Final Erp_5th Edition

8/6/2019 Final Erp_5th Edition

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Instructors Resources for

Economic Report of the President

Ron CronovichUniversity of Nevada, Las Vegas

to accompanyN. Gregory Mankiw

macroeconomics fifth edition

WORTH PUBLISHERS


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Instructors Resources for Economic Report of the President by Ron Cronovichto accompany

N. Gregory Mankiw: Macroeconomics, fifth edition

Copyright 2004 by Worth Publishers

All rights reserved. No part of this publication may be reproduced, stored in aretrieval system, or transmitted in any form or by any means, electronic, mechanical,

photocopying, or otherwise, without the prior written permission of the publisher.

Printed in the United States of America

ISBN: 0-7167-8713-X

First printing

Text Design: S. B. Alexander

Worth Publishers41 Madison Avenue

New York, NY 10010www.worthpublishers.com


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CONTENTS

To the Instructor v

Activities for Chapter 1: The Science of Macroeconomics 1

Excel Exercises for Chapter 2: The Data of Macroeconomics 4

Excel Exercises for Chapter 4: Money and Inflation 5

Excel Exercises for Chapter 5: The Open Economy 6

Activities for Chapter 6: Unemployment 7

Activities for Chapters 7 and 8: Economic Growth 10

Excel Exercises for Chapter 9: Introduction to Economic Fluctuations 14

Activities for Chapters 1012: Aggregate Demand and Economic Fluctuations 16

Excel Exercises for Chapter 13: Aggregate Supply 19

Excel Exercises for Chapter 15: Government Debt 22

Activities for Chapter 16: Consumption 23

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TO THE INSTRUCTOR

The Economic Report of the President (ERP) is a rich source of real-world examples and data for the intermediate macroeconomics course. This Instructors Resources providessuggestions for using the ERP, which is bundled with Macroeconomics, fifth edition, by

N. Gregory Mankiw.

For selected chapters from Macroeconomics, we identify a corresponding readingassignment in ERP, followed by reading comprehension questions and discussion ques-tions. We also include exercises requiring students to look up and perform calculationson relevant data from the statistical tables in the ERPs appendix. Answers to the read-ing comprehension questions and data exercises and suggested discussion points for each discussion question are provided.

Most intermediate macro students have basic Microsoft Excel skills, and so instructorsare now requiring (or would consider requiring) their students to use Excel to work withreal-world macroeconomic data. The ERP includes a great many statistical tables (alsoavailable online in Excel format), so we include several exercises involving the use of Excel to prepare graphs of the ERP data (see instructions on p. vi). Students are alsoasked to discuss the connection between the behavior of the data they have graphed and the implications of the models they are learning from the text.

This Instructors Resources is also available in Microsoft Word and PDF format, so youcan easily create handouts or answer keys for your students or copy any of the included graphs into PowerPoint presentations for use in your teaching. It can be downloaded from http://bcs.worthpublishers.com/mankiw5/. If you are registered, simply enter your username and password to access the instructors side of the Web site. If you are not reg-istered, please click Instructor on the left-hand column to do so and gain access. If youencounter any problems, please contact Worth Publishers technical support departmentat [email protected] or 800-936-6899.

We hope you find the ERP and this manual to be a positive addition to your intermedi-ate macroeconomics course.

Ron Cronovich November 2003

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Instructions for Exercises Requiring the Use of Microsoft Excel

For Chapters 2, 4, 5, 9, 13, and 15 of Mankiws Macroeconomics, we provide exer-cises that require the use or Excel or other spreadsheet software to work with data

provided in the ERPs Appendix B. The ERP tables are available in Excel f iles at

http://w3.access.gpo.gov/usbudget/fy2004/erp.html

Some points that may be helpful when using Excel to work with these files:

These files contain the year as a text string rather than a number. If you wish tocreate a time series graph with the year measured on the horizontal axis, you mayhave to convert the year data to numerical values.

When graphing two variables with different units of measurement (e.g., GDPmeasured in trillions and the inflation rate measured in percent per year), meas-ure one of the variables on the secondary Y axis. To do this, double-click onone of the data series, choose Format Data Series . . . , then click the Axistab, then click Plot series on Secondary axis.

vi TO THE INSTRUCTOR


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ACTIVITIES for Economic Report of the President

CHAPTER 1THE SCIENCE OF MACROECONOMICS

READING ASSIGNMENT: the ERPs Overview, pp. 1525

READING COMPREHENSION

1. Describe the behavior of output during the contraction of 2001, and in 2002.

ANSWER: Output fell by 0.6 percent during the contraction and then grow at anannual rate of 3.4 percent during the first three quarters of 2002 (p. 16).

2. How does the ERP define corporate governance? What are the three core principles of corporate governance?

ANSWER: Corporate governance is the system of checks and balances that servesto align the decisions of corporate managers with the desire of shareholders to max-imize the value of their investments (p. 17). The three core principles are: accura-

cy and accessibility of information, accountability of management, and independ-ence of external auditors (p. 18).

