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Macroeconomics – 5th edition

Sample Essays for Macroeconomics


Chapter 1 ........................................................................................................................... 3
Question 1 .............................................................................................................................................................. 3
Question 2 .............................................................................................................................................................. 3
Question 3 .............................................................................................................................................................. 3
Question 4 .............................................................................................................................................................. 3
Chapter 2 ........................................................................................................................... 4
Question 1 .............................................................................................................................................................. 4
Question 2 .............................................................................................................................................................. 5
Question 3 .............................................................................................................................................................. 5
Question 4 .............................................................................................................................................................. 5
Question 5 .............................................................................................................................................................. 6
Chapter 3 ........................................................................................................................... 6
Question 1 .............................................................................................................................................................. 6
Question 2 .............................................................................................................................................................. 7
Question 3 .............................................................................................................................................................. 7
Question 4 .............................................................................................................................................................. 7
Question 5 .............................................................................................................................................................. 8
Chapter 4 ........................................................................................................................... 9
Question 1 .............................................................................................................................................................. 9
Question 2 .............................................................................................................................................................. 9
Question 3 ............................................................................................................................................................ 10
Question 4 ............................................................................................................................................................ 10
Question 5 ............................................................................................................................................................ 10
Question 6 ............................................................................................................................................................ 11
Chapter 5 ......................................................................................................................... 11
Question 1 ............................................................................................................................................................ 11
Question 2 ............................................................................................................................................................ 12
Question 3 ............................................................................................................................................................ 12
Question 4 ............................................................................................................................................................ 13
Question 5 ............................................................................................................................................................ 13
Chapter 6 ......................................................................................................................... 14
Question 1 ............................................................................................................................................................ 14
Question 2 ............................................................................................................................................................ 14
Question 3 ............................................................................................................................................................ 14
Question 4 ............................................................................................................................................................ 15
Question 5 ............................................................................................................................................................ 16
Chapter 7 ......................................................................................................................... 16
Question 1 ............................................................................................................................................................ 16
Question 2 ............................................................................................................................................................ 16
Question 3 ............................................................................................................................................................ 17
Question 4 ............................................................................................................................................................ 18
Question 5 ............................................................................................................................................................ 18
Chapter 8 ......................................................................................................................... 18
Question 1 ............................................................................................................................................................ 18
Question 2 ............................................................................................................................................................ 19
Question 3 ............................................................................................................................................................ 19
Question 4 ............................................................................................................................................................ 20
Question 5 ............................................................................................................................................................ 21
Chapter 9 ......................................................................................................................... 21
Question 1 ............................................................................................................................................................ 21
Question 2 ............................................................................................................................................................ 21
Question 3 ............................................................................................................................................................ 22
Question 4 ............................................................................................................................................................ 23
Chapter 10 ....................................................................................................................... 23
Question 1 ............................................................................................................................................................ 23
Question 2 ............................................................................................................................................................ 24
Question 3 ............................................................................................................................................................ 25
Question 4 ............................................................................................................................................................ 26
Question 5 ............................................................................................................................................................ 26

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Macroeconomics – 5th edition
Sample Essays for Macroeconomics
Chapter 11 ....................................................................................................................... 26
Question 1 ............................................................................................................................................................ 26
Question 2 ............................................................................................................................................................ 27
Question 3 ............................................................................................................................................................ 27
Question 4 ............................................................................................................................................................ 27
Question 5 ............................................................................................................................................................ 28
Chapter 12 ....................................................................................................................... 28
Question 1 ............................................................................................................................................................ 28
Question 2 ............................................................................................................................................................ 29
Question 3 ............................................................................................................................................................ 29
Question 4 ............................................................................................................................................................ 29
Question 5 ............................................................................................................................................................ 30
Question 6 ............................................................................................................................................................ 31
Chapter 13 ....................................................................................................................... 31
Question 1 ............................................................................................................................................................ 31
Question 2 ............................................................................................................................................................ 31
Question 3 ............................................................................................................................................................ 32
Question 4 ............................................................................................................................................................ 32
Question 5 ............................................................................................................................................................ 33
Chapter 14 ....................................................................................................................... 33
Question 1 ............................................................................................................................................................ 33
Question 2 ............................................................................................................................................................ 34
Question 3 ............................................................................................................................................................ 34
Question 4 ............................................................................................................................................................ 34
Chapter 15 ....................................................................................................................... 34
Question 1 ............................................................................................................................................................ 34
Question 2 ............................................................................................................................................................ 35
Question 3 ............................................................................................................................................................ 35
Question 4 ............................................................................................................................................................ 36
Chapter 16 ....................................................................................................................... 36
Question 1 ............................................................................................................................................................ 36
Question 2 ............................................................................................................................................................ 36
Question 3 ............................................................................................................................................................ 37
Question 4 ............................................................................................................................................................ 38
Question 5 ............................................................................................................................................................ 38
Chapter 17 ....................................................................................................................... 39
Question 1 ............................................................................................................................................................ 39
Question 2 ............................................................................................................................................................ 39
Question 3 ............................................................................................................................................................ 39
Question 4 ............................................................................................................................................................ 40
Question 5 ............................................................................................................................................................ 40
Chapter 18 ....................................................................................................................... 41
Question 1 ............................................................................................................................................................ 41
Question 2 ............................................................................................................................................................ 41
Question 3 ............................................................................................................................................................ 41
Question 4 ............................................................................................................................................................ 42
Question 5 ............................................................................................................................................................ 42
Chapter 19 ....................................................................................................................... 42
Question 1 ............................................................................................................................................................ 42
Question 2 ............................................................................................................................................................ 43
Question 3 ............................................................................................................................................................ 43
Question 4 ............................................................................................................................................................ 43

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Macroeconomics – 5th edition
Sample Essays for Macroeconomics
Chapter 1
Question 1
The business cycle is the economist's metric for describing the current state of the
economy: Ranging from economic boom to recession. How would you describe the U.S.
economy's current position in the business cycle?

See recent newspaper (NY Times or Wall Street Journal) for latest summary of economic
conditions.

Question 2
How will a change in the price of steel affect the price of automobiles and quantity of
automobiles sold on the market? Illustrate your answers with a graph of supply and
demand in the automobile industry. What are the exogenous and endogenous variables in
this question?

An increase in the price of steel should lead to an inward shift of the supply curve for
automobiles due to the high cost of steel in the production process. The new equilibrium
will have a higher price and a lower quantity of cars. The price of steel is the exogenous
variable in this question, while the price and quantity of automobiles are the endogenous
variables.

Question 3
Macroeconomic models often assume that all people are identical. Why might this not be
a good assumption when analyzing the market for new computer sales?

Consumers often purchase a computer with a specific functional use in mind, so they will
request a product that is best equipped for their intended use. These differences in
computer preferences cannot be captured in a model that does not allow for differences
among individuals. For example, a model that assumes that all individuals are equal will
not be able to make predictions about changes in demand from desktop to laptop
computers because the simple model will state that one type of computer is preferred by
all.

Question 4
For each of the following markets, describe whether the market is better characterized as
having sticky prices or as exhibiting market clearing behavior.

i. a grocery store

i. Sticky prices. Grocery store prices often remain fixed for long intervals of time.

ii. a stock market

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Macroeconomics – 5th edition
Sample Essays for Macroeconomics
ii. Market clearing behavior. The stock market is a type of auction market where the price
of shares are constantly adjusting to changes in supply and demand.

iii. the personal computer market

iii. Market clearing behavior. In recent years, computer manufacturers have changed
prices more frequently in response to increased competition and the use of Internet sales.

iv. a pizza delivery service

iv. Sticky prices. Pizza places change prices infrequently because they do not want to
incur the costs associated with reprinting and redistributing their updated menus to
customers.

b. What do you think causes the slow price adjustments in the sticky price markets you
described above?

b. Slow price adjustments are common in situations where prices have to be printed for
display and therefore are costly to reprint. Also, firms may be reluctant to change prices
if they believe that individuals will change their demand behavior if they are confronted
by frequent changes. These firms prefer to wait longer periods of time before changing
prices and then make a larger increase when the price change is made. 0

Chapter 2
Question 1
Jimmy is an avid candy connoisseur. Last year, he purchased 75 Snickers bars costing $2
each and 100 Butterfinger bars costing $1 each. This year, he purchased 120 Snickers
bars for $1.50 each and 90 Butterfinger bars for $1.75 each.

a. Assume that a typical consumer basket includes 50 bars of each type. Compute a
consumer price index for each year and determine the percentage change in the index
over the two years.

a. The basket cost $150 ($2*50+$1*50) in the first year and $162.5 ($1.50*50+$1.75*50)
in the second year. The percent increase is 8.33% ((162.5-150)/150).

b. Calculate Jimmy's nominal spending on candy bars in each year. Does nominal
spending increase or decrease?

b. Nominal spending increased: Jimmy spent $250 ($2*75+$1*100) in the first year and
$337.50 ($1.50*120+$1.75*90) in the second year.

c. Using the first year as the base year, determine Jimmy's real spending on candy bars in
each year. Does real spending increase or decrease?

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c. Real spending increased: Using the first year as the base year, Jimmy spent $250
($2*75+$1*100) in the first year and $330 ($2*120+$1*90) in the second year.

d. Calculate the implicit price deflator (defined as nominal spending divided by real
spending). How does this deflator compare the CPI calculated in part (a)? Which
measurement do you think is more relevant in determining the change in Jimmy's cost of
living?

d. The implicit price deflator is 1 in the first year ($250/$250) and 1.02 ($337.50/$330) in
the second year. The percent increase in the deflator is 2%, which is lower than the
change in the CPI index. The implicit price deflator is more directly related to Jimmy's
cost of living since it is based upon his purchases in each year.

