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10. Stagflationwasacombinationofstagnation(highunemployment)andinflationinthe
1970s.ItchangedeconomistsviewsbecausetheKeynesianapproachcouldntexplain
stagflationsatisfactorily.
11,712.5
1,178.1
1,791.4
2,001.0
2,383.0
12,455.8
1,303.1
2,019.9
2,246.8
2,555.9
13,008.4
1,405.4
2,170.6
2,473.2
2,637.9
10.1%
15.3%
5.2%
10.5%
16.2%
5.8%
10.8%
16.7%
5.9%
17.1%
20.3%
3.3%
18.0%
20.5%
2.5%
19.0%
20.3%
1.3%
a.
Exports/GDP
Imports/GDP
Tradeimbalance/GDP
b.
Federalreceipts/GDP
Federalexpenditures/GDP
Deficit/GDP
4. (a) Positive.Thisstatementtellswhatwillhappen,notwhatshouldhappen.
(b) Positive.Eventhoughitisaboutincomedistributionissues,itisastatementoffact,not
opinion.IfthestatementsaidThepayrolltaxshouldbereducedbecauseit...,thenit
wouldbeanormativestatement.
(c) Normative.Sayingtaxesaretoohighsuggeststhattheyshouldbelower.
(d) Positive.Sayswhatwillhappenasaconsequenceofanaction,notwhatshouldbedone.
(e) Normative.Thisisastatementofpreferenceaboutpolicies.
Chapter2
Chapter 2 Review Questions
1. Thethreeapproachestonationalincomeaccountingaretheproductapproach,theincome
approach,andtheexpenditureapproach.Theyallgivethesameanswerbecausetheyare
designedthatway;anyentrybasedononeapproachhasanentryintheotherapproaches
withthesamevalue.Wheneveroutputisproducedandsold,itsproductioniscountedinthe
productapproach,itssaleiscountedintheexpenditureapproach,andthefundsreceivedby
thesellerarecountedintheincomeapproach.
3. Intermediategoodsandservicesareusedupinproducingothergoodsinthesameperiod
(year)inwhichtheywereproduced,whilefinalgoodsandservicesarethosethatare
purchasedbyconsumersorarecapitalgoodsthatareusedtoproducefutureoutput.The
distinctionisimportant,becausewewanttocountonlythevalueoffinalgoodsproducedin
theeconomy,notthevalueofgoodsproducedeachstepalongtheway.
4. GNPisthemarketvalueoffinalgoodsandservicesnewlyproducedbydomesticfactorsof
productionduringthecurrentperiod,whereasGDPisproductiontakingplacewithina
country.
Thus,GNPdiffersfromGDPwhenforeignfactorsareusedtoproduceoutputinacountry,
orwhendomesticfactorsareusedtoproduceoutputinanothercountry.GDPGNPNFP,
whereNFPnetfactorpaymentsfromabroad,whichequalsincomepaidtodomestic
factorsofproductionbytherestoftheworldminusincomepaidtoforeignfactorsof
productionbythedomesticeconomy.Acountrythatemploysmanyforeignworkerswill
likelyhavenegativeNFP,soGDPwillbehigherthanGNP.
5. Thefourcomponentsofspendingareconsumption,investment,governmentpurchases,and
netexports.Importsmustbesubtracted,becausetheyareproducedabroadandwewant
GDPtocountonlythosegoodsandservicesproducedwithinthecountry.Forexample,
supposeacarbuiltin
JapanisimportedintotheUnitedStates.ThecarcountsasconsumptionspendinginU.S.
GDP,butissubtractedasanimportaswell,soonnetitdoesnotaffectU.S.GDP.However,
itiscountedinJapansGDPasanexport.
7. Nationalwealthisthetotalwealthoftheresidentsofacountry,andconsistsofitsdomestic
physicalassetsandnetforeignassets.Wealthisimportantbecausethelongruneconomic
wellbeingofacountrydependsonit.Nationalwealthisrelatedtonationalsavingbecause
nationalsavingistheflowofadditionstothestockofnationalwealth.
