Book Solution Economics N Gregory Mankiw Mark P Taylor All Problems en Applications PDF

 

 

Problems and Applications

1.

2.

a.

A family deciding whether to buy a new car faces a trade-off between the cost of the car and other things they might want to buy. For example, buying the car might mean they must give up going going on vacation for the next two two years. So the real cost of the car is the family's opportunity cost in terms of what they must give up.

b.

For a member of the government deciding whether to increase spending on a new national football stadium, the trade-off is between the stadium and other spending items or tax cuts. If money is spent on the stadium, that may mean less spending on national defence or on the police force. Or, instead of spending more money on the stadium, taxes could be reduced.

c.

When a company chief executive decides whether to open a new factory, the decision is based on whether the new factory will increase the firm's profits compared to other alternatives. For example, the company could upgrade existing equipment or expand existing factories. The crucial question is: which method of expanding production production will increase profit the most?

d.

In deciding how much to prepare for a lecture, a lecturer faces a trade-off between the value of improving the quality of the lecture compared to other things she could do with her time, such as working on additional research.

When the benefits of something are psychological, such as going on a vacation, it isn't easy to compare benefits to costs to determine if it's worth doing. But there are two ways to think about theon benefi benefits. ts. One is toyou compare the vacation what would do inThen its place. If you ydecide ou didn't go vacation, vacation, would buy something like with a new setyou of golf clubs? you can if you'd rather have the new clubs or the vacation. A second way is to think about how much work you had to do to earn the money to pay for the vacation; then you can decide if the psychological benefits of the vacation were worth the psychological cost of working.

3.

If you are thinking of going to the football match instead of working at your part-time job, the cost of attending the game includes its monetary and time costs, which includes the opportunity opportunit y cost of the wages you are giving up by not working. If the choice is between going to the match and going to the library to study, then the cost of watching the match is its monetary and time costs, including the cost to you of getting a lower grade in your course.

4.

If you spend €1,000 now instead of saving it for a year and earning 5 percent interest, you are giving up the opportunity to spend €1,050 a year yea r from from now. The idea that money has a time value is the basis for the field of finance, the subfield of economics that has to do with prices of financial instruments like stocks and bonds.

5.

The fact that you've already sunk €5 million isn't relevant relevan t to your decision anymore, since that money is gone. What m matters atters now is the chance to earn profits profits at the margin. margin. If you spend another €1 million and can generate sales of €3 million, you'll earn €2 million in marginal profit, profit, so you should do so. You are right to think that the project has lost a total of €3 million (it’s going to generate €6 million in costs and only €3 million in revenue) and you shouldn't have started it. That's true, but if you don't spend the additional additional €1 million, you won't have any sales and your losses will be €5 million. So what matters is not the total profit, profit, but the profit you can earn at the margin. In fact, you'd you'd pay up to €3 million to complete development; any more than that, and you won't be increasing profit at the margin.

6.

The first witch suggests looking at whether productivity would rise or fall. Productivity is certainly important, since the more productive workers are, the lower the cost per gallon of potion. ⎯The second witch to to look at average average cost. . But are missing missin g the other sicosts de ofand the equation revenue. A firmwants wants maximize its cost profits, so both it needs to examine both side revenues. So the third witch is right⎯it’s best to examine whether the extra ex tra revenue would exceed the extra costs. The third witch is the only one who is thinking at the margin.

 

  14  Chapter 1/Ten Principles of Economics

7.

a.

The provision of social security benefits lowers an individual’s incentive to  save for retirement. The benefits provide some level of income to the individual when he or she retires. This means that the individual is not entirely dependent on savings to support consumption through the years in retirement.

b.

A person gets less social security benefits the greater are his or her earnings. So there is an incentive not to work (or not not work as much) after age 65. The more you work, the lower your social security benefits will be. Thus the reduction of social security benefits discourages work effort after age 65.

8.

By specializing in each task, you and your flat-mate can finish the chores more quickly. If you divided each task equally, it would take you more time to cook than it would take your roommate, and it would take him more time to clean th than an it would take you. By specializing, you reduce the total time spent on chores. Similarly, countries can specialize specialize and trade, making both better off. For example, suppose it takes Spanish workers less time to make clothes than tha n French workers, and French workers can ma make ke wine more efficiently than Spanish workers. Then Spain and France can both benefit if Spanish workers produce all the clothes and French workers produce all the wine, and they exchange some wine for some clothes.

9.

a.

Being a central planner is tough! To produce the right number of DVDs by the right artists deliver them to the right people and requires amount ofYou information. You need toand know know about production techniques costsaninenormous the DVD industry. need to know each person's musical tastes and which artists they they want to hear. If you make the wrong decisions, you'll be producing too many DVDs by artists that people don't want to hear, and not enough by others.

10.

b.

Your decisions about how many DVDs to produce carry over to other decisions. You have to make the right right number of DVD players for for people to use. If you make too many DVDs and not enough cassette tapes, people with cassette players will be stuck with DVDs they can't play. The probability of making making mi mistakes stakes is very high. You will also be be faced with tough choices about the music industry compared to other parts of the economy. If you produce more sports equipment, you'll have fewer resources for making DVDs. So all decisions about the economy influence your decisions decisions about DVD production.

a.

Efficiency. The market failure comes from the monopoly power of water companies.

b.

Efficiency. The market failure comes from the monopoly power of electricity companies. (Though there nay be competition between electricity generating companies, there is much less likelihood of competition between electricity transmission and supply companies.)

c.

Equity.

d.

Efficiency. An externality arises because second-hand smoke harms non-smokers.

e.

Equity.

f.

Efficiency: There is an externality because of accidents caused by drivers driving under the influence of alcohol. Economics, 2nd edition N. Gregory Mankiw and Mark P. Taylor ISBN 978-1-84480-870-0 © 2011 Cengage Learning EMEA

 

  Chapter 1/Ten Principles of Economics

11.

a.

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If everyone were guaranteed the best health care possible, much more of society’s  society’s   resources would be devoted to providing health care than is now the case. Would that be efficient? If you think that currently doctors form a monopoly and restrict health care to keep their incomes high, you might think efficiency would increase by providing more health care. care. But more likely, if the government mandated increased spending on health care, the economy would be less efficient because it would give people more health care than they would choose to pay for. From the point of view of equity, if poor people are less likely to have adequate health care, providing more health care would represent an improvement. Each person would have a more more even slice of the the economic pie, though the pie would consist of more health care and less of other goods.

b.

When workers are laid off, equity considerations argue for the unemployment benefits system to provide provide them with some income until they can find new jobs. After all, no one plans to be laid off, so so unemployment benefits are a form of insurance. But there’s an efficiency problem⎯why work if you can get income for doing nothing? The economy isn’t operating efficiently if people remain unemployed for a long time, and unemployment benefits encourage encourage unemployment. Thus, there’s a trade-off trade-off between equity and efficiency. The more generous are unemployment benefits, the less income is lost by an unemployed person, but the more that person is encouraged to remain unemployed. So greater equity reduces efficiency.

12.

Since average Western European countries increased greatly the better past standard century, we areincome likely toinhave a better standard of livinghas than o ur parents, our andover a much of living than our grandparents. This is mainly the result of increased productivity, so that an hour of work produces more goods and services than it used to. Thus incomes have continuously risen over time, as has the standard of living.

13.

If Europeans save more and it leads to more spending on factories, there will be an increase in production and productivity, since the same number of workers will have more equipment to work with. The benefits from higher productivity will go to both the workers, who will get paid more since they're producing more, and the factory owners, who will get a return on their investments. There is no such thing as a free lunch, however, because when people save more, they are giving up spending. They get higher incomes at the cost of buying fewer goods.

14.

To make an intelligent decision about whether to reduce inflation, a policy maker would need to know what causes inflation and unemployment, as well as what determines the trade-off between them. Any attempt to reduce inflation may be expected to lead to higher unemployment in the short run. A policy maker thus thus faces a trade-off trade-off between the benefits of lower inflation compared to the cost of higher unemployment.

Economics, 2nd edition N. Gregory Mankiw and Mark P. Taylor ISBN 978-1-84480-870-0 © 2011 Cengage Learning EMEA

 

 

Problems and Applications

1.

a.

Drought damages the olive crop, reducing the supply of olives. This can be seen in Figure 6 as a shift to the left in the supply curve for olives. The new equilibrium price is higher than the old equilibrium price

 

 

b

Figure 6 The Olympic Games attracted a lot of extra visitors to Athens and they all needed somewhere somewhe re to stay during their their visit. So the the demand for hotel rooms in Athens increased. The The result, as shown in Figure 7, is a shift to the right in the demand curve. The equilibrium price of Athenian hotel roo ms was thus higher when the Olympics were taking place, as the figure shows.

Figure 7

c.

When a war breaks out in the Middle East, many markets are affected. Since much oil production takes place there, the war disrupts oil supplies, shifting the supply curve for petrol to the left, as shown in Figure 8. The result is a rise in the equilibrium price of petrol. With a higher higher price for for petrol, the cost cost of operating operating a pe trol -guzzling -guzzling car, like like a Mercedes, will increase. As a result, the demand for used Mercedes will decline, as people in the market for cars w ill not find M ercedes as attractive as before. In addition, some people who already own Mercedes will try to sell them. The result is that the demand curve for used Mercedes shifts to the left, while the supply curve shifts to the th e right, as shown in Figure 9. The result is a decline in the equilibrium price of used Mercedes.

Economics, 2nd edition N. Gregory Mankiw and Mark P. Taylor ISBN 978-1-84480-870-0 © 2011 Cengage Learning EMEA

 

  26

 Chapter 4/The Market Forces of Supply and Demand

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Figure 8

2.

Figure 9

The statement that "an increase in the demand for mozzarella raises the quantity of mozzarella demanded, but not the quantity supplied," in general, is false. As Figure 10 shows, the increase in demand for mozzarella results results in an increased increased quantity supplied. The only way the statement would be true is if the supply curve was a vertical line, as shown in Figure 11.

Figure 10

Economics, 2nd edition N. Gregory Mankiw and Mark P. Taylor ISBN 978-1-84480-870-0 © 2011 Cengage Learning EMEA

 

  Chapter 4/The Market Forces of Supply and Demand

3.

a.

Figure 11 If people decide to have more children (a change in tastes), they will want larger vehicles

for carrying their children around, so the demand demand for large family saloon saloon cars will increase. Supply won't be affected. The result is a rise in both price and quantity, as Figure 12 shows.

b

 27



Figure 12 If a strike by steelworkers raises steel prices, the cost of producing a car rises (a rise in input prices), so the supply of family cars decreases. Demand won't be affected. The result is a rise in the price of family cars and a decline in the quantity, as Figure 13 shows.

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  28

 Chapter 4/The Market Forces of Supply and Demand

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Figure 13

c.

The development of new automated mach inery for the production of cars is an improvement improv ement in technology. technology. The reduction in firms' costs resul results ts in an increase in supply. Demand isn't affected. The result result is a decline decline in the price price of family cars and and an increase in the quantity, as Figure 14 shows.

Figure 14 d.

The rise in the price of estate cars affects minivan demand because estate cars are substitutes for large family saloons (that is, there is a rise in the price of a related good). The result result is an increase increase in demand for for family family ssaloon aloon cars. cars. Supply is not affected. In nd Economics, 2  edition N. Gregory Mankiw and Mark P. Taylor ISBN 978-1-84480-870-0 © 2011 Cengage Learning EMEA

 

  Chapter 4/The Market Forces of Supply and Demand

 29



equilibrium, the price and quantity of minivans both rise, as Figure 12 above shows. e.

The reduction in peoples' wealth caused by a stock market crash reduces their income, leading to a reduction in the demand for family saloons, since family saloons are likely a normal good. Supply isn’t affected. As a result, both price price and quantity decline, as  as  Figure 15 shows.

Figure 15

4

Technological advances that reduce the cost of producing computer chips represent a decline in an input price for producing a computer. The result is a shift to the right in the supply of computers, as shown in Figure 16. The equilibrium price falls falls and the equilibrium quantity rises, as the figure shows.

Figure 16 Economics, 2nd edition N. Gregory Mankiw and Mark P. Taylor ISBN 978-1-84480-870-0 © 2011 Cengage Learning EMEA

 

  30

 Chapter 4/The Market Forces of Supply and Demand

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Since computer software is a complement to computers, the lower equilibrium price of computers increases the demand for software. As Figure 17 shows, the result is a rise rise in both the equilibrium price and quantity of software.