Question 2
An American farmer sells a truckload of sugar cane to an American sugar refinery for
$200. The refinery extracts the sugar from the sugar cane and sells it to Coca-Cola for
$350. Coca-Cola uses the sugar in its bottling plant in Toronto, Canada and the resulting
Cola is sold in Canada for $575. How will this string of transactions affect U.S. GDP?
How will it affect U.S. GNP? How will it affect Canadian GNP and GDP?

U.S. GDP increases by $350 since it measures only production within the borders of the
U.S. U.S. GNP increases by $575 because it included production owned by U.S.
companies and citizens. Canadian GNP does not change since businesses involved are all
American owned. Canadian GDP increases by $225 due to the value added of the Coca-
Cola plant in Toronto. 0

Question 3
GDP was described as a flow variable in the chapter. Explain whether the unemployment
rate is a measurement of a flow or a stock variable? Based upon your answer, why do you
think this is a better measurement than the other option (stock or flow)?

Unemployment is a stock variable since it is the total number of people looking for work
at a particular point in time. While changes in the unemployment rate (flow) are
important to monitor, the unemployment rate (stock) is the better indicator for the
analysis of the U.S. economy because it describes the exact status of the labor market.

Question 4
In the country of Plutonia, the working-age population is 75,000. There were 10,000
discouraged workers and 8,000 unemployed laborers.

a. What is the labor force of this country?

a. The labor force is 65,000 (75,000-10,000). Discouraged workers are not counted in the
labor force because they are not actively searching for a job.

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b. Calculate the unemployment rate and the labor-force participation rate.

b. The unemployment rate is 12.3% (8,000/65,000). The labor-force participation rate is


86.7% (65,000/75,000).

c. Suppose that 2,000 of the unemployed workers decided to give up looking for work.
Redo the calculations in part (a) and part (b).

c. The labor force is now 63,000 (75,000-12,000). The unemployment rate is 9.5%
(6,000/63,000). The labor-force participation rate is 84% (63,000/75,000).

d. How did the unemployment rate change from part (b)? Using Okun's law, how would
this change in unemployment change GDP? Do you think the prediction of Okun's law is
realistic in the situation?

d. The unemployment rate fell from 12.3% to 9.5%. According to Okun's law, output
should increase by 8.6% (3%-2*(9.5%-12.3)). This prediction is not realistic because the
only change in the economy is that some people stopped looking for work. There has
been no increase in production.

Question 5
Most economic statistics are seasonally adjusted to remove annual patterns in the
variables. Why do you think it is important for the data to be modified in this way? What
analysis mistakes might occur if someone mistook non-adjusted data for seasonally
adjusted data?

For economic analysis, it is essential to remove seasonal changes so that increases in


economic variables due to annual events, such as the Christmas shopping rush, are not
interpreted as key changes in the business cycle. Without such adjustments, an observer
might think that a slowdown in production in August, associated with workers taking
their summer vacations, signaled a downturn in the economy. If the government then
reacted to this analysis by increasing government spending, the result may be that the
economy overheats instead of maintaining a steady growth rate. 0

Chapter 3
Question 1
Suppose the government decides to decrease taxes in an effort to increase consumer
spending and investment in the economy.

a. Will this plan succeed in accomplishing both goals?

a. Y – C(Y – T) – G = I(r) If taxes are decreased, consumer spending will increase.


National savings will be decreased (S = Y – C – G), therefore investment will have to
decrease.

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b. In equilibrium, what happens to interest rates as a result of this action?

b. To lower investment in the equilibrium, the interest rate must increase.

c. Would you characterize this as a case of fiscal crowding out? Explain.

c. Yes, the decrease in taxation is like an increase in government consumption. The


overall result is a decrease in investment because the government has to borrow more
money due to the decrease in tax revenue.

Question 2
Suppose an automobile manufacturer is choosing between two production options. It can
produce 100 cars with 200 workers and 50 machines, or it can produce 166 cars with 300
workers and 75 machines. Would you describe the manufacturer’s production function as
exhibiting decreasing, constant, or increasing returns to scale? Explain.

The capital stock and the labor force increase by 50% and the output increases by 66%.
This is increasing returns to scale.

Question 3
If the government wants to increase the amount of savings in the economy, how should it
alter government spending? What effect will this action have on the interest rate in the
economy? (Use the appropriate graph to help demonstrate the effect.)

S = Y – C – G The government should decrease spending to increase national saving.


This will lower the interest rate. (Shift out the savings line in the interest rate equilibrium
graph. The interest rate falls due to the downward slope of the desired investment line.)

Question 4
Suppose the production function of a company exhibits increasing returns to scale. Both
capital and labor are required for production, and each factor is subject to diminishing
marginal productivity.

a. Explain how it is possible for a company to have increasing returns to scale and yet
have diminishing marginal productivity for both factors of production.

a. Increasing returns to scale refers to the change in output when both factors are
increased in the same percentage. Diminishing marginal productivity describes the
change in output when only one factor is altered.

b. If the firm increases its labor force and keeps the capital stock constant, how will this
effect the real wage and the real rental price of capital?

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Macroeconomics – 5th edition
Sample Essays for Macroeconomics

b. Increases in the labor force will drive down the real wage because the marginal product
of labor is now lower (diminishing returns). The real rental price will be higher because
each machine has more labor to assist in production.

c. If the firm increases both factors by the same percentage, what will be the effect on the
real wage and real rental price?

c. The real wage will now increase because of increasing returns to scale. Output grew by
a larger percentage than the increase in each factor, so each worker is not producing more
than before (i.e., the marginal productivity for each factor has increased). 0

Question 5
Let the following equations characterize an economy: (note the addition of a tax rate on
output)

Y=C+I+G
Y = 200
C = 23 + 0.8(Y – T)
I = 50 – 9r
G = 60
T = 40 + 0.1Y

a. Calculate national saving, private saving, and public saving.

a. S = Y – C – G = 200 – (23 + 0.8*200 – 0.8*40 – 0.8*0.1*200) – 60 = 5


S(public) = T – G = 40 + 0.1*200 – 60 = 0
S(private) = S – S(public) = 5 – 0 = 5

b. Determine the equilibrium interest rate.

b. 200 = 23 + 0.8*200 – 0.8*40 – 0.8*0.1*200 + 50 – 9r + 60

r=5

c. Suppose that output increases to 209. Redo the calculations in (a) and (b). Explain (in
terms of savings and investment) the reason for the interest rate change.

c. S = Y – C – G = 209 – (23 + 0.8*209 – 0.8*40 – 0.8*0.1*209) – 60 = 7.52


S(public) = 40 + 0.1*209 – 60 = 0.9
S(private) = 7.52-.9 = 6.62
The interest rate decreases due to the increase in savings of the economy (excess supply
of loanable funds).

d. What caused the change in private savings? Why did public savings change?

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d. Private savings increased because not all of the additional income is spent on
consumption. Public savings increased because of the marginal tax rate charged on the
additional income.

Chapter 4
Question 1
Explain the phrase double coincidence of wants. How does the introduction of fiat money
change the requirement of double coincidence of wants for trade?

The double coincidence of wants is the condition where both people must desire what the
other person has in order for a trade to take place. Fiat money facilitates trade because
people will always be willing to accept it in exchange for a good. They can then use the
money to purchase the good they desire. This eliminates the difficulty associated with
barter trade, where people spend time searching for a situation where someone has the
good they want and are willing to trade for the good they have.

The double coincidence of wants is the condition where both people must desire what the
other person has in order for a trade to take place. Fiat money facilitates trade because
people will always be willing to accept it in exchange for a good. They can then use the
money to purchase the good they desire. This eliminates the difficulty associated with
barter trade, where people spend time searching for a situation where someone has the
good they want and are willing to trade for the good they have.

Question 2
Explain the effects of the following changes on the nominal interest rate, money demand,
and price level.

a. a one-time increase today in the money supply

a. A one-time increase today in the money supply will result in an increase in the price
level. Money demand and the interest rate will remain unchanged.

b. a decrease in the real interest rate

b. A decrease in the real interest rate will lead to a fall in the nominal interest rate since
the nominal interest rate is the sum of the real interest rate and expected inflation. The
fall in the nominal interest rate will cause an increase in real money demand. The rise in
real money demand will lead to a fall in the price level, which increases the real money
supply (M/P) to match the increase in real money demand.

c. an increase in output

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c. An increase in output will lead to an increase in real money demand. This will lead to
an fall in the price level. Interest rates will remain unchanged.

d. an announcement today of a planned decrease in the money supply growth rate

d. An announcement today of a planned decrease in the money supply growth rate will
lead to a fall in expected inflation, which in turn will cause a fall in nominal interest rates
due to the Fisher effect. The fall in interest rates will lead to an increase in real money
demand. The price level will decrease in order for the real money supply to increase with
real money demand.

Question 3
Explain the difference between ex ante and ex post real interest rate. Why don't investors
know the ex post rate when they make their initial investment?

The ex ante real interest rate is the interest rate expected when the loan is made. The ex
post real interest rate is the realized rate after the loan has been repaid. Investors are
unable to know the ex post rate when the investment is made because they do not know
what the inflation rate will be over the course of the investment. 0

Question 4
How does the U.S. inflation tax affect foreign countries that use dollars as a medium of
exchange? Why would countries such as Panama decide to switch from their own
currency to the U.S. dollar as the primary medium of exchange and face a U.S. inflation
tax?