8. RealGDPistheusefulconceptforfiguringoutacountrysgrowthperformance.Nominal
GDPmayrisebecauseofincreasesinpricesratherthangrowthinrealoutput.
9. TheCPIisapriceindexthatiscalculatedasthevalueofafixedsetofconsumergoodsand
servicesatcurrentpricesdividedbythevalueofthefixedsetatbaseyearprices.CPI
inflationisthegrowthrateoftheCPI.CPIinflationoverstatestrueinflationbecauseitis
hardtomeasurechangesinquality,andbecausethepriceindexdoesntaccountfor
substitutionawayfromgoodsthatbecomerelativelymoreexpensivetowardsgoodsthat
becomerelativelycheaper.
10. Thenominalinterestrateistherateatwhichthenominal(ordollar)valueofanassetincreases
overtime.Therealinterestrateistherateatwhichtherealvalueorpurchasingpowerofan
assetincreasesovertime,andisequaltothenominalinterestrateminustheinflationrate.The
expectedrealinterestrateistherateatwhichtherealvalueofanassetisexpectedtoincrease
overtime.Itisequaltothenominalinterestrateminustheexpectedinflationrate.Theconcept
thatismostimportanttoborrowersandlendersistheexpectedrealinterestrate,becauseit
affectstheirdecisionstoborroworlend.
5.
(a) FurnituremadeinNorthCarolinathatisboughtbyconsumerscountsasconsumption,
soconsumptionincreasesby$6billion,investmentisunchanged,governmentpurchases
areunchanged,netexportsareunchanged,andGDPincreasesby$6billion.
(b) FurnituremadeinSwedenthatisboughtbyconsumerscountsasconsumptionand
imports,
soconsumptionincreasesby$6billion,investmentisunchanged,governmentpurchases
areunchanged,netexportsfallby$6billion,andGDPisunchanged.
(c) FurnituremadeinNorthCarolinathatisboughtbybusinessescountsasinvestment,
soconsumptionisunchanged,investmentincreasesby$6billion,governmentpurchases
areunchanged,netexportsareunchanged,andGDPincreasesby$6billion.
(d) FurnituremadeinSwedenthatisboughtbybusinessescountsasinvestmentand
imports,
soconsumptionisunchanged,investmentincreasesby$6billion,governmentpurchases
areunchanged,netexportsdeclineby$6billion,andGDPisunchanged.
Givendata:I40,G30,GNP200,CA20NXNFP,T60,TR25,INT15,
NFP
792.SinceGDPGNPNFP,GDP200(2)202Y.SinceNXNFPCA,
NXCANFP20(2)18.SinceYCIGNX,CY(IGNX)202
(4030(18))150.
Spvt(YNFPTTRINT)C(202(2)602515)15030.Sgovt(TTR
INT)G(602515)3010.SSpvtSgovt30(10)20.
(a) Consumption150
(b) Netexports18
(c) GDP202
(d) Netfactorpaymentsfromabroad2
(e) Privatesaving30
(f) Governmentsaving10
(g) Nationalsaving20
6.
Baseyearquantitiesatcurrentyearprices
Apples
Bananas
Oranges
Total
3000$3$9,000
6000$2$12,000
8000$5$40,000
$61,000
Currentyearquantitiesatcurrentyearprices
Apples
Bananas
Oranges
Total
4,000$3$12,000
14,000$2$28,000
32,000$5$160,000
$200,000
atbaseyearprices
3000$2$6,000
6000$3$18,000
8000$4$32,000
$56,000
atbaseyearprices
4,000$2$8,000
14,000$3$42,000
32,000$4$128,000
$178,000
(a) NominalGDPisjustthedollarvalueofproductioninayearatpricesinthatyear.
NominalGDPis$56thousandinthebaseyearand$200thousandinthecurrentyear.
NominalGDPgrew257%betweenthebaseyearandthecurrentyear:
[($200,000/$56,000)1]100%257%.
(b) RealGDPiscalculatedbyfindingthevalueofproductionineachyearatbaseyear
prices.