3. How did the number of people employed change from the beginning to the end of 2002?

ANSWER: Employment fell by 181,000 from December 2001 to December 2002(p.19)

4. What is meant by the double taxation of corporate income? What is the effect of thisdouble taxation?

ANSWER: Corporations pay taxes on income they earn. This income is taxed a sec-ond time when shareholders receive it in the form of dividends. This double taxationdistorts corporate finance decisions, reduces the after-tax return to investment, and therefore reduces capital accumulation. This slows the growth of worker productiv-ity and real wages (p. 22).

CHAPTER 1 THE SCIENCE OF MACROECONOMICS 1


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DISCUSSION QUESTIONS

1. What do macroeconomists study? List as many examples from the ERPs Overviewas you can.

DISCUSSION POINTS: This question is meant to tie content from the ERP withtext section 1-1 (What Macroeconomists Study). The potential list of examplescould be quite long. For instance, students might include any of the following: theeconomys total output; the components of demand (consumption, investment, gov-ernment purchases, net exports); the capital stock (the value of the countrys stock of productive assets); the growth rate of productivity (output per worker); employ-ment, unemployment, and job creation; the Federal Reserves monetary/ interest rate

policies; tax cuts and how they support economic activity; the current account (i.e.,trade) deficit; inflows of foreign capital; corporate governance; government policiesto promote employment; regulation; tax policy; the relation of domestic and foreigneconomic growth.

2. The first statistic mentioned in the ERPs Overview is the recent behavior of the U.S.economys total output of goods and services. The first data graph in text Chapter 1

shows data on output per person. Why do you think the behavior of output is of suchcentral importance? In what ways might the behavior of aggregate output affect you,

your parents, businessmen and woman and workers in your community, or otherordinary individuals?

DISCUSSION POINTS: Macroeconomics is the study of aggregates, perhaps mostimportant, aggregate output/income. The objective of this question is to get studentsto see the connection between the behavior of aggregate output and the well-beingof ordinary individuals. The behavior of total output affects the ability of new col-lege graduates to get good jobs, the success or failure of small businesses in the com-munity, and the incomes of people in the economy (since total output = sum of everyones income).

3. The ERP is written by economists. What key concepts or principles seem to guide or pervade their thinking and writing about the economy?

DISCUSSION POINTS: This question is meant to tie content from the ERP withtext section 1-2 (How Economists Think). The following words appear repeatedlyin the ERP Overview: dynamism, efficiency, flexibility, incentives, and markets. (The first sentence under Developing Regulation for a DynamicEconomy on p. 20 summarizes it all very nicely.) These words are key concepts ineconomics. If time permits, you might ask students what each term means and whyit is important in economics.

2 CHAPTER 1 THE SCIENCE OF MACROECONOMICS


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DATA EXERCISES

1. To put the recent behavior of output in context, compute the average annual growthrate of output (Real Gross Domestic Product, in Table B-4) from 1959 to 2001.

ANSWER: The average annual growth rate of output between 1959 and 2001 was3.45 percent.

2. In how many years from 1959 to 2000 was the growth rate lower than in 2001? Please specify which years.

ANSWER: Six years: 1970, 1974, 1975, 1980, 1982, 1991.

CHAPTER 1 THE SCIENCE OF MACROECONOMICS 3


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EXCEL EXERCISES for Economic Reportof the President

CHAPTER 2THE DATA OF MACROECONOMICS

1. Use the data in Table B-2 and B-42 to create a replica of Figure 2-5 on p.36 of thetext. (You may omit the year-labels that appear next to some of the data points in

Figure 2-5.)

4 CHAPTER 2 THE DATA OF MACROECONOMICS

Three measures of Velocity, 1960-2001

0.0

1.0

2.0

3.0

4.05.0

6.0

7.0

8.0

9.0

10.0

1960 1965 1970 1975 1980 1985 1990 1995 2000

Velocity (PY/M)

V (PY/M1) V (PY/M2) V (PY/M3)


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CHAPTER 4MONEY AND INFLATION

1. What does the Quantity Theory of Money assume about the behavior of velocity?Solve the quantity equation for velocity (the income version of velocity, not thetransactions version). Use your result, and the data in Tables B-1 and B-69 to createa time series chart of three measures of velocity: one using M1, one using M2, and

one using M3. Which of these three monetary aggregates would be most appropriateto use with the Quantity Theory of Money? Explain.

ANSWER: The quantity theory of money assumes that velocity is constant. In thegraph below, its easy to see that M 1 velocity is not constant, so it would not beappropriate to use M 1 with the Quantity Theory. M 3 velocity has a slight downward trend, but is much more stable than M 1 velocity. M 2 velocity appears to be the moststable of the three measures, so M 2 is probably the most appropriate choice of thethree monetary aggregates for use with the quantity theory of money.

CHAPTER 4 MONEY AND INFLATION 5

Three Measures of Velocity, 19602001

0.0

1.0

2.0

3.0

4.05.0

6.0

7.0

8.0

9.0

10.0

1960 1965 1970 1975 1980 1985 1990 1995 2000

Velocity (PY/M)

V (PY/M1) V (PY/M2) V (PY/M3)


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CHAPTER 5THE OPEN ECONOMY

1. Prepare a scatter chart measuring net exports as a percentage of GDP on the horizontal axis, and the trade-weighted real exchange rate (Broad index) on the vertical axis. The latter series can be found in Table B-110 for years 1982 through 2002.

