Answers to Odd-Numbered Self-Test Questions

Answers to Odd-Numbered Self-Test Questions

Chapter 1

1. Answers will vary. Microeconomics is the study of the allocation of resources and of price determination in individual markets for goods and services. Macroeconomics is the study of a nation's aggregate economic activity. Rather than focus on individual markets for goods and services, macroeconomics focuses on the study of aggregate economic variables (e.g. total output, the overall price level, aggregate employment).

3. As we shall see later in the text, production is a function of employment, the capital stock and technology (in addition to any other factors of production). In particular, differences in nations' populations can cause differences in the levels of production. For example, a country with a larger population will have, all else fixed, a higher level of production. In practice, a simple comparison of the level of output for two countries can provide misleading information about the standard of living of individuals in these two countries. Economists often measure output on a per capita (i.e., per individual) basis to adjust the output levels for any differences in the size of populations. Output per capita provides a better signal about the performance of a nation's economy since we can obtain information about the amount of output 'available' to each individual in that country. While output per capita will not necessarily be a perfect measure of the performance of an economy or of the well being of all individuals (we might, for example, also be interested in the distribution of the output across individuals), it is a better measure than the level of total output.

Chapter 2

1. Answers will vary. GDP is the market value of all final goods and services produced within a nation's borders during a given period. GNP measures the market value of all final goods and services produced by domestically owned factors of production. GNP, therefore, includes the earnings of domestic residents who live abroad and excludes the income of foreign residents who live in, for example, the United States. GDP excludes the earnings of domestic residents who live abroad and includes the income of foreign residents who live in, for example, the United States.

3. Answers will vary. Nominal GDP is the value of all final goods and services produced within a nation's borders during a given period measured in current prices. Real GDP is the value of all final goods and services produced within a nation's borders during a given period measured in some particular year's prices (i.e., the base year).

1. It is important that the individual (i.e., student!) realize the overall balance of payments records all transactions with the rest of the world. Consequently, for each transaction between a domestic resident and a foreign resident, there is both a payment and a receipt. When we combine all transactions in all the accounts included in the overall balance of payments, the overall balance of payments must be equal to zero.

Chapter 3

1. In this model, output is determined by the equilibrium level of employment given some aggregate production function. Therefore, output growth will be determined by the rate of growth in equilibrium employment (which will be affected by, all else fixed, population growth) and any factors that cause the aggregate production to shift. Consequently, output growth will also be affected by changes in technology, land (i.e., resources), capital, and entrepreneurship.

3. The analysis for question 2 indicates that this increased participation by women in the labor force will cause an increase in aggregate supply. The increase in aggregate supply (i.e., the rightward shift in the aggregate supply curve) will cause an increase in equilibrium GDP and a reduction in the aggregate price level. Why does P fall? At the initial price level, firms are willing to produce more goods and services than households are willing to purchase. As a result of this, P falls to restore equilibrium.

5. The reduction in the capital stock causes a reduction in aggregate supply. At the initial price level, firms are willing to produce fewer goods and services than households are willing to purchase. Consequently, the aggregate price level will rise.

Chapter 4

1. In this case, the demand for loanable funds would rise and the money supply would not change. So, we would observe no change in P and an increase in both the nominal and real interest rates.

3. The real interest rate is determined by the supply of and demand for loanable funds. The real interest rate will remain constant when saving and investment (plus any budget deficit/surplus) do not change. The nominal interest rate would fall as a result of any event that causes in this model a reduction in the aggregate price level. As the aggregate price level falls, inflation would fall and, therefore, the nominal interest rate would fall. Could the real interest rate increase as the nominal rate falls? Yes. In fact, this is what occurred in the early to mid 1980s in the United States. This would require either a reduction in saving (decrease in the supply of loanable funds) or an increase in investment (or increase in the budget deficit) to cause an increase in the real interest rate. We would also have to observe some reduction in expected inflation. It is important to emphasize, however, that the reduction in expected inflation would have to exceed the increase in the real interest rate to cause the nominal interest rate to fall. The drop in expected inflation could be caused by, for example, a reduction in the money supply.