The U.S. inflation tax will affect foreign countries just as it will affect people holding
dollars in the U.S. Anyone holding cash will lose purchasing power as inflation pushes up
prices for goods. Countries such as Panama are willing to accept the U.S. inflation tax
because U.S. monetary policy has been much more stable over time. Many countries have
had a long history of hyperinflation because their governments have printed money to
pay off debts. By accepting the U.S. currency as the official medium of exchange, these
countries can inherit the price stability found in the U.S. 0

Question 5
Suppose real GDP is growing 3 percent, the money supply is growing at 10 percent, the
velocity of money is constant, and the real interest rate is 5 percent.

a. What is the current inflation rate and nominal interest rate?

a. According to the quantity theory of money, the money growth rate is equal to the sum
of output growth and inflation, assuming velocity is constant. Thus, inflation is the
difference between the money growth rate and output growth: 10-3=7 percent. The

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nominal interest rate is equal to the sum of the real interest rate and inflation: 5+7=12
percent.

b. If the money supply growth rate increases to 15 percent, how will your answers in part
(a) change?

b. The increase in the money growth rate will lead to inflation of 12 percent (15-3). The
nominal interest rate will be 17 percent (5+12).

c. If you were an investor, how would the change in the money supply growth affect your
real profitability, assuming that you now receive the new nominal interest rate?

c. Real profitability on investments will still be 5 percent if you received the new nominal
interest rate.

d. Based on your previous answers, would you prefer a fixed or a floating interest rate on
your investments? Which would you prefer if you thought the money supply growth was
going to be reduced?

d. In this situation, the floating interest rate would be preferred. If the nominal rate
remained fixed at 12 percent, the real return would drop to 0 (12-12). If the money
growth rate was going to be reduced, one would prefer a fixed nominal interest rate
because then the real return would increase as inflation fell.

Question 6
Why might there be a benefit of inflation?

Some economists argue that a little inflation helps to clear the labor markets. Their
argument is based on the observation that cuts in nominal wages are rare: firms rarely cut
their workers’ nominal wages and workers are reluctant to accept them. If nominal wages
can’t be cut, then the only way to lower real wages is to allow inflation to do the job.
That is, inflation might help to reduce real wages when a reduction is required to ensure
that labor demand equals labor supply.

Chapter 5
Question 1
The United States has run a trade deficit over the past two decades. Has this deficit been
good or bad for the economy? Be sure to discuss the implied change in net capital
outflow and the advantages/disadvantages of this change?

Over the past two decades, the United States has imported more than it has exported. This
has been a benefit in the sense that consumers have been able to consume a wider array
of goods and increase the standard of living. The potential downside of the increase in
imports over exports is that the U.S. has had to sell assets in order to pay for the excess
imports, i.e. net capital outflow has decreased due to the trade deficit. If the sale of U.S.

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Macroeconomics – 5th edition
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assets results in foreign investment in profitable ventures, the U.S. will benefit in terms of
strong growth of the economy and low unemployment. If the trade deficit were to
continue for several more decades, the concern would be over the size of foreign
investment in the U.S. This could lead to problems seen in other countries when foreign
investors suddenly lose faith in a country's economy. This loss of confidence can lead to
a huge crisis as they quickly withdraw their investments.

Question 2
In the 1980's, the United States had large government deficits and large trade deficits. In
the late 1990's, the government deficit has been eliminated but the large trade deficit
remains. Using the link between net exports, savings, and investment, why did the trade
deficit remain so large when the government deficit was eliminated?

The link between government deficits and trade deficits can be most easily seen by
splitting savings into two categories: private savings (SP) and government savings.
Government savings is simply the difference between taxes (T) and government spending
(G). So we can describe savings as S = SP + (T - G). Substitute this into the relationship
between net exports, savings, and investment to get NX = SP + (T - G) - I. Now we can
see that if private savings and investment remain constant, a decrease in government
savings (increased budget deficit) will lead to a decrease in net exports (increased trade
deficit). This describes the situation in the 1980's. In the late 1990's we have seen an
increase in government savings. This has not lead to a corresponding increase in net
exports, which must indicate that private savings and investment have changed. Higher
investment and lower private savings could account for this outcome, and there is
evidence that both of these changes have occurred.

Question 3
Suppose that the expected inflation rate is 10 percent in the United States and 5 percent in
Japan. The real interest rate is 3 percent in both countries, and assume that purchasing
power parity holds.

a. What is the nominal interest rate in each country?

a. The nominal interest rate is the sum of the real interest rate and expected inflation. For
the U.S., this rate is 13 percent (3+10). For Japan, this rate is 8 percent (3+5).

b. What are the expected changes in the real and nominal exchange rates?

b. Differences in inflation rates will lead to expected changes in the nominal exchange
rate. The Yen/$ rate should decrease by the differential in expected inflation, which is 5
percent (5-10). The real exchange rate is not expected to change unless there is a
fundamental change to savings, investment, or demand for net exports.

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c. If the Federal Reserve increases the money supply and inflation expectations rose to 12
percent in the U.S., how would this change affect the expected changes in the real and
nominal exchange rates? If you had planned to invest money in the United States, would
this policy change affect your decision?

c. An increase in inflation expectations in the U.S. would lead to a higher expected


decrease in the Yen/$ exchange rate. This expected decrease is now 7 percent (5-12). The
real exchange rate should remain unchanged. For a U.S. investment, you would now need
to receive a higher nominal interest rate or else your real return will fall due to the
increase in inflation.

Question 4
Suppose the U.S. government has decided to enact a quota on Swiss watches to reduce
the trade deficit. What impact will this quota have on the trade balance? How will this
change affect real and nominal exchange rates? What impact does the quota have on U.S.
importers and exporters who are not involved in trading watches?

The new quot will have no impact on net exports unless there is a change in savings or
investment. The quota will cause the real exchange rate to increase due to the decreased
demand for imports in the U.S. The nominal exchange rate should increase by the same
percentage as the change in the real exchange rate. Even though the total amount of net
exports remains unchanged, individual importers and exporters will be affected by the
change in exchange rates. The higher exchange rate means that U.S. goods will be more
expensive, thus exports will fall. Imports will now be cheaper, so they will increase. The
changes in imports and exports will offset the fall in imports of watches so that total net
exports remain unchanged.

Question 5
You are presented with the following foreign exchange situation: you can trade dollars
and pounds in London at a rate of 1.5 $/£ and in New York at a rate of 1.6 $/£ .

a. Show through an example if it is possible to profit from currency trading in New York
and London?

a. Suppose you start with $100. If you buy pounds in London, you will receive 66.67
pounds (100/1.5) for your $100. Now return to New York and buy $. You will receive
$106.67 (66.67*1.6) and you have just made a profit of $6.67.

b. Would you expect these rates to exist for long in the market place? Why or why not?

b. Now if everyone tried to make a profit in this manner, the high demand for pounds in
London would drive up the value of the pound (an increase in the $/£ exchange rate). The
high demand for dollars in New York would drive up the value of the dollar (a decrease
in the $/£ exchange rate). This process would continue until the exchange rates are equal,
at which point there is no opportunity to profit.

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Chapter 6
Question 1
The separation rate in an economy is 5 percent and the rate of job finding is 7 percent.

a. If this economy has 500 workers in the labor force, calculate the steady state
unemployment rate and the unemployment level.

a. The steady state unemployment rate is the point at which the number of people finding
jobs equals the number of people leaving jobs: fU=sE. We can substitute for employed
workers using E=L-U. Solving for U/L: U/L = s/(f+s)=(0.05)/(0.07+0.05) *100= 41.7%.
Since the labor force has 500 workers, the unemployment level = 0.417*500 = 208
unemployed.

b. If the separation rate falls to 3 percent, what happens to the steady state unemployment
rate and unemployment level?

b. If the separation rate falls to 3 percent, the unemployment rate will now be U/L =
0.03/(0.07+0.03)*100= 30%. Then unemployment level is 150 (0.3*500) unemployed.

c. Now if the labor force suddenly increases to 600 workers (the separation rate remains
at 3 percent), what is the immediate change in the unemployment rate? What is the new
steady state rate of unemployment? Also describe the immediate and steady state change
in the unemployment level.

c. The new unemployment rate immediately after the change increases because of the
addition of 100 new unemployed people (150+100)/600*100=41.7%. The steady state
unemployment rate remains unchanged at 30%. The unemployment level will initially be
250, and it will slowly decline to the steady state level of 180 (.3*600).

Question 2
Describe the ways in which government policy affects frictional unemployment. Be sure
to include a discussion of search time and its relation to frictional unemployment.

Unemployment insurance increases the amount of frictional unemployment by providing


workers with a base income while they search for work. Since they are not as financially
constrained during their search, they will often take longer to find a new job.
Retraining programs and improved listings of job vacancies help to reduce frictional
employment by improving the matching process for firms and workers. Thus, the search
time required to find a new job will be reduced.

Question 3
Describe the effect of the following changes on the unemployment rate, wages, and
waiting time:

a. an increase in union membership


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a. Increased union membership will increase wages through collective bargaining. The
higher wages will lead to more unemployment as firms decrease their labor demand and
longer waiting times for jobs

b. a decrease in the minimum wage

b. A decrease in the minimum wage will decrease the unemployment rate as firms
increase their demand for labor. Wages will fall and waiting time will decrease as more
job openings are available.

c. an increase in unemployment benefits

c. An increase in unemployment benefits will increase the waiting time as people can
search longer for a better job while receiving government assistance. This will increase
the unemployment rate. Wages rates should also rise because people will not accept the
low wage jobs as quickly as before. Thus, firms will have to offer higher wages if they
want to find new employees.

d. a decision by companies to introduce an efficiency-wage pay scale

d. If firms offer a higher pay scale, wages will increase and frictional unemployment
should decrease as workers are less likely to leave their jobs. The unemployment rate
could fall if frictional rate decreases, but it may also rise if firms now need fewer workers
since each worker now has the incentive to be more productive.