Thus,fromthetableabove,realGDPis$56,000inthebaseyearand$178,000inthe
currentyear.Inpercentageterms,realGDPincreasesfromthebaseyeartothecurrent
yearby
[($178,000/$56,000)1]100%218%.
(c) TheGDPdeflatoristheratioofnominalGDPtorealGDP.Inthebaseyear,nominal
GDPequalsrealGDP,sotheGDPdeflatoris1.Inthecurrentyear,theGDPdeflatoris
$200,000/$178,0001.124.ThustheGDPdeflatorchangesby[(1.124/1)1]100%
12.4%fromthebaseyeartothecurrentyear.
(d) NominalGDProse257%,pricesrose12.4%,andrealGDProse218%,somostofthe
increaseinnominalGDPisbecauseoftheincreaseinrealoutput,notprices.Noticethat
thequantityoforangesquadrupledandthequantityofbananasmorethandoubled.
7.
Calculatinginflationrates:
192930:[(50.0/51.3)1]100%2.5%
193031:[(45.6/50.0)1]100%8.8%
193132:[(40.9/45.6)1]100%10.3%
193233:[(38.8/40.9)1]100%5.1%
Theseallshowdeflation(pricesaredecliningovertime),whereasrecentlywehavehad
nothingbutinflation(pricesrisingovertime).
8.
Thenominalinterestrateis[(545/500)1]100%9%.Theinflationrateis[(214/200)
1]100%7%.Sotherealinterestrateis2%(9%nominalrate7%inflationrate).
Expectedinflationwasonly[(210/200)1]100%5%,sotheexpectedrealinterestrate
was4%(9%nominalrate5%expectedinflationrate).
NationalsavingdoesnotrisebecauseoftheswitchtoCheapCallbecausealthough
consumptionspendingdeclinesby$2million,sohavetotalexpenditures(GDP),which
equaltotalincome.Sinceincomeandspendingbothdeclinedbythesameamount,national
savingisunchanged.
3.
(a) Theprobleminaplannedeconomyisthatpricesdonotmeasuremarketvalue.When
thepriceofanitemistoolow,thengoodsarereallymoreexpensivethantheirlisted
pricesuggestsweshouldincludeintheirmarketvaluethevalueoftimespentby
consumerswaitingtomakepurchases.Becausetheitemsvalueexceedsitscost,
measuredGDPistoolow.
Whenthepriceofanitemistoohigh,goodsstockedontheshelvesmaybevaluedtoo
highly.Thisresultsinanovervaluationoffirmsinventories,sothatmeasuredGDPis
toohigh.
ApossiblestrategyfordealingwiththisproblemistohaveGDPanalystsestimatewhat
themarketpriceshouldbe(perhapsbylookingatpricesofthesamegoodsinmarket
economies)andusethisshadowpriceintheGDPcalculations.
(b) ThegoodsandservicesthatpeopleproduceathomearenotcountedintheGDPfigures
becausetheyarenotsoldonthemarket,makingtheirvaluedifficulttomeasure.One
waytodoitmightbetolookatthestandardoflivingrelativetoamarketeconomy,and
estimatewhatincomeitwouldtakeinamarketeconomytosupportthatstandardof
living.
Chapter 3 Answers
Chapter 3 Review Questions
1. Aproductionfunctionshowshowmuchoutputcanbeproducedwithagivenamountof
capitalandlabor.Theproductionfunctioncanshiftduetosupplyshocks,whichaffect
overallproductivity.Examplesincludechangesinenergysupplies,technological
breakthroughs,andmanagementpractices.Besidesknowingtheproductionfunction,you
mustalsoknowthequantitiesofcapitalandlabortheeconomyhas.
2. Theupwardslopeoftheproductionfunctionmeansthatanyadditionalinputsofcapitalor
laborproducemoreoutput.Thefactthattheslopedeclinesaswemovefromlefttoright
illustratestheideaofdiminishingmarginalproductivity.Forafixedamountofcapital,
additionalworkerseachaddlessadditionaloutputasthenumberofworkersincreases.Fora
fixednumberofworkers,additionalcapitaladdslessadditionaloutputastheamountof
capitalincreases.