Figure 17 Since typewriters are substitutes for computers, the lower equilibrium price of computers reduces the demand for typewriters. As Figure 18 shows, the result is a decline in both the equilibrium price and and quantity of typewriters.

Figure 18

5.

a.

When a drought in Egypt damages the cotton crop, it raises input prices for producing Economics, 2nd edition N. Gregory Mankiw and Mark P. Taylor ISBN 978-1-84480-870-0 © 2011 Cengage Learning EMEA

 

  Chapter 4/The Market Forces of Supply and Demand

 31

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sweatshirts. As a result, the supply of sweatshirts shifts to the left, as shown i n Figure 19. The new equilibrium has a higher price and lower quantity of sweatshirts.

Figure 19

b.

A decline in the price of leather jackets leads more people to buy leather jackets, reducing the demand for sweatshirts (on the assumption that sweatshirts and leather jackets are substitutes for one another). The result, shown in Figure 20, is a decline in both the equilibrium price and quantity of sweatshirts.

Figure 20

c.

The effect of universities requiring students to engage in morning exercise classes in appropriate attire is to raise the demand for for sweatshirts, as shown in Figure 21. The Economics, 2nd edition N. Gregory Mankiw and Mark P. Taylor ISBN 978-1-84480-870-0 © 2011 Cengage Learning EMEA

 

  32

 Chapter 4/The Market Forces of Supply and Demand

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result is an increase in both the equilibrium price and quantity of sweatshirts.

Figure 21

d.

The invention of new knitting machines increases the supply of sweatshirts. As Figure 22 shows, the result is a reduction in the equilibrium price and an increase in the equilibrium quantity of sweatshirts.

Figure 22

Economics, 2nd edition N. Gregory Mankiw and Mark P. Taylor ISBN 978-1-84480-870-0 © 2011 Cengage Learning EMEA

 

  Chapter 4/The Market Forces of Supply and Demand

6.

 33

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A temporarily high birth rate in the year 2005 leads to opposite effects on the price of babysitting services in in the years 2010 and 2020. In the year year 2010, there are are more 5-year olds who need sitters, so the demand for baby-sitting services rises, as shown in Figure 23. The result is a higher price for baby-sitting services in 2010. However, in the year 2020, the increased number of 15-year olds shifts the supply of baby-sitting services to the right, as shown in Figure 24. The result is a decline in the price of baby-sitting services.

Figure 23

7.

Figure 24

Vinegar is a complement for chips. When the price of chips rises, the quantity demanded demande d of hot d ogs falls, thus reducing the demand for vinegar, causing both price and quantity of vinegar to fall. Exactly the same argument may be applied to the markets for ketchup and fish - both are complementary products for chips. The impact on the market for orange juice is less obvious - orange juice is unlikely to be considered either a s ubstitute or complement for chips. However, since the quantity of ketchup falls, the demand for tomatoes by ketchup producers falls, so both price and quantity of tomatoes fall. When the price of toma toes falls, producers of tomato juice face lower input prices, so the supply curve for tomato  juice shifts shifts out, out, causing causing the price of tom tomato ato juice juice to fall fall and the quantity quantity of tomato tomato juice juice traded in the market to rise. The fall in the price of tomato juice causes people to substitute tomato juice for orange juice, so the demand for orange juice declines, causing the price and quantity of orange juice to fall. fall. Now you can see clearly why a rise in the price of hot dogs leads to a fall in price of orange juice!

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 Chapter 4/The Market Forces of Supply and Demand

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Figure 25

8.

9.

a.

Cigars are substitutes for cigarettes, since a higher price for cigarettes would increase the demand for cigars.

b.

An increase in the tax on cigarettes leads to increased demand for cigars. The result, as shown in Figure 25 for cigars, is a rise in both the equilibrium price and quantity of cigars.

c.

The results in part (b) showed that a tax on cigarettes leads people to substitute cigars for cigarettes when when the tax on cigarettes rises. rises. To reduce total tobacco tobacco usage, policymakers might also want to increase the tax on cigars.

Quantity supplied equals quantity demanded at a price of €6 and quantity of 81 pizzas (Figure 26). If price were greater than €6, quantity supplied would exceed quantity demanded, so suppliers would reduce reduce their price to gain sales. If price were less than €6, €6, quantity demanded would exceed quantity supplied, so suppliers could raise their price without losing sales. In both cases, the price would continue to adjust until it reached reac hed €6, the only price at which tthere here is neither a surplus nor a shortage.

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  Chapter 4/The Market Forces of Supply and Demand

 35

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Figure 26

10.

a.

If the price of pig feed falls, since it is an input to the production of bacon, the supply curve for bacon would shift to the right. right. The result, shown in Figure 27, would be a fall in the price of bacon and a rise in the equilibrium quantity of bacon.

Figure 27 Since eggs are a complement complement to bacon, the fall in th the e equilibrium price of bacon increases the demand demand for for eggs, eggs, as shown in Figure 28. The re result sult is a rise rise in both the equilibrium price and and quantity quantity of eggs. So, a fall in the price of pig feed indeed raise raisess both the equilibrium price of eggs and the equilibrium quantity of bacon. Economics, 2nd edition N. Gregory Mankiw and Mark P. Taylor ISBN 978-1-84480-870-0 © 2011 Cengage Learning EMEA

 

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 Chapter 4/The Market Forces of Supply and Demand

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Figure 28

What happens if the price of chicken feed falls? Since chicken feed is an input to the production of eggs, the fall in the price of chicken feed leads to an increase in the supply of eggs. This leads to a decrease in the price of eggs (Figure 29), rather rather than a rise in the price of eggs. So a fall in the price of chicken feed could could not have been responsible for the events observed.

Figure 29

b.

In part (a), we found that a fall in the price of pig feed led to a rise in the price of eggs Economics, 2nd edition N. Gregory Mankiw and Mark P. Taylor ISBN 978-1-84480-870-0 © 2011 Cengage Learning EMEA

 

  Chapter 4/The Market Forces of Supply and Demand

 37

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and a rise in the equilibrium quantity of bacon. If the price of of pig feed rose, rose, the opposite would be true; it would lead to a fall in the price of eggs and a fall in the equilibrium quantity of bacon. Since the question question says the equilibrium price of eggs has risen, it could not have been caused by a rise in the price of pig feed. What happens if the price of chicken feed rises? From part (a), we found that a fall in the price of chicken feed caused a decline in the price of eggs, so a rise in the price of chicken feed would cause a rise in the price of eggs. Since bacon and eggs are complements, the rise in the price of eggs would reduce the demand for bacon, as Figure 30 shows. The result result is a decline decline in the equilibrium equilibrium quantity of bacon. bacon. So a rise in in the price of chicken feed does cause both a rise in the price of eggs and a decline in the equilibrium quantity of bacon.

Figure 30

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  38

 Chapter 4/The Market Forces of Supply and Demand

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11.

a.

As Figure 31 shows, the supply curve is vertical. The constant quantity supplied makes sense because the basketball arena has a fixed number of seats no matter what the price. (We are considering the primary market in which the only supplier is the football club, not the secondary market for tickets in which ticket touts sell on tickets they have bought.)

Figure 31

b.

Quantity supplied equals quantity demanded at a price of €30. The equilibrium quantity  quantity  is 30,000 tickets.

c. Price  €10    €10 20 30 40 50

Quantity Demanded 50,000 40,000 30,000 20,000 10,000

Quantity Supplied 30,000 30,000 30,000 30,000 30,000

The club should charge an admission price between €20 and €30 if its aim is to fill th e s tadium. Given the apparently linear nature of the demand schedule it is plausible to suggest the price that will equate quantity demanded and quantity supplied will wil l be €25. 12.

The executives are confusing changes in demand with changes in quantity demanded. Figure 32 shows the demand curve prior to the marketing campaign (D1 ), and after the campaign (D 2 ). The marketing campaign increased the demand for champagne, as shown, sho wn, leading to a higher equilibrium price and quantity. The influence of the higher price on demand is already reflected in the outcome. It is impossible for the scenario outlined by the executives to occur.

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  Chapter 4/The Market Forces of Supply and Demand

 39



Figure 32

13.

Equilibrium occurs where quantity demanded is equal to quantity supplied. Thus: Qd = Qs 1,600 - 300P = 1,400 + 700P 200 = 1,000P P = €0.20 Qd = 1,600 - 300(0.20) = 1,600 - 60 = 1,540 Qs = 1,400 + 700(0.20) = 1,400 + 140 = 1,540. The equilibrium price of a chocolate bar is 0.20 and the equilibrium quantity is 1,540 bars.

14.

A perfectly competitive market is a market where there are many buyers and sellers of an identical product. No buyer or seller has the ability to influence the price of the product. No, ice cream is probably not a very good example of a perfectly competitive market. Each competitor sells a product that may taste differently or may come in a different variety of flavours. The market for ice cream is better characterized as a monopolistically competitive market.

Economics, 2nd edition N. Gregory Mankiw and Mark P. Taylor ISBN 978-1-84480-870-0 © 2011 Cengage Learning EMEA

 

 

Problems and Applications:

1.

a. b. c.

d. e. f. g.

Consumption increases because a refrigerator is a good purchased by a household. Investment increases because a house is an investment good. Consumption increases because a car is a good purchased by a household; but investment decreases because the car had been counted as an investment good when it was built and put into stock, and now it is counted as negative investment when it is removed from Aston Martin’s inventory.  inventory.  Consumption increases because pizza is a good purchased by a household. Government purchases increase because the government spent money to provide a good to the public. Consumption increases because the bottle is a good purchased by a household, but net exports decrease because the bottle was imported. Investment increases because new structures and equipment were built.

2.

With transfer payments, nothing is produced, so there is no contribution to GDP.

3.

Purchases of new housing are included in the investment portion of GDP because housing provides services for a long time. For the same reason, purchases of new cars cars could be thought of as investment, but by convention, they are not. The logic could apply to any durable good, such as household appliances.

4.

If GDP included goods that are resold, it would be counting output of that particular year, plus sales of goods produced in a previous year year.. It would double-count goods that were sold more than once and would count goods in GDP for several years if they were produced in one year and resold in several subsequent years.

5.

a.

Calculating nominal GDP: 2008: (€1 per litre of milk × 100 litres milk) + (€2 per litre of honey × 50 litres honey) =  €200 2009: (€1 per litre of milk × 200 litres milk) + (€2 per litre of honey × 100 litres honey) = €400 2010: (€2 per litre of milk × 200 litres milk) + (€4 per litre of honey × 100 litres honey) = €800 Calculating real GDP (base year 2003): 2008: (€1 per litre of milk × 100 litres milk) + (€2 per litre of litre  of honey × 50 litres honey) =  €200 2009: (€1 per litre of milk × 200 litres milk) + (€2 per litre of honey × 100 litres honey) = €400 2010: (€1 per litre of milk × 200 litres milk) + (€2 per litre of honey × 100 litres honey) = €400 Calculating the GDP deflator: 2008: (€200/€200) × 100 = 100 2009: (€400/€400) × 100 = 100 2010: (€800/€400) × 100 = 200

b.

Calculating the percentage change in nominal GDP: Percentage change in nominal GDP in 2009 = [(€400 - €200)/€200  €200)/€200]] × 100 = 100%.

 

  14  Chapter 23/Measuring A Nation’s Income

Percentage change in nominal GDP in 2010 = [(€800 - €400)/€400  €400)/€400]] × 100 = 100%. Calculating the percentage change in real GDP: Percentage change in real GDP in 2009 = [(€400 -  €200)/€200] ×  100 = 100%. Percentage change in real GDP in 2010 = [(€400 - €400)/€400] × 100 = 0%. Calculating the percentage change in GDP deflator: Percentage change in the GDP deflator in 2009 = [(100 - 100)/100] × 100 = 0%. Percentage change in the GDP deflator in 2010 = [(200 - 100)/100] × 100 = 100%. Prices did not change from 2008 to 2009. Thus, the percentage change in the GDP deflator is zero. Likewise, output levels did did not change from from 2009 to 2010. This means that the percentage change in real GDP is zero. c.

Economic well-being rose more in 2009 than in 2010, since real GDP rose in 2009 but not in 2010. 2010. In 2009, real GDP rose and prices didn’t. In 2010, real GDP didn’t rise and  and  prices did.

6.