Adjust the scale of the vertical axis so it just encompasses the range of values of the

exchange rate series. Finally, right-click on any data point on the chart and chooseAdd Trendline to add a linear trendline. Which graph or curve from Chapter 5is represented by your trendline? How do you explain points off the line?

ANSWER: See graph below. The trendline is most similar to the NX curve fromFigure 5-7 on p. 130. Each point is for a different year. If the true NX curve wasshifting around over time, then most points would be off the trendline. Hence, thetrendline represents the average position of the NX curve during the 20 year period covered by the data.

6 CHAPTER 5 THE OPEN ECONOMY

U.S. Net Exports and the Real Exchange Rate,19822001

859095

100105110115120125

-4.0% -3.0% -2.0% -1.0% 0.0%

NX (as a % of GDP)

T r a

d e - w e

i g h t e d r e a

l

e x c

h a n g e r a

t e


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CHAPTER 6 UNEMPLOYMENT 7


CHAPTER 6UNEMPLOYMENT

READING ASSIGNMENT: Chapter 3 of the ERP, pp.109134READING COMPREHENSION

1. According to data cited in the ERP, how long are people typically unemployed? What does this data imply about the job finding rate (denoted f in text Chapter 6)?

ANSWER: On page 121, the ERP notes that the median duration of unemploymentis 8.2 weeks in the year after a recession and 6.6 weeks otherwise. These numbersimply that the normal (nonrecession) job finding rate is about 0.15 (in the typicalweek, about 15% of unemployed workers will find jobs); in recessions, the rate fallsto about 0.12.

2. What data does the ERP cite regarding the relationship between education and wages? What about the relationship between education and unemployment?

ANSWER: The return on each additional year of education is 6 to 10 percent high-

er wages. The median earnings of adults with bachelors degrees in 2002 was $944 per week, compared to $545 for adults with only a high school diploma. The unemployment rate for the former group was 3.0 percent; for the latter group, it was 5.1 percent (ERP p. 133).

3. What evidence does the ERP cite regarding the effects of unemployment insurance(UI) on unemployment?

ANSWER: In one study, 40 percent of unemployed workers not receiving UI becameemployed again within 4 weeks of job loss; only 35 percent of unemployed workersreceiving UI were employed after 4 weeks. In another study, the duration of unem-

ployment increases one day for each additional week of UI eligibility. In Europe, UIis more generous, and unemployment periods last longer than in the United States.In addition, research shows that the probability of unemployed workers receiving UIreturning to employment increases when benefits are about to expire, but the prob-ability of finding a job does not increase at the same point among unemployed work-ers not receiving UI benefits (ERP p. 122).


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8 CHAPTER 6 UNEMPLOYMENT


1. The ERP discusses unemployment insurance (UI), the Earned Income Tax Credit (EITC), and President Bushs proposed Personal Reemployment Accounts. Comparethe merits of these three policies.

DISCUSSION POINTS: The ERP stresses the employment disincentives of unemployment insurance, as does the Mankiw text. However, while the text conjecturesthat UI might result in better matches between jobs and workers, the ERP cites evi-dence (pp. 123, 126) that the extra search time afforded by UI has not lead to better

jobs for the workers that enjoyed this extra time. The EITC subsidizes the wages of low-income workers, which increases their incentive to work and likely reducesunemployment among this group of workers. (That the EITC imposes a high mar-ginal tax rate in the income range in which it is phased out would affect only the mar-ginal work effort of the employed; it would not affect unemployment.) The PersonalReemployment Accounts (PRA) program is designed specifically to reduce the dis-incentive to work caused by UI.

2. Is most unemployment short-term or long-term? Why is this an important question?

DISCUSSION POINTS: According to data cited in the ERP and the text, most peri-ods of unemployment are fairly short in duration, but most unemployment isaccounted for by a small number of long-term unemployed persons. This question isimportant because its answer will help determine which policies are likely to be mosteffective in reducing unemployment.

3. The ERP states labor markets work best when they are fluid and flexible (p. 113).What does this mean? Can you think of examples of policies or institutions that inhibit the fluidity or flexibility of labor markets?

DISCUSSION POINTS: The ERP describes fluid and flexible labor markets asthose in which workers and employers can change their mutually agreed-uponworking arrangements as they see fit, to meet changing needs. Workers can change

jobs easily when better opportunities become available at other firms, and firms canhire or let go of (lay off or fire) workers easily as economic conditions change. Wagerigidities such as the minimum wage inhibit labor markets from functioning effi-ciently, as do policies such as unemployment insurance, which prolong the jobsearch for the unemployed.