Question 4
Consider the following Cobb-Douglas economy: Y=F(K,E)=K0.5E0.5
where E represents the number of employed workers. The separation rate in this economy
is 2 percent, the job finding rate is 8 percent, the savings rate is 20 percent,and the
depreciation rate is 6 percent. There is no population growth or technological progress.

a. Calculate the steady state capital stock per employed worker and output per employed
worker.

a. The steady state capital stock per employed worker is the solution to the following
equation: s*f(k) = (d +n+g)k. Substituting in the values yields 0.2* k0.5 = (0.06)k. Solving
for k: k = 3.332 = 11.1. Output per employed worker is k0.5 = 11.10.5 = 3.33.

b. If this economy has 100 people in the labor force, what is the unemployment rate and
the unemployment level in steady state?

b. The steady state unemployment level is U/L = s/(f+s) = 20 percent. The unemployment
level is 0.2*100 = 20 people.

c. What is the steady state output level in the economy? What is the steady state capital
stock?

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c. Since output per worker is 3.33, a country with 80 employed workers has an output
level of 80*3.33 = 266.4. The steady state capital stock is 80*11.1 = 888.

d. If a new government policy is able to increase the job finding rate to 10 percent, how
would your answers in parts (a), (b), and (c) change?

d. An increase in the job finding rate will not affect the steady state capital stock per
employed worker or the output per employed worker. The unemployment rate will fall to
0.02/(0.02+0.1) = 16.7 percent and the unemployment level will fall to 17 workers. The
output level will increase to 83*3.33 = 276.4 and the capital stock will rise to 83*11.1 =
921.3.

Question 5
The unemployment rate fell below 5 percent in 1998, 1999, and 2000 before climbing
above that rate in the second half of 2001. Do you think this decrease reflected a change
in the natural rate of unemployment? If so, what factors have contributed to the decline in
the natural rate? (Hint: be sure to consider possible changes in the labor supply and labor
demand curves.)

It appears that the natural rate of unemployment has decreased because unemployment
rates fell dramatically in 1998 and 1999 without a strong increase in wages. Thus, the
supply and demand for labor appear to be near equilibrium. Many factors may have
contributed to this lower natural rate. One current theory is productivity has increased at a
faster rate the past few years due to the use of computers and other technology. Thus,
each worker is now more productive, so firms have increased their demand for workers.
The frictional rate may also have been reduced by government policy changes, especially
the reduction of welfare benefits.

Chapter 7
Question 1
According to the Solow growth model, why will an economy move towards its steady
state if the current capital stock per worker is below the steady state value?

If the economy is below its steady state, the savings of the economy (s*f(k)) will be
greater than the capital depreciation (dk). Therefore, the capital stock will increase over
time until the steady state is reached.

Question 2
Assume an economy has the following production function: Y=F(K,L)=K0.4L0.6

a. State the per-worker production function.

a. y = k0.4

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b. If the savings rate is 0.2 and the depreciation rate is 0.05, calculate the steady-state
capital stock per worker, output per worker, and consumption per worker.

b. 0.2* k0.4 = 0.05*k; k = 41.666 = 10.08


y = k0.4 = 10.080.4 = 2.52

c = y – i = 2.52 - d k = 2.52 – 0.05*10.08 = 2.02

c. Now suppose the government increases spending, reducing the country’s savings rate
to 0.1. Redo the calculations in (b) based upon this change. What is the effect on the
government spending on the economy?

c. 0.1* k0.4 = 0.05*k; k = 3.17


y = k0.4 = 1.59
c = y – i = 1.43

The increase in government spending reduces consumption in the economy.

Question 3
The population of the United States grew rapidly in the late 1800’s as large numbers of
immigrants arrived from Europe. Assume that the United States was in a steady state
before the population increase.

a. What effect should the increase in the population growth rate have on the steady state
level of capital per worker?

a. The increase in the population growth rate will lower the steady state.

b. Explain how the transition to the new steady state will take place. Is the growth rate of
output per person in the economy positive or negative during the transition? What about
the growth rate of total output?

b. Compare savings to depreciation (which includes the effect of population growth)


s*f(k) vs. (d +n)k
With a higher population growth rate, the capital per worker needed for replacement is
higher than the savings, so the capital stock per worker will fall until the new steady state
is reached.

c. Assume the original steady state was below the Golden Rule level of capital. Why
would policy makers not want to alter the savings rate to reach the Golden Rule level of
capital? Could the subsequent increase in the population growth rate offer a less costly
way to reach the Golden Rule? Explain.

c. If the Golden Rule level was above the original steady state, it would be costly for the
government to increase the savings rate to reach that level. Politicians are often not
willing to sacrifice the standard of living of people today in order to benefit future

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citizens. But with an increase in the population growth rate, the golden rule level of
capital per worker has decreased. So this would be a good opportunity to increase the
savings rate and reach the Golden Rule level before the steady state begins to decline as
described in part (b). 0

Question 4
In the future, if the United States is able to produce capital that does not depreciate, how
would this affect the steady state of the economy? Would the economy now be able to
have unlimited growth?

The new steady state would be determined by increasing the capital stock per worker
until the marginal product is equal to zero. This does not lead to unlimited growth,
because diminishing marginal productivity of capital implies that eventually, the next unit
of capital added will no longer increase output.

Question 5
Suppose two countries have identical constant-returns-to-scale production functions and
start with the same capital stock per worker. Both countries have a population growth rate
of 2 percent and a depreciation rate of 10 percent. The savings rate, however, differs in
each country. Country A saves 20 percent of its income, while Country B saves only 15
percent.

a. Assume that the initial capital stock per worker lies below each country’s respective
steady state level. Which country will exhibit faster growth in the first few periods?
Explain.

a. Country A will grow faster because it is saving a larger fraction of its output to add to
the capital stock.

b. Now supposed the population growth rate in Country A increases to 5 percent. Which
country will have the higher steady state level of capital per worker? (Hint: use the
capital accumulation equation and the fact that the production function exhibits
diminishing marginal productivity with respect to increases in capital per worker.)

b. The steady state is determined by solving s*f(k) = (d +n)k which can be rewritten as
f(k) = ((d +n)/s)*k
Evaluating ((d +n)/s) for each country yields 0.8 for country A and 0.75 for Country B.
By graphing a generic production function and the following function -- ((d +n)/s)*k –
you will see that Country A will have the lower steady state value.

Chapter 8
Question 1
Over much of the 1990s, the U.S. economy grew at a faster rate than the Mexican
economy. Does this observation necessary contradict the prediction of economic
convergence? Explain your answer.

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No, there are several reasons why the U.S. may be growing faster than Mexico. First, the
U.S. may have a much greater rate of technological growth. Second, the countries may be
converging to different points. Other reasons include possible differences in saving rates
and population growth rates.

Question 2
Assume an economy has the following production function: Y=F(K,L)=K0.4(E*L)0.6.

a. State the production function per effective worker.

a. The production function per effective worker is y = k0.4.

b. For this economy, the savings rate is 25 percent, the depreciation rate is 5 percent, the
population growth rate is 2 percent, and the technology growth rate is 3 percent.
Calculate the steady-state capital stock per effective worker, output per effective worker,
and consumption per effective worker.

b. The capital stock per effective worker is the solution to s*f(k) = (d +n+g)k.
Substituting in the values yields 0.25* k0.4 = (0.05+0.02+0.03)k.
Solving this for k: k = 2.51.67 = 4.61. Output per effective worker = k0.4 = 1.84.
Consumption per effective worker = f(k) - (d +n+g)k = 1.84 - 0.461 = 1.379.

c. If the technology growth rate increases to 5 percent, what happens to the capital stock
per effective worker and output per effective worker? Will this change cause total output
to increase or decrease?

c. Now we solve the following equation for k: 0.25* k0.4 = (0.05+0.02+0.05)k. The
answer is k = 2.081.67 = 3.39. Output per effective worker = 1.63. Total output will
increase as a result of the higher technology as the economy is now more productive. 0

Question 3
An economy has a capital-output ratio of 2, a depreciation rate of 8 percent, a savings rate
of 30 percent, and a population growth rate of 2 percent. Capital income is about 35
percent of output. Assume that the economy has a Cobb-Douglas production function and
is in a steady state.

a. Calculate the technology growth rate for this economy.

a. Calculate the technology growth rate by solving: s*y = (d +n+g)k.


0.30 = (0.08 + 0.02 + g)*k/y where k/y = 2.
The solution is g = 0.05.

b. What is the marginal product of capital for this economy?

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b. From Chapter 3 we know that capital owners earn income of MPK from each unit of
capital. Therefore, MPK*k = 0.35*y. We can rewrite this as MPK*(k/y) = 0.35. Since k/y
equals 2, we can solve for MPK. MPK = 0.175.

c. Is the economy at the Golden Rule steady state? If not, should the savings rate be
increased or decreased in order for the Golden Rule capital stock level to be reached?
How will this change affect the marginal product of capital? How will it affect the
capital-output ratio?

c. The Golden Rule steady state is MPK - d = n + g. Here the return to capital (MPK - d )
of 9.5 percent exceeds the growth of the economy (n + g), 7 percent. Thus, we need a
higher savings rate to increase the capital stock. An increase in the capital stock will
reduce the marginal product of capital due to diminishing returns. The capital-output ratio
will increase, also due to diminishing returns. An extra unit of capital will not produce
the same amount of output as the previous units, so k/y will increase as the capital stock
is expanded.

Question 4
An often debated government policy is the funding of medical research.

a. Using the concepts of externalities, social returns, and private returns, discuss why the
government should or should not allocate money for medical research. How can the
government encourage private companies to increase research spending?

a. Medical research is an area where the social returns to the elimination of a disease are
often greater than the private returns that any one company could earn from discovering a
cure. The failure of firms to account for the large social returns in their decision making
process is an example of an externality. Profit-maximizing firms only respond to direct
costs and benefits when planning their research agendas. Thus, the government may need
to finance research in situations where private firms are not actively engaged in socially
beneficial research. In addition, the government can give firms incentives, such as tax
breaks, in order to help them internalize the social benefits of research on a particular
medical illness.

b. If the government feels that more funds need to be devoted to medical research, do you
think it is better for the government to finance the research directly, or should it give
incentives to private companies to finance the research? How do you think each plan
would affect the resulting costs of the drugs once they are produced?

b. The benefit of research conducted by private firms is that they are trying to minimize
costs. Thus, they are often more efficient in their research. The problem, as before, lies
with the externalities that do not enter into the decision-making process of firms. If the
firm does not see a financial benefit in fully curing an illness, they will not undertake the
research even though it may help thousands of people. The profit motive is visible in the
high costs of prescription medicines. Firms that undertake the costs of research want to

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be compensated for their efforts, and the people with the illness are the ones who must
bear the costs. If the government undertakes the research, then all taxpayers are bearing
the cost. The resulting medications can be sold at much reduced rate since the research
has been publicly funded.