3. Themarginalproductofcapital(MPK)istheoutputproducedperunitofadditionalcapital.
TheMPKcanbeshowngraphicallyusingtheproductionfunction.Forafixedleveloflabor,
plottheoutputprovidedbydifferentlevelsofcapital;thisistheproductionfunction.The
MPKisjusttheslopeoftheproductionfunction.
4. Themarginalrevenueproductoflaborrepresentsthebenefittoafirmofhiringanadditional
worker,whilethenominalwageisthecost.Comparingthebenefittothecost,thefirmwill
hireadditionalworkersaslongasthemarginalrevenueproductoflaborexceedsthenominal
wage,sincedoingsoincreasesprofits.Profitswillbeattheirhighestwhenthemarginal
revenueproductoflaborjustequalsthenominalwage.
Thesameconditioncanbeexpressedinrealtermsbydividingthroughbythepriceofthe
good.Themarginalrevenueproductoflaborequalsthemarginalproductoflabortimesthe
priceofthegood.Thenominalwageequalstherealwagetimesthepriceofthegood.
Dividingeachofthesethroughbythepriceofthegoodmeansthatanequivalentprofit
maximizingconditionisthemarginalproductoflaborequalstherealwage.
5. TheMPNcurveshowsthemarginalproductoflaborateachlevelofemployment.Itis
relatedtotheproductionfunctionbecausethemarginalproductoflaborisequaltotheslope
oftheproductionfunction(whereoutputisplottedagainstemployment).TheMPNcurveis
relatedtolabordemand,becausefirmshireworkersuptothepointatwhichtherealwage
equalsthemarginalproductoflabor.SothelabordemandcurveisidenticaltotheMPN
curve,exceptthattheverticalaxisistherealwageinsteadofthemarginalproductoflabor.
6. Atemporaryincreaseintherealwageincreasestheamountoflaborsuppliedbecausethe
substitutioneffectislargerthantheincomeeffect.Thesubstitutioneffectarisesbecausea
higherrealwageraisesthebenefitofadditionalworkforaworker.Theincomeeffectis
smallbecausetheincreaseintherealwageistemporary,soitdoesntchangetheworkers
incomeverymuch,thustheworkerwontreducetimespentworkingverymuch.
Apermanentincreaseintherealwage,however,hasamuchlargerincomeeffect,sincea
workerslifetimeincomeischangedsignificantly.Theincomeeffectmaybesolargethatit
exceedsthesubstitutioneffect,causingtheworkertoreducetimespentworking.
7. Theaggregatelaborsupplycurverelateslaborsupplyandtherealwage.Theprincipal
factorsshiftingtheaggregatelaborsupplycurvearewealth,theexpectedfuturerealwage,
thecountrysworkingagepopulation,orchangesinthesocialorlegalenvironmentthatlead
tochangesinlaborforceparticipation.Increasesinwealthortheexpectedfuturerealwage
shifttheaggregatelaborsupplycurvetotheleft.Increasesintheworkingagepopulationor
inlaborforceparticipationshifttheaggregatelaborsupplycurvetotheright.
8. Fullemploymentoutputisthelevelofoutputthatfirmssupplywhenwagesandpricesinthe
economyhavefullyadjusted;intheclassicalmodelofthelabormarket,thisoccurswhenthe
labormarketisinequilibrium.Whenlaborsupplyincreases,fullemploymentoutput
increases,asthereisnowmorelaboravailabletoproduceoutput.Whenabeneficialsupply
shockoccurs,thenthesamequantitiesoflaborandcapitalproducemoreoutput,sofull
employmentoutputrises.Furthermore,
abeneficialsupplyshockincreasesthedemandforlaborateachrealwageandleadstoan
increaseintheequilibriumlevelofemployment,whichalsoincreasesoutput.
9. Theclassicalmodelofthelabormarketassumesthatanyworkerwhowantstoworkatthe
equilibriumrealwagecanfindajob,soitisnotveryusefulforstudyingunemployment.
