

3. The three functions of money are: (1) it serves as a medium of exchange; (2) it serves as a unit of account; and (3) it serves as a store of wealth.

4. In order to maintain money's usefulness and to prevent large fluctuations in the price level, the money issuer, which in the United States is the Federal Reserve Bank, must issue neither too much nor too little money. To issue money without restraint would destroy the social convention that gives money its value.

5. Two components of M2 that are not components of M1 are savings deposits and small denomination time deposits.

6. The equation for the simple money multiplier is 1/r; the equation for the approximate real-world multiplier is 1/(r+c). Since c is positive the simple multiplier is larger.

7. Money doesn't have to have any inherent value to function as a medium of exchange. All that's necessary is that everyone believes that other people will accept it in exchange for their goods. This is the social convention that gives money value.

8. If the U.S. government were to raise the reserve requirement to 100 percent, the interest rates banks pay to depositors would decrease and possibly even become negative (you'd have to pay to have the bank handle your money), because significant opportunities for profitable loans would be lost.

9. A benefit of government guarantees is that it prevents inappropriate panic about a bank’s ability to pay back its obligations; a cost of government guarantees is that it prevents appropriate panic about a bank’s ability to pay back its obligations.

10. What brought the S&Ls down was bad loans, particularly in real estate. The reasons that S&Ls made those bad loans are more complex. Government deregulation in the 1980s expanded the kinds of loans S&Ls could make and the ways they could compete for deposits. Due to moral hazard and perverse incentives (government, not the bank managers, would have to pay if the S&L went down), S&Ls made risky loans and paid high interest on their deposits.


When the real estate market soured, S&Ls' net worth crumbled, and the government had to step in to bail out depositors.

11. Panics occur when depositors lose faith in a bank and all try to take their funds out at once. The U.S. banking system is less susceptible to panics because the government guarantees the obligations of various financial institutions. Panics may still occur if the government is perceived as unwilling or unable to live up to those guarantees.

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


1. a. If individuals hold no cash, the simple money multiplier is the reciprocal of the reserve requirement. Thus for the following reserve requirements the simple multiplier is found by dividing the requirement percentage into 1: 5%, 20; 10%, 10; 20%, 5; 25%, 4; 50%, 2; 75%, 1.33; 100%, 1.

b. If individuals hold 20% of their money in the form of cash, the multiplier becomes (1)/(r + c) and so for the following reserve ratios their multipliers are now: 5%, 4.0; 10%, 3.33; 20%, 2.5; 25%, 2.22; 50%, 1.43; 75%, 1.05; 100%, 0.83.

2. For a deposit of $100 and a reserve ratio of 5%,a. the bank can lend out $95.b. There is now $195 of money.c. The multiplier is 20.d. John's $100 will ultimately turn into $2000

3. a. Neither b. Both c. M2 d. Both e. Neither f. Neither g. Both

4. a. money; b. not money; c. not money; d. money;e. money;f. not money; g. not money

5. a. Nothing happens to M2. M1 declines by $200b. Nothing happens to M1 or M2c. Nothing happens to M2, M1 rises by $50d. Nothing happens to M1 or M2.

Web Questions

1. a. Beenz is an alternative to money that aims to become globally acceptable. Its main purpose is to reward on-line consumer behavior. You can earn beenz by signing up, and ‘surfing’ various specific websites. Likewise, one can spend


beenz at various websites to purchase goods etc.b. Currently, beenz is not as liquid as money. It will take time before it can be used

as a generally acceptable medium of exchange. However, it does fulfill the three functions of money as far as the websites where beenz is accepted are concerned.

c. Beenz is money in the sense that it has the potential to fulfill the functions of money if people start believing that others will accept it in exchange for their goods.

2. a. There is about $500 billion of U.S. currency in circulation today but most of it resides outside of the U.S. Assuming that the world population is about 6 billion, this means that there is approximately $83 per person in the world.

b. People typically withdraw cash at ATMs over the weekend, so there is more cash in circulation on Monday than on Friday.

c. 1.5 years.d. Most of this is in the form of U.S. Government Securities owned by the Federal

Reserve System. Some of it also consists of gold certificates, special drawing rights, and “eligible” paper such as bills of exchange or promissory notes.

e. Bureau of Engraving and Printing.

Appendix A

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

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

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

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

5. An investment bank facilitates borrowing. It does not take in deposits and often does not make loans. A commercial bank takes in deposits and makes loans.

6. False. The difference has nothing to do with which is more important. The difference is that in primary markets new issues are sold and in secondary markets existing stocks and bonds are resold. The secondary market is much larger.

7. The prospects must not be very good or the interest rate must be extremely high. Generally, stocks sell for a minimum of multiples of ten or twelve times earnings. This multiple can be roughly determined by dividing the expected earnings (the annuity) by the interest rate. More recently the average price/earnings ratio has been 30, a historically high figure.


8. On the surface it might seem that the primary market contributes more to the production of tangible real assets because it is here that new firms find the financing for their ideas. A secondary financial market only transfers existing financial assets from one saver to another, and such a transaction does not represent any new savings. However, the existence of a secondary market plays an important role in enticing people to buy in the primary market because it makes their financial asset more liquid, and, hence, more valuable. Thus on a deeper level it is hard to say which contributes more.

9. Money market assets usually pay lower interest rates than do longer-term capital assets because they offer the buyer more liquidity and less risk of asset value fluctuation.

10. Asset Liability Market a. Lamar Credit Union money

b. Pension USA Sandra capital First bank initially held the asset, but then FNMA held it. Finally, Pension USA

held it as owner of share in FNMA mortgage fund. All along it was a liability to Sandra.

Asset Liability Market c. First Bank Sean moneyd. residents of

Providence Providence capital e. Lanier the firm capital

No financial asset has been created, it has just changed hands.

Asset Liability Market f. Lanier the firm capital

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

b. We disagree with this statement. If both the real and financial asset are worth $1,000,000, then they have the same value as long as they are valued at market prices. Just as financial assets bear a risk of no repayment, real assets bear a risk of a fluctuation in prices.

c. Although financial assets have a corresponding liability, they facilitate trades that could not otherwise have taken place and thus have enormous value to society.

d. This is false. The value of an asset depends not only on the quantity but also its price per unit. The price of land per acre in Japan exceeds that in the U.S. by so much that its total value also exceeds that in the U.S.

e. This is false. The stock market valuation depends on the supply and demand for existing stock. There is, however, a relationship between relative growth in GDP


and the rise in stock prices to the extent that growth in stock prices and GDP growth both reflect economic well-being in a country. Also, many of the companies are multinational companies and where the company is based may not reflect where its value added is generated.