Question 5
Compare the two-sector endogenous growth model to the Solow model. What are the
similarities of the models? What assumptions are different between the two models?
Which do you think is more realistic? Explain.

Both models have a production function, savings, depreciation, labor and capital.
The endogenous growth model does not assume an exogenous growth process. Instead, it
models the growth as a result of research by a subset of workers. In addition, this model
does not assume that capital has decreasing returns. Increased savings can lead to a
higher steady state growth rate, while in the Solow model, the savings rate does not affect
the steady state capital stock.
The endogenous growth model is more realistic in the sense of allowing for human
capital and a more detailed explanation for the presence of growth. The Solow model is
more realistic in its assumption of diminishing returns for capital. 0

Chapter 9
Question 1
Explain why the long-run aggregate supply curve is vertical and the short-run aggregate
supply curve is horizontal.

The short-run aggregate supply curve is horizontal because prices are assumed to be
sticky in the short run. Therefore, producers will be willing to increase quantity supplied
at a constant price. The long run aggregate supply curve is vertical because output is
determined in the long run by the amount of labor and capital in the economy, along with
the available technology. Therefore, changes in price will not affect the amount supplied.

Question 2
Supposed there is an increase in the velocity of money caused by the increased use of
ATM machines.

a. How would prices and output be affected in the short run?

a. In the short run, prices remain fixed. According to the quantity theory of money, the
increase in velocity must be matched by an increase in output since the money supply and
prices are fixed.

b. If the Federal Reserve's objective is to keep prices stable in the short-run, how should
it respond?

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b. Since prices are fixed in the short run, the Federal Reserve does not have to make any
response initially.

c. In the long run, what will happen to prices and output? If the Federal Reserve's
objective is to keep prices stable in the long run, how should it respond? When should it
undertake its response -- immediately or once the "long run" is reached?

c. In the long run, output is determined by the factors of production. Therefore, the
increase in velocity will not affect output. Prices must increase to match the higher
velocity if output and the money supply remain unchanged. With a long-run goal of price
stability, the Federal Reserve needs to decrease the money supply to offset the effect of
the higher velocity. In terms of the quantity theory equation, MV=PY, if the decrease in
money is proportional to the increase in velocity, there will be no change in the right-
hand side of the equation. This monetary policy response should be enacted immediately
so that there is no short run pressure on output. If output increases, this will lead to price
increases in the long run to reduce output to its original position.

d. Based upon your answer in part (c), how would you respond to those who argue that
the Federal Reserve should wait until inflation appears before reacting?

d. Due to price stickiness in the short run, inflation pressures build up before inflation is
actually present in the economy. To prevent the price increase, the Federal Reserve needs
to respond to these pressures before the inflation occurs. If the Federal Reserve waits
until inflation is visible, its response will be too late because changes in the money supply
only have a long-run impact on prices.

Question 3
The length of time between the short run and long run varies across sectors of the
economy. For the following industries, estimate the time it takes to reach the "long run"
based upon your knowledge of how quickly prices in this industry change in response to
the given shock. Describe the rational underlying each of your estimates.

a. gasoline prices after an announcement of a reduction in OPEC production

a. Gasoline prices respond very quickly to changes in oil production. The long run may
be reached in as soon as 2 weeks.

b. Sears catalog prices after an increase in the price of cotton used for making clothing

b. Since catalogs are only printed a few times each year, it may be six months to a year
before increases in input prices affect the price of clothing.

c. orange juice prices after a severe frost destroys crops in Florida

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c. The price of oranges reacts very quickly to changes in production. A severe frost will
probably translate into higher juice prices within a month.

d. GM car prices after auto workers receive an increase in wages

d. Car prices may respond slowly to wage increases because prices are often established
on a yearly basis that corresponds with the introduction of new models. The impact may
be more indirect in terms of fewer rebate offers and fewer sales. 0

Question 4
Suppose there was a huge drought in the U.S. that cut farm production in half for one
year.

a. What happens to the aggregate demand and aggregate supply curves?

a. In the short run, the aggregate supply curve would shift up. The aggregate demand
curve and the long-run aggregate supply curve remain unchanged.

b. How will output and prices change in the short and long run?

b. In the short run, prices will increase and output will decrease. There will be no change
in the long run.

c. How would this affect net exports in the short run?

c. In the short run, U.S. agricultural exports should decrease due to the reduced
production, and imports will increase as consumers buy food from other countries.

d. If the drought continued for several years, what would you expect to happen to net
exports and the real exchange rate? (Hint: Use the models in Chapter 8 to describe the
long-run changes. Assume that real interest rates are fixed.)

d. In Chapter 8, we learned that net exports are determined by the difference between
savings and investment. If there is no change in savings and investment, then net exports
will not change. A decrease in demand for net exports caused by lower exports and
higher imports would lead to a fall in the real exchange rate. If the fall in production was
large enough to lead to a significant fall in U.S. GDP, this may lead to a fall in savings. If
savings decreased (assuming no change in investment), then net exports would fall and
the real exchange rate would rise, as seen in the real exchange rate equilibrium graph
from Chapter 8.

Chapter 10
Question 1
Explain how velocity is affected by interest rates and money demand. If the Federal
Reserve increases the money supply, will there be a bigger change in output if the

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velocity remains constant or if it adjusts as you just described? (Hint: Use the quantity
theory of money equation to discuss the impact of changes in money and velocity on
output.)

Interest rates affect the money demand of individuals. As interest rates increase, people
hold less money because their opportunity cost of holding money (the interest they could
receive in a savings account) has increased. A change in money demand will in turn
affect the velocity. With a lower money demand caused by higher interest rates, the
velocity of money will increase because the money people held will be used more
frequently.
Using the quantity theory of money equation, MV=PY, we see that an increase in the
money supply will lead to a proportional increase in output if velocity is constant
(assuming prices are fixed). The increase in the money supply will lead to an increase in
money demand and a decrease in interest rates, as shown in the money-market
equilibrium graph. If velocity is a function of interest rates, we will see a decrease in
velocity as people hold more money, and therefore spend the money at a slower rate.
Using the quantity theory equation, the fall in velocity will diminish the increase in
output caused by the increase in the money supply.

Question 2
Let the following equations characterize an economy:

C = 400 + 0.8*(Y-T)
G = 300
T = 250
I = 200

a. Draw a graph of planned expenditures for this economy and calculate the equilibrium
level of output.

a. The equilibrium is calculated by solving the following equation for output:

Y = C(Y-T) + I + G
Y = 400 + 0.8*(Y-250) + 200 + 300
Y = 900 + 0.8*Y - 0.8*250 = 700 + 0.8*Y
(1-0.8)Y = 700
Y = 700/(1-0.8) = 3500

In the graph, the planned expenditure line should have an intercept of 700 and a slope of
0.8. It should cross the Y=E line at Y=3500.

b. Suppose output this year was 3000. Is the economy in equilibrum?

b. If actual expenditure is 3000, then the economy is below the equilibrium value.

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c. If the government wanted to use fiscal policy to move the economy to equilibrium, by
how much would it have to increase government spending? What is the government
spending multiplier?

c. The government spending multiplier is 1/(1-MPC) = 5. To increase output from 3000


to 3500, government spending should be increased by 100. The multiplier effect is 100*5
= 500, which will increase output to the equilibrium level.

d. If the government decided not to change fiscal policy, describe the process by which
the economy would move toward equilibrium.

d.If the government does not increase spending, the economy will move toward
equilibrium on its own. From the graph we see that actual output is less than planned
expenditure. Therefore, firms are seeing an unplanned decrease in inventories. They will
boost production to meet the planned expenditures until the equilibrium level is reached.

Question 3
Describe how the following changes will affect the LM curve

a. An increase in the money supply

a. An increase in the money supply (holding output constant) will lead to a lower interest
rate, thereby shifting the LM curve downward.

b. An increase in output

b. An increase in output will lead to an increase in money demand and an increase in


interest rates. This relationship is the basis for the LM curve, so we simply move along
the curve.

c. A one-time increase in the price level

c. A one-time increase in the price level will cause a decrease the real money supply,
M/P, assuming the nominal money supply (M) remains fixed. This will cause an increase
in interest rates and shift the LM curve upward.

d. A decrease in the money demand function caused by the increased use of ATM
machines (people demand less money at any given interest rate)

d. A decrease in the demand for money caused by the increased use of ATM machines is
illustrated by an inward shift of the money demand function in real money equilibrium
graph. This will lead to a lower interest rate and will cause the LM curve to shift
downward.

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Question 4
In previous chapters we discussed how increased government spending leads to crowding
out of investment. Based upon the model in this chapter used to generate the IS curve,
will an increase in government spending lead to a decrease in investment? Explain.

An increase in government spending will lead to an increase in output at any given


interest rate. Therefore, this is represented by an outward shift in the IS curve. If we now
look at these two curves and hold the output level constant, we see that the shift has
resulted in a higher interest rate. This would lead to a decrease in investment. Here the
output level has not changed, so the increase of government spending has led to an equal
decrease in investment — total crowding out. The extent of crowding out in equilibrium
will be determined by the effect of government spending changes on the interest rate. If
interest rates are unchanged, there is no crowding out, but as the interest rate increases,
there will be a higher degree of crowding out.