Economists ignore the rise in people's incomes that is caused by higher prices because although incomes are higher, the prices of the goods and services that people buy are also higher. Therefore, they will not necessarily be able to purchase more goods and services. For this reason, economists prefer to look at real GDP instead of nominal GDP.

7.

Many answers are possible.

8.

a. b. c. d. e.

9.

In countries like India, people produce and consume a fair amount of food at home that is not included in GDP. So GDP per per person in India and the UK will differ by more than their comparative economic well-being.

10.

If we are analysing the total income of domestic residents we should use GNP, since this measures income earned by residents irrespective irrespective of the country in which it was earned. If we are analysing the total amount of economic activity occurring in the economy we should use GDP, which measures the level of production in the country, whether produced by domestic citizens or foreigners.

11.

a.

The increased labour-force participation of women has increased GDP, since it means more people are working and production has increased.

b.

If our measure of well-being included time spent working in the home and taking leisure, it wouldn't rise as much as GDP, since the rise in women's labour-force participation has reduced time spent working in the home and taking leisure.

c.

Other aspects of well-being that are associated with the rise in women's increased labour-force participation include increased self-esteem and prestige for women in the

GDP equals the dollar amount Boris collects, which is €400. €400.   NNP = GDP - depreciation = €400 - €50 = €350.  €350.  National income = NNP - sales taxes = €350 - €30 = €320.  €320.  Personal income = national income - retained earnings = €320 - €100 = €220. €220.   Disposable personal income = personal income - personal income tax = €220 - €70 =  =   €150.

workforce, especially at managerial levels, but decreased quality time spent with Economics, 2nd edition N. Gregory Mankiw and Mark P. Taylor ISBN 978-1-84480-870-0 © 2011 Cengage Learning EMEA

 

  Chapter 23/Measuring A Nation’s Income

children, whose parents have less time to spend with them. difficult to measure.

 15

Such aspects would be quite

 

 

Problems and Applications 1.

a.

The price of tennis balls increases 0 percent; the price of tennis racquets increases 50 percent [=(€60[=(€60- €40)/€40  €40)/€40 x 100%]; the price price of of Cola Cola increas increases es 10 100 0 percent percent [= (€2  €1)/€1 x 100 100%]. %].

 

 

To find the percentage change in the overall price level, follow these steps: 1)

Determine the fixed basket of goods: 100 balls, 10 racquets, 200 Colas.

2)

Find the price of each good in each year: Balls Racquets 2009 2010

b.

2

 €2  €2   €2     €2

 €40  €40   €60     €60

Cola  €1  €1   €2     €2

3)

Compute the cost of the basket of goods in each year: 2003: (100 x €2) + (10 x €40) + (200 x €1) = €800 €800   2004: (100 x €2) + (10 x €60) + (200 x €2) = €1,200 €1,200  

4)

Choose one year as a base year (2009) and compute the CPI in each year: 2009: €800/€800 x 100 = 100 2010: €1,200/€800 x 100 = 150  150 

5)

Use the CPI to compute the inflation rate from the previous year: 2010: (150 - 100)/100 x 100% = 50%

Tennis racquets are less expensive relative to Cola, since their price rose 50 percent while the price of Cola rose 100 percent. The well-being of some people changes relative to the well-being of others. Those who purchase a lot of Cola become worse off relative to those who purchase a lot of tennis racquets or tennis balls.

To find the percentage change in the overall price level, follow these steps: 1)

Determine the fixed basket of goods: 100 heads of cauliflower, 50 bunches of broccoli, 500 carrots.

2)

Find the price of each good in each year:

 Year 2009 2010

Cauliflower  €2    €2  €3    €3

Broccoli  €1.50    €1.50

Carrots  €0.10  €0.10

 €1.50    €1.50

 €0.20    €0.20

3)

Comput Compute e the cost of the basket of goods in each year: 2009: (100 x €2) + (50 x €1.50) + (500 x €.10) = €325 2010: (100 x €3) + (50 x €1.50) + (500 x €.20) = €475

4)

Choose one year as a base year (2009) and compute the CPI in each year: 2009: €325/€325 x 100 = 100  100  2010: €475/€325 x 100 = 146  146 

5)

Use the CPI to compute the inflation rate from the previous year: 2010: (146-100)/100 x 100% = 46%

3

Answers depend on the date at which students look at the CPI data.

4.

a. introduction of new goods; b. unmeasured quality change; c. substitution substitu tion bias; d.

 

  12  Chapter 24/Measuring the Cost of Living

unmeasured quality change; e. substitution bias 5.

a.

If the elderly consume the same market basket as other people, the state pension would provide the elderly with an improvement in their standard of living each y ear because the CPI overstates inflation and state pension payments are tied to the CPI.

b.

Since the elderly consume more health care than younger people, and since health care costs have risen faster than overall inflation, it is possible that the elderly are worse off. To investigate this, you would need to put together a market basket for the elderly, which would have a higher weight on health care. You would then com pare the rise in the cost of the "elderly" basket with that of the general basket for CPI.

6.

Many answers are possible. A common answer may be that, as students, they spend a greater proportion of their income on tuition and books than the typical household. If the prices of tuition and books have risen faster than average prices, students face a higher inflation rate than the typical household.

7.

When bracket creep occurs, inflation increases people's nominal incomes, pushing them into higher tax brackets, so they have to pay a higher proportion of their incomes in taxes, even though they are not getting higher real incomes. As a result, the government’s real tax real tax revenue rises.

8.

In deciding how much income to save for retirement, workers should consider the real interest rate, since they care about their purchasing power in the future, not the number of pounds they will have.

9

a.

When inflation is higher than was expected, the real interest rate is lower than expected.

b.

Since the real interest rate is lower than was expected, the lender loses and the borrower gains. The borrower is repaying the loan with money that is worth less than was expected.

 

 

Problems and Applications

1.

The facts that countries import many goods and services yet must produce a large quantity of goods and services themselves to enjoy a high standard of living are reconciled by noting that there are substantial gains from trade. In order to be able to afford to purchase goods from other countries, an economy must generate income. By producing many goods and services, then trading them for goods and services produced in other countries, a nation maximizes its standard of living.

2.

a.

Producing cars requires a factory with machines, robots, and an assembly line, as well as human capital that comes from training workers.

b.

Producing secondary education requires books, computers and buildings as well as human capital from the teachers.

c.

Producing plane travel requires planes and airports as well as human capital in terms of pilots' knowledge.

d.

Producing fruits and vegetables requires irrigation systems, harvesting machinery, and trucks to transport the goods to the market, as well as human capital in the form of agricultural knowledge.

3.

Today's standard of living differs from those of our great-grandparents because of improved transportation, communications, entertainment, machinery for household work, and computers, among other things.

4.

In the manufacturing sector, employment has fallen sharply but output has not. This is good for the economy because because it is the result of increased productivity. Many manufactured goods are much cheaper than they used to be.

5.

a.

More investment would lead to faster economic growth in the short run.

 

  Chapter 25/Production and Growth

6.

7.

 13

b.

The change would benefit many people in society who would have higher incomes as the result of faster economic growth. However, there might be a transition period in which workers and owners in consumption good industries would get lower incomes, and workers and owners in investment good industries would get higher incomes. In addition, someone would have to reduce their spending for some time so that investment could rise.

a.

Private consumption spending includes buying food and buying clothes; private investment spending includes people buying houses and firms buying computers. Many other examples are possible.

b.

Government consumption spending includes paying workers to administer government schemes, and in the UK to run the NHS; government investment spending includes buying military equipment and building roads. Many other examples are possible.

The opportunity cost of investing in capital is the loss of consumption that results from redirecting resources towards investment. Over-investment in capital is possible because of diminishing marginal returns. A country can "over-invest" in capital if people would prefer to have higher consumption spending and less future growth. The opportunity cost of investing in human capital is also the loss of consumption that is needed to provide the resources for investment. A country could "over-invest" in human capital if people were too highly educated for the  jobs they could get⎯for example, if the best job someone with a Ph.D. in philosophy could find is managing a restaurant.

8.

9.

a.

When a South Korean firm opens a factory in northern England, it represents foreign direct investment.

b.

The investment increases UK GDP since it increases production in the UK. The effect on UK GNP would be smaller since the owners would get paid a return on their investment that would be part of South Korean GNP rather than UK GNP.

a.

The United States benefited from the Japanese investment since it made the US capital stock larger, increasing US economic growth.

b.

It would have been better for the United States to make the investments itself since then it would have received the returns on the investment itself, instead of the returns going to Japan.

10.

Greater educational opportunities for women could lead to faster economic growth in the countries of South Asia because increased human capital would increase i ncrease productivity and there would be external effects from greater knowledge in the country. Second, increased educational opportunities for young women may lower the population growth rate because such opportunities raise the opportunity cost of having a child.

11.

a.

Political stability could lead to strong economic growth by making the country attractive to investors. The increased investment would would raise economic growth. growth.

b.

Strong economic growth could lead to political stability because when people have high incomes they tend to be satisfied with the political system and are less likely to overthrow or change the government.

Economics, 2nd edition N. Gregory Mankiw and Mark P. Taylor ISBN 978-1-84480-870-0 © 2011 Cengage Learning EMEA

 

 

Problems and Applications 1.

a.

The bond of an eastern European government would pay a higher interest rate than the bond of the UK government because there would be a greater risk of default.

b.

A bond that repays the principal in 2031 would pay a higher interest rate than a bond that repays the principal in 2011 because it has a longer term to maturity, so there is more risk to the principal.

c.

A bond from a software company you run in your garage would pay a higher interest rate than a bond from BP because your software company has more credit risk.

d.

A bond issued by the national government would pay a lower interest rate than a bond issued by a local authority because local authority bonds are usually regarded as having greater credit risk than national government bonds. However, the difference may be very small. (In some countries bonds issued by national and local local governments are subject to different tax treatment and this can also influence the before-tax interest rate they pay.)

2

Many answers are possible. Price-earnings ratios vary. A high price-earnings ratio might indicate either that people expect earnings to rise in the future or that the stock is overvalued. A low price-earnings ratio might indicate either that people expect earnings to fall or that the stock is undervalued.

3.

The stock market does have a social purpose. Firms obtain funds for investment by issuing new stock. People are more likely to buy that stock because there are organized stock markets, so people know that they can sell their stock if they want to. Gambling at cards leads to transfers of money between between gamblers. It does not serve serve any purpose akin to the stock stock mar market. ket. Lotteries could be seen to serve a social purpose as funds are raised for socially desirable purposes.

4

Stock prices are viewed as harbingers of future declines in real GDP because people value stocks based on the expected future profitability of the firm. If stock p prices rices fall, this must mean that investors expect a lower future future profitability for for the firms. firms. This means that we might expect output in these firms to decline as well.

5

When the Russian government defaulted on its debt, investors perceived a higher chance of default (than they had before) on similar bonds sold by other other developing countries. Thus the supply of loanable funds shifted to the left, as shown in Figure 1. The result was an increase in the interest rate.

Economics, 2nd edition N. Gregory Mankiw and Mark P. Taylor ISBN 978-1-84480-870-0 © 2011 Cengage Learning EMEA

 

  Chapter 26/Saving, Investment, and the Financial System

 13

Figure 1

6.

Companies encourage their employees to hold stock in the company because it gives the employees employ ees the incentive to care about the firm’s profits, not just their own salary. Then, if   employees see waste or see areas in which the firm can improve, they will take actions that benefit the company company because they know know the value of their stock will rise as a result. And it also gives employees an additional incentive to work hard, knowing that if the firm does well, they will profit. But from an employee’ s point of view, owning stock in the company for which she or he work s can be risky. The employ employee’s ee’s wages or salary salary is already tied to how well the firm firm performs. If the firm has trouble, the employee could be laid off or have her or his salary reduced. If the employee owns sto ck in the firm, then there is a double whammy⎯the employee is unemployed or gets a lower salary and the value of the stock falls as well. So owning stock in your own company is a very risky proposition. Most employees would be better off diversifying⎯owning stock or bonds in other companies⎯so their fortunes wouldn’t depend so much on the firm for which they w ork.

7.

To a macroeconomist, saving occurs when a person’s income exceeds his consumption, while  while  investment occurs when a person or firm purchases new capital, such as a house or business equipment. a.

When your family takes out a mortgage and buys because it is a purchase of new capital.

b.