Appendix B

1. Starting with the initial balance sheet:

Assets Liabilities & Net WorthCash 20,000 Demand dep 200,000Loans 225,000 Net worth 150,000Phys assets 105,000 Total 350,000 Total 350,000

a. If an immigrant enters the country and deposits $10,000 in a bank the result is:

Assets Liabilities & Net WorthCash 30,000 Demand dep 210,000

Loans 225,000 Net worth150,000 Phys assets

105,000 Total 360,000 Total 360,000

b. If the bank keeps 10% of this deposit and lends the rest, the result is:

Assets Liabilities & Net WorthCash 21,000 Demand dep 210,000

Loans 234,000 Net worth150,000 Phys assets105,000

Total 360,000 Total 360,000c. 80% of the loan amount ($9000) gets deposited back in the bank, and the result

is:

Assets Liabilities & Net WorthCash 28,200 Demand

dep 217,200 Loans234,000 Net worth 150,000Phys assets 105,000

Total 367,200 Total367,200d. After the money multiplier is all through multiplying, the initial $10,000 will

have become $40,000 (if everyone deposits 80% of what they receive back into the bank), and the final balance sheet will be:


2. a. Assets LiabilitiesCash 10,000 Demand deposits

50,000- 1,000 - 1,000

9,000 49,000Loans 100,000 Net worth

110,000 Phys. assets 50,000

Total Assets 159,000 Total Liabilities and net worth 159,000

b. The reserve ratio is now 18 percent. This is less than the required 20 percent. The bank must decrease loans by $800 to meet the reserve requirement. But this shows up as $800 less in demand deposits and 800 less in cash. The bank must again reduce loans but this time by 640. Demand deposits once again decline. This continues until the final position indicated by the following T-account:

Assets LiabilitiesCash 9,000 Demand deposits 45,000Loans 96,000 Net worth 110,000

Phys. assets 50,000 Total Assets 155,000

Total Liabilities and net worth155,000

c. The money multiplier is 5.d. Total money supply declined by 5000.

3. a. The bank is holding $7500 in excess reserves.b. $50,000 new money would be created: (1/0.15) * 7,500.The final T-account is

shown below:

Assets LiabilitiesCash 30,000 Demand deposits 200,000Loans 370,000 Net worth 550,000

Phys. assets 350,000 Total Assets 750,000

Total Liabilities and net worth750,000

Chapter 30: Monetary Policy and the Debate about Macro Policy



1. The Fed is a semi-autonomous agency of the federal government. Although it is owned by member banks, its officials are appointed by government. It is a creation of Congress, but has much more independence than do most public agencies.

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

3. Six explicit functions of the Fed include: 1) conducting monetary policy; 2) supervising financial institutions; 3) serving as a lender of last resort; 4) providing banking services to the U.S. government; 5) issuing coin and currency; and 6) providing financial services to commercial banks.

4. Three tools by which the Fed can affect the money supply are: 1) changing the reserve requirement; this changes the amount of reserves banks need and thereby changes the money supply; 2) changing the discount rate; this changes the cost of borrowing by banks from the Fed and thereby changes the money supply (Actually, it works more as a signal.); and 3) open market operations; as the Fed buys and sells bonds, it change reserves and thereby changes the money supply.

5. When the Fed buys bonds the price of bonds rises and the interest rate falls.

6. The Fed funds rate is the interest rate that banks change one another for Fed Funds or reserves. As the Fed buys and sells bonds, it changes reserves and thereby directly affects this short term overnight interest rate. Other longer-term interest rates such as the Treasury Bill rate are only indirectly affected.

7. Defensive policies are simply changes to offset fluctuations in the demand for money. Therefore a change in the direction of monetary policy would be an offensive action.

8. When the Fed takes money out of the economy, banks are in violation of Fed regulations and have no choice but to contract their loans in order to meet their reserve requirements. When the Fed puts money into the economy, banks have excess reserves but there is no regulation that they are violating. Although they may have a financial incentive to make loans, they are not required to do so. Since they are not required to make loans, the phrase, "You can lead a horse to water, but you can't make it drink," is relevant.

9. To increase income by 240, investment should increase by 80 (the income multiplier is 3). To increase investment by 80 requires decreasing the interest rate by 4 percentage points (investment increases by 20 for every 1 percentage point


drop in interest). To change the interest rate by 4 requires a change of 20 in the money supply (each change of 5 in the money supply changes the interest rate by 1 percent). Since the money multiplier is 4, reserves should increase by 5. Thus the recommended policy is an open market purchase that would increase reserves by 5.

10. The nominal interest rate is equal to the real interest rate plus the expected inflation rate. If the nominal interest rate is 6 percent and the expected inflation rate is 5 percent, the real interest rate is 1 percent.

11. If we consider the example of an open market sale by the Fed, the initial transaction or "splash" would be that a person writes a check to the Fed, and the Fed presents it to the person's bank for payment. The bank now must adjust to this change, and the "ripples" will show up on its balance sheet. The loss of cash to the Fed means that the bank's reserves are too low, and the bank must figure out a way to meet its reserve requirement. It may call in loans to do so, but that in turn could mean that someone paid the loan from a checking account, which has further balance sheet implications.

12. Treasury bills pay interest; cash does not.

13. From 1996 to 1997 the Fed tightened monetary policy slightly; in 1998 it loosened it slightly and in 1999 it tightened it.

14. The Taylor Rule suggests that the Fed will increase the Fed Funds rate by 1.5% because inflation is 1% above desired.