Question 5
Explain why the tax multiplier is smaller than the government-purchases multiplier.

The tax multiplier is smaller than the government-purchases multiplier because of the
initial effect on the economy. When the government spends an additional $100, the entire
amount contributes to output (Y=C+I+G). When taxes are reduced by $100, the effect on
the output depends on the change in consumption. If the marginal propensity to consume
is 80%, that means only $80 of the $100 tax cut will be spent. The $20 used for savings
does not contribute to the output in the formula above. Thus, the government spending
impact on the economy is $100/(1-0.8), whereas the tax cut contributes $100*0.8/(1-0.8)
or $80/(1-0.8).

Chapter 11
Question 1
Assume that the economy is at full employment. The government decides to cut taxes to
give the economy an extra boost.

a. Show the short run effect of this tax cut using the IS-LM model. What will happen to
output and the interest rate?

a. The tax cut will shift out the IS curve. Output and interest rates will rise.

b. What will happen in the long run?

b. In the long run, prices will rise due to the fact that output is above the full-employment
level. This decreases the real money supply (M/P), and results in an inward shift of the
LM curve.

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c. If the Federal Reserve is following a policy of price stability, how should they react to
the tax increase? If the Fed action is implemented, will the tax cut succeed in boosting
output?

c. If the Federal Reserve wanted to avoid the price increase, then it should decrease the
money supply in the short run. This will shift in the LM curve and output will return to
the full employment level. Thus, there was no boost to output.

Question 2
In previous chapters, the government-purchases multiplier described the impact of a
change in government spending on output. In the IS-LM model is multiplier effect larger
or smaller than in the simple Keynesian-cross model? (Hint: Use the IS-LM graph to
show how assumptions of each model lead to different multiplier effects.)

In the IS-LM model, the government multiplier effect is smaller due to the crowding out
of investment. An increase in government spending will shift out the IS curve and result
in higher interest rates. The higher interest rates will lower investment spending, thereby
lowering the boost to output. The difference in multipliers can be seen on the IS-LM
graph. If the interest rate is held constant (by a flat LM curve), and increase in
government spending will have a large effect on output. If the LM curve is upward
sloping, the output boost due to the government spending is diminished by the interest
rate increase.

Question 3
Why does the government spend money surveying consumers and firms on their current
level of confidence in the economy? How might the Federal Reserve react to a sudden
drop in consumer confidence?

Consumer and producer confidence surveys provide a good gauge for expectations. If
people suddenly become pessimistic, they may decrease consumption. This will lead to a
fall in output, and the consumer pessimism will have led to a downturn in the economy.
The Federal Reserve, however, can react to confidence surveys by changing the money
supply to prevent the undesirable movements in output.

Question 4
Describe how the following events change the aggregate demand curve:

a. a decrease in money demand caused by the introduction of a new electronic money


card

a. A decrease in money demand will shift the LM curve outward. The aggregate demand
curve should also shift outward because there will now be a higher output level at any
given price.

b. a decrease in the money supply

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b. A decrease in the money supply will shift the LM curve inward and decrease output.
This translates into an inward shift of the aggregate demand curve.

c. an increase in the price level

c. An increase in the price level is displayed by a movement along the aggregate demand
curve.

d. an increase in government taxes

d. An increase in government taxes will shift in the IS curve and reduce output. The
aggregate demand curve will shift in to reflect the lower output at any given price.

Question 5
Explain the Pigou effect and why economists thought this would help end the Great
Depression. Why did this theory fail to improve the economy? What actions should
fiscal and monetary authorities have taken to end the depression sooner?

The Pigou effect is the prediction that falling prices will expand income due to the
increase in real money balances (M/P). Consumers should feel wealthier since their
money will now buy more goods than before. Therefore, they should increase spending.
Unfortunately, the Pigou effect was dominated by other problems in the economy and
output continued to fall. Some of these problems included debt deflation and the effects
of a fall in price expectations. The Federal Reserve could have helped the situation by
increasing the money supply to avoid the destabilizing deflation. Increased government
spending would have reduced unemployment and helped increase aggregate demand.

Chapter 12
Question 1
A hurricane has just wiped out several shipbuilding companies in a small open-economy
country. These companies were the primary exporters for the country. Assume that the
country had been at full employment. In addition, the country has a flexible exchange
rate.

a. If the government does nothing to respond to this crisis, what will happen to output, the
trade balance, and the exchange rate in the short run?

a. The reduction in the export industry will lead to an inward shift in the net exports
schedule. This will cause an inward shift in the IS* schedule. Since the LM* curve is
vertical, output will remain unchanged, but the exchange rate will fall. This will serve to
reduce imports to match the export reduction caused by the hurricane. The trade balance
will therefore remain unchanged.

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b. Should the government intervene in this situation? If so, what policy would you
recommend?

b. With a floating exchange rate, the government does not need to intervene. Output will
remain at its original level.

c. How would your answers have changed if the country had a fixed exchange rate?

c. With a fixed exchange rate, output would fall as a result of the inward shift in the IS*
curve. The government should respond with increased government spending to make up
for the decrease in exports until the shipbuilding industry has time to rebuild.

Question 2
Suppose a small country's risk premium decreased due to a reduction in the government
deficit. Assume that the country has a flexible exchange rate.

a. Show the effect of this change on the IS*-LM* graph. What has happened to output
and the exchange rate?

a. A decrease in the risk premium will lower the interest rate and shift out the IS* curve
due to higher investment. The LM curve will shift inward due to the increase in money
demand caused by the lower interest rate. As a result, output has decreased and the
exchange rate has increased.

b. What has happened to the trade balance?

b. The increase in the exchange rate will cause the trade balance to worsen as imports
become cheaper and exports more expensive.

Question 3
Explain why the LM* curve is vertical.

The LM* curve is vertical because the interest rate must match the world interest rate.
This means that the output level is determined in the money market, independent of any
exchange rate. Thus, the LM* curve is vertical to reflect that the exchange rate does not
influence output.

Question 4
Describe changes in aggregate output, the exchange rate, and the trade balance in
response to the following effects on the country under a fixed exchange rate system:

a. an increase in taxation

a. An increase in taxation will shift the IS* curve inward. To keep the exchange rate
fixed, the Federal Reserve will shift in the LM* curve. Output will decrease. The trade
balance will decrease because of the drop in savings due to the fall in output (NX = S - I).

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b. a decrease in investor confidence that leads to a reduction in domestic investment

b. A decrease in investment will shift in the IS* curve, and the LM* curve will shift in to
keep the exchange rate fixed. Output will fall. The effect on the trade balance is unclear
because both investment and savings have fallen. If savings falls by more than
investment, then the trade balance will fall.

c. a sudden increase in demand for the country's computer exports due to a faster chip
design

c. A sudden increase in demand for the country's computer exports will shift out the net
exports schedule. This in turn will shift out the IS* curve. The LM* curve will shift out to
keep exchange rates fixed, and output will increase. The trade balance will increase due
to the increase in savings caused by higher output.

d. an increase in domestic prices caused by a labor shortage

d. An increase in domestic prices will shift the LM* curve inward. This will put pressure
on the exchange rate to increase, so the Federal Reserve will have to shift the LM* curve
back out. The result is no change for output or the trade balance.

Question 5
a. Explain how fiscal policy is ineffective under a flexible exchange rate.

a. With flexible exchange rates, the output level is determined in the money market where
the interest rate is set equal to the world interest rate. Any change in government policy
will only affect the exchange rate.

b. In previous chapters, we discussed how fiscal policy crowds out investment. Is that
true for small open-economy countries? Why or why not?

b. In small open-economy countries, fiscal policy will not crowd out investment because
the interest rate is fixed.

c. What component of output is crowded out by government spending? What could the
government or central bank do to prevent this crowding out?

c. An increase in government spending will shift out the IS* curve and drive up the
exchange rate. This action will crowd out exports as they become more expensive for
foreigners. The central bank could reduce the crowding out of exports by increasing the
money supply and shifting out the LM* curve.

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Question 6
Do you think the United States and Canada could benefit from a monetary union?
Discuss the pros and cons of this proposal. Which country do you think would benefit
most from such a union?

The United States and Canada could benefit in several ways from monetary union. A
common currency would eliminate the need to exchange currencies and reduce the risk
associated with unexpected changes in exchange rates. One cost of a monetary union
would be the loss of separate monetary policies. In addition, a central government would
be needed to redistribute resources among regions. The populations of each country are
fairly mobile, so people may be willing to move to more prosperous regions to alleviate a
regional recession.

Chapter 13
Question 1
Answer the following questions about the short-run aggregate supply equation:

a. Let  = 0.5. Draw the aggregate supply curve.

a. The aggregate supply curve should be graphed from the following equation:

where the first group of terms are the intercept and the slope is 1/ .

b. As the term  increases, how does this change the supply curve?

b. As  increases, the aggregate supply curve becomes flatter and the intercept with the y-
axis increases

c. If the expected price level increases, how does this change the supply curve?

c. An increase in the expected price level will shift up the supply curve.

Question 2
The sticky-wage model is based upon the assumption that nominal wages are designated
by long-term contracts.

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a. If the variability of inflation increases, how would this affect the desired contract
length of workers? If the contract length was changed, how would this affect the
calculation of the expected price level -- would it change faster or slower in response to a
price change?

a. As the variability of inflation increases, workers will want shorter contract lengths
since inflation is more unpredictable. The shorter contracts essentially allow workers to
update their price expectations more frequently with the signing of new contracts. Thus,
the expected price level should respond more quickly to a price change.

b. If workers stopped signing long term contracts, how would this change the aggregate
supply curve?

b. If workers no longer signed long term contracts, wages would be as flexible as prices.
The aggregate supply curve would now be a vertical line.

Question 3
What is the difference between cost-push and demand-pull inflation? Which was the
primary cause of inflation in the early 1970's? What type of inflation has the Federal
Reserve been trying to prevent in 1998 and 1999?