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CHAPTER 6 UNEMPLOYMENT 9

DATA EXERCISES

1. The ERP also says A vibrant economy created over 40 million new jobs between1980 and 2002. In the Appendix tables, find the data that support that assertion.Then, break down that job creation by U.S. president: That is, f ind the number of jobscreated under Ronald Reagan, George H. W. Bush , Bill Clinton, and George W.

Bush. Finally, compare job creation under Reagan with that under Clinton. If yourea Democrat, how do you use these numbers? What if youre a Republican?

ANSWER: Table B-36 on p.320 shows that civilian employment increased by 35million. If the ERPs statement is correct, then noncivilian employment must haveincreased by 5 million. In any case, the rest of this exercise uses the following data,from Table B-36:

Year Employment President Total Job Job Creation per (in 1000s) Creation (1000s) Year (1000s)

1980 99,303 Reagan 15,665 1958

1988 114,968 G. H. W. Bush 3,524 8811992 118,492 Clinton 16,716 20902000 135,208 G. W. Bush 939 4702002 134,269

If youre a Democrat, you note that the economy created more jobs per year on aver-age under Clinton than under Reagan. If youre a Republican, you compare not theabsolute number of jobs created but the number relative to total employment. Jobcreation relative to total employment was slightly higher under Reagan (0.0197 =1,958/99,303) than under Clinton (0.0176 = 2,090/118,492).

2. Sectoral shifts over the short run contribute to the natural rate of unemployment. Identifying sectoral shifts, though, is easier over the long run and across broadlydefined industries, such as those in Table B-46 of the ERP. Use these data to com-

pute the share of total non-agricultural employment accounted for by durables man-ufacturing and by the services sub-category of service-producing industries forthe years 1960, 1970, 1980, 1990, and 2000. What shift do these data show?

ANSWER:

Year Employment Share of Employment Share of Durables Manufacturing Services

1960 13.6% 13.6%1970 11.6 16.31980 9.0 19.81990 7.3 25.52000 5.6 30.7

The data show a pronounced shift from the manufacturing sector to the service sector.


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CHAPTERS 7 AND 8ECONOMIC GROWTH

READING ASSIGNMENT: Chapter 6 of the ERP, pp.213255


1. Name a region of the world that has enjoyed faster-than-average growth between1980 and 2000. Name a region that has experienced slower-than-average growth

during this period.

ANSWER: The East Asia and Pacific regions have grown faster than average,whereas Latin America and sub-Saharan Africa have grown slower than average.(p.216)

2. What percentage of the worlds population lives below the $1/day poverty line,according to the World Bank?

ANSWER: 20% (p. 222)

3. How does geography affect growth?

ANSWER: Landlocked countries have lower growth rates because of the higher costof transporting goods to and from overseas markets. Tropical countries have healthissues, such as malaria, that significantly affect productivity and incomes.Geography also affects a countrys resource endowments and the frequency of natu-ral disasters such as hurricanes (p. 224).

4. Does the Bush administration prefer loans or outright gifts of aid to developing countries? Why?

ANSWER: The administration aims to help poor countries make productive invest-ments without saddling them with ever-larger debt burdens (p. 254). The ERP

briefly notes the difficulties that arise when countries default on their debts; grantseliminate the possibility of default because they are given without expectation of repayment.

10 CHAPTERS 7 AND 8 ECONOMIC GROWTH


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1. What does the ERP mean by the rule of law? Why is it important for growth? What variable or parameter in the Solow model do you think would be affected by the

strength of a countrys rule of law?

DISCUSSION POINTS: The rule of law is a state in which property rights are pro-tected, dispute mechanisms exist, and people generally have faith that contracts will

be enforced. Weak rule of law discourages investment (both by domestic and foreignresidents), because it increases risk/uncertainty and therefore reduces the parameter s (the rate of saving and investment) in the Solow model (see p. 236 of the ERP for a more detailed discussion).

2. How might education affect growth? How might growth affect education? Underwhat circumstances might education fail to significantly increase growth?

DISCUSSION POINTS: Education affects growth, because a worker with more edu-cation is more productive, earns a higher income, and generates a greater marginal

product for his or her employer. In the Solow model (with technological progress),an increase in the average workers level of education could be represented by anincrease in the efficiency of labor (the variable E ). Also, a better-educated popula-tion is more likely to elect competent leaders and hold them accountable.

Growth affects education, because growing incomes make education more afford-able and less of a luxury. Also, expected future growth increases the expected returnto education and therefore encourages people to acquire more education.

Education might not promote growth if educated workers are not getting jobs thatallow them to use their skills to achieve to greater productivity. This is most likely tooccur in countries with corruption, excessive regulation, a large share of state-owned enterprises, and other such inefficiencies (see ERP p. 240 for a more detailed dis-cussion).

3. Chapter 8 of the text states: As a matter of accounting, international differences inincome per person can be attributed to either (1) differences in the factors of pro-duction or (2) differences in the efficiency with which economies use their factorsof production (p. 221). According to the ERP, the three factors important for growthare openness, the protection of property rights, and macroeconomic stability. Foreach factor, discuss whether it affects growth through factor accumulation or pro-duction efficiency.