1. In each of the three cases, expansionary monetary policy shifts the AD curve to the right. The difference is whether the shift results in an increase in real output, an increase in the price level, or a combination of the two.

a. In the short run, when the economy is in the Keynesian range, the shift of AD curve to the right from AD0 to AD1 will increase output with no change in the price level. The economy moves from point A to point B (output rises to Q 1 but the price level remains at P0) in the graph below.

b. When the economy is in the intermediate range, the effect if the shift of AD curve to the right depends upon how close to potential the economy is. The closre to potential, the more the increase will result in an increase in the price level and not an increase in real output. One example if for the economy to move from point B to C shown in the graph below. The AD curve shifts from AD1 to AD2. Input prices begin to rise and the AS curve shifts from AS0 to AS1. Output rises to Q 2

and the price level rises to P1.c. When the economy is in the Classical range, the effect of the shift of the AD

curve to the right is entirely on the price level, not output. Graphically this can be shown as an economy moving from point C to point D in the graph below. The


AD curve shifts from AD2 to AD3, but the AS curve shifts up so much that output remains at Q2 while the price level rises to P2.

2. a If people hold no cash, the money multiplier is (1/r). If this is equal to 3, then the current reserve requirement is 33%. To increase the money supply by 200 the Fed should lower the reserve requirement to 32%.

b. Lowering the discount rate will encourage banks to borrow. This will increase the amount of reserves in the system so the money supply increases. If the Fed wishes to increase the money supply by 200, and the multiplier is 3, reserves must be increased by 66.67. If banks will borrow an additional 20 for every point the discount rate is lowered, the Fed should lower the rate by 3.33 percentage points.

c. To increase the money supply by using open market operations the Fed should buy bonds, thus increasing the level of reserves in the banking system. To achieve an increase of 200 (if the multiplier is 3) the Fed should buy 66.67 worth of bonds.

3. a. Decreasing the reserve requirement from 20 percent will provide banks with excess reserves and will increase the multiplier. To calculate exactly how much we would need to know the current money supply.

b. The Fed would buy $400,000 worth of bonds, increasing reserves, and so increase the money supply.

4. a. Increasing the reserve requirement would lower the multiplier, calculated as [l/(r + c)]. To calculate exactly how much we would need to know the current money supply.

b. The money multiplier is [l/(r + c)] = 2.5. If the Fed sold $800,000 worth of bonds it would decrease reserves and so decrease the money supply.

c. This part of the questions requires students to obtain information from a local bank, and reevaluate a and b in view of what they learn.

5. a. The money multiplier, assuming no cash holding, would be one.b. The money supply would decrease enormously.c. This could be offset by the Federal government buying up Treasury bills, directly

increasing the money supply or by the Federal government making loans directly.


d. Since this eliminates a significant role of banks as lenders, eliminating a market within which they receive at least a normal profit they would most likely oppose it.

6. a. This would increase excess reserves enormously.b. Banks would most likely favor this proposal because they would now earn

interest on their assets held at the Fed.c. Central banks would likely oppose this because it would reduce their superiority

and may require that they ask Congress for appropriation to pay the interest reducing their political independence.

d. This would increase the interest rate paid by banks because the additional interest would increase their profit margin. The initial increased profit margin would shift the demand for depositors out as new banks entered the market and as existing banks competed for more deposits. This would increase the interest paid to depositor until the normal profits are once again earned.

7. For every percentage point inflation is above (below) the Fed’s inflation target, the Fed funds rate will rise (fall) by 1.5 percentage points; for every percentage point the economy’s total output is above (below) its potential output, the Fed funds rate will rise (fall) by half a percentage point.

a. Fed funds rate will fall 2.5 percentage points.b. Fed funds rate will rise 4.5 percentage points.c. Fed funds rate will rise 0.5 percentage point.

Web Questions

1. a. Alan Greenspan is chairman. He has been the chairman since August 11, 1987.b. The seven members are nominated by the President and confirmed by the Senate.

The current members others than Greenspan are Roger W.Ferguson Jr, Edward W.Kelley Jr, Laurence H.Meyer and Edward M.Gramlich. The remaining two seats are currently vacant.

c. All of them have an economics bachelor’s degree, a Ph.D. in economics and/or a MBA degree. Some of them have held posts in private consulting firms, and most of the have had prior experience in public economics related commissions and committees. Some like Meyer are specialists in economic forecasting.

2. a. According to the report of February 2000, the economy has continued to perform exceptionally well. Inflation has remained low due to the increases in productivity.

b. Inflation.c. In order to sustain growth with low levels of inflation, the Fed has been

encouraging tighter monetary policy. Proof of this is the recent half percentage-point increase in the interest rate.

Appendix A


1. Since the question does not indicate a reserve requirement or an initial bank balance sheet, let’s assume a 10 percent reserve requirement and an initial bank balance sheet shown below.

Initial Bank Balance SheetAssets LiabilitiesReserves 100,000,000 Demand deposits 1,000,000,000

T-bill holdings 0 Net worth 5,000,000

Loans 905,000,000 Total Assets 1,005,000,000 Total Liabilities 1,005,000,000

First, individuals buy $1 million T-bills from the Fed, by withdrawing $1,000,000 from the bank leaving the bank with no reserves.

Assets LiabilitiesReserves 99,000,000 Demand deposits 999,000,000

T-bill holdings 0 Net worth 5,000,000Loans 905,000,000 Total Assets 1,004,000,000 Total Liabilities 1,004,000,000

To meet its reserve requirement the bank must call in $900,000 in loans. These loans are repaid by individual withdrawals of demand deposits of $900,000.

Assets LiabilitiesReserves 99,000,000 Demand deposits 998,000,000 loans repaid +900,000 deposits withdrawn -900,000


Again the bank calls in loans to meet reserve requirements. Each round, the amount called in gets smaller and smaller until the bank arrives at its final position with money supply having fallen by 10,000,000.

Liabilities AssetsReserves 90,000,000 Demand deposits 900,000,000T-bill holdings 0 Net worth 5,000,000

Loans 905,000,000 Total Assets 995,000,000 Total Liabilities 995,000,000


2. Since the question does not indicate a reserve requirement or an initial bank balance sheet, let’s assume a 10 percent reserve requirement and an initial bank balance sheet shown below.

Initial Bank Balance SheetAssets LiabilitiesReserves 100,000,000 Demand deposits 1,000,000,000

T-bill holdings 0 Net worth 5,000,000


First, individuals sell $2 million T-bills to the Fed, and deposit the $2 million in the bank. The bank now has more reserves than is required

Assets LiabilitiesReserves 102,000,000 Demand deposits 1,002,000,000


It has excess reserves of $1.8 million, which it lends out. These loans are redeposited at the bank as demand deposits

Assets LiabilitiesReserves 102,000,000 Demand deposits 1,002,000,000 loans given -1,800,000 New deposits +1,800,000 new deposits +1,800,000T-bill holdings 0 Net worth 5,000,000Loans 906,800,000 Total Assets 1,008,800,000 Total Liabilities 1,008,800,000

It still has excess reserves of 1.62 million, which it lends out. Each round, the amount called in gets smaller and smaller until the bank arrives at its final position with money supply having risen by 20,000,000.