5. There are two simultaneous events here: (1) the increase in the budget deficits; and (2) the increase in the money supply. The increase in budget deficits will cause an increase in the demand for loanable funds and an increase in the real interest rate. The increase in budget deficits has no effect on aggregate demand, real GDP and the price level in the Classical model. The response of the central bank to purchase the bonds causes an increase in the money supply, an increase in aggregate demand, an increase in the price level and, again, no change in real GDP. The nominal interest rate will rise for two reasons: the increase in the real rate and the increase in the rate of inflation (as the price level rises to its higher level). With P higher, the domestic currency must depreciate to maintain purchasing power parity. Therefore, E is higher.

Chapter 5

1. Increases in population growth will most likely cause an increase in labor force participation and, therefore, an increase in employment. This increase in employment (a factor of production) will cause an increase in the rate of growth of output (y) and, therefore, tend to cause an increase in economic growth. At the same time, an increase in population growth will have a direct negative effect on per-capita GDP. This tends to offset the first effect. Therefore, the effects of population growth on economic growth are ambiguous.

3. The more productive is capital, by definition, the higher is the marginal product of capital. As the marginal product of capital increases, investment will increase. Increases in investment will cause increases in the capital stock. Greater capital accumulation will causes increases in economic growth.

1. One of the factors that determines economic growth is the extent to which individuals can use technological improvements to raise their productivity levels. Increases in education (i.e., the accumulation of human capital) will allow individuals to better use improvements in technology and, therefore, increase economic growth. Furthermore, the relationship between education and capital formation, new growth theorists argue, can make economic growth self-perpetuating. Increases in capital formation make it more profitable to acquire information. The acquisition of this knowledge, in turn, may make it more profitable to invest. Hence, capital formation increases further.

Chapter 6

1. The trough of the business cycle occurs at that level of output that maximizes the difference between natural GDP and actual GDP. Throughout the entire business cycle (with the exception of negative supply shocks which would cause a reduction in natural GDP), natural GDP increases at some positive rate of growth. As the economy enters a recession, output begins to fall. At some point, the level of output will hit some minimum level and begin to increase. This minimum level of output is not the trough. As y begins to increase (as depicted in Figure 5-1), the now positive rate of growth in actual GDP, while positive, will remain below the rate of growth in natural GDP. Consequently, the gap between natural GDP and actual GDP will continue to increase. Once the actual GDP growth exceeds the rate of growth in natural GDP, the gap between the two measures decreases. This turning point, at which the rates of growth in actual and natural GDP are equal, is the trough. The same type of analysis applies to the peak. The peak occurs at that level of output where the difference between actual and natural GDP is maximized. At some point, the rate of growth in y will fall (but remain positive). Given that natural GDP increases at some positive rate of growth, the difference between the two measures of output will decrease despite the fact that the level of actual GDP is still increasing and will, at some point, reach some maximum before the economy enters another recession.

3. Suppose your disposable income increases by 100. A certain percentage of this will be used to purchase domestic goods, while a certain percentage of it will be used to purchase foreign goods. Whatever remains, by definition, is allocated to saving. Hence, all of the additional disposable income is allocated in some fixed proportions to c, im and s. The sum of these proportions must equal one. Since these proportions represent the MPC, MPIM and MPS, we know that the sum of these marginal propensities must equal 1.

Chapter 7

1. The marginal tax rate represents how much one's taxes increase for a given change in income. The average tax rate is simply the ratio of the total level of taxes to total income.

3. A change in lump-sum taxes causes an equal change in disposable income and aggregate expenditures (via consumption) at each level of income. Hence, the aggregate expenditures schedule shifts when lump-sum taxes change. A cut in the income tax rate will cause the aggregate expenditures schedule to become steeper. With a lower tax rate, a given change in total income now has a greater effect on disposable income and, therefore, on consumption. Hence, a given increase in income now has a greater effect on aggregate expenditures. The aggregate expenditures schedule is steeper to reflect this.

5. If the Ricardian equivalence proposition holds, we should observe increases in saving when budget deficits increase. Individuals, realizing that increases in budget deficits today will cause increases in taxes in the future, will increase saving today. During the 1980's, we observed increases in budget deficits and reductions in saving rates. This observation tends to refute the predictions of the Ricardian equivalence proposition.