DISCUSSION POINTS: openness: factor accumulation (inflows of foreign capital finance investment) and

production efficiency (specialization according to comparative advantage).

CHAPTERS 7 AND 8 ECONOMIC GROWTH 11


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protection of property rights: factor accumulation (by affecting the incentive toinvest) and possibly production efficiency.

macroeconomic stability: probably both factor accumulation and production effi-ciency. High inflation creates uncertainty and discourages investment, which affectsgrowth through the factor accumulation channel. Also, recall from Chapter 4 of thetextbook that high inflation creates relative price variability (because firms dont allraise prices at the same time), which distorts the allocation of resources.

4. Describe the Bush administrations proposed Millennium Challenge Account (MCA) program. What is its objective? How does it aim to achieve this objective? Do youthink it would work?

DISCUSSION POINTS: The MCA proposal is designed to promote growth among poor countries by providing grants to countries that demonstrate measurable progress in creating the circumstances in which growth can flourish on its own. The policymakers that designed the MCA clearly had in mind the principle that peoplerespond to incentives. The prospect of MCA grants creates an incentive for poor countries to design and implement meaningful reforms. One pitfall, though, is thatsome poor countries have corrupt leaders, who may find it more personally prof-itable to continue expropriating their citizens property than to enforce propertyrights, especially if the funds from an MCA grant would not enhance their own per-sonal wealth. Thus, it might be more effective in such cases to offer corrupt leadersan amount greater than what they can get from abusing their power in exchange for implementing the kinds of reforms that create an environment in which growth canflourish. But just how far are we willing to go with this line of reasoning? Its aninteresting topic for student discussion.

DATA EXERCISES

1. Compute the average annual U.S. saving rate (gross saving as a percentage of grossnational product, Table B-32) in each decade from the 1960s through the 1990s. Isthere a trend? Does this trend appear to be continuing into the current decade?

ANSWER: The average annual U.S. saving rate by decade:1960s: 20.9%1970s: 19.6%1980s: 18.3%1990s: 17.1%

The trend is clearly downward, by about 1.3 percent per decade. The trend appearsto be continuing: The most recent data in Table B-32for the first three quarters of 2002shows a saving rate of 15 to 15.5 percent.

12 CHAPTERS 7 AND 8 ECONOMIC GROWTH


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2. By what percentage did U.S. real GDP per capita grow over the periods 19601970,19701980, 19801990, and 1990-2000? How does the trend compare with thetrend in the saving rate you found in question 1? Is this comparison consistent withthe predictions of the Solow model?

ANSWER:1960-70: 32.7%1970-80: 23.4%1980-90: 24.7%1990-2000: 21.4%

The trend in growth mirrors that in the saving rate. According to the Solow model,a decrease in the saving rate should cause a decrease in the steady-state level of income but should not affect its growth rate. A possible explanation for the discrep-ancy between theory and data is that we are not actually measuring the steady stategrowth rate in this exercise. Another possibility is that the saving rate really doesaffect the growth rate, as in some endogenous growth models, such as the AK

model described in Chapter 8 of the text.

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CHAPTER 9INTRODUCTION TO ECONOMIC FLUCTUATIONS

1. Using the data in Table B-2, create the growth rate of real GDP, consumption, and investment. Create a time series graph of these three growth rates. What do you learn

from this graph?

ANSWER: See graph below. Investment is more volatile than GDP or consumption.Consumption appears to be approximately as volatile or slightly less volatile thanGDP.

14 CHAPTER 9 INTRODUCTION TO ECONOMIC FLUCTUATIONS

Growth Rates of GDP, Consumption, and Investment, 19602001

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

1960 1965 1970 1975 1980 1985 1990 1995 2000

Y C I


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2. One of the variables that fluctuates over the business cycle is the unemployment rate. Another is the capacity utilization rate, the percentage of the capital stock that isactually being used in production. What relationship would you expect between theunemployment rate and capacity utilization rate? Prepare a time series chart show-ing both of these variables. Data on the unemployment rate is in Table B-42 whilethe capacity utilization rate is from Table B-54 (use the one for manufacturing).

ANSWER: One would expect a negative relationship between the unemploymentrate and the capacity utilization rate. This relationship is very apparent in the graph

below.

CHAPTER 9 INTRODUCTION TO ECONOMIC FLUCTUATIONS 15

Unemployment and Capacity Utilization Rates, 19592001

2

4

6

8

10

12

1959 1964 1969 1974 1979 1984 1989 1994 1999

Unemployment(% of

l a b o r

f o r c e

)

30

40

50

60

70

80

90

Capacityutilization(% of

capitalstock)

unemployment rate capacity utilization rate (mfg)


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CHAPTERS 1012AGGREGATE DEMAND

andECONOMIC FLUCTUATIONS

READING ASSIGNMENT: Chapter 1 of the ERP, pp. 2771


1. Which of the four components of aggregate demand played the biggest role in theU.S. economys recovery in 2002?

ANSWER: Consumption. Consumption continued to be the prime locomotive for the recovery in 2002, rising at an annual rate of 3.0 percent over the first three quar-ters of the year (p. 29).