Liabilities AssetsReserves 102,000,000 Demand deposits1,020,000,000T-bill holdings 0 Net worth 5,000,000



Chapter 31: Inflation and Its Relationship to Unemployment and Growth


1. Lenders lose out because they are paid a fixed nominal interest rate. They would not lose out if the interest rate were indexed to inflation or if the lender was able to adjust the interest rate periodically.

2. Adaptive expectations.

3. 2 percent.

4. MV = PQ.

5. The three assumptions are that velocity is constant, real income is constant and the direction of causation is from money to prices.

6. Inflation is always and everywhere a monetary phenomenon.

7. Inflation will be 10 percent.

8. Financial institutions changed enormously and financial markets become increasingly connected internationally, increasing the flow of money among countries.

9. Developing countries. In those countries the money supply is growing so quickly it dominates any other factors that might affect the relationship.

10. Governments and central banks sometimes increase money supply even when they know the consequences because sometimes the political ramifications of not increasing the money supply (which can include a collapse of government) are thought to be worse.

11. An inflation tax is an implicit tax on the holders of cash and the holders of any obligations specified in nominal terms. The holders of cash and the holders of any obligations specified in nominal terms pay the tax.

12. Quantity theorists are more likely to support rules because they have less trust in government undertaking beneficial actions. Rules limit those actions.

13. From right to left.


14. The labor market is central to inflation because wages make up 60% of the costs of production. These labor markets are often influenced by social factors and only slowly respond to economic pressures.

15. The insider/outsider theory of inflation divides workers into insiders and outsiders. It is an example of an institutionalist theory of inflation where social pressures prevent economic pressures from working. In it insiders push up wages, and the outsiders find themselves experiencing the unemployment. So there is little pressure on insiders not to raise wages.

16. The quantity theory emphasizes control of the money supply; Institutionalist theories also require control of the money supply, but they have other methods such as labor market structural changes or income policies that are used in conjunction with control of the money supply.

17. The short-run Phillips curve is illustrated on page 714 of the text in Figure 31-3(a). The short-run curve shows the trade-off between inflation and unemployment when expectations of inflation are constant. The long run Phillips curve is shown in Figure 31-4(b) as the vertical curve. The long-run curve shows the trade-off (or lack thereof) when expectations of inflation equal actual inflation.

18. No, as long as expectations of inflation are constant, the economy will stay on the same short run Phillips curve.

19. It depends. With short-run, long-run, and shifting curves, just about any combination of inflation and unemployment rates can fit some Phillips curve. So, yes, the Phillips curve is a figment of economists' imaginations. But then again, aren't all models simply structures imposed on reality and doesn't reality only get interpreted through imaginary imposed structures? If so, to suggest that the Phillips curve is "nothing but a figment" is incorrect. Reality is itself a figment of imagination. (If you follow this answer, you might consider shifting to a philosophy major.)

20. Economists see a tradeoff between inflation and growth because low inflation reduces price uncertainty and thereby encourages investment, increasing the efficiency of the market system.


1. a. Use the equation, MV = PQ. Real output is $2,000.b. Nominal output is $4,000.c. If the money supply rises from 500 to 600, the price level will rise from 2 to 2.4.d. If the government established price controls, either shortages would result if the

economy were perfectly competitive, or real output would rise if the economy had monopolistic elements.


e. We would look at the empirical evidence, and see whether it has remained constant in the past when similar circumstances have prevailed.

2. a. The economy is at point A on short-run and long-run Phillips curve on the graph

below.b. The answer to this question really hinges on what kind of change would be

popular. Should you try to cut unemployment further? If so, then we would recommend increasing government expenditures, moving the economy to a point such as B in the graph on the right. Or would a better strategy be cutting inflation? If so, then we would recommend reducing government expenditures, which will increase unemployment while reducing inflation.

c. We have chosen the “lower unemployment” option. An increase in aggregate expenditures will cause a movement up along the short run Phillips curve. Unemployment will fall, but inflation will rise. In the long run, as expectations of inflation adjust to actual inflation, the short run Phillips curve shifts up. Unemployment returns to its target rate of 5%, but inflation is higher than before as shown as point C on the graph on the right.

3. a. Stopping inflation tends to transfer money from debtors to creditors. Creditors are generally rich, and can golf regardless of their wealth. Debtors, faced with a decrease in their wealth, must cut back on discretionary expenditures, of which golf is one.

b. Since the exchange rate was fixed, any differential in inflation rates between the two countries could not be offset a change in the exchange rate. The fact that goods in dollar equivalent pesos in Argentina were higher than in NYC suggests that the Argentinean inflation rate remained greater than in the U.S. and the high prices of goods were serving as an anchor on the economy.

c. In an inflation (with interest rates falling behind inflation), people look for real assets to buy to protect their wealth. This increases the demand for goods relative to services increasing their price. When the inflation is stopped, the opposite occurs.

d. One reason why luxury auto dealers were shutting down was the same as the argument given in (a). A second reason is equivalent to that given in (c). A third reason is that wealthy Argentineans who would most likely purchase such a car


also probably had foreign bank accounts denominated in dollars. The car in dollars was cheaper because the peso was overvalued at the fixed exchange rate. The demand for luxury cars fell as Argentineans substituted dollar-denominated luxury cars for peso-denominated cars.

4. a. The advantage of indexing grades is that it provides a benchmark with which to measure a student's performance in his/her class. It would distinguish between an A received in a difficult class in which many did not receive A's and an A earned in an easy class in which A's were plenty. The disadvantage is that it would not distinguish between an A earned among A's in a class where A's were given generously without work an A earned among A's in a class of geniuses. It might result in professors making distinctions among bright students whose abilities are virtually the same just to make a given distribution of grades.

b. This is parallel to the argument for fixed exchange rates that place limitations on individual grade policies (their distributions) for professors.

5. a. One would expect real output to decline.b. One would expect unemployment to rise.c. One would expect inflation to fall.