Using your €200 wage payment to buy stock in BP it is saving, because your income of Economics, 2nd edition N. Gregory Mankiw and Mark P. Taylor ISBN 978-1-84480-870-0 © 2011 Cengage Learning EMEA

a new house, that is investment,

 

  14  Chapter 26/Saving, Investment, and the Financial System

 €  €200 200 is not being spent on consumption goods. c.

When your flatmate earns €100 and deposits it in her account at a bank, that is saving, saving,   because the money is not spent on consumption goods.

d.

When you borrow €1,000 from a bank to buy a car to use in your pizza-delivery that is investment, because the car is a capital good.

business,

8.

We know that Y = 5, T = 1.5, Spriv ate = 0.5 = Y - T - C, Spublic = 0.2 = T - G. Since Sprivate = Y - T - C, then rearranging gives C = Y - T - S private = 5 - 1.5 - 0.5 = 3. Since Spublic = T - G, then rearranging gives G = T - S public = 1.5 - 0.2 = 1.3. Since S = national saving = S private + Spublic = 0.5 + 0.2 = 0.7. Finally, since I = investment = S, I = 0.7.

9

a.

If interest rates increase, the costs of borrowing money to invest in the oil field exploration become higher, so the returns from the exploration may not be sufficient to cover the costs. Thus, higher interest interest rates make it less likely that BP will will undertake the exploration.

b.

Even if BP uses its own funds to finance the exploration, the rise in interest rates still matters. There is an opportunity cost in using the funds. Instead of investing in the factory, BP could use the money to buy bonds to earn the higher interest rate available there. BP will compare its potential returns from oilfield exploration to the potential returns from the bond market. So if interest rates rise, so that bond market returns rise, BP is again less likely to invest in the exploration.

Figure 2

10.

a.

Figure 2 illustrates the effect of the €5 billion increase in government borrowing.   Initially, the supply of loanable funds is curve S 1, the equilibrium real interest rate is i1, and the quantity of loanable funds is L1. The incr ease in government borrowing by €5 billion reduces the supply of loanable funds at each interest rate by €5billion, so the new Economics, 2nd edition N. Gregory Mankiw and Mark P. Taylor ISBN 978-1-84480-870-0 © 2011 Cengage Learning EMEA

 

  Chapter 26/Saving, Investment, and the Financial System

 15

supply curve, S2, is shown by a shift to the left of S1  by exactly €5 billion. As a result of the shift, the new equilibrium real interest rate is i 2. The interest rate has increased as a result of the increase in government borrowing. b.

Since the interest rate has increased, investment and n ational saving decline, and private saving increases. The increase in government borrowing reduces public saving. From the figure you can see that equilibrium level of loanable funds (and thus both investment and national saving) decline by less than €5 billion, while public saving declines by €5 billion and private saving rises by less than €5 billion.

c.

The more elastic is the supply of loanable funds, the flatter the supply curve would be, so the interest rate would rise by less and thus national saving would fall by less, as Figure 3 shows.

Figure 3 d.

The more elastic the demand for loanable funds, the flatter the demand curve would be, so the interest rate would rise by less and thus national saving would fall by more, as Figure 4 shows.

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  16  Chapter 26/Saving, Investment, and the Financial System

Figure 4

e.

If households believe that greater government borrowing today implies higher taxes to pay off the government debt in the future, then people will save more so they can pay the higher taxes, so private saving in will increase, as thus will the supplythe of loanable funds. future This will offset the reduction public saving, reducing reducing amount by which the equilibrium quantity of investment and national saving decline, and reducing the amount that the interest rate rises. If the rise in private saving was exactly equal to the increase in government borrowing, there would be no shift in the national saving curve, so investment, national saving, and the interest rate would all be unchanged. (This is the case of Ricardian equivalence.)

11.

Since new computer technology enables firms to reduce inventory investment, the demand curve for loanable funds shifts to the left, as shown in Figure 5. As a result, the equilibrium quantity of loanable funds declines, as does the interest rate. The decline in the interest rate increases investment in factories and equipment (shown by the movement from L 2 to L3) so that overall investment declines by less than the initial fall due to reduced inventory investment (shown by the movement from L1 to L2).

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  Chapter 26/Saving, Investment, and the Financial System

 17

Figure 5

Figure 6

12.

If world savings declines at the same time world investme nt demand rises, the supply curve of loanable funds shifts to the left and the demand curve shifts to the right. Figure 6 illustrates the result that the world interest rate will rise, while the overall effect e ffect on the equilibrium quantity of loanable funds is ambiguous⎯it depends on how big the shifts of the two curves are relative to each other other,, and on their elasticities.

13.

a.

Investment can be increased by reducing taxes on private saving or by reducing the government budget deficit. But reducing taxes on private saving has the effect of increasing the government budget deficit, unless some other taxes are increased or government spending is reduced. So it is difficult to engage in both policies at the same time.

b.

To know which of these policies would be a more effective way to raise investment, you

 

  18  Chapter 26/Saving, Investment, and the Financial System

would need to know: (1) what the elasticity of private saving is with respect to the posttax real interest rate, since that would determine how much private saving would increase if you reduced taxes on saving; (2) how private saving responds to changes in the government budget deficit, since, for example, if Ricardian equivalence holds, the decline in the government budget deficit would be matched by an equal decline in private saving, so national saving would not increase at all; and (3) how elastic investment is with respect to the interest rate, since if investment is quite inelastic, neither policy will have much of an impact on investment. 14.

The case for regulating CDS is not set out in the chapter. One argument for regulation is that because the market is not exchange based, no one knows the extent of market participants’ liabilities, making it difficult to assess counterparty risk. (The use of collateral goes some way to addressing this concern.) Since CDS CD S are tradable and may be cash settled, there is n no o limit to the value of CDS contracts that may be based on an underlying asset (bond). However, CDS are based on sound principles and became a problem only when the US housing market collapsed and it was realised that many the mortgage backed securities that had been insured using CDS were far higher risk than had been believed.

15.

CDOs based on residential mortgages were developed in the early 21st century when interest rates were low and investors were anxious to buy assets that offered better yields. Packaging up lots of sub-prime mortgages into CDOs seemed to be a way of reducing risk and providing attractive yields for investors. When interest rates started to rise, sub-prime mortgage borrowers began to default in large numbers, causing major problems for the CDOs based on them. It was this problem in the housing market that led to the crisis.

Economics, 2nd edition N. Gregory Mankiw and Mark P. Taylor ISBN 978-1-84480-870-0 © 2011 Cengage Learning EMEA

 

 

Problems and Applications 1.

a.

A UK penny is money in the UK economy because it is used as a medium of exchang exch ange e to buy goods or services, it serves as a unit of account because prices in shops are listed in terms of pounds and pence, and it serves as a store of value for anyone who holds it over time.

b.

A euro is not money in the UK economy generally, because it is not used as a medium of exchange, and prices are not given in terms of euros, so it is not a unit of account. It could serve as a store of value, though. In some parts of the UK, such as London and and at airports and euros mayas bepounds. accepted as a means of payment and prices may even bechannel markedports, in euros as well

2.

c.

A Picasso painting is not money, because you cannot exchange it for goods or services, and prices are not given in terms of Picasso paintings. It does, however, serve as a store of value.

d.

A plastic credit card is similar to money, but represents deferred payment, rather that immediate payment. So credit cards do not fully represent the medium of exchange function of money, nor are they really stores of value, since they represent short-term loans rather than being an asset like currency.

For an asset to be useful as a medium of exchange, it must be widely accepted (so all transactions can be made in terms of it), recognized recognized easily as money (so people can perform transactions easily easily and quickly), divisible divisible (so people can provide provide change), change), and difficult difficult to counterfeit (so people will not print their own money). That is why nearly all countries use paper

 

  18  Chapter 29/The Monetary System

money with fancy designs for larger denominations and coins for smaller denominations. For an asset to be useful as a store of value, it must be something that maintains its value over time and something that can be used directly to buy goods and services or sold when money is needed. In addition to currency, financial financial assets (like stocks and bonds) and physical assets (like real estate and art) make good stores of value. 3 If someone in the euro area discovered an easy way to counterfeit hundred euro notes, they could flood the country with counterfeit currency, thus reducing its value. The resu lt might be a switch to a different type of currency. 4

When your uncle repays a €100 loan from Tenth European Bank (TEB) by writing a cheque from   his TEB current account, the result is a change in the assets and liabilities of both your uncle and TEB, as shown in these T-accounts:  Your Uncle  Assets

Liabilities

Before: Checking Account  After: Checking Account

 €100   Loans  €100

 €100    €100

 €0   Loans  €0

 €0    €0

Tenth European Bank  Assets

Liabilities

Before: Loans  After::  After Loans

 €100   Deposits  €100

 €100    €100

 €0   Deposits  €0

 €0    €0

By paying off the loan, your uncle simply eliminated the outstanding loan using the assets in his checking account. Your uncle's wealth has not changed; he simply has fewer assets and fewer fewer liabilities. 5

a.

Here is BEB's T-account:

Reserves Loans b.

Beleaguered European Bank  Assets Liabilities  €25 million  million  Deposits  €250 million  million   €225 million  million 

When BEB's largest depositor withdraws €10 million in cash and BEB reduces its loans  loans   outstanding to maintain the same reserve ratio, its T-account is now: Beleaguered State Bank  Assets  Asse ts Reserves Loans

Liabili Liabilities ties  €24 million  

Deposits

 €240 million  

 €216 million  

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  Chapter 29/The Monetary System

 19

c.

Since BEB is cutting back on its loans, other banks will find themselves short of reserves and they may also cut back on their loans as well.

d.

BEB may f ind it difficult to cut back on its loans immediately, since it cannot immediately force people people to pay off loans. Instead, it can stop making new loans. But for for a time it might find itself itself with more loans than it wants. It could try to attract additional deposits to get additional reserves, or borrow from another bank or from the c entral bank.

6.

If you take €100 that you held as currency and put it into the banking system, then the total amount of deposits in the banking system increases by €1,000, since a reserve ratio of 10   percent means the money multiplier is 1/0.10 = 10. Thus the money supply increases by €900,  €900,   since deposits increase by €1,000 but currency declines by €100. €100.

7

With a required reserve ratio of 10 percent, the money multiplier could be as high as 1/0.10 = 10, if banks hold hold no excess reserves reserves and people people do not keep keep some of the the additional currency. currency. So the maximum increase in the money supply from a €10 million milli on open-market open-market purchase is €100  €100  million. The smallest possible increase is €10 million if all of the money is held by banks as  as  excess reserves.

8.

a.

If the required reserve ratio is 5 percent, then First European Bank's required reserves are €500,000 x .05 = €25,000. Since the bank’s total reserves are €100,00 €100,000, 0, it has  has  excess reserves of €75,000.  €75,000. 

b.

With a required reserve ratio of 5 percent, the money multiplier is 1/0.05 = 20. If First National lends out its excess reserves of €75,000, the t he money supply will eventually increase by €75,000 x 20 = €1,500,000.

a.

With a required reserve ratio of 10 percent and no excess reserves, the money multiplier is 1/0.10 = 10. If the ECB does does not renew €1 million of loans, reser ves  ves will decline by €1 million and the money supply will contract by 10 x €1 million = €10 million.

b.

Banks might wish to hold excess reserves if they need to hold the reserves for their da yto-day operations, such as paying other banks for customers' transactions, cashing cheques, and so on. If banks increase excess reserves such that there is is no overall change in the total reserve ratio, then the money multiplier does not change and there is no effect on the money stock.

a.

With banks holding only required reserves of 10 percent, the money multiplier is 1/0.10 = 10. Since reserves are €100 billion, the money stock is 10 x €100 billion = €1,000  €1,000   billion.

b.

If the required reserve ratio is raised to 20 percent, the money multiplier declines to 1/0.20 = 5. With reserves of €100 billion, the money stock would decline to €500 billion,  billion,  a decline decline of €500 billion. Reserves would be be unchanged. unchanged.  

a.

If people hold all money as currency, the quantity of money is €2,000. €2,000.  

b.

If people hold all money as demand deposits at banks with 100 percent reserves, the quantity of money is €2,000.  €2,000.  

c.

If people have €1,000 in currency and €1,000 in demand deposits, the quantity of money  money 

9.

10.

11.

is €2,000.  €2,000.  Economics, 2nd edition N. Gregory Mankiw and Mark P. Taylor ISBN 978-1-84480-870-0 © 2011 Cengage Learning EMEA

 

  20  Chapter 29/The Monetary System

d.

e.