Cost-push inflation is caused by supply shocks that alter the cost of production. Demand-
pull inflation is caused by upward pressure on prices from high aggregate demand. In the
early 1970's, the OPEC oil price shock was a primary cause of the high inflation. This is
an example of cost-push inflation. In 1998 and 1999 the Federal Reserve was worried
about demand-pull inflation caused by high demand in the current economic boom.

Question 4
a. Explain what it means for real wages to behave cyclically.

a. Cyclicality of wages means that real wages increase as real GDP increases.

b. Based upon this cyclicality, do you think workers are more productive or less
productive in an economic boom? (Hint: Link the real wage with marginal productivity
of labor.)

b. In competitive models, firms will only pay a higher wage if workers are more
productive. Thus, the productivity of the last worker hired (marginal productivity) has
increased when we view a higher real wage.

c. If an economic boom was caused simply by firms hiring more workers, would you
expect the real wage to move cyclically? What could explain the cyclicality of real
wages?

c. If output was increased by just hiring more workers, we would expect the real wage to
fall due to diminishing marginal productivity. Without adding more capital and other

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input factors, each additional worker will be less productive. In this situation, we would
expect the real wage to fall. The cyclicality of real wages must be caused by other factors,
such as sticky prices or technology shocks that shift the labor demand curve. An outward
shift in the labor demand curve will increase employment and the real wage.

Question 5
a. Explain the link between the aggregate supply curve and the Phillip's curve.

a. The aggregate supply curve provides the link between output and prices, which can be
modified to link output and inflation. By incorporating Okun's law, which links output
and unemployment, we then have the Phillip's curve relationship between inflation and
unemployment.

b. If the natural rate of unemployment falls, how will this affect the Phillip's curve?

b. The Phillip's curve is graphed from the following equation:

where the first group of terms is the y-axis intercept and the slope is - . A decrease in the
natural rate will shift down the Phillip's curve.

c. If the sacrifice ratio was 5 and the central bank wanted to lower inflation by 8
percentage points, how much GDP would have to be sacrificed? Would you recommend
reducing the inflation all at once, or spreading it out over several years? What would a
proponent of rational expectations theory recommend?

c. The sacrifice ratio is the percentage of a year's GDP that must be forgone to reduce
inflation by 1 percentage point. With a sacrifice ratio of 5, lowering inflation by 8
percentage points would require 40 percent of GDP to be sacrificed. This would be a lot
of GDP to lose in a one-year period, so it may be best to spread it out over several years
in order to avoid mass unemployment. On the other hand, a proponent of rational
expectation would argue that committing to the policy with a quick reduction would be
the best solution. They argue that this quick-reduction policy will alter people's
expectations and allow prices to fall quickly without the large loss in GDP.

Chapter 14
Question 1
According to the Lucas critique, why should policy makers not rely upon the Phillip's
curve relationship between inflation and unemployment as the formula for monetary
policy.

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If policy makers consistently used the Phillip's curve to determine how much inflation
was needed to lower unemployment, people would react to this policy by expecting
higher inflation every time unemployment was high. This change in inflation
expectations would cause an outward shift in the Phillip's curve, and an even higher rate
of inflation would now be needed to lower unemployment.

Question 2
Describe how automatic stabilizers can help to "cool off" an economic boom.

Automatic stabilizers are policies that help stimulate or slow the economy when needed
without requiring any specific policy change. One stabilizer that helps slow a booming
economy is the income tax. As people earn more in a boom, the amount of taxes they pay
increases. This prevents consumers from spending all of their additional income, which
would further boost the economy.

Question 3
Describe two benefits and two costs of an inflation-targeting rule for monetary
authorities.

The benefits of inflation targeting include the increased accountability of the central bank
because people are able to easily judge its performance. Another benefit is added
credibility caused by providing clear guidelines for the goals of monetary policy. Costs of
inflation targeting include a lack of discretion to address other economic problems that
may occur. Also, the targeting may require extreme policy adjustments to keep inflation
within the required bands, which may lead to higher volatility in other areas such as GDP
and unemployment.

Question 4
Why do you think the level central-bank independence is not correlated with a country's
average growth rate of real GDP?

From our study of money neutrality in previous chapters, we know that monetary policy
does not affect real GDP in the long run. Thus, we should expect that the degree of
central-bank independence is not correlated with the country's average (long run) growth
rate.

Chapter 15
Question 1
Supposed that the government currently has a balanced budget. The politicians note that
consumers spend 80 percent of their disposable income.

a. What is the tax multiplier?

a. The tax multiplier is -MPC/(1-MPC) = -.8/.2 = -4.


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b. If the policy makers use this multiplier, how much of a tax reduction is required to
boost GDP by $100 million?

b. To boost GDP by $100 million, the government needs to cut taxes by $25 million
(100/4).

c. According to Ricardian equivalence, do you think the government estimate is correct?


Why or why not?

c. According to Ricardian equivalence, people will save the tax cut because they know
that the government is going to have to repay the deficit later. Thus, there will be no
boost to consumption or GDP.

Question 2
a. Explain the link between life-expectancy and forecasts of future government deficits.

a. As life expectancy increases, people will be receiving Social Security payments for a
longer period of time. Thus, the government expenditures will increase with the larger
and longer-lived elderly population, but tax revenues will not increase since the working-
age population has not changed. As a result, government deficits will become larger.

b. How would these forecasts be affected by:

i. increases in the retirement age

i. Increases in the retirement age will reduce forecasted deficits because people will be
earning income (and paying income taxes) for a longer period, and they will received
Social Security benefits for a short period.

ii. increases in immigration

ii. Increases in immigration could have various effects. If the immigrants are of working
age, they will help reduce the deficit through their income taxes. If the immigrants are too
young or old to work, they will lead to an increased deficit through increased government
expenditures on services such as schooling and medical aid.

iii. increases in birth rates

iii. Increases in birth rates will initially increase the deficit through costs of public
education. As this group reaches working age, they will help reduce the deficit through
income taxes and contributions to Social Security.

Question 3
In 1999 and 2000, the U.S. government recorded large budget surpluses. In 2001, the
budget surplus declined considerably.

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a. How do you think cyclically-adjusted budget surpluses would differ from the reported
surpluses? What do you think the impact of an economic slowdown would be on the
cyclically-adjusted budget surpluses and the reported budget surpluses?

a. In 1999 and 2000, the economy was in an economic boom and the government was
receiving large tax revenues from the high output. In 2001, economic activity slowed
down considerably and a tax cut was implemented. As a result, the reported budget
surplus declined significantly. A cyclically-adjustment budget measurement would show
a much smaller surplus (or possibly a deficit). This measurement would not change much
due to a slowdown because the measurement is based upon assuming output is near the
full-employment level. The regular budget measurement, on the other hand, would
display a huge deficit as tax revenues fell due to lower output/income.

b. How would the inclusion of uncounted liabilities affect the budget surpluses?

b. The inclusion of uncounted liabilities would turn the budget surplus into a deficit and
increase the government debt because of the large population that is nearing retirement.
The government has committed to paying retirees Social Security and Medicare, so the
large liabilities would outweigh the contributions of a smaller future workforce.

Question 4
What are the benefits of inflation-indexed bonds? How can these bonds assist an
inflation-targeting central bank?

Inflation-indexed bonds provide the opportunity for people to invest at a guaranteed real
interest rate, since the nominal return adjusts with inflation. These bond also reduce the
government's incentive to increase inflation as a way of lowering the real value of
repayment. For central banks, these bonds help predict the market's expected inflation.
By monitoring the trading price for these assets, the central bank can infer the predicted
inflation by the market. The central bank can then alter policy if inflation expectations
move outside of the target zone.

Chapter 16
Question 1
Why did the Keynesian consumption function lead to fears of secular stagnation?

The Keynesian consumption function predicts that as income grows over time, people
will consume a smaller share of this additional income. The fear was that people would
save too much and there would be no good investment opportunities for which to use the
funds. If this process continued, eventually the economy would stagnate.

Question 2
In the two-period Fisher model, suppose Bill earns $100 in the first period and $200 in
the second period.

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a. If Bill consumes $140 in the first period and $150 in the second period, what is the
interest rate?

a. The interest rate is determined by solving the following equation for r:


140 + 150/(1+r) = 100 + 200/(1+r)
40 = 50/(1+r)
1+r = 1.25
r = 0.25 or 25 percent

b. Now if Bill's consumption changes to $150 in the first period and $140 in the second
period, what is the new interest rate?

b. The new interest rate is solved as:


150 + 140/(1+r) = 100 + 200/(1+r)
50 = 60/(1+r)
1+r = 1.2
r = .2 or 20 percent

c. Explain the income and substitution effect and discuss which effect dominated after the
interest rate change from part (a) to part (b).

c. As the interest rate decreases, this will cause the budget constraint to rotate. In part (a),
Bill was borrowing money in the first period to finance consumption. Now that the
interest rate has fallen, it has lowered the cost of borrowing. The income effect is the
change in consumption caused by the movement to a higher indifference curve. Since
borrowing costs are lower, Bill will feel that he has a higher real income. Therefore, the
income effect says that he will consume more of each good. The substitution effect is the
change in consumption resulting from the change in the relative price of consumption in
each period. Since it is now less expensive to borrow to finance consumption in the first
period, the substitution effect says that Bill will consume more in the first period than
before and less in the second period. To determine which effect dominated, examine the
overall change in consumption. For consumption in the first period, both the income and
substitution effects state that he should consume more. For consumption in the second
period, the income effect states that he should consume more, but the substitution effect
says the reverse. Bill's consumption fell from 150 to 140, so the substitution effect
dominated.

d. Based upon Bill's actions, is he consumption smoothing?

d. Yes, Bill is consumption smoothing because he is borrowing in the first period against
his higher income in the second period.