6. a. He would likely be a quantity theorist since they see inflation most connected to long term growth because low inflation means that the informational job of prices is working better and more investment will take place.

b. Inflation can affect household decisions in a number of ways. It can add uncertainty about the future, leading them to save less. Alternatively, it could lead them to temporarily supply more labor than they would otherwise, causing a temporary spurt in growth, and then a fall in growth once they recognize their mistakes.

7. a. Answers may differ. Five goods we buy frequently are newspapers, soda, gas, shirts, and coffee.

b. This requires research by the student. Answers will depend on goods chosen.c. Answer will depend on good chosen.

Web Questions

1. a.Year M1

billionsGNP billions

Velocity

1959 140.3767 507.425 3.6147391960 140.3108 527.375 3.7586191961 143.0525 545.625 3.8141591962 146.4758 586.525 4.0042441963 150.9275 618.675 4.0991541964 156.7958 664.375 4.2371981965 163.465 720.1 4.405224


1966 170.9617 789.3 4.6168241967 177.6692 834.075 4.694541968 190.1333 911.45 4.7937411969 201.4192 985.35 4.8920371970 209.1208 1039.675 4.9716471971 223.1692 1128.6 5.057151972 239.0542 1240.425 5.1888871973 256.3458 1385.55 5.4050031974 269.2033 1501 5.5757111975 281.4358 1635.175 5.8101171976 297.1942 1823.925 6.1371491977 319.9783 2031.4 6.3485551978 346.305 2295.875 6.6296331979 372.7117 2566.375 6.8856851980 395.7467 2795.55 7.0639891981 424.8842 3131.35 7.3698911982 452.9992 3259.225 7.194771983 503.165 3534.95 7.0254291984 538.6517 3932.75 7.3011011985 586.9975 4213 7.1772031986 666.5058 4452.85 6.6808871987 743.6267 4742.475 6.3774951988 774.9767 5108.325 6.5915861989 782.4733 5489.05 7.0149991990 811.0733 5803.25 7.1550251991 859.5342 5986.225 6.9644991992 966.3583 6318.95 6.5389311993 1078.999 6642.325 6.1560061994 1145.484 7054.3 6.1583571995 1143.095 7400.55 6.4741341996 1106.316 7813.175 7.0623371997 1069.881 8300.725 7.7585511998 1080.712 8759.95 8.1057241999 1102.438 9256.15 8.396077

b. One dollars in 1960 supported approximately $3.8 in total income. This rose to about $5.0 in 1970, and $7.1 in 1980. By 1990, one dollar circulated enough to support approximately $7.2 in total income.

c. As can be seen the velocity of money has on average been rising over the last couple of decades.

d. The quantity theory of money assumes that the velocity of money is constant. This is obviously not the case as can be seen by the above chart. Thus, this theory will not be able to predict accurately the growth in nominal GDP due to the growth of the money supply.

2. a. The article suggests that there is an inverse relationship between the two (i.e. as


interest rates rise, inflation falls). b. The article emphasizes the quantity theory viewpoint since it says that changes in

interest rates (due to changes in money supply) will lead to changes in the inflation rate.

c. The Fed has to estimate the state of the economy and then make decisions regarding interest rates.

d. The terrain could include variables like production, employment, consumer expenditures and their expectations etc.

Chapter 32: Open Economy Macro: Exchange Rate and Trade Policy


1. If a country is running a balance of trade deficit, the amount of goods it is exporting is less than the amount of goods it is importing. This is only one part of the current account, which is the part of the balance of payments that lists all short-term flows of payments. A deficit in merchandise could be offset by a surplus in other areas of the account.

2. When someone sends 100 British pounds to a friend in the United States, the transaction will show up in the component of the current account called net transfers, which include foreign aid, gifts, and other payments to individuals not exchanged for goods or services. It will also appear on the capital account as a receipt of foreign currency just like the purchase of a British stock or bond.

3. The capital account measures the flow of payments between countries for assets such as stocks, bonds, and real estate, and a surplus means that capital inflows were more than capital outflows. To buy United States assets, foreigners need dollars, so the net capital inflows represent a demand for dollars that can balance the excess supply of dollars due to a current account deficit.

In the short run, a current account deficit balanced by a capital account surplus is nice because current expenditures, which include the trade balance, give society immediate pleasure.

4. In the reverse situation, a capital account deficit will mean an excess supply of dollars, which could be offset by the added demand for dollars created by a current account surplus. In the long run, capital account deficits are nice because you are building up holdings of foreign assets.


5. A non-convertible currency cannot be freely exchanged with other currencies. Such a currency can only be bought from the country's government and sold to it. The exchange rates of such currencies do not fluctuate in response to shifts in supply and demand. The major disadvantage of this is that it makes trade difficult. Yet countries use this to avoid making the economic adjustments that international considerations would otherwise force upon them.

6. Holding the exchange rate above the equilibrium market exchange rate will make a country's exports more expensive and its imports cheaper than they otherwise would have been. It will also require the country to finance the deficit using reserves or borrowing to do so. It can allow the government to temporarily not make the contractionary macro adjustments that otherwise would be necessary to bring the economy into equilibrium.

7. We would use a combination of purchasing power parity, current exchange rates, and estimates of foreign exchange traders to determine the long-run exchange rate of the Neverback. This combination approach can only be justified by the "that's all we have to go on." defense. Since no one really knows what the long run equilibrium exchange rate is, and since that exchange rate can be significantly influenced by other countries policies, the result we arrive at could well be wrong.

8. Both fixed and flexible exchange rate systems have advantages and disadvantages. While fixed exchange rates provide international monetary stability and force governments to make adjustments to meet their international problems, they have some disadvantages as well: they can become unfixed, creating enormous instability; and their effect of forcing governments to make adjustments to meet their international problems can be a disadvantage as well as an advantage. Flexible rates provide for orderly incremental adjustment of exchange rates and allow governments to be flexible in conducting domestic monetary and fiscal policies, but also allow speculation to cause large jumps in exchange rates (and, as before, the government flexibility may be a disadvantage too). Given the pluses and minuses of both systems, most policymakers have opted for a policy in between-partially flexible exchange rates.

9. He will more likely prefer fixed exchange rates. They provide an anchor, which restricts government temptations to use expansionary monetary policy.