12.

If banks have a reserve ratio of 10 percent, the money multiplier is 1/0.10 = 10. So if people hold all money as demand deposits, the quantity of money is 10 x €2,000 =    €20,000.  €20,00 0.   If people hold equal amounts of currency (C) and demand deposits (D) and the money multiplier for reserves is 10, then two equations must be satisfied: (1) C = D, so that people have equal amounts of currency and demand deposits; and (2) 10 x (€2,000 - C) = D, so that the money multiplier (10) times the number of euro bills that are not being held by people (€2,000 - C) equals the amount of demand deposits (D). Using the first equation in the second gives 10 x (€2,000 - D) = D, or €20,000 - 10 D = D, or €20,000 = 11 D, so D = €1,818.18. Then C = €1,818.18. The quanti quantity ty of money is C + D = €3,636.36.

a. The investors buy protection by entering into a CDS agreement with a protection seller (the insurance company). The insurer will compensate the investors if certain conditions are met, which would be termed a credit event. b. The investors will receive compensation from the insurer. The originator will probably suffer a loss because they would probably have taken a first loss position. However, this loss will be smaller than it would have been had they held on to the mortgages.

13.

It has been suggested that the asset purchase programme would have been more effective if the Bank of England had bought toxic debt from the banks rather than gilts. After all, it was the toxic debt that was the chief problem causing difficulty for the banks. However, it has also been suggested that buying gilts made it cheaper and easier for corporates to raise finance from the capital markets by issuing corporate bonds. Some of the money raised may be used to repay bank debt, so relieving the pressure on banks and increasing their capacity to lend, relative to what it would have been in the absence of the asset purchase programme.

14.

Quantitative easing (QE) would be expected to be inflationary insofar as it leads to an increase in bank lending and an increase in money supply. However, there are also arguments about the output gap in the economy. If there is an output gap then it may be argued that additional money supply may boost spending and economic activity without leading to inflation, at least in the short run. Of course, if the banks don’t increase lending then money supply will not increase, and might even fall. This appears to be what happened, at least in the early stages of QE.

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Problems and Applications 1.

In this problem, all amounts are shown in billions. a.

Nominal GDP = P x Y = €10,000 and Y = real GDP = €5,000, so P = (P x Y)/Y =  = 

 

  14  Chapter 30/ Money Growth and Inflation

 €10,000  €10 ,000/€5, /€5,000 000 = 2. Since M x V = P x Y, then V = (P x Y)/M = €10,000/€500 = 20.

2.

b.

If M and V are unchanged and Y rises by 5 percent, then since M x V = P x Y, P must fall by 5 per cent. As a result, nominal nominal GDP is unchanged.

c.

To keep the price level stable, the central bank must increase the money supply by 5 per cent, matching the the increase in real GDP. Then, since velocity is unchanged, the price level will be stable.

d.

If the central bank wants inflation to be 10 per cent, it will need to increase the money supply 15 per cent. cent. Thus M x V will rise 15 per cent, causing P x Y to rise 15 per cent, with a 10 per cent increase in prices and a 5 per cent rise in real GDP.

a.

If people need to hold less cash, the demand for money shifts to the left, since there will be less money demanded at any price level.

b.

If the central bank does not respond to this event, the shift to the left of the demand for money combined with no change in the supply of money leads to a decline in the value of money (1/P), which means the price level rises, as shown in Figure 1.

Figure 1

c.

If the central bank wants to keep the price level stable, it should reduce the money supply from S1 to S2 as shown in Figure 2. This would cause the supply of money to shift to the left by the same amount that the demand for money shifted, resulting in no change in the value of money and the price level.

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  Chapter 30/ Money Growth and Inflation

 15

Figure 2

3.

With constant velocity, reducing the inflation rate to zero would require the money growth rate to equal the growth rate of output, according to the quantity theory of money (M x V = P x Y).

4.

Lenin is right that governments can confiscate the wealth of citizens with inflation. Inflation acts like a tax on people who hold money, by reducing its value. The government can finance its expenditures by printing money and using it to buy things, which results in a higher money supply and inflation. The result is a transfer of wealth from holders of money to the government.

5.

If a country's inflation rate increases sharply, the inflation tax on holders of money increases significantly. Wealth in savings accounts is not subject to a change in the inflation tax tax because the nominal interest rate rate will increase with the rise in inflation. But holders of savings accounts are hurt by the increase in the inflation rate because they are taxed on their nominal interest income, so their real returns are lower.

6.

Hyperinflations usually arise when governments try to finance much of their expenditures by printing money. This is unlikely to occur if the central central bank (which is responsible for controlling the level of the money supply) is independent of the government.

7.

a.

When the price of both goods doubles in a year, inflation is 100 percent. The total cost of purchasing equal amounts of beans and rice equals the quantity of each good times its price, added together for all goods. That is, if x is the quantity of beans, which also equals the quantity of rice, then the cost of beans and rice for the year is x(P B + PR ). In the second year, the cost is x(P B' + PR '), where the ' mark refers to the price in the second year. Then we can define define a price index with a value of one in the first year. In the second year, the price index has the value of the cost of goods in the second year divided by the cost of goods in the first year. Thus the pric price e index in the second year is x(PB' + PR ')/x(PB + PR ) = (PB' + PR ')/(PB + PR ) = (€2 + €6)/(€1 + €3) = €8/€4 = 2. The inflation rate is then (2 - 1)/1 x 100% = 100%. Since the prices of all goods rise by 100 percent, the farmers get a 100 percent increase in their incomes to go along with the 100 percent increase in prices, so neither is affected by the change in prices.

b.

If the price of beans rises to €2 and the price of rice rises to €4, then the price index in Economics, 2nd edition N. Gregory Mankiw and Mark P. Taylor ISBN 978-1-84480-870-0 © 2011 Cengage Learning EMEA

 

  16  Chapter 30/ Money Growth and Inflation

the second year is (PB' + P R ')/(P ')/(PB + PR ) = (€2 + €4)/(€1 + €3) = €6/€4 = 1.5, so the inflation rate is (1.5-1)/1 x 100% = 50%. Toto is better off because because his euro revenues doubled (increased 100 percent) while inflation was only 50 per cent. Dorothy is worse off because inflation was 50 percent, so the prices of the goods she buys rose faster than the price of the goods (rice) she sells, which rose only 33 percent. c.

If the price of beans rises to €2 and the price of rice falls to €1.50, then the price ind ex B in the second year is (Prate ' +isPR (0.875-1)/1 ')/(PB + PR x) = (€2 + €3) =is better €3.50/€4 = =   0.875, so the inflation 100% = €1.50)/(€1 -12.5%. +Toto off because his euro revenues doubled (increased 100 percent) while prices overall fell 12.5 percent. Dorothy is worse off because inflation was -12.5 percent, so the prices of the goods she buys didn't fall as fast as the price of the goods (rice) she sells, which fell 50 percent.

d.

8

The relative price of rice and beans matters more to Toto and Dorothy than the overall inflation rate. If the price of the good that a person produces rises more than inflation, he or she will will be better off. If the the pri price ce of the good a person perso n produces rrises ises less than tha n inflation, he or she will be worse off.

The following table shows the relevant calculations:

(1) Nominal interest rate (2) Inflation rate (3) Before-tax real interest rate (4) Reduction in nominal interest rate due to 40% tax (5) After-tax nominal interest rate (6) After-tax real interest rate

(a) 10.0 5.0 5.0 4.0 6.0 1.0

(b) 6.0 2.0 4.0 2.4 3.6 1.6

(c) 4.0 1.0 3.0 1.6 2.4 1.4

Row (3) is row (1) minus row (2). Row (4) is 0.40 x row (1). Row (5) is (1 - 0.40) x row (1), which equals equals row (1) minus row (4). Row (6) is row (5) minus row (2). Note that that even though part (a) has the highest before-tax real interest rate, it has the lowest after-tax real interest rate. Note also that the after-tax real interest rate is much less than the before-tax real interest rate. 9.

The shoeleather costs of going to the bank include the value of your time, gas for your car that is used as you drive to the bank, and the inconvenience of not having more money on hand. These costs could be measured by valuing your time at your wage rate and valuing the gas for your car at its cost. Valuing the inconvenience of being short of cash is harder to measure, but might depend on the value of the shopping opportunities you give up by not having enough money to buy things you want. The head of your university diff ers from you mainly in having a higher wage, thus having a higher opportunity cost of time.

10.

The functions of money are to serve as a medium of exchange, a unit of account, and a store o f value. Inflation mainly affects the ability of money to serve as a store of value, since inflation erodes money's purchasing power, making it less attractive as a store of value. Money also also is not as useful as a unit of account when there’s inflation, because stores have to change prices more often and because people are confused and inconvenienced by the changes in the valu e of money. In some countries with hyperinflation, stores post prices in terms of a more stable currency, such as the US dollar, even when the local currency is still used as the medium of exchange.. And sometimes exchange sometimes countries countries even stop stop using t heir local local currency altogether, altogether, using a foreign currency as the medium of exchange as well.

11.

a.

Unexpectedly high inflation helps the government by providing higher inflation inflat ion tax Economics, 2nd edition N. Gregory Mankiw and Mark P. Taylor ISBN 978-1-84480-870-0 © 2011 Cengage Learning EMEA

 

  Chapter 30/ Money Growth and Inflation

 17

revenue and reducing the real value of outstanding government debt.

b.

Unexpectedly high inflation helps a homeowner with a fixed-rate mortgage because he pays a fixed nominal interest rate that was based on expected e xpected inflation, and thus pays a lower real interest rate than was expected.

c.

Unexpectedly high inflation hurts a union worker innominal the second of aexpected labour contract because the contract probably based the worker's wageyear on the inflation rate. As a result, the worker receives a lower than expected real wage.

d.

Unexpectedly high inflation hurts a retired person that has invested his savings in government bonds because the higher inflation rate means he is receiving receiving a lower real interest rate than he had planned for.

12.

The redistribution from creditors to debtors is something that happens when inflation is unexpected, not when it is expected. The problems that occur with both expected and unexpected inflation include shoeleather costs associated with reduced money holdings, menu costs associated with more frequent adjustment of prices, increased variability of relative prices, unintended changes in tax liabilities due to non-indexation of t he tax system, and the confusion and inconvenience resulting from a changing unit of account.

13.

a.

The statement that "Inflation hurts borrowers and helps lenders, because borrowers must pay a higher rate of interest," is false. Higher expected inflation means bo rrowers rrowers pay a higher nominal rate of interest, but it is the same real rate of interest, so borrowers are not worse off off and lenders are not better better off. Higher une xpected inflation, on the other hand, makes borrowers better off and lenders worse off.

b.

The statement that "If prices change in a way that leaves the overall price level unchanged, then no one is made better better or wors worse e off," is false. Changes in relative relative prices can make some people better off and others worse off, even though the overall price level does not change. See problem 7 for an illustration illustration of this.

c.

The statement that "Inflation does not reduce the purchasing power of most workers" is true. Most workers' workers' incomes incomes keep up with inflation reasonably well.

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Problems and Applications

1.

a.

When a British art lecturer spends the summer touring museums in Europe, he spends money buying foreign goods and services, so UK exports are unchanged, imports increase, and net exports decrease.

 

  Chapter 31/Open-Economy Macroeconomics: Basic Concepts

2.

 15

b.

When students in Paris flock to see the latest Royal Shakespeare Company production of King Lear, foreigners are buying a UK good, so UK exports rise, imports are unchanged, and net exports increase.

c.

When the lecturer buys a new Volvo, a UK resident is buying a foreign good, so UK exports are unchanged, imports rise, and net exports decline.

d.

When the student in Munich buys an official Manchester United shirt, foreigners are buying UK goods, so UK exports increase, imports are unchanged, and net exports increase. (Note that we could also answer, nothing changes, since the shop in Munich has already bought the Manchester United shirt and the increase in exports occurred at that stage.)

e.

When a British resident shops in Calais, a British resident is buying foreign goods, so UK exports are unchanged, imports are increased, and net exports decrease.

a.

Wheat is traded more internationally than in the past because shipping costs have declined, as have trade restrictions.

b.

Banking services are traded more internationally than in the past because communications costs have declined, as have trade restrictions.

c.

Computer software is traded more internationally than in the past because the computer industry has grown and the software is easier to transport (since it can now be downloaded electronically).

d.