2. How does the ERP explain the growth in the U.S. trade deficit during 2002?

ANSWER: U.S. GDP growth, while not spectacular, was higher in 2002 than wasGDP growth in most of the countries that buy U.S. exports. As a result, U.S. demand for imports grew faster than foreign demand for U.S. exports (pp. 4546).

3. How would you characterize U.S. fiscal policy in 2002?

ANSWER: Expansionary. Page 46 of the ERP notes that real federal governmentspending rose at an annual rate of 6.4 percent during the first three quarters of 2002,nearly twice as fast as GDP, which rose 3.4 percent (p. 27). In March 2002, the JobCreation and Worker Assistance Act provided tax cuts intended to boost consump-tion and investment, and expanded eligibility for unemployment insurance benefits.As a result of tax cuts and spending increases, the government budget turned fromsurplus to deficit.

16 CHAPTERS 1012 AGGREGATE DEMAND and ECONOMIC FLUCTUATIONS


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4. According to the ERP, what are the four channels through which a decrease in inter-est rates stimulates aggregate demand?

ANSWER: First, lower interest rates encourage consumption, particularly of big-ticket consumer durables such as cars, which are often bought on credit. Second, afall in interest rates stimulates business f ixed investment by lowering the cost of cap-ital. Third, lower interest rates increase the demand for housing, causing an expan-sion of residential investment. Fourth, a fall in interest rates causes depreciation of the exchange rate: The fall in rates causes financial capital to flow out of the coun-try in search of higher foreign returns, which translates to an increase in the supplyof dollars in the foreign exchange market, thus causing the exchange-rate value of the dollar to fall. The depreciation makes U.S. exports cheaper to people in other countries, while making imports more expensive to people in the United States,causing net exports to rise.


1. What grade would you give U.S. fiscal policy in 20012002? What about monetary policy? Justify your grades carefully, based on economics, not politics.

DISCUSSION POINTS: This, of course, is a highly subjective question. Oneapproach is to base the grade on the economys actual performance. During 2002,GDP grew modestly, inflation and interest rates were low, and productivity growthwas healthy, but unemployment remained high and the budget deficit increased sharply. Students grading policy on the basis of economic performance might, there-fore, give policymakers a B or C.

However, this approach effectively gives to policy all the credit or blame for eco-

nomic performance, and we know from text Chapters 9 through 13 that other factors(demand and supply shocks) affect inflation, economic growth, and unemployment.So, a second and perhaps fairer approach might be to grade policy on the basis of the extent to which the appropriate policies were implemented.

In 2001, monetary policy was aggressive, with the Federal Reserve cutting the Fed Funds rate eleven times. The Fed knows that rate cuts do not affect the economyimmediately, so the Fed held monetary policy fairly steady during 2002, allowing therate cuts of 2001 to continue to stimulate the economy. The timing of fiscal policymeasures is more difficult to gauge, due to the long lags associated with the legisla-tive process. However, government spending increases and tax cuts in 2001 and 2002acted to shift the IS curve to the right, that is, to stimulate the economy in the shortrun, and reductions in marginal tax rates were aimed at shifting the vertical long-runaggregate supply curve to the right. In this light, fiscal and monetary policymakers

probably deserve a fairly high grade.

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Keep in mind, though, the source of the ERP. Although the ERP appears to be fairly balanced and very well-grounded in mainstream economic theory, it is written byeconomists appointed by the White House. Thus, one cannot be absolutely certainthat the ERPs discussion of fiscal policy is perfectly balanced.

2. Does the stock market affect the macroeconomy, or vice versa? Explain.

DISCUSSION POINTS: Both occur. See if your students can think of specif ic chan-nels through which the stock market affects the macroeconomy, or vice versa. Hereare some examples, discussed in more detail in the ERP.

If the macroeconomy is doing poorly, firms suffer reduced profits, whichcauses stock prices to fall. Also, saving usually falls sharply in a recession,which reduces demand for stocks and hence depresses stock prices.

If the stock market is doing poorly, consumers feel worse off and generallycut back on expenditures, causing the macroeconomy to suffer. A boomingstock market expands household wealth and empowers consumers to spend more. Also, if stock prices are high, then firms can more easily raise fundsto finance investment projects. Also, rising stock prices often coincide withfalling interest rates, which, again, facilitates increases in investmentspending.

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CHAPTER 13AGGREGATE SUPPLY

1. Make a scatter-type graph with the U.S. unemployment rate on the horizontal axisand the inflation rate on the vertical axis. You can find the unemployment data inTable B-42, and the inflation rate in B-63. Does your graph show evidence of atradeoff between unemployment and inflation?

ANSWER: See the graph below. The graph shows no evidence of a negative rela-tionship or any systematic relationship.