10. They will sell that currency, which will force the government to use reserves to protect the currency.

11. Three types of regulatory restrictions are tariffs, quotas and non-tariff barriers. Tariffs are taxes on imports. Quotas are quantity restrictions on imports and non-tariff barriers are a combination of regulatory restrictions that make importing harder. The advantage of tariffs is that they bring in revenue. The advantage of quotas is that politically, they are often more easily implemented than tariffs. The


advantage of non-tariff barriers is that governments can claim that they are not really barriers to trade.

12. A tariff is a tax on imports; a quota is a quantitative restriction on imports.

13. As you can see in the graph on the right, a tariff of T brings in revenue to the government shown by the boxed area while a quota of Q1 that achieves the same quantitative restriction gives that revenue to producers in the form of increased profits.

14. An inefficient customs agency can act as a non-tariff barrier. It restricts imports in the same way that a tariff or quota does.

15. No. Assuming that we had suggested free trade, we would continue to suggest free trade. The recession will likely reduce imports, improving the trade balance, but it will also increase unemployment, which will increase political pressure to restrict imports. Since we have been convinced by economic arguments for free trade, we would not change our advice.

16. He was advocating significant trade restrictions. These trade restrictions would have likely provoked retaliation by our trading partners, hurting international cooperation, and hurting the world economy.

17. No. It is extremely difficult to affect exchange rates. Since we don't know what the correct exchange rates are, it is probably best not to try to significantly change the exchange rates determined by the market by foreign exchange intervention. If one is going to change exchange rates one must change one's domestic monetary and fiscal policies.

18. The U.S. would want to hold up the value of the dollar to help prevent the surge in prices that would result from the fall in exchange rates, and to keep foreigners


from buying our assets cheaply. Other countries would want a higher value of the dollar in order to keep their goods competitive with U.S. goods.

Problems and Exercise

1. The graph to the right shows the fundamental analysis of the supply and demand for British pounds sterling in terms of dollars, and the effect of the following changes:

a. A rise in the UK price level causes foreign goods to become cheaper. British demand for foreign currencies will tend to increase, and foreign demand for pounds will tend to decrease. Thus supply of pounds shifts outward fro S0 to S1 and the demand for the pound shifts inward from D1 to D0. The exchange rate value of the pound falls from P1 to P2.

b. The United States price level rising has the effect noted above, but the graph illustrates the impact of the change in the value of the dollar on the pound in terms of dollars. As the value of the dollar falls, the value of the pound in terms of the dollar rises, and so shifts are opposite to those of part a. That is the supply of pounds shifts inward fro S1 to S0 and the demand for the pound shifts outward from D0 to D1. The exchange rate value of the pound rises from P2 to P1.

c. A boom in the UK economy means an increase in its income, causing an increased demand for imports and an increase in the demand for the foreign currency to buy those imports, thus resulting in an increase in the supply of pounds. (This may also set off an expectations effect.) Thus, the supply of pounds shifts outward from S0 to S1. If demand is at D0, the exchange rate value of the pound falls from P0 to P2.

d. If interest rates in the UK rise, there will be an increased demand for its assets, so the demand for pounds will increase from D0 to D1 and the supply of pounds will decrease from S1 to S0 as fewer British investors sell their pounds to buy foreign assets. The exchange rate value of the pound rises from P2 to P1.


2. a. This is an enormous change. In order to bring it about, the Never-Never government would have to run an enormously expansionary monetary policy, reducing the real interest rate possibly to negative amounts, and probably generating significant inflation.

b. Holders of Neverbacks will demand foreign currencies (increase supply of Neverbacks) since the return on Neverback assets has declined. This is shown as a rightward shift in the supply of Neverbacks. Likewise, potential foreign investors will demand fewer Neverbacks for the same reason. This is shown as a leftward shift in the demand for Neverbacks from D0 to D1. The effect is to reduce the exchange rate value of the Neverback to $10 per Neverback.

3. a. Supplier b. Supplier c. Supplier d. Demander e. Demander f. Demander.

4. a. We would suggest buying U.S. dollars and selling currencies of EU.b. We would suggest buying U.S. dollars since interest rates in U.S. are expected to

be higher, the quantity of U.S. assets demanded will rise, and thus the demand for dollars will increase.

c. Since the market will likely already have responded to the higher expected interest rates, the rise will likely have the same effect as a fall in interest rates. Thus I would suggest selling U.S. dollars.

d. We suggest selling U.S. dollars by similar reasoning in b.e. We would suggest selling U.S. dollars in the expectations of a decrease in

demand for U.S. dollars as U.S. goods become more expensive. Also U.S. denominated assets such as bonds will be worth less with greater inflation making foreign assets more attractive to investors.

5. a. Current account b. Current account c. Current and capital accounts d. Current account e. Capital account

6. a. Three assumptions of the law of one price are (1) zero transportation costs; (2) the goods are tradable and (3) there are no barriers to trade. (There are many others.)

b. For it to apply directly to labor would have to be completely mobile. Thus it does not apply directly. However, assuming capital is flexible, there will be significant indirect pressure toward an equalization of wage rates.

c. Since capital is more mobile than labor, we would expect that the law of one price would hold more for capital than for labor.

Web Questions


1. a. Country Implied PPP of the Dollar Exchange RateAustralia 1.03 1.68Britain 1.32 1.58Israel 5.78 4.05Malaysia 1.8 3.8Russia 15.7 28.5

All the currencies are overvalued except the Isreali shekel, which is undervalued.b. The Big Mac Index is limited because it measures purchasing power parity only

in terms of Big Macs. People don’t just consume Big Macs. Including more goods in a purchasing power parity index would make the index more accurate.

c. In designing an index it would be important to include a wide variety of goods in order to measure overall changes in purchasing power parity, everything from food and clothing to tires and light bulbs.

d. You could check the validity of the Big Mac index by comparing its implied purchasing power parities in U.S. dollars to actual exchange rates.

2. a. The mission of the International Trade Administration is to encourage, assist, and advocate U.S. exports, to ensure that U.S. business has equal access to foreign markets, and to enable U.S. businesses to compete against unfairly traded imports and to safeguard jobs and the competitive strength of American industry.

b. Two hot issues on the ITA website include food biotechnology and commercial privacy.

c. The U.S. has the largest surplus with the Netherlands and the greatest deficit with Japan.

