Chapter 6 - Answer

Solutions Manual

CHAPTER 6 APPLICATIONS OF MACROECONOMICS THEORYAS A BASIS FOR UNDERSTANDING THE KEY ECONOMIC VARIABLES AFFECTING THE BUSINESS SUGGESTED ANSWERS TO THE REVIEW QUESTIONS I. Questions 1. The four broad classification of factors of production are: a) Labor – (Effort and skill of a carpenter; The ability of an actor) b) Land – (Trees; Water) c) Capital – (Tractor; Factory building) d) Business Know-How 2. A mixed economy involves reliance on both the market and command mechanisms. Most coordination is carried through the market mechanism but there are many economic decisions which are either made by or regulated by the government. 3. Scarcity is the universal condition that human wants always exceed the resources available to satisfy them. The fact that goods and services are scarce means that individuals cannot have all of everything they want. It is therefore necessary to choose among alternatives. Scarcity is a problem of essentially infinite wants and limited resources. While cooperation is one way to organize our activity or confront the problem of scarcity, it cannot eliminate it and therefore cannot eliminate economic problems. 4. Wants reflect our unlimited desires for goods and services without regard to our ability or willingness to make the sacrifices necessary to obtain them. The existence of scarcity means that many of those wants will not be satisfied. On the other hand, demands refer to plans to buy and therefore reflect decisions about which wants to satisfy. 5. Any “three” events that are consistent with the following will increase the demand for peanut butter.

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a) An increase in consumer income (assuming that peanut butter is a normal good) b) An increase in population size c) A change in tastes that now makes peanut butter more desirable Any of these will increase the demand for peanut butter and will thus cause the price of peanut butter to rise and the quantity of peanut butter traded to increase. 6. The existence of s surplus means that, at the current price, the quantity supplied is greater than the quantity demanded. Thus, to eliminate the surplus, either the quantity demanded must increase or the quantity supplied must decrease (or both). As the price falls, we get exactly the necessary results; the quantity demanded increases and the quantity supplied decreases (due to the laws of demand and supply). 7. Due to the tremendous pace of technological advance, not only has the demand for personal computers been increasing, but the supply has been increasing as well. Indeed, supply has been increasing much more rapidly than demand, which has resulted in falling prices. Thus, much (but not all) of the increase in sales of personal computers reflects a movement along a demand curve rather that a shift in demand. 8. This argument confuses a movement along an unchanging demand curve with a shift in the demand curve. The proper analysis is; the increase in the tax on crude oil will increase the cost of the primary resource used in production of gasoline and thus shift the supply curve for gasoline to the left. This will cause the equilibrium price of gasoline to increase and thus the quantity of gasoline demanded will decrease – demand itself will not decrease (i.e., the demand curve will not shift). The decrease in supply causes a movement along an unchanged demand curve. 9. The value of money is the quantity of goods and services that can be purchased with one unit of money. Since inflation means that prices are rising on average, it means that one unit of money will buy less. Thus the value of money falls when there is inflation. 10. Because both borrowers and lenders realize that inflation reduces the value of money, loan agreements will specify a rate of interest that reflects the anticipated rate of inflation. In particular, if they expect a high rate of inflation, they will agree to a higher interest rate. If the rate 6-2

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of inflation turns out to be less anticipated, borrowers are hurt and lenders benefit since the agreed upon interest rate, after adjusting for inflation will be higher than expected. 11. When an expenditure is made, firms receive money payments. The amount received by firms in the aggregate is aggregate expenditure. All that firms receive is distributed as income to households who own the factors of production. Remember that profit is income. Since the aggregate amount firms receive is expenditure and firms pay out all they receive as income, in the aggregate economy, income equals expenditure. 12. Macroeconomic equilibrium occurs when the quantity of real GDP demanded is equal to the quantity of real GDP supplied. Graphically, macroeconomic equilibrium occurs at the intersection of the aggregate demand and short-run aggregate supply curves. 13. The price level can rise as the result of either an increase in aggregate demand or as the result of a decrease in aggregate supply. Indeed both of these forces have contributed to periods in which the price level rose. The steady and persistent increases in the price level, however, have been due to steady and persistent increases in aggregate demand. The most important reason for this behavior of aggregate demand is persistent increases in the quantity of money. 14. A unit of account is an agreed measure in which prices of goods and services are stated. Money serves as a unit of account when all prices are stated in terms of units of money (e.g., peso, dollars and so on). 15. Financial intermediaries create liquidity by borrowing short and lending long. They borrow funds by creating deposits which they promise to repay on short notice but loan funds for long periods of time. The deposits they create are much more liquid than the assets that result from the ultimate loan contracts. Indeed, some of the deposits created by banks are money and are thus perfectly liquid. 16. The three main policy tools of the Central Bank are: a) Required reserve ratios b) Discount rate c) Open market operations

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17. An open market purchase of government securities by the BSP increases the monetary base by increasing one of its components – bank’s deposits at the BSP. The process by which this takes place depends on whether the securities are purchased from banks or from the nonbank public. If the purchase is from banks, the process is direct – the BSP pays for the securities by crediting the bank’s deposit at the BSP, which directly increases the monetary base. If the purchase is from the nonbank public, the BSP pays by writing checks on itself which the sellers of the securities deposit in their banks. The banks in turn present the checks to the BSP, which credits the bank’s deposits at the BSP. Thus, in either case, the monetary base increases by the amount of the open market purchase. 18. The three main motives for holding money are: a) The transactions motive b) The precautionary motive c) The speculative motive 19. If the demand for real money is very sensitive to changes in the interest rate, the demand curve for real money is very flat. Thus, when the money supply increases and the supply curve for real money shifts to the right, the resulting change in the equilibrium interest rate will be small. A small interest rate change will lead to small change in investment, a small change in aggregate planned expenditure and thus an increase in aggregate demand. II. Multiple Choice Questions 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11.

D A D D D C D D C D B

12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22.

A C D B B A D B C A D

23. 24. 25. 26. 27. 28. 29. 30. 31. 32. 33.

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B D C D C A C D D C D

34. 35. 36. 37. 38. 39. 40. 41. 42. 43. 44.

B A C D C B D A B D A

45. 46. 47. 48. 49. 50. 51. 52. 53. 54. 55.

A B B C A D B C C B C