Cars are traded more internationally than in the past because transportation costs have declined, as have tariffs and quotas.

3.

Foreign direct investment requires actively managing an investment, for example, by opening a retail store in a foreign country. Foreign portfolio investment is passive, for example, buying shares in a retail chain in a foreign country. As a result, a corporation is is more likely to en engage gage in foreign direct investment, while an individual investor is more likely to engage in foreign portfolio investment, though often through an investment fund.

4.

a.

When a British mobile phone company an office makes in the Czech Republic, UK in net capital outflow increases, because establishes the U.S. company a direct investment capital in the foreign country.

b.

When a US company’s pension fund buys shares in BP, net capital outflow decreases, because the US pension fund makes a portfolio portfolio investment in the UK. (We are are assuming the shares are newly issued or purchased from a UK resident. In fact, of course, many BP shares are already held by non-UK citizens.)

c.

When Toyota expands its factory in Derby, England, UK net capital outflow declines, because a foreign company makes a direct investment in capital in the UK.

d.

When a London-based investment trust sells its Volkswagen shares to a French investor, UK net capital outflow declines (if the French investor pays in UK pounds), because the UK company is reducing its portfolio investment in a foreign country. Economics, 2nd edition N. Gregory Mankiw and Mark P. Taylor ISBN 978-1-84480-870-0 © 2011 Cengage Learning EMEA

 

  16  Chapter 31/Open-Economy Macroeconomics: Basic Concepts

5.

If national saving is constant and net capital outflow increases, domestic investment must decrease, since national saving equals domestic investment plus net capital outflow. If domestic investment declines, the country's accumulation of domestic capital declines.

6.

a.

The newspaper shows nominal exchange rates, since it shows the number of units of one currency that can be exchanged for another currency.

b.

Many answers are possible.

c.

If UK inflation exceeds European inflation over the next year, you would expect the pound to depreciate relative to the euro because a pound would wo uld decline in value (in terms of the goods and services it can buy) more than the euro would.

a.

US pension funds holding French government bonds would be happy if the euro appreciated. They would then get more dollars for each euro they earned on their French investment. In general, if you have an investment in a foreign country, you are better off if that country's currency appreciates.

b.

German manufacturing industries would be unhappy if the euro appreciated because their prices would be higher in terms of foreign currencies, which would reduce their sales.

c.

Australian tourists planning a trip to Europe would be unhappy if the euro appreciated because they would get fewer euros for each Australian dollar, so their vacation would be more expensive.

d.

A British firm trying to purchase property overseas would not care if the euro appreciated unless it were trying to buy property in the euro area. If it were trying to buy property in the euro area then it would be unhappy because it would get fewer euros per pound and could therefore afford to buy less property.

7.

8.

All the parts of this question can be answered by keeping in mind the definition of the real exchange rate. The real exchange rate rate equals the nominal exchange rate times the domestic price price level divided by the foreign price level. a.

If the Swiss nominal exchange rate is unchanged, but prices rise faster in Switzerland than abroad, the real exchange rate rises.

9.

b.

If the Swiss nominal exchange rate is unchanged, but prices rise faster abroad than in Switzerland, the real exchange rate declines.

c.

If the Swiss nominal exchange rate declines, and prices are unchanged in Switzerland and abroad, the real exchange rate declines.

d.

If the Swiss nominal exchange rate declines, and prices rise faster abroad than in Switzerland, the real exchange rate declines.

Three goods for which the law of one price is likely to hold are farm goods like wheat, which are nearly identical no matter where they are produced, technological goods like computer software, which have low shipping costs because they are light, and clothing, which also has low shipping costs. Three goods for which the law of one price price is not likely to hold are real estate, because you can't move land or buildings from one country to another; goods that are mainly consumed Economics, 2nd edition N. Gregory Mankiw and Mark P. Taylor ISBN 978-1-84480-870-0 © 2011 Cengage Learning EMEA

 

  Chapter 31/Open-Economy Macroeconomics: Basic Concepts

 17

in one country and so are not traded, like frog’ s legs that are consumed in France but generally not elsewhere; and services like haircuts, which cannot be arbitraged even if the price is very different in different countries. 10.

If purchasing-power parity holds, then 12 pesos per can of lemonade divided divided by €0.75 per can of lemonade equals the exchange rate of 16 pesos per euro. If prices in Mexico doubled, the exchange rate will double to 32 pesos per euro.

11.

a.

To make a profit, you would want to buy rice where it is cheap and sell it where it is expensive. Since American rice costs $1 per kilo, and the exchange rate is 80 yen per dollar, American rice costs 1 x 80 equals 80 yen per kilo. So American rice at 80 yen per kilo is cheaper than Japanese rice at 160 yen per kilo. So you could take 80 yen, exchange them for $1, buy a kilo of American rice, and then sell it in Japan for 160 yen, which you can then convert back to dollars and receive $2 - a profit of $1. As people did this, the demand for American rice would rise, increasing the price of rice in America, and the supply of rice in Japan would rise, reducing the price of rice in Japan. The process would continue until the prices in the two countries were the same.

b.

If rice were the only commodity in the world, the real exchange rate between the United States and Japan would start out too low, then rise as people bought rice in America and sold it in Japan, until the real exchange became one in long-run equilibrium.

12.

If you take X units of for foreign eign currency per Big Mac Mac divided by $3 per Big Mac, you get X/3 units of the foreign currency per dollar, that’s the predicted exchange rate. a.

Indonesia: 14,550/3 = 4,850 rupiah/$ Hungary: 536/3 = 179 forint/$ Czech Republic: 57.10/3 = 19 koruna/$ Canada: 3.20/3 = 1.07C$/$ Purchasing power parity explains the actual observed exchange rates quite well for Hungary and the Czech Republic, but it does not appear to explain so well the exchange rates of the Indonesian rupiah or the Canadian dollar.

b.

Under purchasing-power parity, the exchange rate of the Hungarian forint to the Canadian dollar is 536 forints per Big Mac Ma c divided by 3.20 Canadian dollars per Big Mac equals 167 forints per Canadian The actual exchange rateper is 188 forints doll perar. US dollar by 1.23 Canadian dollars dollar. per US dollar per equals 153 forints Canadian dollar. That isdivided pr pretty etty close!

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Problems and Applications

1.

Japan generally runs a trade surplus because the Japanese saving rate is high relative to Japanese domestic investment. The result is high net capital outflow, which is matched by high net exports, resulting in a trade surplus. The other possibilities (high foreign demand for Japanese goods, low Japanese demand for foreign goods, and structural barriers against imports into Japan) would affect the real exchange rate, but not the trade surplus.

2.

A reduction in the US government budget deficit would increase national saving, shifting the supply curve of loanable funds to the right in Figure 3. This would reduce the real interest rate in the United States, thus increasing net capital outflow, and reducing the real exchange rate. Thus the real value of the dollar would decline, not increase as the presiden presidentt suggested.

 

  14  Chapter 32 Macroeconomic Theory of the Open Economy

Figure 3

3.

If the government passes an investment tax credit, it subsidizes domestic investment. The desire to increase domestic investment leads firms to borrow more, increasing the demand for loanable funds, as sshown hown in Figure 4. This raises the real interest rate, thus reducing capitalinoutflow. The net capitalraising outflow the supply of domestic net currency the market fordecline foreigninexchange, thereduces real exchange rate. The trade balance also declines, since net capital outflow and hence net exports are lower. The higher higher real interest rate also increases the quantity quantity of national saving. In summary, saving increases, domestic investment increases, net capital outflow declines, the real interest rate increases, the real exchange rate increases, and the trade balance decreases.

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  Chapter 32 Macroeconomic Theory of the Open Economy

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Figure 4

4.

a.

A decline in the quality of US goods at a given real exchange rate would reduce net exports, reducing the demand for dollars, thus shifting the demand curve for dollars to the left in the market for foreign exchange, as shown in Figure 5.

b.

The shift to the left of the demand curve for dollars leads to a decline in the real exchange rate. Since net capital outflow is unchanged, and net net exports equals net capital outflow, there is no change in equilibrium in net exports or the trade balance.

c.

The claim in the popular press is incorrect. A change in the quality of US goods cannot lead to a rise in the trade deficit. The decline in the real exchange rate means that US residents get fewer foreign goods in exchange for their goods, so their standard of living may decline.

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  16  Chapter 32 Macroeconomic Theory of the Open Economy

Figure 5

5.

A reduction in restrictions of imports would reduce net exports at any given real exchange rate, thus shifting the demand curve for dollars to the left. The shift of the demand curve for dollars leads to a decline in the real exchange rate, which increases net exports. Since net capital outflow is unchanged, and net exports equals net capital outflow, there is no change in equilibrium in net exports or the trade balance. But both imports and exports exports rise, so export industries benefit.

6.

a.

When the French develop a strong taste for British wines, the demand for pounds in the foreign-currency market increases at any given real exchange rate, as shown in Figure 6.

b.

The result of the increased demand for pounds is a rise in the real exchange rate.

c.

The quantity of net exports is unchanged.

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  Chapter 32 Macroeconomic Theory of the Open Economy

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Figure 6

7.

An export subsidy increases net exports at any given real exchange rate. This causes the demand for domestic currency to shift to the right in the market for foreign exchange, as shown in Figure 7. The effect is a higher real exchange rate, but no change in net exports. So the trade trade minister is wrong; an export subsidy will not reduce the trade deficit.

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  18  Chapter 32 Macroeconomic Theory of the Open Economy

Figure 7

8.

Higher real interest rates in Europe lead to increased US net capital outflow. Higher net capital outflow leads to higher net exports, since in equilibrium net exports equal net capital outflow (NX = NCO). Figure 8 shows that the increase in net capital outflow leads to a lower real exchange rate, higher real interest rate, and increased net exports.

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  Chapter 32 Macroeconomic Theory of the Open Economy

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Figure 8

9.

10.

a.

If the elasticity of German net capital outflow with respect to the real interest rate is very high, the lower real interest rate that occurs because of the increase in private saving will increase net capital outflow a great deal, so German domestic investment will not increase much.

b.

Since an increase in private saving reduces the real interest rate, inducing an increase in net capital outflow, the real exchange exchange rate will decline. If the elasticity of German exports with respect to the real exchange rate is very low, it will take a large decline in the real exchange rate to increase German net exports by enough to match the increase in net capital outflow.

a.

If the Japanese decided they no longer wanted to buy US assets, US net capital outflow would increase, increasing the demand for loanable funds, as shown in Figure 9. The result is a rise in US interest rates, an increase in the quantity of US saving (because of the higher interest rate), and lower US domestic investment.

b.

In the market for foreign exchange, the real exchange rate declines and the balance of trade increases. Economics, 2nd edition N. Gregory Mankiw and Mark P. Taylor ISBN 978-1-84480-870-0 © 2011 Cengage Learning EMEA

 

  20  Chapter 32 Macroeconomic Theory of the Open Economy

Figure 9

11.

The flight to safety led to a desire by foreigners to buy US government bonds, resulting in a decline in US net capital outflow, outflow, as shown in Figure 10. The decline in net capital outflow also means a decline in the demand for loanable funds. As the figure shows, the shift to the left in theIn demand curve in aindecline in the real interest rate the in the United States. addition, theresults decrease net capital outflow decreases supply of dollars in the foreign exchange market, causing the dollar to appreciate, shown a ass a rise in the real exchange rate. The lower real interest rate causes national saving to decline, but increases domestic investment. Since net capital outflow is lower, net exports exports are lower, thus the trade balance declines.

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  Chapter 32 Macroeconomic Theory of the Open Economy

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Figure 10

12.

a.

When US investment funds decide to invest more in the EU, EU net capital outflow declines as the US investment funds make portfolio investments in EU stocks and bonds. The demand for loanable funds shifts to the left and the net capital outflow curve shifts to the left, as shown in Figure 11. As the figure shows, the the realEU’s interest rate declines, thus reducing privateEU saving in the outflow EU, but increasing domestic investment. In equilibrium, net capital declines.

b.

Since the EU’s domestic investment increases, in the long run, the EU’s capital   stock will increase.

c.

With a higher capital stock, EU workers will be more productive (the value of their marginal product will increase) so wages will rise. Thus EU workers will be better off.

d.