Chapter 33: International Dimensions of Monetary and Fiscal Policies


1. At the time that this was written, it was believed that the dollar had risen high enough. That is, the yen was as low as was desired. A higher yen against the dollar would make imports more expensive, contributing to inflationary pressures, and exports to Japan cheaper, exerting an expansionary effect on the economy. In the early 2000s, the risk of inflation exceeded the risk of recession. Thus, one would not desire a higher yen. A lower yen would have the desired effect of lowering inflationary pressures and keeping the U.S. economy from overheating.

2. At the time that this was written the U.S. trade deficit had risen to record highs. Still, it is unclear whether we should want to lower the U.S. trade deficit. The trade deficit was in part due to the fact that the economy has been growing for 9 consecutive years. As long as the U.S. can borrow or sell assets, we can have a trade deficit. On the other hand, the more we borrow, the more U.S. assets foreigners own. Eventually, the U.S. will have to run a trade surplus.


3. If Japan ran an expansionary monetary policy, it would increase Japanese imports of U.S. goods and thereby decrease the U.S. trade deficit. The U.S. dollar would rise relative to the Japanese yen.

4. A contractionary monetary policy by Japan would have the opposite effect as described in question #3; the exchange rate on the U.S. dollar would fall, and the U.S. trade deficit would worsen.

5. Since the effect of monetary policy is to push the exchange rate down in all effects, this will not change the effect presented in the chapter, other than to eliminate the effect through income and replace it with the effect through prices.

6. The effect of expansionary fiscal policy on the exchange rate is ambiguous, while contractionary monetary policy has the effect of increasing exchange rates. The net effect will depend on which influence is stronger.

7. The answer to this question hinges on what is meant by "justified." If that means that the United States is complaining about the actual negative consequences it experiences because of this policy, as a matter of fact, one can say the complaint is justified. If the argument centers on fairness, the issue is clearly complicated by the question of whether a nation should put its goals ahead of or secondary to international goals.

8. In the 1990s one international goal of Germany was the European monetary system and a common European currency. Domestically, one goal was keeping inflation low. To keep inflation low, the Bundesbank followed tight monetary policy. This action, however, boosted interest rates and the German exchange rate, which conflicted the international goal of monetary union.

9. If the recession was caused by a fall in domestic expenditures, we would expect that its trade balance was falling. If, however, the recession was caused by a fall in exports, we would expect that its trade balance was rising. The G-7 countries were trying to get Japan to boost its economy by increasing aggregate expenditures and expansionary monetary policy.

10. When the U.S. debt in internationalized, there is a capital inflow into the U.S. Thus the U.S. can consume more than it produces. Domestic borrowing would cause crowding out but when foreigners make the loans that does not happen.

11. The costs of internationalizing the debt is that interest and profits must be paid on the foreign capital. Future consumption must be reduced to pay that amount.


1. See page 759 in the textbook.


2. See page 757 in the textbook.

3. a. A decrease in a country's competitiveness and an increase in the trade deficit is probably due to expansionary fiscal policy which would increase inflation, reducing competitiveness, and increase income, increasing imports and increasing the trade deficit. Expansionary monetary policy would make the trade deficit larger, but its effect on competitiveness through the exchange rate is ambiguous.

b. If interest rates have risen steadily along with a rise in the exchange rate, it is likely that fiscal policy has been very expansionary.

c. Running more contractionary fiscal policy and expansionary monetary policy would reduce the interest rate and thereby push down the exchange rate making the country more competitive, while maintaining a constant domestic macro policy.

4. a. We would suggest that the IMF require both a contractionary monetary and fiscal policy. I would, however, suggest a relatively more contractionary fiscal policy so that the exchange rate would also fall, while inflation falls, boosting exports.

b This would tend to slow inflation, after an initial burst due to a fall in the exchange rate. This, however, would hinder growth and push the economy into a recession.

c. We suspect that the country would not be happy about the proposal because its adoption might lead to a deep recession, which is politically unpopular.

5. The first advice I would give would be to explain that at most, I can talk about tendencies rather than achieving goals. Not all goals are simultaneously achievable. That advice given, I would provide the following recommendations:

a. We would suggest a contractionary fiscal policy, which lowers inflation and the interest rate directly and reduces the trade deficit by lowering income. It will also increase the capital inflow, which will tend to allow an increase in the trade deficit.

b. This would require a combination of monetary and fiscal policies—contractionary monetary policy to head off inflation and increase interest rates and increase the value of the dollar to encourage imports and discourage exports to reduce the trade deficit. To further decrease the trade deficit, a slight expansionary fiscal policy could be implemented, but that will have a tendency to push the interest rate up.

c. An expansionary monetary policy will reduce interest rates, depressing the dollars, which will tend to reduce the trade deficit. This will tend to reduce unemployment too. However, the increase in income and prices will tend to increase the trade deficit.

d. This combination of goals is difficult to achieve. Expansionary fiscal policy will tend to reduce unemployment and increase interest rates. But to offset the effect of higher income on increasing the trade deficit, an expansionary monetary policy will have to be implemented to depress the dollar and spur exports to lower the trade deficit. Reducing employment and the interest rate, this works in the


opposite direction from expansionary fiscal policy by reducing employment and the interest rate. Life is tough.

Web Questions

1. a. Canada, Mexico, Japan, Federal Republic of Germany, China. b. Canada, Mexico, Japan, Federal Republic of Germany, China.c. We would encourage them to follow expansionary monetary and fiscal policies.d. Netherlands, Australia, Hong Kong, Belgium and Switzerland.

2. a. Conditionality is the requirement by the IMF that its aid recipients follow certain policies, or conditions, in order to receive aid.

b. Typical IMF financing preconditions include reducing government spending, budget deficits, and foreign (external) debt, reducing the rate of money growth to control inflation, raising real interest rates to market levels and removing barriers to export growth. When implemented, these conditions lead in the short term to (a) a devaluation of local currency, (b) a lower trade deficit and (c) domestic problems including slower growth and unemployment.

c. Mexico, Russia, Pakistan, Thailand and South Korea are examples of countries that have received IMF financing over the past five years.

d. Mission creep is the term used to describe the increasing influence of the IMF on domestic policies of its aid recipients. In addition to the enforcement of financial reform in exchange for aid, the IMF has been accused of advocating an agenda in relation to geopolitics and international security, social safety nets, government corruption, the environment and human rights.

