Ep 2

G.M. Chapter 23

1. Explain why an economy’s income must equal its expenditure. 

An economy's income must equal its expenditure, since every transaction has a buyer and a seller. Thus, expenditure by buyers must equal income by sellers.

2. A farmer sells wheat to a baker for $2. The baker uses the wheat to make bread, which is sold for $3. What is the total contribution of these transactions to GDP? 

The contribution to GDP is $3, the market value of the bread, which is the final good that is sold.

3. The “government purchases” component of GDP does not include spending on transfer payments such as Social Security. Thinking about the definition of GDP, explain why transfer payments are excluded. 

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

4. What components of GDP (if any) would each of the following transactions affect? Explain. a. A family buys a new refrigerator.  b. Aunt Jane buys a new house. c. Ford sells a Thunderbird from its inventory. d. You buy a pizza. e. California repaves Highway 101. f. Your parents buy a bottle of French wine. g. Honda expands its factory in Marysville, Ohio. 

a.

Consumption increases because a refrigerator is a good purchased by a

household.  b.

Investment increases because a house is an investment good.

c.

Consumption increases because a car is a good purchased by a household, but investment decreases because the car in Ford’s

inventory had been counted as an investment good until it was sold. d.

Consumption increases because pizza is a good purchased by a household.

e.

Government purchases increase because the government spent money to provide a good to the public.

f.

Consumption increases because the bottle is a good purchased by a household, but net exports decrease because the bottle was imported.

g.

Investment increases because new structures and equipment were built.

G. M. Chapter 24

1. Describe the three problems that make the consumer price index an imperfect measure of the cost of living. The three problems in the consumer price index as a measure of the cost of living are: (1) substitution bias, which arises because people substitute toward goods that have become relatively less expensive; (2) the introduction of new goods, which are not reflected quickly in the CPI; and (3) unmeasured quality change. 2. Explain the meaning of nominal interest rate and real interest rate. How are they 

related? 

The nominal interest rate is the rate of interest paid on a loan in dollar terms. The real interest rate is the rate of interest corrected for inflation. The real interest rate is the nominal interest rate minus the rate of inflation.

3. How do you think the basket of goods and services you buy differs from the basket  bought by the typical U.S. household? Do you think you face a higher or lower inflation rate than is indicated by the CPI? Why? 

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.

4. When deciding how much of their income to save for retirement, should workers consider the real or the nominal interest rate that their savings will earn? Explain. 

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 dollars they will have.

G. M. Chapter 26

1. What is the role of the financial system? Name and describe two markets that are part of the financial system in our economy. Name and describe two financial intermediaries. 2. The financial system's role is to help match one person's saving with another person's investment. Two markets that are part of the financial system are the bond market, market, through which large corporations, the federal government, or state and local governments borrow, and the stock market, through which corporations sell ownership shares. Two financial intermediaries are banks, which take in deposits and use the deposits to make loans, and mutual funds, which sell shares to the public and use the proceeds to buy a portfolio of financial assets. 3. Describe a change in the tax code that might increase private saving. If this policy were implemented, how would it affect the market for loanable funds? 

A change in the tax code that might increase private saving is the introduction of a consumption tax to replace the income tax. Since a consumption tax would not tax the returns to saving, it would increase the supply of loanable funds, thus lowering interest rates and increasing investment.

4. Declines in stock prices are sometimes viewed as harbingers of future declines in real GDP. Why do you suppose that might be true? 

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 prices fall, this must mean that investors expect a lower future  profitability for the firms. This means that we might expect output in these firms to decline as well.

5. When the Russian government defaulted on its debt to foreigners in 1998, interest rates rose on bonds issued by many other developing countries. Why do you suppose this happened? 

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 developing countries. Thus the supply of loanable funds shifted to the left, as shown in Figure Figure 1. The result was an increase in the interest rate. Figure 1

G. M. Chapter 33

1. Explain why the long-run aggregate-supply curve is vertical. 

The long-run aggregate supply curve is vertical because in the long run, an economy's supply of goods and services depends on its supplies of capital, labor, and natural resources and on the available production technology used to turn these resources into goods and services. The price level does not affect these long-run determinants of real GDP.

2. List and explain the three theories for why the short-run aggregate-supply curve is upward sloping. 

Three theories explain why the short-run aggregate-supply curve is upward sloping:

(1) the sticky-wage theory, in which a lower price level makes

employment and production less profitable because wages do not adjust immediately to the price level, so firms reduce the quantity of goods and services supplied; (2) the sticky-price theory, in which an unexpected fall in the price level leaves some firms with higher-than-desired prices because not all prices adjust instantly to changing conditions, which depresses sales and induces firms to reduce the quantity of goods and services they produce; and (3) the misperceptions theory, in which a lower price level causes misperceptions about relative prices, and these misperceptions induce suppliers to respond to the lower price level by decreasing the quantity of goods and services supplied.

3. Why do you think that investment is more variable over the business cycle than consumer spending? Which category of consumer spending do you think would be most volatile: durable goods (such as furniture and car purchases), nondurable goods (such as food and clothing), or services (such as haircuts and medical care)? Why? 

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 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 nondurable 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.

4. Suppose that the economy is currently in a recession. If policymakers take no action, how will the economy evolve over time? Explain in words and using an aggregatedemand/aggregate-supply diagram. 