10. Thelaborforceconsistsofallemployedandunemployedworkers.Theunemploymentrateisthe
fractionofthelaborforcethatisunemployed.Theparticipationrateisthefractionoftheadult
populationthatisinthelaborforce.Theemploymentratioisthefractionoftheadultpopulation
thatisemployed.
11. Anunemploymentspellisaperiodoftimethatapersoniscontinuouslyunemployed.
Durationisthelengthoftimeofanunemploymentspell.Twoseeminglycontradictoryfacts
arethatmostunemploymentspellshaveashortdurationandthatmostpeoplewhoare
unemployedataparticulartimeareexperiencingspellswithlongdurations.Thesecanbe
reconciledbyrealizingthattheremaybealotofpeoplewithshortspellsandafewpeople
withlongspells.Onanygivendate,asurveyfindsafairlylongaveragedurationforthe
unemployed,becauseofthepeoplewithlongspells.Forexample,supposethateachweek
onepersonbecomesunemployedforoneweek,sotherearefiftytwosuchshort
unemploymentspellsduringtheyear.Andsupposethattherearefourpeoplewhoare
unemployedallyear,sotherearefourlongunemploymentspellsduringtheyear.Inany
givenweekfivepeopleareunemployed:oneunemployedpersonhasaspellofoneweek,
whilefourhavespellsofayear.Somostspellshaveashortduration(fiftytwoshortspells
comparedtofourlongspells),butmostpeoplewhoareunemployedatagiventimeare
experiencingspellswithlongduration(oneshortspellcomparedtofourlongspells).
12. Frictionalunemploymentarisesasworkersandfirmssearchtofindmatches.Acertain
amountoffrictionalunemploymentisnecessary,becauseitisnotalwayspossibletofindthe
rightmatchrightaway.Forexample,anunemployedbankermaynotwanttotakeajob
flippinghamburgersifheorshecannotfindanotherbankingjobrightaway,becausethe
matchwouldbeverypoor.Byremainingunemployedandcontinuingtosearchforamore
suitablejob,thebankerislikelytomakeabettermatch.Thatwillbebetterbothforthe
banker(sincethesalaryislikelytobehigher)andforsocietyasawhole(sincethebetter
matchmeansgreaterproductivityintheeconomy).
13. Structuralunemploymentoccurswhenpeoplesufferlongspellsofunemploymentorare
chronicallyunemployed(withmanyspellsofunemployment).Structuralunemployment
ariseswhenthenumberofpotentialworkerswithlowskilllevelsexceedsthenumberofjobs
requiringlowskilllevels,orwhentheeconomyundergoesstructuralchange,whenworkers
wholosetheirjobsinshrinkingindustriesmayhavedifficultyfindingnewjobs.
14. Thenaturalrateofunemploymentistherateofunemploymentthatprevailswhenoutputand
employmentareattheirfullemploymentlevels.Thenaturalrateofunemploymentisequal
totheamountoffrictionalunemploymentplusstructuralunemployment.Cyclical
unemploymentisthedifferencebetweentheactualrateofunemploymentandthenatural
rateofunemployment.Whencyclicalunemploymentisnegative,outputandemployment
exceedtheirfullemploymentlevels.
15. OkunsLawisaruleofthumbthattellshowmuchoutputfallswhentheunemploymentrate
rises.Itiswritteneitherintermsofthelevelsofoutputandunemployment,asinEq.(3.5),(
Y Y)/ Y 2
(u u ),orintermsofchangesinoutputandunemployment,asinEq.(3.6),Y/Y32
u.SincetheOkunslawcoefficientis2,a2percentagepointincreaseintheunemployment
ratecausesoutputtodeclineby4%.
(a)
N
1
2
3
4
5
6
Y
8
15
21
26
30
33
MPN
8
7
6
5
4
3
MRPN(P 5)
40
35
30
25
20
15
MRPN(P 10)
80
70
60
50
40
30
(b) P$5.