CHAPTER 13 AGGREGATE SUPPLY 19

U.S. Unemployment vs. Inflation, 1960-200

0

2

4

6

8

10

12

14

0 2 4 6 8 10 12

unemployment rate (percent of labor force)

i n f l a

t i o n r a t e

( p e r c e n

t a g e

i n c r e a s e

i n C P I )


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2. Make a scatter-type graph with cyclical unemployment on the horizontal axis and unanticipated inflation on the vertical axis. Cyclical unemployment in any yearequals the actual unemployment rate minus the natural rate of unemployment. Thenatural rate cannot be specified; a simple way to estimate it is to use the averagevalue of the actual unemployment rate. Unanticipated inflation in any year equalsactual inflation that year minus expected inflation. There are no data on expected inflation. However, in the model of adaptive expectations discussed in Chapter 13,the expected inflation rate in any year equals the previous years actual inflationrate.

ANSWER: See the graph below.

3. Which of the two graphs you constructed provides the most supportive evidence forthe Phillips Curve (PC)? Which of the two graphs is a fairer test of the Phillips

Curve model?

ANSWER: The second graph provides evidence for the PC, because it shows a neg-ative relationship; the first graph does not. The second graph is also a fairer testof the PC. If the PC equation in Chapter 13 is true, the first graph would show a

20 CHAPTER 13 AGGREGATE SUPPLY

U.S. Cyclical Unemployment vs. UnanticipateInflation, 1961-2002

-6.0

-4.0

-2.0

0.0

2.0

4.0

6.0

-3.0 -2.0 -1.0 0.0 1.0 2.0 3.0 4.0 5.0

Cyclical unemployment rate

U n a n

t i c

i p a

t e d i n f l a

t i o n r a

t e


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negative relationship only if expected inflation and the natural rate of unemploymentremained constant over time. The second graph allows expected inflation and thenatural rate to vary.

4. Open your second graph in Excel. Right-click on any of the data points. A little menuwill pop up. Select Add Trendline . . . and add a linear trendline. Assuming that the

Phillips Curve model is correct, give two reasons that the points are not all on thetrendline.

ANSWER: First, we used crude estimates of expected inflation and the natural rateof unemployment, which surely introduced some error. Second, the Phillips Curveequation also includes a term for supply shocks, which we have not accounted for here.

CHAPTER 13 AGGREGATE SUPPLY 21


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CHAPTER 15GOVERNMENT DEBT

1. Prepare a time-series graph showing the federal budget surplus/deficit, both in nom-inal terms and with the inflation correction described on p. 410 of the text. For theinflation rate, use the percentage change in the GDP deflator, provided in ERP Table

B-7. The other data are available in ERP Table B-78 (omit the transitional quarter

data).ANSWER: The graph below shows that the inflation correction adds significantly tothe budget surplus (or reduces the deficit) in all years since the early 1970s.

22 CHAPTER 15 GOVERNMENT DEBT

U.S. Federal Budget Surplus/Deficit, with and withoutinflation correction

-400

-300

-200

-100

0

100200

300

400

1960 1965 1970 1975 1980 1985 1990 1995 2000

$billions

surplus w/o correction surplus w/ inflation correction


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CHAPTER 16CONSUMPTION

READING ASSIGNMENT: Chapter 5 of the ER P


1. According to the ERP, whats wrong with the current income tax system?

ANSWER: It distorts incentives and alters the economys allocation of resources. Itinvolves staggering costs of compliance. It reduces saving and therefore impedescapital accumulation and long-run growth in living standards. And its unfair:Different people with the same income have different tax liabilities.

2. Text Chapter 16 discusses the life-cycle hypothesis and the permanent incomehypothesis. Can you find any allusion to these theories in Chapter 5 of the ERP?

ANSWER: The first two paragraphs of page 181 of the ERP discuss both theorieswithout mentioning them by name.


1. What does tax policy have to do with consumption?

DISCUSSION POINTS: Tax policy affects current disposable income, an importantvariable in most of the consumption functions discussed in Chapter 16. Tax policyalso affects the after-tax real interest rate, which is the relative price of current con-sumption in terms of future consumption.

CHAPTER 16 CONSUMPTION 23


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2. The ERP discusses the differences between current income and lifetime or perma-nent income. Should income taxes be based on current income (as they are now) oron permanent income (assuming it could be measured, or, at least, proxied by con-

sumption or other observables)? Discuss the pros and cons of each. What is your position?

DISCUSSION POINTS: The ERP asserts that the income tax system should relatea taxpayers tax liability to his or her ability to pay and to his or her well-being(p. 179) and argues that permanent income rather than current income is a better indicator of well-being. This may be true, but for consumers facing liquidity con-straints, current income is a better indicator of ability to pay. College students and other young adults are likely to be more sensitive to this issue, as their permanentincome is surely far higher than their current income. And what about persons tem-

porarily unemployed during a recession? The taxation of current income is an auto-matic stabilizer that helps cushion the blow of negative transitory income shocks. If the government taxed permanent rather than current income, a temporary loss of cur-rent income would have little to no effect on a persons current tax liability, which

could be a huge problem for individuals who cannot borrow freely out of their futureincome.

3. One of the tax reform ideas discussed in the ERP involves replacing the current sys-tem of taxing income with a consumption tax. In which of the various consumptiontheories from Chapter 16 would it make the most sense to model the switch to a con-

sumption tax? How would you model it? What effects would it have in other models youve learned in this course?