Chapter 34: Tools, Rules and Policy: The Art of Macro Policy


1. The straight production possibility curve represents constant marginal opportunity cost. The bowed out production possibility curve represents increasing marginal opportunity cost.

2. GDP rose by 4 percent.

3. Classical growth theory emphasizes saving and investment, and concludes that increases in the growth rate are limited in the long run due to diminishing


marginal returns. New growth theory emphasizes technology and sees increases in the growth rate as unlimited due to increasing returns.

4. We would respond that obviously they are not using this book. This book emphasizes that the financial health of the economy, not the deficit, is the key issue in budget policy and that commitments can be made that do not show up as a deficit but which pose significant future problems.

5. Increase by $200.

6. Depreciate because the real interest rate in the United States is –1 percent and the real interest rate in the rest of the world is 1 percent. The demand for the dollar currency will fall and the supply will rise.

7. As with most economic answers, it depends. In this case it depends on what the inflation rate is. If the inflation rate is about 50% they can both be correct; John is talking about real rates; Bob is talking about nominal rates.

8. Monetary policy is considered the more effective tool since politically fiscal policy has proven almost impossible to use due to the time lag.

9. Policies followed now affect expectations of future policies, and those expectations can affect how the economy operates. By thinking about policy as a process, not a one time event, these affects are taken into account.

10. A policy regime is a contingent rule about how policy makers will respond to different events; a policy is a one-time action that does not consider policy as a process.

11. Who knows? Clearly in the early 2000s the economy has operated at lower inflation rates and unemployment rates than economists thought possible. In that sense it is a new era. But most economists question whether the new era has begun and whether the inflationary consequences of low unemployment are just around the corner.

12. Three explanations for why the U.S. economy did no well in the late 1990s are: 1) increases in technology; 2) international competition; and 3) the policies the U.S. has followed that have reduced regulation and started a balanced budget regime.

13. The trade deficit is a potential problem because it means that our prosperity is based on the inflow of foreign capital. Foreigners are owning more and more of the assets in the U.S. If that foreign capital dries up, it could being the new era to a sudden halt. Some economists dismiss this argument, arguing that the inflow is due to the investment opportunities in the U.S. and that these will not suddenly end.



1. a. The supply curve shifts to the right. Equilibrium price falls and equilibrium quantity rises. The supply curve shifts from S0 to S1, equilibrium price falls fr om P0 to P1 and equilibrium quantity rises from Q0 to Q1.

b. The supply curve shifts to the left. Equilibrium price rises and equilibrium quantity falls. The supply curve shifts from S1 to S0, equilibrium price rises from P1 to P0 and equilibrium quantity falls from Q1 to Q0.

2. a. Since actual income is 400 lower than targeted income, we would suggest increasing government spending by 40. Since the multiplier is 10 this would increase output by 400 assuming the multiplier model was the correct one.

b. The budget deficit would increase by 40. If taxes were dependent on income, then this would be offset somewhat by new revenue.

3. We would work backwards. Since we want to increase income by $200 million, and the multiplier is 10, we want to increase investment by 20 million. That will require a .20 (twenty basis points) fall in the interest rate, or a $10 million increase in the money supply. Since the money multiplier is 3.33, we would have to increase reserves by $3 million. Thus, we would issue a directive for the Fed open market window to buy $3 million worth of government bonds.

4. a. Forgetting about the rise in the price level initially, we would want to increase income by 1,000. Since the multiplier is 5, that would require increasing government spending by 200. However, since that will move the economy to above potential income, income will rise by less than 1,000.

b. Follow the same policy as in a and output will rise by 1,000.c. See the graphs below. In the AS/AD model on the left, the AD curve shifts to the

right by 1,000 to point B. Since the price level rises above 5,500, the AS curve shifts from AS0 to AS1 and output rises by less than the desired amount. This same scenario is shown on the right. The AE curve shifts up by 200 and equilibrium output rises to 6,000. As the price level rises, however, the AE curve shifts down to AE2 until equilibrium output is 5,500.


5. a. Since the money multiplier is 2.5, we would issue a directive for the Fed open market window to buy 24 worth of government bonds.

b. We could have also reduced the discount rate and lowered the reserve requirement, although by how much cannot be determined with the information given.

c. Based on the quantity theory we would predict that the price level would rise because of the increase in the money supply.

6. a. Expansionary fiscal policy will increase the trade deficit and have an indeterminate affect on the exchange rate.

b. Contractionary monetary policy will increase the exchange rate and decrease the trade deficit.

c. This combination would most likely decrease the exchange rate, and have an indeterminate effect on the trade balance. The actual effects depends on how the relative strengths of the policies.

7. An increase in U.S. tariffs will reduce the supply of dollars to buy im ports. This shifts the supply curve for dollars from S0 to S1. The dollar’s value rises and quantity sold falls.

Web Questions

1. There are a number of these jokes, many poking fun at the assumptions need to conclude that no one would ever find a $20 lying on the sidewalk.


2. a. Consumer spending was strong and met expectations. In labor markets, difficulty in finding and retaining qualified employees remained a common problem. Wages experienced expansionary pressures and increasing input prices were noted in almost every region. Industrial activity was strong overall.

b. The most recent monetary policy action taken by the FOMC was a 50 basis point increase in the discount rate to 6 percent.

b. The FOMC should take into account growth rates, unemployment and inflation in any decision to change the discount rate. In this case, the effect of the last rate hike remains to be seen. However if present conditions continue unchecked another hike may follow.

3. a. Dollarization is the process by which a country would eliminate its own currency and adopt the dollar as legal tender.

b. Upon dollarization of its economy, a country would have to forego the profit from issuing currency and adjust its policies to account for the loss of independent monetary policy.

c. Dollarization abroad would stabilize and expand export markets, thereby helping U.S. workers and businesses. Dollarization would reduce currency risk, thereby helping U.S. investors. It would strengthen foreign economies, thereby reducing the need to use taxpayers' money to bail out countries due to sudden currency-related economic problems.

c. Ecuador and East Timor have enacted legislation to dollarize, while Argentina and El Salvador have expressed interest in the idea. These are all emerging markets that share a desire to avoid sudden currency-related crisis and would benefit from measures to lower inflation and interest rates.