Chapter 8

1. Answers will vary. The LM curve represents the combinations of the nominal interest rate and level of real income that maintain equilibrium in the money market. An increase in y will cause an increase in both the transactions and precautionary demand for money. At the initial interest rate, there will exist an excess demand for money. Equivalently, there will exist an excess supply of bonds. Bond prices will fall and the interest rate will increase. The interest rate will continue to increase until equilibrium is restored. Hence, an increase in output requires an increase in the nominal interest rate to maintain equilibrium. Therefore, the LM curve is upward sloping.

Changes in y will only cause movements along the LM curve. Given the definition and construction of the LM curve, the effects of changes in y on the money market are already incorporated in the shape of the LM curve. The LM curve will shift when the real supply of money changes or when exogenous changes in money demand occur.

3. If the economy is operating on both the IS and LM curves, we know that both the goods market and money market are in equilibrium. We also know that there will be no pressure for firms to change output (since actual investment equals desired investment). We also know that there will be no pressure for the interest rate to change since the money market and bond market are in equilibrium. When the economy is operating at a point of IS-LM equilibrium, there is no pressure for either r or y to change.

Chapter 9

1. An appreciation makes domestic goods relatively more expensive. Therefore, exports fall and imports rise. This will cause a reduction in demand and a leftward shift in the IS curve. With an appreciation, net exports will fall causing, all else fixed, a BP deficit. To maintain BP equilibrium, either y must fall (to cause imports to fall to offset the initial reduction in net exports) or the domestic interest rate must rise to cause a capital inflow. Either explanation indicates that an appreciation causes the BP curve to shift to the left (or up).

3. Regardless of the degree of capital mobility, the economy would return to its original level of income and interest rate. Suppose the monetary contraction causes a private payments surplus. This would be represented by an increase in the demand for the domestic currency. To prevent the appreciation of the domestic currency, the central bank would have to buy foreign currency and, therefore, increase it foreign exchange reserves. As it does this AND does not sterilize, the money supply will increase. This continues to occur until the private payments surplus is eliminated. In short, the LM shifts left and then returns to its original position.

5. Regardless of the degree of capital mobility, the monetary contraction will initially cause a private payments surplus. This surplus will cause an appreciation of the domestic currency. For example, in the United States, the dollar would appreciate. As the dollar appreciates, both the IS and BP schedules adjust causing the private payments surplus to disappear.

Chapter 10

1. Aggregate demand in the classical model is a special case of aggregate demand in the Keynesian model. Specifically, money demand is independent of the interest rate in the classical model. Using the IS-LM model, any increase in government spending will have no effect on equilibrium income when the LM curve is vertical. Therefore, changes in g have no effect on aggregate demand when money demand is independent of the interest rate. Alternatively, there is complete crowding out in the classical model preventing any shift in the aggregate demand schedule. In the Keynesian model, money demand is a function of the interest rate. Consequently, the LM curve is upward sloping and changes in g do cause changes in equilibrium real income. So, changes in g do cause changes in aggregate demand in the Keynesian model.

3. parts (a) and (b). The answer to this question can be illustrated using one graph and two different BP curves. In the low mobility case, a BP deficit will occur that will cause a depreciation and further stimulate output. In the high mobility case, a BP surplus will occur causing an appreciation. This appreciation will cause net exports to fall and partially offset the effects of the increase in g on y and, therefore, on aggregate demand.

5. A reduction in the expected price level will cause labor supply to increase (i.e., shift to the right). For any given price level, this rightward shift in labor supply will result in an increase in employment and, therefore, an increase in output. In terms of the aggregate supply curve, this reduction in the expected price level indicates that the level of output will be higher at each price level. In short, the aggregate supply schedule shifts to the right when the expected price level falls. See the graph below. Note: NS' and yS' refer to the labor supply and aggregate supply schedules which correspond to the lower expected price level. To save space, I have omitted the graph of the aggregate production function.

7. The views are clearly not affected by the classical model since changes in the money supply will have no real effects in the classical model (i.e., the Fed cannot affect output in that model). We should note that in both the Keynesian and monetarist models the Fed can affect output in the short-run. Therefore, the implicit assumption in these views (i.e., that the Fed can affect real economic activity) is consistent with both the Keynesian and monetarist theories. The views are most likely swayed by the Keynesian theory since the individual is concerned with the Fed's policy negatively affecting output in the short-run (and long-run). An individual influenced by the monetarist theory would understand that Fed actions will have no effect on output in the long-run.