Question 3
What is the difference between Modigliani's life-cycle hypothesis and the Keynesian
consumption function?

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The Keynesian consumption function states that consumption is only affected by current
income. The life-cycle hypothesis states that consumption is based upon a person's
lifetime resources, composed of wealth and lifetime earnings.

Question 4
Based upon the permanent income hypothesis, how would you expect consumption today
to be affected by the following changes:

a. A worker takes a two-year leave from a job to enroll in business school.

a. A business school degree should significantly increase lifetime earnings, despite the
cost of going to school. Therefore, the person should increase consumption today.

b. A person decides to accept an early retirement offer. Before accepting the offer, the
worker had planned on working 10 more years. As part of the offer, the company offered
the worker 80 percent of the final salary over those 10 years, and the benefits for the
following years would remain unchanged.

b. Based upon the early retirement offer, the expected income has permanently fallen.
This should lead to a decrease in consumption.

c. The government issues a temporary tax increase.

c. A temporary tax increase should have very little effect on consumption.

d. A worker fails to get a 20 percent raise that he had counted upon receiving.

d. Even though actual income did not fall, the worker will lower consumption because his
expected permanent income has decreased.

Question 5
In the permanent income model, how do borrowing constraints alter the affect of a
temporary increase in taxes?

In the permanent income model, a temporary increase in taxes should have very little
effect on output, but if consumers face borrowing constraints the results will differ.
Normally, people would simply borrow money to pay for the temporarily higher taxes
and allow consumption to remain unchanged. But if they cannot borrow funds, they will
have to lower consumption in order to pay the higher tax bill. This decrease in
consumption will lead to a decrease in output.

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Chapter 17
Question 1
Explain how the following events affect the rental price of capital in an economy with a
Cobb-Douglas production function:

a. A large earthquake destroys 20% of the capital stock.

a. A decrease in the capital stock will increase the marginal productivity of the remaining
capital. This will cause the rental price to increase.

b. A supercomputer is invented that increases the productivity of each worker.

b. An increase in technology will increase the marginal productivity of the remaining


capital. The rental price will increase.

c. The labor force shrinks as the baby boom generation begins to retire.

c. A decrease in the labor force will lower the marginal productivity of capital, and the
rental price will decrease.

Question 2
How is the stock market a good indicator of economic activity? Does an increase in the
stock market signal a good time to increase or decrease the capital stock?

Based upon Tobin's q theory, a change in the stock price will alter the value of Tobin's q.
If the stock market rises, this increases the value of q, making investment more attractive.
The stock market also is an important part of household wealth. An increase in the stock
market could lead to increased consumption due to increased wealth of consumers.
Finally, a change in the stock market may reflect changes in expectations of future
profits, thus signaling changes in the natural rate of output.

Question 3
The federal government offers loans to small business that would otherwise be unable to
borrow funds.

a. How does this program affect output in the economy?

a. This government program helps firms that face financing constraints. By providing
loans, small firms can undertake profitable investments. This will lead to a boost in GDP.

b. What is the danger in making these loans? Could this program actually cause a
decrease in output?

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b. The danger in this program is that some of the loans may go to unprofitable
investments. If there are too many bad loans, this extra government spending may lead to
a decrease in GDP because the money could have been put to better use elsewhere.

Question 4
How will the following events affect the supply of new residential housing:

a. an end of rent control for apartments

a. An end of rent control will increase the supply of new housing because the higher costs
of apartments will increase housing demand.

b. a decrease in the real interest rate

b. A decrease in the real interest rate will increase the supply of housing due to the lower
cost of borrowing and the lower opportunity cost of housing investments.

c. an end of the tax deduction for mortgage interest

c. An end to the mortgage interest deduction will lower the supply of housing. The cost of
owning a home has increased due to the loss of the tax deduction.

d. a decrease in the population

d. A decrease in population will lower the housing supply due to the accompanying
decrease in housing demand.

Question 5
Compare the production smoothing motive for holding inventories with the accelerator
model. Do these models predict the same pattern of inventory behavior as the economy
enters a predicted economic boom? How would your answer differ if the boom was
unpredicted?

The production smoothing model predicts that firms will build up inventories during
times of low sales and reduce inventories during periods of high sales. The accelerator
model predicts that firms will increase inventories during periods of high output. In a
predicted economic boom, firms would anticipate the increase in sales. According to the
production smoothing model, firms would have built up inventories beforehand and allow
the stocks to diminish during the boom. The accelerator model predicts that if firms
expect a boom and increase production, they will increase their inventory holdings. If the
boom is unexpected, inventories will still fall in the production smoothing model. In the
accelerator model, firms will not have increased production because they do not expect a
boom. Therefore, inventories will not increase, and they may actually decrease due to the
high demand for goods.

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Chapter 18
Question 1
Explain how the Baumol-Tobin model supports the specification of the money demand
function, L(i,y).

The Baumol-Tobin model provides a framework in which an increase in the interest rate
leads to a reduction in money demand (average money holdings) and an increase in
output leads to an increase in money demand.

Question 2
Suppose the banks in an economy have a reserve-deposit ratio of 10 percent and the
currency-deposit ratio is 20 percent.

a. If the Federal Reserve increases the monetary base by $500 through open market
operations, what will be the increase in the money supply?

a. The money multiplier is (0.2 + 1)/(0.2 + 0.1) = 4. An increase in the monetary base of
$500 will increase the money supply by $2000 (500*4).

b. If the Federal Reserve increases the discount rate and firms react by increasing the
reserve-deposit ratio to 15 percent, what is the change in the multiplier? Will this change
increase or decrease the money supply?

b. The new money multiplier is (0.2 + 1)/(0.2 + 0.15) = 3.43. This will lead to a decrease
in the money supply because banks will hold more reserves and issue fewer loans.

c. In anticipation of the Y2K problem, many people withdraw their deposits from the
bank in December 1999. What impact will this have on the money multiplier, high
powered money, and the money supply?

c. Suppose many people withdraw their deposits from the bank due to higher economic
uncertainty. What impact will this have on the money multiplier, high powered money,
and the money supply?

Question 3
Explain how changes in the money multiplier contributed to the severity of the Great
Depression. What could the Federal Reserve have done to restore the money multiplier to
its original level?

The primary change in the money multiplier was due to the large number of bank
failures. This led to an increase in the currency-deposit ratio due the drop in confidence in
the banking system. The increase in the ratio led to a fall in the money multiplier and in
the money supply. The large number of bank failures led the remaining banks to increase
the reserve-deposit ratio, which further decreased the money multiplier and the money
supply. The actions in response to the banking crisis lead to a huge fall in the money
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supply which in turn led to high interest rates and a fall in investment. To restore the
money multiplier to its original level, the Federal Reserve would have needed to address
the public's fears of the banking system by providing emergency loans and additional
money to the system.

Question 4
In the Baumol-Tobin model, trips to the bank cost $10. The interest rate is 10 percent.

a. If Paul plans to gradually spend $1800 this year, how many trips to the bank should
Paul make? What is his average money holding?

a. The number of trips to the bank is solved as


N = square root of 0.1*1800/(2*10) = 3 trips to the bank
The average money holding is 1800/(2*3) = 300.

b. If interest rates increase to 15 percent, how does this affect the number of trips Paul
will make to the bank?

b. The number of trips increases to 3.67 on average (square root of 0.15*1800/(2*10).

c. If Paul moves farther away from the bank, so that trips now cost $20, what will be the
change in his average money holdings?

c. The increase in the fixed cost of a visit to the bank will increase average money
holdings to $424 (square root of 1800*20/(2*0.1)).

Question 5
How has the introduction of near money changed the Federal Reserve's ability to control
the money supply? Do you think this will diminish the power of the Federal Reserve?
Explain.

The introduction of near money has made the demand for money unstable as people now
have more alternative ways of holding their liquid assets. The Federal Reserve has
reacted to this problem by placing emphasis on the setting of interest rates, which it can
control more accurately. Thus far, the Federal Reserve has proved to have maintained its
effectiveness in the implementation of monetary policy.

Chapter 19
Question 1
Explain the role of intertemporal substitution of labor in the real business cycle theory.
Based upon this theory, would you expect the real wage to be procyclical or
countercyclical? (Hint: Think of labor productivity in the Robinson Crusoe example and
the link between marginal productivity and the real wage.)

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In real business cycle theory, the intertemporal substitution of labor plays the primary
role in determining labor supply. People are willing to work harder only if they receive a
higher intertemporal real wage. Based upon this theory, an economic boom that includes
higher employment must mean that the workers are receiving a higher real wage. The
higher wage is the incentive needed to boost employment. Therefore, this theory would
predict that wages are procyclical.

Question 2
How does labor hoarding affect the Solow residual in a recession?

The Solow residual is the percentage change in output minus the percentage change in
inputs weighted by factor shares. In a recession, output has fallen, but if firms hoard their
workers, there will not be an accompaning fall in employment. Therefore, the Solow
residual will appear to fall by a larger degree due to the labor hoarding.

Question 3
How does the presence of an aggregate-demand externality affect prices and output in the
economy?

An aggregate-demand externality of the variety seen in menu cost studies leads to higher
prices and lower output. This is caused by the fact that an individual firm has little
incentive to change prices frequently due to the menu cost it must pay for each change.
For example, if a firm has set its price too high, it may not want to incur the menu cost to
reduce the price. Society would prefer that the firm would lower its price because this
would lead to a boost in sales (and output). If there are many such firms that behave this
way, the externality for society becomes large.

Question 4
Is money neutral in the short run in a model of staggered wage and price setting? Is it
neutral in the long run? Explain.

In the staggered wage and price setting model, unexpected changes in the money supply
will lead to output effects in the short run because firms are unable to adjust prices and
wages. In the long run, however, firms will eventually be able to adjust to the changes in
the money supply. Therefore, this model predicts that money is neutral in the long run,
but not in the short run.

Mankiw 43