DISCUSSION POINTS: The objective of replacing the income tax with a con-sumption tax is to increase the incentive to save. The consumption theories best suit-

ed for modeling this are the forward-looking theories in which rational consumerschoose the optimal amount to save for future consumption, namely the theories of Irving Fisher, Franco Modigliani, Milton Freidman, and Robert Hall. In Fishers the-ory of intertemporal choice, the switch to a consumption tax would make the budg-et line steeper, as it would raise the after-tax real interest rate. As long as the substi-tution effect is greater than the income effect for the average consumer, current sav-ing would rise and current consumption would fall. The theories of Modigliani,Freidman, and Hall are just variations on Fishers model and would generate similar results. For example, in Modiglianis life-cycle model, the higher after-tax interestrate would reduce the height of the consumption path, increasing the gap betweenconsumption and income, and causing wealth to accumulate more quickly until

retirement (see Figure 16-12 on text p. 450).

24 CHAPTER 16 CONSUMPTION


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David Laibsons model is probably not an appropriate framework for analyzing theshift from an income tax to a consumption tax for two reasons. First, it is not reallya formal model of consumption. Second, in his view, the consumer is less than per-fectly rational.

You might think it would be easy to use the simple Keynesian consumption functionto model tax reform. If the tax reform really does reduce consumption and increasesaving, then one might model this as a downward shift of the Keynesian consump-tion function, resulting in higher saving at each value of income. However, theKeynesian consumption function does not allow consumers to be forward-looking or to alter their consumption in response to changes in the (after-tax) interest rate. If your students are proficient in algebra, you might consider having them compare theslope and intercept of a linear Keynesian consumption function under a simple lin-ear income tax to the slope and intercept of the same consumption function under asimple linear consumption tax. For reasonable parameter values, the consumptionfunction has a lower intercept but a higher slope under the consumption tax thanunder the income tax! Moreover, at incomes higher than the point at which the two

consumption functions cross, saving is lower under the consumption tax than under the income tax. This is not a case of the income effect exceeding the substitutioneffect. It is a case of asking a model to do more than it was intended to do.

The question about the effects of the tax reform in the various macroeconomy mod-els is equivalent to asking students to compare the effects of an exogenous increasein saving in the different models. In the IS-LM model (Chapter 10), the tax reformwould represent a negative IS shock, so the Central Bank should consider easingmonetary policy to prevent a (temporary) fall in output and employment. In the loan-able funds model (Chapter 3), the saving or loanable funds supply curve would shiftto the right, reducing interest rates and increasing investment. In the Solow model

(Chapter 7), the saving rate would rise, leading to faster growth until the economyreached a new steady state with a higher standard of living. In the long-run openeconomy model (Chapter 5), the increase in saving would cause an increase in netcapital outflows, a decrease in the exchange rate, and an increase in net exports (or,equivalently, a decrease in the trade deficit).

4. Do you think the tax system should be used to achieve social objectives? What arethe costs and benefits of doing so?

DISCUSSION POINTS: This is getting a bit off the topic of Chapter 16, but its agood topic for economics majors to think about, and it will certainly give rise to live-

ly discussion. First, some examples of using tax policy for social objectives: Thetobacco tax is intended in part to reduce teen smoking (as teen demand for tobaccois more price elastic than adult demand); the gas tax might be raised to encourage

people to buy smaller cars, live closer to work, reduce congestion, conserve gas, and produce fewer greenhouse gases; the tax deduction for mortgage interest encourageshome ownership.

CHAPTER 16 CONSUMPTION 25


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The benefits of using tax policy to achieve social objectives: People respond toincentives, and the tax system can increase the incentive for people to behave insocially desirable ways (e.g., buy a gas-electric hybrid car in exchange for tax cred-its) and can reduce the incentive for socially undesirable behavior (e.g., smoke and drink less or not at all to avoid taxes on tobacco and alcohol). If your students havehad a microeconomics course recently, they might express this idea in terms of tax-ing activities that have negative externalities, and subsidizing those with positiveexternalities.

The costs of using tax policy to achieve social objectives: It makes the tax systemmore complicated and less fair, because it results in differences in the tax liability of individuals in the same income group. It can also distort the allocation of resourcesand cause people to expend effort and money to devise strategies to reduce their taxliability. If you distrust politicians, you might worry that politicians would create

politically-motivated tax breaks for certain groups of individuals or businesses.Completely disallowing the use of tax policy for social objectives would signifi-cantly reduce the power of special interest groups to affect policy and the allocation

of resources. Finally, the existence of deductions for various activities reduces thetax base, requiring a higher tax rate to raise a given level of revenue.

DATA EXERCISE

1. Using data from Table B-1, compute the average propensity to consume in the years1960, 1970, 1980, and 1990. Does the APC appear roughly constant over time, ordoes there seem to be a trend?

ANSWER: The APC equals 0.63 in 1960, 0.624 in 1970, 0.631 in 1980, 0.66 in1990, and 0.68 in 2000. The APC remained roughly constant until about 1980, whenit began an upward trend.

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