The shift of investment into the EU means increased US net capital outflow. As a result, the US real interest rises, leading to less domestic investment, which in the long run reduces the US capital stock, lowers the value of marginal product of US US workers, and therefore decreases the wages of US workers. The impact on US citizens would be different from the impact on US workers because some Economics, 2nd edition N. Gregory Mankiw and Mark P. Taylor ISBN 978-1-84480-870-0 © 2011 Cengage Learning EMEA

 

  22  Chapter 32 Macroeconomic Theory of the Open Economy

US citizens own capital that now earns a higher real interest rate.

Figure 11

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  Problems and Applications

1.

The main reason why recessions and depressions occurred was inadequate aggregate demand. Keynes suggested policies to increase aggregate demand, including government spending on public works.

2.

Planned expenditure is the desired or intended expenditure of households and firms. Actual expenditure is the expenditure that actually occurs - it is the outcome of households’ and firms’   actions.

3.

Figure 8 illustrates a deflationary gap. The economy is in equilibrium where the expenditure line intersects the 45 degree line. In figure 8 this is at Y 1, below full employment output. There is insufficient demand to maintain full employment. The expenditure line would need to be at C + I + G + (X - M)1 in order to eliminate the deflationary gap labelled Z.

 

  16  Chapter 33/Keynes and IS-LM Analysis

o

45

Total expenditure

C+I+G+(X‐M)1

Z

C+I+G+(X‐M)  C+I+G+(X‐M) 

o

45

Y1

Yf

National income

Figure 8

4.

a.

The total increase in expenditure = the autonomous increase in expenditure x the multiplier (k). So 30 = 10 x k Therefore k = 3. 2 The multiplier is given by 1/(1-MPC) so (1-MPC) = 1 /3 and so MPC =  / 3

5.

b.

Allowing for crowding out our answer would be smaller because the multiplier effect would be offset by the effect of higher interest rates.

a.

The initial effect is to increase aggregate demand by €1.5 billion (€2 billion x 0.75).  

b.

There will be additional induced changes in expenditure, ie a multiplier effect. The total effect is given by:  €1.5 billio billion n x k where k is the multiplier. The value of the multiplier is 1/MPC, and MPC in this case is 0.75, so that k = 1 1 /3. Therefore the total effect of the tax cut is to increase aggregate demand by €2 billion.

c.

6.

The total effect of a €2 billion increase in government purchases will be larger because all of that €2 billion will be injected into the economy, not just three quarters of it. The total effect of a €2 billion increase in government purchases will be to increase aggregate demand by €2.67 billion.

The effect of a cut in autonomous expenditure will be to reduce the equilibrium level of national income and thus reduce economic activity and increase unemployment. Figure 9 illustrates.

 

  Chapter 33/ Keynes and IS-LM Analysis

 17

o

45

Total expenditure

C +I+G+( X ‐M)1

C +I+G+( X ‐M)2

o

45

Y 2

Y 1

National income

Figure 9

7.

8.

The IS curve shows all combinations of interest rate and national income at which the goods market is in equilibrium. The LM curve shows all combinations of interest rate and national income at which the money market is in equilibrium. The slope of the IS curve is determined by the responsiveness of consumption and investment expenditure to changes in interest rates. The slope of the LM curve is determined by the responsiveness of the demand for money to changes in interest rates. In both cases, it is not the existence of a relationship that economists disagree about, but the strength of the relationship  just how respons responsive ive is consumption consumption and investment investment expenditure expenditure to interest interest changes? changes? And how responsive is the demand for money to interest rate changes? The argument is really about the extent of the crowding out effect. The more sensitive is consumption and investment expenditure to changes in interest rates the greater will be the crowding out effect.

9.

General equilibrium refers to a situation in which both the goods market and the money market are in equilibrium. There will be only combination of interest rate and national income where this is the case, and this combination will be the one at which the IS and LM curves cross. In general equilibrium planned expenditure is equal to actual expenditure.

10.

a.

Significant cuts in government spending will shift the IS curve to the left. The extent of the fall in interest rates and national income that result will depend on the slope of the LM curve, and this depends on how responsive is the demand for money to changes in interest rates. Assuming that the LM curve has a positive slope and is not vertical, there will be some reduction in interest rates and the effect of reduced government spending on economic activity will be less than would otherwise have been the case.

b.

Expanding the money supply will shift the LM curve to the right. The extent of the fall in

 

  18  Chapter 33/Keynes and IS-LM Analysis

interest rates and the rise in national income that result will depend on the slope of the IS curve, and this depends on how responsive is consumption and investment expenditure to changes in interest rates. c.

If the central bank wishes to raise interest rates it must engage in open market operations to sell bonds and so reduce the money supply. This action is reflected in a rightward movement of the LM curve. This size of the reduction in money supply needed to raise interest rates to a particular partic ular level will depend de pend on the slope of the IS curve - the flatter the IS curve the greater the shift the LM curve that will be needed, and the greater will be the associated reduction in national income.

d.

11.

12.

An increase in taxation will shift the IS curve to the left. The effect will thus be similar to that described in answer to question 10a.

The aggregate demand curve plots the relationship between national income and the price level, P. In the IS-LM model, the money supply refers to the real money supply, M/P, where M is the nominal money supply. A rise in P will reduce real money supply sup ply and so cause the LM curve to move to the left. le ft. This leads to the establishment of a new general equilibrium at a lower level of national income, and aggregate demand. A fall in P will have the opposite effect. Thus the IS-LM model shows that there is a negative relationship between the price level and the level of national income - the aggregate demand curve slopes downwards. A period of deflation refers to a period in which the price level, P, falls and so the supply of real money balances increases. This is illustrated in the IS-LM IS -LM model by a shift to the right in the LM curve.  A new general general equilibrium equilibrium w will ill re result, sult, w with ith low lower er interest interest rates and a higher higher level level of national income. The effect may be illustrated also by a move down the aggregate demand curve; see figure 10. Panel (a) shows the effect of a fall in P in the IS-LM model and panel (b) shows how this can be translated into the aggregate demand curve.

Interest rate LM1 LM2 i1 i2

IS

Y 1

Y 2

Panel (a)

National income

 

 

Chapter 33/ Keynes and IS-LM Analysis

 19

Price level

P1

P2

AD

Y 1

Y 2

National income

Panel (b)

Figure 10

13.

The main difference between the IS-LM IS-LM model and David Romer’s IS-MP IS-MP model is as follows. Romer’s model explicitly assumes that central banks adjust the money supply in order to secure the interest rate they desire. The desired interest rate is assumed to be determined by the central bank’s inflation target and so we can talk about a monetary policy reaction function. Romer assumes that when output rises the central bank raises interest rates to dampen inflationary pressure.

14.

Answers may vary. At the time of writing, there is much debate about the relevance of both Keynesian and Austrian perspectives.

 

  Problems and Applications

1.

Investment is more variable than consumer spending over the business cycle because firms can curtail investment spending more easily than households can curtail consumption spending. In recessions, firms know they will not be able to sell as many goods, so they want to produce less and therefore they put off buying capital (they do not expand factories or buy new equipment). Much of consumer spending is on necessities, like food, which cannot decline as much in recessions. So, investment spending spending is more variable over the business cycle than consumer spending. For similar reasons, durable goods spending is the most volatile sector of consumer spending. Durable goods, such as furniture and car purchases, are more volatile over the business cycle than non-durable goods, such as food and clothing, or services, such as haircuts and medical care, for the same reason. People put off buying durable goods and just make do with older cars and furniture when economic times are bad.

2.

a.

The current state of the economy is shown in Figure 6. The aggregate demand curve and short-run aggregate supply curve intersect at a point on the long-run aggregate supply curve.

b.

A stock market crash leads to a leftward shift of aggregate demand. The equilibrium level of output and the price level will fall. Since the quantity of output is less than the natural rate of output, the unemployment rate will rise above the natural rate of unemployment.

c.

If nominal wages are unchanged as the price level falls, firms will be forced to cut back on employment and production. Over time as expectations adjust, the short-run aggregate supply curve will shift to the right moving the economy back to the natural rate of output.

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Figure 6

3.

4.

a.

When a country experiences a wave of immigration, the labour force increases, so longrun aggregate supply increases as there are more people who can produce output.

b.

When the government raises the minimum wage above the national average wage level, the natural rate of unemployment rises, so the long-run aggregate supply curve shifts to the left.

c.

When a war destroys a large number of factories, the capital stock is reduced, so longrun aggregate supply declines.

In Figure 34.8 in the textbook, the unemployment rate at point B is higher than the unemployment rate at point A because output is lower at B than at A. The unemployment rate at point C is the same as that at point A because output is the same at both points. According to the sticky wage explanation of the short-run aggregate supply curve, output is lower at point B than at point A because wages have not adjusted. The nominal wage rate at points points A and B is the same, but since the price level is lower at point B the real wage is higher, hi gher, so firms hire fewer workers and thus output is lower. Point C is on the long-run aggregate supply curve, as is point A, so tthe he real wage must be the same at the two points. Since the price level is lower at point C C,, the nominal wage at point C must be lower.

5.

a.

The statement that "the aggregate demand curve slopes downward because it is the horizontal sum of the demand curves for individual goods" is false. The aggregate demand demand curve slopes downward because a fall in the price pri ce level raises the overall quantity of goods and services demanded through the wealth effect, the interest-rate effect, and the exchange-rate effect.

b.

The statement that "the long-run aggregate supply curve is vertical because economic forces do not affect long-run aggregate supply" is false. false. Economic forces of various kinds (such as population and productivity) do do affect long-run aggregate supply. The Economics, 2nd edition N. Gregory Mankiw and Mark P. Taylor ISBN 978-1-84480-870-0 © 2011 Cengage Learning EMEA

 

  22  Chapter 34/Aggregate Demand and Aggregate Supply

long-run aggregate supply curve is vertical because the price level does not affect longrun aggregate supply. c.

The statement that "if firms adjusted their prices every day, then the short-run aggregate supply curve would be horizontal" is false. If firms adjusted prices quickly and if sticky prices were the only possible cause for the upward slope of the short-run aggregate supply curve, then the short-run aggregate supply curve would be vertical, not horizontal. The short-run aggregate supply curve would be horizontal only if prices were completely fixed.

6.

d.

The statement that "whenever the economy enters a recession, its long-run aggregate supply curve shifts to the left" is false. An economy could enter a recession if the aggregate demand curve or the short-run aggregate supply curve shift to the left, while aggregate supply was unchanged.

a.

According to the sticky wage theory, the economy is in a recession because the price level has declined so that real real wages are too high, thus labour demand is too low. Over time, as nominal wages are adjusted so that real wages decline, the economy returns to full employment.  According to the sticky price theory,  According theory, the economy is in a rrecessi ecession on because not all prices adjust quickly. Over time, firms are able to adjust their prices more fully, fully, and the economy returns to the long-run aggregate supply curve.  According to the misperception  According misperceptionss theory, the economy is in a recession recession when the price level is below what was expected. Over time, as people observe the lower price level, their expectations adjust, and the economy returns to the long-run aggregate supply curve.

b.

The speed of the recovery in each theory depends on how quickly price expectations, wages, and prices adjust.

Figure 7

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7.

If the central bank increases the money supply and people expect a higher price level, the aggregate demand curve shifts to the right and the short-run aggregate supply curve shifts to the left, as shown in Figure 7. The economy moves from point A to point poin t B, with no change in output and a rise in the price level (to P2). If the public does not change its expectation of the price level, the short-run aggregate supply curve does not shift, the economy e ends nds up at point C, and output increases along with the price level (to P 3).

8.

Figure 8 depicts an economy in a recession. The short-run aggregate supply curve is AS1 and the economy is in equilibrium at point A, which is to the left of the long-run aggregate supply curve. If policymakers take no action, the economy will return to the long-run long-ru n aggregate supply curve over time as the short-run aggregate supply curve shifts to the right to AS2. The economy's new equilibrium equilibrium is at point B.

Figure 8

9.

a.

If people suddenly come to believe that inflation will be high over the next year, workers will demand higher nominal wages. If the price price level does not rise as much as wages do, real wages will increase, so firms will not hire as many workers.

b.

Figure 9 shows the economy starting out at point A on short-run aggregate supply curve  AS1. With higher nominal nominal wages, the short-run aggregate supply curve will shift to the the left to  AS2. The new new equilibrium is at point B, with output less than long-run aggregate supply. In the short run, the price level rises and output falls. In the long-run, the economy will return to point A, as the decline in output eventually leads to a decline in the price level and the short-run aggregate supply curve returns to AS 1.