Figure 8 depicts an economy in a recession. The short-run aggregate supply curve is AS 1 and the economy is at equilibrium at point A, which is to the left of the long-run aggregate-supply aggregate-suppl y curve. If policymakers take no action, the economy will return to the long-run aggregate-supply curve over time as the short-run aggregate-supply curve shifts to the right to  AS 2. The economy's new equilibrium is at point B.

figure 8

G. M. Chapter 29 1. What distinguishes money from other assets in the economy? 

Money is different from other assets in the economy because it is the most liquid asset available. Other assets vary widely in their liquidity.

2. What is commodity money? What is fiat money? Which kind do we use? 

Commodity money is money with intrinsic value, like gold, which can be used for purposes other than as a medium of exchange.

Fiat money money is money

without intrinsic value; it has no value other than its use as a medium of exchange. Our economy today uses fiat money. 3. What characteristics of an asset make it useful as a medium of exchange? As a store of value? 

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 easily as money (so  people can perform transactions easily and quickly), divisible (so people can  provide change), change) , and difficult difficu lt to counterfeit coun terfeit (so people peo ple will not print their the ir own money). That is why nearly all countries use paper 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 assets (like stocks and bonds) and physical assets (like real estate and art) make good stores of value.

4. The Federal Reserve conducts a $10 million openmarket purchase of government  bonds. If the required reserve ratio is 10 percent, pe rcent, what is the largest l argest possible p ossible increase in the money supply that could result? Explain. What is the smallest possible increase? Explain. 

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

The smallest

 possible increase is i s $10 million if all of the th e money is held by banks bank s as excess reserves.

G. M. Chapter 31, 32

1. Define net exports and net foreign investment. Explain how and why they are related. 

The net exports of a country are the value of its exports minus the value of its imports.

Net capital outflow refers to the purchase of foreign assets by

domestic residents minus the purchase of domestic assets by foreigners. Net exports are equal to net capital outflow by an accounting identity, since exports from one country to another are matched by payments of some asset from the second country to the first. 2. Holding national saving constant, does an increase in net foreign investment increase, decrease, or have no effect on a country’s accumulation of domestic capit al? 

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. 3. Why are budget deficits and trade deficits sometimes called the twin deficits? 

Government budget deficits and trade deficits are sometimes called the twin deficits because a government budget deficit often leads to a trade deficit. The government budget deficit leads to reduced national saving, causing the interest rate to increase, thus reducing net capital outflow, which in turn reduces net exports.

4. Suppose that Congress passes an investment tax credit, which subsidizes domestic investment. How does this policy affect national saving, domestic investment, net foreign investment, the interest rate, the exchange rate, and the trade balance? 

If Congress 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 shown in Figure 4. This raises the real interest rate, thus reducing net capital outflow. The decline in net capital outflow reduces the supply of dollars in the market for foreign exchange, raising the real exchange rate. The trade balance also declines, since net capital outflow, hence net exports, are lower. The higher real interest rate also increases the 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. Figure 4

G. M. Chapter 30

1. Explain how an increase in the price level affects the real value of money. 

An increase in the price level reduces the real value of money because each dollar in your wallet now buys a smaller quantity of goods and services.

2. According to the quantity theory of money, what is the effect of an increase in the quantity of money? 

According to the quantity theory of money, an increase in the quantity of money causes a proportional increase in the price level.

3. Recall that money serves three functions in the economy. What are those functions? How does inflation affect the ability of money to serve each of these functions? 

The functions of money are to serve as a medium of exchange, a unit of

account, and a store of 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 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 value of money. In some countries with hyperinflation, stores  post prices in terms of a more stable currency, such as the U.S. dollar, even when the local currency is still used as the medium of exchange.

And

sometimes countries even stop using their local currency altogether, using a foreign currency as the medium of exchange as well. 4. Explain one harm associated with unexpected inflation that is

not

associated with

expected inflation. Then explain one harm associated with both expected and unexpected inflation. 

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 the tax code, and the confusion and inconvenience resulting from a changing unit of account.

G. M. Chapter 28

1. Is unemployment typically short-term or long-term? Explain. 

Unemployment is typically short term. Most people who become unemployed are able to find new jobs fairly quickly.

But some unemployment is

attributable to the relatively few workers who are jobless for long periods of time. 2. How do unions affect the natural rate of unemployment? 

Unions may affect the natural rate of unemployment via the effect on insiders and outsiders. Since unions raise the wage above the equilibrium level, the quantity of labor demanded declines while the quantity supplied of labor rises, so there is unemployment. Insiders are those who keep their jobs. Outsiders, workers who become unemployed, have two choices: either get a job in a firm

that is not unionized or remain unemployed and wait for a job to open up in the union sector. As a result, the natural rate of unemployment is higher than it would be without unions. 3. Explain four ways in which a firm might increase its profits by raising the wages it  pays. 

Four reasons why a firm's profits might increase when it raises wages are: (1)  better paid workers are healthier and more productive; (2) worker turnover is reduced; (3) worker effort is increased; and (4) the firm can attract higher quality workers.

4. Between 1997 and 1998, total U.S. employment increased by 2.1 million workers, but the number of unemployed workers declined by only 0.5 million. How are these numbers consistent with each other? Why might one expect a reduction in the number of people counted as unemployed to be smaller than the increase in the number of  people employed? 

The fact that employment increased 2.1 million while unemployment declined 0.5 million is consistent with growth in the labor force of 1.6 million workers. The labor force constantly increases as the population grows and as laborforce participation increases, so the increase in the number of people employed may always exceed the reduction in the number unemployed.

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