(1) W$38.Hireoneworker,sinceMRPN($40)isgreaterthanW($38)atN1.Do
nothiretwoworkers,sinceMRPN($35)islessthanW($38)atN2.
(2) W$27.Hirethreeworkers,sinceMRPN($30)isgreaterthanW($27)atN3.Do
nothirefourworkers,sinceMRPN($25)islessthanW($27)atN4.
(3) W$22.Hirefourworkers,sinceMRPN($25)isgreaterthanW($22)atN4.Do
nothirefiveworkers,sinceMRPN($20)islessthanW($22)atN5.
(c) Figure3.10plotstherelationshipbetweenlabordemandandthenominalwage.This
graphisdifferentfromalabordemandcurvebecausealabordemandcurveshowsthe
relationshipbetweenlabordemandandtherealwage.Figure3.11showsthelabor
demandcurve.
Figure 3.10
Figure 3.11
(d) P$10.ThetableinpartashowstheMRPNforeachN.AtW$38,thefirmshould
hirefiveworkers.MRPN($40)isgreaterthanW($38)atN5.Thefirmshouldnthire
sixworkers,sinceMRPN($30)islessthanW($38)atN6.Withfiveworkers,output
is30widgets,comparedto8widgetsinpartawhenthefirmhiredonlyoneworker.So
theincreaseinthepriceoftheproductincreasesthefirmslabordemandandoutput.
(e) Ifoutputdoubles,MPNdoubles,soMRPNdoubles.TheMRPNisthesameasitwasin
partdwhenthepricedoubled.Solabordemandisthesameasitwasinpartd.Butthe
outputproducedbyfiveworkersnowdoublesto60widgets.
(f) SinceMRPNPMPN,thenadoublingofeitherPorMPNleadstoadoublingof
MRPN.SincelabordemandischosenbysettingMRPNequaltoW,thechoiceisthe
same,whether
PdoublesorMPNdoubles.
5.
(a) Ifthelumpsumtaxisincreased,theresanincomeeffectonlaborsupply,nota
substitutioneffect(sincetherealwageisntchanged).Anincreaseinthelumpsumtax
reducesaworkerswealth,solaborsupplyincreases.
(b) IfT35,thenNS2212w(235)9212w.LabordemandisgivenbywMPN
3092N,or2N309w,soN154.5w/2.Settinglaborsupplyequaltolabordemand
gives154.5w/29212w,so62.512.5w,thusw62.5/12.55.Withw5,N92
(125)152.
(c) Sincetheequilibriumrealwageisbelowtheminimumwage,theminimumwageis
binding.Withw7,N154.57/2151.0.NotethatNS92(127)176,soNS
>Nandthereisunemployment.
7.
(a) Atanydate,25peopleareunemployed:5whohavelosttheirjobsatthestartofthemonth
and20whohavelosttheirjobseitheronJanuary1orJuly1.Theunemploymentrateis
25/5005%.
(b) Eachmonth,5peoplehaveonemonthspells.Everysixmonths,20peoplehavesix
monthspells.Thetotalnumberofspellsduringtheyearis(512)(202)100.
Sixtyofthespells(60%ofallspells)lastonemonth,while40ofthespells(40%ofall
spells)lastsixmonths.
(c) Theaveragedurationofaspellis(0.601month)(0.406months)3months.
(d) Onanygivendate,thereare25peopleunemployed.Twentyofthem(80%)havelong
spellsofunemployment,while5ofthem(20%)haveshortspells.
(a) Anincreaseinthenumberofimmigrantsincreasesthelaborforce,increasing
employmentandincreasingfullemploymentoutput.
(b) Ifenergysuppliesbecomedepleted,thisislikelytoreduceproductivity,becauseenergy
isafactorofproduction.Sothereductioninenergysuppliesreducesfullemployment
output.
(c) Bettereducationraisesfutureproductivityandoutput,buthasnoeffectoncurrentfull
employmentoutput.
(d) Thisreductioninthecapitalstockreducesfullemploymentoutput(althoughitmayvery
wellincreasewelfare).