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  24  Chapter 34/Aggregate Demand and Aggregate Supply

Figure 9

c.

In the short-run, expectations of higher inflation were somewhat accurate, as the price level is higher at point than at point A (however, priceinlevel at point as was expected). ButB inflation expectations werethe wrong the long run.B is not as high

Figure 10

10.

a.

If households decide to save a larger share of their income, they must spend less on consumer goods, so the aggregate demand curve shifts to the left, as shown in Figure 10. The equilibrium changes from from point A to point B, so the price level declines and output declines.

b.

If cattle farmers suffer a prolonged period of foot-and-mouth disease, their output will be reduced. This is represented in Figure 11 by a shift to the left left in the short-run aggregate supply curve. The equilibrium changes from from point A to point B, so the price level rises and output declines. Economics, 2nd edition N. Gregory Mankiw and Mark P. Taylor ISBN 978-1-84480-870-0 © 2011 Cengage Learning EMEA

 

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Figure 11

Figure 12

11.

c.

If increased job opportunities abroad cause people to leave the country, the short-run aggregate supply curve will shift to the left because there are fewer people producing output. The aggregate demand curve will shift to the left because there are fewer fewer people consuming goods and services. The result is a decline in the quantity of output, as Figure 12 shows. Whether the price level rises or declines depends on the size of the shifts in the aggregate demand curve and the short-run aggregate supply curve.

a.

When the stock market declines sharply, wealth declines, so the aggregate demand curve shifts to the left, as shown in Figure 13. In the short run, the economy moves from point A to point B, as output declines and the price level declines. In the long run, the short-run aggregate supply curve shifts to the right to restore equilibrium at point C, with unchanged output and a lower price level compared to point A. Economics, 2nd edition N. Gregory Mankiw and Mark P. Taylor ISBN 978-1-84480-870-0 © 2011 Cengage Learning EMEA

 

  26  Chapter 34/Aggregate Demand and Aggregate Supply

Figure 13

Figure 14

b.

When the government increases spending on national defence, the rise in government purchases shifts the aggregate demand curve to the right, as shown in Figure 14. In the short run, the economy moves from point A to point B, as output and the price level rise. In the long run, the short-run aggregate supply curve shifts to the left to restore equilibrium at point C, with unchanged output and a higher price level compared to point  A.

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Figure 15

c.

When a technological improvement raises productivity, the long-run and short-run aggregate supply curves curves shift to the right, as shown in Figure 15. The economy moves from from point A to point B, as output rises and the price level declines.

Figure 16

d.

When a recession overseas causes foreigners to buy fewer U.S. goods, net exports decline, so the aggregate demand curve shifts to the left, as shown in Figure 16. In the short run, the economy moves from point A to point B, as output declines and the price level declines. In the long run, the short-run aggregate supply curve shifts to the right to restore equilibrium at point C, with unchanged output and a lower price level compared to point A. Economics, 2nd edition N. Gregory Mankiw and Mark P. Taylor ISBN 978-1-84480-870-0 © 2011 Cengage Learning EMEA

 

  28  Chapter 34/Aggregate Demand and Aggregate Supply

12.

a.

If firms become optimistic about future business conditions and invest a lot, the result is shown in Figure 17. The economy begins at point A with aggregate demand curve AD1 and short-run aggregate supply curve AS1. The equilibrium has price level P1 and output level Y 1. Increased optimism leads to greater investment, so the aggregate demand curve shifts to AD2. Now the economy is at point B, with price level P2 and output level Y 2. The aggregate quantity of output supplied rises because the price level has risen and people have misperceptions about the price level, wages are sticky, or prices are sticky, all of which cause output supplied to increase.

b.

Over time, as the misperceptions of the price level disappear, wages adjust, or prices adjust, the short-run aggregate supply curve shifts up to AS2  and the economy gets to equilibrium at point C, with price level P 3  and output level Y 1. The quantity of output demanded declines as the price level rises.

Figure 17

c.

The investment boom might shift the long-run aggregate supply curve to the right because higher investment today means a larger capital stock in the future, thus higher productivity and output.

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Problems and Applications

1.

a.

When the central bank’s bond traders buy bonds in open-market open -market operations, the moneysupply curve shifts to the right from MS1 to MS2, as shown in Figure 1. The result is is a decline in the interest rate.

Figure 1

b.

When an increase in credit card availability reduces the cash people hold, the moneydemand curve shifts to the left from MD1 to MD2, as shown in Figure 2. The result is a decline in the interest rate.

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  14  Chapter 35/The Influence of Monetary and Fiscal Policy on Aggregate Demand

Figure 2

c.

When the central bank reduces reserve requirements, the money supply increases, so the money-supply curve shifts to the right from MS1 to MS2, as shown in Figure 1. The result result is a decline in the interest rate.

d.

When households decide to hold more money to use for holiday shopping, the moneydemand curve shifts to the right from MD1 to MD2, as shown in Figure 3. The result is a rise in the interest rate.

Figure 3

e.

When a wave of optimism boosts business investment and expands aggregate demand, money demand increases from MD1 to MD2  in Figure 3. The increase in money demand increases the interest rate.

f.

When an increase in oil prices shifts the short-run aggregate supply curve to the left, the Economics, 2nd edition N. Gregory Mankiw and Mark P. Taylor

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  Chapter 35/The Influence of Monetary and Fiscal Policy on Aggregate Demand

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increased price level increases money demand. The money-demand curve shifts to the right from MD1 to MD2, as shown in Figure 3. The result is a rise in the interest rate.

Figure 4

2.

3.

a.

When more ATMs are available, money demand is reduced and the money-demand curve shifts to the left from MD1 to MD2, as shown in Figure 4. If the central bank does not change the money supply, which is at MS 1, the interest rate will decline from r 1 to r2. The decline in the interest rate shifts the aggregate demand curve to the right, as consumption and investment increase.

b.

If the central bank wants to stabilize aggregate demand, it should reduce the money supply to MS2, so the interest rate will remain at r 1 and aggregate demand will not change.

A tax cut that is permanent will have a bigger impact on consumer spending and aggregate demand. If the tax cut is permanent, consumers will view it as adding substantially to their financial resources, and they will increase their spending substantially. If the tax cut is temporary, consumers will view it as adding just a little to their financial resources, so they will not increase spending as much.

4.

a.

The current situation is shown in Figure 5.

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  16  Chapter 35/The Influence of Monetary and Fiscal Policy on Aggregate Demand

Figure 5

b.

The central bank will want to stimulate aggregate demand. Thus, it will need to lower the interest rate by increasing increasing the money supply. This could be achieved if the central bank purchases government bonds from the public.

Figure 6

c.

 As shown shown in Fi Figure gure 6, the central central bank’s bank’s purchase purchase of government government bonds shifts shifts the the supply of money to the right, lowering the interest rate.

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Figure 7

5.

d.

The central bank’s purchase of government bonds will increase aggregate demand as consumers and firms respond to lower interest rates. Output and the price level will rise as shown in Figure 7.

a.

When banks begin to pay interest on current accounts the effect is to increases the return to money relative to other financial assets, thus increasing money demand.

b.

If the money supply remained constant (at MS1), the increase in the demand for money would have raised the interest rate, as shown in Figure 8. The rise in the interest rate would have reduced consumption and investment, thus reducing aggregate demand and output.

c.

To maintain a constant interest rate, the central bank would need to increase the money supply from MS1 to MS2. Then aggregate aggregate demand and output would be unaffected.

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  18  Chapter 35/The Influence of Monetary and Fiscal Policy on Aggregate Demand

Figure 8

6.

The demand for net exports is stimulated by expansionary monetary policy through the exchange rate effect. The decline in the interest rate rate increases net capital outflow, thus increasing net exports.

7.

If government spending increases, aggregate demand rises, so money demand rises. The increase in money demand leads to a rise in the interest rate and thus a decline in aggregate demand if the central bank does not respond. respond. But if the central bank maintains a fixed interest rate, it will increase money supply, so aggregate demand will not decline. Thus, the effect on aggregate demand from an increase in government spending will be larger if the central bank maintains a fixed interest rate.

8.

a.

Expansionary fiscal policy is more likely to lead to a short-run increase in investment if the investment accelerator is large. A large investment accelerator means that the increase in output caused by expansionary fiscal policy will induce a large increase in investment. Without a large accelerator, investment might decline because the increase in aggregate demand will raise the interest rate.

9.

b.

Expansionary fiscal policy is more likely to lead to a short-run increase in investment if the interest sensitivity of investment is small. Since fiscal policy increases aggregate demand, thus increasing money demand and the interest rate, the greater the sensitivity of investment to the interest rate the greater the decline in investment will be, which will offset the positive accelerator effect.

a.

An increase in government spending would shift the aggregate demand curve to the right, increasing output. The rise in output would raise consumption spending, since people would have higher incomes, and raise investment spending through the accelerator. But money demand would also increase, raising the interest rate. This would tend to reduce consumption, as people would save more, and reduce investment, since the cost of investing would be higher. Overall, the changes in both consumption Economics, 2nd edition N. Gregory Mankiw and Mark P. Taylor

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and investment are ambiguous. b.

A reduction in taxes would directly increase consumption spending, since people would have higher after-tax incomes. incomes. Also, since the reduction in taxes increases consumption spending, aggregate demand increases, so total output increases. The rise in output would raise consumption spending further, since people would have higher incomes, and raise investment spending through the accelerator. But money demand would also increase, raising the interest rate. This would tend to reduce consumption, as people would save more, and reduce investment, since the cost of investing would be higher. Overall, consumption must increase (otherwise aggregate demand would not have increased at all) while the change in investment is ambiguous.

10.

11.

c.

An expansion in the money supply reduces the interest rate, thus increasing aggregate demand and output. The rise in output would raise consumption spending, since people would have higher incomes, and raise investment spending through the accelerator. The lower interest rate would increase consumption, as people would save less, and increase investment, since the cost of investing would be lower. Overall, both consumption and investment would increase.

a.

Tax revenue declines when the economy goes into a recession because taxes are closely related to economic activity. In a recession, people's incomes and wages fall, fall, as do firms' profits, so taxes on all these things decline.

b.

Government spending rises when the economy goes into a recession because more people get unemployment insurance benefits, welfare benefits, and other forms of income support.

c.

If the government were to operate under a strict balanced-budget rule, it would have to raise tax rates or cut government spending in a recession. Both would reduce aggregate demand, making the recession more severe.

a.

If there were a contraction in aggregate demand, the central bank would need to increase the money supply to increase aggregate demand and an d stabilize the price level, as shown in Figure 9. By increasing the money supply, the Fed Fed is able to shift the the aggregate demand curve back to AD1 from AD2. This policy stabilizes stabilizes output output as well as the price level.

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  20  Chapter 35/The Influence of Monetary and Fiscal Policy on Aggregate Demand

Figure 9

b.

If there were an adverse shift in short-run aggregate supply, the central bank would need to decrease the money supply to stabilize the price level, shifting the aggregate demand curve to the left from AD 1 to AD2, as shown in Figure 10. This worsens the recession caused by the shift in aggregate supply. To stabilize output instead of the price level, the central bank would need to increase the money supply, shifting the aggregate demand curve from AD1 to AD3, but this action would raise the price level.

Figure 10

12.

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13.

 21

Note that the way the Taylor Rule is expressed in this question is not quite the same as the way it’s expressed in the chapter.  chapter.  a.

The logic lying behind the use of such a rule is that it will require interest rates to be raised (lowered) when inflation is above (below) target and when GDP is above (below) potential GDP. Thus monetary policy will be tightened when inflation is too high and loosened when economic activity is below trend. There may be advantage in doing this because it gives financial markets the opportunity to second guess what the central bank will do. Students may have different views about the desirability of having a central bank follow such a rule. At a time of stagflation the rule may not achieve the outcome that is desired because the authorities will have to choose between tackling inflation and tackling unemployment. The rule will be conflicted: one part urging higher interest rates on account of the fact that inflation is above target but one part urging lower rates because output is below potential output. There is also an argument to be made about the time lags that we expect to see before monetary policy changes impact on the real economy.

b.

Using forecast values for inflation and the output gap means that monetary policy changes can be made in a way that allows for the time lags that will occur before those changes impact on the real economy. However, the forecast values may turn out to be inaccurate, and even data for the recent past can be subject to revision, making forecasting very difficult.

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